Will we be a world-beater or an also-ran?

First published in the Telegraph on 17 June 2010

The trouble with granting people independence is that they often develop a mind of their own. George Osborne learnt this to his cost this week, when his new Office for Budget Responsibility (OBR) published its assessment of the British economy and the public finances ahead of next Tuesday’s emergency Budget.

The OBR was supposed to be one of the key tools in the new Government’s quest to impose austerity measures. The idea was that the independent committee, with its remit to advise the Chancellor on how much to cut, would at least share some of the blame for any pain inflicted. But, at first glance, the OBR’s report has made life even more difficult for Osborne and David Cameron.

For one thing, it has proved that, far from being worse than expected, the public finances are, in most respects, in slightly better condition than was thought at the time of the election. This means that the onus remains very much on the Government to make the case for the deep spending cuts that the vast majority of economic experts believe are necessary to bring Britain back to economic health.

For another, it has shed light on another, rather more worrying, aspect of the British economy, which austerity alone cannot remedy. Quite simply, Britain is not as prosperous as it thought, and never will be. Or to put it in technical terms, the country’s long-term growth rate is no longer as punchy as the previous government estimated it to be, at 2 per cent rather than 2.75 per cent.

This might not seem to make much odds, until you realise what a massive difference to our wealth and welfare that readjustment could mean when compounded over decades. Those minuscule percentage points are the difference between remaining one of the world’s rich nations and becoming an economic also-ran.

A country’s gross domestic product is a measure of all the extra value – the added wealth – that it creates each year, which is then shared among the population. It is not for nothing that it is one of the main yardsticks of a nation’s economic health. If the economy grows at an average rate of 2.75 per cent a year, then in 30 years it will have more than doubled, from £1.5 trillion to some £3.3 trillion. Should Britain expand by only 2 per cent, our annual economic output at that point will be a staggering £630 billion smaller. This would amount to a potential shortfall of around £20,000 for every household in the country – annually. In effect, we would have “lost” 11 years of growth.

What did the UK do to deserve this? A combination of two things. First, the financial crisis may have taken a significant chunk off Britain’s potential growth rate. According to the OBR, our previous conception of what constitutes “normal” growth had been overinflated by the cheap credit flowing around the economy; much of that money won’t be available in the future, meaning that companies will be less quick to invest and households less quick to spend. The measures laid out by George Osborne in his speech at the Mansion House in the City of London last night will amplify this: in future, the Bank of England will have far greater control over Britain’s banks and their lending plans. The upshot is likely to be that there is less money available for overextended households, creating a far more anaemic economy.

The second explanation, however, is even more worrying: it is that a combination of demographic factors and deepseated economic inefficiency means that Britain is simply no longer capable of generating the growth necessary to make it a world-beater. The demographic issues are awkward for Cameron, because they suggest that one way to reinject some pace into UK plc, and compensate for an ageing population, would be to encourage more immigration. But even more profound is the lesson about the structure of Britain’s economy.

The Budget next week is likely to concentrate on the austerity measures necessary to prevent Britain from following in the wake of Greece, which has had to take out an emergency loan from the International Monetary Fund, and Spain, which looks on the brink of following suit. As the OBR report underlines, the challenge is not merely to cut the deficit, but to do it in a way that rejuvenates our economy.

Britain’s potential growth rate is low partly because the private sector – which is inherently more dynamic and efficient – has been crowded out by a state that dominates the economy in a way that it has not done for a generation.

In other words, cutting public spending is not merely about avoiding fiscal oblivion; it is about restoring Britain’s economic health.

This is the message Osborne should hammer home next week. Since the start of his premiership, the Prime Minister has portrayed spending cuts as an unpleasant necessity, forced on us in part by the chaos we have witnessed in the euro area. That is misleading. The markets are no longer panicking about Britain; our public finances, though still atrocious, look in a better state than they did at the election. But this is a once-in-a-generation chance to make the economy a contender again, and prevent a lapse into mediocrity. That was Labour’s legacy; it is time for Cameron to reverse it.