COMMENTARY.

Weale, Martin ; Young, Garry

Introduction

The average of the growth rates for the UK economy, forecast for 2000 by independent forecasters, is currently 3.1 per cent; and in his Budget statement of 21 March the Chancellor of the Exchequer forecast growth of 2 3/4-3 1/4 per cent. Since these forecasts were produced, the picture building up from first quarter data suggests that growth has been slower than at the end of last year. Industrial production has continued its decline, with manufacturing output looking weak under the influence of the high exchange rate and the mild winter having depressed the output of the energy industries. In such circumstances, extremely rapid growth from the service sector would be needed to deliver boom performance for the economy as a whole. Accordingly, our forecast for economic growth during 2000 is, at 2.8 per cent per annum, slightly below that of the consensus. Our forecast of 2 1/2 per cent in 2001 is in line with other forecasters.

However, looking further ahead, we see a favourable constellation of events, with economic growth continuing at above-trend growth rates. This is made possible because we anticipate relatively rapid productivity growth. In the late 1990s, as employment expanded, productivity growth was very slow. This may have been because the productivity levels of the new entrants into the labour force were low. We anticipate that, as their experience of work builds up, so their productivity will rise, and the economy will therefore be able to make up the lost productivity growth of the late 1990s. Thus productivity growth, after its recent poor performance, is expected to rise above 2 per cent per annum for much of the new decade.

While this acceleration of productivity growth will, if it materialises, be very welcome, it is important to remember just how large the gap is between the United Kingdom and our neighbours. O'Mahony (1999) found that, in 1996, output per hour worked in the market sector of the economy was 28 per cent higher in the US, 20 per cent higher in France and over 30 per cent higher in Germany than in the UK. It would take eighteen years with productivity growing 1 per cent per annum faster than in France for the gap with France to be closed. Preliminary work suggests that, at least with respect to the US and Germany, these gaps have widened since 1996.

The Budget

The Government produced an expansionary budget. The effect of policy measures was to increase spending and reduce taxes by a combined amount of [pounds]4bn in the current year rising to [pounds]11bn next year and [pounds]l6bn in 2003-4. Increased spending accounts for most of these figures. It is true, as the Government claims, that surpluses are higher than was forecast a year ago, but it is a mistake to infer from this that the budget is restrictive. The economy has reached its current level despite the fact that tax revenues have been higher than anticipated. Relative to where we are now, demand is being expanded by the modest tax cuts and more substantial increases in public spending announced in the budget.

The episode demonstrates the inadequacy of the Government's fiscal rules when faced with a budget surplus. The rules are set in terms of ceilings for the debt/GDP ratio and for current borrowing averaged over the cycle. They offer a useful format for policy when public finances have been lax and need to be brought back under control. They offer no guide in the current situation, although the Treasury has interpreted them to say it should aim for zero current deficit in the medium term. The increase in tax revenues certainly means that, defined relative to the fiscal rules, the budget appears restrictive. But it is adding to demand relative to what would have happened if taxes had not been reduced and spending had not been increased. The fact that the budget surplus is larger than had been forecast last year simply demonstrates that last year's forecasts were, as often happens with forecasts of public borrowing, incorrect.

The Government's fiscal slackening affects the rest of the economy. Were taxes to have been increased to pay for the extra public consumption, then the impact would have been spread reasonably evenly across the economy as a whole. By leaving the question of managing demand to the Monetary Policy Committee, the Government makes it likely that the adjustment will be focussed on those parts of the economy which are exposed to external trade, at least during a substantial adjustment period.

Because government spending is to be increased, those resources have to be supplied from elsewhere. Even if, as our forecast suggests, the presence of spare resources, or normal technical progress, mean that the extra output appears without any other industry contracting, the fact remains that the share of other output in total GDP will be reduced. If the whole of the adjustment is borne by manufacturing, and if the health sector increases by 1 per cent of GDP, for example, then the effect will be to depress manufacturing output by about 5 per cent, compared to where it would have settled. The budget means that manufacturing will become relatively less important to the economy.

Sterling and EMU

The high value of the pound has made the value of Britain's output higher than that of France for the first time since the 1967 devaluation. This 'achievement' is less impressive than might be thought when it is remembered that France has a population of similar size to Britain's, but has a smaller workforce and a much higher unemployment rate. Despite what one sometimes hears about the superiority of the British economy as compared to our continental neighbours, the fact remains that, in terms of output per worker, Britain is still performing less well than France. The combination of Britain's labour market performance with France's productivity would be impressive indeed.

For three years now the failure of the high exchange rate to have much impact on the economy may have been something of a puzzle. In the light of this experience the general consensus is that the equilibrium exchange rate is higher than was believed two years ago. Then it was suggested that a sensible rate for the pound would be around [epsilon]1.20; now a range of [epsilon]1.35-1.40 is more widely discussed. Should sterling hold its current level, estimates of a reasonable exchange rate will probably rise to around [epsilon]1.50.

However, the high exchange rate does now seem to be having the effect of depressing manufacturing output. In particular, it seems to be making the production of motor cars unprofitable, or at least not sufficiently profitable in Britain. A striking difference from the concerns expressed eighteen months ago is that then world trade was stagnant; now it is buoyant. It may well be that producers were putting up with the exchange rate, believing the level to be temporary and expecting the Government to proceed towards membership of the euro at a more competitive rate. Now producers who see the high exchange rate as permanent, and particularly those who invested in Britain in the mid-1990s when sterling was weak, regard production in Britain as uneconomic. But it also still seems to be the case that the difficulties are restricted to a relatively small part of the economy. Despite a weak trade performance overall growth remains brisk.

Nevertheless, the difficulties faced by the government's policy with respect to the euro are gradually becoming apparent. Britain could not enter the euro without agreeing an entry rate with the existing Euro-11. At the present exchange rate the UK government would probably be reluctant to join the euro, while the existing euro members might welcome the chance to lock in sterling at an uncompetitive rate. Should there be a period of sterling weakness, the position is likely to be reversed, with the UK government keen to lock in at a competitive rate and the existing Euro Area being unlikely to agree to this. During a period of prolonged sterling weakness, the UK and the Euro Area might be able to agree on a rate which is well below today's level, but which is not regarded as giving the UK a competitive advantage. Until this happens, while the UK may meet the formal entry requirements, agreement on entry may be difficult. While exchange rates do often change suddenly, a period of prolonged undervaluation of st erling probably needs to be built into the timetable. This presses against the political problems the country may face while it stays outside the Euro Area.

Of the current members of the EU, it seems likely that Denmark, Greece and Sweden will join shortly, leaving the UK as the only one of the IS outside the euro. in such circumstances, were the EU to retain its current size or new entrants into the EU also join the euro, it is possible to imagine a dynamic which would result eventually in the UK leaving the EU, even though no major political party in the UK is currently advocating this. With the UK as the only outsider, decisions will increasingly be made with reference to the 14 rather than the 15, and those decisions may increasingly conflict with the UK's interests. Where unanimity is required, the consequence may be acrimonious disagreement. Thus the UK may eventually face a stark choice between membership of the euro and departure from the European Union. It is with this in mind that Pain and Young (2000) discuss the benefits to the UK of EU membership.

Benefits of EU membership

Their study looked at Britain's links with the European Union and also at the costs of withdrawal from the Union. It suggested, first of all, that, 3.2 million jobs in Britain are connected with trade with the EU. It is, nevertheless, a mistake to infer that these jobs would be lost were Britain to leave the EU. Industrial structures evolve, and Britain's would probably be different outside the EU than in it. But trade with the rest of the EU would not fall very much even if Britain were to leave. Close to full employment is delivered by an efficiently-working labour market and not by membership of any trading organisation. Thus an estimate of the number of jobs linked to trade with the rest of the EU is, on its own, no guide at all to what might happen if Britain were to leave the EU.

EU membership confers two benefits on the economy. The first is that it provides access to a large market with no tariff barriers and without even the costs of customs checks and border controls. This increases the scope for Britain and the other members to specialise in the activities in which they have a comparative advantage. If we were to leave the EU, the benefits of trade would be adversely affected by tariff barriers, although, in view of the international agreements promoted by the World Trade Organisation, tariff rates on trade with the remaining EU are unlikely to be large, even when the additional costs of border controls and related administration are taken into account.

The second benefit is much more substantial. The UK has been very successful at attracting foreign investment over the past fifteen years or so. The evidence suggests (Barrell and Pain, 1997, 1998) that this has been a factor behind the improvement in UK productivity, and also that EU membership is one of the factors which makes the UK an attractive base for foreign companies. One can infer that, if the UK were to leave the European Union, inflows of foreign investment would be adversely affected. Since the process is one of 'stock adjustment' the outcome is one in which the stock of foreign investment continues to grow, but is always lower than it would have been inside the European Union. This effect is estimated to give a level of output inside the EU which is 2 per cent higher than it would be outside.

Membership of the EU also incurs a cost arising from the Common Agricultural Policy. This has the effect of supporting an industry which should probably be allowed to decline. The UK can buy its food more cheaply in world markets than by paying European farmers to produce it. Resources deployed in farming could instead be employed in industries which are competitive in world markets; if this were done living standards would be raised.

However, within the margins of uncertainty associated with such calculations, the costs of the CAP roughly offset the benefits of free trade, and neither turns out to be large compared with our estimate of the benefit conferred on the UK economy through inflows of foreign investment. Thus we put the long-term cost to the UK economy of leaving the European Union as delivering an output trajectory 2 per cent lower than we would expect the economy to realise inside the Union. Artis (2000) gives no reason to suggest the benefits of EU membership would be greatly modified by joining the monetary union.

As explained above, lower output need not be associated with any unemployment. People would be poorer and the gap with France and Germany would widen but, provided labour markets continue to function, they would have jobs. On the other hand, the actual process of leaving the Union is likely to be disruptive. It is quite possible that this could lead to temporary unemployment and income losses larger than those which persist in the long term.

Economic prospects

Our central view is that the economic situation looks very favourable. As we have explained, an improvement in productivity growth means that a period of faster than usual growth is likely. Inflationary pressures are likely to remain relatively subdued, although we do expect the interest rate to be raised to 6 1/2 per cent per annum in light of the recent Budget. In the longer term our forecast suggests that UK interest rates can converge with those in the Euro Area, meeting at 5 1/4 per cent per annum. Unemployment is set to remain low, with the claimant count stable at current levels, and inflation will remain under control.

There are, nevertheless, three main causes for concern in the UK economy at the moment. The first is that the exchange rate may now have reached the point where people start to scale down production of traded goods in the UK much more generally than has happened so far. The second concern is that, measured by the Average Earnings Index, average earnings are now rising at about 6 per cent per annum. The third is the situation faced in the world economy and discussed in pp. 33-61 of this Review. For the first time in a number of years the world economy is showing buoyancy. In a number of countries, as in the UK, tax revenues are buoyant. Governments see this as an opportunity to cut taxes, adding to demand at an inappropriate time and fuelling inflation. In consequence interest rates may well have to be raised more than markets are currently expecting.

If our first concern materialises, then demand will be inadequate to sustain the growth we have forecast and, as a consequence, the public sector finances will be worse than we have suggested. The second concern is about the supply side and raises the possibility that policy will have to be more restrictive than we forecast in order to prevent an inflationary boom. We have assumed that the rise in the earnings data reflects bonuses paid at the end of the year, rather than a sustained rise in labour costs; so far the Monetary Policy Committee seems to have taken a similar view. If it becomes clear that our view of the labour market (see pp. 8-12) is wrong, we would expect the Monetary Policy Committee to raise interest rates substantially faster than our forecast shows. Similarly, should our third concern be realised, and inflationary pressures build up in the world as a whole, then interest rates in the UK are likely to be higher and growth may be lower than we currently anticipate.

References

Artis, M. (2000), 'Should the UK join EMU?', National Institute Economic Review, 171, January, pp. 70-80.

Barrell, R. and Pain, N. (1997), 'Foreign direct investment, technological change and economic growth within Europe', Economic Journal, 107, pp. 1770-86. (1998), 'Real exchange rates, agglomerations and irreversibilities: macroeconomic policy and FDI in EMU', Oxford Review of Economic Policy, 14/3, pp. 152-67.

O'Mahony, M. (1999), Britain's Productivity Performance, 1950-1996, London, National Institute of Economic and Social Research.

Pain, N. and Young. G. (2000), 'Continent cut off: the macroeconomic impact of British withdrawal from the EU', National Institute of Economic and Social Research, www.niesr.ac.uk/niser/ukineu.pdf.

 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]
1999 - - 2.3 2.1 -0.1
2000 80 1 3.6 2.8 1.2
2001 56 9 2.7 2.5 1.6
 Retail pirce index [f]
 Unemploy- Excl. Current
 ment [e] All items mortgages balance [g] PSNB [h]
1999 1.7 1.4 2.2 -12.0 -10
2000 1.7 3.4 1.8 -15.8 -6
2001 1.6 2.7 2.2 -18.3 -2
 World economy
 Real Consumer World
 GDP prices [i] trade [j]
1999 3.4 1.3 5.6
2000 4.1 2.0 9.0
2001 4.1 1.9 8.8

(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] billion.

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

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

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