When the dust settles on the deal under which China’s Nanjing Automobile Corporation acquired the MG Rover factory at Longbridge, two things will be clear. One is that while there may be some car assembly at Longbridge, it will involve fewer than 2,000 workers (probably a lot fewer) and most of the components they will be screwing together will be made in China.

The other is that, whatever happens, the deal will represent a transfer of manufacturing, and in this case intellectual property, from Britain to China. The assembly lines for the Rover 25, 45 and probably the 75 will be shipped to China, as will the Powertrain engine plant.

And what is happening at Rover is representative of British manufacturing in general. Under the pressure of competition from China it is withering, and rather faster than in the countries of most of our competitors.

While German industry is undergoing a revival on the back of strong export orders, and American manufacturers have been doing well because of the growing US economy, the story in Britain appears to be one of continuous struggle.

Last week the CBI reported that manufacturing orders have dropped to their weakest in two years and that firms feel as much under the cosh as ever. Just as a glimmer of light was starting to appear on exports, a drop in domestic demand has hit them hard. It’s grim.

The statistical backdrop to this was provided by the latest official figures on the contributions of the various sectors to the nation’s economic output. These, contained in the latest input-output tables, show that manufacturing’s contribution has slumped from 20.1% in 1998 (the last time it was above 20%) to just 14.9% in the latest figures, for 2003. We do, it seems, fit Napoleon’s celebrated putdown, “a nation of shopkeepers”, rather better than any pretensions we might have to be still regarded as the workshop of the world. Retailing and wholesaling account for 15.7% of output.

More to the point, we are a nation of accountants, consultants and financial advisers. Financial and business services now provide 31.7% of Britain’s annual output, up from 27.6% in 1998 and 24% in 1992.

There is nothing new, of course, about the declining share of manufacturing. One of the iron laws of economics is that with rising prosperity and economic development the primary sector — agriculture and mining (together worth 3% of output) — is the first to decline. Then the same thing happens to the secondary sector, manufacturing.

Observers were fretting about the decline of manufacturing at the time of the Great Exhibition of 1851.

In 1960, when manufacturing was about 35% of gross domestic product, the worry, justifiably, was that competitors were overtaking us.

What has been unusual in recent years has been the speed of manufacturing’s decline — a drop of five percentage points of output share in as many years. Steve Radley, chief economist at the EEF, the engineering employers’ federation, said that at a time when other sectors have been strong, manufacturing has been hard hit by the rise of China, the strength of the pound against the euro and uncertain world markets. Even so, he expects manufacturing’s share to shrink further.

Does it matter? Could we manage without a manufacturing sector at all? In theory, yes. In practice, almost certainly no.

The relative decline of manufacturing, for a start, skews regional imbalances in Britain even further. London and southeast England has its share of manufacturing activity, but as part of a diversified economy. In too many regions in Britain the gap left by declining manufacturing has not been filled, or it has been partly filled by an expanded state. Figures earlier this year showed that in some northern regions the public sector accounts for some 60% of gross domestic product.

New projections from Experian Business Strategies, covering the period 2005-15, show a clear north-south split in growth prospects. The fastest-growing parts of Britain will be Bedfordshire, Berkshire, Buckinghamshire, Hertfordshire, inner London and Oxfordshire. The slowest growing will include large areas of Scotland, the Tees Valley and Durham, Cumbria and Merseyside.

Trade is another concern. Even in reduced circumstances manufacturing industry managed to export at the annual equivalent of £167 billion in the first half of this year. Manufacturers still account for more than half, 55%, of Britain’s total exports of goods and services. The further that manufacturing declines the bigger would be the hole at the heart of the balance of payments. Manufactured imports are running at an annual rate of £209 billion.

Economies are, of course, always in a state of flux. The 10 industries identified by the Office for National Statistics (ONS) as having declined most sharply — man-made fibres, non-ferrous metals, insulated wire and cable, leather goods, textile fibres, clothing and fur, footwear, knitted goods, iron and steel and coal extraction — mainly belong to another age.

But these are not necessarily being replaced by the kind of activities we need to develop to compete in the future. Michael Saunders of Citigroup makes the point that in the period 1992-97 there was a clear shift in manufacturing to high-technology activity. In the period since then, however, high-technology manufacturing has declined at a faster rate than its medium and low-tech equivalents.

Britain is still doing well when it comes to knowledge-intensive services. The ONS’s list of the top 10 expanding areas — computer services, other business services, insurance and pension funds, recreational services, owning and dealing in property, letting of dwellings, market research and management consultancy, construction, hotels and catering, and retailing — is fairly healthy, although at least two are reflections of the long housing boom.

The question is whether we can compete in high value-added activities in the future. In manufacturing that battle appears to have been lost. In services that will depend, as Saunders notes, on Labour’s success in keeping Britain competitive when it comes to taxes, regulation and labour-market flexibility. Sadly, that battle may be being lost too.

PS: Do we gain as a nation from having Peter Mandelson represent us in trade negotiations? For years, since Brussels acquired “competence” over trade, we have endured successive European trade commissioners playing the Common Agricultural Policy card to block trade liberalisation.

Mind you, I would not be surprised to see some retailers trying to capitalise on the “buy now while stocks last” story. They need all the help they can get.

From The Sunday Times, August 28 2005

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A comprehensive guide to the changing structure of the UK economy in recent years is provided by the latest input-output analysis from the Office for National Statistics. It describes, among other things, how manufacturing now accounts for under 15% of economic output, compared with 31.7% for business and financial services. Read the report here.

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Readers with long memories may recall Goodhart’s law, devised by former Bank of England chief adviser and monetary policy committee (MPC) member Charles Goodhart. This Murphy’s law of economics states that any indicator you target soon becomes unreliable.

It applied to the Thatcher government’s attempts to find a reliable measure of the money supply in the 1980s. It applies now to the consumer prices index (CPI), the inflation measure the Bank was switched to by Gordon Brown after the Treasury’s last assessment of Britain’s readiness for the euro two years ago.

Inflation on the CPI measure “jumped” to 2.3% last month, above the 2% target. The old target measure, the retail prices index excluding mortgage-interest payments, also showed a rise, to 2.4%, but this was below its previous target of 2.5%.

One of the key differences between the two is that the CPI excludes house prices. When the change was made, Brown was criticised for choosing a measure that left out an inflationary part of the economy. Now the inflation rise on the new measure reflects mainly the unfettered impact of higher oil prices. The lesson? Don’t tinker with the target.

Britain’s inflation rate of 2.3% is now running above that in euroland (2.2%) for the first time in a very long time. Britain is still growing faster than the euro area, but only just — gross domestic product here rose by 0.4% in the second quarter compared with 0.3% in euroland. Italy grew by a surprising 0.7%.

We should put the rise in UK inflation in perspective. The consumer prices index is above target but it rose by only 0.1% last month. In contrast, consumer prices in Zimbabwe rose by 47% in July alone. In the mid-1970s, when Britain really did have an inflation problem, prices rose by 4.2% in a single month, May 1975.

All that is by way of a preamble. The big story of the past two weeks has been the bonfire of interest-rate-cut hopes. I cannot remember a time when hopes of lower rates have been battered so comprehensively.

First there was the Bank’s inflation report, which implied that the markets were mad to be pricing in further rate cuts, and that the inflation target would only just be met with a 4.5% rate.

Then we had those inflation figures. Despite an apparent rise in “core” inflation, this is essentially an oil story. As discussed last week, inflation will drop as the oil price falls. So-called second-round effects are not coming through; wage settlements, if anything, are drifting lower. But the news was not good.

Not only that, but retail sales volume fell by just 0.3% last month, suggesting that the British Retail Consortium (BRC) — with its tales of high-street Armageddon — has been crying wolf.

I hold no brief for the BRC but that’s unfair. The retailing picture is indeed very weak, particularly for non-food sales, where most discretionary spending is concentrated. Retail-sales volume in the latest three months was up by only 1.3% on a year earlier, the weakest since February 1999. Household-goods stores’ sales volume dropped 0.9%, their poorest performance since December 1992. The value of all non-food sales last month was down by 1.8% on a year earlier.

Tie the retailers’ experience to the latest job statistics, which show the sixth successive rise in unemployment claims, and the economic slowdown looks genuine, not a figment of statisticians’ imagination.

Most significant of all, last week we had the minutes of the MPC’s meeting earlier this month, its 100th, which showed that it celebrated in unusual style. Not only was the vote close, just 5-4 for a cut, but Mervyn King voted against — the first time a governor has been outvoted on a rate change. He was joined by his two deputies, Rachel Lomax and Sir Andrew Large, along with Paul Tucker, the Bank’s executive director responsible for markets. Charles Bean, its chief economist, was the sole member of the Bank establishment who joined the four external members in voting for a cut.

This looks odd. How can the head of an organisation, and his deputies, be outvoted on the Bank’s core task of setting interest rates? Eddie (now Lord) George never allowed it to happen; Alan Greenspan would not countenance it. How can King and his colleagues defend the strategy of the majority if they disagree with it? Should the rest of us regard this month’s cut in base rate as not genuine and likely to be reversed at the earliest opportunity? The Bank’s view is that this month’s vote shows how the system was meant to work. All MPC members are equal and the governor, like any other, can be outvoted.

Except, of course, they are not all equal. King devised the Bank’s inflation report and presents it to the world at a press conference, as he has done for the past 12 years. This month’s report, as noted, was unusually hawkish in tone. Would it have been presented differently by one of the five who voted for lower rates? I suspect so. The Bank establishment may have been in the minority but its view came across louder and clearer than the majority.

Am I arguing that King should have bitten his lip and voted for a cut in rates even if he thought it was wrong? To some in the City his “no change” vote, coupled with the subsequent inflation numbers, make him something of a hero.

I’m not sure about that. The case for lower rates was based on the weakness of the economy in the first half of the year. It was a good case. What appears to have held the Bank establishment back is the worry that, if they acceded to a rate cut, it would be difficult to explain a subsequent increase if it proved necessary.

That goes against what the MPC was supposed to bring to monetary policy. When chancellors used to set rates they found U-turns hard because their political opponents would seize on them. The MPC has never had this problem, and nor should it. It should always be flexible, never rigid.

So what will happen to rates? It would take a brave man to predict another rate cut before the end of the year after recent events, though a weak economy could still bring that about. Looking into next year, it would be an odd interest-rate cycle that featured just one cut. The probability is of more.

PS Lest we get too worried about inflation, bear in mind the consumer prices index has risen only 13.6% since 1996, roughly 1.5% a year. Within that, however, there have been some huge increases. The biggest is home heating oil, up 95%, outstripping a 57% increase in petrol and motor oil.

Finally, the cost of education is up 62%. Some of that reflects university- tuition fees but most of it is private education. No wonder the A-level results were so good.

From The Sunday Times, August 21 2005

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The minutes of the Bank of England monetary policy committee's August meeting have been released and show a much closer vote 5-4, than was expected. As significantly, for the first time, a governor (Mervyn King) was outvoted on a rate change, as were his two deputies. Tie this with the rise in inflation to 2.3% last month - above the target - and it will take quite a lot to persuade the MPC to cut again in the near future. Read the minutes here.

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The August sun has been beating down and the driving season is in full swing. And, oh yes, oil prices have been hitting record highs again, topping $65 a barrel.

The driving season, usually thought of as an American phenomenon, kicks off on the Memorial Day holiday weekend in late May and lasts until Labor Day in early September, when American motorists take to the highways in large numbers in search of rest and recreation. But it is also a European thing and, judging from my recent experiences on our crowded motorways, one we embrace enthusiastically here, even with petrol at 90p a litre.

Its significance is that it is associated with strong demand for oil, putting pressure on limited refining capacity. Everything, in fact, seems at present to be conspiring to push up oil prices. The driving season gives way to autumn and winter heating demand. If the weather is cold, oil demand increases; if global warming makes it hot, turn up the air conditioning.

Our appetite for oil continues unabated in spite of record prices. The eastward shift of the global economy and rising demand from China, with its 9.5% growth rate, is another seemingly permanent oil-price booster.

I will return to that in a moment. The big domestic economic news this month, however, has been generated by the Bank of England, first by cutting base rate from 4.75% to 4.5% on August 4.

Then last week, Mervyn King, the Bank’s governor, presented a new inflation forecast that offered little encouragement to the interest-rate doves. If the Bank’s forecast turns out to be correct, the monetary policy committee (MPC) will see little need to cut rates further.

There are some serious questions about that forecast. Growth over the past 12 months has been roughly half what the Bank expected last summer, yet it persists in predicting an early bounce-back in activity — from where is not entirely clear.

That was not the only curiosity. King has stressed that the Bank can achieve as much when not cutting rates as when it does, as long as people expect it to do so. The prospect of a succession of cuts could have cheered up households, encouraging more spending, so minimising the need for the MPC actually to make those cuts. Last week’s signals went against that spirit.

The Bank, it should be said, will always have a built-in bias towards saying that the present level of interest rates is right. Otherwise, why not change it immediately? To me, however, the big issue has been oil. Inflation, on the consumer-prices-index measure targeted by the Bank, stood at 2% in June, exactly in line with the target. A year earlier it was 1.6%, three months before that just 1.1%.

What has caused this rise? The Bank offers two competing views. One is that inflation has moved up because of pressure of demand. Firms, in other words, have got back some of their pricing power because of the strength of the economy. The other explanation is oil. In just over two years, oil prices have gone up from the mid-$20s to more than $60 a barrel. Petrol has risen from under 70p a litre to more than 90p. In this context, the surprise is not that inflation has risen but that it has risen so little. At a time when world oil prices have more than doubled, 2% inflation is a minor miracle.

And last week’s inflation report offered no definitive answer on this, something I would want as a priority if sitting on the MPC. Is it really plausible that the strength of demand has pushed up inflation? Not according to retailers, who say consumer demand has been weak.

So we should look to oil, both for its effect on inflation — “core” inflation, excluding energy and seasonal food, is running at only 1.5% — and its impact on growth. Part of the slowdown we have seen in Britain is due to the fact that high oil prices act as a tax on growth. The more people and businesses spend on energy, the less they have for other things.

Petrol prices have yet to reflect the impact of the latest rise in crude oil. Gas and electricity bills will rise further over the winter. As the Bank said, the current inflation rate of 2% is unlikely to represent the peak.

What happens then? While the futures market suggests that oil prices will head gently lower, many market participants are not so sure. Options markets suggest that the chances of a big rise in prices are greater than those of a big fall, with a 1-in-20 chance of prices being $100 a barrel or more in a year.

I’m not so sure. This is a nervy time for the global oil market, but the surge in prices has all the characteristics of a classic bubble. The International Energy Agency, in its latest oil-market report last week, said: “The unfolding statistical picture increasingly reveals that fear of the unknown and the consequent desire to make forward oil purchases is behind oil’s higher price path.”

It also warned that while the emphasis now was on the risks of higher prices, “as stocks and spare capacity increase, it must not be forgotten that the downside price risks will eventually emerge as well”. It predicts a rise in oil demand of 1.75m barrels a day in 2006, but a bigger increase in supply, split between Opec and non-Opec countries. Opec’s margin of spare capacity, currently a wafer-thin 1m barrels a day, will rise to 3m.

That does not mean oil prices are going to collapse. It does mean they are likely to return gradually to earth — which probably means a sustainable $40 a barrel — when geopolitical worries subside. That, in turn, will expose the fact that Britain’s higher inflation is largely an oil phenomenon, enabling the MPC to reduce rates further.

And what if oil prices were to hit $100 a barrel? The Bank would need to cut in those circumstances, too, to prevent an already slow-growing economy sliding into recession. Either way, despite the Bank’s cautious message last week, this month’s rate cut will not be the last.

PS: Robert Solow, the Nobel prize-winning American economist, once gave us his famous productivity paradox: “You see computers everywhere, except in the productivity statistics.” How come, in other words, a labour-saving device as significant as the personal computer hasn’t made us all much more productive?

The trouble is this better performance has been offset by declining productivity elsewhere in the economy. The Bank cites the construction industry’s poor recent record. I am sure readers can think of others.

From The Sunday Times, August 14 2005

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The Bank of England's inflation report is always worth reading. The August report presents a cautious view on rates, suggesting 4.5% is appropriate for some to come. I'll have more to say on this on Sunday.

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A second edition of Free Lunch is planned and this is your chance to influence its content. For those familiar with the first edition, and those who are not, suggestions are welcome for some of the topic areas/ideas/great economists/etc, that should be included in the new and improved version. Many thanks.

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