Commentary.

Pain, Nigel ; Weale, Martin

Introduction

Two factors have served to worsen the economic outlook as compared to the picture in the early Summer. In this country, the signals from the data have been changed by the sharp fall of industrial output in June. The bulk of the fall was almost certainly due to the Jubilee holiday, with some firms shutting down for the whole week. But the recovery in July was to a level lower than had been reported in May and the August figures also show only modest growth. What had been interpreted as rapid recovery in the Spring now seems to have been exaggerated by businesses producing extra output in May, in advance of the slowdown in June, so that it is unlikely that the shortfall in June was made up in the third quarter. The implication is that growth in the year as a whole is going to be lower than appeared likely ahead of the June figures.

The second factor has been the continuing weakness of international stock markets. In preparing our latest forecast we assumed that the FT-All Share Index in the fourth quarter would be 25 per cent lower than in the second quarter. This would be 15 per cent lower than had seemed likely at the time of our July forecast. Day-to-day movements remain volatile, and the market has since recovered a little, but it remains significantly lower than in the first half of 2002. Offsetting this worsening there has been a sharp fall internationally in long-term interest rates, at least on highly rated debt, as investors have switched from shares to bonds.

Our analysis in the July Review (Barrell, 2002) suggested that the market movement between our July forecast and preparation of this forecast could take 0.2 per cent off UK growth in the current year, with a further reduction of about 0.5 per cent next year. While share prices in Europe are no longer far from 'normal' levels, those in the United States are still high compared with historical norms. Given the short-term correlation between movements in European markets and those in the United States, the risk of a further downward adjustment in the United States may well have implications for European markets and this creates a downside risk for our forecasts. On the other hand, given the market fall which has already taken place, this downside risk is smaller than at any time in the last four years.

The possibility of war with Iraq remains. We have constructed our forecast on the assumption that a war, if it takes place, does not have a substantial disruptive influence on the world economy, although higher oil prices will push up consumer price inflation a little.

These factors, and particularly the stock market movements, have pushed discussion of the exchange rate into the background. The euro has weakened slightly in the last quarter while the US dollar has been stable against sterling. Much less is heard about the overvaluation of sterling now than in the early part of the year. Our view is that the main reason why businesses seem less concerned about overvaluation is the fact that exports have picked up considerably since the start of the year, although the third quarter has been less good than the second. If UK export demand weakens further, we will probably hear complaints from business about sterling being overvalued once more.

Convergence with the Euro Area

The debate over Iraq has meant that the question of UK membership of the Euro Area is less prominent in the news. On page 58 of this Review we present further analysis of the question of convergence between the UK and the Euro Area. It is shown there that absolute divergences in cyclical positions are much smaller than they were in the late 1980s, when the UK was affected by the Lawson boom, and the early 1990s, when Germany was stimulated by the boom which followed re-unification. Correlations between cyclical positions are, on the other hand, relatively low and, in particular, lower than they were during the period of fixed exchange rates. The main inference to be drawn from the study is that, without country-specific shocks, whether policy-induced (as in the UK) or exogenous (as in Germany), the cyclical divergences between the UK and the Euro Area are not very great even though the correlation is low. But the evidence for the fixed exchange rate period points to the possibility that the convergence proces s may be endogenous, with the correlations depending on the exchange rate arrangements in force.

Meanwhile one can draw attention to one of the paradoxes of the debate. Growth in the Euro Area has recently been lower than in the United Kingdom, and the outperformance of the latter is believed to concern the European Commission. In the public debate it is widely believed that, were Britain to join the Euro Area, its economic performance might be damaged. But if Britain were to join the Euro Area with even the latter's current interest rate, the rate in the United Kingdom would be lower than it is now. In fact we expect a reduction to Euro Area interest rates, enhancing the effect. If the entry took place at the sort of exchange rate we have recommended in the past, [pound sterling]1 = [euro]1.45-1.50, then there would be some additional stimulus from the fall of sterling against the euro. These two factors taken together would be bound to stimulate rather than depress growth in the United Kingdom, at least in the short term, and the worry would be more that they might be excessively expansionary rather th an in any sense contractionary. Thus, while the European Commission is right to be worried about poor growth in the Euro Area, it does not follow that UK growth would be depressed by UK membership.

While HM Treasury has identified a number of subsidiary questions over membership as developments of the five tests, the most substantial residual question is whether, or how easily, the UK could move to a situation in which interest rates and probably the exchange rate are lower than at present without an excessive expansion. Our analysis last July (p. 43) suggested that membership in the exchange rate range mentioned above would give a limited and tolerable boost to inflation. It would also boost economic growth. In producing our forecast, however, we continue to assume that the UK will not join the euro.

Fiscal policy and the Stability and Growth Pact

The evolution of the fiscal position is of considerable political interest. HM Treasury may well bring its forecast for growth this year, which, when published in April, was 2 per cent, into line with other forecasters. This will take account of the depressing influences which have emerged in the past three months. A reduction of growth from 2 per cent to say 1 1/2 per cent is not a large change over the course of a year and the fact that it is likely to lead to a shortfall of tax revenue is not of enormous importance. Of greater concern is the fact that the Treasury's medium-term projections assume considerable revenue buoyancy -- an issue which we discuss on page 42. We project a revenue shortfall of 1.3 per cent of GDP by 2006-7. This points to a need for further tax increases to reach the Government's borrowing targets. Additional tax rises are probably needed beyond these to restore long-term solvency to the public finances.

A separate worry is, however, the possibility that Britain's rate of productivity growth may have slowed. Between 1979 and 1997, output per hour worked grew by 2.3 per cent per annum. Between 1997Q2 and 2002Q2, output per hour worked grew at 1.7 per cent per annum but over the past two years the growth rate of output per hour worked has fallen to 1.2 per cent per annum. Productivity growth is often slow during periods of weak demand growth; firms are thought to hoard labour in downturns so as to avoid costs of recruiting new workers in upturns. But the period from 1997 to 2000 was certainly not a downturn and since then demand weakness has not been universal. If these figures do represent a situation in which output per hour is going to grow considerably more slowly than it had in the past, then a situation will develop in which very substantial tax rises will be needed to meet the Government's spending plans.

The last few days have seen, essentially, the repudiation of the Stability and Growth Pact. Had the large economies of the Euro Area stabilised their public finances ahead of the recent economic weakness, the pact would have survived. But this would have required lower interest rates and there has been no satisfactory means of coordinating monetary and fiscal policy in the Euro Area. Some form of fiscal rule is undoubtedly needed, but the question of proper monetary/fiscal coordination needs to be addressed Any fiscal rule including the UK's own rule, faces the problem that a temporary breach doesn't matter, while a permanent breach does. The requirement that the rule should apply 'over the cycle' rather than year by year does not resolve this fundamental problem.

Monetary judgement

The Monetary Policy Committee faces difficult judgements. On the one hand, it sees output growing at slightly below the trend rate and inflation also below its target. This might provide a basis for a rate cut. On the other hand, house prices have continued to rise very sharply, and a cut to interest rates would be likely to aggravate house price inflation. It can be argued that such a situation is desirable because it provides a stimulus to consumer demand which is able to compensate for the weakness in other areas and so maintain a reasonable overall rate of growth. But one can understand why the Monetary Policy Committee would feel unwilling to treat the aftermath of the stock market bubble by inflating a house price bubble even further. With low interest rates it is likely that sustainable house prices are higher (relative to incomes) than was the case in the late 1980s. But it is less likely that the previous peak ratio of house prices to incomes, just reached, is now the norm. And it is also unlikely th at the government will adopt innovative fiscal means (a tax on mortgage payments) as a means of bringing the bubble under control.

Markets are giving a mixed picture of expected interest rate movements. Yields on government stocks with a life of one to two years are around 3 3/4 per cent per annum, indicating that, at some time over the next two years, markets are expecting the Monetary Policy Committee to set a short-term rate of 33/4 per cent per annum, the lowest since 1955. On the other hand, money market rates for the next year do not point to a cut. Perhaps a reduction in the United Kingdom is most likely if there are substantial reductions in the other major economies: otherwise there would be concern about a new rise in sterling. On balance, we think the interest rate should not be reduced at present and we have constructed our forecast with this assumption.

Risks of deflation and Japanese problems

A number of commentators have recently drawn attention to the risk of deflation, as though falling prices were bound to be associated with weak economic growth. Japan is often cited as the only recent example of this phenomenon. It is necessary first of all to state quite clearly that falling prices need not be associated with poor economic growth, as Britain's experience in the 19th century demonstrates. Thus between 1880 and 1890 output grew at 2.2 per cent per annum, while prices fell by 0.6 per cent per annum. The question arises whether the factors which made it possible to thrive in a deflationary environment have disappeared; the best case one could make for this is that wage reductions are harder to impose than they were in the 19th century, so that with modestly falling prices relative adjustments to wage rates are harder to achieve, and this may impede economic growth.

The concern about deflation is such that even price falls in some sectors of the economy are taken as a sign that deflationary problems are about to emerge. It is plain that sectoral price falls are not a problem. In 1998 and 1999 UK producer output prices fell. But 1998 saw growth of 2.9 per cent and in 1999 output grew by 2.4 per cent.

The reasons usually given for deflation leading to weak growth are that falling prices discourage consumption because they generate a real return on cash, and that they increase the burden of debt. These points are both true but they have to be kept in perspective. In Japan the real return on cash is lower than was the inflation-adjusted return on UK building society deposits in much of the 1980s. Positive real returns to saving do not, in themselves, damp consumption. Secondly, people who borrowed, at least on fixed rates of interest, find that the burden of their debts is increasing. Exactly the same thing happened in Britain as the inflation rate came down. Firms who borrowed for twenty years in the early 1980s when the long-term interest rate was 12-15 per cent face a much larger real burden than they had expected. The effects of mild deflation are no different from this, except that the move from an inflation rate of 2 1/2 per cent per annum to one of -1 per cent per annum is much less than a change from expected inflation of say 10 per cent per annum to the current target of 2 1/2 per cent per annum.

The implication of these various observations is then that the deflation in Japan is the consequence rather than the cause of its problems. There are two fundamental causes of Japan's difficulties. First of all, for years Japan has been overcapitalised and has invested too much, leading to low rates of return. Even in 2001 the private sector invested 19 per cent of GDP, as compared to an average of 15.8 per cent in the United States (1991-2001). By any reasonable measure Japan invests too much. Secondly, Japan has an ageing population and therefore has a very high level of saving ahead of retirement. Logic dictates that Japan's savings should be invested abroad rather than at home, but this requires (i) a much lower exchange rate and (ii) a willingness of its trading partners to allow it to run large trade surpluses. An end to deflation will not change these facts.

Japan is badly affected by bad debts owed to the banking system. These are largely a consequence of it having over-invested at home instead of having been able to run the external surplus it needs. Deflation has aggravated this problem. Rising prices and negative real interest rates would transfer resources from the public at large to the banking system and restore its solvency. Politically this may be the easiest solution, but it is not the only one. For example an alternative would be to commit public money, with the extra spending financed by expanding the monetary base. Inflation is a tax much like other taxes. Whether the bank debts are covered by inflation or by taxation the cost is borne by households.

Should prices start to fall and demand falter outside Japan, financial policy could be used to restore demand. An income tax holiday with public spending financed by monetary expansion would eventually exert a stimulus. In a parliamentary democracy such as Britain's, measures of this type could be implemented from one day to the next. The real worry about a combination of deflation and weak demand is that other political systems, such as the United States', may nor have the flexibility which would be needed.

The policy set out above can be seen as a practical form of the fiscal policy described by Friedman (1969). He discussed a "helicopter drop" of money - essentially a fiscal transfer to the public at large financed by an expansion of the monetary base.

UK prospects

We see output growing by 1.4 per cent in 2002, mainly as a result of the pause in economic activity last winter. Next year we expect to see the growth rate increasing to 2.5 per cent, a value close to the long-term trend. There are no inflationary risks present, but, with the gradual revival in economic activity, we expect to see inflationary pressures rise slightly, taking inflation to its target in 2004. Public sector borrowing is forecast to be [pounds sterling]14.1bn, as compared to [pounds sterling]11bn predicted by the Government at the time of the Budget. The current balance is expected to show a deficit of nearly [pounds sterling]2bn as compared to the surplus predicted by the Government of [pounds sterling]3bn.

Summary of the forecast

 UK economy

 Probabilities (a)

 Inflation Real gross
 target Output national Real Manufacturing
 met (b) falling (c) income (d) GDP (d) output (d)

2001 - - 2.8 2.0 2.3
2002 100 1 2.7 1.4 -3.8
2003 84 4 2.5 2.5 2.0

 UK economy

 Retail price index (f)


 Excl. Current
 Unemployment (e) All items mortgages balance (g)

2001 5.1 1.8 2.1 -2.1
2002 5.2 1.5 2.1 -1.3
2003 5.4 2.4 2.2 -1.5

 UK economy World economy




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

2001 0.0 2.2 2.1 0.3
2002 1.3 2.8 1.8 2.7
2003 1.6 3.4 1.9 7.4

(a) In percentage terms.

(b) Inflation excluding mortgages between 1 1/2 and 3 1/2 per cent annum
at the end of the year.

(c) A fall in annual output.

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

(e) ILO definition, fourth quarter, rate.

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

(g) Year, % of GDP.

(h) Public sector net borrowing, fiscal year, % of GDP.

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

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

REFERENCE

Friedman, M. (1969), 'The optimum quantity of money' in The Optimum Quantity of Money and Other Essays, London, Macmillan, p.4.