Unnatural rate of growth

In recent years, both the British and US economies have grown at a rate far exceeding what was regarded as their rate of growth of productive potential, but with minimal inflation.

How is that possible, and can it last?

On an orthodox view of the world, such a happy combination of circumstances is not possible because the growth of productive potential is taken as rigid, as if given by God, and inflation is assumed to result from actual output growth in excess of potential output growth.

The growth of productive potential is often referred to by economists as the natural rate of growth. The term was coined by the Oxford economist Sir Roy Harrod.

What has become apparent from the experience of the last few years, however, particularly in the US, is that there is nothing natural about the natural rate of growth (just as there is nothing natural about the natural rate of unemployment), and that the underlying growth rate of an economy is very responsive to the pressure of demand (or actual output growth).

If wage inflation is moderate as the economy expands and unemployment falls, it is possible to sustain high growth rates for long periods without inflation. This is basically because demand creates its own supply and there is no pressure on costs.

There are a number of ways in which the growth potential of an economy responds to demand. First, the labour force is extremely elastic. The unemployed are drawn into work, participation rates rise, hours worked increase, part-timers work longer, and countries often draw on migrant labour.

Secondly, the growth of labour productivity responds to the growth of output itself. Growth encourages capital accumulation which embodies technical progress; higher output brings scale economies, and the higher the level of output the more adept workers become (learning by doing).

Miguel Leon Ledesma and I show in a forthcoming paper* that in all OECD countries in the past 35 years, the underlying growth of economies has expanded by roughly 60% of the increase in the actual growth of output, and by more in countries with higher labour reserves such as Greece and Italy.

Two major factors constrain output growth and therefore put a brake on the real growth of living standards; one is inflation and the other is the balance of payments.

The conventional wisdom in the US and Britain used to be that the inflation rate would take off if output growth exceeded 2.5%-3% because this would push unemployment below some natural rate leading to a wage-price spiral.

Experience has shown that the concept of a natural rate of unemployment is a theoretical construct with no empirical counterpart that can be identified.

It all depends on wage behaviour. Not so long ago, the natural rate of unemployment in the US was said to be 8%. When unemployment came down to 7% without accelerating inflation, the natural rate was redefined as 7%.

When unemployment came down to 6%, the natural rate was redefined again. Unemployment is now less than 4% and there is still no sign of accelerating inflation.

The same story can be told for the UK. What both economies have demonstrated is the simple Keynesian point that sustained demand expansion can lead to sustained higher output growth without infla tion as long as supply responds and costs don't rise. Euroland would do well to take a leaf out of the Anglo-Saxon book and try the same medicine.

In the present benign climate of wage negotiations - a far cry from the turbulent years of the 1970s when the golden age of growth without inflation of the 1950s and 1960s was brought to a sticky end - the most likely check on the growth of output will be the balance of payments.

In Britain the deficit to GDP ratio is approximately 2%, while in the US it is 4%. Not even the US can go on borrowing indefinitely, although it is not easy to predict when the world's investors will at long last lose confidence in the strength of the almighty dollar.

Until then, faster growth than experienced in the 1970s and 1980s, but perhaps not as fast as the 1990s, should be sustainable provided wage demands do not accelerate.

The elasticity of productivity to output growth is not something temporary, and reserves of labour still exist to be tapped.

• The Endogeneity of the Natural Rate of Growth, published in the forthcoming Cambridge Journal of Economics.

Tony Thirlwall is professor of applied economics at the University of Kent at Canterbury