The economy in 2014

However, forecasters are usually wrong – not because they are stupid, but because the economy is inherently unforecastable. We can quantify this. My table compares the consensus forecasts made in December for GDP growth and RPI inflation the following year to their out-turns. This shows that the average error (ignoring the sign) in GDP forecasts has been 1.1 percentage points, and the average error in inflation forecasts has been 0.9 percentage points.

This numbers imply that we should regard the forecast of 2.3 per cent GDP growth next year as telling us to expect growth to be in the range of 1.2-3.4 per cent. And we should expect inflation to end 2014 somewhere between 1.5 and 3.3 per cent.

The question, then, is not: will the consensus be wrong? History tells us it will be. It’s: in what ways might it be wrong? Let’s take the bullish case first.

Any serious upturn requires that companies step up their spending; this is because higher corporate spending usually leads to increased consumer spending as it creates jobs and raises real wages. And there’s a reason to think that companies will indeed invest more. It's that economic sentiment is improving. One good measure of this is not just that share prices have risen, but that smaller stocks and Aim have out-performed. This is a sign that equity investors have become more optimistic and more willing to take risk. And this should – if history’s any guide – lead to boardrooms becoming more willing to invest in real assets such as capital and buildings.

It’s not just companies that might be preparing to spend more, though. So too are households. In recent months, there’s been a big shift in the composition of their savings – out of long-term savings accounts and into instant access ones. This could be a sign that savers have finally become so cheesed off with nugatory returns that they have decided to spend rather than save, and the money is in accounts waiting to be spent. This, of course, is exactly what the Bank of England intended to happen when it slashed rates in 2009.

But here’s the thing. Economic upswings tend to feed on themselves. One reason for this is that our spending decisions – like our investment choices and much else – are influenced by our peers. If our friends and neighbours spend more, so do we. A second reason is that expectations are infectious; optimism spreads through people in the much the same way that diseases do.

Although economic science has shown that these interactions apply to households, it’s highly likely that they are true for companies too. This implies that quite small initial upswings can become bigger as companies and households emulate each other and spend more. The fact that forecasters have tended to over-predict GDP in bad years and under-predict in in good is consistent with this.

Such an upswing might be amplified by something else – the possibility that monetary policy will stay loose.

The Bank of England has promised not to raise Bank rate at least until unemployment drops below seven per cent; it’s currently 7.6 per cent. And even if output grows nicely, unemployment won’t fall quickly.

One reason for this is that the stagnation in labour productivity since 2007 could end, which would mean that output will grow without creating many jobs. Nobody knows exactly why productivity growth has stopped, but there are at least two plausible reasons which are temporary.

One is that companies have hoarded labour in anticipation of an upturn. As this materializes, hitherto under-employed workers will work more, which will raise productivity.

The other is that productivity has been depressed by weak bank lending. Traditionally, a lot of productivity growth has come not from existing firms becoming more efficient, but from the Darwinian process of new, more efficient firms entering markets and inefficient ones exiting. The lack of bank lending, though, has slowed down the entry process and so retarded this source of productivity growth. But there are now signs of lending resuming; in the last four months, non-financial firms have been net borrowers from banks, having spent the previous four years paying off debt. If so, the entry process that raises productivity growth could return.

What’s more, even insofar as the recovery does create jobs, unemployment won’t fall one-for-one. There are 2.3 million people outside the labour market who want a job. And on average, over 100,000 of these find work each month. If this continues, employment will grow without a commensurate drop in the unemployment rate.

There’s a double benefit here for equity investors. Insofar as unemployment stays high, wage growth will stay low. This will tend to hold down inflation – thus adding to the assurance that interest rates will stay low. And insofar as productivity rises, such low wage growth will help to raise profit margins. Previous recoveries – such as those of the early 80s and early 90s – saw profits rise faster than GDP. History, then, points to this being an upturn for equity investors.

So much for the optimistic case. What of the pessimistic one?

This starts by noting three headwinds to growth.

One is that fiscal austerity will intensify next year. The OBR estimates that cyclically-adjusted net borrowing – a measure of fiscal policy if nothing else – will fall by 0.9 percentage points of GDP between 2013-14 and 2014-15. That compares to a fall of just 0.3 percentage points this year.

Secondly, although interest rates probably won’t rise next year, anticipations that they will do so will strengthen. This could encourage businesses and households to hold onto their cash in the hope of better returns.

Thirdly, the overseas environment isn’t favourable for UK growth. Purchasing managers surveys show that whilst the euro area is at least growing now, the recovery has if anything lost momentum recently. And in the US, economists suspect that GDP growth slowed in the fourth quarter, implying that it too is losing momentum.

The OECD forecasts that developed economies will grow by 2.3 per cent next year, after 1.2 per cent this. As there’s only been one year since 1995 in which the UK has grown by a percentage point more than the OECD average, this warns us that the odds are against strong growth here.

These headwinds matter because they could exacerbate the longstanding problem that companies are loath to invest. Signs of an improvement in sentiment raise the question: what are they supposed to invest in? For the last 11 years – that is, well before the recession – firms’ capital spending has been lower than their retained profits, in part because technical progress has slowed, or because such progress as there is no longer generates profitable investment opportunities . Sure, there’s plenty of talk of new technologies - 3D printing, graphene, self-driving cars, robots, drones, nanotechnology and suchlike – but the actual hard cash going into these is undetectable at the macroeconomic level. And given that there’s still plenty of spare capacity in the economy, firms have little need to invest in older, established technologies either.

Economic forecasters – especially the OBR – have been too optimistic about business investment for years. This warns us that there are structural forces holding back growth – the dearth of investment opportunities or secular stagnation. These haven’t disappeared.

It is, of course, silly to try to adjudicate between these bullish and bearish views; the future is inherently unknowable. Investors should never make big bets upon the future, but rather spread risk in such a way that they are comfortable with the risks they are taking. You don’t need futurology to do this.