United Kingdom: Recent Economic Developments

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

Abstract

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

II. POTENTIAL GROWTH AND THE OUTPUT GAP17

A. Introduction

40. There is an ongoing debate in the United Kingdom on whether in recent years the potential growth rate of the economy has increased and whether over the medium-term the economy could grow at a higher rate than in the past without generating inflationary pressures. This paper presents new estimates for the potential growth rate, the output gap and the natural rate of unemployment. These estimates are compared with those obtained by the United Kingdom Treasury, the National Institute of Economic and Social Research, the OECD, and a number of other investigators. The paper also examines the reasons for the differences between the various estimates and the underlying determinants of the potential growth rate.

41. The analysis of the paper provides the following main conclusions. First, the structural reforms implemented over the last decade have had a positive impact on productivity growth and have been associated with a decline in the NAIRU.18 However, the benefits of these reforms for overall growth may have been offset to some extent in the 1980s and possibly early 1990s by exogenous shocks and by macroeconomic instability, so that a measurable increase in potential output growth is not apparent in historical data. Looking ahead, however, a number of factors suggest that over the medium term the potential growth rate could be somewhat higher than in the past. Finally, as growth has been generally below potential in the first half of the 1990s, there is probably currently a negative output gap, although its precise magnitude is not clear. This suggests that the United Kingdom economy could grow somewhat above trend for the next two to three years without generating inflationary pressures.

42. The discussion below is organized as follows. Section B discusses the various techniques for estimating the potential growth rate while Section C briefly summarizes the estimates obtained by existing studies, and provides some cross-country comparisons. Section D provides new estimates of the potential and output gap and assesses the medium-term prospects, while Section E provides evidence on the natural rate of unemployment. The last section examines the impact of structural reforms and analyzes factors which may have influenced the potential growth rate in the past.

B. Approaches to Estimating Potential Output and Output Gap

43. The concept of trend or potential output—output that can be sustained without generating inflationary pressures—provides a key benchmark for assessing the pace of sustainable growth in the short and medium-run and plays an important role in economic policy. The output gap, the difference between actual and potential output, provides a reference point for assessing short-run inflationary pressures and is an important consideration in stabilization policies. Inflationary pressures will tend to fall when actual output is below trend, although inflation may also be affected by the rate of output growth as well as the output gap. Potential output and the output gap are also used extensively to estimate cyclically adjusted budget and trade imbalances.

44. Since trend or potential output is an unobserved variable, a number of statistical techniques have been used in the past to estimate it and the corresponding output gap. The estimates presented below use four such techniques, highlighting the sensitivity of the estimates to alternative methodologies. Given the various limitations of these methodologies, the estimates are subject to fairly wide confidence intervals. This imprecision has often led to the argument that an assessment of trend output or the output gap might warrant the use of proxies, such as survey evidence on capacity utilization and perceived constraints on output. However, while such evidence can provide a very useful guide to pressures in particular sectors of the economy, no single survey has the depth of coverage to make it an adequate proxy for the output gap for the entire economy.

45. The first technique for estimating trend growth uses the “split time-trend” method which allows trend growth to change between cycles, although not within each cycle.19 The cycle is defined as the period between peaks in growth and the trend is estimated according to the following equation:

yt=α0+Σi=1nαiTi+εt(1)

where yt is the log of real GDP, αi is the trend growth coefficient for the ith cycle, Ti is the segment of the time trend corresponding to the ith cycle and et is the error term.

46. A limitation of this technique is that it imposes a deterministic trend during the course of each cycle, permits structural breaks to occur only at the peak of the cycle, and suffers from the familiar “end-period” problem. It also assumes that successive peaks of the growth cycle are points of equal demand pressure. A more sophisticated procedure is the Hodrick-Prescott (HP) filter which generates a potential output series by minimizing a weighted average of the gap between output and trend output, at any given time, and the rate of change in trend output at that given time. That is, the trend is estimated to minimize the following:

Σt=1Tyt*min(ytyt*)2+λΣt=2T1[(Yt+1*yt*)(yy*yt1*)]2(2)

where yt is actual real GDP, yt* is the potential or trend GDP, and λ is the smoothing parameter.

47. While the filtering technique is straightforward, it is again sensitive to end points when trend and actual series move together. In addition, this method has a number of other drawbacks, including the excessive smoothing of structural breaks. The filter also requires the specification of an arbitrary smoothing parameter since there is no statistical criterion to guide the choice of this parameter.

48. A third procedure for estimating the trend is the multivariate detrending technique. This is used somewhat less frequently than the univariate techniques noted above but has some useful characteristics. It is based in part on the premise that any approach to estimating trend output can extract useful information by decomposing cyclical fluctuations into those due to supply-side and those due to demand side shocks. The existence of these two types of shocks, and their implications for the measurement of potential output, are discussed by Blanchard and Quah (1989). Formally, the procedure entails estimating a bivariate vector autoregression (VAR) of the following form:

yt=α10α12Ut+b11yt1+b12Ut1yt(3)
Ut=α20α21yt+b21yt1+b22Ut1ut(4)

where yt is output, Ut is the unemployment rate, and ∊yt and ∊ut represent shocks to yt and Ut respectively. The estimation results noted below used the first difference of output (the level of output is not stationary) and the detrended unemployment rate, using the HP filter (to remove the secular component in actual unemployment).

49. The fourth technique is based on an aggregate Cobb-Douglas production function. Unlike the above techniques, the production function approach explicitly takes into account information about the structural constraints and limitations on production through the availability of factors of production or other endogenous influences in estimating potential output.20 The approach first requires the estimation of a function for the whole economy of the following form:

yt=α0α1nt+(1α1)kt+et(5)

where yt = real GDP, nt = labor input (adjusted for hours worked), kt = capital input, et = total factor productivity, and α1 = average labor share parameter; all variables are in natural logs.21

50. The estimated residuals from this equation are then smoothed using the HP filter to provide a measure of trend total factor productivity. Potential output is computed by combining trend total factor productivity with the actual capital stock and estimates of potential employment, defined as the level of labor resources that might be employed without resulting in additional inflation. This amounts to adjusting the actual labor input used in the estimated production function for the gap between actual unemployment and the estimated NAIRU level. The production function approach can provide useful information on the basic determinants of the potential growth rate. However, this approach is data intensive and to the extent that there are measurement errors, for instance, in the capital stock, it can lead to erroneous estimates of potential. The estimates are also sensitive to the smoothing techniques used in adjusting the component series.

C. Existing Studies and Cross-Country Comparisons

51. A number of recent studies have examined potential growth and the output gap in the United Kingdom. Several of these studies are forward-looking and do not provide an assessment of what the potential growth rate has been in the past. The United Kingdom Treasury in the November 1995 “Financial Statement and Budget Report” for 1996/97 considered the trend growth to be around 2½ percent but notes that the trend growth could be higher if the impact of supply side reforms is greater than assumed in its projections. It does acknowledge, however, that there is a great deal of uncertainty surrounding estimates of the trend growth rate and the associated current output gap. For the purpose of medium-term budgetary projections, the Treasury assumes GDP growth of 3 percent in 1997–98 and 2¾ percent a year thereafter. According to these estimates, the output gap that opened up during the 1990–92 recession has probably narrowed since 1993 as the economy has grown at above the trend rate. Nevertheless a negative output gap probably still remains in the economy as a whole.

52. The Treasury Panel of Independent Forecasters recently provided its own report on the trend growth and output gap (Treasury 1996). The Panel uses the concept of “short-run” when trend or “equilibrium” output is at a level at which the margin of spare capacity is just sufficient to keep cost pressures in check. Thus, the level of short-term equilibrium output takes the capital stock as given and is determined by the size and productivity of either the capital stock or the labor force, whichever is the tighter constraint. In the long run, the capital stock adjusts to its desired level, and equilibrium output is at a level consistent with full employment of the effective labor supply. The binding constraint on output in this case is the supply of labor forthcoming at the market clearing real wage. Thus measures that reduce the natural rate of unemployment, encourage greater labor force participation, or increase labor productivity will increase the equilibrium level of output.22

53. In effect, for the long run, the Panel uses a framework based on the following identity:

logYlog(YN)+log(NL)+log(LP)+logP(6)

where Y = real GDP, N = total employment, L = labor force, and P = total population. (Note that (N/L) = 1 - u where u is the unemployment rate.)

54. This framework specifies growth as a function of labor productivity, the participation rate and the underlying rate of unemployment. The Treasury Panel suggests that the long-run growth rate in the United Kingdom is in the range of 2⅛ to 3 percent, with an average of 2.4 percent (Table 1). However, they indicated several reasons why the potential rate may be increasing. First, there is likely to be higher participation among younger workers, and greater re-employment of older workers who became unemployed from full time jobs with relatively high levels of skills and productivity. Second, higher participation among younger workers could also be of some benefit to productivity growth if these workers acquire higher levels of skills while working. The panel notes that, as of mid-1996, there was a short-term output gap of around 1¾ percent (with a range at mid-points of 0.37 to 3.0 percent) and a long-term gap of around 3¼ percent (with a range at mid-points of 1½ to 7 percent). One implication of these estimates is that real GDP growth of close to 3 percent a year or higher may be sustainable over the next three to five years.

Table 1.

United Kingdom: Comparison of Potential Growth Rate, Output Gap, and Projected Growth 1/

(In percent)

article image
Source: See text.

Output gap is defined as actual output minus potential output as a percent of potential output.

Long-term output gap, short-term output gap average is 1.7 percent, with a range at midpoints of 0.37-3.0 percent.

The range is based on production function estimates.

55. The National Institute suggests in a recent study that the medium-term potential growth in the United Kingdom is around 2.7 percent, compared with an average of 1.85 percent over the period 1973–90 (Weale and Young, 1996).23 It projects growth to rise to 3.5 percent in 1997 and remain above 3 percent for the rest of the decade. There are essentially two factors underlying this projection. First, there is the substantial pool of unused labor to draw from, allowing the participation rate to rise considerably if more jobs become available; in the transition to a new equilibrium participation rate, the growth rate would be higher than in the recent past. Second, improvements in the working of the economy and management changes in the public sector are likely to have raised labor productivity growth. An earlier study by the National Institute (Barrell and Sefton, 1995) had also suggested that government policies to reduce the equilibrium unemployment rate will be effective, albeit slow-acting, and this will add a quarter to a half a percentage point to sustainable growth over the next decade.

56. The OECD recently concluded that potential output growth in the United Kingdom is around 2½ percent a year, with productivity growth accounting for 1¾ percentage points, and employment and capital stock ½ and ¼ percentage points respectively (OECD, 1996).24 Given the current output gap, estimated at around 2 percent, the economy could grow somewhat faster than potential over the next few years before capacity constraints become binding (OECD, 1996).

57. Finally, there have been a number of studies undertaken by private forecasters which reach conclusions similar to the above. For instance, Mackie (1996) analyzing the relationship between actual output and survey measures of capacity utilization, and the growth of labor force, argues that the economy’s productive potential is not growing any faster than it did in the 1980s. Specifically, he argues that potential growth in manufacturing remains around only 2 percent while in the service sector it is around 2½ percent. Combining these estimates with those for other sectors, he concludes that the potential growth in the economy remains at around 2¼ percent, not much changed from the pace seen in the 1980s. Unlike other studies cited, his analysis does not foresee an increase in the potential and his estimates do not suggest any substantial output gap.

58. The issue of whether in recent years there has been a change in the potential growth rate and the current level of the output gap has also been examined in the other countries, generating a lively debate in the United States, and with more of a consensus emerging in several major European economies. In France, production function estimates suggest that potential growth has decreased over the last four years to around 2 percent, from 2¾ percent in the late 1980s, mainly due to low levels of investment (IMF, 1995; Barrell and Sefton, 1995), but is projected to increase to almost 2½ percent over the medium term. The potential growth rate has apparently also declined in Germany in recent years and is projected to remain around 2¼ percent over the medium term.

59. The potential growth rate for the United States is now estimated at around 2¼ percent according to the new chain-weighted index, about half of which is expected to be contributed by productivity growth. Dornbusch (1996) has emphasized that such an estimate of potential is likely to be subject to considerable uncertainty given the important changes in the structure of the economy over the past decade. The U.S. economy is far more open than it was in the past and both product and labor markets have become more competitive. Mundell (1996) has argued that if the U.S. can increase its saving rate from the current 10 percent to 15 percent—which could occur in the medium-term in part due to demographic changes—the potential growth rate could increase by nearly 1 percentage point.

D. Empirical Estimates

60. The results of estimating the potential growth rate for the United Kingdom, using the four econometric techniques summarized in Section II above, are given in Chart 1 and Table 2. Although the estimates for the different periods over the last 30 years vary somewhat, they all suggest a similar conclusion: trend growth declined markedly from the second half of the 1960s to the 1970s, then increased to somewhat more than 2¼ percent in the 1980s. During the 1990s, potential growth appears to have declined again, but this is due in large part to the deep and prolonged recession earlier in the decade. As the last row in Table 2 suggests, the potential growth in the period since 1993 would appear to be in the range of 2¼ to 2½ percent.

Chart 1.
Chart 1.

United Kingdom: Actual and Potential Output 1/

(Index 1980 = 100)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A002

1/ Real GDP.
Table 2.

United Kingdom: Actual and Potential GDP Growth

(In percent per annum) 1/

article image
Source: Actual, CSO; potential; staff calculations.

Potential output growth is estimated using the four methodologies discussed in the text.

61. These estimates were obtained using standard values of the smoothing parameter.25 A number of simulations were undertaken to examine the sensitivity of the estimates to changes in the values of these parameters. In general, the higher the value of the parameters, the less sensitive was the potential growth rate to cyclical changes in activity, and the more stable the trajectory of the growth path. For instance, in the case of the production function, greater smoothing of the underlying series dampens the average potential growth rate during the 1980s to 2.3 percent and raises the growth rate in the 1990s to 2.0 percent. In general, however, even sizable changes in the smoothing parameter did not affect the broad conclusions reached above using standard values of the parameters.

62. The estimates of the output gap shown in Chart 2 and Table 3 reflect the estimates of potential output shown in Table 2. Thus, according to the split time-trend measure, the output gap opened up during the second half of 1991, became pronounced during 1992–93, and began to close in the last quarter of 1993. However, with the faltering recovery last year, a small gap began to appear again in the second half of the year which has become somewhat bigger this year.26 The other two time series methods also suggest that by early this year, output was somewhat below trend. According to the production function estimates, an output gap has persisted over the past four years, although it began to narrow considerably in the second half of 1994.

Chart 2.
Chart 2.

United Kingdom: Estimates of Output Gap

(in percent potential output)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A002

Table 3.

United Kingdom: Output Gaps 1/

article image
Source: Computations based on estimates of potential shown in Table 2.

Defined as actual output - potential output as a percent of potential output.

63. The production function approach also allows a decomposition of the trend growth rate into the three components: capital, labor, and total factor productivity. Total factor productivity has played an important role in determining the potential growth rate in the United Kingdom, accounting for nearly half to two-thirds of the potential growth rate (Table 4). After a marked decline in productivity growth during the 1970s, there was a rebound during the 1980s. During this decade, the recession led to a sharp fall in productivity growth which has bounced back over the last three years. Indeed, over these years, productivity growth offset the very small contribution of labor. The latter reflects in large part the decline in the participation rate—the proportion of people of working age in employment—since the late 1980s (Chart 3). Part of the explanation for this lies in the early retirement of men and the increased participation of young people in higher education.

Chart 3.
Chart 3.

United Kingdom: Unemployment Rate and Labor Force Participation Rate.

(in percent)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A002

Table 4.

United Kingdom: Contributions to Trend GDP Growth

(In percent per annum)

article image
Source: Staff calculations using production function.

64. The production function framework also provides a means to assess the medium-term potential growth rate of the economy. This is important since the mechanistic use of past Chart 3 trends can be misleading (see Davies, 1996). For instance, if investment and output are temporarily depressed due to policy or exogenous shocks, an extrapolation of past trends would understate the potential growth rate. Similarly, to the extent that the recent decline in the participation rate slows or is reversed and productivity growth reverts to its pace before the temporary downturn, potential growth could accelerate somewhat over the next few years.

65. We have used the production function approach to project the medium-term potential growth rate for the United Kingdom’s economy under the following assumptions: (i) total factor productivity growth continues at the same rate as in the 1980, somewhat below the rate since the last recession; (ii) the labor force rises as labor participation rate begins to revert to more “normal” levels and (with a turning in demographic trends) the working age population begins to grow; while the NAIRU is about 7 percent; and (iii) the low rates of investment in the 1990s are reversed, with investment growing at the marginally higher rates of the last decade. Given these fairly weak assumptions, the potential growth rate for the United Kingdom economy over the next few years would be in the range of 2½ percent. Given the existing slack in various sectors of the economy and the overall output gap, this potential growth rate would suggest that the economy could grow at a rate of close to 3 percent for the next two to three years without generating inflationary pressures.

E. Estimates of the Natural Rate of Unemployment

66. As noted in Section B, the concept of the natural rate of unemployment and the potential level of output are closely linked, as disequilibrium pressure in the labor market will spill over into the market for output, and vice versa. The links between the two concepts can be seen clearly from equations (7) and (8) below:

y*=α0+α1n*+(1α1)k+ε*(7)

where y* is real potential output, n* is potential employment, k is capital stock, and ∊* is trend factor productivity.

Potential employment is computed as:

n*=L(1NAWRU)(8)

where L is smoothed labor force and NAWRU is the estimated non-accelerating wage rate of unemployment. Clearly a decline in NAWRU would increase n* leading to an increase in y*.

67. Most current theories of the labor market define the natural, or equilibrium, level of unemployment as that which is consistent with stable wage inflation. Thus the non-accelerating wage rate of unemployment (NAWRU) theory is based on the premise that, once unemployment has reached a specific level, growth beyond what is necessary to employ new entrants into the labor force will raise wage rates and the rate of inflation.27

68. As for potential output, there are a number of alternative techniques for estimating the NAWRU. The method used earlier for identifying the NAWRU is to assume that the change in wage inflation is proportional to the gap between actual unemployment and the NAWRU. That is:

D2wt=a(UtNAWRUt)a>0(9)

where D is the first difference operator, w denotes log of the wage level and Ut is the actual unemployment rate. Assuming also that the NAWRU changes only gradually over time, successive observations on changes in wage inflation and the actual unemployment rate were then used to calculate a time series corresponding to the implicit value of NAWRU. The resulting series were then smoothed using an HP filter, to eliminate erratic movements. This measure of the natural rate was compared with the results of comparable methods which use alternative Okun or Beveridge curve relationships as a starting point.28

69. There is a wide range of estimates for NAWRU for the United Kingdom. At one extreme is the analysis by Minford and Riley (1994) who argue that the natural rate is around 2½ percent, which would mean an unemployment level of well under a million. Barrell, Pain, and Young (1994) calculate, however, that the NAWRU in the United Kingdom has varied over the 1980s but by the early-1990s it was no lower than 7–8 percent. The latter estimate is similar to the OECD estimates (Giorno and others, 1995). If labor has a ⅔ share in output, then the difference between the two sets of estimates alone would cause the output gap estimates to differ by a substantial margin.

70. The estimated NAWRU as well as the consensus estimate—the average obtained from a number of studies—is shown in Chart 4. Since the confidence interval for the estimate is quite wide (around 1½ percent), the estimates obtained by the above methodology are consistent with the estimates in the literature. By all accounts, the natural rate of unemployment in the United Kingdom increased very sharply during the 1970s. It stabilized during the mid to late 1980s and has been on a downward path since then.

CHART 4
CHART 4

UNITED KINGDOM: Estimates of Natural Rate of Unemployment

(in percent)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A002

Source: Data received from the authorities and staff estimates.1/ HP filter (1) uses a smoothing parameter of 1600, while HP filter (2) uses a smoothing parameter of 16000.

F. Determinants of Potential Growth Rate

71. The evidence that United Kingdom’s potential growth rate has not increased over the last decade and a half may appear somewhat surprising. After all, the labor, product and financial market reforms of the 1980s were supposed to lead to significant improvements in capital investment and productivity growth and push the economy to a higher growth path. This section discusses the hypothesis, implicit in several of the studies noted earlier, that while the supply side reforms were effective in improving the flexibility and perhaps the productivity of the economy, their impact may have been offset in the 1980s and early 1990s by various policy and exogenous factors. If this is the case, and these factors are not expected to recur, then the medium-term potential growth rate may also be expected to increase. It has also been noted that in the United Kingdom the growth of capital stock has been restrained—the United Kingdom invests a smaller proportion of its GDP than many of its competitors (Chapter I)—and had it not been for the structural reforms implemented during the last decade, the potential growth rate would have been lower still.

72. The recent literature on determinants of long-run growth has emphasized that factors like saving and investment, labor force growth and accumulation of human capital determine not only the transition to a long-run steady state growth path, as was assumed in the traditional neo-classical framework, but also the growth path itself (Barro and Sala-i-Martin, 1995). In addition, this literature has shown how factors that improve the efficiency of resource allocation and reduce uncertainty can raise the long-run steady-state growth rate.

73. As Table 4 showed, there was a clear evidence of an improvement in United Kingdom’s overall productivity growth during the 1980s. Moreover, as Table 5 shows the United Kingdom’s performance improved relative to other countries. During 1960-73, the United Kingdom had the lowest labor productivity growth rate among G–7 countries except for the United States, and in 1973–79 the lowest of all G–7 countries. However over the period 1979–94, United Kingdom productivity grew more rapidly than in any other G–7 country except Japan, with particularly sharp improvements in the manufacturing sector. Since the early 1980s, total factor productivity has also risen faster in the United Kingdom than in many of the other major industrial countries (OECD 1996).

Table 5.

G-7: Growth in Labor Productivity 1/

(In percent per annum)

article image
Source: Oulton (1995).

Output per hour in manufacturing.

74. One explanation for the acceleration of labor productivity growth has been in terms of international convergence of productivity levels. By the 1970s there had developed a significant gap in labor productivity between the United Kingdom and the other major industrial economies. Accordingly, there was a potential for an acceleration of United Kingdom productivity growth to narrow this gap. However, in the absence of a subsidiary hypothesis as to why it was during the 1980s that the acceleration occurred, this explanation is not convincing.

75. The structural reforms in the United Kingdom are reckoned to have been, in large part, responsible for the improvement in productivity growth in the 1980s These reforms improved the efficiency of resource allocation and the labor market. More specifically, the reforms in the wage bargaining system, the reduction in the influence of unions, and the removal of restrictive work practices increased labor market flexibility and competition; these changes also led to more decentralized wage determination and strengthened links between pay and performance (see Chapter VI). The strengthening of competition and market forces gave firms the incentives to take measures to improve efficiency, and the better climate of industrial relations enabled them to introduce such improvements readily.

76. A large number of industry and firm level studies links the labor market reforms to the improvement in productivity growth in the 1980s. For instance, Bean and Symons (1989) showed that improvements in productivity growth in the manufacturing sector between 1974–79 and 1980–86 were positively correlated with plant size (used as a proxy for multiple trade unions) and with the proportion of workers covered by collective agreements. This study showed that the reduction in union power had strong effects on productivity, especially where the influence of trade unions on the wage bargaining process had been greatest. Oulton (1990) showed that the productivity improvement in the 1980s in manufacturing was greatest in the industries that had been more heavily unionized in the 1970s. Bean and Crafts (1995) show that the major change in the 1980s was the elimination of the distortions associated with multi-unionism in large plants. A study by Gregg, Macklin, and Metcalf, (1993), using firm level data suggests that the disadvantages of unionization for productivity growth were reduced or even eliminated in the late 1980s as management regained flexibility in the introduction of product and process innovations.

77. Productivity growth may also have been boosted by the sharp increase in inward foreign direct investment in the late 1980s and early 1990s (see Chapter VII). While the reasons for this increase are still being debated, recent evidence suggests a positive relationship between the volume of such investment and the rate of productivity growth.

78. In addition to the effect on productivity growth, the contribution of labor to potential output has been increased by the recent declines in the natural rate of unemployment. The labor market reforms could have worked in a number of different ways to reduce the NAWRU, including increasing incentives for unemployed workers actively to seek employment. It has also been argued that greater labor-market flexibility resulting from curtailment of unions, reform of labor laws, and tighter rules on unemployment benefits have helped to create favorable conditions for creating jobs quickly (OECD, 1996). This explains the fact that unemployment, which had risen sharply in the early 1980s to well above EU and OECD averages, fell rapidly during the current cycle and is now well below the average for the EU.

79. Given the increase in productivity growth and labor supply factors, what then accounts for the unchanged rate of trend growth over the past decade? One explanation could be in terms of inappropriate macroeconomic policies, particularly those that led to the recession at the beginning of the decade, which was deeper than in any other G7 country (Oulton, 1995). An interpretation of the recession has been as a consequence of the overexpansion of demand in the preceding boom, and the decision to enter the ERM at a greatly overvalued exchange rate. More generally, while international comparisons tend to be sensitive to the precise measures used, it does appear that in the United Kingdom macroeconomic instability may have been greater than in the other major industrial countries. For instance, over the 25 year period 1970–1994, United Kingdom had the highest variance of GDP growth rate of all the G–7 economies (Oulton, 1995). An analysis of the inflation rate, a commonly used indicator of instability, also shows that over the 1980–1995 period, with the exception of Italy, the United Kingdom had the highest average consumer price inflation of the G-7 countries. Again, excepting Italy, over this period the United Kingdom had the highest long-term interest rates of all the G-7 countries. During the 1980s, among the major European countries, the United Kingdom had the highest variation in the real effective exchange rate.

80. These indicators, while not conclusive, do tend to support the view that in the past the macroeconomic environment may have been more unstable than in the other major industrial countries. But why should macroeconomic instability matter for long-run growth? The main effect is through uncertainty, which in turn operates through two channels. First, policy induced uncertainty can reduce the efficiency of the price mechanism, reducing the level of productivity as well as the rate of increase of productivity (Fischer, 1995). Second, as shown by Pindyck (1988), macroeconomic uncertainty reduces the rate of investment, as potential investors wait for the resolution of uncertainty before committing resources. There is considerable empirical evidence showing how uncertainty affects potential growth through both these channels (see, for instance, Grier and Tullock, 1989 and Fischer, 1995). This type of evidence suggests that the cycle of inflationary boom followed by deep recession in the United Kingdom has been a disincentive to committing funds to capital projects with anything but a short pay-back period. In other words, had the environment been more stable, it is plausible to argue that productivity growth would have been higher still, and there would have been greater investment.

81. In the most recent period, the United Kingdom has been entering a more stable macroeconomic environment. In the current recovery, growth has been fairly smooth and inflation has been lower than for the past 30 years. Another important development in recent years has been an increase in human capital, with the proportion of school leavers going into higher education increasing from 12 percent in 1979 to 30 percent in 1995. Prospective demographic trends are also more favorable than in many others industrialized countries, with the working-age population expected to grow in the coming years. If, over the medium term, these trends continue and the labor market remains flexible, an increase in the potential growth rate of the economy to about 2½ percent would appear likely.

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17

Prepared by Manmohan S. Kumar.

18

The non-accelerating inflation rate of unemployment (NAIRU) is the most widely-used measure of the natural rate of unemployment; an alternative measure, the non-accelerating wage rate of unemployment (NAWRU), a measure more explicitly linked to the labor market, is the focus of Section E.

19

This technique has been used extensively by the OECD. (See, for instance, Giorno and others, 1995) The UK Treasury uses a variant of this technique whereby trend output is calculated by linear interpolation between successive on-trend points at like stages of the cycle.

20

This method was used by Artus (1977) for estimating potential output in the manufacturing sector for 8 industrial countries for the period 1955–1975. Adams, Fenton, and Larsen (1987) broadened the coverage for the manufacturing sector to the economy as a whole.

21

In the empirical estimation, the weights on capital and labor were first obtained endogenously—that is, by estimating an unconstrained augmented production function.

22

The Treasury panel also makes a distinction between short-term and long-term output gaps with the former measuring the difference between actual and trend output when the capital stock is held fixed and the latter measuring that difference when the capital stock is allowed to vary.

23

The London Business School, using a framework similar to that adopted by the National Institute, also suggests that the potential growth rate over the next decade is likely to average between 2.4 and 2.9 percent per annum (see Sentance, 1995).

24

Earlier estimates, based on a variety of techniques, suggested trend output growth to be around 2¼ percent (see Giorno and others, 1985).

25

For the HP filter and the production function estimates, this entailed setting the value of λ to 1600. In the Blanchard-Quah estimates, the same parameter value was used for detrending the unemployment rate; the split time-trend does not require any smoothing.

26

Estimates for the first quarter of 1996 should be regarded as preliminary.

27

While full employment of all resources places a barrier on noninflationary increments to employment, it does not necessarily fix the rate of growth (see, for example, Mundell (1996)). Given full employment, potential output can be increased by raising the saving rate or productivity growth.

28

Adams and Coe (1990) augmented the basic production function estimation procedure to take account explicitly of the relationship between wage and price inflation, potential output, and the natural rate of unemployment for the United States.

United Kingdom: Recent Economic Developments
Author: International Monetary Fund
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    United Kingdom: Actual and Potential Output 1/

    (Index 1980 = 100)

  • View in gallery

    United Kingdom: Estimates of Output Gap

    (in percent potential output)

  • View in gallery

    United Kingdom: Unemployment Rate and Labor Force Participation Rate.

    (in percent)

  • View in gallery

    UNITED KINGDOM: Estimates of Natural Rate of Unemployment

    (in percent)