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What Derailed The UK Recovery? Rising Energy Costs

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Frances Coppola, Coppola Comment

When businesses cut energy consumption due to rising costs they also cut production. When households cut energy consumption due to rising costs they do fewer activities and travel smaller distances. So expensive energy is a serious drag on economic growth.

 

Here’s a horrible chart:

It comes from ONS’s Economic Review for July 2013.

There are a couple of key things that this shows. The first is systematic underestimation of the damage to the UK’s economy. The 2008/9 recession was deeper than previously estimated and output remains lower. But the second is to my mind more interesting.

The 2008/9 recession was originally thought to be similar to the 1979 recession. We now know it was quite a bit deeper and lasted longer. But the shape of the curve was actually more like the 1990 recession, which unlike the 1979 recession involved a property market crash. Indeed the two lines parallel each other nicely – even with the revision – until the 10th quarter after the crisis. Then it all went wrong: even though the second dip shown on the original line has now turned into simply a flattening of the curve, the economy stopped recovering then and there has been little growth since.

It is all too easy to blame this on the Coalition government that took office in May 2010 with a deficit-cutting agenda. But at the time, the economy was growing and the big issues were government finances and inflation. No-one thought that GDP was at risk: the trajectory was for a recovery similar to that in the 1990 recession, and there was no particular reason to think that it would fail. Even when the economy tipped into recession in Q4 2010, the ONS review for February 2011 blamed it on bad weather.

The abrupt change of growth trajectory suggests that a pretty major exogenous shock hit the economy towards the end of 2010. But finding out what that shock was, and why it derailed the recovery so comprehensively, requires some detective work.

Despite numerous claims that the recovery was “killed by austerity”, there is actually nothing very obvious on the Government’s part to explain such a change at that time. The economy was already slowing in the third quarter of 2010, which is before any of the Government’s spending cuts took effect. There was the increase in VAT to 17.5% – but really that should not have been sufficient to knock the economy off course, since all it was doing was reversing a previous reduction. And the second VAT rise didn’t happen until January 2011.

There is one very obvious external shock – the Irish sovereign bailout in November 2010, to which the UK government contributed. Ireland is one of the UK’s most important trading partners and the two financial systems are deeply interconnected. A major shock to the Irish economy would inevitably rebound to the UK. But….was that bailout really such a shock? It was widely expected, and the Irish banking system whose failure made the bailout necessary had already been moribund for two years. The conditions of the bailout would involve harsh austerity measures in Ireland, which would affect the UK’s exports and the activities of UK companies in Ireland – but those would take time to kick in. And anyway, is the rebound from a shock to an economy the size of Ireland really capable of knocking the UK out of orbit? I am unconvinced. Ireland obviously had some impact, but I think we need to look elsewhere for the main cause.

In fact another look at these curves suggests an alternative explanation for the UK’s trajectory change and stagnation. From Q4 2010 onwards, the curve looks less like the 1990 and 1979 curves, and much more like the 1973 one. It’s bumpy – which suggests a series of shocks rather than one single shock. Now we know that the 1973 crisis was triggered by an oil price shock and was characterised by energy shortages, although it also had a bit of a banking crisis attached. And it involved high inflation – admittedly much of this was domestically generated due to loose monetary and fiscal policy fuelling a wage-price spiral, plus the devaluation of sterling, but the oil price shock itself also increased inflation due to the UK’s external energy dependence. Do we possibly have a similar situation from the second half of 2010 onwards?

I think we do. The UK’s CPI inflation at that time was surprisingly high and rising:
Historical Data Chart

 

source: Trading Economics. Larger version here

The ONS says that the principal cause of this was imported energy costs. Now, it is not the world price of oil so much as the domestic cost of energy and fuel that affects economic performance. Here is a nice graph showing UK road fuel prices from March 2010 to March 2012:

 

 

Source: DECC. Larger version here

So from September 2010 to June 2011 road fuel prices – both petrol (gasoline) and diesel – rose by about 17%. That would particularly have hurt three groups: the haulage business; businesses that depend on frequent stock deliveries; and households where the principal earner(s) are essential car users.

Industrial fuel prices also rose considerably at this time. The graph shows actual prices rebased to 2005, which is not entirely helpful. So I have also shown the percentage increase from October 2010 to October 2011 for each fuel category and for total fuel:

 

 

Source: DECC. Larger version here.

Household energy prices rose even more (again the chart is rebased to 2005 prices, so I have included the table showing percentage year-on-year increase). The rise in domestic gas prices was a whopping 20.3% from Q4 2010 to Q4 2011, and the total rise across all types of fuelwas not a great deal less, at 16.2%:

 

Source: DECC. Larger version here

 

So the picture is one of a promising recovery being kneecapped by an energy crisis. […]

When businesses cut energy consumption due to rising costs they also cut production. When households cut energy consumption due to rising costs they do fewer activities and travel smaller distances. So expensive energy is a serious drag on economic growth.

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