By far the most important issue for modern economies is the ability to achieve and sustain economic growth. This does not necessarily mean the level of Gross Domestic Product, the total value of goods and services produced by an economy in a given year, but rather the annual increase in the actual living standards conferred by the full exploitation of technological advances. By way of illustration, just try to imagine your life had you lived in the year 1750, around the time when modern economic growth began. As a percentage of your wage, you would most likely pay a substantial amount on heating and lighting your home with candles and coal, have no access to running water, not be able to travel abroad due to the great expense of time and money, just about be able to fund a social life (consisting at best of limited reading, an infrequent trip to the theatre and the occasional sip of the relatively new imported luxury of coffee), and work back-breakingly long hours in your chosen profession. To make a bad situation worse, you would also lack any effective treatment for that broken back. In short, the world of 1750 was significantly poorer than it is today, a situation that is only partially reflected in the figures for GDP per capita growth.*

At the same time, while inequality of wealth or income may be a little higher than we would like, inequality of living standards has decreased dramatically. The difference between the 1% and the other 99 was once meat and fish on the table, affordable clothes, and the ability to comfortably survive the winter. In modern times, even some of the most dispossessed live an incomparably better existence than their ancestors. Think cheap cotton clothes, versus the fact that even wealthier, middle-class individuals less than a hundred years ago would only be able to afford two or three shirts, worn or passed down until they disintegrated. Within even living memory, relatively well-off families in the United States, the world’s economic leader, would resort to wrapping their family’s solitary pair of shoes in plastic bread bags or clingfilm in order to preserve them during the winter. Today, US families earning under $5,000 a year spend only 16% of their budgets on food, and 3.5% on clothing. That’s compared to the urban “middle class” family of 1901 spending a whopping 46% on food, and 15% on clothing.

The key point here is that economic growth trumps all other political concerns. It decreases the inequality that really matters, improves our health, prolongs our expected life-span, makes nearly every good or service you can think of cheaper over time, and even invents new ones to choose from. As individuals and as a society, we work significantly fewer hours than at any time in human history, and yet still create more value for the rest of humanity at the same time! By working fewer hours while increasing living standards, we have more time than ever before to spend with families and friends, playing sports, consuming entertainment, and engaging in progressing culture. In short, sustained and persistent economic growth is humanity’s greatest achievement; from its source, all else flows. It’s such a large and indisputable phenomenon, that some economic historians have taken to calling it “The Great Fact”.

The Remarkable Persistence of Trend Economic Growth

What created the modern world was a rapid acceleration in invention and innovation, followed by the marshalling of investment to exploit those new innovations to their full potential. Nevertheless, the Britain of the Industrial Revolution grew by only around 0.5% of GDP per capita for about a century.  In the modern day, however, we have largely managed to systematise that innovative process, while eliminating some of the barriers to growth such as imperfect capital markets. We now generally expect around 1-3% GDP per capita growth per year; anything less is labelled either stagnation or recession.

Indeed, what is most striking about trend economic growth is its remarkable persistence. Take France, a country that regularly practises the sort of extractive policies, with high taxes and burdensome regulation, which would generally suggest the strangulation of economic growth. And yet, France is wealthier in terms of GDP per capita than the UK. That is also the same France that had drastic political institutional changes in 1789, 1804, 1814, 1830, 1848, 1852, 1870, 1940, 1946, and 1958. The last time that Britain had any such sweeping political change was as long ago as 1688! One would expect the dramatic upheaval of formal institutions to significantly dent trend growth rates, but it seems as though a culture of innovation and investment is so persistent as to trump political change. This is not to deny the fact that some policies may harm economic growth or be costly to society, but that once they already have that tendency to innovate, people seem to do so even under substantially less-than-ideal circumstances.

This point can also be illustrated by evaluating the effects of pro-growth policies too. Most proposals for boosting economic growth either actively raise the amount of spending in an industry so that it can more fully exploit its technological potential; or else they seek to boost potential GDP and then wait for spending to catch up. You might broadly characterise these as demand-side and supply-side policies, respectively. However, neither of them will change the trend economic growth rate very much. That’s not to say that these policies may not boost the overall level of GDP, but that they are unlikely to have any effect on raising that underlying and broadly sustained 1-3% growth rate that we’ve come to expect.

Do any policies actually boost Trend Growth?!

The problem with demand-boosting policies is that while they result in some rather large short-term growth, they will only ever be one-off spurts: there is no way that they can boost spending beyond the technological potential. To illustrate, imagine a country with some farms that use horse-drawn ploughs, and others that use more productive tractors. Boosting agricultural spending by whatever means may result in all farms adopting the more productive tractors. This could very well achieve a rapid increase in economic growth, perhaps achieving that potential in a short amount of time. But ultimately, demand-side policies won’t do anything to boost the rate of growth once all farms have adopted tractors, at least until someone comes up with an even more productive machine.

On the other hand, supply-boosting policies may actually affect the trend rate of economic growth, but only by a tiny amount. Without accompanying demand-side policies to bring economic growth closer to its potential, all they do is raise the potential level of growth. The rate at which actual spending catches up with potential is estimated at around 2% of the gap per year. Thus, if you had a 2% growth rate and increased potential GDP by, say, a huge £1Trn from £16Trn to £17Trn, then the trend growth rate would only increase to 2.13% per year. A trillion pound increase in potential GDP is massive, and essentially unprecedented in terms of domestic economic policies, yet even then would only increase economic growth by a rounding error.

Nevertheless, there may be some policies that boost trend economic growth rates by further systematising the innovation process. If we could develop as a society from experiencing about 0.5% annual growth during the early stages of the Industrial Revolution to now expecting 1-3% annually, it is plausible that there may be policies to boost that trend rate still further. Despite the massive importance of such a change, the issue of increasing innovation within an economy is rarely discussed as part of the predominant political debate over economic policy. This largely stems from the difficulty in assessing changes – innovation is a gradual and incremental process, making it all the more difficult to measure. Indeed, both the origins of sustained economic growth in the 18^th Century and the original process of systematisation around the 1870s are still poorly understood, with little consensus among economic historians.

In the long-term, finding out what boosts innovation in a society could have transformative effects. While the difference between 2% and 4% annual growth does not sound like much, achieving it would involve a doubling of the rate at which we as a society enrich ourselves and increase living standards. As such, there ought to be greater emphasis in both academic and policy-making circles on finding out what causes an increase in the rate of innovation. 

There are, of course, a few candidate policies that might plausibly boost the rate of innovation, and might be a starting point for further study: encouraging greater spending by firms and individuals on Research and Development; directly boosting R&D spending by governments; ensuring a more efficient pipeline for new ideas and discoveries on their route from university laboratories to shop-fronts; ensuring that unproductive firms are not insulated from the productivity-enhancing pressures of competition; ensuring that legislation and policy can rapidly accommodate technological developments without quashing them; perhaps some kind of patent reforms; or perhaps ensuring that populations are both educated and skilled enough to be capable of further innovations.

Why Monetary Policy Matters

In the short- and medium-terms, there are policies by which the UK can ensure greater economic stability and higher levels of GDP, even if it cannot boost the underlying trend rate. After all, there are periods like the most recent recession, when growth falls far short of its potential. So while demand-side policies have their limits in terms of boosting growth, they could potentially ensure that output (i.e. inflation-adjusted GDP growth) never falls short. In other words, the UK and many other countries often unnecessarily fall short of fully exploiting the opportunities of currently available technologies. Indeed, this appears to be what happened in the UK from mid-2007.

Establishing the size of this output gap between current and potential GDP is, of course, extremely difficult. However, many modern central banks rely on inflation-targeting in order to bring the amount of money in the economy up to the amount where there is enough to fully exploit the available technological opportunities. After all, one would expect to have moderate inflation if there were only slightly too much money sloshing around the system. This makes the system fairly good at responding to demand-shocks, when the amount of available money falls short for whatever reason, and thereby brings economic growth down with it. Under its existing mandate, a fall in inflation would cause the Bank of England to decrease interest rates, or, once it has reached the point where interest rates cannot fall any further (i.e. just above 0%) to find other means to increase available money, such as through Quantitative Easing.

Ways to Keep Economic Growth at Trend

However, there are cases when inflation can be caused by supply shocks, which can complicate the signal. For example, the recent drop in the price of oil would both decrease inflation and increase output. Under inflation-targeting, this positive supply shock would make it appear as though output had fallen short of its potential when it had not. A subsequent increase in money would thus risk causing an unsustainable economic bubble and later inflation, with the amount of money far exceeding what was necessary to fully exploit the opportunities offered by existing technologies. Conversely, a hypothetical increase in the price of oil would increase inflation while decreasing output. It would thus appear as though the output gap had been closed when in fact it had widened. If the Bank of England were to blindly follow the inflation-targeting rule, it would thus tighten money in the economy, further widening the output gap as output fell, and potentially causing unnecessary recession and unemployment.

In practice, the Bank of England tries not to blindly follow the inflation-targeting rule. As has happened in the case of the recent supply shock from falling oil prices, the Governor of the Bank of England wrote to the Chancellor to explain the very good reasons he allowed inflation to fall below its 2% target. However, this raises the problem of giving too much discretion to the individuals who run the Bank of England. As such, it leaves businesses and investors hanging on the every word of the Governor of the Bank of England, rather than giving them a more predictable, rule-based system. More importantly, the problem of discretion is compounded by the fallibility of even experts – if the Bank of England were to incorrectly assess whether or not a fall or rise in inflation were due to supply or demand factors, the consequences for the economy could be devastating. Given economic data’s complexity, time lags and myriad measurement problems, such a catastrophic mistake seems likely.

One increasingly popular alternative to inflation-targeting that avoids many of these pitfalls is Nominal GDP Level-targeting (NGDPLT), most recently popularised by economist Scott Sumner. Rather than seeking to separate inflation and real output growth, the central bank would instead target a trend growth line of Nominal GDP (i.e. GDP growth without stripping out the effects of inflation, or Real GDP plus inflation) of perhaps 5% per year. By simultaneously measuring both output growth and inflation growth, NGDPLT  would accommodate both demand and supply shocks.  For example, should a negative supply shock occur to increase inflation and decrease output (such as an increase in Value Added Tax) then the effect on NGDP would take into account which effect was greater. As such, the appropriate policy response would be more likely to be chosen automatically. If the fall in output were completely offset by the increase in inflation, then this effect would show up in no change to trend NGDP, without the need to measure real GDP and inflation separately. The central bank would therefore keep money stable, rather than running the risk under an inflation-targeting regime of a rise in inflation being met by tighter money and unnecessarily plunging the economy further into recession.

NGDPLT therefore removes a large element of discretion from central bankers, as well as making them more likely to make the correct decisions in the case of various economic shocks. The removal of discretion increases investor stability and confidence, rather than forcing them to wait with bated breath as to how the Bank of England will interpret each economic shock. There is a further policy innovation that would allow the central bank to rely on immediate market signals rather than taking a ‘wait and see’ approach to each change. The central bank would only need to measure the inflation expectations indicated by markets in order to see if its policies are having the desired effect. After all, it is inflation expectations that actually influence interest rates in the wider economy, and thus the level of money available. The central bank should thus examine how inflation-protected securities and various other asset markets respond within minutes of each announcement.

A second element to the debate around monetary policy is that it potentially renders the debate around austerity meaningless from the point of view of general economic growth. Austerity policies may very well have both winners and losers in terms of the distribution of resources, but central banks have the ability to keep overall economic growth and thus overall improvements in living standards on a stable upward trajectory. Central banks can offset any decreases in government spending on goods and services in the economy by boosting available money and allowing growth to continue regardless. The ability of monetary policy to offset economic shocks does not change according to whether or not that shock came about as a result of Treasury policy. As such, in macroeconomic terms, the level of spending boosts or spending cuts should make little difference under an effective monetary policy regime such as NGDPLT.

Why the General Election result barely matters

None of the major political parties going into the General Election have provided a coherent policy response to the two most important economic issues facing the UK: the boosting of the trend economic growth rate; and maintaining actual economic growth at its technological potential. As such, the result of the General Election will not matter all that much.

With regards to boosting the trend economic growth rate, the parties may be excused by the lack of a clear understanding among even academics and policy-makers as to what exactly may increase trend growth rates further. The responsibility therefore lies with them to provide politicians with the policy tools by which to greater enrich society. As to the negative effects of any particular party in power, the example of persistently developed economies such as France indicates that trend economic growth is surprisingly persistent.

With regards to maintaining actual economic growth at its technological potential, any government economic policies are likely to at most involve tinkering around the edges, with the Bank of England attempting to offset any particularly major economic shocks. Indeed, it is from the independent Bank of England, insulated from the pressures of elections, that there are signs of an intellectual shift away from inflation-targeting. Should the Governor openly advocate a new target, the government would surely approve the change, bowing to the greater expertise of central bank officials. Nevertheless, such a change could happen irrespective of the party in power.

The lack of the General Election’s significance for trend economic growth should therefore be both a source of disappointment, that we do not know how to boost it further; but also a source of optimism, because it is remarkably robust. Rather than hanging on the election result, let us hope that the Bank of England will soon provide us with a policy of Nominal GDP Level Targeting to better keep our economy fulfilling its technological potential.

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* Nevertheless, GDP is still one of the best measures we have, as quality improvements from technological advances are difficult to quantify

** The benefit of targeting a trend line rather than purely a growth rate would allow monetary policy to restore an economy back to trend rapidly, should it fall short. Hypothetically, should an economy with NGDP of £100bn in one year experience a recession bringing it down to £95bn, then level-targeting would seek to boost it back to £105bn (100 x 1.05) for the next year rather than to £99.75bn (95 x 1.05) if the growth rate were targeted instead.

Edit: I had unintentionally copied and pasted from an early draft in which I had not corrected “credit” for “money” where necessary. This has been corrected.

This is a re-print of my cover article that appeared in KCL Politics Society’s Magazine. You can check out the other articles here.