The Office for Budget Responsibility is making a critical mistake in being excessively gloomy about a lack of productive potential in the UK since the 2007 crisis.
One of the characteristics of the recession has been how quickly employment levels have returned to pre-recession levels. The OBR interprets this as being a result of severe damage to the productive capacity of the economy. Any demand expansion through fiscal policy to stimulate growth would, in its opinion, quickly run into production bottlenecks and hence price increases rather than an increase in output. OBR estimates put spare capacity, the potential to meet any new demand, at below 3 per cent. The issue is, where's the firm evidence for this view?
Historically, the UK economy has always returned quickly to its underlying long-run trend in productivity growth following a recession, and there's nothing to suggest this pattern has changed. The OBR is simply being far too pessimistic. Based on the evidence from past trends, the current level of spare capacity is likely to be nearer to 12 per cent than 3 per cent, mostly in the form of underemployed labour. Employers have decided to hold onto workers rather than risk running down their workforce.
The OBR has powerful allies in its position on capacity from the Treasury and the Bank of England. So who's right? What can look like an academic detail around the nature of 'spare capacity' has a direct impact on the livelihoods of huge numbers of workers and their families. It's important that such powerful institutions take a closer look at why there is so much disagreement between experts.
The first step is to understand how the current recession differs from those in the past and the implications. The drop in output has been more severe and persisted far longer than all previous recessions in the past forty years. Output has still not reached its pre-recession level after five years and there is little chance of it doing so before 2015. At the same time, employment growth has confounded the forecasters. Employment fell by 600 thousand following the 2008 downturn but recovered to exceed its pre-recession level by 2012. Despite stagnant output growth, employment increased by 700 thousand (2 percentage points) between 2010 and 2012.
The overall increase in employment between 2010 and 2012 is not all that it seems at first sight. Firstly, more than half of the additional jobs have been for part-time, not full-time, workers. For women, nearly three-quarters of the extra jobs have been for part-time workers. Secondly, workers are not working as many hours as they would like. According to the Office for National Statistics, one in ten workers wanted to work more hours than they were offered during 2012; and between 2008 and 2012, the number of workers who wanted to work more hours increased by one million. Thirdly, there were half a million fewer full-time jobs in 2012 than at the start of the recession.
Employers are temporarily "hoarding" labour so that output can be increased more rapidly when demand recovers. They don't want to lose skilled and experienced workers; keeping workers on during periods of slack demand can help build morale and good relations; and laying workers off can be difficult and expensive. There is also, for example, no evidence of large-scale scrapping of plant and machinery as happened in the manufacturing sector during the recession of the early 1980s.
The likelihood that low productivity in the UK is a consequence of labour hoarding is supported by international trends. Employers in the USA are less reluctant to shed labour during recessions than UK employers. The drop in labour productivity following the financial crisis was consequently much smaller in the USA than in the UK despite a very similar drop in output. The German experience has been similar to the UK. Jobs were protected in the early part of the recession through government sponsored short-time working schemes. This resulted in a sharp drop in labour productivity and a rise in labour hoarding.
The OBR is surely wrong to assume there has been no growth in productive potential since 2007. This not only assumes that technological progress has come to a stop because of the recession, which seems most unlikely, but also denies the likelihood that productivity has been held down because of substantial labour hoarding. The existence of large amounts of spare capacity in the UK economy implies that a demand expansion could be achieved without any serious inflationary consequences. Even if the growth in productive capacity has not kept pace with its historical trend, a growth rate of only half the historical trend would still leave enough spare capacity to justify a demand injection in order to bring a quicker end to the recession.
It is surely the right time to get the economy moving forward again by financing much needed infrastructure projects and new housing developments. To do otherwise would be seriously wasteful and ongoing pessimism could lead to a withering of productive capacity over the longer term. It is high time the Treasury took some positive action instead of burying its head in the sand.