Until last week, a question had been nagging away at me. Politically, another big rise in taxes was always a no-no for Gordon Brown, as I wrote immediately after the March budget. As long as he remained chancellor, Labour could not whack taxpayers with another hike, not least because of the way it would colour attitudes to his hoped-for transition from 11 to 10 Downing Street.

But in economic terms, it seemed, he was in a cleft stick. His precious golden rule — borrowing only to fund investment over the economic cycle — was under serious threat. On one side stood the risk to his political reputation, on the other the credibility of his fiscal rules. Which would he choose?

My question has been answered and it was, to use the expression identified by readers as the most irritating jargon, a no-brainer. Kenneth Clarke, Brown’s predecessor, liked to refer to what the regulars talked about in the Dog & Duck. It is hard to imagine them discussing the fiscal rules. Higher taxes, on the other hand, would feature. Politically, the imperative was to avoid tax rises, even at the expense of the rules.

Until last week Brown’s fiscal rules had little salience among the public. Now they have little relevance, or credibility, in the City. Since they were designed to underline the government’s prudence for the financial markets’ benefit, that is not good news, though so far the damage has been limited.

What happened last week? Invited by the Commons Treasury committee to talk about the G8, Brown used the occasion to make an important statement about domestic economic policy. The statement, that new official figures justified a rethink about the economic cycle, so it is now thought to have started in 1997 rather than 1999, kicked tax hikes into the very long grass. A bit of cyclical trickery can work wonders.

The reason is simple enough. To meet the golden rule, the chancellor has to balance surpluses and deficits on current spending and tax receipts over the economic cycle. By putting back the start of the cycle a couple of years he gains the benefit of the healthier public finances when he was first in charge at the Treasury, and genuinely was prudent.

As is characteristic of the Brown Treasury, the announcement was accompanied by a lot of paperwork. Just as last year’s “no” decision on euro entry required 18 technical studies and an assessment, this one had a 58-page document on the theory and practice of economic cycles.

This is not the place to go into the details of that paper, and whether the Treasury has made its case convincingly or not. Plenty of independent economists say not.

But Brown insists the change was fully justified. The Treasury’s previous belief, that there was a mini economic cycle between 1997 and 1999, always looked odd and the new growth figures confirmed that, though they also suggest that the cycle ended a couple of years ago.

The point is that if it looks like a fudge and tastes like a fudge, it probably is one. Appearances matter, and this change was just too convenient. Last week’s shenanigans in effect buried the golden rule.

Policy rules must be simple and easily understood. If they require that Treasury mandarins have to burrow deep into statistical history to determine whether they have been met or not, they are worse than useless.

Brown has another rule, the sustainable investment rule, to keep government debt below 40% of gross domestic product, compared with 35.3% now. On the face of it, this is being met comfortably but the government’s use of off-balance sheet funding, notably through the private finance initiative (PFI), means that this, too, has to be questioned. The Office for National Statistics is examining the way it treats PFI spending.

All this sounds arcane. The Treasury, however, has always insisted the fiscal rules are as important as Bank of England independence. That was never a very plausible claim; now it looks ridiculous. The Tories have promised an independent committee to monitor the fiscal rules. They should first devise new rules.

The irony is that if Brown tries to stick to his golden rule, there is still no guarantee it will be met. The Treasury had expected the economic cycle to end this year but that depends on its strong (3%-3.5%) growth forecast. The chancellor is still upbeat about prospects. If he is wrong, the cycle could last another two to three years, during which time borrowing would remain high.

No matter how it is finessed with fancy rules, there are eternal verities associated with fiscal policy. If you spend more than you raise in taxes, there will be a budget deficit. Mr Micawber understood this; many chancellors try to avoid it.

Brown’s early prudence was replaced by strong growth in spending, with the assumption that tax revenues would keep up. They haven’t. Figures last week showed government borrowing was rising, not falling, and in the first three months of this fiscal year was significantly up on the same period of 2004-5. The current budget deficit was £13.1 billion, compared with £11 billion.

That puts the onus on spending, assuming Brown wants to make good use of the time he has bought himself on tax. The other announcement from the Treasury last week was that the government is to hold a “second” comprehensive spending review, to be concluded in 2007, which will set out priorities for the next 10 years, the first having been in 1997.

I had naively thought, looking at the documents on my desk entitled “comprehensive spending review”, that the government had had a few of these, in 2000, 2002 and 2004. But apparently only the first, actually published in 1998, really mattered, as will the one coming up. It does not take much detective work to conclude that the first was intended to cover the Blair era, while the next one will set priorities for Brown’s intended long reign.

What will it come up with? The biggest priority has to be much slower growth in spending, to bring it back into line with tax receipts and allow the public services to digest the big rises they have already had. If not, then while Brown’s manoeuvres last week may have headed off tax hikes while he is chancellor, they won’t stop them if he manages to become prime minister.

PS At least one aspect of policy is straightforward. The Bank of England’s monetary policy committee (MPC) can do one of three things: put interest rates up, cut them, or leave them alone. This month, for the 11th in a row, it chose the last course, though it was a close-run thing, 5-4. David Walton, the committee’s newest member, marked his debut by voting for a cut, against Mervyn King, the governor.

So a cut from 4.75% to 4.5% is on the cards for August 4. Friday’s growth figures, showing a rise of just 1.7% on a year earlier, should have been the clincher. More interesting, perhaps, is what the Bank’s inflation report will say about future rate prospects a few days later.

From The Sunday Times, July 24 2005

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A lot of ink has been used up, and airtime wasted in the past few weeks, analysing the decision by the people of France and the Netherlands to reject the proposed constitution for the European Union. The “no” votes from two of the EU’s six founder members, in late May and early June, which effectively killed off the constitution, were attributed variously to concern over the “Anglo Saxon” nature of the treaty to protest votes against national governments.

Such complicated explanations are, however, unnecessary. All elections are, in the end, “pocketbook” elections. People vote, in other words, according to the state of their wallets and purses. In France and the Netherlands they voted against the constitution because the EU, far from bringing the prosperity associated with its early decades, has become synonymous with economic failure.

Ask the man or woman in the street in Paris or Amsterdam, or for that matter London or New York, for a thumbnail sketch of the European economy and you can bet they will give you a description that includes high unemployment and slow growth. Not all of them will correctly diagnose the cause of this as the rigidities of the EU economy, and in particular its labour market, but they will know that Europe, once an economic success story, is now struggling.

A decade ago, there was little to choose between unemployment in Britain and the 12 countries that make up “euroland”. Both had jobless rates of around 10 per cent of the workforce. Since then, however, UK unemployment has more than halved and stands at 4.7 per cent on an internationally comparable basis, while the euroland rate is still close to 9 per cent. In a generally benign period for the global economy, Britain has created three million new jobs, overwhelmingly in the private sector. The “old” European economies – France, Germany, Italy – have created barely any.

Lord Layard of the Centre for Economic Performance at the London School of Economics has just published a new edition of his book Unemployment, co-written with Stephen Nickell and Richard Jackman. In it he looks at why unemployment has diverged so sharply in the past decade or so.

The difference, he says, is between those countries who reformed their labour markets, as Britain did in the 1980s (as a Labour peer he pays tribute to the Thatcher reforms) and those that did not. The three big economies of “old” Europe fall into the second category and are suffering for it.

It is not just, of course, in the unemployment figures that the damage is being done. The longer that people are unemployed the more they become distanced from the world of work and the harder it is to re-engage them with it. High unemployment breeds high unemployment.

It damages in another way. The big difference between the growth performance of the euroland economies and those of Britain and America is the behaviour of domestic demand. Anglo-Saxon consumers have been willing to spend; those in Europe have not. The fear and the reality of unemployment, and the reluctance in consequence to take on debt, explains much of this. In the past 10 years the UK economy has grown by an average of 2.7 per cent annually. Germany has expanded by barely more than a third of that rate, at just over 1 per cent. The difference is accounted for by the behaviour of domestic demand – strong in Britain, weak in Germany – in the two countries.

Euroland is caught in a vicious circle. The Paris-based Organisation for Economic Co-operation and Development recently revised down its growth forecast for the area for this year from 1.9 to 1.2 per cent, warning of depressed consumer and business confidence, and arguing for a cut in interest rates by the European Central Bank (ECB). The very credibility of monetary union was threatened by economic stagnation, the OECD warned.

This was what the people of France and the Netherlands were voting against. Like the character played by Peter Finch in the film Network, they were saying: “We’re not going to take it any more.” Europe was supposed to be about rising prosperity – as indeed it once was – not about becoming permanently becalmed in the economic doldrums.

What has happened to peg the EU economy back? A large explanation for the problem is that provided by Layard. The turning point came a decade or so ago. Instead of promoting reform and flexibility, EU leaders focused on the task of achieving monetary union and promoting closer integration. These aims were perfectly laudable on their own but, in the absence of flexibility, were doomed to difficulty.

Otmar Issing, chief economist at the ECB, has recently admitted something I have long argued; that Europe was not an “optimal currency area” when the euro came into being at the beginning of 1999. An optimal currency area, which was the focus of my book ‘Will Europe Work?’ was introduced by the Nobel prize-winning economist Robert Mundell. He said that for a currency area to work it had to have wage flexibility, geographical mobility of labour and a large enough central budget to offset economic shocks. The EU had none of those things.

According to Issing, perhaps only five of the original 11 (later 12) euroland economies were sufficiently converged for monetary union to work. It went ahead anyway, for political reasons, on the assumption that convergence would follow and an optimal currency area evolve. That has not happened.

Flexibility was not just an add-on for Europe, therefore, it was essential. It was essential for the euro to work and it was essential if the EU economy is ever going to be able to compete with America, let alone China and India.

Flexibility was the aim of the Lisbon agenda but at its halfway stage, as even a sympathetic high level committee of experts concluded, progress was dismal. Now the constitution is gone, the priority for Europe, and more particularly for national governments, has to be to urgently pursue economic reforms and achieve that necessary flexibility.

Will it happen? It would be unwise to bet on it. Europe has had a wake-up call. Experience would suggest it will not necessarily respond to it.

From Business Voice, July-August 2005

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The more you look at the anatomy of the slowdown under way in Britain’s economy, the more multifaceted it appears. What is also becoming clear is that, while lower interest rates will help, they will not quickly restore economic growth to the kind of rude health it enjoyed as recently as last year.

We know that on the consumer side the slowdown goes beyond the mere fact of borrowers responding to higher interest rates. Nearly a year has elapsed since the last time the Bank of England hiked rates to 4.75%. But the housing market, one of the key ingredients of the weaker growth in spending, was slowing even before the Bank had done raising rates. The sheer level of house prices, and the fear of taking on more debt, has done as much to kill the housing boom as the actions of the monetary policy committee and Mervyn King’s famous “proceed with care” warning of last summer.

Consumers are feeling squeezed and so, though this has merited rather less attention, are companies. And the squeeze on firms, which is having a clear impact on Britain’s hitherto very strong job market, threatens to become self-reinforcing.

Official figures show that industry’s raw-material and fuel costs rose by 12.1% in the 12 months to June, their biggest increase for more than 20 years. Oil prices at $60 a barrel provided most, though not all, of the explanation.

In the past, firms would have been able to pass such cost increases on but that is not happening; the latest figures also showed that industry’s output price inflation was just 2.4% in June, down from 2.7% in May.

Industry is being squeezed by the China factor. China’s demand is helping to push up commodity and fuel costs, while its competitiveness is holding down the prices of industrial products. Add to that the “Primark” factor — the rise and rise of the discount retailer — and it is small wonder that companies feel under the cosh.

Two figures stand out from the latest consumer-price figures, which had inflation at a “seven-year high” of 2% (and won’t stop the Bank cutting rates). One was the continued fall in clothing and footwear prices, dropping by 5% a year and down nearly 40% since 1996. Stuart Rose, chief executive of Marks & Spencer, took comfort last week from the fact that M&S had kept the bargain-hunting hordes back by delaying its summer sale. But not for long — sale signs appeared on Thursday.

The other figure that fascinated me was that data-processing equipment — personal computers and the rest — has dropped by more than 90% in price in the past nine years. Lower prices for goods have become the norm in many sectors.

That is not the only problem for British business. The British Chambers of Commerce (BCC), in its quarterly survey last week, reported what it described as “disturbing” results, particularly for the service sector, which was weaker across the board.

Manufacturing, perhaps surprisingly, did better in the second quarter than the grim first, but suffered a significant drop in export orders. Both sectors experienced a sharp decline in employment expectations.

David Frost, the BCC’s director-general, said: “The deterioration in the service sector’s position is very disturbing, given the critical role of services in sustaining UK output and employment, and given the persistent weakness of manufacturing.”

There is a direct read-across, it seems, from this survey to the labour market. Unemployment on the claimant-count measure rose by 8,800 last month and has now increased for five months in a row, making this the biggest sustained rise in the jobless total since 1992, clearly more than a blip. Employment fell by 72,000 in the three months to May, its biggest fall since 1993. The number of economically inactive people who want work but cannot find it rose by 114,000.

As John Philpott, chief economist at the Chartered Institute for Personnel and Development, put it: “The spring labour-market figures are easily the weakest for some time. Only in the public sector is employment and pay still buoyant.”

This is true. One of my informal economic indicators is the Sunday Times Appointments section, which has not really recovered its poise since the good times back in the year 2000, and is just 10 pages this week, a shadow of its former self.

A detailed look at the employment figures tells the story. The Transport & General Workers’ Union has warned there will be no manufacturing jobs left in Britain by 2029, and things are heading that way. Depending on which measure you choose, there are either 3.2m or 3.5m such jobs left, down by 80,000-90,000 over the latest 12 months. That is familiar territory.

Service-sector employment growth has also tailed off. Jobs in distribution, hotels and restaurants are flat over the past year. Employment in transport and communications is down fractionally. The only significant private-sector growth area has been financial and business services, up 96,000.

That leaves the growth in jobs firmly lodged in the public sector, and also in construction, which is heavily dependent on government spending. Employment in education, health and public administration is up by 89,000 over the latest 12 months, to 7.5m. Construction jobs are up by 81,000 to 2.2m.

Can this go on? Growth in public spending will continue at a reasonably robust rate over the next three years, although not as rapidly as in the recent past. The Treasury is ostensibly in the middle of driving through civil-service job cuts in line with the Gershon efficiency review. The preferred official measure of public- sector jobs rose by 72,000 to 5.8m in the year to the first quarter, half the 144,000 rise over the previous 12 months.

The economy, in any event, cannot rely on the public sector to “create” jobs. The key short-term question is whether Britain can avoid the kind of jobs shakeout that would wreak havoc on consumer confidence and already weak retail sales and the housing market. Longer term, the key question is where the new jobs will come from.

PS: We worry, understandably, about whether Britain will ever be able to compete with China. So is this new economic leviathan responsible for most of Britain’s trade gap? The answer, interestingly, is no. Figures last week show the UK’s trade deficit in goods is running at about £5 billion a month. But the biggest gap is not with China, but with Germany.

Even so, the German lesson is worth noting. If countries such as Britain are to compete with the emerging economic giants of China and India, with their ultra-low labour costs, the first task is to start competing more effectively with economies with similar cost structures. A look at the trade figures and our big deficits — not just with Germany but Italy, the Netherlands, Belgium and Luxembourg and to a lesser extent France — suggests this is not happening.

From The Sunday Times, July 17 2005

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It has been a hell of a party. We’ve enjoyed ourselves for years. But now it is the time to count the cost. That, it seems, is going to be the story of the next few years. Consumers have had an unprecedented time, household spending rising at a faster rate than overall gross domestic product (GDP) in every year since 1997. There is no record of that happening over such a prolonged period before.

Consumers have been the beneficiaries of a number of factors. Combine low interest rates and a strong pound, not something that Britain has experienced very often, and households are already on to a winner. Low interest rates directly encourage credit-hungry consumers, boost the housing market and reduce the incentive to save. The strong pound improves Britain’s terms of trade – cutting the cost of imports relative to exports. Consumers are the main beneficiaries of these lower import prices.

There’s more. In the past consumers have taken fright when fears of redundancy increase, and actual unemployment starts to rise. That has not been the case for the past decade. Some three million more people are in work and unemployment, on the claimant count measure, is in the 2 to 3 per cent range traditionally defined by economists as “full” employment.

Why should any of this change? Interest rates, at time of writing, are a mere 4.75 per cent and appear to be at or close to their cyclical peak. True, they dropped to just 3.5 per cent in 2003 but that was exceptionally low. Prior to 2000 they had not been below 5 per cent for nearly four decades.

What we have seen, however, is a build-up of personal sector debt, and that is starting to impinge on people’s spending decisions. While the debt-servicing burden remains relatively light – 9 per cent of disposable income compared with 15 per cent in the recession of the early 1990s – capital repayments are beginning to creep higher. The burden of interest plus capital repayments is already 17-18 per cent of disposable income, compared with a recession-inducing 20 per cent back in 1990.

That is not the only thing missing. The boost to consumers from a strong pound is unlikely to be repeated. Sterling is not expected to collapse, but the big rise that gave households such a terms-or-trade boost will not happen again.

What about the labour market? Private sector employment has been weak for the past 3-4 years, the labour market gap being filled by the rise in public sector jobs and by self-employment. Some of the latter is almost certainly involuntary – people who have left employment but are retained as consultants, often on a part-time basis – and the rise in public sector employment is tailing off.

It is possible, indeed, to scare up a very nasty scenario, in which consumers’ reluctance to spend results in lay-offs among retailers and other consumer market providers, with the resulting rise in unemployment making consumers even less willing to spend, and so on. They call it a vicious circle.

There is another factor. Gradually the realisation has sunk in that pensions are not what they were. People may not be aware of the four options set out by Adair Turner’s Pensions Commission for filling the pensions’ gap – later retirement, higher taxes, compulsory savings or an increase in voluntary savings – but they will be increasingly aware of it when the Commission publishes its final report later in the year. Many people meanwhile have already had direct or indirect experience that tells them the income they can expect in retirement will be lower than they would have expected even a few years ago.

This will be a significant factor tilting the balance back towards saving – compulsory or voluntary – over the next few years.

Not everybody agrees that consumers have pushed the boat out too much. Some economists argue that the rise in debt, to nearly £1,100 billion (£1.1 trillion) is impressive but is mainly a response to the ability of households, at lower interest rates, to finance it. Household sector assets, after all, are six or seven times household liabilities, not least because of the house-price boom.

The drop in the saving ratio, those economists argue, is also mainly a response to changed economic circumstances. When unemployment is low and people are reasonably confident about prospects, they see less need for “precautionary” savings. Low savings, therefore, are less a sign of irresponsibility, more a sign of what individuals see as the new reality.

Those who spring to the defence of the consumer also point out that consumer spending looks much less robust in cash terms than in “real” terms. One of the big stories of recent years has been the decline in goods prices – as a result of competition from China, the strong pound and, in areas like car prices, official and consumer pressure to move into line with international, and in particular European, pricing.

Consumers have been quick to take advantage of these lower prices. They have been quicker to respond, in fact, than the official statisticians. So while the spending numbers look high in real terms, they look rather less concerning in cash terms. Last year, for example, household spending was 65 per cent of GDP when measured in real terms (constant 2001 prices), but only 62.5 per cent in cash terms, that is in the prices prevailing during 2004.

These are fair points. The consumer boom of the past few years has not been a runaway affair like that of the late 1980s, when households had their first experience of unrestricted access to credit and behaved like greedy children let loose in a sweet shop.

At the same time, however, consumer spending has undoubtedly had a strong run and for the factors outlined above needs to slow. Whether that slowdown can be achieved gradually rather than suddenly will be one of the interesting questions for the next few months. The other is whether, as consumers scale back, something else can take up the growth slack.

From Professional Investor, July-August 2005

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With due respect to my own piece below, economics always runs the risk of sounding inappropriate or feeble when it comes to terror attacks. We cannot deal adequately with the loss of life and human tragedy, and we cannot offer good explanations for why these things happen. They are treated, in the jargon, as an external shock, the question being how the economy responds to them. This piece, by Brian Walden, is better than anything else I have read on the London attacks.

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We have learnt a lot about how economies respond to terrorist attacks. The immediate reaction to the September 11 attacks four years ago was that such an assault on America’s financial capital (and simultaneously on its seat of government) would devastate the United States, if not the entire global economy.

At the time I took a different view, arguing that the damage to consumer and business confidence would be short-lived, and that the policy response, in interest-rate cuts and expansionary American fiscal policy (extra federal spending and tax cuts) would ensure a quick bounce-back.

This is what happened. America’s economy contracted in the third quarter of 2001 but recovered strongly in the fourth — and has continued to grow ever since. In the final three months of 2001, encouraged by lower interest rates and a patriotic duty to spend, consumers ensured that American retail sales rose at the fastest rate for 10 years.

The Madrid bombings of March 2004, in which there was a bigger death toll than the London attacks, had no discernible impact on the Spanish economy. Spain’s central-bank governor, reporting recently on his country’s stronger-than-expected 3.1% growth last year, made no mention of any terrorist effect.

So what about Britain and the impact of the London bombings? The first clue has to come from the response of the Bank of England’s monetary policy committee (MPC). The MPC, which was meeting as news of the attacks unfolded, had already been under pressure to cut rates because of the economy’s recent weakness.

Instead it decided on a “business as usual” approach. Most economists had expected the Bank to wait until August, and its next inflation report, before changing direction on rates, and that is what the MPC did, leaving base rate unchanged at 4.75%. Although there was economic justification for a cut, to have done so could have looked like panic, and a delay made good sense.

The question, however, is whether the weakness the MPC was being urged to respond to ahead of Thursday’s meeting will now intensify. Have the terrorists, in other words, hit the economy when it was already down? Talking economic numbers when there has been large-scale injury and loss of life always verges on the callous but the question bears asking.

For retailers across the country, recent months have been grim. The British Retail Consortium reported last week that in relative terms June was not as bad as May, because the weather picked up a bit. Like-for-like sales, though, were still down on a year earlier.

London retailers, moreover, could be forgiven for thinking events are conspiring against them. On Monday the central London congestion charge, which shops large and small say has already hurt trade, went up from £5 to £8. Tie that in with fresh worries about using public transport and you would not want to be a London retailer. The hope of an immediate feelgood factor arising from the award of the Olympics has been dashed. The fear is that the tourist trade will be hit.

The housing market, slow across the whole country, is particularly soft in London. The latest Halifax house-price index, published last week, showed that prices nationally were up by 3.7% on a year earlier.

In Greater London, however, they were down by 2.5% in the second quarter compared with the same period in 2004, the first time annual London house-price inflation has turned negative on the Halifax measure for 10 years.

The housing market is, of course, at the heart of the current slowdown in the economy. Mortgage-equity withdrawal, the amount of capital people take out of housing, usually in the act of moving or remortgaging, has slumped. Figures last week showed that equity withdrawal dropped to £6.4 billion in the first quarter, compared with £15.9 billion a year earlier. It will fall further.

In the absence of a strong consumer and buoyant housing market, the problem is that there is little growth coming from anywhere else. Official figures show manufacturing is close to recession, although some industry bodies think this overstates the gloom. Even so, Britain’s production sector is certainly not striding forward.

That leaves the economy without an obvious motor. After the shock downward revision of growth in the first quarter to 2.1%, Geoffrey Dicks at Royal Bank of Scotland points out that even if there is growth of 0.5% or 0.6% for each of the remaining quarters, the annual figure for 2005 will only scrape up to 2%, barely half the chancellor’s 3% to 3.5% forecast. Even that may be pushing it. The National Institute of Economic and Social Research estimates that the economy expanded by only 0.3% between the first and second quarters.

This growth shortfall does not mean, by the way, that the chancellor will be rushing to put up taxes. The fiscal rules are devised on a cyclically adjusted basis, specifically so they do not require the Treasury to make a bad situation worse by making a weak economy even weaker with tax hikes.

But what about that terror impact? Before the bombers struck on Thursday morning, we were all busy working out how big an economic effect the 2012 Olympics would have. The answer, despite the hype, was that it would be small. The impact of last week’s terrorist attacks will be even smaller; tiny in fact, and we should not fall into the trap of blaming the weakness that was there anyway on a few lunatics with explosives.

The question for the MPC will be how to inject some impetus into the economy in response to that weakness. It has done it before, but this time the task looks more challenging.

PS: Most things will carry on as usual. On Tuesday George Osborne, the shadow chancellor, will give a Centre for Policy Studies lecture, “Principles of a Conservative economic policy”. As Gordon Brown’s seventh opponent in just over eight years — and by some distance the youngest — he faces a tough task. The Tories have not used their time in opposition to build a credible alternative economic policy.

But Brown’s solution, increasing the size of the state, raising the tax burden and bogging down enterprise with red tape and tax complexity, mean policy is pointing in precisely the opposite direction to the rhetoric. The chancellor has presided over a system of tax credits that has been expensive and hugely inefficient. His failure to get to grips with Britain’s supply-side shortcomings compound that. If Osborne is able to build on this well-aimed criticism, he may do much better than his predecessors.

From The Sunday Times, July 10 2005

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Free Lunch: Easily Digestible Economics, my introduction/refresher to economics, is gradually conquering the world. After the Chinese, Russian, Indian and Korean editions, there is now a German version. I understand there is no direct translation for 'There's no such thing as a free lunch' in German, so the title is something like 'Lunch is for losers'.

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The results of the latest Shadow Monetary Policy Committee (SMPC) monthly e-mail poll for the Sunday Times are set out below. Members of the Institute for Economic Affairs’ (IEA’s) SMPC speak in a personal capacity and their contributions are arranged in alphabetical order. The rate recommendations are with respect to the MPC rate decision to be announced on Thursday 7 July. On this occasion, five SMPC members voted to hold rates in July, while three voted for a ¼% rate cut and one for a ¼% hike.

The wider economic background is discussed in more detail in the quarterly SMPC minutes. The next quarterly SMPC meeting will be held at the IEA on Tuesday 19 July, and the minutes from this quarterly physical meeting will be released about a week afterwards.

Comment by Roger Bootle
(Economic Adviser to Deloitte)
Vote: Cut Rates by ¼%

The time has arrived to reduce interest rates. All the signs are that the consumer slowdown is intense and is unlikely to be reversed any time soon. Meanwhile, overseas markets, particularly in the Euro-zone, look likely to be soggy. Although it has risen, inflation is still just below the target and the increases have been due largely to one-off rises in oil and other commodity prices, rather than a response to excessive demand.

It is important for the MPC to set monetary policy to anticipate inflationary moves in the future, and if it does not cut rates soon, there is a serious prospect that inflation could undershoot the 2% target by a considerable margin. This reduction should be the first of many. I expect rates to reach 3.5% next year.

Although I vote for a cut now, for presentational reasons the Bank may well prefer to wait until August, which is an Inflation Report month. A reduction could then easily be associated with the crystallisation of the downside risks to growth, which the Bank has noted before.

Comment by John Greenwood
(Chief Economist, AMVESCAP)
Vote: No Change

Strength in particular sectors suggests that UK economic weakness has been overstated. Although retail sales, housing, and business investment have softened in recent months, there is plenty of strength elsewhere in the UK economy that warrants the continuation of monetary restraint. The labour market remains tight, the number of jobs continues to expand, and wage growth is buoyant. Consumer confidence, as measured by the GfK index, weakened in April and May, but was still higher than in any month of 2004 except January. In addition, government expenditure continues to expand vigorously (6.8% in the year to May). Finally, the 11.6% growth of M4 broad money in the year to May, and the 11.2% increase in bank and building society lending, implies rates are too low, risking a shift of these funds from the wholesale sector (and asset markets) to the retail sector (and goods and service markets).

Inflation could rise if sterling falls. Although the core CPI is only 1.5%, oil prices are likely to stay firm, pushing up costs across the economy. The headline CPI is currently marginally below target, at 1.9% in April, and manufacturing output prices remain on a plateau (up 2.7% in May). Both could rise further as sterling falls.

Capacity constraints. A temporary easing of growth when the economy is close to full capacity does not justify rate cuts. Previous episodes of resurgence in consumer demand caution against easing policy too soon.

Comment by Dr Andrew Lilico (Europe Economics)
Vote: No Change

The MPC would have more scope for rate cuts now if it had raised rates around the turn of the year. If the MPC had raised rates more late last year or earlier this, now would probably be the time for cutting. But with monetary growth still so strong, as highlighted by the Governor recently, and with little sign of relief in commodity prices, it still seems reasonable to expect that inflation will rise over the coming months. On the other hand, recent retail sales growth has been very modest, and quite a significant slowdown in consumption (probably associated with the slowing housing market) might yet feed through into prices in the medium term. It is unclear how these factors will play out. There may yet be a case for further interest rate rises, although it seems unlikely that the MPC will agree, given that it has not raised rates when the case has been much stronger in recent months. But if the next moves are down, we should recognise that the scope for cuts will be limited by the likely tendency for inflation to be rising. Interest rates can have a powerful effect upon the economy through changes, as well as levels, and the MPC’s reluctance to raise rates further recently has limited its scope to make downwards changes. Perhaps that is why it is discussing the possible effectiveness of Maradona-style bluffing…?

Comment by Professor Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: No Change

MPC’s ‘do nothing’ policy is working. In the face of conflicting signals on the state of the economy, the current ‘do nothing’ policy of the Bank of England is not only appropriate, it also appears to be working. The real side continues to send out signals of a slowing down, while the monetary side, with double-digit M4 growth in May, continues to signal future expansion and inflationary pressure. The speed at which market sentiment adjusted from expectations of a rise in interest rates, to a fall, now expected in the autumn, is another indicator of the difficulty in interpreting the conflicting signals on the economy. With markets expecting a cut, a policy of holding interest rates will produce just the right amount of tightening that could see broad money slip back to single-digit growth. While money supply continues to grow at current rates, there is no argument for a cut; while the economy shows signals of increasing sogginess, there is no case for a rise. Keep interest rates on hold.

Comment by Professor Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut Rates by ¼%

MPC has purposely engineered the slowdown, but may have overdone it
It is clear that the UK economy is slowing, probably rather sharply. The Bank has certainly achieved its objective, if such it was, of puncturing household ‘over-confidence’ in economic prospects and the housing market. This slowdown has ‘made in Threadneedle Street’ stamped on its rear end. A recession looks unlikely, but cannot be ruled out if rates are not cut. Matters are not improved by uncertainty over what the government will do to resolve its persistent deficit. Tax increases are now widely expected. The Bank’s problem will be to revive demand so that it grows closer to the growth rate of supply, which may now have recovered to 3% with better productivity growth and faster immigration from New Europe.

Comment by Professor Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Raise Rates by ¼%

Money indicators suggest that the economy is relatively buoyant
For several months the monetary indicators have been predicting that the economy will be more buoyant than non-monetary data suggest. So far this has not been surprising, because the time lag between changes in the money supply and the response of the economy is notoriously long and variable. The suggestion was that the economy would be more buoyant next year, rather than this. Nevertheless, the two sets of indicators usually come into line. It would not have been surprising if some real economy data had been revised upwards, or if the monetary data had become less buoyant. So far this has not happened. Monetary growth has, in fact, done the opposite and accelerated: the three-month annualised growth of broad money has risen to an eight-year high of 15.6%. Bank lending, although below its peak, grew rapidly over the same period, which does not suggest that people are repaying loans instead of spending their income on goods and services, as some have argued.

Asset prices are consistent with monetary laxity view: The effect of the buoyant monetary growth on asset prices has been in line with expectations. There has not been a crash in house prices. Financial institutions are struggling to find attractive investment opportunities. The price of agricultural land is higher than can be justified by farming profitability. The price of commercial property seems expensive relative to weak rental growth, particularly in the City of London office market where vacancy rates remain high.

Economy will rebound: The conclusion remains that the economy will, in due course, become more buoyant, and that the next move in interest rates will be upwards.

Comment by Professor Anne Sibert
(Birkbeck College)
Vote: No Change

Negative output gap will emerge in next two years. Recently released data include a small, but expected, downward revision in first-quarter GNP growth, a fall in manufacturing output and an increase in the trade deficit. The employment rate is unchanged from the previous quarter, but total hours worked declined and the claimant rate and inactivity rose. These signs strengthen a belief that the next two years will see an emerging output gap in the United Kingdom that will put downward pressure on UK inflation. May CPI inflation remained steady and slightly below target; house price inflation has stalled; and there is no indication of a weakening in sterling.

The latest oil price shock. A jump in crude oil prices to over US$60 a barrel produces difficulties for monetary policy makers. If the rise is viewed as temporary, then uncertainty about the timing and size of the effect, the long and uncertain lags associated with monetary policy, and the dampening effect on economic activity, all suggest that following a monetary policy that is more contractionary than would otherwise be followed may do more harm than good. However, if the shock has a permanent component - as this one probably does - then monetary policy ought to be tighter than it otherwise would be: the higher prices of energy goods will increase consumer prices over time, as producers pass on their higher costs.

A rate cut may be needed. Current developments are not sufficient to make a case for a cut in the interest rate but, should the softening of economic activity persist, a reduction may be called for.

Comment by David B Smith
(Chief Economist, Williams de Broë plc)
Vote: No Change

Financial markets may have got ahead of themselves in anticipating European rate cuts. The Swedish Riksbank’s decision to cut its official interest rate by ½%, rather than the expected ¼%, on 21 June, the latest increases in the price of oil, and the fact that two MPC members voted for a rate cut in June, appear to have convinced the financial markets that both the ECB and the Bank of England might cut interest rates in the near future, even though the US Federal Reserve is expected to increase the Fed Funds rate from its present 3% to 3¼% on 30 June. The markets may be wrong about the ECB, which believes that the Euro-zone’s sluggish growth and high structural unemployment are due to the adverse effects of interventionist tax-and-spend policies, and would not be cured by running a laxer monetary policy. The much tighter demand gap in Britain suggests that a rate cut here would be even less appropriate than would be the case on the Continent.

Monetary background ought to rule out a rate cut, but oil price uncertainties suggest a hike would be inappropriate. In particular, excessive monetary ease in a supply-constrained British economy is more likely to induce higher inflation than increased output. British broad money supply growth, at 11.6% in the year to May, is more than twice the 5.2% recorded in the core OECD area in the year to April, and remains a serious concern. UK lending, excluding the effects of securitisations, has risen by 12.6% over the past year, and CPI inflation is nudging up against its central 2% target, having been 1.9% in March, April and May. The ‘old’ sterling index was 105.5 (1990=100) on 27 June, which is slightly high but not a level where a rate cut seems urgent. A British REPO rate cut on 7 July might represent a serious error, if the world economy bounces back towards the end of this year, although the uncertainties caused by the vagaries in the price of oil are such that the case for a rate rise is not overwhelming. However, the 4 August rate decision, when the MPC will have a new Inflation Report in preparation, is more likely to see a rate change than the July one.

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Cut Rates by ¼%

Fourfold evidence of UK slowdown warrants a rate cut. Evidence of a marked deceleration in the pace of UK economic activity is available now on four fronts. In the housing market, a 30% drop in housing market turnover has tilted the balance of power towards home buyers, and asking prices are drifting lower. The peak season for transactions has passed and it is now safe to cut the REPO rate without fear of reigniting speculative activity. Retail sales values have slowed from a 6% annual pace to a virtual standstill. VAT receipts are decelerating accordingly, and the growth of total tax receipts seems to have peaked. Finally, the labour market shows signs of stagnation outside the still-buoyant areas of business and financial services and public sector-driven demand for construction. In the monetary data, the slowdown is clear from the pace of household borrowing and the growth of M4 deposits of private non-financial corporations. Balance sheet expansion by the financial sector is responsible for the strong headline growth of M4, giving support to financial asset prices but posing no immediate threat to consumer price inflation. The private sector component of the Retail Price Index shows an annual inflation rate of just 0.8%. All in all, the evidence commends an easing of the interest rate stance.

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IN years to come we may look back on this week’s G8 summit in Gleneagles as the end, or at least the beginning of the end, of an era. These summits have had a pretty good innings, dating from the “Library Group” of finance officials from Europe, Japan and America, invited to Washington in 1973 to discuss the first Opec oil crisis.

Two years later France’s president, Valéry Giscard d’Estaing, invited the leaders of America, Britain, Germany, Italy and Japan to Rambouillet, near Paris, for a world economic summit. The rest is history. Canada was soon invited; Russia more recently as a reward for abandoning communism.

In 30 years, it is doubtful whether any summit has been surrounded by as much hype as this one. Yesterday’s Live8 concerts had a potential worldwide television audience of 5.5 billion, although an actual one much smaller. We have had marches, soppy dramas by Richard Curtis and a whole lot else. There will be more to come.

So why, when G8 summitry is apparently at the height of its powers and influence, do I say its days may be numbered? One factor, plainly, is that the world economy’s axis is shifting.

Half the G8’s members are from Europe. Three — France, Germany and Italy — are from the eurozone. This cannot last. In 2004 China contributed three times as much to global growth as the 12 euro member countries combined. India provided more of a growth contribution than euroland. The G8’s membership is wrong, and the first step should be the replacement of Italy and Canada with India and China. In 30 years, the big three economies will be America, China and India.

That is not the only problem. There are some fairly pressing economic issues, high among them the effect on the global economy of high oil prices and the dangers of world economic imbalances, most notably the yawning American current- account deficit — and Europe’s chronic problem of weak growth. There is also, as most people in business now recognise, the pressing need to do more about climate change, and the environmental impact of fast-rising Chinese and Indian energy demand.

Oil prices dipped back below $60 a barrel last week but could yet go higher. The Basle-based Bank for International Settlements, the central bankers’ club, warned in its annual report last week that the consensus may have underestimated the effect of high oil prices and that further increases could do a lot of damage. That was not its only concern.

“A return of unusually low long-term interest rates to more normal levels could curtail spending by households,” it said. “Moreover, there has been little progress in tackling internal and external imbalances. Household debt has continued to rise and savings have declined in many advanced industrial countries while fiscal deficits have remained high. The reduction of current-account imbalances, which have widened further since the beginning of the year, remains a big global challenge.”

Here in Britain, it seems, many of those factors are coming together to give us decisively slower growth. Last week’s revised gross domestic product figures for the first quarter were a shocker, showing growth down from 2.7% to 2.1%. Gordon Brown’s growth forecasts have escaped, Houdini-like, on several occasions when all seemed lost. There can be no escape this time. The Treasury forecast of 3% to 3.5% growth will not be achieved.

Nobody would suggest that the G8 should focus its discussions this week on the death of the British consumer. But weaker growth for the UK economy is part of a wider global malaise. Curing the world’s problems is a lot easier when economies are growing robustly.

It is worth recalling what the leaders who attended that first summit at Rambouillet said in their declaration. The discussion was heavily economic in nature, focusing on the need to respond to high energy prices, control inflation, cut unemployment and contain global economic imbalances.

It also called for a renewed impetus in cutting trade barriers, something that was soon achieved. It also recognised the symbiotic relationship between rich and poor countries. “Sustained growth in our economies is necessary to growth in developing countries; and their growth contributes significantly to health in our own economies,” it said. What was true then remains true now.

Surely, however, it is good news that the G8 is getting to grips with the scandal of poverty in Africa? Well yes, but it is also quite painless. The centrepiece of this week’s announcement will be the cancellation of between $40 billion and $55 billion of the debt owed by up to 38 of the so-called heavily indebted poor countries, mainly in Africa.

That debt, of course, was always unlikely to be repaid. The issue, thrashed out at last month’s meeting of finance ministers in London, was who would pick up the interest bill on the debt, mainly owed to the World Bank, International Monetary Fund and African Development Bank. The hat was passed round, and everybody chipped in. But the sums are small — up to £530m spread over 10 years for Britain, and just over £900m for America. That, to finance ministers used to dealing in tens of billions, is loose change. Direct aid is also increasing but not in a way that threatens domestic priorities.

Whether giving Africa a huge amount more would do good or harm is open to debate. It would, however, have involved some hard choices. And that, more than anything, is what the modern G8 always avoids.

PS: How long before the first base-rate cut in this cycle? Last week’s grim reading from the CBI, which said retail sales last month suffered their worst year-on-year fall in the 22 years of its distributive trades survey, made the case for a cut as early as this week, as did that surprise downward revision to growth in the first quarter from 2.7% to 2.1%. Other evidence, including May consumer-credit and mortgage approvals — with the Bank of England saying the latter were the strongest since last July — argued for delay.

The “shadow” monetary policy committee, like the actual MPC, is moving closer to a rate cut. Its latest vote, conducted for The Sunday Times, has three members in favour of an immediate lowering of rates, five for no change and one for a hike. Apart from the hike vote, the actual MPC, with two members already in the cutting camp last month, may split along similar lines.

What will the real MPC do? Probably not much this week, although the chances of a cut are growing and would not be a huge surprise. August, when the committee has the benefit of a new set of economic forecasts, still looks a better bet.

From The Sunday Times, July 3 2005

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