Sunday, January 23, 2005
Sun shines on UK prospects
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

THE starting gun may not have been fired officially, but the election is under way. My verdict on the Tories’ tax and spending plans can be found in the news section of the paper.

So let me focus here on a couple of other important issues. Some elections, as in 1992, are good to lose. This one is good to win because new research suggests that, short-term worries aside, Britain is very well placed in economic terms.

Professor Steve Nickell of the London School of Economics and the Bank of England’s monetary policy committee, has written a paper with two colleagues for the Economic Journal. Called Explaining the Rise in Unemployment in Europe Since the 1960s, it does what he says in the title.

In the 1960s, unemployment in America, and for that matter Britain, was higher than in the big European economies. Today that position is reversed. Germany, France, Italy and Spain have chronically high unemployment. America’s job market is strengthening again and Britain is flirting with full employment, with the claimant count showing a jobless rate of 2.7%.

Why is this? Most of Europe’s unemployment rise is caused by what the authors describe as changes in labour-market institutions. Of this rise, some 39% is due to changes in unemployment benefit systems, 26% to increases in labour taxes, 19% to the increased power of trade unions and 16% to changes in employment protection law — making firing more difficult and thus discouraging hiring.

Britain followed this trend during the 1960s and 1970s but moved sharply in the other direction during the 1980s. There is justifiable concern about the re-regulation of the labour market under this government but so far the damage appears to be limited.

This is confirmed by another piece of research, from Michael Saunders of Citigroup. He has looked in more detail at what lies behind a stunning statistic: economic growth in Britain has outstripped that in euroland, the 12 countries that make up the single currency, for 11 years in a row.

Part of the explanation lies with macroeconomic management. The Bank of England has shown itself to be more fleet-footed than the European Central Bank since 1999, and Europe’s fiscal rules, the stability and growth pact, are clumsier than Gordon Brown’s.

But the real story when it comes to Britain’s long-term outperformance has to do with the supply side, and Saunders has a particular view on that.

A common image of Britain’s economy is that we have too many low-skilled people. In fact, so- called knowledge-intensive sectors account for 41% of employment in Britain, higher than in France, Germany, Italy and Spain and well above the EU average of 33%. This is based on figures from Eurostat, Brussels’s statistical arm.

Knowledge-intensive sectors include computing, telecoms, financial and business services as well as legal and technical services, education and healthcare. They tend to be the parts of the economy growing fastest — and this, says Saunders, is the key to Britain’s success.

The flexible job market, and the light regulatory touch established by the Tories, allows the “creative destruction” that is characteristic of successful economies. Declining sectors shed labour; expanding sectors take on workers. This is a lot easier in economies where companies are not constrained by excessively rigid hire-and-fire rules. The main concern is how much Britain has slipped back in flexibility in the past few years.

But there is another reason to be cheerful about Britain’s prospects. The McKinsey Global Institute has just published a major study, The Coming Demographic Deficit: How Aging Populations Will Reduce Global Savings.

Its starting point is that the world, and in particular the advanced world, is getting older. Over the next 20 years the median age of the Italian population, for example, will rise from 42 to 51, while in Japan the rise will be from 43 to 50.

Real-world savings tend to follow the life-cycle hypothesis developed by Franco Modigliani, the late Nobel prize-winning economist. People do not save much when they are young, build up a lot of savings during middle age, and draw down those savings in retirement.

The hypothesis is embodied in pensions. The more old people there are in the population, the greater the proportion who will be in this drawdown phase of their savings lifecycle. If overall savings are down, so is the prospect for future financial wealth. McKinsey calculates that the annual growth rate of net financial wealth in America, western Europe and Japan will drop from the 4.5% of the past three decades to 1.3% over the next two.

Britain, however, does better than most, for three reasons. The first is that savings in Britain have tended to be lower than in other countries — as Mervyn King noted last week — and they are less of a direct contributor to the growth in net financial wealth.

The second reason is that Britain is less affected by ageing than elsewhere, partly because of continued immigration. The median age of the UK population will rise by only three years between now and 2025, from 38 to 41.

The third reason is the most interesting of all for economists. Whereas all other advanced economies obey the life-cycle hypothesis, Britain, according to the McKinsey evidence, does not. People carry on saving into old age and retirement, perhaps because of the generosity (in the past at least) of company pension schemes. Ageing, therefore, has less of a negative effect on savings than elsewhere.

The result of all this is that while the growth in net financial wealth will fall from 5.1% to 3.2%, it will do so by much less than elsewhere. This is good news, and has little to do with politicians — which will be worth remembering amid the claims and counter-claims of the coming weeks.

PS: One of the great debates at the moment, apart from whether house prices will crash, is what would happen if they did. The Financial Services Authority (FSA) last week bravely had a stab at predicting the consequences of a 30% fall in house prices.

Inflation-adjusted house prices dropped by more than 30% in the last recession and by nearly as much in 1973-76, but cash prices have never fallen so much nationally.

The Bank of England, out of which the FSA grew, normally tries to avoid such talk. In fact, it has been arguing that a fall in house prices might not have much effect on the economy because the link between housing and consumer spending appears to have broken during the latter stages of the boom.

The Bank’s economists could not, however, reasonably stretch this to cover a 30% drop in prices, which would hit the economy hard. December’s 1% drop in retail sales could, in other words, be the shape of things to come.

According to the FSA, there would be a considerable kerfuffle if prices fell that much. Household wealth would be hit by the best part of £1 trillion and consumer spending would drop. This would result in higher unemployment, in turn hitting economic activity further.

The Bank would cut interest rates, the FSA says, but this would be unlikely to stop the damage, at least in the short term. A house-price crash, in other words, would be associated with a general recession.

Will it happen? I will soon be debating the housing market again with Roger Bootle — entering the bear’s lair — and will report back.

From The Sunday Times, January 23 2005

Comments

"too many low-skilled people"

“Skill” is normally measure by educational attainment, on which measure Britain compares poorly with Europe. However many of the skills required for “so- called knowledge-intensive sectors” are best learnt on the job as opposed to in education – in particular cutting edge computing skills. Thus a degree of the success of the British economy can be attributed to the fact that bright kids were working as opposed to taking 7 year undergraduate degrees learning redundant concepts like their peers in Germany.

Again the question then needs to be asked about whether the expansion in higher education is therefore going to hinder this competitive advantage.

Posted by: Giles at January 23, 2005 07:26 PM