Authors: David Smith
Are we getting better off?
The economics of happiness is closely tied to another question, that of economic progress. When John Major was Prime Minister of Britain he made what to many seemed like a rash promise – that of doubling living standards over twenty-five years. Actually it was a rather safe pledge, on two counts. The first was that by the time anybody was able to check, Major would be long gone from politics (he soon was anyway). The second was that he was describing, more or less, what was already happening. The power of compound numbers is a wonderful thing. Economic growth of a shade over 2.5 percent a year will produce a doubling of living standards every twenty-five years, just as economic growth of 4 percent annually would produce it in fifteen years. Whether a doubling of gross domestic product per head, after allowing for inflation, is the same as a doubling of living standards is a matter of some debate. Many people would argue that while they are materially better off, the downsides of modern life – crime, congestion, stress, even declining moral standards – mean that GDP per capita is a poor measure of progress. Some economists favour other measures, which try to take into account other factors. The United Nations’ human development index, which is particularly useful for measuring progress in poorer countries, takes into account factors such as life expectancy and educational provision.
The fact is that, in the absence of recessions, which tend to be short-lived, we do become better off each year. Harold Macmillan, one of Major’s Tory predecessors, became associated with the phrase ‘You’ve never had it so good’, when he said in 1957: ‘Let us be frank about it: most of our people have never had it so good.’ Few Prime Ministers, in fact, would have been unable to make that boast. Living standards tend to improve, but at what rate? The answer to this, fairly obviously, is that it depends on circumstances. Nick Crafts, an economic history professor at the London School of Economics and a noted expert on long-term growth trends, has tracked Britain’s growth rate, on a per capita basis, back to the nineteenth century. Dividing the period into four, 1870–1913, 1913–50, 1950–73 and 1973 until the end of the century, the results show rising GDP per capita in all four periods, but at different rates. In the first period, 1870–1913 (which included the so-called great depression of the late nineteenth century), GDP per capita rose by an average of 1 percent a year. The second period, 1913–50, included two world wars and the more familiar Great Depression, and growth did well to average 0.9 percent a year. The period 1950–73, known by economic historians as the ‘golden age’ of healthy growth, low inflation and full employment, saw GDP per capita rise by 2.4 percent a year (Major was clearly thinking of a new golden age), while from 1973 onwards, as the economy hit oil crises, financial market instability, regular recessions and generally greater turbulence, growth slipped to 1.8 percent a year.
More interesting than these bald figures is what was happening elsewhere. In the earliest period Britain’s 1 percent growth rate was by no means high, but it was in the same broad area as that of other countries. Already, however, with American per capita GDP rising by 1.8 percent a year in the 1870–1913 period, the writing was on the wall. Again, in the period 1913–50, Britain held her own in comparison with other European countries but was well behind America’s 1.6 percent growth rate (think of the power of compound numbers). It was in the golden age, however, that a gap really opened up. Britain’s 2.4 percent growth rate over the 1950–73 period sounds respectable, and in fact matched that of America, but it was well behind France, 4 percent, Germany and Italy, each 5 percent, and Japan, 8 percent. Crafts’s contention is that over the past twenty years or so Britain has stopped the rot of relative economic decline, largely because of the policies adopted by the Thatcher government, many of which Labour retained when it took office in 1997. There have, of course, been countries with more rapid growth rates during this period, notably the Asian ‘tiger’ economies, at least up until the 1997–8 Asian crisis. There is no sign yet, though, that on a long view the British economy is performing better than that of competitors.
What causes economic growth?
Economies grow, and so do living standards, but why? Adam Smith gave us one important route – the gains from trade and from the division of labour mean that productivity, output per worker, increases from one year to the next. Karl Marx gave us another clue in his observation that all capitalists are interested in is investing, accumulating capital. A rise in the amount of capital equipment per worker will also tend to be associated with rising output per worker. Growth theory is an entire branch of economics in its own right. One interesting but difficult exercise is to try to account for economic growth by splitting it into its component parts. Angus Maddison, a specialist in this so-called ‘growth accounting’, has produced results that suggest investment other than in housing is the most important source of growth, with significant contributions also made by rising educational standards, trade and, for most countries, a ‘catch-up’ effect as they adopt the technology or methods used by countries with higher productivity levels.
Extra investment, the main source of growth, does not always flow smoothly. It is subject to – indeed is one of the primary causes of – the business cycle. It is also subject to more pronounced fluctuations, as new technologies become available. When people spoke of the ‘new economy’ of the ICT revolution of the 1990s, they were following a long tradition. There have been many ‘new’ economies over the ages, from the transformation of the cotton industry by the spinning jenny of James Hargreaves, Thomas Arkwright’s water frame and Samuel Crompton’s mule. Steam, canals, railways, electricity, radio in the 1920s and television in the 1950s – all have provided spurts of large-scale investment activity and an apparent move up to a new and higher plane of economic growth. In each case, the initial effect is to produce a sharp rise in productivity in the sector concerned, whether it is transport (canals and railways), energy production (electricity), media or ICT. Then, as this increase in productivity is passed on, falling prices lead to a boom in investment. There is also, typically, a restructuring of the economy around the new technology.
Why, if we have had all these ‘new’ economies over the decades, has productivity not grown even faster over time? To an extent, the story of the twentieth century, and in particular its second half, was about not just the invention of new technology but also the realization of its potential. There is also a sense, however, in which maintaining economic growth requires these bouts of what the Austrian economist Joseph Schumpeter called ‘creative destruction’. He saw capitalist economies leading to episodes that ‘incessantly revolutionise the economic structure from within, incessantly destroying the old one, incessantly creating a new one’. Put another way, when the effects of a technological revolution wear off, it is time for another one, otherwise growth will slow. Fortunately, capitalism has been reasonably good at coming up with periodic breakthroughs. There is one other lesson from ‘new’ economies, both ancient and modern. It is that in each case there is usually a stock market boom that anticipates the mass application of the new technology. The railway mania in Britain in the 1840s, when the shares of railway firms soared to sky-high levels before crashing back down to earth, was very similar in character to the Nasdaq boom of the 1990s. The lesson, in all cases, is that while some lucky investors do well, many have their fingers burned, both by the ups and downs of the share prices of even the successful innovating firms, and because there is inevitably a winnowing out process as the majority fall by the wayside. For every Microsoft that makes it, there are thousands of others that do not. New technology usually helps the economy more than it does the bank balances of investors.
Why do we need low inflation?
This is the kind of question you do not ask in the company of central bankers. It is also less commonly asked than it used to be in general conversation but you still hear it from time to time. When the Bank of England’s monetary policy committee meets to set interest rates each month, there is often a trade union leader or Labour MP on hand to question its ‘anti-inflation obsession’, even though the government, not the Bank itself, sets the 2.5 percent inflation target. The European Central Bank, which to some is afflicted by an even greater obsession (it sets its own target, an inflation ‘ceiling’ of 2 percent), is according to its critics responsible for Europe’s low growth and high unemployment. If only central bankers would loosen up a bit, the argument goes, the economy would do a lot better. Such criticism should not be dismissed out of hand. It is not as if when countries have had significantly higher inflation than now, growth suddenly grinds to a halt. Britain’s inflation rate averaged nearly 7.5 percent during the 1980s and yet the economy enjoyed one of its longest upswings on record, lasting from the spring of 1981 to the summer of 1990. The other question is one of degree. Suppose a central bank is determined to achieve 1 percent inflation through thick and thin, whether oil prices surge to $100 a barrel or there is some other inflationary shock. Would that be at the expense of growth and jobs? Certainly, although most central bankers would argue that they would never interpret their remit so inflexibly.
The argument that just a little bit more inflation, in normal circumstances, would give us more economic growth dates back to the era of the simple Phillips curve trade-off. Under this, it appeared that there was indeed a choice between unemployment and inflation. As we now know, and as a Labour government discovered as long ago as the 1970s, it does not work like that. Countries that try to buy growth by permitting a little more inflation usually end up with a lot more inflation and little to show for in faster growth. Policies that permit higher inflation may provide a temporary boost – Friedman likened the effects to that of a drug – but eventually make things worse. When expectations enter the equation – people cannot be fooled over and over again – inflationary policies are doomed to failure. In the jargon, there is no long-run trade-off between inflation and growth. Low-inflation economic stability is the best environment for growth. But what is the right inflation rate to aim for? Alan Greenspan, the Federal Reserve Board chairman, defined the right level of inflation as one that does not interfere with economic decisions. At 10 percent inflation people and businesses start to behave in a way in which at least some of their actions are conditioned by the need to protect themselves against inflation, perhaps by buying index-linked bonds or investing in property. At 2 percent or 2.5 percent (the UK target) that is probably not the case. There is also some persuasive evidence, because of the role of expectations, that higher inflation rates are unstable. A country trying to run a 10 percent inflation target would, according to some research, find itself unable to hold it there, and would face the risk of the disaster of hyperinflation.
All this sounds like carte blanche for the central bankers’ club and, indeed, research by Albert Alesina and Larry Summers and others suggests that the more independent the central bank, the better the unemployment–inflation trade-off. With the right policy framework, it seems, you can have it all – low unemployment and low inflation. There is always a risk, though, that central bankers will try a little too hard. Since being given independence in 1997, the Bank of England has tended to undershoot its 2.5 percent inflation target, despite a requirement that it operate symmetrically around it. Mistakes by the Bank of Japan emanating from excessive worries about inflation helped give the country its deflation of the 1990s, with damaging consequences. Deflation, when the real value of debt increases and monetary policy can become ineffective, is a more dangerous condition than inflation. Why is this? Suppose you take out a mortgage of £100,000 that has to be paid back after twenty-five years. If there is no inflation, then £100,000 is the amount that has to be paid back in real terms. At a 2.5 percent inflation rate, however, the real value of that debt would halve, so the equivalent of £50,000 would have to be paid back. The knowledge that inflation tends to erode debt’s real value is one reason why people and businesses are willing to borrow. Suppose, though, we had deflation – prices falling by 2.5 percent a year. The real value of the debt would rise, to the equivalent of £200,000, even as the property on which the mortgage was taken out fell in value. In a period of deflation few would want to take on new debts, and defaults would be common. The economy would start to grind to a halt. That is why deflation is to be avoided. Central banks have to be watched closely for this reason alone.
Does manufacturing matter?
Finally, because time is getting on, a perennial question. At a time when three-quarters of the new cars sold in Britain are imported, and the country’s factories have long ago ceased to make many of the things sold in our shops, does it matter? Would we be worse off if there was no UK car industry? After all, it does not seem to matter that the big car manufacturers are not British-owned. In other words, does manufacturing matter? The short economic answer to this is no. The decline in manufacturing’s share of the economy to under 20 percent has gone alongside rising, not falling prosperity. Richard Scase has pointed out that more people in Britain work in Indian restaurants than in shipbuilding, steel and coal mining combined, and that there are more public relations consultants than miners. Out of an employed workforce of nearly 30 million, only 4 million are in manufacturing. If Britain’s comparative advantage lies elsewhere than in manufacturing, say in tourism or financial services (the City), then the optimal position could be to have no manufacturing industry at all. In fact, there is a long-standing debate between, on one side, those who say the City has never benefited British industry, and those in the Square Mile who say that if only UK manufacturing was as internationally competitive as financial services, the economy would be hugely successful. The arguments for retaining manufacturing become strategic, not economic. Would we really want to have no domestic defence equipment manufacturers? Or, thinking back to the Second World War, would we really, in admittedly very different circumstances, want to be in a position where there would be no domestic manufacturing capacity to convert to producing the modern equivalent of Spitfires?