The recent OBR report on the UK economy suggests that the recent financial crisis / recession has led to a decrease in the UK's long run trend rate. They have downgraded growth forecasts to 2.35% until 2013, and then fall back to 2.1%. For similar reasons, the OBR has cut the estimate of the amount of spare capacity in the economy at the end of 2009 - from 4% of GDP to 2% of GDP.
A lower average growth rate (long run trend rate) means the economy will expand at a slower rate. It means tax receipts will grow slower than expected, making it more difficult to reduce budget deficit.
If the data about spare capacity is correct, it means demand pull inflationary pressures may return sooner than expected.
A prolonged recession has the capacity to reduce long run trend rate of growth because:
- Rise in unemployment can lead to loss of skills, people becoming demotivated, leaving labour market early (e.g. going on disability benefits)
- The recession highlighted the flimsy nature of a consumer led (asset price) driven growth.
- Financial sector has taken a hit
- Banks become more cautious in lending, making finance more difficult.
- Change in attitude by consumers and firms.
The bad news about the report is that growth forecasts of 2.25% don't really take into account
- prospect of spending cuts
- prospect of European wide slowdown, from Euro austerity packages.
- Growth forecasts for 3-4 years in future are notoriously difficult to predict. Given volatility in the world, a lot can change.
- If we are willing to turn a blind eye to inflation, then loose monetary policy may be sufficient to offset the deflationary impact of fiscal policy.
- It may also be too early to judge about the long run trend rate of growth. Technological factors may still enable 2.5% growth.