OIL at more than $50 a barrel concentrates the mind. What looked like a spike in prices is now taking on an air of permanence. Even when the price subsides, as it will, it will remain higher than seemed likely even a few months ago.

The future of oil, given geopolitical uncertainties and the tightness of supply and demand, looks more precarious than it did before. Having promised some weeks ago to look at the future of energy supplies, this is a good time to do it.

In July this year an internal Department of Trade and Industry document had the following to say about Britain’s energy situation: “Self-sufficiency in gas is coming to an end . . . self-sufficiency in oil will end in the foreseeable future . . . UK coal mines produce about half the nation’s needs . . . nuclear generating capacity is approaching the end of its life, coal-fired generation is ageing and will need to be replaced by lower-carbon technologies or refurbished . . . the energy workforce, across all sectors, is ageing.”

It paints a pretty bleak picture. The report, to set it in context, was intended to warn that Britain would need new power stations in the coming years and might not have the skills or industrial capacity to create them. But there is a wider issue here for Britain and the world, and $50-a-barrel oil, while unlikely to be sustained, is a wake-up call.

How do we reduce our reliance on oil? To avoid a huge mailbag, let me point out that supplies are not about to run out. Professor Peter Odell’s intelligent new book, Why Carbon Fuels will Dominate the 21st Century’s Global Energy Economy (Multi-Science Publishing), states that there are a conservatively estimated 5,000 billion barrels of oil left, and he does not see oil production peaking until about 2050, by which time it will have been overtaken in importance by natural gas.

Gas production, he predicts, will not peak until about 2090.

Other people have different views on these so-called Hubbert peaks for oil and gas production. One striking forecast from Odell is that the world will consume 1,660 gigatons (1,660 billion tons) oil equivalent of carbon energy in the 21st century, more than three times as much as the 500 gigatons consumed in the 20th century.

The point is that even if there is plenty of oil around there will also be plenty of demand, and not just from the new economic giants, China and India. Developing countries will be lifting their energy consumption towards advanced-country levels (at present the richest 20% of the world’s population consumes two-thirds of global energy). Oil output can increase further, but it cannot increase by enough to keep up with rising demand.

Not only that, but government commitments to reduce carbon- dioxide emissions, whether or not America persists with its Kyoto opt-out, will frame energy policy. Britain under this government is committed to a so-called “low carbon” economy and a 60% cut in carbon-dioxide emissions by 2050.

That implies a huge change. At present Britain is very much a carbon economy with nearly nine-tenths of primary energy demand being met by gas (39%), oil (35%) and coal (15%). Restraining demand, by using energy more efficiently in cars, homes and commercial buildings, will help, building on past experience. Since the 1970s the economy has doubled in size in real terms, but energy consumption has risen by only 15%.

Restraining demand will not, however, change the energy mix. Here, there are huge holes in the government’s strategy. While renewables — wind, water and biomass — are scheduled to provide 10% of electricity generation by 2010 (compared with 2% in 2002), this will still represent a small portion of total energy use. Alternatives tend to be expensive and have environmental question marks of their own. They can help, but they will not solve the problem.

Nuclear, it seems, is a much better bet, but the government as yet cannot bring itself to admit this. Its updated energy strategy, released earlier this year, said “we do not rule out the possibility” of new nuclear power stations, but noted that “the current economics of nuclear power make it an unattractive option for new generating capacity and there are also important issues for nuclear waste to be resolved”.

But higher oil prices, if sustained, change the relative economics of nuclear power. The industry is also getting better at cleaning up sites. Only this month the UK Atomic Energy Authority announced a reduction of £1.5 billion (from £6.3 billion to £4.8 billion) in the decommissioning costs of existing plants at Winfrith, Harwell, Windscale, Dounreay and Culham, and cut the end-date for decommissioning by up to 35 years. Things are changing in a way that will make the nuclear option hard to reject.

That is also true on a global scale. Even a carbon man like Odell predicts a rise to 30% in the portion of energy from non-carbon sources, including nuclear.

A recent interdisciplinary study from the Massachusetts Institute of Technology (MIT), The Future of Nuclear Power, noted that nuclear faced four hurdles: costs, safety, proliferation risks and waste. But it also suggested that work should proceed on overcoming these problems, notably by developing the technology known as the once-through fuel cycle, because of the contribution nuclear could make to reducing the global warming that would otherwise occur. There were, it also concluded, plenty of uranium resources available at reasonable cost.

But the MIT report also underlined the scale of the challenge. Nuclear currently supplies 17% of world electricity. To increase that share even modestly, to 19% by 2050, would require a near-trebling of nuclear capacity. Put another way, between 1,000 and 1,500 large nuclear power stations would have to be built worldwide.

Gaining public acceptance for such a programme presents an enormous challenge; protecting them from terrorists another. But it has to be done. The world faces a choice between chronic energy shortages and allowing a bigger role for nuclear power. And it is not one that can be ducked for much longer.

PS When is a bubble not a bubble? John Calverley, chief economist and strategist at American Express, has written an entertaining and informative book, Bubbles and How to Survive Them (Nicholas Brealey, £20). His news peg is the housing market, which he says is more likely to crash than not. America’s housing market, which has also risen strongly, has a better chance of a soft landing, he says, although the risks are there, too.

People will have different views on this, but mine is that, while this accurately describes the mood of the housing boom of the late 1980s, it does not fit the recent price rise. We have had exuberance but most of it has not been irrational — people have been responding rationally to an era of lower interest rates and more secure employment prospects. And if it hasn’t been a true bubble, there is less chance of it bursting.

From The Sunday Times, October 24 2004

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A feature I wrote for non-economists for The Geographer magazine

Every day, thanks to tens of thousands of mouse-clicks in London, New York, Tokyo, Singapore or Sydney – or as many shouted telephone instructions – tens of billions of pounds, dollars, yen and euros move around the borderless world that is the global financial system. What is the effect of this vast flow of money?

Daily turnover in the world’s currency markets is $1,210 billion (£670 billion). That, leaving aside weekends and public holidays when the markets are closed, is roughly $302,500 billion (£168,000 billion) annually.

These are big numbers. To put them in perspective, the UK’s annual gross domestic product – the combined value of all we produce, or spend, or earn – was £1,100 billion in 2003.

That is not all. The fastest growing financial market sector is so-called derivatives trading. Derivatives sound more complicated than they are – they are merely financial instruments derived from a basic financial instrument. The most common derivatives are futures – instruments that are based around a transaction that will occur at some future date. Currency futures, for example, are based around the notional purchase or sale of a currency at some defined date in the future. Trading in derivatives globally was $600 billion (£330 billion) a day at the latest estimate, and is rising rapidly.

The size and the power of global financial flows are not in doubt. On September 16 1992, “Black” Wednesday, when the UK government was trying to keep the pound within the European exchange rate mechanism (ERM), the euro’s forerunner, the authorities were overwhelmed by the markets. The speculators amassed enough funds aimed at driving the pound down to make Britain’s entire foreign exchange reserves look puny. The pound was forced out.

Or, to take a more recent example, a few months ago, the dollar came under heavy selling pressure because of concerns about the American economy and Iraq. Asian central banks, particularly China and Japan, were reluctant to see their currencies rise against the dollar.

They were more successful than the Bank of England in 1992 but only as a result of buying tens of billions of dollars. More importantly, they diverted the selling pressure on the dollar to Europe, so that the euro rather than Asian currencies rose strongly.

What drives these flows of international capital between countries and continents? It is not international trade. It used to be the case that the only reason for anybody to want to change currencies was for exporting and importing purposes. This is not so any more. A week’s trading on the currency markets is equivalent to a year’s world trade. Even adding tourism does not begin to square the circle.

Capital is driven around the world by two factors – risk and return. International investors are looking for the best return, and do not mind where they get it. Return can mean chasing the highest interest rate or the best performing stock market. But return has to set against risk. There may be a reason why a developing country (an emerging market to investors) has 30% or 40% interest rates, and that is because its currency and its economy are wobbly.

In seeking the best return, investors do not want to be left holding the baby of a collapsing currency. In times of international tension, or when concerns about inflation re-emerge, investors seek “safe haven” currencies such as the Swiss franc, or safe-haven assets such as gold.

Is all this money flowing around the world healthy? James Tobin, the late American Nobel prize-winning economist, proposed a “Tobin tax” on currency trading to curb speculative buying and selling of currencies. There is no doubt some such trading is destabilising.

The problem is in distinguishing between the speculative and the beneficial. Developing countries cannot generate the savings they need to invest for the future. Inward investment, either direct (new factories built by multinationals) or indirect – foreign money that enables locals to invest is needed. This year, according to the Institute of International Finance in Washington, long-term capital flows to developing countries will reach $225 billion (£125 billion), their highest since 1997. But emerging economies can find themselves on the wrong side of the vagaries of short-term capital. In the 1990s, international investors favoured the so-called mini-tiger economies of Asia, like Thailand, Taiwan, South Korea and the Philippines. There were long-term capital flows into these countries but also plenty of short-term speculative capital, chasing stock market returns. When such capital suddenly took flight, on fears that economic risks had increased, it created the problem investors had feared – the Asian financial crisis of 1997-8.

It is not just developing countries that are in need of foreign capital. America has a trade gap, a current account deficit, of $500 billion (£280 billion) and needs foreign capital inflows to fund it. One of the big risks to the global economy is the over-reliance of the United States on foreign capital and the danger that a sudden loss of international appetite for American assets could lead to a dollar collapse.

From The Geographer, September 2004

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Another part of the The Geographer feature

The world economy is dominated by the G7 (Group of Seven) countries – the United States, Japan, Germany, Britain, France, Italy and Canada – who gather at the top table for their regular summits. But the world is changing, and we are witnessing the rise of some economic giants of the past.

In the early 19th century, when Europe was in the full throes of the industrial revolution, which two countries dominated the world economy? The answer is perhaps surprising. Two hundred years ago China and India accounted for 45 per cent of global gross domestic product. With their huge populations, even then, their economic weight was enormous.

The story of most of the two centuries since then, of course, has been the economic rise of Europe, followed by the United States and Japan. The European century may have given way to the American century but both continents were where the economic action was.

Today, the world’s biggest economy is America, accounting for more than fifth of global GDP, followed by Japan, Germany, Britain and France. America, Europe and Japan, as well as dominating trade and investment, are the domiciles for most of the big multinational companies. Big negotiations on world trade are hammered out between these three blocs. Talks on agriculture founder because of the power and influence of Japanese rice farmers or modern French peasants. The G7, which has taken to inviting Russia to its gatherings, makes its declarations on the big economic and geopolitical issues of the day from the lofty heights of its summits.

But the world is changing, and it is not fanciful to believe that we could be on the way to a revival of the status quo of the early 19th century. “Through the 19th century, China shunned progress and closed its economy to the outside world, distrustful of foreign traders,” points out Gerard Lyons, head of research at Standard Chartered, a bank which has long operated in both China and India. This continued, and was reinforced, by Communist rule in the 20th century.

China and India are now, however, open to the world, and the effect is dramatic. In 2002 and 2003, when global economic growth was subdued, China’s contribution was vital, accounting for more than a third of the rise in world GDP. India, while smaller in both population (1.05 billion versus China’s 1.3 billion) and GDP, is also coming up fast. India has also raised deep concerns in Britain and elsewhere about a newly-named global economic phenomenon, so-called “offshoring” of call centre and other jobs.

Projections from Goldman Sachs, the investment bank, put some flesh on the likely rise of China and India. They took the four biggest and fastest-growing emerging economies - Brazil, Russia, India and China, which they call the BRICs - in a paper by Dominic Wilson and Roopa Purushothaman entitled ‘Dreaming with BRICS: The path to 2050’.

The exercise was not mere straight-line extrapolation, factoring in some slowdown from present rapid growth rates (China has grown by more than 8 per cent a year since the late 1970s). Even so, the results were intriguing.

China has already overtaken Italy (which has a seat at the G7 table), and will this year overhaul France. Chinese GDP will be bigger than Britain’s next year, and by 2007 China will be bigger than any European economy, leaving behind Germany. The Goldman Sachs’ projections foresee Chinese GDP becoming bigger than Japan in 2016 and, finally, America in 2041.

This does not mean, of course, that in 40 years time the Chinese will be better off than Americans. A large population is an advantage in terms of economic weight but it also means there are more people around whom the wealth has to be spread. Even by 2050, per capita GDP in China will be less than half that projected for Britain at that time, and under 40 per cent of that in America. On that basis, the real Chinese catch-up may not occur until the 22nd century.

Similar caveats apply to India, projected to become the world’s third biggest economy, behind America and China, in the 2030s.

Is this tilting of the world economy to the east preordained? Demography is as big as a disadvantage to Europe – Spain, Italy and Germany will see their working populations drop by a third by 2050 – as it is an advantage to China and India. As long as these countries, with their huge populations, remain engaged in the world economy, a prolonged period of growth seems guaranteed.

The challenges go beyond those of economic diplomacy. China and India will be massive consumers of world resources. They will also pose a significant environmental risk, not least if they want to emulate America in this respect too.

From The Geographer, September 2004

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This is a text of the Leverhulme Globalisation Lecture I gave at the University of Nottingham on October 12 2004.

If I have to dedicate this lecture to anybody it is Gregory Mankiw. He will be known to some but I suspect not all of you. For those who don’t know him, Professor Mankiw, a distinguished Harvard University economist, is chairman of George W. Bush’s Council of Economic Advisers. We’re used to hearing Karl Rove described as Bush’s brain but Mankiw can lay claim to at least a lobe.

Earlier this year, Mankiw caused a political storm when he released his Economic Report of the President. According to CBS News he was guilty of “political ineptitude” of the kind that had characterised the way the Bush Administration has “stumbled and bumbled” its way through office. Others described it as political tone deafness. Tom Daschle, the Democrat Senate Minority Leader, accused him of spouting “Alice in Wonderland” economics.

Even from Bush’s own side, the condemnation was swift. Dennis Hastert, the Republican House Speaker, said Mankiw’s theory “fails a basic test of real economics”.

So what did he say that was so outrageous? Simply this section in the Economic Report: “One facet of increased services trade is the increased use of offshore outsourcing in which a company relocates labour-intensive service industry functions to another country … Whereas imported goods might arrive by ship, outsourced services are often delivered using telephone lines or the Internet. The basic economic forces behind the transactions are the same, however. When a good or service is produced more cheaply abroad, it makes more sense to import it than to make or provide it domestically.”

Most of us, I suspect, would not disagree with much of that, although the sharp-eyed will have noticed that, put like that, Mankiw is advancing the law of absolute advantage, not comparative advantage. Economists know that there are circumstances in which it is better to produce something at home if the advantage to overseas producers is even greater in other products or services. Even so, for a general audience, the point is well made. So why so controversial?

The fact is that offshoring is a hot issue, both here and more particularly in the United States. When we write about it at The Sunday Times we get more response than on any other economics-related issue. Whether you call it offshoring or overseas outsourcing it seems to have struck a chord. People who barely blinked when manufacturing jobs were shifted abroad in the 1970s and 1980s – and right up to date (three-quarters of a million such jobs have gone in the past 10 years) have become alarmed by the loss, both actual and potential, of service-sector posts.

The most common response is that, if these jobs are going, what will be left? Unions, who once condemned the replacement of industrial jobs with call-centres, now bemoan the loss of those call-centre jobs, almost as if they were our true industrial heritage. The rejoinder to this should be easy – just because some service-sector jobs are going does not mean they all are – there is “churning” within the sector, by which I mean a constant process of job destruction and creation. But people often don’t see it that way, particularly if the new jobs, as Alan Greenspan pointed out recently, are in areas we have not really thought about, or can scarcely imagine. To give one example, it is possible that nanotechnology will be a huge employer in the future. But most of us can’t even define nanotechnology, let alone begin to predict its employment consequences.

There’s also a sensitivity about offshoring among the companies that do it. Sir Keith Whitson, until last year HSBC’s chief executive, caused controversy when he said, of Indian call-centre staff: “They’re quicker at answering the phone, highly numerate and keen to come to work every day. Staff are hugely enthusiastic about their jobs, they dress well. A lot have degrees.” Most companies, in contrast, tread a lot more carefully, because they’re worried about a backlash, either from customers or the workforce. The National Westminster Bank boasts in its television advertisements that it has “UK-only call-centres”.

The backlash is already there in America. John Kerry has toned down some of his remarks but what he said earlier in the year, about so-called Benedict Arnold CEOs who transfer jobs overseas still sticks in the mind. Indeed, this has set the tone for the way many Americans think about offshoring – that it is negative for the economy and, in some way, un-American. America, of course, has always been more of a free market than a free trade country – protectionist sentiment never being too far below the surface in Congress. There are more than words involved in this. More than 100 pieces of anti-offshoring legislation have been introduced in at least 36 US states. The effect of these is mainly to prevent government services from being outsourced overseas.

Britain is very different. There’s a lot that you can criticise this government for but it has taken a very positive and grown-up attitude on offshoring. Patricia Hewitt, the trade and industry secretary, said earlier this year: “Just as consumers can now buy products or services from around the world, investors can invest anywhere so companies can now locate themselves where they like. We can't resist this and we shouldn't want to. Globalisation means greater growth, a better quality of life and more opportunities for all countries, poor and rich alike, to share in rising prosperity.”

The interesting thing about this is that it conveys two messages. The first is that if we in Britain try to cut ourselves off from the global economy by limiting offshoring the UK economy will suffer. I’ll return to that point. The second is that there is also a positive development message. Offshoring helps economies poorer than ours, and that is a good thing. As I say, American political thinking is not nearly as enlightened although the stronger the US job market, the less negative attitudes will be.

What about the economics of offshoring? I usually like to mention Russell Crowe at some stage. Why? There aren’t many Hollywood movies about economists, and not that many economists look like Russell Crowe but we can live in hope. I’m assuming everybody has seen A Beautiful Mind, a fictionalised account of the life of John Nash, the brilliant game theorist. Nash gave us the win-win game – all players can win – as opposed to the zero sum game. We can, of course, just go back to Ricardo, and the law of comparative advantage, for proof that free trade, of which offshoring is a type, is of mutual benefit.

Let us have a look in more detail at the economic benefits:

The first benefit comes in lower costs and, to the extent that there is a flow of these jobs overseas, lower inflation. In raw terms, an Indian call-centre worker gets paid a tenth of his UK counterpart. Even adjusting for purchasing power parity, Indian IT professionals are paid about a third of their UK counterparts and a quarter of the going rate in America. These labour cost differences exaggerate the full cost saving. Even so, after allowing for relocation costs and productivity differences, few companies would shift operations overseas if they weren’t saving at least 20% to 30%.

The second gain is in real incomes. A popular view is that all the income gains go to the host country. In fact, and this is where economics has to work quite hard, all the studies suggest that most of the gains, perhaps 70% to 80% go to the offshoring country. That is hard to explain to somebody whose job has just been displaced. The real income gains, at least in the first-round, come directly from lower prices and indirectly, through the boost to corporate profits and therefore dividends.

Third, even where countries have relatively high unemployment they usually suffer from specific shortages of particular types of labour. That is not always the main motivation for outsourcing but it is certainly a significant factor. When unemployment is low that point is even more powerful. In the UK at the moment we have an estimated 660,000 job vacancies, half a million of them in the private sector.

The fourth advantage is that the shift of jobs overseas enables workers to be moved into higher value-added/higher productivity jobs. As note earlier, people seem unprepared to accept the same logic for services they were happy to do for manufacturing. This is particularly the case on this point. It has long been accepted that British industry could not compete with, say, China in the mass production of low valued-added goods, and so for survival UK manufacturing had to move up the value and technology chains, and workers into higher-productivity functions. That’s exactly the effect – and the benefit – from offshoring service-sector activities. Routine tasks can be outsourced, allowing workers to be redeployed up the value chain.

What about the potential disadvantages? Is it all plain sailing or does the anti-offshoring school have a point? It is easy to assume perfect mobility of labour, and the seamless transfer of displaced workers here into new jobs. Life is not like that. There will be mismatch and frictional problems, some serious. The ex-steelworker in Rotherham who has re-trained to become a call-centre operator may not have another career change left in him. Some of these effects can be quite serious, particularly in certain high-unemployment areas, which have not really solved the problem of permanently replacing the old mass employers.

Not only that but the microeconomic effects on the outsourcing company can be adverse. It only takes a couple of examples of poor service for things to go quite badly wrong. Customers are not, in general, sympathetic to offshoring. Offshore centres almost have to outperform the domestic alternative to achieve customer acceptance.

Why do companies move activities offshore? A survey carried out by Nirupam Bajpai of the Earth Institute at Columbia University gives some useful insights. The overwhelming motivation, mentioned by 70% of firms surveyed, is to cut costs. Other factors, such as increasing capacity, taking advantage of offshore labour, gaining access to better technology and systems and improving service levels come well down the list.

What kind of activities are offshored? This is a survey of US companies so the results might be slightly different for the UK but I suspect not dramatically so. IT development is easily the most popular activity, mentioned by more than 60% of firms, followed by customer service – this includes call-centres. Then we have a range of back-office functions, including payroll management, IT support, processing and paying-out expenses and managing transactions.

If cost saving is the motivation, how much do companies reckon to save? For most – more than three-quarters – the savings are between 10% and 50% compared with the costs of carrying out the same operations at home. For a few there are even bigger savings.

Is offshoring at the expense of quality? There is a question about whether firms, even in the privacy of a questionnaire, would admit to this, but at least in their own estimation, offshoring is not at the expense of quality, in fact it improves it. About a third says quality improves significantly, and a third that it just improves. Fewer than 10% report a decline in quality.

That does not mean firms regard this as risk-free. For those who have outsourced to overseas businesses outside the organisation there is a worry that they are losing institutional knowledge. Communication problems are a concern, as are cultural differences. There are worries about the security of databases about the financial stability of the partner company and, interestingly, about a customer backlash. That tells me that firms do not go into this lightly.

When we think of offshoring services, we always think of jobs being transferred to Mumbai or Bangalore. That certainly has been making the headlines recently. But it we look just three years ago, the most popular destination in terms of cumulative activity transferred for offshored services was Ireland and I can’t remember any backlash about that. I am not suggesting that there is anything racist about the response to India, merely that Ireland was somehow more easily handled because the cost advantages were not so enormous. But Ireland had many of the same advantages as India – educated workforce, English language, and so on.

A prime driver of offshoring, of course, is the fall in telecommunications costs and the increase in broadband capacity to places like India. Peak call rates between India and the US were 60 rupees a minute before 2001. Now they are well under 10. In the case of the UK the drop has been from 48 to about 6. Ireland was a great location for offshoring because of telecoms links within Europe and between Europe and America. But the telecoms map is being redrawn.

When it comes to the UK debate, we should recognise that offshoring is happening from a position of considerable economic strength. I never tire of pointing out that this is the longest period of economic growth since records began, largely explained by the combination of a successful macroeconomic framework and the microeconomic reforms of the 1980s.

Not only that but, unusually for Britain, that this has occurred without inflation. Inflation has averaged 2.5%, on the old RPIX measure, since we adopted an inflation target, then 1% to 4%, in the autumn of 1992. Bank of England independence has consolidated this process, its main effect being to significantly bring down inflation expectations into line with the target.

Perhaps unsurprisingly, 12 years of economic growth has meant high employment. The employment currently stands at over 28 million, a record. We have seen a strong rise in recent years, in both public and private sector employment, and an increase in workforce participation. The contrast with the 1980s when even a long period of economic growth left unemployment high, partly because of adverse demographics, is plain.

What is also interesting, although perhaps not that surprising, is that services have been responsible for this growth in employment. While manufacturing jobs have continued to shrink, service-sector employment has risen, both absolutely and as a proportion of total employment. In a decade, service sector employment has risen from just over 75% to more than 80% of total employment. The point I am making is that the threat to service sector jobs from offshoring, such as it is, comes from a very high base.

Just to complete the macro jobs picture, the contrast between the UK, close to full employment on the claimant count – roughly 5% on the internationally comparable measure – is striking. Unemployment in the euro area is roughly twice as high, and importantly has stayed high. In Europe there is a bit of a debate about service-sector offshoring. Mostly, though, they are still running with the debate over manufacturing jobs, and the threat, particularly from large German companies, to shift production to Eastern Europe.

And just to complete the macro picture for services, there are legitimate worries about UK service-sector productivity, which seems consistently and in some cases dramatically below the market leader, America. But this is not yet reflected in the trade position on services, which is healthy. The service-sector trade surplus has continued to grow. Again, I would argue that we are facing the challenge of offshoring from a position of considerable strength.

What empirical work has been done on the economic effects of offshoring? Quite a lot, although some of it comes with a little bit of a health warning attached, in that much of it is research commissioned by organisations such as NASSCOM, which represents Indian software companies, or by consultants hoping to make money out of persuading their clients to outsource. Even so, choosing selectively from this research we can put a little flesh on some of the economic benefits.

One piece of research, by Evalueserve, looked at likely labour supply and demand between now and 2010, assuming the latter would rise in line with recent experience and the former would be constrained by demography. Its conclusion was that there will be a labour gap that will only be made up by working-age immigrants and decisions by UK companies to offshore. So offshoring a cumulative 270,000 jobs is necessary to head off labour shortages. This presupposes continued strength in the labour market but seems broadly plausible. Already some offshoring is occurring because of the difficulty in recruiting and hanging onto certain workers.

Most of the detailed work has been done from America, The estimate you will see everywhere is that a cumulative 3.3m US jobs will be offshored over the next decade or so. But the estimate, from McKinsey, also came with some context attached. That was that the annual flow of jobs overseas was small in relation to the normal job market inflows and outflows. Annual flows of jobs offshore, in fact, are broadly equivalent to a good month’s employment growth.

What about some of those wider economic benefits listed earlier? To what extent will offshoring boost GDP in the country sending jobs overseas, and to what extent will inflation be kept down by outsourcing? Global Insight, a US economic consultancy, has tried to put some numbers on this. The GDP boost, which comes from higher real incomes and the shift of workers into more productive activities, is estimated by them to reach $124 billion by 2008. That sounds like a lot, but it is only around 1% of GDP.

What about inflation and interest rates? Global Insight tried to estimate this too and came up with the result that the cost-reduction effect will be worth a cumulative 2-2.5% off the level of the GDP deflator by 2008, and that other things being equal interest rates will be 0.4 per cent lower than otherwise. Again, we can debate the figures, although the direction is plausible.

This then allows the crucial third step in the economic argument. How many more jobs will be created by stronger economic growth and lower inflation? They suggest quite a lot, and certainly more than are lost due to offshoring. In this example a quarter of a million IT service jobs will have been lost by 2008, but 600,000 additional non-IT jobs created. The net effect is more employment.

That sounds pretty impressive, but it also underlines the problem that economists have in this area. The 600,000 people who have jobs as a result of offshoring-related economic growth will think their good fortune is due to happenstance, and their own efforts, and has nothing to do with the decisions by companies elsewhere in the economy to outsource service jobs. But the quarter of a million IT service sector workers will complain loudly about their plight. The economic benefits of offshoring outweigh the costs. Unfortunately they are less visible.

So on the other side of the debate there are the arguments put forward by organisations like the union-supported Economic Policy Institute in Washington. This is that the effects of offshoring are, firstly, an alarming increase in US IT imports from India, which looks as worrying, no doubt, as the rise in Japanese motorcycle imports was for UK workers in the 1960s and 1970s.

Not only that but according to them there is a direct read-across from the offshoring of US jobs to the rise in Indian employment in the sector, and the loss of IT jobs in America.

We could replicate this for other sectors in the economy subject to offshoring but it would not change my fundamental view that this kind of activity is just another aspect of free trade and that, as with all restrictions on free trade, attempts to limit it would be economically damaging.

But in conclusion, as I know from my postbag, it is unwise to tread on people’s sensitivities too hard in this area. Those who lose out from offshoring, even only temporarily, are entitled to squeal. We have to be patient in explaining that it is economically beneficial. Offshoring is good for us. Whether we in Britain have the productivity and skills to take full advantage of this new and more footloose world, and not be damaged by offshoring is a question that would need another lecture.

References

Bajpai, Nirupam, Sachs, Jeffrey, Arora, Rohit, and Khurana, Harpreet, Global Services Sourcing: Issue of Cost and Quality, CGSD Working Paper No. 16, June 2004.

Global Insight, The Impact of Offshore IT Software and Services Outsourcing on the U.S. Economy and the IT Industry (2004).

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Anybody who has studied economics will have misty recollections of Keynes’s so-called paradox of thrift. This was the conundrum, identified by the great man, in which a decision by everybody to save more would actually — and paradoxically — result in total savings in the economy falling.

How so? A big increase in saving now would mean less spending, slower growth, higher unemployment, weaker incomes and, ultimately, lower saving. Prudence would have come at a price, and that is worth bearing in mind in the current debate.

While the paradox of thrift, like a lot of Keynes’s thinking, has suffered with the passage of time, it is an observable fact that economies can have too much saving and too little spending. Think of Germany and Japan over the past decade.

I thought of this last week when I heard Adair Turner, chairman of the Pensions Commission, being asked whether we should be saving an extra £57 billion a year towards pensions. His answer was a horrified no.

Not only would the loss of demand of more than 5% of gross domestic product send the economy tumbling into recession, but such a wall of money would severely test the capacity of the savings industry and probably result in lower returns.

We do, however, have to save some more, or be forced to through higher taxes or compulsory pension contributions. The question is how much. And the answer depends on the extent other things change.

One eye-catching figure in the commission’s report was £57 billion. This is the annual amount the government would have to add to state provision through higher taxes and National Insurance contributions, at current prices, to guarantee that pensioners in 2050 are “on average as well off as today”.

But there were other eye-catching figures too, notably the £2,250 billion people own in housing equity. We are supposed to be sniffy about the idea that “housing is your best pension”, but the Turner report suggests we should rein in our contempt. The amount of housing equity is nearly twice the £1,300 billion held in occupational and personal pension funds. Drawing down housing wealth will not provide a retirement income solution for all, but it will for many.

The report also draws out the huge inequalities in pensions. This is not just that some current pensioners are enjoying the fruits of the “golden age” of occupational pensions while others are not. It is not just the fact that, according to Turner, more than 9m people are under-saving, some severely. But there are also inequalities, depending which part of the economy you work in.

Britain’s public sector accounts for 18% of jobs and earnings but 36% of accrued pension rights — and the latter share is predicted to increase over time. Superior public-sector pension rights are in danger of becoming a hugely distorting factor in the job market.

There is one other fact, among many, worth recounting.

Compulsion, in terms of pension contributions, has had a bad name, the argument being that if you compel companies and individuals to pay into pensions, other savings will collapse. But the report leaves open the door to compulsion, quoting evidence from the Reserve Bank of Australia that net savings have risen, particularly among lower earners.

However, compulsion has to be handled with care. Relying on employers for compulsory contributions, as in Australia, just increases the burden of employing people. Compulsory contributions from individuals are just a disguised form of tax.

Even more undesirable are explicit extra taxes to pay for better pensions. Had Labour conceded the scale of the future pensions crisis in 1997, and directed its efforts — and higher taxes — towards it, that would have been one thing. But we have had the increases in taxes and spending, on health, education and the chancellor’s misdirected tax credits. Not only would more taxes be damaging, but people are no longer prepared to believe pension promises from this government.

So what is the solution? There is no doubt that in economic terms the most desirable response is later retirement. It adds to the supply of labour and the length of time in which people are paying into the system — private and public — rather than taking from it. It is the logical response to greater longevity.

But it is not as straightforward as it looks. One of the Turner report’s fascinating findings is that, because of the effect of baby boomers passing through working age and into retirement, any increase in retirement ages in the coming years would need to be greater than the rise in longevity to guarantee adequate pensions.
Men currently retire at an average age of 63.8, but this would need to rise by six years to 69.8, on top of equalising the male and female retirement ages at 65.

That is possible for a substantial part of the workforce, and employers have to rethink the way they treat older workers — a gradual glide into retirement being much better than a sudden jump. But later retirement on its own will not solve the problem.

This means it must be combined with higher saving. While an enormous increase in saving would take us towards Keynes’s paradox of thrift, some increase would be healthy. It would help rebalance the economy away from consumer spending and provide funds for productive investment. How to achieve it?

Brown is never going to reverse his £5 billion annual raid on pension funds, but he should be locked in a dark room until he agrees to restore some decent savings incentives.

The barriers between pensions and other assets, including housing, need to be broken down. The corrosive impact of means testing, in effect the renationalisation of pensions, needs to be lifted, mainly by scrapping Brown’s pension credit.

There is a solution to the pensions crisis, through later retirement and reviving the “voluntarist” approach to saving. Whether this government has the wit to do it is another matter.

PS: A game of hard cop/soft cop is going on at the Bank of England. In the past month two members of the monetary policy committee (MPC), Kate Barker and Steve Nickell, have suggested that interest rates are close to their peak. But last week Mervyn King, the governor, generated headlines by suggesting that there were further rises to come.

Whether anything more needs to happen next year depends on how long we get bogged down in the soft patch. It may be some time.

From The Sunday Times, October 17 2004

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For a brief moment on Thursday, as I watched the seconds tick down to noon and the Bank of England’s interest-rate announcement, I wondered whether the nine men and women of its monetary policy committee (MPC) might surprise us all and announce a change.

What I was thinking was not that the Bank might give us a shock increase but that it would astound us with a cut. A flight of fancy? As it turned out, yes. The frisson of excitement came and went as the clock tolled 12. But the recent run of data has been relentlessly gloomy. Stranger things, moreover, have happened before. In the summer of 1998, when the Bank was still getting used to independence, it changed tack abruptly from raising rates in the summer to cutting them in the autumn.

As it happens, I do not expect the Bank to begin cutting rates any time soon. The MPC has worked hard to get base rate up to something approaching its “neutral” level, where it is neither pressing on the accelerator or the brake (last year’s emergency low of 3.5% being clearly below neutral). So it would think long and hard about another excursion into sub-neutral territory.

The more pressing question, however, and one that has been dominating discussion in the money markets, is whether the Bank will need to raise rates any more beyond the present 4.75%.

Before coming on to that, let us look at what the recent slew of weak data might mean. I commented in early September that the economy had hit a soft patch, with retailing, housing and manufacturing all showing signs of weakness. The global economic recovery appeared less robust, under the impact of oil then trading at just over $40 a barrel. Since then, there has been another month of weak data.

This suggests that the consumer and housing slowdowns reflected more than just the vagaries of the summer weather. True, the Halifax’s latest survey showed a 1.4% bounce back in prices last month but that seems an aberration. The same concerns about the world economy apply, and were voiced at last weekend’s G7 meeting in Washington, but this time at an oil price of $50 a barrel.

In shorthand terms, the economy has lost momentum because the consumer, its driving force for at least the last seven years, has pulled into a layby. Meanwhile, industry, together with parts of the service sector that rely on the strength of the global economy, is feeling the first draughts of economic winter.

After last week’s poor manufacturing output figures — the third successive monthly decline — the National Institute of Economic and Social Research estimated GDP growth in the third quarter to be a mere 0.4%, less than half the 0.9% rate officially recorded in the second quarter. Growth has slumped from well above trend to significantly below trend (trend is about 0.6% a quarter).

It seems likely that this period of slower growth will continue for a while. Not only were the manufacturing figures weak, but the latest purchasing managers’ survey for the services sector came in below expectations. The oil price refuses to lie down and will have a dampening effect on the world economy.

Uncertainty about the outcome of next month’s American presidential election will also hold back economic activity, although presumably there will be no repeat of the “tied” vote of 2000, when Americans stayed at home and the economy slid into recession.

So what does this mean for interest rates? My view has long been that the neutral interest rate was between 4.5% and 5%. We are there, the economy has slowed and inflation, at 1.3% on the consumer prices index measure, is below the 2% target and likely to remain so.

If I were on the MPC we would already have hit the peak in rates.

But I am not, and part of this job is to second-guess those who are. In August, when the Bank published its last inflation report, it gave a clear signal that base rate needed to rise a little more — to 5% or slightly higher — to meet the inflation target in two years. That was despite the fact that it also forecast a significant slowdown in growth.

That slowdown has been rather sharper than it expected, although sterling has also been weaker. The former eases the interest-rate pressure, the latter adds to it. Even so, barring a sudden return to robust health in the data, it is now hard to see the climate being right for the MPC to raise rates next month, as many had expected.

As for the following month, in more than seven years of independence the Bank has never increased rates in December. That should mean rates have risen for the last time in 2004.

What about 2005? Here views start to diverge. On one side are those, like Tim Congdon of Lombard Street and some other members of the “shadow” MPC reported last week, or Michael Saunders of Citigroup, who think the Bank has not done enough, that the pause will be temporary, and that the base rate will need to go up to 5.5% or more.
Lending support to their bullishness is the stock market, which appears to be looking through the present slowdown to stronger world growth next year.

At the other extreme are those who see current economic weakness as the shape of things to come, and predict that the MPC will soon be cutting rates. Thus, at the end of next year the base rate could be 6% or 4%. In the present climate that is quite a range.

We will know a lot more when the Bank publishes its next inflation report in November. Reading the runes, I would say there is significant but gradually diminishing chance of one more rise, to 5%, next February, followed by a prolonged rate freeze. The peak is in sight. We may already be there.

PS: I happened to be in Wales last week when Eurostat, the EU’s statistical arm, left it off the map, and the country appeared to be pretty solidly there to me. But, to prove all publicity is good, the controversy encouraged me to dip into Eurostat’s new statistical year book.

And just to continue with the energy theme I have promised to return to, it is argued that renewable energy sources, such as wind, water and solar power, can never make more than a marginal contribution. That is certainly true in Britain at present. But renewables provide 15% of electricity across the EU as a whole, with 70% in Austria and more than 50% in Sweden.

From The Sunday Times, October 10 2004

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AT this time of year, when politicians traipse down to the seaside to display their wares, it is unwise to expect too much in the way of economic content. The days when currency dealers listened intently to the conference speeches of chancellors and prime ministers for market- moving announcements are long gone.

In their place, by and large, are re-announcements and political knockabout. And even that’s not what it used to be. Tony Blair, in his big address, laid into the Tories for giving the country 10% mortgage rates during their boom-and-bust years. But why not attack them for 15% rates, which is what we had?

There was some economics in Gordon Brown’s speech, as you might expect, even though it was not market-sensitive. With an election looming, the chancellor is looking to the future. The theme for this autumn’s pre-budget report, and other upcoming set-piece occasions, will be to chart the economy’s course for the next 10 years or so.

That does not mean he plans to stay at the Treasury that long, for we now know the prime minister intends to serve for roughly five more years. It does mean there will be a big focus on the “supply-side” themes of productivity, enterprise, competition and competitiveness.

When China and India were producing a combined total of 4m graduates a year, and their wages were 5% of ours, he noted in Brighton, the central question was whether we could compete in future. That meant, said Brown, exploiting “the ingenuity, talents, dynamism, creativity and inventiveness of all our people”. More simply, it means raising productivity — the amount each worker does. Paul Krugman, the American economist, once said: “Productivity isn’t everything, but in the long run it’s almost everything.” And Britain’s record is wanting.

By coincidence, new evidence was presented last week at a Treasury seminar on Britain’s relative productivity performance. The research, based on a series of projects funded by the Economic and Social Research Council (ESRC) made sobering reading. When Labour took office more than seven years ago, Brown also showed he was a long-term thinker, by committing himself to a productivity agenda. At that time, American productivity was some 40% higher than in Britain while France and Germany were about 20% ahead.

On the latest figures, according to the ESRC research, US output per worker is 39% higher than here, with France and Germany 22% and 19% ahead respectively. No progress there.

Why does Britain lag behind? According to its report (available on esrc.ac.uk), the reasons are many, including “a relative failure to invest, failure to innovate, poor labour relations, trade distortions attributable to Empire, antagonism towards manufacturing, ‘short- termism’ among business leaders and financial institutions, technological backwardness, lack of entrepreneurship, over-regulation of business, an overly-instrumental attitude to work among employees, and the rigidities of the class structure. The list is not exhaustive”.

Ministers have tried to tackle some of these long-standing problems, with mixed results so far.

The productivity gap’s history is interesting. At the end of the second world war, America’s lead over all other advanced economies was acknowledged, and explained by superior industrial organisation and better technology, as well as natural advantages such as bigger markets.

During the “golden age” of the world economy in the 1950s and 1960s, Europe narrowed the productivity gap, as a result of adopting US technology and methods, and removing trade barriers within Europe. But Britain was less successful than France and Germany.

From the 1970s onwards, in an environment of generally weaker productivity growth, Europe further closed the gap, to the point where by 1990 France and Germany looked to be on the brink of overtaking America, which looked like a lumbering giant. Britain also made big strides in the 1980s, largely as a result of the labour-market flexibility achieved by reducing the power of the unions under Margaret Thatcher.

Since then, however, US productivity growth has undergone a “structural shift” upwards, from just over 1% a year to well over 2%, conservatively estimated. And Europe, and Britain, have failed to respond. The productivity revolution, on the back of new technology, has remained largely a US phenomenon.

Why hasn’t Britain, with most of the flexibilities of the 1980s still in place, and a 12-year run of continual, non-inflationary growth, done better? The gap with France and Germany can largely be explained by two factors, according to the ESRC. One is that we have under-invested over decades; investment per worker is 40% higher in France and 60% greater in Germany than in Britain. The other is that we suffer from a lack of skilled workers. Whereas 20% of German workers and a third of those in France are characterised as having low skills, this applies to 55% of the UK workforce.

As for America, the big gap is partly due to under-investment — US capital per worker is 25% higher than in Britain — but mainly due to the “x factor” known as total factor productivity. And this, put bluntly, is code for management. It is often the great unsaid in the productivity debate. Ministers go out of their way not so say it. But the fact is, as the research shows, that a large part of our enduring productivity gap is due to inferior management.

This cannot be explained either by the fact that all the smart people go into accountancy, the City or banking, rather than manufacturing. Compared with America, Britain is well behind in terms of productivity in financial and business services, as well as areas such as retailing.

On the day the new productivity research was presented at the Treasury, coincidentally, official figures were released showing an upturn in productivity — from 2% annual growth in the first quarter to 2.9% in the second. That may just be a flash in the pan. Let’s hope not. On Brown’s central question, of whether we can compete with China and India, the jury is very much out.

PS My promise at the end of last week’s column to examine our future energy needs, and whether this will inevitably mean a much bigger role for nuclear power, will be fulfilled very soon. With oil at more than $50 a barrel it needs to be. In the meantime, a brief progress report. Mere mention of the word “nuclear” produced a flood of responses.

The second argument is that nuclear power is not emission-free, particularly when poorer grades of uranium are used. The construction, operation and decommissioning of nuclear power plants mean significant CO2 emissions. In some instances, say Van Leeuwen and Smith, these will be as high over the lifetime of the plant as a gas-fired power station. Such claims have, inevitably, produced a fierce response from the nuclear industry. They do, however, show that the search for a painless, post-oil energy future is probably a vain one.

From The Sunday Times, October 3 2004

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