Forget the granny tax, forget the 50p rate of tax and forget the pasty tax. The most important, but least discussed element of last week’s Budget is the continuing evidence of Britain’s underlying economic weakness.

The Office for Budget Responsibility hinted at the scale of the problem, venturing the judgment that “potential output has grown a little less than 1 per cent per annum, on average, since the recession ended”. Averages hide many sins and the OBR’s words underplay the more recent crisis on the supply side of Britain’s economy.

In 2011 the economy expanded by only 0.6 per cent, excluding the effects of North Sea oil, while the OBR’s estimate of spare capacity in the economy shrank by 0.7 per cent. Without saying so, it has judged that Britain’s potential output fell in 2011.

If true, this is as striking as it is worrying. If the trend continues, Britain will be much poorer in the long term than we currently expect. The situation will require greater austerity than the seven years already planned as we cannot expect growth to do as much to eliminate the deficit. And interest rates will have to rise well before the economy regains the output lost since 2008, as the lack of spare capacity will prove inflationary.

The OBR’s assessment of supply- side weakness raises three important questions. Is it reasonable? What is the cause? And will it last?

Since the growth of potential output and spare capacity are concepts that cannot be measured, the first question does not have a precise answer. But it is hard to refute the OBR’s estimate that the economy is running with spare capacity of 2.5 per cent of national income or that spare capacity has fallen over the past year. Cyclical indicators – reasonable guides in the past – underpin the calculation. Unemployment at 8.4 per cent is consistent with the OBR’s guess. Productivity growth has been feeble. And the OBR’s figure is bang in the middle of other economists’ punts.

The current evidence suggests several causes for the economy’s underlying weakness.

There is little doubt that a credit squeeze is part of the story, limiting small companies’ borrowing and productive investment (though we should not exaggerate the financing constraint on investment when small companies contribute only about 20 per cent of the total). Another factor is weakness in the output and productivity of the financial sector as it adjusts from the unsustainable business models of the last decade.

The fact that in much of the service sector employees have to work harder to make sales also reduces the amount they can reasonably expect to produce. And some companies have hoarded labour, for fear of recruitment difficulties when the upturn comes.

To these well-known reasons, we should now add the worrying earnings trends of people in their 20s. These have stagnated in real terms for a decade, suggesting that in the labour market, younger people fail the L’Oréal test – they’re not worth it. As they become an ever larger part of the workforce, this may be a problem for everyone else.

The one reason advanced that may not stack up is that austerity is causing tomorrow’s supply problems. Certainly long-term unemployment erodes people’s skills and corporate failures destroy some productive capacity, but there has been less of both than expected. Long-term unemployment is far lower now than after the recessions of the 1990s or 1980s. As Adam Posen, external member of the monetary policy committee, said last month: “I do not think our supply capacity is eroding very quickly and, therefore, we do not need to worry about the output gap in the near term being closed by supply constraint.”

Without one overriding cause of weak potential growth, the UK authorities cling to the belief that, while they have revised down their estimates of potential output growth for nearly five consecutive years, things will soon return to normal. The OBR expects good times to return to the UK supply side at about the turn of 2013 to 2014.

This is a guess based on an assumption that the financial sector will claw its way towards a stable position in 2014. We have to hope the OBR is right. If 2011 represents the shape of things to come, Britain’s glory days are not about to return.

Get alerts on UK Budget when a new story is published

Copyright The Financial Times Limited 2019. All rights reserved.
Reuse this content (opens in new window)

Follow the topics in this article