Britain's GDP: A Caveat and Two Threats

The 0.7% qoq GDP contraction reported yesterday by Britain's Office of National Statistics (ONS) is hard to believe, and the presentation of the accounts are unhelpfully opaque, so very hard to analyse beyond the bullet-points given.  But if true, there are two big problems coming Britain's way over the next year.

• First, the surprising resilience of UK labour markets is explicable – but there's no reason to expect it to survive much longer.
• Second, unlike what we see in other economies (US and China for example) the contraction in GDP cannot be ascribed to the private sector ratcheting up its private sector savings surplus in response to the unfolding Eurozone catastrophe. In this powerful sense, Britain's recession hasn't even started yet. Even if it has.

So if the UK's preliminary GDP data is roughly accurate, we should be very worried by them, because the structure of growth suggests there's plenty of potential for things to get worse, not better, in the medium term.

The Caveat
But before any analysis, we need to pause to register some serious caveats about these estimates. Two problems should be immediately acknowledged. First, the way this data is presented by the ONS is about as opaque as any outside China. Economists are presented merely with a number of bullet-points breaking down growth estimates by very broad industry groups, and a few movements of chain-weighted indexes. Good for a powerpoint presentation, high on media-impact, but effectively useless for anyone trying to dig into the data.

The second problem throws more light on the first: recent GDP estimates have been hard to square with other data which is available. For example, if one tracks momentum of domestic demand by looking at employment, retail sales and vehicle sales, you simply don't see a picture of a deepening recession.

Similarly, someone needs to explain the massive difference between what the construction industry is telling Markit's pollsters, and what it is telling the Office of National Statistics. One or the other is grievously wrong – and I don't know which.

More generally, Britain presents a major problem of : 'if they can't measure it, I can't forecast it'. Outside the M25, Britain's economy is characterised by an unusually high degree of globally-operating service businesses, run by an army of individual entrepreneurs usually unwilling to tangle with the regulatory nightmare of European labour laws. How do you observe their economic output? I live in a North Yorkshire village which to all outward appearances depends on farming and tourism, but where a surprisingly high proportion of my neighbours, like me, trade with the world and live and die by the internet. Can the ONS really count the number of films made, the foreign surgeons trained, the fashions planned, the long-distance management of farms in Argentina and Ethiopia – all work which goes on in our sleepy backwater? Even in theory, that's hard. In practice, I doubt it's possible.

The opacity of presentation, the divergence from other data, and the improbable difficulty of the task – none of this necessarily means the 2Q GDP estimate is 'wronger than usual'. But the caveats should not be ignored when trying to work out what's likely to happen next in the British economy.

For now, though, the caveats are over. For the rest of this piece, I shall take the data at face value. Doing so uncovers two potentially serious threats which we can expect will intensify the cyclical downturn from here: the first is to do with labour markets; the second is to do with savings behaviour and domestic demand.  

Threat One – Labour Markets

The fact that labour markets have been relatively buoyant throughout this depression has baffled many. Between the onset of the current phase of recession (back in June 2011, apparently) and May, Britain's employed workforce has risen by 89k, and on current trends this will have risen to 150k by June. May's data shows a growth in employment of 75k over a year; 370k over two years; 356k over three years; and 197k over the pre-crisis May 2007. Britain's economy may be dying, but you wouldn't know it from the employment data.

This becomes less mysterious if you grapple with what's been happening to real labour productivity. I attempt this by deflating real GDP output per worker by movements in the amount of capital per worker. (As usual, I estimate a country's capital stock by depreciating all gross fixed capital formation over a 10 year period). The cyclical pattern which emerges is hardly surprising: the underlying trend since at least 1998 is for real output per worker to drop about 2% a year. The financial crisis initially led to a drop of over 8% on this measure – a typical cyclical event. During 2010 and 2011 as capital formation slowed sharply, and the initial layoffs were made, the picture changed, with this measure of real labour productivity rising around 2% in 2010, and about 1% in 2011. As the chart below shows, what was happening was simply that labour productivity was catching up some of the ground lost in 2009. As that improvement occurred, it made sense that labour markets would recover.  

The problem is that the gains of the last three years have now returned productivity to its trend-level. No further gains in productivity (relative to trend) are being made, it seems. If so, it's not clear why we should expect the relatively buoyant labour market conditions to be maintained.

Threat Two : Savings Behaviour

The second problem is over something that hasn't happened: unlike in the US and China, whatever is driving the renewed recession, it is not the result of the private sector taking fright at the future and so scaling up their savings surpluses at the expense of current consumption and investment. Indeed, so far as one can tell (from the trends in Britain's public finances and current account balance) during the last year Britain's private sector savings surplus (PSSS) has fallen from around 5.4% of GDP to around 2.5% (on a 12m basis). The crucial thing to bear in mind is that a retreat in the PSSS represents a rise in the proportion of income/profits spend on consumption/investment – in other words, it is a boost to domestic demand over and above the current rate of income/profit growth.      

The threat, is now that this ratio will start rising again, pushed by either an intensified recession, or renewed alarm about developments in the Eurozone. This, after all, is what is happening in major economies elsewhere in the world (China, Japan, US). I can see no reason not to expect it in Britain. If so, the fact that the ratio continued to fall quite sharply during 1H12 means that the whiplash impact on domestic demand in Britain during the coming year is likely to be sharper than expected, and sharper than that developing elsewhere in the world. In short, based on private savings behaviour. . . . the recession hasn't started yet. Even if it has.