Sunday, October 16, 2005
Imbalances make the economy look wobbly
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Two weeks ago I asked whether, in the light of weak growth figures, rising unemployment and retailing armageddon, Gordon Brown’s luck had run out.

The jury is still out, but the headlines are not getting any better. Mervyn King, Bank of England governor, warned last week that the “nice” decade (non-inflationary, consistently expansionary growth) might be about to be replaced by something rather nastier.

The Organisation for Economic Co-operation and Development (OECD), which usually pulls its punches when criticising countries, told the chancellor that he would have to raise taxes by £10 billion or more. One big imbalance in the economy is Brown’s budget deficit.

Almost hidden among all this was the news that the trade deficit — the other big imbalance — hit a record £5.3 billion in August, taking goods and services together. In the old days a set of trade figures that bad would have had the chancellor writing his resignation letter. Indeed, one of the questions I get asked most often is how the country can run such a large trade deficit.

Those who remember when television news bulletins led with the trade figures wonder what has happened. Part of the answer is that television producers liked the trade deficit because it was one of the few economic indicators they could illustrate — usually with footage of ships and cranes.

But if the trade figures were such news then, why aren’t they news now? The stock answer is that trade has been dwarfed by capital flows. In the 1960s, when bad trade figures meant pressure on the pound and the threat of higher interest rates, capital movements were subject to tight controls. Now they are not.

A trade gap presents no problem as long as there are enough short and long-term capital flows. The United Nations Conference on Trade and Development (Unctad) says foreign direct investment into Britain last year exceeded that into China. We should note that long-term capital outflows from Britain were also enormous. But the point is that Britain’s trade deficit, and the wider, current-account deficit, are being easily financed by capital flows.

The trade gap may, however, represent a symptom of something deeper. This was one of King’s themes last week, in a speech to the CBI at Gateshead. For years the governor and his colleagues have been warning that, at some point, consumer spending would have to slow to allow the economy to “rebalance” in favour of exports and investment.

That moment has arrived or, as he put it, the risks of significantly weaker growth in consumer spending have “crystallised”. I will return to the implications of that for interest rates in a moment.

The OECD, which had nice things to say last week about Britain’s macroeconomic management but was down on just about everything else, offered a twin explanation for Britain’s economic imbalances. One is that growth in Britain has been stronger, and more biased towards the consumer and government spending, than in other countries, particularly in continental Europe. On that basis the cure for the trade deficit lies with slower growth in demand in Britain. The solution to the budget deficit lies with slower growth in public spending or higher taxes.

The OECD’s analysis also suggested, however, that the problem goes beyond this. Its list of Britain’s supply-side failings pretty well cover the ground, including low levels of skills and education standards, “mediocre” innovation performance, poor productivity, poor value for money in government spending, a creaking and unreliable transport infrastructure and a failure to tackle unemployment that is disguised as incapacity.

The bottom line is that, for all the recent success in controlling inflation and maintaining growth, Britain is uncompetitive, hence we have a permanent or “structural” trade imbalance. We do not make enough things people want to buy, but we will always want to buy things made in other countries. Hence also the fact that big increases in government spending have left us with a large budget deficit but not world-class public services. None of that will come as a huge surprise to British readers, though the OECD imprimatur gives it extra weight.

Is this all too gloomy? The stand-off between the chancellor and most independent economists on fiscal policy has been going on for some time. He insists, without closing the door entirely, that he will not have to raise taxes substantially. They insist he will. He, of course, makes the decisions, and is the guardian of his own fiscal rules, as well as his political destiny. For both reasons I would bet against big tax hikes.

As for trade, the latest horror was partly due to Hurricane Katrina, and payments by Lloyd’s of London that reduced the surplus on services. There was also an unexpected — and temporary — deterioration on oil trade as a result of North Sea shutdowns. Overall export volumes in the latest three months were, surprisingly, up 8.8% on a year earlier. But even so, the annual deficit on goods is running at £60 billion, and on goods and services at more than £40 billion.

Will the rebalancing in favour of exports and investment occur and allow the economy to grow even if consumer spending is weak, simultaneously reducing the trade gap? The Ernst & Young Item club, which uses the Treasury’s model of the economy, is mildly optimistic. Its new forecast, to be published this week, predicts a pick-up in growth from 1.6% this year to 2.2% next without any rise in consumer spending. It also thinks this will happen without any help from the Bank, and sees base rate staying at 4.5%.

I’m not so sure about that. While King’s speech was interpreted as hawkish, he has moved from where he was when he was outvoted on the rate cut in August — when he questioned whether consumer spending was slowing — to his current position of questioning how much the Bank should do about it.

Other members of the monetary policy committee will just see the fact that growth is weak, and should be prepared to do something. Whether that gives us a cut in rates next month is still open to debate. Like much else, it’s in the balance.

PS: Everywhere I go there are roadworks. Roads that look to me to be perfectly well surfaced are being resurfaced. Pavements that have coped for years are being repaved.

One side of the Blackwall tunnel in east London is undergoing a refurbishment that began in 2002 and was due to be finished 18 months ago. After that they will begin work refurbishing the other side.

The consequence of all this is an increase in traffic delays and congestion, which has an economic cost. Nobody appears to co-ordinate these things or attempt to minimise the disruption. You can bet that if one road is being dug up you are bound to see roadworks on the alternative route too.

All this generates work for JCB drivers and tarmac spreaders. Keynes once observed that a good way to generate work was for the Treasury to bury old banknotes deep under the ground and leave it to private enterprise to dig them up. This may be the modern equivalent.

There is an economic explanation for this digging. Thanks to a decision by the Office for National Statistics earlier this year, much road maintenance and repair work counts as public investment — capital spending — rather than current expenditure. Brown’s golden rule, simply defined, is to only borrow to fund such investment over the economic cycle. The more roadworks, the more he can borrow.

Just as well he doesn’t drive.

From The Sunday Times, October 16 2005


Mervyn King was dead on in his speech this week.

We have had an economy based mostly on consumer spending for the past several years, encouraged by ultra-low interest rates and borrowing on the back of a house price bubble.

So, now this is over, the economy has to swing further back to business investment and exports.

Oh - but look what's happened in the meantime - we have been deteriorating in the face of the sweatshop economy in China and India who are getting stronger than they ever have before, and business in this country have no loyalty anymore to Britain, they just want the cheapest and that's what these countries give them.

It seems to me that now we are going to be relying in future on both manufacturing imports, and now energy imports as well since North Sea oil has peaked and we must also bring in gas from other countries.

What have we got left ? The house price bubble doesn't look so clever now, does it ?

Posted by: Warwickshire Lad at October 16, 2005 09:51 PM

It was good of the ITEM Club to put the boot into Gordon as well this week by blaming the UK’s problems on the house price bubble, consumer borrowing2spend and public spending – rather than the oil price excuse:

It’s also worth mentioning another peculiarity about British trade. In Q2, yes we did have a massive trade in goods deficit of £14.6bn and a tiny trade in services surplus of £4.8dn – but we also had a whopping surplus of £9.2bn in investment income. That took our current account deficit down to 1% of GDP, rather than 3% of GDP a year ago. So perhaps those financial bods in the City really are worth their bonuses after all.

But now we have the Sept. inflation figures. A lot is being made of CPI inflation being ‘only’ 2.5%, up from 2.4% in Aug. But RPIX fans will have noticed that RPIX took a bigger leap, up to 2.5% from 2.3%. RPIX has now reached the old target level, taking away any easy excuse to cut rates.

There’s also a simple explanation why the rise in inflation was ‘surprisingly’ low – those moaning retailers have delayed introducing their expensive autumn/winter lines until October again, just like last year.

Looking at the graphs:

The first one shows monthly RPIX inflation. Sept. this year (black bar) is above last year (red bar) but well below the long-term average (blue bar). Sept. is usually a high-inflation month, when retailers introduce new lines. But last year they delayed that introduction until October – (see red and blue bars). It looks as though the same will happen again this year.

The second graph shows how retailers cope with the January and July Sales. They had a very good July ’05, hardly reducing prices at all. But January ’05 was a disaster – almost as bad as the 2001 near-recession. Then again, the Jan. ’05 disaster was entirely the retailers’ fault. From the first graph we can see they really pushed up prices in Dec. ’04 (red bar). It’s not surprising they were stuck with stock and had to discount heavily in Jan. and Feb. ’05 (black bars).

A last point; the fourth graph shows the ‘real’ interest rate – base rate minus RPIX inflation. This has fallen from near 3% a year ago to 2% now. From what we now know, this seems to show that a real 3% is no longer stimulative – but my guess is that a real 2% is stimulative. If inflation keeps rising, interest rates should rise too.

Posted by: David Sandiford at October 18, 2005 01:02 PM

What about the workers?

“24 Perhaps the most quantitatively important impact of higher oil prices on potential supply could come indirectly if workers resisted any deterioration in real wage growth… If workers tried to bid up their wages in response to the higher oil price, then it was likely that there would be lower employment.”

From the October MPC minutes – this means presumably that interest rates would rise until worker resistance was crushed.

But, otherwise, the MPC gave us a 9-0 vote for no change. It was interesting that Charles Bean kept his head down this time, after leading the charge for the previous rate cut. He must have been shocked by the media attention surrounding the August rate cut decision. He must also have been relieved that a sleepy press didn’t hold him to account in the August press conference.

Posted by: David Sandiford at October 19, 2005 12:06 PM