How to Increase Economic Growth

Readers Question: from solutions to economic crisis? I agree on ‘growth’ but we don’t understand how to achieve sustainable growth. This can only come from either continuing to increase the UK’s population or by continuing to improve efficiency. The first is clearly impossible as we would bust at the seams. This means the only choice we have is INVESTMENT – And in the RIGHT areas. Our politicians (and most economists?) do not understand this.

There are two main aspects to economic growth:

  1. Aggregate demand (AD) (consumer spending, investment levels, government spending, exports – imports)
  2. Aggregate supply (AS) (Productive capacity, efficiency of economy, labour productivity)

Since 1945, the UK economy has grown by an average of 2.5% a year. Most economists would argue that, on average, the UK’s productive capacity can increase by around 2.5% a year. This is known as the ‘trend rate of growth’ or ‘underlying trend rate’.

Note, even when the government tried supply side polices, they usually failed to shift this long run trend rate. (e.g. supply side policies of 1980s, did little to alter the long run trend rate)

The graph below shows how actual GDP fell below the trend rate from 2008. This was due to the recession and significant fall in Aggregate Demand.

source: leftoutside

Growth in productive capacity (AS) occurs because of:

  • Improved technology developed by private sector which enables higher labour productivity (e.g. development of computers enables greater productivity)
  • Improved management techniques which enable more skilled workforce.
  • Improved education and training by both private sector and public sector
  • Investment in infrastructure, e.g. building new roads and train lines. This is mainly the responsibility of the government.

Overall, I would say most productivity growth is determined by the private sector. With a few exceptions, most technological improvements come from private firms. It is the private sector which develops new technology which enables the vast majority of productivity growth we see in the UK. I’m sceptical of the governments ability to invest in new technology which would boost this rate of productivity growth.

However, the government can play a role in boosting infrastructure and improving education. These are areas neglected by free markets. If the government didn’t provide these public services it would harm the long run trend rate of growth. If the government really could improve standards of education and training, it may enable a higher sustainable rate of growth.

The Problem of Demand

Since 2007, UK growth has fallen way below the trend rate. This is not due to a sudden halting of technological change or productivity growth. The problem was the precipitous fall in AD that occurred in 2009, and is occurring again in 2011.
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Demand fell in 2009 because

  • Credit crunch – banks stopped lending. Firms couldn’t borrow to invest
  • Fall in consumer confidence from financial concerns
  • Rise in unemployment created negative multiplier effect
  • Fall in house prices led to negative wealth effect and fall in confidence.

Demand in 2011 is very weak because:

  • Government spending cuts
  • Fear of unemployment
  • Low wage growth; real wages are falling because inflation is higher than nominal wage growth.
  • Continuation of credit crunch

Unsurprisingly, this fall in economic output, led to a sharp rise in unemployment.

The fundamental problem in the UK is insufficient aggregate demand. To increase the growth rate in the short-term, we need to increase AD.

Also, it is important for long term sustainable growth. If we persist with insufficient demand, then this will discourage private firms from investing. We could end up with a lost decade like Japan.

Investing in the right areas (e.g. education, transport and technology) would provide some short-term boost to demand. Also, if the investment (from private and public sector) was very successful and actually increased productivity growth, then it may also lift the UK’s long run trend rate of economic growth, and in future decades, the long run trend rate could be 3% rather than 2.5%. But, now the immediate problem is lack of demand. This lack of demand and deflationary pressure is harming long term growth prospects.

Related

Causes of economic growth
Factors affecting economic growth
The Role of Supply side policies in a recession
Can governments increase the rate of growth?

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