LabourÕs Economic Performance - a commentary

Publication date: 30 Apr 2005 | Publication type: National Institute Economic Review | NIESR Author(s): Barrell, R; Kirby, S; Weale, M | Journal: National Institute Economic Review No. 192

* This is a summary of the full article: "The Labour Government's economic record and economic prospects", taken from the National Institute Economic Review, no. 192, April 2005. The National Institute Economic Review is published quarterly by Sage Publications. Please visit the Sage Publications web site at: <a href="http://ner.sagepub.com/">http://ner.sagepub.com/</a> for more information and subscription details. *

When the Labour Party came to power in 1997, it had an agenda for reforming the functioning of the UK economy. It planned to introduce a stability-oriented macro-economic policy that would enhance growth. It was critical of the high level of borrowing that the previous Government had undertaken, and promised to be more prudent. It wanted to increase participation and employment in the economy as a means of both increasing output and reducing poverty. It also aimed to improve the quality of the labour force by enhancing the educational standard of the population and to close the productivity gap between Britain and other European countries.

<strong>Macroeconomic policies and outcomes</strong>

Although the Labour Government's plans were less radical than those of its predecessor in 1945, it acted quickly. The Bank of England, which had been nationalised in 1945 to ensure that it could be subject to political control, became operationally independent and a framework for fiscal responsibility was announced. The aim of this change was to provide a guarantee that the Government's commitment to low inflation would be honoured so that people would plan on the assumption that the rules would be kept rather than that they would be broken.

The independence of the Bank was widely welcomed, and inflation expectations, as indicated by the yield spread between indexed and un-indexed government bonds fell rapidly by almost 1 percentage point. It is more difficult to assess the impact of the fiscal commitment, but a surge in tax revenues meant that the budget moved into surplus supporting the Government's claims of fiscal prudence.

<strong>Output growth</strong>

Chart 1 (available in full version - see subscription information above) shows that output growth has been at a rate similar to that of the last four Conservative years and much more stable as well as faster than in the period 1989Ð92. Growth was more rapid in the mid-1980s but this came after the recession of 1981 and led up to the second recession in 1992. This chart illustrates that, since 1997, growth has been relatively stable, reflecting the absence of a significant recession.

<strong>Inflation</strong>

In the period since 1997, inflation rates have been lower than the previous eight years. Indeed the period 1988 to 1996 was relatively worse for the UK than the previous eight years when performance on both the level and year-on-year volatility of inflation had perhaps been better than in France and was comparable to that in the US. It is probably the case that by 1989 France benefited, at least in terms of the level and volatility of inflation, from having settled in to membership of the ERM while the United Kingdom joined only in extremis and, after leaving in 1992, adopted an alternative policy framework for delivering low and stable inflation.

<strong>Fiscal management</strong>

The Government committed itself to a prudent fiscal policy in its fiscal framework, setting itself the task of borrowing only to invest and of keeping government debt below 40 per cent of GDP. It is relatively hard to find a sound economic case for the Golden Rule (borrow no more than investment), although it has the ring of the Scottish Presbyterian minister about it. Limiting borrowing to keep debt in bounds is wise, but can be interpreted in many ways. Our assessment is that the economic cycle has just ended and the latest government borrowing figures suggest that the Golden Rule has just been broken. No great economic importance can be attached to this and the breach of the rule is indicative of a flaw in the rule rather than an inherent indicator of economic mismanagement.

We expect the Golden Rule will be hard to meet over the new economic cycle without an increase in taxes. We do, however, note that the sharp increase in oil prices this year has improved the Government's fiscal position. If oil prices remain at current levels or rise further, then the fiscal position is considerably better than our earlier forecast, based on much lower oil prices, had suggested. Overall a more stable macroeconomic environment appears to have been created, and this in part may be the consequence of the policies directed to borrowing and central bank independence. Policies towards increased competition and to more integration with our European neighbours have probably also increased the stability of the economy by reducing vulnerability to shocks and increasing the insurance provided by risk-sharing.

<strong>National saving</strong>

Focus on government debt has a justification because a high level of debt requires high taxes to collect the interest needed to service that debt; these taxes may have substantial deadweight disincentive effects. However, there is a separate concern whether the country is saving enough. This has not featured in the Government's assessments of the state of the economy, or in the policy aims it expressed on coming to power. It is, nevertheless, a key economic issue. Failure to save adequately has implications for the rate of growth of future income. The United Kingdom has historically been a low-saving country - the most visible sign of our history of low saving is the current pensions crisis Ð many people, not having saved adequately in the past, are now surprised to discover that their pensions are not as generous as they had hoped.

Despite this, as chart 2 shows (available in full version - see subscription information above), Britain's saving record has been better under the Labour Government than it was in the previous eight years under the Conservatives. The proportion of GDP saved, measured net of depreciation, has been higher than in both earlier four-year periods. Although saving has been lower in the first years of the 21st century than it was in the last years of the 20th, the decline in the savings rate has not been as sharp as it was in France or in the United States. Although saving is still too low, there is little doubt that Britain has improved, both relative to its past performance and relative to other major economies.

<strong>Productivity and productivity growth</strong>

Chart 3 (available in full version - see subscription information above) shows that Britain's economic performance measured in terms of output per hour worked is still somewhat below that in the United States; the gap relative to France is more substantial.

Looking at the three eight-year periods, the United Kingdom's productivity growth rate has been extremely stable. In the first eight-year period its productivity growth rate was markedly below that of France, while from 1989Ð96 some of the lost ground was made up. Until 1996 productivity growth was appreciably faster than in the United States.

The recent United States Ôproductivity miracle' meant that its productivity growth rate moved in line with those of France and the United Kingdom; the faster performance it shows since 2001 is for too short a period to know whether it is of any real importance.

Thus our conclusions about productivity growth are that while there has been no obvious improvement since 1997 but that the United Kingdom is no longer falling behind France (and other European countries) in the way it did for 40 years after the Second World War. At the same time, we are not obviously closing the gap with France and we may have stopped closing the gap with the United States. Obviously improvements in the quality of education may affect productivity but they cannot be expected to do so in the short term.

<strong>Employment and labour supply</strong>

Employment rates have risen steadily since 1993. Although activity rates still remain slightly below those of the boom of the late 1980s, the current activity rate appears to be sustainable while in the late 1980s it was associated with rapidly accelerating inflation. These improvements can be seen as a significant success, but they are the continuation of a trend which began in the mid-1980s. Employment rates for prime-age men and women are now higher than in both the United States and France. This contrasts with the position up to 1998 when, with the brief exception of 1990, they were lower than in both other countries. Employment rates for people aged between 55 and the state retirement age have also tended to increase in the past ten years, reversing the earlier drift towards early retirement.

A number of employment policies were introduced to Ômake work pay'. These took the form of tax credits designed to smooth out the very high marginal tax rates which had previously been generated by the benefit system. Slower rates of benefit withdrawal mean that people face lower marginal tax rates than they used to on moving from non-employment to employment. On the other hand, the prolonged benefit tapers associated with the tax credits mean that many more people face high effective marginal tax rates than used to be the case. While this has disincentive effects of its own, a reasonable judgement is that the current structure promotes employment more effectively than did its predecessor.

The National Minimum Wage (NMW) was introduced by the Labour government along with the first tax credit system, so as to prevent tax credits from Ôsubsidising' low-paying employers. It is of course questionable whether that would happen in a competitive labour market and economists' concern focused on the risk that it would price some people out of work; that can be seen as part of a package of policies such as the various tax credits intended to Ômake work pay'.

Recent research suggests that there has not been any significant negative effect on employment associated with the introduction of the NMW or its subsequent upratings (Stewart, 2004). Equally the introduction of the NMW reduced wage inequality by only a limited amount (Dickens and Manning, 2004). Turning to the evidence from in-work benefit schemes, Blundell and Hoynes (2004) suggest that the Working Families Tax Credit has had a positive but small effect on employment, although the effect is concentrated more into particular subgroups, such as lone parents and workless couples with children. The fall in youth unemployment rates was helped by the New Deal (see Riley and Young, 2001 and van Reenen, 2004).

<strong>Labour's economic record summarised</strong>

We suggest in this research that Labour's economic record has been very satisfactory. Nothing has gone badly wrong with the economy over the period since 1997. Inflation has been low and stable and output growth has also been stable, at a rate consistent with most views about the trend rate of growth. By contrast with earlier periods, the public finances have been reasonably well controlled and our current position is better than that in both France and in the United States in this respect. Employment conditions have improved markedly continuing earlier trends.

There remain the noted above substantial flaws in Britain's economic performance. These were both problems inherited by the Labour Government. First of all, although the rate of national saving has risen compared to 1989Ð96, it is still almost certainly too low to allow incomes to grow in line with labour productivity. There is no real evidence that the Government has grasped that saving is a macroeconomic issue and not simply something to do with pensions which can be dealt with once a broad consensus has been established.

Secondly, productivity is lower than in both the United States and France (and other countries in North-Western Europe). In the mid-1990s there was a modest closing of the gap with France. Over a much longer period the gap with the United States was being closed, but the data suggest that, in the new century the United States has moved ahead again. The Government has embarked on a long-term programme of improving the educational quality of the workforce but this, even if successful, will affect productivity only over a very long period.

<strong>References</strong>

Balls, E., Grice, J. and O'Donnell, A. (2004), ÔMicroeconomic Reform in Britain', Palgrave for H.M. Treasury.

Barrell, R. and Gottschalk, S. (2004), ÔThe volatility of the output gap in the G7', National Institute Economic Review, April.

Barrell, R., Metz, R. and Riley, R. (2004), ÔRecent UK growth: a comparison with France, Germany and the US' National Institute Economic Review, April.

Barrell, R. and Mitchell, J. (2004), ÔCyclicity and international financial developments: cycles and systemic risks, contagion and globalisation and institutions and financial stability', Monetary Policy, Economic Cycles and Financial Dynamics, Bank of France Bulletin.

Blundell, R. and Hoynes, H. (2004), ÔHas 'in-work' benefit reform helped the labour market?', in Blundell, R., Card, D. and Freeman, R. (eds), Seeking a Premier Economy: The Economic Effects of British Economic Reforms, 1980Ð2000, University of Chicago Press.

Byrne, J. and Davis, E.P. (2004), ÔPermanent and temporary inflation uncertainty and investment in the United States', Economics Letters, 85, pp. 9Ð16.

Dickens, R. and Manning, A. (2004), ÔHas the national minimum wage reduced wage inequality?', Journal of the Royal Statistical Society, Series A, pp. 613Ð26.

Massman, M. and Mitchell, J. (2002), ÔHave UK and Euro Zone business cycles become more correlated', National Institute Economic Review, 182, pp. 58Ð71.

Pomerantz, O. and Weale, M.R. ( 2005), ÔAre we saving enough? The macroeconomics of the savings gap', National Institute Economic Review, 191, pp. 79Ð93.

Riley, R. and Young, G. (2001), ÔDoes welfare-to-work policy increase employment?: evidence from the UK New Deal for Young People', National Institute Discussion Paper No. 183.

van Reenen, J. (2004), ÔActive labour market policies and the British New Deal', in Blundell, R., Card, D. and Freeman, R. (eds) Seeking a Premier Economy: The Economic Effects of British Economic Reforms, 1980Ð2000, University of Chicago Press.

Sefton, J. and Weale, M.R. (forthcoming), ÔThe concept of income in a general equilibrium', Review of Economic Studies, revision of National Institute Discussion Paper No. 163.

Stewart, M. (2004), ÔThe employment effects of the national minimum wage', The Economic Journal, No. , pp. C110-C116.