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Issue 1116, 12 August 2022. Subscribers: read the digital edition here

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From Andrew Van Sickle, MoneyWeek’s editor

“The only function of economic forecasting is to make astrology look respectable,” said JK Galbraith. Predictions about stockmarkets, earnings or macroeconomic trends can be safely ignored, especially if you are a picky Virgo like me. That is why we haven’t been too fazed by the Bank of England’s forecast of a 15-month recession. Its record is no better than any other forecaster’s, to put it charitably. A year ago it thought inflation would peak at 4%. Now it thinks inflation is heading for 13%. It was too gloomy about the impact on GDP of the Brexit vote and failed to predict the 2008 financial crisis. All official forecasters did. 

The US Federal Reserve said in January 2008, when the credit crunch was spreading fast, that the US would expand by up to 2% in 2008 and up to 2.7% in 2009. But GDP shrank by 0.3% in 2008 and 2.8% in 2009. Andy Haldane, the former chief economist at the Bank, compared economists’ failure to predict the crisis with Michael Fish missing the 1987 storm.

The bigger picture is that the stagflationary hurricane is well and truly here, regardless of whether the economy ends up shrinking for several months or not. The Bank, like its counterparts elsewhere, has been caught on the hop by inflation. Now it will try to subdue it by hiking interest rates, and talk has turned to what measures could alleviate the pain and bolster growth – state payments to help with energy bills and tax cuts, principally.

Overlooking the key ingredient

The fuss over the downturn and fiscal stimuli misses a key point, however. The measures being discussed relate to the demand side of the economy, but it is improving the supply side that will do the most good over the longer term. The last time we escaped stagflation, in fact, reforms to improve the productive capacity of the economy, such as privatising state behemoths and taming trade unions, helped pave the way for a lasting recovery. Those reforms helped bolster productivity, and we urgently need to do that again. “Productivity isn’t everything, but in the long-run it is almost everything,” as economist Paul Krugman put it.

The more effectively an economy uses its workforce and capital, the richer it will get. But Britain’s productivity growth is abysmal, as Neil Shearing of Capital Economics points out. Average output per hour worked rose by just 0.7% a year in the ten years before Covid-19, a far cry from the 1.7% average in the five years to 2008 and the 2.8% seen in the 1980s. Productivity growth hasn’t been this low since the start of the industrial revolution, says David Smith of the Sunday Times.

According to The National Institute of Economic and Social Research, if productivity had grown by an annual 2% in the past decade, the average worker would now be £5,000 better off. 

So what’s the problem? What isn’t? It’s a toxic cocktail of shabby infrastructure, low business investment, poor skills, and over-centralisation (which implies less scope for a region’s institutions to galvanise growth and innovation, among other things). There is no way of cutting this Gordian knot, but you have to start somewhere, and it would have been helpful to hear from the Tory leadership candidates how they might approach it. Liz Truss may present a plan when she wins. But don’t hold your breath – and perhaps top up your gold.