Economic prospects. Nasty awakening

Date: 15/10/05

...after a nice decade

IN HIS first speech after becoming governor of the Bank of England in 2003, Mervyn King dubbed the period since 1992 as the nice--non-inflationary consistently expansionary--decade. In a speech on October 11th, he said it was unlikely that the next ten years would be so pleasant.

There are immediate worries about both inflation and growth. Inflation has risen over the past year from 1.1% to 2.4%. Growth has slowed to 1.5%, its lowest for 12 years. Mr King said that the Bank's interest-rate-setting committee had been surprised by both the economic slowdown and the rate at which inflation had picked up.

No more than half of the acceleration in inflation could be ascribed to higher oil prices, the governor argued. There were broader inflationary pressures from an economy operating close to its capacity. Furthermore, the rise in oil prices would dent capacity growth by making some capital equipment unprofitable to use. Such remarks suggested that Mr King, who voted against the cut in interest rates in August, is likely to oppose a further reduction in November.

Mr King's hawkish stance was backed a day later by the OECD which said there was "not a compelling case for further rate cuts". Although it is now forecasting growth of only 1.7% this year, the OECD said in an economic survey of Britain that the level of output was close to capacity. It also gave warning that tax rises were needed for the government to meet its fiscal rules.

The OECD pinpointed a number of structural flaws that are likely to hold back the economy in the longer term. Low productivity remains its Achilles heel, with no clear signs of any recent pick-up in its trend growth. As a result, Britain remains stuck behind other countries such as France and America in GDP per hour worked.

Poor skills contribute to the productivity gap. Compared with most other advanced countries, British workers are poorly educated. This may help to explain why investments in information technology have failed to push up productivity growth, unlike in America.

Another brake on productivity growth is poor transport infrastructure. But the OECD reserves its fiercest criticism for Britain's record on innovation which it describes as "mediocre". Across a range of indicators, including R&D spending, patenting and the employment of scientists and researchers, Britain scores badly compared with top-performing countries.

The report also highlights the worryingly high level of people on incapacity benefits. The share of prime-age (25-54) men who are inactive because of illness and disability is the highest among OECD countries.

The government is striving to tackle these weaknesses, but its efforts do not seem to have worked so far. Indeed Labour has harmed the supply side of the economy by increasing the regulatory and pension burden on companies. As a result, both the economy's short-term and longer-term prospects are far from nice.