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On diminished expectations

Expectations for the UK economy are low. This is a problem, as expectations can be self-fulfilling
July 19, 2018

Back in 1989, Paul Krugman wrote a book called The Age of Diminished Expectations. He was 30 years ahead of his time, because now is truly the age of diminished expectations.

We’ll see this next week. Official figures then are likely to show that the UK’s real GDP grew by 0.3- 0.4 per cent in the second quarter, and this will be welcomed as a pick-up after the first-quarter’s sluggish growth.

In truth, though, there’s nothing impressive about this. It’s only half the average growth we saw before the crisis; in the 50 years to 2007 growth averaged 0.7 per cent per quarter. What would once have been a sign of a slowdown is now welcomed as a recovery. Our expectations are diminished.

There are, of course, good reasons for this. Brexit and ongoing fiscal austerity are exacerbating weak productivity growth.

Some of you might think that such low expectations are merely the result of “Project Fear” talking down the economy’s prospects.

Even if this is the case, however, we have a problem: low expectations can be a cause of weak growth in themselves. As Olivier Blanchard has pointed out, pessimism reduces capital spending. The share of business investment in GDP is now lower than it was in 2015, despite the fact that increased capacity utilisation should now be raising it. And Christopher Gunn at Carleton University notes that diminished expectations can cause low productivity growth. If companies expect low demand they’ve less incentive to innovate. And if they believe their rivals aren’t innovating, they’ve less need to improve their competitiveness by doing so themselves.

Low expectations, then, can be self-fulfilling.

You might wonder, though: are expectations really so low? The fact that savings ratio is low and stock market high suggests otherwise.

Certainly, there are some signs that investor sentiment is high, such as the high ratio of Aim shares to the FTSE 100. But, on the other hand, the FTSE 250 has underperformed the MSCI world index (in sterling terms) in the last seven years. That’s a sign that investors’ expectations for UK growth are weak.

Nor is it the case that consumers are ebullient. The low savings ratio probably reflects efforts to maintain spending in the face of a long squeeze on real incomes rather than any optimism about the future. In fact, from another perspective, spending is low. The ratio of retail sales to the All-Share index is below its post-1996 average (when current official sales data began), and significantly below its post-2002 average. This matters a lot, because this ratio has in the past helped predict both GDP and the All-Share index, with a low ratio leading to low growth in both.

Again, this is consistent with diminished expectations being self-fulfilling; if consumers expect low incomes, they’ll spend less and this of course causes low incomes.

Pessimism, therefore, is a threat to the economy whether it is well-founded or not. Which poses the question: what if anything can be done to increase expectations? An obvious possibility would be for the government to adopt policies which will actually raise future GDP. As for the chances of this happening, well...