Too good to last?

‘Most of our people have never had it

 so good… What is beginning to worry some of us is, is it too good to be true?

Or perhaps I should say, is it

too good to last?’

—Harold Macmillan, 20th July 1957

Fifty years on from ‘never had it so good’, we can ask the same question about the British economy today. We have had 15 years of steady, but not spectacular, economic growth. The gap in living standards with France and Germany which opened up in the 1960s has been first closed and then reversed. But is it too good to last?

The economy has been growing at slightly above its trend rate in the last year, although given the uncertainty about the scale of immigration, few people would claim that they can identify the trend with any precision. But for the last year or so household real income has not been rising in the same way as GDP. Household saving has dropped to a very low level and is negative once one takes account of depreciation.  The delayed effects of recent interest rate rises mean that a further squeeze on household income is likely as mortgage payments rise.

There are two factors behind these changes to the balance between household income and GDP.

First of all, profits have been very buoyant. These do not feed into household income directly unless they are paid out as dividends, but retained profits result in higher future profits and thus higher future dividends. We have seen a shift in incomes within the private sector away from households and towards businesses.

Since businesses are owned by households, it is not clear that this is of macro-economic importance although it is probably one reason why the balance of economic growth has shifted away from consumption and towards investment.

Secondly, in the late 1990s and in the early part of the current decade, the country enjoyed falling import prices. This had the consequence that income grew faster than GDP.  More recently,  as raw materials prices have turned up, this process has come to an end, at least for the time being.

After ten years where incomes have grown faster than output we may now be entering a period where they grow more slowly than output.

It is helpful to think of  GDP as being divided between labour income, on the one hand and profits, including rent, on the other. Recently both the share of profit in GDP and  the rate of return on capital have been rising. One needs to look at what has been driving this process to understand whether it is likely to continue.

The buoyancy in profits can probably be attributed, like the fall in import prices, to the opening up of the Chinese economy. At a global level this has had the effect of introducing a lot of extra labour into the world economy. An increase in the ratio of labour relative to that of capital normally has the effect of raising both the rate of return on capital and the share of capital in GDP.

International trade in goods and services means that the effects of this are felt throughout the world economy and not simply in the region where the change is taking place.

But there is a puzzle in the story.  We have seen a period of unusually low interest rates which is just coming to an end. The bank base rate fell to 3.5 per cent per annum,  its lowest level for about 50 years in July 2003 and long-term rates have also been unusually low.

People usually pay most attention to the ‘bog-standard’ interest rates on mortgages and so on, but it is worth noting that the rate on ten-year government debt fell to just below four per cent in January of 2006. The rate on ten-year index-linked securities, which provide protection from inflation and therefore represent a real rate of interest, fell to 1.2 per cent at the same time from a  peak of  five per cent per annum in the early 1990s. Since then the nominal rate has risen to 5.3 per cent and the real rate to 2.2 per cent.

It is not always easy to discern a relationship between the interest rate and the rate of return on capital. But possibly simplistic economic theory postulates that the return on risky investments, such as capital invested in businesses, should equal the rate of return on safe assets such as government debt plus a risk premium which compensates investors for the risks that they are running.

Thus with low interest rates we would expect to see low returns on capital unless investment has become more risky recently. While risk is difficult to judge there is a strong body of opinion that the economic environment over the last decade or so has been less uncertain than normal. In other words, the rate of return should be low rather than high, both because interest rates are low and because perceived risk has been reduced.

A more probable explanation is that the combination of low interest rates and a high rate of return is an anomaly. One might speculate that, despite the high return on capital, businesses have found it difficult to adjust their investment plans to globalisation so that high returns on capital have not provided the immediate incentive to invest that would have been expected.

Given this, central banks have needed to cut interest rates to support household consumption so as to maintain overall demand, and to prevent inflation falling below desired levels.

If this hypothesis is correct, the recent strength in investment may indicate that the economic incentives are finally asserting themselves. The consequence will then be that internationally we should expect a period of investment-led growth with higher than normal interest rates as well as higher than normal rates of return on capital.

The shift to a sustained period of high interest rates may not be as smooth as one would hope. While investment has been low, the last few years have seen an expansion of debt. Businesses have become more geared and the combination of low interest rates and easy credit has supported house- price booms in the United Kingdom and elsewhere.

The pattern of long-term interest rates suggests that, despite the rises of the last few months, markets have still not adjusted fully to the possibility that interest rates will remain at normal levels (say in the 5-6 per cent per annum range), let alone that there may be higher than normal rates in the medium term.

Indeed, it is possible that the low interest rates of the last few years encouraged businesses to think more about changing their capital structures, increasing gearing and floating a range of novel securities than to focus on the income that could be earned from more conventional business activities such as investment. Thus low interest rates may not only have been a response to the failure of investment to respond but also, paradoxically, to have impeded its response.

This analysis, if correct, has a number of implications. The trend identified above of slow growth in household income and in household consumption is likely to continue as the pattern of economic growth changes. Weakness in house prices, far from being a macro-economic problem, will be a part of the mechanism by which consumption growth is held down to make room for more investment. Indeed it will have the impact of mitigating the rise in interest rates that would otherwise be needed.

Obviously some people will be badly affected if the economic environment changes in the way suggested. Any businesses that focused too much on financial engineering and not enough on keeping abreast of global developments will find life difficult.

Individuals who assumed that very low interest rates would continue indefinitely are likely to be squeezed. But most of the evidence suggests that the United Kingdom economy is not saving what is needed to make a sensible provision for the future, and especially so as the baby-boomers move into their mid-forties..

The recent growth in household consumption has probably been too good to last. But the foundations for sustainable prosperity will be better laid by a higher rate of saving and investment. The changes of the last few months suggest that we are finally moving in that direction.

Dr Martin Weale is Director of the National Institute for Economic and Social Research.