Economists do not predict the future, and can't explain the past

The financial crisis surprised the 'experts'. Now they can't agree on the reasons for the recovery

Ben Chu
Saturday 16 August 2014 19:16 BST
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We know that economists are no great shakes when it comes to foretelling the future. But the past? That must be within their capabilities? Just how hard can it be to explain? The answer is harder than you might think.

Consider the UK's recovery. The data shows that the economy started growing at a reasonably strong rate in 2013. The Bank of England last week said it expects GDP to grow by 3.5 per cent this year, which would be the quickest rate among large developed nations. So what happened? Why, after two years of stagnation, did the blood of commerce, expenditure and general economic activity start flowing?

"Two Jews, three opinions," goes the old joke. Well that seems to be true of economists too. According to some, the explanation can be found in the dwindling impact of George Osborne's austerity policies. They point to estimates from the Government's official forecaster, the Office for Budget Responsibility, which show the drag on annual growth from the Chancellor's consolidation measures (the tax rises and spending cuts of his "emergency" 2010 budget) easing in the 2013-14 financial year. That's roughly when GDP started growing again, they note.

Another common opinion is that Mr Osborne's housing market subsidies unblocked the arteries. The Help to Buy scheme in the 2013 Budget, according to this view of the world, sent a powerful signal that the Government wanted to see house prices rise and, indeed, was prepared to use taxpayers' money to make sure this happened. This sent house prices up, which boosted consumer confidence, which led to more household spending and, finally, higher GDP.

Others say that the Bank of England, rather than the Treasury, turned the tide. They argue that the stimulus from Quantitative Easing (the £375bn of new money injected into the economy through the Bank's acquisition of a large chunk of the British government bond market) had the desired effect on aggregate spending. The recovery, in short, followed the money.

But some economists argue a different Bank of England scheme should take the credit. They say the Bank's 2012 Funding for Lending Scheme (channelling cheap funds to commercial banks) ended the great contraction in banks' balance sheets and encouraged them to lend. This new lending, these analysts say, was what boosted the housing market and, thus, the confidence of consumers and spending.

Still others tend to look overseas for the explanation. They note that the eurozone crisis abated in the summer of 2012 when the President of the European Central Bank, Mario Draghi, pledged to do "whatever it takes" to prevent the eurozone breaking apart. These words calmed global financial markets and so helped to ease financial conditions in Britain indirectly. British businesses and households also responded to the waning of the single currency crisis and the fall in the price of credit by loosening their purse strings. It was "super Mario", then, to Britain's rescue.

Of course many economists say a mixture of these influences played a part. But it is nevertheless striking how they place varying weight on each factor. We are a year-and-a-half into the recovery and no single narrative of how we got here has taken root.

Does it matter? It does, because if the analysis of the recovery is wrong, then misguided policy could easily follow. For example, if rising house prices are the main prop of growth then it could be dangerous for the Bank of England to put up interest rates too soon. Conversely, if it was monetary policy that did the trick, then policymakers should probably be looking to wind down the low interest rate stimulus now. Otherwise they could risk overdosing on a powerful medicine.

We are not completely in the dark.The data shows that growth over the past year has been mainly driven by services output and household consumption. Household incomes are lagging behind spending and the gap has been filled by a reduction in the savings rate. Overall bank lending has not, in fact, grown much. And trade isn't providing a consistent boost to the economy. The trade deficit remains worryingly wide. Investment by businesses is higher than it was a year ago but, again, the data shows that this hasn't been driving overall expenditure. In short, the long desired rebalancing of the economy towards manufacturing, exports and investment has not yet happened.

Economists are likely to continue to disagree over what led to the return of growth. But while this fundamental macro-economic imbalance persists, the argument that the recovery is not as robust as some of the figures suggest will, justly, be persuasive.

Hamish McRae is away

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