The Bank of England needs a new method for predicting UK growth

THIS week’s barrage of economic figures confirmed a gloomy picture for Britain. The Bank of England’s inflation report suggests sluggish growth into next year – just 1 per cent in 2013. Jobs figures show high (though falling) unemployment – still at 7.8 per cent of the workforce. And Tuesday’s rise in inflation confirmed a squeeze on living standards.

But what lessons can we take from the past? During the 1930s, economic policy was failing, GDP was falling and unemployment soared. John Maynard Keynes reinvented economics, and explained how deficit financing could be used to help restore the economy. His General Theory of Employment, Interest and Money revolutionised economic thinking and transformed policy.

During the 1970s, the problem was inflation. Milton Friedman challenged economic orthodoxies by arguing that governments should be determined to reduce it, even at the cost of lost output and a rise in long term unemployment. Despite this, the cost was less than many had feared.

But can we reinvent economic theory again – like Friedman and Keynes – to help Britain cope with its current economic problems?

We shouldn’t be overambitious. As the West loses its monopoly over the production of sophisticated products, growth in Western living standards will fade at best, and there’s a real risk that they will fall. If someone opens a shop next door to you and sells the same things more cheaply, you have to assume that you will not be as well off as you were before.

Worldwide shortages of primary products will also create inflation, even as labour costs fall. Total world growth will be constrained by rises in the costs of commodities and energy.

We therefore need a different theory of economic growth to take account of these factors. We need to look at how inflation and the balance of payments interact to constrain growth. This new theory shows – significantly for Britain – that growth does not automatically bounce back to some traditional rate after an economic perturbation.

The Centre for Economics and Business Research has used this theory for some years, and we believe it explains why we have been the best in the UK at forecasting GDP. Both the Office for Budget Responsibility and the Bank of England could improve their forecasting if they adopted our new theory and our approach.

More important than getting the forecasts right, however, is how improved forecasting could improve government economic policymaking. The government needs a better understanding of what drives and what constrains economic growth. Taking this new theory into account, the government could fine-tune its deficit reduction strategy and make it less painful and more successful.

First, it should stop using tax rises to reduce the deficit. The rise in VAT and the potential future rise in fuel duties are a shot in the foot.

Second, it should be honest with the public about how public spending has spiralled out of control. Public spending should be reduced, not because of the deficit, but because it has risen beyond the point when it yields significant benefits. It now results in seriously damaging rates of taxation. We need a plan to reduce public spending over at least ten years.

Third, with a credible plan to reduce spending, there would be some scope for tax cuts, even at the expense of a temporarily higher deficit.

Finally, the government should give up on dodgy accounting tricks to reduce the deficit. No one is fooled. If the economic situation can stand a higher deficit temporarily, it should say so directly. The markets will show some tolerance, provided it is clear that wasteful public spending is under control.

This approach won’t bring back the world of the late 1990s, when we had rapid growth and rising living standards. But there is no trick available that could do this. What it could do is edge GDP growth up a bit, however, and help accelerate the welcome fall in unemployment.

The chancellor’s hand contains no aces and few face cards. But there is still scope to do better and this new approach shows how.

Douglas McWilliams’s third lecture as Gresham professor of commerce, given with Charles Davis and Oliver Hogan, will be held in the Chartered Accountants’ Hall, Moorgate Place, at 6.30pm tonight. Professor McWilliams is also chief executive of the Centre for Economics and Business Research.

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