Hamish McRae: Creating jobs is a good sign, but there are still worries about growth

A year of the coalition, a year of OK-ish recovery, and a year of worryingly-high inflation.

So what's next? A good place to start is the monthly tally of GDP done by the National Institute, which has a neat graph on its website showing how this recession and recovery compares with those of previous cycles. I have given it another airing in the main graph above.

As you can see, we seem to have slipped below the profile of the 1980s cycle, the one that most closely resembles the present one, which is discouraging – doubly discouraging when set against the strong growth figures from the eurozone published on Friday.

On the other hand, employment is climbing, with the private sector creating three new jobs for every one lost in the public sector, unemployment is falling and hours worked rising quite sharply. The little graph on the right shows hours worked. This divergence between the GDP data and the employment/hours worked data leads to a short-term puzzle and a longer-term worry.

The puzzle is why is the economy creating so many jobs – roughly 50,000 a month – if the economy is growing so slowly? Some of us think that the economy is growing faster than recorded and that GDP growth will be revised upwards. But even if we are right, I don't think anyone believes the growth is great: maybe 2 per cent a year. That, you would expect, would not be enough tocreate many new jobs. Productivity ought to be rising at something like that rate, so where are the new jobs coming from?

That leads to the worry. In the short-term, of course, it is great that more people are being pulled into employment. But in the long-term it raises several disturbing questions about productivity growth and hence about the long-term trend growth of the economy.

Put at its simplest, growth can only come from two quarters: increases in the size of the workforce and the hours worked; and increases in the productivity of those working. The size of the British workforce has been rising, partly because of demographics (the baby-boomers are only just starting to reach retirement age) and partly because of immigration. Estimates about what will happen to the workforce vary, not least because there is uncertainty about the future immigration, but, to put the point at its weakest, growth in the workforce is likely to be slower than it has been in recent years. In some European countries, notably Germany, the workforce has started to decline.

So most growth in the future will have to come from higher productivity. There you immediately hit a problem. It has proved reasonably easy to increase productivity in manufacturing but much harder to do so in service industries. You can automate a car production line but you can't automate an old-age home. But manufacturing is a much smaller sector than services, so to boost productivity in the economy as a whole, services have to find ways of lifting output without increasing employment, using the new communications technologies to help do so.

There is one obvious area where that can happen, indeed is happening: the public sector. Until recently public sector productivity has been stable or falling. Even assuming that the public sector is successful at doing more with less, the main burden will fall on private sector services, which make up more than half the economy.

That leads to a debate that has just begun and of which we will hear a lot more in the coming years: what is the trend growth rate of the economy?

This matters a lot. The difference between, say, 2 per cent trend growth and 2.5 per cent may not sound a lot but it works out at around a 6 per cent difference over a decade. That is 6 percentage points available to lift living standards. Much angst has been generated by the evidence that living standards are falling and by the end of the year may be back tolevels of five years ago. But the overall decline in living standards from peak to trough will be nothing like 6 per cent; perhaps less than half of that.

Moreover, the bigger the economy the smaller the burden of servicing debt. Given that everyone now looks closely at the ratio between government debt and GDP, the faster the economy grows, the less pressure there is to cut overall debt.

So what do we know about the long-term growth potential of the British economy? Surprisingly little. There is lots of work on it but remarkably little agreement. The working assumption a decade or more ago was that it was somewhere between 2.25 per cent and 2.5 per cent. Then in the early 2000s there were some suggestions that it might be a bit higher, say 2.75 per cent. Gordon Brown's projections for the public borrowing looked rather better if you assumed a higher growth rate, though this was never formally incorporated into government forecasts.

Now there have been suggestions that the underlying growth potential may be below 2 per cent, something around 1.8 per cent. That is based partly on assumptions about a lower level of inward migration but also on the probability that the industries with very high productivity, notably financial services, will not contribute much to growth in coming years. If that were to happen, it would have the effect of dragging down the productivity of the economy as a whole.

The short answer is that none of us can know. But the debate goes to the heart of what seems to me to be the biggest economic question the UK faces: what can we do that other lower-waged economies cannot do just as well and more cheaply?

If we cannot figure out ways to increase productivity, we cannot increase our living standards. We start with a disadvantage: the huge pile of debt that is still being accumulated will have to be serviced and paid down. So we have to find ways of not wasting human resources: everything from making sure that we train people better, through to cutting silly bureaucratic procedures.

Not easy; got to be done.

It is wrong to blame rising income inequality on the last Labour government

Still on living standards, the Institute for Fiscal Studies has just calculated what happened to them under the last Labour government.

There are three conclusions. First, average living standards rose by 2 per cent a year but only by 1 per cent a year between 2002/3 and 2008/9. So, the fastest growth in living standards took place in the early years of Labour stewardship. Second, child poverty fell from 27 per cent to 21 per cent of children between 1996/7 and 2004/5, but then failed to decline further during the third term of office. And third, income inequality rose over the period as a whole despite tax and spending measures that acted against such a movement.

These results will confirm the gut feeling of many people that the first term of Labour was a success, the second saw things start to slip and the third was a disaster – that is what the polls would suggest was our verdict. But I don't think we should see this too much in political terms. The UK is after all affected by what happens globally.

That is most relevant to the figures about rising inequality, for one of the features of our world is that inequality between nations is falling while inequality within nations is rising. This is partly because lower-skilled workers in the West are having to compete with increasingly well-educated ones in the emerging world.

Also, that returns to the highly-skilled in the West (sports people, professionals) have risen as the premium on the very best over the competent average rises. And there are some distortions, particularly in the corporate world, where average performers are over-rewarded for simply doing their job.

We need to try and understand the phenomenon, not simply huff and puff about it, and not use it as ammunition to attack the last Labour government.