Rising productivity is boosting the UK's growth rate, and may even justify a high rate for sterling

The recent economic review of the National Institute of Economic and Social Research on the state of the British economy takes an interestingly different stance from its rivals. Like them, it forecasts a UK base rate peak of 6½ per cent - if only to guard its flank against what might be decided today. But whereas other reviews warn of dangers, the NIESR is more upbeat.

It expects growth of over 3 per cent per annum both this year and in 2001 - above the estimated 2½ per cent trend growth rate of the British economy. As that is - outside the international exposed manufacturing sector - operating at pretty near full employment, the conventional response is to talk of overheating and to put the blame on the bump in spending indicated in the Public Expenditure Review.

The reason why the institute is more sanguine is fairly straightforward. It does not depend on a new paradigm or any other such fantasy. It is straightforward elementary economics. Productivity has been rising at well below trend since the mid-1990s, just as much under the Labour as under the previous Conservative government. The NIESR attributes it to the absorption into the labour force of the most marginal and least productive workers. But as they become more fully integrated their productivity is likely to rise.

There is an even simpler way of reaching the same conclusion, which would have been familiar to the celebrated English economist David Ricardo two centuries ago. This is that if you increase the amount of labour working with a given stock of capital eventually you get into "diminishing returns". (Hence the law of the same name). On this analysis, productivity will recover once the capital stock catches up with the rising labour force.

The first chart shows why the NIESR calls it only a mini-miracle. Productivity is simply returning to its earlier trend rather than breaking through to new ground. Thus the NIESR forecast, even if true, does not itself validate the target the Treasury has set for itself of trend productivity growth above 2½ per cent. For that to happen output must grow by the expected 3 per cent for several more years.

I have previously criticised the use of productivity as a sufficient policy objective for the euro-zone, much of which suffers from deficiencies in employment levels. The eurocrats have in essence accepted this critique by talking about the need for "job-rich growth". This is a euphemism for growth with low productivity. There is nothing that turns me off the EU more than these ghastly euro-euphemisms.

Why has UK unemployment been able to fall so far without an acceleration of inflation? The Organisation for Economic Co-operation and Development has helpfully put together a list of likely reasons on page 35 of its recent report on the UK. The writers of these reviews are clearly sympathetic to New Labour. But they are analysts and not spin doctors. Their list of factors contains some of Labour's reforms. But they also highlight the decline of union membership, the decline of out-of-work benefit relative to in-work income and other items going back to Margaret Thatcher's government of the 1980s, none of which would be mentioned by Gordon Brown, the chancellor.

The NIESR review also looks at possible criticism from the other side - the growth merchants. These might claim that, despite the improvement in the unemployment figures, the UK still has a lot of hidden unemployment shown by the relatively low level of participation in the labour force. But there is an impressive chart showing that this under-utilisation of labour occurs mainly in the more depressed regions in the north and west. In the south-east, utilisation is just as high as it was in earlier boom periods.

Of course, the optimistic forecast is subject to numerous caveats. One of the main ones relates to spending. The NIESR forecasts a gradual recovery of the household saving ratio from the low value of 3.8 per cent of income in the first quarter of this year to an average of 6 per cent in 2002. The basis for this seems to be the well known device of "regression to the mean". If you know a better method, please send it to the NIESR on a postcard.

The authors still hope that fiscal policy can be used to offset any unexpected buoyancy in consumer spending. Some hope! When the UK economy looked as if it might be heading for a hard landing at the time of the Asian crisis of 1998-99, Mr Brown did not hesitate to use his margin of manoeuvre within his fiscal guidelines to give the economy a small stimulus. But when he came to the opposite problem of an economy working at full stretch, he did not hesitate to add to the burdens on it with his expenditure review.

Nor is this a particularly British perversion. Almost every international economic body tells the Irish Republic, which is regarded as having too loose a fiscal policy, to raise tax. But this has been ruled out by the Irish government because its incomes accord with the unions calls for lower rather than higher taxes.

The discrepancy in demand pressure between different UK regions shows how difficult it is to set a monetary policy for the whole of the UK. Does that mean that the difficulty will increase if the UK adopts the euro, and the ECB has to set a single interest rate for a large slice of Europe? Wilhelm Buiter, until recently a member of the Bank of England monetary policy committee, thinks not. He argues that discrepancies in demand pressure between different countries in the euro area are not inherently greater than differences inside individual countries. (Centre for Economic Performance, Report 462).

The most interesting conclusion of the NIESR review is that sterling is not nearly as overvalued as popularly supposed. It argues that traditional signs of over-valuation would be a large budget deficit associated with a balance of payments deficit and a depressed economy. But the British economy is not depressed and there is a large budget surplus.

Moreover, the recovery of productivity will reduce over the next few years any residual overvaluation. "This small scale productivity miracle makes it possible to join the euro at an exchange rate of E1.55 to the pound despite the fact that it is high compared with past experience." The rate is equivalent to DM3.03 or a trade-weighted average of just over 103.

An upward revision of the likely equilibrium exchange rate matters irrespective of European monetary union. It will disappoint the most vulnerable exporters who would have hoped for a bigger fall to make their products more competitive. But for the rest of us it will, if true, be good news, as it will mean that the UK can trade on better terms with the rest of the world.