Commentary.

Riley, Rebecca ; Pain, Nigel ; Weale, Martin 等

The current situation

The last quarter has seen something of a recovery in economic sentiment from the low levels reached in the autumn, while the recent economic data present a confused picture with output weak and demand growing strongly. Industrial production fell sharply in October and suffered a further, more modest fall in November. For last year as a whole the growth rate of 2.4 per cent is just below the figure forecast by the Treasury and ourselves in the spring of last year, but slightly higher than we were expecting in the summer and autumn. Perhaps the most extraordinary aspect of the year, as far as the UK's economy has been concerned, was the degree of gloom associated with a GDP growth rate close to the long-term average.

2002 began with a market expectation that interest rates would rise in the first half of this year, reaching well over 5 per cent per annum by the end of the year. Data released in January, together with comments from the Governor of the Bank of England, damped expectations of an early interest rate rise. No change is now expected until the middle of the year but markets continue to expect an interest rate of 5 per cent at the end of the year. Our forecast suggests that this is compatible with inflation being on target (2 1/2 per cent per annum) in two years time, although it will be lower this year and could drop below 1 1/2 per cent per annum, the lower limit of the official range, in the middle of the year. Our forecast is produced on the assumption that the Bank of England stays independent and that Britain does not join the European Monetary Union.

The improvement in sentiment does not necessarily presage a recovery, although there are reasons for expecting one. First of all, the recession in the United States was caused by the collapse of an investment bubble. During the boom the share of investment in GDP had risen considerably. On page 13 we show that the ratio has now fallen back to the average of the last twenty-five years. It is also the case that ratios of inventories to sales are low, even when allowance is made for the steady downward trend in the ratio. The best explanation of this is that it is because demand has been higher than businesses expected. In consequence they are likely to want to increase inventory levels; in itself this will create extra demand. Thus the combination of less downward pressure on fixed capital formation and efforts to rebuild inventory levels should support the early stages of an economic recovery in the United States and thus in the world economy.

Despite these positive arguments, it is perfectly possible for green shoots of recovery to wither and there remain two main reasons why this might happen; we have discussed both at length in the past. First of all, the growth of consumption, both in the United Kingdom and in the United States, has been supported by declining household saving. This is an unusual feature of an economy in recession like the United States but is probably what would be expected in an investment-led recession. Economic theory suggests that consumers should use savings to smooth out fluctuations in incomes. Unless consumption is depressed by long-term fears about the growth rate of income, this naturally implies that, during a recession, saving should be low.

Theory aside, it is a source of concern that household debt levels in both the United Kingdom and the United States are high, but of course low interest rates make the debt easily affordable. In the United States the household debt interest burden has fallen recently to its lowest level for two years as interest rate reductions have more than offset the effects of rising debt; in neither country do we see a return to the high interest rates associated with the inflationary periods of the past. Nevertheless, growth in both countries is vulnerable to changing saving behaviour. There has been some concern that rising saving may be provoked by rising unemployment. But, compared with past experience, unemployment rates in both countries are low. In the United Kingdom we do not anticipate a return to the high levels of unemployment seen in the 1980s. In any case the effect of unemployment is likely to arise mainly through its impact on consumer confidence and, as we have shown recently (Pain and Weale, 2001), the e ffect of consumer confidence, as measured in surveys, on consumer spending is small.

The second threat to economic growth continues to arise from the levels of major stock markets. Looking at prices as multiples of earnings these are high by comparison with anything except the recent past. A further fall of share prices would depress consumer spending and result in economic growth slower than we have forecast.

But the two factors which gave the UK average growth in 2001 remain in place in 2002. There is the stimulus to consumer spending offered by monetary policy. There is also the continuing rapid growth in public spending. Public consumption of goods and services rose by 3 per cent last year and the government's spending plans point to a further increase of 4.8 per cent per annum this year. Growth in public sector consumption and investment is expected to add 1.2 per cent to the overall growth rate after a public sector contribution of 0.8 per cent in 2001. With the combination of this fiscal stimulus and the monetary stimulus offered by low interest rates it is not surprising that the economy has been able to withstand the contractionary pressures of weak investment and declining world trade much better than the three larger economies, the United States, Germany and Japan.

The exchange rate

The physical appearance of the euro has given a new stimulus to the debate about Britain's entry and also the debate about the rate at which entry is appropriate, he manufacturing sector, in particular, is arguing that the current exchange rate is far too high, and that a substantial depreciation of sterling is needed before euro membership could be entertained. HM Treasury, on the other hand, has been concerned about the possible inflationary consequences of euro membership. With increasing recognition that the five tests cannot be answered unambiguously by economists (National Institute Economic Review, July 2000, p.4), the economic debate on membership is increasingly likely to shift to a discus ion of an appropriate rate for membership.

Manufacturing accounts for less than 20 per cent of the overall economy, but about two-thirds of exports; manufacturing is therefore disproportionately affected by problems in export markets. It follows that, at least in part, the argument from manufacturers for a lower exchange rate may be a response to the weakness of world markets rather than a reflection of the fact that, in normal trading conditions, the exchange rate would be self-evidently much too high. Profit margins are already so low that manufacturers are unable to increase their share of a declining market by means of price reductions. A depreciation of the exchange rate would give them room to improve their sales performance.

In 2000 Britain's exports grew almost as fast as world trade; last year the data so far suggest that they grew slightly faster. The rise in the exchange rate since the mid-1990s led to a fall in Britain's share of world trade over the period 1997-9; the stability in Britain's trading position relative to the rest of the world last year reinforces our earlier view that the economy has now broadly adjusted to the high exchange rate. The share of imports in final demand continues to rise but this is a normal consequence of economic growth and does not, in itself, indicate incomplete adjustment to the exchange rate. The fundamental question is whether this adjustment has led to an external deficit which is in any sense too large. In 2001 our analysis suggests that the deficit was 1.4 per cent of GDP, down from 1.8 per cent of GDP in 2000. A larger deficit is projected this year with an increase to over 3 per cent of GDP in 2004 before falling back to under 2 per cent of GDP. Much larger trade deficits are offset by surpluses in invisibles. The latter include a number of erratic items, making them difficult to predict. But if the United Kingdom retains an external deficit of 2 per cent of GDP as our long-run forecast suggests and continues to grow in nominal terms at around 5 per cent per annum, then its net external debts will settle at 40 per cent of GDP as compared to a current value of 10 per cent of GDP. We do not see this as posing any particular problems. As a part of the process, payments of interest and dividends to the rest of the world will rise and the real exchange rate will have to depreciate so that export earnings rise enough to cover this. But the process is slow and can be accommodated by an inflation rate lower than the average of our trading partners, particularly since these include developing countries with rapid inflation as well as developed countries with low inflation. Nevertheless, we continue to believe that a lower exchange rate against the euro would be better and believe that EMU entry, if it occurs, should be at around [pounds sterling]1 = [euro] 1.50 rather than the current rate of [pounds sterling]1 = [euro]1.61.

Government spending and the fiscal position

The government's fiscal rules are that the current account should at least be in balance over the cycle and that public debt should be kept below 40 per cent of GDP. The cumulated current account surplus since 1999, when the Government believes the current cycle began, has been over [pounds sterling]40bn; we forecast a further surplus of [pounds sterling]13bn this year. Taken together, these mean that that deficits of well over [pounds sterling]50bn can be incurred in the rest of the cycle, whilst meeting the fiscal rules.

This shows a weakness of the first fiscal rule. The timing of the cycle is outside government control. If the cycle ends next year the rule does not allow the cumulated surplus to be spent. If the current cycle persists for a further ten years, then there will be plenty of opportunity for spending the cumulated surplus. The rule would be less arbitrary if it were defined in terms of a fixed window, say five or seven years.

Looking ahead, recent weaknesses in the tax base, combined with planned increased spending, leads to a current account of around zero from next year onwards. This assumes growth in real spending on goods and services of about 2.5 per cent in 2004 and 2005.

The outcome is spending over [pounds sterling]8 billion higher than in the Government projection in 2005. If the recommendations of the Wanless Report were implemented spending on health might rise by around [pounds sterling]10bn (Wanless, 2001). It is not clear how much of this would be investment rather than current spending. But our projection suggests nearly all of the spending can be accommodated without leading to a current deficit. Even if all of the increase were current spending and the introduction of the Child Tax Credit, which provisional estimates suggest could cost [pounds sterling]3 billion, led to an overall increase in spending of [pounds sterling]13bn compared to existing government plans, the cumulated surplus over the cycle so far would be enough to pay for the extra public spending for several years with no increases in taxes. We doubt that such a fiscal boost would be consistent with a well-balanced economy, but it is important to note the degree of flexibility available within the Gover nment's fiscal rules. The budgetary position does not point to a need for tax increases in the March budget, although taxes could still be raised if the Government feels that this would improve macroeconomic stability.

We continue to be concerned that the Government finds it difficult to meet its investment targets; this is probably because of excessive reliance on public-private partnerships. Their complexities mean that they can slow down the decision-making process and put obstacles in the way of public investment.

Chart 1 shows just how low public net investment has been in this country as compared to the United States, a country not noted for the size of its public sector. The data for both countries are taken from their national accounts so as to put them on a comparable basis. The UK figures thus exclude capital grants to the private sector which are included in HM Treasury figures for public net investment. The comparison is all the more marked because the UK figures include investment in areas such as the health service which are in the private sector in the United States.

Arguably the official Treasury data overstate the Government's true contribution to net investment as well as being not comparable with those of some other countries. The figures include capital grants to the private sector. However, unless the depreciation of investments financed by such grants is included in the depreciation total, the figure is a combination of net and gross amounts rather than a genuine net figure.

Productivity

We present on pages 38--43, our estimates of how productivity has changed in France, Britain, Germany and the United States and also an assessment of relative productivity levels.

The good productivity growth of the United States has been widely discussed. So it is striking that our figures suggest that Germany's productivity growth has been slightly better both in the late 1990s and in the longer run. The factors behind Germany's recent success are likely to be different from those influencing the United States. At the start of the last decade Germany had just been reunited. Productivity levels in East Germany were very poor and there was considerable room for improvement.

The figures show that Britain itself continues to suffer from low productivity. It might be hoped that Britain would benefit from the same sort of catch-up process which has taken place in East Germany but these data suggest that it is not doing so. A number of reasons are advanced for this, with our preferred explanation being that Britain's teaching and education system does not match the performance of others in Europe (see OECD, 2001a, p. 45). In our previous issue we carried articles on the problems with Britain's system of vocational training; here we include two articles on maths teaching in Britain, where much of the evidence suggests hat standards remain poor and could be improved relatively cheaply by helping teachers to teach better.

It has to be said, however, that a recent study by the Organisation of Economic Co-operation and Development (OECD, 2001b) suggested that maths teaching in Britain's schools performs now well by international standards. A National Institute paper (Prais, 2002) raises a number of questions about the way that his study was carried out, and suggests that these could have led to substantial biases.

The short-term economic outlook

We expect the broadly favourable position that Britain enjoyed last year to continue with a growth rate of 2.1 per cent forecast for 2002 and 2.6 per cent in 2003. The international picture is likely to improve as a US recovery is set in train. Inflation prospects continue to be favourable, with inflation to the end of 2002 projected at 1.6 per cent per annum rising to 2.5 per cent a ear later. The overall budget surplus is forecast to be [pounds sterling]1 1/2bn with a surplus on the current account of [pounds sterling]13bn. These figures are contingent on the government managing to achieve its spending plans; past experience suggests hat there remains some risk of under-spending.

REFERENCES

OECD (2001a), OECD Economic Survey: United Kingdom, Paris, OECD.

--(2001b), 'Knowledge and skills for life. First results from PISA 2000'. 322 pages, Paris, OECD.

Pain, N. and Weale, M.R. (2001), 'The information content of consumer surveys', Notional Institute Economic Review, 178, pp. 44-7.

Prais, S. (2002), 'Cautions on the recent OECD Educational Surveys, NIESR, mimeo.

Wanless, D. (2001), Securing our Future Health: Toking a Long-term View, London, HM Treasury, http://www.hm-treasury.gov.uk/Consultations_and_Legislation/wanless_i ndex.cfm?

[Graph omitted]

Summary of the forecast

 UK economy
 Probabilities (a)
 Inflation Real gross
 target Output national Real
 met (b) falling (c) income (d) GDP (d)

2001 - - 3.5 2.4
2002 84 1 2.2 2.1
2003 50 3 2.7 2.6

 UK economy
 Retail price index (f)
 Manufactring
 output (d) Unemployment (e) Excl.
 All items mortgages

2001 -2.2 1.55 1.0 2.0
2002 -1.8 1.68 2.3 1.6
2003 2.1 1.75 2.6 2.5

 UK economy World economy
 Retail price
 index (f)

 Current Real Consumer
 balance (g) PSNB (h) GDP prices (i)

2001 -14.0 -1.4 1.9 2.3
2002 -22.9 10.5 2.3 1.0
2003 -30.1 14.4 3.5 2.3

 World economy


 World
 trade (j)

2001 0.3
2002 4.0
2003 8.1

(a)In percentage terms.

(b)Inflation excluding mortgages below 2 1/2 per cent per annum at the
end of the year.

(c)A fall in annual output.

(d)Percentage change, year-on-year.

(e)ILO definition, fourth quarter millions.

(f)Percentage change, fourth quarter on fourth quarter.

(g)Year, [pounds sterling] billion.

(h)Public sector net borrowing, fiscal year, [pounds sterling billion.

(i)OECD countries, percentage change, year-on-year.

(j)Volume of total world trade, percentage change, year-on-year.