David Smith' s magazine articles Archives
Friday, February 16, 2007
The end of a record-breaking chancellorship
Posted by David Smith at 11:00 AM
Category: David Smith' s magazine articles

This is the year when the Blair premiership comes to an end but it should also, barring a political earthquake, mark the end of the Brown chancellorship. Most of the attention, inevitably, will focus on the former; Tony Blair’s decade in charge. But Gordon Brown’s length of stay at the Treasury is, in many respects, no less remarkable.

It is nearly three years since Brown became the longest-serving chancellor of the modern era, beating David Lloyd George, who did the job for just over seven years from 1908 until 1915 (on his way, via the War Office, to 10 Downing Street).

The present chancellor is unlikely to beat Nicholas Vansittart, the 1st Baron Bexley, who served from May 1812 to December 1822. And he will not beat William Gladstone’s cumulative 12 years as chancellor, though that was achieved over a 30-year period in four separate spells.

Brown’s achievement has been to have lasted as long as he has in what is generally regarded, in today’s high-pressure world, as one of the most demanding jobs in government. In the post-war period, only Nigel Lawson – six and a half years from 1983 to 1989 – comes anywhere close.

Perhaps he (Brown) had an early inkling of the long haul ahead when he made the Bank of England independent within a few days of taking over at the Treasury. Not for him, from then on, the need to agonise over interest rate decisions and then tour the radio and television studios to explain them. And not for him something that had dogged every previous Labour chancellor – a sterling crisis. The two things are related; the pound’s stability owes much to the fact that the Bank, in its nearly 10 years of independence, has built itself a strong reputation in the financial markets.

How will history assess the Brown chancellorship? It is easy, and not a little cruel, to say that much of the action was, rather than being spread over 10 years, concentrated in the first 10 weeks or so. Did he know in May 1997 that nothing would surpass, in importance, the Bank decision? Perhaps not, but it is true.

Brown’s supporters would argue that announcing Bank independence was one thing; making it work was another. The chancellor has direct control over the appointment of the four “external” members of the monetary policy committee (MPC), and indirect control over the choice of the Bank governor and his deputies. As importantly, he has had to resist the urge to interfere, or even comment, on Bank decisions. That must have required some self restraint from a politician who likes to have fingers in most pies.

His supporters would also argue, less convincingly, that what has happened on the fiscal policy side, notably the two self-imposed fiscal rules, has been almost as important as monetary policy. They would also point to the decision to make competition policy independent of government, free from ministerial interference, with the Competition Commission inquiring into markets, mergers and regulation, usually in response to an Office of Fair Trading recommendation.

Whether it was just the Bank, or whether it was a bit more than that, it is hard to find too much to criticise in the macroeconomic record of the past 10 years. Any chancellor who leaves office having presided over growth in every single quarter can be proud (Kenneth Clarke did so too, but over four years, not 10). But unless the economy takes a dive in the next few weeks, that will be Brown’s achievement. Continuous growth has been accompanied by low levels of both inflation and unemployment.

But has he made the most of this benign economic environment, and has he left the economy in a better shape than he found it? Both public spending and the tax burden have risen sharply, and the public finances, despite the rules, have shifted heavily into the red. In effect we have seen two chancellors. “Austerity” Brown, the one in charge for the first couple of years, succeeded in reducing public spending to just 37.1 per cent of gross domestic product in 1999-2000, from the 40.8 per cent he inherited in 1997. “Expansionary” Gordon has pushed it back up to 42.5 per cent this year, an extraordinary rise in six years or so.

The picture on taxation has been more consistently upwards, from 34.8% of GDP in 1996-7, to an estimated 37.3 per cent in 2006-7 (with further increases built into the numbers). Austerity Brown appeared bent on repaying the national debt, running a budget surplus of 3.8 per cent of GDP in 2000-1. Expansionary Gordon, in contrast, is running a deficit of 3 per cent of GDP.

There is more, of course, to tax and spend than just the numbers. Critics would say that Brown’s legacy is a tax system of enormous complexity, in an economy that has been extensively re-regulated. They would also point to relatively poor return for taxpayers’ money in terms of improvements in public services.

Brown’s aides dispute claims that higher taxes have undermined the economy (though the CBI and others have highlighted the fact that the UK business tax regime is no longer internationally competitive). There is, however, a degree of exasperation at the Treasury that public services have not improved more, particularly as Brown’s last act as chancellor will be a comprehensive spending review that will impose a tough squeeze on departmental budgets. We are back to traditional Treasury thinking – the best way to achieve public sector efficiency is to keep the financial reins tight.

Is Britain more or less competitive, in general, than when Brown took over? Taxes and red tape would suggest not. But Britain remains an attractive location for foreign investors, even stripping out big takeover deals. There are areas of the economy, most notably the City of London, where Britain’s competiive advantage has increased.

As always, it is a mixed picture. The macroeconomic record is good but the rest is at best debatable. Mind you, Brown may yet have time to make amends. Even more than Margaret Thatcher in her heyday, Brown as prime minister will be his own chancellor, even if the job title goes to Alistair Darling or Ed Balls. In this respect, at least, he could have a few years running the Treasury left in him.

From Business Voice, February 2007

Monday, July 10, 2006
A deal too far?
Posted by David Smith at 06:45 PM
Category: David Smith' s magazine articles

Barely a week goes by without news of a new takeover of a British “asset” – a UK company – by a foreign firm. This year we have seen BAA, the airports operator, taken over by Spain’s Ferrovial, and O2 being acquired by Telefonica, also from Spain. Other recent instances of high profile firms falling into foreign hands include P & O, Pilkington and Associated British Ports.

Why is this spate of foreign takeovers occurring, and does it matter? The figures show that it is not just an impression that UK plc is being snapped up by foreign buyers.

Official statistics show that in the first quarter of 2006 foreign companies paid £19.4 billion in taking over businesses in Britain. On the other side of the balance sheet, overseas acquisitions by British firms were a mere £6.8 billion.

Figures like these are always likely to be distorted by large “lumpy” transactions and, sure enough, the first quarter numbers were significantly boosted by Telefonica’s £17.7 billion takeover of O2. In the other direction, there were few big deals, the most significant being Old Mutual’s £3.4 billion purchase of Skandia.

There is, however, a pattern here. In 2005 British companies spent £32.7 billion in 365 transactions buying overseas companies, but this was swamped by the £50.3 billion spent on acquisitions by foreign firms in the UK. Foreign takeovers are fewer in number - last year there were 242 in total - but they are typically bigger in size.

Britain went into “deficit” on mergers and acquisitions relatively recently, the shift occurring in 2004, when foreign takeovers in the UK were worth £29.9 billion, against £18.7 billion of British acquisitions abroad.

Before that, for many years, British firms had ensured that, in net terms, UK plc steadily built up its assets. Between 1996 and 2003, for example, British firms spent £469 billion acquiring overseas companies; an average of nearly £60 billion a year. Foreign acquisitions in Britain, in contrast, totalled only £234 billion. Each year, the balance was heavily in Britain’s favour – we were more predators than targets.

There is another element in the story. British firms with existing investments abroad are scaling back their overseas presence at a faster rate than foreign firms are in the UK. UK disposals overseas in 2005 raised almost £13 billion, against £8 billion of foreign disposals in Britain.

Why is this occurring? Part of the reason is the breakdown in the old cosy relationships between British firms and their institutional shareholders. Hedge fund managers tend to be less sentimental, perhaps, than shareholders were in the past.

The shareholder base of many quoted UK firms now tends to be both wide and varied, and usually includes a high proportion of foreign-based shareholders. Times have changed from the days when the old boy network meant that shareholders would stay loyal to the existing management, often through thick and thin. That is still the case in Germany, Spain and many other continental countries, but rarely in Britain. The loyalty of shareholders is to themselves and the clients for whom they are managing funds. That means, very often, firms are up for grabs by the highest bidder.

British firms are also often cheap relative their overseas competitors. The underperformance of the London stock market in recent years, coupled with the continued strength of sterling, has made British firms attractive to foreign predators.

The wave of foreign takeovers has also undoubtedly been helped by the green light provided by the government. Since it was elected in 1997, the Labour government has had a very different philosophy to its predecessors.

Ministers have argued that the only way to create a competitive UK economy was to expose all sectors to the maximum amount of competition. That has meant encouraging free trade at a global level; it has also meant free movement of capital. Foreign takeovers, on this view, have benefited the economy.

They also, argue ministers, benefit employees. Research from Nottingham University showed that workers in firms taken over by foreign firms enjoy 13 per cent higher wages, partly on the back of an improved productivity performance.

But how much is too much? Some in business are concerned that foreign predators have unfair advantages, to do with the structure of their shareholdings, borrowings and tax system. Telefonica and Ferrovial, for example, benefited from Spanish tax relief on the goodwill acquired in taking over foreign firms.

Business concern about the ease with which foreign firms can acquire UK targets is shared by voters. A Harris poll in June found that 68% of people in Britain though it was “too easy” for overseas companies to take over UK firms.

This was higher than in countries which have acted to block foreign takeovers. In Germany, 57% of people thought takeover controls were too lax, in France 52% and in Italy 50%. There’s a balance in these things. Perhaps we should indeed be asking whether we in Britain have got the balance right

From The Manufacturer, July 2006

Saturday, December 31, 2005
The EU's new boys are shaking up Europe
Posted by David Smith at 05:00 PM
Category: David Smith' s magazine articles

The European Union has had five enlargements in its history, which now stretches to nearly half a century (slightly more if you date it from the start of the European Coal and Steel Community). From a British perspective the most important was in 1973, when the UK, along with Ireland and Denmark, joined the original six of Germany, France, Italy, Belgium, the Netherlands and Luxembourg.

That 1973 enlargement had a profound effect on the EU, and continues to do so, probably much more than the three subsequent expansions that took in Greece (1981), Spain and Portugal (1986) and Austria, Finland and Sweden (1995).

It is doubtful, however, whether any of the EU’s enlargements have had as big an immediate effect as the one that occurred in May 2004. That was when what had become the 15 were joined by Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia.

Before this latest enlargement fears were expressed that the new members would impose a burden on the existing EU, through both the Common Agricultural Policy and the EU budget more generally. Some of the rich EU countries undoubtedly looked down on those joining the club. In fact, the impact has been almost wholly positive.

Not only does the new EU of 25 have a different dynamic than its smaller version (though this was of no help in the task of securing public backing for the Constitution) but the new members have been very influential in other respects.

In Britain, the most obvious impact of the latest enlargement has been on the labour market. Coming at a time when Britain’s job market was very tight and employers were complaining of serious skill shortages, the effect of the arrival of migrant workers from the new member states, particularly those in eastern Europe, was beneficial.

The Bank of England, in its latest inflation report, published in November, noted that new estimates suggested the working-age population was 136,000 higher than previously thought, and that much of the increase was to do with arrivals from the “new” Europe. Britain has had a more liberal attitude towards immigration from the new members than other EU countries and has particularly felt this effect. Direct migration from the 10 countries which joined the EU in May 2004 is officially estimated at 75,000.

Throughout this period the Bank’s regional agents have found in conversations with companies that business has been turning with enthusiasm to this new source of labour supply. The workers themselves appear enthusiastic to come to Britain, and with good reason. Not only has the government taken a liberal attitude to immigration but gross earnings in Britain are roughly six times those in Poland and Hungary.

Indeed, there is tentative evidence that employers prefer eastern European workers to the extent that some of the existing unemployed are being squeezed out. The Chartered Institute of Personnel and Development sees this year’s combination of rising employment and a steady increase in claimant unemployment as a reflection of this. Faced with competition from better qualified immigrants, some indigenous workers are missing out.

In the main, however, the effect is of benefit to Britain’s economy. According to the Bank: “Overall it seems likely that net migrant flows to the United Kingdom have acted to reduce inflationary pressure in the past. In the future, these flows might be expected to continue raising potential supply, and provide some further boost to demand.”

Low-cost labour among the new member states is, of course, having an impact even in those EU countries that have restricted migration. The threat of transferring jobs to eastern Europe has been a significant factor in allowing corporate Germany to push through changes in working practices.

Perhaps even more important than this for business, though, is the impact on taxation. Everybody by now knows of the flat tax revolution started by Estonia in 1994, with a flat tax on corporate and personal income, and followed by eight other countries, including not only Latvia and Lithuania but also Russia. Flat taxes have made governments and oppositions think again about the complexity of their tax systems. George Osborne, shadow chancellor at time of writing, has launched a tax commission to examine aspects of flat taxation that could be introduced in Britain.

The tax impact of the new member states goes beyond merely that of sparking a flat tax debate, however. For a start, the new members have lower tax burdens than existing EU countries. Lithuania and Latvia have tax burdens of 28.5 and 29 per cent of gross domestic product respectively. Most of the new members have burdens of less than 40% of GDP. This compares with almost 51 per cent in Sweden and typical burdens of 45 to 50 per cent in “old” Europe.

One possibility, clearly, is the new members will converge to the relatively high tax levels of longstanding EU countries. The signs are, however, that this is not occurring.

As far as corporate tax rates are concerned, the new members have long recognised that low rates are a surefire way of attracting inward investment. The average headline corporation tax rate in the 10 accession countries in 2000 was 27.4 per cent. Now it is 20.4 per cent. Driven by this tax competition on their doorstep the existing member states have respond. The average corporation tax rate in the old EU-15 has fallen over the same period from 30.5 to 30.1 per cent. The biggest cut has come in Germany, which is where it was probably needed most.

Some EU member states have been unhappy with this drive to lower tax rates. As Gaëlle Blanchard of Societe Generale in Paris points out: “The low-tax policies of the new states prompted some of old countries’ governments to call for an EU minimum company tax standard. Tax harmonisation appears however quite remote since the rejection of the European Constitution by France and the Netherlands.”

In place of harmonised corporate tax rates the Commission is pushing for a harmonised EU corporate tax base. Again, however, this appears quite remote, not just because of opposition from the new members but also from Britain and Ireland.

The new member states have, by and large, an economic philosophy built on low tax rates and flexible markets. The models they look to are those established by Britain (flexibility) and Ireland (low tax rates), rather than those of, say, France and Germany. Their impact is a breath of fresh air within the EU. Long may it continue.

From Business Voice, December 2005/January 2006 edition

Monday, November 21, 2005
Not betting on a high oil price
Posted by David Smith at 11:00 AM
Category: David Smith' s magazine articles

When we look back on 2005, will we think of it as one of those odd years when oil prices temporarily spiked higher, to subside just as quickly? Or is this the beginning of a new era of expensive oil, with permanently high prices.

The record, $70.85 a barrel for crude oil at time of writing, may well have been broken by the time you read this. The American government has said that prices will top $70 a barrel again before the winter is out, and will average $63 next year. Morgan Stanley agrees, expecting a 2004 average of $64 a barrel (a barrel is equivalent to 35 imperial gallons).

If that sounds like an aggressively high forecast, what about Goldman Sachs, which has warned of the possibility of a “superspike” to $105 a barrel, and expects prices to average $68 a barrel next year and $60 a barrel over the next five years?

Or how about the Canadian Imperial Bank of Commerce (CIBC), which predicts an eye-catching average price of $84 a barrel in 2006 and $93 in 2007? The price, it says, will rise to $100 a barrel by the fourth quarter of that year and stay there.

These are big numbers. Some of them, it should be said, come from organisations that have taken large positions in the oil market. That does not mean their forecasts are wrong, or in any way coloured by those market positions, merely that some people have a vested interest in high oil prices, at least for now.

So plenty of people think this is indeed a new era of expensive oil. The arguments are familiar ones. Oil demand is increasingly rapidly, most notably from China and India – rapidly growing and speedily industrialising. But demand is also strong elsewhere; in America and in the Middle East, where oil producers are developing their own “downstream” activities such as petrochemicals.

Supply, meanwhile, is tight and precarious. The margin between demand and supply this year has sometimes been 1m barrels a day or less, compared with a normal level of 2-3m barrels or more. Oil supplies are threatened by war, revolution, pestilence and flood. The insurgence in Iraq hangs over the country’s oil industry, which a couple of years ago the optimists expected to be firing on all cylinders by now. The death this year of King Fahd in Saudi Arabia resurrected fears about the longevity of the country’s pro-western regime. Governments in many oil-producing countries, for example Ecuador and Venezuela, are either unstable or hostile to America.

America itself, of course, suffered severe supply disruptions when Hurricane Katrina struck in late August, wiping out oil production and refinery output. The effect was temporary but underlined the fragility of supplies.

There are those who think these supply disruptions, which have been coming thick and fast, are a symptom of a more general problem for oil. Is the stuff running out? The idea of a global peak for oil, a so-called Hubbert peak (after M King Hubbert, a geologist who in 1956 correctly predicted the early 1970s’ peak for US oil production) is a popular one. Oil production in the UK sector of the North Sea, which was extraordinarily useful to the British economy, has already passed its peak and is now in decline.

Some forecasters, however, see the risks of decline even among those states we generally regard as having limitless supplies of oil. Matthew R Simmons, in a book published this year, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy (John Wiley & Sons) argues that Saudi oil production comes mainly from mature fields that are looking long in the tooth, and that output is only being maintained by methods such as water injection. He argues that oil output from the Kingdom is at or near maximum sustainable levels and will go into decline in the near future.

So does this tell us that this is indeed a new era of expensive oil, and that $100 a barrel will soon become the norm? The first thing to say is that this has been said every time oil prices have spiked higher – in 1973-74. 1979-80 and 1990-91. Each time prices have subsided sharply, usually resulting in very low prices.

By 1984 the world had got used to the higher prices established by OPEC a decade earlier, but then prices collapsed, dropping below $10 a barrel. There was a similar sharp fall after the first Gulf War of 1990-91. The 1990s were largely a cheap oil era and the world economy benefited as a result.

The idea of unfettered demand also needs challenging. Last year saw an unusually big increase in oil consumption in China and America but that has not carried into this year. Nor, according to the International Agency, will it do so next year. Some of the more aggressive oil prices forecasts are based on an extrapolation of the 2004 demand rise. That looks unrealistic. For one thing, oil demand itself responds to high prices.

We should also tread warily on the idea of supplies running out. There are clearly geopolitical worries now and the threat of terrorist attacks directed at oil installations. But it is a stretch to move from these worries to the idea that the oil will no longer be there. Big supply increases are coming through from places like Russia. High oil prices are leading to a rise in exploration activity, including incidentally in the UK sector of the North Sea.

For all these reasons, part of the current high oil price looks speculative. History tells us that prices never stay very long above the equivalent, in today’s prices, of $40 a barrel. History is usually a pretty good guide on these things. The normal laws of supply and demand have not been suspended. I wouldn’t bet on prices getting to $100 and staying there. But I would bet on them dropping back below $40 a barrel.

From Professional Investor, November 2005

Saturday, October 01, 2005
Will the global economy catch bird flu?
Posted by David Smith at 08:00 PM
Category: David Smith' s magazine articles

When it comes to “shocks” that could undermine the world economy most recent attention, understandably, has been on the oil price. As the price of crude hit new records over the summer questions were asked about the ability of the big economies to grow through it, particularly given the grim past relationship between oil and past global recessions.

All the caveats this time are justified. The advanced economies are less sensitive to oil than they were, thanks to the decline of big energy-using heavy industries. Those countries that still are highly energy-intensive, like China, genuinely do have enough momentum to grow through it.

Oil will have an effect. World economic growth will be weaker next year as a result of the rise in prices we have seen so far. If global growth was going to be 3.5 to 4 per cent, it will probably now be nearer to 2.5 to 3 per cent. That, however, is a long way, from recession.

Could something other than oil creep up on us and provide a recession-inducing shock to the world economy? For some time health experts have been warning that the world is overdue another major influenza pandemic, following the 20th century’s notable episodes.

Most people are familiar with the Spanish flu pandemic of 1918-19, easily the most serious, which killed an estimated 50 million people worldwide, including half a million in America. The worldwide death toll, famously, was roughly three times the number of military and civilian deaths in the First World War.

Other notable 20th century pandemics, the Asian flu of 1957-58 and the Hong Kong flu of 1968-69, were less serious but still represented major public health challenges. In America, for which detailed data is available, Asian flu killed 70,000, Hong Kong flu 30,000.

Are we due for the next big one? According to the World Health Organisation, influenza A type H5N1, usually known as bird flu or avian flu, is endemic among birds and animals in Asia. In August, in response to its spread to migratory birds in Russia, the Dutch government instructed all farmers to take their chickens indoors, to help protect them from the disease. Other European governments also took preventative steps.

As far is as known, more than 100 humans in Asia have contracted the disease, and half of these have died as a result. As far as is also known at time of writing, all caught it from animals or birds, rather than in human-to-human transmission. A degree of scepticism is, however, in order; reporting and disclosure standards in Vietnam, North Korea and China may not be what they should be, as was discovered in the case of SARS (severe acute respiratory syndrome) two years ago.

Already governments are stockpiling vaccine for use against avian flu. Significantly perhaps, because there will not be enough to go around, the priority in any vaccination programme in Britain and elsewhere will be key government workers, including some politicians, those working in essential services and others concerned with maintaining the basics of society. The implication is that if the flu strikes in a big way, the economy will be effectively wound down to operate on a skeleton basis. Even that may be easier said than done.

As one WHO official put it, talking about what could happen on a global scale: “Billions would fall sick; billions more would be too afraid to go to work, leading to a collapse of essential services.” This is not, it should be emphasised, the usual kind of winter flu we are familiar with in Britain.

All this suggests that the economic impact could be huge. According to a recent report by BMO Nesbitt Burns, a Canadian stockbroking firm, this could indeed be the case. The headlines about its report, An Investor’s Guide to Avian Flu, suggested a publicity-grabbing exercise but this is not so. It is a sober, well-researched exercise. And Canada, which was hit hard by the SARS outbreak in Toronto in 2003, is perhaps more attuned to the dangers than we tend to be in Britain.

Dr Sherry Cooper, the firm’s chief economist, says that the prospect would be of a vicious circle of declining activity. In the case of SARS, Hong Kong’s economic growth rate was halved and Ontario suffered 28,000 lost tourism jobs and a £1 billion drop in revenue. A mass outbreak of avian flu in humans would dwarf these effects.

She writes: “Businesses would voluntarily quarantine a meaningful proportion of their essential staff at remote locations to have a stand-by team in case of emergency. Large cities with dense populations in residential, shopping and office space would be most harshly impacted. People would shun high-rise office buildings and large condos, not because of terrorism but instead because of nature’s microbial attack. Stockpiling of basis food, drug, water, energy and safety supplies would initial lead to shortages and skyrocketing prices.

“In relatively short order, the deceleration of almost all non-essential economic activity would trigger a rampant decline in spending. Then, deflation and high levels of ‘involuntary’ unemployment would set in. Households would be unable to make their mortgage and credit card payments. Businesses, as well, would default on their debt.”

The really scary thing about a global flu pandemic, of course, is that we have a global economy. The interconnectedness of the world would multiply the vulnerability of countries to the economic effects of any pandemic.

Cooper likens the possible effect, in terms of hitting world trade and the movement of people, to America’s Smoot-Hawley Tariff of 1930, notorious for helping plunge the global economy into slump. Indeed, as she puts it: “Its economic impact could be comparable, at least for a short time, to the Great Depression of the 1930s.” China and India, the two fast-growing emerging giants of the world economy, would be particularly hard hit because of the close proximity of many people to their animals and birds in these countries.

It may never happen. Experts have been warning of a global flu pandemic for a long time; one day they will be right but not necessarily yet. The economic effects of SARS, it is fair to say, were widely predicted to be worse than they turned out to be.

Even though, this is one to be watched closely. We tend to look for the economic dangers emanating from economic sources. Sometimes those dangers come from elsewhere. And the potential dangers from avian flu are not to be sneezed at.

From Business Voice, October 2005

Wednesday, September 14, 2005
Has Brown solved his tax problem?
Posted by David Smith at 07:20 PM
Category: David Smith' s magazine articles

Another look at the UK's fiscal situation, written for Professional Investor.

From well before the general election last May until just before the politicians disappeared for their holidays in late July one question dogged Gordon Brown. Would he repeat the tactic he used after Labour’s two previous election victories and raise taxes after a decent interval has elapsed?

Or, as the chancellor insisted repeatedly during the election campaign – and continued to insist after it – would it be different this time? Could the public spending plans really be affordable so the £10 billion of tax hikes long regarded as necessary by the Institute for Fiscal Studies and others will not be needed?

In July we had part of the answer to that question. There had been a big risk that the chancellor would break his own “golden rule” of only borrowing to fund investment. The consensus among analysts was that an economic cycle beginning in 1999-2000 and ending in 2005-6 – the Treasury’s working assumption – would see an overall deficit when it came to the balance between current spending and receipts.

Brown, however, neatly extracted himself from that one, albeit at considerable cost to the credibility of his golden rule. By seizing on revised growth figures from the Office for National Statistics, he was able to put the start of the economic cycle back to 1997-8, add in the healthier public finances for that period, and give himself a margin of error for meeting the rule. At the stroke of a statistician’s pen, his tax dilemma appeared to be solved.

Or was it? The bigger issue has always been not the narrow question of whether the golden rule will be met in the current cycle but whether tax revenues will rise by enough to fund the government’s spending pledges going forward.

The public finances are not obviously getting much worse. But they are not getting better, as the Treasury predicted. Nor has the chancellor had much help from the economy. The sharp slowdown in consumer spending and the housing market is directly reflected in lower indirect tax revenue – VAT, stamp duty and the rest. High oil prices are benefiting the Treasury, by enough for Brown to be able to postpone the excise duty hike on petrol and diesel which had been due on September 1. But the net effect is that revenue growth is weaker than the Treasury was counting on. Meanwhile, there is no let-up in the growth in public spending.

A budget deficit that owes something to weaker economic growth is not in itself a reason to put up taxes. Even so, and after his statistical sleight of hand, Brown faces a predicament. He is the runaway favourite to succeed Tony Blair if the prime minister sticks to his pledge not to fight another election (a pledge it would take a Houdini-like escape to get out of). Would the British public warm to Brown when he has just put up their taxes?

That is why I don’t think we will see another highly visible tax hike like the 1 per cent NI increase, for both employees and employers, announced in 2002, worth an extra £8 billion a year to the Treasury.

Instead we’ll see a lot of reliance by the Treasury on fiscal drag – raising extra tax from people as they move into higher tax brackets. We will also see a huge amount of emphasis on closing tax loopholes, for both individuals and companies, some of which will involve tax hikes in all but name. There will also be an emphasis on value for money throughout government. If public spending does not quite increase in line with plans from now on, that will be attributed to efficiency savings, not going slow on programmes. The next spending review, now postponed until 2007, will be tough. The watchword, I think, will be to avoid a big upfront increase in taxes. Stealth taxation is back – if it ever went away.

Will it work, as both an economic and political strategy? George Osborne, the shadow chancellor, argues that even without further tax increases Britain is losing tax competitiveness. Five years ago only 10 of the 30 advanced industrial countries had corporate tax rates lower than in Britain. Now 20 countries do and others are examining the possibility of reducing their rates.

Osborne has been studying the flat tax revolution sweeping through former parts of the Soviet empire. The flat tax, discussed here in June, is not easily transferable to economies such as Britain’s. But it provides a good indication of the way things are heading. Countries see low taxes as a way of attracting inward investment, and of positioning themselves in the global economy. In Britain, in contrast, tax rates are largely seen as a domestic matter.

The Treasury’s counter to this is that there is no evidence yet that changes in Britain’s tax regime are having an adverse effect. Recent official figures produced by UK Trade and Investment, the body responsible for attracting projects to Britain, show that a record number of new investments came from overseas during 2004-5.

Nearly 40,000 jobs were created from 1,066 projects, an increase from the previous year’s figure of just over 25,000 jobs from 811 projects. Nearly a quarter of the projects, 240, were in IT and software, up 61 per cent on the previous year.

Alan Johnson, the trade and industry secretary, said: “International comparisons continue to show the UK as Europe's top investment destination.” But he warned that the challenges would grow. Britain, he said, had to move forward by “adding value and exploiting technology”.

All this is true. But tax is important too. International firms are increasingly footloose, as they have shown by migrating to countries with low labour costs. They will also move toward countries with the lowest tax rates. It is not, by any stretch, the only factor that drives international investment. But it is an important one. The risk is that, both for the great bulk of firms operating in Britain, and those thinking of coming here, tax will become a significant handicap.

Add to that the risks to the wider economy of higher taxes and the inference is clear. We all have an interest in avoiding another round of tax hikes – and of taxes going up too much by stealth.

From Professional Investor, September 2005

Monday, July 18, 2005
A wake-up call for Europe
Posted by David Smith at 09:12 AM
Category: David Smith' s magazine articles

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

Thursday, July 14, 2005
Spending less and saving more
Posted by David Smith at 09:10 PM
Category: David Smith' s magazine articles

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

Tuesday, June 28, 2005
Dropping shopping
Posted by David Smith at 05:58 PM
Category: David Smith' s magazine articles

One of the constant refrains about Britain’s economy in recent years has been its over-reliance on the consumer and, in consequence, the unbalanced nature of growth. The figures speak for themselves.

Over the period 1997 to 2000 consumers accounted for 80 per cent of the rise in total economic activity. The share dropped slightly after that, but only because of the sharp rise in public spending. Growth in Britain has been on a record run – 51 quarters and counting – but “productive” growth, in the form of investment and exports, has been in short supply.

Lately, however, there are signs that not all is well for Britain’s once-unstoppable consumers. Since before Christmas retailers have been grumbling about the reluctance of shoppers to spend, irrespective of the inducements that are put their way.

For once the retailers, who are given to moaning, have a point. Consumer spending did indeed slow sharply at the end of last year; in the fourth quarter of 2004 it rose by just 0.7 per cent at an annualised rate, compared with nearly 5 per cent at the beginning of the year.

Regular reports from Britain’s high streets and shopping malls so far this year suggest the malaise has continued. The British Retail Consortium said year-on-year performance in April was the worst since 1992, when the economy was just emerging from the last recession. Several retailers have posted profits warnings or grim trading statements. Shoppers, it seems, have gone on strike.

It is not obvious why this should be happening, as John Butler, UK economist at HSBC, points out. “Consumer spending has been slowing in a background in which employment and financial wealth has been rising,” he says. “And if the consumer is tired, what parts of the economy will take up the growth baton?”

The slowdown in spending, as Butler points out, is intimately related to what has been happening to the housing market. Last year the Bank of England created controversy by suggesting that even if house prices fell, consumers would not respond by cutting their outgoings. House prices have not fallen, at least nationally, but the market has stagnated and that has had a significant impact, it seems, on consumers.

The direct effects of a loss of momentum in the housing market are well known. When people aren’t moving they don’t spend as much on carpets, curtains, furniture and redecoration. And, while few tears will be shed, they also deprive a whole range of service providers, from estate agents and solicitors through to removal firms, of business.

The indirect effects are, however, arguably greater. Mortgage equity withdrawal, the act of taking out housing wealth to use for other spending, happens most when property transactions are booming. When lending slows sharply, as it has, there is far less of it. Equity withdrawal dropped from £16 billion in the final quarter of 2003 to £6 billion a year later. There are probably more falls to come. The upshot is that you did not need a house-price crash to produce a spending slowdown.

Tied to that is another factor. The rise in debt has been going on for so long that we have begun to take it for granted. Household debt has soared to nearly £1,100 billion (£1.1 trillion) and from 100 to 140 per cent of annual household income.

Most of that debt is in the form of mortgages. This spring, however, something curious happened. Consumers paid off more non-mortgage debt (credit cards and other loans) than they took out. Net borrowing fell. Was the penny dropping on debt?

We haven’t suddenly switched from being a nation of borrowers to being newly thrifty. Maybe, though, the past rise in debt is catching up on households. While the debt-serving burden remains low, because interest rates are modest. The picture changes dramatically once capital repayments are factored. On that basis the squeeze on indebted households is not far short of what it was in the early 1990s, when interest rates were two or three times present levels.

You write Britain’s consumers off at your peril. But what about that other question: What will take up the growth slack? That is not immediately clear. As Butler points out: “The global economy also has problems, which means the cavalry in the form of a strong export or investment recovery is unlikely to arrive.” A consumer slowdown may mean an overall growth slowdown.

One bit of good news in all this, of course, is that for once the interests of consumers and manufacturers are neatly entwined, at least in one important respect. In the past interest rates had to be higher than was comfortable for industry to keep rampant shoppers and homebuyers in check. That is no longer the case. Both firms and individuals need lower interest rates. With 4.75 per cent looking like the peak for base rates, they should get them before too long.

From The Manufacturer, June 2005

Monday, May 09, 2005
Euro off the agenda
Posted by David Smith at 09:15 AM
Category: David Smith' s magazine articles

It barely seems like any time at all since we were all abuzz with the question of Britain’s entry into the euro. The issue, often said to be at the heart of the long-running dispute between Tony Blair and Gordon Brown (although personal rivalry explains it better), was expected to dominate Labour’s second term in office.

As it was, that term was dominated by Iraq and the drive to improve public service delivery. That did not mean, however, that nothing happened on the euro. Before the 2001 general election the prime minister committed Labour to publishing a full assessment of whether Britain was ready to join the single currency; an assessment of whether the famous five economic tests were met.

Those tests, to remind you, were, first, are business cycles and economic structures compatible between Britain and Europe to permit the UK to exist comfortably in the euro; second, is there sufficient flexibility to deal with problems?; third, would joining improve the environment for long-run investment decisions in Britain; fourth, what would be the effect on financial services; finally, would entry be good for growth, stability and jobs?

That assessment, together with 18 accompanying studies, was published in June 2003. But the Treasury did not close the door completely. It conceded that progress had been made towards convergence with Europe. It announced a change to the Bank of England’s inflation target to the new, euro-compatible consumer prices index – a similar measure to that used by the European Central Bank (ECB). It also adopted the same target, 2 per cent, as the ECB.

Blair did not give up without a fight. He insisted that his entire cabinet was involved in the decision, and that all ministers were able to study the 18 technical studies in advance (whether they understood them was another matter). He made sure that the announcement was a full and separate parliamentary occasion, while Brown had wanted to get it out of the way in his budget. He also insisted that the Treasury review progress towards convergence with “euroland” and therefore entry into the single currency, each year.

So why has it all gone quiet? It used to be said that Blair’s ambition before he left Downing Street was to get Britain into the euro. It still is, but another European priority has jumped the queue. This is the referendum vote on the proposed EU constitution, due to take place next year. This presumes, I should say, Labour’s return to office in the general election.

While euro entry would involve deepening the degree of integration between Britain and Europe, a failure to approve the constitution could threaten Britain’s whole future in Europe. That may overstate it, but it would certainly represent a crisis in UK-EU relations.

How will the constitution referendum go? Until recently, the general view was that voters would overwhelmingly reject it, scared by talk of a giant step towards a federal Europe. However, recent polls conducted on the basis of the actual question that will be asked in the referendum have suggested a pretty evenly split vote. The question is: “Should the United Kingdom approve the treaty establishing a constitution for the European Union?” It sounds less than alarming, much to the disgust of the anti-constitution campaigners, A bigger fear than federalism may be the worry that Britain will be left behind, which the government will play on.

Would not a “yes” vote on the constitution enable an emboldened Blair to go for “one more heave” into the euro? After all, the Treasury probably cannot keep saying no to entry for ever. Privately, officials concede that the next assessment, if there is one, will have to come up with a positive verdict.

It could happen, so that by the end of the parliament Britain would have both signed up to the constitution and be happily ensconced in the single currency, the European Central Bank (ECB) taking our interest rate decisions.

But that seems unlikely, for several reasons. The first is that to secure a yes vote in the constitution referendum, the government will have to provide certain reassurances. One of those, most probably, will be that backing the constitution will not mean a rush into the single currency. Any suspicion among voters that this is the case could easily swing it towards a no vote.

Secondly, hostility to the euro goes deeper than to the constitution. There was a time when many British people thought the only argument about the euro concerned issues such as whether the Queen’s head would be on the notes, versus the convenience of not having to change currency at each European border crossing.

Things have moved on. There is now an implicit understanding amongst a large swathe of voters that adopting the euro means more than changing the currency you carry in your wallet. People are aware of the fact that Euroland appears stuck with slow growth and high unemployment. This many not be the fault of the euro and the ECB, but it is a reality, Voters may also be dimly aware that the euro’s fiscal rules, embodied in the stability and growth pact, have been flouted by Germany and France, and may never achieve credibility again.

All this is important. To argue the case for the euro, the government has to believe it. As far as the chancellor (who was once a believer) is concerned, that requires two things. One is a belief that the ECB and stability pact would be at least as good as his own fiscal rules and the independent Bank of England. He is a long way from believing that.

The second is that Europe is serious about increasing its flexibility, particularly in labour markets. A recent report by a high level group of experts under the chairmanship of Wim Kok, the former Dutch prime minister, concluded that this is far from the case, and that the EU is proceeding at a snail’s pace in this area. And as long as that is the case, the euro is off the UK agenda.

From Professional Investor, May 2005

Monday, April 25, 2005
Over a $105 barrel
Posted by David Smith at 07:00 PM
Category: David Smith' s magazine articles

One of the most striking developments in the global economy, with direct effects on businesses and consumers everywhere, has been the performance of oil prices. As I write this the price of crude in New York is nudging $60 a barrel and this, I am happy to acknowledge, is not something I had expected. There may yet be worse to come.

A plausible story about oil prices, indeed one I have told here, was that they would spike higher during the invasion of Iraq two years ago, but subside pretty quickly afterwards. This, after all, was precisely what happened during and after the first Gulf war. Then, oil prices rose when Saddam Hussein invaded Kuwait in the summer of 1990, but fell back sharply after the allied victory in early 1991.

Even when this did not happen in 2003, it was possible to argue that this was just a delay. The security situation in Iraq, the insurgency, had made it hard to lift oil output and cast a shadow over prospects for oil supplies elsewhere in the region. But the return to normality, surely, was only a matter of time.

Now, however, we have to recognise a rather different reality. Iraq, it seems, was a red herring in the oil story. While it raised some short-term questions over global oil supplies, the real action was on the other side of the equation – the rise in demand for the precious black stuff.

It is this new reality that recently prompted Goldman Sachs, the investment bank, to come up with the eye-catching suggestion that crude could hit $105 a barrel. That, to put it in perspective, is four times the official $22 to $28 a barrel target range the Organisation of Petroleum Exporting Countries had ahead of the Iraq war.

Goldman Sachs, it should be said, is not predicting that oil prices will stay at $100 a barrel plus. Their forecast was for a “spike”, in other words a temporary move, in prices to this level. In certain circumstances, they warn, that spike could see prices as high as $135. But even the Goldman forecast of longer-term sustainable prices offers little comfort. It predicts an average of $50 a barrel for US crude (so-called West Texas intermediate) this year, rising to $55 a barrel next. What happened to the prospect of a new cheap oil era?

Nor, it should be said, is this an ivory tower forecast. Goldman Sachs is one of the biggest traders in energy derivatives and knows the market well. That does not mean their forecasts will be right; it does mean it comes from a position of some knowledge.

Why are prices so high? We all know the China story, and rising demand from the world’s fastest growing big economy. This remains important, and is the single biggest reason for the tightness of the supply-demand equation in recent years. At current (and rising) levels of demand from China, there is very little spare supply capacity in the world, despite efforts by the OPEC to dampen down prices.

But China is not alone. An important part of the Goldman Sachs forecast is that prices have not yet risen by enough to bring about a cut in demand in America. American motorists changed their driving habits (and the size of their cars) after the two oil shocks of the 1970s. Then, spending on gasoline reached 4.5 per cent of gross domestic product, or 6.2 per cent of personal disposable income. This time, even if we get to $105 temporarily, and stay in $50 a barrel plus territory, the equivalent figures are 3.6 per cent of GDP and 5 per cent of personal disposable income. It could take a spike to $135 a barrel to persuade US motorists to part with their gas-guzzling giant SUVs (sports utility vehicles).

What will be the consequences for the economy and industry of, say, long-term $50-60 a barrel oil prices? Despite some signs that inflation is re-emerging, notably in America, the biggest impact of dearer oil is likely to be on growth, not prices. The proper way of looking at high oil prices is as a tax levied by the producing nations on consuming countries. Like tax, high prices are not something that consumers can avoid.

Britain is relatively well placed compared with other industrial countries, not just because of North Sea oil (though output is in decline) but also because the UK economy is less oil-dependent than America and most EU economies. Some of that, sadly, has to do with our relatively small manufacturing sector.

That is little comfort to energy-intensive sectors, which will bear the brunt of the price rise. I do not think it is going to tip the world into recession but it is not going to be comfortable. Dear oil, it now seems, is here to stay.

From The Manufacturer, April 2005

Thursday, April 07, 2005
When does red tape start to strangle?
Posted by David Smith at 08:29 PM
Category: David Smith' s magazine articles

The great economist Adam Smith, who had a cynical attitude towards the motivations of businessmen, once wrote that whenever they got together “the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”.

These days, of course, the prospect of the Office of Fair Trading breathing down your neck means that when businessmen get together they emphatically do not discuss this kind of thing. It is a fair bet, however, that seldom do they meet and the conversation not turn to regulation and red tape.

Red tape is not confined to business. All aspects of our lives have become more regulated, and thus more complicated. The evidence is indeed that we live in a more litigious society, despite the fact that in most respects we lead safer and healthier lives than ever before.

But for business, red tape and regulation is more than an irritant. It costs money and, in some cases, it means that some things are no longer viable. And it is getting worse. According to the British Chambers of Commerce’s ‘Burdens Barometer’, published recently, the cumulative cost to firms of regulations introduced since 1998 is now £39 billion.

This figure is not snatched out of the air. It is compiled by academic experts Francis Chittenden and Chanyeon Hwang of Manchester Business School, together with Tim Ambler of the London Business School and, crucially, all the numbers are extracted from the government’s own estimates in so-called regulatory impact assessments (RIAs).

The £39 billion cumulative cost, in fact, is likely to be an underestimate. It is the cost of the 46 major regulations introduced by the present government (or European Union directives implemented during their period in office). Smaller regulations and some significant policies – most notably the national minimum wage (which is due to rise to £5.05 an hour in October, and £5.35 next year) are excluded.

The really costly regulations included in the calculation are the working time directive, with a cumulative cost of £13.6 billion; the vehicle excise duty (reduced pollution- regulations, £5.5 billion; the data protection bill, £5.3 billion; the control of asbestos at work rules, £1.4 billion; the disability discrimination regulations, £1.2 billion; the so-called National Insurance service provision through intermediaries rules, otherwise known as IR35, also £1.2 billion; and the flexible working (procedural requirements) regulations, £0.7 billion.

“British businesses are fed up with the spiralling costs of regulation,” says David Frost, the BCC’s director-general. “Businesses must be free to compete in the global economy. They simply cannot afford to be held back by the mounting costs of complying with regulation. As well as the cost, firms tell us all the time that they are spending too long dealing with paperwork and trying to get their heads around each and every regulation. Small firms say it takes large chunks out of their day, when they should be concentrating on running their businesses.

“While we recognize the need for proportionate regulation, the government must ensure that new regulations are well targeted and business friendly. Unnecessary burdens are not a sustainable option for our firms.”

Many would agree with his diagnosis, and with his concern that, on top of this, the proposed increases in the national minimum wage will hit firms in certain sectors – usually those already struggling to compete – hard. Red tape and regulation, together with the widespread perception that this is a government that does not really understand how business works, has been the bugbear of companies for the past few years.

What is harder, however, is to demonstrate the damage that this onslaught of red tape is causing. If we look at the big numbers for the UK economy – fifty consecutive quarters of economic growth (a record), record employment and the lowest unemployment for 30 years and, just recently, a revival for business investment, it is hard to claim that this is an economy hamstrung by over-regulation. Britain’s performance, in fact, is demonstrably superior to the euroland average, in spite of our having acquired a lot of new EU regulations over the past few years.

It would be wrong, though, to conclude from this that no damage is being done. The first point is that we do not know what would have happened in the absence of this additional red tape. Britain has done pretty well in comparison with the rest of Europe but less so in relation to other “Anglo-Saxon” economies such as America and Australia. It may be that the re-regulation of the UK economy is to blame for this.

The second key point is that these things take time. It took until well into the 1990s before the labour market reforms introduced when Margaret Thatcher was in office began to show through in improved flexibility. For some thing, there may be a 10-15 year lag between changes being introduced and their impact. By the same token, the red tape now being introduced may not have an adverse effect on the economy until after 2010. And by that time, there will still be plenty of people around ready to say: “I told you so.”

From British Industry, March 2005

Wednesday, February 16, 2005
Technology the herald?
Posted by David Smith at 08:00 PM
Category: David Smith' s magazine articles

For the technology sector the past few years have been like the proverbial rollercoaster. The upward climb during the 1990s was dizzying, the subsequent drop both nerve-racking and sickening.

Technology has been through a torrid time, the bursting of the internet bubble being followed by a post-millennium (Y2K) downturn in investment and a US/world recession that began in 2001 and was not really shrugged off until last year. Pride came before a long fall. The Nasdaq’s rise and fall – even now it is at barely 40 per cent of its spring 2000 peak – tells the story.

Those in the sector could be forgiven for thinking this is the way it always has to be. They, in other words, are doomed to experience a much more volatile cycle than the rest of the economy. It can be exhilarating, but it can also be damaging and dispiriting.

In fact, there are reasons to think the current upturn in the technology sector is more durable than its predecessor in the 1990s. Carly Fiorina, the then chairman and chief executive of Hewlett Packard, said at last month’s World Economic Forum in Davos that she expected turnover this year to rise at twice the rate of gross domestic product. That may be a pale shadow of the performance of HP and other companies in the late 1990s, when turnover rose at five times the rate of GDP, but it looks rather more sustainable.

To put that in perspective, US and world GDP will rise by 3-4 per cent this year. And to achieve a turnover gain of double that, HP has to offset annual price deflation of between 20 and 30 per cent. That means pumping through a lot more volume.

Technology, according to Rob Lloyd, European president of Cisco Systems, is benefiting from a number of forces. The first is that the replacement cycle is kicking in, particularly when it comes to corporate investment, the last good year for which was 2001.

Second, businesses are upgrading and improving systems, not least to guard against online security threats. The battle to keep ahead of the internet vandals and their increasingly sophisticated viruses is an ongoing one.

Third, firms are increasingly using IT as a tool for raising productivity, whether it is through improving internal processes, or via outsourcing. And fourth, particularly for firms like Cisco, important new markets are opening up in fields like education. This is not just in the advanced economies. Countries like Jordan and Egypt in the Middle East, and Hungary and the Czech Republic in Eastern Europe are realising that IT is the quickest route to catching up when it comes to education and skills.

Tie this is to the fact that we are in an interesting phase of the consumer product cycle, with huge demand not only for the latest generation of mobile phones and Ipods, but also for Blackberry-style mobile devices. This has a lot further to run.

What does the technology upturn tell us about the economic outlook more generally? It tells us that business optimism is in pretty good shape, and indeed this was the message emerging from the Davos forum. It also tells us that business investment is picking up, and that this recovery will probably last. It is also a vote of confidence in firms that have continued to innovate even during a period of relatively weak demand.

The news on technology combines with another optimistic pointer for Britain’s economy. Michael Saunders, an economist with Citigroup, has looked in detail at some data from Eurostat, the European Commission’s statistical agency. They show that so- called knowledge-intensive sectors account for 41% of employment in Britain, higher than in France, Germany, Italy and Spain and well above the EU average of 33%. This is fascinating, and runs against the usual perception that we have too many workers stuck in low-value areas.

These knowledge-intensive sectors include computing, telecoms, financial and business services as well as legal and technical services, education and healthcare. They tend to be the parts of the economy growing fastest. The fact that Britain has a higher proportion of people in these areas is, says Saunders, one reason why economic growth in Britain has exceeded that in the eurozone for 11 consecutive years.

The message that has been drummed into us for many years is that the only way economies like Britain can compete with the emerging giants of China and India is to move up the value chain. That, it seems, is precisely what the UK has been quietly achieving for some time. The technology upturn is good news and it is not the only bit of good news around just now. Let us hope it lasts.

From The Manufacturer, February 2005

Tuesday, January 04, 2005
Finessing the North-South divide
Posted by David Smith at 03:58 PM
Category: David Smith' s magazine articles

FOR those of us who have, over the years, monitored regional differences in the United Kingdom, one constant stood out. This was that the people of the north-east felt most let down by the way the economic cards had been dealt.

The north-east, having borne the brunt of successive industrial declines, and most notably the loss of coal, steel and shipbuilding, has always felt itself of the receiving end of the rough end of national policies.

Lord “Eddie” George, the former governor of the Bank of England, was once persuaded by a journalist to concede that high unemployment in the north-east was “a price worth paying” for low inflation in the rest of the country. The resulting headlines were some of the worst the Bank has had in recent years.

Going further back, to the dying days of the Macmillan government in the early 1960s, Lord Hailsham was appointed minister for the north-east in addition to his several other ministerial responsibilities and, on a visit to Darlington, symbolically donned a cloth cap. Later, at a “ten shilling a head” roast beef dinner, Hailsham promised speedy regeneration for the region. It did not happen, at least not in the 1960s and 1970s.

The north-east has, to add insult to injury, had to put up with the fact that Scotland, its neighbour, has always done better in terms of political representation at Westminster, the ability to attract inward investment through its own development agency and significantly higher levels of public spending per capita. More recently, of course, Scotland has had her own parliament.

If anywhere if the country was going to vote in favour of a regional assembly, therefore, it would be the north-east. That was why last autumn’s referendum result was so extraordinary. In a 47.8 per cent turnout, the north-east voted by 696,519 to 197,310 – more than three to one – against the assembly championed by John Prescott, the deputy prime minister. Every district in the north-east, from Alnwick to Wear Valley via Durham, Gateshead and Sedgefield (where Tony Blair is MP), voted an overwhelming no. This had the effect of persuading the government, sensibly in the circumstances, that it was not worth pursuing assembly plans for other regions.

And, while opponents of the assembly had successfully persuaded voters that the north-east assembly would be an expensive talking-shop, and an unnecessary layer of bureaucracy, the “no” vote may also have reflected subtle but important changes in perceptions about the north-south divide.

Take unemployment, the most enduring measure of regional economic differences. Which part of the north has the highest unemployment rate in the UK? None, in fact. The Labour Force Survey has unemployment in London at 7.1 per cent, compared with a national average of 4.6 per cent. The north-east, to be fair, comes next on 5.9 per cent, followed by Scotland (5.2 per cent), Northern Ireland (5.1 per cent), the West Midlands (5 per cent) and Wales (4.9 per cent). But even these higher unemployment regions are not that much above the average.

The same is true, incidentally, of the claimant count, which comes up with lower levels and rates of unemployment. On this measure the north-east is at the top of the unemployment league. But its rate, 3.9 per cent, would have been regarded as extraordinarily low even a few years ago, and it compares with a national average of 2.6 per cent. The days when the north-east had 12, 13 or 15 per cent unemployment are long gone.

The narrowing of the unemployment gap does not tell the whole labour market story. There has been an increasing focus in recent months on economic inactivity, and the rise to eight million in the number of economically inactive people of working age.

Employment and activity rates tend to be higher in the south. In the south-east, East Anglia and the south-west around 82 per cent of the population is economically active, compared with 78 per cent in the north-west and Yorkshire & Humberside, and just over 74 per cent in the north-east. Here again, however, the differences are not what they were and Greater London, with an activity rate of 75 per cent, is in a similar position to the northern English regions.

Nobody would pretend that regional differences have been eliminated in the UK. On many of the measures, however, whether it is gross domestic product per head, disposable incomes, per capita consumer spending or relative wages, there is evidence that the gap has stabilised. In 1990, for example, the north-east’s disposable income per head was 88 per cent of the UK average, a decade later it was 89 per cent. In the case of the north-west, it remained at 94 per cent of the UK average.

More recently, too, the house-price boom has spread from south to north. Figures from the Office of the Deputy Prime Minister show that in the 12 months to mid-2004 there was a 12 per cent rise in UK house prices. Prices in the south-east rose by less than 5 per cent over the period, while in the north-west there was a 23 per cent increase, and in the north-east one of 26 per cent. This south-to-north “ripple” effect has, of course, been a feature of the mature phase of previous house-price booms.

Perhaps the biggest change, though, is not in the statistics but in perception. It is now widely recognised that there are two economies in Britain. The one centred on London and the south-east is increasingly international in outlook and influence, dominated as it is by sectors such as financial services. Then there is the rest of the UK, what Kenneth Clarke, the former chancellor, used to call the real world. This no longer means an economy dominated by metal-bashing or heavy industries, although it does imply a productive economy in a more general sense.

Government policy can affect the distribution of economic activity between the London and south-east economy and the rest of the UK at the margin, for example by transferring civil servants to the regions from Whitehall. But, and this is now central to Labour’s policy approach, there would be no gains for the north by restricting growth inside the M25. Meanwhile, London’s labour market problems are testimony to the fact that not all its streets are paved with gold.

The proposed regional assemblies were an idea left over from the days when regions competed with one another for jobs and prosperity. That has changed. What is good for one region is good for others, and for the UK economy as a whole. This is not a zero sum game. And that, instinctively, is what the people of the north-east believed when they buried the idea of regional assemblies.

From Business Voice, December 2004

Wednesday, December 08, 2004
The economic headwinds of 2005
Posted by David Smith at 09:25 PM
Category: David Smith' s magazine articles

Whenever I talk to audiences about the UK economy, particularly younger ones, I find it necessary to remind them that it has not always been like this. Such as been the stability of recent years that, not only do I have to pinch myself to be sure it is not a dream, but the memories of the wild volatility of the past start to fade, even for me.

Thus, the economy has grown consistently, quarter-on-quarter, since as long ago as the spring of 1992. By next spring, barring accidents, the recovery will have been in place for 13 years. Thinking about it in terms of the lengths of parliaments – assuming we have a general election about then – the upturn will have lasted three. Put another way, the Tories still had another five years to run in government when the economy emerged from its last recession.

This success is not purely a New Labour phenomenon. The current long run of growth was well-established well before Gordon Brown took the helms at the Treasury, although the Conservatives and Kenneth Clarke were unable to take political advantage of it.

The current run of growth is, as the chancellor keeps reminding us, the longest since quarterly records began in the 1950s, and since annual records started 200 years ago. It is likely, given the natural volatility of the economy in pre-industrial days (the vagaries of climate and harvests) that we are living in the most enduring recovery ever.

Not only that, but it has been combined with stubbornly low inflation. When the Conservative government, in the guise of Norman Lamont, Clarke’s predecessor, gave us an inflation target in the autumn of 1992, it was well chosen. The target was for 1% to 4% inflation on the retail prices index (excluding mortgages). Since then, while the target measure has recently changed, inflation has averaged within a whisker of 2.5%, bang in the middle. Britain’s formerly recession-prone, inflation-prone economy has changed its ways.

The question, as we look into 2005, is whether it can last. In theory, the answer should be straightforward enough. With each quarter, and each year, of economic stability, it becomes more ingrained. This is important. If businesses and consumers think that in general things will turn out fine, and have the confidence to take decisions on that basis, there is a good chance that, indeed, things will turn out fine.

The alternative argument, of course, is that the longer it goes on, the greater the risk that the economy’s run of luck will come to an end. So what are the risks for 2005?

The first set of risks relates to the global economy. Terrorism, global economic imbalances, China’s overheating, and Europe’s sluggish performance are ever-present dangers. The biggest uncertainty, however, emanates from oil prices, which rose to more than $50 a barrel in the autumn.

This is uncharted territory. Oil prices have been higher than this in real terms before, most notably in the early 1980s. Advanced economies are less oil-sensitive than they were in the past, because of the decline of heavy, energy-intensive industries and the rise of more energy-efficient vehicles (although this is offset by the rise in vehicle numbers). That should mean that the effects of high oil prices are to dampen global growth rather than bring it shuddering to a halt. But the risk is of something worse.

Nearer to home, the second big risk relates to house prices and debt. For several months now the Bank of England and others have been working hard to argue that a fall in house prices would not be devastating for the economy. Consumer spending and house-price inflation are linked, but not mechanically. Consumers will carry on, the argument goes, even if there is a crash in housing values.

My view remains that there will not be a crash, although we have already entered what could be a long period of housing stagnation, necessary if incomes are to “catch up” and reduce the extent of the property market’s overvaluation. Housing stagnation is consistent with slower growth in spending by individuals.

But could it be worse? The virtuous circle supporting housing has been one of low interest rates and a strong job market. Remove those props and things could look rather different. Interest rates have already risen significantly. How strong is the underlying picture in the job market?

This, conveniently, brings me to my third point. Fiscal policy in Britain under Brown has fallen neatly into two halves. For the first three years after 1997, when the economy was benefiting from the 1990s’ global boom, he ran a tight ship, keeping public spending under control. After that, however, things changed.

As the global economy slowed, and America slipped into recession, the chancellor’s big relaxation of spending, particularly directed towards the National Health Service but also affecting other public services, came through. That has been the story for the past four years, and the effect has been to add to growth, and transform what would have been a dull job market picture into something very buoyant.

That will change this year. Slower growth in public spending will coincide with a tougher attitude on public sector recruitment, with some 80,000 (net) civil service jobs due to bite the dust.

That is not the only fiscal policy question. There is still a big debate about whether taxes need to rise to pay for past spending increases, and that will become clearer after the general election. Even without new taxes, some fear the damage has been done. Derek Scott, for 10 years Tony Blair’s economic adviser, believes higher taxes and the re-regulation of the economy under Labour will soon begin to have a serious impact on growth.

The headwinds are there. The likelihood is that in a year’s time we will look back on another year of this remarkable recovery. But we might also look back and conclude that it was more disappointing than it might have been.

From Professional Investor, December 2004/January 2005

Monday, November 08, 2004
Riding the long wave
Posted by David Smith at 09:13 AM
Category: David Smith' s magazine articles

Economy-watchers have always been fascinated by cycles, the idea that the ups and downs for businesses and consumers follow regular patterns. Economic cycles, like stars, are named after their discoverers. The standard business cycle, the Kitchin cycle, goes from peak to trough to peak again within the space of five years.

A longer cycle, the Juglar cycle, has major peaks separated by around 8-10 years. Think of the top of the global economic cycle at the end of the 1980s and then at the end of the 1990s.

These are bread and butter cycles. There is nothing pre-ordained about them but they have a habit of coming back. They are driven by economic behaviour – businessmen and consumers becoming over-optimistic and gearing up too much for the upturn, then cutting back when they discover they have over-committed. Governments and central banks also have a clear influence on the cycle, applying the accelerator when the economy has cooled too much and the brakes when it is overheating.

Importantly, the fact that there are cycles does not mean that booms have to be followed by recessions. A “growth recession”, a period of slower growth within a period of overall expansion, is more usual. Britain has had a couple of these since emerging from the last proper recession in 1992.

More interesting than these economic cycles, however, are the extended cycles or “long waves” most associated with the Russian economist Nikolai Kondratiev. Kondratiev was an official in the Soviet finance ministry under Stalin and had politically incorrect economic views. He thought, for example, that the Soviet regime should see what it could learn from market economies and, for his troubles, ended his life in the Gulag just before the Second World War.

Before that, however, he had put forward the idea of long cycles in economic activity, their peaks separated by 50 or 60 years, dating back to the 18th century and the dawn of the industrial age. Kondratiev’s long waves – 25 to 30 year upswings followed by downswings – offered a pretty good explanation of the depression of the inter-war years and, while he was not around to see it, the global economy’s “golden age” from the 1950 to 1973. His work was popularised by the great economist Joseph Schumpeter.

Does Kondratiev have any relevance for the modern age? Some think so. A couple of years ago, explaining what was then Japan’s long period of stagnation, an official from the country’s central bank told journalists that: “We have the bad luck to be in the downward phase of the fourth Kondratiev cycle.”

Now Brian Reading of Lombard Street Research, in a paper entitled “Synchronised Sinking”, has examined the relevance of cycles to the global economic outlook. He notes that to the extent that Kondratiev long waves have been identified, they are – as Schumpeter also argued – largely a product of technological innovation. Thus, the upswing from 1790 to 1814 was largely the product of developments in the cotton industry, that of 1845 to 1870 by steam and the railways, the upwave of 1896 to 1929 as a result of cars and electricity, and the post-World war Two upswing happened as a result of innovation across a range of fronts, including plastics, chemicals and the jet plane. The 1990s appeared to see the beginning of another such upswing, on the back of the IT revolution.

But will it end in tears? Reading, without being a paid-up member of the Kondratiev club, which he thinks is largely a technological phenomenon, argues that there are reasons to expect the two motors of the global economy – America and Asia – to have a prolonged correction.

The 1990s, apart from the IT revolution, saw the emergence of a “new dollar area”, in which half the world returned to something like the post-war Bretton Woods system of fixed exchange rates. This was driven, of course, by the desire of the Asian economies, and in particular China and Japan, not to allow their currencies to rise against the dollar.

As he argues: “The new dollar area comprises the US, an inner circle of countries whose currencies are pegged to the dollar and an outer circle of currencies managed against it.” The circles take in China, Hong Kong, Malaysia, Japan, India, South Korea, Taiwan, Thailand, Indonesia, Singapore and Russia – half of global gross domestic product.

The consequences of this are well known. The dollar has not been allowed to depreciate in a way that would begin to correct America’s widening trade deficit. The quid pro quo for the stable dollar policies of Asia has been that they have been prepared to finance the twin deficits – current account and budget - of the United States.

The outcome, according to Reading, is not in doubt. “The new dollar area, like Bretton Woods, must end in tears,” he writes. “The synchronised boom it has created cannot continue. There can be no soft landing for either the US or China. Quite simply, Americans save too little and must save more, meaning demand and incomes will contract. The Chinese invest too much and must invest less, meaning demand and incomes will contract. This is the recipe for synchronised sinking.”

Is he right? Stripping away the elegant gloss of economic cycles – short and long – the argument is a familiar one; US imbalances can’t last and unwind nastily. Against that is the view that American and Asian economic dynamism (perhaps itself a Kondratiev upswing) will always trump Europe and that, as a result, the scope for working through these imbalances is far greater than the pessimists would allow. The outcome of that debate will profoundly affect prospects for the global economy for years to come.

From Professional Investor, November 2004

Wednesday, October 20, 2004
The global money go-round
Posted by David Smith at 08:36 PM
Category: David Smith' s magazine articles

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

The changing geography of the global economy
Posted by David Smith at 08:33 PM
Category: David Smith' s magazine articles

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

Wednesday, September 01, 2004
Will the world slow down next year?
Posted by David Smith at 08:27 PM
Category: David Smith' s magazine articles

The approach of autumn is a good time to be looking forward. Many of the trends for next year are already in place. By the time autumn turns to winter they will be rock solid. So how is 2005 looking?

The starting point for looking into our crystal ball has to be the fact that 2004 has turned out to be a pretty good year for the world economy, easily the best since 2000. Between 2000 and now, of course, plenty of water has flowed under the bridge – the bursting of the stock market bubble, the 9/11 attacks on America, a US (and global) recession, the Iraq war and the return of high oil prices.

World economic growth will be around 4.2 per cent this year, up from 2.9 per cent last year and 2.1 per cent in 2002. America is leading the way, with a likely growth rate of nearly 4.5 per cent for the year. Next among the G7 countries, perhaps surprisingly, is Japan, where growth should top 4 per cent. For an economy not long ago apparently condemned to permanent stagnation, Japan’s revival this year has been quite a story. I’ll come on in a moment to the question of whether it can be sustained.

Britain can hold her head up high, with likely growth of 3.5 per cent this year – in line with the upper end of Gordon Brown’s forecast range – up from 1.7 and 2.2 per cent in 2002 and 2003 respectively. That ranks as a stellar performance among Europe’s bigger economies. Germany and Italy will grow by less than 1.5 per cent; France by around 2 per cent. Euroland, which has been crawling along at growth rates of below 1 per cent a year for the past 2-3 years is doing better though not dramatically so. This year’s expansion will be about 1.75 per cent.

The story of 2004 has thus been one of good growth, although it has been unbalanced, with the euro countries lagging behind, Britain doing very well but the real growth action being in America and Asia. I have not mentioned China, which should grow by 8 per cent this year or India, not far behind on about 7 per cent. So what about 2005?

Let me start by listing what economists describe as the “headwinds” facing the global economy. The first is monetary policy. Central banks, particularly in the wake of 9/11, decided that their economies needed a substantial tailwind in the form of very low interest rates. Now they are in the process of removing that stimulus, for fearing of allowing inflation back into the system.

The Bank of England started the ball rolling in November last year and has continued raising rates in a steady way since. It was followed by the Federal Reserve in June, which also seems set on a course of raising rates steadily, admittedly from the very low level of 1 per cent. In China the authorities have also taken action, by squeezing bank lending and liquidity in an attempt to cool an overheated economy. Higher rates in Europe and Japan will come, though perhaps not for a while.

If the monetary stimulus is being removed, so is that provided by fiscal policy. Most countries have larger budget deficits than they would like. In the case of Britain and some of the bigger Euroland economies, the fiscal rules have either already been broken or under threat. A tightening is therefore in progress. Whoever wins the November presidential election in America, it is hard to see them not taking action to cut the deficit.

A third headwind is provided by high oil prices. One of the surprises this year has been the failure of oil prices to lie down. The ingredients are familiar – high levels of demand from a strong global economy (boosted by the China effect), supply worries directly and indirectly resulting from the Iraq war, more general Middle East tension, worries over Russian production, and so on. Most analysts now expect oil to settle in the mid-$30s a barrel, $10 more than they expected a few months ago. Even that may be too optimistic. In real terms oil is well below previous peaks but even at $40 a barrel or more it has the capacity to do damage, effectively acting as a tax on growth.

A fourth possible constraint is China itself. Such has been the consistency of Chinese growth that it is tempting to think of it as a kind of economic perpetual motion machine. But the authorities have taken action against overheating for good reason – the risk of rapid inflation. Some see a risk of a significant Chinese slowdown.

Finally, and this almost goes without saying, the terrorist risk now seems to be an almost permanent economic headwind. Even the White House has warned of taking emergency measures should the presidential election be disrupted by terrorism.

Adding all this up, most economists think the world economy will come off this year’s pace next year. There are already some signs of that in America, with second quarter growth slowing to an annualised rate of just per cent, from 4.5 per cent in the first. That may have been a temporary effect or a sign that, even before the Fed has really started raising rates, momentum is fading.
Broadly speaking, though, the expectation is of an easing of the pace of growth, not a sudden halt. America will grow a little slower; perhaps 3.5 rather than 4.5 per cent, and Japan will come back down to earth, growing by about 2 per cent. Britain should manage 3 per cent, while Euroland will again struggle to hit 2 per cent.

Where do the risks lie to this consensus? Probably on the downside. According to economists at Schroders, a Chinese “hard landing” and an abrupt post-election slowdown in America could make next year feel distinctly cool, with growth sharply lower. Economists at Dresdner Kleinwort Wasserstein have similar fears.

What about the risks on the other side? There is, as Schroders acknowledges, also a realistic “no landing” scenario, in which the US economy powers ahead through the election period, and China shrugs off the attempts by the authorities to slow it down. If we wanted to think of a “no landing” in Britain, it would be that the housing market – against all predictions – continues to rise by 20 per cent a year.

Which will it be? I’ll go for the modest slowdown, while acknowledging that this is also the safe option. Not for the first time, we’re left hoping for a Goldilocks world economy, not too hot and, most definitely, not too cold either.

From Business Voice, September 2004

Monday, August 23, 2004
Don't exaggerate the North-South divide
Posted by David Smith at 12:03 PM
Category: David Smith' s magazine articles

The North-South divide is a topic guaranteed to get attention. I know. Fifteen years ago I was interested enough in it to write a book, North and South. This was the late 1980s, when regional differences – in employment, house prices, per capita incomes, health and just about everything else – were wider than they had been for a long time. The prosperity of the 1980s was spread pretty unevenly.

I revisited the issue with a second edition of the book a few years later. This was after the “southern” recession of the early 1990s, when London, the South East, East Anglia and the South West were hit particularly hard by the crash in house prices and negative.

My conclusion then was that the “divide” had narrowed somewhat but that the forces that favoured the South were still in place. Even then it seemed that manufacturing was facing a difficult time and that the more diversified economy of the South would act to its advantage. The full extent of the stock market boom of the 1990s was not fully evident, even 10 years ago, but the financial services industry, disproportionately concentrated in the South East, appeared due for a successful few years.

London’s dominance of political and economic life in Britain, the location advantages of the South East when it comes to access to European markets (still a plus despite the disappointing performance of the euro-zone economy), the concentration of wealth in London and the South East – all looked set to reinforce the divide.

That prediction, according to a new report, appears to have been right. Two researchers at Sheffield University have analysed the results of the 2001 Census and compared it with its predecessor in 1991. Their results, published in a book, ‘People and Places: A 2001 Census Atlas of the UK’, by Daniel Dorling and Beth Thomas, suggests not only that the North-South divide has widened but that it has reached critical proportions.

So wide do London’s tentacles spread, it says, that places like Cambridge and Northampton can be regarded as among its suburbs, while Norwich and Ipswich also come under the capital’s immediate influence.

“The South is London and London is the South; and regional divisions in between are meaningless," it says. In the 10 years from 1991 to 2001, the migration of skilled workers from North to South has accelerated, to the point that most cities in the North are “slowly sinking” as their populations drift away. Between the two censuses Manchester’s population dropped by 10% and that of Liverpool by 8%. Meanwhile, over 1.7m jobs were created between 1991 and 2001 in the booming financial sector, mostly concentrated in the South East.

According to Professor Dorling, one of the co-authors: “Our conclusion is that the country is being split in half. To the south is the metropolis of Greater London, to the north and west is the ‘archipelago of the provinces’ - city islands that appear to be slowly sinking demographically, socially and economically. The UK is looking more and more like a city-state. It is a kingdom united only by history, increasingly divided by its geography.”

Dramatic stuff. Can it be right? Readers will be familiar with the two-tier economy, and the superior performance of services compared with manufacturing over the past decade. This has undoubtedly contributed to faster growth in the South compared with the North. This year, interestingly, analysts at Experian Business Strategies say that the North will outgrow the South. This partly reflects the fact that the housing boom has rippled out from the South East but is mainly due to the global economic upturn, which is boosting manufacturing.

Another surprise is in the unemployment figures. Taking the widest unemployment measure, based on the Labour Force Survey, Greater London – that super economic magnet for the rest of the country – turns out to have the highest regional jobless rate, 6.9%, in the UK. Even allowing for London’s special problems – poor boroughs like Hackney and Tower Hamlets – this does not follow the North-South divide script. Unemployment in the North East, 5.2%, compares with 3.9% in the South East, one of the smallest differences I can remember.

I would not pretend there are no regional differences in the UK. In wealth, per capita incomes and most other respects, the South East is well ahead of the rest of the country, and its influence is indeed growing. But it is important to remember that disparities within regions are greater than those between them. It is important too not to be too apocalyptic about the North-South divide, which the Sheffield study is in danger of doing.

The onus remains for regional development agencies to perform well. They are indeed making progress but, as a recent Trade and Industry Select Committee report observed: “To date, RDAs have not made much impact on reducing the confusingly large number of business support organisations and the schemes they offer.”

The other concern is over regional assemblies. As Bill Midgley, president of the British Chambers of Commerce, has put it: “As things stand businesses see regional assemblies leading to increased costs, more tiers of government and extra bureaucracy with decision-making power becoming less accessible to local communities.” The regions need help, not hindrance.

From British Industry magazine, July 2004

Sunday, August 01, 2004
Iraq and the oil factor
Posted by David Smith at 08:59 AM
Category: David Smith' s magazine articles

This year, as manufacturers know, high oil prices have returned as significant factor. The rise in prices to a record high of more than $42 a barrel in the summer, and the apparent certainty of $30-a-barrel plus crude for the foreseeable future is a reminder of our continued vulnerability to this most economically-significant of commodities.

The latest scare reflected a combination of several factors. A synchronised global economic recovery, sharply rising demand from China – now taking its permanent place as one of the world’s big economic players - the security situation in Iraq, terrorism fears in the Middle East, the situation at Russia's Yukos, all combined to push crude prices well above $40 a barrel (35 gallons).

Adjusted for inflation, prices have been higher in the past. After the fall of the Shah of Iran in 1979, prices rose to the equivalent now of nearly $80 a barrel. Readers will not need reminding of the savage manufacturing recession that this, combined with high interest rates and a high pound, caused.

But the oil story always comes back to the Middle East, and with good reason. The latest BP statistical review of world energy, the industry’s bible, underlines the huge importance of the region.

Saudi Arabia, with 36 billion tonnes of proven reserves, has 22.9% of the world total, followed by Iran (18 billion), Iraq (15.5 billion), Kuwait (13.3 billion), the UAE (13 billion), Venezuela (11.2 billion) and Russia (9.5 billion). Nearly two-thirds of global oil reserves are in the potentially unstable Middle East. America, where the global oil era started a century ago with the discovery of the Spindletop field in Texas, is estimated to have only 4.2 billion tonnes left, and only just scrapes into the top 10.

While the reserves are mainly in the Middle East, the demand is plainly elsewhere. The United States accounted for no less than 25.1% of global consumption last year, followed by the EU, with 17.6%, China (7.6%), Japan (6.8%), Russia (3.4%) and India (3.1%).

The world’s reliance on the Middle East suggests that oil crises, probably more serious than this year’s, will be an all-too-frequent occurrence. The vulnerability of Saudi Arabia, the world’s pivotal producer, is worrying. With its attacks on Western targets in the country, particularly expatriate oil workers, Al-Qaeda has already demonstrated a new and potentially dangerous tactic.

One big question, however, concerns the role of Iraq. On June 28, two days earlier than planned, America handed Iraq over to the country’s interim government. After its recent bloody history, and the war, Iraq has begun to make the slow journey back towards democracy. If it succeeds on that journey, the implications could be hugely significant.

Conventional wisdom is that the big achievement in Iraq will be getting oil production back to its pre-war levels of around 3m barrels a day. That would restore the country to its position as a major oil producer but, compared with Saudi’s 9m-10m barrels a day would leave it as a junior partner. Raising production much beyond that, the argument goes, will require huge investment in an infrastructure run down badly during the Saddam years.

But according to Leonardo Maugeri, a senior vice-president at Eni, the Italian state oil and gas firm, conventional wisdom hugely understates Iraq’s potential. In a recent article, he pointed out that Iraqi oil has never been properly developed, not least because Iran, Kuwait and Saudi were the preferred Middle East locations for the oil majors.

The result is that only a minority of Iraq’s fields have been developed. As he put it: “A large part of the country—the western desert area—is still mainly unexplored. Iraq has never implemented advanced technologies—like 3-D seismic exploration techniques or deep and horizontal drilling—to find or tap new wells. Of more than 80 oilfields discovered in Iraq, only about 21 have been at least partially developed. And 70 percent of current capacity derives from just three old fields: Kirkuk, discovered in 1927, and North and South Rumailah, discovered in 1951 and 1962, respectively.”

Iraq’s true oil reserves, he suggests, could be more than 300 billion barrels, rather than the currently accepted 110 billion. If he is right, the potential for a stable Iraq is huge. And it will shine a light amid the current gloom over oil.

From The Manufacturer, July 2004

Tuesday, June 01, 2004
The inflation danger from China
Posted by David Smith at 07:09 PM
Category: David Smith' s magazine articles

China, as everybody knows, is becoming a dominant player in the global economy. Long-term projections from Goldman Sachs show that in three years time China’s gross domestic product will have overhauled that of France, Britain and Germany, Europe’s big three. By 2020 China will be bigger than Japan and during the 2040s larger than America, and thus the world’s biggest economy.

There is, it should be recognised, many a slip ‘twixt cup and lip. It may be that China’s path towards matching her economic importance to her huge population of 1.3 billion is not quite as straightforward as that. But we do not, in any case, have to wait 40 years for a demonstration of China’s significance.

In 2002 the Chinese economy grew by 8% - a typical rate of expansion - and in doing so contributed no less than 36% of global economic growth. In 2003 China again boomed (as it has done, more or less, since the late 1970s), with growth this time of 9.1%. In a stronger international environment, China’s global contribution slipped slightly. But it was still equivalent to a third of total world economic growth. The global economy, plainly, has been tilting towards the east.

There is another way of demonstrating this.

China, still for the moment only the world's sixth largest economy, is a voracious consumer of raw materials to fuel the industrial boom, accounting for between a fifth and a third of global consumption of aluminium, iron ore, zinc, copper and stainless steel. Antofagasta, the Chilean copper-mining firm that entered the FTSE-100 in March, has been one of the most obvious beneficiaries of booming Chinese demand.

It would be wrong, however, to think of China as merely a consumer of large quantities of commodities. Volkswagen sells more of its vehicles in China than in Germany. General Motors is increasing Cadillac production by 50% to cope with demand from China’s new business elite. And this is merely scratching the surface of the country’s emergence as a consumer on a huge scale. After all, gross domestic product per capita in China only a twentieth of average levels in the European Union. Real incomes are set to grow hugely, and rapidly.

If all that makes China the most exciting story of the world economy, it also raises one or two worries. Given the fact that China is already emerging as a dominant player, these worries fall into two related categories.

The first relates to the sustainability of the Chinese boom and, in particular, the consequences of any bursting of what could be an economic bubble. As China has become the world’s leading recipient of foreign direct investment, the reverberations of a sudden economic cooling, let alone a crash, would be felt around the global economy.

The second relates to the effects of the boom itself. Commodity prices have been rising sharply in world markets. This is partly a consequence of the weak dollar, as producers have sought compensation for the US currency’s weakness, most commodities still being priced in dollars. But it is mainly due to rampant Chinese demand for raw materials. Against expectations of a price fall following the Iraq war, oil has stayed high, mostly above $30 a dollar. Many metals and other commodities stand at their highest level for a decade, and have risen particularly strongly over the past year or so.

Not only that but China itself is emerging from a long period of deflation – falling prices – and is experiencing inflation again. Food prices are showing annual rises of 9-10%, while general inflation is closer to 3% but is rising. Higher food prices are not necessarily a bad thing in China, because they have the effect of redistributing income to the rural poor, but they underline the re-emergence of inflationary pressure.

A monetarist looking at China, indeed, would conclude that there is an inflation accident waiting to happen. The M2 money supply measure has been growing by more than 20%. Actions by the authorities to intervene in the currency markets to preserve the renminbi-dollar link have had the effect of sharply boosting China’s foreign exchange reserves, and therefore the money supply.

So how big are the risks? The investment boom is of legendary proportions. This is an economy bent on building for the future, to the point that investment has risen to more than 40% of GDP. This raises the spectre of “over-investment”, something rarely seen in Western economies, but typical of Asian countries ahead of the Asian economic and financial crisis of 1997-98. Thailand. Singapore and Malaysia all had investment-GDP ratios of around 40%.

How big is the risk of a Chinese economic accident, with nasty knock-on effects elsewhere? While it is tempting to draw parallels between China and the Asian economies of a few years ago, it is also unnecessarily alarmist. For one thing China’s sheer size means its capacity to absorb large amounts of foreign direct investment is enormous.

In addition, the Chinese authorities are in far greater control of events than the governments and central banks of the smaller Asian economies. A run on the renminbi, of the kind that brought down the Thai baht a few years ago, is almost unthinkable, not least because all the pressure on the Chinese currency has been upwards, but also because of the ability of the authorities to control dealings in the currency.

What about the inflation danger from China? It is undeniable that the China effect has pushed commodity prices up sharply. It is also clearly the case that China has moved from deflation to inflation.

Neither, however, should worry us too much. Commodities, even oil, do not have the impact on inflation that they used to, because Western economies have become less industrial, and therefore less sensitive to shifts in raw material costs. As for Chinese inflation, it is only necessary to go back to the mid-1990s for a time when prices were rising at a 25% rate, without affecting the benign global inflation environment. A much smaller rise in inflation is in prospect this time, and the effects outside China will be minimal.

Indeed, it may be entirely the wrong thing to look for inflation from China. For the past decade the China effect has been deflationary, through lower prices for industrial products. That effect has not gone away. Low-cost Chinese production will continue to help keep a lid on global inflation.

From Professional Investor, June 2004

Thursday, April 29, 2004
The last shoe to drop
Posted by David Smith at 08:51 PM
Category: David Smith' s magazine articles

Manufacturing has had a good first few months of 2004. While official figures on the sector's output have been unexpectedly weak, surveys point to quite a vigorous recovery in demand, largely on the back of much stronger export markets.

The British Chambers of Commerce (BCC), for example, in its spring quarterly survey, reported a positive balance for manufacturers' home sales of 19%, up from 17% in the previous quarter and the strongest reading since the end of 1997. Other figures in the survey were also strong. Home orders jumped to their highest level since 1999.

The biggest change, however, is coming from exports, with sales and orders both hitting their best for seven years. Confidence was at its highest for five years, while even employment expectations turned higher, and reached their strongest for three years.

It is not hard to explain why this is happening. Manufacturing is acutely sensitive to the global economic cycle. Over the past three years timely cuts in interest rates by the Bank of England, together with tens of billions of extra public spending from Gordon Brown, have kept the overall economy growing. For manufacturing, however, there was no such comfort. But now that global growth is turning up, manufacturing is plainly benefiting.

It could be benefiting by more - weak economic growth in the euroland economies, which are on course for an expansion of less than 2% this year, mean the world upturn remains tilted firmly towards America and the Far East. But export market growth is back, after a long absence. And sterling, which earlier this year appeared set for a period of uncomfortable strength, has slipped lower.

That is not the only good news about manufacturing. Profitability among UK manufacturers rose strongly in the final quarter of 2003, official figures show. The net rate of return rose to 8.6%, from 7.7% in the previous quarter. Profitability has gradually recovered from a low of 6.4% in 2001.

So what’s missing? The confirmation of this manufacturing recovery, the shoe that has yet to drop, will come with an upturn in investment. That would not only show that the sector is putting its money where its confidence but it would provide a much-needed boon for capital goods industries.

So what has been happening to manufacturing investment? The good news is that the latest official figures show manufacturing investment rising - up 5.5% in the final quarter of 2003. The bad news is that this was still 1.5% down on a year earlier. For 2003 as a whole, manufacturing investment was down a worrying 7.6% on 2002. The latest quarterly figure, while slightly up, was 22% lower than the recent peak recorded in the spring of 2001.

This cautious message was confirmed by the BCC survey. It showed a drop in investment intentions for manufacturing in the first quarter, implying that even the modest fourth quarter recovery may have been a flash in the pan. Manufacturing investment, it seems, remains in the doldrums. How long will that last?

The Treasury and independent forecasters are upbeat about prospects for overall business investment. The official forecast is for 3.5% to 4% growth this year and between 5.5% and 6.25% next year. Royal Bank of Scotland says that this will be the best year for business investment since the late 1990s. But while the overall business investment climate may be good, manufacturing has good reasons to be cautious.

There have been false dawns for the sector before, and several in recent years. Profitability may be improving but there are other factors, like the problems of pension fund deficits, which continue to hold back investment. Manufacturing investment will recover, of that there can be no doubt. But we will probably have to wait until later in the year, at the earliest, for this particular shoe to drop.

From The Manufacturer, May 2004

Monday, April 12, 2004
Sending the economy offshore
Posted by David Smith at 05:44 PM
Category: David Smith' s magazine articles

Times have changed. In the high-employment 1980s, the headlines merely told us about job losses. ITN’s ten o’clock news used to regularly run a map of Britain showing where the axe had fallen.

Now we are in the high-employment early 21st century and the job headlines are different. Now it is about jobs, in call centres and other support activities, that are being “offshored” – transferred abroad, mainly to India. Barely a week goes by without such an announcement, the most recent being from Abbey and Norwich Union. If ITN ran a map today it would show places like Bangalore and Bombay.

In both cases, however, such news remains controversial. Just as people were gloomy about job losses in the 1980s, so they are downbeat about job transfers now. Call centres were once seen by the unions as not worthy of their members, an inadequate replacement for lost industrial jobs. Now union leaders appear every bit as determined to cling onto such jobs as they once were when it came to steel, shipbuilding or coal mines.

Is offshoring a big deal or just media hype? Certainly there is no doubting the trend. Figures from India’s National Association of Software and Service Companies (NASSCOM) show “offshored” employment rising by upwards of 100,000 a year, with the numbers clearly accelerating.

Projections by Deloitte Research suggest that 2 million of the 13 million jobs in financial services in western economies will be transferred to India by 2008, three-quarters of a million of them from Europe. This, in turn, will produce an estimate cost saving of $138 billion (£73 billion) for the top 100 financial services firms. Only a small minority of firms will not choose to offshore some jobs over the next few years.

Estimates by Amicus, the trade union, that more than 200,000 British back-office and call-centre jobs will be lost, mainly to India, by 2010, look cautious in this context. And this is not just a UK phenomenon. Forrester Research suggests the number of US jobs “offshored” will increase from under half a million now to 3.3 million by 2015. No wonder it has become a hot political issue in America, with presidential hopeful John Kerry accusing chief executives who transfer jobs overseas of treachery.

Why is offshoring happening? The most obvious reason is cost. Even adjusted for relative prices (purchasing power parity), an IT professional in India is paid a third of typical rates in Britain, and a quarter of what is usually paid in America. In terms of raw salary comparisons the differences are even more dramatic, as they are for lower-skilled staff to work in call centres.
Another reason is quality. 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.” HSBC is in the process of transferring a further 4,000 jobs overseas.

A third argument relates to the cost and quality of telecommunications links. Until three or four years ago large-scale offshoring was not a viable option for companies because of call charges were high and networks unreliable. That has changed dramatically. Reliability has improved hugely and international call charges are already under a sixth of their level three years ago and still falling.
It is not hard to see why companies, particularly in financial services, seek to take advantage of offshoring, although it is also the case that some have looked at the possibilities and decided it is not for them. But what is the impact of offshoring on the British economy? Is this loss of jobs a worrying comment on our economic future, as some fear?

The fear goes something alone these lines: it was bad enough when manufacturing jobs were being lost to overseas competitors, or firms transferred operations to cheaper locations. It quite another thing, however, when service-sector jobs are going in their tens of thousands. These, after all, are the mainstay of employment in Britain. This fear exists in spite of the fact that the labour market is strong, with employment standing at more than 28m and unemployment, on the claimant count measure, at just 2.9% of the workforce, its lowest for almost 29 years.

There are, though, some pretty clear economic advantages to Britain in transferring jobs overseas. This is why, against what intuitively might be thought to be the case, studies show consistently that the economic gains to the country exporting jobs, Britain, are greater than those accruing to the recipient nation, India.

One source of such gains relates to the tightness of the labour market. Offshoring will help to head off labour shortages in Britain. A study by Evalueserve, a firm of consultants, projects that 275,000 UK jobs will be moved to India between now and 2010. That will help to offset what it says will be a demand-supply gap for workers in Britain of about 700,000. Most of the rest of that gap is expected to be closed by immigration into Britain.

A second set of benefits comes from the fact that consumers, through lower prices, and investors, through higher profits, gain economically when British firms shift some of their operations offshore. Consumers’ real incomes are boosted, increasing their spending power, which in turn generates jobs. For every call-centre job lost, other jobs are gained — in retailing and elsewhere.

A third avenue for gains comes from the fact that offshoring should raise productivity. Just like the shift of basic manufacturing jobs overseas, the transfer of routine service-sector functions should allow workers here to be moved into higher-productivity, higher-value roles.

Studies by the Centre for Economics and Business Research undertaken for Logica-CMG suggest that offshoring/outsourcing could, via this route, boost productivity growth in Britain (output per head) from just under 2% a year to nearly 2.5%. Given that the government’s objective is to close the productivity gap relative to other advanced countries, this could be a significant help.

All that is reassuring, although it cannot disguise the fact that offshoring also poses serious economic challenges. We need to have workers with the skills ready to move into higher-value work. And we have to be aware of the fact that some of these arguments might not look so clever in the event of an economic downturn and a significant rise in unemployment.

From Professional Investor, April 2004

Sunday, March 28, 2004
Tied up in red tape
Posted by David Smith at 08:50 AM
Category: David Smith' s magazine articles

Scratch most businessmen and not far below the surface there will be a concern about red tape and regulation. Not only that but there will be a strong belief that things are getting worse, that new and more onerous forms of bureaucracy are being layered on top of those already in place.

For many in industry, red tape is a bit like traffic jams or trash television. It undoubtedly exists but there is not much you can do about it. And ministers keep insisting that the problem is getting better, not worse.

Now, however, we have firm evidence that this is very much not the case. The British Chambers of Commerce (BCC), in its latest burdens barometer, estimates that the cumulative cost to business of red tape and regulation introduced under this government has risen to more than £30 billion. That is up by a staggering 46% on the £20.6 billion estimate of a year ago. What is more it excludes the national minimum wage, the cost of which to business is £13.5 billion and rising.

How can anybody possibly guess at the cost of red tape? A good question, but this is the beauty of the BCC’s estimates. All the figures are taken from the government’s own regulatory impact assessments (RIAs). Thus the only guesswork involved is on the part of officials but the government cannot deny its own estimates.

Where does the burden of red tape fall heaviest? In terms of the cumulative burden, new employment regulations and payroll obligations rank highest. The biggest single burden is represented by the working time regulations – the 48-hour week and associated rules – introduced five years ago, with the cumulative cost to business now £11.1 billion. Other big ones include the data protection act, £4.6 billion, changes in vehicle excise duty rules, £4.2 billion, the control of asbestos at work rules, £1.4 billion, disability discrimination regulations, £1 billion, and the IR35 contractors’ rules, also £1 billion. In some ways, however, the biggest damage is done by the sheer range of rules and regulations, and their quantity, rather than any individual measure.

As David Frost, the BCC’s director-general, puts it: “British business cannot compete with a £30 billion millstone around its neck. Government must simplify the UK's regulatory framework, and properly assess both the costs and the benefits of new regulations. Their own rules require them to do this.”

What can we do about red tape apart from moaning about it? The first thing is to get the government to recognise the problem. Gordon Brown argues that, just as farmers complain about the weather, businessmen will always gripe about red tape. Go to any country in the world, he argues, and you will hear the same complaints, even in America, supposedly the land of the entrepreneur. The key in Britain, though, based on the government’s own figures, is that things are getting worse at a faster pace than elsewhere.

The second requirement is to have realistic ambitions. Governments are not going to scrap regulations they have introduced, often as in the case of employment rules with a political fanfare. What they might be persuaded to do is tear up some of the regulations introduced by their predecessors. The idea of “sunset” clauses in the regulatory framework – phase them out when they have served their purpose – should be the way to proceed.

Third, business has to keep the pressure up, not give up on the argument that it is not a battle worth fighting. The Treasury claims it is interested in creating a genuinely enterprise-friendly environment. The planned merger of Inland Revenue and Customs & Excise, unveiled in the March 17 budget, is intended to ensure that small and medium-sized businesses are only encumbered with one set of taxmen. Treasury ministers should be kept to their word.

Red tape is undoubtedly shackling British business. A vital challenge for the next few years is to find ways of cutting through it.

From The Manufacturer, April 2004

Monday, March 15, 2004
Europe's growing pains
Posted by David Smith at 03:27 PM
Category: David Smith' s magazine articles

On May 1, as everybody knows, the European Union will undertake its biggest ever enlargement – in terms of the number of new members – in its near 50-year history.

The 10 joiners – Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia – will for the most part be completing a journey that began only 15 years ago under the yoke of Soviet rule and Communist central planning.

While large in terms of numbers, and to a lesser extent population – the addition of around 75 million people is equivalent to adding almost another Germany, or 20%, to the EU’s citizenry – the initial economic impact is rather smaller than might be expected. Because these economies lag well behind the existing EU members in terms of per capita incomes, with crude comparisons showing some to be only a fifth as well off as their wealthier neighbours, it will be some time before they punch their full economic weight. Thus, a 20% increase in EU population, courtesy of the new members, will result in only a 5% boost to EU gross domestic product.

Even so, adding these new members to the existing 15 is proving to more complicated than anticipated. If the new boys thought they were going to be welcomed with open arms, they were in for a rude awakening.

The first problem area has been the status of the EU’s 75 million new citizens. High employment economies such as Germany and France, alarmed by the prospect that workers from the accession countries would be drawn into them by the lure of gold, took steps to impose transitional arrangements. People from the new member countries will be entitled to work anywhere in the EU, but not for a while.

This left Britain in a minority of countries offering an open door policy. That has now changed. The door is still open, it seems, for genuine workers with job offers but not for those seeking to come purely to claim benefit. The government is torn between the Treasury’s diagnosis that Britain needs and will benefit from skilled migrants, and the political fear that this will be seen as too liberal for the likes of voters, Squaring the two looks fiendishly complicated.

The second problem area has arisen over the running of the EU itself. On the one hand it was perfectly sensible to use the opportunity of enlargement to streamline the running of the EU by cutting down on the number of commissioners and making decision-making by the council of ministers easier.

On the other, it was hardly the most intelligent move to hand over the project to Valery Giscard D’Estaing, the former French president, to draw up a grant EU constitution that some members were bound to find objectionable. Nor was it sensible to try to take away voting rights from Poland and Spain that had already been agreed. Thus, talks over the proposed new EU constitution in Brussels last December collapsed in abject failure, and probably will not be revived for two years, well after the enlargement has taken place.

Clumsiness also appears to be the order to the day when it comes to the EU budget. One of the big stories of recent months has been the effective collapse of the euro stability and growth pact, under which members of the single currency were required to keep their budget deficits below 3% of gross domestic product or face hefty fines.

Late last year, when it became clear that France and Germany were heading for such fines under the rules, both countries pressured other European finance ministers into suspending sanctions under the pact, in other words extracting its teeth. The European Commission has thus embarked on legal action against the finance ministers. One bit of the EU is suing another.

That is bad enough, but to add insult to injury Romano Prodi, the Commission president, also wants existing member countries to dig into their pockets to fund an increase in the EU’s central budget because, as he has put it, “we are on the eve of the biggest enlargement in the EU’s history”. The budget is currently 1% of GDP, or gross national income to use the definition preferred by Brussels.

The aim is to increase it to nearly 1.25% for the 2007-13 period. This may not sound like very much but it is equivalent to adding £30 billion a year to the existing budget of just under £70 billion.

The proposal, unsurprisingly, has gone down like a lead balloon. Hans Eichel, Germany’s finance minister, has said: “You cant say on one hand, you in Germany you have to save money and cut down expenditures, and demand at the same time: you have to pay more money to Brussels.”

Gordon Brown has also made clear his outright opposition, not just to any increase in the EU budget, but to any suggestion that the budget rebate famously secured by Margaret Thatcher should be revisited. Opposition to the budget increase is led by Germany, Britain, France, Austria, Sweden and the Netherlands.

It all looks like a bit of a mess. Few doubt the economic benefits that EU enlargement will bring. Accommodating the new arrivals, however, is proving to be far from easy. The spirit of EU co-operation looks under strain.

From British Industry (formerly Industry), March 2004

Monday, March 01, 2004
Gordon Brown's date with destiny
Posted by David Smith at 04:39 PM
Category: David Smith' s magazine articles

As Gordon Brown prepares to deliver his penultimate budget before the next election, two things will be firmly on his mind. The first is that, as chancellor, he is already looking very long in the tooth.

I’m referring, of course, not to his age – there have been plenty of older chancellors – but his longevity in the job. Last year he overtook Nigel Lawson (chancellor 1983-9) as the longest serving post-war chancellor. This year, assuming he stays in post, he will in June overtake David Lloyd George (1908-15), who currently holds the record for the longest in the job since 1900.

If Brown wants to beat the all-time record, held by William Gladstone, he has a few more budgets to deliver. Gladstone is easily the longest-serving chancellor, spending a total of 12 years and four months at the Treasury, although admittedly in four separate spells over a 30-year period, 1852-82. The great Victorian also puts all his rivals to shame in terms of despatch-box endurance, once delivering a budget speech lasting 4 hours and 45 minutes, using just a few brief notes to help him along.

Most British chancellors have managed to get into trouble long before clocking up anything like Brown’s time in the job, let alone that of Gladstone. And that’s the second thing on Brown’s mind. Is this the time when a successful chancellorship goes off the rails? Now that the prudence of the early years has given way to borrowing on a huge scale is his period of tenure at the Treasury, like that of so many of his predecessors, doomed to end in failure?

In December, presenting his pre-budget report, Brown came clean on the size of this year’s black hole, £37 billion. That was not as big a deficit as some independent estimates, although it exceeded others. Significantly, it was £10 billion above the Treasury’s previous estimate, in last April’s budget, and nearly four times the borrowing level officially predicted for 2003-4 just a couple of years ago.

That £37 billion will, in all likelihood, survive more or less intact in the coming budget. While nobody can ever predict these things with precision – government borrowing is the difference between the two very large numbers of spending and taxation – something rather bad would have to have happened to the public finances in the past few weeks to make a much larger borrowing figure plausible.

The problem, instead, comes as the chancellor peers into the future. His budget projections, while still being finalised in the Treasury, will almost certainly maintain the downward profile for borrowing that was a feature of his pre-budget report. This year, in other words, is as bad as it gets for the public finances.

In 2004-5, if he sticks to this profile, public borrowing will be a few billion below the £37 billion for this year, and it will continue to trend very gradually downwards after that. In the context of a generally accepted shift into stronger economic growth, it looks plausible.

Except for a couple of things. Tax revenues have a tendency to lag behind economic growth. The Treasury, which played a long game of “hunt the missing revenues” in the first half of the 1990s, knows this only too well. It has been criticised for assuming too speedy a return to strongly growing government receipts.

Another problem is on the expenditure side. Although the chancellor has been making tough noises about reining back public spending, there is a lot of momentum behind the present increases. And even if most programmes can be brought under control, there is the not-so-small matter of the National Health Service, guaranteed 7%-plus real annual growth in spending through to 2007-8.

There’s an additional problem. We became used, during the first 3-4 years of Brown’s tenure at the Treasury, to the borrowing numbers coming in consistently better than expected, and for his fiscal rules being comfortably met. The two rules, to remind you, are the golden rule of only borrowing to finance public investment (as opposed to current spending on, say, wages and salaries) and the “sustainable investment rule” of keeping the public sector’s net debt below 40% of gross domestic product.

Now, even on the Treasury’s own figures, the golden rule is only narrowly met over the course of the present economic cycle. Most independent economists, on the other hand, think it will not be met, and that taxes will have to go up by about £10 billion – but not until after the next election – to meet the rule. Public sector debt, meanwhile, will creep towards that 40% level, albeit it only slowly.

Analysts are also coming to realise what the golden rule means in terms of extra borrowing. The government’s investment programme is worth £25-30 billion a year. Borrowing that much each year would have been regarded as irresponsible not so long ago. Now it is becoming the default position for the government.

Does any of this represent a serious challenge to Brown’s reputation? After all, the economy continues to grow, and interest rates, inflation and unemployment are all low. The fiscal rules are under threat but they are, it should be said, self-imposed. Not only that but, unlike in previous episodes where British chancellors have got into difficulty, there is no suggestion this time that fiscal problems are unique to Britain.

America has a budget deficit of 5% of GDP, compared with just over 3% in Britain, Japan is running a 7% deficit, while both France and Germany have burst through the 3% limit allowed for deficits under Europe’s stability and growth pact. The chancellor is in good company and he has things under better control than most of his finance minister colleagues.

All that is true, and it helps explain why Brown is facing up to his fiscal problems with confidence. There are signs, however, that the public is tiring of tax hikes and the slow pace of delivery when it comes to public services. It also becomes more difficult for Labour to claim the high moral ground over the Tories on economic policy, as it could when borrowing was firmly under control. High borrowing will continue to erode the chancellor’s reputation.

From Professional Investor, March 2004

Monday, February 09, 2004
Return of the $2 pound
Posted by David Smith at 08:26 PM
Category: David Smith' s magazine articles

When it comes to the currency markets, nothing is predictable. When the euro was launched at the start of 1999, many pundits predicted that the new currency would strengthen as central banks and institutions diversified their holdings away from the dollar.

The opposite happened. From a launch level of $1.16 against the dollar, the euro slid to just 83 cents. The pound also gained vis-à-vis the beleaguered single currency with the euro hitting a low of just 57p (not far short of a two euro pound), reinforcing another surprising trend in the foreign exchange markets – more than seven years of unexpected sterling strength.

The pound’s “re-rating” dates back to the summer of 1996. Sterling had been through a turbulent few years, beginning with “Black Wednesday”, September 16 1992, when it was forced out of the European exchange rate mechanism on a day of national humiliation (but considerable long-run economic benefit).

The pound lurched lower in the autumn of 1992, and it had another downward lurch about 18 months later. But in the late summer of 1996, despite the uncertainties of an impending change of government, the markets pushed it sharply higher, taking it above three D-marks in those pre-euro days.

Many of those moves of a few years ago have now reversed themselves. The euro has climbed against the dollar from that low of 83 cents to just below $1.30 at time of writing, a spectacular gain. Moreover, this has happened despite a woefully disappointing economic performance from the “euroland” economies and the collapse of Europe’s fiscal rules, embodied in the so-called stability and growth pact.

Sterling has come down from the heights in relation to the euro. From that low of 57p, the euro has climbed back to just below 70p. That has eased the pressure on exporters, although what they have gained on the euro swings they have lost on the dollar roundabout.

Until recently the pound could be relied on to stay in a range of $1.40 to $1.60 against the dollar, and usually at the lower end of that range. While sterling’s strength against the euro was uncomfortable, a fair rate against the dollar helped ease the strain.

That was until the dollar started falling. The dollar’s weakness, which has gained momentum in recent weeks, can be put down to several factors, not least the “twin” deficits, with America $400 billion in the red on its budget and a $600 billion gap on the current account of the balance of payments. In combination with US interest rates of just 1%, the arguments in favour of holding the dollar have weakened considerably.

More important than these, however, has been a change of attitude on the part of the American government. Seldom has economic policy in a major country been so geared towards a single aim, and that aim is to get George W Bush re-elected. If a significantly lower dollar helps in that aim, and gets the manufacturing lobby off the president’s back, so be it.

So the pound has strengthened, in a climb that has so far seen it rise into the high $1.80s, admittedly followed by a bout of profit-taking, with the smart money on the return of the $2 pound. Apart from a brief flirtation with this level in the early 1990s, this would take us back to where we were shortly after a fresh-faced Margaret Thatcher became prime minister in 1979.

What does a strong pound against the dollar mean, and how long will it last. Sterling’s strength, or rather the dollar’s weakness, is unfortunately timed. European economies remain weak, experiencing a low-key recovery at best. America, our biggest single market, is in contrast powering away. But the pound’s rise will make it harder to benefit from that economic strength.

The latest official figures show that Britain ran a record deficit of £10.2 billion on trade in goods and services in the September-November period of 2003.

They also show that exports to non-EU countries, of which America is the biggest, were down on a year earlier. Exporters have been doing well in the US market, so any reversal will be a disappointment, but the strength of sterling against the dollar may already be having an impact.

How long with sterling stay at this kind of level? Many currency forecasters think the dollar will stay weak for a long time, because the twin deficits will take years to work off. I’m not so sure. The Federal Reserve will soon be raising interest rates from the present very low 1% level. Not only that, but America’s greater dynamism guarantees more rapid economic growth than Europe over the medium and long-term. This will be reflected in the dollar’s level, possibly quite soon. In my view the dollar’s weakness is likely to be measured in months, not years. But it could be an uncomfortable few months for exporters.

From Industry magazine, February 2004

Monday, February 02, 2004
A year of returning normality
Posted by David Smith at 10:58 AM
Category: David Smith' s magazine articles

How unusual have the past three or four years been for the economy and financial markets? And what are the prospects of something like a return to normality in 2004?

For equity investors, the most unusual feature of recent years was the unusually long bear market. That came to an end in 2003, the first year the market has risen this century, although some have not yet been prepared to let it go. So one question is whether the equity market upturn is sustainable and another is where it might end up.

For economic policy-watchers, something rather strange has been happening to monetary policy. Central banks have been applying a degree of monetary stimulus that not so long ago would have been regarded as irresponsible. All the major central banks have presided over the lowest interest rates since the 1950s.

Not only that but governments have also felt it necessary to boost their economies by fiscal means. Allowing budget deficits to rise during a period of slower economic growth is known by economists as allowing the “automatic stabilisers” to operate. In many cases, led by America, governments have gone further by cutting taxes and boosting government spending.

What kind of economy have we had? The world has been through a recession, although it was relatively mild (in spite of September 11 2001 and the war with Iraq) and it is starting to fade rapidly in the memory, at least in the case of America, first into the downturn and first out of it. At time of writing the latest US growth figures were those for the third quarter, and they were spectacular – an annualised rate of 8.2%.

Britain endured a period of slower growth but, unusually, no recession. Again, there is now firm evidence of stronger growth – the 0.7% rise in GDP in the third quarter (not annualised) was at or slightly above trend. The euro area is also easing itself into stronger growth, albeit in a recovery that appears dependent on exports rather than domestic demand.

The world recession and its aftermath coincided with a reappraisal of the balance of global economic power. While Japan has finally shrugged of its prolonged period of stagnation, the performances of China and India have really captured the eye. In a way that was not apparent even a couple of years ago, these are now seen as the emerging economic giants.

If that is where were have been, where are we headed? Let me make a few predictions. First, the markets. The recovery in equity markets is in my view real and has further to go. Last year I predicted a 20% rise for equities. This year I think we will see between 10% and 15%, on the back of stronger economic growth and rising profits, and I don’t think the recovery will end there. Bond market prospects are less bright, for reasons I’ll explain in a moment.

Second, monetary policy. The Bank of England led the way among the big central banks by raising rates from 3.5% to 3.75% in November. The Bank’s monetary policy is engaged in the task of returning rates to normal or “neutral” levels of 4.5% to 5%. We should reach the lower end of that range by the end of the year. What about other central banks? The European Central Bank is constrained by slow growth, the Federal Reserve by the presidential election (although it would never admit as much), the Bank of Japan by fears of renewed stagnation, although inflation has just turned positive again.

Even so, I would expect all to either have moved to tighten monetary policy – raise interest rates – by the end of the year, or at least signalled their intention of doing so.

Third, governments will talk about maintaining fiscal responsibility but are unlikely to do much about it. Elections and austerity do not make compatible bedfellows, In America George W Bush is unlikely to raise taxes or rein back government spending in an election year. Indeed, the opposite is more likely to be true. In Britain an election is also looming, probably in the summer of 2005. Taxes will surely rise after that but Gordon Brown will move heaven and earth to avoid doing so beforehand.

In Europe, where France and Germany have managed to avoid sanctions under the terms of the stability and growth pact by getting it suspended, neither country is about to submit voluntarily to tax hikes or spending cuts. Germany, in fact, has just introduced income tax cuts. What this means, in summary, is that 2004 will not be year of fiscal retrenchment. That won’t come until 2005 at the earliest, implying additional pressure on monetary policy (higher interest rates than would otherwise be the case) and a relatively poor outlook for bond markets.

Fourth, the economic outlook. The White House has thrown everything at ensuring a strong election-year economy, and America will be the growth-leader among leading economies, with perhaps a 4% to 5% growth rate. Britain should manage 3%, Japan something similar. Euroland will do well to grow by 2% but overall this is a return to something like normal growth among the G7 economies. But I still think we will be looking in wonderment at China and India.

What could get in the way of this return to normality? Terrorism is the usual reason, though that is a little glib. We have got used to living with a certain level of terrorism. It is a question of degree.

Closer to home, although this also applies to America, some fear a day of reckoning arising from high house prices and record levels of household debt. I don’t but I would concede that it would be hard for Britain to enjoy a normal recovery alongside tumbling house prices. I think the Bank of England can steer the housing market towards a soft landing. Let’s hope I’m right.

From Professional Investor, February 2004

Monday, January 05, 2004
Brown's gamble on growth
Posted by David Smith at 09:06 PM
Category: David Smith' s magazine articles

The start of the year is always a time to take stock, for chancellors as well as managers. Now that Gordon Brown’s set-piece economic events are drifting later into the year, his most recent effort, the pre-budget report (PBR), provides a useful framework for looking forward.

Not so long ago budgets were always in March, while the PBR (or autumn statement that preceded it) tended to be in early November. This year, Brown’s budget was in April, ostensibly delayed by the war with Iraq (but also by the government’s internal squabbles over the euro). The PBR did not appear until December 10, well into the Christmas party season.

So what did it tell us, looking back on 2003 and forward into 2004? It told us that it was by no means a bad year for the UK economy, with growth estimated at 2.1%, in line with the chancellor’s April forecast (of 2% to 2.5% growth).

Armed with this knowledge, Brown felt emboldened enough to stick with his 3% to 3.5% forecast for 2004, with the same rate of expansion projected for 2005.

2003 was not a great year for manufacturing, growing by only a quarter of a percentage point, according to the Treasury’s estimates. Business investment hardly fared better, up only 0.75%. Both are predicted to do rather better in 2004, with growth rates of 2% (for manufacturing) and 3% to 3.5% for business investment, forecast.

Only certain people look at, or for that matter take seriously, official economic forecasts. What everybody looks at, or should do, is the amount the government borrows. This was the great fat cuckoo sitting in Brown’s nest. The chancellor was desperate to tell us how well the economy had done under his management – the longest period of economic growth since 1870, low and stable inflation since the early 1990s – all true and commendable (even if the run started under the Tories).

But when that same chancellor has to tell us he is borrowing £37 billion this year, and expects to borrow £31 billion next year, the record starts to look more than a little tarnished.

Brown’s justifications were, firstly, that his fiscal rules will still be met over the medium-term and, secondly, that every country is borrowing heavily. So, while Britain’s budget deficit is 3.3% of gross domestic product this year, France and Germany are borrowing 4.2%, America 4.9% and Japan 7.4%. Next year, borrowing in all these countries stays comfortably above 3% of GDP, while Britain’s deficit is projected to drop to 2.6%.

Not everybody, however, is borrowing. Canada has a budget deficit of 1% of GDP and falling, while Italy, usually thought of as fiscally flaky, is staying below 3%.

Will it all come right? The interesting thing this year was that borrowing came out well above target – two years ago Brown was forecasting just a £10 billion deficit for 2003-4 – even though growth was on track. The great danger, as independent economists have warned, is that funding big increases in public spending is dependent on wildly optimistic forecasts for growth and tax revenues.

What else did we learn on December 10? New financial vehicles, real estate investment trusts, will be launched to direct funds into private rented housing. The government, responding to the Barker review, will try to lean on local authorities to ease the planning constraints for new housing. It will also try to lean on the mortgage lenders to direct their customers away from short-term discounted deals and towards long-term fixed rate loans.

We also discovered that the Treasury wants to push ahead with its planned pension reform, including the controversial £1.4m lifetime cap on the size of individual funds eligible for tax relief. But just to make sure it has asked the National Audit Office to check its calculations that only 5,000 people will be adversely affected immediately, and 1,000 a year thereafter.

There were some bits and pieces for business, including a widening of the scope of the R & D tax credit, 40% capital allowances for small manufacturers and an apparent “bonfire of controls” with 147 separate bits of red tape to be scrapped. But new red tape was also introduced including, for larger companies, new transfer-pricing rules. Employer training pilots will be extended while North Sea companies can benefit from more generous exploration reliefs.

The key point, though, is that we are already into the electoral game. Brown’s “giveaways” – questionable for a chancellor already borrowing so much – consisted of nearly £900m for childcare and more than £400m to head off big council tax increases come April. That, and heading off any big tax hikes until after the election, was the purpose of the PBR.

Did it add up to a coherent strategy to improve the economy and raise competitiveness? No, but the lesson in these matters is never to expect too much. An election is not too far away and budgets, or PBRs, are as much about politics as economics.

From Industry magazine, January 2004

Tuesday, December 09, 2003
What price free trade?
Posted by David Smith at 08:51 PM
Category: David Smith' s magazine articles

When George Bush experienced the pomp and the protests (although he didn’t see many of those) on his three-day state visit to Britain in November, the hope was that he would also offer Tony Blair a concession on trade.

The hated steel tariff was in place at the start of the president’s visit, however, and it remained in place at the end of it. As you read this, Washington has moved to amend it under the threat of a retaliatory response from Europe, authorised under World Trade Organisation rules.

But nobody should believe that this would mean America had seen the error of her protectionist ways. It is extraordinary that a president at the head of a supposedly free trade administration resorted to protectionist measures, not just in steel but in agriculture. Even more extraordinary is the fact that this has occurred in spite of the tariff being demonstrably ineffective. It has failed to protect the uncompetitive parts of America’s steel industry. And it has meant higher prices for the big steel users, such as the Detroit car giants.

Protectionism has been shown to have the impact the textbooks would predict – a net loss for the economy introducing it, in this case the United States.

It gets worse. When Bush was enjoying his stay in Buckingham Palace his government, far from reining back on protectionism, was increasing it. On November 18 Don Evans, Bush’s commerce secretary, announced that the US Committee for the Implementation of Textile Agreements (CITA) had agreed to impose quotas on imports from China of knit fabrics, brassieres, dressing gowns and robes. What were quickly dubbed the “Bra wars” had begun.

The imposition of quotas on Chinese textiles differs in important respects from the steel tariff. While the steel tariff was unilateral and clearly against WTO rules, those on Chinese textiles were allowed under the conditions of China’s accession to the trade organisation, which takes effect on January 1 2005.

Under those terms, America was allowed to impose annual quotas for up to three years if it believed Chinese imports were hurting its own domestic textile manufacturers. Having decided that the exponential rise in imports (up more than 100% on a year ago) was indeed doing that, the new restriction will limit growth to just 7.5% over the next year.

The fact that America believes it is playing by the rules in the case of Chinese textiles does not help too much in limiting the damage. For China, which provides a sixth of US clothing imports, Washington’s action amounted to the first shot in a trade war. Two days later, China announced it was imposing restrictions on certain imports from America, ostensibly in response to the earlier steel tariff. China has pointed out that the US action did not conform to its interpretation of the transitional arrangements for its membership of the WTO.

The Bush administration’s action is blatantly political. Alabama, Georgia, North Carolina, South Carolina and Virginia, won narrowly by the president in the November 2000 presidential election, are all textile-producing states. Textile employment has dropped by 33% in the past seven years. North Carolina has seen a drop of nearly 80,000 in the number of textile workers. When Levi’s announces it will no longer be manufacturing in America, you know this is an industry in deep difficulty.

Ohio and West Virginia, which also went narrowly to Bush, are steel-producing states. Then there are the steel-producing states the president would like to win in November 2004, such as Pennsylvania.

The trouble is the outbreak of protectionism we are seeing in America is not narrowly political. Both Republicans and Democrats seem too ready to resort to protectionism in order to prevent job losses in industry – factory jobs have fallen in every single month Bush has been at the White House - and keep the powerful manufacturing lobby happy. Free trade is not a popular campaigning slogan in America these days.

The trouble is too that many in America also see an economic argument in favour of trade barriers. America has a huge trade deficit, around $600 billion, $120 billion of it with China. Even if the dollar falls a lot further, the argument goes, it cannot fall far enough to offset the huge cost disadvantage of American textile producers vis-à-vis China.

This is where it could get very worrying. We have already seen a stalling of progress towards further liberalisation of global trade, with September’s inconclusive break-up of talks in Cancun, Mexico. If this is combined with the new protectionist attitudes now being seen in America, the prospects start to look quite grim.

Those who argue for protectionism in American are trying to stop the economic clock. Part of the process of world economic development is the current “offshoring” of jobs to economies like China and India. Attempting to stop that progress is a bit like the approach Canute had when he thought he could stop the tide coming in. America should be concentrating on developing new industries, not propping up dying old ones. As long as US politicians believe the latter is the best policy, there will be a big cloud hanging over trade.

From Industry magazine, December 2003

Friday, December 05, 2003
The return of the golden 1990s?
Posted by David Smith at 10:21 PM
Category: David Smith' s magazine articles

For stock market investors, the 1990s now seems like a very distant golden age. Share prices trebled on average during that glorious decade, and by many times that for some sectors and shares. The end of the Cold War appeared to have given way to an impressive exercise of economic power by the capitalist system.

With the ideological conflict behind us in the 1990s, it seemed there was only unfettered economic growth ahead. Technology, unleashed to its full potential in both consumer and business applications, opened up limitless possibilities. The new economy was appropriately named.

Not everybody got caught up with it, of course. When the Wall Street economists came over to Britain with their stories of an American economy that could grow indefinitely at a 4.5% or 5% rate, we questioned it. No advanced economy, particularly a lumbering giant like America, can transform itself in that way. The United States, to listen to some of the stories, had been magically altered from an economy with a problem of low productivity growth to one where nothing could hold it back.

The same was true, of course, of the stock market. Many doubted the rise, pointing to its obvious bubble characteristics. Few got much credit for doing so. The smart fund managers were those who rode the market boom but turned defensive in time to avoid the full consequences of the bust.

It seems, as I say, like a different era. It is worth remembering, however, that there are plenty of similarities between then and now. The long boom of the 1990s started in 1991-2, immediately after the first Gulf war, helped by a drop in world oil prices. We have just had, of course, the second Gulf war, and while oil prices have not tumbled as hoped – partly because of supply problems in war-torn Iraq – most analysts expect that to happen after the winter.

There is a president in the White House who is worried about whether the economic recovery will be strong enough to get him re-elected. George W. Bush knows all about that. His father faced exactly the same problem in 1991-2 and lost to Bill “It’s the economy – stupid” Clinton.

Bush junior’s problem is the same as his father’s. All the statistics say the US economy is recovering but voters do not believe it. That is because it is a “jobless” recovery, one which is not impacting on unemployment. In the early 1990s, when the American news magazines ran cover features on corporate downsizing and the absence of new jobs, the problem was exactly the same.

In Britain there were parallels too. A government that had prided itself on tight control of the public finances suddenly found that it was forced to borrow massively. Then it was the Tories. Now it is Labour. The credibility problems are the same. Tony Blair has not yet reached the end of the road, as Margaret Thatcher did at the end of 1990, but he has started to look frayed around the edges.

The point is that nobody was very optimistic then. Inflation was still a problem, particularly in Britain. Unemployment came within a whisker of 3m. In Europe, German unification had provided a short-lived boom but a hangover was on the way.

How did gloom give way to boom? One was the fairly rapid realisation that the so-called jobless recovery was merely a manifestation of the normal lags between an economic upturn and a fall in unemployment. Another was the disappearance of low inflation as a problem for policymakers, enabling monetary policy (low interest rates) to be highly accommodative when it came to growth. Even in the 1980s there was a perception that inflation was merely dormant, and waiting to surprise you, as it in fact did.

Another notable element of policy was the deliberate decision by governments to cut back budget deficits. This was the most important element of Clintonomics, and brave for a Democrat president. In Britain the Conservative government set about slashing the budget deficit it had created, a task continued after the 1997 election by Gordon Brown. In Europe, countries cut their budget deficits to meet the Maastricht criteria for monetary union.

Significantly, the only major country that increased its budget deficits substantially during the 1990s, Japan, suffered economic stagnation.

So can history repeat itself? In many ways the prospects are brighter now than they were a decade ago. Inflation is not a worry. The main concern for central banks is steering clear of deflation, although the risks there appear to be diminishing.

The productivity gains of the 1990s, particularly in America, were not a mirage. While some of the claims made then were overdone it does seem that, partly as a result of new technology, the United States is leading the global economy into an era of stronger productivity growth, which will feed directly into rising living standards and increases in corporate profitability.

Britain is in an unusual position going into a global upturn having missed out on recession (with not a single quarter of negative growth since 1992). The contrast with the bruised and battered economy of the early 1990s could barely be greater.

To be optimistic about the global economy does not mean share prices will treble by 2010. The gains of the 1990s did owe quite a lot to special factors, including the then unexpected conquering of inflation. But the kind of economic environment I expect does not sit easily alongside the idea of stagnant stock markets. Share prices will be a lot higher at the end of the decade than they are now.

What could governments do to help this recovery process along? One thing is to learn the lesson of the 1990s. Aggressive cuts in budget deficits were, contrary to the advice of some economists, hugely beneficial for growth. The current concern, described here last month, is that governments seem content to allow deficits to grow. They should study the evidence of the golden 1990s and think again.

From Professional Investor, December 2003-January 2004

Wednesday, November 05, 2003
Whatever happened to fiscal prudence?
Posted by David Smith at 09:40 PM
Category: David Smith' s magazine articles

In Britain Gordon Brown is preparing to deliver his pre-budget report, in which he will acknowledge that government borrowing is coming in significantly higher than he predicted. In America, George Bush is heading for a $500 billion budget deficit – nearly 5% of gross domestic product – and has asked Congress for another $87 billion to fight terrorism and make Iraq safe. He may need more for both purposes.

Europe may have had its differences with America on Iraq but it is at one when it comes to government borrowing. Both France and Germany have signalled that they will break the 3% limit for government borrowing in 2004, thus cocking a snook at the euro stability and growth pact. The only difference between the two countries is that German is breaking the borrowing limit with regret, while France appears almost gleeful about doing so.

Across the world in Japan, the government has been borrowing heavily for years, to finance a series of fiscal packages aimed – without much success – at boosting the economy. The result has been rising government debt and a big budget deficit.

Big borrowing by governments, it seems, is back in fashion. Not so long ago politicians stressed the importance of fiscal prudence. Now they are wallowing in ever-increasing amounts of borrowing. No wonder bond markets have been displaying nerves.

To be fair, the decision to borrow more was not a collective decision by G7 (Group of Seven) finance ministers. In the case of Japan it goes back years. Once the bubble economy had burst in the early 1990s, the classic Keynesian solution of introducing public works programmes to generate jobs and growth seemed the obvious one.

What the Japanese authorities had not reckoned on was the response of their own consumers. Japanese households, rather than warming to their government’s fiscal boosts, instead were alarmed by what it might mean for their future tax bills and so saved rather than spent, nullifying the effect.

Economists call this effect Ricardian equivalence, after the great English economist David Ricardo. It took successive Japanese finance ministers several years to work this out, by which time deficits and debt were sky-high.

For France and Germany, borrowing is more recent. Both countries entered the euro with their public finances in good shape. The Maastricht treaty required budget deficits to be below 3% of gross domestic product to qualify for euro membership and most European economies over-achieved on that. Their expectation, however, was that once the euro was up and running they could relax a bit. The single currency would generate economic growth, and this would help the public finances.

Instead “euroland” has found itself stuck in slow growth and high unemployment, and we know from past British experience that government borrowing soars in such circumstances. Even such a determined deficit-cutter as Margaret Thatcher found herself borrowing huge amounts when the UK economy was so affected.

When it comes to George Bush and America, he took the decision early on that budget surpluses were for wimps. Having inherited a situation from Bill Clinton in which surpluses were stretching out into the indefinite future, the president immediately embarked on a programme of aggressive tax cuts. America’s 2001 recession came when the stock market bubble burst, with predictable consequences for the public finances.

The unpredictable event, of course, was September 11 2001. After that nobody questioned Bush’s strategy of spending public money to rebuild the damaged parts of New York and Washington and to beef up homeland security. Few questioned the war with Afghanistan, or for that matter Iraq (although many more do so now).

In the 1980s, under Ronald Reagan, America had the famous twin deficits – on the budget and current account of about $200 billion each – and under the second George Bush they are back with a vengeance. Except that, in both cases, the deficits are a lot bigger. With the budget deficit heading for $500 billion, the current account will be more than $600 billion in the red. Actually, America has a triple deficit problem. Household and corporate borrowing means America’s private sector, as well as its public sector, is in deficit. More than ever, it relies on the rest of the world as a source of funds.

There is no prospect of this changing, at least this side of next year’s presidential election. Indeed, if securing a Bush re-election means a government borrowing binge, the attitude seems to be that this will be a price worth paying. The mess can be cleaned up later.

Which brings us to Britain. Gordon Brown did not want to be a borrowing chancellor but he is. This year, according to independent forecasters, borrowing will be £31 billion, next year £34 billion - £4 billion and £10 billion above the Treasury’s forecasts. Over the next few years, forecasters say, the chancellor will have to face up to the fact that his fiscal rules are not going to be met. That will mean higher taxes or, as we are seeing from the noises coming from the Treasury, a determined effort to rein back public spending.

There was always something inevitable about the position Brown would find himself in. For his first two or three years at the Treasury he kept the tightest of grips on public spending – coming in even below the Conservative targets he inherited – and stealthily raised taxes.

Then, on the assumption that the public finances had been restored to health, he announced a big relaxation of spending, led by record increases for the National Health Service. Under Labour NHS spending was to double in real terms. Nor was the extra spending a flash in the pan. In the case of health, commitments were made to raise it by 7% annually right through to 2007-8. That was a huge pledge.

Once the taps were turned on, however, the revenues needed to pay for it started to fade. This was partly for cyclical reasons but also probably for structural reasons. The chancellor based his spending increases on a false promise as far as revenues were concerned.

And now he is left having to justify large budget deficits and promising that they will come down as the economy recovers. His reputation for fiscal prudence is tarnished. But at least he’s in good company.

From Professional Investor, November 2003

Sunday, October 12, 2003
A borrowing binge by governments
Posted by David Smith at 09:58 PM
Category: David Smith' s magazine articles

What was the common theme from finance ministers and national leaders just a few years ago? It was that the road to economic success ran via fiscal prudence. Control budget deficits, we were told, and you convince people you are serious about keeping a lid on inflation, allowing interest rates, both short and long-term, to fall.

Lower interest rates on government bonds, even better when accompanied by budget surpluses, have the desirable effect of reducing debt interest payments. Instead of public money going on servicing the national debt, it can be used for higher spending on health and education. As virtuous circles go, it did not get much better.

And there was no sign, certainly during the 1990s, that fiscal prudence had any adverse impact on economic growth. The opposite, in fact, seemed to be true. The more that governments put their budget house in order, the more this appeared to release the animal spirits of the private sector to generate powerful economic momentum.

Things have changed. The same people who preached the virtues of fiscal prudence a few years ago are now arguing the case for temporary imprudence. In Britain, Gordon Brown budgeted for government borrowing of £27 billion this year, just over 2.5% of gross domestic product, falling to £24 billion next year.

Those figures were high, spectacularly so when set against the chancellor’s early prudence, but the outturn is likely to be significantly higher. So far this year, official figures show borrowing running at a £40 billion rate. Even allowing for some improvement in later months from somewhat stronger economic growth, the deficit is unlikely to come in much below £35 billion – comfortably over 3% of GDP – with something similar next year.

In Europe, budget deficits for the euro economies are supposed to be constrained by the stability and growth pact (SGP), under which governments face fines if they do not keep their borrowing below 3% of GDP. But the pact, insisted on by Germany ahead of the euro’s launch to keep other countries in line, is being flouted by the single currency’s two biggest economies.

In September France and Germany launched a 10-point infrastructure plan, designed to boost the euro economies over the longer-term through the traditional remedy of public works. They also said they will stick to their plans to cut taxes, in spite of the fact this will guarantee their budget deficits stay over 3% of GDP in 2004.

America under George Bush, meanwhile, is proving that political labels do not mean much when it comes to the public finances. When the Republicans took over in the White House, the budgetary position they inherited from Bill Clinton’s Democrats was healthy. Three years on, after tax cuts, 9/11, and a big programme of public spending – including the cost of Iraq – it is anything but. The budget deficit is heading for $600 billion, 6% of GDP, and even the US upturn now under way will not bring it down much.

Japan, for the record, is another big borrower, the result of a series of failed fiscal packages during its decade of economic stagnation. Its budget deficit, 7.5% of GDP, is the biggest of the lot in relative terms.

Politicians, of course, have an excuse for this. The rise in budget deficits is, they say, a reflection of what economists call the “automatic stabilisers” at work. When growth slows public spending naturally goes up, for example on the unemployed, while tax revenues weaken. It would not make sense to try to prevent that by raising taxes or cutting spending.

Unfortunately that only goes part of the way to explaining the deterioration in the public finances. The International Monetary Fund calculates so-called “structural” budget deficits, in other words excluding the effects of the economic cycle. It estimates that for this year Britain’s structural deficit is 2.1% of GDP and set to rise further as the government’s public spending increases come through. For France the structural deficit is 2.7% of GDP, Germany 2.3%, America a massive 5.1% and Japan an even bigger 6.7%.

What that tells us is that these deficits will remain even as the global economy recovers. One clear consequence of this is that, unlike in the 1990s when the public sector stood aside, now it will hamper the private sector. This “crowding out” will occur partly through higher bond yields, which is already happening. And, to the extent it is associated with aggressive increases in public spending, an expansion of public sector jobs makes it more difficult, in a tight job market, for the private sector to recruit.

Longer-term, of course, the private sector will have to pick up the bill. Governments can reduce budget deficits either by cutting back their spending, and there will be some of that. But there will also, inevitably, be tax hikes. And business is only too aware of where they are likely to fall.

From Industry magazine, October 2003

Sunday, October 05, 2003
Moving the inflation goalposts
Posted by David Smith at 09:35 PM
Category: David Smith' s magazine articles

In November, if he sticks to his planned timetable, Gordon Brown will introduce the biggest change in monetary policy since the Bank of England was given independence – control over interest rates – in May 1997.

Since that time, indeed for five years before that, monetary policy in Britain has been geared towards a simple aim, that of keeping a well-known measure of inflation, the retail prices index excluding mortgage interest payments, within strict bounds.

Prior to independence, the policy was to keep RPIX, as it is called, within a 1% to 4% range, although the then Conservative government also pledged to have inflation running at 2.5% or below by the time of the 1997 election.

After independence, the target became simpler, an uncomplicated 2.5%, to be achieved at all times. There was, however, an implicit range in the target set for the newly independent Bank. If inflation dropped below 1.5% or rose above 3.5% the governor would be required to write a public letter of explanation to the chancellor.

The intention was not only to keep the Bank on its toes, and prevent inflation drifting too far away from target, it was also to underline that the approach to policy was strictly symmetrical. It would be just as bad, in other words, to undershoot the target too much as it would be to overshoot. The purpose of this, in turn, was to reassure those worried that an independent central bank, left to its own devices, would overachieve in terms of getting inflation down, perhaps thus threatening economic growth.

Symmetry will continue to be the watchword when Brown makes his change in his November pre-budget report. It will, however, be based on a different target. Out will go RPIX, which in one form or another has provided the basis for measuring inflation in Britain for most of the past century. In will come the “harmonised” index of consumer prices (HICP), which is very much the new kid on the block.

The HICP, as the “harmonised” part of its name implies, is intended to provide a measure of inflation that is comparable across countries, in this case the countries of the European Union. Whereas RPIX is designed and produced by Britain’s official statistics body, the Office for National Statistics, what goes into the HICP, and how it is calculated, is the responsibility of Eurostat, the EU’s statistical agency.

The express purpose of the chancellor’s change, indeed, is to bring Britain more into line with Europe. He announced he would change the target on June 9, when presenting the Treasury’s verdict that Britain was not yet ready for euro membership but would be working to make itself ready. The likely inflation target on the new measure, 2%, will be identical to that used by the European Central Bank in Frankfurt. The only difference, to return to the symmetry point, is that there will be a “letter-writing” range for the Bank governor based on the new target, probably 1% to 3%.

Changing from one measure to another may sound like a matter of statistical detail, and one strictly for the aficionados. It is, however, quite important and poses challenges that have made the Bank’s new governor, Mervyn King, more than a little uneasy.

First, when the change comes the inflation picture will change abruptly. At present RPIX, rising by nearly 3%, is above target. But HICP, which shows an inflation rate of just over 1%, is well below its likely target. The difference in inflation shown by the two measures, in fact, is at a near-record level, hardly the best time to make the change. The Bank fears people will think the inflation goalposts have been moved, so achieving the target suddenly becomes very easy. While the old target implies that the Bank should be thinking of raising rates, the new one appears to suggest cuts should be on the agenda.

Second, HICP is notable for what it leaves out of the inflation measurement. There is a big debate in statistical circles about whether house prices should be included in an inflation measure. Some argue that rising house prices are more important for their impact on household wealth than living costs. We do not include share prices in RPIX, so why house prices?

The fact is, however, that house prices have been part of RPIX, though what is called the housing depreciation component, and given their importance in the UK economy, it has been a good thing that they are. Without the housing element, inflation and by implication interest rates would have been lower. The dangers of housing boom and bust would have been greater.

HICP, for good or bad, does not include house prices. Eurostat is examining whether it should do so. Most EU countries, however, have very poorly developed measures of housing inflation, making a change any time soon highly unlikely. The result, the Bank fears, is that it will be flying blind as far as the housing market is concerned. HICP inflation could be very low, requiring the Bank to cut interest rates, even when house prices were rising at, say, 20% or 30%.

Finally, the shift to HICP will move the Bank away from the inflation measure used widely across the economy. RPIX (or just plain RPI) is used to uprate pensions and welfare benefits, and across a wide-range of index-linked financial products. It is the starting point for wage negotiations, understood and trusted by employers and trade unions alike. It has retained the trust of people even when other statistical measures produced by the government, for example the unemployment figures, have lost it.

The HICP is unknown and will be regarded with suspicion. The unions will see it as an attempt to artificially foist a lower inflation rate on the country, squeezing the pay increases of their members. For the Bank, which has been trying to educate the public on RPIX and the importance of low inflation, it will be back to square one.

Moving the goalposts is never a good idea. The chancellor is likely to find that the crowd does not like it one bit.

From Professional Investor, October 2003

Wednesday, October 01, 2003
Gordon Brown confronts his borrowing problem
Posted by David Smith at 09:26 PM
Category: David Smith' s magazine articles

Almost a year ago, in November 2002, Gordon Brown experienced the worst time, and the worst headlines, since becoming chancellor of the exchequer in May 1997. After five years in which the iron chancellor had kept a vice-like grip on the public finances, the autumn of 2002 saw a big change.

Until then, Brown had always managed to come in even below his own tight forecasts for borrowing. The public finances, were often in surplus and debt being repaid, even without such helpful windfalls as the £22.5 billion auction of third generation mobile phone licences.

The chancellor and his Treasury team wore their prudence with pride. This was a different kind of Labour government, one that made room for extra spending in priority areas but only after sorting out the books first. Previous Labour administrations had spent first and picked up the pieces later. Under Brown, prudence produced a win-win situation. Reducing government debt, for one thing, cut debt interest payments, and the money could instead be channelled into health and education.

So when, in his pre-budget report, the chancellor unveiled big increases in government borrowing - £20 billion for 2002-3 and £24.5 billion for 2003-4 – it was a highly significant event. For both years the new borrowing projections were about twice what the chancellor had forecast the previous spring.

The indignities were many. On the day after the pre-budget report the headlines read “Goodbye Prudence” and the commentators asked whether this Labour chancellor was going the way of his predecessors. His early prudence may have delayed the consequences of tax and spend (particularly spend) but they were now coming through with a vengeance. Brown was prepared for a poor reception but still winced at the blows.

The Treasury, of course, denied any loss of control over the public finances. The world economy was emerging only slowly from recession and in every country the public finances were coming under pressure. But it made no sense at all to try to tighten fiscal policy by cutting spending or raising taxes further during a period of economic weakness (less pronounced in Britain than in other countries). The “new prudence” was to allow the automatic stabilisers to operate by borrowing more at a time of below-trend growth.

Brown and his advisers also insisted that there was no question of the government failing to meet its fiscal rules – the “golden” rule of borrowing over the economic cycle only to fund investment, and the sustainable investment rule, of keeping government debt below 40% of gross domestic product.

There was even a hint that the borrowing forecasts may have been deliberately over-egged. £20 billion was more than independent forecasters had been predicting at the time and the chancellor had a history of coming in on the right side of his fiscal numbers.

A year on, and the latter point can safely be laid to rest. Borrowing in 2002-3 was £22.2 billion, and thus above the £20 billion forecast, and there was worse to come. In his April budget this year, the chancellor was forced to revise up his 2003-4 borrowing projection up to £27 billion, followed by a slight drop to £24 billion in 2004-5.

Now, as Brown prepares to step up to the plate to deliver his 2003 pre-budget report, he faces an unpalatable choice. He could stick to the borrowing projections he made in April, in which case nobody would believe him. Or he could revise them up again, and accept another batch of humiliating headlines. The only comfort is that this being economics, the law of diminishing returns probably applies. This year’s headlines, in other words, will not be quite as bad as last year’s.

The chancellor’s problem is that the numbers are going against him. With figures in for nearly half of the 2003-4 fiscal year, tax revenues are running below the Treasury’s forecasts, while government spending is coming through much faster. Current spending by government is up 9 per cent, the Institute for Fiscal Studies says, against a projected 6.5 per cent. Capital spending is up by a massive 175 per cent, which could be great news for the infrastructure but does not help a chancellor watching his budget deficit grow wider by the day.

Independent economists surveyed by the Treasury expect, on average, borrowing of £31 billion this year, 2003-4, and £34 billion next - £4 billion and £10 billion above the Treasury’s projections. More worryingly, unlike the Treasury, they do not expect borrowing to come down from that £30-40 billion level in subsequent years. The National Institute of Economic and Social Research says Brown has only a 50-50 chance of achieving his golden rule. Since that rule has been presented as sacrosanct, the potential for further serious damage to the chancellor’s reputation is large.

The borrowing problem has three sources. The economy, while avoiding recession, has been growing below trend, and this has naturally pushed up borrowing. With optimism increasing, that factor should diminish in importance.

Second, tax revenues have been weak, even in relation to the sub-trend growth. Corporate tax revenues, in particular, have been well below what the Treasury expected. The danger here is a repeat of the first half of the 1990s, when for several years economic recovery did not produce the revenue boost the then Conservative government was relying on.

Third, public spending appears to be obeying the old rule that once let off the leash it becomes impossible to keep under control. It took time on this occasion for spending to get going. Now it has, it looks unstoppable.

The Treasury is trying to act on that. Paul Boateng, the chief secretary, has warned Whitehall departments to expect tough times ahead. Initial sparring has begun for the 2004 comprehensive spending review and he has circulated a letter to cabinet ministers warnings them that from 2005-6 “most departments should assume that they will receive no more than flat real increases in their overall budgets, some departments may receive less.”

Bringing spending back under control will not be easy, and by the time it is plenty more big borrowing numbers will have flowed under the bridge. The chancellor has insisted he will not break his own rules. The alternative course, as businesses will be well aware, will be another round of tax increases. We have not reached that point yet but it may not be too far away.

From Business Voice, October 2003

Wednesday, September 10, 2003
When will the investment upturn come?
Posted by David Smith at 09:52 PM
Category: David Smith' s magazine articles

Just when industry thought that the investment picture could not get any worse, it has. This was the time when many were looking for a recovery in capital expenditure, on the back of a strengthening world economy and, for exporters, a more competitive exchange rate.

Instead, the latest figures were little short of disastrous. Overall business investment dropped in the second quarter to £26.8 billion. This was a drop of 1.1% compared with the first quarter and 3.5% in comparison with a year earlier.

For industry, there was even worse news in the detail. Capital spending by manufacturers dropped by 10.1% during the quarter to £3.3 billion, and was 13.3% lower than a year earlier. From its recent peak of £4.5 billion in the first quarter of 2001, manufacturing investment is down by 25%.

Not only was the latest quarterly fall the biggest on record for the sector but, according to the Engineering Employers’ Federation, manufacturing investment this year is heading for its lowest total, relative to output, since 1970. Martin Temple, its director-general, says that pension shortfalls, higher National Insurance contributions and sharply rising liability insurance bills are squeezing firms hard. On top of this managers lack that vital ingredient for investment, confidence in a global economic upturn.

The weakness of investment, the CBI points out, is bad news for Britain’s future ability to compete. Just when firms should be investing to improve productivity, and thus take advantage of sterling’s lower level against the euro, they are cutting back.

Ian McCafferty, its chief economic adviser, says levels of investment are “worryingly weak”, adding that: “Corporate investment - on which so much of this recovery depends - will continue to constrained by weak global demand, excess capacity, low returns and increased cost burdens such as pension provision.” He sees business investment at best flat between now and the end of next year.

A new paper by the Institute of Directors, “Uncertainty, uncertainty, uncertainty – the outlook for business investment”, takes a similar view on the outlook. There are one or two positive factors in the short-term investment outlook, it says, notably lower prices for IT-related equipment.

But negative factors dominate. They include subdued profit expectations, continued high levels of corporate gearing, a capacity overhang from the investment upswing of the 1990s, pension-fund deficits, global economic weakness and persistent deflation worries, and geopolitical uncertainty. That does not mean investment will not recover. It does mean we should not hold our breath.

Where the IoD takes issue with other business bodies is on the implications of the current investment downturn. It points out that there was what it describes as “an explosion” in business investment in the late 1990s, with a rise of 45% over the 1995-98 period.

Despite the fall of the past 2-3 years, levels of business investment, it points out, are as high relative to gross domestic product as at the peak of the last cycle in the late 1980s. That is not true for manufacturing, clearly, although it does hold for business taken as a whole.

The IoD also suggest we should not be too obsessed about pursuing higher investment for its own sake. Japan has had had a history of high investment but for a decade now has been the least successful of the world’s big economies. Britain has a flexible job market, in contrast to much of the rest of Europe, so somewhat lower capital-intensity – more workers and less equipment – might be justified.

There’s a bit of truth in these arguments but you can only take them so far. France, for example, has 80% more capital for each worker than Britain. Not only that, but while levels of service-sector investment in Britain look adequate, and indeed remain quite buoyant, this does not apply to manufacturing.

Another new report, from the Institute for Public Policy Research, “Manufacturing in the UK”, takes the view that we do indeed need a manufacturing investment boost. “It is not in question that the UK manufacturing sector operates with a significantly lower capital stock than comparable countries and that this materially affects its relative productivity,” it says.

The report argues against boosting investment allowances, although it says the competitiveness of the corporate tax regime should be kept under review, and that specific investment support measures from the government have been poorly designed and monitored.

Its broad conclusion is that manufacturing investment was particularly hard hit by sterling’s strength against the euro. Now that the pound is at a lower level, this, combined with a period of macroeconomic and microeconomic stability, should produce the necessary investment upturn.

It may not happen straight away but, if the analysis is right, it will not be that long in coming. Let us hope so anyway. Otherwise industry’s future would be rather bleak.

From Industry magazine, September 2003

Friday, September 05, 2003
The deflation fear that won't go away
Posted by David Smith at 09:30 PM
Category: David Smith' s magazine articles

It is now some time since financial markets began to contemplate a life beyond inflation, or put another way a world of deflation or falling prices. By now, though, those worries should have gone away.

It is two years, after all, since America succumbed to what was, with hindsight, a very shallow recession. And, while the global economy also met the standard recession definition (2% growth compared with a 4% norm and a virtual standstill in world trade), things were by no means as bad as they could have been.

And yet, in the recovery phase, the deflation doubts remain. The global recovery is certainly not strong enough to produce a revival in inflation. And if we are not careful, it seems, it may be soggy enough to allow deflation to take hold.

The reasons for this are familiar enough. America, while in little danger of a “double-dip” recession is growing at a slower rate than the post-recession norm, or at least the norm that applied until the early 1990s.This recovery, perhaps alarmingly for George Bush junior, is rather similar to the one presided over by his father, with disastrous electoral consequences.

Europe, meanwhile, is stubbornly refusing to play its part in the global recovery. Reluctant euroland consumers and confidence-sapped businesses have pushed growth below 1% this year, with little reason to be much more optimistic about prospects for 2004.

Japan, for once, has been surprising on the upside, with growth coming through a little stronger than expected. Nobody yet believes, however, that the world’s second biggest economy is out of its prolonged depression.

In Britain, for once, the picture is relatively healthy. The economy sailed through the world recession of 2001 and has continued to grow, albeit relatively slowly. No economy is immune to what’s happening elsewhere, though, particularly Britain with a somnolent euroland on its doorstep. Growth in the first quarter, at just 0.1%, was the slowest for 10 years.

The proof of economic weakness, and the associated deflation fear, is in what policymakers have been doing. Central banks have continued to cut, at a time in the cycle when they would normally be thinking of raising rates. Thus, the Federal Reserve under Alan Greenspan has cut to just 1%, and the Bank of England under Mervyn King to only 3.5%. In both cases rates are at their lowest level since the 1950s. The European Central Bank has joined in the act, reducing rates to 2%. The Bank of Japan, with rates already at zero, has had to resort to alternative measures for boosting liquidity in the economy.

So how serious is the deflation risk? In Japan, of course, we have a living example of the phenomenon at work. Consumer prices have been falling for the past 4-5 years; property and share prices since the bursting of the “bubble” economy a decade ago.

One of the most thoughtful contributions on the subject of deflation came a few months ago from Ben Bernanke, the former Princeton professor who is now a Fed governor. He distinguished between price falls in individual sectors, which may be due to productivity gains or other factors, and price falls across the economy – deflation.

As he put it: “Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.

“Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress.” In America during the great depression prices fell by about 10% a year during the 1930-33 period.

Bernanke made several points to justify his view that America was unlikely to succumb to deflation in the modern era. In Japan, as he pointed out, deflation came as a surprise in spite of the bursting of the bubble economy. In contrast, the Fed, like other central banks, is well aware of the danger and has acted to head it off.

He also pointed to the dynamism of the US economy, its flexible nature providing “a remarkable ability to absorb shocks of all kinds, to recover and to grow”. A similar view applies among policymakers in Britain. The Bank of England, for example, sees little risk of deflation. Its inflation forecasts have a negligible probability of it happening over the next two years.

The European Central Bank, it should be said, takes a similar view even though inflation in Germany, Europe’s biggest economy, is under 1% and falling. The common theme among central banks is that they have further room to cut interest rates (although not very much) and that if that is not enough they can resort to unconventional means of boosting liquidity – metaphorically if not literally like Milton Friedman’s helicopter drop of money.

What if they are wrong? Deflation worriers point to the downward pressure on prices resulting from new global capacity, notably in China, like Japan an economy experiencing falling prices. They also point to very low inflation rates worldwide, suggesting it would not take too much to tip many more countries over into deflation.

The difficulty about deflation, of course, is that it is the economic equivalent of a quagmire. Once in it is hard to fight your way out. For all the talk of unconventional measures, if we see US and European interest rates drop to zero we will know we’re in trouble.

There’s another view – there always is among economists. It is that the current obsession with deflation, and the determination to head it off, can only have one result – the return of inflation. Government bond markets picked up a little whiff of that worry earlier in the summer.

More likely, policymakers will just about manage to negotiate a course that avoids deflation without rekindling inflation. Even a few years ago, the idea that we would be worried about the return of 1930s-style falling prices would have seemed fanciful. But deflation is a worry that won’t quickly go away.

From Professional Investor, September 2003

Monday, September 01, 2003
Industry may be getting a productivity bonus
Posted by David Smith at 03:45 PM
Category: David Smith' s magazine articles

Something rather interesting has been happening to Britain’s productivity figures. Data for the early months of this year show that for the economy as a whole, growth in productivity (output per person employed) was an unexceptional 2.3 per cent against a year earlier, marginally weaker than the 2.4 per cent rate recorded at the end of last year.

In manufacturing, however, it was a different story. Productivity growth in the quarter was a very respectable 3.8 per cent compared with a year earlier and appears to be bouncing back quite strongly after a lull.

Before anybody gets too excited, there is an important caveat. There are essentially two types of productivity growth. One is when output is rising faster than employment. That is the healthiest kind.

The other, of course, is when output is stagnant or falling but employment is falling even faster. That is the less desirable kind of productivity growth. It is more or less what happened in the Thatcher “productivity miracle” of the 1980s, and it is what is happening now. Splitting that 3.8 per cent rate of productivity growth into its components shows that it was almost entirely due to falling employment, with virtually none of it explained by rising output.

There are reasons, however, to believe that, come the next upturn, British industry has a reasonable chance of achieving some “good” productivity increases.

The National Institute of Economic and Social Research recently examined the comparative record of industry in Britain and America in investing in new technology – mainly in information and communications technologies (ICT) – and in skilled workers.

A paper, by Mary O’Mahony and Catherine Robinson, found that, while America’s “new economy” boom in ICT investment commanded the headlines, industry in the UK was not very far behind when it came to spending on new technology.

Interestingly, the National Institute also found that important changes had occurred in the composition of the manufacturing workforce, notably through the recruitment of workers with higher ICT skills. Firms had tended to recruit workers at the higher end of the skills range, one reason why skill shortages have persisted even as the sector has been shedding labour overall. The job losses, in other words, have tended to be at the lower end of the skills range.
According to the National Institute paper: “This, coupled with the continuing strong investment in ICT capital, suggests that UK manufacturing was not falling behind competitors such as the US in investment in new technology inputs.”

Or, put another way: “(UK) manufacturers have increased demand for skilled workers throughout the years of the slowdown while continuing to shed labour at the bottom end of the quality range and have invested rapidly in ICT. This pattern is widespread across industries in manufacturing.”

That still begs the question of why industry has not enjoyed “good” productivity growth. One explanation, considered by the researchers, is that Britain’s managers have not been as good as their US counterparts in turning investment in ICT and skilled workers into higher output and productivity.

This cannot be dismissed out of hand. A recent study by Proudfoot Consulting suggested that both American and German managers consistently operated plant closer to capacity than their British counterparts, implying more efficient use of resources.

A more convincing explanation, however, according to the National Institute, is that the benefits of improving the skills mix of the workforce and of ICT investment will show through, but only after a lag. Thus, the potential is there, but it is not yet showing through in the data.

Lags are normal but in the case of Britain’s manufacturing sector, the likelihood is that they have been exacerbated in recent years by the strength of sterling against the euro, which has tended to depress output. On this view, given that sterling has come down to more competitive levels against the euro, there is reason for hope on output and productivity, even if it is not yet showing through in the surveys or data.

What may also be happening is that genuine productivity and output improvements are occurring in areas where investment in ICT and skills has been greatest but this is not showing through in the overall manufacturing data because of weaker performances by those sectors hit hardest by the pound’s earlier strength.

There is another important element to the productivity story, told in a piece of research by Richard Disney, Jonathan Haskel and Ylva Heden, which was published in the July edition of the Economic Journal.

They found that productivity growth is driven by what might be described as a Darwinian “survival of the fittest” approach. Whereas we tend to think of internal restructuring – the adoption of new processes or methods within plants – as the main driver of productivity, their research suggests that external restructuring is, if anything, more important.

External restructuring, which they define as the closure of inefficient plants and their replacement by newer, more efficient ones, accounts for roughly half of labour productivity gains in manufacturing, and an even higher proportion of improvements in capital productivity.

It is happening, it seems, on an extraordinary scale. According to this research, some 25,000 plants close each year, between 18 and 19 per cent of the total, and are replaced by a similar number of new ones. Part of this occurs as a result of company failure, much through rationalisation and restructuring by multi-plant organisations. This huge “entry and exit” traffic shows the extent of this productivity-driven effort. It is, in turn, driven by competitive pressures – the strength of international competition as opposed to the mere strength of the exchange rate. It almost goes without saying that plant closures and openings are at their most intense in sectors exposed to the toughest international competition.

As Professor Stephen Nickell of the Bank of England’s monetary policy committee put it when discussing his own, similar findings, again in the Economic Journal: “Perhaps competition works not by forcing efficiency on individual firms but by letting many flowers bloom and ensuring only the best survive.”

All of which suggests we should be reasonably optimistic about productivity prospects. At the very least, UK firms have been doing many of the right things in their search for higher productivity. And there is a fair chance that they will, in time, be successful.

From Business Voice, September 2003

Friday, August 15, 2003
Will a dose of Thatcherism rescue Germany?
Posted by David Smith at 03:50 PM
Category: David Smith' s magazine articles

Germany, as anybody in industry knows, is a formidable competitor. Legend has it that the first time British manufacturers knew they had a fight on their hands was when they saw the products German firms put on show at the Great Exhibition of 1851.

More recently, Germany has shown that modern economies do not need to turn their back on manufacturing. The German economic miracle was built on industrial exports. Manufacturing remains the backbone of the economy.

Lately, though, Germany has ceased to be a strong competitor in one important sense. In terms of economic performance, Europe’s biggest economy has become its laggard. For the past three years it has suffered from economic stagnation and rising unemployment. The jobless total has already risen above 4.5 million and is tipped to break five million in the coming winter.

This was not how it was supposed to be. Many predicted that the advent of the euro, with other European countries no longer able to devalue their currencies vis-à-vis Germany, would play directly into the hands of German exporters. As it is, for most of the euro’s life the economy has been in and out of recession.

Looking a little further back, the unification of West Germany with the communist German Democratic Republic in 1990 was predicted to foreshadow a time of enormous economic and political strength for Germany. Margaret Thatcher feared it for that reason. Instead, unification is now seen as a huge burden on German taxpayers, and the former GDP, with its relatively high costs, is under pressure from cheaper locations in eastern Europe, in countries like Poland, Hungary and the Czech Republic, which are about to join the EU.

Germany’s troubles go deep. Britain’s long-run, or trend growth rate is reckoned by the Treasury to be 2.75% a year. America is slightly higher. In Germany, however, trend growth is thought to be only 1% annually. That is not only weak growth; it is also insufficient to reduce unemployment. The risk is of a vicious circle, in which higher unemployment interacts with a slow-growing economy. One obvious impact of this is that the country’s budget deficit is more than 3% of gross domestic product, and set to continue that way. The irony of this is that it puts Germany in breach of a euro stability and growth pact that it insisted on. If it goes on much longer Germany could face hefty fines.

In Britain, this combination of circumstances, and in particular the loss of control of interest rates implied by euro membership, would be political dynamite. In Germany they take rather a different approach. Few people speak out against the decision to join the euro. Membership has become an accepted fact.

Instead, the focus has switched to so-called structural reforms and they involve, perhaps surprisingly, a large dose of Thatcherism. From the beginning of next year, for example, income tax rates are to be cut, with the top rate cut from 48.5% to 42%and the starting rate from 19.9% to 15%. Not long ago Germany’s top rate was close to 60%. From January it will be close to that of Britain. These cuts will be paid for, in part, by a scaling back of subsidies, notably those for homeowners.

Cutting taxes is not the only “Thatcherite” move. As part of the so-called Agenda 2010 reform package, the maximum length of time people will be allowed to draw unemployment benefits is to be cut from nearly three years to 12 months. That is not the only labour market change. “Hire and fire” rules are to be made less stringent for smaller firms and for newly-established businesses. The idea is that if it is easier for these firms to get rid of staff they will be keener to hire them. In order to encourage small business creation, Germany’s tight “craft” restrictions, which limit certain trades only to master craftsmen, are to be relaxed.

There are other proposals, some far-reaching. In order to wean people off expensive state provision – Germany has a pressing ageing population problem – a new funded system is being established, and the retirement age will gradually be raised to 67 from 2011. Other proposals aim to cut the taxpayer costs of public services, such as by charging for certain consultations and treatments.

It adds up to quite an impressive first reform step. Will it work? The history of labour market and other reforms is that they take time. Cutting back the power of the unions in Britain, which began in the early 1980s, did not really pay dividends until well into the 1990s. There is a danger, as happened here, that things will get worse before they get better.

The hope in Berlin is that the tax cuts in January will give an immediate boost to the economy, giving it a momentum that will carry it through the reform process. If it doesn’t - and the jury is out - Germany’s woes will be far from over.

From Industry magazine, August 2003

Tuesday, July 15, 2003
King of the Bank
Posted by David Smith at 03:46 PM
Category: David Smith' s magazine articles

After 10 years as Bank of England governor, and more than 40 as a Bank official, Sir Edward (“Eddie”) George retired at the end of June, handing over to Mervyn King, one of his two deputies.

What is the changeover likely to mean for interest rates? And is George, as the first governor of an independent Bank of England, handing over to somebody who will effectively be the last? Membership of the euro, which must be a possibility during King’s governorship, would mark the end of the Bank in its present form.

George served two terms, beginning in the summer of 1993. If you cast your mind back to that time it was a troubled one for the British economy and for monetary policy. The humiliation of Black Wednesday, September 16 1992, was still fresh in the memory. Sterling had been chucked out of the European exchange rate mechanism (ERM) and some of the blame for not defending the pound properly had been laid at the Bank’s door, most notably by its German counterpart, the Bundesbank.

A new monetary framework had been hastily put together by the time George took over, involving an inflation target (then a 1% to 4% range), a quarterly Bank inflation report and regular monthly interest rate meetings between the governor and the chancellor of the exchequer. These became known as the “Ken [Clarke] and Eddie show”, although they started life as meetings between Robin Leigh-Pemberton and Norman Lamont. “Robin and Norman” did not have quite the same ring to it.

These new arrangements were new in 1993 and nobody had too much faith in them. It was only a matter of time, it seemed, before the old inflationary problems reasserted themselves, not least as a result of sterling’s post-ERM dive.

It did not happen. Under George’s watch inflation averaged exactly 2.5%, the current target. Interest rates, with 15% still fresh in the memory when he took over, never rose above 7.5% in his 10 years as governor. The holy grail of monetary policy is to have economic growth exceeding inflation and that, by a small margin, is what was also achieved.

There were, of course, plenty of changes and challenges along the way, including the Barings’ collapse (the interesting thing about which was that it was allowed to fail), and the granting of independence by Gordon Brown to a surprised George in May 1997. There was a lot of tension surrounding that announcement. Brown’s team had made no secret of the fact in opposition that it did not favour retaining George as governor. He contemplated resignation when, soon after gaining the prize of independence, he was told by the chancellor that the Bank’s role of supervising the banking system was to be taken away and given to a new Financial Services Authority.

They overcame that, and most people would say independence has worked very well for the British economy, if not necessarily for manufacturing because of the associated, perhaps coincidental, strength of sterling. At his final Mansion House dinner in June, having not had to write a letter to the chancellor explaining why inflation had missed the target, George handed one over to Brown anyway. It contained just two words – “thank you”.

In six years’ of meetings as chairman of the Bank’s monetary policy committee (MPC), George was never outvoted once. On several occasions he used his casting vote to secure a 5-4 majority against a rate rise favoured by his more hawkish MPC colleagues.

One of those hawks was often King, the new governor. Bank-watchers will be studying the Bank’s discussions and votes very closely in the coming months to see whether the change of governor leads to a more hawkish approach, and thus higher interest rates, than under George. My prediction, at this early stage, is that there won’t be much in it but that King’s appointment, together with other changes in committee membership, will result in marginally higher rates than would otherwise have been the case.

One drum King will be beating is that of rebalancing the economy. He has already spoken of the need for consumer spending to grow at a slower rate in the coming years, and for the producing side of the economy to expand at a more rapid rate, benefiting industry. That means he will be keen the keep sterling at around its present levels against the euro, to the extent that the Bank is able to influence that. It should also mean the gradual disappearance of the two-tier economy.

All that could be wishful thinking. King’s point is that such a rebalancing has to occur at some stage, even if predicting exactly when is difficult. A new era has begun at the Bank, and it promises to be different from the old one.

What about the euro? King has tried to disown some remarks he made a couple of years ago, when he said it would need up to 300 years of data to be sure Britain was ready. The Bank has no interest in signing up but has to try to keep its opinions to itself. My guess is that King will maintain his predecessor’s sceptical tone.

From Industry magazine, July 2003

Saturday, July 05, 2003
The decline of the mighty greenback
Posted by David Smith at 09:24 PM
Category: David Smith' s magazine articles

The expression “roller-coaster ride” is one of the most overused amongst journalists. For once, however, it may be appropriate. If we look at the performance of the dollar over the past few years, it does indeed appear to have given a fair impersonation of the big dipper.

At the start of 1999, when the euro came into being with great fanfare as an electronic and accounting currency, it was worth about $1.17. Many people predicted that the euro would strengthen from that level, as central bank and other portfolios were shifted in favour of the new currency. There was also a hope that the single currency would prove to be the economic elixir that Europe so badly needed.

The euro strengthened, but only for a day or so, and then embarked on a long decline. That was partly a euro story; people soon saw that Europe’s economy was not being transformed and they were unimpressed with the new European Central Bank. But it was mainly a reflection of the dollar’s remarkable strength.

Remember that in 1999 the great bull market was not over. It had, in fact, yet to experience its final, exuberant spurt. Remember too that at that time talk of an American recession seemed fanciful. The “new” US economy, driven forward by IT and other technological innovations, was carrying all before it. The question was not of a normal business cycle; it was whether America would grow at 4% or 5% a year.

So the dollar rose, making a mockery of predictions that the euro would wipe the floor with it. Its climb was a reflection of America’s economic dominance. Japan was in trouble, mired in deflation and bureaucratic indecision. Europe remained economically sclerotic. Investing on Wall Street provided the quickest way into America’s remarkable new economy.

The euro mirrored that rise, dropping through one-for-one parity with the dollar before eventually hitting a low of just 83 US cents - $0.83. The pound, while exhibiting some of its longstanding special relationship with the dollar, and thus not falling as far as the euro, also dropped. Sterling fell from the mid-$1.60s to $1.40.

Then, of course, the new US economy was proved to be not all it had been cracked up to be. It did not insulate Wall Street from a crash, as was in most spectacularly in the case of the Nasdaq, which peaked at more than 5,000 in March 2000 and subsequently plunged to a quarter of its value. And it did not insulate America from recession, which duly arrived in 2001, and predated the September 11 terrorist attacks.

Curiously, not all of this immediately impacted on the dollar, which was still supported by its earlier momentum. By the beginning of 2002, however, when the euro entered its second and final stage as a physical currency, the tide had begun to turn. And, as far as the dollar is concerned, it has continued to ebb away.

Soon, the euro was back through parity against the dollar. This year, the dollar’s slide has accelerated. At time of writing the euro was trading just below $1.20 – higher than at its birth at the beginning of 1999 (and nearly 50% above its lows) – with analysts predicting a climb to $1.30 or $1.40. The pound has retraced its steps back from $1.40 up to the mid-$1.60s and may also have further to go. The mighty greenback is no more.

Why is this? The first and most plausible explanation relates to America’s $500 billion current account deficit. The deficit was building during the dollar’s rise and, indeed, the strong dollar contributed to it by making imports cheaper and US exports uncompetitive. Somehow, though, it did not seem to matter then. The deficit was more than offset by huge capital inflows, as foreign investors bought into the new economy dream. On a simple flow of funds argument, the dollar rose.

Now, however, foreign investors have much less of an appetite for US financial assets. Their fingers were burned by the Nasdaq, and they are concerned that the strong budgetary position George W.Bush inherited from Bill Clinton is no longer there, replaced by deficits stretching out into the indefinite future. On that same flow of funds argument the dollar has lost its visible means of support.

Second, currency dealers have detected an important shift of strategy within the US administration. Following Bush’s reshuffle of his economics team last year, bringing in John Snow as treasury secretary, it not longer seems that America sets much store by the strong dollar policy of the past, despite paying lip service to it. US economic policy is now seen to be driven by the sole aim of achieving strong enough economic growth to secure a Bush election victory next year. If a weak dollar is the consequence, that is seen as a price worth paying.

Third, the diversification out of dollars into euros, predicted in 1999, may finally be happening. Central banks are increasing the proportion of euros in their official holdings. There is talk that the oil producers, partly for political reasons, will switch to euro pricing. The euro has its troubles but as an international reserve currency it may slowly be coming of age.

The decline of the greenback is not costless. While it probably will help the American economy, it promises to do quite a lot of damage in Europe. An already very weak growth prospect among the euroland economies now starts to look even dicier. Eventually, Europe’s economic weakness will pave the way for a dollar revival (assuming Japan also stays weak). That, however, may take a little time. For the moment, the dollar’s fall looks to have further to run.

From Professional Investor, July-August 2003

Tuesday, July 01, 2003
Housing blocks the road to the euro
Posted by David Smith at 03:51 PM
Category: David Smith' s magazine articles

The dust has settled on Gordon Brown’s June 9 “not yet” assessment of Britain’s readiness for euro entry but the questions remain. Can the chancellor possibly conclude by the time of his budget in March or April next year that enough has changed to justify another assessment?

The suspicion has to be not, and that his promise to keep progress towards economic convergence under review for the remainder of this parliament was mainly a concession to the prime minister. But the doubts, and uncertainties, will persist. With a fair wind and a referendum next year, euro entry could take place as early as 2005.

More likely it will take far longer, until 2008 or beyond. Depending on economic and political circumstances both in Britain and the euro zone, it might yet not happen at all. Logically, entry is considerably closer now than it was in 1997. As far as business is concerned, however, it is still a case of planning for an uncertain future.

A big part of that uncertainty relates to the housing market. In his statement Brown said that most of the “stop-go” problems of the British economy over the past 50 years had their roots in housing market instability. For those yearning for early euro entry, it is an enormous source of frustration that the boom-bust tendencies of the housing market, particularly in the south-east, are holding up progress. According to the Treasury’s detailed studies, housing is a “high risk” factor when it comes to joining the single currency.

For everybody else, and for the government, housing is something that needs to be fixed irrespective of its role in the euro decision. If housing volatility has generated overall economic volatility, as it plainly has, a government riding with a “no more boom and bust” pledge, has every incentive to try to permanently damp down housing market fluctuations. For business, having for years seen housing as the main cause of the two-tier economy (strong consumption, weaker production) the need for reform is no less pressing.

According to the Treasury, in its study, ‘Housing, consumption and Emu’, there are two essential differences between Britain’s housing market and those in euroland (although the study also notes that are important differences within euroland). One of those differences, contrary to popular impression, does not relate to levels of owner-occupation. Although the UK’s 70 per cent owner-occupation rate is higher than Germany (just over 40 per cent) and France (55 per cent), it is close to the EU average and below Luxembourg, Belgium, Greece, Ireland and Spain.

Instead, one of the big differences relates to how we buy our houses. In the UK more than 60 per cent of mortgages are variable rate, and thus sensitive to changes in monetary policy. The rest are on short-term fixed rates. This contrasts, say, with Germany, where 80 per cent of mortgages are on long-term fixed rates of more than five years, with the rest on short-term fixes, and France, where 60 per cent are on long-term fixed rates, the remainder short-term. Add in the fact that Britain’s mortgage debt is significantly high than the EU average, at 60 per cent of GDP, and you have a high degree of household sensitivity to interest rates changes.

Politically this is important because, inside the euro, such an important element in household budgets would be decided outside Britain, setting up the risk of a backlash. Economically it matters because the European Central Bank would only play small attention to the UK housing market in setting rates. Even outside the euro, it is undoubtedly the case that if the Bank of England was not constantly worried about sparking a housing boom, or exacerbating one, base rates could have been lower than they have been.

Professor David Miles of Imperial College London, who has been asked by the chancellor to report on the scope for developing a long-term fixed rate mortgage market in Britain, has an important task on his hands. He will provide an interim report for the November pre-budget report and is likely to point out that there are important differences even between countries where such mortgages are the norm.

In Germany, a long-term fixed rate mortgage tends to mean just that – the borrower is normally locked in for the full-term. In America, the long-term mortgage market has given rise to a mortgage-backed bond market and, via the operations of the agencies Fannie Mae and Freddie Mac, such mortgages are seen as having implicit government backing, hence their highly competitive rates. But the long-term in America’s mortgage market does not mean for ever.

In the past few years there has been a re-mortgaging boom, which has helped to sustain consumer spending, as borrowers have switched out of their existing fixes to lower rates. That kind of market might have a lot of appeal in Britain but it would not necessarily make our housing market more like those in Europe.

An even tougher problem relates to housing supply, the subject of a second Treasury investigation by Kate Barker of the Bank of England’s monetary policy committee, and formerly of the CBI. Annual investment in housing has dropped from 6 per cent of GDP 30 years ago to 3 per cent now. Annual new housing completions are running at about 0.7 per cent of the existing housing stock. Put another way, house-building is running at around 160,000 new homes a year, the lowest peacetime level since the 1920s, while housing demand would require new-build of at least 220,000.

Part of the reason for the decline in house-building, of course, has been the sharp scaling-back of the public sector’s role. The fact remains, however, that Britain has had a chronic problem of under-supply, and this has contributed to the fact that over the past 30 years real house price inflation has averaged 3.3 per cent a year, the highest in the EU, compared with 1.2 per cent in France, 0.1 per cent in Germany and Sweden. For those who own it, housing in the UK has been a pretty good investment.

Can under-supply be fixed? Among the things Barker is likely to advise is easing up on planning constraints. Ministers talk of forcing through many more new housing developments against local objections. Politically, that may be easier said than done. Identifying Britain’s housing problem is easier than fixing it.

From Business Voice, July-August 2003

Sunday, June 15, 2003
No euro road map for industry
Posted by David Smith at 03:42 PM
Category: David Smith' s magazine articles

Gordon Brown duly published his “not yet” verdict on euro entry on June 9, as widely expected, and by sounding positive managed to bridge the gap between the pro and anti camps within the government.

Honour was satisfied for the prime minister, because of the chancellor’s pledge to review progress towards convergence with euroland at the time of his next budget in the spring and, if there has been enough movement, hold a further assessment (the third) of his five economic tests.

The Treasury, meanwhile, remains happy because it retains control of the decision. For Brown, the worst outcome this time would have been if Tony Blair had thanked him for his work but said that, in future, any euro decision would be for the cabinet as a whole, with the five tests effectively consigned to the dustbin.

But the tests are still alive, and the chancellor will retain control of them. A future euro decision will depend on the economics being right. It is a neat political deal.

For business, however, it is not nearly as good. Martin Temple, director general of the Engineering Employers’ Federation, spoke for many in industry when he said: “We support the conclusion that the time is not right to propose joining the euro and we welcome the chancellor' s renewed commitment to work for flexibility in the UK and eurozone economies.

“However, the government has failed to remove the potentially damaging speculation surrounding euro entry in this parliament. The economics on which a decision to join are based are so fundamental that it is difficult to envisage how they could be re-addressed in the current parliament. In the meantime, we run the risk of the government being increasingly distracted from its main task of maintaining the growth and stability of the UK economy.”

I share his sense of exasperation. We have had two years of on-off speculation about euro entry during this parliament but at least the June 2003 deadline appeared to offer a deadline, a chance of clarity to last for a time. The result of the assessment, of course, had been common knowledge for some time, which made the wait even more frustrating.

Now for at least the next nine or 10 months, a repeat performance is in prospect. Every speech will be read for signs that the chancellor believes enough progress is being made to have another assessment (which in practice would be a formality – it is hard to see him deciding to hold one and coming up with another negative assessment). Then, if the time is not right at the time of the next budget, perhaps it will be the one after that.

It is, in effect, the rolling assessment that business did not want and the Treasury insisted would never happen. And if the uncertainty undermines the economy, the government will only have itself to blame.

What else did we discover on June 9? We learnt that, in the opinion of the academic experts commissioned by the Treasury, the appropriate entry rate for sterling into the single currency would be about 1.37 euros, not far from the level it is at time of writing.

The chancellor also announced that, in future, the Bank of England will have a new inflation target, based on the so-called harmonised index of consumer prices (HICP), which differs from the retail prices index (RPI) mainly because it excludes housing.

This may look like one for the aficionados but it could have big implications. HICP inflation is currently 1.5%, compared with 3% for the Bank’s current target measure of inflation. Even with a lower target than the current 2.5%, the new measure would imply lower interest rates than we have had. That, indeed, is the point – euro interest rate levels have tended to be below those in Britain.
We also discovered that there are some potentially large trade benefits to be accrued from being part of euroland. The range of estimates is wide, but over the long-run trade with the euro economies could be boosted by up to 50% (or admittedly by as little as 5%). Even taking the midpoint of this range, it seems we are missing out by not being in the euro.

A little caution is, however, in order. While the potential trade benefits of being part of a successful single currency are very substantial, try telling that to Germany. Indeed, it is a feature of the euro area since 1999 that there is little evidence of the kind of dynamic gains such studies suggest.

Not only that, but there is a long way to go – in terms of changes in both Britain and Europe – before we are safely convergent with the euroland economies. The chancellor has paid lip service to the idea of a referendum before the next election. I, for one, would be very surprised if we get one.

From Industry magazine, June 2003

Thursday, June 05, 2003
Gulf War II - an economic non-event?
Posted by David Smith at 09:19 PM
Category: David Smith' s magazine articles

The second Gulf War, or more accurately the campaign to depose Saddam Hussein, was over remarkably quickly, in little more than a month. Militarily it was a success, despite regrettable civilian casualties, but what about the economic impact?

Before the latest war with Iraq, the economic template was provided by the first Gulf war. Stock markets fell by around 20% following Iraq’s invasion of Kuwait in July 1990. They began recovering strongly with the onset of military action against Saddam’s forces in January 1991 and by the time of the ceasefire were around 10% above their initial level.

This time the pattern was slightly different. Markets embarked on a further downward leg in the autumn of last year, partly on war worries. These jitters turned into a fully-fledged sell-off in January and February, at the low point of which the London market was about a third down on its “pre-Iraq” level. The market recovery started earlier than in 1990-91, shares rising even before the bombs started dropping. Victory maintained the market recovery, although far less convincingly than in response to the previous Gulf conflict. At time of writing global markets were still between 10% and 15% below their autumn levels.

The oil market also responded differently. After Iraq’s invasion of Kuwait, crude oil prices rose to more than $40 a barrel, equivalent to $60 a barrel in today’s prices, before falling sharply in its aftermath, dropping to under $15 a barrel within a couple of years.

This time, oil’s response has been much more muted. Brent crude oil hit a peak of just over $35 a barrel and, like stock markets, began to move even before the fighting started, to about $25. But there was no immediate collapse in prices on victory. It may yet happen, and the betting remains on prices of under $20 a barrel by the end of the year. But those who expected a Gulf victory to bring the onset of a new era of very cheap oil have so far been disappointed.

Why, if the victory was quicker than many had feared, has the reaction – in markets and economies – been relatively muted? Mark Cliffe, chief economist at ING Financial Markets, put forward a “V for victory” view last autumn, in which equities and economic activity would weaken significantly ahead of the war but then recover sharply afterwards on reduced geopolitical uncertainty, lower oil prices and extra government spending.

The reason it has not happened that way, he argues, is because of the collateral damage incurred in the run-up to war. That includes the damage to relations between America and Europe, which could have knock-on effects for world trade. It also includes the relationship between the Arab world and America. What looked good to American viewers on CNN would have seemed like a humiliation of a fellow Arab country when viewed on Al-Jazeera or Abu Dhabi TV. This in turn raises the rise that one threat – from Iraq – has diminished, but at the expense of creating many more terrorist martyrs.

That does not tell the full story. The damage to US-European relations can be repaired, and in most respects the effect on Arab public opinion of the toppling of Saddam has been milder than many feared.

The real difficulty is that the war was not, nor ever could be, a panacea for problems that existed before the White House and the Pentagon embarked upon on it. Those problems are familiar, While many equity markets now look attractive in valuation terms, the market that everybody looks to for leadership – Wall Street – still looks dear to many investors. Only if they were convinced that US economic growth was about to rehearse the dynamism of the 1990s would there be a convincing case for driving the market sharply higher.

Instead, the prospect appears to be for what the Organisation for Economic Co-operation and Development, in a post-war assessment, describes as an “unspectacular” global recovery. That recovery may be somewhat stronger in North America and Britain than in euroland and Japan – where serious doubts remain - but it nevertheless looks to be some time before the world can begin to fire on all cylinders.

The best example of this is in business investment, which in Britain and elsewhere has been through a savage retrenchment, dropping 9% last year alone. The hope was that the removal of war uncertainty would release the logjam holding back corporate spending. Talk to any businessman, however, and they will give a long list of other reasons for maintaining a cautious approach, from lack of pricing power and the need to top up company pension schemes, to continuing economic uncertainties. It is a chicken and egg situation – businessmen won’t invest until they see stronger growth but stronger growth may not happen without that investment – and will not be resolved for a while.

We should not be too gloomy. Hindsight tells us that the first Gulf conflict, more than a decade ago, was followed by an instant return to growth and optimism. The reality was rather different. George Bush senior lost an election nearly two years after that war, partly because of continuing doubts about the economy. The build-up to recovery, and the roaring nineties for the stock market, took time.

History, in that respect, could yet repeat itself. Then, as now, though, we just need to be patient. After all, if wars solved all our economic problems, it would be a strange sort of world.

From Professional Investor, June 2003

Tuesday, June 03, 2003
The threat to global free trade
Posted by David Smith at 04:00 PM
Category: David Smith' s magazine articles

For anyone interested in global free trade, and that includes pretty well everybody in business, these are worrying times. The Doha development agenda, the trade round launched under the auspices of the World Trade Organisation (WTO) in November 2001, is stalled.

Whether or not we should take seriously the idea of a post-Iraq trade backlash, and a breakdown in EU-US relations, the omens are not encouraging. Even before the war America was fully-prepared to abandon aspects of free trade, by imposing steel tariffs and more generous support for its farmers. The Bush administration may use the language of free trade but the reality has often been different.

In Europe, too, the momentum for trade liberalisation appears to have faded. Some in the EU argue that there has already been a huge amount of liberalisation, so why risk upsetting the farm lobby by going further for marginal gains that may involve significant political costs.

Or, it is said, why bother with external trade liberalisation when there is a huge amount still to be achieved in terms of internal liberalisation within the EU. Let’s focus on the challenging task of completing the single market and turning the EU into a genuine free trade bloc. Or let’s concentrate on the job of integrating the accession countries of eastern Europe into the EU.

Thus, the Doha round, launched at a time when advanced countries wanted to reach out to the developing world, is struggling for familiar reasons. The EU is unwilling to make concessions on the Common Agricultural Policy, making progress in other areas, including services, difficult.

World trade, meanwhile, remains depressed, growing by only 2.5 per cent last year against an average of 7 per cent annually during the 1990s.

It is easy to forget, at a time like this, the huge benefits global trade liberalisation have conferred, most notably to EU countries. Six of the world’s top 10 exporters of goods are EU countries – Germany, France, Britain, Italy, the Netherlands and Belgium. During half a century of trade liberalisation under the General Agreement on Tariffs and Trade (GATT) and the WTO world trade has increased 20-fold, in real terms. As average tariffs in the industrial countries have come down, from 40 per cent to under 5 per cent, so trade has gone up. This a proven economic relationship. During normal times, roughly speaking, world trade grows about as twice as fast as world output.

There remains, however, a great prize to be had from the liberalisation of services. Trade in services accounts for only a fifth of all world trade. There is a significant disconnect between the situation in most advanced economies, where two-thirds of gross domestic product is accounted for by services, and the 20 per cent share it has of world trade.

Even allowing for the fact that some services cannot easily be traded internationally, services are lagging well behind. Growth in trade in services is picking up, but from a very low base, and needs new momentum, which was one of the aims of Doha. It is also the case that whereas goods prices are subject to deflation, this is less the case for services.

For the EU, there is enormous potential from the liberalisation of services – seven member states (Britain, Germany, France, Spain, Italy, Belgium-Luxembourg and the Netherlands) are in the top 10 exporters of services. Britain, sixth among goods exporters, is second only to America as an exporter of services. Nor are there only selfish gains to be had from freeing trade in services. The World Bank has estimated that the benefit to poor countries would be of the order of $900 billion.

There is another reason why Europe should be pushing hard to get some momentum back into the Doha talks. Trade, through increased competition, puts pressure on countries to sharpen their economic act. EU economies badly need that competitive spur to become more flexible and less regulated, even if not all of their political leaders accept this.

GDP per capita in America is roughly 40 per cent above the EU average, while US GDP growth exceeded that of the EU throughout the 1990s – the longest period in modern times it had done so. EU R & D spending is under 2 per cent of GDP and steady, while in the US it is nearly 3 per cent and rising. The EU employment rate is 65 per cent, compared with nearly 80 per cent in America. Europe has, it seems, been suffering more than America from the downturn in world trade of the past two or three years. The internal market has not proved sufficient to offset the chill winds of a global trade recession, or provided the spur for efficiency and enterprise.

That is why, far from hiding behind the political difficulties of reforming the CAP, the EU should be pushing the process forwards. That is without taking into account the enormous benefits to EU consumers, and taxpayers, as well as farm exports in the developing world, from genuine reform of the CAP, the existence of which in its present form is something like a badge of shame in Europe. If the CAP is responsible for derailing the Doha round, which is a danger, that would add hugely to the damage it has already done.

The EU has a special interest in pushing trade liberalisation now, when America’s attitude to free trade is in question, and when many in Washington would favour a more isolationist approach. Even before the election of George W. Bush, and the recent downturn, there was evidence of a loss of momentum. World trade growth in the 1990s was healthy but it represented a slowing from the heady days of the 1950s and 1960s. What is crucial is that we do not go back to the grimness of the 1970s, when there was a real danger of permanent trade dislocation.

What are the potential gains from freeing trade up further? One partial estimate comes from calculations done on the benefits of liberalising transatlantic trade. According to the Treasury, which has updated these estimates, removing remaining barrier between the EU and North America would generate 1.3m EU jobs and provide an annual GDP boost of 1.1 per cent.

That would be well worth having. The danger is that potential gains like this are slipping into the distance. The EU has an enormous amount gain from trade liberalisation, and everything to lose if the process starts to go backwards.

From Business Voice, June 2003

Wednesday, May 07, 2003
Infecting the global recovery
Posted by David Smith at 09:21 PM
Category: David Smith' s magazine articles

As far as the world economy is concerned, it appears to be a case that when one door opens, another slams hard in your face. Barely had businesses got used to the end of the war with Iraq than along came SARS (severe acute respiratory syndrome) to pose a new uncertainty.

The impact of SARS, on certain Asian economies and on the travel and tourism industries, is potentially serious. Hong Kong, in the grip of a prolonged property bust and already suffering deflation, is in the eye of the storm. Before SARS, economists thought the Hong Kong economy could grow at a respectable 3%-4% rate this year. Now, with the tourists and shoppers staying away, they think it will struggle to grow at all.

Elsewhere in Asia, the impact of SARS is also to downgrade prospects, although not as dramatically as in the case of Hong Kong. Asia ex-Japan will still probably grow at a reasonable 4%-5% rate this year but 6% or more was in prospect before the virus struck. Leading forecasters at the OECD, IMF and World Trade Organisation are either revising down their numbers, or warning of enhanced risks.

SARS has also opened the window on China. It has provided a reminder that there is more to China than just a giant magnet for foreign direct investment, and a growing competitive threat – last year it overtook Britain as the world’s fifth largest exporter (behind America, Germany, Japan and France).

China, as the place where SARS started, is suffering directly – economists at Goldman Sachs say growth, which has averaged 7%-8% in recent years, and was 9.9% at an annualised rate in the first quarter, might end up at only 6% this year, its weakest for several years.

Behind the immediate disruption, a question of trust has also emerged. China did not tell the world about the dangerous SARS virus and, when the world became aware, insisted it was under control. This was confirmation, were it needed, that China is a long way from being an open society. For businesses entering long-term relationships with China, this lack of openness remains a concern. SARS has proved that China has much further to go if it is to be a trusted partner as well as a competitor. In all likelihood the virus will prove to be only a blip on the country’s rapid development, although for that to happen the authorities have to take heed of the lessons the episode has provided.

Will we remember SARS in a year’s time? Probably not, except perhaps as an inconvenient interlude after the end of the second Gulf war. What we will remember is a pretty subdued world recovery. It is a fact that when economic growth is strong, it can take wars and other shocks in its stride. Only when underlying growth is weak to we dwell on the economic danger from unexpected developments such as SARS.

Global growth is weak, and the causes are closer to home than China and the other Asian economies. The euro’s appreciation has provided welcome relief for British exports, and offers a reasonable outlook for the coming months, despite weak overseas markets. But the effect in the euro area has been exactly the opposite.

Deutsche Bank predicts euroland growth of just 1% this year, with only a gradual improvement next year. The National Institute of Economic and Social Research says the effect of the euro’s rise has been to redistribute growth away from Europe to the United States. Add in the fact that Japan appears to have hit new troubles and the world economy is a couple of cylinders short of running at full power. A “normal” year for the world economy is 4% growth. As recently as 2000 growth was 4.7%. This year the National Institute expects below-par growth of just over 3%.

This, unfortunately, is the way it is going to be. After the strong American-led global expansion of the 1990s, a period of correction and consolidation was always likely. With America’s current account deficit at a record $500 billion and US households seeking to repair their balance sheets after the excesses of the past, the economy is in no position to act as the kind of powerful locomotive to global expansion it has been before. The world’s only superpower, in addition, has no serious rival for this locomotive role.

That does not mean we should despair. As both Gordon Brown and Alan Greenspan , the Federal Reserve Board chairman, have said, the global economy will gradually pick up momentum in the second half of the year, and should be stronger next year. But neither the end of the war with Iraq or the containment of SARS will provide a panacea. More than anything else, reinvigorating the world economy requires time.

From Industry magazine, May 2003

Monday, May 05, 2003
All change at the Bank
Posted by David Smith at 09:04 PM
Category: David Smith' s magazine articles

The Bank of England, which has won many plaudits for its conduct of monetary policy since being given independence by Gordon Brown in May 1997, is about to face its biggest challenge.

Not only is the Bank about to have its biggest personnel shake-up since taking control of interest rates six years ago, but those changes come at a time when policy is moving into a tricky period.

First those changes in personnel. At the end of June, after serving the Bank for more than 40 years, and over a decade as governor, Sir Edward (Eddie George) will retire. He has seen it all during his period at the Bank, ranging from the great inflations of the 1970s and early 1980s, the unsuccessful attempt to keep Britain in the European exchange rate mechanism (ERM) in 1992, various banking crises, including BCCI and Barings, and the “Ken (Clarke) and Eddie show” – the quasi independence of the 1992-97 period that preceded the real thing.

It is hard to imagine the Bank without him. His successor, Mervyn King, is first to concede that George will be a very hard act to follow. King, however, has excellent credentials. As chief economist and then deputy governor he was responsible for creating the Bank’s quarterly inflation report, and for giving it a top-class reputation in economic analysis and forecasting.

When he succeeds George, his job as deputy governor will be taken by Rachel Lomax, most recently permanent secretary at the transport department, before that a leading light at the World Bank and the Treasury. When she joins, a third of the members of the nine-member monetary policy committee (MPC) will be women, along with external members Kate Barker and Marian Bell. That may not sound a particularly high proportion in this day and age but for the Bank, traditionally the most staid of institutions, it borders on revolution.

Lomax is not the only new face. Richard Lambert, ex-editor of the Financial Times, is also joining the MPC. If the quality of the Bank’s decision-making goes down from now on, some will undoubtedly blame the day that a journalist was allowed on board.

Apart from King, Lomax, Barker, Bell and Lambert, there will be four other members of the MPC, Sir Andrew Large, deputy governor with responsibility for financial stability, Charles Bean, the current chief economist, Paul Tucker, Bank executive director responsible for markets, and Steve Nickell, a London School of Economics professor.

There are two things to note about this team. Not all are economists. Although Lomax trained as an economist, most of her career has been as an administrator. Lambert does not even have an economics background, neither do Large or Tucker. A deliberate decision appears to have been taken by the chancellor, who is responsible for making or recommending the appointments, to balance a strongly economic governor, King, with non-economists.

The other point is that it is quite an inexperienced team. King will be the only survivor from May 1997, and the time when the Bank was granted independence. None of the rest were on the MPC before 2000 and, when the new committee is fully in place on July 1, five will have been members for less than 12 months.

Does it matter? After all, the Bank is generally agreed to have done a good job so far, keeping inflation very close to its 2.5% target and moving in quickly with interest rate cuts to head off trouble, notably in 1998 and in the wake of the terrorist attacks of September 11, 2001.

Right now, however, the Bank is up against it. Inflation has hit a five-year high of 3% at time of writing, even alongside quite a sharp slowdown in the economy. Many in the City expect the inflation rate to top 3.5% this summer, the level at which the governor has to write a public letter of explanation to the chancellor.

This may not sound like much of a sanction but it would, in effect, be a public admission of failure. If it came at the start of the King era as governor, the new man would have got off to an inauspicious start.

The problem for the MPC is that, while it is supposed to hit the inflation target at all times, monetary policy does not operate instantaneously. If inflation is high now, it reflects decisions taken 12 or 18 months ago, in other words those rate cuts after September 11.

Actually, the current inflation blip reflects two factors, housing and oil. Higher house prices and the rise in oil prices ahead of the war with Iraq were responsible for pushing inflation up. Oil is outside the Bank’s control, although housing is not – and one area where its economists have got it wrong is the housing market.

So should the new-look committee be raising interest rates? The difficulty is that if it did so, the governor could by this time next year find himself having to write a public letter of explanation for precisely the opposite reason, because inflation has dropped below its effective lower limit of 1.5%. This is because both factors that have pushed up inflation – housing and oil – are either going into reverse or are about to. If he is unlucky, the new governor could find himself having to write two letters, for opposite reasons.

He may be lucky. So far the inflation figures seem to have been on magic elastic, pulling back from the 3.5% or 1.5% inflation barriers just as it has seemed certain they would breach them. The MPC will be hoping the magic still works.

From Professional Investor, May 2003

Thursday, May 01, 2003
Look to technology for the investment upturn
Posted by David Smith at 04:05 PM
Category: David Smith' s magazine articles

One of the striking features of this economic cycle has been the weakness of investment. Business investment fell by 8 per cent in Britain last year, the worst performance since 1991. This was, in other words, a recession-style drop in investment at a time when the economy as whole carried on growing, by nearly 2 per cent.

Globally, it has also been a savage investment downturn. In the past three years business investment has declined in relation to gross domestic product in all major economies, dropping from 14 to 10 per cent in the United States, with similar falls elsewhere. As far as boardrooms are concerned, the 21st century has, so far at least, been characterised only by corporate retrenchment.

Why has investment fallen so much? To answer that, it is necessary to look at why it rose in the first place. A prime factor was the rise in IT investment ahead of the millennium. It is easy to forget now but an enormous amount of IT investment was squeezed in to beat the bug. We will never know exactly what would have happened if this investment had not occurred and the bug had been given free rein. The suspicion must be that a lot of the bringing forward of spending was necessary.

Second, companies, particularly in America, had been responding to what they believed was a new era of technology-led growth, egged on by the markets. The US economy was still enjoying its longest-ever expansion as the roaring nineties rolled on. Any chief executive who adopted a cautious approach was regarded with disdain by investors. In the “new” economy, boldness was the key.

Third, money was easy. Raising finance for investment was never easier than during the 1990s, through equity or bond issues. What we saw, according to Bijal Shah of Societe Generale in London, was an enormous “debt-funded business investment boom”, of the kind last seen in the 1970s.

What went wrong? The seeds of the present downturn were sown more than five years ago, in the Asian economic crisis. Asian economies, already highly competitive, benefited from currency devaluations. This was not the beginning of the period of intense global competition and goods deflation but, along with the spectacular rise of China, marked its intensification. Suddenly, the world was facing a problem of too much manufacturing capacity and very little pricing power.

Meanwhile, the new economy of the 1990s proved no more durable than its many predecessors. Rather than being able to sustain an annual growth rate of 4 or 5 per cent a year, pulling the rest of the world behind it like some powerful locomotive, America proved vulnerable to the usual cyclical forces. Suddenly, all the investment that was predicated on non-stop new era growth rates was left high and dry. It happened in America, in Britain, and in the rest of Europe, and it was exacerbated by the pre-millennium surge in spending.

This, in turn, left companies exposed by high levels of debt. In the 1990s, debt was easy and profits did not matter. In the 21st century both did. Firms found themselves in a position where debt interest payments accounted for 45 or 50 per cent of pre-tax profits. Given that investment had been the cause of the debt problem, the natural response of managers was to cut back sharply on it.

Where do we go from here? Investment remains very subdued, which was one reason why the CBI urged action from the chancellor in his budget to stimulate it. War, terrorism and an uncertain global economic outlook have all contributed to a downbeat outlook for capital spending by businesses. While most economists think this year will not see a repeat of last year’s 8 per cent drop in business investment in Britain, few see much of an upturn.

Let us not, however, be too gloomy. While investment has fallen, it has not collapsed. The rise in investment in Britain during the second half of the 1990s had the effect of lifting it significantly as a share of GDP, to around 14 per cent. This compared with under 10 per cent from the mid-1960s to mid-1980s (the famous legacy of under-investment). Even now, at about 12 per cent of GDP, it is as high as at the end of the 1980s.

Companies also look ready to invest when they deem conditions are right. Corporate debt has risen, with the sector’s financial liabilities rising from 65 per cent of GDP in 1998 to 95 per cent at the end of 1992. Beneath the surface, however, firms have been quietly rebuilding their balance sheets. The evidence is that the main thing holding back investment is confidence, not finance.

Most of all, we should look to what drove this investment downturn, which was a sharp downturn in TMT (technology, media and telecommunications) investment. According to a paper from Bill Martin of UBS Global Asset Management: “The abnormal investment cycle was driven by the fall in the relative price of information technology equipment, which encouraged firms to become more IT intensive, and by the stock market bubble and bust, which fed – and was fed by – a marked cycle in credit expansion.”

They may be straws in the wind but the evidence is that technology investment is recovering. In America, for example, the national accounts show that technology investment hit a trough as long ago as the second half of 2001 and has been recovering steadily since. Martin is cautious about overall prospects for capital investment but he thinks there is a good chance of a reasonably strong upturn in IT investment, partly driven by falling prices. The replacement cycle for IT-related investment tends to be shorter than for other capital equipment, implying some of that pre-millennium investment is now obsolete.

If we look at the data in Britain, there is also evidence of a modest upturn in IT investment, with hardware investment hitting a trough of £1.3 billion in the second quarter of last year, before recovering to £1.6 billion by the final quarter.
As I say, straws in the wind. But something to comfort us until a more general recovery in business investment kicks in. With a fair wind for the global economy, that should be next year.

From Business Voice, May 2003

Saturday, April 12, 2003
Not a budget for industry
Posted by David Smith at 09:16 PM
Category: David Smith' s magazine articles

What did industry get from Gordon Brown’s April 9 budget? One is tempted to say zero, zilch. That may be going too far but the verdict of the Engineering Employers’ Federation – “manufacturers had low expectations from this budget and were not surprised by the result” – got pretty close to it.

Industry did get, it should be said, some new forecasts. According to the chancellor, the expected manufacturing recovery has been postponed again. Output, after sliding by 4% last year, will grow by only 0.25% to 0.75% this year, strengthening to 2.25% to 2.75% next year. In case anybody is tempted to think this is the start of a new industrial renaissance, however, the Treasury offers little encouragement. Output growth slips back to between 1.75% and 2.25% in 2005 according to the new forecasts.

If this sounds like a fairly downbeat prospect, that impression is reinforced when taken in conjunction with what is an upbeat overall growth forecast. This year, to take the mid-point of his range, Brown expects the economy to grow by 2.25%, accelerating to 3.25% for each of the following years. Industry, again, is expected to lag overall economic growth by some distance.

One reason is that previous predictions of an early recovery in business investment have come to nothing. The Treasury is now looking for a drop of between 1% and 1.5% in business investment this year, after last year’s 8% fall, The following years look better, with investment predicted to rise by 5% and 5.6% respectively. Given the record, however, it is probably not wise to bet the business on it.

Before leaving the macroeconomics of the budget, it is worth mentioning two other things. The first is that, if the chancellor is too optimistic on growth, or on tax revenues, there will be a hole to be fixed in the budget – beyond the £27 billion of borrowing predicted for this year. Business has borne the brunt of Brown’s tax hikes so far, and would have reason to be fearful if he has to put up taxes again.

Second was what the budget said, or did not say, about euro entry. The chancellor singled out slow growth in Europe, and its contrast with Britain, which has not had a quarter of declining GDP since 1992. But he did not (or was not allowed to) unveil his expected “no, not yet” verdict on euro entry. It would nevertheless be a surprise if there is a Treasury green light for membership any time soon.

What about the budget detail? As I say, this was not a package that could remotely be described as a “budget for industry”, although there were a few crumbs from the table.

They included, for small businesses, extending 100% capital allowances for investing in formation and communication technology (ICT) for a further year; improvements to the R & D tax credit, enabling more businesses to claim a wider range of relief, together with consultation to ensure the scope of the credit remains competitive internationally; and additional measures to promote workforce skills, including the launch of six new Employer Training Pilots.

Industry also welcomed the freezing of climate change levy (CCL) rates, and the chancellor’s announcement that there will be a further discussion with business on expanding CCL agreements.

That, in a budget tight for cash, was that. For industry, then, hopes must rest with some of the longer-term hares set running by the chancellor. Thus, he called for an investigation into housing supply by former CBI chief economist and monetary policy committee member, Kate Barker. The Treasury wants to free up planning to allow more houses to be built, in the hope that this will damp down housing boom and bust.

At the same time, another economist, Professor David Miles of Imperial College, London, will examine whether there is scope for shifting mortgage finance in Britain to long-term fixed interest rates – more than the five years that is the usual maximum for fixed rates at present.

These investigations may not come to anything, and they may not sound directly relevant to industry. But they could turn out to be significant. Britain’s housing market has been the main factor, over time, keeping interest rates higher than they needed to be.

There are other straws in the wind. Brown seems serious about achieving a genuine spread of economic activity around the country, partly by shifting more civil servants out of London, partly by encouraging enterprise and business development. Again, it may turn into nothing, but it is worth keeping an eye on.

In the end, business has to hope Brown is right in his optimism about economic recovery, and too downbeat about how industry will do within that recovery. The budget was a holding operation, at a time when the chancellor did not have very much to say. The hope has to be for genuinely better news next time, but don’t hold your breath.

From Industry magazine, April 2003

Saturday, April 05, 2003
Germany's lost decade
Posted by David Smith at 08:29 PM
Category: David Smith' s magazine articles

A few weeks ago George W. Bush was reported to have said that the problem with the French is that they did not have a word for entrepreneur. Whether he said it or not, there is now an alternative on the other side of the Rhine: What is the German for angst?

Germany’s economy is deeply angst-ridden. It has just slipped back into “technical” recession, with a drop in gross domestic product in the final quarter of 2002 likely to have been followed by another in the first three months of 2003. Economic growth this year, which even the government forecast at only 1%, is likely to be zero at best.

DIHK, the German Chamber of Commerce, finds in its latest survey of small and medium-sized firms, the legendary Mittelstand, that business expectations are at their weakest since the last time the economy was in recession, in 1993.

Mittelstand firms, the cornerstone of German economic success, are being hit in several ways. As family firms, they are encountering a reluctance to take on the business by younger family members. Unlike bigger multinational companies, it is difficult for them to uproot and move to cheaper locations. They are suffering from the relatively high exchange rate at which Germany entered the euro. And they are experiencing a “credit crunch” as banks are increasingly reluctant to lend.

Small and medium-sized firms are not the only ones in trouble. Bigger German companies are increasingly exasperated with the lack of direction from Gerhard Schroder’s government. The big German banks, with an average return on equity of under 2% (compared with 11% to 23% for UK banks) are warning that things cannot go on this way.

Nor is there any cheer among consumers. Businesses and households are usually on the same wavelength in Germany, and today is no exception. Unemployment of over 4m and deep corporate gloom is enough to keep consumers from spending.

What’s gone wrong for Germany? Like that other post-war economic giant, Japan, its previous strengths are now seen to be weaknesses. The problem for economies built on consensus is that they find it hard to change.

Germany has the highest labour costs in the industrialised world and some of the toughest labour laws. It probably needs a Margaret Thatcher to shake up its working practices but there is little likelihood of a reforming politician being elected, at least not until the economic crisis is several notches worse than now. Edmund Stoiber, the defeated conservative candidate in last year’s federal election, promised only modest reforms.

As already mentioned, Germany’s last full-blown recession was in 1993. The great optimism that greeted the tearing down of the Berlin Wall in 1989 and formal unification in 1990 produced a powerful but short-lived boom. On one explanation, the very subdued growth since then, Germany’s equivalent of Japan’s lost decade, can be put down to a huge and prolonged post-unification hangover. Fiscal transfers from the former West Germany to the eastern states, equivalent to up to 5% of gross domestic product, represent a substantial, and continual, burden.

The unification factor should not be dismissed, even if policy mistakes made it worse than it needed to have been. Helmut Kohl, Schroder’s predecessor, made the political gesture of converting the ostmarks to deutschemarks at a one-for-one exchange rate, despite the East German economy’s woeful lack of competitiveness. Both eastern and western länder continue to pay for that decision.

It is not all unification, however. Some would say that European monetary union was also essentially a political act for Germany. Certainly is it hard to see what it has got out of the euro. Not only did Germany enter with very high labour costs, she also entered at a high exchange rate. Perhaps there was a belief that the miracle economy of the post-war years, the Wirtschaftswunder, which thrived on a strong currency, could be recreated. If so, the faith was misplaced.

For a British audience, there is a close parallel between Germany’s euro difficulties and that of Britain in the European exchange rate mechanism (ERM) in the early 1990s. Germany desperately needs lower interest rates, as Britain did then. But Germany has to wait until the European Central Bank (ECB), based just along the road from the Bundesbank in Frankfurt, decides lower interest rates are appropriate for the whole of the “euroland” area. So far the ECB has been slow to respond to Germany’s particular needs.

In some ways Germany’s plight is more serious than Britain’s ERM straitjacket. There was nothing in the early 1990s to prevent the UK government relaxing fiscal policy, a freedom John Major’s government seized upon enthusiastically. But Germany is constrained to keep her budget deficit below 3% of GDP, as a result of the Stability and Growth Pact (SGP) it campaigned so hard for to prevent countries like Italy operating reckless fiscal policies.

So what does Germany need? It needs a lot of reform to its labour markets and to the other laws and red tape constraining business. It needs either a reduction in labour costs or a big increase in productivity. And it needs a more flexible monetary and fiscal policy approach in the euro area.

Whether it gets any of these is open to serious doubt. In the meantime there is another big problem looming. The recent rise of the euro has substantially increased the risk that Germany will slip into deflation – falling prices. And that, alongside the country’s existing economic stagnation, is a very dangerous combination, as Japan can testify.

From Professional Investor, April 2003

Tuesday, April 01, 2003
Germany and Japan - too close for comfort
Posted by David Smith at 04:29 PM
Category: David Smith' s magazine articles

For many businessmen I speak to, the big worry is Germany. Germany’s problems seem to go from bad to worse, and its woes are dragging down European economic growth, to the point where the region as a whole appears dangerously stagnant.

Forecasters now predict zero growth this year for Germany, below even the government’s downbeat forecast of a mere 1 per cent expansion. It is probable, as this is being written, that the economy has slipped back into technical recession. German businesses are gloomier about prospects than at any time since the last full recession in 1993.

Nor is there much schadenfreude in Britain about Germany’s difficulties. The problems for the German economy, and in particular very weak domestic demand there, means that the competitive pressures on UK exporters are, if anything intensified.

Like Japan, the other miracle economy of the post-war period, Germany has fallen on hard times that would have seemed inconceivable a few years ago. And, given that Japan has had more than a decade of stagnation, which shows no sign of coming to an end, that is a worrying thought. The parallels between Japan and Germany, indeed, are disturbingly close. Here are a few of them:

1. Both economies are suffering long, post-boom, economic hangovers, In Japan’s case it was the “bubble economy” boom of sky-high stock markets and property prices. In the case of Germany, the tearing-down of the Berlin wall in 1989, followed by formal unification in 1990s produced an immediate boom, particularly in construction, followed by recession, in 1993.

2. Both have suffered weak growth for years. Japan’s “lost decade” of the 1990s saw the economy slipping in and out of recession, with only weak growth in between. In the case of Germany, growth has been well below the previous trend since that 1993 recession. Economists believe that “trend” growth in the two economies is now just 1 per cent a year, compared with 2.5 per cent or more in Britain.

3. Both have serious demographic problems. Japan has the oldest population in the world, while Germany is facing the biggest decline in population, certainly in Europe. Germany’s ageing population interacts worryingly with its generous state pensions system, implying a rising fiscal burden in the future.

4. Both are consensus-based societies. Germany’s non-confrontational system was once held up as a model by British commentators, including Will Hutton in The State We’re In a few years ago. But that model has proved to be a serious barrier to the kind of economic reform Germany needs to regain competitiveness. Meanwhile Britain’s tradition of confrontation in industrial relations has evolved. Like Japan, where consensus is needed for change, Germany does not vote for the kind of political leader likely to bring it about. At the last federal election Edmund Stoiber, Gerhard Schroder’s conservative opponent, proposed only modest reforms.

5. Both have serious banking problems. Again, the close relationships between banks and industrial and commercial companies, and the absence of hostile takeovers, were seen to be great post-war advantages for Japan and Germany. Now the legacy of those relationships is seen in vulnerable banking systems. A recent International Monetary Fund report pointed out that the return on equity of Deutsche Bank is just 0.42 per cent, with other German banks scraping in at just over 1 per cent Comparable figures for leading UK banks range from just over 10 per cent to over 20 per cent.

6. Deflation is a reality in the case of Japan, where consumer prices have been falling for three years (and share and property prices for a decade). It is also in prospect in Germany. Economists had expected the German economy to skate clear of deflation but the euro’s recent appreciation has brought it clearly into view, for later this year or next year.

7. Both had their greatest strength in manufacturing. The German and Japanese educational system seemed to be particularly attuned to producing skilled industrial workers and managers. But Germany, like Japan, has been less good at producing entrepreneurs in the service sector and in new technologies. Arguably, given the failure of the Neuer Markt, Germany’s Nasdaq, it suffered worse problems with new technology than other economies.

8. Both are seriously uncompetitive. Germany has the highest labour costs in the world, Japan some of the highest living costs. Just as Japanese firms have sought cheaper locations elsewhere in Asia, German companies are taking similar action in Eastern Europe. The existence of cheap locations on Germany’s borders, coupled with the near-term prospect of EU accession, is accentuating the “hollowing out” of the Germany economy.

One should not pretend, despite these similarities, that the difficulties Germany and Japan face are identical, or indeed that identical solutions are appropriate to their problems. I have barely mentioned unification, which many see as Germany’s biggest problem. Nearly a decade and a half after the Berlin wall came down, the former East Germany remains a high-unemployment, low-performing economy, requiring fiscal transfers from west to east of as much as 5 per cent of GDP.

There is also an interesting debate to be had over monetary and fiscal policy. Japan, free from any external constraints, has had a series of fiscal packages, which are now regarded with weary resignation by consumers and businesses, and increased its budget deficit to 7 per cent of gross domestic product.

Germany, of course, cannot do this, being constrained by the euro Stability and Growth Pact (SGP) to keep its deficit to 3 per cent of GDP or below. While many would argue that further fiscal relaxation is the right thing for Germany, maybe Japan’s experience shows it serious limitations.

Similarly, the Bank of Japan has cut interest rates to zero in an effort to stimulate the economy, while Germany has had to endure somewhat higher interest rates (willingly, it should be said) because the European Central Bank sets monetary policy for the whole of the euro area. The Bank of Japan’s lack of success suggests, again, that easier monetary policy would be no panacea for Germany.

Instead, Germany desperately needs labour market flexibility and creation of a new entrepreneurial culture in place of the old corporatism. Its Mittelstand of small and medium-sized firms, once the envy of Britain, is creaking. Without thoroughgoing reforms, Germany will continue to creak. Reform is in the air. The question is whether it is thoroughgoing enough.

From Business Voice, April 2003

Friday, March 07, 2003
Saying 'No' Gracefully
Posted by David Smith at 08:37 PM
Category: David Smith' s magazine articles

Gordon Brown and Tony Blair have a tricky decision ahead of them. By that, I do not mean the decision on whether to hold a referendum this year on euro entry. I am assuming that, while the formalities have yet to be completed, that decision has already effectively been taken.

Given the state of public opinion, with opposition to the euro growing rather than diminishing, and given the enfeebled state of the European economy (not to mention the prime minister’s battles with EU partners on matters such as Iraq), I would be flabbergasted if Blair and Brown chose to try to win a referendum battle at this stage.

No, the tricky decision is how to present a “no, not yet” verdict in a way that leaves out EU partners convinced that we are still keen to join at some future stage and, more importantly, to persuade footloose foreign businesses that Britain has not turned her back permanently on the single currency.

First a brief recap. The Treasury, as most people will be aware, is engaged on the task of assessing the chancellor’s five economic tests for euro entry (whether Britain is sufficiently converged, whether there is enough flexibility on either side, and whether or not joining would be good for jobs, the City and investment).

In preparation for that exercise it has been compiling 18 separate studies, covering everything from housing markets in Britain and Europe to what is likely to happen to prices in the event of a changeover from sterling to euro notes and coins. The Treasury buzzword in this is “rigour”. This will be the most rigorous, and biggest, exercise that the Treasury has ever undertaken.

Why, if the work has still to be completed, is it possible to be confident about the verdict? Well, apart from the factors described above, the government occasionally gives us a glimpse into its thinking. The Treasury did so in November, at the time of the chancellor’s pre-budget report, when it put out a paper unfavourably comparing the framework under which the euro operates – the European Central Bank and the so-called stability and growth pact – with the system in Britain.

And it did so again in February, this time with Blair firmly on board, when it published another paper, this time on European economic reform. Remember that one of the tests for entry is that there needs to be flexibility on both sides. According to the February paper, EU economies are for the most part unreformed and inflexible.

“Europe’s weakness in the face of a global slowdown has underlined the need for structural reform,” wrote Blair in his introduction. “There remains a daunting amount to be done. EU states are still not doing enough to tackle the fundamental barriers to job creation.”

Flexibility is not going to come quickly, even if EU countries were to show more of an appetite for it. For the Treasury to come up with an early “yes” in this context – its assessment has to be completed by June – would invite ridicule and rejection.

But that leaves the government with a problem. The one test for entry that is met, at least as far as inward investors are concerned, is that it would be good for investment. This may only be a valid view for the short-term, for if euro entry had the effect of shackling the economy that would be bad for investment. It is also the case that Britain is suffering a loss of inward investment for other reasons than the euro, notably the cost competitiveness of the new EU entrants from eastern Europe, and of China.

But a survey in the Financial Times in February showed that 61% of 31 large inward investors questioned said they were less likely to invest in Britain if the government delayed joining the euro. One of those surveyed, Mike Baunton, president of Perkins Engines, the diesel-engine maker owned by Caterpillar of the US, said small suppliers were being hit hard by sterling’s strength, and euro entry would solve this problem.

Interestingly, the pound has been trending lower, particularly against the euro, even in the absence of any indication of early euro entry. Many manufacturers, however, would like something more permanent.

This is why the way the government handles the June decision is important. Some in government prefer “yes, but not at the moment” to “no, not yet” as the language that ministers will use. The idea will be that, while immediate entry is not appropriate, neither has the issue been kicked into the very long grass.

Instead, the word will be that it remains on the cards in the relatively near future. It may be, unlike in October 1997, when entry was ruled out for Tony Blair’s first term in office, the option is even left open for a referendum before the next election. My guess would be that such a referendum is not winnable. But then I’m not a politician.

From Industry magazine, March 2003

Wednesday, March 05, 2003
Riding the fiscal cycle
Posted by David Smith at 05:06 PM
Category: David Smith' s magazine articles

Of all the economic cycles that govern the ups and downs of business and of markets, none operates more dramatically than the fiscal cycle. Three years ago America was looking at budget surpluses stretching out in the indefinite future and Gordon Brown was criticised for being the policy equivalent of Lord Weinstock, building up a cash mountain while the country was crying out for more to be spent on essential public services and the creaking infrastructure.

Lord Weinstock’s cash mountain disappeared more quickly than you could say GEC, or Marconi, once his successors got hold of it. The chancellor, similarly, is finding that the same critics who attacked him for adopting an excessively cautious approach to the public finances are now admonishing him for his reckless abandon.

As he prepares for his spring budget, due this year in March, he has had to endure criticisms from several quarters. The Institute for Fiscal Studies (IFS) says he will eventually have to raise taxes by a further £11 billion to keep with his “golden” rule (only borrow to finance investment). The chancellor’s other rule, the “sustainable investment rule”, requires that government debt be kept below 40% of gross domestic product. With debt currently just over 30% of GDP, that is not under any threat at present.

It is not only the IFS that is worried about the public finances. The National Institute of Economic and Social Research estimates that the chancellor’s borrowing on his current budget (that is, excluding capital spending) will be a cumulative £35 billion between now and 2006-7. The Treasury, in contrast, expects a surplus of £5 billion over the same period. The difference, £40 billion, is significant, supporting the old adage that, a billion here, a billion there, and you’re soon talking about real numbers.

Even outside Britain, Brown’s public finances are running into criticism. The International Monetary Fund, having praised the chancellor’s stewardship, is now a little worried about the return to borrowing. The European Commission has warned that Britain’s budget deficit could soon rise to 3% of GDP. The significance of that number is that, were we inside the euro, the so-called stability and growth pact would require action to cut public spending or raise taxes, suggestions that are as welcome to the chancellor as a cold shower in a snowstorm.

The Treasury insists, as you would expect, that people are getting excited about very little. All over the world countries have seen budget surpluses turn to deficit, because of the global slowdown. Slower growth, which has turned to recession in some countries, means that tax revenues take a hit. Add in the need for extra government spending on, for example unemployment benefits, and it is not surprising that the public finances come under pressure.

But, the Treasury also insists, the appropriate response to this cyclical deterioration is not to put up taxes or cut spending on public services or the infrastructure. That would only make things worse. The right thing to do is to allow the “automatic stabilisers” to operate, to allow the budget deficit to increase during bad times, in the knowledge that there will be a return to surplus when the good times return.

Not only that, say officials, but the present situation, with projected public borrowing of £20 billion this year and £24 billion in 2003-4, is a pale shadow of the situation under the Tories in the first half of the 1990s, when the budget deficit hit £45 billion.

All that is true. The trouble is that, according to independent forecasters, this is not a problem that will disappear with the up phase of the cycle. Both the IFS and the National Institute fear that, as in the late 1980s and early 1990s, the government is overestimating the “normal” levels of tax revenues and that there will be a sizeable hole in the public finances even after the economy has recovered.

The IFS, for example, is worried on two main counts. It thinks the Treasury is being too optimistic about the taxes it will raise from financial companies, the City. Weak markets and low levels of merger and acquisition activity mean, it believes, that profits and hence taxes are likely to remain depressed for some time to come. The IFS also thinks the chancellor is unduly upbeat about corporation tax in general. The Treasury, it points out, is assuming a significantly higher level of revenues than the present system would have generated over the past 15 years.

The National Institute has similar worries. Part of the reason it expects bigger budget deficits than the Treasury over the next few years is that it thinks growth will be somewhat slower than the official forecasts. But this only accounts for a third of the difference. Most is due to independent weakness of tax revenues. If the chancellor is not careful, it warns, people may soon starting “unkind parallels” with his Tory predecessors who, like Mr Micawber, were always looking for the public finances to improve much more quickly than they did.

None of this is set in stone. Forecasting tax revenues is an imprecise art. Brown will certainly not want to act on these warnings in this budget, which will be neutral. Indeed, he will want to put off the day when he has to act as long as possible. So far he has managed to tie tax increases to specific increases in public spending, particularly on health. Putting up taxes just to mend the public finances is much less appealing.

From Professional Investor, March 2003

Friday, February 07, 2003
A bad year for the euro
Posted by David Smith at 08:32 PM
Category: David Smith' s magazine articles

It seems like a long time ago now but at the start of last year there was a lot of excitement about the euro. The changeover from national currencies to euro notes and coins – three years after the single currency came into being as an electronic currency – created a real buzz.

Against predictions that it would cause problems that would put Britain’s switch to decimal coinage three decades ago in the shade, the changeover went very smoothly. There were no huge heists by a new breed of euro criminal, who it was feared would take advantage of the massive amount of cash on Europe’s roads in the run-up to January 1. There were a few isolated examples of unsuspecting people being passed off with the European equivalent of monopoly money, and there were many complaints about retailers profiteering from the switch by marking up prices.

Overall, though, it went incredibly smoothly. Anybody who has travelled to Europe in the past year may have experienced what I have, that it looks as though the euro has always been there. National currencies have gone, and they are quickly being forgotten. There was even, as people in Britain watched the changeover from a distance, a brief flurry of support for our membership of the single currency. It appeared we were missing out. Mind you, predictions that we would all be soon happily using euro notes and coin in our local branch of Marks & Spencer also proved to be wide of the mark. Retailers say that euro use in the UK is minimal. People who return from holiday with spare euros either keep them for their next trip or convert them back to sterling.

If the euro changeover was a big logistical success, that is more than can be said for the European economy. Indeed, far from gaining a new impetus from the formal introduction of the euro, Europe seems to have sunk further into the economic morass. Last year, while the American economy grew by about 2.5% (and remember it is recovering from recession), and Britain by about 1.75%, the euro zone managed at best 1%.

For some countries within the euro area, the picture is even gloomier, most notably its biggest economy. The German economy struggled to grow by 0.5% in 2002 and is likely to disappoint again this year.

Nor is the gloom confined to the short term, according to economists. They see barely any improvement for the next couple of years, and continue to expect euro zone growth to lag behind America and Britain.

Slow growth is not Europe’s only problem. When the euro was established its key institution was the European Central Bank (ECB), based in Frankfurt. The other was the so-called Stability and Growth Pact, set up on the insistence of Germany, which requires member countries to keep their budget deficits below 3% of gross domestic product in normal circumstances. Germany was worried that countries which placed a lower priority on fiscal rectitude (Italy was the usual example) would wreck the system.

As it is, embarrassingly, Germany has fallen foul of the pact, with a budget deficit over the 3% limit this year, and the possibility of fines if it does not take measures to correct the problem. France is also close to breaking the rules, although its government has said that election promises to cut taxes are more important than sticking to the pact, and it wants defence spending to be excluded from the sums. Even Romano Prodi, president of the European Commission, has described the pact as “stupid”. In short, it is a bit of a mess.

Europe’s travails are obviously very important for Britain. The economies of the euro zone are our major customers and competitors. Indeed, with domestic demand weak, the only thing the euro countries seem to have achieved a degree of success at is exporting, because of the weakness of the currency.

The problems are also important because of the impending UK decision on euro entry. Pro-euro voices in government had hoped for two things by now. One was that the European economy would be showing both dynamism and stamina. It may have been a case of the tortoise and the hare, but the hope was that the European tortoise would be doing well in comparison with America. That, plainly, is not happening.

The other problem is that, to join the euro, we would not only have to swap the Bank of England for the ECB but we would also have to accept the Stability Pact instead of Gordon Brown’s own fiscal rules. That would be a very poor swap – at present the British versions are working better in both cases. And it is hard to see a government that designed its own economic framework exchanging it for an inferior model.

The euro is alive and kicking. But Europe’s woes mean Britain won’t be joining it for some time.

From Industry magazine, February 2003

Wednesday, February 05, 2003
Still not ready for the euro
Posted by David Smith at 05:01 PM
Category: David Smith' s magazine articles

The clock is running down on one of the most important economic decisions in recent years. The Treasury has until the end of June to produce its assessment of Britain's readiness for euro entry, based on the famous five economic tests.

In practice, we are told, the assessment is likely to come some time ahead of the deadline, to avoid destabilising speculation in the markets. It could happen any day now.

So should we get ready with our Union Jacks and EU flags for the referendum battle ahead? Or will the Treasury, as its body language has suggested, kick the issue into the very long grass?

Let me say at the outset that the argument is not as clear cut as those on opposite extremes of the debate would suggest. As one who has argued against entry, I would concede that the case for euro entry has grown somewhat stronger in recent months.

If we look at the plus side, the euro over the past year has ceased to be a "basket case" currency (some in the currency markets had even ruder nicknames). Against the dollar it has shown a decisive recovery, of nearly 20% from its 2002 lows at time of writing.

The European Central Bank (ECB) can look forward this year to the appointment of the Frenchman Jean-Claude Trichet as the replacement for Wim Duisenberg as president, a move that will be welcomed in the markets. Even before that change of personnel it has started to talk some sense.

While Europe's political leaders continue to debate the institutional changes that will accompany enlargement to the east, the ECB is already working on some firm proposals. It wants, for example, to limit the size of its decision-making council to 21 members, however large the European Union, or rather the euro zone, becomes. That still sounds somewhat unwieldy in comparison with our own nine-member Bank of England monetary policy committee but it is a move in the right direction.

The ECB is also taking a look at the way its inflation target operates. Since the euro's inception in 1999, it has operated with a 2% inflation ceiling. This has been a little embarrassing, given that for quite a lot of the time inflation has been above 2%.

Now the ECB is talking of a 1% to 3% target range, which would be a significant change. It would mean that, like the Bank, it would be operating with a symmetrical target, with penalties for undershooting as well as overshooting.

There are still problems with the institutional framework under which the euro operates. The ECB will never, it seems, publish the minutes of its meeting or details of votes on interest rate changes, even if those votes take place.

The fiscal policy side of the euro, in addition, remains problematical. Not only was the stability and growth pact (SGP), which limits budget deficits to 3% of gross domestic product, badly designed. It could also pose problems for Gordon Brown quite early on. His own fiscal rules are flexible enough to permit the present increase in UK government borrowing as a "prudent" response to slower economic growth. The SGP would be less forgiving, requiring tax hikes or spending cuts.

If the institutional argument has, on balance, been moving in favour of entry, so have some of economic arguments. It seems, though the figures are still the subject of some debate, that Britain has been losing inward investment in the past two or three years. There could be any number of explanations for that, including higher UK taxes and the economic problems in America, Japan and the rest of Asia. But it is happening, and at the margin Britain's non-participation in the euro may be a factor.

Will all this be enough for the Treasury to deliver a "yes" verdict? I think not. The central requirement for safe entry into the euro is sustainable convergence between Britain and the euro economies. Britain, as a recent analysis by HSBC suggested, may be more converged with the core euro economies than Germany, formerly Europe's core economy.

Even so, there are areas of acute divergence between Britain and the euro area. Even with somewhat higher interest rates, the UK has had a house-price boom and sustained strength in consumer spending, in contrast to most of the rest of Europe. Britain is running its worst monthly trade deficits since record began in 1697, while the other big European economies are running surpluses.

If you could wave a magic wand in response to this set of circumstances, you would be right to conclude that the UK economy needs a somewhat lower exchange rate and rather higher interest rates. Euro entry should be at a lower level for sterling but it would also involve lower, not higher, interest rates. The risk would be an Irish-type acceleration of the housing market, consumer spending and inflation.

There are other arguments against euro entry. I would argue that Europe is a long way from being an optimal currency area, mainly because of its inflexible, geographically immobile labour markets.

I suspect, however, the Treasury's big concern will be that entry would risk the macroeconomic stability the government has been so proud to achieve. "If it ain't broke, don't fix it," is likely to be the Treasury's motto, however much a decision to go for entry would please the chancellor's Downing Street neighbour. And "no, not yet," is likely to be the official verdict on entry. No need to get the flags out this year.

From Professional Investor, February 2003

Saturday, February 01, 2003
Negotiating a difficult pay round
Posted by David Smith at 08:57 PM
Category: David Smith' s magazine articles

One of the most encouraging features of Britain’s economy in the past few years has been that falling unemployment, now back under 1m on the claimant count measure, has not resulted in an acceleration in pay settlements.

Those of us with memories of dangerously destabilising wage-price spirals, an Achilles heel of the economy in the past, have to wonder each time we look at the data whether there has been a permanent shift in wage bargaining behaviour, or whether the danger is merely dormant. Average earnings growth, which never dropped below 7.5 per cent in the 1980s, even when inflation was low, is currently rising at just half that rate, 3.7 per cent.

In the past few years the labour market has thrown up benign wage outcomes against, it should be said, the predictions of many analysts. Not so long ago, economists used to think a drop in the unemployment rate below 6 or 7 per cent would result in a significant increase in pay pressures. Instead, the jobless rate spent last year a shade over 3 per cent but wage increases stayed low.

The CBI’s own figures, for example, showed manufacturing pay settlements at around 2.5 per cent and, if anything, decelerating as the year went on. Service sector settlements were higher, by a percentage point or so, but not by enough to raise serious worries.

So why should we worry about this year’s pay round? The reason, as the Bank of England has pointed out, is that several factors are coming into play this year that pose potential problems. Achieving the same kind of benign outcome as in recent years will take some doing.

There are three main threats. The first is the effect of a rapid expansion of public sector employment, the consequent risk of higher public sector pay settlements, and the worry that this will carry over to the private sector.

The second, probably uppermost in the minds of most firms, is the coming increase in National Insurance contributions. This could be, if we are not careful, a double whammy for business. The certain effect is the 1 per cent rise in employers’ contributions, which will cost business £3.9 billion in the first year.

The other potential effect comes from the 1 per cent rise in employee contributions, which will raise just over £3.5 billion for the chancellor but could also be an extra burden on firms’ costs, if employees expect to be compensated by higher pay.

The third problem comes from inflation itself. Part of the reason for the benign pay rounds of recent years has been that inflation has been low. For the best part of four years the Bank has done its job a little too well, and inflation has come in below the official 2.5 per cent target. That is no longer the case.

Inflation is above the target at time of writing and set to remain so for the first half of the year. As every pay negotiator knows, the current inflation rate is usually the starting point for talks.

So how bad is it going to be? Let us take the three factors in turn. Aggressive public sector recruitment is certainly in evidence. Most of the executive appointments sections, including in The Sunday Times, are now dominated by public sector positions, with a distinct shortage of private sector jobs. The same is true, although perhaps to a slightly lesser extent, at lower levels. The irony will not be lost on business that this expansion of public sector employment is made safer by the fact that private sector recruitment is at such a low ebb. Gordon Brown would call this good planning, but it is plainly just good luck.

Even so, public sector unions know that delivery of better services is vital to the government’s second term. They have also been pushing hard for better pay packages to compensate for, for example, high housing costs in the South East. Having said that, there is no sign that the government is abandoning its relatively tight rein on public sector pay settlements, and its tough line in the fire-fighters’ dispute has demonstrated that. Some slippage is occurring, and we can expect average earnings in the public sector to outstrip those in the private sector for a while, but there is no sense of an impending free-for-all.

The National Insurance increases are another matter. This year is a terrible time for them to be happening. One of the warnings the Bank made public in its latest Inflation Report was of a greater “pass-through into wages and prices of the increases in NI contributions”. Indeed, companies and their workers are left to choose between two evils. For manufacturers, in particular, the climate is likely to be so tough that compensating workers for the NI rises will have to be resisted, in which case it will be employees who suffer a squeeze. For firms in the more buoyant service sector, particularly those competing for employees with the public sector, there may be no option but to concede higher settlements. Either way, it is something business could have done without.

The risk from the third factor is, I think less. If pay negotiators are prepared to accept that the current period of above-target inflation is temporary, as it should be, and the rate will be back below 2.5 per cent in the second half of the year, there will be no case for ratcheting settlements higher.

So a difficult few months lie ahead. I suspect, in the end, we will not see a decisive break from the recent benign pattern of pay outcomes. This is because, I hope, common sense will prevail. But it is also because a long shadow of uncertainty continues to hang over the business outlook. The chancellor may get away with his NI increases in terms of their impact on wage inflation but only because the economy is likely to be weaker than he expected. The lesson must be that he should not try anything like it again.

From Business Voice, February 2003

Tuesday, January 07, 2003
Brown waits for industry to turn up
Posted by David Smith at 08:27 PM
Category: David Smith' s magazine articles

For years we have become used to the competence of Gordon Brown. He has been bold, he has been lucky, and he has done industry few favours. But it has worked. Whenever there appeared to be a danger that the economy was going off course, the worries have turned out to be unnecessary.

Now, however, the chancellor has reached a pivotal moment. For him, there were three big events during 2002 – the April budget, the summer comprehensive spending review (CSR) and the end-November pre-budget report (PBR).

In the budget he announced a big increase in NHS spending, and a big tax hike, deferred until the coming April, to pay for it. In the July CSR he announced big spending allocations for other departments, notably education and transport. The November PBR was mainly notable for a big increase in government borrowing, of which more in a moment.

For economists, the interesting thing about the three events was that each time economic prospects had deteriorated. Back in April many warned that Brown’s projections were too optimistic, particularly his decision to revise up the Treasury’s estimate of the economy’s long-run growth rate. The warnings were not ones that a chancellor embarking on huge boost to public spending wanted to hear, so he decided to ignore them.

By the summer, when global stock markets had embarked on a new and sickening downward lurch, the chancellor decided to stick with his optimistic view. On the day he unveiled his tens of billions of pounds more for public services, the London stock market plunged by more than 200 points.

Finally in November, some of those chickens came home to roost. Brown was forced down his growth forecasts for 2002 from his original 2% to 2.5% range to just 1.6%. No shame in that, given the rocky performance of the global economy. What was embarrassing, for a chancellor who has prided himself on his stewardship of the public finances, is that he was forced to revise up his estimates of public borrowing for this year from £11 billion to £20 billion, and for next year from £13 billion to £24 billion.

While these are big numbers, few analysts would argue, hand on heart, that they are courting disaster. Public borrowing was twice as high as this in the early 1990s. The “new prudence”, that it was better to borrow than raise taxes or cut public spending, applied (although whether it was wise to embark on such an ambitious boost to spending in the first place is another matter).

The trouble is, as in April and July, the chancellor appears to have been optimistic in his assumptions. The 2003 economic forecast is interesting in two respects. The first is that, in predicting 2.5% to 3% growth, the chancellor is more upbeat than the majority of independent forecasters. The 2004 forecast – 3% to 3.5% growth – is even more optimistic. Yet if growth is weaker than this the public finances will turn out a lot worse. Already some independent forecasters are saying borrowing will have to rise to £35 billion.

The second point is that the chancellor envisages a “dream” rebalancing of the economy, in which manufacturing output and business investment recover well but consumer spending and the housing market slow. The latter seems quite likely – the April tax rises will eat into income growth and a consensus is emerging that the housing market is riding for a fall, at least in London and the south-east.

What looks less likely is the manufacturing and investment revival. Business surveys suggest the prospects for industrial output, at least for the first few months of 2003, are at best flat, at worst down. Confidence is weak and investment plans are on hold. The best hope of any upturn is later in the year. The big danger is that the economy will lose some of its consumer impetus, without business and industry being able to take up the slack. The only boom in town then would be the one in government spending.

What did industry get from the chancellor during 2002? Not much. The main memory will be of the unexpected hike in employer National Insurance contributions, a punch in the solar plexus at a difficult time. The PBR itself merely confirmed that one of the big concerns over the next few years will be the impact of environmental taxes. Landfill tax is going to rise from £13 to £35 a tonne and, while ministers say that green taxes will not be allowed to damage competitiveness, most managers will believe that when they see it.

It is, as I say, a pivotal moment for the chancellor. The public finances are looking shaky and the government’s productivity and enterprise agendas appear becalmed. In 2002 Brown has been able to say that Britain’s economy – if not its manufacturing sector - has done better than most other countries. If we are not careful, that boast won’t last long.

From Industry magazine, January 2003

Wednesday, January 01, 2003
The peculiar problems of the UK housing market
Posted by David Smith at 08:42 PM
Category: David Smith' s magazine articles

In the spring of 1988 I was lunching with a very senior Treasury official. We had done a run around the houses when the time came to part. As we did so, he leaned towards me and said: “We’re a bit worried about house prices.”

He had good reason to worry. Interest rates had just been cut to 7.5 per cent and the chancellor had announced a clampdown on the so-called living in sin loophole for mortgage tax relief. Unmarried couples living together had been able to claim two sets of relief, giving them an advantage over their married counterparts. Nigel Lawson decided to close the loophole but gave people five months of grace before the shutters came down.

The result of low interest rates (7.5 per cent was low then) and the scramble to take advantage of the loophole was the final phase of the 1980s’ housing boom. House price inflation hit 35 per cent and, while many recognised price rises on that scale were unsustainable, few thought prices would actually fall. Property, it seemed, was safe, not least in comparison with the stock market, with the October 1987 crash fresh in the memory.

The unthinkable, of course, happened. Interest rates rose from 7.5 to 15 per cent. Housing boom turned to savage bust. House prices fell nationally for the first time in the post-war period. It took until the late 1990s until the legacy of the bust, widespread negative equity, was over.

So many fingers were burned that, while I got optimistic about house prices five or six years ago, I did not expect a return to that kind of boom for a generation. But here we are. House prices are rising by more than 30 per cent. Everybody agrees it is unsustainable. Few, however, think prices will crash. Are they right, or is history going to repeat itself?

Before answering that, it is worth a reminder that Britain’s housing experience is by no means typical. Figures from the Bank for International Settlements show, in real terms, UK house prices have risen by 50 per cent since 1995 and more than 100 per cent since 1970. House prices tend to rise in line with average earnings. Average earnings outstrip inflation. Therefore house prices rise in real terms. Other countries, such as the Netherlands and Ireland, have also followed this pattern, if anything with even more vigour.

Plenty of others, however, have not. France has seen house prices creep rather than leap higher. Prices have risen by about 20 per cent in real terms since 1995, and only by about 50 per cent since 1970. American house prices have only risen by 20 per cent in real terms in 30 years. In Germany and Switzerland prices are no higher in real terms than they were in 1970. In Italy, inflation-adjusted prices have been static in recent years.

Why the differences? Patterns of household formation differ widely. In many countries it is unusual for young people to leave the parental home before marriage. In others house purchase usually happens much later in life. Britain’s problem of scarce building land – house building is running at its lowest peacetime level since the 1920s – is not matched in all other countries. There are international differences in real income growth and attitudes to debt.

As an aside, the performance of the UK housing market, and its contrast with those elsewhere in Europe, is featuring quite prominently in the Treasury’s assessment of Gordon Brown’s five economic tests. On the face of it, Britain’s housing performance is a significant obstacle to membership.

The strength of Britain’s housing market is not all bad news. At a time of weak and volatile equity markets housing has been a source of rising personal sector wealth, without which consumer spending would have been a lot weaker.

It is also perfectly possible for high house price inflation to co-exist with low general inflation. Housing is a classic “swing” market where a small change in the balance between supply and demand can have a big impact on prices.

The other key point regards affordability. The house price-earnings ratio measures the relationship between house prices and average earnings. Over the long-term, it averages about 3.5. Currently it is well above that, over four times' earnings nationally, and decisively so in London, where the ratio is nearer six.

But the crude house price-earnings ratio does not take account of another important determinant of affordability, the level of mortgage rates. People have adjusted to the fact that we have moved into an era of permanently lower interest rates. For a given level of house prices, monthly mortgage payments are lower. There is a strong “gearing” case for higher house prices.

These were good arguments for not worrying unduly about the housing market, even when house price inflation went above 10 and then 20 per cent. There is, however, a limit and the recent acceleration in prices may have taken us to that limit. Over the summer the three-month annualised rise in prices hit 40%.

Ordinary home-buyers, as is their right, were responding to low interest rates. So were investment buyers, aiming at the rent-to-buy market. So were old-fashioned property speculators. The market, however, began to take on classic bubble characteristics, as in 1988. People became anxious to get in before prices rose further. That is dangerous.

Is it going to crash? As the Bank of England said recently, the longer this period of rapidly rising prices goes on, the greater the danger of a painful correction, including falling prices. This could happen, by the way, without a sharp rise in interest rates. As in all markets, sentiment can quickly turn. For housing, the lessons of history, and the warnings of the present, both argue for caution.

From Business Voice - December 2002/January 2003

Thursday, December 05, 2002
The housing bubble revisited
Posted by David Smith at 04:55 PM
Category: David Smith' s magazine articles

Once again the topic dominating the dinner tables of Middle England coincides with that of the top tables of economic policymakers. What is going to happen to house prices? Is there a bubble and, if so, is it going to burst? If not, how big a danger does the house price boom pose to economic stability?

House prices are certainly rising. At time of writing the latest Nationwide figures show prices up by 24% on a year ago. The housing market is the main motor behind strongly rising consumer borrowing, up by nearly 14% on the year.

It is also an important driver of consumer spending. This year, according to the Centre for Economics and Business Research (CEBR), mortgage equity withdrawal will total £39 billion, and finance nearly 6% of consumer spending. Equity withdrawal happens when people re-mortgage or move house, taking some of their accumulated equity out for non-housing purposes.

So the strength of the housing market, and the immediate effects of that strength, are not in doubt. Nor, while booming house prices are usually seen as an evil, should the benefits be understated. At a time of falling equity markets, housing has been a source of rising personal sector wealth, without which the economy would have been deprived of at least some of the benefits of consumer spending growth, the main bulwark against recession over the last couple of years. What is going to happen now?

Let me start by putting a few cards on the table. I am not one of those people who worry each time house price inflation gets into double figures. Housing is one of the those "swing" markets where a small change in the supply-demand balance can have a big impact on prices. It is perfectly possible, as we have seen, for high house price inflation to go hand in hand with very low general inflation.

The second card I would put down relates to affordability. Many people swear by the house price-earnings ratio. This does as it says on the box, measures the relationship between house prices and average earnings. Over the long-term, the ratio averages about 3.5. Currently it is well above that, at well over four times' earnings nationally, and decisively so in London, where the ratio is nearer six.

But the crude house price-earnings ratio does not take into account another important determinant of affordability, the level of mortgage rates. I have been a strong advocate of the "gearing" case for higher house prices. People have adjusted to the fact that, as I wrote here a couple of months ago, we have moved into an era of permanently lower interest rates.

Purists would say that what matters in this context is the level of real, that is after-inflation, interest rates. A mortgage rate of 6% at a time of 2% inflation, in other words, is no different to a mortgage rate of 15% when inflation is 11%.

I'm not at all sure about that. For one thing a cut in the nominal interest rate has the most decisive effect on the proportion of income that goes towards mortgage payments. For another, it is not clear what measure of inflation one should choose. If a borrower is taking out a loan for the purpose of house purchase there is a case for saying that the inflation rate on the asset concerned, in this case housing, is the appropriate measure. On this basis, in real terms mortgage rates are currently negative.

So is it all hunky dory? Should we celebrate rather than curse the housing boom? Not quite. I was very comfortable with my gearing and "swing market" arguments until a few months ago. What has made me uneasy has been the recent acceleration in house prices, at a time when there were good reasons to expect a slowdown. Over the summer the three-month annualised rise in prices hit 40%.

We known why this was. Ordinary home-buyers were responding to low interest rates while speculators saw housing as a better bet than, for example, the stock market.

What we began to see, in other words, was a market taking on classic "bubble" characteristics, with buyers apparently determined to get in before prices rose even further, whether or not they regarded a property as good value or comfortably affordable. That way lies extreme danger.

The position now is that the longer this period of rapidly rising prices goes on, the greater than danger of a painful correction, including falling prices. What could bring that about in the absence of a sharp rise in interest rates? The answer is that it could occur for macroeconomic reasons - slower growth in incomes and an upward drift in unemployment - both of which are quite likely. It could also occur because of the housing market's internal dynamics. Once buyers start to believe prices may fall, demand will drop right back. If, at the same time, there is forced selling by some overstretched borrowers, the impetus will be there for a sharp drop in house price inflation, if not outright price falls.

The CEBR, for example thinks that house price inflation will decelerate to under 3% by early 2004. That would mean, in some areas, falling prices.
We should not be too gloomy about this. A repeat of the early 1990s, with the horrors of widespread negative equity, is not in prospect. Sometimes, too, people need to be reminded that prices can go down as well as up.

From Professional Investor, December 2002-January 2003