The benefits of rising output, as of most things, are subject to diminishing returns

One of the many disadvantages of the British Budget ritual is that interesting information released on that day gets crowded out by the inevitable preoccupation with headline Budget decisions.

This has been the fate of a Treasury paper entitled Trend Growth. This is almost entirely analytical. There are expressions of hopefulness in separate boxes attached to summaries of government reforms and consequent references to upside risk. But the basic analysis shows no partisan bias and contains some remarkable findings.

The most interesting is exhibited in the first chart of the growth of output per hour. Despite the obsession of governments of different persuasions with productivity, its trend has shown almost no change over 30 years, veering on either side of 2 per cent per annum. An authoritative study by Professor Nicholas Crafts suggests that recent productivity growth is faster than in the 80 years from 1870 to 1950 when output per hour grew by 1 ¼ per cent per annum. But it has been slower than in 1950-73 when it was 3 per cent and may still have been affected by post war catch-up. The overwhelming impression is that UK productivity growth converges towards 2 per cent. (Britain's Relative Economic Performance, 1870 to 1999, Institute of Economic Affairs).

Of course bad government policy can make matters worse, as we see in Argentina. What has probably happened in Britain is that mistaken courses have provoked a reaction which has led to their own reversal. For instance when union power was threatening in the 1970s to make Britain the sick man of Europe, there was first the sterling and IMF crisis and then the election of Margaret Thatcher.

Given the stability of underlying performance, why have there been such great changes in Britain's position in the international league tables? In the first few post war decades, continental productivity was rising faster than Britain's until eventually it overtook it. In the last two decades of the 20th Century, under the Thatcher, Major and Blair governments, UK performance has not improved, but continental productivity growth has slowed down. Thus the adverse productivity gap has stopped widening but not been reversed.

Some europhile economists have suggested that joining the euro would promote a productivity breakthrough. A thorough-going productivity study by Mary O'Mahony in the April National Institute Economic Review concludes that "trends in productivity largely reflects long term structural aspects but that EU membership might have a small favourable impact". Like Crafts she attaches most importance to factors such as the skills of the labour force, the rate of introduction of new technology and competition and regulation.

A more euro-enthusiastic article by Ray Barrell in the same issue suggests that "the variability of inflation and of interest rates should be reduced in the euro and that greater transparency of prices will enhance competitive pressures". But Barrell himself has a chart showing that entry above around E1.50 or E1.55 to the pound would depress output over the next five years. He warns too that "even if the rate looks right on entry, circumstances may change and a realignment of the dollar and the euro may produce strains in the UK that would be larger than in other EMU countries". Medium term
fluctuations in output are not of course the same as underlying productivity. But they could easily undermine the stability argument.

The existing 2 per cent trend rate of UK productivity advance is in fact quite tolerable. It involves an approximate doubling of income per hour over 35 years - only slightly worse than the doubling of living standards over a generation towards which, RA Butler, Conservative chancellor in the early 1950s, looked forward and which was nearly achieved.

We have not reached economic saturation; and gains in real income are still desirable. But the benefits of rising output, as of most things, are subject to diminishing returns.

Stability in the sense of moderating cyclical fluctuations and low inflation become important in their own right. So do other matters such as the environment - in the true sense of our visual and cultural surroundings - and the attack, not on "inequality", but on poverty.

The underlying stability in productivity has been obscured by large year-to-year fluctuations reflecting the economic cycle and other shocks. Such fluctuations have been much less in the last eight or nine years than in earlier periods. The change came too early to be associated with the election of the Labour government. If there is any policy event which marks off the recent period it is the adoption of an inflation target which came after Britain's ejection from the European Monetary System in 1992 and well before the Bank of England's formal operational independence.

But I would be cautious about attributing too much to any purely British policy. Greater stability has been experienced by most industrial countries. Events such as the Russian and east Asian crises, the pricking of the bubble in high technology stocks and - so far - even the terrorist attack of September 11, have had a smaller effect than expected.

Given the past and prospective stability in UK productivity, we come to a lesser question. How does the Treasury justify raising the projected trend rate of output growth from the 2 ½ per cent it has used up to now, to 2 ¾ per cent per annum in the five years to 2006? The second chart brings out the main factors. In fact the projected acceleration is very moderate. About half simply reflects the fact that trend growth has been better since 1997 than originally projected, so that earlier estimates seem too cautious.

It is simplest to make comparisons with the last full length economic cycle from 1986 to 1997. Comparing this cycle with the period up to 2006, there is expected to be some gain in output from taking up the slack which existed early in the early 1990s. On the other hand the employment rate for people of working age is expected to rise less rapidly.

These effects cancel each other out; and the whole of the net improvement results from a faster increase in the population of working age, itself reflecting almost entirely expected legal immigration. Here too the change has already occurred;and all that has happened is that the government actuary has adjusted his projections upwards in line with events. Quite sensible, but not evidence of a breakthrough in economic performance.

Postscript

Is the 2002 Budget likely to threaten economic performance or increase instability? It represents a fiscal loosening compared with what was expected last year. But by then policy was already stricter than originally envisaged under the medium term guidelines. If every chance tightening of the policy stance is to be built in forever into the medium term framework, we would see a continuous policy tightening until the national debt is entirely repaid!

A more valid criticism is that budgetary policy will be adding to demand pressures in coming years. There will thus be more upward pressure on interest rates than would otherwise be the case. This is something we could live with, at least outside the euro; and it may in any case be desirable to put a curb on the housing boom and the rapid rise in consumer debt. A more serious criticism is that the government has played down the likelihood of further tax increases to finance National Health spending after 2006.

In fact Gordon Brown has got away with a falsely modest impression of the latest tax rises. Popular attention has concentrated on the one per cent increase in employees National Insurance contributions. Business criticism has concentrated on the one percentage point increase in employers contributions. Yet the economic effects are very similar and in total are equivalent to a two percentage point increase in the basic rate of income tax.

Unfortunately business lobbies have made the wrong criticism of the Budget strategy. The NI contributions are unlikely to have much effect on output, investment or employment. They will either be passed back in lower wage increases or passed forward in higher prices. The latter is slightly more likely, as the contribution increases are a common pressure known to affect all of a businessman's competitors, but need not price him out of foreign markets under a floating exchange rate. The small adjustments in the UK price levels can be fitted in under the existing inflation targets over two or three years.

The real criticism of the Budget is that it makes the tax system even more complex and any intention of helping smaller business is defeated. These criticisms apply just as much to the fiscal carrots as the sticks. Either businesses will be diverted from their proper role into investigating how to play the system; or the sanctions and incentives will be overlooked. Unfortunately organisations such as CBI were handicapped in making such criticisms because of their own prior enthusiasm for some of the carrots such as research incentives. The result will be UK performance less good than it otherwise might be but no worse than in the past.