David Smith's other articles Archives
Sunday, October 15, 2017
Don't give up the ghost entirely on Britain's productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The biggest UK economic news this week came from an unusual source. When the Office for Budget Responsibility (OBR), reviews its own forecasts, as it does regularly, this is normally one for the nerds and pointy-heads.

But, without wishing to align myself too much with either group, the latest Forecast Evaluation Report from the government’s fiscal watchdog had bite as well as bark. One Treasury official described it as a “bloodbath” for the public finances.

The issue is a straightforward one, which has appeared on many occasions in this column. Productivity is the key to prosperity and living standards. Higher productivity – more output for every worker or hour worked – determines the growth of real wages and the economy’s ability to grow with a given size of workforce. It is, as the economist Paul Krugman once memorably put it, not everything, “but in the long run it is almost everything”.

It is also intimately linked to the state of the public finances; government debt and deficits. Productivity growth has a direct impact on tax revenues and establishes the economy’s “speed limit”. The lower that speed limit, the more difficult it is to grow your way out of a budget deficit. As the OBR puts it: “Other things being equal a downward revision to prospective productivity growth would weaken the medium-term outlook for the public finances.”

The significance of its latest assessment is that the OBR has been dutifully waiting for something to turn up on productivity for many years. Every year since 2010, when it came into being, it has assumed a recovery in productivity growth to its long-run average of around 2% a year. Every time it has been disappointed.

Even when all the ducks have been in a row for a rise in productivity, it has failed to happen. Instead of a 2% annual rise in productivity, the past five years have delivered just 0.2% a year. Productivity is no higher than it was a decade ago, when a normal performance would have delivered a 20% rise.

So, while the OBR has not said precisely what figures it will use to underpin the November 22nd Budget, it has said it will be “significantly reducing” its assumption for productivity, to bring it more into line with the recent disappointing experience.

The story of how it has got to this position reads a little bit like a Whodunnit. Post-crisis productivity weakness is not confined to Britain but the gap with other countries – German output per hour is 36% higher than British, France’s 29% - is embarrassing.

One of the first explanations for the weakness of productivity in Britain was that firms had hoarded labour during the 2008-9 recession, during which employment fell a lot less than feared. With a surplus of workers relative to output, productivity weakness was not surprising.

However, as the OBR notes, that explanation “became less appropriate once firms began hiring again”, so attention turned to other factors.

High on the list of these was that problems in the banking system had prevented the normal process of creative destruction to work. The banks forgave weak businesses which in other circumstances might have failed, and failed to lend enough to new, dynamic, high-productivity firms.

Clearly, there was some truth in that. But, as the OBR again concedes: “The banking system is now much better capitalised and more robust than it was in the immediate aftermath of crisis, so this explanation no longer looks as relevant as it once did.”

That still leaves us with plenty of explanations. One, which I devoted a piece to here a few weeks ago, is that ultra-low interest rates have contributed to productivity weakness. The banks showed forgiveness and near-zero official rates made it easier for them to do so. Zombie firms have stalked the land, driving down productivity.

Sectoral shifts in the economy have also been important. I have yet to come across a business which says it is not making an effort to boost productivity and, in most cases, achieving gains. Yet if there has been a shift from higher to lower productivity activities, as there has been, it is perfectly possible for the majority of firms to be increasing productivity while the performance of the average stagnates.

The single most important explanation for the weakness of productivity, however, jumps out of the OBR report. 10 years on from the start of the financial crisis, business investment is just 5% above its pre-crisis peak. At this stage in the two previous recessions and recoveries, in the 1980s and 1990s, business investment was up by 63% and 30% respectively. This is an enormous contrast.

A couple of years ago Britain appeared to be on the brink of a significant upturn in business investment. Predicted annual growth rates of 8% or 10%, sustained for some time, were not unrealistic. Then came the referendum and, according to the Bank of England, the level of business investment by 2020 will be 20% lower as a result. We should also be concerned about Britain’s ability to attract inward investment in future.

The delayed investment upturn may mean we have to get used to weaker productivity than is healthy for a while yet. But we should not throw in the towel entirely on a productivity revival, and I would not expect the OBR to do so.
For one thing, we have a labour market that is tight, with an unemployment rate of just 4.3%, and a labour supply shock on the horizon. I do not buy the simplistic argument that EU migrants have enabled firms to employ rather than invest. In most cases a decision to employ also means a decision to invest, for example in new outlets.

But migration from the EU to Britain is already falling and, given the tightness of the labour market, we will soon facing the choice of raising productivity or not growing at all.

The shift in the mix of economic activity to lower-productivity sectors, made possible by a good supply of labour may also have run its course. It is hard to expand the number of coffee shops or sandwich bars when there is nobody to staff them. Meanwhile the latest figures for manufacturing, which had a good summer, is outgrowing services and generally has higher productivity. We may be seeing a shift back towards higher-productivity activities, or at least the start of it.

Above all, the idea of permanently stagnant productivity is too depressing to contemplate. Stagnant productivity means stagnant living standards. The OBR is right to adjust its projections in the light of productivity weakness. It would be wrong to give up the ghost entirely.

Sunday, October 08, 2017
Clueless on Brexit - and it is taking its toll
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Give Us a Clue was a popular TV show featuring the entertainer Lionel Blair. It was also what Tony Blair, no relation I think, was reported to have said to Gordon Brown when the latter, as chancellor, was refusing to divulge his budget plans to his prime minister.

Give us a clue is back, though in a more important context. Sixteen months on from the EU referendum, and less than 18 months until Britain’s formal departure, business still does not have much of a clue about Britain’s future relationship with the EU.

It is, frankly, astonishing that so far into the process, the government does not have a Brexit blueprint that it can communicate. This is not, to be clear, to avoid showing our negotiating hand to the EU. There is no blueprint.

Leaving aside the difficulties she encountered during her Manchester speech, the furthest Theresa May could go in her more substantive Florence speech last month was to say that neither a Canada-style free trade agreement with the EU (which took seven years to negotiate), nor Norway-style European Economic Area membership – staying in the single market but not the customs union – would suit Britain. We thus know what the government is against, but not yet what it is for, a familiar Brexit position, and the frustration is growing.

“Businesses are clear that they want a comprehensive transition period, lasting at least three years, and pragmatic discussions on the future trading relationship between the UK and the EU firmed up by the end of 2017,” said the British Chambers of Commerce. “They will judge the government’s progress on Brexit by this yardstick and will take investment and hiring decisions accordingly.”

The Institute of Directors attacked “the big let-down” of the party conference season and the fact that “far too little time has been spent explaining the plan for how we leave the EU.”

This is not just a matter of the convenience of business. Those that have made contingency plans for a Brexit deal that falls well short of what they need to operate in the EU and have either pressed the button on those plans or are close to doing so. Sam Woods, a deputy governor of the Bank of England, warned a few days ago that if we get to Christmas and no agreement has bene reached on transition arrangements what he described as “diminishing marginal returns” will kick in. The City, in other words, will take action on the basis of no deal and no transition.

The economy, meanwhile, is prey to the uncertainty. The construction sector is struggling because of a lack of new projects and may be back in recession, while service sector growth has slowed. The economy is crawling along, with the third quarter of the year set to similarly weak growth as the first two quarters.

When businesses hear that the government is making contingency plans for a no deal outcome from the negotiations, they wince. Those that have looked at it in any detail also wince when they hear blustering Brexiteers blithely saying that Britain could happily manage on WTO (World Trade Organisation) rules.

Such talk misunderstands the nature of our trading relationship with the EU, and the degree to which the British economy is integrated within the EU economy. Many British businesses see their exports embodied as intermediate components of the EU’s exports, as Mark Carney pointed out in a recent speech, in a way that barely happens in the rest of the world. They are part of an EU supply chain.

British exports to the rest of the world travel long distances, taking a long time, by ship or plane. British exports and imports to the EU travel short distances, usually by lorry, and operate on tight schedules, because they are carrying components needed for just-in-time production, or perishable food products and other products where time is of the essence. Delay these movements and you have serious problems.

The Port of Dover used advertising space at the Tory conference to demonstrate that the 10,000 lorries it handles each day are cleared through the port in an average of two minutes. Extend that average time by just two minutes and there would be 17-mile queues on the English side of the Channel with something similar on the other side. Operation Stack, the occasional queues of lorries on the M20, would become a permanent feature, and worse. Without frictionless trade, there would be chaos, confusion and considerable economic damage.

We come back to a simple point. The single market has changed the nature of Britain’s economy, enabling the advantages of free trade, as well as economies of scale, to be more fully exploited. Withdrawing from it, as the Bank governor put it recently, is an example of “deglobalisation”, which comes at a time when the share of Britain’s exports taken by the EU is growing again. From a low of 46.6% in 2015, the share of UK goods exports destined for the EU was 48.4% in the first half of this year.

Given the recovery in EU economies, it may be heading back above 50%, though any rise will not survive leaving the single market. Smart detective work by Ed Conway, Sky’s economics editor, suggests the true share is already above 50%. Though Britain produces no gold, or at least no gold in significant quantities, gold exported from the London bullion market to Switzerland for processing counts as non-EU exports. The numbers are big enough to make a difference.

The big picture is that about half of Britain’s trade, taking exports and imports together, and on this basis also taking goods and services together, is with the EU, and slightly more with the European Economic Area, countries such as Norway and Iceland which are not in the EU but are in the single market. More than that, much of that trade is currently conducted with as little friction as if it were between Yorkshire and Lancashire. Whether post-EU frictionless trade is even possible remains to be seen.

In an article in the London Review of Books, London Schools of Economics’ economists Swati Dhingra and Nikhil Datta, both pour cold water on the prospect of quick and workable non-EU trade deals and point out how far they would have to go to come anywhere close to compensating for the potential loss of EU trade. China, for example, accounted for a mere 4% of Britain’s goods exports last year.

As they put it: “Countries have always traded the most with their biggest, closest neighbours. This is by far the most reliable fact about international trade and holds true no matter which set of countries, time period or sector (goods, services, e-commerce, foreign investments) is looked at. Given that the EU is within swimming distance from the UK, has a population of more than 500m and a GDP of almost $20 trillion (double that of China), an equivalent replacement is effectively impossible. EU standards on goods and labour are more acceptable to British people than those in the US, China and India.”

The view among the sensible people in government, amid growing realisation of the damage that failure to secure a comprehensive deal with the EU would do. It may be that this week will see a breakthrough in the talks that would allow both sides to move on to the future relationship, but it would be unwise to rely on it. There is fault on both sides but the EU recognises that the weakness of the government’s position is preventing it from moving the negotiations on from matters such as the divorce bill and EU citizens’ rights to more important matters.

As things stand, the best business can hope for is agreement on lengthy transition arrangements, during which very little changes. As to where Britain ends up in the long-term in its relationship with the EU, it is still not getting much of a clue.

Sunday, October 01, 2017
Lessons in how to wreck an economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This is the way economies descend into chaos and failure. A weak and divided government, out of energy and ideas, capitulates to the most left-wing Labour government in recent times. The difficulties of Brexit are compounded by an anti-business, anti-enterprise agenda.

Two years ago this would have been the stuff of fantasy, a “what if?” scenario that had no chance of becoming reality. Voters, we thought, would never support anything like this. Now, it is becoming a serious possibility.

There is clearly a direct link between Brexit, and the way in which in last year’s vote unfolded, and the fact that Labour could talk confidently at its Brighton conference about forming the next government without being laughed off stage.

Without Boris Johnson and Nigel Farage, we would not be talking about the prospect of Jeremy Corbyn and John McDonnell getting their hands on the levers of power, not so much Little England as Little Venezuela.

Fake news has a lot to answer for, as well as misuse of statistics. But so too do the warnings of an immediate and damaging economic fallout following the referendum and, indeed, a Donald Trump victory in last year’s presidential election. The negative economic impact of the Brexit vote is, of course, already apparent but the danger is that people will take with a pinch of salt warnings of the adverse consequences of a Labour victory.

This is despite the fact that McDonnell, the shadow chancellor, has rather cleverly said that Labour is “war-gaming” the run on the pound that would follow an election victory for his party. By doing so, he was following a Labour tradition. In 1964, George Brown and Harold Wilson, secretary of state for economic affairs and prime minister respectively in the 1964-70 Labour government, criticised the “gnomes of Zurich” who were selling the pound. By pitching himself against the speculators, the shadow chancellor has pitched himself into a battle in the court of public opinion which he can win.

That is not the only problem. A few days ago I attended a conference at Nottingham University with Sir Vince Cable, the Liberal Democrat leader, at which we both spoke.

He recounted his frustration at talking to young people about Labour’s economic policies, reminding them of the importance of fiscal discipline. He would tell them there was no magic money tree. They would insist there was and that he was stuck in the past.

In this respect quantitative easing (QE) has a lot to answer for. It is no magic money tree – the money created is matched by the assets purchased, mainly government bonds – but many people think it is.

Labour would borrow more, issuing apparent limitless quantities of government bonds (gilts) just to fund its part-compensation plans for its renationalisation programme and taking PFI (private finance initiative) contracts back into the public sector. Borrowing to spend more would come on top of this. With the public finances still in a shaky enough state to warrant a further downgrade of Britain’s sovereign debt rating a few days ago, this would be testing the appetite of investors for UK government debt to destruction.

There was a time when the trade unions lobbied the Labour leadership in vain on policy. Not any more. The unions’ cups runneth over. They are getting things from the current leadership they were not bold enough to ask for. And we should remember in all this that fewer than a quarter of employees, and fewer than a fifth of all workers, are union members.

Could it happen? There was a time when , faced with the risk of a lurch to the left, you would not expect Tories to be as ill-disciplined and stupid as to hand power on a plate to Labour. True, it happened before, in the 1992-97 parliament under John Major, when divided Tories made a Tony Blair landslide inevitable. Blair, of course, was no Corbyn and today’s Brexit-obsessed Tories are, if anything, even more ill-disciplined than they were two decades or so ago.

The important thing with Labour’s programme is not to assess the individual policies, troublesome though they are. Everybody can find things to criticise with individual PFI programmes, though there have been cost-savings and refinancing in recent years. Five years ago, the Treasury launched a revised version of PFI. Similarly, everybody can find things to criticise in the performance of some privatised industries.

But none of this should suggest a blanket and wasteful “taking back control” of PFI projects and wholesale renationalisation, even if ideology blinds you to the central logic behind all this; bringing private sector efficiency to the delivery of public projects and public services.

Even this, however, is not the real danger, Assuming that at some stage the stalled Brexit negotiations get started again, it is still the case that Britain will end up with a worse deal when it comes to doing business with the EU than we have now. Near-membership of the single market and a customs agreement can never be as good and frictionless as the real thing.

I do not blame the new, conciliatory Theresa May for this, though it has taken her time to come round to a sensible view on transition. I do blame those in her cabinet and party constantly snapping away at her ankles.

Brexit will make plenty of international businesses wonder whether Britain is still the best place to locate. Against the loss of single market and customs union membership, Britain can offer low corporate taxes, generally low personal taxes, and the most lightly-regulated economy in Europe.

Now replace that with a government that wants to put up corporate taxes, increase personal taxes, particularly for higher-earners and re-regulate the economy. Replace it with a government which wants to greatly extend the size of the state, taking industries back into public ownership without offering full compensation to shareholders.

As a business, would you want to invest in a post-Brexit Britain of this kind? As a business currently invested in Britain would you want to stay? The only thing flying in Britain would be a tattered red flag.

The combination of a messy Brexit and Labour’s economic agenda would be highly toxic. If it comes to pass, we will have a lot more than a run on the pound to worry about.

Sunday, September 24, 2017
It's been a woman's world in the job market
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It would have been easy this week to focus on the latest projections from the Organisation for Co-operation and Development (OECD), which are for a slowing British economy at a time when the global economy is speeding up, something which does not normally happen.

And, while some will say you should never believe forecasts, the OECD is merely extrapolating what is already happening. The global economy is growing more rapidly this year while Britain has cooled, and you do not need to be Miss Marple, or perhaps more appropriately Hercule Poirot, to work out what is happening.

Or I could have focused on Friday evening's downgrade of Britain's sovereign debt rating by Moody's, taking the country even further away from the old AAA rating.

But, while mention of Brexit is guaranteed to send some people frothing at the mouth, which can be entertaining, the OECD forecast has been well covered. I sensed some glee behind the decision to splash it all over the front page of George Osborne’s Evening Standard, the London free newspaper. And government bond yields have not risen, despite the post-referendum ratings downgrades.

It was another aspect of the OECD’s new interim economic outlook, however, I wanted to focus on and it relates to the job market. This is the interesting fact that, across the industrialised world, the post-crisis recovery in jobs has been led by women.

For OECD countries as a whole, the male employment rate is still lower than it was in 2008, when the economic downturn as a result of the global financial crisis began to hit. The female employment rate, by contrast, is up sharply compared with the pre-crisis peak. The OECD’s index of its members’ employment rates is up by around 5% for women, while down by 1% among men.

Male employment has been recovering from its post-crisis lows. But it was harder hit by the crisis and has not got back to where it was. Female employment, in contrast, suffered a smaller hit in the crisis and has enjoyed a stronger recovery.

The picture in Britain follows a similar pattern though with some differences. Both male and female employment rates are above pre-downturn peaks, though the rise in the female employment rate – up from 67.1% in March-May 2008 to 70.8% now, has been bigger than the rise in the male rate, which is up from 79% to 79.8%. As far as jobs are concerned it has been a woman’s world.

I have been aware of the faster rise in female employment in recent years for some time. One special factor has been the move to equalise the state pension ages of men and women, a process that has increased the proportion of women in the 50-64 age group in work. As the Office for National Statistics notes, the changes mean that fewer women are retiring between the ages of 60 and 65,

But the narrowing of the gap between male and female employment rates is part of a long-term trend. In 1971, the starting point for Britain’s Labour Force Survey, the male employment rate was 92.1% and the female rate just 52.7%, a gap of nearly 40 percentage points. Now, the gap is down to just nine percentage points, and closing. While the female employment rate has never been higher than now, a male employment rates of just under 80% would once have bene regarded as quite low.

There are long-term trends at work here. That and the fact that as the OECD points out, what is happening is international in nature, suggests this goes well beyond changes in pension age.

Government policy has made a difference, both over the decades of rising female employment and more recently. Improved childcare arrangements and assistance and enhanced parental leave have had an impact, and not just in Britain.

In the mid-1990s Japan had a lower female employment rate than most other countries. Now it is in the centre of the pack thanks to targeted policy and campaigns aimed at increasing the proportion of women in work. The initiatives included additional allowances for new partners, subsidised nursery care and allowing parental leave to be shared between mothers and fathers.

The relative success of women in the workforce is also explained by the shifting patterns of employment and output in the economy. Manufacturing and construction are, despite the efforts of firms in these sectors, male-dominated.

Manufacturing and construction are, moreover, the laggards when it comes to both output and jobs. Employment in these sectors is down on pre-crisis levels, as is output. Employment in more female-friendly service industries, on the other hand, is about 2m above pre-crisis levels in Britain and output in this, the dominant sector of the economy, is also significantly higher than it was.

This, while creating opportunities, also creates challenges. In some of Britain’s old mining and manufacturing areas the absence of traditional male jobs has led to decades-long blight.

The service sector is also more likely to be associated with flexible working arrangements. Part-time employment is still relatively unusual among men; only 13% of men in work are part-timers. It is much more common among women, where 42% are part-time workers.

This relative shift towards female employment – since the crisis the proportion of women in employment has risen from 46% to 47% - is welcome. But it may have another consequence, which can be added to the explanations of why the growth in wages has been so weak in recent years.

"Employment rates for women have grown faster and are above where they were in 2008, but employment rates for men have not even gotten back to where they were,” said Catherine Mann, the OECD’s chief economist, said in an interview with the BBC World Service after the publication of its interim outlook.

“That [must be seen] in conjunction with what we know about women's wages - that women are paid less than men. You've got more women employed, as compared to men, so the algebra works out to be a downward pressure on wage growth.”

Compositional changes – shifts in employment between sectors and high and low-skilled jobs - have been an important factor in the weakness of wages in recent years, alongside poor productivity, a weak bargaining position for employees and an acceptance by many workers of 2% pay rises as the going rate. In an ideal world of pay equality between the sexes, this particular compositional change would not matter. In the real world unfortunately it does.

Sunday, September 17, 2017
The Bank can't afford to cry wolf on rates again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A Rip Van Winkle who went to sleep 20 years ago and woke up around midday last Thursday, when the Bank of England made its latest interest rate announcement, would be more than a little bemused. The level of official interest rates – 0.25% - the lowest in the Bank’s history would be a source of amazement; 20 years ago the rate was 7%.

So, and only slightly less so, would be the excitement generated by the Bank’s broad hints that at some stage in the coming months interest rates might rise from this extremely low level. Veterans of monetary policy remember the days when rates went up, without warning, by large amounts.

Even leaving aside special episodes like Black Wednesday in September 1992, discussed here last week, I can remember months like January 1985, when we saw two rate rises of two percentage points each, within the space of a couple of weeks.

That was in response to a very weak pound. Our very weak pound now got a boost from the more hawkish talk from the Bank on Thursday and, in particular, the phrase in its minutes that “a majority of MPC (monetary policy committee) members” think that if the economy continues on its current path “some withdrawal of monetary stimulus is likely to be appropriate over the coming months”.

It was given a further boost on Friday from hawkish comments by the MPC member Gertjan Vlieghe, previously thought to be the committee's arch dove.

Some withdrawal of monetary stimulus, to translate from Bankspeak, means in the first instance a rise in interest rates, and it has been a long time since that happened; more than 10 years.

Nor should this “hawkish” message been much of a surprise. It was implied by the Bank’s inflation report last month. It has been given added urgency by the jump in inflation to 2.9% last month, with Bank economists expecting it to exceed 3% in October.

The strength of the labour market, with the employment rate hitting a record high of 75.3% in May-July and the unemployment rate dropping to 4.3%, its lowest since 1975, has pushed the economy closer to capacity.


There are three other things to know about the Bank’s approach, and its “hawkish” hints of a rate rise on the short-term horizon. The first is that while it was prepared to used monetary policy – last August’s rate cut to 0.25%, the extension of quantitative easing and the launch of the term funding scheme to cushion the shock of the Brexit vote, it cannot prevent the long-term damage from Brexit.

As it put it on Thursday: “Monetary policy cannot prevent either the necessary real adjustment as the United Kingdom moves towards its new international trading arrangements or the weaker real income growth that is likely to accompany that adjustment over the next few years.” So, while a renewed downward lurch for the economy as a result pf Brexit uncertainty would change its plans, it cannot be expected to leave rates on hold for the years it will take for the Brexit dust to have settled.

The second important factor is that it does not take much growth these days before the economy bumps up against the Bank’s speed limits. Brexit and other factors have damaged the economy’s supply-side, to that potential or “trend” growth is only about 1.5% a year. Growth of 0.25% a quarter, the average for the first half of the year, is below that potential but only a small rise would take it above it. The economy, in other words, does not have to be racing away to justify higher interest rates.

The third point related to wages, a key factor. After Wednesday’s official figures showed average earnings growth at just 2,1%, weaker than expected, some in the markets decided that rate hikes were off the agenda. They were mistaken.

The Bank thinks that the underlying growth in pay is stronger than the figures suggest. Official statisticians point to so-called “compositional” effects in the job market; the mix of skills, sectors (some pay a lot less than others) and occupations. Adjusting for changes in these, Bank staff think the underlying growth in pay is nearer to 3% than 2%; these effects depressing earnings growth by 0.7 percentage points.

Bank economists have also gradually discovered, in their quest to find the “equilibrium” rate of unemployment – below which wages start to accelerate – that something fundamental has changed. The search for that equilibrium goes back some years. When Mark Carney became governor in the summer of 2013 and famously launched his forward guidance on interest rates, it was to say that the MPC would not consider a rate hike until the unemployment rate dropped below 7%. It did, quite quickly, but the Bank gave scant consideration to hiking rates.

Then estimates of the equilibrium rate dropped to 5%, then 4.5%. Now, even with an unemployment rate of 4.3%, wages are not accelerating. Why isn’t falling unemployment pushing up wages at a faster rate? The answer, which is implicit in the Bank’s unemployment analysis, is the crucial new factor is productivity.

If productivity is weak, as it is, employers will not give bigger pay rises even in a tight labour market. They have to be justified by higher productivity; output per worker. Looking for the inflationary impulse from wages could be the modern equivalent of Goodhart’s law, invented by the economist and former MPC member Charles Goodhart. This, which emerged during the 1980s’ monetarist era, was that any measure targeted by the authorities automatically became distorted. The same may now apply to wages.

So what happens now, and what should happen? Mention of forward guidance is a reminder that we have been sold a pup by the Bank on interest rate warnings before. The governor followed his 2013 guidance with a mid-2014 warning that rates could rise sooner rather than later. A year later, in July 2015, Carney travelled up to Lincoln Cathedral to deliver a speech warning that a decision on rates would move “into sharper focus” at the end of the year. Though in the run-up to June 2016 the Bank did not warn explicitly of rate hike in response to the weaker pound that would follow a Brexit vote, merely saying it would present a trade-off, others including the then chancellor did.

That is why the latest warning is being taken by some with a pinch of salt. Thrice-bitten, twice-shy is not a proverb but in this context it probably should be.
It is why, for the sake of its own credibility, the Bank has to follow through this time. Of course things can change, and that would be understood. The initial move on rates would be to reverse last summer’s emergency rate cut and then stake stock before embarking of further modest and gradual rises.

But doing nothing after another signal that higher rates are on the way would be a mistake. The Bank cannot afford to cry wolf again.

Sunday, September 10, 2017
Lessons from the first Brexit for Britain's EU departure
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The Brexit process is proving slower and more difficult than even I expected. Fifteen months after the vote, and with a failed election gamble in between, we have barely got to first base. David Davis, the Brexit secretary told the House of Commons last week that nobody said it would be easy, though he and plenty of other Brexiteers suggested it would be.

The process has made some yearn for what is sometimes called the first Brexit, Britain’s abrupt departure from the European exchange rate mechanism (ERM), 25 years ago this Saturday.

I shall provide a reminder about what the ERM was – and an introduction for younger readers – in a moment. But in that episode, Brexit occurred in a matter of hours, not years. It happened in spite of government policy, which was to stay in, rather than because of it. It marked, if not the start, then the impetus for the longest period of continuous economic growth in Britain’s history, and one of the strongest.

It also, according to a new book from OMFIF (the Official Monetary and Financial Institutions Forum), one in a series of “great British financial disasters”, set Britain on a course of greater Euroscepticism, for which the bigger Brexit we have now embarked upon was a natural consequence.

By the by, it destroyed the Conservative party’s reputation for economic competence, a blow from which the Tories took “nearly 20 years to recover”, according to John Nugee, former manager of reserves at the Bank of England, observes in an introduction.

The book, Six Days In September: Black Wednesday, Brexit and the Making of Europe, by William Keegan, David Marsh and Richard Roberts, has the virtue of having spoken to the main players, either now or at the time, and uses material released from the archives.

Before coming on to what that first Brexit might mean for this Brexit, and for the outlook for sterling and the economy, as promised a brief recap.

The ERM, an attempt to bring currency stability to Europe after the turbulence of the 1970s, was part of the European Monetary System, established in 1979. Member currencies were allowed to fluctuate in either narrow bands (2.25% either side of agreed central rates), or broad ones (6% either side). Exchange rates could and did adjust, in regular realignments, usually to allow the deutschmark to rise.

As was common in EU initiatives, Britain did not join at the outset, leaving it until October 1990, by which time much blood had been spilt in the Tory party. John Major, then chancellor, persuaded a sceptical Margaret Thatcher, not least by pointing to ERM membership as a way to get Britain’s sky-high interest rates, then at a 15% level which were destroying home owners and small businesses.

Entry was messy, as the book recounts. I remember being summoned to the Treasury in the late afternoon of Friday October 5 1990 to be handed a statement, the first line of which was to announce an interest rate cut from 15% to 14%. The much bigger announcement, that Britain would be in the ERM the following Monday, was accorded second place.

It was messy in another way. Britain’s economy had entered recession a few months earlier, as a consequence of those high interest rates, though that was yet to be acknowledged within government. The German economy, meanwhile, was embarking on its post-unification boom. And a booming German economy could, as students of the Federal Republic’s inflation aversion were aware, only mean higher German interest rates. This, Keegan, Marsh and Roberts reveal, was not taken into account by British officials.

Britain struggled in the ERM for 23 months, with the government insisting it could make its attempt to put Britain at the heart of Europe work. Interest rates were brought down to 10%, and inflation fell sharply. But Britain’s weak economy needed rates of well below 10% and that could not be achieved unless Germany’s powerful Bundesbank reduced its interest rates.

Events came to a head in mid-September, as they often do (think of the Lehman Brothers collapse on September 15 2008). On September 15 1992 Helmut Schlesinger, head of the Bundesbank, gave an interview warning of the ERM’s vulnerabilities. It was seized upon by George Soros, the hedge fund titan, and others, to launch a wave of selling of sterling the following day. Interest rates were raised to 12%, with a promise of 15% the following day (which was never enacted) and the Bank expended all its foreign exchange reserves trying to prop up the pound. It was all in vain. Sterling crashed out of the ERM, never to return.

Schlesinger apologises for his part in sterling’s downfall in the book, which is unusual. But the writing was on the wall. Modesty almost prevents me from mentioning a piece I wrote on the Sunday before Black Wednesday, quoted in the book, which said that if the Treasury was waiting for a German interest rate cut to relieve the pressure on the pound it was whistling in the wind.

Are there lessons from that first Brexit for this one? Liberation from the ERM and departure from the EU are very different animals. I used to think that Britain’s post-ERM success was mainly about a rare devaluation that worked. Now, the evidence is that it was mainly that exit provided an opportunity to cut interest rates from an inappropriately high level and to do so very quickly. Rates were cut by four percentage points in four months. No such monetary stimulus is possible now.

Not only that, but it helps hugely to have a successful alternative policy framework. Within weeks of Black Wednesday, and from a standing start, the government had adopted an inflation target and given the Bank the enhanced role that paved the way for independence in 1997. That new framework not only benefited the economy but also pushed up the pound. By the end of the 1990s, and the dawn of the euro, sterling was above the level s against the deutschmark that were regarded as too high in 1990-92. Bank independence transformed international attitudes to UK economic policy. No such game-changer is in sight now.

As noted, that first Brexit proved toxic for the Tories, even as the recovery resulting from it came through. History could repeat itself, particularly with Theresa May once more being pushed by some of her hardline backbenchers towards a no deal, no divorce bill, cliff-edge departure. This would, according to The UK in a Changing Europe, an independent research body, have “widespread, damaging and pervasive” effects. And the Tories would deserve their punishment.

Sunday, August 13, 2017
Job done: How we got down to work after the crisis
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is time to give credit where it is deservedly due. I am referring to something that, without which, recent years would have been infinitely more difficult than they have been. The old adage, that it is a recession when your neighbour loses their job, a depression when you lose yours, has not been played out anywhere near as much as was feared. Britain’s job market has changed, and not always for the better, but it has done what it does best, which is to generate employment.

A few days ago the Recruitment and Employment Confederation (REC) reported that permanent staff placements had reached their highest level for 27 months, with overall staff demand at its strongest for nearly two years. Its survey, based on responses from recruitment agencies, pointed to continued buoyancy in employment.

That chimes with official figures showing that in the March-May period of this year total employment rose above 32m for the first time, with the proportion of 16-64 year-olds in work reaching 74.9%. This was the highest since comparable records began in 1971.

Before looking in a little more detail at what is happening now, let me first track back to the time when we first realised that the job market was behaving differently. When the financial crisis hit a decade ago, it took a while before the economy succumbed to recession.

The last hurrah for the great expansion that began in the very early 1990s was the first quarter of 2008, after which the economy dived into its deepest recession in the post-war era. Current data how that by the time the economy troughed in mid-2009, it had shrunk by 6.3%.

Previous experience might have suggested that employment would have fallen by at least as much. It did not. From an employment peak of 29.75m in March-May 2008, it dropped to a low point of 29.01m in January-March 2010.

The fall in employment in that deep recession, of 2.5%, was remarkable for how small it was. The experience of the great recession of 2008-9 stood in sharp contrast to its much milder predecessor in the early 1990s. In the 1990-1 recession, the economy contracted by just 2%, though it seemed worse at the time. It certainly was worse in terms of employment, which dropped by a hefty 6.2%. In this tale of two recessions, the later one was a mirror image of the earlier downturn.

So it has continued. After the great recession, it was widely expected that, having hoarded workers during the downturn, employers would be slow to hire during the upturn. Critics of coalition policy, including the Labour party, said that austerity cuts in public sector employment would not be replaced by an increase in private sector jobs.


Both views were wrong. Though employment growth was initially subdued, with a significant concentration of part-time work, it picked up and shifted decisively towards full-time jobs.

As for replacing those lost government jobs, public sector employment has fallen by just over 1m since 2009, with the bulk of the drop concentrated in local government. Overall employment, meanwhile, has risen by 3m. The private sector has not only replaced those lost public sector jobs but it has done so four times over.

Why has the labour market done so well? The flexibility established in the 1980s has come good, albeit with a lag, in recent years. Part of that flexibility has been reflected in the weakness of wages. No central planner could have done what Britons collectively did off their own bat when the crisis hit, which was to price themselves into jobs.

Monetary policy has also helped deliver more employment, both since the financial crisis and since last year’s EU referendum. Andy Haldane, the Bank of England’s chief economist, recently suggested that higher rates could have delivered slightly higher productivity but at the expense of around 1.5m jobs.

What about the current situation? Forecasters were wrong to assume that Brexit would result in an immediate rise in unemployment; the experience of the crisis and recession showed a far more resilient labour market than that.

Employment growth has slowed a little – in the past 12 months it has risen by 324,000 compared with 636,000 in the previous 12 months – but it remains healthy. The Bank predicts that the unemployment rate will remain at around its current 40-year low of 4.5% over the next three years. You should never say never but the prospect of a return to the double-figure unemployment rates we saw as recently as the 1990s seems remote.

The question is whether there is scope for employment to rise much further. One of the sources of Britain’s labour market flexibility in recent years has been the availability of EU migrant workers. They have not prevent employment among UK nationals rising to record levels but they have provided a key source of labour supply.

That supply has itself been flexible. It is not generally known but, after EU enlargement in 2004, net migration into Britain rose sharply until the crisis hit, but then did not get back to its 2007 level until 2014. It was responsive to the state of Britain’s labour market.

Now, net migration from the EU is falling again, to 133,000 last year from 184,000 in 2015 (new figures will be released on August 24). Employment among EU nationals continues to rise, up 171,000 over the latest 12 months, but this was slower than the 226,000 rise of the previous 12 months. And there has been a shift in recent months towards EU nationals from Romania and Bulgaria and away from those of from the EU’s Western European member states; traditionally the higher-skilled, higher-earning EU workers.

The REC’s Report on Jobs, referred to earlier, found that alongside strong demand for staff, availability is falling. Some employers are responding by offering higher pay, many others are struggling to recruit. Kevin Green, the REC’s chief executive, says parts of the economy most dependent on EU workers are under the greatest pressure. This comes, of course, before Brexit, though at a time when the weak pound has made working in Britain less attractive for EU workers.

When it comes to the labour market people will complain, sometimes but not always with justification, about insecure jobs, zero hours contracts and exploitative “gig” economy arrangements. These things would, however, be a lot worse in the context of a weaker job market in which opportunities were far harder to come by.

Britain’s labour market has been a success story, which has saved us from much worse fates. Let us hope nothing scuppers that success.

Sunday, August 06, 2017
A spanner in the works for Britain's growth potential
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This has been like one of those moments when you get somebody to look under the bonnet of your car because it has been making a strange noise and seems incapable of maintaining any sort of speed.

The mechanic takes a look and emerges with a shake of the head. Some serious damage has been done and it is going to be hard to fix. Better find some alternative arrangements.

In the case of the economy, the man with the oily rag is Mark Carney, the Bank of England governor, assisted by his colleagues on the monetary policy committee (MPC), and the bad news he delivered was in the Bank’s latest inflation report.

Let me make clear what I mean by the bad news. It was not the downgrading of the Bank’s growth forecast for this year than next, which recent weak data made inevitable. It was not the fact that Brexit uncertainty is undermining investment by making businesses unwilling to commit. Anybody with half an eye on the economy knew that too.

They also know, to take one of the Bank’s other points, that the Brexit fall in the pound is the main mechanism for the current squeeze on household real incomes, which is hitting consumer spending and thus the growth in demand.

No, the really bad news in the Bank’s report was its assessment of what is known as potential, or trend, growth in the economy. Last week I addressed the question of weak growth from the demand side: can stronger exports and investment compensate for weaker growth in consumer spending?

The Bank’s point was a related but different one. The economy’s potential growth derives from the supply side. How fast is the economy capable of growing before its speed limit is reached, before inflationary pressures return?

The answer, according to the Bank, is a lot slower than it used to be. Even very modest growth of 1.7% or 1.8% a year will be above the economy’s “reduced potential rate”, it says. The crunch will not come immediately, but it will happen in a year or so.

Hence the Bank’s St Augustine message on interest rates; “Lord make me pure but not yet”. Two members of the MPC . Michael Saunders and Ian McCafferty, think the purity should start now, and rates should be going up. The others will give it a little while longer but were still happy to sign up to the Bank’s message to the markets, that in time rates will rise by more than they think.

Let me focus on that gloomy view of potential growth. The Bank thinks the economy is capable of perhaps only about 1.5% a year. I can remember a time when we snootily used that kind of number as representing all that the sclerotic eurozone, which now has a bit of a spring in its step, was capable of.

To put it in context, just over 10 years ago, the Treasury’s estimate for trend growth was 2.75% a year, and the “cautious” assumption for the public finances was for growth of 2.5% a year. Some Treasury officials thought that the numbers could even support a trend growth estimate of 3% a year. The economy’s potential growth rate, it seems, has roughly halved, or at the very least come down by a percentage point or so.

If you want to know what that means in practical terms, contrast two versions of trend growth, the Bank’s reduced estimate and the Treasury’s old cautious assumption of 2.5% a year. An economy capable of growing by 2.5% a year is by 2030 about 15% larger than one that grows by 1.5% a year.

There are two components to this trend growth gloom. The most important is the most familiar: the failure of the economy to generate normal, or even any productivity growth, alongside continued weak investment. It remains a problem. The level of productivity, output per hour, is lower than at the end of 2007 and has weakened this year.

The other component is population, or more relevantly, labour force growth. The Bank is still using the Office for National Statistics’ assumption of net migration into Britain of 185,000 a year between now and 2039. No official body expects net migration to be reduced to the tens of thousands, the prime minister’s target. If the Bank did, it would reduce its estimate of potential growth further.

Not all the gloom about the supply side is due to Brexit, though to return to my car analogy, that clanking sound you hear is the giant spanner that it threw into the works.

To improve productivity and the economy’s productive potential you need investment and, as the Bank noted, it now expects cumulative business investment growth to be 20 percentage points lower at the end of the decade than it did in May last year.

What else do you need to boost productivity and thus trend growth? The answers are familiar, if delivering them is easier said than done. Philip Hammond has said that if every region of the UK could match the productivity performance of London and the south-east then there would not be a productivity problem, and the London School of Economics, which published its latest Growth Commission update a few weeks ago, is doing some good work on this.

Sir Charlie Mayfield, chairman of John Lewis and head of the government-backed Productivity Leadership Group, rightly says that if the productivity performance of the weakest firms in each sector could be brought up to that of the strongest, there would be a step change in Britain’s performance. Its Be The Business initiative encourages firms to assess their own productivity performance and take steps to improve it.

We know too from successive reports commissioned by many governments over the years, that education, skills and infrastructure are the key to ensuring that individuals, and the economy, achieve their potential. The trouble is that they take time, and rather a lot of it.

They also require a lot of attention. In 1997, when Gordon Brown gave the Bank independence, it was so the Treasury could become an economics ministry, concentrating specifically on improving the economy’s supply-side performance. That was in an era when Britain achieved productivity growth we would give our eye teeth for now.

In the 1980s, under Margaret Thatcher, Britain had a productivity miracle of sorts, particularly in manufacturing. That followed a relentless focus on the supply-side through extensive labour market reform, corporate tax changes which promoted investment and personal tax changes which restored incentives.

Things are different now. As was entirely predictable, Brexit has become all-enveloping for the government and for those businesses most exposed to it. The Treasury is fighting hard its corner hard in its efforts to limit the damage. The government is struggling to get out a consistent message. Thank heavens Theresa May does not tweet.

In the meantime, there is drift, and the economy’s potential is drifting lower. And that is not good news for anybody.

Sunday, July 30, 2017
Britain's big challenge is getting out of the slow lane
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

So it has come to pass that Britain’s economy has experienced its weakest first half for five years, having undergone what the Office for National Statistics describes as a ~notable~ slowdown in growth this year.

Notable, and predictable. Slower growth has been staring us in the face since sterling’s referendum plunge guaranteed a squeeze on household real incomes and a cloud of renewed uncertainty descended on business.

Gross domestic product growth of 0.2% in the first quarter and 0.3% in the second represents a halving of the post-crisis trend, and averages barely a third of what was being achieved in the years leading up the crisis. GDP per head, which showed no growth in the first quarter and 0.1% in the second, is now stagnating.

The economy defied gravity for a while, thanks to the willingness of consumers to borrow and to run down their savings. There are still elements of that unsustainability even in the slower growth that Britain is now experiencing; the economy’s weak growth was bolstered by a rebound in retail sales in the second quarter.

Consumer confidence is falling. The latest closely-watched GfK consumer confidence barometer shows a further fall for this month to -12, taking it back to levels last seen in the immediate aftermath of last year’s referendum. Households are gloomy about the economic outlook. The brightest spot for consumers remains the strength of employment.

Despite this, the appetite for consumer credit remains very strong, according to the latest financial activity barometer from John Gilbert Financial Research, which will worry the Bank of England. This barometer, based on additional questions in the GfK survey, suggests falling savings and increased borrowings have become the norms for British households. The CBI’s distributive trades survey, suggesting warm weather kept sales strong into the first half of this month, also suggested that consumers are not quite dead yet.

But, by definition, something that is unsustainable cannot continue for long. Oxford Economics’ spending power index points to a “very subdued” outlook for consumer spending this year and next. Colin Ellis of Moody’s Investors Service predicts a “prolonged moderation” of consumer spending.

We come back to some basic questions for Britain’s economy. Where will the growth come from? And can we avoid getting stuck in the slow lane?

Before coming on to those, let me deal with a couple of puzzles. The first is the contrast between upbeat surveys of manufacturing and downbeat official data, which showed a 0.5% drop in the second quarter. The CBI’s industrial trends survey said that output in the three months to July grew at its fastest pace since 1995 and that order books, while slightly down, remained robust.

It is a challenge translating survey data into hard numbers. When firms say they are producing more than in the previous three months, in surveys they usually do not say by how much. In numerical terms, the idea that we are currently seeing the strongest output in more than 20 years, admittedly from a smaller manufacturing sector, does not stack up.

The hard evidence we have, from one of the bright spots of British manufacturing, leans towards the official data. Car manufacturing dropped sharply in June, by nearly 14% on a year earlier, and in the first half of the year was down by 2.9% on a year earlier.

The other puzzle is that something that does not normally happen, weaker growth in Britain at a time of stronger global growth, is indeed occurring. The International Monetary Fund, in its latest update, maintained its global upturn forecast of 3.5% growth this year and 3.6% next, despite downgrading both Britain and America. Stronger growth in the EU and in emerging economies has been the compensating factor.

The downgrade for Britain mainly reflected the growth disappointment so far this year. The downgrade for America reflected the fact that the much-trumpeted Trump stimulus - $1 trillion of infrastructure spending and big personal and corporate tax cuts – has not been forthcoming, and may not be.

The strengthening global economy is one of the ways in which Britain can avoid staying in the economic slow lane indefinitely. The record of sterling devaluations in delivering sustained, export-led growth is, it should be said, very poor.

What matters for growth, of course, is the difference between exports and imports. If indeed we are to see subdued growth in consumer spending, which seems highly likely, then that should be associated with a slowdown in the growth of imports.

Exports do not, in other words, have to race away to contribute to economic growth at a time when import growth is subsiding. A bigger contribution to growth from net exports is one of the factors that has been driving the hawks on the Bank of England’s monetary policy committee (MPC) to push for a hike in interest rates, the other factor being that they expect business investment to hold up better than feared.

I don’t expect the hawks, who were three in number last time the MPC voted on rates, to swing the argument for a rate hike this week. One of them has left the committee and weak second quarter growth should have persuaded other MPC members to stay their hands, though it promises to be an interesting meeting. Soon the Treasury’s chief economic adviser Sir Dave Ramsden will be joining the MPC as one of the Bank’s deputy governors, though not in time for this week’s meeting.

The hawks’ argument, that we are seeing a forced rebalancing of the economy thanks to the lower pound and the squeeze on consumers, is perhaps the best hope for the economy.

It is also, however, asking rather a lot. Periods of strong export and investment-led growth are rare in Britain. When the consumer is subdued so, in general, is the economy. A stronger global economy will help keep Britain to keep growing, but that growth may not be very strong. Maybe the best hope, unsustainable though it would be, would be for consumers to continue to binge on credit.

The certainty that business is crying out for, meanwhile, is not there. Even Philip Hammond says he cannot promise transitional arrangements for leaving the EU. Nor can he, for they are not within his gift, though they are plainly now the government’s preference.

When businesses hear the international trade secretary say a trade deal with the EU will be the easiest in history, they do not know whether to laugh or cry. What matters is not just the starting point but future arrangements and how regulatory divergence is managed and policed, as useful research from the Institute for Government points out.

The very public debate in cabinet, on everything from chlorinated chickens to immigration and the desired length of time for transitional arrangements, is also doing nothing for confidence.

So, getting out of and staying out of the slow lane is a challenge, particularly in the current environment. We have examples of economies that get stuck in the slow lane, such as Japan in recent decades. And, as we have seen with Britain’s productivity figures, weakness can become the norm.

Sunday, July 23, 2017
Inequality is down - but people don't notice when real wages are falling
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

After a week in which we have been offered a joyous glimpse into what some of the BBC’s highest paid on-air presenters and stars earn – and I know all the arguments about whether or not they could earn more in the commercial sector – it is a good time to look again at inequality.

Inequality has raced up the political agenda even though for the past quarter of a century or so it has either been falling or at worst flat, as a useful new report form the Institute for Fiscal Studies pointed out a few days ago.

The IFS report, Living standards, poverty and inequality in the UK: 2017, noted that income inequality fell significantly during the crisis and recession, particularly between 2007-8 and 2011-12, and has not increased since.

Incomes for people at the 10th percentile – in other words those at the top of the poorest 10% of the population – are up 7.7% since 2007-8, while those in the middle (the 50th percentile) are up 3.7%, and those at the 90th percentile, people better off than 90% of the population, have fallen by 0.6%.

As a result, and depending how it is measured, income inequality is either quite a lot lower than it was in the late 1980s, or is roughly the same as it was 25 years ago. The 90:10 ratio shows a distinct fall in inequality, while another widely-used measure, the Gini coefficient, shows the flatter picture. Neither show rising inequality.

The difference between the two is that the Gini, a traditional measure of inequality, takes into account the top 1%’s rising share of income. Though the figures for earnings in this group are open to dispute, in the 1960s and 1970s, the top 1% accounted for between 3% and 5% of income, rising to 8% by 2000 and nearly 9% on the eve of the crisis, before dropping back to 7% as the crisis hit, and then subsequently recovering some of its lost ground.

The 90:10 ratio, meanwhile, has fallen particularly sharply in London since the financial crisis. The capital’s streets are no longer as paved with gold as they were.

So why, if inequality is flat or falling, is it such a hot button issue? And how do you prevent public concerns over inequality from creating the climate for economically-damaging, incentive-destroying tax changes, such as those proposed by Labour in the recent election?

On the first point, we live in an age of, as well as fake news, a climate of disbelief. Any number of reports from the IFS or other respected bodies would not convince some people that inequality is not rising, to the extent that they think about or understand these things at all.

To those that do, there is the important contrast between levels and rates of changes. Yes, on one important definition inequality has fallen significantly, But the level of inequality, the gap between rich and poor, remains significant, and small steps that have reduced it are seen as just that.

In London for example, where inequality has fallen very sharply, it remains higher than in any other part of Britain.

The richer people are too, the steeper the slope gets. The IFS points out that a household with a net income of £946 a week does better than 90% of the population and has an income of nearly twice the median (£481 a week), and nearly four times that of somebody at the top of the bottom 10%. But 90th percentile man or woman would need to earn at least two and a half times as much to make it into the top 1% of incomes. Those top 1%, the conspicuously rich, help frame the debate on inequality more than any statistic.

Incidentally, there is often a confusion between income and wealth inequality, Britain’s income inequality is higher than most other members of the OECD, the advanced countries’ group. But wealth inequality, based on ownership of assets, is lower in Britain than in many other countries, including France and Germany. The explanation lies with traditionally higher levels of home ownership and occupational pensions in Britain, though both are now in decline.

This speaks to another aspect of the inequality debate, that between the generations. Median incomes for the over-60s are up by 10% since 2007-8. Those for the 22-30 age group are down by 4% over the same period. If there has been a sharper increase in intergenerational inequality than that in recent years, it is hard to think when.

The key point about why income inequality is such an issue despite the numbers, however, is that we are in an era of severely constrained growth in household incomes and falling real wages. When prosperity is scattered all around, people will believe that a rising tide lifts all boats.

Lord Mandelson could and did get away with saying that New Labour was “intensely relaxed about people getting filthy rich – as long as they pay their taxes”. When incomes are rising people may care about what their colleagues and others in their immediate circle earn, but they do not worry overmuch about how others, even BBC presenters, are doing.

When incomes are squeezed, in contrast, people do care. It is of small comfort to learn that the real wage pie is being shared slightly more fairly than it was in the past.

Falling real wages are not the norm in Britain. For a run of wage weakness of the kind we are now experiencing, you have to go back to the 1860s, and what Mark Carney recently described as the first “lost decade” since then.
Falling real wages, and the associated weakness of productivity, frame attitudes to inequality and just about everything else. There is, unfortunately, no easy way out of the torpor. Businesses have enough uncertainties on their plate to want to keep a lid on pay. Despite record employment, the vast majority of employees are unwilling to push things on pay. 1998-2007, when average earnings rose by 4.25% a year alongside low inflation, looks like a distant land of milk and honey.

Then, despite a rise in inequality in the run-up to the financial crisis, most people were indeed intensely relaxed about the filthy rich. Now, despite a fall in inequality, they are not. How that is resolved is both a challenge and a worry.

Sunday, July 16, 2017
We need more globalisation, not less
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

One of the great disadvantages of being a member of the Bank of England’s monetary policy committee (MPC) is that unless you say something about interest rates, people do not take much notice of your speeches.

That was the fate that befell Ben Broadbent, the Bank’s deputy governor for monetary policy, a few days ago. His interesting and welcome speech on globalisation steered clear of any mention of interest rates, though he offered his views on rates in a subsequent interview (he is not an early hiker).

On globalisation, which it is fair to say has had a terrible press in recent years, and is blamed for the rise of populism in many countries including Britain, he pointed out a simple truth. Yes, there will be losers from globalisation, and before her political implosion Theresa May seemed overly concerned with compensating them, but they are greatly outweighed by the winners. And the gains from globalisation are spread among the population, not confined to a small elite.

This is a frustrating time for economists. It is, as Broadbent point out, nearly 250 years since Adam Smith demolished mercantilism; the idea that trade is a zero-sum game and one country’s gains are another’s losses. It is exactly 200 years since David Ricardo gave us the law of comparative advantage, which explained why countries specialise, or should specialise, in the products and services they are relatively better at doing.

And yet, centuries later, we have an American president whose protectionism is based on a mercantilist view of the world. And globalisation, far from being seen as a route to improved living standards, is blamed for their weakness.

To illustrate his theme, Broadbent used the apparently unhelpful example of textiles and clothing. Since the mid-1970s, when import penetration began to rise sharply under the impact of lower tariffs, employment in the sector has fallen significantly; by around 90%. Then It used to count for one in 30 jobs;, now it is one in 370. So people who were employed in this sector were losers from globalisation.

British consumers were, however, significant winners as a result of falling clothing prices. Household incomes are 3% higher in real terms than they would have been in the absence of the fact that, both in absolute terms and relative to other prices in the economy, clothing is a lot cheaper than it was.

A straight comparison between these two effects results in a £36bn gain for consumers, against a £15bn loss of labour incomes for those who were employed in the clothing sector in Britain.

Even this, however, is likely to understate the gains from globalisation. As he put it: “There’s a big difference between particular jobs and overall employment. Individual jobs are lost continually … Yet aggregate employment has risen – since both the mid-1970s and the mid-1990s – and the rate of unemployment has fallen. In any reasonably flexible labour market new jobs are created as others are destroyed. “

The latest figures, indeed, showed a record employment rate of 74.9%; 32m people in work. That does not stop some people from yearning for the jobs of the past, but you cannot run an economy on nostalgia.

What if the new jobs are of poorer quality than the ones they replace? Does not globalisation then lead to a rise in income inequality? All the evidence, most recently an International Monetary Fund study in April, found that technological progress dwarfs any impact on inequality from globalisation. Technology benefits the highly-skilled at the expense of the low-skilled and unskilled.

The irony is that concerns about globalisation have been mounting as it has been struggling, even before Trump’s election. The era of “hyper” globalisation that began in the early 1990s has gone into partial reverse since the financial crisis. World trade, which once led global growth, has barely kept pace with it in recent years. Had it done so, Britain would have had significantly stronger growth.

This matters, particularly for an economy that has embraced globalisation as much as Britain’s. We aspire to be a great nation of exporters again. We are undoubtedly a formidable nation of importers, without the national ties to domestically-produced products that some other countries have retained.

Globalisation matters. When it has gone into reverse growth, productivity and living standards have suffered, as we saw most dramatically between the two world wars. Stronger growth in world trade in recent years would have been associated with faster economic growth and, most importantly, growing rather than stagnant productivity, and rising real wages. Trade stimulates rising productivity, as Smith and Ricardo taught us. Those blaming globalisation for weak living standards have got it 180 degrees wrong. We needed more of it, not less.

It matters too in the long-term. On Thursday the Office for Budget Responsibility issued its Fiscal risks report, and a sobering document it was. The OBR continues to cling to the assumption that productivity will recover to normal growth rates in the next few years; if not, and recent weak productivity trends are the “new normal”, then taxes and/or government borrowing will need to rise, even if the government sticks to its tight spending plans.

Though the clock is ticking, to coin a phrase, it is too early to say where what the OBR describes as “the risks posed by Brexit” will end up. It is less troubled by a one-off “divorce bill” payment to the EU – which will not affect the public finances in the long run - than by what it describes as “the implications of whatever agreements are reached with the EU and other trading partners for the long-term growth of the UK economy”.

The OBR reminds us that it does not take much for real problems to mount. As it put it: “If GDP and receipts grew just 0.1 percentage points more slowly than projected over the next 50 years but spending growth was unchanged, the debt-to-GDP would end up around 50 percentage points higher.”

That is easily possible, or worse. At the G20 meeting in Hamburg last weekend, countries had trouble agreeing on a strong commitment to global free trade. America, as noted, has a protectionist president from whom offers of an early trade deal should be taken with a bucketful of salt. Trade is the key to our prosperity but it is not clear how it can be unlocked.

In or out of the EU, Britain would benefit from a revival of globalisation. Things can change, and quickly, but the omens at present are not good. Aspiring to be a new global champion of free trade is not much use if nobody else is playing.

Sunday, July 09, 2017
Businesses are hungry for certainty, not thin gruel
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Businesses are troubled, and so are consumers. The election a month ago delivered the worst possible outcome in terms of the stability and certainty that the economy needs. The combination of a minority government and a Brexit negotiation that the minister responsible has described as more complicated than the first Moon landing, is undermining confidence.

This is not surprising. I wrote on June 11 that the hung vote would hang over the economy, and so it is, and we have the evidence. All three of the purchasing managers’ surveys, for the manufacturing, construction and service sectors, showed declines in June compared with May.

Their relative strength in the pre-election period will probably mean a slight uptick in quarterly gross domestic product growth in the second quarter compared with the very weak first. But the omens are not encouraging. May official figures for manufacturing and construction were weak.

Services are the dominant part of Britain’s economy and, according to its June purchasing managers’ survey, has seen both a drop in activity and a bigger fall in business optimism.

As Chris Williamson, chief business economist at IHS Markit, which complies the survey, put it: “It is clear that the economy heads into the third quarter losing momentum. With business optimism having been hit by the intensification of political uncertainty following the general election and commencement of Brexit negotiations, at the same time that households are battling against rising inflation, the indications are that the economy’s resilience is being tested.”

The latest GfK consumer confidence barometer, meanwhile, shows households too regard the political situation with concern. The barometer dropped by five points in the wake of the election to -10, a similar bow to confidence as the one that followed last summer’s referendum.

Households have become gloomier about their personal financial situation over the next 12 months, which showed a four-point drop between May and June. They are downbeat about the economy, with a balance of 23% of households expecting it to deteriorate over the next 12 months. People’s willingness to splash out, known in the jargon as the major purchase index, slumped by eight points.

This is consistent with the drop in new car registrations reported by the Society of Motor Manufacturers and Traders (SMMT). Private new car sales last month were down by 7.8% on a year earlier, and were down by 4.8% in the first half of the year. The SMMT separately reported a slump in car industry investment in the first half of the year.

You might say that, like the legendary Brenda from Bristol and her aversion to elections, most people have lives to get on with and do not spend them obsessing about the intricacies of politics. Neither do most businesses. If you said “minority government” to most voters they would not know what you were talking about. If you asked whether they think the government knows what it is doing, you might be closer to it.

Apart from the immediate political uncertainty, however, consumers have much to be downbeat about. I have commented before that, given the ret urn of falling real wages, the prime minister’s decision to call an election was courageous. Courageous in this context is being used in the Sir Humphrey, Yes Minister, sense; in other words foolish,

New official figures show that extent of it. The Office for National Statistics pointed out that real household disposable income per head in the first quarter was down by 2% on a year earlier, a very substantial drop in living standards. To put that in context, this meant that real disposable incomes were back to their level in the middle of 2009, in the depths of the financial crisis and the deepest recession in the post-war period.

What does the piling of uncertainty on uncertainty mean for the economy? The Centre for Economics and Business Research thinks the hit to confidence will hit growth by 0.4 percentage points this year and next, reducing it to just over 1% in each case.

We have, of course, had politically-generated uncertainty before, most notably in the wake of the June 2016 referendum, but it passed. One reason for that was that, apart from the rapid transition to a new prime minister and effectively a new government, with the promise of political stability. Calming measures by the Bank of England also helped.

Jan Vlieghe, a member of the Bank’s monetary policy committee, put it well in an Independent interview the other day. “One of the reasons it didn’t happen [an immediate downturn] is there was a sense it was just too far away,” he said. “So now as it gets closer there is a risk they start worrying again. But if a very strong sense is established that there’s going to be a lengthy transition deal then we go back to that previous regime where [firms think] it might all change but it’s not going to change for a long time so I can just get on with my business and not worry about it. That would be a very positive thing for business and investment and would therefore influence our interest rate policy.”

Even amid the political uncertainty, in other words, it would be better for the economy if businesses believe that they have many years to adjust to Britain’s new relationship with the EU. This is exactly the point that the CBI’s director, Carolyn Fairbairn, and her chief economist, Rain Newton Smith, made in speeches at the London School of Economics on Thursday evening, citing a “drip, drip” of investment decisions deferred or lost.

As Fairbairn put it: “Instead of a cliff edge, the UK needs a bridge to the new EU deal. Even with the greatest possible goodwill on both sides, it’s impossible to imagine the detail will be clear by the end of March 2019. This is a time to be realistic.

“Our proposal is for the UK to seek to stay in the single market and a customs union until a final deal is in force. This would create a bridge to the new trading arrangement that, for businesses, feels like the road they are on. Because making two transitions – from where firms are now to a staging post and then again to a final deal – would be wasteful, difficult and uncertain in itself. One transition is better than two and certainty is better than uncertainty ….The prize is more investment, more jobs and reduced uncertainty for firms here and in Europe.”

The CBI plan, which is backed by other organisations including the EEF, which represents manufacturers, is close to the one that Philip Hammond is arguing for within the government, though he has yet to win the argument. It does indeed make a lot of sense.

Would it end the uncertainty? Not entirely. For some businesses it will merely delay the inevitable. Those planning long-term investments will continue to err on the side of caution. Such is the weakness of the government’s parliamentary position that any pledges it makes would fall if it does. This is a genuine difficulty, created by the election.

So far they are not getting it, Business leaders who met David Davis, the Brexit secretary, at Chevening on Friday were offered thin gruel, not certainty. That needs to change, and quickly.

Sunday, July 02, 2017
When the cap doesn't fit, worry about the deficit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What do you need for a successful policy of deficit reduction, of eliminating the government’s annual borrowing and beginning the process of reducing public sector debt?

Well, you certainly need a strong government which is willing and able to take unpopular decisions. You also need a belief in the policy across government. And you need political leaders looking to the long-term.

You do not have to be Sherlock Holmes to spot that, as a result of Theresa May’s election cock-up, all those ingredients are now missing. The signs of slippage are there to see. Austerity fatigue has set in, and not just among some voters. Many ministers are also baulking at the last push to eliminate a budget deficit officially projected to be £58bn this year, even a last push that was intended to take all of eight years.

A further rise in public sector net debt, currently £1.74 trillion or 86.5% of gross domestic product, is inevitable, and the weaker the economy the more it will go up.

What are the signs of slippage? The first was the cost of the prime minister’s agreement with the Democratic Unionist Party (DUP), a £1bn “bung” which old Treasury hands say will merely be a downpayment, and will lead to increased demand for extra spending from other parts of the UK. That election gets more expensive by the day.

Then there were the hints from Downing Street of a softer approach to public sector pay, as foreshadowed here a couple of weeks ago, followed by an insistence that it remains in place. The 1% pay cap may not survive the autumn, many Tories having decided that it cost them a lot of votes in the election.


Public sector pay has been falling in real terms since the cap was introduced, as a useful analysis by the Resolution Foundation pointed out. But then private sector pay has also been falling in real terms too.

It remains the case, moreover, that public sector pay levels exceed those on average in the private sector, either in absolute terms or, when adjusted for the different mix of skills and qualifications in the public sector. To head off responses from readers, I should also point out that most public sector workers enjoy more generous pensions.

Exhibit three in the evidence for slippage came with the British Social Attitudes survey, which showed what its compilers described as a “leftwards tilt on tax and spend”. People say they are willing to pay more tax to fund better public services.

So what should we make of all this? Philip Hammond is fighting to preserve the government’s fiscal credibility, though even he has admitted that the election sent a message about austerity. He is also fighting on several fronts, and doing battle with some of the government’s nuttier Brexiteers on the terms of Britain’s exit from the EU. Treasury officials are left with the task of insisting that “nothing has changed” when it comes to deficit reduction.

I fear that something has. This is not to say the May government is suddenly going to embark on a spending spree. Austerity, as defined by big real-terms benefit cuts, the continued squeeze on departmental and local authority budgets, will continue.

But there will be drift. Money will be found when the government’s survival requires it. Unpopular policies will be junked. Some already have been. Thanks to the DUP deal and the government’s weak position, the triple lock on pensions remains in place. A promise to bring forward radical proposals on social care is one that we will believe when we see it. The government’s weakness will mean weaker public finances.

There are a couple of things I would say about this. One is that, if the government is expecting any political dividends from this, beyond survival, it will not get them. The DUP deal has given public spending a bad name and, when it comes to public attitudes to politicians and their parties, leopards do not change their spots.

George Osborne did not become a hero of the working-classes when he introduced the national living wage, and the prime minister cannot expect to overcome the hostility of public sector workers when a relaxation of public sector pay policy happens. Some things are deeply ingrained and they will be not flocking to the Tories. One prominent Tory MP said to me after the election that there should be a purdah period for public sector workers, so fed up was he of the tide of anti-government propaganda, some of it sent by teachers to parents on school notepaper.

If there is a case for a relaxation of public sector pay, it should be in response to recruitment and other practical difficulties, not because of the hope that it will buy popularity and votes. It will not.

The other point is that we should be very sceptical of survey results which suggest that people are prepared to pay more tax for better public services. That was the standard result during the Thatcher years, during which people were happy to deliver large majorities to a party robustly promising and delivering exactly the opposite.

Nor was this the message of the recent election. The one party promising an across-the-board tax hike to fund extra public spending, the Liberal Democrats, did not do well. Labour’s pitch was that it could end austerity in a way that, for the vast majority of people, would not mean higher taxes. Perhaps surprisingly, many people believed it. When somebody else is making the sacrifice, it is easy to vote for more government largesse.

How worried should we be about the slippage in the public finances that we will see as the government tries to cling to power? Thanks to the progress of recent years, we have a budget deficit of 2.4% of GDP, the same as in the last pre-crisis year of 2006-7 and sharply down from 9.9% of GDP in 2009-10. In this respect, austerity certainly worked.

But 2.4% of GDP should be an upper limit for public sector borrowing, not a base for pushing it higher. The Treasury will have its work cut out limiting the damage.

Sunday, June 25, 2017
Britain's Brexit journey could yet end up in Norway
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

One year on from the vote, and a couple of weeks on from an election that threw an almighty spanner into the works, the formal negotiations to take Britain out of the European Union have begun.

There will be plenty of ups and downs over the next 21 months, though the “row of the summer” promised by David Davis, the Brexit secretary, never transpired because the government agreed to the EU’s negotiating timetable of divorce bill and citizens’ rights first, a new deal and new trading arrangements later.

There is, however, a puzzling absence from the negotiating stance of both sides, and even of the politicians pushing for a softer Brexit. Philip Hammond did not mention it in his Mansion House speech, and neither did the 50 Labour MPs, or the London mayor Sadiq Khan, who are pushing for Britain to remain in the EU single market.

I am referring to continued British membership of the European Economic Area (EEA) after Brexit, the so-called Norway option. EEA membership would provide for continued membership of the single market but not the customs union, so freeing Britain to negotiate its own trade deals with the rest of the world.

The idea of post-EU EEA membership used to be very popular, particularly among Brexiteers in the run-up to the referendum. Many argued that Britain would be mad to leave the single market, and would not need to do so, and that the be like Norway – “rich”, “happy” and “self-governing” to quote one – was the thing to aim for. One plus for them, apart from the freedom to conduct trade deals, was that EEA membership does not include agriculture and fisheries, thus sparing us the hated common agricultural and fisheries’ policies. The big minus was that EEA membership meant accepting, with one or two wrinkles, free movement of people.

People like me argued that EEA membership would be inferior to being in the EU. We would be subject to single market rules (most of the “laws” imposed by Brussels), but not be able to influence them. We would still pay the equivalent of an EU budget contribution. There were questions about whether the rest of the EU, while happy to accept the smaller economies of Norway, Liechtenstein and Iceland into the family, would be prepared to do so for Britain, or see us as a cuckoo in the nest. Switzerland like these three is a member of the European Free Trade Association (EFTA), the body Britain helped found in 1960, but its people rejected EEA membership in a referendum in the early 1990s.

Despite these reservations, time has moved on. The Norway option, EEA membership, looks better than most of the alternatives and it is not just me who thinks that.

The Institute of Directors, in its response the chancellor’s speech, said remaining in the EEA on a transitional basis “should be actively considered”. Among City watchers of the Brexit process, it is still seen as among the options, even though the May government is not proposing it. Malcolm Barr of J P Morgan puts a 25% probability on time-limited membership of the EEA, while Brian Hilliard of Societe Generale includes it in his 15% probability of a soft Brexit.

There is a view that Britain’s default position on leaving the EU is to remain a member of the EEA. George Yarrow, emeritus professor of economics at Hertford College, Oxford, argues that as a signatory to the EEA Agreement, Britain would need to formally negotiate its exit from that agreement under Article 127. Others, it should be said, say EEA membership would expire with our departure from the EU, and that is the majority view.

Is EEA membership, either for the short or long-term, an option? The reason few politicians are citing it as a possibility is because of Theresa May’s emphasis, in both her party conference speech last October and her Lancaster House address in January, on controlling immigration. Though emergency brakes on immigration are allowed to EEA members, they are limited in scope and would not be compatible with reducing net immigration to the tens of thousands.

Britain has, for this reason, begun with a negotiating position which rules out continued membership of the single market, and anything close to the existing customs union. The EU has prepared its negotiating position on that basis. Before too long it will be too late for either of those positions to change.

But these things are more malleable than they sometimes appear. The prime minister’s position is more precarious than would have seemed possible even weeks ago. David Davis, the Brexit secretary, has said that EU migration to Britain could stay high for some years. Polls suggest that to most voters staying in the single market has priority over controlling immigration, which is in any case falling.

Charles Grant, director of the Centre for European Reform, thinks that because of the impossibility of negotiating a trade deal with the EU within the remaining 21 months – May’s always unrealistic timetable having been made more so by the weeks she wasted with the election – an EEA-type transitional deal will be struck.

It will not be formal EEA membership, because the EFTA countries will not, for now, want all the hassle of readmitting a member just to see it through the departure lounge. It will satisfy the government’s desire to escape the attentions of the European Court of Justice, EEA disputes being settled by the EFTA court. It is possible that, feeling sorry for poor old Blighty, the rest of the EU would cut a bit more slack when it comes to putting the brakes on immigration.

It is even possible, looking at recent comments from Emmanuel Macron, the French president, about EU migrants undercutting wages and sowing doubt among “the lower middle classes” that EU attitudes to free movement could evolve. A temporary EEA-style arrangement could evolve into a permanent one.

It is only a possibility. One year on from the vote, the negotiation has only just begun. Reading between the lines of Hammond’s speech, the Treasury is as worried by the loss of customs union membership, for its effects on jobs and the economy, as leaving the single market. The chancellor is pushing for something close to continued membership of the customs union, “current customs border arrangements remaining in place”, for a transitional period of four years after March 2019, perhaps longer.

This is what now gets the Brexiteers uneasy. Transitional arrangements will be necessary – they were longer than four years on the way into the European Economic Community four decades ago – but the temporary has a habit of turning into the permanent. Leaving the EU could turn into a very long goodbye.

Sunday, June 11, 2017
Hung vote hangs over the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This time last week I devoted quite a lot of space to the prospect of a hung parliament, pointing out that whereas two years ago it was the expected outcome for one Tory prime minister, David Cameron, this time it would be seen as a catastrophe for Theresa May. Combine a hung parliament with EU exit negotiations scheduled for June 19, and you had a recipe for something really destabilising.

Though a hung parliament was a risk, as set out then, I thought along with most other people that the Tories would secure a somewhat larger majority than the one May inherited from Cameron. It would have been one of the least deserved majorities in recent political history. So, while a hung parliament has made us something of a laughing stock and is on the face of it bad for the country – more in a moment on whether it is or not – there was quite a lot of poetic justice in it.

Why undeserved? Any prime minister who ignores the economy in an election campaign and expects voters to troop loyally into the polling booths when their real wages are falling did not deserve victory. People need something to latch onto, some grounds for economic hope and May’s Tories did not provide it. Austerity fatigue is another factor on which no reassurance was offered.

I also think that she made a huge miscalculation, which goes back some time, about Brexit. As a Remainer, albeit a soft one, she overcompensated by either focusing exclusively on the 52% who voted to leave the EU – and implying that those did not were “citizens of nowhere” – or wrongly suggesting that the country was coming together on the issue when it was clearly not. As many people think it was wrong to vote to leave the EU as think it was right,
according to polls. Some out and out Leavers, such as the Brexit secretary David Davis, took a more conciliatory approach to Remainers.

And the hard line Brexit that she decided on – out of the single market and customs union and cutting net migration to less than 100,000 a year, even apart from the “no deal is better than a bad deal” nonsense – appeared designed to inflict maximum damage on the economy.

What does the hung parliament mean for the economy? I think it useful to split this into the short term and the longer-term.

In the short-term, the uncertainty generated by the election means weaker growth is likely to persist. Election uncertainty may have helped depress the housing market and house prices, according to Rics, the Royal Institution of Chartered Surveyors, though housing has been on a weakening trend. The election result has come at a time when the economy too has entered a weaker phase.

Figures on Friday showing weak construction and industrial production figures for April, combined with evidence that May was a poor month for retailers, suggest the economy’s weak start to the year has continued. The National Institute of Economic and Social Research estimated growth of just 0.2% in the three months to May, the same as in the first quarter.

The Organisation for Economic Co-operation and Development (OECD) attracted headlines a few days ago for a downbeat forecast for Britain’s economy, and for suggesting that the government should use the “fiscal space” afforded by low interest rates and the long average duration of government borrowing (the number of years on average that gilts have before they mature), to borrow a lot more for infrastructure investment.

The OECD thinks the Brexit negotiations will weigh heavily on the economy, producing the unusual situation for Britain in which an acceleration in the global economy, from 3% growth last year to 3.5% this and 3.6% next, is accompanied by a slowdown in Britain’s economy, from 1.8% last year to 1.6% this and just 1% in 2018.

The OECD’s forecasts brought to mind a question I am often asked: where will the growth come from? The challenge here is easily stated. Britain’s economy has been, and continues to be, highly dependent on consumer spending. When consumers sneeze, as they did in the first quarter in slowing their growth in spending to a modest 0.3% (with retail sales actually falling), the economy catches a cold.

The drivers of consumer spending are, moreover, looking much weaker. The Brexit-induced rise in inflation has produced a return to falling real wages, which is set to last for some time.

Households’ ability to carry on piling up consumer credit and run down savings, highlighted by the OECD as one of the main means by which the economy has been kept going, does not look sustainable for much longer. The credit card looks as if it is getting close to being maxed out.

When I am asked the question about where the growth will come from, my usual response is to talk about trade. Notwithstanding the disappointing performance of exports so far, the fair wind of a cheap currency and a strengthening global economy, and in particular a strengthening European economy, must surely be good for Britain’s overseas trade.

These are the circumstances in which exports should flourish and we should hope they do, although, as I noted last week, they cannot be turned on with the flick of a switch. Export disappointment is not just a short-term phenomenon. One measure of how exporters are doing is the relationship between their performance and the growth in Britain’s export markets.

As the OECD pointed out, one of those, the growth in exports, has consistently fallen short of the other, the growth in markets. Britain’s export market share has been on a declining trend. The OECD’s index of UK export performance has seen a decline of more than 30% since the mid-1990s. You can lead a horse to water but you cannot make it drink.

So the next couple of years will be a challenge, and if the OECD is right, it will not end there. It is assuming that there will not be a workable EU deal and Britain will revert to World Trade Organisation rules. Is that assumption, made ahead of the election, still valid?

One reason why the market fallout from the election has not been as big as feared is because of the belief among analysts that it will pave the way for a softer Brexit. It may be that the prime minister, if she survives, will be obliged to work with other political parties in a more consensual approach. Leaving the single market and customs union would be up for grabs, and May’s lonely Home Office pursuit of reducing net migration to less than 100,000 a year would be shelved. The no deal option would be dumped.

That would be my hope, but is it wishful thinking? Listening to May’s Downing Street statement on Friday when she declared that she was forming a government, it was hard to detect than anything had changed, including her dashed hopes of a bigger majority. That may be just her style. It is not the only thing that will need to change.

Sunday, June 04, 2017
Election uncertainties to be followed by many more
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

I know you are as keen for this general election to be over as much as I am, and that you are probably not expecting Friday morning to mark the dawn of a bright new era. We have all learned that you can have too much of politicians and that reputations can be lost, or diminished, as well as enhanced.

There is still a possibility, of course, that the election could throw up something really destabilising. Two years ago a hung parliament with the Tories as the largest party was the expected outcome. Now it would be greeted as a catastrophe, not least for the prime minister.

Combine a hung parliament with Brexit and you compound the uncertainty considerably, though some would see it is as pushing the country towards a softer Brexit. The narrowing of the polls has been driving the currency markets, and sterling, in recent days, but it should be said that markets are still assuming a Conservative majority.

If that turns out not to be the case we can expect a much bigger market reaction, though Simon Derrick, veteran chief markets strategist at BNY Mellon, points out that markets are not always averse to hung parliaments and coalition governments over the medium-term.

Sterling was stable when Labour lost its majority in 1977. It fell briefly, by around 5%, after the May 2010 election, when the election failed to deliver a Tory majority, but reached its low point a week after the election, a low point that was to last for several years. It recovered when the Conservative-Liberal Democrat coalition was formed. As he puts it: “Neither a minority government nor a moderate coalition is an automatic negative for the pound.”

Those earlier episodes did not, however, have the additional huge complication of Brexit. As in the past few months, we can expect sterling to be a Brexit barometer. For the moment, to repeat, the assumption in markets is of a Conservative majority this week, though there is not a great deal of enthusiasm for it.

The election is just the latest hurdle for the economy, and business, to negotiate. It is a reminder that these things are never as straightforward as they appear beforehand. This was, after all, expected to be a cake walk for Theresa May.

The tone and content of economic policy in the coming months is important. There have been times in the recent past when rebalancing the economy was regarded as desirable. Now it is essential, if the economy is not to stand or fall on the shoulders of debt-laden consumers.

For business, this has been a sobering time. Their strong majority view, that it was best for Britain to stay in the EU, was rejected by voters a year ago. They have seen, if the polls are anywhere near correct, a sizeable minority of voters being happy to vote for significantly higher corporate taxation and increased taxes on executive salaries.

They have had little comfort from the Tories, who under May have adopted an interventionist and anti-business tone, as highlighted in these pages. Our business manifesto today sets out some ideas for how the Tories could undo the damage.

Amid all this, businesses have been on something of a rollercoaster. One measure of confidence, the Lloyds Bank business barometer, showed confidence slumping last summer, then embarking on a jagged recovery, before slumping again last month.

The 20-point drop in overall business confidence, driven by a big drop in firms’ perceptions of business prospects, may be temporary, economists at Lloyds Bank Commercial Banking, which publishes the survey, suggest.

Another survey, the European Commission’s economic sentiment index, also pointed to a drop in confidence last month, particularly in construction and services. The latest purchasing managers’ index for manufacturing, though down slightly last month, showed sentiment in the sector holding up.

For businesses to also hold the economy up, investment and exports will be vital. Business investment has been up and down over the past 18 months. It rose a little in the first quarter, perhaps surprisingly, but has essentially been flat. The recent pattern, in which firms have been happier to recruit than invest – good for jobs but bad for productivity – persists.

As for exports, we reported last week the disappointing first quarter gross domestic product figures, which showed that in spite of sterling’s Brexit devaluation and a stronger global economy, including a pick-up in European markets, export volumes were down by 1.6% on a year earlier.

Whether this continues to be an unsuccessful devaluation – they usually are – we have yet to see. Surveys remain upbeat for manufacturing exports, though some service-sector exports are under more of a cloud.

It is sometimes forgotten that exports cannot be turned on at the flick of a switch. Developing new markets, and exploiting existing ones, requires investment, sometimes considerable investment. Doing that when future trading arrangements are so uncertain presents, to say the least, a big challenge.

The unexpected uncertainty created by the general election, together with the tenor of the election campaign, has created new concerns for business, and led to some of the drops in confidence we have seen. The great rebalancing has yet to happen.

The election uncertainty will give way to new uncertainties. Two new reports from the Centre for Economic Performance (CEP) at the London School of Economics highlight some of the dangers. On immigration, the CEP concludes that cutting it significantly will result in a lowering of living standards for the UK-born population, the extent of the fall depending on the extent of the drop in net migration. The May target of “tens of thousands” will leave us all poorer.

The report, on the CEP website, is a good mythbuster. Areas of high EU immigration have not seen UK-born workers displaced or suffering weaker wage growth. The route to lower living standards is partly via the fact that migrant workers pay more in taxes than they take out in welfare and use of public services.

The CEP’s other report looks at something that really worries businesses, the prime minister’s “no deal is better than a bad deal” rhetoric. CEP economists Swati Dhingra and Thomas Sampson, using what they describe as a state-of-the-art trade model based on comprehensive data, say that leaving the EU without a deal would result in a 40% drop in exports to the EU over 10 years and a 3% fall in GDP per capita.

Add in dynamic effects and the medium-term economic effects could be double those arising from the model, the authors say.

This leaves aside the immediate dislocation, which would be considerable, of leaving the EU without a deal, which I shall discuss in a future piece. The combined effect would be large and damaging enough to suggest that it is not a serious option for the government, even though the prime minister insists it is.

Maybe, once the election hubbub has died down, wiser heads will prevail, and wiser words emerge. We can but hope..

Sunday, May 28, 2017
Taxes are going up, whoever wins the election
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There are only 11 days to go until the general election and there is still a lot we do not know. That is even on the assumption that we see the Conservative party returned with a larger majority, which remains the most likely outcome despite narrowing polls.

We do not know for sure whether Philip Hammond will be kept in his post as chancellor, Theresa May having so far refused to guarantee his position after reported bust-ups between 10 and 11 Downing Street.

When Hammond presented the budget in March he was happy to describe it as his first and last spring budget. What he meant, of course, was that the spring budget is being abolished but that he would be around for plenty of autumn budgets. Now that is not so certain.

I hope for his sake he is kept in the job. By the time of the election he will have been at the Treasury for 11 months. Most recent chancellors have been long-serving ones, including more than six years for George Osborne and 10 for Gordon Brown. The last short-stayer was John Major in 1989-90, 13 months, though his consolation was being promoted to prime minister.

Personnel uncertainties are one thing, policy uncertainties for the Tories another. A week ago I wrote here that the Conservative policy on social care were messy, incoherent and unfair and “will need to be revisited”. I did not expect them to be revisited, in a tyre-screeching U-turn by the prime minister, the very next day.

For the Tories too, things are more uncertain than they should be on tax. An Ipsos-Mori poll the other day showed that 54% of people expect income tax to rise in the event of a Conservative victory, not that much below the 70% who think it would happen under Labour.

Labour, it should be noted, has said explicitly that it would put up income tax, though only on incomes of £80,000 and above. But for more than half of people to think income tax will rise under the Tories is quite something. The most explicit tax pledge in a not very explicit manifesto was to cut income tax by raising the personal allowance, currently £11,500, to £12,500, and the higher rate threshold from £45,000 to £50,000.

This tells me two things. One is that for all the emphasis in recent years on raising the personal allowance – “taking people out of tax” – many people do not regard this as a tax cut in the way they would a reduction in the tax rate.
The other point is that even if people have got it wrong on the Tories and income tax, they are right to suspect that taxes will be going up in coming years.

There is the cynical argument that governments tend to raise taxes once elections are safely out of the way. There is the fact that the Tories have sensibly abandoned their 2015 pledge not to raise any of the main taxes – VAT, income tax, corporation tax and national insurance – in the next parliament, replaced by a weaker promise to keep taxes “as low as possible”.

And there is the fact that the public finances need higher taxes. Figures last week showed that the public finances got off to a bad start to the new fiscal year in April. Public borrowing for the month of £10.4bn was £1.2bn up on a year earlier, consistent with the rise in borrowing the Office for Budget Responsibility (OBR) expects this year.

Official projections for government receipts show that they are on course to rise by the end of the decade to their highest level as a percentage of gross domestic product since 1986-7, as the Institute for Fiscal Studies pointed out on Friday. Taking only the tax component of those receipts, the IFS also pointed out that they are on course to hit their highest level of GDP since 1969-70.

Some of the sources of this growth in tax receipts are known about but are only just taking effect or have yet to do so. They include the apprenticeship levy, which will raise £3bn a year form this year, the increase in insurance premium tax which will push up receipts by more than 50%, and the cut in the dividend tax allowance from £5,000 to £2,000 next year.

Some it, however, is so far uncosted, or relies on “fiscal drag” from rising incomes. The latest growth figures, revised down to just 0.2% in the first quarter as a result of the squeeze on household real incomes, suggests that revenue growth from this source may be hard to achieve. Weaker-than-expected growth, if maintained, will mean more government borrowing.

The pledge to raise the personal allowance to £12,500 and the higher rate threshold to £50,000, which will cost around £2bn a year in lost income tax revenues, is not included in the figures. That money will have to be found from somewhere.

We know that Hammond, if back in the Treasury, will want to revisit the 2% increase in Class 4 national insurance contributions for the self-employed he announced in his March budget. He was forced to abandon it before the ink was dry because it broke a 2015 manifesto commitment, and which has left him £500m a year short.

It may be brought back as part of a package which will include enhanced rights for the self-employed, to be recommended by the review undertake by Matthew Taylor. Those enhanced rights will not go down well with some firms, and nor will an increase in Class 4 contributions with the self-employed.

I should put the Tories’ tax plans, and their softer pledge to keep taxes as low as possible, in perspective. They will not, this time, raise VAT after the election, as in 1979 and 2010. Income tax, as I say, is going down not up. Corporation tax will be reduced from its current 19% to 17%.

All that can be contrasted with Labour, which wants to soak the £80,000 a year plus rich with a hike in income tax, increase corporation tax to 26% and hit the City with a transactions tax. The Liberal Democrats are also explicit about their plan to put 1p in the pound on income tax across all earnings levels.

In relative terms, the Tories clearly are the lower tax party, though have been quieter than you might expect in attacking Labour’s plans for raising taxes on higher earners, business and the City. That may reflect another set of poll findings, which is that these things are worryingly popular with voters.

We know, however, that this election will not mark the end of austerity. The public finances are still a long way from being fixed. The Tories may not be aiming to balance the budget until the mid-2020s but even that will require the restraint on spending to be maintained. Even harder hit than wage-earners during the coming squeeze will be those reliant on benefits and tax credits frozen in cash terms.

We also know that when it comes to taxation, it is mainly a question of degree. The Tories will raise tax reluctantly, and by less than their opponents. Labour will do it with gusto, while pledging no new taxes for the majority. But taxes are going up, whoever wins the election on June 8.

Sunday, May 21, 2017
Polls apart, but the Tories and Labour both pose risks to the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This election is turning out to be a bit more interesting than I was expecting although, unless the polls are spectacularly wrong, though they are narrowing, it is still unlikely to be much of a whodunnit.

It is interesting because, for the first time in a very long time – perhaps since Michael Foot in 1983 – nobody, not even the Tories, has had to speculate about what dark, left-wing ideas lurk behind a bland Labour programme.

This time, instead, the left-wing ideas are in full view. Labour has produced a manifesto in the image of its leader, which means that a fascinating experiment is now unfolding. There has always been a strand of Labour opinion which holds that the party has suffered electorally, most notably under Ed Miliband two years ago, from not being left-wing enough.

Now that proposition is being tested, though sadly it will not settle the issue. If Labour’s vote share is in the low 30s, similar or better than Miliband in 2015 (30.4%), it will be greeted as progress, with alleged media bias against Jeremy Corbyn blamed for the message not fully getting through.

There are, as with all manifestos, good and bad ideas in Labour’s proposals. A National Transformation Fund, which would take advantage of low borrowing costs to invest an additional £250bn in Britain’s infrastructure over the next 10 years, has a lot to be said for it.

Though the arguments are not as strong as they were, there is also an argument for Labour’s National Investment Bank and its proposed network of regional development banks, which would draw on private finance to generate £250bn of what Labour calls “lending power”, operating in the gaps left by the commercial banks, particularly in small business lending. Calls for such an institution, modelled on European lines, go back a very long way.

Where Labour comes over all unnecessary in its manifesto is its proposal to renationalise chunks of the economy, including the rail companies, the water industry, Royal Mail and by “regaining control” of energy supply networks. The argument that “democratic control” of these industries would bring a better deal for consumers defies the experience of the past, though it would keep the unions happy. As a priority it is a weird one.

Even weirder, though perhaps entirely predictable, are Labour’s tax plans. Raising taxes on high earners may have made sense in the immediate aftermath of the financial crisis, though it is not clear the 50% rate Labour announced then on incomes above £150,000 raised much money.

To go further at a time of Brexit, when Britain needs to prevent its high earners, particularly in the City, from heading to Frankfurt, Paris or Dublin, makes no sense at all. And yet that is precisely what Labour is proposing, and more, with a new 45% rate kicking in at £80,000 and 50% at £123,000.

Similarly, in the context of Brexit, raising corporation tax from 19% to 26% at a time when Britain’s appeal to foreign direct investors is being undermined by our exit from the single market is, as I noted last week, really dumb.

Labour’s defence, that 26% would still be the lowest in the G7, does not wash. These things do not stand still. Donald Trump, if he hangs around long enough, aims for a rate of 15%. And, as the Institute for Fiscal studies points out, the rate is not everything: other countries allow a larger share of capital spending to be offset against tax, together with other reliefs, so even at 19% Britain has “a less competitive tax base than other countries”.

The icing on the cake of Labour’s tax-raising exercise is its proposed policy of converting stamp duty, currently 0.5% on share purchases, into a “Robin Hood” tax on a much wider range of financial transactions. Again, at any time this would be very risky. At this time, making the City much less competitive at a stroke would provide an open invitation for international investment banks and others to migrate en masse to Europe.

The logic behind Labour’s tax policies, which would end up raising very little, is hard to fathom in the context of Brexit. Either the party does not expect to be in power to implement them or it believes it could blame Brexit when everything goes wrong. The worry would be if enough people believed they were the right thing to do. We are still, after all, in a strange era.

You might think after all this that it would be a relief to turn to the party we must now call “Theresa May’s Conservatives”. The prime minister has been happy to accept the soubriquet “bloody difficult woman and would be nothing if she does not come over as a sensible one.

Her Tory manifesto gets some of its economics wrong. Britain is not the fastest growing economy in the G7. Barring revisions, Germany was last year and plenty of other G7 countries were in the first quarter of this year.

Her government’s more relaxed approach to deficit reduction will mean that the public finances will be in the red until the mid-2020s, meaning one of the longest runs of deficits on record. Even then, George Osborne’s ambition of budget surpluses has been replaced by the meeker “balanced budget”.

There are, as with Labour, good things in the Tory manifesto. Though it will not make any difference for several years and not too much then, replacing the triple lock on state pensions with a double lock (pensions to rise by the greater of prices or earnings) is a modest step in the right direction, as is the proposed withdrawal of the winter fuel allowance for better-off pensioners.

The Tory proposals for social care at least address the problem, but they do so in a messy and incoherent and unfair way, particularly in comparison with the Dilnot Commission’s proposals. They will need to be revisited.

The Tories would not renationalize anything but they would intervene willy-nilly. May’s Tories are suspicious of markets and business and have an attitude to foreign investment that verges on protectionism.

There are, moreover, two particular problems with the Tory manifesto. A sensible approach to immigration would have been to acknowledge that voters believe it is too high but also to say that a lengthy period of adjustment will be needed to reduce Britain’s dependency on foreign workers. It would also have made a lot of sense to exclude students from the figures.

Instead, May has gone for a hard-line Home Office approach which will harm the economy and business and, when her “tens of thousands” target is not met, harm her. By doubling down on the migration commitment, toughening the visa requirements for students and increasing the costs for employers of bringing in non-EU migrants, she has prioritized politics over economics. Clamping down on migrants will, according to the Office for Budget Responsibility, hurt the public finances, making even that elongated balanced budget target harder to meet.
The prime minister also rode roughshod over the Leave supporters in her own cabinet who insist Brexit is not about immigration.

The other concern is that “no deal is better than a bad deal” with the EU will, if she is elected on June 8, be part of her mandate. If Britain were to suffer an abrupt, cliff-edge exit from the EU, the damage of which I have written about here before, nobody could say they were not warned, or that she had departed from the script.

People like me are supposed to compare Labour’s wish list and spectacularly ill-timed tax plans and conclude that the country would be better off with sensible Tory policies. But the contrast is less stark than you might think. We are talking mainly about different kinds of damage.

Sunday, May 14, 2017
Our nation of borrowers is storing up trouble
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The governor of the central bank was perfectly clear. High and rising household debt “has made the economy less resilient to future shocks”. It is more likely that, in future, households will respond to an economic shock, or a rise in interest rates, by cutting their spending more sharply than in the past.

“Double-digit growth in debt … at a time of weak income growth cannot be strengthening the resilience of our economy,” he added.

This was not, for once, Mark Carney, but his Australian counterpart, Philip Lowe, governor of Australia’s Reserve Bank, in a speech a few days ago to the Economic Society of Australia, but the parallels with Britain are close.

The good news is that we are not alone in the vulnerabilities and challenges that high levels of household debt, alongside high house prices, pose. The bad news is that household debt in Britain, £1.53 trillion on Bank of England figures, higher on other measures, is higher in relation to income than in most other countries, as are house prices.

The Bank, for its part, has expressed its concern over the rapid growth in consumer credit, currently rising by more than 10% a year, its fastest since before the financial crisis. In its latest inflation report, published on Thursday, the Bank noted that the Prudential Regulation Authority is looking into whether credit quality is suffering, while the Financial Conduct Authority is examining assessments by lenders of the creditworthiness of borrowers.

Figures on Friday from the Finance and Leasing Association showed £5bn of car finance – new and used – in March, up 14% on a year earlier. Over the past 12 months, consumer car finance has totalled £32.6bn. Though this sharply rising debt is mainly on the books of finance companies and the motor industry, with 86.5% of new cars bought with finance it represents a significant monthly payments’ burden for households.

The bigger picture is what high levels of household debt mean for the stability of the economy and, for central bankers, whether they tie their hands when it comes to future interest rate hikes.

The numbers, for Britain, are striking. In the 1980s, after credit controls were abolished as part of a wave of financial liberalisation, concerns were expressed over high levels of household borrowing. Back then, however, we were merely in the foothills. Household debt in 1987 was £185bn. Including both mortgage and non-mortgage borrowing. Thirty years on it is more than eight times that, and has trebled relative to incomes.

The question of what to do about high household debt is one of the questions posed by Jagjit Chadha, director of the National Institute of Economic and Social research, in his introduction to the institute’s latest quarterly review, which has just been published.

Chadha, looking at the challenges the income government, which I guess will be led by Theresa May, not a very bold guess, will face after June 8, apart from you know what, makes the good point that household debt has to be balanced against much higher household wealth. But he notes that the composition of household wealth has become skewed toward housing; 45% of wealth now compared with 32% in the mid-1990s. Not only that, but those who have the wealth are often very different from those racking up the debt. The Bank’s figures for household debt do not include student loans, currently heading up towards £100bn.

I have always been more relaxed than others about household debt. One reason was the aggregate balance sheet; household wealth being always several times the level of debt. The other was that, until relatively recently, a healthy and necessary adjustment had been taking place. So, as recently as late 2013, the cash total for debt held by households was lower than its pre-crisis peak, meaning that debt had fallen both in real terms and relative to income. In Acacia Avenue and elsewhere, the message seemed to have sunk in: too much debt is bad for you.

Since then, however, there has been a change, most dramatically for unsecured borrowing. Debt is rising again, even before the memories of the crisis have faded. Some of that is demand – people have felt confident enough to borrow – and some supply; the lenders have been turning the credit taps on.

The process has been helped along by falling market interest rates.
It is, says Erik Britton, managing director of Fathom Financial Consulting, a familiar pattern, witnessed in Japan and elsewhere. Any pauses in the rise in debt are short-lived. Ultra low interest rates in response to recession and crisis eventually encourage more debt to be taken on.

The problem for central banks, Britton argues, is that they get themselves into a position in which relaxing monetary policy – cutting interest rates further – has little effect but raising them, even by a small amount, would have a significant negative effect because of high levels of debt.

Are we there yet? Though Britain is in the middle of a significant consumer slowdown , notwithstanding an Easter-related retail sales bounce, there is no sign of panic. The Bank, in its new inflation report, expects 1.75% growth in consumer spending this year, slowing to 1% next. In the 10 years leading up to the financial crisis, spending rose by an average of 3.5% a year.

Consumer confidence and employment are high, however, and despite the squeeze on real incomes currently coming through, there is no sign yet that fears of unemployment and being unable to keep up the payments are resulting in the feared sharp drop in spending. That would only happen if consumer became as gloomy about their own prospects as the surveys show they are about the economy, and that is not yet the case. It could become so.

That leaves high household debt as a constraint on interest rates. The central message in the Bank’s inflation report was that markets were too relaxed about the prospect of rate hike; not immediately but in 2018 and 2019. The Bank signalled that if things develop in line with its latest forecast, it would not expect to keep rates on hold until 2019, which markets had been expecting.

It is a reasonable message, albeit one reliant on a punchy forecast of a near-doubling of the rate of growth of wages (average earnings) over the next couple of years. It would enable Carney to leave the Bank in mid-2019 with a rate hike or two under his belt.

The crunch would come if there was greater urgency to push rates higher, because inflation had become more ingrained than the Bank feared. The Bank, with its annual survey of the financial position of households, carried out by NMG Consulting, is aware of the potential vulnerabilities. Some households, though only a minority, would be plunged into financial distress by even a modest rise in interest rates.

A modest rise, at best, is all that is in prospect in coming years, with the Bank aiming for a new normal for interest rates of 2%, though not for some time. But if debt continues to rise, even that could be too high for too many.

Sunday, May 07, 2017
Ultra-low rates made us lose our productivity mojo
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There have been times in the past when voters were entitled to be nervous about interest rates in the run-up to a general election, because of the fear that nasty surprises would be on the way after polling day.

So, in the six months after Margaret Thatcher’s May 1979 victory, interest rates rose by no less than five percentage points (from 12% to 17%), while in the year after her 1983 victory they went up from 10% to 12%. In 1987, rates went up a couple of months after the election, though only briefly.

Before the May 1997 election the Bank, in the person of Eddie George, had been agitating for higher rates, without success. The task of raising them after the election initially fell to Gordon Brown – the last chancellor to raise rates – before being handed over to the newly independent Bank of England. There were six rate rises in the 12 months or so after May 1997.

It is fair to say that few are on tenterhooks this time. Under independence, the interest rate and electoral cycles have not been aligned. In 2001 the monetary policy committee (MPC) was cutting rates before the election and carried on afterwards. In 2005 the MPC held off a rate cut until after polling day. The 2010 election was held with Bank rate at a then record low of 0.5% and it stayed there for the whole five years of the following parliament.

Not only that, but the Bank has shown little inclination to budge from its new record low for official interest rates of 0.25%. It will put flesh on the bone of its intentions with an interest rate decision and new inflation report in one of its periodic “super” Thursdays this week.

But, while one MPC member, Kristin Forbes, has voted for a hike in rates and another, Michael Saunders, recently set out the arguments for doing so, it would be a big surprise if a rate hike happened this week or, indeed, if the Bank signalled its intention of moving on rates in the coming months. Forbes has one more MPC meeting after this one before she steps down.

The markets do not expect a rate hike until 2019 – the 10th anniversary of the move to ultra low interest rates – and some have not given up on the idea of a further rate cut, even from 0.25%, if the economic going gets tougher.

There may be some adjustment around the edges – economists at Goldman Sachs think the Bank may move shortly by tightening what they describe as credit easing; reversing the cut in the so-called counter cyclical buffer made in the wake of the Brexit vote – but the big picture looks to be an unchanging one.

A year ago it was possible to look forward to small and gradual increases in interest rates, but the Bank has responded to Brexit, and will continue to be influenced by its fallout. We will get a new forecast from the Bank this week, which may nudge down this year’s growth forecast, but, comparing its February predictions with those made in May last year, before the vote, it expects the economy in 2019 to be roughly 2% smaller than it did then, and the price level about 2% higher.

The first quarter gross domestic product numbers, released in late-April and showing quarterly growth of just 0.3%, will have reinforced the case from most MPC members for keeping rates on hold. Though April’s purchasing managers’ surveys point to a rebound, the Bank will wait for further evidence on that.

It is easy to forget, given how long we have lived with ultra-low interest rates, how extraordinary they are. A 0.25% Bank rate is mind-bogglingly low but even it does not tell the full story. It ahs been accompanied by unconventional measures, most notably £435bn of quantitative easing (QE). QE was undertaken to provide an additional monetary stimulus to the economy at a time when it was thought impossible to cut interest rates further.

Neil Williams, chief economist at Hermes Investment Management, has applied the rules of thumb offered by the Bank on what its QE programme was equivalent to in terms of interest rate cuts; £200bn of QE is equivalent to 1.5 percentage points off Bank rate, the Bank estimated in 2009. And, because the Bank regards the stock of QE as the key measure, £435bn is equivalent to more than three percentage points off interest rates.

So the true rate of interest, adjusted for QE, is -3% - minus 3% to spell it out, Williams calculates. He thinks, in the absence of rate hikes, the Bank should restore some normality quietly running down QE. It could do this by not reinvesting the proceeds of the maturing gilts – UK government bonds – it has bought under the QE programme. But the Bank’s current policy, most recently set out in November 2015, has been to keep reinvesting those proceeds until Bank rate gets to 2%, which is a long time away. So the stock of purchased assets will be maintained, and the extraordinary looseness of monetary policy will persist.

It is easy to forget, too, that ultra-low interest rates have consequences. One of those consequences is very weak productivity. There are many reasons for the stagnation of productivity (output per hour or output per worker) of recent years. But the weakness of productivity coincides with the period of low rates, and it is not hard to see why.

One of the aims of monetary policy during and after the financial crisis, was to avoid the wave of bankruptcies and redundancies that the scale of the recession of 2008-9 and its aftermath implied. It was supplemented by pressure on banks and other lenders to show greater forbearance to firms in difficulty.

In this, it generally succeeded. On most measures, from corporate failures through unemployment to mortgage repossessions the crisis’s impact was much smaller than feared.

But this, as is also recognised, prevented the process of “creative destruction” that normally happens in a big recession, in which weak firms go to the wall and are replaced by new, higher-productivity businesses.

This effect is acknowledged within the Bank. Andy Haldane, its chief economist, estimated in a recent speech that had interest rates been kept higher – he gave a figure of 4.25% - there would have been a big increase in failures, but also higher productivity. He suggested productivity would have risen by about 2%, though at the cost of 1.5m jobs. He said he would prefer the jobs as, given the choice, would every politician.

I think the productivity effect of ultra-low rates may be bigger than this. They enable healthy firms to coast rather than undertaking productivity-enhancing investment. When businesses cease to expect significant or indeed any rate rises, there is no incentive to invest to take advantage of low rates.

Low rates , to stress again, are not the only reason for weak productivity. But the question, as the clock keeps ticking, is how long this can continue. The near-zero rates that were a logical response to the crisis, and helped the economy trade weak productivity for more jobs, have taken on an air of permanence. So too, unfortunately, has stagnant productivity growth.

Sunday, April 30, 2017
Vive La France - and an economy that's finally on the up
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is not something I recall every saying before, but sometimes other countries’ elections are more interesting than our own. Theresa May’s regal progress towards endorsement by voters of what the Tories keep calling her “strong and stable” leadership seems unlikely to set the pulse rating.

When the most interesting question about the election is how badly the Labour party will do, and when many long-serving MPs have decided that their time is up, mainly Labour but also long-serving Tories such as the Treasury committee chairman Andrew Tyrie, this is no cliffhanger.

Across the channel in France, however, it really is interesting. Though Emmanuel Macron, a political ingénue, is clear favourite to beat Marine Le Pen, who was National Front leader but has temporarily stepped aside from that role, there is much more uncertainty about that outcome than there is about a May victory.

The uncertainty, meanwhile, will not end there. French parliamentary elections, on June 11 and 18, will come after Britain’s June 8 election. The starting point for them is that Macron’s En Marche! movement has no parliamentary representation and the National Front has only two out of 577 National Assembly members.

The conventional view is that, apart from these political hurdles, the next French president will face an uphill struggle in transforming a sclerotic, high-unemployment French economy into something competitive. Le Pen would try to do so via immigration and protectionism, probably pull out of the euro and replace it with the franc and offer French voters a referendum on Frexit. Good luck with that.

Macron, the more likely winner, though with health warnings attached, would relax labour laws, reduce business taxes, reform a system which he says preserves high unemployment and reduce the size of the public sector. In most respects his policies are a paler version of those of the failed conservative candidate Francois Fillon. He would also embrace closer European integration. Good luck with that too.

France does indeed need reforms but its economy is far from the basket case that it is often portrayed as in Britain. Economic growth, according to the purchasing managers’ index, which measures business-to-business activity, is at its strongest for six years.

Having suffered a big recession in the financial crisis, in line with every advanced economy, France suffered again, and badly, in the eurozone crisis and recession of 2011-13, treading water afterwards. In recent months, however, the French economy appears to have put both of those events behind it and enjoyed a growth spurt.

Figures on Thursday for eurozone economic sentiment, derived from measures of both business and consumer confidence, confirmed the improvement in France. After years in which the eurozone has been kept on life support by the European Central Bank, France has become one of the brightest, and perhaps unlikeliest, stars of its revival.

The “basket case” view of France, and her supposed economic inferiority in comparison with Britain, runs up against the reality of some of the numbers. France is Britain’s third largest export market but consistently runs a significant trade surplus with Britain, of around £6bn a year in recent years.

France in many respects has a better balanced economy and is less reliant on consumer spending, which accounts for around 55% of GDP, compared with 65% in Britain, with larger contributions to GDP from investment, net exports and, of course, a larger state.

French productivity, measured by gross domestic product per hour worked, is higher than in Britain to an almost embarrassing extent. Figures published by the Office for National Statistics earlier this month showed that productivity in France is 29.4% higher than in Britain.

Now I have always argued that this is because Britain is a higher employment, lower-investment economy than France, where restrictive labour laws discourage employment and, where it is an alternative, encourage firms to invest. While a machine gets on with it, a French worker responds with a Gallic shrug. But that French worker has significantly more capital equipment at his or her disposal than their British equivalent.

I still think that is the essential part of the story but it is not the only part of the story. A businessman I met a few days ago, who operates plants in Britain and France, told me that if he wanted something done quickly and well, he would look to his French workers, who are more efficient. I am not suggesting for a second that this is typical. Even the 35-hour week, hated by most businesses, may have the effect of making workers more productive in the hours they are employed.

I am not going to go overboard on this. We would not have just had the first round of the presidential election that we did, in which all the mainstream political parties were wiped out, if there was not widespread discontent in France. Much of that discontent arises from the state of the economy.

Though unemployment has started to edge lower, it is still 10% of the workforce, more than double Britain’s 4.7% rate. Unemployment among the under-25s is scarily high, at nearly 24%, almost twice the UK rate.

The employment rate, the proportion of 16-64 year-olds in work, is at just over 64% roughly 10 percentage points lower in France compared with Britain. Though there is no automatic trade-off, French society would benefit if some of its high productivity were traded for higher employment.

Britain still has a slightly larger economy than France, though these days it is very close, and dependent on small movements in the euro-sterling exchange rate. There have been times in recent months when the pound has been low enough to push French GDP above Britain’s.

France perhaps tells us, more than anything, that you can throw a lot of bad policy at an economy and do less damage than you might expect. France has had more of its share of bad policy in recent years but continues to have a lot of strengths. The French state is far too large and the labour market is tied up in too much red tape.

The Macron reforms have been criticised for not being radical enough. But they are a step in the right direction and he has been smart enough to recognise that if you spell out too many of your intentions, which will create some losers, you diminish your chances of election. Margaret Thatcher recognised that in 1979, with a manifesto which was far less radical than she turned out to be.
We will know next Sunday whether Macron has judged it correctly, and we will know in a few weeks whether the parliamentary elections have produced an outcome he can work with.

One thing, however, is clear. France has been a strong competitor even when held back by misguided policies. With some of the right policies, it could become a much stronger one.

PS A few months ago, 0.3% UK growth in the first quarter would have been regarded as good news. Friday’s figures were, however, widely seen as a disappointment. The economy grew, but at half the rate it averaged in the second half of last year. GDP per head rose by just 0.1%.

Though the figures were a little weaker than expected, the slowdown should not have come as a huge surprise. The rise in inflation, much of it down to the pound’s Brexit fall, has already eaten into the growth in real wages, as described here recently. Retail sales recorded their first fall for four years in the first quarter, and their biggest for seven years. As the Office for National Statistics noted, in describing the GDP figures, “there were falls in several important consumer-focused industries, such as retail sales and accommodation”.

The story of Britain’s economy is quite straightforward. Consumer spending has kept it going since the referendum. When spending slows, as it was bound to given that borrowing and the rundown in savings could only go so far in the face of a squeeze on real incomes, the economy will slow. When the dominant service sector which accounts for four-fifths of GDP slows, as it did from 0.8% to 0.3%, so will the economy. The other parts of the economy -production, construction and agriculture – grew by 0.2%-0.3%. Manufacturing was a bright spot, up 0.5%, but it is barely an eighth of the size of the service sector.

Weaker consumer sending will dominate the outlook for the next year or so, for entirely predictable reasons. As it is, growth in the first quarter was a lot weaker than the Bank of England thought – its staff expected 0.6% according to the monetary policy committee’s March minutes. So households will be spared higher interest rates for a while longer yet.

Sunday, April 23, 2017
Hard decisions will be ducked in this Brexit election
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is hard to think it was only two years ago. Then, in the run-up to the 2015 election, it was important to dig into the economic policy agenda offered by Ed Miliband and Ed Balls for Labour, and contrast it with David Cameron and George Osborne’s for the Tories.

Labour’s plans included, for those who have forgotten, no plan for a budget surplus but instead continuing to borrow to invest (in practice about £90bn more debt by 2020 according to the Institute for Fiscal Studies), but alongside a “budget responsibility lock”, bringing back the 50% top rate of tax and a mansion tax.

Apart from the fact that it looks as if we will end up with something like the fiscal numbers set out by Labour two years ago, and not the budget surplus promised by the Tories, so much has changed). We did not get the 50% tax rate or the mansion tax, though some say Osborne’s stamp duty reforms were worse.

And, as we head into another election, which even tests the appetite of an enthusiast like me, the rules of the game have been transformed. So far has Labour moved away from the political mainstream, and so distant is the main opposition party from returning to government, that it is not worth spending time on its economic plans.

The shadow chancellor could propose a 100% tax rate on anybody with two pennies to rub together and we could still relax in the knowledge that it is never going to happen. In all the time I have been writing about these things, there has never been anything quite like this.

The other rule-breaker, and for similar reasons, is that governments usually seek to ensure that voters are nicely buttered up in time for a general election, and feeling confident about the future. But consumer confidence, while a little higher than immediately after last summer’s referendum, is 10 points lower than it was in April 2015.

Households are more upbeat about their own finances than about the economy, with a net 20% expecting the economy to get worse over the next 12 months. The squeeze on people’s real incomes has begun, as I wrote last week. Figures on Friday showed that retail sales suffered their first quarterly fall in four years and their biggest in seven. As Andrew Goodwin of Oxford Economics puts it, the attitude of consumers “appears to have been one of jam today, which leaves very little for jam tomorrow”.

Such “pocketbook”, or wallet, concerns would normally be uppermost in the concerns of election planners. But the Tories under Theresa May are so far ahead in the polls that, as I say, the normal rules do not apply. The last Tory prime minister to gamble and fail on turning a small majority into a larger one and failing was Edward Heath in his “Who governs Britain?” election of February 1974. But, though he won the popular vote, he lost the election, and in the run-up to that the Tories were neck and neck with a more formidable Labour party, not more than 20 points ahead. Accidents do happen but this would be without precedent.

The normal rules do not apply, partly because of the state of Labour under Jeremy Corbyn but mainly because this is the Brexit election. And, from the perspective of Brexit, it makes perfect sense.

It means the negotiations do not nudge up uncomfortably against the next election. It improves the chances of a “softer” version of hard Brexit, as described in detail here three weeks ago. If the hardliners in her own party are neutered, it gives May more opportunity to make concessions, as she will undoubtedly have to do. It means that the necessary transition arrangements, beyond 2019, can be put in place.

It also greatly reduces the risk of a suicidal, cliff-edge “no deal” departure from the EU, which is why sterling has risen in the wake of the election announcement.

What is good for the Brexit timetable and the government’s negotiating position is not necessarily good in other respects. One of the fears about Brexit, that it would divert attention from everything else, is coming to fruition. The Brexit parliament was supposed to be 2015-20. Now it is 2015-17 and 2017-22 combined, unless the prime minister decides in two or three years that she has struck such a good deal that she should have it endorsed in another election. I suspect that the parliament after 2017-22, will be taken up a lot with Brexit too.

In the context of this election, it means all the hard questions will again be ducked. As Paul Johnson of the IFS wrote a couple of days ago: “At the heart of the choices we face is one over the size of the state that we want, and how to pay for it. This is a question which politicians always duck.”

They will do so more than ever this time. The Tories will leave themselves with fewer hostages to fortune than in 2015, when they ruled out increases in all the main taxes. But there will be considerable continuity, for example on arising the personal allowance and the higher rate threshold, to £12,500 and £50,000 respectively. There are hints that the Tories will take the sensible step of promising to scrap the co-called triple lock on pensions, though if so they will surely sweeten the pill for pensioners. Labour will continue to pretend that soaking the rich will pay for everything.

What this means is that, barring a sudden outbreak of candour on the part of the Tories, putting the public finances onto a permanently sounder footing will be deferred.

A few weeks ago the Office for Budget Responsibility (OBR), published its annual fiscal sustainability report. With a few other things going on it did not get the attention it deserved. It defines the country’s fiscal position as unsustainable if the government needs an ever-increasing share of national income to pay the interest on public sector debt.

On that definition, or any other, Britain has an unsustainable fiscal position. The ageing population , together with developments in health technology and the increase in chronic health conditions, will push up spending on the National Health Service and pensions, while leaving revenues broadly unaffected.

The numbers are frightening. Health spending will double from roughly 7% of gross domestic product to over 12.5% over the next 40-50 years, with state pension costs up from 5% to 7.1% of GDP and social care costs doubling to 2% of GDP. After stabilising in the short term, at 80%-90% of GDP, public sector net debt will head up to 230% of GDP and beyond.

These are long-term projections, and as somebody once said in the long run we’re all dead, but the sooner you act on a problem, the better the chances of preventing a dangerous trajectory from developing. As a rough guide, raising taxes or cutting spending by 4% to 5% of GDP, approaching £100bn, would be needed in the next parliament to put the public finances on a more stable footing.

Will we hear that spelled out in the next few weeks? No. The prime minister will surely decide, with Brexit at the forefront of her thoughts that, to coin a phrase, now is not the time.

Sunday, April 16, 2017
Pay hit again by the shrinking pound in your pocket
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The squeeze is back. Real wages have stopped growing in Britain, a few months earlier than expected, thanks to the combination of rising inflation and sluggish pay growth.

After just over two years in which households appeared to have put the financial crisis behind them, and average earnings comfortably outstripped the rise in prices, a couple of years in which real wages fall is in prospect. Regular pay rose by just 0.1% in the year to the December-February period, and that tiny rise looks to be the last for a while.

The first and prolonged fall in real wages from mid-2008 to the autumn of 2014 was directly attributable to the crisis. It was the mechanism by which living standards fell to reflect Britain’s permanent loss of gross domestic product; the lost growth that will never be recovered.

This second fall in real wages reflects two things. Weak oil and commodity prices provided the basis for the recovery in real incomes from autumn of 2014, with the plunge in oil prices from $110 a barrel in mid-2014 to below $30 a barrel in early 2016. The partial recovery from that fall has been one factor pushing up inflation.

The other is sterling’s Brexit-related drop. The pound’s fall, which was the direct result of last summer’s referendum result, and to the Theresa May’s approach to the negotiations – no single market and no customs union – is now the factor coming through most strongly in the inflation figures.

One way of measuring the sterling effect is the difference between Britain’s inflation rate last month, 2.3%, and that in the eurozone, 1.5%. That difference will grow in coming months as inflation in Britain heads towards and possibly above 3%.

This second fall in living standards is the adjustment to what the currency markets, and the majority of economists, think will be a poorer, slower-growth future as a result of Brexit. The fact that we have been here before in terms of falling real wages, and quite recently, may or may not make it easier to bear.

Real wages are, of course, made up of two components. Inflation is one, growth in wages in cash terms, what economists would call nominal wages, the other. The fact that it only takes a small rise in inflation above the official target of 2% to squeeze real wages shows how strangely depressed is the growth in real wages.

Britain’s unemployment rate is currently a very low 4.7%, which is good news. The last time it was this low, in August 2005, average earnings were growing by 4.7%, roughly double the current. If you believe in anything like a traditional Phillips curve – in which falling unemployment pushes up the growth in wages and vice versa – earnings should be growing a lot faster.

Why are they not doing so? A couple of candidate explanations can be quickly ruled out. One is public sector pay policy, which limits most workers to a 1% increase. But, while public sector earnings are growing more slowly as a result, just 1.4% a year at present; the increase in regular pay in the private sector, 2.4%, is also much weaker than past relationships would suggest.

Is it all down to those migrant workers from the EU? We are seeing the first signs of a reduction in EU migrant workers who, contrary to what you may have read in recent days, come here overwhelmingly to work. Unemployment among EU nationals In Britain is under 4%.

There is, meanwhile, no evidence that UK migrants have pulled down wages to any significant extent. Steve Nickell, formerly of the Bank of England and Office for Budget Responsibility, saw his words to a parliamentary committee last year seized on by the anti-migrant lobby. But, as he pointed out recently, any impact on wages, even for the unskilled in Britain, has been “infinitesimally small”.

Meanwhile, migrant workers from the EU14 – the other members before Eastern European enlargement – are the highest paid of any group in Britain, according to new research from the Office for National Statistics. Two in every five EU migrant workers are overqualified for the jobs they do.

If not public sector pay and migrant workers then what? Though the rise in employment has slowed, and in the latest three months was just 39,000, its composition has improved. So one explanation for weak pay growth, that there was insecurity at the heart of Britain’s job creation machine, reflected in part-time, temporary and zero-hours jobs, is losing its explanatory power.

The ONS, analysing the latest labour market figures, noted that a “compositional shift” from part-time to full-time employment is occurring. The share of part-time employment reached a record high of 27.6% in 2012, in the wake of the crisis, but has now dropped to 26.5%, just above its pre-crisis average of 25.5%. The proportion of part-timers who cannot find full-time work has dropped from a 2013 peak of 18.4% to 12.6%. All this should be consistent with rising wage pressure.

Even weak productivity, itself a long-standing explanation for weak wages, does not tell the full story. Productivity, output per hour, is up by 1.2% over the past year, which is nothing to write home about but is a lot stronger than the rise in real wages. In fact, real wages in recent years have lagged behind even a disappointing productivity performance.

The weakness of wages, on the face of it puzzling, may be easier to explain than appears. Firms can point, not just to the fact that the past few years have been ones of uncertainty, with another layer added on to that uncertainty by Brexit, but also to other demands, from pensions through to business rates and the apprenticeship levy. Some have been particularly affected by the national living wage, which this month has risen by an inflation-busting 4.2%. They are in no mood to grant bigger pay increases than they need to.

Employees, meanwhile, seem to be happy with a 2% pay norm, and less willing to move jobs in search of higher pay than in the past. If an acceptable pay increase a few years ago was 4% or 5%, now it is 2%. Some would say that stronger unions would break us out of this new norm, and perhaps they would, but only at the expense of higher unemployment.

If pay sticks at about 2% while inflation moves higher, does that guarantee weak consumer spending? Not necessarily. During the long squeeze on real wages which ended in 2014, spending was kept going by rising employment; even if individuals were squeezed, the overall wage bill was increasing. Households can borrow, or run down savings, as they did in the second half of last year. The more they see the squeeze as temporary, the more they are likely to “look through” it, though borrowing tends to fall when real incomes are squeezed.

The “look through” point also applies to the Bank of England. Most of its monetary policy committee intends to look through this period of above-target inflation, unless or until wage growth accelerates significantly, which would be seen as embedding higher inflation into the economy. If the growth in earnings stays more or less where it is, the Bank will be reluctant to hike rates.

I am not sure about the wisdom of this. There is a danger in tying monetary policy to any one indicator. If, indeed, we are in a period when wage growth trundles along at 2% indefinitely, and this is the new equilibrium, it implies that the so-called normalization of interest rates will never happen. Rates would stay at the “emergency” near-zero levels established at the height of the crisis. That cannot be healthy.

Sunday, April 02, 2017
The inscrutable in pursuit of a softer Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

If you were looking for single word description of our prime minister it would be inscrutable. Her ability to pad away difficult questions with non-answers rivals that of Geoff Boycott. When it comes to inscrutability, the Great Sphinx of Giza has nothing on her.

It would be unwise therefore to read too much into the tone of her letter on Wednesday to Donald Tusk, the European Council president, invoking Article 50. Perhaps, apart from an eye-catching link between trade and security co-operation, which nobody in Europe seems to have much minded, she was just being polite.

But, having warned myself off, I will read something into it anyway. It is that, having talked the language of hard Brexit over the past nine months, not least to convince the Brexiteers in her party that she as a Remainer could be trusted, she is now embarking on a softer and more pragmatic course.

The hard Brexit language – no single market, no full membership of the customs union, reflecting the will of the people on EU migration, no deal is better than a bad deal – will still be wheeled out from time to time.

But it is now possible to see something softer emerging, assuming it can be negotiated and is acceptable to the other members of the EU, the so-called EU27.

What would this kind of softer Brexit entail? In talking to businesses, I have always seen it as including the following. It would involve, not single market membership but a comprehensive trade deal with the EU. Britain would have no influence on drawing up single market rules and directives, as May has conceded, but, except in the few cases where they are inappropriate or irrelevant, British business would still abide by the rules of our biggest market.

There would also be lengthy transitional arrangements, providing for a gradual adjustment for business to a post-Brexit world, as the prime minister has hinted. Nobody with any sense should have any problem with this. There were transitional arrangements stretching for at least eight years when Britain joined the European Economic Community in 1973. If they were appropriate on the way in, they are even more suitable on the way out.

There would be a continuation of significant migration to Britain from the EU27, though employers would have to go through a few more hoops, including visas and work permits. The hope is that these would not be as bureaucratic as the current arrangements for non-EU skilled migrants. Whether overall immigration would fall remains to be seen. In the short-term there is evidence of a drop in skilled EU migration to Britain.

Britain would continue to pay into joint EU-UK schemes post-Brexit, not in the sense of a direct budget contribution, but more in the way that Norway does currently. The full Norway option, which includes membership of the European Economic Area and thus the single market, is not currently open to Britain because it would require free movement of people. That may change, though it would be unwise to rely on it.

As an exercise in damage limitation, such a softer Brexit would beat the alternatives. Britain would formally exit the EU, as the referendum required. It would chime in with public opinion, which in the main wants control of Britain’s borders – hence visas and work permits – but recognises the need for EU workers and is concerned about the trade effects of Brexit. Some would baulk at any payments to Europe but that is probably not an insurmountable barrier.

Something as close as possible to single market membership would still be inferior to what we have now. Apart from losing the ability to influence the rules, Britain would no longer have the opportunity to push for greater liberalisation of trade in services, where much of our comparative advantage lies. As we are already seeing, there will be some loss of activity to the EU in services, particularly financial services, but the hope will be that this can be kept to a minimum. Employing EU migrants will involve more bureaucracy than now, which could affect smaller firms in particular.

A useful report from Open Europe, “Nothing to declare: A plan for UK-EU trade outside the Customs Union”, makes 12 good points about how to make the best of the new situation. Britain, it says, cannot be half-in, half-out of the customs union (the common external tariff and common commercial policy) if it wants to negotiate future trading arrangements with the rest of the world. But an extension of customs union membership for up to two years beyond 2019 makes sense.

Future trade between Britain and the EU will not be frictionless, it notes, creating difficulties for sectors with complex, cross-border supply chains, such as the motor industry, and there will be costs associated with leaving the customs union. But those costs can be minimised with a free trade agreement which seeks to avoid most of the difficulties over so-called rules of origin. This can be achieved by what is known in the jargon as liberal cumulation, under which products that are substantially transformed in the UK or EU, in other words put together from components imported from elsewhere, are assumed to originate there.

The Open Europe paper , recognising that it will take time, probably many years, to negotiate new trading arrangements with the rest of the world, says Britain should seek to replicate, or “grandfather” the 30 free trade agreements the EU has concluded with more than 60 non-EU countries, including the recently concluded agreement with Canada. Given that Tusk, in his reponse to the prime minister, has said no to this, some work will be required. In time, assuming it can be done, those deals may or may not be replaced with bespoke UK deals.

Where there will be scope for improvement, according to another interesting paper, “Post-Brexit trade and development policy”, is in Britain’s trading relationships with poorer countries; the developing world. The paper, published by the Centre for Economic Policy Research, by Richard Baldwin, Paul Collier and Anthony Venables, notes that it will take many years to secure new trade agreements with other advanced economies, including America.

But there will be early scope for making friends and influencing people, and standing Britain in good stead for the future, in negotiating speedy deals with developing countries. These, currently subject to EU agricultural and in many cases industrial protectionism, could be good be good for both the countries themselves and for British consumers.

As the authors put it: “While the British government faces massive complexities in its trade-policy dealings with the EU and other advanced economies, it could, almost instantly, launch bold trade-policy initiatives with respect to developing nations.”

That is food for thought. On the wider point, how likely is a Brexit at the softer, and therefore less damaging end of the spectrum? These are early days. There is the question of the Brexit exit bill, estimated by the influential Bruegel think tank to be between €25.4bn (£21.9bn) and €65.4bn (£56.4bn), and which the EU wants agreement on early. There is the question of what will be acceptable to some of the headbangers and hardliners on the Tory benches and beyond. There is the question of Gibraltar.

A deal can be done. Whether it is a good one remains to be seen. It could yet be a case of the inscrutable in pursuit of the impossible.

Sunday, March 26, 2017
Upbeat manufacturers and the drag from rising costs
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

They are the two sides of the same pound coin. Sterling’s sharp post-referendum fall has pushed inflation above the 2% target and is squeezing household incomes but it is also providing a boon for exporters.

Ben Broadbent, one of the Bank of England’s deputy governors, pointed out in a speech on Thursday that the weaker pound boosted export prices, in sterling terms, by 12% during the course of last year.

Though the pound has perked up a little in recent days that effects, which as Broadbent says “will have significantly boosted exporters’ profitability” is still coming through.

No part of the economy is more exposed to these conflicting effects than manufacturing. For manufacturers, 2.3% inflation – the latest reading for the consumer prices index – is child’s play. They have seen a 19.1% rise in raw material and fuel costs over the past year.

They are also, it is clear, benefiting from the upturn in exports as a result of the weak pound. The latest CBI industrial trends survey, published last week, showed export order books at their healthiest since December 2013, with total order books close to a two-year high and output expectations buoyant.

Surveys by the EEF, the engineering employers’ federation, which represents manufacturers, have shown a similar strong picture, as have recent official figures. The surveys show that industry’s optimism is tempered by its concern over sharply rising costs, but that there is optimism nonetheless.

So how will these two factors balance out? Is it time to celebrate the early stages of a sustained revival in manufacturing, one that we have been waiting for a long time, or will this be another false dawn? Some context is useful here.

Though the latest official figures showed a dip in manufacturing output in the early part of the year, they also recorded a rise of 2.1% in the November 2016-January 2017 period. That, incidentally, was the best three-monthly performance since May 2010.

The comparison is a reminder that there have been high hopes for manufacturing before in the post-crisis period. For a while at least, it seemed that industry would be boosted by sterling’s big 2007-9 fall during the crisis and the fact that the service sector, particularly financial services, would be hobbled by a significant post-crisis hangover.

Britain’s manufacturers were, however, quickly hit by a combination of the eurozone crisis and weak domestic demand, and had a disappointing 2-3 years. Almost as soon as George Osborne had uttered the words “march of the makers”, the sector began to struggle.

2014 was a good year for the economy and for manufacturing, with factory output up by 2.9%. The following two years were, however, disappointing, however, with output slipping by 0.2% in 2015 and growing by just 0.8% last year.

The result of all this is that, even after its recent revival, manufacturing has yet to get back to where it was before the crisis; even after its recent revival its output is 3.3% lower than the pre-crisis peak in January-March 2008. The service sector was not so hobbled after all; its output is almost 14% up on the pre-crisis peak.

What about now? In the eye of the sterling storm, it is important to remember that the same factor affects the various parts of manufacturing in different ways. George Nikolaidis, a senior economist at the EEF, points out that for high-value manufacturers, including aerospace, capital equipment and automotive, the net effect of a lower pound is positive. For these sectors exports are receiving a boost, and that more than outweighs the impact on costs. Other “commodity” parts of manufacturing, including basic metals and basic pharmaceuticals, are also receiving a leg-up.

We should never forget, however, that many manufacturers do not export at all, particularly smaller firms, and so for them sterling’s fall simply adds to costs and does not produce any offsetting benefits. Large parts of food and drink manufacturing, textiles and the building supplies sector are in this position.

How will all this balance out? The EEF champions manufacturers but is far from upbeat about prospects for the next couple of years. It expects manufacturing growth of just 1% this year, slowing to a mere 0.1% next. Weaker growth in consumer spending will hurt domestic-facing businesses, while subdued business investment will hold back firms making capital equipment. If the EEF is right, the net effect will be that manufacturing output will still be below pre-crisis levels in two years’ time, so a lost decade for industry.

What of the longer-term? As I have written before, it would be a huge failure of negotiation if Britain and the EU cannot come up with a decent trade deal for goods, and hence manufacturers. The biggest problems are likely to arise for services.

So should manufacturers be investing, at least in those sectors which benefit from sterling’s weakness, or holding back as the EEF and others expect? They face, as Broadbent pointed out, “a somewhat tricky decision”.

Even for those sectors currently benefiting from the weak pound, higher costs will eventually come through to limit any long-term benefits. That has been the story of Britain’s past devaluations. What he describes as a “sweet spot” will not last.

If, on the other hand, the currency markets have got it wrong, the post-Brexit outcome for Britain’s economy in overall terms is better than feared, then one obvious consequence would be that the pound would claw back some, or all, of its losses. The competitive advantage would be more directly lost.

Though some argue that the pound was overvalued before last summer, there is no good evidence of that. Washington’s Peterson Institute, which pioneered the measurement of so-called fundamental equilibrium exchange rates, suggested that the right rate for the pound in April last year was $1.52.

Either way, businesses may want to wait and see. That leaves, Broadbent says, an argument for investments in manufacturing with “short-term payoffs”. Some exist. Mostly, though, manufacturers like to plan and build for the longer-term. The double-edged coin that is represented by sterling’s fall makes it harder for them to do so.

Sunday, March 19, 2017
After the U-turn - thank the self-employed for Britain's jobs' miracle
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It might be an age thing but the pace of life these days can be dizzying. There was a time when budgets rarely unravelled, and even bad and unpopular measures were seen through to the bitter end. Then, more recently, they started unravelling, but not usually for a few weeks.

Now Philip Hammond has set something of a record, though not of his own making, by dropping his main budget tax-raising measure, the 2 percentage point increase in Class 4 national insurance contributions (Nics) within a week.
Though I argued last week against this tax hike on the self-employed, I am not going to crow about the U-turn. The chancellor has enough enemies. He and the Treasury will take comfort from the argument that they were trying to do the right thing by the public finances and the tax system; correcting important unfairness in the latter. They will argue that politics got in the way of good economics.

I am not sure about that. The Nics’ increase is dead, for this parliament at least, so is water under the bridge. But the review that Theresa May commissioned from Matthew Taylor, chief executive of the Royal Society of Arts, will still be published in the autumn and could recommend enhanced rights for the self-employed. Taylor backed the increase in Nics though said it should not go any further.

The rise in self-employment has been a key contributor to the employment “miracle” in Britain in recent years. Without it, we would have seen a decent post-crisis jobs’ recovery. With the growing army of the self-employed, we have seen a record employment rates, and an unemployment rate, 4.7%, which equals the lowest since the mid-1970s.


The question is whether, once you start to tamper with the self-employment model we have in Britain, which is less-regulated, lower-taxed and on average lower-waged than employment, you kill it off. Has the self-employment boom, in other words, only been possible because of the existing model?

Looking at the numbers, there are 4.8m self-employed people in Britain, 3.44m of them full-time self-employed and 1.37m part-timers. The increase in the number of self-employed people in the past eight years, 1m, compares with a rise of 500,000 in the eight years leading up to the crisis. Without it, the employment rate would be closer to 72% than the current 74.6% record, and unemployment near to 2.5m, or nearly 7.5% of the workforce, instead of 1.6m and 4.7%.

Nor is there evidence of any slackening in self-employment growth. In the latest three months there was a rise of 49,000 in self-employment, almost three times the 17,000 increase in the number of employees. In the past 12 months the figures were 148,000 and 144,000 respectively.

What has been driving the boom in self-employment? A number of factors. Some of it has been straightforward preference. People like self-employment because it offers greater freedom and variety, and not just in the gig economy. For some businesses, it is easier and cheaper to employ contractors than take on full-time staff.

Advances in information technology, meanwhile, have made it easier and cheaper for people to work from a distance and freelance, although that does not explain why the rise of self-employment has been greater in Britain than in most other countries.

Labour market conditions matter. In the aftermath of the crisis, when there was initially a fall and then barely a recovery in the number of employees, many people saw self-employment as an alternative to unemployment. By becoming self-employed they kept their hand in and, while this may have been involuntary self-employment initially, most of those who became self-employed in this way did not return to traditional employment when the opportunities arose to do so.

No story of self-employment is complete without a reference to pensions. A good company pension was once a powerful argument for being and remaining an employee. The decline in company pensions has, however, reduced the attractions of being an employee. At the top end of the scale, where the highly paid have run up against the government’s lifetime allowance, now just £1m, the argument for staying in a company scheme, and therefore in a company, has diminished.

The years of declining pensions, thanks both to government action and ultra-low long-term interest rates have had another self-employment effect. The glory days of retirement in your 50s with a generous pension have long gone for most people. These days, many more need to top up their inadequate pensions with a self-employment income.

How much has the rise in self-employment been driven by its tax advantages? A couple of years ago the Office for Budget Responsibility identified that some of the rise in self-employment may have been driven by access to tax credits. Around a fifth of the self-employed are in receipt of such credits. At the margin this, and lower Nics, will have driven some of the rise in self-employment. I doubt, however, that it explains much of the rise.

The rise of self-employment has been an undoubted boon for the economy, contributing to much better labour market numbers and, overall, helping the public finances, when compared with the alternative of these people not working and not contributing to tax revenues, and drawing more from the state.

The Resolution Foundation, the think tank which emerged as the strongest backer of the move, surprised me more than a little. One of the debates I have had with it in recent years has been over the earnings of the self-employed. Only six months ago it reported that the typical real earnings of the self-employed are lower than they were 20 years ago, and on a like-for-like basis they have fallen significantly since the crisis. This is an odd context to hit somebody with a tax hike.

What about the question, raised by former Treasury officials and others, that if raising taxes is so difficult, we cannot be serious about deficit reduction, and so everybody should have supported the rise in self-employed Nics?

The flaw in this argument is that it is a bit late in the day. The one big tax rise during the government’s deficit reduction programme, the 2001 increase in Vat to 20%, has mostly been given back in the form of increases in the income tax personal allowance, the long freeze in excise duties on petrol, and so on. If there is a need for higher taxes to reduce the budget deficit, they should apply to all taxpayers, not smaller groups. I doubt after last week we will be seeing that from the chancellor, however.

From the government, meanwhile, it will be important to nurture self-employment, not stifle it. That should be the good news from this U-turn.

Sunday, March 12, 2017
Now, more than ever, we need productivity to move up through the gears
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

When it comes to budgets, there are some eternal verities. One is the contrast between the picture of the economy painted by the chancellor and the reality of the numbers. Another is the ability of chancellors to get into political hot water even when apparently treading with the utmost care.

George Osborne managed to do so a year ago when trying not to frighten the horses ahead of the referendum. Philip Hammond has followed his predecessor into the mire by announcing increases in Class 4 national insurance contributions for the self-employed and cutting the dividend tax allowance from £5,000 to £2,000.

In the speech the chancellor lauded the “entrepreneurs and innovators” who are the lifeblood of the economy and said he wanted Britain to be the best place in the world to start and grow a business. But fine words butter no parsnips for those facing these tax hikes.

I do not want to dwell on Hammond’s NI problem and his breaking of what was not a very sensible manifesto promise; no government should tie its hands by ruling out increases in the major taxes. But suffice it to say that the contributory principle, which he used to justify raising the contributions of the self-employed, has worn rather thin in recent years.

And, while tax neutrality is a laudable aim, the implicit understanding has always been that the self-employed deserve to be cut some slack because their incomes are less secure and because they do not enjoy the employment rights of the employed. The £500m a year the NI increases will bring in when fully in place could have been secured in other ways, notably by a modest increase in fuel duty, which would probably have been more palatable to white van man. In net terms, after other NI changes, they will bring in only £145m a year.

Not only that, but if you really wanted to tackle the discrepancies in the system – the chancellor cited a £32,000 employee attracting £6,170 of NI contributions and a self-employed person on the same income just £2,300 – you would address the biggest source of that discrepancy, which is that employers pay 13.5% contributions for their employees, but not self-employed contractors.

Anyway, no doubt this will all come out in the wash in the autumn. The Treasury seems determined not to U-turn on the NI increase, though we have heard that at this stage before.

What I did want to focus on was the big disappointment in the budget, the fact that the government’s fiscal watchdog, the Office for Budget Responsibility (OBR), sees virtually no follow-through from the recent better performance of both the budget deficit and growth.

On the deficit, the OBR attributes this year’s (2016-17) big undershoot, from the £68.2bn it predicted in November to £51.7bn now, to one-off effects and methodological changes. After five years it thinks the deficit will be slightly larger than it predicted late last year. Cumulative borrowing will still be roughly £100bn more than it predicted a year ago.

While revising growth up from 1.4% to 2% this year, largely on the back of the economy’s stronger performance at the end of last year, the OBR sees this short-term strength fully offset by weakness later. In fact the economy ends up fractionally smaller in 2021 than it expected in November.

There are a couple of reasons for this. One is that recent growth, driven by consumers dipping heavily into their savings, is seen by the OBR as unsustainable. The other more important reason is that the watchdog thinks the economy is close to full capacity, indeed slightly above it, so future growth will be constrained by the growth in productivity, which the OBR thinks will recover only gradually.

On consumer spending, it offers alternative “boom” and “bust” alternatives. Under the boom scenario, consumers carry on running down their savings and to keep on spending and the economy grows by 4% this year, before slowing abruptly thereafter. Under the bust, consumers rein back, the economy shrinks by 0.5%, and then resumes growth at a far stronger rate. But while the journey is different, the end-point for the size of the economy is the same.

As it happens, I think the OBR is right to take a cautious attitude about the outlook for both growth and the public finances, given the uncertainties ahead. Some economists think it is still too optimistic. But if you wanted to play devil’s advocate, however, you could say that its approach to medium-term forecasting, while very logical, is also rather rigid.

Spare capacity in modern economies, particularly a service-based economy such as Britain’s, is a bit of a will of the wisp. Unemployment rates that in the past would have provoked bigger wage rises no longer do so. The OBR, in common with the Bank of England, has revised down its so-called equilibrium unemployment rate as a result. Expanding service sector activity does not necessarily require a big increase in investment or staff numbers. Caution, as I say, is justified, but the economy’s ability to grow may be more flexible than the OBR has allowed for.

Where we would entirely agree is that the circle would be squared for the economy in so many ways if productivity – output per hour - were to be stronger and come back more quickly than it and other forecasters expect. The OBR expects a gradual pick-up in productivity growth to 1.9%, just below its long-run average, by the early 2020s, though it has been over-optimistic on productivity before,

That slow pick-up will mean, as Paul Johnson put it in the Institute for Fiscal Studies’ post-budget briefing: “Average earnings will be no higher in 2022 than they were in 2007. Fifteen years without a pay rise. I’m rather lost for superlatives. This is completely unprecedented.”

Suppose that, instead of a slow crawl back towards normal for productivity growth, there was a period in which it grew faster than the norm, say 2.5% or 3% a year, clawing back some of the huge gap that has opened up since the crisis.

In those circumstances, the economy’s capacity to grow would be hugely enhanced, households would spend out of real wage rises justified by higher productivity rather than savings, and the budget deficit would be eliminated within the foreseeable future.

Could it happen? Even Hammond’s best friends would concede that, welcome though his measures were, including the new “T-levels” to boost technical skills and training, they and other aspects of his productivity agenda will take very many years to make a difference, and that difference may be small.
Productivity does not, of course, rely only on government. If, within every sector of the economy, low-productivity firms matched the performance of the best, Britain’s productivity position would be transformed.

Until that happens, we have another contrast between what chancellors say in their speeches and the reality. He wants Britain to be “at the cutting edge of the global economy y”. We have an economy with low productivity which relies too much on consumers running down their savings. As the chancellor said, “there is no room for complacency”.

Sunday, March 05, 2017
Better news - but look before you leap, Phil
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Philip Hammond would rather he did not have to present a budget this week. We know that because, in November, he told us so. The spring budget, he said, had outlived its usefulness, providing chancellors with more opportunities to tinker than is healthy. In future, there will be a single budget in the autumn.

His reluctance may also be because, not for the first time, great things are expected within Theresa May’s government, and probably on Tory backbenches, of this final spring budget. The chancellor is expected to apply some hefty sticking plaster to the social care crisis, ease the burden of business rate changes for the hardest hit firms and provide one or two crowd pleasers for households squeezed by the rise in inflation. There is a bigger demand on him, which is to ameliorate the pressure on low-income and vulnerable households from spending cuts.

For the Treasury, this week’s budget carries an added danger. Had the books been closed for a year in November, when Hammond presented his autumn statement, the Treasury would have had little difficulty fending off demands for largesse.

At the time, the Office for Budget Responsibility (OBR) unveiled a cumulative, like-for-like increase in public borrowing of £114bn by 2020-21, compared with its projections last March, mainly due to weaker actual and potential economic growth, and its resulting impact on tax revenues and spending. There was also a smaller effect from deliberate policy actions; mainly increased capital spending by the chancellor. The OBR wiped away George Osborne’s ambitions of achieving a budget surplus; under Hammond there would still be a deficit of nearly £21bn in 2020-21.

There was an even bigger addition to government debt, up £210bn by 2020-21 to £1,950bn. Debt was predicted to rise by more than the increase in borrowing because the Bank of England’s term funding scheme for the banks counts as an addition to debt.

Since then, however, as a result of methodological changes, stronger economic growth than feared and reasonably healthy revenues, the position has improved. The picture unveiled by the OBR this week will be better than it expected in November, with an upgrading of growth and a downgrading of public borrowing, though still considerably worse than it was projecting a year ago.

The Resolution Foundation, a think tank, estimates that the projected improvement in the public finances between now and 2020-21 will £29bn. John Hawksworth at PWC estimates a £45bn cumulative improvement relative to November by 2021-22.

Will the OBR agree? When the latest official figures for the public finances came out a few days ago, the fiscal watchdog took the unusual step of conceding that there will be a significant undershoot this year compared with its November forecast. Instead of the £68bn borrowing it expected then, that points to a new estimate for this year of between £55bn and £60bn.

The OBR also cautioned, however, that this undershoot did not necessarily have implications for borrowing in future years, though it will be surprising if there is not some follow-through to 2017-18 and future years.

So is the way open for Hammond to splash some cash, to spend some of this borrowing windfall? At moments like these, chancellors are like those fictional characters with a devil on one shoulder and an angel on the other, each whispering furiously into the nearest ear.

People will have different views on which is the devil and which the angel in this context but on one side will be those urging Hammond to use his mini windfall to ensure that the government’s tricky task in coming years is not made even trickier by clumsy changes in business rates, deficiencies in social care that are giving the National Health Service an air or permanent crisis, and welfare cuts that look brutal in the context of rising inflation.

On the other are the guardians of the public purse at the Treasury. They know that any improvement in the public finances since November is relative. The big picture is one in which the government is still borrowing far too much at this stage of the cycle and has yet to stabilise debt. The Treasury is also keenly aware that there are uncosted pledges within the public finances. Fuel duty, for example, seems stuck at present levels for political reasons, and that is increasingly expensive. The government has pledged to increase the personal income tax allowance to £12,500 and the higher rate threshold to £50,000, and to cut corporation tax to 19%.

Which voice will be stronger? Hammond is a fiscal conservative. He knows that one way to ensure that Britain maintains the confidence of international investors during the uncertain negotiations that lie ahead will be to demonstrate that the government retains its grip on the public finances. He knows also that there will be difficult times ahead, during which the demands for Treasury largesse will be even greater than now.

He also knows that improvements in the public finances can flatter to deceive. Osborne had a mini windfall from down the back of the fiscal sofa in November 2015, only to see it and more snatched away from him four months later. As Robert Chote, head of the OBR, observed: “What the sofa gives, the sofa can easily take away.“

The underlying picture for the public finances, meanwhile, remains challenging, as discussed here last month. That does not mean there will be nothing in this week’s budget. It does mean that the voices urging Hammond to beware the fiscal chasm will win the battle over those urging him to throw caution to the wind.

And then, in the long run-up to the first of the 21st century versions of single annual autumn budgets, we should have a serious debate on what levels of public spending the country can afford, and where the tax burden – which looks to have an upper limit of around 37% of gross domestic product – should fall. As he put it in his autumn statement, Hammond wants a country committed to “living within our means”. We are a long way from that.

Sunday, February 26, 2017
This nation of shoppers needs a new growth model
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Every little bit of information adds to our knowledge, and changes our perceptions. In recent days we have had a flurry of such information from the official statisticians. Let me try today to steer through it, and try to answer some key questions about the outlook.

The questions are these. Can the consumer continue to be the mainstay for the economy during 2017? Will imports and exports respond to the weak pound? Are businesses already throttling back on investment and will they continue to do so?

There is another question, and it is whether Britain can move away from a growth model which depends excessively on consumer spending to something more sustainable. The London School of Economics’ Growth Commission, whose first report four years ago was very good, published a second report on last week. More in a moment on whether it has some of the answers.

Starting with those statistics, the second release of gross domestic product figures for the final quarter of last year were rather bitter-sweet. They confirmed the expected upward revision of growth to 0.7% for the quarter, which is above-trend, but they also showed a surprise downward revision of growth from 2016 as a whole from 2% to 1.8%.

Amid the uncertainty of last year, 1.8% growth was perfectly respectable, exceeding most of the G7, though just below Germany. But it was driven, to an almost embarrassing extent, by consumer spending.

While the economy grew by 1.8%, consumer spending rose by 3.1%. The consumer, in fact, accounted for all of Britain’s growth last year and a little more, 1.9 percentage points. Government spending also contributed 0.2 points of growth. The circle is squared by the fact that business investment fell, subtracting 0.1 points from growth, and that net trade, exports minus imports, also acted as a drag on growth, to the tune of 0.4 percentage points. Investment and export-led growth it was not.

Though last year’s £2.7bn fall in business investment was the first since 2009, it confirmed that investment has been a persistent weak spot for the economy. GDP is 8.6% higher than its peak prior to the 2008-9 recession, while GDP per head is up by 1.8%. Overall investment in the economy, including business investment, was however lower last year than in 2007.

What about exports? Net trade – exports minus imports – boosted growth in the final quarter of last year, but does so quite rarely, and may have been distorted, according to the Office for National Statistics, by trade in gold. Export volumes were down on a year earlier, while imports were up.

In the short-term, the outlook for the economy will be determined by the interplay of consumer spending, investment and foreign trade. As is now familiar, the issue for consumers is whether they will try to spend their way through the squeeze on real incomes arising from higher inflation.

We have information on the part of consumer spending accounted for by retail sales. Official figures show that retail sales volumes fell in November, despite Black Friday , fell again in December, despite Christmas, and in January, despite the sales. The CBI distributive trades survey suggest that they have remained subdued this month. British consumers, who you write off at your peril, may just be pausing for breath. But it will be surprising if spending growth this year and next comes close to last year’s 3.1%.

On business investment, there is little in the surveys to suggest an imminent collapse, but little to suggest much growth either. Investment looks likely to tread water until there is greater clarity about the outlook.

Exports are the wild card. The latest figures were distorted, but stronger growth in Britain’s main markets, including the EU, is helping, as should the pound’s big fall. But, while consumer spending has tended to outperform expectations, exports have tended to underwhelm. It remains to be seen whether this time is different.

What about beyond the next couple of years? The LSE Growth Commission’s new report says that now is an ideal time to tackle some of the economy’s longstanding weaknesses, which include low productivity and over-dependence on consumer spending.

The report has a string of recommendations in the four key area of skills and training, industrial strategy, openness (to trade, inward investment and people) and the supply of finance to growing businesses. Britain, it says, has relied too long on migrant labour to plug the holes in an inadequate education and training system. The rise of self-employment has further discouraged sufficient spending on training, and the playing field needs to be tilted back to employees. Britain achieves the worth of both worlds by under-investing in plant, machinery and other capital equipment, despite the tax incentives to do so, while also under-investing in training and skills.

While this country has a world-leading financial centre and a highly competitive financial services sector, there remains a problem with the provision of finance to high-growth businesses and to infrastructure projects.

What the LSE Growth Commission describes a s a new chapter in Britain’s growth story will require continued good access for the two-third of exports that go to either the EU or America, as well as the rapidly growing “frontier” economies elsewhere in the world. It will require, it says, “access to finance for businesses and innovation, including flexible regulation of challenger banks, increased support for the FinTech sector, reform of equity markets, a boosted role for the British Business Bank and a new infrastructure bank”.

There should be a new British state aid law, the LSE argues, both to allow the government to step in a more flexible way than currently allowed under EU rules but also to preserve the most useful aspect of those rules, tying ministers’ hands in a way that stops them propping up uneconomic sectors.

A record deficit on the current account of the balance of payments and a tradition of chromic under-investment speak of a badly unbalanced economy. I have barely scratched the surface of the LSE Growth Commission report but it offers plenty of ideas for turning over a new leaf. And it is more coherent and comprehensive than anything the government has yet come up with.

Sunday, February 19, 2017
Our Goldilocks job market and its three lurking bears
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There is some news we should make a point of celebrating. The announcement a few days ago that Britain’s employment rate hit a record high of 74.6% in the final three months of last year was a good example.

What the figure meant was that in records dating back to 1971, there has never been a higher proportion of 16-64 year-olds in work. Though the records go back only 46 years, I doubt there has been a time in Britain’s history when the employment rate has been higher.

Britain’s employment rate is not only the highest on record but is around five percentage points higher than that of America and some seven percentage points above the European Union average. Among advanced economies, only Denmark, Sweden, Germany and Japan have higher employment rates. At the other end of the scale, Italy has an employment rate of 57.6%, Greece just 53%.

Think about that record for a second. Over the period since 1971 very many more young people stay in full-time education beyond the age of 16, which in normal circumstances ought to mean a decline in the 16-64 employment rate, even allowing for the fact that many students have part-time jobs.

Until recently, there was also a significant erosion of employment among older age groups. Many is the piece I have written over the years about declining employment in the 50-64 age group. The employment rate in that age group in currently just below 71%, up from 69% two years ago. And these days a different phenomenon is at work. On top of 16-64 employment, there are 1.2m people aged 65 and over in work. That may not be an all-time record but it is close to recent highs and underscores the labour market’s success.

The record employment rate is, first and foremost, a reflection of the welcome flexibility of Britain’s labour market, a flexibility which is reflected in the fact that what is now the Cinderella measure of unemployment, the claimant count, is at 745,000 in January, lower than the number of officially-record vacancies, 751,000. If that has ever happened before, it has not done so for a very long time.

Record employment is, secondly, a tribute to the rise of women in the workforce, and the huge social changes of the past half century. The employment rate among men has followed the pattern one might expect; it is lower than it was. The employment rate among 16-64 year-old men, which is now 79.3%, was a very high 92.1% in early 1971.

The employment rate among 16-64 women, in sharp contrast, has risen from 52.8% in early 1971 to 70% now. It will converge further on the male employment rate as the male and female state pension ages are equalised.

The record employment rate also reflects the fact that, under David Cameron and George Osborne, Britain had a particularly job-rich recovery, with a 2.75m rise in employment from early 2010 to the middle of this year. There was a time, you may remember, when some predicted that we were due an employment and unemployment disaster, as a result of public sector job cuts and the more general austerity squeeze on the economy. Precisely the opposite happened.

Whenever I have written before about the miracle of the post-2010 job market, people have always reminded me about falling real wages, insecure self-employment and employment, including zero-hours contracts, the shift from high-quality public sector jobs to some lower-quality private sector ones, and the weakness of productivity growth. These days such observations are supplemented by overwrought, easily wound up oddballs blathering on about Project Fear.

It is fair to say that in the background of Britain’s Goldilocks job market – not too hot to force a wage explosion, not too cold to push unemployment up – there have always been a few bears lurking. Today, behind the good headlines, there are least three of those bears.

Though the employment rate is at a record, the rise in employment has plainly slowed. Not so long ago, Britain was adding half a million or more jobs a year. No longer, the rise over the latest 12 months was 302,000. Moreover, the rate of employment growth slowed sharply in the second half of last year. Of the 302,000 growth in employment, 216,000 or 72% came between the final quarter of 2015 and the second quarter of last year.

There were, in addition, real signs of fatigue as the job market made it over the finishing line to that record 74.6% employment rate. The 37,000 net rise in employment in the final three months of last year was a rather motley collection. None of it came from a net increase in the number of employees in businesses. All of it came from a rise in self-employment (13,000), an increase in numbers on government-backed training and employment schemes (21,000), with the rest unpaid family workers.

Self-employment, which has been responsible for a significant proportion, roughly 40%, of overall employment growth during this job-rich recovery, is controversial. While much of it is what self-employment has always been, an increasing proportion reflects insecure “gig economy” work, which Theresa May’s government has commissioned an investigation into.

The Institute for Fiscal Studies this month highlighted the tax headache for the chancellor in the rise of the self-employed and owner-managers, which will mean £3.5bn less tax at the end of the decade (an Office for Budget Responsibility calculation) than if these people had been employees. It remains to be seen whether Philip Hammond will respond to this in his March 8 Budget.

There are other job market issues. One, highlighted by many firms, is that skill shortages are biting and set to do so harder in coming years. Another is that when it comes to pay, the labour market is a bit too Goldilocks for its own good. The growth in average earnings slipped back from 2.8% to 2.6% in the latest figures, and looks set to drop further at a time of rising inflation. The squeeze on real wages will be one of the stories of this year. Perhaps in anticipation, retail sales volumes have fallen for the past three months.

Finally, there is productivity, a very significant bear. Official estimates last week suggest it rose by a mere 0.3% in the final quarter of 2016, its smallest quarterly increase during the year. We are approaching an interesting test for productivity. It is unlikely that the employment rate can rise much further from here, and workforce growth is set to slow. Prosperity will depend on faster growth in productivity. Can it be achieved? That is something we will all be keeping a very close eye on.

Sunday, February 12, 2017
Spending down, taxes up - but we will keep on borrowing
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The Institute for Fiscal Studies has been producing its “green” budget for 35 years, through changing economic and political circumstances. The latest, the final one (for now) at this time of year because Philip Hammond is moving the budget timetable to the autumn, is a bit of a humdinger.

The IFS pulls few punches in laying out the scale of Britain’s fiscal challenge, leaving me a little punch-drunk. Seven years after the start of post-crisis deficit reduction, the budget deficit is 4th largest, relative to gross domestic product, of 28 advanced economies. Public sector debt, on the same basis, is 6th largest among the same group of advanced countries. It has not been higher relative to GDP since the mid-1960s, when the post-war unwinding of debt was still in full swing.

This is despite a fall in real-terms public spending of 10% since 2009-10, the longest and biggest on record, with more to come. By 2019-20, on present plans, real departmental spending will be 13% lower than in 2009-10.

For every Scylla, meanwhile, there is a Charybdis. With £17bn of tax rises planned for the rest of this parliament, the tax burden will rise to more than 37% of GDP by the end of the parliament, its highest since 1986-7, when the Thatcher government was in the process of aggressively reducing income and corporate taxes. Even then, we will still have a budget deficit.

I have always adopted a “something will turn up” approach to the public finances. In the past, time and economic growth proved to be great healers. In the 1980s, economic revival turned a budget deficit of 4.3% of GDP into a surplus within eight years. In the 1990s the timetable was even shorter. Britain went from a 6.7% of GDP deficit to a budget surplus in just five years.

This time the challenge was greater, with a deficit of 10.1% of GDP in 2009-10. Progress has been made. The latest full-year deficit, for 2015-16, was 4% of GDP. But that is still high, as is this year’s projected deficit of 3.5% of GDP. As the IFS points out, in the 60 years before 2008, Britain has run a bigger deficit in only 13 years, mainly when the economy was in recession.

If ever the economy needed a positive growth surprise, in other words a few years of above-trend economic growth, this is the time. Unfortunately, for reasons I do not need to spell out, that is highly unlikely, notwithstanding Friday’s good manufacturing and construction figures for December.

Oxford Economics, which provides the macroeconomic forecasts which underpin the green budget, is less gloomy on Brexit than most but it sees the next three years as ones of weak growth, with 1.6% this year, 1.3% in 2018 and 1.6% in 2019. At a time when a growth boost would have helped the public finances, the opposite is occurring. The idea that leaving the EU would mean healthier public finances has been exposed for the fantasy that it was.

There is more than just Brexit, of course, weighing on the economy. The loss of underlying oomph, which matters hugely for the public finances, has been with us for some time. Oxford Economics says potential growth over the 2017-21 period is a weak 1.5% a year, barely more than half the 2.7% of the 1996-2006 period, which now seems like another age.

Subdued growth is a problem, but so are the measures that will be required to tackle the underlying or “structural” budget deficit. As anybody who has been anywhere near a television screen or a radio in recent weeks will be aware, the National Health Service is in the middle of a winter crisis which is more severe than most. The pressure on the government to give the NHS and social care a sizeable cash injection, if not £350m a week, is intensifying.

The NHS, of course, benefited from its budget being ring-fenced. In other parts of government the spending squeeze in recent years has been intense. Even ring-fenced, however, the squeeze on NHS spending is considerable. As the IFS points out, the five years to 2015 saw the slowest growth in spending since the mid-1950s, shortly after the NHS came into being.

On present plans, NHS spending per head will be lower by 2020 than it is now, and even lower when adjusted for the fact of an ageing population. Big cuts in welfare are also built into the government’s plans. A four-year cash freeze on most working-age benefits and tax credits will bite hard at a time of rising inflation.

Within the spending numbers, the government is trying to increase the amount spent on capital, including infrastructure, relative to day-to-day spending. So, while in 2012-13 capital spending was 13% of current spending, the aim is to raise that to 21% by 2020-21. Such are the pressures on day-to-day spending, however, that may be unachievable.

Austerity fatigue has set in. When George Osborne aimed to complete most of the job of fixing the deficit by 2015, it was in the knowledge that there was a limit to how long a government could continue to bear down on spending. Hence the relief when some of his successor’s early pronouncements were interpreted, wrongly as it turned out, as an end to austerity.

All this is rather gloomy. The damage to the public finances from the financial crisis and the years of aggressive spending increases under Labour in the roaring 2000s has proved enduring.
It has been compounded by decisions made under both the coalition and the post-2015 Tory government. While the spending cuts have been genuine, the pill has been sweetened for households in other ways. Some taxes have gone up, but others have been cut, notably corporation tax, the prolonged freeze on petrol and diesel duty and the substantial raising of the personal income tax allowance, currently £11,000 and due to rise to £12,500 by the end of the parliament. In contrast, when the Thatcher government wanted to show it meant business on deficit reduction in 1981, it did so by freezing the personal allowance at a time of high inflation. This time, the 2011 VAT hike is the only surviving major tax hike.

So things are different. In the 2020s, remember, demographic pressure for higher government spending will kick in with a vengeance. Perhaps we will have to get used to a world in which borrowing of 2% of GDP or so is the norm, perhaps more, as are higher levels of government debt than we have been used to for most of the past half century.

That, as things stand, looks much more plausible than a future of budget surpluses, or even balanced budgets, and falling government debt. As long as the markets are prepared to lend what Britain needs to borrow, the debt and deficits will be manageable, though with a rising debt interest bill. If not, there will be a problem.

Sunday, February 05, 2017
Basic income, an old idea whose time has not come - until the robots take over
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Sometimes ideas that have been around for a long time suddenly build up a he
ad of steam. So it is with one such idea at the moment, that of a universal basic income, an unconditional payment to every individual in the country, regardless of their circumstances.

A universal basic income (UBI) was last week endorsed by the Indian government’s 2016-17 economic survey, as “a powerful idea …. whose time is ripe for serious discussion” and which would be more effective than the existing system of state benefits.

A trial of the system began at the start of this year in Finland, and there are plans for similar trials in Fife and Glasgow in Scotland. It is part of the policy platform of Benoit Hamon, the French Socialist presidential candidate, admittedly a very long shot for the Elysee Palace. It was part of the Green party’s manifesto in the 2015 general election. Groups like the Citizen’s Income Trust have been advocating it for years.

UBI attracts some strange bedfellows. Though usually associated these days with the political left, it has sparked the interest of Silicon Valley tech entrepreneurs. In the 1960s both Milton Friedman and Martin Luther King advocated versions of it as, more recently, has the libertarian Charles Murray, who has written extensively for this newspaper. Friedrich von Hayek, beloved of Margaret Thatcher, though this was one of his ideas she did not take up, also favoured a guaranteed minimum income.

Why is the basic income idea, sometimes known as a guaranteed or citizen’s income, having been around a very long time, gaining new interest now? There are two main reasons.

One is the rise of what Professor Guy Standing of SOAS (The School of Oriental and African Studies) has described as the rise of the “precariat”. Standing, who presented his arguments at this year’s Davos world economic forum, describes the precariat as the “many millions of people experiencing a precarious existence, in temporary jobs, doing short-time labour, linked strangely to employment agencies, and so on, most without any assurance of state benefits or the perks being received by the salariat or the core.”

His precariat is not the same as Theresa May’s “just about managing” families but is in similar territory, and speaks strongly to the idea of swathes of people being left behind by globalisation, a phenomenon on both sides of the Atlantic.

The second reason for the UBI’s revival, which has particular resonance in Silicon Valley, is the rise of the robots. If robots are indeed set to make serious inroads into employment, as some predict, one estimate suggests that 47% of jobs in America will be automated over the next 20 years, then providing people with a stigma-free alternative income courtesy of the government might be the way to go.

There is a pretty good chance we end up with a universal basic income, or something like that, due to automation,” the tech entrepreneur Elon Musk, responsible for Tesla cars and SpaceX, said recently.

Another argument favoured by advocates of UBI is that it offers the opportunity of radically simplifying current highly complex systems of welfare benefits, tax credits and taxes. A simple handout would replace the current confusing system.

So why not? Many people instinctively smell a rat about basic income, and they are right to do so. Though an unconditional handout would not prevent people from working, and for most would be in addition to their existing earned income, the risk of paying people to be idle, the “why work?” syndrome, would increase.

The flaw in a UBI also comes down to simple maths. If you pay everybody a fixed amount, including the very many who currently receive nothing from the government, the cost of the policy, could be enormous.

As the economist John Kay wrote recently, if you set the basic income at 30% of average incomes, the public spending cost will equate to roughly 30% of gross domestic product, or 50% if it was set at half of average income. Before Swiss voters rejected a basic income in a referendum last summer, their government told them that it would double welfare spending.

To get around these difficulties, proponents often pitch it at a very low level. In Finland, a country of high prices, the experiment is with a basic income of €560 (£480) a month. A proposal for this country by the Royal Society of Arts envisages a basic income for adults of some £3,692 a year at 2012-13 prices.

The problem with this is that it would not cover anybody’s needs, and you would still need a system of welfare arrangements to provide for those with disabilities, caring responsibilities, the long-term unemployed and other additional needs catered for by the benefits system. Welfare is more complicated than it should be, but it is complicated for a reason. People’s needs are complex and varied.

There is no easy way around these problems. A UBI means giving money to people who do not currently get it, and who do not really need it, with the only way of making it affordable being to reduce the benefits going to those who are in genuine need. If that was politically unacceptable, as it would be, then the consequence would be higher overall spending, and significantly higher taxes to pay for it, neither of which we need.

The intriguing aspect to the current debate is, however, the link to automation, and the rise of the robots. I have taken a generally sceptical view of this phenomenon. There will be jobs created in coming years of a kind and in activities that we are currently unaware of. Previous predictions of the death of the job as a result of new technology have been wide of the mark.

Suppose, however, this time is different and the rise of the robot resulted in a dramatic fall in employment, and a dramatic rise in the profits of companies using the new technology. In such circumstances, but probably only in such circumstances, there would be a case for taxing those profits much more heavily and using it to guarantee people a basic income. Which is why this idea, far from going away, will probably , despite its flaws, increase in popularity.

Sunday, January 29, 2017
Smooth so far - but plenty of Brexit bumps on the road ahead
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The scores are in, and they show that Britain’s economy held up very well in the second half of last year, in the aftermath of the vote to leave the EU. I and many others expected weaker growth, and we have yet to see it.

Right to the last, with the 0.6% rise in gross domestic product (GDP) in the fourth quarter reported by the Office for National Statistics on Friday, the numbers surprised on the upside. The expectation was 0.5%.

And, while last year’s growth rate was the weakest for three years, it was the strongest in the G7, and far better than the overwhelming majority of economists expected in the immediate aftermath of the referendum.

The figures are a vindication for those who said that, while the medium and long-term consequences of Brexit would be significant, the impact on growth in 2016 would be negligible. This was the conclusion, for example, of the National Institute of Economic and Social Research (Niesr), in a May 2016 article, The Short-Term Impact of Leaving the EU.

The Treasury, which has a close relationship with Niesr, should have taken a leaf out of its book, though it was under political direction. GDP is the best overall measure of economic activity, though it has its critics and often fails to tell the full story.

The story we have is that in the final quarter of 2016, and indeed in the second half of the year. Buoyant consumer demand led to strong growth in the dominant service sector of the economy. That the service sector is dominant – its output in the final quarter was 1.8% up on the April-June quarter – was a good thing. Had we relied on manufacturing, overall industrial production, construction or agriculture, the economy would be in the doldrums. All ended 2016 with lower output than in the second quarter.

What else do we know? Employment growth has flattened in recent months and inflation is on the up. But this looks like a year in which the chancellor will not have to admit that the official forecast for public borrowing – the budget deficit - was too optimistic. Admittedly that forecast was revised up, to £68bn, in November, but figures last week suggested the deficit may come in below that, though still some way above the Office for Budget Responsibility’s pre-referendum forecast of £55bn.

How should we respond to the economy’s post-referendum resilience as we move from the phoney war over Brexit to the real thing? Though there is no evidence he ever said it, is this a good example of the dictum often attributed to Keynes: “When the facts change, I change my mind. What do you do, Sir?”

In one very simple sense, the economy’s resilience in the second half of 2016 has to change minds about growth forecasts for 2017. Non-economists may find this a puzzle, but the higher the level of GDP at the start of a year, the stronger that measured growth is likely to be for that year. This is because growth is measured on a calendar year basis – the average for 2017 versus the average for 2016 – and GDP starts the year 0.8% above its 2017 average.

Forecasters would also admit to other effects, however, and I would agree with them. Does the strength of consumer spending so far – the 52% celebrating and the 48% spending to ease their pain – tell us that the spree will continue? The Resolution Foundation think tank, in a report today, says the recent mini boom in living standards has ground to a halt because of rising inflation. But household borrowing, currently rising very strongly, could limit the spending slowdown.

We will not know for some time. Early evidence suggests some loss of retail momentum, with the official retail sales figures showing volumes down by 1.9% last month and this month’s CBI distributive trades survey very downbeat. But this could just be a temporary reaction to the strength of spending in earlier months.

Similarly, the extent to which businesses will reduce investment and recruitment, or maintain it, depends on whether they are reassured or concerned by the prime minister’s greater clarity on her Brexit plans. Article 50, and the invoking of it, has been seen as a significant moment for business. We will soon know whether it is.

Most economists who have taken a downbeat view of Brexit, are sticking to their guns. As Simon Tilford of the Centre for European Reform puts it: “The British economy has not weathered the Brexit storm. It is just that the calm before the storm has lasted a bit longer than many had assumed. There is no reason to think Britain will escape serious and permanent damage to its foreign trade and investment and hence living standards.”

Fathom Consulting, which will hold a seminar this week, “Brexit: a storm in a teacup?”, has come to the view that it most definitely is not.” Despite the economy’s resilience in the second half of 2016, its forecasts are resolutely downbeat, just 0.9% growth this year and 0.4% in 2018.

For Fathom’s Erik Britton and Andrew Brigden, Brexit has exacerbated the economy’s other weaknesses, notably persistent weak productivity. Last week’s industrial strategy green paper form the government identified the large productivity gap between Britain and our main competitors but without offering too much hope for closing it.

According to Fathom, weak productivity is not just a temporary post-crisis phenomenon but the new long-term condition. It is exacerbated by ultra-low interest rates, which prevent the process of “creative destruction” – getting rid of older inefficient firms and replacing them with newer and more productive ones – which drive productivity improvements.

In theory, the Bank of England could start the process of “normalizing” interest rates this week. The economy has been notably stronger than it expected when it made its emergency post-referendum cut in Bank rate to 0.25% in August. For a second time since then, it will revise up its 2017 growth forecast, currently 1.4%. It is much more optimistic than Fathom. The upward revision, and the prospect of sustained above-target inflation could provide the Bank with an excuse to reverse last August’s rate cut.

Will it do so? No. Simon Ward, an economist with Henderson Global Investors, has a statistical model that predicts what the monetary policy committee does. It “predicts” that four members of the Bank’s monetary policy committee (MPC) should vote for higher rates this week.

But, as Ward laments, “today’s MPC is a different animal”, with Mark Carney more dominant in its decision-making, and an early rate rise would be interpreted by his many critics as an admission that last August’s decision was a mistake. So it would be sensible not to expect a rate hike for a while yet.

Sunday, January 22, 2017
An EU cliff edge looms - May has to avoid taking us over it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Certainty and uncertainty. The certainty from Theresa May that Britain will be leaving the European Union’s single market is enabling some businesses to prepare now for that eventuality.

For some that is a good thing and for some it will make no difference. But those who need more of their operations to be inside the single market can now plan for that. The car industry is worried. So are others. HSBC and UBS have already told us what they are intending in terms of moving some jobs from London. Others will do so.

Those who think the loss of some investment banking jobs is nothing to worry about, something I hear quite a lot, should remember that the City generates a disproportionate amount of the tax revenue needed to pay for public services.

It still will; on any plausible scenario London will remain comfortably the biggest financial centre in Europe. But such is its lead that it will remain the biggest even if it were to lose a chunk of it activity, and its generation of tax revenues, which seems likely, and which will be bad for Britain.

On top of the certainty of leaving the single market, of which more in a moment, there is the massive uncertainty of what happens after two years. The two-year article 50 period, intended to set the terms of Britain’s departure from the EU, is now intended by the prime minister to also include a “bold and ambitious” trade deal with Europe. That looks not merely ambitious, but unachievable.

In setting a high bar, and an over-ambitious timetable, May has significantly increased the chances of failure. Britain’s combined Brexit and free trade agreement talks with the EU could founder for any number of reasons, including the cost of the divorce settlement, with Brussels talking about a figure of at least €60bn (£52bn).

If not a good deal then, as the prime minister has promised, she will walk away. The “cliff edge” that many thought should be avoided at all costs, and which the government would seek to avoid at all costs, is now part of the official negotiating position. The logic is that the EU would be hit by such an abrupt breaking-off of economic relations, which it would. But Britain would be hit very much harder. That is not bold; it is irresponsible. The prime minister is not only given us a harder Brexit than business feared, but has also inserted a “hardball” element.

Positions will adjust, on both sides, over the next two years. Avoiding the cliff edge, and ensuring what Philip Hammond, the chancellor, describes as a “phased process” of leaving the EU, will be vital.

The prime minister was right last week to say that Britain wants a successful EU, though I am not sure that she was speaking for all, or even most, Brexit voters in saying so. She was also right to say that a strong and close relationship, and not just on economics, is in the interests of both the EU and Britain.

As for her rhetoric about a global Britain being a new force for openness, “the strongest and most forceful advocate for business, free markets and free trade anywhere in the world”, all that is exactly what a prime minister trying to make the best of Brexit should be saying.

But we also have to be realistic. Depending on how it is done, and we have yet to see a successful system, including for non-EU migrants during her six years as home secretary, slashing immigration numbers will be hard to square with the prime minister’s declared aim that “openness to international talent must remain one of this country’s most distinctive assets”. In many parts of the world, and not just in the rest of the EU, Britain is already seen as less welcoming.

Not all of that is the prime minister’s fault. She would like to guarantee the rights of EU citizens already in Britain, but requires reciprocal guarantees for British citizens in Europe, which the EU will not offer until the article 50 process is underway.

The bigger problem is trade. Many things influence trade, and not just trade agreements. Though the share of Britain’s trade conducted with the rest of the EU rose last year, the trend in recent years has been downwards. That reflects a drop in North Sea oil exports and the faster growth of emerging economies such as China and India. Britain’s exports to China have fallen over the past couple of years but the trend has been upwards.

Seven of Britain’s 10 biggest export destinations are, however, elsewhere in the EU (the others are America, China and Switzerland) and membership of the single market is greatly superior to any free trade agreement, particularly as far as services are concerned. In these, as the National Institute of Economic and Social Research (Niesr) put it in its most recent review, “non-tariff barriers such as regulatory constraints play a more important role, especially for high value-added business services such as financial services, legal services or accountancy”.

Calculations by Monique Ebell, an economist at Niesr, suggest that replacing single market membership even with a comprehensive free trade agreement would over time reduce Britain’s exports to the EU by 22% compared with the status quo.

What about the government’s mission to strike trade deals with the rest of the world? Would that not make up the difference? No, not even close. Even on the optimistic assumption of free trade agreements with the rest of the world, Ebell calculates that these would only lift goods exports by 11%-12% to non-EU countries, implying a 7%-8% rise in total trade (goods and services), relative to the previous trend. Most free trade agreements do not cover services in any meaningful or comprehensive way. Unless this changes, in rough terms we will lose nearly three times as much from leaving the single market as we gain from our new buccaneering trade deals with the rest of the world, if an when they can be negotiated.

These numbers can never be precise but they underline the scale of the challenges that lie ahead, at a time when, according to a new EY Item Club forecast to be published tomorrow, Britain faces three years of weak economic growth.

Preventing that sluggish growth from turning into something worse will require an avoidance of the cliff edge exit from the EU, the “walking away” spectre raised by the prime minister a few days ago. Turning Britain into a new post-Brexit global trade champion, on the back of a sustained improvement in export performance and market share, looks even harder.

Sunday, January 15, 2017
Inequality is falling - somebody should tell Theresa May
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Inequality has become the fallback position for politicians in need of a theme, or organisations which want to show they care. Inequality, it seems, is driving political change – pushing voters to extremes - and uncomfortable electoral outcomes.

Inequality threatens the very survival of capitalism, which is why the World Economic Forum, as it gathers in Davos this week, has named it as one of the three key risks facing the world economy over the next 10 years and has as its theme “responsive and responsible leadership”.

Inequality provided the backdrop to Jeremy Corbyn’s populist relaunch and his proposal for a pay cap. Or was it a pay ratio? The maximum wage, last seen in British football in the early 1960s (it was £20 a week, now some earn that a minute), seems to appeal to the Labour leader.

I don’t worry too much about the World Economic Forum, which has to find something to talk about and has a habit of picking the wrong themes. I don’t worry very much about Corbyn either. The idea of a populist relaunch is to make yourself popular, and he is a very long way from that, and from power.

I do, however, worry about somebody who is in power, our prime minster. In her first big speech for a while, Theresa May warmed to a theme which I fear will become a motif for her premiership. Though her speech on the “shared society” focused on mental health, a worthy topic, it was interspersed with other references.

“We need to address the economic inequalities that have emerged in recent years,” she said, so that everybody shares in the country’s prosperity. She criticised “politicians who supported and promoted an economic system that works well for a privileged few, but failed to ensure that the prosperity generated by free markets and free trade is shared by everyone, in every corner and community of their land.”

You might think, if the prime minister is saying this, Britain must be suffering from a crisis of rising inequality. In fact, as official figures released shortly after her speech showed, inequality has been falling. The Office for National Statistics (ONS) reported that in the 2015-16 tax year inequality in Britain measured by the Gini coefficient fell to its lowest since 1986. As the ONS put it: “There has been a gradual decline in income inequality in the last 10 years, with levels similar to those seen in the mid to late 1980s.”

If we take the period since the start of the financial crisis, the poorest fifth of households have seen a 13.2% rise in real incomes (adjusted for the increase in the consumer prices index) since 2007-8, compared with 6.6% for the next quintile, 3.9% for the middle fifth and 4% for the next-to-richest quintile. The best-paid fifth of the population have, in contrast, seen a cumulative drop in incomes of 3.4%, the only group to be worse off than before the crisis.

The experience of the top fifth of the population demonstrates that, apart from the fact that some high-paying occupations have suffered in recent years, redistribution through taxes and tax credits works, as the Institute for Fiscal Studies pointed out on Friday, (and is of course much more sensible than silly ideas such as pay caps).

George Osborne deliberately targeted the lower-paid with his tax changes, excluding those on higher incomes from most or all of the gains from, for example, raising the personal income tax allowance. That and the government’s generosity towards pensioners, of which more in a moment, explain why inequality has been falling.

You may say at this point that it is one thing for those on higher incomes to have suffered a bit since the crisis. In some cases perhaps they deserved to, but that is a small price to pay for having lived high on the hog in the period leading up to it. Surely these global citizens cleaned up then?

Again, no, or at least not disproportionately. The rising pre-crisis tide lifted all boats. Figures from Matthew Whittaker, chief economist at the Resolution Foundation, show that all income groups enjoyed healthy and sustained real income rises in the period 1990 to 2007-8. For those in the bottom fifth, real incomes rose by an average of 2.3% a year, rising to 2.7% for the next band of income. The middle quintile saw an average rise of 2% a year, while for those in the top two groups, the increases were 1.7% and 1.8% respectively. Income inequality has fallen to a 30-year low because lower income groups have done relatively well over a long period.

There are, of course, caveats. Some would say the gains made by the top 1%, or 0.1%, are of greater concern than what has happened to these larger groupings such as the top 20%. Nobody should excuse the excesses, often apparently unrelated to performance, in some boardrooms.

The prime minister’s “privileged few” language, however, risks not only undermining the generally successful growth story of recent decades but deliberately setting different groups against one another. May, who is an unlikely champion of working class people, is in danger of stoking up class war.

There are bigger issues here. One, highlighted by the Resolution Foundation’s Whittaker, is that more important than the distribution of income is the fact that, in the post-crisis period, everybody’s incomes have grown very slowly, and that what in the past was regarded as a normal, unremarkable rise in living standards, has not been achieved. So the middle fifth of the population, having seen their real incomes rise by 2% a year in the two decades leading up to the crisis, have had an annual rise of just 0.5% since then. That should mean a focus on raising productivity, and hence real wages.

The other big issue is how prosperity, particularly in recent years, has been distributed between the generations. As the ONS pointed out, retired households have on average seen a 13% rise in their real incomes since 2007-8, while non-retired households have yet to put their heads above water; their incomes are on average 1.2% lower than they were in 2007-8. Retired households have benefited from government policy on uprating state pensions and have benefited from wealth gains, thanks to policies such as quantitative easing. Though the incomes of younger households have been rising in recent years, this has been a lost decade for them and is not sustainable for the longer-term.

So, while income inequality is a natural target for politicians and businesses wanting to show that they care, generational inequality has been the problem of recent years. And the need for policies, and economic performance, which raise incomes in general is more pressing than ever. Blaming the privileged few is bad economics and questionable politics.

Sunday, January 08, 2017
Shock news: forecasters called the economy about right in 2016
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. The table to accompany the piece is available in the newspaper.

Of all the experts to be castigated in recent months in this strange climate in which we find ourselves, none have got it in the neck more than economic forecasters.

Those who try to predict the economy’s performance in uncertain and in some respects inherently unpredictable times have been attacked for getting things so badly wrong that we would have been better off consulting Paul the Octopus, who developed a reputation for correctly predicting the results of World Cup games, or popping along to the nearest fair and the fortune teller’s tent.

Even Andy Haldane, the Bank of England’s chief economist, has joined in, saying that forecasters had a “Michael Fish moment” in failing to predict the financial crisis, and an echo of it in overestimating the short-term damage from the Brexit vote. The profession, he said, was in something of a crisis.

It may surprise you, therefore, that had you taken most of the economic forecasts published this time last year, you would have been rewarded with a pretty accurate picture of what has happened to Britain’s economy over the past 12 months. In fact, in the very many years I have compiling my annual forecasting league tables, I cannot remember quite so many forecasts clustered around the outturns for the main economic variables.

At the start of last year forecasters were on average a little more optimistic on growth than turned out to be the case. But they were pretty close on inflation, expected the labour market to continue to improve and saw Britain’s balance of payments problem either persisting or getting worse.

Most, of course, would concede that the numbers are one thing, the economy’s story during 2016 another. So, while forecasts made a year ago turned out to be pretty accurate, it was a bumpy ride. This time last year we did not even known for sure whether there would be a referendum on EU membership. When it happened some, not all, responded by revising down their 2016 growth forecasts a little, though most of the serious slashing was reserved for 2017, of which more in a moment.

There are many moving parts in the economy’s performance, and the story of 2016 is instructive. A year ago the growth story most economists had constructed was one in which the economy would be subdued in the run-up to the referendum because of uncertainty and then rebound quite strongly afterwards as that uncertainty was lifted.

As it turned out, growth was not quite as subdued as surveys had suggested in the run-up to the vote – few expected second quarter gross domestic product to be as strong as 0.7% (revised down to 0.6% before Christmas) – though some elements of that weakness remain.

Business investment, for example, looks to have fallen last year, having been expected to rise. Instead of a strong post-referendum bounce, the economy maintained its momentum in the third quarter, and the purchasing managers’ surveys suggest it continued to do so in the final three months of the year. Both, admittedly, showed more resilience than economists expected – and surveys suggested – in the immediate aftermath of the referendum.

Inflation, while ending up more or less where forecasters expected, again did so by a different route. The collapse in oil prices at the start of the year, with a drop into the mid-$20s per barrel, was not widely expected. Its effect was to push inflation lower, averaging less than 0.5% in the first half of the year, providing for stronger growth in real incomes and therefore consumer spending. The rise in inflation now coming through strongly is mainly via a significantly weaker pound, coupled with a later than expected recovery in oil prices.

Interest rates were one area where forecasters were comprehensively wrongfooted. A year ago nobody was predicting a cut in rates; the debate being whether they stayed at 0.5% or began to rise gently. Instead, the Bank of England’s August response to the Brexit vote took them down to a new all-time low of 0.25%.

Having agonised about it, and recognised the strong possibility of another year of unchanged rates, I was among those who thought we would see toe-in-the-water rise to 0.75%. A cut in rates was a surprise, though not in the circumstances.

If forecasters are surprised about rates this year, it will be in the opposite direction. Economists think the Bank will either stick at 0.25% throughout the year or could even cut if the economy weakens sufficiently. I think that may underestimate the chances of a hike but, having been so low for so long, the smart money has to be against it.

As for my other predictions, I thought growth would be stronger, at 2.5%, and inflation a little weaker, at just below 1%.

Forecasters, as I say, did generally well, even if the path to the numbers was sometimes not exactly what they expected. Two did exceptionally well, jointly leading my league table. They were Chris Scicluna and his team at Daiwa Capital Markets, the investment banking arm of Japan’s Daiwa Securities, and Alan Clarke of Scotiabank, the Canadian bank which takes its name from its Nova Scotia roots. Both scored nine out of a maximum 10 in my league table and were impossible to separate. Congratulations to them.

At Daiwa, Scicluna and his colleagues are relatively downbeat about this year, expecting growth of just 1.2% and inflation by the end of the year of 3%. They also fear that the Brexit hangover will last well beyond 2017.

Scotiabank’s Clarke, taking his lead from the strong purchasing managers’ surveys and a model he helped develop which links monetary conditions to economic growth, thinks there is momentum in the economy yet. Monetary conditions are exceptionally loose, largely reflecting 0.25% Bank rate and sterling’s fall.

He thinks growth will come in this year at 1.6%, which is above the consensus, with most of the slowdown being delayed until later in the year when rising inflation really begins to bite into the growth in real incomes.

We shall see. Economists do not get everything right but they do a lot better than they are usually given credit for. Apart from the expected slowdown in growth – the consensus is for 1% to 1.5% this year – most forecasters do not see any significant improvement in Britain’s Achilles heel, the current account, with the average prediction a deficit of over £80bn. The public finances, meanwhile, will improve only at a snail’s pace, from £70bn this year, 2016-17, to £66bn in 2017-18, limiting any room for the manoeuvre for the government.

Though slower growth and higher inflation is predicted for Britain, we start 2017 amid more optimism about the global economy than for some time, particularly in financial markets, and certainly a lot more than this time last year, when George Osborne was warning of a “dangerous cocktail” of risks. The fact that quite a few of those hopes rest on the Trump presidency should perhaps make us a little wary. What, after all, could possibly go wrong?

Sunday, January 01, 2017
Peering through the fog of 2017 uncertainty
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A new year is upon us, and with it the challenge of trying to plot a path through the uncertainty. That there is more uncertainty than usual is not in doubt, as is the fact that there is a range of possible outcomes – good and bad – for both Britain and the global economy.

Forecasting, meanwhile, has become more challenging. Even for those who correctly guessed the outcome of the momentous political events of last year, predicting the market and economic response to them was another story.

I thought, rather than getting bogged down in precise numbers for growth, inflation and other economic magnitudes – don’t worry there will be plenty of those in columns to come shortly – it would be useful to sketch out some broad themes.

The broad themes that will occupy us over the next 12 months, and no doubt there will be more, are Brexit, European politics (and the interaction of the two) Donald Trump’s America and China )and the interaction of those two too).

Let me take them in turn. In the next few months we will move from the phoney war on Brexit to the actual process. Theresa May, who has promised a big speech soon setting out the government’s priorities – it would be unwise to expect too much detail – remains committed to triggering article 50 by the end of March, whatever the Supreme Court decides.

The logic of that timetable, that we will clear the formal two-year Brexit process in time for us not to have European parliament elections in 2019, and well ahead of the 2020 general election, is not that strong. It will be better to have a proper strategy in place than rush it. But, one way or another, it is reasonable to expect article 50 to be triggered in the coming months. That in itself is testimony to how rapidly events have moved. This time last year we did not even know for sure whether there would be a referendum in 2016.

There are two key questions for the post-Brexit vote outlook for Britain’s economy as the process gets underway. One is the response of consumers to higher inflation and the expected squeeze on real incomes. There is some anecdotal evidence, including from the Bank of England’s regional agents, that some people have been bringing forward buying ahead of expected price increases. But the big picture lies elsewhere. When we had a bigger squeeze on real incomes than is in prospect this time, between 2010 and 2012, consumer spending slowed to a crawl.

Whether it does so this time depends partly on the second question; the ability of the government to keep business on side as it embarks on Brexit, and thus to maintain confidence. If not, we can expect weaker recruitment – already evident in the official labour market numbers if not in the surveys – and business investment.

There is a plausible argument that the real issue for business comes later, with the question of whether there will be a “cliff-edge” exit from the EU in 2019 accompanied by the immediate imposition of tariffs. But there will be uncertainty ahead of that, including this year, and with the notable exception of Nissan, the government has so far done a poor job of reducing it.

The Europe Britain will be leaving could, of course, be a moveable feast. How much will this year’s elections change it? The link between politics and economics can be seen clearly in the problems for Italy’s Monte dei Paschi bank – and others – following voters’ referendum rejection of constitutional reforms.

The March election in the Netherlands, where the anti-EU Party for Freedom is ahead in the polls, could result in an in-out referendum there. France’s presidential election, the first round of which will be on April 23rd, is another significant political event. Germany’s autumn election will follow, and will be a significant test for Angela Merkel, not least after recent events in Berlin.

My working assumption is that the Netherlands, a founder member of the EU, will not be leaving. As Capital Economics puts it: “There is little chance of March’s Dutch election resulting in a referendum on EU membership.” The far-right party only commands just over a fifth of the vote.

In France, Marine Le Pen of the National Front should get to the second round but lose, probably to Francois Fillon. A weakened Angela Merkel should still be German chancellor at the end of the year. That assumes the political forces that forged 2016 spread in only a limited way to Europe. But life, as we have seen, is full of surprises.

When it comes to America, the Trump surprise has led most forecasters to revise up their short-term projections for US growth, though few expect a doubling of the growth rate, but also to expect more interest rate rises from the Federal Reserve. Both seem plausible. If aggressive tax cuts and a big infrastructure programme do not result in stronger growth then something has gone wrong somewhere, and small rises in interest rates should not get in the way too much.

Consensus forecasts for US growth this year are still quite modest, 2.3% versus 1.6% in 2016. The risks, as Oxford Economics puts it, are to the upside, largely resting on how aggressive the Trump fiscal expansion is. It sees the strengthening of the dollar as a result of “Trumponomics” pushing the euro down to parity with the dollar by the end of the year. Sterling is likely to come under further downward pressure against the dollar.

Oxford Economics has a useful grid to assess the president-elect’s impact. Its baseline is tax cuts eventually worth $1 trillion (just over £800bn). The upside would be $2 trillion, the downside a “mere” $500bn. Similarly for his infrastructure plans. On trade, its baseline is only limited and targeted restrictions. The upside would be if nothing happens, the downside a serious escalation of protectionism.

This is where America runs up against the global economy, and China. Forecasts for global growth have been nudged higher in recent weeks, partly as a result of the outcome of the US election. China is predicted to grow by 6.4% this year and 6.1% next, according to the OECD (Organisation for Economic Co-operation and Development).

I remain sceptical of a spontaneous hard landing for China, fears of which were at their height a year ago, and may return. Yes, China has had a huge run-up in debt since the financial crisis, and that will come to a head at some stage. I would be surprised, however, if it was imminent.

The bigger risk to China comes from America, and the Trump administration. Chinese growth has had a fair wind for many years, on the basis that its re-emergence into the global economy had many more benefits than costs for the world as a whole.

US-Chinese friction, and Trump’s promise to pull out of the Trans Pacific Partnership, will not prevent China leading in Asia, and may cement its role. But it creates unpredictability for the world economy we could do without.

Sunday, December 25, 2016
A year when all roads led to Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Well. I am spoilt for choice. Do I write about Donald Trump and whether his tax-cutting, infrastructure-boosting plans will mean a new dawn for the American economy? Or, as is also possible, that his protectionism and unconventional way of doing political business will hasten a new dusk for the world economy.

It is tempting. For the moment the conventional wisdom – and the view of the markets - is that good Trump will triumph over bad protectionist Trump, though the president-elect still has plenty of issues with China. We will only know for sure, of course, when he has moved beyond tweeting and into the White House. A sustained boost in US growth, which is what has been driving markets, would be very welcome if it happens.

Or, I could focus on the loss of a prime minister and chancellor, both of whom appeared to have established themselves as semi-permanent fixtures. David Cameron and George Osborne have not exactly disappeared from view but the political waters closed over them with remarkable rapidity, leaving them to ply their trade on the speaker circuit, and their successors made competent starts.

One day, perhaps, there will be a yearning for the Cameron-Osborne era. Even in the Tory party, perhaps especially in the Tory party, that day has yet to arrive. It may be some time coming.

How about the Bank of England and monetary policy? Mark Carney rendered himself permanently unpopular with some sections of the political community by warning that the result of the June 23rd referendum would have consequences, and then by acting on those warnings by leading the monetary policy committee (MPC) into cutting interest rates and further stimulus measures in August.

The reduction in Bank rate in August cut short one record – the longest period of unchanged official interest rates since shortly after the war – but established another. At 0.25% we now have the new lowest official interest rate in the Bank’s history, and that history stretches back to 1694. The rate cut was right at the time, though if the monetary policy committee (MPC) wanted to re-establish the position that rates can go up as well as down, it could do so by taking away that “emergency” August cut.

All roads, however, lead back to June 23rd, and the vote for Brexit. Whether Trump would have won in the absence of the Brexit vote I cannot say – it is certainly possible that it was a decisive factor – but everything else flows from it. Without the vote for Brexit, Cameron and Osborne would still be in power, and the Theresa May era would never have got started.

Without Brexit too, the Bank would not have cut rates. One of the questions for 2017 will be that, with the Federal Reserve plotting several more rate hikes following its move on December 14, and sterling likely suffer as a result, the Bank feels pressured to start following suit.

What is there to left to say about the Brexit vote? When, two years earlier, Scottish voters rejected independence, its referendum followed a well-worn script. The economic risks of going it alone outweighed the emotional and sentimental appeal of independence, particularly for older voters.

The Brexit vote turned this on its head, and notably for older voters. Control of EU immigration, and taking back economic control in general, just about trumped the economic warnings. Maybe those warnings were laid on too thickly, particularly by Osborne – for many his warning of a punishment “emergency” budget to follow a leave vote was the last straw – but this still broke the normal rules. People do not normally vote for a poorer and more uncertain future.

The arguments for staying in the EU, as set out here, weres not that it would suddenly reform itself into a dynamic region of strong growth but, rather that Britain had enjoyed the best of both worlds as a result of our often semi-detached membership, gaining from the single market and continuing to attract the lion’s share of inward investment without being encumbered by membership of the euro.

The figures spoke for themselves. Since the euro came into being in 1999, the Italian economy has grown by a cumulative 4%, which is astonishingly weak, compared with 21%-22% for France and Germany and a very strong 34% for Britain. Since the single market came into being growth in Britain’s per capita gross domestic product has exceeded that of America.

There was no reason why this outperformance could not have continued. The challenge, when Brexit is finally completed, which will no doubt be long after I have stopped writing this column, will be to replicate it on the outside. As things stand, the government is embarking on an exercise aimed at preserving as many of the advantages of EU membership as it can. The EU has an interest in ensuring that it does not preserve all of them.

What about the economy’s performance since the referendum? A smooth change of government, the long run-up to the triggering of Article 50 and the Bank’s actions kept uncertainty to a minimum and allowed growth to continue. Manufacturing and construction have struggled since June but services, and in particular consumer-facing services, have done well. Retail sales have boomed, at least on the official figures. The job market has slowed but not collapsed.

This was a period when, for Brexit supporters, any growth was better than no growth. The economy was unbalanced before and it has become more unbalanced since. The hard part, of course, is yet to come. Whether or not sterling’s fall will produce export-led growth which will offset the malign effects of higher inflation has yet to be seen. Whether businesses can be persuaded to keep investing, and recruiting, during what could be a bruising negotiating process is another central question.

These are issues for next year and beyond. For the moment, we should be pleased that the economy has so far help up well, and that the uncertainty associated with both the referendum and Trump’s victory in America were contained.

This is genuine. I hope we can make the best out of Brexit and I hope that American voters do not quickly come to regret electing Trump. Meanwhile, in this last column of 2016, I can also hope that things are as interesting next year as they were this. Maybe that is too tall an order.

Sunday, December 18, 2016
Clouds start to gather over Britain's households
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

For many people reading this, and for many whose businesses depend on healthy household finances, two trends will dominate the outlook in 2017. One is the extent of the rise in inflation, now clearly coming through in the figures. The other is how far the slowdown in the job market, also evident in the data, extends.

Inflation, which disappeared entirely last year, is ending this year on a rising trajectory. It was 1.2% last month, or 1.4% on the new CPIH (consumer prices including housing) measure favoured by official statisticians, or 2.2% for nostalgia buffs who still follow the old retail prices index.

Most of its rise, and most of the rise yet to come, is a direct reflection of sterling’s post-referendum fall, although some of it is explained by both the reversal of earlier energy and commodity price falls, and those falls dropping out of the inflation comparison.

Indeed, there are some spectacular increases coming through in costs. Industry’s raw material and fuel costs rose by a hefty 12.9% in the 12 months to November. Not all of that will feed through to final prices but some of it certainly will.

In a year’s time, according to most forecasters, consumer price inflation will be close to 3%, though the Bank of England has suggested that the pound’s recent small recovery may mean a slightly lower inflation profile than it feared last month. But the sweet spot we have been enjoying for a while, in which even modestly rising earnings comfortably outstripped the rise in prices, looks to be coming to an end.

The question for household budgets, which will also be of intense interest to the Bank of England, is whether there is an acceleration in pay in response to rising inflation. In the past, when we used to talk about the wage-price spiral, that would have been regarded as a certainty. Now it is not.

One reason for that is because of the softening of the labour market. The other sweet spot of recent times, a prolonged job market recovery, one of the great achievements of recent years, has been fraying around the edges since the summer. The quality of employment growth, which until then had been dominated by full-time employee jobs, has since been deteriorating. Now, according to the latest official figures, the employment recovery itself has stalled. Overall employment fell by 6,000 in the August-October period compared with the previous three months.

Plenty of caveats should be applied to these figures. In an economy in which nearly 32m people are employed, 6,000 is tantamount to a rounding error. Employment surveys have tended to show that many businesses are adopting a business as usual attitude to recruitment, though others point to greater caution.

The details of the job numbers were, however, quite soft. The drop in employment would have been bigger if not for an unusual increase in public employment. There was a fall of 51,000 in full-time employment, partly offset by a rise in the number of part-timers. Unemployment, which is rising on the claimant count measure, would have shown a big across-the-board rise if not for a significant increase in inactivity. Some tens of thousands of people dropped out of the labour market. As it was, the latest published unemployment total, 1.616m, was 12,000 up on the figure published a month ago.

The figures, while confirming that employment remains close to record highs, and that unemployment remains low, reflecting earlier momentum, chime in with the view that employers have become more cautious since the summer. Again, this is expected to continue. Forecasters on average expect a rise of around 200,000 in unemployment over the next 12 months.

This is a miserable, if predictable, way to end the year though none of it, it should be said, is catastrophic. If the peak in inflation is indeed just below 3%, this is high compared with the past couple of years but lower than in 2011, when the rate exceeded 5%. Any rise in unemployment is unwelcome but an increase of 200,000 would not be huge by past standards. What it would so is reverse the improving trend of recent years.

Will it keep a lid on pay? Pay has been the dog that has not barked for many years. Every time the job market has tightened, wages have failed to respond. The latest figures have average earnings growth of 2.5%, split between 2.8% in the private sector and 1.4% in the public sector, where pay restrictions continue to operate.

The Bank expects pay growth to slowly pick up to 2.75% in a year’s time and 3.75% in 2018, though its previous predictions of a strengthening in pay growth did not come to fruition. Many economists think there will be no acceleration in pay growth next year. That is also the broad message from pay surveys.

How will households respond to a squeeze on real incomes and a softening labour market? The consumer picture has been a little more mixed in recent months than it sometimes seems. Retail sales have continued to be very strong. Helped by Black Friday – one US import we could happily export back to them – retail sales volumes rose by 0.2% last month and were a meaty 5.9% up on a year earlier. If you took these figures on their own, you would say retailing has been enjoying a boom of Klondike proportions.

The British Retail Consortium, which represents the sector and produces its own sales data, suggests the picture is rather more subdued and will become even more so during 2017. It is puzzled by what it describes as the “extraordinary” growth in sales the Office for National Statistics finds for smaller retailers.

Other measures of consumer activity also point to a more restrained picture. Private new car registrations have been falling for a few months. Housing transactions are running below the levels of a year ago, though some of that reflects stamp duty changes.

Consumer demand is not about to fall off a cliff. You write off the British consumer at your peril. Equally though, its growth will slow. Household debt, as noted here recently, has been rising quite strongly but I would be surprised if people try to borrow their way through the squeeze.

As for the economy, consumer spending has been what kept it going in the second half of the year. It will need other strings to its bow in 2017, and some of those have their own challenges.

Sunday, December 11, 2016
We need more globalisation and technology, not less
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

These are risky times, in which the dangers of policymakers getting things badly wrong are greater than for a very long time. The lure of populist policies, which appear to help beleaguered voters but will end up doing them harm, is tangible and dangerous.

A few days ago Mark Carney used a speech in Liverpool to pick up on one of Theresa May’s themes. The prime minister, in her Lord Mayor’s banquet speech last month, had repeated her argument that globalisation has left too many people behind.

The Bank of England governor, while absolving monetary policy of the blame the prime minister tried to heap on it a couple of months ago – and doing so quite successfully – also had worries about globalisation. Many people in the advanced economies, including Britain, lament a loss of control and have lost trust in the system.

And, as he put it: “Measures of aggregate progress bear little relation to their own experience. Rather than a new golden era, globalisation is associated with low wages, insecure employment, stateless corporations and striking inequalities.”

The “left behind” arguments about the consequences of globalisation have been seen as key drivers of this year’s dramatic political developments, including the Brexit vote and the election of Donald Trump. As Carney noted, the fact that a more open and connected world economy has lifted over a billion people out of poverty and resulted in a considerable rise in living standards – world gross domestic product per head is two and a half times what it was in 1960 – cuts little ice if people in Britain are in the first “lost decade” for real wage growth since the 1860s.

Add in technology and the rise of the robots, where Carney quoted his chief economist Andy Haldane’s figure that up to 15m current British jobs are at risk of automation, and progress appears to bring only bad news. Automation and its possible consequences for employment is worth a piece on its own, which I shall save for another day.

There is, however, a risk of serious misdiagnosis here. Carney is fundamentally sympathetic to globalisation and new technology, as is the prime minister. Both are right to address the need for growth, not just to be more inclusive, but to be seen as so. “It is not surprising that people are largely ignoring pieties about the virtues of open markets and new technologies,” he said.

Whether ignored or not, however, some things are fundamentally true. One is that trade, and other forms of globalisation, brings benefits, and opportunities for growth, that far outweigh the costs. The other is that new technology is much more likely to be productivity-enhancing, something we desperately need at the moment, than job-destroying.

So how do we answer the arguments against globalisation? The past few years, far from representing a high watermark of globalisation, with jobs being outsourced right, left and centre to lower-cost locations, has seen something of a pause in it.

Just as world trade growth has been subdued since the global financial crisis, so have other manifestations of globalisation. As far as trade is concerned, where it has struggled in recent years even to grow as rapidly as global gross domestic product (GDP), we need more globalisation not less.

Trade is a generator of stronger productivity. Open economies do better in raising productivity, and thus living standards, than countries which close themselves to the world. As the governor argued, the fundamental challenge for monetary policy, and the need for both near-zero interest rates and unconventional policies such as quantitative easing, has been to try to offset the malign effect of a 16% shortfall in productivity since the crisis.

Where does that shortfall come from? Some of it arises from the fact that the globalisation impetus has slackened. Some of it has been due to a reluctance by firms to invest, and in some cases an inability to raise the finance to do so.

For both productivity and living standards, however, a far better culprit than either globalisation or technology is the fact that we have been living with the hangover of the biggest financial crisis in history. It has always been known that the crisis would reduce living standards below what would otherwise have been expected, and that these effects would last a number of years.

The fiscal hangover, mainly as a result of the crisis’s impact but also the public spending boom that preceded it, meant that this expected hit to living standards was compounded by the post-2010 “austerity” years of tight control of government spending.

The banking hangover from the crisis meant that the normal process of creative destruction in and after a big recession – the inefficient being shut down and replaced by new and vibrant businesses – did not operate as it normally should, because lending was rationed.

The performance of real wages in recent years better reflects a post-crisis hit than an ongoing squeeze from globalisation. Real wages fell from 2008-9 to 2013, but have since been recovering. If we are heading for another squeeze now, that will be largely the consequence of the pound’s post-referendum fall.

Broader measures of household income have held up better, partly because of government actions like the raising of the personal income tax allowance, partly because of low interest rates. So real household disposable income per head is 8% above pre-crisis levels. It fell in 2011 and 2013 but rose strongly last year.

As for employment, this remains a very considerable success story. Whether it is measured by the workforce as a whole, or UK-born, or UK nationals, there has never been a higher proportion – roughly three-quarters in all cases – of people of working ago (16-64) in work. This is a vibrant job market, not one where jobs are being stolen by globalisation or robots.

Averages, of course, are averages and some will say that their experience comes nowhere near matching those averages. Some will choose to look at the labour market through a Sports Direct prism and the rise of insecure jobs but that, while regrettable, is not representative.

I am not falling into the trap, identified by Carney, of suggesting we have never had it so good. But things have been a lot better in the wake of the crisis, than they might have been. Anger about the crisis is still justified. Blaming globalisation and technology is mainly not.

In fact, the argument needs to be turned on its head. We need more globalisation and technology to raise productivity and living standards, not less. And in these strange times we need to keep saying it.

Sunday, December 04, 2016
Britain's households are swimming but not drowning in debt - yet
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Household debt is back in the headlines. Official figures show that consumer credit is rising by 10.5% a year, its fastest since well before the crisis, while the Bank of England has warned that the debt being accumulated by households is one of the risks it sees to financial stability, among several others.

How worried should we be about this household debt build-up, which is running in parallel to the rise in government debt described here last week?

Let me start with some numbers. Consumer credit, as noted, was up by 10.5% in the 12 months to October, it fastest rate since October 2005. Consumer borrowing, on this measure, hit a total of £190.1bn. Of the latest 12-month rise, there was an increase of 9% in credit card borrowing and 11.4% in other loans and advances.

The sharp-eyed among you will have noticed that while £190bn is a lot of money, it does not represent anything like the total for the amount that individuals owe to lenders. That total is a chunky £1,508bn - £1.5 trillion – overwhelmingly in the form of mortgages. It is also growing, though at more sedate 4% a year.

Do these figures suggest a return to the pre-crisis bad old days of binge borrowing? No, or at least not yet. The annual growth of consumer credit has been in double figures since June, a mere five months. In the 1990s and 2000s, it was consistently above 10%; from 1994 to the autumn of 2005. In that period, consumer credit growth was often in the mid to high teens, peaking at 17.6%. I would be surprised if that were to happen again.

As for the overall growth in lending to households, it has been running at its strongest levels since the crisis for much of this year but- driven by the mortgage boom of the pre-crisis era – grew much faster in the past. Growth in overall lending peaked at more than 15% in 2004. In the 10 years to September 2008, the amount owed by households rose by almost 160% to £1.39 trillion.

This is where it gets interesting. After the crisis households changed their behaviour, or were forced to do so by cautious banks and other lenders. It took until the autumn of 2013 for household debt, in cash terms, to get back to where it was in September 2008. Mortgage rationing and falling consumer credit played a big part in this.

That was one reason to be fairly relaxed about household debt. Yes, it was high when the crisis hit. But a five-year period in which it did not grow at all constituted a significant repair. More to the point, debt fell in relation to income.
In both respects, however, that process has come to an end. Since recovering to its previous peak in the autumn of 2013, household debt has risen by more than 8%. It has also started to rise again in relation to income, which is one of the reasons why the Bank is concerned.

At its peak, household debt rose to just over 150% of annual household income, dropping to just over 130% in the second half of 2014. Now it is creeping back up again, to 133%. To put that in perspective, 20 years ago debt was less than 90% of income.

For the Bank, both the level and the recent rise in debt are causes of concern. As it put it in its latest Financial Stability Report: “The level of household indebtedness remains high by historical standards. Although average debt servicing rations remain low, the ability of some households to service their debt could be challenged by a period of higher unemployment. These households could affect broader economic activity by cutting back sharply on expenditure in order to service their debts.”

On the recent rise in unsecured consumer credit, the Bank notes that it stands on sharp contrast to expectations of a a weaker outlook for the economy, and that “it raises the prospect of a further rise in household indebtedness as increases in unsecured debt outpace growth in real incomes”.

There are some fascinating snippets in the Bank report. People are borrowing longer. Roughly 35% of new mortgages are for terms of more than 30 years, rather than the 25 that used to be the norm. Just over a quarter of new mortgages are for four or more times income, while a fifth are now for 90% or more of the value of the property. The Bank remains convinced, in spite of this, that there has been no slippage in mortgage lending standards.

Some of the rise in debt, it should be said, reflects changes in buying patterns. New car purchases, together with those of many used cars, are now overwhelmingly on finance and, as the Bank says, “growth in dealership car finance has been particularly strong in the past three years”.

But in the end, the issue of household debt comes down to the question of how well people are placed to cope with two things which, if not as certain as death and taxes, will happen at some stage. One is a rise in unemployment from current very low levels. The other is a rise in interest rates towards more normal settings.

A meaningful rise in unemployment would double the number of households in serious difficulty, according to the Bank, while many hundreds of thousands would struggle if Bank rate, currently 0.25%, were to rise to 2%, even gradually, and other rates in the economy adjusted accordingly.

So how worried should we be? The fact that the post-crisis repairing of household finances has come to an end is a little disturbing, though the rise in debt in relation to income has so far been modest. The Office for Budget Responsibility (OBR), which until now had predicted a sharp rise in debt, said a few days ago that it now thinks the process will be a gentle one. Using a slightly different, and larger, measure to that used by the Bank, it sees a rise in debt from 142% of income now to 149% by 2022.

The key question is whether the recent strength of credit growth reflects a determination by households to borrow their way out of trouble – or into it – or whether it will slow as household incomes are squeezed and the job market softens. The GfK index of consumer confidence took a sizeable five-point drop last month as people began to fret about the economic outlook, and adopt a more downbeat attitude towards major purchases.

That should signal a more cautious attitude towards greater indebtedness, though perhaps not until after Christmas. The experience before the crisis, however, was that once people get the debt bit between their teeth, they are reluctant to let go. It is easy to see excessive debt as somebody else’s problem. So we should keep a close eye on the credit and debt numbers.

Sunday, November 27, 2016
Why Brexit will mean a bigger debt burden
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

In announcing that Wednesday’s autumn statement will be the last (at least until a future chancellor decides to reinstate it), Philip Hammond abandoned one tradition.

He has, however, established another. This is that when he presents and responds to new forecasts from the independent Office for Budget Responsibility (OBR), as he will be required to do twice a year, it can be guaranteed that a storm of criticism will be unleashed.

In the toxic post-Brexit vote environment that we are in, we have already had plenty of prattle, as some Tory MPs and unnamed ministers queued up to attack the OBR for predicting that Brexit will mean somewhat slower growth and significantly higher debt and deficits. Most of those doing the attacking, I suspect, will not even have opened the OBR document.

Next year, when we will have two budgets, the last spring budget in March and the first of the new autumn super-budgets in November, I suspect we will see some more of this. The fact that Brexit, as well as causing an inflation-inducing drop in the pound, will mean more government borrowing and higher public sector debt is unsurprising. It was pointed out, including here, on many occasions before the referendum, and it is happening.

The striking thing about the OBR’s forecasts, notwithstanding the attempts by critics to undermine it, is that they could have been a lot gloomier. It sees a temporary and modest slowdown in growth to 1.4% next year, picking up to 1.7% in 2018 and 2.1% (in line with its pre-referendum forecast) in 2019.

Its predictions for growth are thus above-consensus and, incidentally, stronger than those from the Bank of England. It could have been a lot gloomier, particularly about prospects towards the end of the decade. Its forecast is supposed to be based on government policy, so naturally it asked the government for its policy on Brexit. In return it was sent two anodyne paragraphs from Theresa May speeches, which said nothing more than that the government will aim to achieve the best of all possible worlds. To assume a normal rate of growth in 2019 on the basis of a policy vacuum was more than generous to the government.

The OBR, similarly, is not as gloomy about inflation as most forecasters, some of whom think it will hit 4%. It sees a peak of 2.6%.

Nor has the OBR laid it on thick when it comes to the details of the forecast. At a time when business organisations fear sharp weakness in investment, notwithstanding its small rise in the third quarter, the OBR’s forecast – a tiny 0.3% drop in business investment next year followed by a 4.1% rise in 2018 – are optimistic.

In terms of longer-term damage, in the absence of a Brexit vote the OBR was ready to revise up the economy’s growth potential because net migration was clearly rising at a rate well above the “tens of thousands” targeted by David Cameron’s government. Now, in the light of the referendum it has abandoned that upward revision and revised growth potential lower, on the assumption that net migration drops gradually to 185,000 a year, from 330,000 last year.

The biggest uncertainty about the economic outlook as it affects the public finances is productivity. The lower productivity growth – output per hour – the weaker the prospects for tax revenues. Fathom Consulting points out that the OBR has been assuming a gradual return to normal rates of productivity growth since its inception in 2010. It is doing so again, predicting that by the end of the decade productivity will be growing by 2% a year. Other forecasters say this will be hard to achieve given the recent record of disappointingly weak productivity and the likelihood that one of the drivers of productivity growth – international trade – will be hit during the government’s efforts to negotiate new trading arrangements.

The chancellor’s £23bn national productivity investment fund (NPIF) showed that his priorities are right: infrastructure will be one of the keys in the long-term to raising productivity. Long-term is, however, the operative word here.

So the OBR’s prediction of a £122bn deterioration in the public finances by 2020-21, of which just under half, £59bn, is directly attributable to Brexit, looks reasonable, even cautious. Public sector debt, on its forecasts, will top £1.9 trillion by the end of the decade, up from £500bn 10 years ago and £1 trillion in 2010. The Brexit effect is an addition to government debt we could have done without.

Nor is the pressure over for further additions to debt and deficits. Hammond fought off Downing Street demands to do more this time, but that was just one battle in what will be a long war. When the squeeze on real wages hits next year, it will revive the disappointment over income growth that has led to so much disenchantment.

As Paul Johnson, director of the Institute for Fiscal Studies, memorably put it, in the wake of the autumn statement: “Real wages will, remarkably, still be below their 2008 levels in 2021. One cannot stress enough how dreadful that is – more than a decade without real earnings growth. We have certainly not seen a period remotely like it in the last 70 years.”

People will say that that is not what they voted for in June, or indeed were promised. But reality is sinking in. Markit’s UK household finance index, using data from Ipsos-Mori, asked people in July whether they expected economic prospects to be better or worse over the next 10 years as a result of Brexit.

In July there was optimism. In the North East, for example, a net 7.5% of people thought the next 10 years would be better for the economy as a result of Brexit; now a net 19.1% believe it will be worse. In the South East net optimism of 8% in July has turned into net pessimism of 30.4%. Across all income groups there is pessimism about prospects. Only the oldest age groups are positive, though by a smaller margin that they were.

The backdrop to this, as well as that provided by the IFS, was the conclusion by the Resolution Foundation, a think tank, that the poorest third of households face falling living standards over this parliament, with overall living standards stagnating. It is a pretty grim backdrop and one which might require an easing up on welfare cuts.

The chancellor, who has also been criticised for not responding to the crisis in social care, within an overall squeeze on NHS funding, has left himself some room for manoeuvre – about £27bn – within his looser fiscal rule of getting the budget deficit below 2% of gross domestic product by the end of the parliament. That would mean yet higher government debt. He may well have little choice.

Sunday, November 20, 2016
Hammond has no room for populist giveaways
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Chancellors of the exchequer do not normally elicit much sympathy, usually falling effortlessly into the role of pantomime villain. It is hard, however, not to feel a bit sorry for Philip Hammond, as he prepares for his big day on Wednesday, his autumn statement.

If the new chancellor discovered a “there’s no money left” note from George Osborne in his Treasury office when he took over in the summer he has not yet let on. But he inherited the task of completing the job of restoring the public finances to health, and a continuing austerity programme.

Hammond also inherited, thanks to the Brexit vote – and perhaps his predecessor’s campaign tactics – a deteriorating outlook for the public finances. We do not know exactly what the Office for Budget Responsibility (OBR), the independent fiscal watchdog, will come up with on Wednesday. It is unlikely, however, to be too different to the cumulative £100bn underlying overshoot by 2020-21 (compared with the OBR’s March predictions) estimated by economists at PWC, the professional services firm.

Faced with a worsening of the public finances of this sort, due to the expectation of slower growth in the years ahead as a result of Brexit uncertainty, it would make little sense for the chancellor to weigh in with tax increases or additional spending cuts to try to bring his predecessor’s deficit reduction programme back on track.

This has already been acknowledged by the government, indeed by the new prime minister. No longer will the government aim for a budget surplus by the end of the parliament. The “automatic stabilisers” – tax revenues down and some government spending up as a result of slower growth – will be allowed to operate. That makes perfect sense.

What also makes sense is for the chancellor to focus on the two areas which need extra spending and support: infrastructure and business investment. The abandonment of Osborne’s fiscal rules – all three have been dumped or missed since the May 2015 election - gives him plenty of room for the former.

Fiscal rules, as the Institute for Fiscal Studies has noted, have not been built to last. Of the 12 adopted since 1997, 10 were broken, the others superseded. Chancellors still need them, however. In spite of their record investors and the ratings agencies need to know that governments operate under some fiscal constraints and are not free simply to let rip.

Fortunately for Hammond, there is an off-the-shelf fiscal rule that would work well for him, and permit a substantial increase in infrastructure spending, spread around Britain’s regions. Combined with tapping into private sector funding of infrastructure, and the chancellor should be able to unveil a decent-sized “rebuilding and upgrading Britain” package. It will not come close to rivalling Donald Trump’s $1 trillion (£800bn) mainly private-sector funded and delivered infrastructure plan, though we have yet to see whether that will be deliverable.

How can Hammond spend if the public finances are in a worse state? The answer is to revert to the fiscal target Osborne originally had, which in turn had a powerful echo of Gordon Brown’s original 1997 rules. This is to concentrate on balancing the current budget deficit – the balance of day-to-day spending and receipts – while leaving room to borrow to invest.

A target of balancing the current budget should be achievable by the end of the parliament – PWC suggests a 0.6% of gross domestic product surplus on this measure in 2019-20 - provided that Hammond is able to restrict his giveaways in other areas. Most projections suggest eliminating the current budget deficit remains on course in spite of Brexit. Markets, meanwhile, would not go out of their way punish a government that chooses to spend more on infrastructure. The international tide is turning.

That, with a bit of help for business, should be that. Firms would like to see the back of the apprenticeship levy, want extra help on business rates and would like more incentives to invest during a time of uncertainty. Anything Hammond does is unlikely to prevent business investment being weak over the next couple of years but could mitigate it.

Unfortunately, it seems, that will not be that as far as the autumn statement is concerned. The chancellor is being leaned on by Tory MPs, and more importantly by Downing Street, to announce some populist measures. Wednesday would be a great opportunity for Hammond to pause the policy of raising the personal income tax allowance and the higher rate threshold by more than inflation. But the indications are that he will press on with it.

Fuel duty, successive freezes on which add up to a lot of lost revenue for the Treasury, is also part of the populist agenda. The chancellor should not be trying to shield motorists from the higher petrol and diesel prices, much of which is directly linked to sterling’s post-referendum fall. It seems, however, that he will.

When it comes to populism –and the perceived need to help the prime minister’s "jams", the just about managing families (which has now replaced “hard-working” families) – the list is endless. Does it mean extra money for the National Health Service? It might well do so. Does it mean scrapping or at least modifying Osborne’s planned four-year cash freeze on most working-age benefits, including tax credits? Again, that is very much on the agenda.

As always, there are good arguments to be made for all sorts of things. But this is not a time for fiscal largesse across the board, for the chancellor to play Lady Bountiful. The public finances still need to be repaired.

Nor, looking at the numbers, can it be argued that households are showing great signs of distress, in fact the opposite. Retail sales figures three days ago showed a 1.9% jump in sales volumes last month, for an increase on a year earlier of an extraordinary 7.4%; the fastest rate of spending growth since April 2002. At one time, remember, some feared that consumer confidence would be hit so hard by the Brexit vote than an emergency Vat cut would be on Hammond’s autumn statement agenda.

Now, I am quite prepared to accept that some of the strength of spending reflects foreigners taking advantage of bargain-basement prices. I am also quite prepared to accept that many households are in no position to splash out and that the figures were are seeing now represent something of a last hurrah for consumers, before higher inflation begins to put a serious squeeze on their real incomes.

Even so, the chancellor should be treading carefully. Money is tight and his priorities should be clear. Giveaway measures aimed at households will leave him with a messy and unconvincing hotch-potch statement. He should stick to infrastructure and investment.

Sunday, November 13, 2016
The last thing we need is a protectionist president
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The way we used to worry about the intrusion of politics into the economy and business now seems quaint and old-fashioned, belonging to a very different era. It is hard to believe it is only 18 months since the Conservatives and Labour squared up in the 2015 general election.

And, despite everything written at the time, including by me, the economy’s path under the economic policies put forward then would not have been very different whatever the outcome, though Labour would not have had a referendum.

2016 has changed that. Politics has become predictably unpredictable. Brexit and Donald Trump’s victory will bring much more change than any conventional election. Change, after all, is what people voted for. And, with important French and German elections coming up next year, there is plenty of scope for more unpredictable outcomes.

Even in Britain, the next election would at least throw up the possibility, however remote, of a shift away from the narrow territory around the centre-ground; in the form of a Labour government under Jeremy Corbyn.

What will the latest intrusion of a different kind of politics mean for Britain? If you were looking for historical precedents, Donald Trump could be seen as a hybrid of Dwight D Eisenhower and Ronald Reagan; rebuilding America’s crumbling infrastructure and slashing taxes to boost America’s growth rate.

That, notwithstanding the impact of this expansionism on America’s debt and deficits – which will worry some - together with his pledge that Britain would be at the front rather than the back of the queue when it comes to new trade deals, sounds very positive.

America, after all, is Britain’s single biggest export market, accounting for 17% of exports of goods and services. It is also a country that, unusually, Britain runs a sizeable trade surplus with, even in goods. That surplus was £14bn last year, and will be helped by sterling’s post-referendum fall to the lowest level in three decades. There is also a good platform for future trade growth. Britain’s exports of goods to America, £47bn last year, were up by nearly a fifth on two years earlier.

But then there is the other Trump; the protectionist Trump, the America First Trump who also wants to cut America’s admittedly large financial commitment to Nato. In 1930 Herbert Hoover signed into law the Smoot-Hawley tariff on a huge range of imports, provoking the trade war which deepened and prolonged the Great Depression.

Trump as Hoover proposes a 45% tariff on Chinese and 35% on Mexican imports. He would revisit Nafta, the North American Free Trade Agreement, inevitable if he carries out his threat on Mexican tariffs and building a wall. The Trans-Pacific Partnership (TPP) would be sunk, as would the the barely-alive Transatlantic Trade and Investment Partnership (TTIP).

All this arises from a very different attitude towards globalisation than that taken by the British government. Theresa May and her ministers recognise that there are losers as well as winners from globalisation and that more should be done to help them. Trump appears to want to tackle the problem at source, on the argument that globalisation mainly benefits other countries and big corporations and should be reined back.

This is an argument that should have been challenged more aggressively, particularly in the years since the crisis. Economists have taken it as given that free trade delivers sustained economic gains, which is supported both by theory and the post-1945 growth and prosperity of the world economy.

Now the argument is in danger of being lost. Clemens Fuest, president of the Munich-based Ifo Institute economic think tank, said: "If Trump goes ahead and erects trade barriers as planned, the damage will be huge.”

There would never be a good time for a president with highly protectionist policies to be elected, but this is a particularly bad one. The missing ingredient from the world economy since the crisis has been world trade growth. Before 2008, world trade grew significantly faster than global gross domestic product, usually around twice as fast, sometimes more.

Since it, it has struggled to keep pace with global GDP. World trade has not been a driver of global growth because of subtle protectionism, constraints on trade credit, and so on. The World Trade Organisation says 2016 will be the weakest year for world trade growth since the crisis and will be the first in 15 years in which world trade grows more slowly than global GDP. It has called on countries to “heed the lessons of history and re-commit to openness in trade”.

There are, it should be said, other forms of globalization than physical trade. A recent report by the McKinsey Global Institute pointed out that cross-border data flows are 45 times larger than they were a decade ago. Digital globalization continues apace.

But the weakness of conventional trade matters a lot, particularly to Britain as an open economy, a trading nation. Britain’s exports have been going nowhere fast in recent years. Last year the total, for exports of goods and services, £509bn, was down in their level two years earlier and a mere 2% up on 2011, making a mockery of George Osborne’s target of doubling exports by the end of the decade. Some of this was due to a drop in oil exports, from £39bn in 2011 to £21bn last year, but exports of goods excluding oil have also disappointed, down from £270bn to £262bn.

This was partly as a result of the eurozone crisis but largely down to the post-crisis weakness in world trade. The last thing Britain’s exporters want is a president whose policies will mean a further reduction in world trade growth. Any advantage bestowed on Britain by Trump’s renewal of the special relationship would be more than offset by the danger of tit-for-tat protectionism and a modern-day trade war.

Will it happen, or was Trump’s campaign bark on protectionism a lot worse than his presidential bite will turn out to be? China’s vice-minister for finance Shi Yaobin said as much on a visit to London last week, suggesting that Trump’s tough words on China and trade were to win election and that the president-elect would soon realise the benefits of co-operation with China.

He may be right, though it is too early to say. Trump as Eisenhower-Reagan, emphasising infrastructure and cutting taxes, including America’s higher 35% corporate tax rate, would be positive for Britain and the world economy. Trump as Hoover most definitely would not be. We have to hope that the right one wins out.

Sunday, November 06, 2016
Sterling's ill-wind could blow us back to balance
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

You would have to say that it has been bracing, not least for the pound. Blown in one direction – down – by the referendum result and government indications that it will be pursuing a harder form of Brexit – sterling was blown back up a little on Thursday by the High Court’s ruling that Parliament must have a vote on the triggering of the formal Article 50 process and ended the week above $1.25.

But the pound remains very substantially lower than it was, which will have some of the consequences, notably higher inflation, we are familiar with. It is an ill wind, however, which blows nobody some good.

Manufacturers are benefiting from the lower pound. The latest purchasing managers’ survey for the sector from Markit showed that export orders are driving a mini-revival in Britain’s factories.

That is good news but perhaps most remarkably, if a new forecast is right, one of Britain’s longstanding Achilles’ heels will, in just a few years, have been eliminated. I am referring to the current account deficit, the balance of payments gap, the amount that this country is in the red in its transactions with the rest of the world. Times have changed, but it used to be regarded as one of the best measures of the nation’s economic health.

The deficit, as regular readers will know, has been running at record levels. Last year it was no less than £100.2bn, 5.4% of gross domestic product. In the first half of this year it averaged 5.8% of GDP. It was this that led Mark Carney, who has had a busy week, to say that Britain would be dependent on the kindness of strangers to fund all this red ink.

The good news then is that Britain may not be dependent on this kindness for too much longer. The latest forecast from the National Institute of Economic and Social Research (Niesr) attracted a lot of attention a few days ago because of its prediction that inflation will rise to 4% during next year, putting a big squeeze on real – after-inflation – household incomes, and thus restraining spending.

Also in the forecast, however, was a remarkable set of numbers on the prospects for Britain’s current account deficit. Niesr expects this year’s figure to average out at 4.5% of GDP, a small improvement on last year. Next year there is a bigger drop in the deficit, to 2.7% of GDP. It is what happens next, though, which really caught my eye. The deficit is predicted to virtually disappear in 2018, dropping to a mere 0.1% of GDP. But then this is followed by three successive annual surpluses beginning in 2019, of 1.2% of GDP, 1.2% and 0.9% respectively.

Before explaining how this is expected to come about, it is worth taking a moment to record how unusual a single current account surplus, let alone three in a row, would be. Britain has not had an annual surplus in the past three decades. The Office for National Statistics’ dataset, going back to 1987, shows that the nearest we had to one was a 0.2% of GDP deficit in 1997. Last year, as noted, it was a record 5.4% of GDP. So this would be a very big change.

How does it happen? There are three main things happening in the Niesr forecast. Though it notes that Britain’s exports often respond disappointingly to falls in the pound - in the jargon the elasticities are low - it does expect some impact on export growth. But, as far as trade is concerned, weaker domestic demand and higher import prices have the effect of reducing growth in the goods and services we buy from abroad. This indeed is what it sees as the main channel through which the trade picture improves.

The result is that net trade (exports minus imports) having made a negative contribution to growth in recent years, despite post-crisis hopes of export-led growth, makes a significant positive contribution next year and beyond. The trade deficit in goods and services, £39bn last year, is predicted to disappear before the end of the decade.

The second big factor is investment income, which has been responsible for much of the lurch into record current account deficit in recent times. This was the phenomenon under which foreigners were earning larger returns on their investments in Britain than British people and institutions were on their investments overseas.

The lower pound affects this in two ways. It boosts the sterling value of foreign assets and thus improves Britain’s net international investment position; while leaving the sterling value of foreign-owned assets in Britain unchanged. It also boosts the sterling value of foreign income. It is enough to return to surplus this component of the balance of payments, the so-called primary income account, perhaps even before the end of this year.

Finally, in what Simon Kirby, who runs Niesr’s UK forecast, admits might be a heroic assumption, another source of improvement is that Britain stops paying contributions to the EU in 2019-20. That assumes exit by March 2019, an assumption perhaps complicated by the High Court judgment, and assumes exit is not followed by the kind of arrangement Switzerland and Norway have with the EU, which involve contributions.

Anyway, the prospect of a return to surplus on Britain’s current account, particularly from a position of record deficit, is encouraging. The Bank of England, by the way, also sees the deficit narrowing significantly but its forecast does not run as long as Niesr’s.

Will it happen? Forecasts – good and bad - are forecasts, and subject to the usual health warnings. I had thought the big fall in the pound from the autumn of 2007 to early 2009 would lead to a big improvement in Britain’s current account position but the outcome was disappointing, not least because of the weakness of Britain’s export markets in the eurozone (one reason for the decline in the EU share of exports).

Niesr assumes the pound stays roughly where it was at the time of its forecast, $1.22 and €1.11, which implies a prolonged period in which sterling is below both fair value and historical averages. Currencies move, as we saw on Thursday. Depending on what happens on Tuesday in America, the dollar could move quite a lot. Currency market indications in recent days are that it would fall a lot on a Donald Trump victory, pushing the pound higher.

There is also, of course, that elephant in the room of Britain’s future trading arrangements. Niesr expects the trade and current account positions to start deteriorating again in the first half of the 2020s. If Britain fails to secure good trade deals with the EU and the rest of the world, that deterioration could be very significant indeed. We should enjoy this return to surplus while it lasts.

Sunday, October 30, 2016
Hard or soft Brexit? Britain needs a middle way
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

To the frustration of many MPs, and the concern of many businesses, the shape of Britain’s post-EU future remains clouded in uncertainty. When Jeremy Corbyn said to Theresa May a few days ago that her cunning plan was that she did not have one, it was not just his own MPs who nodded in approval at a rare hit for the Labour leader.

The prime minister continues to insist that she will seek combine maximum possible access to the single market with controls on EU migration. The fact that the economy has so far held up well in the face of the Brexit vote, with third quarter gross domestic product rising by 0.5%, may strengthen her hand, and those of the Brexiteers in the government. It is, though early days, and Brexit will be a long process. Even more encouraging was the decision by Nissan to build the new Qashqai and X-trail in Sunderland. It has clearly been led to expect than any future deal will involve something close to existing single market arrangements for cars.

As I noted last week, second-guessing the government is probably not the most productive thing to do at the moment. Fortunately, there is plenty happening outside government, which one would hope will have an impact on the official negotiating position. Does Brexit have to be “hard” or, given that a “soft” Brexit – one involving continued unrestricted free movement – is unlikely, is there a middle way that would work to the benefit of both Britain and the EU?

Let me begin with some definitions. Economists at HSBC, in a useful recent report “Brexit getting harder”, took eight conditions and applied them to different arrangements between Britain and the EU. As an EU member Britain is in the single market, has duty free trade in goods, market access for services but cannot negotiate its own trade deals. It must adhere to EU social and employment rules, contribute to the EU budget, is in the Common Agricultural Policy (CAP) and cannot restrict EU migration.

Of the six other models HSBC looked at, the hardest were the WTO (World Trade Organisation) and Canada models. Under a WTO model none of the eight conditions of EU membership would apply. Under a Canada-style agreement, similar to the on-off-on comprehensive economic and trade agreement between Canada and the EU, there would be duty free trade in goods and partial access for services.

In between these extremes, if it is right to call EU membership an extreme, there were however other options. The most interesting of these is the so-called Continental Partnership, proposed a few weeks ago in a report from Bruegel, the Brussels-based think tank.

The continental partnership proposal, authored by Jean Pisani-Ferry, Norbert Rottgen, Andre Sapir, Guntram Wolff and our own Sir Paul Tucker, former deputy governor of the Bank of England, sees the Brexit vote as an opportunity for restructuring Europe in a more fundamental way. In essence, it would head towards an inner circle of countries committed to monetary and political union and an outer circle, including Britain, more interested in economic relationships, including trade and financial services, as well as security co-operation, while limiting free movement.

As the paper put it: “We propose a new form of collaboration, a continental partnership. The UK will want to have some control over labour mobility, as well as leaving behind the EU’s supranational decision-making. The proposed continental partnership would consist in participating in goods, services, capital mobility and some temporary labour mobility as well as in a new system of inter-governmental decision making and enforcement of common rules to protect the homogeneity of the deeply integrated market.

“The UK would have a say on EU policies but ultimate formal authority would remain with the EU. This results in a Europe with an inner circle, the EU, with deep and political integration, and an outer circle with less integration. Over the long-run this could also serve as a vision for structuring relations with Turkey, Ukraine and other countries.”

The authors have since come back with a follow-up, prompted by criticism that the continental partnership sounded a bit too much like allowing Britain to have her cake and eat it. They say, on the contrary, that it would not be a route to allowing EU members to restrict free movement of people, or risk what they describe as “political contagion”. Instead, they say, it would be the best way for the EU “to maintain strong economic and security cooperation with the UK, while defending themselves against dumping and vetoes”.

Will the continental partnership fly? From a British perspective it should, though the rest of the EU may see it differently. As Lord Hill, Britain’s former European commissioner, put it recently, it is a common view in Brussels that Brexit will not actually happen. For those who believe it will the language so far has pointed towards an acrimonious rather than an amicable divorce. Politics and punishment may take precedence over economics.

That leaves Britain to think about how to secure its best interests in future EU negotiations. Another useful paper, from the Centre for Economic Performance at the London School of Economics, sets out the four principles Britain should adopt.

The four principles: you get what you give; where negotiations start from matters; bargain from a position of strength, and invest in negotiation capacity, make a good deal of sense. So the author, Thomas Sampson, argues that a bold gesture like unilaterally removing Britain’s tariffs, as advocated by some, would remove an important bargaining chip.

Britain has the advantage of already being in the single market, which is the status quo, so any negotiation starts from that position rather than with a blank sheet of paper. But one potential advantage, the timing of the start of the notionally two-year Article 50 process, has been lost. Sampson says Britain should neutralise this by seeking an agreement on transitional trading arrangements between the EU and Britain, in which things would continue as now until such time as a new and comprehensive deal, which could take many years, was concluded.

There is, very clearly, a lot to play for. It is in Britain’s best interests, as well as those of the EU, to co-operate once the rancour fades. A hard and damaging Brexit would hurt Britain most, but it would also harm the EU. For both sides, there has to be a middle way.

Sunday, October 23, 2016
Stormier weather ahead for a nation of shoppers
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

For Britain’s retailers – at least those who are not threatened with having their knighthood taken away – this should be a time of celebration. The latest official figures show that the volume of retail sales in the three months to September was 5.4% up on a year earlier.

That was mighty strong. You have to go back to early 2015 for anything stronger. A jump in retail sales in July, the month after the referendum, was followed by a flat August and September. Even so, it is hard to see anything resembling consumer retrenchment in these figures.

So why the long faces? Some of the strength of sales was because, perhaps because of all those staycations, we bought more petrol and diesel. Even excluding those, however, retail sales volumes were up 5.1% in the third quarter.

Some retailers have always had difficulty reconciling their own experience with the official figures but they can agree on one message from the numbers. This is that they have to work hard, though discounting and special sales events, to achieve their sales.

In more normal times – times of higher inflation than in recent years – the growth in sales values always exceed that of volumes, Two things drove shop takings; the number of goods sold and the price, usually rising, at which they were sold. That, however, is not the case now. While volumes of retail sales (excluding fuel) were up by 5.1% in their third quarter, values – which are what we really count – were up only 3.4%.

The bigger worry is what comes next. Last week brought news of a bigger rise in inflation than expected. True, consumer price inflation only rose from 0.6% to 1% (inflation on the old retail prices index is 2%) but pretty well everybody thinks this is the beginning of a long climb. The median expectation among forecasters is of a rise in inflation of 2.5% next year, with the gloomiest expecting something closer to 4%. Last year, when we had no inflation at all, on the consumer price index measure, looks to have been a one-off.

These days, of course, it does not take much of a rise in inflation to overtake the growth in wages, leading to a fall in real incomes. Both including and excluding bonuses, average earnings are currently rising by 2.3% a year, which is where forecasters expect them to stay. Will they? Won’t employees seeking compensation for rising prices?

In the past they would, whether represented by trade unions or not, but this mechanism appears to have changed, as has the old Phillips curve trade-off between unemployment and wage inflation. We have low unemployment by modern standards but weak wages. These days, 2% is something like the norm for wage increases.

The EEF, the engineering employers’ federation, which represents Britain’s manufacturers, finds that the most common pay rise among its members is “up to” 2% and that a growing number of businesses have imposed pay freezes this year, which it ascribes to greater uncertainty.

Pay is not the only potential source of a squeeze on real incomes. One of the decisions for the chancellor in his November 23 autumn statement in whether to persist with the freeze to 2020 on working-age benefits and tax credits bequeathed to him by George Osborne. This freeze, which will hit many of Theresa May’s “just managing” families, will cost the average household in receipt of benefits and credits £360 a year by 2020 according to new calculations by the Institute for Fiscal Studies. Excluding those families which only receive child benefit, the cost rises to £470. Just managing will become more difficult.

When it comes to consumer demand, real income growth is important, but so is growth in employment. A rising number of people in work can keep spending going even when individual real incomes are being squeezed. That, indeed, was what happened in much of the last parliament. And, on the face of it, it is continuing. Employment rose by 106,000 in the June-August period, new figures show, and was a very strong 560,000 up on a year earlier.

There were, however, one or two signs in the figures of a softening in job growth, even apart from the small rise in unemployment the figures also showed. So the latest quarterly rise was dominated by an increase in part-time employment.

Over the past year less than a quarter of the rise in employment has been in traditional full-time employee jobs; the increase has been mainly due to self-employment and part-time employee jobs. There is nothing wrong with those, though research last week by the Resolution Foundation showed that the typical earnings of the self-employed are lower in real terms than they were 20 years ago. Business surveys suggest, meanwhile, that firms are becoming more cautious about recruitment.

If the outlook for real wages and employment has deteriorated, could the retail sector, and the economy in general, be saved by borrowing. Will households ease the pain, and maintain their spending, by running up more debt? It is happening now. Consumer credit, according to Bank of England figures, is up by 10.3% on a year ago, its fastest rate of increase since 2005.

In the years after the crisis, households ran down their borrowings. Now they are running them back up again, to the concern of some. While ultra low interest rates are a powerful incitement to borrow, debt-driven consumer spending is probably not the way we should be going.

Fortunately, if not for the consumer spending outlook, we may not be. Household debt, particularly consumer credit, is not an alternative to growth in real incomes; it is more usually an accompaniment. People borrow when they are feeling confident about their jobs, incomes and prospects. The strong growth in consumer credit over the past couple of years has accompanied good growth in real wages, not been a substitute for it.

Nor, I would suggest, can one of the saving factors of this summer – shopping tourists, or tourist shoppers taking advantage of the pound’s fall to buy goods in Britain – be expected to be more than a passing phase. Given that many of the things they have been flocking to buy are imported, the price advantage will soon be self-correcting, because new stock will be cost more to import as a result of the pound’s fall. Again, you cannot build Britain’s economy on selling Swiss watches to tourists.

None of this means consumer spending is about to collapse. The environment will, however, get tougher. Forecasters expect consumer spending to grow by just over 1% next year, its weakest since 2011, when households were hit by a combination of a Vat hike and rising oil prices. Consumers will struggle to beat this renewed squeeze.

Sunday, October 16, 2016
Uncertainty to choke off business investment
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What is the biggest risk to Britain’s economy over the next couple of years? Anybody watching sterling’s gyrations in recent days might conclude that, as on so many occasions in the past, it is the exchange rate, itself the product of the government’s uncertain steps towards the Brexit door.

The pound’s performance is, however, merely the canary in the coalmine, a symptom of a wider uncertainty. Its average value, its trade-weighted index, fell to an all-time low last week. Its volatility adds to that uncertainty; for businesses, individuals and for the government. Whether or not a downward adjustment in sterling was needed, which is debatable, the process itself is unsettling.

When it comes to being unsettled, there are three central risks to growth over the next couple of years. They are that, in an atmosphere of uncertainty, businesses will be very cautious about investing, that a similar caution will affect recruitment, and that the inflationary impact of sterling’s fall will squeeze real incomes and consumer spending, more than offsetting any beneficial effect on exports. After that, the risks will centre on the nature of Britain’s new relationships both with the European Union and the rest of the world, including trade and migration.

Let me this week take just the first of those risks; business investment. If you were looking for an explanation of Britain’s poor productivity performance, business investment would be high on the list. It has been lower, over time, than most of our competitors. Some but not all of that reflects the larger decline in manufacturing, which is more investment-heavy than other sectors.

On the most recent official figures, business investment surprised on the upside in the second quarter, rising by 1%, though it was nevertheless down on a year earlier, and its rise mainly reflected additional spending on transport equipment; cars, vans and lorries.

Overall, business investment is 7% higher than it was before the global financial crisis hit the economy, similar to the rise in the overall economy; gross domestic product. It has, however, been a very patchy recovery. It has fallen in nine of the 28 quarters since the economy hit its recession low point in the middle of 2009. The normal post-recession exuberance of business investment was missing, not least because of the difficulties of raising finance.

What about now? The past is another country and March this year seems very different indeed. At the time of George Osborne’s last budget the Office for Budget Responsibility (OBR) predicted a 2.6% rise in business investment this year and a 6.1% increase next year.

The OBR is currently running through the numbers for the chancellor’s November 23 autumn statement, and they will make interesting reading. In the meantime we have a new forecast, to be published this week, from the Ernst & Young (EY) Item Club, which uses the Treasury’s model of the economy. It predicts that business investment will drop by 1.5% this year and by 2.3% next year. Some other independent forecasters are significantly gloomier about the outlook for business investment. The fall predicted by the EY Item Club, and the difference between it and the rise predicted by the OBR in March, is however almost enough on its own to account for the expected drop in overall economic growth next year from more than 2% to less than 1%.

Before the referendum a big concern was whether Britain could maintain her appeal as a magnet for foreign direct investment in the event of a vote to leave. That remains a big concern, particularly now that leaving the single market looks increasingly likely, if not certain. There will still be some investment flowing into Britain, not least to snap up what, thanks to sterling, are bargain-basement assets. But the loss of appeal is real.

Foreign businesses do not, however, operate in a vacuum. The concerns they have are shared by many domestic businesses, some of which need to be in the single market, some of which are just concerned about an uncertain future.
Fears of a drop in investment are not just forecasters’ guesswork. Investment intentions have weakened since the referendum. The Bank of England’s regional agents, who regularly survey firms in their areas, record what are known as agents’ scores across a range of measures of business activity. Its latest reading showed that these scores for investment intentions have dropped to their weakest since the financial crisis. The “animal spirits”, to use Keynes’s expression, have dropped.

The British Chambers of Commerce, in its latest quarterly survey, published a few days ago, recorded an eight-point drop in manufacturers’ investment intentions and, perhaps as worryingly, a 12-point decline in plans to invest in training by service-sector firms.

Worries over investment were at the top of the Bank’s concerns when it chose to cut interest rates in August, and why it may yet do so again, though probably not this year.

Ben Broadbent, one of its deputy governors, set this out very clearly in a recent speech. Investment decisions are, as he put it, “at least to some degree – irreversible. Once made, they can’t be easily or costlessly unmade.” They are also closely correlated with uncertainty.

The Bank’s own index of economic uncertainty has, Broadbent demonstrated, been closely correlated with business investment during the past three decades. Even when firms go ahead with investment during periods of uncertainty, they are only likely to do so when the rate of return is high; uncertainty raises the investment “hurdle”. Uncertainty also makes businesses more likely to employ temporary workers rather than take on new permanent staff.

Broadbent also made two points directly relevant to post-referendum Britain.
The first was that the longer-lasting the investment, the more that business will want greater certainty than currently exists on Britain’s future trading relationships. The second was that the flow of new investment matters more than the flow.

As he put it: “A lack of clarity about the UK’s future trading relationships needn’t result in visible, headline-grabbing closures of productive capacity. The effect is likely to be more insidious: decisions to expand, that might otherwise have been taken, are delayed.”

What can be done to maintain investment in this time of uncertainty? Philip Hammond is being pressured to announce some short-term measures to help firms overcome their doubts. The annual investment allowance, currently £200,000, was raised to £500,000 from April 2014 to the end of 2015 and was associated with generally stronger investment. Whether the same trick could work again remains to be seen. The priority is to put an end to the uncertainty, and that may not be in the chancellor’s gift.

Sunday, October 09, 2016
More nasty lurches ahead on this sterling rollercoaster
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The pound in your pocket is worth a lot less than it was, as Harold Wilson did not quite say. Actually, the reference to the most famous devaluation broadcast in history is not inappropriate. The former Labour prime minister was trying to tell people in 1967 that a 14% fall in the pound would not make them any poorer. After another torrid week, sterling’s average value is also 14% lower than it was in late May, before referendum jitters set in.

It was torrid even before the “flash crash” that hit sterling in the early hours of Friday morning, and which pushed it as low as $1.15, before it settled at a weak $1.24.

The current prime minister, who last week declared herself untroubled by the pound’s renewed tumble, will not be broadcasting to the nation about it. She also broke the unwritten rule, adopted by ministers and prime ministers since independence in 1997, of not criticising the impact of the Bank of England’s policies. This was not the first time she had criticised low rates and quantitative easing (QE), though I doubt it will have any impact on what the Bank decides to do in coming months.

Is Theresa May right to be sanguine about the pound’s drop to new 31-year lows against the dollar and a five-year low against the euro?
In the short-term, up to a point. A weak pound is providing a safety-valve for the economy now, as it did in 2007-9, when the global financial crisis hit.

Together with the actions of the Bank, it represents a dramatic loosening of monetary conditions, at a time when the economy needed it. The rebound from the July wobbles owed at least something to the sterling safety-valve.

And, while the pound in your pocket will be worth less as the inflationary impact of sterling’s fall comes through via higher import prices, it is better that that process starts when inflation is very low (0.6%) and oil and commodity prices relatively weak. One of the reasons that there has been less of an inflationary uptick so far is that we had a weak summer for oil prices.

Has the pound, thanks to the Brexit vote, merely found its natural level? One useful way of thinking about where sterling should be is looking at long-term averages. The 10-year average for the dollar against the pound is $1.64, while the 30-year average is very close, $1.65. So $1.24 looks very cheap. The average for the euro to the pound since the beginning of 1999, when the single currency was launched, is €1.37. So, again, €1.11 – sterling’s new five-year low against the euro - looks very cheap. It is enough to push Britain down from fifth to sixth largest economy in the world; back below France.

A more sophisticated approach, pioneered by the Peterson Institute for International Economics in Washington, is to calculate what are known in the jargon as fundamental equilibrium exchanges rates (Feers). It redoes the calculation twice a year. When it last did so, in May, the “right” rate for dollar-sterling was $1.52 and, using its calculation for dollar-euro, the appropriate euro-sterling rate was around €1.26.

All of which suggests that the pound has fallen to a level at which it is now undervalued. That could mean a short-term bonanza for exporters; short-term because currencies do not stay undervalued for too long. Or it could mean that Britain’s economic prospects have deteriorated so much that a significantly lower exchange rate is justified.

The pound’s latest tumble came as ministers – and the prime minister – were setting out their stalls at the Tory conference in Birmingham. It dashed hopes, for now at least, that the EU settlement will involve something close to existing single market arrangements but with some restrictions on free movement. That may never have been a possibility but the Tory conference, with its sometimes xenophobic emphasis on immigration, and a clear message that controlling immigration takes priority over the single market, confirmed it. “Smexit” – single market exit – is now seen as a certainty by the City, and damaging certainty at that. Philip Hammond, the chancellor, is fighting the fight on that, and the battle to remain in the EU customs union, but he is outnumbered by the Brexiteers.

So sterling has sold off, bringing memories of previous episodes of pronounced weakness. It might have been expected to recover some ground on the evidence that the short-term damage from the Brexit vote has been less than feared. In Wilson’s day it was the “gnomes of Zurich” who did all the selling. These days it would probably be the wolves of Wall Street or, given London’s dominant role in currency trading, perhaps the cheeky chappies of Chigwell. Or maybe the robots.

How worried should we be? In a piece for the OMFIF (Official Monetary and Financial Institutions’ Forum) website, Desmond Lachman, a fellow of the American Enterprise Institute said he found it difficult to understand the complacency “surrounding the likely fallout from a ‘hard’ Brexit – particularly at a time when the UK is suffering from acute external; vulnerabilities that are heightening the prospects of yet another sterling crisis”. Having witnessed a few of those over the decades, my ears pricked up.

The biggest vulnerability is, of course, the current account deficit, nearly 6% of gross domestic product. It will be helped by the pound’s fall, but perhaps not quickly enough to remove the danger.

A falling pound only turns into a proper sterling crisis when action – notably higher interest rates – is need to stem the slide. In January 1985, when the pound fell to all-time lows against the dollar (a smidgeon above parity), interest rates were pushed up from 9.5% to 14%. That was just one of many episodes of sterling-generated pain.

Lechman raises the possibility of a monetary response to sterling’s weakness though, with the Bank having only just cut rates – and signalled its intention of doing more – that looks a long way off.

Even so, we should take note of sterling’s weakness. Theresa May says she does not want to give a running commentary on Britain’s Brexit negotiations. Then again, she would not want a feeble pound to provide the backdrop for her government. It is saying that a struggle lies ahead, at the end of which the uplands will be far from sunlit.

Markets, of course, do not have perfect foresight. Hammond, interviewed by Bloomberg on his post-Tory conference visit to New York, suggested a “win-win solution” in Britain’s negotiation with the EU; one that starts with hard positions on both sides but which develops into a mutually beneficial outcome. He appears to have the task in government of trying to clear up the mess created by his colleagues, including May. We have to hope his optimism is justified. The pound’s future performance will tell us whether it is or not. Expect, as he has acknowledged, some more sickening lurches on this rollercoaster.

Saturday, October 01, 2016
The lessons of history - and don't expect a borrowing spree from Hammond
Posted by David Smith at 04:24 PM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It may be the nature of the beast, but economic anniversaries tend to be unhappy ones. Fortyyearsago,Britainwas in the middle of one of the most humiliating episodes of the post war era, the bailout by the International Monetary Fund.

The IMF rescue,which came only three decades after Britain was instrumental in the creationof the organisation, is the stuff of legend. Denis Healey, the chancellor, had tried to spend his way out of recession. On his way to a finance ministers’ meeting in Hong Kong on September 28, 1976, he was forced to turn back at Heathrow to formally apply for the IMF loan.

It was an important time for economic policy in Britain. Three years before Margaret Thatcher came to power, theLabour prime minister James Callaghan signalled a shift away from the Keynesian consensusofthe postwar era,tellinghisparty conference that you can’t spendyourway out of recession.

That did not mean Labour was grateful for the IMF’s intervention. Healey, one of the great characters of British politics, looked forward to what he described as IMF “sod-off day”. He went to his grave last year believing the $3.9bn rescue was unnecessary.

That is not how it looked at the time but the numbers now suggest that the picture, while bad, was not as dramatically bad as we have experienced recently. In terms of the twin deficits — the budget deficit and the current account of the balance of payments — the situation in 1976 was that the budget deficit peaked at 6.4% of gross domestic product in 1975-6, while the current account was in the red by 0.9% of GDP, having peaked at 3.8% in 1974.

The recent peak in the budget deficit — public sector net borrowing — was much higher than during the IMF crisis,at 10.1% of GDP in 2009-10. The latest annual reading for the current account deficit, 5.4%, also exceeds anything in the 1970s. The deficit in the second quarter was 5.9% of GDP.

Those who ignore the errors of history are condemned to repeat them. I am not suggesting Britain is about to turn to the IMF for another bailout — it has other things on its plate—but if Labour has anything to do with it, we might at some stage take a trip down that particular memory lane.

Shadow chancellor John McDonnell managed in his party conference speech to both criticise the level of government debt, £1.6 trillion, and promise to add at least£250bn more to it than implied under government plans. After the mild tax and spend of Ed Miliband and Ed Balls in last year’s general election, we now have the full-blooded socialist version.

Fortunately, rather than being the “government in waiting” that McDonnell claimed his party was, Labour looks to be destined for opposition for many years to come. That, however, does not necessarily eliminate the risk. Political parties compete. McDonnell’s pledge ofa£10 an hournational living wagewas a ratcheting up of George Osborne’s policy, which implies a rate of just over £9 by 2020. When it comes to fiscal policy, there is also the possibility of competition. Though chancellor Philip Hammond will not take many of McDonnell’s ideas and run with them, an expectation is growing that his “reset” of fiscal policy will imply something significantly looser than his predecessor’s.I say expectation, because we are still pretty much in the dark on this, as we are about quite a lot from this government. There is talk of an end to austerity, as part of Theresa May’s attempt to reach the parts of society the recovery left behind. There is talk, more plausibly, of a new infrastructure drive, aimed particularly at the regions. With the government able to borrow over 10 years at a rate of 0.7%, what could be more sensible?

Let’s be clear. If the government could ring-fence a set of infrastructure projects and fund them at the current very low borrowing rates, it would make a lot of sense. Britain needs more and better infrastructure,and theeconomywill need the boost that it could bring. Reallife is,however,a bitmore complicated than that. Infrastructure projects are prone to delays and big cost overruns. The burden of those — and the risks — would staywith taxpayers and addtogovernment debt. This is why, so far at least, we have had a lot of talk of infrastructure bonds but very little action.

The assumptions of economic models, that infrastructure projects pay for themselves because of the boost they provide, can be elusive in practice. The widerpoint, when it comes to both austerity and infrastructure, is that the public finances are a long way from being fixed. Yanis Varoufakis, the former Greek finance minister, won last week’s pot-kettle-black award when he said on BBC radio that Osborne had been a“particularly inept”chancellor.

But Britain has addedalot of public sector debt in recent years—it has more thantripled fromjust over £500bn in April 2007 — and the deficit has been more stubborn than hoped. At 4.1% of GDP in 2015-16 it is smaller than it was when Britain had to turn to the IMF, but not that much smaller. Meanwhile, the Office for Budget Responsibility will surely confirm in the autumn statement on November 23 what bodies such as the Institute for Fiscal Studies have already told us. This is that while there are swings and roundabouts, including the help thatlower debt interest will provide, the net effect of Brexit will be to make the public finances worse.

What about those low interest rates? Surely any government would be foolish not to borrowwhenitis socheap to do so? Again, it is not as simple as that. Governments are not households, but sometimes the standard advice for households is useful.Do not assume interest rates will be this low for ever. Debt has to be rolled over, and in time it will be rolled over at higher rates than now.

All of which should mean that Hammond, whose instincts appear to be fiscally conservative, willnot take toomuch of a leaf out of his Labour opponent’s book. The aim, I judge, will be to keep the budget deficit on adownward track,while announcing some eye-catching but inexpensive initiatives. That will disappoint some, but it would demonstrate that at least one party has learnt the lessons of history.

Sunday, September 25, 2016
Central banks try to squeeze out the last drop
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A few days ago it was announced that Minouche Shafik, who joined the Bank of England as one of its deputy governors two years ago, would shortly be leaving. Her departure, to take up the post of director of the London School of Economics, was perhaps understandable; she described it as an opportunity that was impossible to resist.

It was a reminder, however, of what an extraordinary period we live in as far as monetary policy and the actions of central banks are concerned. When Shafik was appointed in 2014 she was given the role of managing the unwinding of the Bank’s quantitative easing (QE) programme, in others words organising the process by which the £375bn of gilts (UK government bonds) it has purchased were sold back to investors.

At the time, with the effects of the crisis fading and the economy enjoying strong growth, reversing QE was firmly on the agenda, as were higher interest rates. In August 2014, the Bank was working with financial market assumptions that interest rates would be 2% by now.

Things have turned out rather differently. The Bank, rather than running down QE, has just announced £60bn more of it, together with £10bn of corporate bond purchases. Interest rates have been cut to 0.25%, with the Bank’s latest minutes saying most members of the monetary policy committee (MPC) are minded to cut further, to just above zero (which could mean 0.05% or 0.1%), later in the year. It should be said that one MPC member, Kristin Forbes, has said she is not yet convinced of the need for a further cut.

When will the Bank’s QE be reversed? Will it ever be reversed? Given that it has just cut interest rates and may do so again, and given that it has just launched another QE round, any reversal is years away. The Bank, as it told us last November, will not even contemplate a back-door reversal of QE – not reinvesting the proceeds of the maturing gilts it has in its portfolio – until interest rates have reached 2%.

That suggests a timetable stretching well beyond Mark Carney’s stint at the Bank, which is currently due to end in mid-2018 although, no doubt to the fury of some Brexit headbangers, he may stay on until 2021. It suggests Shafik could go away and pursue a successful LSE career lasting many years, and come back to the Bank in time to administer the QE reversal, not that I think she will.

The Bank, of course, was responding to Brexit, without which it is very unlikely there would have been an interest rate cut or more QE. But it is part of a wider phenomenon in which central banks, after years of near-zero interest rates, are still attempting to squeeze the last drop out of monetary policy.

Last week saw two interesting announcements from the big central banks. The Federal Reserve in America came closer than it has for a while to a hike in interest rates, with a 6-3 vote for no change. The fact remains, however, that last December’s token quarter-point rise in rates, intended to be the first in a regular sequence, still stands alone.

By this time, according to the guidance then, we would have had the third of four Fed rate hikes in 2016. We have yet to have any. And, while last week’s strong guidance from Janet Yellen, the Fed chairman, was that markets should expect a rate rise at its December meeting, there is many a slip ‘twixt cup and lip, not least the uncertainty that would follow a Donald Trump election victory in November.

Even more interesting was the Bank of Japan (BoJ). It has already adopted negative interest rates and expanded QE at a faster rate than any other major economy. The central bank is in the forefront of “Abenomics”, the effort by the Japanese prime minister Shinzo Abe to shake the economy out of its torpor.

Ahead of last week’s meeting, some in the markets expected the BoJ to announce even more negative interest rates and expand its already large QE programme. In the event it did something slightly different. It announced that it would continue with QE until Japan’s inflation rate, currently -0.4%, is both positive and above 2%. It will keep pumping money in, in other words, until deflation – a falling price level – has been comfortably eliminated.

Even more interesting was that it set a target for the yield – the interest rate – on 10-year government bonds. The BoJ will aim to keep that yield at exactly zero , indefinitely, implying that the Japanese government will be able to undertake its borrowing, or at least its 10-year borrowing, free of charge.

What should we make of all this? Ben Bernanke, the former Fed chairman, earned the nickname “Helicopter Ben”, for a speech he gave in 2002 outlining the mechanics of a so-called helicopter drop of money.

Helicopter money has its advocates, including Lord Adair Turner, the former Financial Services Authority chairman who now chairs the Institute for New Economic Thinking. It takes many forms, ranging from the central banks creating money to hand out to households to what is known as monetary finance.

Monetary finance is a bit like QE without the safeguards. Central banks create money to fund the budget deficit, without governments having to issue new bonds. As Bernanke has put it using the example of the US, “the Fed credits the Treasury with $100bn in the Treasury’s “checking account” at the central bank”, with those funds being used for boosting public spending or tax cuts. Governments can expand budget deficits without having to go near the markets. Monetary and fiscal policy go hand in hand.

Many people, myself included, regard this with deep concern. Where would the process end, if not with irreversible reputational damage for the central bank, and the prospect of significantly higher inflation in future? And, while we may trust our current politicians to be reasonably responsible, once the rubicon was crossed what would there be to stop future politicians taking enormous liberties with the public finances? The discipline of the market is quite a useful one to have.

Central bankers, on the face of it, agree. Haruhiko Kuroda, the BoJ, governor has spoken out against helicopter money. Carney said last month: “I can’t conceive of a situation in which there would be a need to have such flights of fancy here in the UK.”

The question is whether central banks are drifting into helicopter money by default. Bernanke, analysing the BoJ’s announcements for the Brookings Institution, wrote that “a policy of keeping the government’s borrowing rate at zero indefinitely has some elements of monetary finance”.

In the case of the Bank of England, there is a finer line than Carney would like between helicopter money and a QE programme that may not begin to be reversed until the 2020s, if then. Its effect has been to reduce the government’s cost of borrowing – to zero in the case of the gilts bought by the Bank – and make it easier to run large budget deficits, something the new chancellor may be glad of. Monetary and fiscal policy have overlapped. The helicopters have not yet taken off but there are a few drones already buzzing around.

Sunday, September 18, 2016
Hammond needs to get Britain's productivity mojo back
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

One of the challenges Philip Hammond has set himself for his autumn statement on November 23, among many others, is to boost Britain’s productivity. In this, the new chancellor is very much following in the footsteps of his predecessors.

Gordon Brown had his productivity agenda – even at a time when productivity (output per hour worked) was growing at a rate we would give our eye teeth for now – while George Osborne had his productivity plan. Every occupant of 11 Downing Street has sought to raise Britain’s productivity game both in absolute terms and in relation to other countries. Most have struggled to make any discernible difference.

The issue is more pressing for Hammond. The productivity performance he inherits is a particularly feeble one. Though there has been a modest improvement since the depths of the crisis in 2009, output per hour across the whole economy at the end of last year was lower than at the end of 2007. Nor is there any sign of improvement. The latest labour market statistics showed a rise of 2% in the number of hours worked over the past year, roughly in line with the growth in the economy.

Eight years without any growth in productivity is extraordinary. In the previous eight years, when Brown was trying to improve it, it rose by 19%, and in the eight years before that by 20%. Something has snapped and the new chancellor’s task is to try and fix it.

Most countries have experienced weaker growth in productivity since the crisis but Britain’s performance is particularly stark. GDP (gross domestic product) per hour worked is 36% higher in Germany, 31% higher in France and 30% higher in America than in Britain. Even Italy is 11% more productive.

The weakness of productivity is not just a statistical curiosity or a matter of international bragging rights. Most people know the American economist Paul Krugman’s famous remark that “productivity isn’t everything but in the long run it is almost everything”. Productivity – getting more output out of a given input – is the key to prosperity; to living standards.

It also matters hugely for the public finances. You may remember that Osborne’s final autumn statement a year ago was notable for the £27bn that the Office for Budget Responsibility (OBR) discovered down the back of the fiscal sofa, thanks to changed assumptions about tax receipts and the interest on government debt. Less well remembered, because other things dominated the headlines, is that the OBR took away roughly double that £27bn in Osborne’s final budget in March, because it took a gloomier view about productivity after the publication of poor official data.

Even its gloomier view assumed a significant pick-up in productivity growth, to 2% by 2019, not far from its long-run average. Without that, the prospects for growth, living standards and the public finances would have been notably worse.
Hammond is a fiscal conservative and will not let rip with the public finances. He also knows, because he mentioned it in giving evidence to the House of Lords, that there are huge regional variations in productivity in Britain. Put simply, if the rest of the UK matched London’s productivity performance, which is 30% above the national average (measured by gross value added per hour worked) this country would be near the top of the international comparisons rather than languishing near the bottom.

This tells us, for a start, that anything that seriously damages the London economy over the next few years would hurt the economy as a whole. Undermine your highest-productivity region and the country’s ability to improve living standards and fund public services would suffer. The aim must be to lift the rest of the economy up to London’s high value-added, high productivity levels, not drag the capital down. George Osborne, who on Friday launched his Northern Powerhouse Partnership think tank, understood this very well.

Can Britain become a high-productivity economy? Everything these days has to be seen through the prism of the Brexit vote, and it could go either way. To the extent that employers have found it too easy to find labour as a result of immigration, and have chosen employment over investment, there could be a positive effect on productivity. After all, one reason why French productivity is so much higher than in Britain is because of its inflexible labour market. French businesses choose to invest rather than recruit, though high unemployment is the unfortunate side-effect.

A new system of controlled immigration, prioritising skilled migrants, could help to boost productivity, partly because of their direct contribution and partly because a reduction in the numbers of unskilled migrants would force employers to more aggressively seek productivity improvements.

Against this there are factors which could push Britain towards even lower productivity. One is the threat to the London economy, and particularly the financial services sector, from leaving the single market. London will still be the financial capital of Europe, indefinitely, but it could retain that position even if it lost 20% or 30% of its activity. Any such loss would, however, be negative for the economy.

The other is the outlook for business investment, including foreign direct investment. Foreign investment has been an important driver of productivity improvements in Britain. On average, foreign-owned businesses demand and achieve higher levels of productivity than their domestic competitors.

When business investment – both domestic and foreign – boomed in the 1980s, the talk was of a British productivity miracle under Margaret Thatcher. When it did so again, in the 1990s, the healthy productivity numbers described above were the result. But it is a long time since business investment has boomed, and bodies such as the British Chambers of Commerce and Institute of Chartered Accounts have warned that it is likely to fall over the next couple of years.

Productivity could go either way in this new era. As a first step on the road to improving productivity, Hammond will need to come up with measures that encourage business investment in an uncertain environment and provide reassurance to a City of London that fears land grabs from the rest of Europe and the rest of the world. Can it be done? Nobody told him that his new job was going to be easy.

Sunday, September 11, 2016
May starts on the long and winding road to Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Summer is turning to autumn, though the weather has yet to adjust in some parts of the country. An Indian summer is perhaps appropriate for post-Brexit Britain, though readers will be aware that the term originated in North America, not the subcontinent.

We are, of course, not yet post-Brexit Britain, though at some point we will be. In a moment I shall talk about the three stages of Brexit.

First, what do we know so far? The shock predicted here duly happened, reflected in a sharp fall in sterling and an immediate drop in confidence and activity. Despite a small recovery, the pound’s average value against all currencies remains 9% below pre-referendum levels and 13% lower than a year ago. Many people who in the past would have regarded a big fall in the pound as a sign of failure have become enthusiastic devaluationists.

The shock has been contained. No prediction of an immediate dive into recession was ever made in this column – I can’t speak for George Osborne – and indeed I was surprised at the extent of the slump in some of the surveys in July, which deteriorated at a faster pace than when the global financial crisis hit.

On July 31 I wrote that confidence could be rebuilt and the shock contained, as long as common sense prevailed and policymakers reacted. So it has proved.

The Bank of England, despite much misplaced criticism, has been instrumental with its “whatever it takes” measures, in turning sentiment around. All the August survey improvements followed its actions.

The swift transition to a new administration under an apparently sensible prime minister has also been very helpful. Remember that we could, by now, have only just seen the end of a bruising Tory leadership contest. Anybody who needs reminding of how unsettling that could have been should recall Andrea Leadsom’s brief leadership campaign, the strange bunch of Tory MPs on their “Leadsom for leader” march down Whitehall, and Boris Johnson’s odd endorsement of her. For that, even more oddly, he was rewarded by Theresa May with the job of foreign secretary.

There have been other confidence-enhancing factors. The Brexit vote did not provoke a wider crisis in Europe. Markets, meanwhile, remain obsessed with monetary policy. Brexit meant, not just lower rates in Britain but less likelihood of higher rates elsewhere, so boosted stock markets. Perhaps disturbingly, the market reaction to a Donald Trump victory in America might be dominated by what it means for the Federal Reserve’s next interest rate decision.

This is the first stage of Brexit, and we are only a little way through it. It is, if you like, the phoney war stage, when nothing important has actually happened. The second stage will begin when the government invokes Article 50 of the Lisbon Treaty, probably in the first half of next year, and begins the formal two-year process of exiting from the EU.

Stage three is when that process is “complete” and Britain begins the formal task of negotiating her post-EU future with the rest of the world. Complete is in inverted commas because nobody expects Britain to have fully or even mainly extracted herself from the EU within two years. Many EU laws will remain on the UK statute book.

Sharp-eyed readers will have noticed that there might have been only two stages of Brexit. Before the referendum Downing Street suggested that Article 50 would be invoked immediately in the event of a Brexit vote, a view endorsed – at least for a few weeks – by the Labour leader Jeremy Corbyn.

Stage one has some way to go and, while most of the recent evidence has been reassuring, it would be wise not to get as carried away as some of the tabloids have. Long experience has taught me that upside surprises are often followed by downside ones.

The very level-headed Institute of Chartered Accountants in England and Wales (ICAEW) said in its new forecast on Friday that the government needs to act quickly to prevent a slump in business investment this year and next. The big worry in stage one is that falling business investment coincides with weaker consumer spending, as households are hit with rising prices. It does not have to happen – the pass-through from a lower pound to inflation may be less than feared - but it is a significant risk.

The National Institute of Economic and Social Research says the economy has been close to flat-lining since April, and that there remains a heightened risk of a technical recession – two successive quarters of falling gross domestic product, between now and the end of 2017.

That covers the period straddling the end of stage one and the start of stage two. What the government does between now and the invoking of Article 50 is important, not least Philip Hammond’s first big set of announcements in his autumn statement on November 23. The new chancellor is clearly not one to rush things, though has hinted at more infrastructure spending.

Even more important is what the government says when it invokes Article 50. May said last week she does not want to give a running commentary on Brexit, or reveal her negotiating hand, not least because she is not yet sure what it will be. But clarity, if not full detail, will be needed when the formal process of exiting from the EU begins. Business will need much greater certainty than it has now.

Achieving that certainty, particularly when it comes to stage three and Britain’s post-Brexit future is perhaps the greatest challenge. Sir Andrew Cahn, the former head of UK Trade & Investment, the official body, knows what he is talking about when he says it will take a decade or more to negotiate post-Brexit trade deals with the big global economies. That process will not start until we have formally left the EU.

Where Britain ends up, despite the bullish talk of early trade deals with countries such as Australia, represents a huge challenge, and is a recipe for continued uncertainty. One example of that was provided a few days ago by the Construction Products Association, whose industry forecasts are closely-watched in the sector.

Normally it produces forecasts for five years ahead, important for a sector that has to plan for the long-term. This time, it has decided it can only do so to cover the period until the end of 2018, beyond which, it says, there is just too much uncertainty to produce sensible forecasts. Its central forecast is for a mild construction recession next year, with optimistic and pessimistic scenarios on either side of it.

The government will need to work hard to minimise uncertainty and maintain confidence through the long process of forging Britain’s new place in the world. Nobody in government pretends that will be easy.

The prime minister does have one important advantage, however. Because there was no workable policy content in the Brexit campaign, and certainly no useable economic policy content, she starts with a blank sheet of paper. As we have seen with her dumping of the Australian points-based system, described here on May 29 as thoroughly unsuitable for Britain, it is up to her to define what she means by Brexit. A pragmatic approach beckons, which could succeed. In coming weeks, when events permit, I shall describe some elements of what that pragmatic approach should involve.

Sunday, September 04, 2016
Now is not the time to get rid of cash
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The other day I was queuing up at the bank, waiting while the woman in front of me handed over a large bundle of cash to pay her gas, electricity and phone bills. As we waited patiently she explained to the cashier she did not have a bank account, preferring to do everything in cash.

If some economists have their way she will not be able to do this much longer. The Bank of England is about to release the new, long lasting plastic (polymer) £5 note but some economists say physical cash is a relic of a bygone age, which should be consigned to the incinerator of history.

You may recall Andy Haldane, the Bank’s own chief economist, who has been saying one or two controversial things in these pages over the summer, floated this idea in a speech a year ago. Willem Buiter, chief economist at Citi, the global bank, and a Bank alumnus, has also done so.

Now Kenneth (Ken) Rogoff, former chief economist at the International Monetary Fund (IMF), a longstanding abolitionist, has devoted an entire book to scrapping cash. The Curse of Cash, from Princeton University Press, is published this week.

Rogoff is always worth listening to. His work with Carmen Reinhart on previous financial crises – eight centuries of them – was invaluable in informing the path out of the 2007-9 crisis. His related work on government debt and the safe limits on it, while it did not go unchallenged, was influential.

Surely all this is very different from the case for abolishing cash? After all, though we do not use notes and coins as much as we used to, they still account for almost half of all payments in Britain. Cash may not be quite the king it was but it has not yet been dethroned.

Rogoff, however, makes a persuasive case. “There is little question that case plays a starring role in a broad range of criminal activities, including drug trafficking, racketeering, extortion, corruption of public officials, human trafficking and, of course, money laundering,” he writes.

It is also central to illegal immigration, and the exploitation of both legal and illegal immigrants. Cash allows unscrupulous employers to bring in illegals and to pay them, and other workers, on a cash-in-hand basis, often well below the minimum wage.

Those two arguments have been around a long time. Rogoff’s third is particularly topical, which is why there is a renewed interest in the abolition of cash. While some central banks have moved to marginally negative interest rates to boost their economies – the European Central Bank and Bank of Japan most notably – they are constrained from moving more aggressively into negative territory by cash. Who would hold Treasury bills or other financial instruments with a negative interest rate of, say, 3% or 5% - losing money by doing so – when the interest rate on cash cannot fall below zero?

As he puts it: “The main obstacle to introducing negative interest rates on a larger scale is legacy paper currency, particularly the large-denomination notes that would be at the epicentre of any full-scale run from Treasury bills into cash.”

At this point some will be shaking their heads in disbelief. Zero or near-zero interest rates are bad enough. Surely seriously negative rates – paying the banks to hold your deposits - would be a disaster? His response, which will persuade some but not all, is that it is better to have a short burst of negative rates to lift economies onto stronger growth paths than a decade stuck at zero.

Governments, of course, make money from printing and coining cash, so-called seigniorage. It is not to be sneezed at, averaging around 0.4% of gross domestic product (GDP) in America and about half that in Britain. Even this is small beer, however, compared with the potential benefits of clamping down on illegal activities and aggressive tax avoidance.

What about the practicalities? Technology has moved on. I still take innocent pleasure in making a contactless payment with a debit card, only partly tempered by the fear that somebody else could be doing so just as well if they got hold of it. The technology exists for many, probably most, cash payments to be made electronic.

How about the unbanked? According to the Financial Inclusion Commission, 1.5m adults in Britain do not have a bank account and about half of people with a basic bank account choose to manage their money in cash. Rogoff says governments should take the lead in getting everybody into a bank account and a debit card. Indeed, there are sound public policy reasons for doing so. Financial exclusion often goes hand in hand with economic and social exclusion.

So is it case proven? Not quite. Negative interest rates still make me very uneasy and, as we have seen in recent years, emergency monetary policy moves have a habit of becoming permanent. If the existence of cash acts as a constraint on central banks cutting interest rates well below zero that is no bad thing.

This may also be a very bad time to advocate the abolition of cash. While cash’s role in payments is in decline, demand for notes and coin is accelerating. It rose sharply during the worst of the crisis and is rising again now. The 12-month growth rate of notes and coin, 8.2% in July, was the strongest since August 2009. Some of that is because people still do not trust the banks, especially when zero rates give them little incentive to keep money in them. Telling people they have to throw their lot in with the banks at this time would risk a popular uprising.

Where Rogoff is on very solid ground is when he says the process of weaning us further off cash should begin with the abolition of high-denomination notes. These are used disproportionately in illegal activities and money laundering and serve no useful social purpose. Already the European Central Bank has said it will not supply any more 500-euro notes and the Bank has hinted that the switch to polymer could be an opportunity to phase out the £50 note. Cash is not going to disappear, but we can do more to prevent its misuse.

Finally, before leaving money, I shall throw an intriguing thought your way. There appears to have been a post-referendum acceleration in the growth of the money supply, more broadly defined than just cash.

One measure, which brings together all the different ways of calculating the money supply, known in the jargon as Divisia money, accelerated in July to 10.2%, its fastest growth rate since current records began in 1999. Costas Milas, an economist at Liverpool University, who spotted it, points out that strong growth in this measure is normally associated with robust rises in GDP, and it should get a further boost from the Bank’s relaunching of quantitative easing. Interesting.

Sunday, August 28, 2016
Hammond faces a steeper climb up debt mountain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is back to work, in my case after escaping to the Outer Hebrides, where the people were a lot friendlier than the weather and where I discovered that Breakfast means Breakfast.

On the return-to-work theme, much has been made of Theresa May’s challenging in-tray, and the fact that the new prime minister has a lot on her plate. But do not underestimate the tricky terrain faced by Philip Hammond, the new chancellor, and the Office for Budget Responsibility (OBR), which will help frame his decisions this autumn.

Hammond, who has been described as “swashbuckling” by the Financial Times, perhaps for the first time in his life, has been helped by the fact that the immediate post-referendum shock has been contained. The actions and assurances of the Bank of England and the swift transition to a new government helped a lot; do not forget that we could now have still been in the middle of a Tory leadership contest.

So did the plunge in the pound, probably not mainly by boosting exports but by encouraging more foreign visits to bargain-basement Britain, as predicted here. Selling Swiss watches to tourists has been good business, while retailers in general have done better than they feared. For a fuller reading of the economy’s performance this summer, we will this week get the first of the purchasing managers’ surveys for August, following their plunge in July.

The welcome absence of an immediate crisis only partly eases the pressure on the chancellor, however, and barely makes the OBR’s task any easier. It, remember, has the job of assessing the outlook for the public finances, not just in the short-term, but also in the medium and long-term. It will have to make assumptions about Britain’s post-Brexit future, including future trading relationships, at a time when the government is only starting to grapple with these questions.

Hammond’s autumn statement, drawing on the OBR’s work, has become the key focus for the government’s economic policy approach in this parliament. As Paul Johnson, director of the Institute for Fiscal Studies, has pointed out, we thought George Osborne’s autumn statement last year had performed that role, but things have moved on. The king is dead, long live the king.

An expectation has built up that the chancellor’s promised autumn “reset” of policy will include a sizeable fiscal stimulus, a growth-boosting “giveaway” in the form of additional infrastructure spending, tax cuts, or both.

This is despite the fact that, according to most economists, the prospect is for bigger budget deficits and more government debt even if he chose to do nothing. The latest Treasury compilation of independent forecasts has growth of 0.7% next year, down from 0.8% last month and 2.1% in June. 2017 was always expected to be the year of greatest weakness, with business investment and employment subdued and households suffering an income squeeze as a result of the rise in inflation resulting from sterling’s fall.

Slower growth, in turn, feeds through to higher borrowing, and thus more debt. In June, the average forecast was that borrowing this year (2016-17) would be £61.7bn, falling to £46.7bn next year, 2017-18. Now the predictions are for £66.9bn and £59.8bn respectively.

Should Hammond, knowing that Osborne’s old target for a budget surplus by the end of the decade had been dumped by May even before she appointed him chancellor, throw caution to the wind? Should he go for a package of big personal and business tax cuts, as well as a significant infrastructure boost, to show that Britain is determined not to succumb to gloom? After all, those once-cherished AAA sovereign debt ratings have now all gone.

Well he could, but there will be plenty of voices, including in the Treasury, who will advise him not to. The situation we are in now is in no way comparable to the global financial crisis but there are lessons to be learned from that period. Back then, Alistair Darling unveiled a modest fiscal stimulus to offset the so-called demand effects of the downturn, mainly in the form of a temporary cut in VAT from 17.5% to 15%.

What was not fully realised was that the crisis also inflicted damage on the supply-side of the economy, hence subsequent very weak productivity growth and progress in reducing the budget deficit being slower than hoped.
The OBR, in framing the outlook for the economy and the public finances will be required to take into account both the demand and supply-side effects of leaving the EU. Assessing the latter, as noted, could be the trickiest of tasks.

For those urging a cautious approach on the chancellor, however, there is likely to be plenty of ammunition. These demand and supply-side effects imply significantly higher government borrowing for the rest of this decade, after which demographic factors in the form of an ageing population kick in and, as the OBR has previously warned, put further upward pressure on borrowing and debt.

Allan Monks, an economist with J.P. Morgan, has tried to pull all this together. Even assuming that the OBR is not as gloomy as the Bank on the hit the economy, and its supply potential, and assuming Hammond unveils a modest fiscal stimulus in the autumn, he comes up with numbers in which borrowing stays close to 4% of gross domestic product until 2018-19, before dropping to just under 3% of GDP in 2019-20 (which was intended to be the first of Osborne’s surplus years).

The cumulative addition to borrowing over the next five years, including this year, is more than £200bn, at today’s prices. For those concerned about government debt, there could be quite a bit more of it.

For this reason, we may see a more cautious approach from the chancellor this autumn than some hope. Yes there will be more infrastructure spending, but perhaps with the government as the enabler of private sector spending – permitting new airport runways for example – than spending itself. Given that the challenge is not just a short-term one, temporary tax cuts do not seem like an obvious thing to do. But it is early days. Guidance at the moment is that the autumn statement might not be until the last week of November. That is a long time in politics - and in economics.

Sunday, August 07, 2016
The Bank's big guns won't stop us taking a hit from Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

You will forgive me, I hope, for being in a state of excitement since Thursday lunchtime. I cannot remember exactly what I was doing in March 2009, the previous time interest rates were cut. I can confirm I had fewer grey hairs back then. But, having sometimes despaired about whether I would ever see another interest rate change, the Bank of England duly delivered.

True, until June 23rd it seemed much more likely that the next rate rise would be up rather than down, though not yet. And true, we thought we had seen the last of quantitative easing (QE) from the Bank. Its invention of a new term funding scheme (TFS), intended to ensure that the rate cut from 0.5% to 0.25% gets fully passed on by the banks and other lenders, is another initiative that owes its life to the referendum result.

I’ll come on in a moment to the Bank’s measures, and whether they will work. Even without the additional QE and the launch of the TFS, however, it was clear that this rate cut was more controversial than most. Before it was announced, some former members of the Bank’s monetary policy committee (MPC) joined other pundits in arguing against it.

One tabloid newspaper which had supported Brexit aggressively bemoaned the fact that its elderly readers were about to be hit with a double whammy of lower interest rates on their savings and higher inflation. To which the answer is, they got what they voted for. Unless, of course, those older readers backed Brexit because they believed George Osborne’s warning that it would mean higher interest rates.

What were the arguments against cutting rates? One was that it is still early days, and that we do not yet know how big a negative hit to the economy the Brexit vote has caused, a question I put to Mark Carney at Thursday’s press conference. The answer, from his colleague, the deputy governor Ben Broadbent, was that the plunge in the composite purchasing managers’ index – the biggest monthly fall on record – provided the Bank with a pretty clear steer.

It would have been unthinkable in the past for the MPC not to respond to such a plunge in the PMI. Even aiming off slightly from it, as the Bank has done in its forecasts, produces an abrupt slowdown. Other evidence, from property and other sectors, pointed to the clear need for a stimulus. Bank insiders say a report from the Bank’s own agents was misreported as suggesting there was no negative Brexit effect on the economy.

The agents, as reported in Thursday’s inflation report, have found that the decision to leave will have a measurably negative impact on investment, hiring and turnover over the next 12 months. Above all, the Bank has to anticipate as well as respond to events. It anticipates a very sharp slowdown in the economy, so action was required. The referendum “regime change” described by Carney – hopefully a bit more successful than the one which got rid of Saddam Hussein – needs some heavy nurturing.

What about another argument, that this is a time, not for the Bank to squeeze the last drop out of what it can do on interest rates, but for the government to take up the baton with fiscal policy? Why not a big increase in infrastructure spending – taking advantage of already very low government borrowing costs – or tax cuts?

There may be a place for both of these things. Increasing infrastructure spending is easier to defend at a time of high levels of government borrowing than cutting taxes, because the so-called multiplier effects – the beneficial impact on growth and therefore government revenues – are larger. But infrastructure is the slow-moving tortoise of economic policy, while monetary policy is the hare. Over time, higher levels of infrastructure spending will be more beneficial to the economy than sustained near-zero interest rates. But as a short-term response to an immediate downturn it is pretty near hopeless.

The third objection to a rate cut was that it would squeeze margins at the banks and other lenders which, if not posing the kind of problems they encountered in 2008-9, might make them less willing to lend, and would make them reluctant to pass the rate cut on to households and businesses.

Though the Bank said 18 months ago that the “effective lower bound” for rates was no longer 0.5% but lower, the banks seem to have been slow to wake up to this. Fortunately for them, the Bank’s £100bn new funding scheme, the TFS, should deal with the problem. Banks that maintain or increase their borrowing will be able to borrow at close to Bank rate, implying funding costs well below those available in wholesale markets. It is the most imaginative aspect of the package of measures announced on Thursday.

Will it, the quarter-point rate cut, £60bn more of quantitative easing (taking the total to £435bn) and £10bn of corporate bond purchases, work? The Bank used its big guns because it thinks the economy needed it and also to show it has not run out ammunition. Another rate cut, to 0.1% or 0.05% (though not negative rates), is assumed by most MPC members before the end of the year. There could be additional QE. We have embarked on another leg of a monetary easing cycle that first began almost a decade ago.

Even with the Bank’s package, growth will slow to a crawl for the rest of this year and be very weak at 0.8% next year. Unemployment will rise by around a quarter of a million. Without it, the Bank thinks unemployment would have increased by half a million or more, with very little economic growth over the next 18 months.

Could the Bank’s actions backfire, by reducing rather than boosting confidence? Is there a danger that by drawing attention to the post-referendum weakness of the economy, it could add to uncertainty?

That danger has been greatly overstated. The downward revision to the Bank’s growth forecast for next year (from 2.3% to 0.8%) was the largest since it became independent in 1997. But importantly, the Bank offered reassurance that, with the right policies, the economy can be guided through these short-term difficulties without falling in to outright recession. That will still leave some substantial long-term difficulties, of course.

The Bank’s big guns will not fire up the economy but they will prevent a sharper slowdown than would otherwise have happened. The Bank has done its bit. It could not have done much more.

Sunday, July 31, 2016
Confidence has crumbled - but it can be rebuilt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We are at an interesting moment, something which will be of intense interest to future economic historians. Business and consumer confidence have taken a battering since the Brexit vote on June 23. Is the slump in confidence an inevitable harbinger of very tough times ahead for the economy, a recession, or can it be turned around?

That confidence has fallen sharply is not in doubt. One of the longest running measures of business confidence, dating back to the 1950s, is the CBI’s industrial trends survey. Its latest reading, published a few days ago, was a bit of a shocker.

Optimism over the business situation fell at its fastest pace since January 2009, which was in the depths of the global financial crisis. The drop in confidence was similar to previous periods in the survey’s history when the economy has been in recession.

It is not just businesses which are feeling downbeat. In the immediate aftermath of the referendum GfK, which has been monitoring consumer confidence in Britain since the 1970s, released a “snap” survey showing a sharp fall.

Some suggested that this was a knee-jerk reaction which overstated the true picture, and that confidence would soon settle down. Well on Friday GfK released final figures for July, which showed that the drop was even more dramatic than it had first thought. Instead of falling by eight points, confidence this month was down by 11 points compared with the pre-referendum period.

This, to put it in perspective, was the biggest fall in confidence for 26 years – bigger even than during the financial crisis. Consumers are particularly gloomy about the general economic outlook though they are also worried about prospects for their personal finances.

This downbeat mood among consumers has not been without real consequences. As well as its industrial trends survey, the CBI released its distributive trades survey last week. It showed that retail sales have fallen this month at the fastest pace for more than four years.

We are, as I have noted before, still in the dark when it comes to hard data. In some of the sillier corners of Fleet Street, the second quarter gross domestic product figures, which showed a rise of 0.6%, were greeted as a post-Brexit triumph.

In fact the figures contained virtually no information collected since the referendum and were boosted by an unexpected and slightly odd looking leap in industrial production way back in April. Service sector growth slowed compared with the first quarter and the construction industry, in figures which are admittedly volatile, is officially in recession, shrinking for a second successive quarter.

It would be wrong to deny, however, that on the available evidence we have, the picture in recent weeks has been mixed. At the gloomy end of the spectrum, apart from the confidence readings, was that “flash” purchasing managers’ index, touched on last week. Its drop from 52.4 to 47.7 reflected not just a fall in business expectations, but also in output and new orders, particularly in the service sector.

It was enough to persuade Martin Weale, the outgoing “hawk” on the Bank of England’s monetary policy committee (MPC) to sound the alarm. The figures, which he described as “the best short-term indicator we have”, were “a lot worse than I had thought” he said.

Other evidence has been a little less scary. The CBI’s industrial trends survey, despite the plunge in confidence reported by participants, was relatively upbeat on output and new orders. Some companies too have chosen to emphasise their confidence in Britain since the referendum, such as GlaxoSmithKline’s pledge to invest £275m in its UK manufacturing and McDonald’s promise of 5,000 new jobs by the end of next year. Lloyds Bank announced job losses but its own business barometer survey was surprisingly upbeat.
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My informal soundings suggest that for many firms it is indeed business as usual, with no discernible impact on activity in the past few weeks, while for others the uncertainty has hit home, and quite hard. Most of the gloomier ones will, however, take stock after the summer holidays rather than acting precipitately.

That suggests there is time to turn things around. The good news about consumer confidence is that, while it has fallen a lot, it has done so from very high levels, so much so that even after its drop this month it is well above where it was during the crisis, or even as recently as 2013. This is not surprising, given the recent experience of strong employment growth and rising real wages. Households are downbeat but they have not thrown in the towel.

As for business confidence, there have been times when its plunge has either been a harbinger of recession, or has occurred in a recession. Most, it should be said, have been when the global economy has also been in trouble. And, while the world economy is not in great shape now, the clouds hanging over it have lifted a little since the start of the year. America’s Federal Reserve hints at a rate rise in the autumn because the risks to US growth have diminished, notwithstanding Friday's weak second quarter GDP figures.

There have been a couple of occasions in the past quarter of a century when business confidence has fallen very sharply without signalling impending recession. One was in the autumn of 1998 when the simultaneous Asian financial crisis, Russian bond default and the failure of the Long Term Capital Management hedge fund spooked markets and central banks. The other was in the aftermath of the 9/11 attacks on New York and Washington.

In both cases the Bank responded with aggressive cuts in interest rates and the danger passed. There was no recession. The Bank will respond again this week. It does not have a huge amount of room to cut rates but it has other weapons in its armoury, including quantitative easing, which we did not even think about a decade and a half ago.

The Bank, of course, cannot do everything. What the politicians do also matters. At the moment, having found themselves in jobs they did not expect to be doing, including the new prime minister, they are mainly treading water. There will come a time, however, when bland words of reassurance will have to be followed by action. We face what could be one of the most interesting autumn statements for many years, yet without much clue about what the “reset” of fiscal policy hinted at by Philip Hammond might mean.

In the meantime, the small group of headbangers in the Tory party who talk of an early “hard Brexit” and distancing Britain from the single market as quickly as possible would do well to shut up. If anything is like to further undermine business confidence and turn the existing fall in optimism into something more concretely negative for the economy that is it.

Sunday, July 24, 2016
Bank will fight the economic downturn, not the upturn in inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

2015 was an unusual year, though not as extraordinary as 2016 is turning out to be. Last year was strange because for the first time in more than half a century there was no inflation at all. Inflation, which in one way or another has dogged most of our lives, disappeared.

Indeed, there were three months last year when Britain experienced technical deflation; consumer prices lower than a year earlier. Before anybody writes in, not all inflation disappeared; there was still plenty of it in the housing market. But the overall price level stabilised.

That brought direct benefits to households. Even modestly rising average earnings of 2% to 3% looked good when set against zero inflation, delivering solid gains in real incomes and boosting consumer confidence.

Inflation remains very low now. The latest figures, for June, showed a rate of just 0.5%, up from 0.3% in May. We have, however, said farewell to the days of zero inflation, and of flirting with deflation. From here, the direction is up.

Some of this was going to happen anyway, as a result of the recovery in oil and commodity prices, and their earlier falls dropping out of the year-on-year comparisons. It has been given an additional boost, of course, by the pound’s post-referendum fall.

The extent of that inflation boost is a matter of some debate. The consensus in the new independent forecasts assembled by the Treasury since June 23 is that the economy will experience mild stagflation next year, with growth of just 0.5% and inflation by year-end of 2.5%.

Mild, however, is the operative word. After all, 2.5% inflation is only a smidgeon above the official 2% target. Some forecasters, it should be said, see a much bigger pass-through from the lower pound, and predict 4% inflation next year, but that is not the majority view.

Even so, the coming rise in inflation has two important implications. One is that, unless there is an accompanying increase in the pace of pay rises, there will be a return to at best stagnant growth in household real incomes, at worst falling living standards. In the latest official figures, for May, total pay was only up by 2.1% on a year earlier. A squeeze on real incomes will have implications for consumer spending and consumer confidence.

The second, which is as interesting, is what it implies for monetary policy and, in particular, interest rates. Not for the first time in recent weeks I have felt a lot of sympathy for Mark Carney. In contrast to the dithering and confusion that marked the response to the onset of the global financial crisis nine years ago, his has been a textbook central banker reaction.

He offered reassurance – and a promise of £250bn of additional liquidity – in the early morning of June 24. Six days later, in a speech at the Bank, he pledged that the Bank would do its utmost to “support growth, jobs and wages” during this time of uncertainty.

Carney was not the only one to offer reassurance. So, once he got over the shock of the referendum result, did George Osborne, the former chancellor. The rapid coronation of Theresa May as prime minister, also helped to settle nerves.

One response to Carney’s success in helping to calm market nerves, which is that he was wrong to warn of the economic dangers, can be easily dismissed. He has done exactly what everybody is supposed to do: accept the result, deal with the consequences, and move on.

What is also clear, however, that the calming of nerves has revived a debate within the Bank of England. In May, when the Bank published its last inflation report, it talked of a “challenging trade-off” between the inflation and growth impacts of a vote to leave the EU. Should the Bank, in other words, respond to the threat of high inflation or the risks of a prolonged period of weak growth?

We know now that different members of the monetary policy committee (MPC) have different views on this. One, Jan Vlieghe, had already seen enough by July 14 to vote for a rate cut. Carney, in his June 30 speech, said “some monetary policy easing will likely be required over the summer”.

Andy Haldane, the Bank’s chief economist, said just over a week ago that he would “rather run the risk of taking a sledgehammer to crack a nut” and said “a package of mutually-complementary monetary policy easing measures is likely to be necessary”.

But not everybody agrees. Martin Weale, whose final MPC meeting will be next month, struck a cautious note, saying he would need to be sure that weakness in the economy will be large enough to “more than to compensate for any overshoot in inflation”.

Kristin Forbes, another MPC member, wrote in the Daily Telegraph that until there was more hard evidence, her instincts were to “keep calm and carry on”. She also pointed out that there are costs as well as benefits to cutting rates, and not just for savers.

So what does all this mean? Will the Bank cut on August 4, or not? One thing the current debate has done is kill the idea that the Bank is Carney’s fiefdom, and that the rest of the MPC is just there to carry out his instructions. That was said a lot, including by former Bank insiders, in the run-up to the July 14 meeting at which the MPC surprised the markets by holding rates. We should hear less of it now.

I still think, however, that there will be a cut on August 4, probably of 0.25 points, along with other measures, including more quantitative easing and a rebooting of the funding for lending scheme. The justification will come from a sharp downgrading of the Bank’s growth forecast and the argument that it is right to “look through” the temporary effects on inflation of the pound’s fall.

Will it be the right thing to do? Until Friday, and the release of an alarming new purchasing managers' survey, there was a debate to be had. The Bank's own agents had found little evidence of a sharp post-referendum slowdown. The composite purchasing managers' index plunged from 52.4 to 47.7, however, with its services component recording its sharpest reversal in its 21-year history. How long this very deep gloom lasts can be debated. For the moment, however, the MPC has little choice but to respond aggressively.

Sunday, July 17, 2016
Osborne: much better than his critics said, but plenty of unfinished business
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

So no more George Osborne. Hello Philip Hammond. But 0.5% Bank rate, the record low rate that lasted for the whole of Osborne’s chancellorship, lives to fight another day. I’ll come on in a moment to the question of whether the Bank’s decision not to cut on Thursday was the right thing to do.

On Osborne, the game was up for him in the early hours of Friday June 24, though he made a spirited effort to demonstrate he was irreplaceable in the days that followed. Sadly, none of us are.

I’d like to say I’ll miss my fireside chats with the former chancellor at No.11. I’d like to say it but I can’t. They never happened, and they won’t now.

I do, however, feel quite a lot of sympathy for him. The referendum was David Cameron’s idea, not his. No chancellor, and certainly not Osborne, would have taken the risk. As it is, Cameron left office with the cheers of the House of Commons ringing in his ears, while Osborne left by the back door of 10 Downing Street.

Now it is over, how should we view the Osborne supremacy? Was he a good chancellor? There have been few recent chancellors who have divided opinion more. My view is that he was not as bad as his critics alleged, nor quite as good as he and his supporters thought.

His own parting shot, that he hoped he had left the economy in a better state than he found it, can be answered in the affirmative. The recovery got stronger – latterly becoming the strongest in the G7 – and the employment rate rose to record levels. Never before has a higher percentage of the 16-64 workforce (74.2%) been in work. In 2010 Labour said the private sector would never replace the public sector jobs being cut. It did, several times over.

The strength of employment was in contrast to the weakness of wages, damagingly so during the bouts of high inflation, notably in 2011, during his chancellorship. Collectively, people priced themselves into jobs. Osborne’s last big announcement, the introduction of the national living wage, was an attempt to break that low-wage cycle.

Despite weak wages, Osborne presided over a post-crisis decline in inequality – not that you would notice from the debate – and an increase in the share of income tax paid by those at the top of the scale.

His big ambitions have, however, mainly been unachieved. The budget deficit, public sector net borrowing, was £75bn, 4% of gross domestic product, in 2015-16, his last full year as chancellor. That is better than the level of borrowing he inherited, which was more than 10% of GDP, but is a long way from job done. The budget surplus he coveted will not even be a target any more.

His “march of the makers” – a recovery built on manufacturing – did not happen; industry remains below pre-crisis levels. His ambition of doubling exports by 2020 will not happen; it will be missed by a huge margin. The Northern Powerhouse is still a work in progress. Pension reform is incomplete.

But Osborne was more pragmatic than his critics allow; some of his missed deficit targets were unintended, but some of it was because, as an austerity chancellor, he also prioritised cuts in personal and corporate taxes. It would have been possible to eliminate the deficit but the past few years would have been far grimmer. As it was, he managed to maintain the confidence of the markets while presiding over a slower pace of deficit reduction than he intended.

Reducing the deficit was, however, important, and lesser chancellors would have been diverted from the task much more than he was. A deficit of 4% of GDP is still too high, but entering this period of post-Brexit economic uncertainty with it much higher would have increased Britain’s vulnerability. Even so, Britain’s sovereign debt rating has been downgraded since the referendum.

His was, however, a very messy chancellorship. His last budget, in March, contained more individual measures than anybody can remember, and was followed by the forced abandonment of its two headline announcements; disability cuts and turning all schools into academies. His own joke about the 5:2 diet, that in two out of every five budgets he had to eat his own words, was a little too close to the truth. Having mocked Gordon Brown for making the tax system much more complex, he leaves it even more so. History will remember him as a chancellor who took over in a crisis and helped steer the country out of it. It is unlikely to remember him as a great reformer.

How will history judge Mark Carney’s period as Bank governor? Thursday’s decision to leave rates on hold, albeit with what looks like a pretty clear promise to make a move next month, was a sensible one. The monetary policy committee (MPC) fears that that the problems in commercial property and what looks like a sharp slowdown in the housing market presage a wider slowdown in the economy.

But it wants to have a new, fully-worked forecast before deciding on its course of action, and it will have that in three weeks’ time. MPC members have discussed “various possible packages of measures”, which they are ready to unleash next month. It will be surprising if that does not include a cut in rates.

And what about Philip Hammond? Had the Tories won an outright majority in 2010 he would have been Treasury chief secretary, the post he had shadowed in opposition. He would have been responsible for controlling/cutting public spending.

As it is, his route to the Treasury has been a circuitous one, via transport secretary, defence secretary and foreign secretary. In all those roles he has been quietly competent, never making too much of a fuss; the archetypal safe pair of hands.

That is not a bad quality for a chancellor, though the same was said of Alistair Darling when he was appointed in June 2007, and his stint at the Treasury over the following three years was anything but quiet; it was one of the scariest for decades, though Darling did well with the hand he was dealt.

The challenges faced by Hammond will be different ones. And, while most people I have come across have greeted his appointment without a huge amount of enthusiasm, an important part of any chancellor’s duties is to offer reassurance. He will probably be quite good at that.

It may also be that, partly as a result of Brexit and the need to negotiate new arrangements for Britain, and partly because of the new prime minister’s declared intent to pursue a wider economic agenda, run from Downing Street, that the Treasury is less powerful than in the recent past.

In the days of Gordon Brown, and more recently in the case of Osborne, the Treasury has called all the shots. It will still be one of the biggest beasts in the Whitehall jungle but it may have to get used to a slightly more truncated role. That may be no bad thing.

Sunday, July 10, 2016
Why we should all mind Britain's very large gap
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This continues to be a record-breaking time, though the records being broken are not necessarily those you would want. So, the pound’s peso-style two-day fall in the wake of the referendum was the biggest in the post-Bretton Woods era, in other words for four and a half decades.

Consumer confidence has also taken a tumble, according to a snap assessment published by GfK on Friday. Having been very high – last year was the best year for confidence in the more than 40 years GfK has been surveying it – the post-referendum dive was the sharpest for over 20 years. People may be more worried about their jobs. Another firm, CEB, which monitors online job postings, says they almost halved in the week after June 23.

These things will, as I noted last week, take time to fully reveal themselves. The problems in commercial property which have led to the suspension of withdrawals in several property funds may be the isolated difficulties of an overextended sector or the canary in the coalmine. It is reassuring, I hope, that banks have been stress-tested against a 30% fall in commercial property values.

This week I want to concentrate on what is potentially both a short-term and long-term problem for Britain. I had planned to look at the current account deficit regardless of the referendum outcome. It is timely to do so now.

Just to be clear on terminology, because I know some people get confused, I am talking here of the current account of the balance of payments, which comprises the trade deficit/surplus on goods and services, primary income (mainly investment income) and secondary income (including transfers such as payments to and from the EU).

That something unusual has been happening to the current account is not in doubt. In the final quarter of last year the deficit reached £34bn, a record 7.2% of gross domestic product. It narrowed in the first quarter, but only slightly, to £32.6bn, 6.9% of GDP. The last time we really worried about the current account deficit was in the late 1980s, at the end of the Lawson boom. Its peak then was however smaller, at 4.8% of GDP.

Why has the current account deficit widened so dramatically? Five years ago, the deficit was close to being eliminated, if only for a couple of quarters. Its widening to record levels is not mainly due to the usual culprit, the trade deficit. Though bigger than is healthy, at 2.5% of GDP, it is pretty close to its average of the past decade and a half, 2.4% of GDP.

The problem, instead, lies on the income side, mainly investment income. Just over a decade ago, during 2005, Britain had a surplus on primary income of 3.1% of GDP. Now there is a deficit of a similar among; exactly 3.1% of GDP in the first quarter. It is the turnaround on investment income which has put the current account into a parlous state.

Why the turnaround? It mainly reflects a substantial drop in the investment income that British residents, and British businesses, are getting from their investments abroad, while foreigners’ earnings on their investments in Britain have held up.

Some of that – about half – is directly related to weak oil and commodity prices. Energy and mining companies have seen their overseas earnings slump. Some of it reflects the fact that Britain’s economy has been growing more rapidly - generating more investment income – than most other advanced economies.

Does a big current account deficit matter? The balance of payments has to balance, as every student is taught. A current account deficit has to be matched by capital inflows.

The Bank of England’s financial policy committee, in its twice-yearly financial stability report last week, put the current account deficit at the top of its list of concerns. As it put it: “The current account deficit is high by historical and international standards. The financing of the deficit is reliant on continuing material inflows of portfolio and foreign direct investment.

“During a prolonged period of heightened uncertainty, the risk premium on UK assets could rise further and overseas investors could continue to be deterred from investing in the United Kingdom. Persistent falls in capital inflows would be associated with further downward pressure on the exchange rate and tighter funding conditions for UK borrowers.”

Incidentally, there is a strand of bonkers criticism around about the Bank and its governor, Mark Carney. Having warned against the consequences of Brexit, he and his colleagues have been quick to take action to minimise those consequences. The Bank’s actions may extend to a cut in interest rates this week. Yet all this, according to some economic illiterates out there, is merely an extension of pre-referendum scaremongering.

Will the risks from Britain’s gaping current account deficit diminish, or will they crystallize, to use the Bank’s phrase, in an even lower pound than we have seen so far? The balance of payments, as noted, has to balance, the question is at what exchange rate it does so.

On the current account itself, there are reasons to believe that over time the deficit will narrow rather than widen to, say, 10% of GDP. The fall in the pound so far will help, though not in the way most people expect. The drop in sterling has a direct translation effect on Britain’s overseas investment income, boosting receipts on assets denominated in foreign currencies. This is the main mechanism the Bank sees through which the deficit will narrow.

The trade deficit may respond to sterling’s weakness. The usual way this would happen is through the so-called “J-curve”, whereby the deficit initially worsens as imports become more expensive but then improves as Britain’s exports become more competitive. It could happen, though as I noted last month, sterling’s 25% fall in 2007-9 was notable for its disappointing impact on exports. Foreign tourists will find Britain cheaper, while British tourists will see the cost of their foreign holidays rise. The Brexit vote could thus see more foreigners flocking to Britain.

The current account could also improve if there is a further recovery in oil and commodity prices, boosting the overseas earnings of firms in this sector. There has been a recovery in prices from the lows of earlier this year, though so far it has only taken us back to where we were in the final months of last year.

Finally, the deficit could narrow if the hit to growth in Britain both reduces demand for imports – already we have seen the first signs of a weakening in new car registrations – and results in lower investment income for foreigners with British investments. This, of course, would be the least desirable way in which the deficit becomes less of a problem.

Will the current account deficit narrow by enough to take it off the Bank’s list of critical risks for the economy? That is the big question. To do so it probably needs to be no more than half its present level of nearly 7% of GDP. Getting there may take some time.

Sunday, July 03, 2016
Carney in a battle to head off a post-Brexit recession
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

What an extraordinary time it has been. During the worst of the global financial crisis I wrote that we had 10 years of big economic and financial stories crammed into about 10 weeks. Something similar has been happening in the past few days.

Even leaving aside what is going on at the top of British politics, which is completely barking, this is an action-packed time. Remember all that agonising about whether Britain’s AAA sovereign debt rating would be downgraded? On Monday, the last remaining AAA rating, from S & P, vanished with a big downgrade and Fitch, another agency, also took us down another notch.

Sterling has tumbled but not yet collapsed, though has hit a 31-year low, while the stock market has almost been a caricature of itself; despair followed by euphoria. I would like to take some reassurance from the euphoria bit though, thinking back to the crisis, I recall that the FTSE-100 was still surprisingly buoyant in the late spring of 2008 and gave little sign of the horrors to come.

Meanwhile, as if on cue, official figures reminded us of one of Britain’s important sources of vulnerability. The current account deficit in the first quarter – the red ink on the balance of payments - was a worryingly large 6.9% of gross domestic product, only marginally down on the record 7.2% of the final quarter of 2015.

So what is going to happen? We are still in a state of limbo in terms of the economic impact, short and long-term, of the referendum decision. There is some preliminary evidence that consumer confidence has taken a hit and a lot of talk of cancelled investment projects but very little hard evidence.

That will be the case for some time. Even the June purchasing managers’ surveys, normally a good indicator of what is currently happening, are based mainly on data collected before June 23. For most surveys, and even more so for the official statistics, we may have to wait until August for hard evidence, and that will only be for the initial impact.

In the absence of that, however, economists have been busy adjusting their forecasts downwards. A sample assembled by Consensus Economics gives an idea. Before the referendum the expectation was for 1.9% growth this year, 2.1% next. Now the numbers are 1.4% and 0.4% respectively. That does not sound too bad, but it implies a technical recession – two or more quarters of declining gross domestic product – between now and next summer.

And, if the consensus is right then, for those nostalgic for one of the high spots of the referendum campaign, it implies that GDP per household will be about £1,450 lower by the end of next year than it otherwise would have been.

Some are even gloomier. The Economist Intelligence Unit, which topped my annual forecasting league table in 2012, predicts an outright recession, with the economy shrinking by 1% next year on the back of a big fall in investment and weaker growth in consumer spending. GDP by the end of next year will be 4% lower than it otherwise would have been. Unemployment will rise, it says, and the budget deficit go back up to 5.5% of GDP (from about 4%) and public sector debt rise to 100% of GDP in coming years, from 84% now.

Why should we go into recession? Business investment, which was falling earlier this year on pre-referendum uncertainty, seems likely to be very weak for some time to come. Consumers, apart from feeling unsure, will be hit by the rising prices that result from sterling’s fall.

And, if you really want to be depressed, listen to the respected John Llewellyn, former OECD chief economist, and his team at Llewellyn Consulting. In a note to clients the firm said: “We are more worried - for the UK, though importantly not for the world - than we were in 2008 or any other post-WWII crisis. And between us we have been present for every one of them. The scale of all this will start to unfold in coming weeks.”

The challenge for the authorities is to turn this gloom around. And, in the state of political limbo in which we find ourselves, that for the moment means the Bank of England. On Thursday I, along with other journalists and a large invited audience from the City, assembled in the Court Room of the Bank of England to hear Mark Carney. There was a frisson when, talking about jobs, the governor asked: “Will I keep mine?” He was putting into words the concerns ordinary people have when times are uncertain but he also faced questions about whether he would survive in a post-Brexit government. My view is that the worst thing you could do for confidence is get rid of the Bank governor, but anything is possible amid the current madness.

Carney, as you will have read, had one important message. The Bank’s monetary policy committee (MPC) had been expecting to raise interest rates over the next 2-3 years. Now it is likely to cut them, even from the record low of 0.5%, starting on July 14. Before August is out interest rates could be zero, and another round of quantitative easing (QE) is a possibility. I do not see negative interest rates but other policy tweaks are possible, including so-called credit easing, with the Bank buying assets other than gilts, and action on the Funding for Lending scheme.

Such moves will help ease the shock to the economy but we should not overstate their potency. A cut in rates from 0.5% to zero does not take us very far. QE may be of limited use when long-term interest rates are already very low. Carney himself made the point that there are limits to what monetary policy can do, and that – even when it is effective – its impact is not immediate.

The best the Bank can do may be to reassure. When Mario Draghi, the president of the European Central Bank, promised to do “whatever it takes” to hold the eurozone together, it helped do so. Carney’s “all the necessary steps” message is in a similar vein. The Bank, like the rest of us, has to hope it helps stop some of the nastier outcomes now predicted by economists from becoming a reality.

Sunday, June 26, 2016
I'm not going to sulk - we have to make the best of a bad job
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

For many people reading this, Friday morning will have dawned as a moment of triumph, of liberation. That was not how I saw it, as you might have gathered from my series of pre-referendum pieces. But, admittedly after a dishonest campaign, the voters decided otherwise. Democracy does not always throw up the outcomes we would like, or think sensible. We face a poorer and more uncertain future.

Despite his “no regrets” statement in Downing Street on Friday, I doubt if David Cameron now thinks that of the referendum that is bringing an end to his prime ministerial career. You only ask a big question of voters if you are sure of the answer. Downing Street thought it was sure of the answer as late as Thursday evening but it was wrong. As it is, a Tory prime minister Sir Edward Heath is most remembered for taking Britain into Europe 43 years ago, and Cameron will go down in history as the prime minister responsible for taking us out.

The Cameron-George Osborne double act, meanwhile, does not have much further to run. As with the referendum outcome, people will have mixed feelings about this. The chancellor has had more than his fair share of setbacks, particularly since last year’s election. As he joked himself, his version of the 5:2 diet is one in which in two out every five budgets he has to eat his words.

Osborne wanted to be remembered as the chancellor who took over at a time of crisis and, while courting unpopularity, fixed the public finances, alongside some long-term reforms, including pensions. Now, the abiding memory will be of the warnings on the economy that he commissioned or co-ordinated not being enough to persuade voters. Indeed, if the evidence of the polls is anything to go by, those warnings backfired with many voters. It is not hard to think who might succeed Cameron as prime minister. A successor to Osborne is rather harder to think of.

Osborne’s efforts were not enough, and neither were those of the overwhelming majority of economists, including highly respected bodies such as the Institute for Fiscal Studies (IFS). Businesses, big and small, were much less influential than expected, even locally. Nissan’s presence was not enough to prevent a big vote for Brexit in Sunderland, nor Honda in Swindon, nor Airbus in Flintshire.

I noted last week that economic arguments would not be enough to prevent a big vote for leave and a very close outcome on Thursday, and so it proved.

Many have said that those of us inside the “bubble” were unaware of the anger out there from the economic have-nots, some of which pre-dates the global financial crisis. I was well aware of such anger, particularly in Wales, the poorest part of the UK, where most local authority areas voted for Brexit. But the Brexit vote, as I also know, included many usually non-political, comfortably-off middle-class voters in the south-east.

One thing I do not have the slightest regret about is setting out the strong economic case for staying in the EU. I doubt it swung a single vote but I would have felt permanently guilty if I had not done so, particularly towards the young, many of whom feel they have just had part of their future snatched away by leave-supporting older voters. The baby boomers have done it again.

Many divides were thrown up by the referendum, but the inter-generational one is perhaps the most regrettable. Many young people, including those in my family and their friends, were almost inconsolable after the result became known.

The other thing that my series of pieces did was to provide a road map for the kind of post-EU response we should have. The first response to calm the market reaction, from Mark Carney on Friday morning, managed to make a nasty situation somewhat less toxic without saying all that much, other than that the Bank of England is prepared for all eventualities.

There will be important decisions from the Bank in the coming weeks. In one sense, it is good that Carney and his colleagues have the experience of 2007-9 to draw on, a period in which the authorities’ reaction was less than surefooted.

Whether the Bank needs to cut rates (or raise them to support sterling) and whether it needs another round of quantitative easing (QE) will become clearer in the coming weeks. The Bank’s preferred response will be to content itself with supporting financial stability, riding out the storm without adjusting rates or engaging in another round of QE, which was why there was no knee-jerk reaction on Friday.

What about the fiscal policy response? One campaigning line which Osborne was unwise to pursue was the idea of putting up taxes or slashing spending in the wake of a Brexit vote. That was when he departed from economic logic. If your economy takes a hit, as Britain’s will do, the sensible response to it is not to amplify that hit. Deficit-reduction is appropriate, when needed, in a growing economy, not one that has just been hit by a sock.

The public finances will have to take the strain. Osborne’s deficit targets were slipping anyway, partly because of the pre-referendum slowdown in the economy. His successor will have to decide whether to aim for a budget surplus. There will be downgrades of Britain by the ratings agencies, because of Britain’s record current account deficit, as well as the budget deficit, but that is probably one of the least of our worries.

More important than the short-term monetary and fiscal response are the decisions that need to be taken in the coming months to limit the long-term economic damage from Brexit. Despite silly attempts to disparage it by Vote Leave campaigners, the single market is hugely important to Britain’s economy. It is important for goods, and it is important for services, including financial services.

It is too much to hope for a deal in which Britain could be fully part of the single market while being outside the EU but something as close to that as is feasible has to be the aim. The UK, like Norway and Iceland, will need to be in the European Economic Area but with enhanced arrangements for the City. There will be a price to be paid in terms of what will effectively be a contribution to the EU budget but that would be a small price compared with significantly restricted access to our most important market.

What can be achieved on the single market will be key to Britain’s ability to continue to attract foreign direct investment (FDI). This will be the test in the coming years. Will multinationals automatically choose to access the single market from EU locations, or will it be possible to neutralise the impact of exit by replicate as close as possible existing arrangements? FDI does not come without a huge effort, and those trying to attract it to Britain will fear they have one hand behind their back.

The final area is immigration. We have a system for non-EU migration which does not work well, and an apparent plan to apply that to EU migration as well. In all the debate over immigration, and “taking back to control”, it is often forgotten that it is not just doctors and engineers we need but also in many sectors, unskilled workers.

So, this was not a result I wanted but congratulations to those who did and I am not going to sulk. The task now is to make the best of a bad job.

Sunday, June 19, 2016
A hard pounding - and with so very little to show for it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The moment is nearly upon us. Like the Scottish referendum in September 2014 but with even more at stake, a nerve-racking few days lie ahead. Either way, we will wake up to a different world on Friday morning , a very different one in case of a vote to leave.

One point is worth making. It is that economic models tend to underestimate the impact of shocks, as we saw in 2008. Some people say leaving the EU will be a little like leaving the European exchange rate mechanism (ERM) in September 1992. Apart from the fact that both narratives involve a plunging pound, the similarities end there. In 1992 we left a currency arrangement after 23 unhappy months having joined, as was said then, at the wrong rate, the wrong time and for the wrong reasons.

Leaving allowed an overvalued pound to come down to earth, and made room for big cuts in interest rates, which are simply not an option this time. As for sterling’s fall providing us with the elixir of export-led growth, it did not happen after the pound’s 25% fall in 2008-9, and there is no reason – with world trade depressed – it would be any different now.

Voting to leave the EU after 43 years in which our economy has become increasingly intertwined with the rest of Europe, and done well out of it, would be a very different proposition to being kicked out of the ERM. Even leaving the ERM made the Tory economic brand toxic for years. Apart from the economic and financial fallout, the political instability that would result from a Brexit vote would be much bigger. Whether this would be helped or hindered by George Osborne’s threatened £30bn emergency austerity budget – and whether it would happen - is one of the many questions that would arise.

It would be foolish to deny that any of this will prevent a big vote for leave and a close outcome on Thursday, and that those expecting “it’s the economy stupid” to have clinched it were wrong. A minority probably believes in the “project fantasy” of a seamless transition to a world waiting for British goods and services if only the EU were not holding us back, and the mythical pot of fiscal gold and bonfire of red tape beyond Brexit.

Rather more believe much more important is to “claim back our country”, which for most means sharply reducing immigration, even if there is an economic sacrifice. For some, where the pressures on local services are acute, and where there has been a sudden increase in the migrant population, such concerns are valid.

But there is also something more visceral happening elsewhere, the fear that hordes of Syrians, Iraqis, Turks, Libyans and those who use Libya as a jumping-off point are about to hit our shores, as well as legitimate economic migrants from the EU. They are not and politicians will regret stoking up the immigration issue. If there is a vote to leave, we will replace one set of politicians who unwisely promised and predictably failed to reduce net migration to the tens of thousands with another, unless the labour market is so badly affected it ceases to be a magnet.

Non-EU net migration from the Commonwealth but also China (mainly students), Russia and America, has averaged more than 200,000 a year this century. As for EU migration, over the long run it might be reduced but it would not stop.

But there are other pro-Brexit views out there, not specifically related to immigration, some of which I received in response to last week’s piece, which should be addressed.

The first is the eurozone. The argument here is straightforward. Why should we stay in the EU when the eurozone, its centrepiece, is heading for disaster? I wrote here on April 24 about the need for further eurozone reform. The much-misinterpreted Five Presidents’ report of last summer (the presidents of the Commission, Council, Central Bank, Eurogroup and Parliament) is about precisely that, rather than creating a “superstate”.

Its aim, to ensure that the single currency works for all its members and avoids being caught out as it was in 2008, is laudable. It wants member states to establish more flexibility in their economies and to build fiscal buffers so they can cope with future downturns. It is an agenda Britain should support. The worry is that, because of other issues, including the migration crisis and, yes, the referendum, it is not being implemented rapidly enough. But it is lazy to assume another eurozone disaster is looming. Lessons have been learned.

The eurozone’s experience demonstrates that, far from being a superstate, its members are not integrated enough. The European Central Bank had less freedom than other central banks to engage in unorthodox monetary policy, which is why it came to quantitative easing so late, because it had to deal with national sensibilities. That was also why its rescues of troubled eurozone countries were so fraught. Is the eurozone clear of the crisis? No, but as I noted last week, Britain is also in a state of convalescence.

The second strand is a familiar one. It is that, even if there is an economic price to be paid for Brexit, it is worth it to be freed from the yoke of the “unelected bureaucrats” in Brussels, restore our sovereignty and stop the EU making all our laws. In short, why should we stay with an imperfect EU? Space is limited, and these are big issues, but briefly.

It would be foolish to deny there is a democratic deficit in the EU, but it is worth digging into. European Commissioners are proposed by democratically elected national governments. The Commission president, chosen by the European Council (leaders of member states) by qualified majority voting, has to be approved by the European Parliament.

In Britain, moreover, we have a curious attitude to European democracy. If we wanted better scrutiny of the European Commission we would take European Parliament elections more seriously. But two-thirds of us do not bother to vote and we do not mind sending Westminster rejects and anti-EU oddballs there.

You could have direct elections for the Commission and its president (last time there were primaries) but that would be seen by critics as a step towards the superstate they fear.

On sovereignty, no country is truly sovereign in the modern world but we have independent economic and monetary policy, independent foreign and defence policy. Talk of an EU army – if Britain stays - should rightly be taken with a large pinch of salt. Steve Peers, professor of EU law at Essex University, pointed out in a recent article that Britain has vetoes in all the important areas, including defence, transfers of power, enlargement, taxation, non-EU immigration, asylum and criminal law, the single currency (including participation in bailouts and Britain’s opt-out) and the EU budget rebate.

Where there is qualified majority voting, future British governments can and should build alliances. People who think Britain can bestride the world, striking deals left, right and centre, strangely fear we are either incapable, or too timid, to stand up for ourselves in Europe.

These issues deserve a lot more space, as does the idea that most of our laws come from the EU; they don’t and most of those that do are the legal detail of single market rules. Old prejudices die hard, however, Since the days of Jacques Delors, some people have chosen to believe that Brussels only exists to do Britain down. It doesn’t. In this mad campaign, however, some people will believe anything.

Sunday, June 05, 2016
Leaving the single market risks a world of pain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Judging by the many ideas I have had for post-referendum subjects – keep them coming – I sense that June 23 cannot come too soon for most. Are we nearly there yet? Yes.

Soon there will be no more of the Brexit camp’s bogus £350m figure, or its fantasy pledges of spending £100m a week more on the NHS or cutting Vat on fuel, which are an insult to voters’ intelligence.

Next week I shall pull all this together and the following week I shall clear up some important loose ends, but today’s piece is a reminder of how far we have come.

When, seven months ago – before we even had a date for the referendum – I wrote that if we left the EU we would lose the single market, the reaction from many Outers was that we would do nothing of the sort. The rest of Europe would be so keen to trade with us that they would allow us to leave while staying in the single market.

Time has moved on. Vote Leave’s position is clear on one thing; that a post-Brexit Britain will not be in the single market. What it will be in is not clear. The small group known as Economists for Brexit has suggested no trade deals at all and the unilateral removal of all trade barriers by Britain. I shall come back to that.

It is important in this debate to know what the single market is. It is not just a trade deal. It is one of the most important ways in which Britain has influenced the EU. When Margaret Thatcher took up the idea of the single market in the mid-1980s, and set Britain’s European commissioner Lord Cockfield the task of pushing it through, it was against the protectionist instincts of some other EU countries.

The single market is still a work in progress but it has come a long way. By setting the same regulatory standards, state-aid regulations and other rules across the 28 members, it guards against unfair competition. Those same standards mean that firms do not have to go through the rigmarole of complying with different sets of rules, including product and safety standards, to sell in different European countries.

The single market has created an integrated European economy, taking advantage of the economies of scale of a 508m population grouping of countries. Supply chains operate across borders. Within a business, some components will be made in one country to be combined with others made in another. Dismantling these supply chains, or putting tariff and other barriers up within them, would be both time-consuming, costly and a recipe for inefficiency.

Most importantly, as far as Britain is concerned, progress is being on a single market in services. When EU leaders such as Donald Tusk talk of deepening the single market, it is an agenda we should enthusiastically embrace. British exports of services to the EU have almost doubled in a decade and trebled in 15 years. The passporting regime, as the Bank and England and others have noted is important for Britain’s financial services sector. In its absence, some activity and employment would be relocated to inside the single market.

Much of the debate on the single market is stuck in the world of 40 years ago. When the Brexit camp say a way would be found for Germany to sell its cars or the French to sell their cheese in Britain, they are reflecting that world. Perhaps the strangest recent comment – in a crowded field - was from Steve Hilton, David Cameron’s former “blue sky” thinker, who said: “The US is not a member of the EU, but the last time I checked, General Motors had no problem selling cars there.”

GM, of course, exports very few cars from America to the EU, but is part of the integrated single market, with local manufacture at Vauxhall in Britain, Opel in Germany, and extensive operations in Spain, Hungary, Poland and Austria.

As for a deal to sell German cars in Britain, maybe. But most of the 80% of British cars built for export are sold elsewhere, including elsewhere in the EU, and a deal to maintain access could be difficult. No wonder Britain’s Society of Motor Manufacturers and Traders reports that 77% of its members favour continued EU membership and only 9% want to leave.

The single market, named by 79% of inward investors in Britain as a key driver of location decisions in the latest EY attractiveness survey, clearly matters for both trade and investment.

It is also a dynamic process. When the rules evolve – and in the case of Brexit without any British influence on those changes – firms selling into the EU would have no choice but to abide by them. Without Britain at the table to push for further liberalisation, and with new barriers erected, our strongly-growing services to Europe would languish.

What about the fact that fewer than half of our exports now go to the rest of the EU? This tells me two things. One is that EU membership is not preventing us exploiting other markets. The other is that it is an inevitable consequence of the rise of China and other emerging economies. As the share of the older industrial economies in the global economy has declined, so their share of UK exports has fallen.

But the EU remains crucial. We sell almost as much to the 450m people in the rest of the EU, as to the 6.5bn or so people in the rest of the world. Making it more difficult to do that does not look like an obviously sensible strategy.

What about the idea, associated with Professor Patrick Minford of Economists for Brexit, of no trade deals at all, and a unilateral removal, by Britain, of all trade barriers? I know Minford well, but I think he is onto a loser with this one. He himself has said it would probably mean the elimination of manufacturing industry in Britain.

An assessment of his proposal by the Centre for Economic Performance at the London School of Economics, using up-to-date trade models and empirical evidence, says the negative impact on living standards in Britain would be similar to the so-called WTO (World Trade Organisation) option. The WTO option is, in any case, quite problematical, as its director-general has pointed out. Whatever future Britain had outside the EU, it would involve extensive and painful negotiation to get there, generating significant uncertainty.

But, as I say, one thing is clear. If we were to vote to leave on June 23, it would be a vote to leave the single market. Some will not mind that. Many, including many in business, will be deeply worried.

Sunday, May 29, 2016
Plenty of migrants - but plenty of jobs for UK workers too
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The economic debate over EU membership rages on, with the heavy weaponry overwhelmingly on one side. I can only hope there will be a ceasefire on June 24 but I cannot promise it.

So in the past few days we have had the Institute for Fiscal Studies confirming the conclusion of this column on May 1st, “There’s no pot of gold at the end of the Brexit rainbow”, and that there will not be the Leave campaign’s dodgy £350m a week figure to spend on the National Health Service or anything else.

Because the public finances will suffer in net terms from Brexit, on all plausible assumptions, there will be less to spend on services, not more. The IFS, for pointing out this simple truth, got accused by the teenagers who run the Vote Leave campaign of being a propaganda arm of the European commission or, even more absurdly, by Nigel Farage – EU-funded for the past 17 years – of being biased because it gets some funding from the EU.

The IFS’s great achievement over decades has been to rise above politics, informing the debate. Its intervention on the likely consequences for the public finances of a Brexit vote maintained that tradition.

What about the Treasury’s prediction of a short-term Brexit shock of between 3.5% and 6% of gross domestic product, and up to 820,000 fewer jobs than under a Remain scenario? Given that it probably did not need to do it, or be asked to do it, did the Treasury lay it on a bit thick?

Perhaps. Confidence effects are hard to measure, and they could be smaller or bigger than the Treasury assumes. In the political chaos that would follow Brexit, a rapid handover to a government composed of prominent Brexiteers would put the wind up many in the markets and in business. And hte direction of travel of the Treasury's assessment is similar to other, independent analyses.

One criticism of the Treasury exercise I would defend it against is that it did not take into account the monetary policy response to a Brexit vote. If interest rates were cut, in other words, it could mitigate some short-term confidence effects. The reason the Treasury was right not to include such a response is that Mark Carney has made clear it could go either way; interest rates could rise or fall. Even if they were cut from 0.5% to zero, I doubt there would be much of an impact on the economy or confidence. It could even be seen as a panic move.

Anyway, all this is grist to my mill. I shall pull together the economics in a couple of weeks’ time. For now, let me focus on a topic of the moment, one on which Vote Leave feels more comfortable, immigration.

Immigration is subject to more deliberate misreporting and scaremongering than any other subject. If there’s Project Fear on one side on the economy, there’s more Project Fear on the other on immigration. Anti-immigrant sentiment is stoked up as aggressively now as at any time I can remember. Partly because of this immigration, as I wrote when last in this territory in February, is economically beneficial but has become politically toxic, even in areas where there is not a large immigrant population.

This was the context in which the Office for National Statistics released its latest migration statistics. They showed net migration of 333,000 in the 12 months to last December – in other words 2015 – up a little, 20,000, though not in a “statistically significant” way, on the figure for 2014. Net migration, which measures the difference between long-term arrivals and departures, rose compared with 2014 because of a drop in emigration.

As before, and as has always been the case since we joined the European Community in 1973, non-EU net migration exceeded EU migration, though only slightly. EU net migration into the UK was 184,000, non-EU migration 188,000. The 333,000 number for overall net migration arises from 39,000 of net emigration by British citizens.

The ONS also provided some useful information on short-term migration. A couple of weeks ago, many newspapers ran stories about “hidden” migrants, people who come to Britain for between one and 12 months. They do, and always have, some for seasonal work, some for study, some for other reasons. But British people travel abroad for these reasons too. In the year to June 2014, there were on average nearly twice as many short-term emigrants – people from Britain leaving for between one and 12 months (420,000) – as short-term immigrants (241,000). The effect of short-term migration was to reduce not add to the population.

When people have a problem with immigrants that is not simply dislike of foreigners it usually arises from two sources. One is the additional pressure they impose on public services. The figures are, however, clear on this. HMRC data show that migrants who arrived in the past four years paid £2.5bn more in taxes in 2013-14 than they received in tax credits and benefits. That money is currently being used, at least in part, to reduce the budget deficit. But it is also as available as anybody else’s taxes to pay for public services.

The other problem people have with immigration is the “they’re taking our jobs” objection. David Davis, the former shadow home secretary, who I normally have a lot of time for, described the EU as “a job transfer machine – switching employment from British workers to those on the continent”. He is not alone. Many people think that the jobs created in Britain in recent years have mainly gone to eastern Europeans.

Leaving aside the fact that this is also an area of regular misreporting – new jobs and a net increase in employment are not the same thing – the true picture is very different. Since January-March 2010, the post-recession low-point for employment, the number of UK-born workers in employment has risen by 1.1m to a new record level of 26.25m. Not only was the number a record, but so, in 2015, was the proportion of UK-born people aged 16-64 in employment, 74.3%. In the six years to the first quarter of this year. there was a rise from 70.7% to 74.6% in the UK-born employment rate.

There was, it should be said, also a net rise of 633,000 in the number of EU migrants from the new eastern European member countries in work - more than 80% of those of working age do so - and one of 309,000 in those from long-standing EU counries in western Europe. But this rise occurred alongside, not instead of, a sustained increase in UK-born employment.

Employment among UK nationals rose even more, by over 1.5m, in the six years to the first quarter accounting for two-thirds of the overall rise in employment It has also never been higher as a percentage of the 16-64 workforce.

Could there have been a bigger increase in UK-born or UK nationals' employment? Maybe a little, but probably not by much. Given that a significant proportion of the 16-64 workforce is in full-time education and not working, or looking after children and other family members, or unable to work for other reasons, the current UK-born employment rate is probably quite close to the maximum.

What about the kind of migrants we have? Would not we do better with the much-vaunted points-based system, based on the Australian model, promoted by Boris Johnson and Michael Gove, as well as Ukip? Well, we have such a system for non-EU immigration, and even its best friends would say it is not working that well.

As for applying such a system to immigration from Europe in the event of Brexit, even Migration Watch criticises it for its extreme complexity and for the fact that it is a system intended to encourage immigration; Australia’s net migration per capita is roughly three times that of the UK. It is, it says, “thoroughly unsuitable” for Britain.

The majority of EU migrants to Britain would still qualify under skilled-labour criteria under a points-based system. But this additional layer of bureaucracy, whether the onus would be on workers or those seeking to recruit them, would make it harder for firms to fill gaps in their workforces. Those who say they would reduce red tape would merely tangle business up in more of it. And Britain’s labour market would become more inflexible.

Sunday, May 22, 2016
We hate EU red tape - but others are tied up more than we are, and there'll be no bonfire of it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A few weeks ago I came across a woman who told me that she was voting to leave the European Union because it had stopped her buying traditional light bulbs. She was, pun intended, incandescent.

I suggested that this was not a very sensible basis on which to base a decision but she was having none of it. The EU had gone too far. I tell the story because it illustrates a wider theme, the perception that Brussels is foisting things on us that, were we to leave, we would no longer have to do; that it is strangling us in its unnecessary red tape.

In the case of incandescent light bulbs, the position is clear and entirely the opposite of that perception. Hilary Benn, environment secretary in the Labour government, announced in 2007 an agreement with retailers to phase out the sale of incandescent light bulbs by 2011. Britain, he said, was “leading the way”.

His initiative came two years before an EU agreement to phase out the bulbs. In this, as in many things, the EU was going with the flow. Most countries have plans in place to phase out old-fashioned energy-inefficient bulbs. In Britain, I should say, nearly a decade after Benn led the way in banning them you can still buy them if you know where to go.

It would be unfair to blame my light bulb lady. For years, blaming Brussels for most things has been the default position of a significant proportion of the media and, it should be said, quite a lot of politicians. The EU provides good cover.

Nor will this stop. The Arthur Daleys abound in the referendum debate. I heard one the other day giving a ludicrous figure for the cost of EU regulation, repeat the now discredited £350m a week figure we “send” to Brussels and claim most businesses in Britain favour Brexit. They don’t. Every credible business survey, covering firms from the large to the very small, show a net position in favour of staying in the EU, apparently in spite of all that red tape.

Red tape is an important issue. None of us like it and for some firms it goes beyond being a mere irritation. There is often a sense among firms I talk to that Britain obeys the rules, and even “goldplates” them, while other EU countries adopt a more relaxed attitude.

But it is also important to be realistic. Some red tape simply represents the fact that things that were acceptable on health and safety or other grounds in the past no longer are. Like lower-energy light bulbs, they have would have happened whether or not we were in the EU. Some may yearn for the days when every new electrical appliance was supplied with bare wires, for the householder to fit the plug – not always successfully – but those days are not coming back.

Not only that, but much red tape is home-grown. Her Majesty’s Revenue & Customs has been trying to reduce the administrative burden on business – hard when you have had successive chancellors addicted to tinkering with the tax system – but it is still a work in progress.

It is also the case that, far from EU rules being foisted on an unwilling Britain, successive governments have often initiated them - as we initiated the single market – or been perfectly happy to go along with them. In Facts, a group which seeks to promote accuracy in the referendum debate, points out that of nearly 2,600 EU votes since 1999, Britain has voted no only 56 times and abstained 70 times. On more than 95% of occasions, in other words, we have been quite happy.

Just because ministers are happy does not, of course, mean business is happy but there are two essential points in this debate. The first is that, however bad it may seem, Britain is less regulated than our EU competitors. This is not that surprising; it is one reason why inward investors have favoured Britain as their location of preference within the EU single market. It is confirmed by Britain’s high ratings in the World Economic Forum’s international competitiveness league table and the World Bank’s “ease of doing business” rankings.

It is quantified in successive studies from the Organisation for Economic Co-operation and Development (OECD). These have the virtue of showing, not only that some EU countries are more regulated than others – look at the French, German, Italian, Dutch and Belgian labour markets – but also that Britain is among the least regulated advanced economies, in or out of the EU.

For product market regulation, Britain is the second least regulated of 34 OECD countries, and marginally less regulated than America. For employment legislation, Britain is the fourth least regulated. However bad the red tape burden seems, it could be a lot worse. The think tank Open Europe points out that even at EU level there has been some progress in reducing red tape over the past two years.

In a letter last week organised by Vote Leave, some 300 business people said that “Britain’s competitiveness is being undermined by our membership of a failing EU”. Now, there are many reasons why Britain is not more competitive, ranging from shortcomings in education and skills, low productivity, a failure to invest enough, including in infrastructure, and lack of innovation is some sectors.

Blaming it on the EU, however, seems to me to be the worst kind of bleating, given that our regulatory burden is lower than the vast majority of our competitors. When we look for failings, we should look in the mirror.

This brings me to me second point. Would there be a bonfire of red tape if Britain left the EU? Open Europe, which is strong in this area, estimates the annual cost of EU red tape to be £33bn a year. There is, it should be said, a parallel estimate of the benefits to Britain of EU regulations of £58.6bn a year, also based on official impact assessments.

How can there be benefits of red tape? The Treasury, in its assessment of the costs and benefits of EU membership, lists some of them, such as the fact that a single testing regime for cosmetics reduces costs, that there have been significant gains to both operators and consumers in the transport sector, and so on. The public benefits from measures to protect the environment while, in the field of labour market regulation, one firm’s burden is its employees’ workplace protection. Estimates of the benefits of EU regulation, to be fair, include those from rules not yet fully enacted.

Staying with the costs, however, Open Europe calculates that a politically feasible maximum for the amount of red tape that could be reduced is £12.8bn out of £33bn, most coming from scrapping some labour market and environmental regulation, some from easier regulation of financial services.

It is a reasonable stab, but I think it is likely to be a significant overestimate. Think of the climate that we have been in, in which a majority Conservative government has had to backtrack on plans to cut tax credits and disability benefits. Think too of the continued debate over zero hours contracts and claimed exploitation of workers, or of the row over diesel emissions, where EU regulations have been attacked for being too lax, rather than too tight.

The idea that a post-Brexit Tory government, facing significant opposition from within its own side as well as from Labour and the Scottish Nationalists, could push through a programme of scrapping workers’ rights, reducing environmental legislation and adopting a softer-touch regulatory regime for the City, seems to me entirely unrealistic.

There is v ery unlikely to be any bonfire of red tape. Given that that has been a significant plank in the case for leaving the EU, this is a big flaw in that case.

Sunday, May 15, 2016
Amid all the referendum excitement, the long wait for a rate hike goes on
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Thursday’s Bank of England inflation report press conference was, by my calculation, the 29th since interest rates last changed. I may have missed one or two but sat though most.

If you think that’s a burden, think of the members of the monetary policy committee (MPC) itself. The latest “no change” verdict from their May monthly meeting was the 86th in a row. The personnel have changed along the way, and MPC members would not doubt say there was nothing they would rather have been doing. But no wonder, perhaps, the Bank is reducing the number of MPC meetings from 12 to eight a year.

There was a time when the Bank was expected to be the first of the big central banks to hike rates. Then, when it became clear that America’s Federal Reserve would be the first-mover, which it was last December, that the MPC would follow soon after. Now, it is fair to say that there is more speculation about a cut than a rise.

Part of that, of course, arises from the part of the Bank’s inflation report that Mark Carney, its governor, described as “the elephant in the room”. Its view that a decision to leave would have “material economic effects”, including weaker growth, higher inflation and rise in unemployment, was explicit.

Sterling would fall, “perhaps sharply”, and: “Aggregate demand would also likely fall, relative to our forecast, in the face of tighter financial conditions, lower asset prices, and greater uncertainty about the UK’s trading relationships. Households could defer consumption, and firms could delay investment. Global financial conditions could also tighten, generating potential negative spillovers to foreign activity that, in turn, could dampen demand for UK exports.”

The Bank’s frankness has provoked predictable fury from the Leave camp. My tip for them would be not to challenge the Bank’s independence or its governor’s integrity – these verdicts were unanimously agreed by all nine members of the MPC and the 10 members of the financial policy committee – but to argue that a bit of short-term pain would be worth it for what they see as the long-term gain. I doubt if they will take that advice.

The referendum is the latest obstacle to a return to some kind of normality for interest rates, adding to a very long list. The Bank held rates at their record low to help the economy cope with George Osborne’s fiscal tightening, and kept them there and unleashed another round of quantitative easing when the eurozone was mired in its deepest crisis. It passed up an opportunity to raise them in 2014 when growth was strong and unemployment falling far faster than it expected, and well below the 7% rate cited by Carney in his forward guidance the previous summer.

When rates were first reduced to 0.5%, in March 2009, MPC members did not think they would stay there long, probably less than a year. Now, according to the markets, it will be touch and go whether they go up before the 10th anniversary of that cut, in 2019.

Andrew Sentance, the former MPC member and long-time hawk has promised to assemble a live band outside the Bank to celebrate the first hike. I think it will take more than that, maybe a streak down Threadneedle Street. Either way, according to the markets, it looks a long way off.

Is that a reasonable expectation? Let me take two scenarios, Brexit and non-Brexit. The Bank’s response to big events usually has the virtue of being clear-cut. In the global financial crisis cutting rates was a no-brainer.

In the case of Brexit, as Carney and his colleagues made clear, the decision would be more balanced. The slump in sterling and the consequent rise in inflation would argue for higher rates, while the hit to growth would make the case for a cut. A cut would not do much – I am pretty sure the Bank will not want to follow other central banks and opt for negative rates, so from 0.5% to zero would be as far as it goes. A half-point cut in interest rates would not do much to offset a growth shock. As the governor said, there is only so much that monetary policy can do.

Which way would it go? The Bank is not saying. If it thought the rise in inflation resulting from Brexit was temporary, then it could “look through” it, as it has done before, and cut to try and keep growth going. If, on the other hand, a post-Brexit slump in sterling turned into a rout, the Bank might have no option but to raise rates to prop it up. After two decades in which sterling has not been a driver of interest rate hikes in Britain, it could make an unwelcome return. This is the kind of nostalgia we can do without.

The other point about interest rates post-Brexit is that even if policy rates were cut, actual rates in the economy might well rise, because of the increase in bank funding costs. Carney told me that the Bank would do its best to mitigate such effects by providing liquidity, but even that might not do the trick.

What about interest rates under a Remain scenario? That is easier to address, because it is the assumption on which the Bank has based its new forecasts. There is a view that, once the referendum uncertainty is out of the way, the Bank will feel liberated enough to give serious thought to raising rates. Not immediately – August would be too soon – but perhaps as early as November.

A post-referendum bounce in economic activity would provide the context, while the Bank’s forecast that inflation in two years will be back above 2% would give the justification. Quite a few economists in the City subscribe to this view. Add in one or two more rate rises between now and November from the Federal Reserve and the Bank could see itself as going with the flow.

On the other hand, as noted above, there have bene plenty of opportunities to grasp the nettle on rates in the past few years, and it has gone ungrasped. In its inflation report, the Bank devoted a large panel to the effects of uncertainty, and how they can linger even after the event that has caused the uncertainty has come and gone. The post-referendum bounce in the economy would have to be big and very obvious for the Bank to move. And 2016, for all its other excitements, would go down as another year in which nothing happened on interest rates. In which case, maybe next year?

Sunday, May 08, 2016
Housing: a simple story of supply and demand?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Let me take a break from the heat of the Breferendum debate this week and enter the calmer but only slightly less contentious waters of the housing market. Another set of elections have passed, amid ambitious promises to sort out the problems of housing. I think I can guarantee that when these elections are next held in a few years’ time those problems will still not have been sorted out.

Britain’s housing problem is easily described. There is plenty of housing demand but not enough supply. And, while it has been possible to comfort ourselves in recent years with the fact that supply, while inadequate, was moving in the right direction, it now appears that it no longer the case.

In such a situation there is only one outcome, prices will rise and housing will become more unaffordable. It is not unaffordable to the vast majority of existing home owners, most of have substantial equity in their properties and continue to benefit from very low mortgage rates. If housing was unaffordable to the majority, prices would fall.

But the problem of unaffordability impacts particularly on new entrants, the first-time buyers faced with a dauntingly large first step to get on the housing ladder. Hence the renewed interest in the leg-up role of the Bank of Mum and Dad, which according to Legal & General is part-funding at least a quarter of mortgages this year. And hence the return of the 100% mortgage from Barclays, an idea which had apparently perished in the ashes of the banking crisis, though this one comes with more strings attached (in the form of parental support) than was the case then.

Let me start with housing supply. One of the best indicators of supply is provided by NHBC, the old National House Building Council. It provides building guarantees, and all but a fraction of new homes being built are registered with it.

Its latest numbers show that in the first quarter of the year, 36.566 new homes were registered, which sounds reasonable enough but represented a drop of 9% compared with the first quarter of 2015, when 40,144 new homes were registered. There were declines in both private registrations, down 7% on a year earlier and in social housing, down 15%.

That first quarter fall was enough to bring an end, for now at least, in the upward trend of housing supply. For the 2015-16 financial year, a total of 152,329 new homes were registered, virtually unchanged on the 2014-15 figure of 152,262. Mike Quinton, NHBC’s chief executive, said the supply of new homes was “consolidating”, though also pointed to an 80% rise in registrations compared with the lows of 2008-9. It is consolidating in spite of continued support from, for example, the government’s Help to Buy equity loan scheme for new homes. We should, remember, be building around 250,000 new homes each year.

In London, where the housing shortage is most acute, and where the mayoral candidates battled among other things over the provision of 50,000 new homes a year, separate figures from Stirling Ackroyd, estate agents, showed that London boroughs approved just 4,320 new homes in the first quarter, down 64% on a year earlier. Those who are quick at mental arithmetic will have noticed that 4,320 new homes in a quarter represents barely a third of an annual target of 50,000.

New housing is not the only source of supply, as I often point out. What existing homeowners do is also very important. The cycle of trading up as families expand and downsizing when they have flow the nest is part of the essential ebb and flow of a properly functioning housing market. But that cycle, if not broken, is severely damaged.

According to Rics, the Royal Institution of Chartered Surveyors, “lack of supply is still an overriding feature of the market”. While the number of people putting homes on the market is better than it was a few months ago, it remains well below normal. I put a lot of that down to high transaction costs – stamp duty and other fees provide a significant deterrent to move – but there are other factors. Older people wanting to downsize also complain of a shortage of suitable properties.

What about demand? Latest Bank of England figures show that mortgage lending is strengthening. In March lending was up by 3.4% on a year earlier, while its annualised growth in the latest tree months was a robust (by recent standards) 4.7%. A year ago mortgage lending was trundling along at less than 2%.

Some of its recent strength, it should be said, reflects a buy-to-let and second home rush ahead of George Osborne’s imposition of a 3% stamp duty premium on such purchases, which took effect last month. But part of it reflects the underlying growth in demand you would expect in a rising population, and the gradual normalization of the mortgage market. Housing supply, in all its forms, is inadequate to meet housing demand.

We see the consequences of that, of course, in prices. The Halifax, part of Lloyds Banking Group, will provide an update on prices tomorrow but its last bulletin had prices rising at an annual rate of 10.1%.

The official house price index, from the Office for National Statistics, has prices growing at a 7.6% annual rate, but that is still more than three times the growth in average earnings. A glance at the ONS’s long-run chart shows that prices are currently more than 120% higher than in 2002, the base-date for the index, and 20% above their pre-crisis peak. As time goes by the crisis will come to look like barely a blip on the house-price radar.

I said this was a non referendum piece but it would be wrong to ignore the impact of the forthcoming vote on housing. Brexit uncertainties are weighing on the economy, and thus on the housing market. Rics, to quote them again, says that we should look to commercial property for the biggest effects, but that housing will also be affected, with prices pushed lower “in the immediate to short term”.

In the long run, however, it is the fundamentals that will determine what happens to housing. The problem of inadequate new housing supply pushing up prices was, after all, quantified by Kate Barker in her review for the Labour government in 2004. This was before the surge in migration from the rest of the EU and it is a verdict that will survive the end of that surge. Leaving the EU might moderate the long-term upward pressure on house prices but would not remove it.

The problem of unaffordability for those wanting to get on the ladder – and the difficulty of saving for a deposit while renting – will remain. Many people say the housing market is not working. In one key respect, however, it is. When supply is weak and demand strong, prices will tend to rise. That’s what happens in all markets.

Sunday, May 01, 2016
There's no magic money tree if we leave the EU
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There are two things that even the most casual observer of the EU referendum debate will have heard. One is that we “send” £350m a week to Europe. The other is, in a pattern familiar in politics, those who favour Brexit have come up with various ways in which this money could be better spent, the latest being to settle the junior doctors’ dispute.

If there is one thing I can impress on you as we approach our date with destiny on June 23, it is to expunge that £350m figure from your mind, because it is wrong. That is not an easy thing to do because it is so often said. But ignore any politician who says we send £350m a week to the EU. Tear up any leaflet that makes that claim.

A second thing I would urge is to reject what I would call the crude accountancy approach to Britain’s contribution to the EU budget, or others might term a reductio ad absurdum about this debate. In other words, the effect on Britain’s public finances, or for that matter the balance of payments, will be dwarfed by the wider effects of a decision to leave the EU. The analogy is not perfect, but it is a bit like deciding whether or not to buy a prestigious car on the basis of the cost of replacing the wiper blades. There is a lot more to it than that.

Let me start with the contribution itself. The odd thing about the £350m figure is that it is widely used by many Brexit campaigners who profess admiration for Margaret Thatcher, while conveniently ignoring the EU rebate she successfully negotiated at Fontainebleu in 1984 and which for three decades has reduced Britain’s budget contribution before anything is “sent” to Brussels.

The rebate has outlasted her, and it will outlast the current generation of politicians should Britain remain in the EU. The rebate was worth £4.4bn a year in 2014, the latest full year for which data is available, and averaged of £3.5bn over the period 2010-14. It is deducted from the £17.4bn annual gross contribution over that period.

That is not the only necessary deduction. An average of £5bn a year flowed back to Britain’s public sector during 2010-14, reducing the net contribution to £8.9bn, or £170m a week. Roughly £2bn a year comes from the EU to the private sector in Britain. On this basis, the net contribution over the latest five years averaged £7.1bn a year, £135m a week. In 2014 alone, it averaged £110m a week; less than a third of the claimed £350m.

These figures, I should say, come from correspondence between Sir Andrew Dilnot, the head of the Statistics Commission, the independent statistical watchdog and Norman Lamb, the Liberal Democrat MP who had complained about the use of the £350m figure. Sir Andrew agreed that it was “potentially misleading”, which means it should not be used.

The method in the Brexiteers’ madness may be that, even though they know £350m is misleading, any figure which runs at more than £100m a week is still a very large number. They, in other words, do not mind a debate about it. £110m or £135m a week is a lot of money to most people.

It is, however, small in relation to government spending; well under 1%. Could that money, small though it is in terms of the public finances, be used instead for domestic priorities? The answer to that comes in two parts.

The first is that any post-Brexit trade deal with the EU comes with a bill attached. Both Norway and Switzerland have deals which give them less favourable access to the single market than Britain has now, and no influence over the way single market rules are made. Norway pays only a slightly smaller per capita contribution as Britain.

Switzerland pays less, but misses out on, amongst other things, the financial passporting scheme that Mark Carney, the Bank of England governor, has said is very important for London’s role as a global financial centre. Switzerland would dearly love to have it. Nobody can say what the bill to access the single market would be but it is not impossible that it would be larger than now. The budget rebate would, after all, die with the end of Britain’s EU membership.

Even more important than this is the second key point, which is that any savings on the budget contribution would be dwarfed by the wider economic effects. As foreshadowed here last week, the Organisation for Economic Co-operation and Development (OECD) added its voice to the many warning of the economic costs of Brexit.

Angel Gurria, its secretary general, said Britons would pay a “Brexit tax”, equivalent to a month’s salary by 2020, adding that it would be “a pure deadweight loss, a cost incurred with no economic benefit”. It was an odd way of putting it but I think we know what he meant. Gross domestic product would be 3% lower than under a remain scenario by 2020 and between 2.7% and 7.5% lower by 2030.

As he put it: “While no one knows precisely what the costs would be, what is striking about our estimates and those produced by most others is that all the numbers under a Brexit case are negative. The best outcome under Brexit is still worse than remaining an EU member, while the worst outcomes are very bad indeed.”

On the budget contribution, the OECD’s assessment noted that “net transfers to the EU budget are relatively small, at 0.3% - 0.4% of GDP per annum in the years ahead, and the saving from a reduction in these transfers would be more than offset by the impact of slower GDP growth on the fiscal position”.

Like the assessments of the International Monetary Fund, the Treasury and the London School of Economics, the assumptions used in coming to such verdicts can be challenged. But all are remarkably similar and, in the case of the Treasury like the OECD, imply that far from Brexit helping the public finances by reducing budget contributions, the net effect would be “higher government borrowing and debt, large tax rises or major cuts in public spending”. Tax receipts by 2030 would be between £20bn and £45bn lower.

Some economists are attempting a fightback against what is becoming the prevailing wisdom. Three I know very well – Patrick Minford, a long-term “better off out” campaigner, Roger Bootle of Capital Economics and Gerard Lyons, economic adviser to Boris Johnson – are part of Economists for Brexit, which launched on Thursday. They are in a small minority against the economic mainstream but I shall take their views into account in my overall assessment.

Oxford Economics, which has no axe to grind in the debate, says that even the most benign Brexit outcome - one that does not harm the economy over the medium to long-term - would produce a “negligible” dividend for the public finances.

So the Brexiteers should stop pretending that leaving the EU would suddenly free huge sums to spend on what we like. There is no magic money tree. It is an insult to voters’ intelligence to suggest there is.

Sunday, April 24, 2016
In or out of the EU, we need a euro with stronger foundations
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There are now just two months to go (two months!) to the referendum and as promised another instalment in my series on the economic issues. So this week, the euro. Do the single currency’s flaws mean we would be better off leaving the EU?

A few days ago the Treasury produced a comprehensive and rather impressive 200-page assessment of the impact of EU membership and the alternatives, taking the economic debate to a new level. I suspect most of its critics either have not read it or did not understand it. This week the Paris-based Organisation for Economic Co-operation and Development (OECD) will be the latest heavy-hitter to warn of the consequences of Brexit.

Even the most sophisticated economic modelling cannot, however, either product or sufficiently allow for disaster and crisis, as we saw in 2008. What if the subsequent near break-up of the euro was just one of a series of damaging convulsions that will be the norm for the eurozone in coming decades?

The euro and I go back a long way. Two decades ago, with my former colleague Andrew Grice, we had the world exclusive on the single currency’s name. Like all great stories, it did not make it onto the front page.

In 1999, my book Will Europe Work? was published, which concluded that the euro, as it had been set up, could not. The euro lacked the conditions of a so-called optimal currency area and would struggle. When it was published I encountered a small army of enthusiasts for early UK membership of the euro. They included Adair Turner, now Lord Turner, when he was director-general of the CBI. He has since admitted that he was wrong to advocate membership. Most of the others have airbrushed it from their memories.

Perhaps the euro advocates were not as out of step as it looks now. In the early 2000s, we started regular polling on the issue with the new (at the time) firm of YouGov. Throughout 2002, the year euro notes and coins were introduced, a majority of British people thought we should either join immediately or when conditions were right.

It is intriguing that, a decade or so after a time when joining the euro, or not, was the hottest topic in British politics – 2003 was the year of the Treasury’s famous five tests exercise – voters should be deciding on whether to leave the EU, something few thought was even the remotest of possibilities back then.

So what of the euro and its flaws and dangers? It is fair to say that the eurozone has been held together, sometimes against the odds, by the extraordinary actions of the European Central Bank. Since Mario Draghi, its president, said in 2012 he would do “whatever it takes” to save the euro, the ECB has run through its armoury of weapons, including most recently negative interest rates and quantitative easing. It has resulted in a return to modest growth and falling - though still very high - unemployment. The euro has held together.

Lessons have been learned. I would be surprised if a crisis of the kind that hit the eurozone in a series of waves between 2010 and 2015 were to repeat itself exactly. That was the time when its banking, sovereign debt and competitiveness crises came together. These were special and unusual circumstances. Glib forecasts of another big impending crisis should be taken with a large pinch of salt.

Even the euro’s best friends would admit, however, that much more needs to be done to make the eurozone secure, and turn it into a monetary union in which more than modest growth is possible.

Some things have been done since the crisis, of which the move towards banking union is the most impressive. But some initiatives, such as the so-called euro plus pact agreed at the height of the crisis, have foundered. Last summer’s “five presidents” report, Completing Europe’s Economic and Monetary Union, set out an ambitious programme, including fiscal union (one of the conditions for an optimal currency area).

But the attention of Europe’s leaders has wandered, to the migration crisis and even Britain’s referendum. Reform of the eurozone still has a very long way to go.

What does that mean for Britain? Both sides of the EU debate would agree on one thing; this country cannot be moved to another part of the world. Proximity is important. When the eurozone slid into a second recession in the 2011-13 period, Britain was affected, despite the attempt of some to portray the slowdown in that period as entirely home-grown.

But Britain’s growth over that period, 2%, 1.2% and 2.2% (2011, 2012 and 2013) was better than the achieved by Switzerland, a non-EU country, and Sweden, like Britain in the EU but not in the euro. I have mentioned before that being inside the EU but sensibly outside the euro has been good for Britain’s relative growth performance. Since January 1999, Britain’s economy has grown by twice as much as Germany and France and 10 times as much as Italy.

Are there enough safeguards to prevent Britain being dragged into future eurozone crises, as and when they occur? As a European country, Britain would be affected, but one key element of David Cameron’s now largely forgotten renegotiation is that the rights of non-euro countries have been given enhanced protection. Britain will never have to participate in eurozone rescues, except as a member of the International Monetary Fund (which would continue to be the case outside the EU).

And, according to last week’s Treasury assessment: “The new settlement provides the basis for stable and sustainable economic governance arrangements. It puts in place a set of legally-binding principles, supported by a new safeguard mechanism, that will ensure the UK is not penalised, excluded or discriminated against by EU rules because it is not part of the euro area. The new settlement recognises that not all member states have the euro as their currency and that the UK should not be forced to participate in measures designed for euro area countries. “

It would be better, of course, if Europe’s leaders were able to move on from the migration crisis and focus on strengthening the euro. Its existence makes life easier for British businesses, while Britain’s non-euro status provides us with the most important freedom in this debate; freedom to pursue an independent monetary policy. And we should not be too gloomy. The euro is here to stay. One way or another, we have to live with it.

Saturday, April 16, 2016
Let's hope it's just fear of Brexit hitting growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The sun has been shining, the birds singing and the days getting longer. But if the economy has a spring in its step it is keeping it well hidden. That squelch you hear underfoot is a soft patch.

The National Institute of Economic and Social Research, which uses official data and other information to calculate gross domestic product a monthly basis, reckons growth slowed to just 0.3% in the first quarter, half its rate in the final three months of last year, and its slowest since late 2012.

The British Chambers of Commerce, in its latest quarterly survey a few days ago, reported that growth had softened in the first quarter, “with most key survey indicators either static or decreasing”.

A similar message has been emerging from the monthly purchasing managers’ surveys compiled by Markit, the information services provider. As Chris Williamson, its chief economist, put it: “Survey data indicate a slowing in UK economic growth in the first quarter, with the suggestion that the pace is more likely to ease further rather than recover in coming months as business confidence remains unsettled by worries at home and abroad.”

In fact, though these things can change, it has been hard to find very much of cheer in the recent numbers. Even consumers appear to have been letting the side down. The British Retail Consortium reported that the value of retail sales in March was flat compared with a year earlier, with so-called like-for-like sales down by 0.7%. It ascribed this “relatively disappointing” picture to the timing of Easter, though in the past Easter has often provided a spending boost.

In some ways, weaker growth is not a surprise. Though the storm has now passed, the first few weeks of the year were characterised by a mood of deep gloom, and some deeply gloomy reporting of it, with markets plunging, the oil price apparently tumbling towards $10 a barrel (it is now in the mid-$40s) and George Osborne warning of a dangerous cocktail of risks. I am not suggesting your average Primark shopper keeps a close eye on the daily gyrations of the FTSE 100 but these things do percolate through to the mood.

Fortunately, too, we have another ready explanation for this period of weaker growth. I am not sure how wise it was for the International Monetary Fund to enter the Brexit debate a few days ago. At a time when at least some British voters are fed up with unelected supranational institutions throwing their weight around, another one sticking its oar in was not necessarily very deft.

I am not sure either that the chancellor should have celebrated that intervention so enthusiastically. The IMF is saying “heightened uncertainty” about the referendum is already hitting the economy and that Brexit itself would be a significant economic shock, with the potential for “severe regional and global damage”, according to Maurice Obstfeld, its chief economist.

But this apparently growth-damaging, risk-enhancing event has been created by the prime minister, with the full support of a chancellor whose long-term economic plan was supposed to take Britain away from danger. In this respect at least, you might argue, the economy would have been safer with Ed Miliband and Ed Balls.

The idea that Brexit uncertainty is to blame for the current period of weaker growth is not confined to the IMF. The Bank of England’s monetary policy committee (MPC) left interest rates unchanged at 0.5% for the 86th month in a row on Thursday.

In detailing that decision the MPC both outlined its view that “a substantial proportion of the recent fall” in the pound reflected referendum uncertainty, and that nervousness about the vote was weighing on growth.

As it put it: "There had been signs that uncertainty relating to the EU referendum had begun to weigh on certain areas of activity. Media references to uncertainty had jumped, though the impact of this on household spending was unclear. The likelihood that some business decisions would be delayed pending the outcome of the vote was consistent with the easing in survey measures of investment intentions, reports of the postponement of IPOs and private equity deals and a softening in corporate credit demand. The fall in commercial property transactions in Q1 had been particularly striking. Thus, there might be some softening in growth during the first half of 2016.”

It will surprise nobody that the Bank will be doing nothing between now and June 23. Whether it has to do anything afterwards, and particularly in the event of a vote to leave, it says it will “use its tools” to respond to what might be “an extended period of uncertainty about the economic outlook”. Osborne has talked about rate hikes but it could include interest rate cuts, even from 0.5%, reluctant though the Bank is to do that, and more quantitative easing, as well as emergency liquidity and other measures.

The EY Item Club, in its latest forecast out tomorrow, is also strong on the Brexit uncertainty point. As its chief economist Peter Spencer discussed here last week, it expects consumer spending to be less buoyant next year. Fortunately – on its assumption of continued EU membership – the cavalry will arrive in the form of stronger business investment.

“With the recent drag from uncertainty assumed to fade, companies are likely to resume their investment drive, putting their healthy balance sheets and high profits to good use,” he says. “This bounce back in business investment should more than offset the slowdown in the consumer sector.”

So we have a story here. The economy has slowed but a large part of that slowdown is due to pre-referendum uncertainty. Once that uncertainty is out of the way with a vote to remain, there will be other things to worry about, including the US presidential election, but growth should rebound.

It is a decent story, but it is not one we can be certain about. There is plenty of anecdotal and survey evidence that referendum uncertainty is having an impact but very little hard data. Recent weakness in manufacturing, exemplified by the problems in the steel industry, reflects fundamental rather than temporary factors, and is not just affecting Britain. Britain, as the IMF reminded us, is still in the process of fiscal consolidation – deficit reduction – with Osborne still hoping for that budget surplus. Global growth prospects, as the IMF also reminded us, have deteriorated a little in recent months.

We should not be too gloomy, but we should also not assume that with one bound we will be free to grow more strongly if there is a vote to remain. Ahead of the Scottish referendum in September 2014 there was a lot of talk of referendum uncertainty weighing on growth. But if there was a post-referendum bounce it was short-lived. In a picture admittedly complicated by oil weakness, the Scottish economy grew by just 0.9% between the fourth quarters of 2014 and 2015. All I can say is it would have been a lot worse with a vote for independence.

Is there a bigger uncertainty effect weighing on UK growth now than there was in Scotland then? We have to hope so, but it is by no means guaranteed.

Sunday, April 03, 2016
Britain would struggle to maintain inward investor appeal after Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The referendum on Britain’s membership of the EU is still more than two months away, though the campaign seems to have been going on forever. Given that most election campaigns do not get properly in their stride until the final weeks, I cannot offer any early relief.

Instead, as promised, I will continue my series on the economic aspects of Leave and Remain. Shortly before the referendum, all these will be pulled together in a single piece and a verdict.

So far I have done five pieces. I began last November with trade, pointing out if you leave the EU then, unless you replicate the conditions of membership (including free movement of people and a budget contribution) you lose the single market. There is a lot of misunderstanding about that, mainly because many do not appreciate the difference between a trade agreement and the single market.

At the start of the year I warned, even when talk was of global risks to the recovery, that the referendum represented the biggest threat to Britain, a theme that has since been widely taken up. In February I looked at migration, under the heading economically beneficial, politically toxic.

I also examined in February at how Britain’s relative economic performance had improved since we joined the European Economic Community (EEC), the EU’s forerunner, in 1973. Mark Carney, the Bank of England governor, got into trouble with some Tory MPs for making a similar point. Finally, ahead of the budget, I wrote about how the chancellor would be seeking to emphasise the economic dangers of Brexit, while presenting a safety-first budget to minimise referendum risks. Whether or not he succeeded with the first, he failed with the second.

Today, let me examine another aspect of the economic debate, inward investment into Britain. The starting point, overwhelmingly supported by the evidence, is that EU membership has been good for inward investment, particularly foreign direct investment (FDI), for entirely logical reasons. The question is whether Britain’s attractions for inward investors could be maintained outside the EU.

Foreign companies have been attracted to invest in Britain, over decades, because of the combination of a less regulated and taxed economy and access to the European market. The phenomenon goes back at least as far as the 1970s, and decisions by American multinationals to increase investment when this country joined the EEC.

It accelerated in the 1980s with Japanese car manufacturers – starting with Nissan in Sunderland - establishing operations in this country. It has increased further since the single market began in 1993.

Over this period Britain has regularly been the biggest European recipient of foreign direct investment from outside the EU, though often vying with Germany for top slot. A process that began with America, then shifted to Japan and Korea, has moved more recently to the new economic giants of China and India.

The ‘voice of Indian business and industry’, the Federation of Indian Chambers of Commerce & Industry (Ficci), put it straightforwardly last month. “Britain is considered an entry point and a gateway for the EU by many Indian companies,” its secretary-general said.

Inward investment from distant nations like India creates a lot of attention, and in examples like Tata and Jaguar Land Rover, and much more challengingly in recent days in steel and Port Talbot, deservedly so. But, importantly, about half of the stock of foreign direct investment in Britain is from closer to home: the rest of the EU. Britain is integrated with the EU economy via investment as well as trade.

Let me make one thing clear. EU membership is not the only reason why there is foreign direct investment in Britain. Britain’s attractions include openness, a flexible labour market with pools of particular skills, the English language and the English legal system.

In many cases, such as much-needed foreign investment in Britain’s energy or transport infrastructure, it is hard to see that there would be very much difference whether we were in or out, except to the extent that Brexit reduces future growth prospects.

But it would also be folly to deny that EU membership is an important determinant of inward investment. EY, the accountancy and professional services firm, provides the most comprehensive annual survey of FDI. In its 2016 survey, to be published next month, it will look specifically at the potential effects of Brexit.

In the meantime, we have last year’s survey to go on. It showed a record 887 inward investment projects in Britain in 2014, up 11% on the previous year, and an increased European market share of 20.4%. It also found that 72% of inward investors cited access to the single market as important in their decision.

The question can be asked why, with the referendum on the horizon, inward investment in 2014 was so strong. The answer is that at that time business put a very low probability on Brexit.

What impact would Brexit have? We will await EY’s verdict next month but its rivals PWC had a stab in its work for the CBI, predicting that there would be an overall negative effect on inward investment even if a free trade agreement for trade in goods were to be swiftly negotiated. Service sector inward investment would still be “negatively affected”. The Bank of England, while stressing the many reasons why there has been foreign investment in financial services in Britain, also highlighted the importance EU’s “passporting” regime for banks.

Do we need inward investment? Yes. It makes for a more successful and dynamic economy and, while we are now in the middle of a period of productivity disappointment, foreign-owned businesses have made an important contribution to Britain’s economic performance over decades.

Could steps be taken to maintain Britain’s appeal to inward investors after Brexit? Yes, though some of them would involve a possibly tortuous renegotiation in order to try to re-establish what we already have, and at a cost. Whatever was negotiated in terms of access to the single market would probably not be as good as now. Impressions count, and the impression from afar – let alone from the rest of the EU – would be that Britain had moved from being semi-detached to being detached from the rest of Europe.

In my younger days I used to enthuse about the idea of Britain as the Hong Kong of Europe, free of eurosclerosis, with low taxes and with the most deregulated economy. As I have grown older I have become more realistic. Britain already has among the most deregulated product and labour markets in the advanced world, according to the OECD. There is red tape but much of it is home-grown. Her Majesty’s Revenue & Customs does not get its instructions from Brussels.

As for tax, George Osborne is already aiming for the lowest corporation tax rate, 17%, in the G20. He could aim to reduce it to 12.5%, matching Ireland, but the public finances are still not fixed, and voters – already pretty fed up with what they see as sweetheart tax deals for multinationals – would look askance at tax cuts intended to make life even easier for them.

As well as this, inward investors know that business tax cuts or supposed bonfires of red tape are prey to shifts in the political wind – the next government could reverse them at the drop of a hat – but EU membership and access to the single market have been regarded as permanent. If it ceases to be so, it seems inevitable inward investment will suffer.

Sunday, March 27, 2016
A big rise for the low paid - will it cost jobs?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

On Friday this week, the biggest government intervention in wage-setting since the introduction by the Blair government of the minimum wage in 1999 will occur.

The national living wage of £7.20 an hour for the over-25s will come into force. It is, curiously, exactly double the original minimum wage of £3.60 an hour of April 1999. More importantly, it is 50p an hour, or 7.5%, above the existing minimum wage of £6.70 an hour.

It seems a long time since George Osborne announced his version of the living wage in his post-election budget last July. Iain Duncan Smith, who had apparently not been told in advance, celebrated with some energetic fist-pumping on the floor of the House of Commons. It was probably the moment of maximum togetherness between the chancellor and the former work and pensions secretary.

Incidentally, there has been far too much excitement about the supposed “black hole” in the public finances following the abandonment of the disability cuts that supposedly provoked Duncan Smith’s departure. £4.4bn between now and the end of the parliament and £1.3bn in 2019-20 does not constitute even a pale grey hole. There are many much larger challenges on the chancellor’s rocky road to a budget surplus, not least the questions of whether he will ever raise fuel duty and the cost of further raising the personal tax allowance and higher rate threshold.

But back to the living wage. It was, in many ways, a curious policy announcement from a Tory chancellor. At the time I noted that had the election turned out differently, and the living wage had come from Ed Balls in an Ed Miliband government, the response might have been quite different. Many in business, and many commentators, would I suspect have said that it was an intervention that showed how little Labour understood how the economy really worked.

Politically, too, what some saw as Osborne’s masterstroke – seizing the centre ground from a wounded Labour party – can now be seen as jumping the gun. At the time, most thought that Jeremy Corbyn’s candidacy for the Labour leadership was a curiosity and that one of the mainstream candidates would win. It was not, so Labour left the centre-ground of its own volition. The chancellor had no need to muscle in to push it aside.

The other thing about the national living wage announcement, which speaks to some of the recent criticism of Osborne’s approach, is that it was deliberately intended to shock and awe. This was the rabbit out of the budget hat. There was thus little consultation ahead of it. Anybody who has read the Low Pay Commission’s deliberations on the minimum wage will know the careful analysis that goes into them, including detailed assessments of the impact on different sectors of the economy.

No such detailed analysis preceded the living wage announcement. Some sectors, including care homes, domiciliary care, cleaning, and parts of retailing, catering and the hotel trade are exposed. Others, except to the extent that they use the services of some of these exposed sectors, are not much affected. When governments have intervened in pay-setting, way back to the wages councils that were eventually abolished in 1993, they have taken into account these sectoral differences.

Even within the affected sectors some will be more exposed than others. Certain employers have taken steps to trim elements of pay, such as overtime rates, ahead of the introduction of the living wage, in order to control the pay bill. Others have embraced it. Whitbread, for example, says it will pay above the national living wage to all its Costa and Premier Inn employees, even those aged under 25 and apprentices. The British Retail Consortium (BRC), on the other hand, cited the living wage as one of the factors in its prediction of 900,000 retailing job losses by 2025.

The most vulnerable employers (and employees) are probably those in the care sector, caught between rising wage costs and squeezed local authority budgets.

So what will happen? One certain effect is that the living wage will provide a significant boost for the lower-paid. A Resolution Foundation analysis, out today, shows that, in combination with October’s rise in the minimum wage, people on the lowest rung of the pay ladder will have seen a 10.8% rise in pay once the living wage comes in this week. That is four times the increase in pay for workers as a whole, and it is not a one-off.

Resolution expects the lowest-paid to enjoy a 5.7% average annual pay rise between now and 2020, compared with a 3.7% workforce average (which looks optimistic). The living wage will, says Resolution, provide an immediate boost to 4.5m workers and “make significant inroads into tackling Britain’s low pay problem”.

Will it cost jobs as the BRC and others fear? The issue came up at the Royal Economic Society’s annual conference at Sussex University last week. If I were to sum up the position among economists who have researched this, always a tricky thing to do, it would be that the adverse employment consequences of minimum wages have been overestimated in the past – job losses were expected to be bigger – and that the same will probably be true of the living wage. The Bank of England, for example, expects it to add only 0.1 percentage points to overall pay growth; not enough to cost many jobs.

But this is an uncertain area. A new survey of economists carried out by the Centre for Macroeconomics, which I take part in and which encompasses the universities of London and Cambridge as well as the Bank and the National Institute of Economic and Social Research, is on this very subject.

It shows that by two to one, 57% to 33%, economists do not expect the living wage to lead to significantly lower employment. More convincingly, by 76% to 11%, they believe it will have only a muted effect on wages and prices across the economy as a whole.

We should not, however, be too complacent. The fact that many economists do think the living wage will lead to sizeable job losses is a worry. So is the fact that, while researchers agree that introducing a minimum wage at an appropriate level and increasing it gradually does not have a big employment cost, the chancellor may be testing that theory to destruction. A 10.8% pay rise for the lower paid at a time of zero inflation is big in anybody’s book.

So Friday sees the start of an experiment. The hope has to be that employers can absorb the increase in wage costs, or neutralize it by achieving productivity improvements. It will be good for everybody is that is also the reality. But that is not guaranteed.

Sunday, March 20, 2016
Why two Osbornes and one Duncan Smith don't mix
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

My initial reaction to Wednesday's budget was that, apart from being the fiddliest I could recall, it would not stay long in the memory. That was before it exploded on Friday evening with Iain Duncan Smith's resignation.

We are four days on from a budget that included 77 separately costed measures – more in a single budget than anybody can remember – as well as some of most obvious and ungainly fiscal gymnastics.

So, I was fully geared up to hold forth on a chancellor more addicted to unnecessary tax tinkering and more prone to using smoke and mirrors to meet his fiscal rules than that legendary exponent of the art, Gordon Brown.

And I was all ready to weigh in an assault on George Osborne for failing so soon in this parliament on two of his fiscal targets; the so-called welfare cap (breached in November and still breached now) and reducing debt as a percentage of gross domestic product every year, which is breached now according to the Office for Budget Responsibility. If this, his eighth budget, were also to be his last because of a Leave vote in the EU referendum, it would not have been a great swan song. It wasn’t even the safety-first budget the referendum had apparently required.

Then, two things happened. One was that plenty of other people immediately weighed in with a similar critique of the chancellor, so there was no point in repeating what is already out there. The other was the surprise resignation of Duncan Smith as work and pensions secretary on Friday evening, ostensibly about cuts to disability benefits. In leaving, he attacked Osborne’s entire approach.

Before coming on to that, I do not want to add to the unjustified gloom that surrounded much of the budget coverage. True, there is a significant referendum risk to growth, described here last week. Otherwise, however, Britain does not look like an economy in all that much trouble.

On the morning of the budget official figures showed a rise of nearly half a million in the numbers of people in work over the latest 12 months. A record percentage of people are in employment and growth in wages has ticked higher.

The biggest surprise in the OBR’s projections was a downward revision of its prediction for government borrowing this year, 2015-16. Instead of the £73.5bn of borrowing it projected in November, and a near-unanimous view among outside economists that there will be a sizeable overshoot, the OBR expects the number to come in at £72.2bn.

It is quite likely too that Osborne’s debt rule, having been broken in 2015-16 on this occasion, will be subsequently found to have been met. The rule was broken, not because of higher debt – it is a little lower than expected in November - but because of lower nominal, or cash, GDP. As the official statisticians get round to revising the GDP figures, most likely upwards, so this apparent failure could revised away.

Similarly, the almost universally downbeat view on growth and productivity – the biggest single economic change underlying the budget – should be taken with an appropriate quantity of salt The OBR responds to the latest data at its disposal. The productivity numbers in the final quarter of last year were thoroughly gloomy, so the OBR gave up the ghost on its previous productivity expectations.

But these are murky waters. Sir Charlie Bean’s independent review of official statistics, the recommendations of which were fully accepted by Osborne, pointed out the challenges of measuring both output (GDP) and labour input (hours worked) in a changing economy and labour market. Productivity growth has undoubtedly slowed since the crisis but the extent of that slowdown is complicated by measurement challenges.

Why is productivity so important for the public finances? As the OBR says: “Lower productivity growth means lower forecasts for labour income and company profits, and thus also for consumer spending and business investment. In aggregate this reduces tax receipts significantly.” If the OBR is right and, as I wrote a couple of weeks ago we should learn to live with weak productivity, we may also have to learn to live with weaker tax receipts than we would like.

This brings me on to my big point. When Osborne misses his fiscal targets, and has to perform contortions with the timing of corporation tax changes and infrastructure spending to keep his target of a budget surplus alive, some of that is due to factors outside his control, including the performance of the global economy. If Britain’s productivity performance has deteriorated then anything that has been done since 2010 to try to fix it – and there is a legitimate debate about whether it should have been more – will not show through until long after this chancellor has moved to pastures new. Supply-side reforms take time.

Some of the missed targets are, however, entirely deliberate. There are two Osbornes; the Jekyll and Hyde of the Treasury. There is Osborne the deficit cutter, harsh and unbending in his determination to slow and eventually eliminate the rising tide of debt. Osborne the deficit cutter wanted to get rid of most (not all) of the deficit by the end of the parliament.

Then there is Osborne the politician who, like all politicians, wants to be loved. He is not, as we have seen in recent days, necessarily all that good at it. This Osborne developed his economic philosophy in the years of plenty. “Sharing the proceeds of growth” between tax cuts and spending was the Osborne and David Cameron call when Labour was in office. It has survived into the era of austerity and big deficits.

A good example is fuel duty. Wednesday marked the sixth successive year in which fuel duty has been frozen. The chancellor is proud of the fact that pump prices are 18p a litre lower than they would have been if the pre-2010 duty escalator had been maintained, and that the average motorist spending £450 a year less on fuel than five years ago (not just because of duties). The cost of this admittedly popular freeze compared with the alternative is at least £6bn this year and cumulatively several times that, according to the OBR. Assuming the freeze continues, that cost will continue to rise. Deficit-cutting Osborne would have had no truck with this; for politician Osborne it was second nature.

Or look at the details of last week’s budget. Faced with a £56bn underlying deterioration in the public finances, the deficit-cutter would have bent over backwards to squeeze more revenue and cuts out of the system, eschewing any giveaways.

Politician Osborne, in contrast, found room for reducing business rates, corporation tax and capital gains tax, and for generous increases in the personal tax allowance to £11,500 next year and in the higher rate threshold to £45,000. Every tax-raiser, such as the sugar levy, was immediately spent. As I sometimes remind people, in his austerity budget of 1981 Lord (Geoffrey Howe) froze allowances and thresholds at a time of high inflation. Osborne prefers to increase them at a time of no inflation.

Politician Osborne may be right. Most voters do not follow the finer details of the public finances. Many do not know the difference between debt and the deficit. They do know when the cost of filling up the car goes up. Holding out the ambition of a surplus is an important signal, drawing the distinction between the Tories and Labour. Achieving that surplus may be less important.

But the Duncan Smith resignation has also exposed the weakness of the “two Osbornes” approach. Had the chancellor stuck to deficit-cutting, eschewing giveaways, the former work and pensions secretary would not have had much of an argument, leaving aside the obvious differences over Europe. Welfare cuts and deficit cuts need to go hand in hand. Because Osborne did not, preferring to splash some of the welfare savings around, he left himself open. It remains to be seen how quickly he can recover.

Sunday, March 13, 2016
Osborne skates on thinner ice as Brexit fears hit growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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When George Osborne started thinking about his eighth budget a few weeks ago he probably knew that by the time March 16 came around the EU referendum battle would be in full swing. That did not, however, stop him pushing ahead with ambitious plans to reform the way pensions are taxed, with his preference for a wholesale switch to a so-called pension ISA (individual savings account).

We know now that this will not happen, or at least not this week. Fear of doing anything potentially unpopular in the run-up to the referendum, as changing the existing system of tax relief would have been, led to the plans being shelved. There had been murmurings from Tory MPs.

Chancellors are supposed to do unpopular things in the interests of the longer-term good of the country. Osborne is finding it difficult to do so, particularly since the election. We may look back on the 2010-15 coalition as a model of stable government, certainly in comparison with what has followed.

Tory MPs have discovered their power. It only takes 30 or so of them, sometimes less, to force a retreat. That, more than the chancellor’s political opponents, forced the U-turn on cuts to tax credits last November. Tory MPs, by voting against the government, helped defeat plans to relax Sunday trading laws. There is a gathering revolt against a fuel duty rise this week, a rise that is counted in the government’s fiscal calculations. With dozens of Tory MPs openly campaigning against the EU stance of the prime minister and chancellor, this is turning out to be a chaotic government.

Osborne is quite good at pulling rabbits out of the hat, even if often on closer examination they turn out to be tiny kittens, so do not discount the possibility of a populist surprise or two this week. Even if there are, however, the chancellor will not want to let the moment pass without issuing stark warnings against the dangers of a vote to leave the EU.

Saying anything that suggests leaving the EU will have negative consequences and that membership has benefited Britain is tricky territory, as Mark Carney discovered a few days ago. The Bank of England governor can look after himself but when faced with attacks by oddball Tory MPs and an out-of-control “big beast”, the former chancellor Lord Lawson, there must have been moments when he wished he was back in Ottawa.

Jacob Rees-Mogg, the Tory MP for North East Somerset, accused him of making “speculative” pro-EU comments that were “beneath the dignity” of the Bank. Peter Bone, his Wellingborough colleague, said Carney should consider his position and drew the contrast between the Bank governor and John Longworth, the “Brexit martyr” who resigned as chief executive of the British Chambers of Commerce (BCC) after speaking out at its annual conference.

MPs have sunk low in recent years but this really was scraping the barrel. Carney was not speculating but accurately reflecting the view of his institution, as set out in its carefully-researched report last October, EU Membership and the Bank of England, which provided extensive evidence that trade openness with the EU, inward investment to access the single market and free movement of labour “reinforces the dynamism of the UK economy”. Longworth, in contrast, deliberately went against the agreed position of the BCC, the organisation he was paid to run.

Lord Lawson was even worse. Suggesting in a BBC interview that Carney was driven by the desire to curry favour with Goldman Sachs, his former employer, and get a good job there when he steps down from the Bank, was beneath the dignity of a former holder of the office of chancellor.

Fortunately for Osborne, one accusation that was levelled at Carney, that he was guilty of wading into politics, cannot be legitimately directed at him. The chancellor is meant to be knee-deep in politics, though sometimes he is up to his neck in it.

The chancellor has promised a full Treasury analysis of the costs and benefits of leaving versus staying in the EU, though the only guidance on timing is that it will be published between now and the referendum. One thing that would help frame the debate, an Office for Budget Responsibility forecast showing the outlook for the economy and the public finances on “In” and “Out” is, officials say, outside the OBR’s terms of reference. It can only forecast on the basis of government policy, which is to stay in the EU.

It is, however, generally accepted that Brexit would be a negative shock for the economy. The long-term consequences or leaving can be debated. In the short-term it would, as the prime minister put it in a speech last week, cost growth and jobs.

As a report last month, London: The Global Powerhouse, commissioned by Boris Johnson, the pro-Brexit mayor of London, put it: “Leaving the EU would be an economic shock. Most, if not all, economic shocks depress economic activity. Thus economic forecasts that focus on, say, a couple of years ahead would tend to show that leaving the EU is always worse than the alternative.”

How big a short-term negative shock might there be? Kevin Daly, UK economist at the aforementioned Goldman Sachs, says that there would be “a damaging uncertainty shock for the UK” which could be prolonged. “Business investment accounts for 10% of UK GDP,” he writes in a special report. “A collective decision to pause a significant share of this spending would be materially negative for UK output.”

ABN-Amro, another investment bank, says Brexit would push Britain’s GDP down by between 1% and 3% next year. An effect at the upper end of that range would push the economy back into recession. Societe Generale, in a new report, says Britain’s growth would be reduced by between 0.5% and 1% for a period of 10 years.

A bigger concern than these effects on GDP, which can never be precisely measured, would be if things really got out of control. That is why Carney announced measures to see the financial system through a Brexit shock, if it occurred. Even that might not be enough. Berenberg Bank warns that a crisis in the second half of the year would follow a vote to leave. Neil Williams, chief economist at Hermes, the investment managers, thinks the Bank of England would be forced into another round of quantitative easing, last undertaken four years ago.

This is where it gets interesting, and where useful anti-leave ammunition for Osborne could turn into something more dangerous. The public finances, as the chancellor often reminds us, are still not fixed. He is likely to announce further action this week to restrain spending over the medium-term.

Even without a Brexit vote he is heading for a £50bn borrowing overshoot over the next five years compared with the OBR’s November forecast, according to a new analysis published today by PWC. It will not be surprising, given the downward revision of so-c alled nominal GDP since November, if the OBR has presented the Treasury with similar numbers.

With Brexit, borrowing could easily shoot up to more than £100bn annually, creating powerful echoes of the crisis of a few years ago, and fatally undermining Osborne’s efforts to restore the country to fiscal health.

The chancellor has been steering a fine line between keeping the markets and international investors happy with deficit reduction and not killing the recovery with excessive austerity. A Brexit vote, or even the heightened fear of it, could mean that he has been skating on very thin ice.

Sunday, March 06, 2016
Let's relax and learn to live with low productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We all need a break from the referendum this week, so I will provide one here. The only thing I will mention in passing is the question of whether Brexit fears are already weakening the economy as they have weakened the pound.

Brexit uncertainty is one factor cited by Markit, which produces the monthly purchasing managers’ surveys, all three of which (manufacturing, construction, services) weakened last month. If Brexit is indeed a factor in what looks to be a slowdown, it plays both ways.

The Remain camp will say it shows anticipation of how the economy will suffer if we leave. The Leavers will argue that it is not Brexit fears hitting growth but wider worries about the global economy. The rest of us might conclude that a government that says we should not take risks with the economy has itself introduced risk by holding the referendum.

Anyway, it is another area of weakness I want to address this week; productivity. Britain’s poor productivity performance has been one of the stories of the post-crisis period. Productivity – output per hour or output per worker – is the lifeblood of the economy, the source of all our prosperity. In the famous phrase, “productivity isn’t everything but in the long run it is almost everything”.

But if productivity is almost everything, in recent years it has not been very much at all. Output per hour across the whole economy has crept above its pre-crisis level, but only just. In the latest figures last year it was 1.6% higher than in early 2008. That, however, was nothing to celebrate. The Office for National Statistics points out that had it kept up with the pre-crisis trend it would be 13% higher than it is.

I should say at the outset that plenty of business people dispute the extent of the productivity gloom. My colleague Dominic O’Connell encountered such scepticism at a high-level dinner a few days ago. The EEF, the engineering employers, published a major report on productivity recently which found that for many in industry, official measures of productivity are poorly specified and poorly measured. Economists at Legal & General, in a new report, say official statisticians are “failing to capture the revolution in distributed networking and cloud computing”.

But, staying with the official numbers, a large chunk of potential productivity growth has been lost, apparently never to be regained. Even now, while output per hour is rising, it is doing so at barely half the rate that was the norm before the crisis. The picture for output per worker, another productivity measure, is, if anything, even more muted as a result of the strength of employment growth. The latest figures had it just 0.7% up on pre-crisis levels. If it had grown as fast as in the seven years leading up to the crisis it would be 14% up.

If you want to get really depressed about productivity, meanwhile, look at the comparisons with other countries. Official figures last month showed that output per hour in Britain in 2014 was 18 percentage points below the average for the rest of the G7 (America, Germany, Japan, France, Italy and Canada).

Worse, Britain appears to be doing appallingly badly in comparison with our near neighbours. French output per hour is 31% higher than Britain’s. In the case of Germany, the gap is a whopping 38%. The British disease, once characterised by too many strikes and tea breaks, appears to be back. How worried should we be?

In terms of the international comparisons, there is not a lot to the proud of, but the picture is not as black as it first appears. German and French workers have much shorter average working weeks than their British counterparts, 26.4 and 28.3 hours respectively, compared with a British average of 32.3.

Some of that is explained by legislation, some by the part-time, full-time split. But it means that if we take an alternative measure, output per worker, then Germany is a more manageable 11% higher than Britain, and France 15%.

There is another comparisons produced by the Office for National Statistics. This, a constant price productivity measure, suggests that Britain achieved significantly stronger growth in output per hour in the 10 years leading up to the crisis, and somewhat weaker since. Britain is behind, but on this measure by only a few percentage points.

The bigger question is how worried we should be about the weakness of productivity which, in the post-crisis period, has not been just a British affliction. The point has often been made in recent years, including by me, that strong employment growth has been a price worth paying for weak productivity but that it cannot go on forever.

Now I wonder, both whether lower productivity is temporary and also whether we should be that worried about it, a suggestion that is almost sacrilege in economic circles.

Many years ago, in the 1980s, when the world was looking to Japan, both as a tough competitor and a model economy, international productivity comparisons showed up something very curious. Despite its fearsome reputation Japan’s productivity was lower than the other big industrial countries, including Britain.

Japan, in those days and indeed now, combined high levels of productivity in the export-facing sectors it needed to compete, including manufacturing, with low productivity across large swathes of the rest of the economy, including much of the service sector and agriculture. Japan combined a high degree of competitiveness with a high employment, indeed virtually full employment and a lifetime system of job security.

Japan is no longer a model to follow in a general sense, but its productivity approach has a lot to be said for it. Combine high productivity in export-facing sectors such as manufacturing and internationally-traded services with low productivity across a whole range of domestic service industries and you end up with something that, if not ideal, is not bad. Having the most productive hairdressers in the world will not necessarily help Britain compete.

Low-productivity services, of course, imply low wages, or else there would be an inflationary threat. But they also imply high employment.

What about the sectors in which we need to compete? The EEF notes that manufacturing productivity has grown at twice the rate of the rest of the economy, and of services, over the past 20 years. Its chief economist Lee Hopley, noting that good data is hard to come by, cites figures showing that Britain’s manufacturing productivity grew faster than Germany, France, Italy and the Netherlands in the five years straddling the crisis. But there is work to be done – a lot of it – to make manufacturing more productive.

As for internationally-trade services, the picture is mixed. Productivity growth in financial services has gone into reverse since the crisis, while business services continue to perform pretty well. Across the services where Britain is strongest, there is no reason for complacency but none for deep gloom either.

Productivity matters, but it matters more in some sectors than others. It is those sectors in which government should direct its efforts. And it is in those sectors – not everything – we should worry when we fall behind.

Sunday, February 28, 2016
Inside the EU, we whistled a happier tune
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

History does not necessarily repeat itself, but it is a long way from being “more or less bunk” as Henry Ford famously put it. History looms large in the politics of the EU referendum. Now, as 40 years ago, we have a prime minister trying to sell his renegotiation to voters, while presiding over a divided cabinet. For David Cameron, read Harold Wilson.

There is also useful history in the economics of Britain’s relationship with Europe. Campaigners for Brexit look to a future in which Britain is disentangled from the constraints of the EU and free to forge new and stronger economic relationships with the rest of the world. I shall have a look in more detail what this might mean between now and June 23rd.

Before that it is worth reminding ourselves of that tangle-free world, because Britain has been there before. In the 1950s and 1960s, while the original six members of the EU were forging ever closer economic relationships, beginning with the coal and steel community and then the European Economic Community (EEC), Britain ploughed a very different furrow.

By staying out of the talks leading to the establishment of the coal and steel community in the early 1950s because, in the words of Herbert Morrison, Labour’s deputy prime minister (and Peter Mandelson’s grandfather), “the Durham miners won’t wear it”, Britain had already demonstrated a hostility to European integration. It was no great surprise when the EEC, created as a result of the Treaty of Rome of 1957, and starting in 1958, did not include Britain among its original members (Germany, France, Italy, Belgium, the Netherlands and Luxembourg).

While Europe was busy integrating, the world was Britain’s oyster. Where there had once been the Empire, on which the sun never set, now there was the Commonwealth. There was the special relationship with America. There were opportunities well beyond the narrow confines of the EEC.

The world, however, was not enough. Commonwealth countries such as Australia and South Africa, far from being happy to be easy markets for British exports, wanted to develop their own industries and imposed tariff barriers against the mother country. India was heavily protectionist from the time of independence in 1947.

As a result of this and other factors, Europe’s grass started to look a lot greener. Britain’s economic performance in the 1950s and 1960s, while reasonable in comparison with later decades, was poor in relation to the EEC pioneers. Germany and France had a lot more catching up to do after the devastation of the war but, even allowing for this, achieved growth well in excess of Britain.

In the period 1950-73, sometimes known as the golden age, gross domestic product per head rose by an average of 2.4% a year in Britain, 4% in France and 5% in Germany. By 1960, Germany was once again producing more cars than Britain and had secured a bigger share of world trade.

Having sampled life outside, successive British governments wanted in, and desperately. Having tried a smaller alternative to the EEC, the European Free Trade Association (EFTA), established in 1960, Britain applied, and was rejected for EEC membership, in 1963 and 1967, before being finally admitted at the start of 1973. Envy of Europe went deep. The 1964-70 Labour government, under Wilson, consciously and unsuccessfully tried to imitate France’s successful experiment with economic planning.

The politicians of the 1960s and early 1970s were not daft. Having lagged behind growth in the EEC prior to membership, Britain caught up and then overhauled the original six. Their growth became no longer a cause for envy. Growth rates slowed everywhere after the golden age, but Britain’s relative performance improved. Plainly not all of this was due to being in the EEC. Clearly, some of it was.

Joining the EEC was a considerable economic success, according to a new paper The Growth Effects of EU Membership for the UK: A Review of the Evidence, by the noted economic historian Professor Nick Crafts of Warwick University.

“Membership has raised UK income levels appreciably and by much more than 1970s’ proponents of EU entry predicted,” he writes. “Joining the EU raised the level of real GDP per person in the UK compared with the alternative of staying in EFTA. The deeper economic integration EU membership entailed increased trade substantially and this had positive effects on income.” His calculations suggest that the positive economic effects of membership have outweighed the cost of Britain’s EU contributions and red tape by a factor of about seven to one.

The world was different in 1973 when Britain joined the EEC, and 1975, when we had a referendum, comfortably won, on whether to remain in. Many people who did have a vote in 1975, and some who did not, claim that the country was conned, that we voted to join a common market and ended up with ever closer union, migration and a single currency on our doorstep.

It is true that at the time of the 1975 referendum the government chose to emphasise the trade aspects of membership to the exclusion of almost everything else. But freedom of movement and equal treatment of people were part of the Treaty of Rome, though in the 1970s most people expected the flows to be from Britain to Europe, not the other way around. The subsequent TV series Auf Wiedersehn Pet was about British migrant workers in Germany.

As for the single currency, when Ted Heath began his successful entry negotiations, the EEC was still officially on course for monetary union, the Werner Report of October 1970 having set the target of achieving it by 1980. It took a further two decades but Europe’s intentions were pretty clear.

A stronger point is that Europe has changed in 40 years. No longer do we envy our European partners their growth, although I find that many people I talk to still have a lot of envy for Germany, and even France. The world has changed too, with the rise of China and other emerging economies. Trade is freer, for goods, if not yet enough for services, though Britain is making great strides: service-sector exports doubled between 2006 and 2014.

The question which I will address in the coming weeks is whether things have changed enough for life to be better outside. Does our EU membership prevent us taking full advantage of the wider world, or is that an escapist fantasy? Germany has been a notable success, from within the EU, in selling to the world. Only China and America, with much larger populations, export more. A few decades ago we found that life outside Europe was cold. The question is whether it would be any warmer now.

Sunday, February 21, 2016
EU migration: economically beneficial, politically toxic
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is the biggest and most toxic issue in the referendum debate, central to the deal concluded by David Cameron late on Friday. It is the one in which emotions run highest. I am talking about immigration, safe in the knowledge that whatever I write today plenty of people will disagree with me.

Immigration from the rest of the European Union to Britain has got caught up in the public mind, wrongly, with the EU migrant crisis; the flood of asylum-seekers from Syria and elsewhere making their way across Europe and threatening the EU’s open borders, the Schengen agreement. Britain, of course, is not part of that agreement and never likely to be.

But figures this week will confirm that “normal” net migration into Britain – the number of immigrants minus the number of emigrants – is at or close to all-time highs. Thursday’s figures, covering the period to September last year, are set to show a rolling total similar to the 336,000 for the 12 months to June 2015, which was a record.

The figures will provoke a row, again making a mockery of David Cameron’s always unachievable 2011 “no ifs, no buts” pledge to reduce net migration to the tens of thousands. Before getting into the arguments, let me provide a little more detail on the previous set of numbers.

The 12-month total to June last year comprised 636,000 immigrants and 300,000 emigrants (many previous immigrants). Of the 636,000, 294,000 came to work, 192,000 to study, and 80,000 accompanied or joined other family members.

Just as there is confusion over migration and the asylum crisis, so there is a widespread assumption that immigration into Britain is overwhelmingly from the rest of the EU. That is not the case now, nor has been true at any time in the 43 years of Britain’s EU/EEC (European Economic Community) membership.

In the 12 months to June 2015, EU net migration to Britain was 180,000, non-EU migration 201,000. If you think that does not add up to the 336,000 net migration total you would be right. The circle was squared by 45,000 of net emigration by British citizens (much of it to the rest of the EU). That continued a long-term trend. In only one year in the past 40, 1985, has there been no net emigration by British citizens.

Immigrants from the EU tend to come to Britain to work. They accounted for at least 162,000 of the 294,000 migrants coming for work reasons. Non-EU migrants, in contrast, are more likely to come to study – 131,000 out of 192,000 – or for family reasons; at least 45,000 out of 80,000.

What about the impact of EU migrants on the job market? Separate labour market figures released last week showed there are now 2.04m non-UK nationals from the rest of the EU working in Britain, about double the number from the rest of the world. In the latest 12 months (between the final quarters of 2014 and 2015) there was a 215,000 rise in employment for EU migrants – two-fifths of the total rise in numbers in work. These were the figures that caused apoplexy on some front pages on Thursday.

Is immigration from the rest of the EU good or bad from the economy? As a thought experiment imagine what the impact would be of waving a magic wand and increasing the working population by hundreds of thousands of mainly young, mainly skilled and mainly educated people. You would expect the economic effects to be beneficial and you would be right.

Studies have consistently found that EU migration provides a fiscal boost, not a fiscal drain, including a much-quoted November 2014 University College London study. EU migrants, on average, pay more tax than they receive in public services or benefits. Notwithstanding a central aspect of the prime minister’s EU renegotiation, migrants mainly come to Britain to work, not to claim benefit. If there is a problem with in-work benefits, including tax credits, the fault lies with the design of the system.

A Home Office review of the evidence two years ago found that EU immigration does not adversely affect native employment during normal times. Only when the job market is weak, such as in 2008-9, is there an adverse effect.

What about pay? A Bank of England working paper last year by Steve Nickell and Jumana Saleheen found that immigration has a small negative impact on average wages, though there was no difference in the impact on earnings of EU and non-EU migrants.

Though other studies have suggested no impact on wages, that conclusion does not seem logical. The effect of immigration is to provide an ongoing boost to labour supply. That means more slack in the job market and at the margin less upward pressure on wages.

But such effects should not be overstated. The overlap between the jobs EU migrants do and those British workers want to do is much less than commonly thought. As Jonathan Wadsworth of the London School of Economics put it in a recent paper, new migrants are much more likely to be close job market substitutes for existing migrants than native-born workers.

I wouldn’t want to use the Pret A Manger close to our offices as typical of the labour market as a whole, but it appears be entirely staffed by young, largely EU, migrants. The availability of migrants for work almost certainly increases employment, currently a record 74.1% of the workforce.

We do not know is what might happen in the long-term if EU migrants stay permanently rather than returning home. Younger workers who stay eventually get old, and the positive contribution they make to the public finances evens out over time. One indicator of that would be if EU migrants were choosing to apply for UK citizenship in large numbers. So far that does not appear to be happening. Poles are remaining Poles: there are 853,000 people of Polish nationality in Britain.

There are swings and roundabouts in EU migration but the evidence points to the economic benefits comfortably outweighing the costs. Why then is migration such a politically toxic issue, the big potential swing factor in the referendum?

One factor, plainly, is the speed of change. Until the mid-1990s there was virtually no net migration from the rest of the EU. Since then there has been lots. In 10 years from 2004 to 2014 the number of EU nationals in Britain rose from just over 1m to nearly 3m. From 1997 to 2015, the proportion of employment accounted for by non-UK nationals rose from 3.8% to 10.2%, driven by EU migration.

Another factor is the uneven concentration of EU migrants. In some areas migrants put intense pressure on schools and public services. Across much of the country migrant-driven population growth exacerbates the housing shortage. Add to that the fact that the losers from migration, perhaps from being squeezed out of housing provision or low-skilled job opportunities, feel those losses much more keenly than those who benefit from economic gains spread across the population.

But those who oppose immigration should not be played for fools. If we left the EU tomorrow there would still be large-scale net migration to Britain. Non-EU migration, which is substantial, would be unaffected. Some EU migration would continue. But business would find it harder to recruit the skilled and productive workers it needs, and gaps in the job market would go unfilled. EU migration both reflects and contributes to Britain’s flexible and successful labour market. Economically, we would lose out.

Sunday, February 14, 2016
Osborne's budget surplus starts to look like a distant dream
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Every recording artist is familiar with the idea of the difficult second album – the tricky follow-up to a successful debut – as is every author of a bestselling first novel. Now George Osborne is experiencing the equivalent, in what so far is proving to be a difficult second term.

To be fair, not all of the chancellor’s first term ran smoothly. The low point was 2012 and the “omnishambles” budget, and there were others. But, as he prepares for next month’s budget, his fourth big set-piece event in 12 months (three budgets and an autumn statement/spending review), even his best friends would admit that things are not going that well. What might have been his golden age – a Tory chancellor in a Tory-only government – is proving a bit of a headache.

Osborne’s U-turn on cuts to tax credits in his autumn statement may have been politically necessary, but it was embarrassing. Another U-turn may be looming over planned reductions in the amount of public money, so-called Short money, opposition parties receive.

Tumbling stock markets, which have taken on a slightly more sinister turn with the sell-off in banking shares, have forced the postponement of the sale of the government’s remaining stake in Lloyds Banking Group, a sale once intended to recapture some of the privatization spirit of the 1980s.

Growth forecasts are being revised down. Both the CBI (down from 2.6% to 2.3% for this year) and the Bank of England (down from 2.5% to 2.2%) predict continued recovery, but at a slower pace. A 1.1% drop in industrial production in December, announced last week, owed much to the effect of exceptionally mild weather on electricity and gas demand but added to the softer growth tone. The chancellor’s “dangerous cocktail” of risks he referred to last month is having an impact. There is also a tricky EU referendum to negotiate.

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The biggest question, perhaps, arises over what is central to Osborne’s chancellorship, his aim of eliminating the budget deficit and leaving a legacy of permanent surpluses. Having planned to eliminate most of the deficit in the last parliament and not succeeded, he moved on to the more demanding target of achieving a budget surplus by the end of this one, and keeping it there.

Recent days have seen one of the biggest events in the fiscal calendar that does not involve the chancellor, the Institute for Fiscal Studies’ annual green budget. The IFS, which is always fair, warned that Osborne is “boxed in by his own rule” (that of achieving a surplus) and “has to pull off a precarious balancing act”.

The all-party House of Commons Treasury committee, which will shortly publish its assessment of the autumn statement and spending review, is also set to criticise Osborne’s fiscal rule, while pointing out that the tax burden in rising as a result of measures such as the apprenticeship levy and the tax attack on buy-to-let landlords. Ahead of the election the chancellor had promised to finish the job of deficit reduction by restraining spending, not raising taxes.

The IFS is right to say that budget surpluses are rare – there have only been eight in Britain over the past 60 years – but wrong to point to a £7bn “black hole” in forecasts for the public finances over the next five years, caused by weaker project growth in earnings and the recent stock market fall.

Its economists know as well as I do, that £7bn in the context of the public finances at the end of the decade is the equivalent of loose change. The path of the budget deficit over the next few years will not be determined by what has happened to the stock market over the past few weeks.

Where the IFS is right is to point to the difficulties of achieving a budget surplus while simultaneously reducing some significant taxes. Osborne aims to increase the personal income tax allowance to £12,500 (from £10,600 now), while also increasing the higher rate threshold. These pledges are so far unfunded. The sums on which the official public finance projections are based assume fuel duties will rise in line with the retail prices index – not the more gently rising consumer prices index – something that the chancellor last did five years ago. Our business-friendly chancellor is bent on cutting the main rate of corporation tax to 18%, the lowest in the G20, even though the main challenge with this tax is getting companies to actually pay it.

This, perhaps, is the nub of the problem. There is nothing wrong with setting a target of achieving a budget surplus in normal times, rare while that might have been in the past. It does not mean starving the country of necessary infrastructure spending: that depends on how much you raise in tax and how you divide up public spending. It does mean you reduce the public sector debt burden more quickly, which after the huge budget deficits of recent years is no bad thing.

Where there is a problem, particularly if you have a chancellor with a populist eye on succeeding David Cameron as prime minister, is trying to combine expensive and supposedly popular pledges, including raising the inheritance tax threshold on family homes to £1m, with the hard job of eliminating the budget deficit. The two may be incompatible.

A few days ago we had a rare speech from Sir Nick Macpherson, the outgoing Treasury permanent secretary, its top official. Normally those in his position adopt a Sir Humphrey-like vow of silence.

He was responding to criticism that the Treasury should have been more Keynesian in its approach in recent years, and less obsessed with getting the deficit down. I agreed with most of his speech, particularly what he described as the “asymmetry” of policy by governments, which find it much easier to relax fiscal policy than tighten it, and to run budget deficits rather than surpluses. I also agree that most economists underestimated what a tightrope Britain was running with the very large budget deficits of a few years ago, and how close the country was to a full-blown fiscal crisis. Sir Nick was weaker on the absence of “shovel ready” infrastructure projects which the government could have spent money on. A government determined to spend more on infrastructure should by now have overcome planning and bureaucratic delays.

In 2009 and 2010, some of Sir Nick’s Treasury colleagues were worried that Gordon Brown, if re-elected, would not have the stomach or the desire to push through the necessary measures to get the deficit down.

Now, they are entitled to wonder whether the same is true of Osborne, or whether populism will win out over eliminating the deficit. A test will come next month. With oil prices hitting new lows, there has never been a better time to start increasing excise duties on petrol again, albeit in the knowledge that it would certainly generate negative headlines for him. Osborne should forget popularity, which may in any case be a lost cause, and do the right thing.

Sunday, February 07, 2016
Britain should never join this negative interest rate club
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Negative interest rates are in vogue. The Bank of Japan a few days ago joined a club which includes Switzerland, Denmark, Sweden and the European Central Bank (for one of its key rates) in pushing the interest rate dial below zero. Three of the world’s biggest central banks have negative rates. I shall come on to the Bank of England in a moment.

After a long period in which interest rates have been close to zero and central banks have engaged – and in some cases are still engaging – in large-scale quantitative easing, it appears that it is still not enough. At least five central banks think negative interest rates are now necessary. Could they ever become the norm?

Negative interest rates are still a strange phenomenon. The idea that anybody should pay for the privilege of depositing funds runs counter to the normal rule of “time preference”, that any rational person, or business, would rather spend now than later. The usual way of dissuading them from doing so, in other words encouraging them to save rather than spend, is an interest rate incentive. We will defer consumption if it is worth our while. That is how it works.

Central banks are different. The interest rate they typically set is on the reserves commercial banks hold with them. In most cases, commercial banks have to hold at least some of those reserves, for prudential and other reasons. They are, in that sense, a captive audience – up to a point.

As Paul Sheard, chief economist at Standard & Poor’s puts it: "Central banks can do this because they get to determine the total amount of liabilities they issue, giving them the unique ability to set both quantity and price. In the real economy, borrowers can't usually force lenders to lend to them.”

So, even in countries which have adopted negative interest rates, ordinary savers are unlikely to have to pay for the privilege of putting their money in the bank, though that may be of small comfort to those who have been enduring near-zero returns for years.

What is the point, then, of negative rates? When the Bank of Japan, or another central bank reduces rates below zero, it is trying to do two things. It is sending out a signal to the markets that whatever expectations they may have of future interest rate rises, they can revise them down. And, by penalising commercial banks – effectively taxing them on their deposits at the central bank – it is hoping that they will use any excess reserves (those above what are required by the regulators) will be used more productively; lending them into the real economy.

Negative rates are, as I say, still a strange idea. In the crisis, and in the post-crisis period, we have, to paraphrase Lewis Carroll, got used to believing many impossible things. This is just the latest.

It is perhaps not so strange when we think about the “real” interest rate; the interest rate adjusted for inflation. A negative “real” rate has been the norm for many years. Rates set by central banks have been well below inflation since the crisis hit.

In Britain in the period since Bank rate was reduced to 0.5% in March 2009, consumer price inflation has averaged 2.4%, implying an average negative real interest rate of almost 2%; -1.9% to be precise. At its worst, during 2011, real interest rates were negative by almost 5%.

Logic would suggest that if a negative real interest rate averaging nearly -2% has been needed to generate recovery over the past seven years then, at a time when inflation is close to zero – and set to remain so for some time – real interest rates might currently be too high.

So, while inflation of 2% or so allowed the Bank to pursue a negative real interest rate strategy by stealth, zero inflation could mean it has to do so in an upfront way. Actual, or what economists would call nominal interest rates, might also need to be negative, perhaps significantly so.

Logic can only take us so far in this, however. There are important practical and symbolic differences between a negative real interest rate achieved when both rates and inflation are positive, and a negative real rate that can only be achieved by cutting below zero. Even then, as noted above, a reduction in general rates throughout the economy would provide a powerful incentive for everybody to keep everything in cash. This was the conundrum addressed by Andy Haldane, the Bank’s chief economist, when he mused a few months ago that negative rates might require the abolition of cash.

So what of the Bank? It, and its governor Mark Carney, tried to be both dovish and hawkish on Thursday, with the publication of the quarterly inflation report. The dovish signal was that the only member of its monetary policy committee (MPC) to have been voting in recent months for a rate rise, Ian McCafferty, has thrown in the towel, for now at least.

The hawkish signal was that the MPC think markets have got ahead of themselves. Ahead of Thursday they were pricing in a 30% chance of a cut in rates, with no increase until 2018. The MPC, Carney said, has not even discussed the possibility of negative interest rates, and believes rates will need to rise to hit and maintain inflation at the 2% target. Not yet, but they will go up. Pressed repeatedly on rate cuts, the governor batted the suggestions away.
This is, as Bank-watchers know, no guarantee but it looks to be a pretty firm stance. The Bank is not even flirting with joining the negative interest rate club. It does not intend to turn Japanese.

That is good news. Britain’s economy is strong enough not to need further monetary help, even with the Bank’s modest trimming of its growth forecast. And, having argued a couple of weeks ago of the dangers of leaving rates too low for too long, I am not now going to argue that they should be cut, let alone go negative. To reprise one of the arguments then, a good way or persuading people and businesses that something must be badly wrong, thereby hitting confidence, would be a negative interest rate. This a club to which we do not want to belong.

Sunday, January 31, 2016
Confidence and a brighter eurozone argue against a Brexit vote
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

We do not yet have a date, and we do not yet have much of a campaign, but the referendum on Britain’s membership of the European Union is slowly looming into view. Moreover, it is already starting to affect the markets.

An opinion poll a few days ago which appeared to offer a greater probability of “Brexit” weighed on the pound. City economists, responding to requests from clients, are busy penning notes both on the effects of referendum uncertainty on the economy and the consequences of a vote to leave if it were to happen.

There will be time to consider these things in the coming weeks. Today, however, to continue my planned programme of pre-referendum pieces, let me address another aspect to the European question.

The euro is the pinnacle, so far, of European integration, and it is the fault-line on which many of the continent’s problems rest. Badly designed, open to too many countries too soon, it brought Europe to the brink of a crisis a few years ago that could have been at least as big in its impact as the banking crisis of 2008-9.

That should have been a wake-up call for Europe’s leaders. So far, however, they have been content mainly to kick the can down the road rather than pick it up and redesign it. The fundamental problem of the eurozone remains. It is not what economists call an optimal currency area. There is no central Treasury, or properly co-ordinated fiscal policy, to offset the power of the European Central Bank. Eurozone labour markets, and wages, are inflexible. And, contrary to what you might think from your TV screens, there is not enough mobility of labour within Europe.

There is a second issue about the eurozone, and it is one that troubles George Osborne, when he can drag his thoughts away from Google. There are 19 members of the euro, out of the EU’s 28 members. 337m people, two-thirds of the EU’s population, live in euro member countries. More countries are likely to join, despite its flaws, in the next few years, though Britain never will.

The danger is that the euro “outs”, comprising a diminishing minority within the EU, gets outvoted and outmanoeuvred by the rest. Ensuring this does not happen, which will be difficult, is arguably the most important aspect of the government’s renegotiation.

For some people, the flawed euro and the risks of being repeatedly turned over by the euro majority in the EU are sufficient grounds for a “leave” vote. As I have said before, I will hold fire on my verdict until nearer the time of the referendum.

In terms of how the economics of the referendum vote will play out, however, and trying to cut through the noise from other issues, let me offer a view of how voters may see things.

Most people do not think too deeply about the euro. They certainly do not trouble themselves over whether the eurozone is an optimal currency area or not. A perhaps disturbingly large number of people in Britain thought – and may still think – that euro membership would be good for us because it would cut out the inconvenience of having to exchange currencies when holidaying elsewhere in Europe.

But people do know when things are going badly. Three years ago, when all the talk was of a double-dip recession in Britain (it never happened), the eurozone had a proper one. It lasted for over a year and it coincided with talk, not just of Greece leaving but of a complete dismantling of the single currency. Eurozone unemployment stood at more than 12% and in Spain and Greece was more than 25%.

This, to not quite paraphrase Groucho Marx, was a European club that we wanted nothing to do with. Polls at the time showed a lead of 20 points or more for the exit camp.

How we feel about Europe matters. How we feel about ourselves also matters. 2012-13 was the time of the squeezed middle, the squeezed bottom, and the squeezed just about everything else. Growth was tentative and the rise in employment, while happening, was weaker than subsequently became the case. Prices were rising faster than wages. Consumer confidence was very depressed. We felt miserable. We probably blamed the eurozone crisis for some of that misery.

There has been a turnaround. The euro’s fundamental flaws have not disappeared but the eurozone has come through its crisis. You would not rule it out indefinitely but Grexit, the departure of Greece from the euro, has ceased to be an imminent threat. It was a close-run thing, but the eurozone has held together.

It has also returned to modest growth. The eurozone started growing again in the spring of 2013 and has continued to grow since. Its current growth rate of 0.3% or 0.4% a quarter is nothing to write home about but it is better than the alternative. The unemployment rate has come down to 10.5%. No longer does Europe appear to be in economic crisis.

As for consumer confidence in Britain, figures on Friday showed it has maintained its strength of last year this month, in spite of tumbling stock markets. Last year was the best for consumer confidence in Britain in the more than 40 years GfK, which surveys the public on behalf of the EU, has been assembling the data. This month has seen a two-point rise in its overall measure of consumer confidence, on the back of continued strong employment growth and rising real incomes. Britain’s consumers are “resiliently bullish” says GfK. They are no longer feeling miserable and they are no longer looking for somebody else to blame.

If these two things persist – a crisis-free and modestly growing eurozone and heightened levels of consumer confidence in Britain – the leave campaign will have its work cut out in trying to persuade voters that change is either necessary or desirable.

That does not, of course, preclude non-economic factors coming to the fore, though people tend to vote with their wallets and purses. The economic backdrop to the referendum is more favourable for a “remain” vote than David Cameron could have imagined when he pledged an in-out vote three years ago this month.

Sunday, January 24, 2016
The dangers of leaving rates too low for too long
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Mark Carney has spoken, in a speech to celebrate 50 years as a professor of economics at London’s Queen Mary University of Lord Peston (Robert’s dad). I don’t think he will have the gall to pop up again this summer and warn us be on the alert for a hike in interest rates at the end of this year.

For the Bank of England governor, who has the ability to generate headlines, being twice-bitten (he gave such warnings in both 2014 and 2015) should mean that this year he will choose to be a little shy.

He could, of course, generate plenty of headlines by starting to drop hints of interest-rate cuts. The Bank’s chief economist, Andy Haldane, appears to be genuinely agnostic about whether the next move in interest rates should be up or down. The Bank has said there are no technical barriers to cutting even from a record low 0.5% rate. Haldane has even talked about the possibility of a negative interest rate.

Carney and most of the other members of the Bank’s monetary policy committee (MPC) continue to insist that they fully expect the next move in rates to be up. Looked at logically and in the context of the governor’s speech, however, it is clear that there are circumstances in which a rate cut could occur.

His three conditions for raising rates were: growth being above its long-run trend, which in practice means quarterly growth of at least 0.5%-0.6%; evidence of a firming of cost (particularly wage) pressures, and a rise in core inflation consistent with getting back to the 2% target.

It is a reasonable set of conditions, but it also opens the way to a possible rate cut. What if quarterly growth were to slow to 0.1% or 0.2%, alongside a further weakening of wage growth and a few more months of inflation being stuck at close to zero, or even going significantly negative on the back of a new round of energy price cuts?

I do not expect it to happen, and I don’t think it would be a good idea, but it is not impossible. There is perhaps a 10% chance of a cut. Earlier this month George Osborne said that a rise in rates would be a sign of strength in the economy. If there were to be a cut he would need another script.

The remaining probabilities I would say are for no change at all this year, maybe 50% (some would put it a lot higher), with a 40% probability still clinging to a very late move this year, though not until November.

The governor’s speech, which was preceded by the MPC’s 82nd consecutive monthly decision to leave interest rates on hold, was unremarkable in its conclusions. With global markets plunging and the oil price slumping, the dust needed to settle. Most of those 82 decisions have been unremarkable.

If you were looking for an ideal time to raise interest rates, with every duck lined up in a row, such times have been in short supply. And, to the extent the MPC is waiting until a decision to raise rates is incontrovertible, a “no-brainer”, the longer we will have to wait for a move.

But, just because each decision to hold rates is defensible, is there a bigger picture danger, which is that ultra-low rates for too long, apart from depriving savers of returns, become dangerous?

Some would see those dangers in the housing market, where the latest Rics (Royal Institution of Chartered Surveyors) survey points to a further acceleration in house prices. For much of the period of very low interest rates, limited mortgage availability has offset the boon provided by low rates, though low rates have also encouraged investors to move into buy-to-let property. Now mortgage availability is improving fast there is a danger that low rates are stimulating the housing market – and pushing up prices – too much.

This is part of a wider point. Early last week I attended and spoke at a conference organised by the Spinoza Foundation in Geneva. One of the other speakers was Bill White, the Canadian former chief economist of the Bank for International Settlements, the central bankers’ bank.

White, who genuinely warned of the crisis before it happened (unlike many who claimed to do so) says central bankers made the mistake of pursuing excessively easy money policies before the crisis, and are making the same mistake again, supplemented by policies such as quantitative easing. Very low rates have had only a limited (and I would say diminishing) effect in boosting growth, while storing up other problems.

Indeed, as he put it in another recent speech, easy money policies may have had the opposite effect of that intended. “Much of what has been done recently smells of panic,” he said. “Arguably, by increasing uncertainty, it might even have encouraged people, both companies and households to hunker down and spend less rather than more.”

The BIS, which presciently warned of the “uneasy calm” in markets last month, thinks central bankers – including the Bank – are collectively making a big mistake. As it put it in its annual report last year: “Low rates are the most remarkable symptom of a broader malaise in the global economy: the economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited. The unthinkable risks becoming routine and being perceived as the new normal.”

The fact that there is even a possibility of a rate cut in Britain from 0.5% would meet the BIS’s definition of “unthinkable”. So would the fact that we are fast approaching the seventh anniversary of a cut to 0.5% in March 2009 that at the time was regarded as emergency and short-term.

The common theme between the pre-crisis period and now is inflation. Before the crisis, central banks focused too much on inflation and missed the dangerous credit bubble that was building. Since the crisis, the Bank ignored above-target inflation for some years, but now sees itself as constrained from raising rates by very low inflation.

Whether these post-crisis easy money policies will ultimately prove to have been dangerous and damaging is hard to say. But there is at least a risk that we will come to regret having near-zero interest rates for so long.

Sunday, January 17, 2016
When world trade struggles. so do Britain's manufacturers
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Another year is now in full swing. Alongside all the other things sent to try us, including weak and volatile stock markets, a plunging oil price and worries about global growth, manufacturing is in the doldrums.

Official figures last week confirmed the gloomy message of industry surveys. Manufacturing output fell by 0.4% in November and was down by 1.2% on a year earlier. Whatever things happened last year, a rise in factory output was not amongst them. And there is, sadly, nothing very new in this.

In the past four years there have been up years like 2014, when manufacturing output rose by a healthy 2.7%, and there have been down years like 2012 and 2013, when it fell by 1.4% and 1.1% respectively.

Broadly speaking, however, and allowing for the fact that there have been winners and losers within the overall numbers, Britain’s manufacturers are now producing what they were in 2011.

That was the year, of course, when George Osborne, in his March budget, talked about “A Britain carried aloft by the march of the makers”, for which he has been much lampooned, the latest in a series of politicians to see a bright future in manufacturing, only to see a grimmer reality kick in.

To be fair to Osborne, he thought in March 2011 that he was simply riding the tide. With parts of the service sector, most notably financial services, reducing activity, there did appear to be a genuine shift back to making things. Manufacturing output rose by a very healthy 4.5% in 2010 and Britain’s factories looked to be set fair.

That, unfortunately, was that. If every part of manufacturing had done as well as transport equipment (including cars), output up 38% since 2010, the chancellor would be hailed as a great sage. Well, he might. But other parts of manufacturing have either not prospered or fallen back sharply, for example in the case of sectors such as basic pharmaceuticals and textiles. Overall, the makers have not marched.

Why is this? Every time we get a disappointing set of manufacturing numbers, industry experts come up with a range of explanations, from skill shortages and high energy costs, through to lack of investment and Britain’s anti-industrial culture. All have a part to play in the long-run story of British manufacturing.

The manufacturing disappointment of recent years has a simpler and more straightforward explanation, however. When world trade does well, British manufacturing does well too. When world trade struggles, so will Britain’s factories.

In 2010, on the back of which Osborne chose to highlight industry, world trade boomed. Having dropped by more than 10% in 2009, the annus horribilis for the global economy, world trade volumes bounced back even more strongly in 2010. For a while it seemed as if normal service was being resumed for the global economy after the crisis, with Britain’s manufacturers playing their full part.

It was a false dawn. One of the missing ingredients of the post-crisis recovery has been world trade. 2011 saw a slowdown, 2012 and 2013 the equivalent of trade being becalmed in the Sargasso Sea. 2014 was better, hence a relatively good performance for manufacturers that year. That last 12 months have, though, seen trade growth fall back.

The CPB Netherland Bureau for economic policy analysis, which records world trade growth, says that it dropped back to just 1.4% in the autumn. As it put it: “Export momentum was down in both advanced and emerging economies.”

I have written before about the post-crisis weakness of world trade, suggesting a combination of lack of availability of export credit, some re-arranging of global supply chains and subtle protectionism.

Trade weakness is plainly not just affecting British manufacturers. The CPB Bureau also produces data for global industrial production, which shows a remarkably similar pattern to that of Britain. In Europe, Germany stands out as the only major economy which has increased its manufacturing output in this period of weak, post-crisis trade growth, with a rise of around 8% since mid-2010.

France, like Britain, is becalmed, while Spain and Italy are down. It is a tough world for manufacturers, and particularly tough in Europe. Maybe, also, something more profound is happening.

I don’t get invited to the Davos World Economic Forum these days but I notice that its theme for this week’s gathering in the mountains is the “fourth industrial revolution”, what it describes as the “ongoing transformation of our society and economy” by various technologies, ranging from robotics to artificial intelligence.

It is easy to mock Davos and its pretensions. Its themes have sometimes been spectacularly mistimed. But technology does change the nature of trade. This may seem an odd point to make when car sales in Britain have just had a record year of more than 2.6m new vehicles registered. We still eat and drink.

But the rise of a new kind of consumer intangible, the most obvious example of which is electronic downloads, is having an effect on trade. It means that, in the case of Britain, exports of services are fast closing on those of goods. As recently as 2010, service-sector exports were less than 70% of the value of exports of goods. In November last year, the figure was just under 90%. Soon Britain will be exporting more services than goods.

Even that may not fully capture the effect of intangibles but the net result will be that there will be a smaller increase in the output of manufacturers, and probably measured trade, for a given increase in gross domestic product and consumer spending in Britain and other advanced economies.

Does that mean we will never see a “march of the makers”? One would hope, despite some of the structural shifts that we are seeing in world trade, that it is not permanently in the doldrums. Some exporters will take comfort from the fact that sterling has come down from last year’s highs, particularly against the euro. At the margin, that will provide a boost for manufacturers.

But it would be unwise to expect too much. Some of Britain’s manufacturers are indeed marching, and long may they do so. Some, equally, are only going backwards.

Sunday, January 10, 2016
Don't drink too deeply of Osborne's dangerous cocktail
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Such is George Osborne’s reputation for political cunning, the natural reaction to anything he does is to look for the true meaning behind the message. Prince Metternich’s observation on the death of Talleyrand – “What did he mean by that?” – springs to mind.

The chancellor is in good health but his warning three days ago, that Britain’s recovery faces “a dangerous cocktail of new threats”, provoked similar thoughts.

When, in November 2014, David Cameron talked of the “red warning lights … flashing on the dashboard of the global economy”, and was quickly backed up by Osborne, it was pretty obvious what they were up to. With the election less than six months away, they wanted to remind people not to risk handing over the economy back to Labour.

As I put it back then, the world was not about to go pop but they wanted voters to think it might, and that only they could be trusted to shield voters from the damage.

This time, some of the chancellor’s motivations are fairly clear. The government has faced criticism over cuts to flood defence spending, as Osborne did last year over his planned – and eventually abandoned – cuts to tax credits. Hence his emphasis on the work still to be done on the budget deficit.

There are two things to say about spending on flood defences. One is that given the scale of the rainfall in recent weeks, the overwhelming majority of the flooding problems we have seen would have occurred with or without the spending reductions of the coalition government’s early years. Spending was cut by 16.5% in real terms in 2011-12 and maintained at the new lower level (which was roughly what was being spent in 2007-8) for two more years.

But we are not talking about billions of pounds here – the 2011-12 cut was less than £100m in cash terms – and even some defences that were considered state of the art proved inadequate. If extreme weather events are becoming the norm, spending on flood defences by all recent governments has been significantly too low.

The second point is that the benefits of good flood defences and related infrastructure improvements far exceed the costs. The fact that those benefits may be intangible – when flooding does not occur it is a non-event – should not matter. Preventative medicine also brings large benefits. That rethink everybody is now talking about on flood defences is necessary. A government that goes on a lot about security must be aware of the insecurity of having your home or business flooded out, or being under threat of it.

But, and this was one of the aims of Osborne’s speech, the public finances are a long way from being fixed. Splashing out on flood defences, no pun intended, will require compensating cuts elsewhere if the chancellor still intends an eventual budget surplus. Six years after it peaked at more than £150bn, public sector borrowing is officially predicted to be more than £70bn this year, and there are pressures on that forecast after a couple of disappointing recent monthly figures.

Was Osborne responding to disappointing pre-Christmas growth figures and getting his retaliation in first ahead of a sharp slowdown this year? As I said at the time, previous experience suggests we should take the late-December data revisions from the Office for National Statistics with a pinch of salt. Most economists expect similar growth this year to last and they are not known for viewing the world through rose-coloured spectacles.

That said, a few things have changed for the worse in the past few weeks. There have been downward revisions to global growth forecasts, particularly for emerging market economies. The World Bank, for example, has just revised down its prediction of global growth this year from 3.3% to 2.9%, and for next year from 3.2% to 3.1%. Both would be better than last year’s estimated growth of 2.4%, which is important to bear in mind, but weaker than hoped.

The World Bank still thinks Chinese growth, at 6.7% this year after 6.9% last, will be with within touching distance of 7%. Investors who have been panicking about China’s prospects in recent days would be more than pleased with that.

It is hard to say whether the Chinese stock market panic reflects genuine concern about the country’s growth prospects or whether it is mainly a response to cackhanded interventions by the authorities. But it has ensured a dreadful start to the year for world markets, including our own FTSE-100, and it has been accompanied by a further plunge in the oil price to a 12-year low of under $35 a barrel.

That further fall in oil prices, when in the past an escalation of tension between Iran and Saudi Arabia might have been expected to push them higher, shows what a changed world we are in. Traders have decided that this oil glut is not going away, and that Iran-Saudi tension means co-operation within the Organisation of Petroleum Exporting Countries to make it do so is even less likely than it was.

So how worried should we be by these recent developments? The stock market’s grim start to the year is not good news but the correlation between what happens in the markets and the real economy is weak, and even more so in China than Britain.

The fall in oil prices is in danger of turning from a helpful boost to growth to a damaging rout which could set back energy investment for years. It looks as if we are now firmly in overshoot territory for oil prices, but without any indications of when prices might start to bounce. The predicted cold snap should help retailers still trying to offload winter clothing lines, and it could help the oil price.

There is nothing wrong, of course, with a chancellor keeping people apprised of the risks that face the economy. But there is a danger, coming after a year in which consumer confidence in Britain has had its best run for more than four decades, that people and businesses overreact to such warnings and they become a self-fulfilling prophecy. The hope has to be that they do not drink too deeply his dangerous cocktail. If they do, 2016 will be “mission critical” for the economy, to use the chancellor’s words, for the wrong reasons.

One thing that should be knocked on the head is the idea, which emerged from some interpretations of Osborne’s speech, that an early rise in interest rates from the Bank of England is inevitable, and that he was preparing the ground for it.

As noted last week, a rise in rates this year is marginally more likely than not but could still very easily not happen. The Recruitment and Employment Confederation said on Friday that pay growth for permanent jobs, crucial to the Bank’s thinking, has slowed to a 26-month low.

More than that, the more that Osborne’s fears about the global economy come to fruition, the significantly less likely a rate rise. If the backdrop remains one of volatile stock markets, weakening global growth and a plunging oil price, the Bank will not be raising rates.

Sunday, January 03, 2016
EU referendum is the biggest cloud on the horizon
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The easiest thing to do when looking ahead is to assume more of the same. That, to let you into a dirty little secret, is how economic forecasting generally works and it is why economists are not bad at identifying trends but not good at predicting turning points.

It also keeps forecasts within realistic limits. Having ended the year at close to zero, you would put a very low probability on inflation rebounding to 10% over the next 12 months. Britain’s twin deficits – the red ink on the budget and current account – are not going to turn to surplus between now and the end of 2016.

The Bank of England’s monetary policy committee (MPC), similarly, will continue to adopt an ultra- cautious approach. After nearly seven years pondering whether the time was right for a quarter-point rise in interest rates, it will not suddenly start jacking them up as if there was no tomorrow.

Things do change in unexpected ways, however, even when they are flagged in advance. Britain’s continued membership, or not, of the European Union will come into focus this year. Even that, of course, is subject to some uncertainty.

We do not know for sure whether the EU referendum will be held in 2016, even though a summer vote appears to be David Cameron’s clear preference.

Assuming the referendum is held this year, we do not know whether it will be an economic non-event or the biggest challenge for Britain’s economy since the global financial crisis. Swap opportunity for challenge and you have both sides of the debate encapsulated. More on that in a moment.

As for the world beyond Britain, the world’s two biggest economies will, unsurprisingly, have the biggest influence. It may be that America’s presidential election is just a bunch of unelectable Republicans providing entertainment before Hillary Clinton’s stately passage into the White House but it cannot be ignored.

The Federal Reserve will raise interest rates further, perhaps as many as four times this year. Markets celebrated last month’s first Fed hike for nine years.

They might not do that every time, though if the Fed feels confident enough to continue the process of “normalizing” rates, it shows it is reasonably sanguine about the US and global economies.

As for China, its landing was hard enough last year to hit commodity and stock markets but in recent weeks the numbers have looked rather better. If you believe the official figures of growth of slightly below 7%, Chinese growth should stabilise around that level this year. That will provide a little support for oil prices. I cannot see a sustained drop in oil to $20 a barrel though I would be surprised to see a recovery to much more than $50.

America and China are not the whole of the world economy but they suggest a picture of reasonable growth; not as good as strong as the 4% trend rate of global expansion but 3.5% is achievable.

What about Britain? Before returning to the EU and the referendum, two things. The first is the argument that this recovery is so long in the tooth that we should be ready for the next downturn. We are now into the seventh year of a recovery that began in the middle of 2009. It sounds like a long time but the recovery that preceded it, from the early 1990s to 2000, ran for more than 16 years. The one before that, in the 1980s, lasted for over nine years. Given how far the economy fell in 2008-9, it is far too early to be calling time on the recovery.

The second thing is to deal with the end of year flurry of nonsense about Britain being in the middle of some kind of debt-fuelled consumer boom. In the national accounts released just before Christmas, the Office for National Statistics reported that aggregate wages and salaries in the third quarter were 4.6% up on a year earlier, pushed higher by both pay rises and employment growth, at a time of zero inflation. Real household disposable incomes were up by 4%. Consumer spending growth of 3% over the same period looks modest by comparison.

And, while household borrowing has picked up a little, it remains remarkably restrained. Overall borrowing has risen by less than 5% over the past seven years, and is significantly lower in real terms and relative to income than it was before the crisis. Unsecured borrowing is 15% lower in cash terms than before the crisis.

So what is in prospect? The big question about the EU referendum is not just the result but whether the uncertainty leading up to it has a significant impact, for example postponed or cancelled investment projects. My judgment is that there will be a little of this, but not too much. Despite the closeness of some polls, most businesses are assuming that the status quo will continue, and that voters will not choose Brexit. If that assumption, which I tend to agree with, turns out to be wrong, then the EU will be the big story for Britain’s economy in 2016. And, whatever your view of the long-term consequences of EU exit, the short-term effects would be significant, and negative.

In the absence of that, what is the outlook? If you took the pre-Christmas gross domestic product figures at face value, which suggested a slowdown, you would expect even slower growth in 2016. But, as I said last week, I did not, so growth of around 2.5% is on the cards for this year.

Inflation, having surprised everybody on the downside last year, should rise very slowly, as some of the helpful “base” effects drop out. But We may still be below 1% at the end of the year. I shall go for 0.75%.

Does that mean the Bank of England will leave interest rates unchanged? I am tempted to say so, conscious of the fact that for the past six years at this time the Bank has been expected to raise rates over the course of the following 12 months, only to do nothing of the sort. But, while fearing another error, there is a limit to the extent to which the Bank can ignore rate hikes by America’s Federal Reserve without at least a token move. So, with trepidation, I will say one move, to 0.75%.

Unemployment should continue to fall, to 0.7m on the claimant count, and just under 5% on the wider Labour Force Survey measure. The current account deficit will still be with us, as noted, but should drop to around £60bn, from nearly £80bn last year.

All that assumes that the economy in 2016 will not be hugely different from the economy in 2015. Meanwhile, the big issues, including productivity, the budget deficit, the EU and trade will continue to exercise us, or certainly me, in the coming months.

Sunday, December 27, 2015
A year in which China slowed, Greece survived and Britain soldiered on
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk, as is the forecasting league table which accompanies the piece This is an excerpt.

So that was that. A year in which plenty happened, and plenty more might have happened. A year in which Greece did not leave the euro but came close to doing so. I predicted Greece would stay in, including to some people worried about their holiday bookings, but it was touch and go for a while.

The Greek crisis quickly gave way to deep worries about China; one of the factors behind the collapse in oil and commodity prices and this year’s exceptionally low inflation. People got a bit too bearish about China, and indeed about the global economy, which has shown tentative signs of strengthening in the final weeks of the year.

Most of what we saw in respect s of China was the necessary slowdown and rebalancing of an economy that had grown for almost 10% a year for three and a half decades. The China story, including its continued emergence as a global player in the international financial system, will continue to fascinate us in 2016.

At home by now, had things gone differently, we could have had a Labour government, perhaps with the support and veto of the Scottish Nationalist Party, with both a budget and a spending review from this strange alliance. But voters decided differently, particularly cruelly in the case of Ed Balls, who went from being chancellor in waiting to ex-MP in the space of a few hours.

The Tories’ electoral position was stronger than it seemed. Indeed, David Cameron secured the support of a higher proportion of overall electorate than Tony Blair in 2001 and 2005. So the euro survived an d the Tories survived, and indeed strengthened their position, with the first Conservative outright majority in a general election since Sir John Major in 1992.

In 1992, as this year, voter doubts about Labour’s economic credibility swung the result. Labour’s further loss of credibility since the election makes the party’s uphill task all the steeper.

The curious economic consequence of the Tory victory was that George Osborne, rather than taking a harder line on public spending when freed from the Liberal Democrat yoke, instead adopted a gentler approach.

The deepest spending cuts offered by the chancellor came in his March budget, when the coalition was still in place. Progressively, in his summer budget and his November autumn statements and spending review, things then got milder. Both of his big post-election set pieces also featured tax increases, significantly in the case of the apprenticeship levy and a tax clampdown on buy-to-let landlords. You would have looked in vain for much hint of these in the run-up to the May election.

Not only that, but Osborne introduced the national living wage, to take effect at £7.20 an hour next April. Some businesses, in care, retailing and catering, will find this difficult, though most in business swallowed their doubts and welcomed the move. As I wrote at the time, the response might have been different had this been introduced by Balls and Ed Miliband in a Labour government.

What was the story of the economy in 2015? One continued theme has been the very slow progress towards normalization. In the case of monetary policy, things are very abnormal indeed or, if this is the new normal, it is a strange one. As I wrote a couple of weeks ago, I expected a token rise in interest rates late in the year. Many forecasters expected more. But we are still stuck with the emergency settings of 0.5% Bank rate (since March 2009) and £375bn of asset purchases under quantitative easing sitting on the Bank’s books.

The other bit of slow progress is on the budget deficit. There were two surprises in the autumn statement from the Office for Budget Responsibility. One was that it found a very useful £27bn down the back of the sofa which was very useful for a chancellor needing to dig himself out of a hole on tax credits. The other was that it took an optimistic view on the public finances for this year, when most economists were looking for a £10bn overshoot.

It remains optimistic, despite last week’s official figures showing that the chancellor has already borrowed £66.9bn in the first eight months of the fiscal year, close to the OBR’s full-year forecast. But I would not dismiss the chances of meeting the forecast. The OBR’s recent record on the deficit has been pretty good.

The other late-breaking pre-Christmas story was the Office for National Statistics (ONS), and its downward revisions of recent growth numbers. How worried should we be by this? Not remotely. I do not know why the ONS does this, save to complicate my annual forecasting league table.

This time last year, when the economy had been on course for 3% growth, the ONS gave us similar revisions which pushed the implied expansion down to 2.5%. Since then, it has spent its time revising the numbers back up, so we now have almost 3% for 2014 again.

This time, an economy that seemed set for roughly 2.5% growth has been pushed down to 2.2% or 2.3%. I have chosen 2.25% for the purposes of the league table, but those who predicted something stronger have every reason to feel miffed. I have no doubt that in the fullness of time growth in 2015 will have been shown to have been at least 2.5%.

The other pre-Christmas ONS highlight was the release of figures showing a current account deficit of £17.5bn, 3.7% of gross domestic product, in the third quarter. The good news is that the deficit has stabilised and is below last year’s peak. The bad news is that at just under £80bn this year (on present trends) it is still very large.

That is a worry, to be examined further next year, Britain’s exceptionally strong labour market and non-existent inflation add up to the very good news of 2015.
Who did best at predicting this? All my top forecasters expected low inflation but none got quite as low as we got. The nearest was the EY Item Club, with just 0.2% inflation in the final quarter. Those who predict ted little or no change in interest rates benefited. Overwhelmingly, forecasters were too optimistic on growth though, as I say, the numbers there are a movable feast.

In the end, it was a very close fought contest between Ross Walker of RBS and Peter Dixon of Commerzbank, both long-time followers of the British economy. Both scored a very creditable nine out of 10, with Walker shading it by the tiniest of margins on the forecasting equivalent of goal difference. But both deserve hearty congratulations.

How did I do, I hear you say? Well, 2.5% growth, 1% inflation, 0.7m claimant unemployment and a £70bn current account deficit was enough for a fluky eight out of 10. It could have been nine if I had not expected that tiny quarter-point rate rise, but that would have been even luckier. I wish all the forecasters success with their predictions for 2016, some of which have already landed.

Sunday, December 20, 2015
Britain heads for another pay rise in 2016
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Pay, the final frontier, or am I getting my Star Trek and my Star Wars mixed up? Anyway, what happens to pay over the next 12 months is important, in many respects.

At its most basic there is the question of whether most people can expect a pay rise, by which I mean the increase in their wages and salaries outstripping inflation, in 2016. There is the issue of how fast pay needs to rise to persuade the Bank of England to follow the Federal Reserve in raising interest rates.

There is also the question of whether Britain is a higher pay country than we often assume, even at the national minimum wage, which has important implications for David Cameron’s efforts to limit immigration from the rest of the European Union.

By happy coincidence, I took part in a Resolution Foundation (RF) discussion on the pay outlook a few days ago, chaired by Linda Yueh, featuring the RF’s Laura Gardiner, George Magnus and Michael Saunders.

We all took the view that there would be a real-terms rise in pay in 2016, which was encouraging, the differences of opinion being mainly whether it would be larger or smaller than in 2015.

At the end of last year average earnings were growing at 2.2% and inflation was 0.5%, so real wages rose by 1.7% over the course of 2014. That was a comfort. At a similar RF event nearly two years ago, I and others said there would be such an increase.

We do not yet have the figures for pay at the end of this year. The latest figures, showing a 2.4% rise in total pay, represented a deceleration compared with recent average earnings growth of 3%, though some of the numbers which make up the calculation. A sharp slowdown in pay growth in business and financial services, to just 1% in the latest month, may for example represent the lull ahead of the bonus season storm.

But let us say that average earnings will have risen by 2.5% in the final three months of the year. Inflation is likely to average precisely zero, so real wages have also risen by 2.5%. 2015 was better than 2014. Will 2016 be better again?

If you wanted evidence that the skill shortages emerging as a result of strong employment growth (up more than half a million over the past year) are pushing up wages, you could look at construction, where pay in the latest three months was 6.1% up on a year earlier. Outside that sector, however, despite reports of skill shortages elsewhere in the economy, there is scant evidence that the traditional Phillips curve relationship – the lower the level of unemployment, the higher is wage inflation – is exerting itself.

Pay settlements, while less important than they used to be, look to be stuck at around 2%. Allowing for drift and factors like the new national living wage, that suggests to me that wage growth over the course of next 12 months will be 2.5% to 3%. Some will get more some, particularly in the public sector, less. If that is the case, how much will real earnings rise? That depends on inflation.

For the second year in a row, the consensus among economists on inflation looks too high. The average prediction this month for inflation at the end of 2016 is 1.5%. That is higher than the Bank of England, 1.1%, and higher than I would expect. Inflation of between 0.5% and 1% at the end of 2016 would translate into a 2% real wage increase, not quite as good as this year but not bad. It would be a little above the prospective growth in productivity, which is running at just over 1.5%, but not excessively so.

What would it mean for the Bank and interest rates? Pay matters a lot for the Bank’s monetary policy committee. Minouche Shafik, one of the Bank’s deputy governors, is the latest to say so, highlighting the fact that pay growth has failed to accelerate as it expected, and has even gone into reverse.

If pay evolves as I suggest over the next 12 months then, alongside recovering productivity, it will give the Bank little reason to raise rates. Of course pay could be stronger, and of course there are other reasons why the Bank might want to follow the Fed. But on the evidence we have, and on the Bank’s signals, you would have to say it looks later rather than sooner.

Before I close on pay, a couple more things to say. One is whether the official figures are giving us anything like a realistic picture. Simon Briscoe, an independent economist and statistician, is particularly exercised by this and has written an extended blog on his website: https://simonbriscoeblog.wordpress.com. The Bank might find it interesting.

Weak average earnings have dominated the debate in recent years, he says, with pay apparently still well below pre-crisis levels. But, as he puts it: “This does not (by and large) reflect falling wages for individuals. The great majority of people in employment have seen wage increases year on year. The average wage is low because millions of low paid jobs have been created …. When the dust has settled and the truth about the statistics emerges, there will be a rewriting of history.”

In similar, though not quite the same vein, it is not generally realised that Britain is, relatively speaking, a high-pay economy, even at the lower end. Britain’s draw, for workers from the rest of the EU, is usually thought to be because more jobs are available. Relative pay is, however, also important.

Michael Saunders of Citi points out that the existing national minimum wage is, when converted to euros, more generous than in any EU economy with the exception of Luxembourg. It is higher than Germany and France, double that in Spain, and roughly four times the level in Poland and most other eastern European EU members.

George Osborne does not intend to let it rest there. The new national living wage will be set at £7.20 an hour next April (the minimum wage is £6.70) and rise progressively to more than £9 an hour by 2020.

David Cameron has been trying to reduce the “pull” factor of Britain for EU migrants in his efforts to renegotiate the terms of Britain’s membership. Meanwhile his chancellor is busy increasing it by raising the statutory minimum employers have to pay. A case, it seems, of the right hand and the left hand not being very well coordinated.

Sunday, December 13, 2015
Cheap oil is a bonus, but not a bonanza
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The drop in oil prices to $40 a barrel, and now to a couple of dollars below that level, resonates a lot with me. Readers with very long memories may recall that when the oil price soared well above $100 a barrel, even coming close to $150, I used to say that the sustainable price was $40.

If you are patient, most forecasts will come right in the end, however eccentric they seem at the time. Oil dropped below $40 a barrel, but only briefly, in 2009, and may have further to fall in the current rout.

There are two aspects of the further drop in oil prices, and in other commodities, that I wanted to discuss this week. The first is what it means for inflation. The second is whether, given the extent of the fall, we should be disappointed about its impact on growth.

On inflation, it seemed likely until recently that the fall in oil prices would soon drop out of the inflation numbers. What I mean by this is that once you get to the point at which prices now are the same as a year ago, there is no additional downward pressure on inflation. And, once we had got to that point, it would be reasonable to expect the inflation rate to start gradually moving higher as underlying inflationary pressures re-exert themselves.

That will still happen, but it will not happen for a while. This time last year crude oil prices were close to $60 a barrel, well above current levels. The average petrol price used by the Office for National Statistics in calculation inflation was 120p a litre in December last year, falling to 109p in January. Now the RAC is talking of an imminent reduction to 103p a litre, with supermarkets already charging less than £1. For most of this year, the average price has been above 110p a litre, often significantly so.

So the fall in prices will keep inflation lower for longer, and may produce more “deflation” readings in coming months. There are many reasons why the Bank of England is not ready to follow America’s Federal Reserve in hiking interest rates, and this provides another.

Bigger than this perhaps is the question of why the fall in oil and commodity prices has not done more for growth. We should be wary of concluding that growth in Britain has definitely slowed this year. The latest figures have yet to undergo much of the revisions process that we have come to know and love. As things stand, however, growth this year is running at closer to 2.5% than last year’s 2.9%.

At a global level, the International Monetary Fund estimates 3.1% growth this year, down from 3.4% last year, and the weakest since 2009, the height of the crisis. What has happened to the oil bonus, the beneficial effects of the good deflation I wrote about this time last year?

At a global level it is not too hard to explain. There are gainers and losers from falling oil and commodity prices. The gainers – every industry in the world which benefits from cheaper fuel and raw materials – will respond by investing more but may take time to do so. The losers will respond by cutting investment sharply, and are doing so. There is an overall benefit from cheaper oil, in other words, but it is complicated by timing differences. You see that in microcosm in the stock market’s poor performance this year, spectacularly so on Friday, where falling share prices for oil and mining firms have outweighed any gains elsewhere.

To take an example, according to IMF calculations, export revenues in the Gulf Co-operation Council countries (Bahrain, Kuwait, Oman, Saudi Arabia, Qatar and the United Arab Emirates) will be $275bn (£182bn) lower this year than last and, of $40 a barrel holds, even lower in 2016. Their combined budget deficit, 12.7% of gross domestic product, is bigger than that of Britain, or for that matter Greece, at the height of the crisis. The Gulf states are close to agreeing on introducing VAT in the region to raise some much-needed non-oil tax revenues.

The global story is thus essentially a tale of two types of economy, rather than a dramatic slowdown or the harbinger of something worse. For emerging and developing economies, including a huge swathe of oil and commodity producers, the fall is mainly bad news. Russia and Brazil, two of the Brics (Brazil, Russia, India and China) are in recession. South Africa is in trouble. China has not been a net oil exporter since the 1990s but its slowdown to growth of less than 7% a year has been the big factor on the demand side of the oil equation. Overall, emerging economies will have grown by around 4% this year, down from 4.6% in 2014 and 5% in 2013.

For advanced economies, the opposite has occurred. Their growth has followed the expected pattern, picking up as the benefits of cheaper oil feed through. Advanced economies should have seen 2% growth this year, up from 1.8% last year and 1.1% in 2013.

What about Britain? In many respects the economy is following the script. Consumer spending, current rising at a 3.1% annual rate, is stronger than last year, when it rose by 2.7%. Business investment, despite North Sea cutbacks, is up by 6.6% over the past year, compared with a rise of 4.6% last year.

The problem lies elsewhere. Another disappointing set of trade figures came out last week, with the overall trade deficit rising from £3.1bn in September to £4.1bn in October, as a result of a surge in imports. Net trade subtracted significantly from growth in the third quarter and may do so again in the fourth.

For this, for once, the blame lies outside the European Union. The volume of exports of goods to the rest of the EU has increased by 12.1% over the past 12 months, nearly four times the 3.2% growth in non-EU exports. Imports from non-EU countries have jumped by 10.2%, against 6.9% from the rest of the EU.

In certain cases, such as China, the fall in UK exports has been spectacular; 36% over the past 12 months. Just as exporters were being encouraged to diversify to emerging economies, which in the long run they should, some have seen the rug pulled from under them

The big fall in oil prices has put more money into British consumers’ pockets, encouraged businesses to invest more and delayed the first hike in interest rates. But it has been disruptive, and it has not necessarily made the world a more comfortable place.

Sunday, December 06, 2015
Low long rates - for as far as the eye can see
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is time for a confession. In my first piece this year, on January 4, while admitting that I was torn on the issue, I predicted a “token” quarter-point rise in Bank rate, to come late in the year.

To be fair to myself, it took me only about three weeks to decide that it was probably not going to happen, after inflation lurched downwards and the two “hawks” on the Bank of England’s monetary policy committee (MPC) withdrew their vote for a rate hike.

There was a brief flurry of excitement in the summer, when Mark Carney warned that a decision to raise rates would come into sharper focus around the turn of the year. But that came to nothing and, barring an enormous surprise this week when the MPC meets, this will be the sixth full year in which there has been no change in rates. The seventh anniversary of the cut to 0.5% comes in March.

The debate about whether or not the Bank should raise rates has been running for so long that most of the arguments are very familiar, though Jan Vlieghe, the MPC’s newest member, brought some fresh perspective when I interviewed him for last Sunday’s paper.

On the question of whether the Bank should follow the Federal Reserve’s likely rate hike later this month, his argument was that what the Fed’s move may tell us about the American economy has to be weighed against what the European Central Bank, which eased again on Thursday, is telling us about the eurozone.

Growth in Britain’s economy is pretty reasonable; expectations following the latest purchasing managers’ surveys are for a 0.6% fourth quarter rise in gross domestic product. But the economy is not racing away, and has slowed compared with last year. Above all, as foreshadowed at the start of the year, there is no inflation and oil prices dropped again last week.

All these are straightforward reasons why the MPC has not pushed the button on interest rates this year. But there is another factor, which is also weighing on the Bank’s decision-makers; the sustained downward pressure on long-term interest rates.

Bank research on it has been described in one of the Bank’s “Underground” blogs and featured in speeches by Carney and Andy Haldane, the Bank’s chief economist. It should be published as a working paper soon under the not so snappy title ‘Secular drivers of the global real interest rate’, by Lukasz Rachel and Thomas Smith. I should declare an interest; one of the authors is my son.

The traditional view of long-term interest rates – such as the interest the government pays on the bonds (gilts) it issues – is that they are determined by the outlook for short rates and the credibility, or creditworthiness, of the issuer.

The traditional view also is that you expect long-term “real” rates – the interest rate less expected inflation – to be positive. Investors do not lend to governments or other bond issuers for nothing; they expect a real return. Three decades ago, that real rate was around 5%

But not now. Though real rates have picked up a little with this year’s very low inflation, the trend has been firmly downwards; if not to zero (though they have been there) to something under 1%.

The Bank’s research looks in detail why this has happened and finds that most of it can be explained by a series of economic factors. It claims to identify why a fall in long-term real interest rates of 4 percentage points, or 400 basis points, is justified by these factors. 50 basis points of the total fall of 450 is unexplained.

The factors are demographics – principally the slowing of global population growth and ageing in advanced countries – which has reduced real rates by 90 basis points; higher inequality within countries, 45 points, and higher savings in the emerging world following the 1997-8 Asian crisis, 25 points.

Other factors include a drop in private investment, 50 points, and a reduced emphasis by governments on public investment, 20 points. Another technical factor is what the authors describe as an increase in the spread between the risk free rate and the return on capital, 70 points. On top of these, which together account for around 300 basis points of the drop in real rates, another 100 is explained by a worsening outlook for trend, or long run, growth in the world economy.

There is no need to get hung up on the precise numbers. The essential point is that long-term interest rates are not just low because central banks have been operating with near-zero short-term rates. They are low because of a range of factors bearing down on them, and most of those factors were in place well before the crisis.

And this is where it feeds back importantly to MPC thinking and the outlook for interest rates, if long-term interest rates are permanently low, there is a limit to how much, when the time comes, the committee can push up short rates. A 5% Bank rate would, for example, be inappropriate in the context of 10-year gilt yield of under 2%, as they are now, or even if they were to rise into the 2% - 3% range, but no more.

That is why those on the MPC who say they are in no rush to raise rates genuinely mean it. If it were a case of having to get rates up from 0.5% to 5%, they might be more impatient to get started. If it ends at 2%, they see time as on their side. It is also why, despite a lot of scepticism about such guidance, it seems reasonable to accept the Bank’s line that interest rates will peak at much lower levels than in the past. If the past seven years have been a nightmare for savers, the next few might not be much better.

Finally, that wait for the Bank to unwind its £375bn of quantitative easing will be a long one. We know now that it will not happen until Bank rate reaches 2%. Not so long ago that would have been a mere staging post for interest rates. Now it starts to look like the final destination.

Monday, November 30, 2015
A interview with the MPC's Jan Vlieghe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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A version of this interview appeared in The Sunday Times

In his job as an economist for one of the world’s biggest and most aggressive hedge funds Gertjan “Jan” Vlieghe tried to second-guess what the Bank of England would do.

Now, as a member of the monetary policy committee (MPC), he offers a pretty clear signal to the markets. As far as he is concerned, interest rates in Britain are going nowhere for some time.

In his first newspaper interview since joining the MPC in September, he reveals himself to be firmly in the dovish camp. While some have speculated that a raising of interest rates by America’s Federal Reserve next month could push the MPC into an early hike, he says he is in no rush at all.

For Vlieghe, who has joint British-Belgian nationality, his MPC appointment marked a return to the Bank, having worked there from 1998 to 2005, latterly as Lord (Mervyn) King’s economic assistant. After that he moved into the City with Deutsche Bank and then Brevan Howard, the hedge fund run by Alan Howard, Britain’s wealthiest hedge fund boss, according to the Sunday Times Rich List.

“In financial markets there is more pressure to be fast, to get there first,” Vlieghe said. “But the fundamental questions are the same. The analysis is the same.” What does his analysis tell him now?

People have been puzzled by the weakness of productivity. But it was only a puzzle, he argues, in the context of a normal recession — 2008-9 was not normal. “Once you realised it was a financial crisis, it really wasn’t that surprising,” he says.

As for what is happening now, he thinks productivity growth has picked up to 1%-1.5%, from about 0.5% 18 months ago but it is still weaker than before the crisis, and may stay weaker from some time.

On what will persuade him that it is time to start thinking about higher interest rates, he cites two factors. Growth in the economy, he points out, has slowed over the past 18 months, from about 3% to 2.3% in the third quarter. “We need to see it stabilise, or even pick up a bit,” he says.

The other factor is wages, which he would want to see rising more strongly — perhaps decisively above 3% a year — before pressing the button, “We’ve seen a little bit of disappointment on wage growth,” he says. He would want to see a much clearer “direction of travel” towards higher pay growth.

Underpinning his view on interest rates is a belief that two forces — the debt overhang and demographics — are weighing down on the global economy, which will mean permanently lower interest rates. Even when rates rise, in other words, there will not be that far to go and so: “I am relaxed about waiting a little longer before we start.”

In fact, the longer you talk to Vlieghe, the more reasons he provides for delaying a rate rise. He snorts at suggestions that central banks might want to start to “normalise” interest rates so they have ammunition to fight the next downturn. Such a strategy would “create the slowdown” they worry about.

A hike in rates by the Fed might tell the MPC that the Fed is more confident about America’s economy but if it coincides with further loosening by the European Central Bank, that would tell you that there is compensating weakness in Europe. Sterling’s rise in the past two to three years is also a factor. “We’ve had a huge tightening from the exchange rate,” he says.

And, while stressing that he expects the next move in rates to be up, like the Bank’s chief economist Andy Haldane he is not afraid to talk about the possibility of further cuts, even a negative rate. “If you had asked me five years ago whether the ECB or SNB [Swiss National Bank] would have had negative interest rates, I would have said no,” he says. “You have to think of it in the context of what other people are doing.”

So, if there was what he describes as an “economic disappointment”, would he favour cutting interest rates or more quantitative easing? “Probably rates first,” he says. The wait for a rate hike could be a long one.

Sunday, November 29, 2015
Osborne keeps the ball rolling on public spending
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is five days since the autumn statement and spending review but it is not too late to give credit to the man who made it possible. Sometimes we do not praise enough.

I refer, of course, to Robert Chote, chairman of the independent Office for Budget Responsibility (OBR). He and his team, by uncovering a £27bn underlying improvement in the public finances over the next five years, drove last week’s announcements.

Most of the improvement was due to a more optimistic view of future tax revenues. Without it, George Osborne would have been in some difficulty.

I should also single somebody else out for a mention: Mark Carney, governor of the also independent Bank of England. When, earlier this month, the Bank clarified its position on quantitative easing, saying that there would be no reversal until interest rates hit 2%, I don’t suppose many people considered the implications for the public finances.

But the OBR did. The £375bn of gilts – government bonds - the Bank holds on its books are effectively an interest-free loan to the government. The longer they are held, the lower the government’s debt interest bill. For complicated reasons, extending the period the Bank holds these gilts adds to government debt. But it reduces borrowing, which was more important in the context of last week’s announcements, by about £6bn over the next five years.

I am not suggesting for a moment that either the OBR or the Bank of England are anything other than independent. Chote and his team made life much easier for the chancellor this time but during the last parliament often made things more difficult. There are swings and roundabouts.

As for the Bank, it would be shocking if the Treasury had suggested that the QE clarification would be very helpful – a clear breach of the independence of monetary policy – that I cannot believe it could have happened.

What is a little disturbing about all this is that the changes announced by the OBR are essentially technical in nature, and they are forecasts. Forecasts, we know, are often wrong. Even this year, in which the OBR is predicting a small fall in the budget deficit compared with its summer forecast even though the monthly numbers point to an overshoot, the forecast could be wrong. The chancellor’s £27bn windfall could evaporate as quickly as it arose.

Would he respond by cutting spending harder or raising taxes further? I think we know the answer to that. This time four years ago the OBR had bad news for Osborne. It took a gloomier view of the economy’s potential and revised up its projections of future borrowing by much more than £27bn over five years. The chancellor could have responded by doubling up on austerity but chose not to do so.

So he is pragmatic, perhaps sensibly, about these things. When the OBR offers him a windfall, he goes out and spends it. When it lands him with a large bill, as it did a few years ago, he chooses to ignore it.

The OBR – set up to adjudicate on but not determine the policy stance – has been the tail that wagged the dog this time. It may do so again, but probably only if it comes up with good news.

Osborne was the lucky recipient of a windfall, although he made some of his own luck, while riding roughshod over his earlier promise to achieve all his deficit reduction through lower spending. He will raise £28.5bn in additional taxes over five years, £11.6bn from the apprenticeship levy, £6.2bn from higher council tax bills and £3.8bn from additional stamp duty on buy-to-let properties and second homes.

What we are left with as a result of this is chancellor who before the election gave us a roller-coaster for public spending – deep cuts in the early years followed by a sudden increase in the run-up to 2020 – with something much smoother. Osborne has done the opposite of what chancellors are supposed to do. For those worried about public spending cuts, he kept the good news back until after the election. Next year, 2016-17, there will be a £6.2bn net fiscal giveaway as a result of the autumn statement, according to the OBR, with a similar figure for 2017-18. There has been a lot of talk recently about the new politics. Post-election giveaways certainly are the new politics.

Osborne, of course, is political to his fingertips. He did not need to be told that he had a problem with tax credits. The losers, as I wrote here, were losing too much too quickly. But he thought it was a good idea to rein back the tax credits bill in July, and he thought it was essential to remain within his welfare cap. Jettisoning both may have been essential in political terms, and the OBR provided him with the means to do it, but it was a lurch, a screeching u-turn.

And we may not have seen the last of it. The Institute of Fiscal Studies and Resolution Foundation have pointed out, rightly, that it is a case of pain postponed for many recipients of the credits, who will face similar cuts with the switch to universal credit later in the parliament. But the chancellor has form. If he was prepared to scrap six months after the election, he will presumably be even more likely to defer or cancel the pain in the months leading up to the next one, even if it were to mean missing his target of achieving a budget surplus.

The big picture is that, while some government departments, and some public services, face further cuts, the squeeze has eased. Osborne is happy to talk about the £4 trillion, £4,000bn, he intends to spend over the next five years as funding “the things we want the government to provide in the modern world”.

In five years’ time, though he may not then still be chancellor, overall public spending will be 1% higher in real terms than he inherited in 2010, and 3% higher than now. Day-to-day spending will be up by 2.5% in real terms over the period.

Spending will be down to 36.4% on gross domestic product, it is true, from a recent peak of 45.7% in 2009-10. But this will have been achieved after more than 10 years of decent economic growth and will be higher, relative to GDP, than in the early 2000s. When the next downturn comes, spending will head back up to 40% of GDP or more.

Maybe Osborne’s bark was always worse than his bite. Maybe he has adjusted to the fact that he no longer has to be so tough on public spending to draw out Labour’s lack of fiscal credibility. Under the party’s new leadership it is on open display.

Or maybe, fiscal fatigue has set in. There were reforms in the spending review. Including devolving decisions to local level and transforming the prison estate, but there were not that enough of them to guarantee a permanently smaller state. Osborne is accused by his critics of wanting to destroy the state. He has just demonstrated, once again, that he means to preserve it.

Sunday, November 22, 2015
It isn't just the deficit where Osborne is struggling to hit his targets
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Though it is easy to dismiss such things as pieces of political theatre, Wednesday’s announcements from George Osborne – an autumn statement and a spending review – are rather important.

Autumn statements, it is true, come round once a year. If you think of them as mini budgets, which the headline writers often do, we have a budget or a mini budget every few months. Spending reviews are rarer. There was only one proper one in the last parliament, five years ago, and Wednesday’s is the big one for this parliament. It is big in more ways than one. As Osborne observed a couple of weeks ago, it will set out how the government will spend an eyewatering £4 trillion - £4,000bn – over this parliament.

What should we be looking for from the chancellor this week? I would say he has four targets. He has to detoxify the tax credit changes he announced in his summer budget, which were subsequently voted down by the House of Lords.

He has to demonstrate that his deficit reduction strategy is on course in this parliament, having been blown off it in the last one. That target will only be achieved if a third one, credible plans for reducing public spending, are in the spending review. Finally, there is a fourth target. Having talked up his commitment to infrastructure spending, and tempted Lord Adonis away from Labour to chair his new national infrastructure commission, Osborne has to match words with deeds.

Let me take these in turn. On tax credits, the chancellor will soften the blow of the cuts announced in the summer, while sticking with his £12bn of welfare reductions, which he needs to remain within his self-imposed cap. I suspect he knows he will take a political hit on this, in that no amount of tinkering or phasing will change the fact that there will be losers from the changes. Wednesday will, be about limiting the damage.

Interestingly, a report from the Institute for Fiscal Studies last week found that the tax credit changes, in combination with the new national living wage, will have one desired effect – apart from reducing the welfare bill – which will be “on average, to strengthen incentives to move into work and to work more if in work”. The trouble with averages, however, is that they can conceal problems. For some, such a single parents, the changes will reduce incentives to work.

Whether tax credits grab the headlines this week, or whether the chancellor comes up with an alternative headline-grabber, which is likely, the budget deficit will be an ever-present, as it has been during his chancellorship.

Indeed, irritated by the fact that some people are starting to argue that it is job done on the deficit – including some who argue that there was never a job to do even when it was more than £150bn – the chancellor and his officials have taken to talking up. Osborne spoke recently of this year’s deficit, predicted by the Office for Budget Responsibility to be just under £70bn – a figure that the latest data (released on Friday) suggested it will be hard to achieve - as adding to the “mountain of debt”. Treasury officials are happy to say that Britain’s deficit is bigger than Greece’s as a percentage of gross domestic product.

What this means is that the aim of achieving a budget surplus and maintaining it “in normal times” remains set in stone. Osborne has listened to the arguments of economists who say you should take advantage of ultra low interest rates and deliberately borrow more, and rejected them.

That means hitting his third target, further sustainable cuts in public spending. The IFS, again, has done the sums on this. In the July budget the chancellor set out plans to cut departmental spending by £11.3bn, or 3.2%, in real terms between 2015-16 and 2019-20. That sounds relatively painless.

Drill down into the numbers, however, and capital investment – infrastructure spending – is planned to increase by £4.9bn, or 11.5%. That increases the cuts to day-to-day spending, so-called resource spending, to £16.2bn, or 5.1%.

Drill down again and take out of that the planned increases of £7.6bn in spending on the NHS, defence, overseas aid and a freeze on schools spending, and the reductions on everything else increase to £23.7bn, or nearly 19%. By the end of the parliament, spending by these unprotected departments will have been cut by 39% in real terms compared with 2010.

Can it be done? The problem with the 2010 spending review was that it contained cuts but not much reform. This week’s effort is intended to include both. It aims to show that government can be smaller, in terms of what it spends, if it is also smarter. The template is the recent announcements on prisons, in which old Victorian prisons will be sold off, some of them to provide bijou apartments for hipsters, and replaced with modern institutions. As well as saving money, the intention is to provide better rehabilitation, saving money by reducing reoffending. Expect more such policies, as well as an outcry when the cuts are announced.

What about infrastructure? For the reasons set out above, Osborne is not going to tear up his deficit reduction plans and engage in a borrowing splurge to pay for a big increase in public investment. He says the government will spend £100bn on infrastructure during this parliament (small in relation to £4 trillion of overall spending). Broader OBR figures are for public sector net investment of £144bn in the next five years.

This will be supplemented by private infrastructure investment, including from abroad. Osborne tweeted approvingly a survey last week from Nabarro, the international law firm, showing Britain to be the top destination in the world for foreign infrastructure investment. Some will applaud that, while some will worry that too much of our infrastructure will be foreign-owned, and not just in the nuclear industry. Whether, even with that foreign input, Britain is spending enough upgrading our infrastructure will be questioned by many.

So four targets: sort out the tax credit mess, convince on deficit reduction, unveil achievable spending cuts and increase infrastructure spending. Whether Osborne can hit them will not be fully resolved this week. It certainly won’t be easy.

Sunday, November 15, 2015
Leave the EU and you lose the single market
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The battle over Britain’s membership of the European Union is now officially joined. It could be all over by next summer, though it could drag on for the next two years.

I presume that if, as is likely, David Cameron decides that the EU has not turned a deaf ear to his fairly modest renegotiation demands, Downing Street will choose a referendum timing which offers the best prospect of a yes vote. That probably means waiting until the refugee crisis has subsided.

Anyway, there is a long way to go, and a lot of areas to cover, between now and even an early referendum. But let me focus on just one today: the issue of trade and access to the single market.

Last week I quoted projections from PWC which demonstrated that, though the share of exports of Britain’s goods and services going to the rest of the EU is in decline – from 55% in 1999 to 45% last year and a projected 37% in 2030 – it will remain, assuming continued EU membership, the key trading partner.

The EU is important even if you adjust for the so-called Rotterdam effect; exports destined for the rest of the world which are shipped via Rotterdam in the Netherlands, and imports from the rest of the world which come in the same way. Exclude all exports to the Netherlands from the numbers and it would still be the case that more than 40% of Britain’s overseas sales are to the rest of the EU.

The EU is even more important when it comes to imports: 53% of the total last year, up from a recent low of 50% in 2011. Britain had an overall trade deficit with the rest of the EU of £62bn last year, compared with a non-EU trade surplus of £28bn.

It is this that has led some in the “leave” camp to conclude either that we would be better off without EU trade – because we have been in long-term deficit with the rest of Europe – or that if there is a vote to leave, Brussels will be desperate to quickly put in place a deal to allow EU exporters to continue to access the British market.

The first can be easily dismissed. Though the far left and extreme right have periodically argued for blanket controls on imports, basic economics tells us that countries gain from trade even when running a deficit.

The serious issue is whether Britain and the EU would rush to negotiate a market access deal even after an exit vote. The answer, provided a few days ago by Lord Mandelson in a speech to the EEF, the engineering employers federation, was a firm no.

The Mandelson speech, delivered at the Royal Society, was interesting. Though the EEF is as broadly pro-EU as the CBI, the event did not attract a silly Vote Leave stunt. There were no students dressed as business people holding up placards.

And, while there is inevitably a strong “he would say that wouldn’t he” element about the former EU commissioner’s remarks, they struck a chord. Whatever else he learned in Brussels as trade commissioner, he quickly discovered that negotiating new trade and market access deals is a thankless task. Such negotiations typically drag on for years, if not decades. Mandelson’s verdict was that, even in the event of a deal, it would not give Britain’s exporters anything like the access to the single market they enjoy now.

These days any such deal would not be mainly about tariffs; industrial tariffs between advanced economics are very low. They are about common product, regulatory and safety standards. For Britain, they are also about completing the single market in services, in many of which we excel; which is proving challenging to negotiate while we remain in the EU, and would be impossible if we were no longer members.

In a recent paper, Brexit: The impact on the UK and the EU, Global Counsel, the strategy advisory firm chaired by Mandelson, looked at the options for Britain outside the EU. The paper, written by Gregor Irwin, former chief economist at the Foreign Office, examined a Norwegian-style European Economic Area (EEA) agreement; a Turkish-style customs union; a free trade area; Swiss-style bilateral trade accords for different sectors, and a so-called most favoured nation approach giving Britain preferential access to the EU but on less advantageous terms than now.

Of these, only the Norwegian option would give Britain full access to the single market, but at the cost of continuing to pay into the EU budget and losing any influence over the regulations and directives British business would be required to adopt to gain access to that market. A free trade agreement would mean that British exports would escape the EU’s common external tariff but not much else. Full access to the single market would be lost.

As for it being in the EU’s interest to quickly negotiate a comprehensive deal to preserve its trade surplus with Britain, that is not how it works, as became clear at the EEF event. For some countries and for some industries, such as the German car manufacturers, it would clearly be of benefit to do so. Getting approval from the remaining 27 member parliaments of the EU, and from the European parliament itself, would be tough in an environment in which there would be little goodwill towards Britain.

Some voters will say that some loss of access to the single market is a price worth paying for, say, regaining control of over our borders (though non-EU net migration is larger than migration from the rest of the EU). Some businesses, particularly those that do not trade elsewhere within the single market, will agree with them. After all, we sell to plenty of countries with whom we do not share a single market, though largely under trade deals negotiated by the EU.

The single market issue is not, on its own, decisive, but it is important. And it is just one of many areas in which, as things stand, a vote to leave the EU would be a step into the unknown.

Sunday, November 08, 2015
Risks start to rise as rates get stuck again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Forecasts are always risky, but if I wanted to venture a couple, it would be these. At some stage next summer Mark Carney, the Bank of England governor, will make a speech warning that interest rates could be going up, perhaps around Christmas.

Then, at roughly this time next year, when it becomes clear they are not, the markets and the Bank will between them push out their expectations of the first rate hike into late 2017 or beyond.

This is not, I should say, some bold leap into the dark, though it could still turn out to be wrong. Friday's strong US jobs report put the Federal Reserve's on-off December rate hike back on again again, showing that these things can change quickly. But expecting a hint next summer from Carney that rates could soon be on the up merely assumes the governor will follow the pattern of the past two years.

In the summer of 2014, at the Mansion House in the City, and in the summer of 2015, at Lincoln Cathedral, Carney put markets, households and businesses on alert for higher rates. And, while he pointed out on Thursday that we have not yet reached the turn of the year, which is when he said the decision on rates would come into sharper relief, the tone of Bank’s latest inflation report was that everybody can stand down; rates are going nowhere.

My other prediction is not particularly bold either. All it assumes is that the history of the past few years will repeat itself and that the Bank’s monetary policy committee will continue to find more reasons not to raise interest rates than to do so. For added comfort, the market assumptions on which the Bank’s latest growth and inflation forecasts are based are for no change in rates next year.

Thus continues an extraordinary period. If, it is indeed the case that interest rates are on hold until 2017, this will be the missing decade, perhaps even the lost decade, for rate hikes. The last change in interest rates – the cut to 0.5% - was in March 2009 but the last hike was as long ago as July 2007. The last time we went so long without a rate hike was in the period which included the Great Depression and the Second World War. Bank rate was at 2% from 1932 to 1951. The last time before that was when Bank rate remained at 5% for over a century, from 1719 to 1821. I don’t think we will beat that one but these are early days.

If rates were still at 0.5% in 2018, Carney would return to Canada as that rarest of modern-day governors; never presiding over a change in rates. He still seems personally keen on getting one under his belt next year, even though the inflation report suggested otherwise. Many City economists also still have a rate hike pencilled in for 2016, though they were surprised by the dovishness of the Bank’s inflation report.

The other extraordinary thing is that the Bank, having never done quantitative easing (QE) before the crisis, is in no hurry to unwind it. Electronically creating money to purchase assets was novel in 2009. By the time the Bank gets around to reversing it, it will be old hat. A few weeks ago I suggested that the Bank might want to run down its QE to take the temptation away from politicians to launch much dodgier versions of it.

Instead, the Bank has hardened its commitment to maintaining QE. Until last week the understanding was that, as soon as interest rates started to rise, it could quietly start the process of running down its QE, by not reinvesting the proceeds of maturing gilts it has on its books. Now it says it will not do that, let alone start the process of actively selling the gilts back, until Bank rate is up to 2%, which might not be until 2020. As well as a decade without rate hikes, we would by then have had a decade or more of large-scale QE.

Does it matter? You could say it does not get much better than this. While savers have been deprived of the return on their savings they would normally have expected, borrowers are continuing to enjoy the bonus of low rates. Indeed, to be charitable to Carney, his 2014 and 2015 warnings were both scuppered by what the Bank regards as an “unforecastable” plunge in oil prices. Indeed, the latest inflation report includes a useful comparison of what the Bank expected in August last year and what subsequently happened. The halving of oil prices since then meant that instead of inflation being just below the 2% target now, as it projected, it is running at -0.1%.

You could also say that consumers have had a double-bonus from cheap oil: the fall itself and the postponement of possible rate hikes. So these are good times for households: real post-tax household incomes will rise by 3% this year and more than 2% annually for the three following years. They are also good times for businesses, with the Bank projecting a 5.5% rise in investment this year, followed by 7.5% t0 8.75% rises for the following three years. Growth is good, inflation is benign, what could possibly go wrong?

Three things. One striking thing about inflation in recent years has been how much it has been driven by factors outside the Bank’s control; the rise and fall of commodity prices, and the fall and rise of sterling. Those factors are currently blowing in a favourable direction. There is no guarantee that will continue, particularly given instability in the Middle East.

Secondly, the longer that interest rates stay low, the greater the danger of risky behaviour. House price inflation is back within a whisker of 10% according to the Halifax and consumer credit is picking up strongly. The intention of low rates is to encourage households to spend and businesses to invest. But spending can turn to splurge and judgments can become very clouded when the risk of higher interest rates appears to have been removed from the table.

Finally, the Bank’s new forecast, in which consumer spending grows by an average of 3% a year and the growth of imports comfortable exceeds that of exports each year, is one that could be expected to exacerbate Britain’s already parlous balance of payments position. In the past we would have worried about that because of the impact on sterling, and the knowledge that a plunging pound has usually meant higher interest rates. This time, so far at least, it has been different. But this time is different does not usually work as a long-term plan.

Sunday, October 25, 2015
A fine mess: How Osborne can dig himself out of his tax credit hole
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

George Osborne, it seems, is on a three-year cycle. Much of the time he gets a pretty good press, given that he has presided over some unpopular policies, and he has had the last laugh over his austerity critics.

Every three years, however, something goes badly wrong. Three years ago it was his “omnishambles” budget, which combined the brave move of cutting Labour’s 50% top rate of tax to 45% with some unwise tinkering with the tax privileges of Cornish pasties and caravan owners.

Now it is his “toxic” cuts to tax credits, which are in danger of joining a long list of policies which look elegant and logical on a Whitehall computer screen are disastrous when implemented. They include Gordon Brown’s abolition of the 10p tax band, the bedroom tax and Osborne’s own child benefit cuts, which penalised higher-paid single-earner families, while letting two-earner couples with high household incomes off the hook. Some are even drawing comparisons with the poll tax, the policy which more than any other brought down Margaret Thatcher.


The chancellor, political to his fingertips, will be aware of all these precedents. But when he presented his summer budget in July, his second in the space of four months, he was perhaps still in the first flush of excitement after the Tories unexpected majority in the May election. As in the early months after the 2010 election, when he was in the first flush of excitement of becoming chancellor, things were done that on reflection might have been done differently.

Let me start, however, with praising Osborne on tax credits. Having inherited a system that was becoming ruinously expensive, and which benefited nine in 10 families with children in 2010, the reforms the chancellor steered through in the last parliament, largely without fuss, went a long way towards putting things right.

The proportion of families with children receiving tax credits has been reduced to six in 10 and the tax credit bill, rather than rising to £37.8bn this year and £40bn in 2016-17 in cash terms, has been stabilised at around £29.5bn, before the summer budget changes kick in. Spending on tax credits has been cut in real terms, and cut dramatically compared with unchanged policy, with the minimum of fuss.

The other essential point to make is that, despite savings such as these, there is a long way to go on the deficit and debt. The September public borrowing figures were “good”, in that they were lower than the markets expected, but the government still spent £9.4bn more than it brought in on taxation. Borrowing so far this year is £7.5bn lower than last year but analysts still think it touch and go whether the official forecast of £69.5bn will be met. Public sector net debt has risen by £70.5bn in the past year.

The question is why Osborne’s latest push on tax credits, which will reduce the number of eligible families with children from six to five in 10 and produce additional saving of less than half what has been saved so far, has caused so much trouble.

The answer is that the tax credit cuts these will usher in from April are large, and people on low incomes hard. So a single-earner household with two children on £6,420 (the old threshold for withdrawing tax credit) will see their tax credits drop from £10,885 to £9,651, a drop of £1,234, or more than 7% of their combined income from earnings and tax credits. Somebody earning the new national living wage, which for a full-timer on 35 hours a week will be £13,100 a year from April, will lose £1,701, cutting their combined income by 8%. A household on roughly double those earnings, £26,530, will lose all their tax credits, currently £2,640 a year.

Given the nightmare complexity of the tax credits system, these things are never straightforward. Osborne, like many before him, may find that what he saves in one part of the welfare system costs him elsewhere. Press down hard in one place and up something pops elsewhere. Paul Ashton, an independent economist, has a plausible example of a single mother getting back much of what she loses in tax credits from higher housing and council tax benefits. It is quite likely that some of those worried most about the cuts to tax credits are not the biggest losers, or even losers at all.

Even so, there are big losers, and they are among the “hard-working families” the Tories want to encourage, and they happen suddenly. So if this threatens to be Osborne’s poll tax moment, how can he escape it?

The first option is to phase in the changes. A 7% or 8% drop in income is a big hit; 1.5% to 2% annually spread over four years is more manageable. People’s circumstances change (admittedly something the tax credits system is not great at dealing with), but with the cuts spread people would have a better chance of working their way through them. This process would be helped by rising wages, notwithstanding the Institute for Fiscal Studies’ (IFS) point that the national living wage will not on its own come close to compensating for the cuts.

The second option is to keep the overall tax credit cuts but push them up the income scale, as suggested by Frank Field, the former Labour welfare reform minister. Under his proposals, which he claims would save as much as Osborne intends, nobody would lose anything on earnings below £13,100, all the losses being above that level.

Field is always worth listening to but his alternative reform would impose unacceptably high marginal rates of tax and benefit withdrawal. David Phillips of the IFS calculates that they would mean a 97% effective marginal rate on earnings above £13,100, once the loss of tax credits, income tax and national insurance are taken into account. If households are on housing and council tax benefit, that marginal rate rises to 99%.

There may be a third way. I would suggest a combination of phasing in the changes and Field’s suggestion of shifting the burden of the cuts to higher income families, but with a crucial addition. This crucial addition would be using higher taxes to reduce the amount that credits have to be cut.

What taxes? It is a pity that the new £1m inheritance tax threshold on family homes passed to children has been announced and is being implemented. That will cost nearly £1bn a year by 2020 and, apart from buying the Tories a few votes in the election, is hard to justify.

Also increasingly hard to justify, however, is the obsession with increasing the personal tax allowance; the amount that people can earn before paying income tax. Raising it to £11,000 next year in the July budget was at a cost of more than £1bn a year, a tax cut that has long ceased to be of benefit to the very lowest paid.

Most obvious of all, at a time of low inflation and low petrol and diesel prices is to push up fuel duty. The chancellor’s “fair fuel stabiliser” four years ago ruled out duty increases when oil prices were above $75 a barrel. They are currently under $50. A 2.5p increase in duties would raise over £1bn and take some of the rough edges off the tax credit changes. It would be unpopular. But not as unpopular as the raw changes in tax credits Osborne seems determined to inflict.

Sunday, October 18, 2015
How Osborne's dreams of a surplus could backfire
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Outside the narrow confines of what is sometimes called the Westminster village, most people will have been getting on with life, rather than following the progress of the government’s Charter for Budget Responsibility; its new set of fiscal rules.

To sum up, for those who missed it, Labour decided that the charter was a very obvious political trap set by George Osborne to demonstrate that the opposition could not be trusted with the public finances. Then, having identified this very obvious trap, the party’s new leadership tried to get all its MPs to hold hands and jump into it. Some sensibly resisted by abstaining on the vote.

John McDonnell, the new shadow chancellor, has made a fool of himself. There was something very odd about his interview with The Guardian on September 25, when he said he would support the charter – which commits the government to an overall budget surplus – while also saying Labour would borrow to fund investment; the party’s position under Ed Miliband.

It looks like he did not understand what he was saying and the illogicality of his position was pointed out to him. That is more convicing than his story, that he had a Damascene conversion when visiting the families of steelworkers in Redcar, should be taken too seriously.

I hope this is the last time McDonnell will feature here for a while. Ed Balls, for all his faults, was 10 times more suited to the job of chancellor than his successor and I did not devote many column inches to him during the last parliament. It would have been very different if the general election had turned out differently for Labour and for Balls.

Just because the new shadow chancellor has been a fool does not, of course, mean Osborne is a genius. The fiscal charter is not, as its opponents suggest, a stunt – he means it - but the highly political way in which it has been used makes it easy to make that claim. Sometimes the chancellor can be too political for his own good. You might have needed a fiscal charter vote to convince voters that a Miliband-Balls Labour party lacked fiscal credibility. You do not need it with a Labour party led by Corbyn; people know that already.

This should be a golden time for Osborne. Though he got on reasonably well with Danny Alexander, the Liberal Democrat Treasury chief secretary, during the coalition, those days are over. The Treasury these days is peopled by like-minded Tory ministers, including Alexander’s successor, Greg Hands.

The economy is doing well. Though there is evidence of a slight slowdown in the third quarter, Osborne can bask in the glory of an economy growing faster than G7 competitors, and the recent upward revisions in gross domestic product which have vindicated his approach.

The labour market is doing extraordinarily well, a recent pause in employment growth giving way to another good rise. In the latest three months employment has grown by 140.000; in the last year by 359,000, and overwhelmingly traditional full-time employee jobs. The unemployment rate has dropped to 5.4%, its lowest since May 2008, and could soon threaten to drop below its lowest point during the long upswing from the early 1990s to the global financial crisis.

Average earnings are growing by 3% - 3.4% in the private sector – at a time when inflation has turned marginally negative, by 0.1%, again. Real wages are rising strongly and, though the path will be bumpy, productivity should also recover. The economy is in a sweet spot.

Instead of basking in this, and the political gift of a chaotic and divided opposition, the Tories are in danger of creating rods for their own backs. The fiscal charter is badly designed and hard to defend, and the cuts in tax credits, which have become the lightning conductor for austerity in this parliament, are being badly handled.

The problem for the charter is not that it aims for an overall budget surplus, and then to keep it there, although Osborne could easily find, like most of his predecessors, that this is a triumph of hope over experience. He came up with his surplus ambition only after his deficit targets had slipped.

After a big increase in government debt before, during and after the financial crisis, it is reasonable to aim to reduce it, if only slowly. Treasury projections produced at the time of the budget showed that, even assuming an economic shock every eight years that pushes public sector debt up by 10% of gross domestic product, a rule that required a small surplus would reduce it from just over 80% of GDP now to just over 50% of GDP by the mid-2030s. Borrowing to invest – running an overall budget deficit - would leave debt close to current high levels.

Nor is it the case that running a small overall surplus means starving means starving the country of much-needed public investment, as is sometimes claimed. There have been times when budget surpluses coincided with near-record lows for public investment, as under Gordon Brown from 1988-99 to 2000-01. But there have also been times when surpluses ran alongside very strong public investment, as in 1969-70 and 1970-71, when public investment averaged well over 6% of GDP, more than four times current levels.

The problem is the way the charter is designed. It aims for an overall budget surplus by 2019-20, which would be the first for nearly two decades, and a reduction in debt as a percentage of GDP each year until then. That overall surplus would then be maintained each year “in normal times”, the requirement only being abandoned if there is a “significant negative shock” hitting the economy, defined as an assessment from the Office for Budget Responsibility (OBR) either that growth has dropped below 1%, or that its forecasts show it doing so.

The problem with this, as Jonathan Portes, former director of the National Institute of Economic and Social Research points out, is that it could lead to mistakenly tight fiscal policy. If growth averaged 1.5% a year rather than 2.5% over a four-year period, the cumulative loss of GDP, and tax revenues, would be considerable but the charter’s get-out clause would not be triggered. Osborne, or his successor, would be required to target a budget surplus even in a period of slow growth.

This would deprive Osborne of flexibility he himself has taken advantage of. The OBR, in its latest forecast evaluation report, just published, looked at why borrowing last year, 2014-15, was more than £50bn more than it predicted in 2010. The problem was a shortfall in economic growth, and the weakness of wages, which meant tax revenues came in £60bn lower than expected. But we now know that growth never fell below 1% during the last parliament. Had the charter applied, Osborne would have had to cut spending more deeply, or raise taxes, to compensate for the shortfall in revenues. It is a problematical piece of legislation.

The government is also getting itself into an unnecessary bind over tax credits. There are plenty of things that need fixing about tax credits. Everybody talks about their positive effects on work incentives but they also operate in the opposite direction. I recently quoted a Low Pay Commission report which found that many lone parents were unwilling to work more than 16 hours a week, and single adults more than 30, because it affected their entitlement to tax credits and other in-work benefits.

What you do not want in any reform are large numbers of seemingly deserving cases, who will lose out significantly from the tax credit changes, in some cases reducing or removing their incentive to work. Chancellors are at their best when following the dictum of Jean-Baptiste Colbert, Louis XIV’s finance minister, of plucking the largest amount of money from the goose “with the smallest possible amount of hissing”.

There is plenty of hissing over the tax credit changes, which strongly suggests they could be done in a better and fairer way.

Monday, October 12, 2015
Geoffrey Howe, exchange controls and the 1981 budget
Posted by David Smith at 01:00 PM
Category: David Smith's other articles

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An extract from my book, Something Will Turn Up

The 1979 budget was big and bold. Rarely has a government set out its stall, and its philosophy, so clearly. The argument was that if these big changes had been delayed, they might never have happened, once events intervened. As significantly as the income tax cuts and the big shift from direct to indirect tax was another section in Howe’s speech.

Exchange controls had been the cross that British individuals and businesses had had to bear through sterling’s long period of vulnerability. During the worst of the country’s ‘sick man of Europe’ period in the 1960s, before and after the 1967 devaluation, a £50 ‘foreign travel allowance; operated, this being the limit on the amount of money British travellers could take abroad. That was probably the least important though most visible aspect of exchange controls. Partly to hold the Bretton Woods system together, most countries operated controls on the amount of capital that could flow in and out. For countries with vulnerable balance of payments positions, which could be exposed by flows of ‘hot’ or short-term money, such controls had come to be seen as very important. All that changed for Britain in the space of just a few months in 1979. In his budget speech, Howe said it was now ‘an appropriate time to start dismantling our apparatus of controls on outward capital flows’.

In his budget speech, Howe suggested that his approach to the removal of exchange controls would be a cautious one. It would be a ‘progressive dismantling’, he said, and determined by the strength of sterling among other factors. In the event, the chancellor was able to proceed a lot more rapidly than he thought. Just four months after his budget he announced to a surprised House of Commons that all the remaining exchange controls were to be abolished. This was quite a moment. Nothing better illustrated the commitment of the Thatcher government to free markets than this bold move to allow people and businesses to decide for themselves how to money across Britain’s borders.

It set the standard for the rest of Europe, which eventually followed suit by removing national exchange controls, though in some cases not for a decade or more. The Labour Party complained that it would cost British jobs, as firms used their new freedoms to invest overseas, although in subsequent years Britain was a net beneficiary of such flows, as inward investment increased sharply, particularly from the Far East. It also signalled to the world that the Thatcher government meant it when it said it would be radical and reforming.

The removal of exchange controls was one of the most important reforms of the Thatcher era, alongside other financial liberalisation including freeing the banks to enter the home loan market, the removal of hire purchase controls and the Big Bang reforms of 1986; which opened the City up to foreign ownership and brought the phenomenon of investment banks to Britain. A controlled financial system became a liberalised one, with both good and bad consequences.

Sir Geoffrey Howe, Margaret Thatcher’s first chancellor, was also the first chancellor I got to know on a personal basis. I was working for Financial Weekly, a now-defunct City newspaper. It had been launched, in 1979, by the then owners of the Daily and Sunday Express, with some fanfare. Money was spent on it, and high-profile columnists hired at considerable cost, including Harold Wilson, the former Labour prime minister. Later I was deputed, with a colleague, to take him to lunch in Westminster and tell him that we could no longer afford to carry his column, news he was able to avoid, on that occasion at least, through the simple expedient of not turning up.

Financial Weekly had failed to live up its founders’ expectations. When I joined in the spring of 1981 it was already clear that neither circulation nor advertising made it a viable proposition. A year later the original owners closed it and everybody received a redundancy cheque. It was a short-lived period of idleness. Two weeks later the title was bought by Robert Maxwell, the flamboyant Czech-born businessman and one-time Labour MP, today remembered for appropriating funds from his companies’ pension funds and dying, in 1991, after apparently falling overboard after a heart attack from his yacht, the Lady Ghislaine, which was cruising off the Canary Islands. That was much later. I remember him as a huge presence, literally, with a domineering manner. Anybody on the receiving end of Maxwell’s bullying, which I fortunately never was, did not forget about it in a hurry. As almost a comic-character magnate, he was also the subject of a lot of gentle mockery. One story about him, which I do not think was apocryphal, was of him coming across a member of staff in one of the corridors in Maxwell House (yet it was called that) on the north side of the City, smoking a cigarette while reading a notice board.

Maxwell, for some reason, took an instant dislike to the person, called him into his office and in his booming voice asked what his annual salary was. He them wrote out a cheque for the amount and told him never to appear in the office again. The man, it turned out, was not a member of staff but a visiting sales representative from another company, who had just enjoyed a large and unexpected bonus. In the meantime, a new proprietor meant a relaunch for the newspaper. We asked the Treasury if Sir Geoffrey Howe would agree to an interview, and he did.

Over the years, Howe has acquired a reputation as one of the most downtrodden political figures of recent times. In 1978, when he was shadow chancellor, he was famously the subject of one of the cruellest House of Commons putdowns of all time. Following an assault on his economic policies by Howe, Denis Healey, the chancellor, said that being attacked by his opponent was like being ‘savaged by a dead sheep’. Once in government, stories began to emerge of Howe being humiliated by Thatcher in cabinet meetings, and later some of those humiliations came out in some of her public utterances. It was no secret that she used her personal economic adviser, Alan Walters, and Sir John Hoskyns, head of the Downing Street policy unit, to bolster her chancellor’s resolve. At a time when the Treasury was resistant to the new government’s policies, she always feared that Howe would go native. One explanation of Howe’s devastating Commons’ resignation speech in 1990, which triggered the leadership contest that brought down Thatcher, was that it was his revenge for years of humiliation. He later denied that strongly, saying his speech was a matter of conscience. When I met him in 1982, it struck me that people had perhaps sometimes confused his courteousness with weakness. He was certainly courteous. When I said we were very pleased to have the interview for our relaunch, he said: ‘Do you think it will get on the front page?’ There was of course never any doubt that it would. The story, a variation on the theme that the economy was decisively on the up, fitted perfectly. That he was able to say in 1982 was far from guaranteed.

This was a year after Howe’s most dramatic moment as chancellor, his 1981 austerity budget. In the depths of the 1980-1 recession, he had turned the conventions of post-war economic policy on their head. Unemployment had risen above two million and was increasing by 100,000 a month. Though there was some tentative evidence that the pace of decline was easing, nobody could be sure that the economy was near a turning point. It was a moment when most governments would have trod carefully, for fear of making a bad situation worse. Instead Howe, egged on by Thatcher and her advisers, unveiled a budget that even with the passage of time looks bold, to the point of foolhardiness. Had it gone wrong, it could have been the end of the Thatcher government.

Though Keynesian economic policies had been abandoned by the Callaghan government in 1976, they were buried by Howe in 1981. His budget raised taxes, mainly by freezing personal tax allowances at a time of high inflation, raising employee National Insurance contributions and announcing big increases in excise duties on petrol, alcohol and tobacco. Popular it was not, even though there was a one-year windfall levy on the banks, which were benefiting from the very high interest rates that were part and parcel of the government’s monetarist experiment. Most notoriously the budget produced a response from 364 economists, a round-robin letter circulated around university departments which was published in The Times, which condemned the government’s approach. The letter, initiated by Frank Hahn and Robert Neild of Cambridge University, two of Britain's most distinguished professors of economics, attracted the signature of four former chief economic advisers to the government, and one future governor of the Bank of England, Mervyn, later Lord, King. ‘There is no basis in economic theory or supporting evidence for the Government's belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment,’ it warned. ‘Present politics will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.’

The letter could have been an epitaph for the Thatcher government’s economic experiment. The story goes that when Michael Foot, the Labour leader, asked her in prime minister’s question time to name two economists who agreed with her policies, she was able to say, quick as a flash, Walters and Patrick Minford. But in the car back to Downing Street she turned to an aide and said: ‘It’s a good job he didn’t ask me to name three.’ 1981 was certainly the government’s toughest year. Just a month after the austerity budget the first of the inner-city riots broke out. The riots, in Brixton in London, Toxteth in Liverpool, Chapeltown in Leeds and Handsworth in Birmingham, appeared to be a direct response to high and fast-rising unemployment, though subsequent investigations showed that the causes were more complex. For several months the austerity budget appeared to be a gamble that had failed. Though it is now seen as one of the episodes that were the making of the Thatcher government, it did not look like that for some time. Figures now show that the 1981 budget did mark the low-point of the recession, and that the 364 economists were wrong. By focusing on fiscal policy – the budget measures – they had failed to spot that the purpose of the budget was to make space for a relaxation of monetary policy. Howe was able to announce a two-point cut in interest rates in the budget and in subsequent months it became clear that the government had moved away from its initial very tough monetarist approach, which Healey had christened ‘punk monetarism’. The pound came down in response, easing some of the pressure on industry. Inflation also began to fall sharply, easing the pressure on living standards. Monetary policy revealed itself to be more powerful than fiscal policy, establishing a pattern for economic policy that was to become the norm.

Sunday, October 11, 2015
China sneezes: Is the rest of the world catching a cold?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

How worried should we be about the world economy and, by extension, Britain’s recovery? Is it time to batten down the hatches or is this just a pause for breath?

Should there be emergency action to boost global growth which, with the monetary levers already turned up to maximum can only mean a massive Keynesian fiscal boost, as advocated a few days ago by Larry Summers, the former US treasury secretary?

Concern over the global economy has been building for some time, most notably in worries over China and even America, where the majority on the Federal Reserve’s decision-making committee is keen to get on with raising interest rates but has so far been thwarted by global developments and disappointing US data.

That concern has been brought into sharper focus, however, by the latest forecast from the International Monetary Fund. The IMF’s forecast for world economic growth this year is just 3.1%; and given how much of the year has gone it is as much an assessment as a forecast.

Growth of 3.1% does not sound that bad. A growth rate in Britain of 3.1% would be very acceptable indeed. But for the world economy it is not good. The normal or “trend” growth rate of the world economy is 4%, or at least it was before the global financial crisis. The IMF’s definition of a world recession is when growth drops to 2% or below. So the current situation sees the world perched, perhaps precariously, halfway between a normal expansion and recession.

Not only that, but after three unspectacular years from 2012, in which the world economy has grown by 3.4%, 3.3% and 3.4% respectively, this year’s 3.1% is the worst since 2009, when there was no growth at all; the weakest in the post-war era. Growth this year is reckoned to be the same as in 2008, when the world was succumbing to the crisis and for the latter part of the year was clearly dragged down by it.

And, for once, it is easy to see where the problem lies. Advanced economies – North America, Western Europe, Japan and a few other parts of the world – are gradually picking up. This year’s 2% growth for advanced economies is nothing to write home about, and weaker than in the years leading up the crisis, where the average was close to 3%. But it is better than we have been used to. In 2012 and 2013, growth was barely above 1%, largely because of the eurozone’s woes.

Britain, incidentally, had its best year for growth last year, according to the IMF, which it puts at 3%, followed by a forecast/assessment of 2.5% this year and 2.2% for 2016. Having beaten the advanced countries’ average for a while, Britain’s growth next year will be exactly in line with it, according to the IMF. It sees advanced countries picking up from this year’s 2% to 2.2%.

Rather than the advanced economies, it is the emerging world where the problem lies. China is slowing and two of the four Brics (Brazil, Russia, India and China) are in recession this year and are expected to stay in recession next year. The IMF has Russia shrinking by 3.8% and 0.6% in 2015 and 2016 respectively, and Brazil by 3% and 1%.

For emerging economies as a whole, growth this year is put at 4%. That is the weakest since 2009, but that does not tell the full story. In 2009, emerging economies carried the world through the crisis. While advanced countries saw their economies dive – gross domestic product plunging by 3.4% (including a 2.8% fall in America and 4.3% in Britain) – emerging economies grew by 3.1%, including a remarkable recession-busting 9.6% expansion in China.

Growth then accelerated in emerging economies, to 7.5% in 2010. That, perhaps unsurprisingly, was the high watermark. Growth in the emerging world has slowed every year since, and this year’s 4% is barely more than half what was achieved four years ago.

Even that, however, does not tell the full story. If we look at the past decade and a half, emerging economy growth has always significantly exceeded growth in the advanced world. Sometimes emerging economy growth has been three times advanced-economy performance, sometimes more.

It was this that led me, and others, to conclude that we had moved into a new era for the world economy. In the 20th century two-thirds of global growth came from advanced economies, one-third, and often less, from the emerging world. In the 21st century, it seemed, those positions had been reversed, with emerging economies the new locomotives, responsible for two-thirds of the world’s growth.

Has that come to an end? Even the more muted growth in emerging economies this year, 4%, is twice the 2% expected for advanced countries. But that is the narrowest gap since 2000. Andy Haldane, the Bank of England’s chief economist, has talked of the emerging market crisis from 2015 onwards as part three of a trilogy that began with the “Anglo-Saxon” financial crisis of 2008-9 and transmuted into the eurozone crisis of 2011-12. Though the Bank’s minutes on Thursday were a little more guarded in their language, when interest rates were left unchanged at 0.5% for the 79th successive month, the emerging market slowdown is clearly a factor weighing on it.

Does it mean that we are going to return to the global economy of the 20th century, in which the West once again calls all the shots?

There is no doubt that emerging economies face challenges. In some ways they are victims of their earlier success, in that some of the international capital that flowed in in anticipation of strong growth forever is now flowing out again. This is similar to what gave us the Asian financial crisis of 1997-8. Investors seeking safer havens in the West have pushed up interest rates – bond yields – in emerging economies and this will affect growth.

In some respects, however, the story is a simple one. As long as China was growing very strongly, it produced a rising tide that lifted a lot of boats. Neither Brazil nor Russia can remotely be said to be well-run economies, and that applies to much of Africa, but as long as China was pushing up oil and commodity prices, growth in these commodity-rich economies was guaranteed.

The China slowdown has exposed underlying weaknesses. When China sneezes, many coountries catch a cold.

Some will fail to adjust but we should not be too gloomy. I am with Capital Economics, which headlines its new report on emerging economies: “One extreme to the other”. “Having been too optimistic on the outlook for the emerging world over much of the past five years, the consensus has now shifted too far in the other direction,” it says.

I’m also with the IMF. It thinks this year will be the low point for the emerging world, with growth picking up to 4.5% next year, building up to 5.3% by 2020, the latter alongside a slowdown in advanced economies. Something like normal recent service will eventually resume.

That, of course, is not guaranteed. And the one thing that looks odd in this context is an early rise in US interest rates. Even if the US economy were racing away, which it is not, there would seem to be a strong case for holding fire because of what is happening outside America. We shall see.

Sunday, October 04, 2015
Those green shoots were always stronger than we were told
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

History has been rewritten. What we were told was happening to the economy two or three years ago was not happening. Growth was stronger than the official figures of the time told us it was. Hundreds of “flat-lining”, “double-dip” and even “triple-dip” headlines were written in vain.

Nor is the process over. The revisions a few days ago to the growth numbers for 2011-13, foreshadowed here last week, are not the end of the history rewriting process. Indeed, we are still very close to the beginning. It will go on for many years.

Long after the figures have ceased to be of interest to anybody other than economic historians, they will carry on changing. There is nothing wrong with that. It is good that the Office for National Statistics (ONS) does not close the books. As new information comes in, or new methodology is adopted, the numbers are revised.

It is important to recognise, however, that these things matter. As I have pointed out before, comparisons between the current recovery and its predecessors are meaningless, because the data on previous recoveries has been through many more revision cycles than recent figures. One day, maybe in a couple of decades, we will know for sure whether this recovery was weaker than its post-war predecessors. We cannot know that with any certainty yet.

It also matters for the decisions that were taken at the time. Rupert Harrison, George Osborne’s former right-hand man, tweeted after the gross domestic product (GDP) revisions were released that they showed that Britain had enjoyed exactly the same growth since the first quarter of 2010, the last quarter before the coalition took over, as America.

He was right. Both Britain and America’s GDP have grown by 11.8% since then, better than the G7 average of 9.1% and the European Union average of 5.8%.

Harrison knows what it was like to be on the inside when the criticisms were raining down on the chancellor and even the International Monetary Fund’s chief economist said he was playing with fire. He had to put up with austerity critics unfavourably comparing Britain’s growth performance with that of America and attributing it all, not to Britain’s proximity to the troubled eurozone but to apparently misguided austerity. Well now we know, and in time we will know more.

Osborne did not bow to the pressure and abandon his deficit reduction strategy, but other chancellors might have done so. Instead, the new figures show that growth was stronger in 2011 at 2%, perhaps the year of maximum austerity, than in 2010, 1.5%.

When history is rewritten, it also reminds us that other decisions might have been different. Andrew Sentance, who was on the Bank of England’s monetary policy committee (MPC) at the time, reminds us that a 6-3 decision to leave interest rates on hold in February 2011 could have gone the other way had the MPC know then what we know now.

Though three MPC members voted to hike rates, others were deterred by the ONS’s initial estimate of a 0.5% fall in GDP in the final quarter of 2010. I know this was the case, from talking to some of those who voted for a hold at the time. It was known that exceptionally bad weather had depressed GDP by 0.5% but the expectation was that the overall number would still be flat. The fall spooked some MPC members and, of course, we are yet to see a rate hike more than four years later.

The new figures show, however, that GDP rose by 0.1% in the final quarter of 2010. There was no fall. Some would say the ONS saved the Bank from an error, in that any hike in early 2011 would have been reversed a year later when the eurozone crisis intensified. Maybe, but it would have re-established the principle that rates can go up as well remain stuck at just above zero.

History is history. What do the figures tell us about what is happening to the economy now? There is some evidence of a slight slowdown in growth in the third quarter but the broad picture is encouraging.

The caricature of Britain’s recovery presented by the new Labour leader and his shadow chancellor at their party conference last week was just that. In the past 18 months more growth has come from net trade (exports minus imports) and investment combined than from consumer spending.

There has been no debt-fuelled splurge. Real household incomes have risen by more since early 2014 than consumer spending. Even the current account deficit, Britain’s Achilles heel, has improved; the deficit in the second quarter, 3.6% of GDP, being just over half the alarming 6.3% of GDP gap recorded in the final quarter of last year.

We may also be moving beyond the productivity crisis. As had been suggested by the GDP and employment figures, output per hour rose by 0.9% in the second quarter, hitting a new record but – more importantly - showing decent growth.

Instead of strong employment, weak wages and stagnant productivity, the new phase looks to be one of slower employment growth, bigger pay rises and a return to something like normal productivity growth. The figures also suggest that inflation will not be at zero for too long. The rise in unit wage costs over the past year, 2.2%, was the strongest for three years. Much more of this and the MPC will start to think a lot more seriously about higher interest rates.

There remain challenges. The current account and budget deficits may be down but they are still too big for comfort. Productivity is 15% below where it would be had it followed its pre-crisis path, even after the latest improvement. Manufacturing is going through a stagnant phase.

The rewriting of history by the official statisticians reminds us, however, that even when things appear grim, they are often better than they seem Some of us knew this. Everybody should know it.

Sunday, September 27, 2015
Bank frets that is has run out of ammunition
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The economic news is generally good, particularly in Britain. Growth has decent momentum, zero inflation is bringing strong gains in real wages, business investment is rising, and consumer and business confidence are high. There are even signs of a productivity revival.

Not only that but this week official figures will show that the recovery was stronger than initially thought, as is often the case. The Office for National Statistics (ONS) will revise growth in 2011 up from 1.6% to 2%, 2012 up from 0.7% to 1.2% and 2013 from 1.7% to 2.2%. The 3% growth number for 2014 will probably stay the same.

These revisions will be a reminder that conclusions drawn about the state of the economy on early ONS data are often misleading. Britain was never “flatlining” during the last parliament. Average growth over 2011-14 was more than 2% a year. Quarterly growth on the new figures was stronger on a number of occasions than in the second quarter of 2010, when the coalition took over and before most deficit-reduction measures were introduced.

I’ll return briefly to those revisions in a moment. The point about the generally good news about Britain’s economy is that it stands in sharp contrast to the fears stalking the world’s stock markets. The Greek crisis gave way to worries about China, which continue. There are now concerns that the Volkswagen scandal could drag down Germany. In a world of worry, it never rains but it pours.

My view is that most of this is overdone. Greece was about as messy as it could have been, given the Syriza government’s hamfisted brinkmanship. But the crisis is now on the backburner. Reaction to China’s necessary slowdown has been overdone.

Willem Buiter, the former Bank of England monetary policy committee member who is now global chief economist at Citigroup, recently generated headlines by warning that China could drag the world into a new recession. Yet Citigroup’s new forecasts for global growth, published a couple of days ago, show a relatively small downgrade compared with what it expected in the spring: growth over the next four years will average 3.2% rather than 3.5% a year. It also expects China to grow by between 6% and 7% a year. Britain, by the way, is predicted to grow by an average of 2.8% a year.

The circle is squared by Citigroup’s belief that Chinese growth is significantly overstated by official figures, so 6% to 7% growth is actually 4%. Adjust for that and global growth next year could be only 2.5%, the firm says, with a 40% chance that it drops to 2%; the usual definition of a world recession (at least until the much bigger one we experienced in 2008-9). We shall see.

As for Germany, while it is tempting to see the VW scandal as the Federal Republic’s Northern Rock moment, or its Libor, or even its version of the financial crisis, that looks like a gross exaggeration. Holger Schmeiding, chief economist at Berenberg Bank, points out that the car industry only accounts for 2.7% of German gross domestic product. “Even a heavy drop in diesel car production and exports would probably not subtract more than 0.2% from German GDP,” he says.

The worries and warnings are not confined to stock market investors. Central bankers, and those who hang on their every word and deed, are also fretting. When the Federal Reserve passed up on the opportunity to raise interest rates 10 days ago, saying “recent global economic and financial developments may restrain economic activity somewhat”, it underlined the difficulty central banks have had in escaping from the so-called zero bound.

More than six years on from the trough of the 2008-9 global recession, no major advanced-economy central bank has raised interest rates and kept them up. Some of the smaller ones, like the Swedish Riksbank were forced to reverse dramatically post-crisis rate hikes. Its main interest rate is negative, -0.35%.

The Fed’s non-hike has pushed out market expectations of the first rate hike in Britain until well into next year, a shift more or less endorsed by Ben Broadbent, the Bank’s deputy governor for monetary policy, who said in an interview with Reuters that the reaction of the markets was “entirely predictable”.

The trouble with interest rates is that there is never a good time to raise them. In the very many years I have been covering these things the number of times when a rate hike has not been met with at least some howls of protest and dire warnings of the damage it would do. The fact that rates have been near-zero for so long means there is now a powerful air of permanence about it.

This, in turn, means that when the downturn does come, central banks will have much less ammunition to fight it than usual. As Andy Haldane, the Bank’s chief economist, pointed out in a recent speech, the average loosening cycle – the amount rates have been cut – has been five percentage points since 1970 and nearly three points even in the period of generally lower rates since the mid-1990s. If you start at 0.5%, achieving anything like that is impossible without moving to what I would regard as unfeasibly negative interest rates.

Similarly, if the Bank goes into the next downturn with £375bn of assets purchased under quantitative easing still sitting on the its books, there is at least some constraint on its ability to do more. "Helicopter" money - the Bank creating money to hand ouit to households - would be a dangerous step on a slippery slope.

There is, as I say, never a good or popular time to raise rates. Had the Bank known for certain that the economy was stronger than it thought, maybe it would have happened some time ago. Had Mark Carney stuck to his summer 2013 forward guidance, and rates had begun to rise when the unemployment rate fell to 7%, we would be now be a few notches above 0.5%. I suspect, however, that the governor was more interested in giving people and businesses reassurance that rates would not go up for some considerable time (in 2013 the Bank did not expect 7% unemployment until 2016) than pinning the decision on a specific number.

There is a lesson here from fiscal policy. Though it would have been easier to postpone tough fiscal decisions until later, and though the latest figures were a touch disappointing, George Osborne’s actions in reducing the budget deficit mean that there is a decent chance that it will have been eliminated by the time of the next downturn. That, in turn, will allow for the possibility of a temporary fiscal stimulus – tax cuts and spending increases – as happened in 2008-9.

Unless the Bank and other central banks give themselves more room to cut interest rates and if necessary embark on a new round of quantitative easing – by reversing some or all of what they did in response to the crisis – fiscal policy will be on its own. Central banks would be spectators, out of ammunition when the battle begins. No wonder they are fretting.

Sunday, September 20, 2015
Even at low rates, infrastructure's not as easy as it looks
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Even without going as far as Churchill – “If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions” – we expect economists to disagree. Consensus is rare, debate and disagreement the norm.

If there is one thing on which you would get something close to consensus, however, it is that the current period of very low interest rates presents an ideal opportunity for governments to borrow and spend on essential infrastructure.

After all, there is no country in the world, not even China after its public investment boom, which could not improve its infrastructure. Britain could certainly improve her roads, railways, schools and hospitals. There is a pressing need for new investment in power generation. The economic effect of building new infrastructure is to generate more employment and economic activity directly, as well as improving the economy’s performance over the long run.

Not many sensible economists would agree with Jeremy Corbyn’s “people’s quantitative easing”, if it ever becomes a policy – and it was good to see Mark Carney put his head above the parapet to attack it – but plenty think there should be more infrastructure spending.

Fiscal multipliers associated with infrastructure spending are higher than for other public spending; in American parlance you get more “bang for your buck”. It looks like a win-win. So why is it not happening?

The first thing to say is that more is happening than has been the norm in recent decades. Taking what was achieved in 2010-15 and what is planned for 2015-20, public sector net investment this decade, averaging £31bn a year in real terms (2014-15 prices), is about a fifth higher than under the Blair-Brown Labour governments from 1997 to 2010, where it averaged just under £26bn a year.

Public sector net investment was much lower in the 1980s and 1990s than now and, while it rose strongly in the late 2000s in the run-up to the London Olympics and in response to the crisis, this was always seen as temporary. Had Labour been re-elected in 2010, it was with a plan to cut public investment even more aggressively from those temporarily high levels than the coalition ended up doing. Not since the period from the mid-1960s to the mid-1970s, when it was swelled by investment by the then nationalised industries (now private sector investment) has it been consistently higher than in the current decade.

Even so, previous governments did not have the benefit of current very low borrowing rates. The yield on 10-year gilts is currently just under 2%, while the 30-year yield is just over 2.5%. Factor in 2% inflation, the official target, and borrowing is very cheap indeed.

So why is there not more of it to fund higher levels of infrastructure spending? The first reason, I think, is that borrowing is borrowing. The budget deficit, while falling, is still large; £88bn or 4.9% of gross domestic product last year. Even if the payback from public investment is larger than for other government spending, the initial effect would be to push the deficit higher.

At times in recent years, when the deficit was barely coming down at all, that was a luxury the Treasury did not think it could not afford. It is still wary. Markets are more concerned with the overall numbers for the deficit and debt than the composition of it.

There is also the political reality of infrastructure versus other government spending. More infrastructure may be good for us, and indeed is essential in the long run. But it is often fraught with political difficulties. Indeed, it is often unpopular. Look at the row over HS2 and the pressure to abandon it, or the third runway at Heathrow, or new nuclear power stations. Anybody who has trundled through miles of coned areas while a “managed motorway system” is being installed is not filled with love for infrastructure.

Though complicated by the issue of nuclear weapons, George Osborne’s announcement of a £500m investment at the Faslane submarine base on the Clyde, guaranteeing jobs, was met with this response from Nicola Sturgeon, the Scottish first minister: “If the chancellor's got £500m to spend then I think he'd be better advised to spend it on health, education, giving young people the best start in life and reversing some of his cruel attacks on the most vulnerable.” Politically, £12bn of welfare cuts and tiny public sector pay rises alongside a huge increase in infrastructure spending would be a tough sell.

Treasury officials are meant to worry about debt and they will never be as relaxed about the prospect of adding to it as economists who do not have to carry the can if things go wrong. Long-term interest rates are very low now, and Britain is fortunate in that the average maturity of government debt is longer than in most other countries. But even under existing plans, more than £500bn of gilts will have to be rolled over in the next five years; new ones issued to replace those maturing. It may be that this can be done on terms as favourable as now but nobody can be sure of that.

Perhaps the strongest argument against turning on the infrastructure taps is that, while we may have got a bit better at these things, the history of massive cost overruns and public sector project disasters is a sobering one. Just because infrastructure spending is cheap to finance does not mean it will be value for money. White elephants and unplanned budget-busting outlays are part of the territory.

A new study by professors Bent Flyvbjerg of Oxford and Cass Sunstein of Harvard, looking at more than 2,000 big projects around the world, found that four-fifths of them “get tripped up by a malevolent hand that hides the true costs of and benefits, resulting in massive economic losses to taxpayers and businesses”.

None of this means things could not be improved. I still like the proposal of the LSE Growth Commission two years ago for an infrastructure strategy board, planning commission and bank to take the politics out of infrastructure and ensure it can be funded in partnership with the private sector. A big disappointment in recent years has been the failure to get more pension fund and insurance company money into infrastructure.

There is also scope to do a lot more on housing. The government is in something of a battle with housing associations at the moment. But they, rather than councils, will deliver the social housing Britain needs. If that means guaranteeing more borrowing by them, the public finance rules should not get in the way of that.

Even housing runs up against Nimbyism, planning delays and lack of skills, of course. There are, or should be, imaginative ways of tacking all these things. But we should not pretend it is easy. We discovered during the crisis that “shovel-ready” infrastructure projects are not a tap waiting to be turned on. Like many apparently easy things, it is a lot more complicated than it seems.

Saturday, September 12, 2015
The Great Escape: How Scotland dodged a bullet
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A year ago this Friday the Scottish people voted on whether to remain part of the UK. It was a big moment, more important because of its irreversibility than this year’s general election. Maybe more important than the coming referendum on European Union membership.

The Scots, of course, voted no, by 55.3% to 44.7%, to my considerable relief and I hope theirs. In doing so, they gave us a Scottish version of The Great Escape. They dodged a bullet. Had Scotland voted for independence, its economy would be in deep trouble. Nicola Sturgeon, its first minister, would not be attacking George Osborne’s austerity but announcing more of it in an effort to prop up Scotland’s chronically weak public finances.

But, and this is not purely a backward-looking exercise, these issues have not gone away. After rejecting independence in September last year, Scottish voters flocked to the Scottish National Party in the May general election, its 50% vote share being enough to give it an astonishing 56 out of 59 Scottish Westminster seats.

Buoyed up by this, some in the SNP have been talking up the prospect of a second referendum, with its former leader Alex Salmond saying it is “inevitable”. A vote to leave the EU would be seen by the SNP as one reason to hold a second referendum but there could be others.

Even if another referendum is avoided, Scotland is getting more fiscal powers under the enhanced devolution promised in the run-up to the referendum. Though the SNP has gone a bit quiet on full fiscal autonomy, the economic stepping stone to independence, it remains a possibility.

Why was it such a lucky escape for Scotland? The main reason, and the biggest change since the independence vote, has been for North Sea oil. The Scots were promised a future of high oil prices and rising production. The reality has been plunging prices and a crisis in the North Sea. The Scots were told that Westminster was keeping secret from them the true picture of future North Sea riches. If anything was being kept secret, it was how bad it would be.

A few numbers illustrate the point. In June the Office for Budget Responsibility (OBR) issued its latest long-term “fiscal sustainability” projections. As far as North Sea tax revenues are concerned, their conclusion was that it would be wise to plan for nothing from 2020 onwards. Total North Sea revenues will be just £2.1bn in the 20 years from 2020, it said, equivalent to a single year’s revenue in a bad year now.

Ahead of the referendum, the OBR’s projections were frequently criticised by nationalists as too pessimistic. In fact, by comparison with its current revenue forecasts, the OBR was looking at the North Sea through rose-tinted spectacles. In 2014 it though revenues in the 20 years from 2020 would be more than £36bn. In 2011 it thought they would be more than £130bn.

Forecasts, like oil prices, go up and down. What about if we saw a big recovery in oil prices closer to home? The OBR had an answer to that. As it put it: “Even an assumption of higher production and oil prices reaching around $210 a barrel leaves revenues as a share of GDP (gross domestic product) at a fraction of the levels seen in the past 10 years.”

As for keeping the good news back, the Scottish government’s own revenue projections from North Sea oil and gas have come down dramatically. In May 2014, a few months before the referendum it said that revenues for the next five years would range between £15.8bn and £38.7bn. In June, updating those projections, it said they would be between £2.4bn and £10.8bn. Taking the mid-point of those ranges, and the mid-point of the latest range looks generous given the oil price, the post-referendum projection is less than a quarter of what it was.

Nor is there any sign of things getting better. Oil & Gas UK, in a report a few days ago, said that 65,000 jobs have been lost in the North Sea since 2014. Exploration is at its lowest since the 1970s and investment is plunging. Even last year, when the plunge in prices was not complete, “more was spent on UK offshore oil and gas operations than was earned on production”.

The response of the Scottish government to this has followed a well-worn path. The North Sea was only ever a “bonus” for Scotland, not the lifeline. The trouble is, at least as far as the public finances are concerned, it is not true. The latest official figures, Government Revenue and Expenditure Scotland (GERS) show that without North Sea revenue, Scotland had a Greek-style budget deficit of 12.2% of GDP in 2013-14. With that revenue, the deficit came down to 8.1% of GDP, still higher than the overall UK deficit of 5.6% of GDP.

Since then, according to the Institute for Fiscal Studies, Scotland’s public finances have gone backwards. After the March budget, the IFS’s David Phillips used OBR figures to calculate a budget deficit for Scotland of 8.6% of GDP this year, 2015-16, the same as in 2014-15. This year’s forecast is more than double that of the UK as a whole (4% of GDP). According to Phillips, events since March will have tended to widen Scotland’s deficit, both in absolute terms and relative to the UK as a whole.

Oil and the deficit were not the only factors a year ago. The SNP went into the referendum on a wing and a prayer, hoping against all the denials that Westminster would allow it to be part of a sterling currency union and threatening to renege on its share of UK debt. An independent Scotland, I wrote then, would be “poorer, unstable and fiscal weak” and, if it carried out its debt threat, a pariah in international markets. There would have been an exodus of big employers.

As I say, these things have not gone away. Angus Armstrong of the National Institute of Economic and Social Research points out that greater fiscal autonomy for Scotland poses huge challenges. The Smith Commission’s proposals for greater devolution will give Scotland control over 60% of spending and 40% of revenues, which he says will make it “one of the most powerful sub-central governments in the OECD”.

Such is the weakness of Scotland’s public finances that it is a very long way from the balanced budget Armstrong says it would be required to follow. Allowing Scotland to borrow on the markets to give it more flexibility would, because of its fiscal weakness “and clear intention to borrow and spend more” attract the attention of the ratings agencies and possibly affect the UK’s credit rating as Scotland’s ultimate backstop.

Scotland may have dodged the bullet on independence. The challenges of its weak fiscal position remain.

Sunday, September 06, 2015
An incoherent lurch to the left
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Next Saturday, if the polls and most of the pundits are right, Jeremy Corbyn will be elected leader of the Labour party. There has to be an “if” there because we have had recent experience of the polls and the pundits not being right. It could yet be that this will be another outcome that is different from the one we have been led to expect.

If that is the case, then this will be my last opportunity to write about “Corbynomics” before it retreats back into obscurity. Even if he is elected leader (though with about as much chance of becoming prime minister as I have), somebody would have to get on with the job of turning vague ideas into workable policy.

But for now, let me work with what we have got and start by praising a round-robin letter from 55 economists published in the Financial Times on Thursday. Such letters have had a bad name since 364 mainly academic economists, including former government chief economic advisers and a future Bank of England governor (Lord King), had one published in 1981 warning that the Thatcher government’s policies would deepen the recession. The letter, of course, coincided with the start of the long 1980s’ upturn.

Lately, such letters have been an outlet, and not a very effective one, for academic economists opposing austerity.

This one, however, was spot on. Corbyn’s economic policies, if ever implemented, would be “highly damaging”, had not been “seriously thought through” and included elements that were “almost unbelievable” it said. The 55 economists, from across the political and economic spectrum, and including some opponents of austerity, were stung into action by suggestions from Corbyn supporters that his ideas represented the economic mainstream.

Those ideas include energy and rail nationalisation, “a national investment bank”, not just to invest in infrastructure but in “the hi tech and innovative industries of the future”. “People’s QE” – quantitative easing forced on the Bank rather the decided on by it – to buy the bonds issued by this new bank.

National Insurance (NI) contributions for anybody earning more than £50,000 – thus including many public employees, including senior teachers and doctors – would go up by 7 percentage points and corporation tax by 2.5 points to pay for the abolition of university tuition fees. £93bn of “corporate welfare” and £120bn of uncollected taxes would apparently provide a pot of gold to pay for replacing public spending restraint with the return of state largesse.

A lot of this is easy to dismiss. The idea that governments, desperate for revenue, have turned a blind eye to £120bn of uncollected taxes annually is laughable.

Renationalising the energy sector would be a hugely expensive folly, costed at £185bn by Jefferies, the City firm. Money spent on that would be wastefully diverted from more productive use. Taking control without full renationalisation would fall foul of the rules. Renationalisation without compensation would be the kind of thing Third World dictators do and destroy Britain’s reputation as a place to do business. Renationalising the railways by the backdoor – not renewing existing franchises but keeping them in the public sector – would take very many years.

Much more than this, renationalisation would harm consumers. Many of Corbyn’s supporters are too young to remember how bad most of the nationalised industries were, and how much better service has been since privatization. The privatized utilities have not been perfect but they have been infinitely better than what went before. This is not the Attlee era, when bombed out sectors needed to be nationalised to ensure their survival.

As for “people’s QE”, forcing the Bank to buy the bonds issued by a new national investment bank, which I touched on a couple of weeks ago, not only would this put an end to the most successful economic policy innovation of the past two decades – central bank independence – but it is entirely unnecessary.

If a future government wants to increase infrastructure spending it can do so. If it did so through a new investment bank, that would also increase spending and debt. But if the new bank was soundly-based, and its bonds guaranteed by the government, financial institutions would queue up to buy them. If, in a subsequent downturn, the monetary policy committee did more QE, it could buy some of these bonds if it chose to do so.

Forcing the Bank to be the exclusive buyer of such bonds in all circumstances, suggests that they would be too dodgy for investors and leave the Bank saddled in way that would risk insolvency (requiring the government to step in and prop it up). Leaving the QE tap permanently turned on would mean higher inflation and interest rates. This is a policy whose time should never come.

There is more. In a mixed economy such as Britain’s what should governments do? Certainly they should provide incentives to encourage business to invest, spend on research and development and export. It should at least ensure that these incentives do not put British business at a disadvantage relative to those in competitor countries. Capital allowances are particularly important for Britain’s manufacturers.

For Corbyn, however, these are part of the £93bn “huge tax reliefs and subsidies” which would be much better used in “direct public investment”. Some of this “corporate welfare” offers no scope for saving at all, such as ensuring all government work is done internally. Most of it would result in a net cost to the Exchequer from the corporate exodus that followed. Business employs the people and generates the revenues to pay for the public largesse the Labour leadership candidate craves.

Scrapping tax reliefs is one way of putting up taxes. Increasing corporation tax and putting up individual taxes, not only with higher NI but by making the tax system “more progressive” would be another. All those French people who came over to Britain to escape the high taxation of Francois Hollande would soon be on the way back again.

Those who ignore the lessons of history are condemned to repeat them. The sad thing about all this is that we have been there before and it failed. Killing off the private sector with high taxation and renationalisation, blind faith in the wisdom of the public sector to make the right decisions on everything else, political control of the central bank and a cavalier attitude to the public finances brought us to our knees before, most notably in the 1970s. We will not go there again, but the fact that so many people appear to think it would be a good idea to do so is rather depressing.

Sunday, August 30, 2015
The world struggles when the trade winds don't blow
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It has been a nasty scare, and it is not yet over. Though I think they are overstated, the doubts about China will persist. Though the sell-off appears to have reduced the ardour among central banks in America and Britain to raise rates – as was suggested in these pages last weekend – that bridge will still have to be crossed at some stage, and Mark Carney said at Jackson Hole yesterday that the rate decision will come into sharper focus around the turn of the year, an unchanged message.

Inevitably, there were fears that we were going back into a huge financial crisis. Larry Summers, the former US treasury secretary, helpfully tweeted that there were echoes of August 1997 (the start of the Asian financial crisis), August 2007 (the start of the global financial crisis) and August 2008 (just before the Lehman collapse).

If that was the equivalent of shouting fire in a crowded theatre, I thought a more sensible parallel was with August 2011. That was the month when the eurozone crisis escalated, America was downgraded following fraught debt ceiling negotiations in Washington and, by the by, riots broke out across England.

That sell-off did not presage a new global crisis and recession – most do not – but it ushered in a period of uncertainty and weaker growth, including a second recession in the space of four years in the eurozone, albeit one that was milder than the first.

It has been a while since markets have been quite so panicked as in recent days. Underpinning the uncertainty among investors, over and above Chinese growth worries, Greek exit fears and rate hike concerns, is the fear that something is not right about the global economy. The world was knocked off balance by the financial crisis and it is yet to recover its stability.

Are such worries justified? On the face of it, global growth is not too bad. The International Monetary Fund, in its latest world economic outlook update, published last month, sees 3.3% global growth this year, 3.8% next.

This year’s forecast is slightly below the 3.4% achieved in both 2013 and 2014, and all four years will see growth weaker than the pre-crisis world norm of 4% a year. But this is a long way from a growth crisis. The IMF, for what it is worth, shares my view of China, which is that we are seeing an adjustment, though a tricky one, to slower but ultimately better balanced growth.

There is something missing from the global economy, however. The Paris-based Organisation for Economic Co-operation and Development (OECD) calls it a “B-minus” world economy. I would call it a world lacking one of its key drivers.

That driver is world trade. A few days ago CPB Netherlands, the Dutch think tank which is a centre of expertise for monitoring world trade, reported that despite a rise in June world trade in goods in the second quarter was down by 0.5%, following a drop of 1.5% in the first quarter. According to CPB: “Import momentum was negative or zero in all major regions. Export momentum was positive in advanced economies, but negative in emerging economies.” Unless the June figures signal a sustained upturn, which looks unlikely given everything, this looks like a weak year for world trade.

CPB monitors trade in goods. Services are also important. But taking goods and services together, we are seeing a prolonged period of weak growth in trade. Alongside the IMF’s estimate of 3.4% economic growth in 2013 and 2014, world trade in goods and services expanded by 3.3% and 3.2% respectively.

For most of the post-war period world trade grew significant faster – often twice as fast – as global gross domestic product. If we take the period 1990-2007, world trade grew by an average of nearly 7% a year, despite a recession at the start of the period and a slowdown at the turn of the millennium.

In contrast, even leaving aside the collapse and rebound in world trade in 2009-10, trade growth in recent years has averaged only 4% a year and – as noted – has often struggled to achieve that.

That is reflected in Britain’s trade figures. Though exports had a good second quarter, helping to boost gross domestic product, until then export volumes had only grown by 1% a year over three years. Import volumes did a little better, though not spectacularly so.

Why the weakness in world trade? In the case of Britain, weak growth in the eurozone has been an important factor. Indeed, Europe’s slow growth has removed an important source of world trade growth.

But there are other factors. Exporters blame the failure of trade credit to get back to pre-crisis levels, even when governments are on hand to help out; some more than others. Risk aversion on the part of businesses may also have undergone a long-term shift as a result of the crisis.

Protectionism has not obviously increased but it may have done so discreetly. Certainly, the momentum for trade liberalisation, which was a key driver of global growth in the second half of the 20th century, has faded badly.

The Doha round, under the auspices of the World Trade Organisation, was launched as long ago as 2001 and shows no sign of reaching the finishing line. Initiatives like the Trans Pacific Partnership (TPP) and TTIP (Transatlantic Trade and Investment Partnership) have run up against a coalition of protectionists, vested interests and left-wing protest groups. Politicians seem to have decided they have enough on their plate without fighting the good fight on free trade.

The result is that the world economy is not firing on all cylinders. It is missing the trade winds that have blown us to prosperity in the past. What that means is that countries are having to generate growth under their own steam.

That is true in Britain, where net trade has made virtually no contribution to the recovery in recent years, though the latest figures were rather more encouraging. It is true in China, notwithstanding this month’s small devaluation of the renminbi.

When world trade is weak, adjustments to domestically-generated growth like those the Chinese authorities are trying to achieve become more abrupt, and more challenging. Recoveries like those in Britain are almost bound to be unbalanced. We would all benefit from stronger world trade. Sadly, it does not appear to be on the horizon.

Sunday, August 23, 2015
QE or not QE? A slippery slope to breaking the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is more than six years since the Bank of England launched quantitative easing (QE) and more than three years since it last actively did any. But QE opened up a Pandora’s box, and it may be only now that we are seeing the consequences of that.

The Labour leadership candidate Jeremy Corbyn has talked of a “QE for the people”, in which the Bank would print money to pay for infrastructure and other projects. Some economists have picked up on an idea, “helicopter money”, originally attributed to Milton Friedman but floated again by Lord (Adair) Turner a couple of years ago, in which in the event of a downturn – or even in the absence of a downturn – the Bank would print money in an open-ended way to finance the budget defciit, and perhaps to hand out to households.

It was perhaps inevitable that a policy which appears to magically conjure up money out of thin air, which can then be used to boost the economy, risked being the first step on a slippery slope. The Bank, in my view, could and should have done more to prevent that from happening.

Let me elaborate, starting with a brief account of what the QE undertaken by the Bank QE is and what it was meant to achieve.

QE was launched in March 2009, the moment the MPC reduced official interest rates to an all-time low of 0.5%. That was when it launched its asset purchase programme (its name for QE); buying assets, overwhelmingly British government bonds – gilts – using newly created “money”. “Money” in this case means, not cash, but central bank reserves. The new “money” is not costless. Interest has to be paid, at Bank rate, on the reserves created.

Over a 10-month period in 2009-10, the Bank created £200bn of such reserves and used it to purchase £200bn of assets. This was not, as is often wrongly thought, part of the bank bailout programme. The assets were largely bought from pension funds and insurance companies, as well as foreign investors in gilts.

QE in 2009 was hard not to support. I certainly did. This was an emergency “all hands to the pumps” period, when the economy needed rescuing. The institutions which sold assets to the Bank used the proceeds to buy corporate bonds, equities (shares) and other assets. This ensured that businesses, particularly larger ones, could access capital markets to keep going, and fund growth.

The key effect of QE was to reduce long-term interest rates. Cutting Bank rate to 0.5% had reduced short-term rates. Asset purchases reduced long rates – significant for investment – and also lowered the spread between government bond yields and those on other long-term investments. Not only did QE make it possible for larger businesses to raise money, bypassing the banks, but it made it cheaper for them to do so.

There were other routes QE boosted the economy, boosting confidence, signalling to the market the Bank was prepared to do whatever was necessary and improving liquidity. It may have helped keep sterling down. The effects of that first £200bn were significant. The Bank estimated it boosted GDP by between 1.5% and 2% and, when there were worries about “bad” deflation – falling prices due to weak growth – it pushed up inflation by 0.75 to 1.5 percentage points.

There were two important things about 2009’s QE. It was fully reversible. The gilts the Bank bought meant that it has assets alongside the reserves it created. When the gilts are sold back into the markets, or allowed to run off as they mature, the “money” created – will also be wound down.

The other is that it was undertaken very much in emergency circumstances, which was why I was less enthusiastic about the second wave of an additional £175bn of QE, which began in the autumn of 2011 and lasted well into 2012. You could argue that with the euro apparently on the brink of falling apart, hitting confidence and growth in Britain, this was also an emergency. But it was less pressing than in 2009.

So what about Corbyn’s “People’s QE” and helicopter drops? I am not sure how serious the Labour leadership candidate is about the policy. It may be a way of diverting discussion from some of his other policies, which I will look into in more detail in coming weeks. Certainly, he does not seem to know a lot about it.

Responding to questions on Radio 4’s World at One a few days ago, he described QE as a £325bn (sic) “loan” to banks, and suggested part of that loan instead should go towards the setting up of a new National Investment Bank, promising to establish a commission to investigate.

In his speech The Economy in 2020 he talked about People’s QE as “one option, under which the Bank would “be given a new mandate to upgrade our economy to invest in new large scale housing, energy, transport and digital projects”. The other option was to slash what he described as £93bn of “huge tax reliefs and subsidies” and fund infrastructure spending that way.

There is nothing new about what some of Corbyn’s supporters think of as a slightly different kind of “People’s QE”. A few years ago I used to get lots of e-mails from advocates of “Green QE” who said the Bank should invest in green projects rather than in the banks. I pointed out to them that QE was not about the banks and that to work, these green projects would need to be funded by the issue of government-backed bonds, which the Bank could buy if it chose to. Issuing these government-backed bonds to fund spending would, of course, add to government debt.

The twist in the People’s QE debate, from Corbyn’s supporters if not yet from him, is that the Bank would be compelled to buy bonds issued by a National Investment/Infrastructure Bank, and not just in emergencies. Compelling the Bank to undertake this kind of QE would kill Bank independence, one of Labour’s proudest achievements. Unless there was a commitment to sell these bonds back, the policy would be irreversible. It would be a strange and roundabout way of doing things, destroying the Bank’s reputation on the way.

Helicopter money would have a similar effect. Handing out cheques to households would clearly be irreversible. The Bank would not take any assets in return. It would have huge liabilities on its balance sheet, but no offsetting assets, requiring the Treasury to keep it keep it solvent. As David Miles, the outgoing MPC member, put it to me last week: “When people say helicopter drop, what they mean is, why doesn’t the government run a larger fiscal deficit?”

An article by Fergus Cumming, a Bank official, on the Bank’s new “blog” site says any extra boost from helicopter money “is either non-existent or comes with a sky-high price tag”. If Lord Turner was suggesting it in his interview to be Bank governor ahead of Mark Carney’s appointment, I can understand why he did not get the job.

That said, you can see why these ideas are around. When the Bank launched QE in 2009, it did not expect to be stimulating a debate six years later. In my view it could have done more to head it off. While the MPC’s reluctance to raise interest rates has been clear, there was no strong reason why it could not have begun to move away from “emergency” policy by selling off in the past couple of years some of the gilts it acquired in 2009-10 and 2011-12.

Had it done so even passively, not reinvesting the proceeds when the gilts it has on its books mature, then including its latest decision it could have run down the stock of gilts it has by around £52bn. But it has decided not do so before raising interest rates.

As for rates, the longer they are kept at 0.5%, the more the clamour will grow for experiments such as People’s QE and helicopter money in the event of the next downturn. The common feature of these is the belief that you can have money for nothing. Sadly, it is not true.

Sunday, August 16, 2015
Productivity lift-off will keep pushing up pay
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

I did wonder if this was the week when, in the light of Corbynmania, and what appears to be the Labour party’s longest suicide vote in history, I should tackle Corbynomics. But, though a victory for Jeremy Corbyn in the Labour leadership contest is confidently predicted, I note that some of those making the predictions also assured us that Ed Miliband would now be prime minister. So I’ll hold off for now.

Fortunately, there’s plenty of other things going on. Greece is not yet out of the woods and China, as I discuss below, has grabbed the markets’ attention. We have also had some interesting job market numbers which, on the face of it, suggest the election came not a moment too soon for the Tories. Before it, employment growth in jobs was powering ahead and unemployment falling.

Since it, the figures show employment falling and, as every new bulletin told us, unemployment rising for two months in a row, something that has been as rare as hen’s teeth in recent years.

Worse, for a government committed to reducing immigration, most of the reporting of the figures suggested that the lion’s share of the new jobs is going to foreigners, particularly foreigners from the rest of the European Union.

A bit of clarification is in order. The labour market numbers can be confusing and as a result are prone to misreporting. The Office for National Statistics (ONS) takes three-month periods as its basis for the employment and unemployment numbers. The latest three-month period is April-June. The three-month period reported in July was March-May. The unemployment number for April-June, 1.852m was slightly lower than the 1.853m for March-May, not higher. Employment, 31.035m, was just over 50,000 up on the 30.982m figure reported for March-May; higher not lower.

So where did the rising unemployment-falling employment story come from? This is because the ONS compares the latest three months with the previous three months, in this case January-March. On that basis, employment was down 63,000 and unemployment up 25,000, but that is different from saying the jobless total rose for a second successive month. Indeed, unemployment on the old claimant count measure – people on jobseeker’s allowance – has fallen every month this year.

As for those jobs going to migrants, having decided to publish the numbers a few years ago, the ONS has been fighting a losing battle since to persuade people not to confuse new jobs with net jobs. It is quite possible, indeed highly likely, that most new jobs are going to natives, because they – UK nationals – account for almost 90% of people in work (for UK-born the figure is 84%).
But it is also true that when it comes to net jobs – jobs added minus jobs lost – most of the gains over the past year have gone to non-UK nationals (61%), or non-UK born (75%), overwhelmingly from the rest of the EU. The distinction is important but does not defuse the tricky politics in this debate.

Having said all that, what is the bigger picture? It is that the job market recovery is maturing, so that in the past year there was an increase of 422,000 in the number of full-time employees, easily outweighing the 63,000 rise in the number of part-timers. Self-employment, which has risen strongly in recent years, has fallen by 95,000 over the latest 12 months. That tells us that there is a shift within the job market back towards conventional full-time employee jobs and away from part-time work and self-employment.

That is important, but arguably more important is that, alongside a recovery in pay, we may finally have arrived at productivity lift-off. It has to be a tentative claim at this stage but the prolonged weakness of productivity, which has puzzled economists for years, may have come to an end.

So in the second quarter, overall employment fell by 0.2% while gross domestic product rose by 0.7%, suggesting a healthy rise of around 0.9% in GDP per worker. Compared with a year earlier, GDP was up by 2.6%, employment by 1.2%.

A similar picture emerges when we look at GDP per hour, another way of measuring productivity. Hours worked fell by 0.2% in the second quarter, when GDP rose 0.7%. Hours worked in the past year were up by 1%.

One swallow does not make a summer but if productivity is indeed reviving, why is it happening? In an important sense, it is happening because it had to. There was a limit to how much unemployment could continue to fall and employment rise without running into serious bottlenecks – in spite of the EU migration safety valve – and skill shortages. The BBC had a nice example last week of a firm which had invested in a machine and doubled a worker’s output. Most productivity-enhancing investment is not so straightforward, but it is happening.

What will rising productivity mean? Two things. The first is that the turbocharged rise in employment we have seen over the past three years will be replaced by a gentler upward trend and that, peering through the latest numbers, may be what we are already starting to see. Unemployment can fall further, though also at a slower pace than we have been used to. Do not forget that when Mark Carney took over as Bank of England governor in the summer of 2013, the Bank did not expect the unemployment rate to fall to 7% until 2016. It is now 5.6%.

The second implication is that the growth in wages will become both more entrenched and, for employers, justifiable. Indeed, many will be looking at ways of pushing through productivity improvements ahead of the introduction of George Osborne’s new national living wage of £7.20 an hour next April.
As it is, the latest figures show total pay rising at an annual rate of 2.4% (2.8% in the private sector) and regular pay by 2.8% (3.3% private sector). Most of Britain is enjoying a meaningful pay rise. Rising productivity should mean that continues.

Sunday, August 02, 2015
Another milestone on the road to normality
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

An economic recovery is all about barriers and milestones. It is a story of getting over the barriers and counting off the milestones as you pass them. Britain has just passed an important milestone. It is one which suggests that at the very least talk of a lost decade for the economy, which was once very common, was misplaced.

It is two years since gross domestic product (GDP), adjusted for inflation, surpassed the pre-crisis level achieved in early 2008 but is only now - or more accurately in the April-June quarter - that GDP per head has regained its earlier peak.

These milestones do move around. As GDP figures get revised, it is quite likely that both will be seen to have occurred earlier than the current numbers suggest. We should not expect miracles, however. The economy was left weak and groggy by the crisis and was always going to take time to get back on its feet.

The barriers to recovery in recent years – from outside Britain – have been several. High global oil and commodity prices gave us high inflation in 2011, intensifying the squeeze on real incomes, a factor that did not dissipate until about 18 months ago.

The eurozone crisis, at its height three years ago, affected Britain’s economy directly through trade, and indirectly by spilling over into renewed concerns about the banking system. What may or not be its last gasp, the Greek crisis of recent months, is no longer critical, but one of its side-effects has been to push sterling up to €1.40-plus heights against the euro, which is hurting exporters.

Now China has emerged as a potential barrier to recovery, though my sense is that any negative effect from China’s stock market woes will be balanced by its effect on oil and commodity prices. Sometimes, as with last year’s sharp fall in oil prices, which has not been significantly reversed, external forces can be more of a springboard than a barrier.

Now that the GDP per head milestone has been passed, what other milestones are there? One is the length of recovery. If we define a recovery as a period of growth unbroken by two successive quarterly GDP falls, this one has now lasted almost six years. It is still in the foothills compared with the 16-year growth marathon between the autumn of 1991 and early 2008 but is catching up on the Thatcher 1981-90 nine-year recovery.

The biggest milestone of all would be if growth in coming years were strong enough to eliminate the “lost” years, in other words to make up for the ground lost as a result of the recession of 2008-9 when GDP fell by 6%.

The five years it took for GDP to get back to pre-crisis levels (seven years on a per capital basis), meant those years of potential growth – when the economy might have been expected to expand by 2.5% a year – were lost. Though growth is now above its long-run average, it is not enough above it to make up that lost ground other than at a snail’s pace. Those years of potential growth, and the rise in living standards associated with them, were largely lost for ever.

That’s enough milestones. Two questions arise. One is whether there is anything to suggest growth will become better balanced than it has been. The other is whether strong growth – the second quarter rise of 0.7% made it six out of the past eight when the economy has grown by that much or better – will be enough to persuade the Bank of England to hike interest rates.

That the recovery could do with being better balanced is not in doubt. The service sector bounced back quickly, getting back to pre-crisis levels of output as long ago as 2011. But manufacturing has yet to do so; it is 4.9% below its early-2008 levels, while construction is still 3.2% down.

Though both sectors disappointed in the latest quarter, perhaps a more nuanced picture is provided by the performance of the three sectors from their recession low points. Construction and manufacturing fell further, so had more to make up. From their respective recession low points, the service sector is up by 11.9% and manufacturing by 8.8%. Construction is actually the strongest of the three, up by 16.8% from its recession trough. But manufacturing could and should be doing a lot better.

What about interest rates? Every quarter of 0.7% growth is a quarter in which a little more spare capacity is used up. We will hear a lot more about this on “super Thursday” this week when the Bank publishes its quarterly inflation report, interest rate decision and monetary policy committee (MPC) minutes simultaneously. In the past these three events were been spread over three weeks.

Will the Bank, while acknowledging the strength of recovery, tone down its language on rate hikes because of the renewed weakness of oil and commodity prices? Brent crude oil is back in the low $50s, while broader commodity price measures dropped to a 13-year low last week.

We will see what happens. But I would be surprised if some MPC members do not vote for a rate hike this week and if the Bank’s broader message is not that people and businesses should be prepared for the start of a gradual rise in rates in the coming months.

When oil and commodity prices were high, the Bank “looked through” the temporary boost they provided to inflation, deciding instead that the economy was not ready for a hike in rates. Now prices are low, they are likely to take the opposite view; that they cannot postpone indefinitely the process of “normalising” interest rates. The new normal will, of course, be lower than the old normal.

Starting to raise interest rates will, when it comes, be a milestone in itself after more than six years in which there has been no change. It will be a milestone of the road back to normality.

Sunday, July 26, 2015
Cuts: the big bad wolf's howl is worse than his bite
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Sometimes I think that when George Osborne looks in the mirror each morning, he thinks: “Now how can I put the wind up the Labour party today?” Then, while holding that thought, he goes on to: “And how can I put the fear of God into people working in the public sector?”

A few days ago, the Treasury produced a 24-page document called ‘A country that lives within its means: Spending Review 2015’. Signed by the chancellor and his Treasury chief secretary, Greg Hands, this was not the spending review itself; that will not be published until November 25.

No, it was the Treasury’s opening gambit in the coming negotiations between it and the spending departments. Unlike in 2010, when the coalition’s first and most important spending review was a bit of the back of the envelope affair, the chancellor does not want to be accused this time of not following proper procedure.

Actually procedure has become a lot more formal during the time I have been following these things. There was a time when to extract from the Treasury, or more likely from disgruntled Whitehall departments, what the mandarins were demanding was gold dust. Now it is set out in black and white in an official document.

Osborne and Hands have asked “unprotected” departments to model two scenarios, of 25% and 40%, for real-terms reductions in their so-called resource budgets. Even in an official document, that is big news. The BBC led on it all day.

Does it mean, as some have suggested, that the Treasury is setting a target for cuts that can never be achieved? Does it mean an ideologically driven plan to shrink the state beyond recognition, so people have no choice but to use the private sector?

I suspect it means neither of those things. There is an interesting question to be asked about what kind of spending review we might have had, if the budget deficit had come down as much as expected in the last parliament. It is falling, but at £88bn in 2014-15 was some £50bn more than Osborne intended in 2010.

Even if the deficit had come down by more, however, there would have been a case for a proper look at public spending, the Canadian-style review the Tories used to talk of fondly before the 2010 election. Time and manifesto commitments have, however, taken their toll.

The government is committed to raising NHS spending in England by £10bn in real terms by 2020-21, to protecting per-pupil funding for schools, and to increasing the Ministry of Defence budget by 0.5% a year in real terms. The overseas aid commitment of spending 0.7% of national income will be met.

Being inside the ringfence, as this spending is, does not preclude efficiency savings, indeed the NHS will be required to deliver significant ones. But it is the non-ringfenced departments – all the rest – which will be bearing the brunt. Will they be cutting by 25% or even 40%? No, the resource budget only encompasses some Whitehall spending, excluding for example capital spending, which is significant for some departments. The Institute for Fiscal Studies estimates that the actual real-terms cut for non-ringfenced departments will be 12.6%. Whitehall should not be as afraid of the big bad wolf as the headlines might have suggested.

This is even more the case if we look at the overall numbers for public spending. According to the Office for Budget Responsibility, it has come down from 45.7% of gross domestic product in 2009-10 to an estimated 39.6% this year. The task for the next five years is to get it down to 36.3%.

How much will overall government spending be cut over the next few years? Not at all. In real terms – 2013-14 prices – it will rise from £724bn this year to £746.5bn in 2020-21, an increase over and above inflation of 3%. Public sector current expenditure rises by more than 2.5% over the same period. We can argue over the composition of spending, and whether the ringfence is in the right place. Some bits of government will see their budgets reduced but in most cases this is a long way from savage cuts. I can understand why Osborne wants to play the big bad wolf but his howl is a lot worse than his bite.

There is another fiscal issue to be touched on here. After the budget I bemoaned the absence of serious tax reform, in particular the failure to mention merging income tax and National Insurance. Since then, though I would not claim cause and effect, it has emerged that the chancellor has commissioned a Treasury study into the integration of income tax and NI into a single “earnings tax”.

The name earnings tax, if it happens, is important. Merging tax and NI and applying it to all incomes would create a large swathe of losers among pensioners, who do not pay NI.

Michael Johnson of the Centre for Policy Studies, who wrote a report last year on NI, called The End Should be Nigh, argued for a single earnings tax with three rates, 32%, 42% and 47%. The lowest rate would kick in at the existing personal allowance, £10,600, which is well above the NI lower earnings limit (£5,824) and the more relevant primary threshold (£8,060). The change would thus help lower earners.

One reason why chancellors have been reluctant to merge income tax and NI is because the latter preserves a semblance of the Beveridge contributory principle, though the Mirrlees review commissioned by the Institute for Fiscal Studies declared in 2010 that NI “is not a true social insurance scheme; it is just another tax on earnings”. Another is that NI is a good stealth tax. Under the last Labour government the basic rate of income tax – which people are more aware of - went down but NI went up.

There is the bigger question of what to do about employers’ contributions, which are responsible for a substantial chunk of the £109bn NI brought in last year. Johnson suggests that these could be replaced by higher corporation tax, though that would go against the grain for a government bent on reducing the corporation tax rate to 18%. The easiest thing would be just to rename employers’ NICs as an employer earnings or payroll tax.

Osborne will not be the first chancellor to have considered merging income tax and NI. Let us see if he will be the one to do it.

Sunday, July 19, 2015
Bank ponders a rate rise as job market changes gear
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Things are getting rather interesting. In the past few days we have had what looks like a concerted attempt by the Bank of England to prepare people for an interest rate rise in the coming months, coupled with an equally explicit effort by Janet Yellen, chairwoman of the Federal Reserve Board, to say America’s rates will also soon be rising.

Mark Carney, the Bank of England governor, travelled up to Lincoln to tell the world that the decision on interest rates would move into sharper focus around the turn of the year, which most people interpreted as signalling the first rate rise since 2007 and the first move in any direction since 2009.

And yet, on the face of it, the numbers have been going against the idea of a rate rise, certainly in Britain. Inflation, having popped up to a heady 0.1% in May, subsided to zero in June. “Core” inflation dipped slightly and British Gas has announced the start of what might be a new round of energy price reductions with a 5% cut in gas prices. Though inflation will rise as we get towards the end of the year, it is not about to race away.

Even more tellingly, the latest job market figures were a lot softer - at least as far as employment and unemployment were concerned – than expected. Could the Bank, having held off from raising rates when jobs were booming possibly do so when employment is slipping and unemployment going up?

The answer is that it depends, and it depends on two things: whether the latest figures were a temporary blip and whether, if they were not, they signal a change of direction we should celebrate, or be worried about.

The headlines from the job figures were that the number of people in employment fell by 67,000 to 30.98m in the March-May period, which was the first quarterly fall since February-April 2013. That, to remind you, was when the air was thick with worries – misplaced as it turned out – that Britain was sliding into a triple-dip recession. As we now know, there was not even a double-dip.

The fall in employment coincided, perhaps unsurprisingly, with a small rise in unemployment, up 15,000 in the March-May period, with the unemployment rate ticking up from 5.5% to 5.6%. This was the first quarterly increase in unemployment since early 2013.

Was it a blip? The quarterly falls in unemployment have been getting smaller in recent months, even as employment growth was continuing quite strongly. That would suggest that the obvious blip factor, uncertainty over the general election, was not entirely to blame. The fact that the claimant count, a narrower measure of unemployment, edged higher in June, supports that verdict. So election uncertainty may have played some part in the unemployment rise but it is far from the full story.

What is also happening, very clearly, is that as the economic recovery matures, so the job market is evolving. In the latest three months there was a 45,000 increase in employees working full-time, alongside a 40,000 drop in part-time employees and a 55,000 fall in the number of self-employed.

We should be wary of reading too much into quarterly changes like these but they are part of a longer-run trend. So over the past 12 months there has been a hefty 382,000 rise in the number of full-time employees, while the rise in the number of part-time employees has slowed to a crawl, up just 46,000 in a year. The number of self-employed people, meanwhile, dropped by 131,000.

So we are seeing a shift from self-employment into employment and from part-time into full-time work. As I noted recently, some people who opted for self-employment as a stop-gap are moving pack into working for somebody else as opportunities become available. Though you would not want this to run alongside rising unemployment and falling employment, it is a healthy development.

The other part of the non-blip story is what is happening to wages and, it appears, productivity. Average earnings growth has been accelerating for some time. Last summer, total pay was up by less than 1% on an annual basis. Now it is rising by 3.2%, with private sector pay in the latest three months up 3.8% on a year earlier. That will settle down a little in the coming months but we appear to have moved back into a world in which private sector pay – the best guide to underlying labour market pressures – rises by 3% or more.

A quick verdict on the latest numbers might be that the old relationship between wages and unemployment, the Phillips curve, is reasserting itself; as wages go up, employment goes down. I am not sure that is the correct verdict because, alongside the uptick in wages – and thanks to zero inflation real wages are now growing very rapidly indeed – there has been an upturn in productivity.

We will not know the official productivity figures for some time, but looking at what we do know in terms of hours worked, it looks like output per hour was up about 0.8% in the second quarter and by at least 2% on a year earlier. That is starting to look like more like normal productivity growth, which is another healthy development.

It will be healthier still, of course, if rising productivity can be combined with rising employment and falling unemployment, albeit with both occurring at a slower pace than we have become accustomed to in the past 2-3 years. So, instead of strong employment growth alongside weak productivity and stagnant or falling real wages, employment rises more modestly but real wages and productivity also increase. That would be a more normal state of affairs.

It would also be consistent with a gradual “normalisation” of monetary policy. David Miles, who is nearing the end of his six years on the Bank’s monetary policy committee (MPC), was if anything more interesting than Carney. He has yet to be part of a vote to change interest rates in either direction. But even he, known to be one of the most “dovish” MPC members said last week that waiting too long to raise rates would be “a bad mistake” and that “the time to start normalisation is soon”. That is unlikely to mean before he leaves the MPC at the end of August but, if the Bank’s reading of the labour market squares with mine, it may not be many months after that.

Sunday, July 12, 2015
Osborne gambles on a pay rise to cushion the cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Five days on from any budget is always a bit of a challenge, particularly one that has been picked over more intensely than most. Fortunately there is still a lot to say on George Osborne’s first budget of the new parliament.

Let me first give thanks for a measure that was not in the budget. Three weeks ago I wrote that a cut in the very top 45% tax rate alongside welfare cuts would send out the worst possible signals. The chancellor was being urged to do it by some senior Tories but fortunately resisted the temptation.

The other omission, which was much less welcome, was sensible tax reform. There was nothing about merging income tax and National Insurance but instead a continuation of the coalition policy of lifting the personal income tax allowance, combined this time with raising the higher rate threshold. Merging tax and NI would help the lower-paid more, while messy aspects of the income tax system remain, including the 60% marginal rate that kicks in at £100,000.

The tax changes that were in the budget, including the new £1m inheritance tax threshold for couples on homes (though not until 2020) and restricting mortgage interest relief for buy-to-let landlords to the basic rate, added to the complexity of the tax system rather than reduced it. Neither the Institute for Fiscal Studies’ Paul Johnson nor me are champions of buy to let, but he is right when he points out that owner-occupation has tax advantages over being a landlord, and will have even more now.

So what was the budget all about? Three things. The budget, rightly, got rid of the roller coaster that the chancellor found himself with after his March budget, because ahead of the election he wanted to rid himself of the silly charge that he planned to cut spending to its lowest since the 1930s.

Though the Treasury was keen to keep that as a surprise, it should not really have come as a surprise that we now have a more measured pace of deficit reduction. I wrote as much on the Sunday after the March budget.

The planned budget surplus, of £10bn, does not arrive until 2019-20, rather than 2018-19, and spending is significantly higher in three years – 2016-17, 2017-18 and 2018-19 – than set out in March. But this is overwhelmingly a story of smoothing rather than largesse. At the end of the parliament overall government spending is just £7.1bn, or 0.8%, higher than under the previous “savage cuts” scenario.

The second thing of note was that, for a government that said fiscal adjustment would come through spending restraint, there were some significant tax increases in the budget. Overall, according to the Office for Budget Responsibility tax policy changes will be raising a net £6.5bn a year more by the end of the parliament.

The new dividends tax will eventually raise more than £2 billion a year, vehicle excise duty reforms nearly £1 billion and increasing insurance premium tax from 6% to 9.5% £1.5 billion. Most of the burden of adjustment will still be on spending, together with the clampdown on tax evasion and avoidance, but these are big revenue raisers and rather stealthily done. If he could bring himself to admire anything Osborne does, Gordon Brown would be proud.

I have left the biggest budget change until last. With his reduction in tax credits and the new national living wage - £7.20 from April, rising to more than £9 (£9.35) by 2020 – Osborne has given us a variation on traditional Tory philosophy: reduce the size of the state, not by assuming the private sector will move into the gap, but intervening to make sure they do so.

The new national living wage is a kind of super minimum wage. I remember when Labour introduced the minimum wage alongside tax credits in the late 1990s Ed Balls telling me that it was essential to have a wage floor so employers could not exploit the new system. Osborne has just raised that floor.

Just as the BBC is taking on some of the welfare bill by funding free TV licences for the over-75s, so business will take on some of the costs of welfare, particularly tax credits, by paying its workers more.

What should we think of this? It is a fair question for people to ask what the response to this might have been if it had been introduced by an Ed Miliband Labour government. It would probably have been dismissed, including by me, as an anti-business, job-destroying intervention by a party that does not understand how the economy works.

This, indeed, is the response of some in business, including the low-wage sectors that will bear the brunt of this, such as care homes and catering. The minimum wage has not been a destroyer of jobs, but only because its level has been carefully calibrated each year by the Low Pay Commission.

Labour, on the other hand, would not have accompanied a proposal to force wages up with welfare cuts on the £12bn scale Osborne announced. Politically, and perhaps economically, the pill needed to be sweetened.

The IFS is perfectly correct when it says that the national living wage will not, on its own, compensate for welfarte cuts. The numbers, £4bn extra from the living wage versus £12bn of welfare cuts, demonstrate that clearly. Some welfare losers will not gain from the living wage.

There will be losers from the welfare cuts, whatever happens to wages and employment. That is inevitable, as is the fact that most of the losses will be for households on lower incomes. What the Treasury has in mind, however, is a more dynamic process than that implied by the raw numbers, in which the living pushes up pay at higher levels and employment grows even more strongly than the 1m over the next five years expected by the OBR. Osborne expects 2m. More, in other words, could be lifted off welfare.

I am still not sure this was the best way of doing it. One of the consequences of the welfare cuts will be that the “why work?” syndrome gets worse. Some people on low incomes will face marginal tax/benefit withdrawal rates of nearly 80%. The issue I have touched on in recent weeks, that what needs to be freed up are the restrictions on the hours people are willing to work under current welfare arrangements, has not obviously been tackled. The new national living wage may make employers less willing to offer more hours. It is in danger of being seen as a sledgehammer to crack a nut

What we are seeing, to use a word that appeared frequently in Osborne’s speech, is a bold experiment. It is intended, not just to raise wages at the bottom but to have knock-on effects right up the pay scale. The aim is indeed to give Britain a pay rise.

Whether this forces the rise in productivity that will justify higher pay is one aspect of the experiment. Whether it leads to bigger job losses than the 60,000 assumed by the OBR – hugely offset by the 1m net new jobs it expects over the next five years – is another. Let us hope so. Boldness is good. But fortune does not always favour the brave.

Sunday, July 05, 2015
Syriza dreamers snuffed out growth and made a difficult situation worse
Posted by David Smith at 12:00 PM
Category: David Smith's other articles

From The Sunday Times, July 5 2015

At the start of this year, things were looking up for the beleaguered Greek economy. Economists polled by Consensus Economics predicted growth of 2% this year, following last year’s modest 0.8% expansion. Unemployment, while still sky-high, had edged lower. There was a flickering light at the end of the tunnel.

That has now been blown out. The latest Consensus Economic assessment is that Greece will experience a small outright recession this year, a consensus forecast that could get a lot worse in the coming days and weeks. Nor can this be blamed on what is happening in the wider eurozone. Forecasters have become more optimistic about eurozone growth in recent months, raising their 2015 forecast from just over 1% to 1.5%.

The gloom has a single explanation. The election of the Syriza government in late January, and the chaotic months of negotiation with Greece’s creditors that followed, plunged the economy into uncertainty and snuffed out the embryonic recovery. The closure of the banks last week, inevitable once the Greek government announced a referendum for today on a bailout package that has since expired, was the final chaotic act by a government that has set new standards of incompetence.

The battle between Alexis Tsipras, the Greek prime minister, and his country’s creditors has been seen in some quarters, including in Britain, as David versus Goliath, dignity versus dictatorship, growth versus austerity, democracy versus the faceless bureaucrats. It could have been all of these things. When Syriza won power it brought with it to the negotiations with its creditors a lot of goodwill. It immediately won a fourth-month extension on its €240bn (£170bn) bailout, which dwarfs the other eurozone rescues, for Ireland, Portugal and the Spanish banking system.

The problem has been that if Syriza wanted to negotiate seriously, it showed little sign of doing so. A competent left-wing government, which built alliances and elicited sympathy for the pain the Greek people have suffered, could have won substantial concessions. Instead, Greece’s creditors were driven to distraction by negotiating positions that appeared to change with each meeting.
Elected on an anti-austerity programme, it has come to accept it, while simultaneously disowning it. It first opposed and promised to reverse privatization before changing its view.

It reversed some reforms previous Greek governments had agreed to, before partially reversing its reversal. It has flipped and flopped; within a few hours last Wednesday Tsipras was apparently willing to accept most of the creditors’ proposals, before going on TV to condemn them. TV images last Sunday showing a smiling Yanis Varoufakis, taking to the streets to join a protest march hours before the country’s banks were shut, told their own story.

If Greek voters say “no” in the referendum today, it will be the second time in six months that they have backed Syriza on a false promise. In January it was the false promise that there would be no more austerity and that the reforms insisted upon by creditors could be reversed. This time it is that a no vote will mean a better deal. It will not. A no vote would mean a return to the negotiating table for a Syriza government that the creditors have already decided they cannot deal with. Even the normally diplomatic Christine Lagarde, the managing director of the International Monetary Fund, has talked of the need for “adults” in the room. If a no vote does not mean a Greek exit from the euro, it is hard to see what would.

Though a “yes” vote should mean the end of Syriza, and its replacement by an alternative government, perhaps a government of technocrats, who would then negotiate with the creditors, Greece’s problems would be far from over. Its six-month experiment with a dysfunctional government of academics and dreamers have set the Greek economy back some years. It has also been expensive.

The IMF, in a “debt sustainability analysis” released last week said that “very significant changes in policies and in the outlook since early this year have resulted in a substantial increase in financing needs”. Having thought Greece would need no further debt relief, it now thinks it will need €50bn (£35bn) of support over the 2015-18 period, €36bn (£27bn) of it from Europe. The Syriza bill is a large one.

Osborne must press the right buttons on tax and productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Given the sheer unpredictability of events in Greece we cannot be sure that George Osborne’s first post-election budget, his seventh in all, will be the biggest economic story this week. But it will be important for all that.

One thing is clear. A budget that merely fills in the details of where the welfare axe will fall will not get the parliament off to a good start. As I wrote last week, there is plenty of scope for savings but they must be in the context of weaning people off welfare and into work, or into working more hours.

There are two other priorities. One is tax reform. Paul Johnson, director of the Institute for Fiscal Studies, is always worth listening to and his proposals for a tax reform programme for this parliament, beginning this week, make a lot of sense.

So the chancellor should begin the process of integrating income tax and national insurance, tackle absurdities such as the 60% marginal rate on earnings between £100,000 and £121,200 (tricky when the beneficiaries of any change are high earners) and reintroduce sensible indexation into taxation.

Johnson points out that we have a hotch-potch of indexation arrangements, with some parts of the system using the consumer prices index and others the now discredited retail prices index. More often, I would add, the decision to index or not, for example in the case of fuel duty, has become highly political. I have lost count of the number of times this chancellor has decided to “be kind to motorists” by not indexing fuel duty. Over time, these things add up to a lot of lost revenue.

The biggest failure to index, as the IFS director points out, is in the council tax system, where the system is based on valuations of nearly quarter of a century ago. This is bonkers.

The chancellor would make his life a lot easier if we were to return to the days when indexation, using a sensible inflation measure, was the normal thing to do. And there is no better time to do that when inflation is very low. If Osborne is to embark on sensible tax reform, not something that stood out in his first five years, now is the time to start. I am not clear that raising the inheritance tax threshold on main homes to £1m, paid for by reducing pension tax relief, is the kind of reform I would have in mind.

What else? Most chancellors, even those like Gordon Brown who introduced his own productivity agenda, have not had to worry overmuch about weak productivity growth.

New figures from the Office for National Statistics show that productivity – output per hour – rose 0.3% in the first quarter and is 1.3% up on a year earlier. They also show, however, how far there is to go.

In the first quarter productivity was just 5% up on its level 10 years earlier. The period straddles the crisis and recession but, even so, for productivity growth to average a little under 0.5% a year over a decade is remarkably weak. It was slowing even before the crisis hit.

For comparison, productivity rose by 22% in the previous decade; 1995-2005; 26% from 1985 to 1995, and 28% from 1975 to 1985. Roughly speaking, we have had a fifth of the productivity growth over the past decade that we should have had.

There are, as noted before, some special factors in that; the shift in the financial services sector from productivity driver to productivity drag and the decline of North Sea oil. Some sectors have bucked the trend. Manufacturing productivity has been up and down recently but is 18% higher than 10 years ago.

But productivity is a bigger problem for Osborne than for his predecessors. Hence the “productivity plan” we will see unveiled this week around the time of the budget.

There is no great mystery about what should constitute a productivity plan. Politicians cannot wave a wand and boost productivity though they can create the conditions under which the private sector can deliver improvements.

That means tackling the usual suspects, the productivity "drivers", though Osborne also appears to have in mind the dynamic drivers of productivity, the cities and other clusters in which those productivity drivers can trhive.

Of the traditional drivers, business investment has been improving recently but the single biggest explanation for why the output of British workers is below that of competitor countries such as France is that they invest more. So expect some modest investment incentives, notably an increase in the annual investment allowance.

A productivity plan means boosting education and skills, incentivising training and apprenticeships. Plenty is being done on this, though governments can probably never do enough.

It should also mean investing in and updating the infrastructure in a timely way and it is here that you realise that this productivity thing is not so easy. In presenting the findings of his Airports Commission Sir Howard Davies fired the starting gun, not on the diggers breaking ground for Heathrow’s third runway but on a prolonged period of argument, dithering and uncertainty.

The announcement a few days earlier of delays in what had been billed as the biggest rail investment programme since the Victorian era, including the postponement of at least one project pivotal to the chancellor’s northern powerhouse, confirmed that we do not do these things well. Anybody waiting for Transpennine electrification to deliver productivity improvements will be waiting a long time.

There is, of course, nothing new in Britain being bad at infrastructure, in business tending to under-invest and in more work being needed to improve education and skills. None of this, however, prevented good rates of productivity growth being achieved in the past.

If you were to put your finger on one big difference since the crisis, it is finance. Availability of credit, of funding for business growth is a factor most people can agree has significantly held back productivity. The process of creative destruction long ago identified by the Austrian economist Joseph Schumpeter has been held back. Banks have kept bad businesses alive while failing to finance new, creative and productive firms. It remains the case that bank lending to business is falling in year-on-year terms, six years into the recovery.

There have been plenty of initiatives in this area, and there are sources of finance, but it is still a problem. Osborne’s current priority is to get Lloyds and Royal Bank of Scotland back into the private sector. Maybe that will deliver stronger lending to business but probably it will not.

It is good that the chancellor has a productivity plan. It has some good elements as well as some familiar ones. But if productivity improves it will probably do so because of an easing of the effects of the crisis and a return to some kind of normality, not because of what will be announced in the next few days. If Osborne is lucky, his plan will coincide with an improvement in productivity. If not, it will be back to the drawing-board.

Sunday, June 28, 2015
Cut tax rates at the bottom, not at the top
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

There is more than a touch of déjà vu about George Osborne’s summer budget on July 8. In June 2010, when Osborne presented his first “emergency” budget, Greece dominated the headlines, having agreed to its first bailout package amid deadly riots and a flurry of ratings downgrades.

Then as now, Britain had a substantial budget deficit which had to be tackled. And, while it has fallen by more than half as a percentage of gross domestic product, at 4.9% of GDP or nearly £90bn in 2014-15 (though falling this year) it remains too high for comfort. Hence, one of the sounds you hear from the Treasury is that of knives being sharpened.

True, this is the first budget in a Conservative-only government since Ken Clarke’s last outing nearly two decades ago in November 1996 (at that time the spring budget had been abolished). And true, the fact the chancellor no longer has to get everything past coalition partners will change the character of next month’s budget. In other respects, however, things are rather familiar.

Let me address three aspects of the upcoming budget: the economic backdrop, whether welfare cuts can be achieved and whether in the context of such cuts, the first Tory budget for almost 20 years should include a cut from 45% to 40% in the top rate for very high earners.

The economic backdrop to the budget is one of a strong job market, low inflation and rising real wages. Independent forecasters expect 2.5% growth this year and, in forecasts published since the election, 2.4% next. Though the talk is of tough, front-end loaded austerity, forecasters do not expect this to have a significant impact on growth.

If so, this would follow the pattern of the last parliament. Though there is a view around that growth stopped as soon as Osborne embarked on austerity (in addition to that he inherited from the previous Labour government), and only started when deficit reduction was relaxed or even abandoned, it is a myth.

Growth in 2010-11 was 2.3% and 1.4% in 2011-12, even as austerity was biting hardest (reducing growth by 1.1 percentage points each year according to the Office for Budget Responsibility). Non-oil growth, which adjusts for sharply falling North Sea oil production, and is a fairer measure of underlying economic activity, was 2.7% and 1.9% respectively. Though tax increases and spending cuts hit growth, as did several other factors, low interest rates and quantitative easing by the Bank of England boosted it. With Bank rate at 0.5% for more than six years, monetary policy remains loose now.

What could hit growth is what happens in the eurozone. Growth slowed to 0.7% (1% excluding oil) in 2012-13, when euro break-up fears were at their height and the eurozone was in a full-blown recession, its second in the space of three years. Currently growth in the eurozone is picking up, which is good. The hope has to be that that continues, notwithstanding a Greek saga that has lurched into new uncertainty this weekend, with the Syriza government's decision to call a referendum next Sunday on a deal which may well have evaporated by then.

The two solid elements of the budget are the planned £12bn of welfare cuts and £5bn of savings from curbing tax avoidance. Nobody will argue with the latter. Plenty will criticise the former.

On welfare, as was made clear in the joint piece in this newspaper last Sunday from Osborne and Iain Duncan Smith, the work and pensions secretary, and a speech a few days ago by David Cameron, the aim is not just to cut but to reform, improving incentives to work and ending what the prime minister called the “merry go round”. Essentially, the more that people receive in pay, the less they will need from working-age benefits.

Is this feasible? There is little evidence that employers deliberately play the system of tax credits by paying the minimum they can get away with (usually the minimum wage), knowing that the government will top it up with tax credits.

There is plenty of evidence, however, that benefit and tax credit rules do affect the hours that people are willing to work, and their willingness to receive bonuses. A Low Pay Commission report earlier this year, the Minimum Wage, Taxes and Benefits, found that over half of employers found that employees did not more hours, because it would affect their entitlement to in-work benefits. This was particularly the case among lone parents at 16 hours, and single adults at 30 hours, in each case the threshold for receiving tax credits and other benefits.

This is because of a longstanding flaw in the system, that higher earnings can result in a marginal effective tax rate of more than 100%. Unsurprisingly, people respond to such disincentives. The system can act as a trap. The switch to universal credit will help, though the Low Pay Commission report notes that effective tax rates of over 70% will remain. Osborne, Duncan Smith and Cameron have the right aim, to reduce welfare dependency, and it seems there is demand from employers to increase working hours – shifting the burden from taxpayers to business – but it is ambitious. Taking £12bn out of a £94bn working-age welfare bill means taking some prisoners.

Whatever the chancellor announces on welfare, it will be greeted as draconian by many, the more so if he were to combine it with a cut in the top rate of tax. This was the intriguing possibility raised by the Financial Times a couple of days ago, citing the fact that Lord Lawson, the former Tory chancellor, is urging Osborne to do it.

Lawson, of course, cut the top rate from 60% to 40% in his penultimate budget in 1988. The current chancellor announced a cut in the top rate from 50% to 45% in 2012, a budget that for a variety of reasons was not his finest hour.

Is there a case to go further, taking it back down to the level that prevailed for 22 years after Lawson’s historic announcement? He did it in the first budget of a new parliament, so there is precedent. The closer you get to an election, the harder it is. Combined with a package of measures that hit higher earners – further limiting pension tax relief and abolishing non-dom status for anybody born here – it could be presented as a fiscally neutral. It would delight many Tory backbenchers.

But, while I am normally as much in favour of lower taxes as anybody, it would look terrible. A tax cut for those earning more than £150,000 alongside significant welfare cuts would confirm very stereotype about the Tories. Getting the top rate down to 40% is a laudable aim. It should wait until the public finances are closer to being fixed.

Sunday, June 21, 2015
Booming job market gives Britain a pay rise
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Apart from a Greek crisis that is in danger of giving a whole new meaning to the term brinkmanship – the usual idea is to stop before you go over the edge – the past few days have brought some other interesting developments.

Though the latest figures show that Britain has edged out of deflation after just a month, the combination of negligible inflation and a strengthening of pay growth means real wages are growing at their fastest since 2007; before the crisis hit home.

Some said this would not happen for a very long time, or that the return of real wage growth last year was merely a product of very low inflation. But the latest rise in average earnings, 2.7%, is enough to outstrip inflation even when it returns to the 2% target.

It runs alongside what the Office for National Statistics says is the longest spell of sustained retail sales growth since records began almost two decades ago. In May, retail sales volumes were 4.6% up on a year earlier. Low inflation has certainly helped here. A drop in petrol prices of more than 10% over the past 12 months has had the predictable effect of increasing the volume of spending, not just on fuel but on other products as well.

The earnings figures provide me with a peg to address three things. One is that the job market is changing as its recovery matures. The second is the sustainability of stronger pay growth when overall productivity is weak. The third is what the numbers tell us about the consumer recovery.

Let me take these in turn. Though the average earnings figures were the most eye-catching element of the latest labour market numbers, they were not the only information of note.

We have an economy which has generated a rise in employment of 424,000 and a fall in unemployment of 349,000 in the past year. There are more than three-quarters of a million unfilled vacancies, which is why many employers complain of problems in recruiting.

Behind these headline figures, something rather interesting is happening. One of the refrains of recent years has been the casualization of employment; the rise of self-employment, part-time jobs and zero hours contracts.

This has been a caricature for some time. Over the latest 12 months there has been an increase of 453,000 in the number of employees working full-time. Sharp-eyed readers will notice that this exceeds the overall rise in employment over the period. This is because, as well as a smaller increase in the number of part-time employees (92,000), there have been falls in self-employment (91,000), unpaid family workers (14,000) and people on government schemes (15,000).

The death of the traditional full-time job - working for somebody else - was greatly exaggerated. Over the past two years, to offer a slightly longer comparison, three quarters of net new jobs created have been for full-time employees.

Some will bemoan the decline of self-employment over the past year, and it is too early to declare it as a trend, but it seems likely that at least some people who were going it alone have been lured back to the security of being a full-time employee as opportunities became available. There is still plenty of scope for entrepreneurs but we may be seeing the beginnings of a decline in involuntary self-employment.

Companies do not recruit, of course, unless they have jobs for people to do. And in general they do not pay higher wages unless they need to do so to recruit and retain staff or because it is justified by higher productivity. Though there is clearly an element of the former in what is happening at the moment, we should not ignore the latter.

This brings me on to my second point. Though the overall numbers for productivity remain weaker than they should be, something is stirring. I have noted before that the sectors and sub-sectors in which jobs are strongest are typically those where output is also rising strongly.

The construction industry increased employment by 1.3% in the year to the first quarter. Earnings growth has also started to pick up quite strongly in the building industry. But output, we now know, showed a hefty 4.4% annual rise in the first quarter, suggesting productivity is on the up. The same is true for wholesaling and retailing – employment up 2%, output 4.7% - real estate, 0.3% and 1.7% respectively; transport and communications, 1.4% and 4.7%, and several other parts of the economy.

The process clearly has further to go, indeed a long way to go. The productivity numbers are still weighed down by North Sea oil and financial services, and by the fact that availability of finance continues to inhibit the growth of younger, high-productivity businesses. But there are signs of change. Even with these factors, the aggregate figures point to productivity growth of between 1% and 1.5%, which is a step in the right direction.

Finally, the latest earnings figures offer an opportunity to bury a myth I often hear repeated, which is that the British economy has been carried along by “debt-fuelled consumption”. The remarkable thing about the past few years is how little household debt has risen, not how much.

Bank of England figures show that household debt stands at £1,434bn, overwhelmingly in the form of mortgages. It has risen by £43bn, or just 3%, from its pre-crisis peak just ahead of the collapse of Lehman Brothers in 2008. In the previous seven years, for comparison, it rose by £602bn, or 76%. Unsecured credit has fallen by nearly a fifth from pre-crisis levels.

And, while lending to households has picked up recently, it is running at a modest 2.5% growth rate, compared with 15% or more at times in the pre-crisis period. For its effects on consumer spending, it is dwarfed by rising incomes.

Tucked away in the official GDP (gross domestic product) figures is a series for compensation of employees, overwhelmingly wages and salaries. It picks up both the growth in earnings and the effects of rising employment. What matters for spending power in the economy is not just the pay rises received by individual workers but the number of people in receipt of wages.

In the first quarter, compensation of employees was up by 4.2% on a year earlier, having risen by 3.2% in 2014 and 3.1% in 2013. Though some of this – a diminishing proportion – was eaten up by inflation, most provided the basis for the growth in consumer spending, which has been running at around 2.5% recently. When incomes are rising, people still need to borrow to move house, and many choose to take out finance to buy cars and other big-ticket items. Overwhelmingly, however, spending is out of rising incomes.

Sunday, June 14, 2015
First get your budget surplus, then try to keep it there
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Neither will welcome the comparison but George Osborne since the election reminds me of Gordon Brown in the weeks after Labour’s 1997 victory. Both hit the ground running, with a flurry of announcements and initiatives while their cabinet colleagues were getting used to being in office or, in the case of the Tories, back but with an overall majority.

For Osborne, it is like a weight has been lifted. Though I am sure he enjoyed the company of Danny Alexander, his former Liberal Democrat Treasury chief secretary, and all those “quad” meetings with Nick Clegg and Alexander as well as David Cameron, the sense of liberation is palpable. The sometimes Eeyore-ish presence of Vince Cable at the business department might have meant slower progress on selling the rest of Royal Mail and embarking on the disposal of RBS. No more.

The chancellor’s biggest offering, however, is what he described in his Mansion House speech as his “new settlement” for the public finances, “a permanent change in our political debate and our approach to fiscal responsibility”.

That new settlement, to legislate for future governments to run a budget surplus “in normal times”, “to bear down on debt and prepare for an uncertain future”, has been widely greeted as a political trick, intended to kick Labour when it is down, by forcing the main opposition party to commit to a fiscal rule it is probably not comfortable with.

There is some truth in that, as there is in the fact that fiscal rules, even those enshrined in law, are made to be broken, and that no government can bind the hands of its successors. On the latter, however, the chancellor may be aiming for the kind of consensus there is now on Bank of England independence. Just as it is hard to see any new government reversing that, it could be a very big deal if future politicians decided to abolish the proposed fiscal law.

Let me leave the politics aside and take the proposed surplus rule at face value. While some see it as a return to the Victorian era, there is much later experience, if not with permanent surpluses, then at least with far tighter public finances than the recent norm.

Reliable figures for the public finances go back to 1948 and, while it is true that there have only been 12 years in that period when the government has run a budget surplus, the deficit over the period 1948-72 averaged just 0.6% of gross domestic product. This, remember, was the period of fiscal activism, Keynesian demand management.

The current budget – excluding public sector investment – was in surplus in every year from 1948 to 1974, that surplus averaging 3.8% a year. The figures, incidentally, give the lie to the suggestion that tight public finances mean governments cannot undertake necessary investment in the economy.

In the three decades from 1948, when the average overall budget deficit was a tiny 0.6% of GDP, public sector net investment averaged 4.6% of GDP annually. That is roughly three times its average over the past 20 years, not least because much of that investment used to be by nationalised industries.

We are a long way from the golden age of the 1950s and 1960s. The budget deficit has averaged 3.6% of GDP since the early 1970s and, pending revisions, was 4.8% of GDP in 2014-15.

Budget deficits are the norm. Even Canada and Sweden, praised by the chancellor for their successful reforms of their public finances in the 1990s are running deficits, though admittedly lower ones than Britain. For those who believe in legislating for these things, Germany is the current poster boy.

In 2009 it initiated its Schuldenbremse or debt brake legislation, embodied in Article 109 of the country’s basic law, which required the federal government to run a structural budget deficit of no more than 0.35% of GDP. So far it is working.

Aiming for a small budget surplus in normal times –as long as that is not at the expense of an adequate level of public sector investment – is perfectly laudable. It produces a gradual fall in public sector debt and a much more rapid drop in debt as a percentage of GDP. The lesson of recent years, discussed last week, is that if you go into a crisis with a significant deficit the subsequent pain is much greater.

There would be battles between the politicians and the fiscal watchdog, the Office for Budget Responsibility, charged with determining what the public finances should be in a given year. For the Treasury this would be ultimately be a good thing; the OBR would be an ally in reining in the spending ministries.

The first big task, however, is to get to a surplus, the equally challenging second to is keep it there. Neither will be easy. Though official projections are for a small budget surplus of 0.2% of GDP in just three years’ time, there is a serious risk that this represents the triumph of hope over experience.

Now he has been liberated from coalition, Osborne has a chance to do what should have been done in 2010; a Canadian-style root and branch review of the role and limits of government, together with a mechanism for ensuring that the lower level of spending is permanent, not just the temporary low point achieved after a long squeeze. Though Canada is now running a small deficit, its public finances are far healthier than Britain’s.

There is a chance to do this in this autumn’s spending review, with the new Treasury chief secretary Greg Hands charged with achieving it. It may be the only chance. Public spending is the equivalent of roughly 40% of GDP, having peaked at nearly 46% of GDP in 2009-10. Tax receipts appear to be stuck at just over 36% of GDP. So spending needs to be brought down to 36% of GDP or less.

That will not be easy, and neither will be keeping it there. The OBR’s latest fiscal sustainability report, which looks at the public finances over the long-term, has some striking findings. Scottish Nationalists hoping to build an economic future on North Sea oil will have discovered that the cupboard is bare. The OBR expects only £2bn of North Sea revenues in the 20 years from 2020 – in total – down £37bn from the OBR’s assessment a year ago.

The ageing population, the biggest source of extra spending, will add 1% of GDP to public spending each decade on current policies. The OBR sees public sector debt falling as a percentage of GDP on current policies until the 2030s, assuming accidents can be avoided, after which it starts to rise strongly again.

In the long run, as Keynes said, we are all dead. But in the long run too there will be significant upward pressures on spending at a time when the outlook for some of the taxes to pay for it is at best uncertain, at worst dire.

It makes sense to try to prepare the public finances for such pressures. If, over the next 25 years, the result was a small budget deficit of the kind we saw from the late 1940s to the early 1970s, rather than the surplus Osborne aims to enshrine in law, it would still be a considerable achievement. But, as I say, it requires some hard thinking about the role and scope of the state. The election campaign, rich with promised giveaways on both spending and tax, was not notable for such hard thinking. Let us see what the next few months bring.

Sunday, June 07, 2015
After wasting five years, Labour will struggle to rebuild economic credibility
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The general election is becoming a fading memory but its implications will be with us for some time. For the Conservatives, there is the task of delivering the spending cuts necessary to complete the task of eliminating the budget deficit.

The Paris-based Organisation for Economic Co-operation and Development (OECD) has offered advice, suggesting to George Osborne that “evening out the profile of fiscal consolidation” would make sense. I don’t think this piece of OECD advice will be particularly unwelcome.

In his March budget, the chancellor left us with a “roller-coaster” public spending outlook; down sharply in the first two years of the parliament, then up dramatically at the end. As I have written before, it will be very surprising if, now he is safely back in 11 Downing Street, he does not take the opportunity, in his July 8 budget and the spending review later in the year, to indeed even out this profile. Thursday’s announcement of a £4.5bn package of cuts and asset sales, includingof £3bn of a £1.5bn sell-off of the government’s remaining 30% stake in Royal Mail, were part of the smoothing process.

To the victors go the spoils, however, and the challenges for the Tories are as nothing compared with those for Labour. Labour has now lost two elections, largely because of a lack of public trust in its ability to run the economy. The task for its leadership hopefuls is to rebuild economic credibility, and it will not be easy.

We will never know whether Labour was ever in with a shout of winning the election, or even being the largest party. One thing that helped guarantee it would not happen, even apart from Ed Miliband’s absurd “Ed Stone”, was the Labour leader’s refusal to concede that his party had overspent when in government.

In 2011, Miliband appeared to be on the brink of wiping the slate clean, apologising for the regulatory failures that contributed to the crisis. Given that London was at the heart of the crisis that was probably the least he could have done. And, given that politicians do not get themselves directly involved in financial regulation, blaming the failure of officials at the Financial Services Authority, Treasury and Bank of England was not too hard.

That same year Ed Balls, then the shadow chancellor, also appeared to be on the brink of truth and reconciliation, apologising both for regulatory failings and for the fact that “we didn’t spend every pound of public money well”. But that was it. The attitude then appeared to shift to blaming everything on the bankers and conceding nothing on the disaster that befell the public finances.

This was strange. While some Labour die-hards insist the party has nothing to apologise for, resorting to the absurd “spending increases did not cause the global financial crisis” the evidence is clear.

Public spending increased by a plainly unsustainable 51% in real terms between 1999-2000 and 2009-10, overwhelmingly ahead of the crisis. The OECD says Britain had an underlying or structural budget deficit of 5% of gross domestic product in 2007, behind only Greece and Hungary. Though its estimate at the time was lower, it believed and said at the time that Britain’s was the fifth largest structural deficit among its members.

The Office for Budget Responsibility’s measure of the underlying deficit, cyclically adjusted net borrowing, hit 4.1% of GDP in the mid-2000s. Between 40% and 50% of the record peacetime structural deficit was in place before the crisis hit. Incidentally, that underlying deficit is now back to where it was in the mid-2000s, suggesting the effects of the crisis have been eliminated, but not the overspending that preceded it. The OBR points out that Britain was one of a tiny number of countries to increase debt as a percentage of GDP from 2004 to 2007.

Overspending was recognised at the time. Martin Weale, the distinguished former director of the National Institute of Economic and Social Research, pointed out repeatedly that the government was bending its own fiscal rules. So did other bodies and commentators.

So, belatedly, did Labour. In 2007, Gordon Brown prepared the ground for a shift from public spending growing more rapidly than GDP to restricting its growth to less than rise in GDP. Spending would still rise, but by 2% a year in real terms, rather than 5%. Whether that slower spending growth would have been achieved in the run-up to a general election with Brown in 10 Downing Street, we will never know. The crisis intervened. The good things Labour did, including Bank of England independence, a strengthened competition regime and some of the increased spending on public services and infrastructure, got lost in the reputational collapse.

The pre-crisis deficit had two implications. One was that the size of the deficit meant the temporary fiscal stimulus introduced to limit the economic damage from the crisis – mainly a 13-month reduction in Vat – had to be small. The second was that roughly half of the austerity programme adopted by the coalition government in 2010 was necessitated, not by the crisis, but by Labour’s pre-crisis spending largesse.

How are the Labour leadership candidates doing in wiping the slate clean and trying to move Labour on? It is given added piquancy by the fact that two of them, Andy Burnham and Yvette Cooper, were Treasury chief secretaries, and so responsible for spending, though in both cases mainly after the damage had been done. Burnham did the job from mid-2007 to early 2008 and Cooper from then until June 2009, when the unfortunate Liam (“there’s no money left) Byrne took over.

Burnham has made an encouraging start. “If we are to win back trust we have to start by admitting that we should not have been running a significant deficit in the years before the crash,” he said recently. Liz Kendall, who should also make it on to the final ballot, has said bluntly: “We were spending too much before the crisis.” But Cooper, who is married to Balls, while shifting her position a little, appears most closely wedded to the line that helped lose Miliband the election. The deficit was small before the crisis, she has said, focusing on its narrowest definition, and it would not have made much difference if there was a small surplus. Voters, rightly, do not believe that.

Whether Labour can begin to wipe the slate clean therefore partly depends on its choice of leader. By 2020, of course, the 2010 legacy will be a distant memory, but these things have a habit of sticking. After the International Monetary Fund crisis of 1976 and the winter of discontent of 1978-9, a lack of economic credibility kept Labour out of power for 18 years, even failing to win in April 1992 when the general perception was that the economy was still in recession.

It required a combination of Tory self-inflicted economic wounds, including the September 1992 ERM (exchange rate mechanism) humiliation and the rebuilding of a Labour economic policy platform under Brown and Tony Blair, to tilt the balance decisively.

Something similar will be needed again, whether or not the Tories implode. Labour has to be trusted to spend prudently, tax sensibly and pursue pro-business policies. After wasting five years not doung any of that, it will be an uphill task.

Sunday, May 31, 2015
Trade is such a drag for Britain's economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A new government is in place and we have had its first Queen’s speech. As far as the economy is concerned, the two most important aspects of its programme are the referendum on European Union membership and the second-half of the deficit reduction programme.

On the first, of which much more no doubt in coming months, I still think it will be a story of some occasionally fraught renegotiation, followed by a yes vote, but we shall see.

On the second, the task for the Tories – given that many people seem to feel curiously cheated by the election result – will be to make deficit reduction seem fair. Without the cover provided by the Liberal Democrats, George Osborne will be under even greater pressure to demonstrate that we are all in it together. Anyway, more on that later too, in the run-up to and after the July 8 budget.

As always, what happens to the economy is not exclusively reliant on what politicians do. They can declare until they are blue in the face that they want to raise productivity but in the end the decisions by tens of thousands of private sector firms will determine whether it happens or not.

Similarly they can set a target, as Osborne has, for doubling Britain’s exports but, again, in a period of slow world trade growth, they cannot guarantee it will happen.

Trade is a big issue for Britain’s economy, as figures a few days ago showed. Against expectations of an upward revision in first quarter gross domestic product growth, the quarterly increase was left unchanged at 0.3%. Manufacturing and construction were stronger than first estimated but services a little weaker. Business services and finance appear to have had an unusually weak quarter.

In the detail of the figures, however, the standout drag on growth was what economists call net trade; exports less imports. Net trade, in fact, was not so much a drag as a giant millstone round the economy’s neck.

So, while there was a decent 0.5% quarterly rise in consumer spending, an encouraging 1.7% increase in business investment and even a small 0.1% upward tick in government consumption, exports fell by 0.3% on the quarter, while imports jumped by 2.3%.

Putting all that together gives you the extent to which our poor export performance and appetite for imports impacts on growth. In the first quarter net trade reduced the change in GDP by 0.9 percentage points. Had the contribution of net trade to the economy been merely neutral, in other words, the rise in GDP in the first quarter would have been more than 1%, rather than just 0.3%.

Or, taking last year as a whole, 2014’s growth of 2.8%, which was perfectly respectable, would have been a heady 3.3% without the 0.5 point drag on growth from net trade.

These things move around from quarter to quarter, and the net trade picture in the first quarter was particularly disturbing. But, while there is some evidence of rebalancing in the pick-up in business investment, the opposite is happening when it comes to net exports.

Is there are any reason to think this might change? After all, this is not just a question of growth being stronger if exporters were doing better (and importers rather worse). Britain’s large current account deficit, 5.5% of GDP, reflects weak investment income but also puts the onus on exporters of both goods and services to raise their game.

One source of hope is the eurozone. The stronger the growth bin the rest of Europe, the better Britain’s exporters should do. The eurozone crisis, and its 2011-13 recession, which followed the deep 2008-9 downturn, were a factor in Britain’s slowdown a couple of years ago.

The unfortunate thing about the first quarter numbers, however, was that they coincided with signs of stronger growth in the eurozone. Though I expect Britain’s first quarter figure to be eventually revised higher, as things stand the 0.4% rise in eurozone GDP in the first quarter exceeded Britain’s 0.3%.

Stronger eurozone growth could yet be threatened by the instability that would follow a Greek exit, though I do not expect that to happen. For the moment, however, even stronger growth in Europe is not helping Britain’s trade position. If anything the opposite is happening.

A pick-up in world trade would help. The odd thing about the post-crisis global recovery has been that, while the rise in GDP has not been that bad, the recovery in world trade – after an initial spurt in 2010 – has been muted. Normally world trade would grow at double or more the rise in global GDP. That has not been happening, perhaps because of the weakness of trade credit, perhaps because of discreet protectionism.

The upshot is that, to the extent that exporters have geared up for a global trade upturn, and refocused their efforts on faster-growing emerging markets, they have got all dressed up with nowhere to go.

What about the exchange rate? Many blame the strength of the pound for Britain’s disappointing export performance. But sterling is below its long-term average against the dollar and does not look fundamentally overvalued against the euro. The fact that exports did not respond well to sterling’s 25% fall between November 2007 and early 2009 suggests we should look elsewhere for the causes of the problem. Maybe a more stable currency would help, though attempts to stabilise sterling in recent decades have ended in tears.

There are two sides, of course, to net trade. Our appetite for imports continues unabated, not just because of consumers. Many manufacturers rely on imported components. Another aspect of disappointing trade performance has been the absence of import substitution among both consumers and business buyers. Again, this is not obviously in the gift of government.

It would be good to predict better times ahead for trade. If you wanted to be optimistic you would look at Britain’s service sector exporters, many of whom genuinely are world beaters. Even in a disappointing first quarter, Britain’s service sector exports totalled nearly £55bn and exceeded service sector imports by more than £22bn.

But if you wanted to be gloomy you would look at those first quarter GDP figures and conclude that one of our traditional Achilles’ heels is continuing to hold us back, and will continue to do so. The traditional complaint, that we do not make enough of what we want to consumer, has some validity.

Britain’s trade performance, like Britain’s productivity performance, needs to improve. As things stand, it is not obvious that it will do so.

Sunday, May 24, 2015
A little bit of deflation does you good
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Britain’s drop into deflation has produced a mix of curiosity, celebration and, in some quarters, alarm. The fact that the consumer prices index (CPI) last month was 0.1% lower than a year earlier (as distinct from unchanged in February and March) is of little practical significance.

But it has certainly provoked a lot of curiosity. Though the CPI was not even a twinkle in the statisticians’ eyes in 1960 – back then inflation was measured by the retail prices index – the Office for National Statistics (ONS) has managed to “backcast” the data to then. So we have been treated to comparisons which show this is the first episode of CPI deflation since Princess Margaret married the future Lord Snowdon, the skiffle artist Lonnie Donegan topped the charts and Wolverhampton Wanderers last won the FA Cup.

If the current deflation episode is as short-lived as many believe, it is a slightly sobering thought that in 55 years’ time somebody could be looking back and running comparisons to the quaintness of life in 2015, and which tunes we were all whistling from the charts. I should probably add a "not" there.

Mostly, the reaction to the drop into mild deflation has been to celebrate it. This has to be right. When I wrote about “good” deflation last year, I think I was one of the first, if not the first in this episode, to do so.

Good deflation in when prices fall in response to a favourable global price shock, in this case a sharp fall in oil prices. Bad deflation is when prices are dragged down by a lack of demand in the economy and is associated with stagnation.

Though the supermarkets might argue there are elements of bad deflation in the current picture – they are fighting like cat and dog for the consumer pound – it is overwhelmingly good. Mark Carney, the Bank of England governor, says that we should enjoy it while we can and he is right. An oil glut has delivered a welcome boost to household incomes and energy-using businesses. Good indeed.

For evidence of good deflation, look no further than the latest retail sales figures, which showed a 1.2% increase in spending volumes last month, for a rise of 4.7% up on a year earlier. A 3.2% drop over 12 months in what the ONS calls shop prices, but in practice was largely driven by a big fall in petrol prices, was a big reason for what is a mini consumer boom.

Some, of course, will always look a gift horse in the mouth and worry that we are about to return to the 1930s, though there was less of this this time than I might have feared.

But the fact that inflation is temporarily sub-zero, and will fluctuate around this rate for the next few months, raises an interesting question; one I have been asked a lot over the past few days. If inflation at close to zero is such good news why do we not make zero the permanent aim? Why do politicians and central bankers talk about price stability and then adopt a 2% inflation target? After all, after 20 years of 2% inflation, prices at the end would be nearly 50% higher than at the start.

Governments do not go for zero inflation targets for a variety of well-known reasons. Sometimes, as often over the past six years, they want a negative real (inflation-adjusted) interest rate, in other words an interest rate that is lower than the inflation rate, to boost the economy. If zero is the target and the norm, the only way that can be achieved is through negative actual interest rates, which are not generally to be recommended.

Aiming for zero would also run the risk of prolonged periods of deflation. At any time there would be an equal risk of inflation being negative and positive. Given the wayward inflation forecasting record of the Bank since the crisis, overshoots into deflationary territory could be prolonged. That would bring into play some of the dangers economists tend to emphasise about deflation, notably the fear that households and businesses will delay purchases until prices are lower. Deflation also raises the real value of debt; not something you want when you have a lot of it.

Because of these and other effects, economists caution against aiming for zero inflation. Almost 20 years ago a group of economists led by George Akerlof, did research for the Washington-based Brookings Institution, and calculated that a zero inflation target would lead to a permanent loss of gross domestic product and jobs of 1% to 3%. The big reason they cited was that zero inflation makes it hard for wages in different parts of the economy to adjust; pay cuts can be as awkward as negative interest rates. Real wages end up too high, and employment too low. Akerlof, as well as being a Nobel laureate, is the husband of Janet Yellen, chairman of America’s Federal Reserve Board.

In all likelihood this period of “noflation”/mild deflation will be short-lived. A one-off price shock will drop out of the inflation comparison by the end of the year. The last time we were briefly negative, all those years ago, inflation rose quite sharply afterwards.

There is a possibility, however, that very low inflation becomes entrenched. Fathom Consulting points out that core inflation, excluding energy, food, alcohol and tobacco, is at a record low of 0.8% and falling. Service sector inflation, which normally outstrips overall inflation, has come down to 2%.

Meanwhile, so-called pipeline inflation pressures are very low. “Factory gate” prices for manufactured goods last month were 1.7% down on a year earlier, or zero excluding energy and food. Raw material and fuel prices, down 11.7%, are still reflecting sharp oil and commodity price falls.

It may be, as noted last week, that rising wage pressures compensate for some of these deflationary impulses, though one of the reasons why both the Treasury and the Bank are keen to emphasise the temporary nature of the current episode is that they do not want employers to respond to zero inflation with zero pay rises.

One thing is reasonably clear. We are now in a prolonged period – 16 months so far – in which inflation has been below the 2% target. It pre-dated the sharp fall in oil prices. It was preceded by 48 months in which inflation was above the target, exceeding 5% at times.

If that tells you we should be sceptical of the ability of central banks to keep inflation on target, whether that target is 2% or zero, it is a good lesson to draw. If it tells you we should expect big inflation swings in the coming years, in both directions, that is a good lesson too.

Sunday, May 17, 2015
Crunch looms as pay picks up but productivity struggles
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The dust has settled, though the politicians – on the winning side at least – have not yet paused for breath. George Osborne, when he has not been trying to turn the north into a powerhouse, has been laying the groundwork for renegotiating the terms of Britain’s membership of the European Union.

These are early days for both of those, so I shall leave them for this week. More interesting is whether the economy has been given a post-election splash of cold water. The Bank of England, whose praises I was singing last week, left it until the new government had its feet under the table before unveiling a downgrading of its growth forecasts.

Had the Bank told us that during the election campaign, say some, it could have eroded the Tory “stick with us for a stronger economy” message. The post-election shock was not a rise in interest rates – that is still perhaps 12 months off – but a gloomier growth outlook.

Hand on heart, I do not think we should get too excited about this. Until Wednesday, the striking thing about the Bank’s growth forecasts was how upbeat they were. Growth of almost 3% a year this year and next – 2.9% in each year - was perkier than almost all other forecasters.

Its new forecast of 2.5% growth this year (an inevitable downgrade following a weak first quarter) and 2.6% next brings the Bank more into line with the consensus. The Treasury’s latest compilation of independent forecasts has an average prediction of 2.6% growth this year, 2.3% next. There was no drama in the Bank’s downgrade. Nothing to see here.

In other respects, however, the combination of the latest very strong labour market figures and the Bank’s inflation report has exposed a dilemma for the British economy. A crunch may be looming, partly as a result of what John Hawksworth, PWC’s chief economist, describes as Britain’s “incredible job creating machine”.

Let me explain. The latest labour market numbers continued what has been an extraordinary story. In the most recent three months, January-March, there were 202,000 more people in work than in the previous three months, with the new total 31.1m. The proportion of 16-64 year-olds in work rose to 73.5%, the highest since records began in 1971, and no mean feat when 200,000 of the 1.25m rise in employment over the past two years has been among those aged 65 and over.

In the first three months of the year we were collectively working 20m, or 2.1% more hours than a year earlier and 84m more than five years before. Unemployment over the past year has dropped by 386,000 to a new post-crisis low of 5.5% of the workforce. Job vacancies, 736,000 in the latest three months, are close to their highest since records began in 2001.

The labour market is tightening quite rapidly; slack is disappearing, and the really interesting thing about this is that it is now starting to be reflected in the pay figures. The first three months were expected to be difficult for average earnings comparisons, because of a tax-related surge in bonus payments in the first quarter of 2014.

If there was a difficulty, however, pay has sailed through it. In March, total pay – including bonuses – was 3.3% up on a year earlier. The latest three months, a better comparison, showed an increase of 1.9%. The figures for the private sector, not subject to government-imposed pay limits, were 4.3% and 2.4% respectively.

For regular pay, not subject to bonus distortions, there was a 12-month rise of 2.7% across the whole economy in March, and 2.2% in the January-March period. The private sector figures were 3.3% and 2.7% respectively.
One swallow does not make a summer. Pay has ticked up before, only to slip back again. But if this is the start of stronger pay growth, which would fit the picture of a tightening job market, it opens up some interesting possibilities.

The Bank’s inflation report, and the fact that it once again downgraded its productivity forecasts, has put the focus again on this important issue. As I have pointed out before, the productivity picture is more nuanced than is usually reported. Some sectors, such as motor manufacturing, have recorded good productivity growth in recent years and output per job across the whole of manufacturing is 14% up on its recession low point in 2009. Across services the rise is 4.9%.

What is not in doubt is that productivity is a lot weaker than it should be. Had output per hour increased over the past seven years by as much as over the previous seven it would be 15% higher than it is.

For most of that seven years, weak productivity was unfortunate but not hugely problematical. It was the counterpart to strong employment growth, and thus preferable to strong productivity and weak employment. It was also accompanied by weak wages. Indeed, low productivity growth was the usual economic explanation for non-existent growth – and often falling real (inflation-adjusted) wages.

But what happens when wages pick up but productivity does not? This is when a benign combination starts turning malign. Rising real wages – and thanks to zero inflation they are rising strongly now – in combination with weak productivity means that unit labour costs go up. Unit labour costs are the key determinant of competitiveness. The risk is that they now start rising quite rapidly.

Economists would say that firms will keep a lid on pay if productivity growth remains weak. Sometimes, however, theory and practice diverge. In a tight labour market with skilled workers in short supply, businesses may have no option but to pay up.

There is, of course, a safety valve for the labour market in the form of immigration. The tighter the job market, the more employers will turn to foreign workers. Of the 576,000 rise in employment over the past year, 294,000, or 51%, has been among non-UK nationals. No wonder firms are not keen on a clampdown on net migration.

So we have reached an interesting point. Productivity remains weak but pay is picking up. Net migration and other ways of increasing the effective supply of labour – older workers and existing workers doing longer hours – can ease the pressure, as the Bank pointed out. But sooner or later something has to give. And the hope has to be that finally, it is the meaningful acceleration in productivity growth the Bank has been predicting for the past few years.


Sunday, May 10, 2015
A victory for common sense - and the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This time last week, when you could still get very good odds on a Tory majority, I missed out on yet another good investment opportunity. In other respects, however, the election showed that, outside Scotland at least, the wisdom of crowds works.

The election, and the unexpected Tory majority, was a victory for economic common sense, though I was sorry to see the Liberal Democrats so badly punished. Whatever voters thought about the future fiscal plans of the parties, they had enormous doubt about putting Labour back in charge of the economy.

Had Ed Miliband conceded when he became leader in 2010 that Labour both messed up on banking regulation and overspent, he would have endured flak but could have had a clean slate. Denying overspending right up to election day, when the numbers show it clearly with hindsight, was a fatal error.

As it is, George Osborne now faces having to accommodate a series of campaign pledges – right to buy for housing association tenants, a law not to raise any of the main taxes and £8bn more for the NHS by the end of the parliament – into a tight fiscal framework. Whether these pledges made any difference is hard to say, but compared with the alternative of defeat, these are headaches the chancellor will regards as the most minor of ailments.

What was most encouraging for me was that voters did not fall for Labour’s populist interventions. I do not want to revisit the columns of recent weeks but there was something fundamentally wrong about an agenda of price freezes and rent controls, a return to “government knows best” interventions in business and the attempt to persuade people that pain could be avoided by soaking the rich, preferably the foreign rich. I have no doubt that all this would have harmed the economy. It is good that voters recognized that.

The other encouraging thing was that the markets never panicked about the election, even when a hung parliament looked likely. For this, we should pay some tribute to the strength of Britain’s institutional set-up, and in particular the independent Bank of England.

The Bank has been a quiet place, a haven of tranquility, amid the pre-election political uncertainty. Mark Carney, no doubt enjoying a quiet cup of Nespresso with his lieutenants, was able to keep a calm eye on what looked like a close race for power in Westminster.

When Gordon Brown announced independence for the Bank five days after the May 1997 election (alongside a rise in interest rates) he perhaps did not have events of the past few days in mind.

Ed Balls, who did much to initiate and design Bank independence back then, certainly would not have expected the outcome he suffered early on Friday morning.

Had things turned out differently, he would have been chancellor this week (I don’t think we would have had an easy relationship). He almost was before the 2010 election. Now I suspect he never will be.

But the independent Bank Brown and Balls forged proved its worth in the run-up to the election, and it will do so again now.

Markets approached the election, if not in a state of serenity, then a long way from panic. The pound’s average or trade weighted value, measured by the sterling index, stood at 89.1 on the eve of the election, 1% up on its level at the start of the year, and 2.5% up on 12 months earlier. The pound is lower against the dollar (though it jumped when the election result became clear) but higher vis-à-vis the euro.

That stability, which also applies looking forward, has much to do with the fact that the Bank has control of the monetary levers.

The markets no longer wait with trepidation for a post-election rise in interest rates. Rates increased soon after the polls of 1979, 1987 and 1997. They did not after the three post-independence elections, in 2001, 2005 and 2010. They will not now.

The Bank’s nine-member monetary policy committee (MPC) deliberated on Thursday and Friday about interest rates and will announce its decision at noon tomorrow. It is fair to say that it will be the shock to end all shocks if it announces a rise. The most we can expect from Carney this week is another open letter to explain why inflation is more than a percentage point below the official 2% target.

There will be a few more “no change” meetings if the markets, which do not expect a rate rise for the next 9 to 12 months, are right. Bank independence takes the pressure off the politicians.

Where do we go from here? Osborne did not like to be reminded a few days ago that Britain has a bigger budget deficit than Greece; 4.8% versus 0.8% of gross domestic product, according to the International Monetary Fund. More comfortable for him, perhaps, is the fact that Britain’s deficit is smaller than Japan’s, 6.2%, and only a bit above America, 4.2%.

But it was a reminder that there is work to do. In contrast to Greece’s brutal austerity, most of which is complete, deficit reduction in Britain has been milder. Though much of the low-hanging fruit has been plucked, and though there are those campaign pledges to accommodate, I think it can continue to be milder than people fear, though getting from 4.8% to zero will require grit and imagination.

The interaction of weak productivity and weak wages of recent years is another challenge. It is clear from the latest US figures, weak productivity is a problem afflicting most advanced economies.

In the end, higher productivity requires an economic climate that encourages business investment and innovation.

This should be the time when it can occur, with post-crisis pressures on funding and credit availability easing. I do not think there is a serious prospect of EU exit, so there are good post-election reasons to be optimistic on productivity and investment. Let us hope so. Finally, politicians from all parties — except perhaps the Greens — talk a good game when it comes to streamlining the planning system and pushing through infrastructure and housing projects, but nothing much happens.

There is a crying need for more airport capacity in London and for investment in transport and energy infrastructure around the country. There is a similar need for much more housing. Planning is the sand that gets into the cogs and stops the economy operating efficiently. It needs fixing, and there is no reason now to delay.

Sunday, May 03, 2015
Deja vu - but the choice is starker this time
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The election is upon us, the party leaders’ voices are getting hoarser, and I don’t suppose many people would mind if they never heard a “cast-iron pledge” aimed at “hard-working families” again.

You will have heard pundits say we have never seen anything quite like this election before. Certainly the rise of the Scottish National Party, and to a lesser extent Ukip, makes it different.

In other respects things are quite familiar. To confirm my sense of déjà vu, I looked back to what I wrote on the Sunday before the May 2010 election.

All three parties were on the receiving end of a battering from the Institute for Fiscal Studies (IFS), then run by Robert Chote, now chairman of the Office for Budget Responsibility, for not coming clean about their policies. Opposition parties took their lead from the government; Labour’s refusal to spell out how it would cut spending (Alistair Darling, under pressure from Downing Street, postponed his spending review). Change the names and not much has changed.

It looked then, as now, that we were heading for a hung parliament, though the Tories were well ahead in the polls. While not then knowing there would be a full coalition, I wrote of a first budget for a new Tory government with Liberal Democrat input and the “obvious” a rise in Vat to 20%. I also warned of a post-election hangover for the economy, whoever won. The eurozone crisis was intensifying, the banking system had not been fixed and deficit reduction was just getting going.

How has the past five years gone? Just in case the LibDems do not make it into government again – and it will be a surprise if they do not lose half of their current parliamentary seats – let me praise them.

All politicians have their eyes on power but the LibDems entered coalition with the Tories in the national interest and have mainly made a positive contribution. The coalition has been more stable and less argumentative than many majority governments.

Nick Clegg has been a calming influence, Vince Cable a solid business secretary and Danny Alexander, who I remember as a young press officer for Britain in Europe, a capable Treasury chief secretary. The LibDems deserve better than the punishment voters appear likely to inflict upon them.

For Labour, the timing of the 2010 election was unfortunate. It presided over the crisis but had no time to clean up afterwards. Even so, the party has been a disappointment in opposition. The great achievement of Tony Blair was to turn Labour into a pro-business left-of-centre party.

Under Ed Miliband that achievement has been junked and, as well as “the cost of living crisis” we have had a string of policy interventions, from price freezes to rent controls, whose common theme is that they never worked in the past. It can only be a matter of time before we have a prices and incomes policy.

The Tories, and George Osborne, deserve credit for not bending under extreme pressure, particularly when the economy almost stalled in 2012. The chancellor has one big reform under his belt, the liberalisation of pensions that took effect last month, and deserves credit for recognising the importance of regional regeneration with his northern powerhouse.

In other respects it has been a bitty chancellorship, with too many initiatives and too little tax simplification. The initiatives may have been there to distract attention from the overriding need to get the deficit down or, as Treasury economists argue, it was necessary to try a series of different things, particularly to get credit flowing.

In the end, it is the overall record that matters and the coalition, under Osborne’s economic leadership, has a good story to tell. The first quarter gross domestic product figures, a 0.3% rise, were disappointing but should be taken with a pinch of salt. Their equivalent five years ago, for the first quarter of 2010, were initially reported as a 0.2% rise but now show a 0.5% increase.

There was no “sharp slowdown” in the first quarter. Non-oil GDP in the final quarter of last year was initially reported as a 0.5% rise. Last week’s preliminary reading for the first quarter was 0.4%.

Even after those figures, Britain’s gross domestic product has risen by more than 9.5% in real terms over the past five years. Non-oil GDP, which is a better measure of underlying activity, is up almost 11%.

The job market story has been astonishing, with a record 31m, or 73.4% of working-age people in jobs, unemployment falling, and private-sector job creation, almost 3m over the past five years, comfortably exceeding the near-1m public sector job cuts. It has been a long time coming but inflation at zero has restored growth in real wages.

Most of all, though deficit reduction has been slower than hoped, because of weak tax revenues, it has ceased to become a crisis issue. Britain has been brought back from the edge of an abyss which, whatever some say now with the benefit of hindsight, was real in 2010.

What about all that we have heard in the past few weeks? A positive economic story has been in danger of being drowned out by the negatives. What should have been a straightforward “sound money” approach to pushing on with eliminating the deficit has too often come over as austerity for its own sake.

As for all the gimmicks and giveaways that the parties have been showering around in recent days, the intelligent voter should ignore most of them. David Cameron, in promising to legislate against any rise in major taxes, is trying to close off the Labour charge that if re-elected he would put Vat up again. It would not have happened anyway, but the fear must have been picked up in focus groups. Like Labour’s silly pledge to reduce the budget deficit every year, there would be a get-out clause. No chancellor could deprive himself of the right to raise tax in all circumstances.

Similarly, the main parties have been trying to outdo each other by throwing money at home-buyers, whether it is the Tories’ planned very large right-to-buy discounts for housing association tenants or Labour’s stamp duty holiday on purchases up to £300,000. None of this addresses the problem of housing supply. Given capacity in the industry I will eat my hard-hat if 1m new homes are built over the next five years.

The big issues affecting the economy: productivity, improving export performance and the current account deficit, rebalancing are not in the gift of politicians. As Osborne discovered, it is one thing to talk about the “march of the makers”, another thing to deliver it.

That said, there is more of a choice this time, though the prospect of a hung parliament makes it a difficult one. Even the most expert of tactical voters could not plan their vote in a way that ensures the continuation of a current coalition. Labour voters may hate the idea of a government propped up by the SNP but may end up getting it. So might Ukip voters.

The choice, in the end, comes down to whether people favour a return to greater interventionism, and policies aimed at taxing the rich more which could make Britain a less attractive location for inward investment, together with higher levels of government debt. We will know in a few days which way the dice has fallen.

Sunday, April 26, 2015
The budget black hole still matters in this election
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It was a big week for the public finances, both where we have been and where we might be going. We can now make a judgment on the past five years and say something meaningful about the next five, though through the murk that passes for serious political debate on debt and the deficit.

Let me start with the record of the past five years. Though the numbers for the public finances are prone to revision – usually downwards in the case of the budget deficit – the Office for National Statistics’ latest figures, released on Thursday, tell the story reasonably well of the past five years.

Public sector net borrowing in 2014-15 was £87.3bn, £3bn less than was expected in last month’s budget. In five years the deficit has come down from £153.5bn, the 2009-10 figure the coalition inherited. That is a drop of 43%, though relative to gross domestic product it has fallen from 10.2% to 4.8%, a fall of more than half.

What about the debt? Public sector net debt at the end of March – the end of the 2014-15 fiscal year – was £1,484bn, 80.4% of GDP, compared with £956bn at the end of 2009-10.

It has thus increased significantly under the coalition, as it was bound to do; you cannot eliminate a £150bn-plus deficit overnight. Nigel Farage keeps saying that debt has doubled under this government, which is wrong; the rise is 55%, though it did more than double in the previous five years under Labour, rising from £448bn in 2004-5 to £956bn in 2009-10, an increase of 113%.

This measure of debt, incidentally, excludes the public sector banks, mainly Lloyds and RBS. Include them and the debt is larger, £1,796bn, but has fallen by £449bn under the coalition.

How much more has George Osborne borrowed than he planned? The official Office for Budget Responsibility (OBR) forecast in June 2010 was for borrowing of £37bn in 2014-15, so the outturn was £50bn higher than intended.

Interestingly, that June 2010 forecast envisaged that debt would rise by more than £500bn over this parliament, and it has done so. Definitional and other changes suggest, however, it is fair to say that Osborne has borrowed around £100bn more than planned.

Why has this happened? If you want a rare example of an astonishingly accurate five-year forecast, look at what the OBR was saying about spending back in 2010. It predicted £737bn of overall government spending in 2014-15 and its latest estimates suggest spending was precisely that. There was no relaxation on the spending side: the government stuck to its plans.

Where the extra borrowing has occurred has been because of the weakness of revenues, some £50bn in the latest year below what was expected five years ago. Some of that was deliberate, reflecting the aggressive raising of the personal income tax allowance to £10,000 and now £10,600. Most of it was accidental, reflecting weak earnings growth; now starting to unwind.

When you hear opposition politicians claiming that they would not have presided over such weakness in pay, treat it with the contempt it deserves. We are many decades from the era of the “going rate” and the idea that politicians can determine what employers choose to pay. What we have had over the past five years – very strong growth in employment alongside subdued pay rises – has been infinitely preferable to the alternative.

What does the recent history of the public finances tell us about the outlook for the next five years? The differences between the parties on deficit reduction are fairly clear, even if some are doing their best to obscure them. Labour, for example, wants to have its cake and eat it; selling itself to voters as the party of significantly less austerity than the Tories but not wanting voters to realise that its definition of “balancing the books” will mean borrowing £25-30bn a year in normal times, as the Institute for Fiscal Studies pointed out in a typically useful analysis last week.

Though some economists, who I would call the Martini set, strangely dismiss the need for austerity any time, any place, anywhere, there is a sensible debate to be had over whether governments should continue to borrow to invest – eliminating only the so-called current budget deficit – or whether they should go the whole hog and aim for an overall budget surplus.

The coalition, after all, had the aim of getting rid of the current deficit, not the whole lot. Gordon Brown’s golden rule was borrowing only to invest over the economic cycle. The lower the interest rates on government debt, the stronger the argument for borrowing to invest in infrastructure and other projects.

There are, however, problems with it. Politicians tend to miss their deficit targets, as we have seen. Brown’s golden rule creaking well before the financial crisis hit, and was destroyed by it. We know now that a supposedly fiscally responsible government was running a structural, or underlying, overall budget deficit of roughly 5% of gross domestic product in 2007.

The coalition followed suit. It probably never would have been credible to eliminate an overall budget deficit of more than 10% of GDP in a single parliament – and that was never the government’s aim – but even getting rid of the current deficit has proved too challenging.

Another difficulty, although I would not overstate it, is that “borrowing to invest” could cover a multitude of sins, allowing governments to boost what they define as investment without limit, although there official checks and balances on this.

The other is the opposite one: some things that should properly be defined as investment these days, such as spending on training and skills, are generally not.

The problem I have with this goes deeper, however. The IFS did its best with the thin gruel the parties provided, but was obliged to take at face value their broad promises. On their stated plans Labour will cut less than the Tories but borrow £90bn more over the next parliament.

The difficulty I have is imagining Labour cutting at all, particularly if it is reliant on Scottish National Party (SNP) support. Labour’s record on cuts is, frankly, almost non-existent. It did so after the International Monetary Fund bailout in 1976, though only under extreme duress. When Labour took office in 1997 it stuck to Tory plans for two years, temporarily earning Brown the sobriquet “iron chancellor”.

In the run-up to the 2010 election, aides and cabinet colleagues found it almost impossible to get Brown the words “cuts” at all. That was why there never was a Labour plan to deal with the deficit, merely a sketch, an artist’s impression.

Not much has changed. When pressed on the cuts Labour would make Ed Miliband mentions a couple of small-scale privileges for better-off pensioners, which would save peanuts, and then moves swiftly on. You could say the Tories and to a lesser extent the Liberal Democrats are not much better but at least they have a track record.

Labour does not. If a minority Labour government did indeed require the support of the SNP, which is committed to ending austerity even if its policies do not imply that, it is hard to see tough decisions on spending getting through the House of Commons. The deficit, which is still closer to £100bn than zero, could easily get becalmed.

After two successive five-year periods in which Britain has added more than £500bn to government debt, a sizeable black hole remains which has to be dealt with. Whether or not that matters to most voters, it should. And it matters to me.

Sunday, April 19, 2015
Parties obsess about "costings", while ignoring the elephants in the room
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

I would not want anybody to think a theme is developing here but, having warned last week that we should take economists’ views on austerity with a pinch of salt, this week I have another warning about this kind of thing.

When you see the words “fully funded” or “properly costed” attached to the plans of political parties, take great care.

Be also sceptical about fake precision. I know why it made the headlines but the difference between an International Monetary Fund forecast that there would still be budget deficit of £7bn in 2020 and the Office for Budget Responsibility’s prediction of a £7bn surplus is margin of error territory.

The IMF predicts a deficit of 0.3% of gross domestic product in five years’ time, the OBR a surplus of a similar amount. This is small change, even when you factor in the possibility that we may have a government in place which is not even aiming to eliminate the overall budget deficit.

The IMF produces its fiscal monitor every six months. The 0.6% of GDP difference between it and the OBR’s projections is not untypical of the size of the IMF’s six-monthly forecast revisions for Britain’s deficit –in either direction – not for five years’ time but for the coming year. Until they have quite a lot of monthly data to go on, forecasters struggle to get within £10bn of the deficit for the current fiscal year, let alone what it will be in 2020. The difference between a small surplus and a small deficit in five years is, as the IMF managing director Christine Lagarde has pointed out, fake precision.

This is not to say that we should just allow the political parties to say what they like, without any nod in the direction of fiscal reality. This may be good enough for those at the fantasy end of the spectrum, like the Greens and the Scottish Nationalists, but neither are going to form a government and, it is to be hoped, will have little influence on the government that is formed.

But there is also a danger in going too far the other way, in which the parties fight over a tiny amount of fiscal territory, ignoring what really matters. In this environment, the political accountants take over. So Labour was keen to show that, as Ed Balls put it: “Every policy fully costed, fully funded, fully paid for with no additional borrowing.”

The Tories followed suit with some things, explaining how they would pay for raising the inheritance tax threshold on homes to £1m and enhanced childcare (reducing pension tax relief for £150,000-plus earners) and the right to buy programme for social housing tenants (sell expensive council properties), while not spelling out how they would pay for £8bn of extra health spending, or how they would fund raising the personal allowance and higher rate threshold.

A looser approach has something to be said for it when you look at some of what else is on offer. So Ukip accompanied its manifesto with a costing exercise produced by the Centre for Economics and Business Research.

The CEBR dutifully looked at the savings from reducing overseas aid, cancelling HS2, the absence of EU contributions (when Britain exits) and scrapping the Barnett formula, and set them against the cost of Ukip’s proposals, including income tax cuts and the abolition of inheritance tax.

What it could not look at, however, was the elephant in the room. What would be the effect on the economy, and on the public finances, of Britain leaving the EU? I cannot tell you precisely what that effect would be, but it would be bigger than all Ukip’s measures combined and overwhelmingly negative for growth and tax revenues, at least in the early years. It is the elephant in the room.

There are other elephants. In December the OBR set out three different scenarios for the economy and the public finances, based on what it described as low and high assumptions for productivity – output per worker - alongside its central forecast or some recovery in productivity growth.

The differences were striking. If productivity growth stays low, essentially the deficit stays high, and government debt rises. But in a high productivity scenario, growth is stronger, the deficit comes down more sharply, and debt falls smartly as a percentage of GDP. The differences were enormous. On a high productivity scenario debt at the end of the decade would be more than £600bn lower than if productivity is weak.

But, while we should be sceptical about the ability of governments to wave magic wands and boost productivity, have we heard anything in this campaign on this subject which is remotely convincing?

Or, when it comes to the outlook for the public finances for the next few years, the oil price is hugely important. In March 2014 the OBR expected the oil price to average $100 a barrel over the next five years. Now it expects $70 a barrel.

The drop in prices was the equivalent of a tax cut that no government could have afforded. As the Ernst & Young Item Club will say in its new forecast, to be published this week, the boost to real incomes from cheap oil, weak commodity prices and supermarket price wars will trump political uncertainty as far as the economy’s performance this year is concerned. If the oil price were to rise, reversing that effect, growth would suffer, and vice versa.

To a certain extent I am saying that Harold Macmillan’s “events, dear boy, events” are more important influences than the relatively things the political parties are arguing, and often deliberately obfuscating, about but there is more to it than that.

What matters is the supply-side of Britain’s economy can be invigorated, delivering the productivity growth that would reduce the need for further fiscal pain and put government debt on a decisive downward track. Labour has proposals that for the most part would damage the supply-side by increasing government intervention, reducing Britain’s appeal to inward investors and making the labour market more flexible.

But the Tories, as noted, have done little to suggest they have taken hold of the productivity issue. And they worry many people in business with the fear, though it is exaggerated, that they will take Britain out of the EU, and by worries that they will indeed clamp down in immigration. For many in business, this is a Tory policy they hope continues to fail.

Maybe there are no votes in the supply-side, when set against the “fully costed” promises the politicians matter. But it is the supply-side rather than those which will determine our future prosperity.

Sunday, April 12, 2015
On austerity, take economists with a pinch of salt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Should you listen to economists during this election campaign? I say that in the full knowledge that it may encourage some to stop reading now, and that the excellent work done by economists at the Institute for Fiscal Studies and other bodies is rightly used as a check on the claims and counter-claims of the parties.

No, I ask because of a survey of mainly academic economists published a few days ago by the Centre for Macroeconomics, which is based at the London School of Economics but which also encompasses researchers from the Bank of England, Cambridge University and other institutions.

The survey asked two questions. One was whether the coalition’s policies had been good or bad for growth over the past five years. The second was whether the outcome of the election would make any difference to growth and employment over the next five years.

The answer to the first question was clear-cut. Two thirds of the economists questioned said that coalition policies – “austerity” – had been bad for growth. The answer to the second question was slightly less clear but the majority view was that the slower the pace of deficit reduction – the less the austerity - the better it would be for economic activity.

I know this survey because each month I take part in it, on a range of different questions. This one got noticed more than usual because of the timing and because it was picked by Robert Peston of the BBC. It was quoted during the televised party leaders’ debate.

I disagreed with the majority verdict. The coalition had been for good growth, I said, because it had pulled Britain back from the abyss and away from a fiscal crisis that could have been hugely damaging.

Sometimes it is said that fears of such a crisis were artificial and that a country with its own currency and central bank should not worry about such matters. But Britain has had more than here fair share of past crises. Attempting to spend our way to growth gave us the IMF crisis of 1976.

As for the next parliament, the most important question is not the relatively small differences in the pace of deficit reduction between the main parties but what the next government can do for the supply-side, for incentives, and for productivity.

I was not alone in saying the coalition has been good for growth. Several distinguished economists, including Patrick Minford of the Cardiff Business School, Nicholas Oulton of the LSE, Costas Milas of Liverpool and Jagjit Chadha of the University of Kent took the same view, and for similar reasons.
Minford argued that the coalition had achieved a balance between deficit reduction and destabilising the economy, Oulton that “austerity has been greatly exaggerated” and Chadha that “sound money” deficit reduction had created the room for aggressive quantitative easing by the Bank of England, alongside low long and short-term interest rates. Milas pointed to Britain’s respectable growth performance in recent years, particularly on IMF figures.

Indeed, the pattern of growth during this parliament was not, as is often said, that growth stopped as soon as the coalition started implementing austerity, roughly two-thirds of which it inherited from Labour. Growth in non-oil gross domestic product, the best undistorted measure of economic activity, exceeded 2% in both 2010 and 2011, only slowing to 1% in 2012 – the height of the euro crisis – before picking up again.

If I am honest, however, I would admit that in my response I was aiming off, as a counter to the inevitable large majority on the other side. If you ask a group of British academic economists whether austerity has been good or bad for growth, whatever the circumstances, the majority answer will be as predictable as if you asked them whether there should be more or less university funding. In that respect, most academic economic opinion has not moved much since 364 economists signed a round-robin letter in 1981 warning that Margaret Thatcher’s policies would deepen the recession. The letter famously coincided with the start of a long upturn.

The correct answer to the first question in my view, though it would not have made for an interesting survey, would have been for respondents to adopt the classic two-handed economist – “on the one hand, on the other hand” – approach. The coalition might have been good for growth, but it might not have been. It depends, and it depends on things we cannot possibly be certain about.

I cannot say for certain there would have been a fiscal crisis if austerity had been abandoned in 2010 but neither can the critics of austerity say there would not have been. We do not know what would have happened to long-term interest rates, or what the Bank would have done. Would sterling have succumbed, pushing inflation even higher and exacerbating the squeeze on living standards? Possibly, but we do not know.

Fortunately, you do not have to take just my word for this. Wouter den Haan, co-director of the Centre for Macroeconomics, who took the neutral view, put it well. “I think the macroeconomics profession doesn’t have the evidence to answer this question,” he said.

Charlie Bean, the former Bank deputy governor, another neutral, also put it well. Coalition austerity was not undertaken in the belief “it would boost demand directly but rather that it would reduce the likelihood of a loss of market confidence in the UK government's economic policies, which - had it occurred - would have necessitated a much sharper consolidation.”

Just as economists cannot really know what would have happened in the absence of austerity, so we should take with a pinch of salt their recommendations on future austerity. Indeed, for some, there should be none at all, even though Britain is running a £90bn deficit.

On this I would give some credit to Ed Miliband and Ed Balls. Though their version of “balancing the books” means running a permanent deficit of around £30bn a year, at least they recognise the need for further deficit reduction.

Both Miliband and David Cameron have found themselves up against other leaders from the smaller parties, most of whom blithely wave away the need for austerity, knowing they will not have to carry the can if Britain goes into the next downturn with the deficit still large and government debt rising. The SNP’s Nicola Sturgeon is the worst but not the only offender in this.

In 2010, the coalition took a judgment that the deficit had to be reduced to bring Britain back from the fiscal edge. Whether or not the net effect of that was to reduce or ultimately boost growth, we cannot know but it gave Britain stability in what could have been a very rocky period..

As things stand now, with the economy growing well and interest rates still low – they have not increased for the whole of this parliament – it is hard to argue that this is not the right time for further deficit reduction, alongside supply-side policies to boost long-run growth. Sensible politicians know this. They have to live in the real world.

Sunday, April 05, 2015
The economy's doing better - have voter memories of past chaos faded too?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A landmark has been passed, and sooner than expected. Living standards, measured in the conventional way, are higher than they were than the coalition took office, as George Osborne was quick to pick up on a few days ago.

Now, the last thing you want to read is somebody slapping themselves on the back but it has long been my expectation – rehearsed here on a number of occasions – that this parliament would not see the first fall in living standards in living memory, as some repeatedly said, but a rise.

The danger was that we would not know about this rise until after the election – had the recovery in real household disposable income per head to spring 2010 levels come in the first quarter of the year rather than the final quarter of 2014 the figures would not have been available until June – so it would have been a forecast rather than a cat. It is now a fact.

Of course, based on current data, the rise since May 2010 – the second quarter of 2015 – is minuscule, just 0.2%. In the circumstances, however, even that is a considerable achievement. It was always the case that the financial crisis was going to make us poorer, as was the task of tackling a record peacetime budget deficit that resulted from a combination of crisis-induced recession and the public spending splurge of the 2000s.

One of the mechanisms for supporting living standards, aggressive cuts in interest rates, had already happened when the coalition took office. Bank rate was cut to 0.5% in March 2009. In May 2010 there was little or no room to cut further. Add commodity price rises (now reversed), negligible credit growth, and the eurozone to the necessary deficit reduction measures and even a modest rise in living standards is much better than it might have been.

The real household income figures came with the latest gross domestic product numbers, which saw growth revised up last year to 2.8%, from 2.6%. Before too long 2014 growth will be shown to have been 3% or more, which is what most of us thought anyway.

We have got so used to this being described as the slowest recovery on record – which we will not know for sure until we have had years of data revisions - and to certain politicians saying there was no growth at all in the coalition’s first three years - that it is worth reminding ourselves of the numbers.

Growth in 2010 was 1.9%, 2011 1.6%, 2012 – when the euro seemed on the verge of break-up – 0.7%, 2013 1.7% and 2014 2.8%. That is an average of 1.75% a year on current data; slow growth but not no growth, at any time.

Take sharply declining North Sea production out of the figures (Scottish Nationalists please note), and you get a better picture of underlying growth. The numbers there are 2.3%, 2.2%, 1%, 1.7% and 2.9%, an even more respectable average of just over 2% a year. Not bad in the circumstances. The mistake was to think normal service could be resumed quickly in the aftermath of the biggest crisis in a century.

Not only are the official economic numbers looking better but so are measures of consumer confidence. The GfK-NOP consumer confidence index has been running since the 1970s and last month rose to its highest level for nearly 13 years.

Nick Moon, the veteran pollster, head of social research at GfK, had thought consumer confidence had hit a plateau at the end of last year after one if its strongest rises on record. In fact it has risen by eight points over the past three months. Much of this reflects public perceptions of the economic situation, up 16 points in the past year, and willingness to make major purchases, up by a similar amount.

The reason I highlight these numbers is that, as well as being a source of fierce debate among the political parties, they have the potential to be an important determinant of the way people will vote on May 7.

The usual narrative on this is that the Tories should be doing a lot better than they are in the polls given the state of the economy, to which the usual counter is that they would be doing better if only most people felt the recovery, which they are not. It takes time, in other words, for an upturn to filter through.

There has to be some truth in that. Real household disposable incomes per head are a mere 0.2% up on the spring of 2010. That average conceals a lot of falls, as well as rises. Most analysis suggests the rises have been particularly concentrated among older voters, who my mailbag and e-mails tell me are inclined to be a little curmudgeonly about it, and do not regard the past few years as a cause of great celebration.

Even so, most people do not, either, ask themselves the Ronald Reagan question – am I better off than four or five years ago? They look at how they are doing now, and here the numbers are rather good. Real disposable incomes per head are up 1.9% over the latest 12 months. Aggregate wages and salaries have risen by 5.3% at a time of virtually no inflation. A rise in employment is included in that but it is still a hefty increase, the biggest for seven years.

All of which raises a second possibility, supported in particular by the consumer confidence index but also by some of the other numbers. This is that, for many voters, the fear has gone. Falling unemployment and low inflation make for a very low misery index but they also make people worried less about the future.

The days when the banks were collapsing are a long time ago. The period when Britain was running a budget deficit which caused the then head of Pimco, the world’s biggest fund manager – which counts Ed Balls’s brother among its senior employees – to say Britain was sitting on “a bed of nitroglycerine” is also a long time ago.

A Labour government may well be chaotic – I cannot remember an opposition less prepared for government – but the potential descent into national chaos under Labour evoked by David Cameron and George Osborne is a hard sell to people who are generally upbeat. People may not think ‘crisis, what crisis?’ but the extreme conditions of 2007-9 have faded in the memory.

Governing parties face a dilemma on this. They want living standards to be rising and for recovery to seem secure, and both those conditions are currently met. The risk for the coalition is that they have also made the economy safe for Labour in the eyes of some floating voters.

It has to be better to have rising confidence and a strong economy to sell to voters than the alternative. It should pull votes back to the Tories and the Liberal Democrats and there is some evidence of that in the polls. But the better people feel, the less they may fear change. That is why this election is far from plain sailing.

Sunday, March 29, 2015
Don't forget asset prices. Cutting rates is not the right response to zero inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

A big fat zero. No inflation at all. Though it is not guaranteed, a run of deflation – prices lower than a year earlier – seems highly likely in the next 2-3 months.

For many people this is uncharted territory. Though retail price inflation fell to zero in February 2009, and was negative for the following eight months, this reflected the sharp reductions in interest rates of the time. Inflation measured by the consumer prices index (CPI) remained positive throughout.

No, you have to go back 55 years, I suspect before many readers were born, for anything like this. The Office for National Statistics (ONS) has usefully modelled the current CPI back to January 1950. It shows that inflation last fell to zero in December 1959, and was negative by 0.5%-0.6% for three months.

Zero inflation is proving to be good news for the economy. Retail sales volumes rose by 0.7% last month and were a booming 5.7% up on a year earlier. As far as retailing is concerned, deflation is not merely on the way. It has been with us for some time.

So what the ONS describes as average store prices fell by 3.6% in the 12 months to February, a record. Stores include petrol stations, so much of this reflected the drop in fuel prices over the past year. But prices were also modestly lower for both food and non-food stores. Falling prices genuinely are putting money into people’s pockets.

At this point it is customary to warn that, while a temporary bout of deflation is a good thing, you would not want to make a habit of it. Indeed.

There are, however, a couple of other aspects to this. History rarely repeats itself but if we look at what happened when inflation last fell to zero and turned negative, it did not usher in prolonged deflation.

By the end of 1960, inflation was heading back up towards 2%. By the end of 1961 it was 4% and by the middle of 1962 it was 5.6%. The 1960s were not a particularly high inflation period, but even with a very low start, prices rose by an average of 3.4% a year over the decade.

Not only that, but it is easy to forget how recent this experience of ultra-low inflation is in Britain. After four years above the 2% official target, inflation only dropped below it at the beginning of last year. As recently as September 2011, Britain had an inflation rate of 5.2%, and as recently as last 2013, the country’s “natural” or normal inflation rate seemed to be 3% rather than 2%. It is far too early to say whether anything fundamental has changed.

The bigger danger is that this brush with deflation will take central bankers’ eyes off the ball. Before the crisis, the criticism was that the obsession with inflation targets allowed a toxic build-up of risk in the financial system and a huge rise in asset prices, particularly house prices but also financial assets.

There is a powerful echo of that today. At exactly the same moment the ONS released the latest inflation numbers a few days ago, it also published figures showing house prices up by 8.4% on a year earlier. Though this is slightly off the pace of last year, the juxtaposition neatly encapsulated the question I get asked very often: How can inflation be so low when house price are rising so fast? Housing, after all, is a significant component of most people’s expenditure.

Inflation measures do not deal particularly well with housing costs. But those that do incorporate housing, the ONS’s CPIH measure and the old retail prices index, while not showing zero inflation, have it very low; 0.3% and 1% respectively.

Nor is housing the only asset price which has been rising strongly. The stock market had a touch of the wobbles last week but is well up on its level of a year ago. Government bonds, gilts, show a 12-month rise of more than 15% on average.

The Bank of England would say some of this is deliberate. Keeping long-term interest rates low has been an aim of policy, and the counterpart to that is rising gilt prices. The housing market has been part of the recovery story, and a deliberate policy target, and a by-product of that is higher prices. Whether or not there is a government bond bubble remains to be seen but there is not a housing bubble yet, and the parts of London where there was the greatest risk of it has been gently deflating.

The risk, however, is that leaving interest rates too low for too long inflates new bubbles. Already the sharp drop in inflation has persuaded the two hawks on the Bank of England’s monetary policy committee (MPC), Martin Weale and Ian McCafferty, to drop for now their call for higher rates.

Mark Carney, the governor, having tried to pull the markets back from the view that rates were never going to go up, has in recent speeches pushed them out again, citing not only the threat from “persistent external deflationary forces” but also the pound’s rise against the euro. Andy Haldane, the Bank’s chief economist, reckons that “policy needs to stand ready to move of either foot”, and that in his view the next move in rates is as likely to be down as up.

That worries me. Kristin Forbes, another MPC member, rightly pointed out in a London Evening Standard article that most domestically-based measures of inflation are stable. Service-sector inflation, which is above 2%, has actually edged up in the past two months.

To be fair, Carney, along with Ben Broadbent, a deputy governor, made clear on Friday that they will not over-react to the drop in inflation, and that they expect the next move in rates to be up.

The one-off effects of the big fall in oil prices will drop out over the next 6-9 months, though second-round effects could last for a little longer. Even so, the right response for the Bank to either high or low oil prices is, to quote Rudyard Kipling, “to treat those two impostors just the same”.

That means preparing the ground for a gradual “normalization” of interest rates over the next 2-3 years, in other words slowly raising them starting later this year or early next, and forgetting talk of further cuts. After all, nobody would forgive the Bank for squandering the gift of low inflation it has been given, and repeating the experience of the early 1960s. And nobody would forgive it for allowing dangerous bubbles to inflate again. Inflation at zero is a happy accident, it should not be allowed at develop into an nasty accident.

Sunday, March 22, 2015
No roller coaster - but the tail wagged the dog in a curious budget
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This is a strange world, and we have just had a rather strange budget. There was some jam today, though it was spread pretty thinly. There was also less austerity tomorrow, as suggested here last week. But the overall impression was odd.

George Osborne had two aims: to demonstrate that only he can be trusted on the deficit and debt, and to kill the silly idea that he was planning, if re-elected, to cut public spending to the levels of the 1930s.

The fact that achieving both of these aims means, at this stage, merely ensuring consistency with the forecasts of the independent Office for Budget Responsibility (OBR) – which even its best friends would say has a forecasting record that leaves a lot to be desired – added to the Alice in Wonderland quality of all this.

We have policy driven by forecasts which will almost certainly turn out to be wrong and, perhaps even worse, we have a fiscal watchdog, the OBR, which has produced a “rollercoaster” projection for spending by government departments over the next few years (down very steeply then up), which no sane person thinks is remotely likely.

How did it come to this? How did the forecasting tail come to wag the policy dog? Why did the OBR, having given us that 1930s’ comparison after the autumn statement in December, give us the rollercoaster this time?

For Osborne, having determined that he would not fight the election with a giveaway but by reinforcing his reputation as the man who brought Britain back from the fiscal brink, it was necessary to resort to a few gimmicks to achieve his original aim of having public sector debt falling as a percentage of gross domestic product by the end of the parliament.

This, you may remember, was one of his original 2010 aims, but appeared to have been pushed out well into the next parliament in 2012. Wrenching it back again was a coup, though lewss of one than it looks.

I imagine the conversation between Osborne’s team and the OBR went along the lines of; Treasury: “What do we need to get debt falling in 2015-16?” OBR: “Quite a lot because that is not what our forecasts are showing.” Treasury: “What if we sold some assets?” OBR: “That could do it.”

So debt is coming down, from 80.4% of GDP this year, 2014-15, to 80.2% in 2015-16, if the new forecasts are right. To achieve it, Osborne has raided the piggy bank. £13bn of Northern Rock and Bradford & Bingley assets acquired in the crisis will be sold off, as will £9bn of Lloyds Bank shares. Nothing wrong with that – their place is in the private sector – but if the timing of the sales is simply to meet a debt target there is a real danger that taxpayers will not get value for money.

The other imperative, to get away from the charge that he was cutting spending to 1930s’ levels as a percentage of GDP, produced even stranger outcomes. I thought I had been pretty hard on the silliness of this comparison, but the eminent economic historian Professor Nick Crafts took me to task for not being even harder. In the 1930s, he points out, public spending was typically 25% of GDP. Spending on social services – education, health, welfare, pensions and housing – was 9% of GDP, compared with 28% now. Overall public spending by 2020 will be at least nine times what it was in real terms in the 1930s.

Nonsensical or not, Osborne felt obliged to respond to it, hence the bizarre lurch at the end of the parliament, when the projected budget surplus of £23bn for 2019-20 (1% of GDP) is slashed to £7bn (0.3% of GDP). Public spending, having fallen, suddenly starts rising strongly, simply to get the ratio of public spending to GDP up from 35.2% - that 1930s’ comparison – to 36%, Gordon Brown in 2000 before the splurge. The tail, again, is wagging the dog.

Because of this, which I suspect happened very late in the budget process, and because of what in the end seems to have been a serious breakdown in relations between the Treasury and the OBR, we now have little idea about public spending in the next parliament. The OBR will not take account of Osborne’s planned £12bn of welfare cuts and £5bn of savings from reducing tax avoidance and evasion because the former are not coalition policy and have not been detailed, and the latter have not been detailed.

The result is a bit of a mess. I am sure that, as the always reliable Paul Johnson of the Institute for Fiscal Studies put it: “We won’t be on the OBR’s rollercoaster” - whoever is in charge. But the OBR could only work with the material it had and the upshot is that, even with an independent fiscal watchdog and work by bodies such as the IFS, we know precious little about the main parties’ plans. I criticised Labour in 2010 for ducking a comprehensive spending review. It is little better now.

Which is a pity. Even on the OBR’s cautious forecasts, it is quite likely that the lion’s share of austerity is already behind us, given the positive effects of lower inflation and lower interest rates on government debt. Osborne’s claim in the budget that Britain is “walking tall again” chimes with most of the data.

For two years the economy has been growing well, even as deficit reduction has continued. Britain compares well with her G7 peers.

The labour market has been a particular success, with the employment rate a record 73.3%, a near 2m increase in employment in this parliament in the context of public sector job cuts, and the growth in jobs concentrated in full-time roles; 85% of the net new jobs created over the past two years.

Real household disposable incomes per head are an appropriate measure of living standards and, as I have frequently pointed out here and the OBR confirms, will be higher at the end of this parliament than at the beginning. This year should see the sharpest rise in living standards since 2001.

It is a good electoral platform. Osborne’s very obvious message was that all this and more would be put at risk by a change of government. Repeated often enough, it should move the Tory dial up in the polls. It is a pity, however, that the budget, and it should be said Labour’s response, merely reinforces the impression that politicians are playing games with the voters. Transparent, it is not.

Sunday, March 15, 2015
Osborne: some jam today, will there be less austerity tomorrow?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

George Osborne’s sixth budget may not go down as his most memorable – the expectation is that it will be a political rather than an economic event – but it will be no less important for that.

The backdrop to the budget is better than the chancellor might have hoped, and not just the “feelgood” effects discussed here last week. The public finances are also looking a little better.

Price Waterhouse Coopers (PWC) predicts that the fall in oil prices and lower gilt (government bond) yields will reduce the budget deficit in each of the next five years compared with the Office for Budget Responsibility’s autumn statement forecast. The cumulative undershoot, £32bn, is not huge but it not to be sneezed at either.

Goldman Sachs predicts a deficit undershoot of £8bn for this year alone, followed by £13bn next year, 2015-16. Its prediction of £83bn of borrowing this year would take Osborne close to halving the deficit in cash terms, in addition to as a percentage of gross domestic product. Next year’s £63bn prediction would take us closer to normality; in the five years leading up to the crisis, the last government borrowed an average of £45bn a year in today’s prices.

The improving public finances should allow Osborne to sprinkle around a few sweeteners; some jam today. They should include a further raising of the personal income tax allowance, now and next year, as reported by this newspaper last week, as well as populist measures on beer, wine and petrol duty. I think we can safely assume that the chancellor will not take advantage of the fall in oil prices to push up petrol duty.

He is constrained by the fact that the deficit, while falling, is still very large, and that this will still be a coalition budget. But Osborne may still give us some old tunes, such as inheritance tax, if only as an ambition if re-elected rather than hard action.

Though pre-election budgets are often holding operations – Alistair Darling’s 2010 effort did not stick long in the memory – there is nothing to stop Osborne being bolder, and I am sure he will try to be. Setting out a series of announcements that will only be implemented if you are returned to office has a certain appeal.

Can Osborne combine jam today with less austerity – or at least a less austere image – in the next parliament? He has a good recent record of wrongfooting Ed Balls, his Labour opposite number, on the deficit and the recovery. He is helped by the fact that his opponent rarely resists the temptation to exaggerate.

The Balls’ approach is often to think of a number and double it. Balls is intelligent – in a New Statesman profile the former cabinet minister Peter Hain says he has the best economic brain in parliament – and affable. But he comes over as a bulldozer and, perhaps because he is intelligent enough to know when he is laying it on too thickly, never entirely convincing.

So in a speech last week he said Osborne had borrowed “a staggering £200bn” more than he planned in 2010. The true figure, confirmed last month by the Institute for Fiscal Studies, is £100bn.

Balls said wages after inflation are down by more than £1,600 a year since 2010. The true figure, using the consumer prices index he was instrumental in making the main measure of inflation, is £700 a year. Adjusted for the old retail prices index, no longer regarded by the Office for National Statistics as being worthy of national statistic status, the fall is bigger but well under £1,600 a year.

As for public spending, and Balls’s “unprecedented” £70bn of cuts, the figures are clear. In cash terms overall public spending will rise by £43bn between now and 2019-20; the duration of the next parliament (assuming it lasts five years). In real terms there is a planned cut, though less than £20bn. To get to £70bn, or anything like it, you have to add up all the areas where the coalition is planning to increase spending, including public investment, and subtract the rest. It is, to say the least, an odd approach.

That said, as I wrote here on February 8, Osborne has got himself into a less than ideal position on public spending. Spending has been cut by much less than most people think (day-to-day spending has not been cut at all in real terms) yet the chancellor is in danger of being seen as a mad axeman, determined to slash the state for ideological reasons.

The Office for Budget Responsibility (OBR), by saying after December’s autumn statement that Osborne’s plans implied the lowest public spending to gross domestic product (GDP) ratio since the 1930s, 35.2%, gave Labour an economic lifeline. It is an almost meaningless comparison. But it has political force.

Part of the chancellor’s task, therefore, is to convince voters, and sceptical financial markets, that his fiscal plans are credible, and can be delivered without extreme pain. Part of the reason Goldman Sachs is more optimistic than the OBR about the budget deficit over the next 2-3 years but not over the longer-term is because, as its UK economist Kevin Daly puts it, it doubts the spending numbers outlined in the autumn statement will be delivered. If there is another coalition after the election, they may never have to be.

Will the public finances improve by enough to allow Osborne to say that he can meet his ambition of delivering a budget surplus while running higher levels of spending than OBR projections suggest?

Those projections suggested spending would need to fall to 36% of GDP to generate a small budget surplus; slightly higher than when Gordon Brown was chancellor in 1999-2000. But to get a surplus of 1% of GDP, it would need to fall to 35.2%.

Can Osborne cast off those comparisons with the Neville Chamberlain era? He could, though it should be said that the Treasury is playing down the extent of any improvement in the public finances since the autumn statement.

They probably would say that but officials say there are swings and roundabouts: lower oil prices hit North Sea revenues first and may or may not boost other revenues later. Low inflation and gilt (government bond) yields produce some savings on debt interest but the effect should not be overstated.

Even so, the budget this week looks like being a combination of some jam today coupled with a little less austerity tomorrow. Whether it works, and whether it is even noticed by voters, will become clearer in the next few weeks. Depending on what the election throws up it may not, of course, be the only budget this year.

Sunday, March 08, 2015
The feelgood factor's back - will it work for the Tories?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The feelgood factor is often elusive. But it is back. Consumer confidence is riding high, wages are once more outstripping inflation and unemployment continues to fall.

The misery index, invented by the American economist the late Arthur Okun, is arrived at by adding the country’s unemployment and inflation rates together. Currently, with an unemployment rate of 5.7% and inflation of just 0.3%, it is at its lowest level since the late 1960s, according to Capital Economics. Both Capital and Oxford Economics expect further falls – a lessening of misery – as inflation and unemployment fall further.

If misery is in retreat, confidence is strong. The GfK-NOP measure of confidence, which has been running for more than three decades, has risen by 30 points over the past two years, is well above both its long-run average and pre-crisis levels and has not been higher for more than a decade.

The Institute for Fiscal Studies attracted a lot of coverage a few days ago for its report that living standards – real household incomes – are broadly back to pre-crisis levels. In fact that was not news; the Office for National Statistics said as much last year on the basis of its real household disposable income per head measure.

There was, though, plenty of interest in the IFS report. One surprise was that the fall in real incomes as a result of 2008-9 recession, the deepest in the post-war period, was at 4% smaller than the 5.7% drop in the early 1980s. That is testimony to The Bank of England’s alacrity in cutting interest rates hard, Alistair Darling’s temporary fiscal stimulus and the fact that benefits were protected until well into the coalition’s period in office.

The IFS also noted that real incomes are now increasing, if not at a riproaring pace, with some of the fastest increases coming through for young people, who were disproportionately hit by the fall in real wages.

The rise in real incomes now under way should mean this will not, as Labour sometimes claims, the first parliament in living memory in which living standards have fallen. The ONS real income per head measure is still a little lower than it was when the coalition took office in May 2010. In the third quarter of 2014, the latest data available, it was 0.8% lower than in the second quarter of 2010. When the numbers are available for the second quarter of this year, which unfortunately will not be until late September, it should confirm an admittedly small rise in living standards.

Labour appeared to switch in recent days to a safer claim, which is that real wages will fall during this parliament. That is still more likely than not. Since May 2010 average earnings have risen by 8.9% while consumer prices are up by 11.1%. But the gap is smaller than many think, and it is closing, though official earnings growth may be adversely affected in the next couple of months by bonus distortions a year ago.

Even so, the Recruitment and Employment Confederation, in its latest report on jobs, published on Friday, noted that permanent and temporary employment is increasing strongly, and that salaries are rising at a “marked” pace across a range of sectors. Engineering, construction, medical and executive and professional roles are where staff demand is strongest and running up against skill shortages.

Nothing will change the fact that the rise in living standards now coming through compares unfavourably with previous recoveries, as the IFS noted. That is part of the price the economy has paid for the cushioning of the fall in real incomes when the crisis hit. It is also a reflection of weak productivity.

It is mainly, and politicians on both sides should be honest about this, the consequence of the permanent loss of prosperity inflicted upon the economy by the crisis. We lost a chunk of gross domestic product that we will never get back, and weak living standards have been a part of the economy’s adjustment to that.

What we do not know, of course, is whether the improving feelgood factor showing through now will translate into votes. Though there is tentative evidence that the Tories are edging up in the polls, they have yet to decisively break away from Labour. In Britain’s electoral system, where the existing boundaries favour Labour, neck and neck is not good enough for the Conservatives. George Osborne’s March 18 budget, of which more next week, may provide a trigger for stronger Tory support but that remains to be seen.

Though the default position for many pollsters is that elections come down in the end to the wallet and purse, what are known in America as “pocketbook” elections, there are important exceptions to the rule. In 1997, Labour won a landslide victory in spite of the fact that real household disposable incomes per head rose by more than 9% in the three years leading up to polling day.

In 1979, astonishingly, real incomes per head rose by more than 15% in just two years leading up to the May poll of that year but voters rewarded Labour by electing Margaret Thatcher.

In both cases there were extenuating circumstances. For Kenneth Clarke, chancellor in 1997, it was an uphill struggle against public perceptions of a Tory party fractured on Europe, tarnished by sleaze, and living with the embarrassing legacy of Britain’s exit from the ERM (exchange rate mechanism) in 1992. For Labour in 1979, there was the humiliation of the International Monetary Fund bailout of 1976 and, more importantly, the winter of industrial relations’ discontent of 1978-9.

This time, the Tories cannot hope to match the pre-1997 and pre-1979 rises in real incomes, still have issues with Europe and have a harsher image with many voters than the actual austerity the coalition has imposed justifies. Labour has the legacy of being in charge when the economy crashed in 2008-9, a leader who does much worse than his party in the polls and a perception, which even many of its best friends would agree with, that it is not ready for a return to government.

It is better for a governing party to be fighting an election against a backdrop of strongly rising employment and rising real incomes than the alternative. Whether the latter has come too late, and will be enough to overcome voter scepticism, remains to be seen. Either it will be a pocketbook election, or another exception to the rule.

Sunday, March 01, 2015
If Europe keeps growing, Brexit won't happen
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Greece’s negotiations with its creditors have provided us all with an entertaining glimpse into the dysfunctional family that is the eurozone. So we have had Wolfgang Schauble, Germany’s finance minister, playing the part of the stern, unbending father figure, almost taking it beyond caricature.

Yanis Varoufakis, his Greek counterpart, has won admirers for his style and his straight-talking approach, the antithesis of most professional politicians. But ultimately he has been cast in the role of the rebellious teenager who insisted over and over again that he would never tidy his bedroom but has now got the vacuum cleaner out.

It remains to be seen where the Greek episode goes next. Syriza’s tactics have alienated many of its eurozone partners and the “deal” (or no deal) it achieved – which if not nothing was not far from nothing – has led to understandable disillusionment at home. Maybe Greek voters always took their new government’s promises with a pinch of salt but Syriza has made the mistake of over-promising and under-delivering, the opposite of what good governments try to do.

There are further episodes in this family struggle to go but, in a curious way, and despite its dysfunctional aspects, it has probably strengthened the euro. The chances of Greece leaving are smaller than they were, and the risks of other governments seeking to overturn austerity – which in many cases has already run its course – are quite low. Germany may not have won many friends but it has prevented what it would see as fiscal anarchy. “Grexit” – Greek exit – is off the agenda for now, and the 19-member euro lives to fight another day.

Less noticed amidst all this is that the eurozone economy, having looked like something of a basket case just a few months ago, has been quietly gaining strength. Maybe most people and businesses in Europe never took the prospect of Grexit seriously, or if they did were not troubled by it, but the eurozone is looking better, even before this month's bond-buying quantitative easing programme from the European Central Bank.

It began with the official figures for growth in the final quarter of 2014, published earlier this month. Though eurozone quarterly growth of 0.3% was weaker than Britain’s 0.5% expansion, it represented an improvement from the 0.1% and 0.2% increases of the previous two quarters. Some eurozone members, notably Germany and Spain, both of which saw a 0.7% rise in gross domestic product, outperformed Britain.

That improvement has carried through into this year, according to the purchasing managers’ index for the eurozone produced by Markit. Its composite measure for February showed a third successive monthly rise, was at its highest for seven months and showed the fastest pace of job creation since 2011.

Germany’s official unemployment figures showed a 20,000 fall for February, with the jobless rate of 6.5% remaining at a record post-unification low. With two of Germany’s biggest industries – metals and electronics – having struck a 3.5% pay deal, Oxford Economics predicts that this year will see the biggest rise in real household incomes since 1991.

Even France, which seemed to be in real trouble, is looking up. Unemployment fell by more than expected in January, admittedly from a record high of 3.5m, and consumer confidence is rising. Italy, judging from its purchasing managers’ survey, is growing. Ireland, Spain and Portugal are looking better.

Eurozone unemployment remains much too high, at 11.4% of the workforce, but is coming down. Growth in the money supply M3, a necessary precondition for continued economic growth, perked up to a perky 4.1% in January.

Nobody is suggesting, of course, that the eurozone is enjoying anything other than a modest recovery. If it grows by 1.5% this year, a percentage point or so below Britain, it will have done well. The eurozone is benefiting from a similar “good” deflation boost to spending power as Britain, though with a bigger risk that deflation becomes entrenched. But a weaker euro may help head off that danger, while also boosting exports.

Though we sometimes take pleasure in the eurozone’s dysfunctional family tearing itself apart, stronger growth in Europe is good for Britain. Much of the growth disappointment in Britain in the early stages of recovery was down to the eurozone’s woes. The better it does, in general, the better we do too.

The performance of the eurozone also has another important British dimension. If Labour policies worry business, the prospect of an in-out EU referendum is the big concern for many of them about the Conservative agenda.

I think fears of “Brexit” – Britain leaving the EU – are overstated. A few days ago a YouGov showed record support of 45% for staying in the EU (in a question that has been asked since 2010), against 35% of people who would vote to leave. The 10-point margin in favour of staying in was also the highest since 2010.

Attitudes to remaining in the EU reflect two things. One is the state of Britain’s economy. The better that people feel about the economy in Britain, the less they will be inclined to take a risk by voting to leave the EU. The second is the state of the eurozone economy. Support for staying in the EU was just 28% during 2012, at the height of the eurozone crisis, and head of Mario Draghi’s “whatever it takes” commitment to holding it together.

A situation in which Britain’s economy is doing pretty well and the eurozone growing slowly but surely is one in which voters in Britain are likely to opt for the status quo, as they did in Scotland when faced with a similarly big decision last September. Open Europe, a think tank, puts only a 17% probability currently on Brexit.

Things could change, of course, between now and 2017, though other polling evidence suggests that voters will not casually vote for EU exit. When people are asked whether they would want to remain in a renegotiated EU, support is around three to one in favour.

That could change if current evidence of a eurozone upturn proves to be a false dawn, and the euro lurches back into crisis. Those who want Britain to stay in the EU have a vested interest in Europe doing better.

Sunday, February 15, 2015
'Good' deflation boosts growth - will it bring forward rate rises?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is easy to get depressed about deflation. Deflation and depression are linked in the mind for good reason. In what economic historians call the first great depression, which lasted from 1873 to 1896, prices fell by a fifth. In the more familiar second great depression, in the 1930s, prices in 1934 were 12% lower than in 1928.

So why, when these gloomy associations are so powerful, has the Bank of England’s response to the prospect of deflation in Britain in the coming months been something close to hanging out the bunting?

Mark Carney, the first Bank governor to predict deflation (though he prefers to call it “temporarily negative inflation”) since Montagu Norman in the inter-war years – and back then the Bank did not do anything so vulgar as issuing a public forecast – was positively upbeat about the “stronger underlying dynamics” affecting the British economy.

The halving of oil prices over the past six months, the main factor pushing inflation towards negative territory is “unambiguously positive” for the global economy, he said. It is also, according to the Bank, manna from heaven for Britain.

Three months ago it expected real post-tax household incomes to rise by just 1.25% this year. Now it expects a 3.5% increase, which Carney reminded us will be the best for a decade. The difference, by the way, is equivalent to a boost to spending power of roughly £25bn.

Some of this will be familiar territory to those of you who have followed my recent pieces on this theme. This, the Bank is saying, is “good” deflation with knobs on, a gift from America’s frackers and the Organisation of Petroleum Exporting Countries to every oil-consuming economy, including Britain.

It is a very far cry from the “bad” deflation of the late 19th century and the 1930s, when falling prices were the product of economic weakness. Bad deflation which becomes entrenched is dangerous for many reasons, not least because the real burden of debt increases, which further hampers growth. A vicious cycle of stagnation and deflation can develop.

The surprise about the Bank’s “good deflation” assessment is not that it is upbeat but that it is quite so upbeat. Britain will enjoy three more years of overall economic growth of close to 3% (2.9% 2015, 2.9% 2016, 2.7% 2017), driven by strongly rising consumer spending but also robust business investment.

Consumer spending will grow at 3.75% this year and 3.5% next, without a meaningful drop in the saving ratio. Households will be spending out of their strongly rising real incomes, with inflation close to zero for most of this year, and set to drop below zero for a month or two in the spring.

Unemployment will continue to fall. Export growth will outstrip that of imports this year. The members of the monetary policy committee (MPC), far from reading from the depression script, are overcome with optimism. Economic spring has sprung early. Had the Treasury produced such a forecast less than three months before a general election, it would have been accused of producing politically-driven predictions. The independent Bank is, of course, above such things.

There are two questions about this. One is whether the Bank may have overdone the optimism, and is at risk of overdosing on happy pills. The other is whether the net effect of a bout of temporary deflation will end up bringing forward the first hike in interest rates.

Is the Bank over optimistic? In its last published minutes, some MPC members fretted about the response of employers to an inflation rate that will fluctuate either side of zero in the coming months. If workers are experiencing no inflation, or a month or two when prices are lower than a year earlier, why award pay increases? Could pay settlements follow inflation down, notwithstanding David Cameron’s plea to firms to boost wages?

The risk is there but the Bank’s central forecast has chosen to ignore it. Currently, average earnings are rising by less than 2%. This year, it predicts, they will accelerate to a 3.5% growth rate – more than it expected three months ago – rising further to 4% in each of the following two years. Such increases, which imply real wage increases running well ahead of productivity, are central to the Bank’s upbeat forecast.

I don’t think there will be an outbreak of pay freezes as a result of the zero inflation/deflation in coming months. If there was it would elevate the risk of prolonged deflation. But it also looks a bit of a stretch that in this environment earnings will soon be rising at double their current rate. The mechanism is that a tightening labour market – falling unemployment – will leave employers with little option but to be more generous on pay. But it is a big uncertainty.

The other is whether the impact of cheap oil on the global economy will be quite so unambiguously good. There is no doubt that it will be beneficial. The question is whether it is beneficial enough to offset other dampening factors, including the continuing uncertainties in the eurozone.

To take my second question, and assuming the Bank is right to be so upbeat, could this bout of temporary deflation bring us closer to the first interest rate hike since 2007, and the first move in any direction since 2009? Some of the headlines generated by the Bank’s inflation report suggested that it was ready to cut interest rates further and unleash another bout of quantitative easing if the temporary dip into deflation proves to be more enduring.

Though that is true, it is not the message the Bank wanted to convey. It thinks its main response on those circumstances would be to keep interest rates at 0.5% for longer.

The broader message was that this year’s zero/negative inflation will pave the way, not only for stronger growth now but for higher inflation and interest rates later, as that stronger growth feeds through to higher prices. Though this was the first inflation report to allow for the possibility of deflation, it was also the first in a long time to suggest that inflation in just over two years will be above the official 2% target.

That does not mean the MPC is going to shock us with sudden and dramatic interest rate hikes; “gradual and limited” are still the watchwords. It does mean, on this forecast at least, that by the time Carney leaves the Bank in the summer of 2018, he expects to have a few rate hikes under his belt.

Sunday, February 08, 2015
Osborne needs to be careful with that axe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

George Osborne has, in spite of everything, a pretty good story to tell on the budget deficit. The scale of the borrowing problem the coalition inherited in 2010 was huge, and was subsequently discovered to be even bigger.

Yet the deficit has come down significantly. Depending on which measure you choose, and where the final destination for borrowing is, between 55% and two-thirds of the necessary action has been taken. Getting there requires a bit more than one more heave but looks far from impossible.

The question is why the chancellor is choosing to present the task ahead in quite the way he does. Stay with me is his message, and there will be years more of spending cuts. Not only will taxes not be used to help achieve the remaining reduction in the deficit but they will be cut. Merely eliminating the deficit, meanwhile, will not be enough. The aim will be to achieve a permanent surplus. I shall return to this curious pre-election message in a moment.

First, the record, and I draw on the Institute for Fiscal Studies’ always excellent annual green budget, which has been published for more than three decades, and is often more interesting than the budget itself. There is also an interesting new report on debt from the consultancy McKinsey.

What has been the story of fiscal policy on Osborne’s watch? Many people think that in 2010 he pledged to eliminate the budget deficit by the May 2015 election. That is not the case. The aim was to get the so-called cyclically-adjusted current budget deficit down to zero (and beyond), but public sector net borrowing – the overall deficit – was predicted to be 2.1% of gross domestic product this year, 2014-15.

There has been slippage, quite a lot of it, so the overall deficit is officially predicted to be 5% of GDP this year. But that slippage is rather less than often portrayed.

Borrowing over this parliament has been higher than Osborne hoped but, as the IFS points out, the true figure for the cumulative overshoot compared with the coalition’s 2010 plans is £100bn, rather than the £200bn Labour is using in its election literature.

Had the plans sketched out by Labour before it left office been followed, the IFS says there would have been “significantly more borrowing”, which would have deferred but not avoided “the need for greater fiscal consolidation”.

The other misunderstanding about fiscal policy is that the chancellor, worried about a stagnating economy, somehow abandoned deficit reduction in 2012, thereby paving the way for recovery.

Again, that is not the case. What actually happened, as the IFS points out, was that official estimates of the size of the “structural” budget deficit – that which is not dependent on the economic cycle – increased between 2010 and the end of 2012. Osborne could have tried to compensate for that underlying deterioration but chose instead to defer the additional deficit reduction needed until the next parliament.

There are therefore three components to Britain’s deficit problem. There was the structural deficit Labour was running before the crisis, estimated to be between 3.9% and 5.3% of GDP. There was the increase in that deficit as a result of the crisis, and there was the further deterioration when it became clear that the supply-side of the economy – and productivity growth – had been damaged.

How much of the deficit has been eliminated? The IFS, noting Osborne’s aim of achieving a budget surplus of 1% of GDP by 2020, calculated that 55% of the tax has been completed, with 45% still to go. It is worth noting, however, that on the original aim of merely eliminating the current budget deficit (in other words continuing to borrow to invest), the chancellor is rather closer to finishing the job.

The IFS also used figures from the International Monetary Fund to compare Britain with other countries. They show that the scale of underlying deficit reduction in some countries has been staggering. In Greece it has been 20.3% of GDP, Iceland 17%, Ireland 9.9%, Latvia 8.2%, Portugal 8.1% and Spain 6.7%.

Underlying deficit reduction in Britain has been 6.6% of GDP, with 3.5% still to go. That ranks only seventh among advanced economies to date, a far cry from the idea that some kind of mad Frankenstein austerity experiment has been carried out. Another myth, that America under Barack Obama has eschewed austerity, is confounded by the figures. America’s deficit reduction has been 5.8% of GDP, not a million miles from Britain’s.

Indeed, figures I highlighted