Commentary.

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

Introduction

It is now reasonably certain that the recovery to growth rates, both in the United Kingdom and internationally, has started. While growth in the first quarter was below the long-run average, we expect a growth rate of about 0.7 to 0.8 per cent per quarter in the remainder of this year; giving a growth rate of 2.6 per cent through the year (2002Q4 relative to 2001Q4) and a level of output 1.8 per cent higher this year than last year. Inflationary pressures remain low and we expect inflation to remain slightly below target until late next year.

For quit a while, and in particular since mid-September, our forecasts have been slightly above the consensus. The experience of the past eight months certainly demonstrates the pitfalls of paying too much attention to movements in consumer and business confidence. However, partly in the light of poor economic growth in the first quarter of the year, lower projections for the growth of government spending this year and a poor performance by British exporters in sales outside the Euro Area, we are now more gloomy than we were three months ago. We had expected the United Kingdom to be the fastest growing major economy this year, as it was last year, while we now expect it to be beaten by both Canada and the United States.

The international environment

In both the United Kingdom and the United States strong growth in private consumption played the major role in sustaining overall output growth at the end of last year. This was, no doubt, underpinned by the interest rate reductions and was sharper in the United States where interest rates were reduced much further. In purely arithmetic terms, growth in government spending in the United States more than accounted for the aggregate rise of 0.4 per cent in GDP in the fourth quarter of last year. Thus it could also be said that the United States avoided a second quarter of falling output only because of this contribution from government spending. Without the expansion of public consumption growth, the United States would have experienced recession and the United Kingdom's performance would have been much more like that of other countries.

The United States is, of course, experiencing further fiscal stimulus, both because of the packages of tax cuts made over the past year, and as a result of the higher military spending associated with the aftermath of the destruction of the World Trade Centre. While we are starting to hear the argument again that fiscal intervention is invariably mistimed, the evidence of the fourth quarter of last year and the prospects for this year suggest that a more appropriate adverb would be sometimes. In 2002 we expect government demand to contribute 0.7 percentage points to growth in the United States and a further 0.6 per cent of GDP is to be added to private sector income through tax cuts. In the United Kingdom government spending will add 1 percentage point to GDP. In the Euro Area, by contrast, government demand will add only 0.3 percentage points to GDP and there is little extra stimulus from tax cuts. While interest rate reductions have undoubtedly been the dominant factor in supporting the world economy, the i mportance of discretionary fiscal developments should not be overlooked.

It is easy, also, to overlook the impact of the developing countries. Measured in purchasing power parity terms, the economies of China and India are now larger than Britain's. On the same basis the expansion of these two economies is estimated to have contributed over 40 per cent of world economic growth in 2001.

Interest rate and inflation prospects

At home there are conflicting signals for interest rates. On the one hand, inflation remains below target and wage pressures are easing despite continued falls in unemployment. On the other hand, as growth rates return to normal and with only a small output gap, it is difficult to see interest rates staying as low as 4 per cent per annum for much longer. The term structure of interest rates suggests that markets expect rates to rise by 1/4 point in the next three months and to reach 5 per cent by the end of the year and our forecast reflects this. This rise is slightly later than had been expected in the winter reflecting, in turn, the fact that growth in the first quarter appears to have been sluggish. However, it is possible that the Monetary Policy Committee will want to wait for evidence that growth rates have returned to the long-run average before they start raising rates. Even then, on past form, the rise may be fairly gradual because of concerns that a sudden rise might weaken confidence again. Thus t he rise could well be slower and later than current market expectations. In the short term, the Budget amounts to a modest fiscal tightening, but beyond 2003/4 it has given a stimulus to the economy, putting upward pressure on interest rates. Indeed by 2006/7 the stimulus reaches about 1 per cent of GDP, similar to the much-discussed fiscal package in the United States. We discuss this further below.

The proposed expansion of the health service and the increase in other categories of public spending does raise some awkward problems about pay, despite the favourable combination of declining wage inflation and falling unemployment which the country has been enjoying in the early part of this years. In April 2001 the average weekly pay of a full-time worker in the public sector was [pounds]432, while for the private sector it was [pounds]450. Increased demand for workers in the public sector is likely to lead to upward pressure on wages, and it is plain that the Government has revised upward its expectations of cost movements in the public sector. The increase in the cost of public sector consumption is now expected to be 1 per cent higher this year than was anticipated in the Pre-Budget Report of November last year.

Focus on the Monetary Union

In this Review we include four articles on aspects of the Euro Area and the European Union. The main points which emerge from our analysis are that there is a body of evidence which suggests that joining single currency areas can have a very favourable effect on trade and income levels, although there are reasons to believe that these overstate the benefits which would be likely to accrue to Britain because they are mainly based on findings for much smaller and less-developed countries. Euro Area membership would be likely to lead to a more stable price level as a result of removing the influences of exchange rate changes against much of Europe and this might be expected to be good for investment, although a reduction to exchange rate uncertainty could actually discourage some types of foreign investment in Britain (Pain, 2002, p.96).

However, O'Mahony (2002, p.72) argues that productivity differences between different European countries are more due to differences in infrastructure and skill bases, so that membership of the Euro Area could be expected to have only a relatively small effect on productivity. Employment depends mainly on labour market structures rather than monetary arrangements, but the effects of improved productivity on real wages could have a favourable effect on labour force participation and thus on employment. In terms of similarities between financial institutions in the United Kingdom and the Euro Area, Byrne and Davis (2002, p. 83) point out the diversity in the structures of financial markets and financial institutions within the existing Euro Area. Britain fits inside the existing spread of Euro Area financial structures instead of lying outside it. Thus there is no reason to believe that Britain would face any particular need to make its structures converge to a monolithic Euro Area model.

It is in the nature of research that, since more and more information can accrue, no one could expect the five rests on Euro Area membership to be answered beyond all reasonable doubt. However; Barrell (2002, p. 54) concludes that they have been met for practical purposes.

The question of the exchange rate continues to dog the issue of Euro Area membership and with it the question of whether and by how much sterling is overvalued. Barrell (2002, p. 54) concludes that the benefits of Euro Area membership should be compared to the transition costs of entering at the wrong rate, either too low or too high. In particular the benefits from greater exchange rate stability may have to be set against the short to medium-term output losses that would come from entering at an overvalued exchange rate. Pain (2002, p.96) acknowledges that joining the Euro Area at too high an exchange rate might mean that the benefits of membership never arrive. Barrell simulates the effects of membership at different exchange rates and suggests that in view of the risks involved membership should take place in the range [pounds sterling]1 = [euro]1.50-1.55. But a particular problem could arise if Britain were to join at even 1.50, and the euro were to subsequently rise markedly against the US dollar.

Perhaps it is harder to see the exchange rate adjusting outside the Euro Area than if Britain were to join. Given the fact that the inflation targets are similar in Britain and in the Euro Area, and that jumps to exchange rates cannot sensibly be forecast, it follows that for the real exchange rate to be expected to change against the euro, either Britain has to be expected to undershoot its inflation target or the Euro Area has to be expected to overshoot its target. With both the Bank of England and the European Central Bank having broadly similar inflation targets, it is difficult to see how this could happen. Financial markets expect only small changes to the nominal exchange rate and they also expect, based on a comparison of the interest rate on indexed government stocks, that inflation in the United Kingdom is expected to be faster than that in France, driving the real exchange rate up rather than down.

We have previously attributed much of the weakness in manufacturing to weakness in world trade (Riley, Pain and Weale, 2002) rather than the high exchange rate, and it will be interesting to see whether manufacturing output starts to recover as world trade improves. Certainly we note that recently business sentiment has improved, which is encouraging. On the other hand, early evidence suggests that, having held its share of world trade for two years, Britain saw it decline in the fourth quarter of 2001. This is, nevertheless, difficult to interpret because the decline was in exports to non-EU countries, while the concern about overvaluation is most marked vis a vis the euro. However, there is no doubt that a lower exchange rate would increase manufacturing margins, which are now low and are probably curtailing manufacturing investment. Manufacturers must be puzzled why the government is concerned about the effects of euro membership on the financial services industry, which are directly explored in one of the five tests, more than it seems concerned about the impact of non-membership on manufacturing industry.

Government spending and the long-term fiscal position

The government's spending plans and the Wanless report (Wanless, 2002) point the way to further increases in taxation. There are several factors compounded. First of all, an analysis by the National Institute based on long-term projections implied that, for the public sector to remain solvent, i.e. with the present discounted value of spending plans equal to the present discounted value of revenues, but not taking account of the budget changes, taxes needed to be raised by 0.5 per cent of GDP. The longer such a tax rise is delayed the larger it becomes. But this calculation inevitably relies on a number of arbitrary assumptions and one could regard the position pre-budget as having been broadly consistent with long-term balance.

Secondly, we are now concerned that the Government's tax revenue forecasts are over-optimistic. Our own model of the economy indicates that, for the Government to meet its own revenue target for 2006/7, a second tranche of taxation equal to 0.5 per cent of GDP is needed. This difference arises mainly because our general view of tax revenue is less buoyant than is the Government's.

Thirdly, even with the tax increase, our forecast shows public borrowing higher in 2006/7 by [pounds sterling]7bn (0.5 per cent of GDP) compared to the Pre-Budget Report. Given the position before the budget, which we regard as reasonably close to long-term balance, this extra deficit needs correcting with an additional tax rise.

Wanless suggests that spending on the health service is likely to need to rise further, from the 7.8 per cent of GDP which the Chancellor expects to reach in 2006/7, to an eventual 9.9 per cent of GDP, creating a need for further taxation of 2.1 per cent of GDP. This figure may be reduced, if rising incomes mean that the proportion of health treatment provided privately increases. But it is more likely that, if the quality of National Health Service treatment improves, there will be a flow of patients back to the National Health Service, and the expenditure faced by the public purse will be increased.

Taking these figures together, the implication is that for the full implementation of the Wanless Report and of the other changes described in the budget, total extra taxation of over 3 per cent of GDP is needed. We should, however, note first that there are inevitably large error margins around these calculations and secondly, that if the tax rises are implemented ahead of the spending increases, then the eventual size of the tax rises is somewhat reduced. But, starting from the finding that the public sector was, before the budget, close to balance, there is the clear implication that, given the budget and if Wanless' proposals are to be implemented in full, very substantial further tax rises will be needed.

Effects on saving

There is another aspect of the Budget which merits some attention. At a time when the government is keen to encourage saving for retirement, there is more than a small risk that the increased revenue will be paid for out of saving rather than out of consumption. Logically, it ought to make no difference whether taxes are collected as payroll taxes paid by firms or as income taxes paid by employees. In much the same way, labour markets should establish wage rates based on overall labour costs, taking on board factors such as employers' pension contributions. But in practice these market forces may take some time to work through the system. Firms are likely to meet at least some of the increased national insurance employers' contributions by reducing pension contributions. Since it is unlikely that such reductions are immediately offset by other increases to household saving, the overall impact may well be a reduction to saving. In consequence, while the extra national insurance contributions will raise revenue , they will not reduce demand as much as might have been expected. It is true that, because national insurance contributions are not paid on employers' pension contributions, there will be a substitution effect encouraging pension contributions. We expect this to be more than offset by the income effect set out above.

This pattern would follow one we have seen since 1997, with a sharp increase in public sector revenues being associated with a sharp fall in household saving. It has the consequence that interest rates will be pushed higher than if the tax revenue had been collected from a tax such as VAT which impacted more upon consumption. In that sense the budget is likely to be expansionary in both the short and the long term.

Summary of the forecast

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

2001 - - 2.9 2.2 -2.3
2002 74 1 1.7 1.8 -2.8
2003 50 2 3.4 2.9 2.0

 UK economy
 Retail price index (f)

 Unemploy- Excl. Current
 ment (e) All items mortgages balance (g) PSNB (h)

2001 5.1 1.0 2.0 -17.4 -2.6
2002 5.4 2.5 2.0 -28.2 12.0
2003 5.7 2.7 2.5 -28.9 15.1

 World economy


 Real Consumer World
 GDP prices (i) trade (j)

2001 2.4 2.1 0.0
2002 2.6 1.5 3.6
2003 3.7 2.1 8.5

(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, four quarter rate.

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

(g)Year, [pounds] billion.

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

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

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

REFERENCES

Barrell, R. (2002), 'The UK and EMU: choosing the regime', National Institute Economic Review, 180, April.

Byrne, J and P. Davis. (2002), 'A comparison of balance sheet structures in major EU countries', National Institute Economic Review, 180, April.

O'Mahony, M. (2002), 'Productivity and convergence in the EU', National Institute Economic Review, 180, April.

Pain, N. (2002), 'EMU, investment and growth: some unresolved issues', National Institute Economic Review, 80, April.

Riley, R, N. Pain and M.R. Weale. (2002), 'Commentary', National Institute Economic Review, 179, January, p. 5.

Wanless, D. (2002), 'Securing our future health: taking a long-term view', http://www.hm-treasury.gov.uk/Consultations_and_Legislation/wanless/c onsult_wanless_final.cfm