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The UK economy in a world context Samuel Brittan: Talk in City of London 29/10/03 A Framework The missing factor in so many attempts to analyse the British or the world economy is the absence of any kind of framework. If we look at so many reports, including I am afraid some from the Bank of England, we see a bewildering number of changing indicators, with no clear idea how to put them together or whether they are even good or bad. Let me therefore try to put forward a framework on the basis of which we can discuss the forces affecting the economy. I shall start with a simple, even simple-minded proposition. This is that the natural tendency of any advanced modern economy is to grow at a rate determined by factors such as productivity, population growth and participation rates -- that is the percentage of the adult labour force in the labour market. If we take an economy such as the UK, productivity has been rising at an underlying rate of around two per cent per annum for several decades and it has stubbornly resisted the attempts of many governments of different persuasions to boost it. On top of that there has been a modest growth in the native born labour force and a substantial boost from immigration, the size of which is difficult to determine because not all of it is legal. But if we add another half per cent for a rise in the labour force we will not go far wrong. This gives us an underlying growth rate of around 2½ per cent. In the USA it may be a bit higher, say just above 3 per cent. In continental Europe it has up to now been not all that different from Britain; but if the structural problems of the euro labour market are not tackled underlying growth could start to fall behind. The controversial proposition I want to start from is that most of this growth takes place automatically without special policies, ministerial exhortation and all the other phenomena about which commentators and journalists become so excited. There is no great mystery about how this happens. In the face of gradually rising productivity, either prices will fall slowly, thus automatically increasing domestic purchasing power, or wages will gradually rise, increasing it in another way. It is now unfashionable to favour the falling prices route, although that was quite a frequent phenomenon in the 19th century. Government policy -- to be more precise monetary policy -- can indeed affect whether we go for the falling prices or the rising wage route. We are of course talking here about broad averages. Even if we settle for price stability or a low positive rate of inflation, some individual prices are bound to fall -- computers and associated products being the obvious example. When competitive forces gather steam and particular sectors come under pressure, we must expect to hear parrot cries of "deflation", although nothing of the sort is to be seen over the economy as a whole. A look at the aggregate US figures makes the talk of inflation being "too low" somewhat puzzling. The consumer price index is 2.2 per cent above a year ago. The only substance I can find for this talk is that unit labour costs in US manufacturing - which is only one sector - fell slightly in 2002, but they are now rising again. You do not need me to tell you that the actual course of economic affairs is not as smooth as the simple model I have outlined. In some years output will grow less than trend. In others it will grow faster. Abnormally rapid growth used to be accompanied in most of the post-war period by rising consumer price inflation; but more recently, as in the 18th and 19th centuries, the excess pressure has shown itself in asset price booms -- above all equities and property. Although some degree of boom and bust is inevitable, the task of the central monetary authorities is to try to reduce the sharpness of fluctuations and try to ensure that they take place around some moderately low level of inflation, and thus avoid the double digit inflation we had as recently as the 1970s as well as the genuine deflation the USA had during the Great Depression in the early 1930s or the much more modest deflation Japan has had in recent years. The UK Record The remarkable feature of the last decade is how stable British performance has been -- that is how near to the simple model with which I started, with much less boom and bust than earlier on. The Governor of the Bank of England, Mervyn King, provided some interesting background in a speech in Leicester on October 14. He reminded us that in the ten years from the second quarter of 1992, the average real annual growth rate was 2.9 per cent -- somewhat above the post-war average of 2.5 per cent. (This is mainly to be explained by the fact that the British economy was starting from a period of slack and recession, following the Major government's ejection from the European Exchange Rate Mechanism.) Inflation averaged 2.5 per cent over that decade and -- most remarkably -- never deviated by more than one percentage point from this average. Unemployment on the claimant count fell from ten per cent to three per cent, its lowest level for three decades, and has been virtually unchanged for the last two years. Moreover output has risen, of course at varying speeds, in every single quarter since the middle of 1992, a better performance than in any other G7 economy. The Governor attempted a slogan for the last decade -- calling it "a NICE decade". This stands for non-inflationary, consistently expansionary decade. It is a good try. But Alastair Campbell could have told him that this mnemonic will never become a household term. Independent economic forecasts, for what they are worth, suggest that this non-inflationary expansion has continued this year and will continue into 2004. The average independent forecast suggests that growth this year will be just under two per cent and rise to 2.5 per cent next year. Inflation, on the old RPIX basis, is put at 2.7 per cent this year and the same next year. The current account deficit is projected at just over £20bn in both years, about two per cent of GDP - this now looks a bit too low. There are one or two outrider forecasters with much higher or lower figures. But what is striking - and perhaps worrying - is that the vast majority of forecasts cluster for safety around the central estimates. Governor King suggests four reasons for improved performance. First there has been a new monetary framework based on an explicit inflation target and transparent policy discussions. The grant of operational independence to the Bank of England by the Labour Government in 1997 reinforced this framework, but did not create it. Secondly there was a substantial improvement in the position of the British Budget, moving from a deficit of eight per cent of GDP in 1993 to less than 1pc. I shall discuss a little later on how far this fair fiscal prospect has been undermined by recent developments. Thirdly, there has been a continuing programme of what the Governor calls "supply side reforms" over 20 years, which reduced the underlying unemployment rates consistent with low and stable inflation. As I can be more politically controversial than the Governor I can suggest that a large part of this improvement was a delayed action effect of Margaret Thatcher's 1980's programme to tame union power - to which I would gladly add a contribution from Gordon Brown's "Welfare to Work" programmes. Fourth, although there were numerous shocks to the world economy, such as the Russian collapse and East Asian bust of 1998, as well as the speculative frenzies in the US in the later 1990s, these external shocks in the end were not as severe as some feared and averaged out over time. The main reason why the Governor emphasised the good fortune of the last decade, was to prepare us for a new period in which he expected greater volatility of both output and inflation. For instance an improvement in the terms of trade of about ten per cent since 1996 allowed living standards to rise faster than output. This can hardly be expected to continue; and the seven per cent fall in sterling's effective exchange rate since the end of 2002 makes it likely that they will henceforth be moving against us. Moreover the margin of spare capacity which existed in the early 1990s has now mostly gone. There are other features of the last few years of an unusual kind. Recent policies have not been neutral but highly stimulative. We have had unusually low real interest rates -- 0.5 per cent according to official estimates. I do not need to tell you about the consumer borrowing spree and associated housing boom. The Governor admitted that the Bank has deliberately allowed domestic consumer demand to rise at above trend rates to compensate for weak external demand. It is over three and a half years since interest rates were last raised -- the longest such period since the 1940s. The Governor said that that "at some point reducing the present degree of monetary stimulus will be necessary to keep inflation on track to meet the target". Translated this means: expect a rise in interest rates; and in my view we should expect one fairly soon. The Mortgage Debt Argument The rapid rise in secured consumer debt to a record 120 per cent of disposable income has touched off much controversy. There are those who regard it as unsustainable and likely to be followed by some collapse. But there are others who point to the low level of interest rates, both nominal and real compared with the last upsurge. You cannot avoid this argument by relating consumer debt to wealth instead of income. The bulk of household wealth consists of residential property; and the boom in house prices has itself been fuelled by the expansion of credit. They are twins that go together. A possible warning of what is in store comes from the experience of the Netherlands. That country has also had a housing boom: residential property prices rose by 20 per cent per annum for two years running around the turn of the century. But a moderate rise in interest rates of less than two per cent in the run up to the establishment of the Eurozone punctured the residential market very effectively. House prices did not collapse, but the rate of increase has fallen to zero and consumer spending this year is estimated to have fallen one per cent compared to a rise of one per cent in the Eurozone as a whole. Britain has, however, important policy advantages compared with Holland. Interest rates can be changed independently of the rest of Europe and the exchange rate is free to move as a regulator. We would be mad to give up these advantages for the dubious benefits of EMU membership.(David Miles Review). Clearly the rise in the debt ratio cannot go on forever. Rather than to try to predict directly when this will happen I would rather bypass the debt argument by looking instead at the composition of the national product over the last five years. It is clear, even after the latest revisions to the national income figure, that consumer spending has been rising much faster than GDP. This is not a pattern that can continue indefinitely. What can take the place of consumer spending as an economic motor? The answer is that government spending already has. (2002-2005: govt consumption to rise by an average of 3pc pa.; public investment by 25pc! Figures exclude transfers.} We may hope for some contribution from investment and exports; but to secure this may require a further depreciation of sterling (already down seven per cent this year on the trade weighted average), perhaps in conjunction with the dollar. The Bank of England has - thank God - no target for sterling, but it does take into account the feedback from the exchange rate into domestic price levels. [As someone who thinks that interest rates have been a bit too low and that the July reduction was a mistake, I would still plead with the Bank not to tighten policy too far on the basis of dubious models linking sterling to domestic prices, but to wait for signs that this feedback is actually taking place. Much depends on the state of the world and British economies, as well as of expectations. I speak as someone who shared the conventional fear when sterling plunged when Britain left the exchange rate mechanism in 1992, that inflation would go through the roof and was relieved to find that it soon resumed its downward drift.] External Shocks It is not a very profound observation to say that the most likely shocks in the next few years will come from the outside world. But what is not so obvious is the continued overwhelming importance of the United States. The US Centre for Transatlantic Relations has made a few useful calculations. (Drifting Apart or Growing Together?, J P Quinlan, Centre for Transatlantic Relations, Johns Hopkins University). We can be misled by the fact that direct trade accounts for less than 20 per cent of transatlantic commerce. In fact UK affiliate sales are more than five times the amount of direct UK exports. US firms put nearly twice as much capital into the Netherlands as into Mexico. European firms accounted for more than two thirds of total foreign assets in the US. Indeed there is more European investment in Texas alone than all the US investment in Japan. The transmission mechanism from overseas owned subsidiaries is somewhat different. If there is a slump in America the effect may be felt over here more in a reduction of corporate earnings than in a fall of direct exports to the American market; and the impact may be somewhat delayed. It is helpful for Europe that the estimated annualised growth rate of US GDP reached an amazing 7 per cent in the third quarter of this year and will of course fall back in the final quarter of the year because of "borrowing" between the two quarters. It reinforces the view that interest rates in both the US and the UK are heading upwards, with the UK in the lead. Dollars and renmimbis China comes into the external picture. Put aside for a moment the predictions that Chinese output will exceed that of the United States in 2025 (Andrew Roberts) or 2039 (G Sachs) or whatever your favourite analyst supposes - not to speak of a permanent base on the moon by 2010 (Roberts). With a population of almost 1.3bn - more than four times as high as America's - at some stage Chinese output is bound to overtake American; but it will be a long time, if ever, before it is translated into higher Chinese real income per head. China has been a country of the future as long as I can remember. (So indeed has been Brazil, as I had to remind some Portuguese friends at a conference I attended recently in Lisbon!) The early impact of China is likely to come through a more mundane route, namely the foreign exchange market. Until recently the vast US balance of payments deficit on current account of over 5 per cent of GDP was financed mainly by business investment from overseas, much of it direct. But in the last few years this has largely dried up and the financing gap has been met instead by the accumulation of fixed interest official dollar assets by the central banks of China and other East Asian countries. The accumulation has been part of an effort to prevent the renmimbi from appreciating, which has annoyed the US administration. (Present rate 8.3y to $). US policymakers would like to see the dollar depreciate further, preferably well ahead of the 2004 presidential election, to give a boost not to Old Europe but to Old America - namely the rust belt industries facing competition from emerging countries. My own view is that the Chinese should be left to decide their own exchange rate policy. By pressing for Chinese revaluation, the US Treasury is playing with fire. Surely by now American Secretaries of the Treasury should have learned that by far the best policy is to say nothing whatever about the desirable value of their own or other people's currencies. I would guess that more Treasury Secretaries have lost their jobs from unfortunate remarks about exchange rates than from any other cause. We may now be heading for another example. How could the Chinese make the renmimbi appreciate? To say so is not enough. They would either have to dump dollar assets or at the very least reduce the rate at which they area accumulating them .There may be some ideal path by which the stimulus to US exports, following a dollar devaluation, would boost the US trade balance of payments and neatly dovetail into the reduction in overseas dollar accumulation. But I am pretty sure that nobody knows what that path is, let alone has any intention of following it. The real danger is that if the Chinese take the Americans at their word and really do stop accumulating dollar assets, there will be both a sharper fall in the dollar than anyone has bargained for and also a rise in American long term interest rates which could more than offset any stimulus from a lower dollar. This could in any case happen even without a revaluation of the renmimbi if the Chinese investment boom makes inroads into the country's overseas surplus and the purchase of dollar assets dries up through this alternative route. Either course of events would lead to cries of outrage from the euro area on the basis that dollar depreciation was killing the modest revival taking place in the European economies. Any attempted retaliation, whether of a financial or through protection, would only make matters worse. The rational course for the euro zone in these hypothetical circumstances would be to offset any demand deficiency arising from foreign exchange market movements by a more expansionary monetary and fiscal policy. We reach here the vexed question of the so called European Growth and Stability Pact which might best be left until after the soup! The British Budget It is almost a relief to turn from these global matters to the British fiscal outlook. An argument is developing between the Treasury and outside analysts on whether Gordon brown will be able to keep to his fiscal framework, which involves inter alia limiting budget deficits to what is needed to cover public sector investment over the business cycle as a whole. The Treasury originally predicted public sector borrowing (for investment as well as current expenditure) of £27bn in this financial year falling to £24bn next year. The average view of the independent forecasters is a borrowing requirement of £33bn this year and £35bn next year. As we will be deluged with projections from the Treasury in the Pre-Budget Report in a few weeks time, let me again try to look at the wood rather than the individual trees. Contrary to what was earlier suggested by City commentators the Budget shortfall so far in this is not due to overoptimistic economic growth projections by the Treasury. What they do reflect is that the revenue return from increases in the national income are rather less than previously supposed. The most likely reason for this is that, although the overall economic slowdown has been very modest, it has been unusually concentrated in the financial sector which in turn has hit tax proceeds severely. There is another bone of contention. According to official estimates the economy this year has been operating at about 1½ to 2 per cent below trend. This belief makes it easier to explain away revenue shortfall on business cycle grounds. Some outside analysts, including the NIESR have suggested that if there is any overall slack in the economy it does not amount to more than some half per cent of GDP at most. The divergence may not seem very much (£10bn), but it can make all the difference between a successful fiscal outcome and falling short of even the Maastricht criteria. Such scholastic arguments might take the Treasury through two further Budgets and beyond the next General Election, to the new public expenditure planning period which starts in 2006. Emphasis is also likely to shift from the current balance to the very low 30 pc public sector debt ratio. But I come back to a long term point. There is no way in which public spending can continue to rise by say 4 per cent per annum or more in real terms while output and income rise by only 2½ per cent. These apparently small differences cumulate over time. What the government will have to decide in the run-up to the next General Election is whether it has embarked on a once for all increase in public spending to make up for alleged past insufficiency or whether it wants to continue the present growth path into the more remote future. In that case the tax burden will have to rise; and we are coming to the end of the stealth taxes which can be raised without anyone noticing. Hence the emphasis on environmental taxes, although higher airport charges would be a bad choice. The Inflation Target There is a footnote point to which I want to draw your attention. The Chancellor is already committed to switching his inflation target from RPIY (retail prices excluding mortgage interest) to the EU Harmonised Index of Consumer Prices (HICP) which excludes housing costs altogether and also uses a different (geometric) way of combining the individual price items. The received wisdom is that the present target of 2½ per cent of the RPI translate into 1¾ per cent on the harmonised index. But I wonder if the government will accept such an awkward fraction. It may well be tempted to round the target up to two per cent, thus loosening it slightly. The Bank of England has already grumbled about the proposed change; and I hope there are betting reasons for it than as an olive branch by the chancellor to the Prime Minister's desire to "look more positive" on the issue of the euro.] Other dangers I have not had the time or expertise to go into the many other dangers risks lurking round the corner. The oil price is already higher than was generally expected and we cannot rule out the possibility of a Middle East conflagration which will send it much higher still, with all the results in stagflation that we know about from the rise after the Yom Kippur War. The IEA worryingly predicts that Saudi arabia and immediate neighbours will supply two thirds of anticipated increase in oil demand up to 2030. US gasolene and oil product taxes are a necessary and sufficient condition of better US energy policy. These would provide market incentives to develop oil substitutes. What keeps me awake at night is not anything on the specific financial front, but the knowledge that despite the controversial campaign in Iraq, the fundamentalist Muslim terrorist group al-Qaeda has still many supporters or sleepers all over the world. I have to agree with Robert Cooper, the Prime Minister's former foreign policy adviser, that a fresh outrage on the scale of September 11, this time in Europe, is more likely than not. It will be difficult if this occurs to just shrug it off as something to do with foreign policy or security policy and hope for a return to business as usual. President Bush was quite right to say some two years ago that the US was at war with global terrorism, whatever one might think of his subsequent policy steps. We may well have to think more in terms of war economics and less in terms of arguments about how many angels can sand on the head of a pin, which has typified so much economic discussion in the last few years.
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