Once again the UK is experiencing two diverging economies. A booming service sector and strong domestic demand lie alongside a weak manufacturing sector possibly on the brink of recession. While two-speed economies are not a new phenomenon, the present dual economy is different both in its persistence and through the influences and implications of current economic policy.
A two-tier rate of growth between manufacturing and the rest of the economy has persisted since 1990, with the divergence increasing since 1994. Between 1990 and 1997 manufacturing output grew by just 4.4%, compared with 13% for the economy as a whole. Such low growth in manufacturing output feeds on itself and has an indirect effect on those sectors which supply manufacturing industry. A change in manufacturing output leads to a change in GDP. Thus while manufacturing accounts for 23% of GDP, a rise in manufacturing output of 1% leads to a 0.44% increase in GDP.
The table compares the actual growth in UK GDP (dual economy) with that which would have occurred had manufacturing output grown at the same rate as that for the whole economy (single economy). It illustrates that if such a divergence in the two economies had not persisted since 1990, UK output and employment would have been quite different. GDP would have risen by 17.4% during the period rather than by 13.2%, and UK employment, of which manufacturing accounts for 18% directly and 4% indirectly, would have grown as opposed to falling. If other factors held constant, there would have been a reduction of the unemployment rate to 3.2% in 1997 and a 15% rise in GDP per head, leaving it 3.7% higher than its current level.
Further persistence of a dual economy through low growth in manufacturing will significantly reduce GDP growth, as happened in the first half of the 1990s. The longer a two-speed economy continues the greater the effects on long-term growth and living standards. Far from rectifying the situation, the present economic policy is exacerbating the problem.
In the aftermath of Labour’s first two Budgets it appears that the Government has not only given the Bank of England independence in setting interest rates in pursuit of an inflation target, but also nominated the Monetary Policy Committee as the sole macroeconomic manager of the economy. The latest Budget was used as a redistributive tool with some microeconomic adjustments to enhance long-term growth, but it was not used to carry out macroeconomic management. Thus, in effect, interest rates have become the sole tool to manage cyclical movements in the economy.
Use of a single blunt instrument to manage the economy is fine if all sectors are moving together, but it cannot, on its own, rectify an imbalance in the economy. In fact it is liable to worsen the situation, especially when the two sectors react differently to that single tool.
Today any further interest rate rises will slow the growth in consumer demand and in turn service and manufacturing output and will also cause sterling to appreciate, bringing additional detrimental effects specific to manufacturing growth and exports. This situation is reminiscent of the Thatcher period where, again, a single policy and one instrument this time interest rates to control the demand for money was used to manage the economy. High interest rates and the subsequent appreciation of sterling in the early 1980s had a dramatic effect on consumer and investment demand for manufactured goods.
Despite fiscal policy being out of vogue, it should have a role in macroeconomic management. When a dual economy persists, more than one economic tool is needed to bring the economy back in balance.
To rectify the current imbalance, specific fiscal incentives could be used to boost manufacturing output. However, this is returning to the old argument that ‘manufacturing is special’, and tends to be counter-productive in the long run.
Alternatively, fiscal policy can be used as a general tool for macroeconomic management alongside monetary policy. Fiscal tightening through consumer taxes to halt rising consumer demand and output would allow a loosening of monetary policy to boost manufacturing through increased exports. After all, the impact of rising exports on GDP is far from insignificant.
Jane Croot is an economist at the Foundation for Manufacturing and Industry in London