Philip Hammond says he plans to use Wednesday’s Budget to get us “match fit” for Brexit. This reminds me of an old error of Chancellors and political commentators – their habit of under-estimating just how damned difficult it is to increase long-run growth.
In fact, John Landon-Lane and Peter Robertson have shown (pdf) that the data are consistent with the possibility that national government policies have no discernible impact upon long-run growth at all. This is because most developed economies grow at much the same rate as each other, give or take a standard error and pathological exceptions such as perhaps Italy or Japan.
Dietz Vollrath has shown why this is. It’s because economies are very slow to converge to higher levels of potential output, even if such levels can be achieved.
To see why, imagine something happens to raise the level of potential GDP growth – say, some technical innovation or your pet policy gets implemented. For this to affect actual growth, companies must first see new profit opportunities, then persuade financiers to back them, and then retrain workers, install new equipment, hire more staff and so on. But there’s mountains of things that can go wrong here: new technology might not work well; it takes time for workers to learn new jobs; managers can lose control of costs as they focus on expansion; and so on. All these problems throw sand into the wheels and stop the economy adjusting swiftly to its higher potential level.
Resources – capital and labour – are not very fungible. One of the consistent errors of free market economists has been their unwillingness to see this.
But it’s not just them who make this mistake. In a new paper Charlie Cai and colleagues show that equity investors tend to pay too much for growth stocks because they under-estimate the difficulties firms have in expanding: expansion usually entails falls in asset turnover and in margins, facts which themselves limit that expansion.
This micro evidence fits the macro evidence that convergence towards higher potential output is slow. It also tells us that the inability to appreciate this doesn’t arise merely from motivated reasoning and political ideology, but rather from a widespread cognitive bias – a tendency to over-rate the importance of salient things such as policy announcements or current corporate growth and so under-rate the importance of the countless low-level barriers to growth.
For me, this has two policy implications.
One is that Chancellors should worry less about raising long-run growth and more about getting macroeconomic policy right. Failings in the latter can easily more than offset good supply-side policies: for example, Nicholas Oulton’s assessment of the Thatcher reforms was that “microeconomic success has been masked by macroeconomic failure.” As James Tobin rightly (pdf) said, “it takes a heap of Harberger triangles to fill an Okun gap.”
Secondly, although the adjustment to higher potential output is slow, that to lower output might not be: companies can quickly close factories and shed workers. Economic policy should therefore obey a form of the Hippocratic oath: first, do no harm.
With this government committed to both fiscal austerity and a hard Brexit, it is disregarding both these principles. As our media is more likely to focus upon Hammond’s cheap talk than upon hard economic realities, it will probably not sufficiently be blamed for this.