David Smith's other articles Archives
Sunday, November 27, 2022
This anti growth coalition is scuppering our prospects
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is easy to get depressed at the moment. The days are getting shorter, the weather has been a bit grim and the country's two main official bodies which produce forecasts, the Bank of England and the Office for Budget Responsibility (OBR), both say we are in a recession which will last for some time. Consumers are downbeat and so are businesses.

The big reason I am depressed this Sunday, however, is that what the former priem minister Liz Truss called the anti growth coalition, which infects the Tory party and has a strong foothold in Labour, has been busy scuppering the UK's growth prospects.

All this is happening at a time when the UK economy is doing badly. Productivity has yet to break out of the stagnation it has suffered since the financial crisis, business investment is embarrassingly weak and our long-term or "trend" growth rate is a pale shadow of what it used to be.

There is no pleasure to be gained from this. Maybe it was inevitable that it happened, given what has been inflicted on the economy, quite a lot of it self-inflicted, but reporting on the UK is a bit like supporting a football team that always loses. I have some experience of that too.

Exhibit One was the government's response to a story this newspaper led with last Sunday, which was that some senior figures were contemplating, over time, a move towards a closer relationship with the EU. Such a relationship could be an adaptation of the Swiss model, a series of bilateral sectoral deals, which was mentioned although has become a source of tension between Switzerland and the EU. But there are other models in which a non-member state could enjoy closer trade relations with the EU, improving on the thin and unsatisfactory deal negotiated by Boris Johnson.

Overwhelmingly, that is what business wants from my experience. The current Brexit arrangements are damaging trade, as the Office for Budget Responsibility (OBR) remined us recently, with the UK on track for a 15 per cent drop in trade intensity. Thousands of small and medium-sized firms have given up exporting altogether because of the red tape now involved in exporting to the EU. Combined that with the clear damage to business investment over the past six years, which is not now expected to get back to pre-2016 levels until the late 2020s, and it is not surprising that we have a serious productivity problem.

And yet, at the mere mention of closer trade relations with the EU, Tory MPs, particularly those of the European Research Group, have an attack of the vapours, forcing Rishi Sunak to say that the government is planning no such thing.

He does not want to be the latest revolving-door Tory prime minister to be brought down since the referendum. Many of those giving him a headache and forcing the retreat used to praise the Swiss and Norway models – both non-members – as well as insisting before the referendum that we could happily stay in the single market.

Almost as bad were the pro-EU ultras, not in this case among Tory MPs, who suggested that the EU would never countenance closer relations with the UK. We should not be defeatist about these things, particularly when it makes no sense.

Business also wants, as it made clear last week, alongside the unions, the government to stop loading it with extra burdens by removing EU-derived laws from the statute book and replacing them with UK laws.

There will inevitably have to be closer economic relations between the UK and the EU in future. The current period reminds me of the 1960s, when businesses could see what they were missing out on and pushed hard for membership of the European Economic Community (EEC). Re-entering the EU is not an option now, nor likely to be for a very long time, but a closer relationship is inevitable in future, if not under a Tory party whose Brexit problem goes deep.

In the meantime, we will suffer the economic consequences. When ministers talk about the benefits of Brexit, such as a freedom to carry out gene-editing in this country, I don’t think they realise how niche that is.

If there is a change of government, it is likely to mean a Labour administration under Sir Keith Starmer. For the moment, however, he appears to be as trapped by Brexit as the prime minister, and this is exhibit two.

A few days ago the Labour went to Birmingham to address the CBI conference, with its call for higher immigration ringing in his ears. As Tony Danker, its director general, put it: "First, we have lost hundreds of thousands of people to economic inactivity post Covid," he said. "And anyone who thinks they'll all be back any day now - with the NHS under the pressure it is - is kidding themselves. Secondly, we don't have enough Brits to go round for the vacancies that exist, and there's a skills mismatch in any case. And third, believing automation can step in to do the job in most cases is unrealistic."

It could almost have been a set-up because Starmer used it as an opportunity to call on business to wean the economy off its immigration dependency and addiction to “cheap labour”.

Close your eyes and it could have been Boris Johnson speaking, though without the Peppa Pig references (though Starmer did sneak one in). It is of course, nonsense. During the period of higher immigration, particularly from the EU, employment rates of UK-born and UK nationals also rose to record highs. The fact that British businesses do not invest enough in trading long predates the rise in immigration of the past two decades and is not a cause of it.

Higher immigration than it expected, particularly from the rest of the world, was the main bright spot in the OBR forecast which accompanied this month’s autumn statement. Higher immigration boosts growth and helps the public finances. There were many special factors in the latest figures, but the Office for National Statistics says net migration in the year to June was a hefty 504,000, the highest on record, though many have not yet been integrated into the labour market.

I know exactly what Starmer was trying to do, which was to try to expunge all memories of his previous position and reassure voters worried that Labour would be soft on immigration. But it is depressing that he has to come to this.

My third exhibit is the Tory revolt on housing targets. Sunak, facing his first big party rebellion, of nearly 50 Tory MPs, was forced to pull a vote due tomorrow on the government’s levelling up bill. Those MPs added an amendment to the bill banning mandatory “top down” housing targets in England.

Under the amendment, local authorities would no longer have to take into account the national housing target, which is to build 300,000 new homes a year, in their own planning decisions. These Tory Nimbys forced a government retreat.

It is hard to overstate the despair with which this was greeted in the housing industry. Builders are being loaded with extra burdens at a time when demand is turning down sharply. One industry body suggested that we were heading, not for 300,000 new homes a year, but just 100,000. Planning reforms were supposed to be part of the supply-side agenda intended to boost long-run economic growth. Not for the first time, it is not happening.

These are not the only areas in which policies could be adopted to boost the UK’s long-term growth prospects. But they demonstrate what we are up against. Margaret Thatcher once said: “I can’t bear Britain in decline. I just can’t.” Whether you agreed with her policies or not, many of us can agree with that.

Sunday, November 20, 2022
Inflation wreaks havoc, and gives us a world of pain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

By now you will have absorbed much of the detail of Thursday’s autumn statement. For some this will have been a painful if well trailed exercise. There were no rabbits out of the hat, in line with Jeremy Hunt’s promises. There were not many laughs either.

For those at the top of the income scale, this has been a cruel autumn. In the space of a couple of months they have seen the abolition of the 45p top rate of income tax dangled before them, only to see it snatched away by the chancellor who announced it, Kwasi Kwarteng, and made more punitive by his successor Jeremy Hunt, with the rate now due to kick in at a lower level of income, £125,140, rather than £150,000.

Not many tears will be shed for the victims of that tax grab. At the other end of the income distribution, people will be pleased by the chancellor’s announcement of targeted measures to ease the energy bill pain. Such help, aimed at pensioners, those on the lowest incomes and people receiving disability benefits will, however, reduce rather than remove an intense squeeze on incomes.

As for those in the middle, a broad swathe which includes what Theresa May used to describe as “just about managing” families, many will be left wondering whether they can in fact just about manage when average household energy bills rise by another 20 per cent to £3,000 in April. Even that price guarantee exposes the public finances to the vagaries of international gas prices, though by less than the Liz Truss two-year freeze at an average of £2,500.

People will also be caught by an even longer freeze on income tax allowance and thresholds, to 2028. Once, becoming a higher rate taxpayer was an ambition, even a badge of honour. Now, creating more higher rate taxpayers is one of many stealth tax rises announced on Thursday.

The big positive of Thursday’s package, though, was that most of the pain is deferred, thus mainly avoiding hitting the economy further hen it is already in recession, the triple whammy I referred to a couple of weeks ago. Markets have to take that deferred pain on trust, and so far mainly are doing so.

There were two key economic backdrops to the chancellor’s autumn statement. The first is inflation, which we heard on the eve of the announcements had hit a new high of 11.1 per cent. Inflation ran through the statement rather like the writing in a stick of rock.

The other significant and related backdrop, as highlighted by Richard Hughes, the chairman of the Office for Budget Responsibility (OBR). Is that what is known by economists as the terms of trade effect will make us a lot poorer. This describes the fact that we are paying much more for those things for which this country is a net importer, mainly energy but also food and other products. It makes us, in fact, spectacularly poorer. The OBR was gloomy about what would happen to household incomes in March, before the full implications of Russia’s invasion of Ukraine were clear. Now it is much gloomier.

Real household disposable incomes per head are predicted to fall by 4.3 per cent this year, 2022-23, the biggest drop since records began in 1956, and by a further 2.8 per cent in 2023-24. This combined 7.1 per cent fall is enormous, and will take real incomes back to where they were in 2013-14; literally a lost decade for incomes. It was a phrase used by George Osborne when he launched austerity in 2010, but as far as the squeeze on incomes is concerned, we really are all in it together.

If you have been wondering why consumer confidence is so weak, there is your answer. GfK has been monitoring consumer confidence since the 1970s and, while it edged up slightly this month, this was from record low levels.
The income squeeze was also highlighted by the latest average earnings figures, which are showing annual increases of 6 per cent for total pay and slightly less for regular pay. While that is too high for comfort for the Bank of England, it is well below double-figure inflation.

Incidentally, if you have wondered why the falls in real wages which lead the news bulletins are not bigger, it is because official statisticians use their preferred measure of inflation, CPIH, the consumer prices index including owner-occupiers’ housing costs, which has inflation running 1.5 per centage points below the 11.1 per cent rate for the consumer prices index. If you prefer the retail prices index, which some do, the fall in real wages is very scary indeed. RPI inflation is running at 14.2 per cent.

Inflation and the terms of trade effect are, then, wreaking havoc on household incomes, which is why the chancellor was keen to say that the government is working in “lockstep” with the Bank to get it down. It is an old trick; the causes of high inflation are global but the credit for getting it down should go to the authorities in the UK. It will be interesting to see if it works politically.

Inflation and the higher interest rate response to it also lie behind the sombre message, backed up with actions, of last week. If you are looking for the single reason why Hunt had to be tough, it is because of the rising bill for government debt interest. That bill, £120.4 billion this year, or 4.8 per cent of gross domestic product, takes us to similar relative levels to those at the end of the Second World War, when debt was about 250 per cent of gross domestic product, compared with just under 100 per cent now.

This year is exceptional, boosted by the impact of very high inflation in the returns on index-linked gilts, but the debt interest bill, has been increased by an average if £43 billion each year from 2023-24 to 2026-27, almost doubling. Without this rise in the debt interest bill, the autumn statement could have been a much more cheerful affair.

One interesting aspect of this is that, as a result of quantitative easing, and the additional commercial bank reserves the Bank created as part of the process, which receive the equivalent of Bank rate as interest, each increase in official interest rates by the Bank’s monetary policy committee comes with a significant bill attached. QE, and its reversal, will cost the Treasury money over the next few years, the OBR predicting that the Treasury will have to transfer a hefty £133 billion to the Bank.

When will the inflation nightmare be over? The OBR, like the Bank, thinks much lower inflation is on the horizon. It expects annual inflation to be just 0.6 per cent in 2024 and for that rare beast, deflation, or a fall in the price level, to occur in 2025, with the consumer prices index falling by 0.8 per cent.

Very low inflation, even temporary deflation, will help a lot, allowing real household incomes to recover. The OBR thinks that this, in combination with a big fall in the saving ratio, will give us 2.6 per cent economic growth in 2025 and 2.7 per cent in 2027. If Liz Truss were still prime minister, she would be proclaiming job doe in raising the economy’s growth rate.

It would be wrong to do so, and those forecasts look rose-tinted to me, even though economies grow faster when they are bouncing back from recession. The OBR thinks the economy’s “trend” or long-run growth rate is 1.75 pe cent, and this is slower than in the 2010-19 period, though looks higher than recent experience would justify.

Overwhelmingly though the picture that we have had of the economy is one of weakness and deep underlying problems, not strength. Productivity growth is expected to be weaker, not least because of the performance of business investment, which is not expected to return to pre-referendum levels until the late 2020s.

The public finances, too, remain very fragile, the chancellor only meeting his softer fiscal rules by a small margin. Even with some uncompromising measures, the government will be borrowing a cumulative £312 billion more by 2026-27 than the OBR expected in March. It is not pretty picture.

Sunday, November 13, 2022
Where did our £50 billion black hole suddenly come from?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

You will have heard a lot about the “black hole” in the public finances that the chancellor, Jeremy Hunt, is grappling with, alongside the prime minister Rishi Sunak, in the run-up to the autumn statement this Thursday. That is not a sentence I expected to be writing a few weeks ago.

I am aware in doing so that it is likely to make anybody who knows anything about science wince. The black hole in this context is the gap, the space, between future tax revenues and public spending, which if wise enough to bust the government’s fiscal rules has to be tackled.

But, as every schoolboy and schoolgirl probably know, and as a useful description from NASA reminds it, that is not what a black hole is at all. As it puts it: “Don't let the name fool you: a black hole is anything but empty space. Rather, it is a great amount of matter packed into a very small area - think of a star ten times more massive than the Sun squeezed into a sphere approximately the diameter of New York City. The result is a gravitational field so strong that nothing, not even light, can escape.”

Anyway, I cannot get out of the habit, but there is another puzzle, not quite as big as the mysteries of the cosmos, that I wanted to tackle today. How did we get into a fiscal mess so serious that Hunt and Sunak have been looking for between £50 billion and £60 billion of annua tax hikes and spending cuts to put the public finances back on track?

There was no hint of it when Sunak was campaigning for the Tory leadership over the summer, merely and rightly pointing out that Liz Truss’s unfunded tax cuts would create such a mess. I shall come back to that.

More importantly, there was little hint of it when the government’s economic and fiscal watchdog, the Office for Budget Responsibility (OBR), assessed the public finances as recently as March. Then, as chancellor, Sunak was able to announce two significant tax cuts. One was to raise the threshold at which people start paying national insurance (NI) to just over £12,500, matching the personal income tax allowance, and thus significantly softening the blow of the increase in NI rates.

The other was a fully costed cut in the basic rate of income tax from 20 to 19 per cent, to take effect in April 2024. That, you may recall, was brought forward to April next year in Kwasi Kwarteng’s mini budget on September 23 but has now been postponed indefinitely, pending what we might hear this week. In the leadership context Sunak promised further cuts in the basic rate, beyond the 2024 reduction.

He was able to do so because, on the face of it, the public finances were in good shape. The two main fiscal rules, government debt falling as a percentage of gross domestic product and the government only borrowing to invest (balancing the current budget), each in the third year of the forecast, 2024-25, were met with a margin to spare.

The debt rule was met by a margin of £27.8 billion, or 1 per cent of GDP, while the current budget rule was met by a margin of £31.6 billion, 1.2 per cent of GDP.

Now, it seems, taxes need to be increased and public spending cut significantly to meet a softer fiscal rule, one in which debt is falling as a percentage of GDP in five years’ time, not three, at which time we could well have a different party in government.

There were health warnings attached to the OBR’s forecast in March, compiled while the implications of the Russian invasion of Ukraine were still unfolding. It noted that the chancellor’s fiscal headroom was no greater than that used by previous chancellors and “could be wiped out by relatively small changes in the economic outlook”.

That is one clue to how things have changed so dramatically. In March the OBR predicted 1.8 per cent growth next year and 2.1 per cent in 2024. Those forecasts look to have been blown out of the window by recent events. The OBR will not necessarily replicate the Bank of England’s economic forecasts, for various reasons, but those forecasts, a 1.5 per cent drop in GDP next year and a further 1 per cent in 2024, show the extent to which things have changed.

Instead of reasonable growth there is recession. On the Bank’s forecasts the economy will be smaller at the end of 2024 than it was at the time of the last election in December 2019.

The big reasons for the shift in the OBR’s assessment of the public finances are, however, inflation and interest rates. In March inflation was predicted to average 7.4 per cent this year and 4 per cent next. Official interest rates were projected to peak at 1.9 per cent next year, in line with market expectations.

That has now changed very substantially. Bank rate is already at 3 per cent and the Bank has not finished hiking it yet. The Bank expects inflation to be 10.75 per cent at the end of this year and 5.25 per cent at the end of 2023. A sustained increase of 1 percentage points in inflation and interest rates adds roughly £20 billion to the annual debt interest bill, according to the OBR. Its new projections for the government’s debt interest payments will make eyewatering reading.

The OBR’s forecast is not the only one in town. You will have seen reports, from think tanks and others, that tax increases and spending cuts are not necessary, either to avoid the errors of post-2010 austerity, or because relatively small variations in forecasts would render them unnecessary.

The National Institute of Economic and Social Research (Niesr), in a pre-autumn statement assessment on Friday, predicted that in the absence of further tax hikes and spending cuts, the economy could grow by 0.7 per cent next year and 1.7 per cent in 2024, avoiding a recession.

It also said that the key measure for the government, debt falling as a percentage of GDP, will begin to occur roughly now, rather than at some distant point in the future, negating the need for further action.

Such alternative views are important, but the only one that matters for the chancellor at present is the one from the OBR. After the drama that greeted the Truss-Kwarteng mini budget, which did not benefit from an OBR assessment, the last thing Hunt could afford to do would be to ignore the OBR. Whether it is right or wrong, it has never been more powerful.

The Truss-Kwarteng episode, most of which has already been binned, will continue to have an impact. It has meant, not only that a thumbs-up from the OBR is essential this week, but also that the new prime minister and chancellor have to bend over backwards to satisfy the markets. Any repeat of the reaction to the September 23 event, even an echo of it, would be disastrous.

Can this week’s measures be delivered without inflicting what I described last week as a triple whammy on a weak economy – higher interest rates, tax increases and spending cuts? The best hope is that enough of this week’s measures are slow-burn enough for their impact to come through only gradually. The virtue of a five-year debt target and stealth tax increases by such means as freezing allowances is that most of the impact comes later.

Hunt and Sunak are determined to fix the public finances and to help the Bank out by bearing down on inflation. They would hope to do that without crashing the economy.

Sunday, November 06, 2022
A triple whammy of rate rises, tax hikes and spending cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Some of you, perhaps not that many, will remember the double whammy. It was used quite effectively by the Tory party 30 years ago, enabling them to win the 1992 general election, against the odds. The double whammy, illustrated with a picture of a very large pair of boxing gloves, were the higher taxes and higher prices that would apparently be the consequence of a Labour government.

These days, a double whammy does not really capture it. The economy is facing a triple whammy of higher interest rates – with another big hike duly delivered by the Bank of England on Thursday – tax increases and spending cuts, of which we will learn more in the November 17 autumn statement. If you want to include higher prices in the mix, we could even make it a quadruple.

Items two and three of the triple whammy, higher taxes and spending cuts were confirmed by Jeremy Hunt, the chancellor, in impromptu remarks at the Sunday Times Business party a few days ago. Businesses and individuals would face higher taxes, he said, and there would be spending cuts across the board. This was not, he said, Treasury expectations management ahead of a big fiscal event, with warnings that turn out be unjustified. He meant it.

The thing about this triple whammy of higher interest rates, tax hikes and spending cuts is that it comes at a time of high inflation, public finances which are shaky enough to concern the Office for Budget Responsibility (OBR) and, by extension, the chancellor and prime minister, but also at a time when the economy is, according to the Bank, already in what could be a long-lasting, if relatively shallow, recession.

Most of the readings we have for economic activity, such as the purchasing managers’ surveys that measure business-to business activity, are at levels that would normally be consistent with cuts in interest rates, not hikes. You do not have to be a Keynesian to think that tax hikes and spending cuts are not what you would normally be doing at a time of economic weakness, The triple whammy pay be what guarantees the recession.

There’s a health warning to be attached to the Bank’s long recession forecast, which that it is conditioned on market expectations for interest rates that may not be fulfilled. But that caveat may be offset by the fact that this monetary tightening is to be accompanied by a fiscal tightening, which is not something that was on the cards even a few weeks back.

A short time ago, we had a prime minister and chancellor determined to avoid recession and go for growth, even by risking the public finances and more prolonged inflation. Now we have a prime minister and chancellor who are not prepared to take risks with the public finances, agree with the Bank that getting inflation down has to be a priority, and are prepared to live with the consequences if they mean that the economy goes into recession. Confused? Perhaps you should be.

The lurch began, it should be said, before Rishi Sunak became prime minister, when Jeremy Hunt junked most of his predecessor’s maxi mini budget and limited the energy price freeze to six months. It was a triumph of Treasury orthodoxy. The question now is how much further it goes on November 17. Two chancellors are running the country, one ex, one current, and even I would conceded that you can have too many of them

There is a template for what Hunt and Sunak are doing, and it goes back 40 years or so. When Margaret Thatcher was first elected in 1979, it was with a determination to bring down inflation and reduce public sector borrowing, the budget deficit, even if that would be painful. The 1981 budget, which raised taxes significantly in the teeth of a recession, was its apogee.

That was the budget which attracted the critical letter from 364 economists, which remains a reference point today. Even recently, some people were saying that economists would be proved as wrong on the “Trusseconomic” unfunded tax cuts as the 364 were in 1981. But no, the majority of economists were proved to be exactly right, as they usually are, particularly when I agree with them.

The hairshirt of 1981 was uncomfortable but it did not stop Thatcher from winning a second general election victory, admittedly against a divided opposition, two years later. By that time inflation had come down sharply and the economy was recovering well, having begun to do so around the time of that 1981 budget. That and victory in the Falklands war saw her home.

This time looks different. I noted last week that most economists expect only a mild recession next year but that we should expect something scarier from the Bank. So it proved and however you cut it, 2023 is looking like a pretty grim year, exacerbated by the impact of the triple whammy.

What could limit the damage? Financial markets have become obsessed with “the pivot”, the point at which central banks, particularly America’s Federal Reserve, realise that they have done enough in raising interest rates, so that the next move will be downwards. We are not there yet, particularly in America, but we should be there in the early months of next year in the UK, particularly when it becomes clear that inflation is on course to head down quite sharply. Some are calling Thursday’s increase in rates by the Bank a “dovish” hike, in that it is possible to see both a slower pace of rate rises from now on and an eventual light at the end of the tunnel.

Full employment, or at least a very low unemployment rate (partly due to a smaller workforce) is another positive. It means that in the housing market we should not see the forced selling that could otherwise precipitate a price crash. For the wider economy, still suffering from labour shortages, it should mean a decoupling between growth and unemployment. In a mild recession, unemployment might not rise by much, if at all.

There is also the factor that at one time was going to be the story of 2022, the unleashing of the involuntary savings built up during the pandemic when people could not spend on the things they normally do. Those savings, of which a central estimate is about £200 billion, are still waiting to be spent. When those who have them feel confident enough to spend, they could make a difference.

Those are potential offsets but this triple whammy still makes me feel uneasy, even if there is no serious alternative to tackling inflation and fixing the public finances. David Owen, a veteran City economist now with Saltmarsh Economics points out that during the period of Austerity 1.0, under David Cameron and George Osborne, investors never questioned the UK’s long-term debt sustainability. The first austerity occurred alongside low inflation and near-zero interest rates.
Now that there is an inflation problem as well as a perceived debt problem things are more uncomfortable, particularly for a government that has ambitions to sort out some of the UK’s deeper problems.

As he puts it: “The combination of a tighter fiscal policy and tighter monetary policy is not the right mix of policies to put forward to try and address the UK’s fundamental problems of a lack of investment and low productivity growth. Indeed, following the EU referendum of over six years ago, we have yet to see the government really put forward a joined-up policy to address all such issues. That will be the true test of the new PM and his chancellor, not whether they have filled what is something of an imaginary hole in the public finances.”

It will indeed. We were in the frying pan when Liz Truss was prime minister. We are still not out of the fire.

Sunday, October 30, 2022
Steady on Rishi, don't overdo the gloom
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Five days on I am still digesting Rishi Sunak’s opening comments when he took over as prime minister on Tuesday. To remind you, he said that the UK is facing a “profound economic crisis”, some of it due to the mistakes made by his short-lived predecessor, which he would seek to fix. Normally you expect to hear this kind of thing when a new government has taken over from another party and cannot believe the state they have left things in.

When James Callaghan entered 11 Downing Street as Labour chancellor in 1964, he found a note in the office from his Tory predecessor Reginal Maudling, saying: “Good luck, old cock …. Sorry to leave things in such a mess.” History repeated itself in 2010, though the other way round, with the infamous “I am afraid there is no money” note from the outgoing Labour Treasury chief secretary Liam Byrne, which he later greatly regretted.

This time of course the wrecking ball was provided by somebody who, until very recently, Sunak sat around the cabinet table with. I took part in a quiz recently in which one of the questions was to name the four most recent chancellors. I obsess about these things and got it right but ask me again in a few years’ time and the names of Nadhim Zahawi and Kwasi Kwarteng may struggle to come to mind. We will wonder whether the Kwarteng chancellorship, like the Truss premiership, was something we imagined, like the dream sequence in Dallas which saw Bobby Ewing eventually restored to life.

Anyway, it really did happen, and created a significant part of Sunak’s profound economic crisis. Incidentally, when people like me talk of economic crisis, profound or not, we are sometimes accused of talking the economy into recession, a particular danger when consumer and business confidence are so weak. It is apparently OK for prime ministers to say so but, and here is the interesting thing, while markets are waiting for the government’s delayed fiscal plan on November 17, one element of the crisis looks to be over.

Sterling is up by roughly 10 per cent from its all-time lows in the wake of the September 23 maxi-mini budget, while the yields on UK government debt, gilts, have come down markedly. The 10-year gilt yield is down by nearly a percentage point to 3.6 per cent at time of writing, while the 30-year yield is no longer 5 per cent but more reassuring 3.7 per cent. The dream sequence has not yet started but it is almost as if September 23 had never happened.

Sunak and Jeremy Hunt, the chancellor, still have some tough decisions to make between now and November 17 but the drop in gilt yields has made their task easier. No longer will the Office for Budget Responsibility (OBR) be basing its debt interest projections on these very high interest rates. The black hole in the public finances, already made greyer by Hunt’s reversal of most of the Truss tax cuts, is not yet closed, but is paler still.

Lower gilt yields, and market rates in general, also mean that mortgage rates, which have already eased back to an extent, should do so further. No longer is the housing market facing fixed rate mortgages of 6.5 per cent plus, with lenders now offering lower rates in response to calmer markets. The job of fixing the public finances is not done but markets have confidence that it will be, which they did not have until the change of chancellor and prime minister.

There is still the small matter of what the Bank of England does on Thursday. The City expects it will follow the European Central Bank (ECB), which raised interest rates by three-quarters of a point, 75 basis points, on Thursday, although some think the Bank will opt for a more modest 50, as with its last two hikes. A 75 basis point increase, taking Bank Rate to 3 per cent, would represent the biggest sustained rise since October 1989. Incidentally, the increases on “Black Wednesday”, September 16 1992, do not count on the record because they were immediately cancelled when unsuccessful in propping up the pound.

The new economic forecasts we will get from the Bank on Thursday need to be looked at in the context of how profound this economic crisis is. According to independent economic forecasts compiled by the Treasury this month, the average new forecast is for a 0.3 per cent drop in gross domestic product next year, in other words a mild recession.

It is quite possible that the Bank will be gloomier than this, as it was in August, its last forecast, but this should be seen as part of its messaging. Its August forecast was based on no further help from the government with energy bills and this week’s forecast, by convention, will be based on market expectations for Bank Rate, which are for a rise to around 5 per cent. A very gloomy growth forecast from the Bank should be seen as a signal that it does not think official interest rates should rise as much as this.

The Bank has a trickier task in forecasting inflation because, as part of the Hunt-Sunak fiscal repair job, the two-year freeze on domestic energy bills, the energy price guarantee, is now only for six months, with a more targeted policy to come into force in April. That will keep measured inflation a bit higher but, given that the Bank thought the freeze would add to, not reduce, underlying inflationary pressures, not raise the medium-term forecast. In August the Bank thought a 3 per cent Bank Rate peak would deliver 2 per cent inflation in two years and less than 1 per cent in three. This week it should say that a lower Bank Rate peak than 5 per cent – I would say 4 – will do the same now.

None of this should disguise the fact that pain is on the way. The cost-of-living squeeze is real and most intense for those on the lowest incomes. For the November 17 fiscal statement, Sunak has to consider whether to reinstate more tax increases – he was very fond of the health and social care levy that had its roots in the now cancelled national insurance hike – alongside spending cuts. There will be unpopular decisions in pursuit of the stability he considers essential for sustained economic growth.

You can call all these things a profound economic crisis but there is a bigger underlying problem, as identified by Sunak when he was chancellor, notably in his Mais lecture at London’s City University in February. The UK’s productivity stagnation is partly explained by low business investment – 10 per cent of GDP in the UK compared with an average of 14 per cent in competitor countries – and insufficient spending on skills on training. UK businesses spend half of the amount their European competitors do on skills’ training.

These were some of the problems Sunak pledged to fix when chancellor, starting with measures this autumn to incentivise business investment despite the coming rise in corporation tax. They should not be forgotten now. Dealing with immediate difficulties is understandably the priority now but there are longer-term problems too, exacerbated by Brexit and the pandemic. A failure to have some kind of plan to tackle them will leave us with a recurring productivity and growth crisis.

Sunday, October 23, 2022
Markets are calmer, but economic prospects are darker
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

The past few weeks have taught us a couple of things, apart from the fact that prime ministers and chancellors do not last very long these days. Fortunately, Jeremy Hunt appears determined to outlast his immediate predecessor at the Treasury and hopes to present the medium-term fiscal plan on October 31. Given the revolving door we have seen, it would obviously be better if he were to remain in post under the new prime minister. A Sunak=Hunt partnership would be well received, but other permutations would be more problematical.

The first lesson of recent weeks is that the traditional complaint of politicians, that nothing they do seems to make a difference, has been comprehensively disproved. The former chancellor Kwasi Kwarteng’s maxi mini budget on September 23 clearly made a difference, and not in a good way, as I do not need to remind you.

Hunt’s scrapping of most of those measures and, importantly, the abandonment of the two-year energy price freeze, has also changed things quite dramatically, calming the markets in spite of political chaos and offering at least a partial fix to the damaged public finances, but with potentially very significant economic implications, of which more in a moment.

Notwithstanding Hunt’s calming measures, the second thing we have discovered is that once you have created a fiscal crisis, it is quite hard to get out of it. Until the government imploded under the now outgoing prime minister, there was no sense that the UK was in a fiscal crisis. Rishi Sunak’s spring statement in March even included a penny off the basic rate of income tax, though not until 2024, which was embodied in the projections for the public finances. That cut has now of course been abandoned indefinitely.

There was pressure on the public spending plans agreed last year because of higher inflation, and most, perhaps all, the fiscal “headroom” left by the former chancellor but two, had been eaten up by events, including the negative impact on growth of the cost-of-living crisis. But the situation was manageable and, as during the pandemic, temporary fiscal support in response to high energy prices was priced in.
Now, despite the many U-turns undertaken by Liz Truss before her resignation, and by Hunt, the fiscal crisis has not gone away. The September 23 budget acted as a wrecking ball, out of which fiscal policy will have to be tighter – with spending cuts and that planned cut in the basic rate of income tax shelved indefinitely – than if it had never taken place. Not only that but some, not all, of the rise in gilt yields, the cost of government borrowing, persists.

This is what makes the economic outlook more difficult than it was. The U-turns have brought down gilt yields from their recent highs, despite the continuing political turmoil and, now that fiscal and monetary policy are pushing in a broadly similar direction – I characterized the Kwarteng approach as push me/pull you economics - should help lower the likely peak in official interest rates. At one time markets saw a peak in Bank Rate of 6 per cent or more, though expectations have eased.

I always thought that a peak of 4 per cent was more likely, and still do so. But this is still nearly double the current rate of 2.25 per cent and more than five times the maximum rate we saw between March 2009 and the end of last year. The chancellor has helped to hose down overexcited money markets, but rates are still going up for households, most notably mortgage rates, and for firms.

Of all the U-turns, though, the most important was on energy prices. When a two-year freeze in household energy prices was announced by Truss on September 8, sadly the day of the Queen’s death, it was a game-changer. It was probably an example of overreach by the state and, as the Treasury now says, having not been allowed to say so then, exposed the public finances to the risks from high and volatile international energy prices.

It was a game-changer because, as Truss often said, it would reduce measured inflation quickly, a probable peak of 13, 15 or 18 per cent over the winter having been brought down to something closer to the latest 10.1 per cent rate.
Looking further ahead, the freeze, which would restrict average household energy bills to £2,500 a year, would guarantee a sharp fall in inflation next year. In the 12 months to September, household gas and electricity bills rose by 70.1 per cent compared with a year earlier and were the biggest contributor to the household goods and services component of the consumer prices index, which contributed about 2.8 per centage points of the 10.1 per cent inflation rate.

Under the freeze, that 70 per cent rise in household energy bills over the past 12 months would have been replaced by something closer to zero over by October next year, pushing inflation down sharply.

Now, while there will be targeted help for those on lower incomes, most households will face significantly higher prices. Cornwall Insight, the specialist consultancy, admittedly offering predictions ahead of the reference period for the new cap, offers ballpark figures of £4,348 for annual bills from April, 74 per cent above the £2,500 level, reducing to £3,697 in July and then heading up slightly to £3,722 in October. If prices were to follow that pattern, October 2023 bills would be on average 49 per cent higher than now.

The dampening effect of the freeze on measured inflation (unlike other energy support it impacted directly on the consumer prices index) would be gone. So, importantly would the key policy initiative easing the squeeze.

It will be interesting to see what the Office for Budget Responsibility (OBR) says on October 31 but we may well be back to the biggest fall in household real incomes since records began in the mid-1950s. In 2023-24, households face higher energy prices, higher taxes and higher mortgage rates. Taxes will go up even if the chancellor does nothing more on October 31 because of the freeze on income tax allowances and thresholds, which will no longer be partly offset by a small cut in the basic rate of income tax. Working-age benefits remain under threat, despite the commitment to honour the triple lock on state pensions.

Can we get through it without a meaningful recession? The energy price freeze, while expensive and poorly targeted, had headed off the most important danger, and many economists thought that in consequence we would have a mild “technical” recession, at worst. I agreed. But the outlook has now become more uncertain.

James Smith, an economist with ING, the bank, describes the change on energy prices as the most “consequential” of the U-turns and is revisiting his base case of a mild recession over the winter. Paul Dales of the consultancy Capital Economics predicts a 2 per cent decline in GDP but warns that “the shift in fiscal policy is generating an extra downside risk”.

The chancellor, in trying to deal with one set of uncertainties, has created another.

Sunday, October 16, 2022
We're still in a mess - and this might help us get out of it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

It is indeed a funny old world, as somebody once said. Elsewhere in today’s paper I analyse the revolving door that now characterises the job of chancellor. To the outgoing chancellor, I can only say: “Alas poor Kwasi, I never knew him.” To his successor, Jeremy Hunt, it is a case of welcome to what may still be a poisoned chalice.

Apart from decidedly skittish markets, perhaps the biggest challenge for the new chancellor will be operating alongside a decidedly skittish prime minister. Credibility and stability were not the words I would use after watching her Downing Street press conference on Friday afternoon. Wooden and unconvincing better fitted the bill.

Until Friday’s dramatic events, I was going to recommend junking much of what was in the September 23 maxi mini budget. But the prime minister, as well as sacking her chancellor, and junking much of here “growth, growth, growth” agenda, got there before me. We are still. however, in a mess, so here are some suggestions about how we might get out of it.

Make sure that the U-turn on tax goes far enough.

Markets thought at one stage last week that the entire September 23 maxi mini budget was going to be scrapped, not just the decision not to proceed with the rise in corporation tax next April from 19 to 25 per cent. That increase has been reinstated, and will eventually raise £18 billion a year, but moat of the other tax cuts remain in place. Taken with the cancellation of the abolition of the 45 per cent additional rate of income tax, there remain some £25 billion of unfunded tax cuts. It is still, if not a black hole, a dark grey one.

It may be that this was the extra pound of flesh that the markets wanted but I would not be too sure about that. The markets are not yet reassured and gilt yields are high, as you might expect when we are onto our fourth chancellor this year and the prime minister’s grip on power looks shakier than ever.

The Bank of England should postpone QT for a year.

QT, or quantitative tightening, is the opposite of QE, quantitative easing. QE involves asset purchases, mainly UK government bonds, gilts. QT involves the sale of the assets brought under QE.

The Bank has intervened directly in the gilt market to try to head off a catastrophe affecting pension funds, an exercise which came to an end on Friday. That catastrophe was a window into what happens when market interest rates rise too rapidly, as they did after Kwasi Kwarteng’s unfortunate fiscal event.
Under current plans, QT will begin in earnest on October 31, the revised date for the publication of the chancellor’s fiscal plan, and the target is for an annual £80 billion in the stock of gilts (currently £838 billion) held by the Bank.

Even before this crisis, the Bank’s QT threatened indigestion in the gilt market. The government will be borrowing a lot more in the market because of its much looser fiscal stance. Instead of the Bank being there to soak up some of that borrowing, its gilt sales will exacerbate the problem, pushing yields – and associated interest rates across the economy – higher. That itself could be a risk for financial stability, as well as bearing down on the economy.

It's an energy crisis, so take it more seriously.

Across Europe, measures are being taken to reduce energy consumption in response to the crisis. In Germany, shops are no longer allowed to keep their doors open on cold days, pouring out expensive energy, many monuments and public buildings are no longer lit up at night, halls and corridors in public buildings will no longer be heated and the maximum temperature in those offices limited to 19 degrees. Italy has introduced Operation Thermostat, lowering temperatures in buildings by 1 degree Centigrade. Many countries have restricted the lighting of shops and illuminated advertising hoardings at night. The European Commission has set a target of reducing gas consumption between August and the end of March by 15 per cent compared with the average of the previous five years.

In the UK there has been nothing, with the prime minister even resisting a public information campaign. In an energy crisis, where supply is restricted and gone up hugely in price, and is being massively subsidised, you need to act on price.

The best way to control public spending is to reform it.

The prime minister, having told the House of Commons on Wednesday that she had “absolutely” no intention of cutting public spending, revealed on Friday that it would grow more slowly than under previous plans. In the language we use about these things, that counts as cuts. Cuts can happen stealthily — by not increasing budgets in line with soaring inflation —and that may be the strategy, But the suggestions is that the government will try to go further than that in reining back spending. Good luck with that, particularly in a situation in which the huge gap between private and public sector pay rises looks unsustainable..

Liz Truss cut her teeth as deputy director of the think tank Reform which, as its name suggests, focuses amongst other things on reforming public services. Such reform is badly needed; nobody would suggest that public services are delivered in the optimal and most efficient way. But you need a coherent programme for that.

Get some more effective active labour market policies in place.

The UK has a workforce crisis which will inhibit growth. The workforce is at least half a million smaller than it was before the pandemic, reversing decades of increases, and labour shortages are rife, alongside this rising economic inactivity.

This country has a long history of “active” labour market policies designed to get people out of inactivity and into work. Today the biggest focus is on the over-50s who have left work and would like to get back into it but need help in training and connecting with employers.

Improve on Boris Johnson’s thin and flawed EU trade deal.

Exports are a key driver of economic growth and the UK’s export performance is very poor, particularly since Brexit. Many small and medium-sized firms who used to export have given up doing so, because of post-Brexit hassle and red tape. The UK’s export engine is sputtering, with overall exports of goods and services in volume terms so far this year down by 7 per cent on 2019 levels, and exports of goods to the EU on the same basis down by 6 per cent. A commitment to developing a closer trading relationship with the EU is essential, before it is too late.

None of these suggestions is rocket science, and there are other things that can be done. But they have to be better than the government’s rabbit in the headlights approach, and its denial of responsibility for what is a very situation.

Sunday, October 02, 2022
They crashed the pound, but mustn't crash the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

You have to hand it to Liz Truss and Kwasi Kwarteng. In less than a month in office they have crashed the pound to a record low against the dollar, destroyed the credibility of UK fiscal policy, brought widespread predictions of a house-price crash and forced the Bank of England to step in with a major market intervention to head off a financial stability crisis. That was threatening something that Tory members and voters hold dear, their pension funds and the assets they hold.

These are world-class levels of ineptitude. In the same month that people across the world saw Britain at its best, with a superbly organised state funeral for the Queen, brilliantly filmed and broadcast by the BBC, we have seen a new administration revealed as a bunch of bungling amateurs. One was soft power. The other is daft power.

Before the chancellor’s “fiscal event” nine days ago, I wrote that what the government saw as shock and awe could well turn out to be shockingly awful. As the economist Jonathan Portes put it, with the classic line from the Italian Job: “You were only supposed to blow the bloody doors off.” Another economist, John Hawksworth, likened it to teenagers breaking into a nuclear power plant to “have some fun” with the fuel rods.

How do we get out of this confidence-destroying made-in-Downing Street mess? The first priority is to admit the errors. While the government and a tiny minority of frankly weird commentators want to blame everybody else, it is crystal clear what has happened. A government that thought it could ride roughshod over basic fiscal convention, having sacked the senior Treasury official who cut his teeth fighting crises, and refusing to call on the services of its own economic watchdog, the Office for Budget Responsibility (OBR), has been punished by the markets, as was inevitable, and we are all suffering the consequences. Promising further tax cuts, as Kwarteng did last weekend, was pouring petrol on the fire.

So it is essential to restore some fiscal credibility. Even an OBR forecast, which will eventually be published on November 23, may not do the trick if it is predicated on unrealistic projections for government spending. Already the talk is of “Austerity II” in which departmental budgets are not adjusted for the high inflation we are seeing and pensions and other benefits are not uprated in line with inflation next April. Let us see how that goes down when it coincides with the reduction in the 45 per cent top rate of income tax, also next April.

The government is said to be looking for efficiency savings to reduce public spending, an ambition always wheeled out at times of difficulty, but usually with little effect.

On the tax side, I suspect that as long as Truss is prime minister any reversal will be regarded by her as “over my dead body”. Stealth tax increases might be another matter. She may not last long as prime minister, and we have learned – again – that leaving the choice to a small number of Tory party members is dangerous, but another change of leader would hardly reinforce the UK’s reputation for stability. A change of government might.

Under this government, the best hope is outside its control. Gas prices have been highly volatile in recent weeks, falling from their highs in response to Europe’s success in filling reserves to see countries through the winter months and falling consumption. If they were to fall decisively it would significantly reduce the cost of the energy price freeze announced by Truss on September 8.

She told local radio listeners on Thursday that the freeze meant nobody would pay more than £2,500 a year for the next two years, though the amount, which in some cases will be much more than £2,500, depends on the type and size of property. Even so, the high cost of the package, and its equivalent for businesses, could come down from the estimated £150 billion or so – estimated by independent forecasters, not the government – if prices were to fall.

That would still leave the permanent tax cuts announced by Kwarteng on September 23 and the hole in the public finances caused by the abandonment of the fiscal repair job that was being undertaken by his predecessor but one, Rishi Sunak. The consequences of them will not be stronger long-term growth but higher government borrowing costs and, closely related to them, mortgage rates.

The question then arises of how much the Bank has to raise interest rates to desal with an inflation problem exacerbated, both in its direct effects and through the weaker pound, by the actions of the government. One route to bearing down on inflation, reversing quantitative easing (QE) through quantitative tightening (QT) has been more difficult by last week’s emergency moves to settle the market. That large-scale bond-buying was not, technically, more QE, but the difference is technical. Selling bonds back to the markets, QT, is harder in this environment.

That puts the onus on interest rates. Before the chancellor’s fiscal event, markets though Bank Rate would peak at 4 per cent or so. Since it, expectations shifted to a more rapid rise, with expectations of a bumper 1.5 percentage point increase on November 3, with further increases taking the Bank to a peak of close to 6 per cent next year. Some are predicting that a 7 per cent rate could be needed.

I don’t think that can or will happen. The Bank’s intervention last week was all about heading off a “material” threat to financial stability. Pushing up rates to those levels would not only crash the economy into recession but it would crash the property market, both of which would represent material threats to financial stability. Yes, the Banks needs to be part of restoring credibility into UK economic policy, which has been so casually damaged, but it is not clear that credibility would be restored by unnecessarily punitive interest rate levels.

It is necessary too to look at the Bank’s motivation for raising interest rates, which is to bring down inflation. In its last set of projections, in early August, conditioned on a rise in Bank Rate to about 3 per cent, inflation was predicted to fall to the 2 per cent target in two years’ time and below 1 per cent, to 0.8 per cent, in three years.

And, while the weak pound and the unfunded giveaways will add to inflation, they will not do so my enough to warrant a Bank Rate above 5 per cent, or probably anywhere near it, That would produce, not just low inflation but deflation, falling prices, and the Bank has no mandate for that, suggesting that the peak for rates should be well below 6 per cent, perhaps 4 per cent, compared with 2.25 per cent now.

Calmer heads need to prevail, and we can only hope they will. The government, far from going for growth, has increased the risk that it will crash the economy. But such an outcome can be avoided, as long as the government does not keep getting it so badly wrong.

Sunday, September 25, 2022
Welcome to Kwasi's world of push me-pull you economics
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Readers with long memories may recall a time when chancellors would announce hikes in interest rates during their budget speeches. This, in the time before Bank of England independence, was usually when the economy needed some nasty medicine, so a rise in interest rates would typically be accompanied by tax hikes, and vice versa.

The past few days have seen something rather different. On Thursday the Bank of England increased Bank Rate from 1.75 to 2.25 per cent, its seventh in a row and the second half-point rise in succession. Until last month, the Bank had never raised by more than a quarter during the independence era, which dates back to 1997.

It could have been more. Three of the nine members of the Bank’s monetary policy committee (MPC) wanted to hike by three-quarters of a percentage point, 75 basis points. While not anticipating Friday’s maxi-budget from Kwasi Kwarteng, they said that the policy of freezing energy prices, at considerable cost to the public finances, “would add to demand pressure” and thus make the task of getting inflation back down even harder.

Then, on Friday, along came Kwasi with the biggest tax-cutting budget since Anthony Barber 50 years ago, according to the Institute for Fiscal Studies. Having leaked part of his statement on Thursday afternoon, revealing that his national insurance (NI) cut would come into force on November 6, a little earlier than expected, he then unveiled a lot more. The Bank would have been prepared for that, and the decision not to go ahead with next April’s planned rise in corporation tax, adding up to a combined £34 billion when fully in place.

More surprising was the other £11 billion of tax cuts, some bonkers, some provocative. Cutting stamp duty is the least sensible use of taxpayers’ money I can think of, at a time when house-price inflation is in double figures and residential transactions are holding up well.

Abolishing the 45 per cent additional rate of income tax – a legacy of the financial crisis – at the same time as lifting the cap on bankers’ bonuses was a combination that the Treasury’s Sir Humphrey, Sir Tom Scholar, would have described as “brave” if he had not been sacked. The 45p rate abolition, which I got wind of a couple of days before the announcement did not cost that much, roughly £2 billion a year, but is hugely symbolic. Together with the move on bankers’ bonuses, it is intended to boost immigration, of international bankers that is. There is still, of course, a higher income tax rate than 45 per cent in the system, the 60 per cent marginal rate that applies on income between £100,000 and £125,140.

Bringing forward a planned cut in income tax to 19p in then pound (from 20p) to April next year is an unashamedly political move but, in tax terms, entirely illogical. The Office of Tax Simplification is being abolished, which is perhaps just as well. Cutting the basic rate of income tax, always the obsession of chancellors from both parties, is a strange thing to do when income tax is being increased through the mechanism of freezing tax allowances and thresholds. Even so, bringing forward the income tax cut at a time when inflation is expected to be still close to double figures will boost demand at a time when the Bank is trying to constrain it.

This a curious state of affairs. You may be familiar with the Pushmi-Pullyu from Dr Dolittle, a strangle, llama-like figure with a head and shoulders at each end of its back. What we are seeing from the new prime minister and her chancellor is push me – pull you economics. The Bank is trying to restrain demand by raising interest rates, while the government is pumping it up with tax cuts and untargeted energy support.

As Lord Macpherson, the former Treasury permanent secretary, who has just seen his successor unceremoniously dismissed, put it: “Historically, the role of UK fiscal policy was to support monetary policy. Now it is to oppose monetary policy. Perhaps, that explains why the long-term cost of borrowing has risen …. We are already paying the price.”

Martin Weale, the usually cautious former member of the MPC and director of the National Institute of Economic and Social Research, warned on Bloomberg TV that the policy conflict and the decision to proceed with large-scale tax cuts would “end in tears”, and could trigger a run on the pound, raising the spectre of the International Monetary Fund bailout of the UK in 1976.

Is there any logic to this push me-pull you economics, apart from the inevitable end product, which is that interest rates will have to rise further and faster than would otherwise be the case? The markets, judging by first impressions, think not.
Sterling plunged after the chancellor’s speech and gilt yields – the cost of government borrowing – recorded one of their biggest increases on record. Markets were looking for credibility, and they did not find it in these announcements.

To be fair to the government, by making the energy price freeze untargeted, albeit at great cost - £60 billion over the next six months alone - Truss has ensured that measured inflation will not rise by too much from current levels. Even the Bank’s hawks say this will restrain inflation expectations “but was not necessarily sufficient to do so alone, given inflation would still be very high for several months”.

To be fair to the chancellor, too, his maxi-budget was not just about a short-term demand boost. The “medium term” is the new sunlit uplands. Growth, he said, would not happen overnight but via the 2.5 per cent target for trend growth in the medium term. The medium term is also when government debt will also be brought under control, he claimed, falling as a percentage of gross domestic product, after first rising sharply.

In a letter to the Bank governor Andrew Bailey before his statement, the chancellor said he was “unashamedly” focused on growth, “which will build stronger capacity to alleviate inflationary pressures”. In the medium-term again.

If we can wait for that medium-term, some of the things he flagged in his speech, which will be works in progress for some time to come, could make a difference. We should be now have learned the lessons of enterprise zones, and ensure that the new, low-tax and low-regulation investment zones create economic activity rather than just pinching it from elsewhere. Measures to speed up the planning process for infrastructure projects could also help, though this has been talked about a lot in the past, with little progress, and need t eb accompanied by meaningful planning reform for housebuilding.

The challenge will be to convert all these ideas lifted from the right-of-centre think tanks into a meaningful plan for growth. The bigger challenge, in the short-term, is to convince financial markets that this is not just a wild excursion into Truss dreamland, a massive gamble with the nation’s finances.

Sunday, September 18, 2022
Rare good news as the misery index dips - but there's a long way to go
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

There has been some rare good news on the economy in recent days. Inflation fell for the first time since September last year, dipping from 10.1 to 9.9 per cent last month and ending a series of upside surprises. The unemployment rate also fell, from 3.8 to 3.6 per cent, pretty much as close to full employment as you can get, and the lowest since mid-1974. I shall dig a little deeper into the unemployment fall a little later, including a technical explanation of why it might have happened.

The misery index, invented by the late Arthur Okun, an eminent American economist, has thus fallen for the first time in a long while. It is the combination of the unemployment and inflation rates, and so is fractionally lower than a month ago but much higher than this time last year and, indeed for many months before that.

Okun also invented the “two successive quarters” definition of recession; gross domestic product (GDP) having to fall for two quarters in a row. As chairman of Lyndon Johnson’s Council of Economic Advisers, he was looking for a way to get LBJ off the hook after some bad economic news. It was a political contrivance and ultimately unnecessary, because LBJ pulled out of the 1968 presidential race. But it has stuck, though not in America, where declaring whether there is a recession or not is the responsibility of the National Bureau of Economic Research’s business cycle dating committee, which is not nearly as much fun as it sounds.

Anyway, the two-quarter definition may soon be tested in this country, depending on how much tomorrow’s bank holiday for the Queen’s state funeral reduces GDP. If that was all that is happening it would be an artificial recession, GDP having fallen fractionally in the second quarter, in which there was also an additional bank holiday. But the economy has clearly lost momentum and is flat at best, even without those special factors.

More on that in a moment, when I return to unemployment. Firstly, what about inflation? The dip in consumer price inflation was not the only bit of inflation good news. What is sometimes called “pipeline” inflation, for producer prices, also edged lower, though remains strikingly higher. Input price inflation, for raw materials and fuels, came down from 22.6 to 20.5 per cent, while output inflation – for prices charged – slipped from 17.1 to 16.1 per cent.

There may be further good news on inflation in the short term. The drop in petrol and diesel prices, the big reason for inflation’s fall last month, has gone further. In August, the average petrol price used by the Office for National Statistics was 175p a litre. The latest, according to the RAC, is 167p.

After that, we will discover that inflation has not yet peaked. The £2,500 energy price freeze level for the average household includes the £400 payment to households the new prime minister has inherited from her leadership rival Rishi Sunak. But that £400 will not be included in the consumer prices index, so energy prices will still be exerting an upward impact on inflation from October 1.
Businesses meanwhile are having to wait for their help.

Inflation will thus rise further over the autumn and winter. Optimists think it will not go much above 10 per cent, pessimists see the peak at closer to 12 per cent.

It is, however, possible to see the light at the end of the inflation tunnel. The “electricity, gas and other fuels” component of the consumer prices index is currently up 69.7 per cent on a year ago. By the autumn of next year, it will be close to zero, and overall inflation will be down to half, at most, its current rate of roughly 10 per cent. The public, I should say, is with ne on this. The latest Bank of England survey of inflation expectations for two and five years ahead shows that they have eased back from 3.4 to 3.2 per cent in two years’ time, and from 3.5 to 3.1 per cent in five years.

There is still pain to go through, with food prices rising at an annual rate of 13.4 per cent, and for the Bank – which is ready to raise interest rates aggressively again this week – “core” inflation is much too high at 6.3 per cent.
The UK and European governments are capping energy prices, and this will hold down measured inflation. Other inflationary pressures, it is assumed, will subside as aa result of economic slowdowns/recessions, partly brought about by higher interest rates, partly the squeeze on real incomes already in place.

That brings me to the second element of the misery index, the lowest unemployment rate since 1974. How can unemployment be falling when the economy has stopped growing? One reason for that is unemployment is a lagging indicator. It responds with a delay to economic growth, so the slowdown may not have taken effect yet.

The technical reason I mentioned was brought to my attention during a webinar a few days ago by Sir Charlie Bean, former deputy governor of the Bank. Many people, I suspect, think the unemployment figures are calculated by using an actual count of people out of work. That used to be the case, when the main measure was the claimant count, which counted the numbers claiming unemployment benefit under its various names.

Now the unemployment and employment totals are taken from the Labour Force Survey (LFS), the largest undertaken by the Office for National Statistics, this year covering nearly 76,000 individuals in almost 35,000 households. For anybody worried that this does not give an accurate picture, a good sample size for, say, an opinion poll would be 2,000.

Those selected for the survey are interviewed five times at three-monthly intervals. Their first interview is Wave 1, through to Wave 5, after which they drop out of the survey to be replaced by others. Now, and this is the point that Bean was making, it so happens that the latest people recruited to the survey, who did their Wave 1 interviews in July, had a very low unemployment rate, just 2.3 per cent, thus dragging down the average, an effect that may continue for some time to come, suggesting that the unemployment rate may have further to fall.

But, and this is important, those latest recruits also had a higher inactivity rate – not in work and not being available for work – 23.4 per cent. It is important because, at present, the low unemployment rate is not a great measure of the health of the labour market. The inactivity rate for people aged 16-64 has gone up from 20.4 per cent before the pandemic to 21.7 per cent now and, judging by the latest LFS cohort, may have further to rise.

Just over 640,000 more people are economically inactive, many due to long-term health issues, though most of these are not long Covid. The rise in inactivity explains why, despite a low unemployment rate, employment is about 330,000 below pre-pandemic levels. It also helps explain labour shortages, along with other factors, including Brexit. The labour market is a long way from being restored to health.

Incidentally, back in 1974, when the unemployment rate was last this low, the labour market was very different. Then, the employment rate among 16-64 men was 91 per cent, compared with 78.8 per cent now; part of that fall being due to more years in education now. It is among women, though, that the change has been striking, with their employment rate up from 55 to 72.1 per cent.

To return to the misery index, it is the unemployment rate that matters. There is still, despite the energy price freeze, a miserable autumn and winter to come, driven by inflation if not unemployment. But we can hope that we will not be so miserable for too long.

Sunday, September 11, 2022
Just wanting a 2.5% growth rate won't make it happen
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

You may have heard enough about the new government already. I call it that because, while it is the same party, it is very different to the one we had until last Tuesday. But bear with me, there are a couple of questions to address.

The first is the impact of the energy price freeze. I am accustomed to using the word bazooka to describe occasions when governments bring out the big guns in response to a crisis. But this very high-cost intervention, like those during the pandemic, takes us towards the Schwerer Gustav as a more appropriate analogy. This was the German heavy artillery – said to be the biggest conventional gun ever – used, though not that successfully, in WW2.

An energy-price freeze is a massive, if untargeted intervention, though so far it is a menu without official prices, in terms of cost. Many of those who condemned it as unrealistic when it was proposed by Sir Keith Starmer have now become great fans. It will bring down measured inflation and help stave off recession. You will remember I and others pointing out that when the Bank of England predicted a significant, five-quarter recession last month, it did not assume any further action from the government, as is its standard procedure. That action has arrived, and it is significant, though it will reduce rather than eliminate the pain for many households and firms.

As an indication of the impact on measured inflation, Goldman Sachs, which a few days ago was suggesting that inflation could peak at 22 per cent early next year, and which had a main forecast of a 14.8 per cent peak then, now thinks the peak will be 10.8 per cent in October.

I use the term “measured” inflation advisedly. As long as gas prices stay high – and there are reasons as I suggested the other day that they might not – this is no more a genuine reduction in inflation than when Denis Healey claimed in the 1970s to have cut inflation at a stroke by reducing VAT. All that is happening is that the inflation is being absorbed by taxpayers, at considerable cost. It remains to be seen how comfortable markets are with that cost. Analysts are already warning of further upward pressure on gilt yields and more sterling weakness. Perhaps paradoxically, they also think this will persuade the Bank of England to raise interest rates by more, not less.

In the meantime, let me turn to another issue, which is the new administration’s ambition to get the economy back up to 2.5 per cent growth, which the chancellor Kwasi Kwarteng reiterated at a meeting with business leaders shortly after taking up his post.

It is an ambition which sounds a bit geeky but which is very important. The economy’s trend growth rate is what determines our prosperity and 2.5 per cent is an interesting number. It is, in fact, exactly the average growth rate for the UK economy since 1949, which is as far back as the Office for National Statistics has formal and reliable data for.

That 2.5 per cent average, however, reflects different experiences for different time periods. Growth was strong in the second half of the 20th century, and the UK outperformed most competitors after joining the European economic Community in 1973. But growth this century has been slower, averaging just 1.8 per cent, and has been particularly weak since the financial crisis, when the average has been just 1 per cent.

Apart from last year’s bounce-back from the pandemic, which followed an even bigger fall in 2020, the only two years of 2.5 per cent-plus growth were 2014 and 2015, s the economy was getting into its stride after the crisis but ahead of the EU referendum.

Pre-crisis, in the 2000s, 2.5 per cent was a very modest ambition for the economy’s trend growth rate. In fact the Treasury, these days thought by the new batch of cabinet ministers to be some kind of malevolent growth-destroyer, used 2.5 per cent as its “cautious” assumption for meeting the government’s fiscal rules, believing that the true trend growth rate at the time was 2.75 or 3 per cent.

When 2.5 per cent trend growth was thought to be the (cautious) norm, it was easily described. Simply put, it consisted of 2 per cent annual growth in productivity, the long-term norm, and 0.5 per cent workforce growth.

Now, 2.5 per cent trend growth looks harder. The Office for Budget Responsibility (OBR), which has always taken a relatively optimistic view on the prospects for productivity recovery, assuming its growth will get back to 1.5 per cent a year after more than a decade of near stagnation. But the OB R also expects the workforce to shrink by 0.1 per cent a year and its estimate of long-run trend growth, published in its Fiscal Risks and Sustainability report in July, is just 1.4 per cent a year. If productivity does not perk up, that might be optimistic.

The trend has been undone by four growth-damaging events; the financial crisis, Brexit, the pandemic and now the cost-of-living crisis. We are back to the age-old question of whether it is possible to waken productivity out of its slumber to get back to the kind of growth we were used to in the past.

Kwarteng, in his meeting with business leaders, was right to focus on “unlocking” business investment as one of the keys to doing this. Rishi Sunak, having identified the problem, was working on this before he stepped down as chancellor. Perhaps his successor will bring forward some of his ideas in coming weeks.

But the challenge of boosting business investment is considerable. Despite a small rise in the second quarter, it remains below pre-pandemic and, indeed, is at pre-referendum levels, despite a large incentive to invest now because of the so-called super-deduction tax incentive.

An excellent new Institute of Government paper by Giles Wilkes, ‘Business investment: not just one big problem’, outlines the difficulty. There are no easy levers for the government to pull to stimulate investment. Merely cancelling next April’s planned corporation tax rise will not do the trick.

“Policy makers once hoped that steadying the macro economy would create the conditions needed for a rise in business investment,” Wilkes writes. “But such stability is often elusive – for reasons both within and beyond the control of politicians … And while macro-economic stability is a necessary condition for growing investment, it may not be sufficient. Nor are the standard recourses of chancellors in the past: financial help for investment, lower interest rates, targeted subsidies or the perennial call for tax cuts. All can make a difference but given the ‘lumpy’ nature of investment none is able to drive new projects when conditions are not otherwise encouraging.”

The policy debate is in danger of getting a bit circular. Business investment would pick up strongly if firms were more confident about UK growth, but long-term growth will not recover without a rise in business investment. It is a bit of a catch-22. Merely talking about growth will not ensure that it happens.

Sunday, September 04, 2022
Slump in sterling and gilts reveals markets' fears for the UK
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

We’ve all done it, and you might describe it as one of those very British problems. You are talking, in hushed tones, and not necessarily unkindly, about somebody in the corner of the room who is hard of hearing. Then suddenly, in an unexpectedly loud voice, they say: “I can hear you; you know.”

I have been thinking about this over the past few weeks, when the Tory leadership candidates, and in particular the frontrunner Liz Truss, have been pitching to the party’s membership about what they want to do to the Bank of England and the Treasury, alongside plans for unfunded tax cuts and spending commitments. For Truss, economic policy appears to consist of telling the Tory membership what it wants to hear.

But there is another audience, which reads the papers, watches TV and listen to the radio, the financial markets. And they, though not the target for the pitch, are saying: “We can hear you; you know.”

It reminds me a bit of some of the episodes of the past few years, when cunning plans to catch the EU out with the latest Brexit negotiating wheeze are briefed to the papers here, on the assumption that Johnny Foreigner in Brussels is incapable of reading them.

August was a cruel month for the pound, its worst for six years against the dollar and pretty ropey against a basket of currencies. Six years ago, of course, it plunged on the referendum result. In the middle of the week there was a neat symmetry about sterling’s exchange rate against both the dollar and euro. Both were at 1.16; $1.16 and €1.16, both massively below what used to be their long-run averages.

People notice the weak pound, directly when they travel and indirectly via higher prices for imports. They may not notice something which is as important, the performance of UK government bonds, gilts. August was also the worst month for a long time for them, with the biggest sell-off since 1994. A sell-off in gilts means a rise in the yield, or interest rate, on them, which in time feeds through to an increase in the cost of government borrowing.

During August, the yield on two-year gilts rose above 3 per cent for the first time since the financial crisis, while 10-year gilt yields rose to their highest for eight years.

Not all of this can be put down to Truss’s economic policy musings on the campaign trail, but judging from some of the market commentary I have been looking at, quite a lot of it can.

Bill Blain, a market veteran who is strategist for Shard Capital, has a big following with his “Morning Porridge” daily notes. One follower is the former chancellor Sajid Javid, curiously a Truss supporter. In fact, I met him at a small breakfast hosted by Javid at 11 Downing Street, two chancellors ago.

A couple of days ago, Blain issued a stark warning. “The UK is at risk of breaking its ‘virtuous sovereign trinity’ of stable politics, currency and bond markets,” he wrote. “Collapsing confidence in politics to stem the slide in sterling and thus gilts, could see the UK stumble into a sovereign financial crisis sooner than we think possible.”
You will remember, after the financial crisis, the then chancellor George Osborne was determined to keep the markets onside and the UK’s sovereign debt ratings intact, to avoid a sell-off in gilts.

Lord Macpherson, Treasury permanent secretary at the time, observed the other day that the combination of a falling pound and rising gilt yields is his former department’s “worst nightmare”. Truss wants to shake-up the Treasury, the Bank and launch her first package of economic measures without an accompanying assessment from the government’s economic and fiscal watchdog, the Office for Budget Responsibility (OBR). The risk is that we are entering a period in which crisis management will be the norm.

Recession fears are growing, with both Goldman Sachs and the British Chambers of Commerce adding their names in recent days to organisations predicting it. Goldman says a further energy price cap in January could push inflation above 22 per cent, which really would feel like a return to the 1970s.

According to Blain, who admits to both voting for Brexit, and for the Tories in 2019, and whose commentary overlays a photo of Truss: “The UK has long prided itself on stable politics. That appears to be breaking down – and it changes global perspectives on UK investment opportunities.”

And, he added: “Sound government by grown-ups would stand a good chance of creating the stability and confidence the UK needs to borrow its way out of the looming crisis. Picking a jury that hasn’t already decided Liz Truss will just be No 4 in line of Tory failures will be a problem. The UK needs a clean start.”

Another commentary that caught my eye was from Steven Bell, chief economist and a director at the fund manager Columbia Threadneedle. In his note to clients, he asks the question: “Will sterling hit parity with the dollar?” I have known him for decades, including at the time when the pound almost did drop to equal just one dollar, in early 1985.

Back then, sterling was regarded as a “petrocurrency” because the North Sea was churning out vast quantities of oil and gas, on a scale that would be rather useful now. The pound fell to just $1.04, in spite of a 4.5 point rise in official interest rates in the space of a month.

Bell now describes what he says is “a deeply worrying background for the UK and sterling in particular”. “If, as widely expected, Liz Truss is the next Prime Minister and responds to the cost-of-living crisis with untargeted tax cuts, the result will be an even wider deficit, higher inflation and perhaps even a political crisis as millions of households struggle to pay their energy bills,” he writes. “Tinkering with the Bank of England’s remit would also worry financial markets.”

The other backdrop is the UK’s large deficit on the current account of the balance of payments, which on an underlying basis reached 7.1 per cent of gross domestic product (GDP) in the first quarter of the year. Mark Carney, the former Bank of England governor, once warned that because of such deficits, the UK was dependent on “the kindness of strangers”. Now the strangers are getting restive and have been selling gilts and the pound.

As Bell puts it: “The UK is running a big current account deficit and the red ink has been flowing for decades. Deficits of this size are difficult to sustain and make currency weakness a real possibility.” He warns that the pound could test its all-time lows against the dollar.

It is not a pretty picture. Of course the new prime minister, assuming as everybody does that it is Truss, could surprise us, and reality replace the froth and nonsense of the leadership campaign. But there is a lot of ground to be made up, and first impressions count, including of a cabinet which, if the advance briefing is to be believed, even its best friends would not describe as being made up on all the talents.

The vultures are circling. The markets have been listening, and they do not like what they have been hearing.

Sunday, August 28, 2022
Debt can only explode when one crisis follows another
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

In the summer of 2021, just over a year ago, I had a long chat with a senior Treasury official – OK it was the former chancellor – who was worried about what the future might bring. At the time, there was a much-quoted estimate from the Office for Budget Responsibility (OBR) doing, which was that a sustained increase of a percentage point in inflation and interest rates would add £20 billion to the government’s annual debt interest bill.

Back then, with Bank Rate stuck at 0.1 per cent, as it had been since March 2020, gilt (UK government bond) yields less than 1 per cent and inflation in July 2021 bang on target at 2 per cent, there did not seem to be too much to worry about.

But Rishi Sunak was concerned, and I owe him, with hindsight, an apology. A few months earlier, at the end of November 2020, in unveiling a one-year spending review, he used the phrase: “Our economic emergency has only just begun.” I and others criticised him for laying it on a bit thick. The economy had bounced back sharply from its slump during the first lockdown in the spring of 2020 and appeared to be coping well with the second lockdown then under way. The prospect was of a strong post-pandemic recovery in 2021.

However, while he could not have predicted the Russian invasion of Ukraine and its consequences, he was right about the emergency. The interlude between end of pandemic restrictions and this cost-of-living and cost-of-doing-business crisis was brief. From the end of the third lockdown in early 2021 to the Russian invasion of Ukraine in February 2022 was less than 12 months. “Normality” was brief; one crisis quickly morphed into another.

It is hard to overstate the seriousness of the current crisis, following Friday’s announcement of the energy price cap for the final quarter of the year. Normally, though it may not always feel like it, household incomes are protected during difficult times for the economy. Real household incomes per head held up well during the financial crisis more than a decade ago, only falling back, but not by much, in the early austerity years after 2010 and after the 2016 referendum.

They also held up well during the recession of the early 1990s and, thanks to large amounts of government support, during the pandemic. That is why the fall in real incomes in prospect now is the biggest since records began at the start of 1955. This is indeed serious.

So it is for business. When the British Chambers of Commerce and others call for Covid-style support for firms during this energy crisis, as this newspaper did last weekend, they know what they are talking about. The increase in energy costs faced by many businesses, notably energy-intensive firms and small and medium-sized businesses (SMEs) represents the difference between survival and closure. Lockdowns are a thing of the past but many, particularly in hospitality and retail, are operating on a partial lockdown basis because of staff shortages and rising energy costs.

Crises, and recessions, are not like London buses. They are not supposed to come so quickly after one another. You will recall that after the global financial crisis, a new one was predicted virtually every year.

As it was, the economy had time to adjust after that crisis, as did the public finances. The budget deficit, which peaked at 10.1 per cent of gross domestic product (GDP) in 2009-10, was down to 2 per cent by 2018-19, the eve of the pandemic.

After the recession of the early 1990s, there was even longer to repair the public finances, though in the event only a few years were needed. A budget deficit of 6.6 per cent of GDP had been converted to a surplus by the late 1990s, the early years of the Blair-Brown government.

This time, after the massive blow of the pandemic, when public sector net borrowing, the deficit, reached a massive £309 billion in 2020-21, 14.4 per cent of GDP, the repair job has hardly begun before another crisis, which will require huge fiscal support, has hit. Even in 2021-22, a recovery year, the deficit was £144 billion, or 6.1 per cent of GDP, close to its peak after the early 1990s’ recession.

Even before the full scale of the energy crisis, the Office for Budget Responsibility was predicting a budget deficit of £99 billion this year, but that has been overtaken by events. The highest forecast for the deficit this year among independent forecasters surveyed by the Treasury is £150 billion, and £130 billion for next year, 2023-24. Even these forecasts do not take into account the full extent of the fiscal support that will be needed during the energy crisis, which is likely to amount to many tens of billions of pounds, possibly even £100 billion or more before the crisis is over, and the revenue impact of the cancelled tax hikes if Liz Truss becomes prime minister.

The profile of government debt, properly measured, is not for the fainthearted. The squeamish should look away now. In 2007, the eve of the financial crisis, public sector net debt was just over £500 billion, or 33 per cent of GDP, well within Gordon Brown’s self-imposed “sustainable investment rule” ceiling of 40 per cent.

By 2010, under the impact of the crisis, the debt had almost double to nearly £1 trillion (£1,000 billion). By 2015, despite coalition austerity under David Cameron and George Osborne, it was up to £1.5 trillion, and 80 per cent of GDP, almost double the “stable and prudent” limit of a decade earlier.

The debt was nearly £1.8 trillion in 2019, having stabilised at around 80 per cent of GDP, but the next shock, the pandemic, pushed it up to a current level of just under £2.4 trillion, or between 95 and 100 per cent of GDP.

What happens now is anybody’s guess, but you would not bet against the debt hitting £3 trillion before too long, and for it to be six times its level in 2007, and for the new norm to be well above 100 per cent of GDP.

There is no alternative to adding to the debt in response to the current crisis, but it comes at the cost of a rising debt interest bill, in the absence of further quantitative easing from the Bank of England, which would be very hard to justify at a time of soaring inflation. When some currency analysts and traders say sterling has taken on the characteristics of an emerging market currency, the UK’s rising debt trajectory is part of the explanation.

Crises are not supposed to follow each other so rapidly. When they do, it is bad news.

Sunday, August 21, 2022
I'm sorry, but both of these have failed the audition
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Never one to pass up the opportunity of a popular culture reference, albeit one that is several decades old, the late John Lennon’s words at the end of the Beatles last live concert – on the rooftop of the Apple (no, not that one) headquarters in London’s Savile Row, were: “I hope we passed the audition.”

I have been thinking quite a lot about that as we have watched the two candidates to be Britain’s next prime minister auditioning for the role. I don’t want to leave you in suspense, particularly since you will have seen the headline, so I can tell you now. No, neither has passed the audition.

Don’t stop reading now because there is plenty more to say. And, I have to tell you, this is not the smartest of career moves. The sensible thing would be to laud Liz Truss, as many Tory MPs and would-be ministers have done since she established herself as favourite, with perhaps just a side-bet of applause for Rishi Sunak. But I have to tell it as it is, so here goes.

Let me start with the frontrunner. Some people have begun to describe her approach as Trussonomics. I think that is going much too far, for I have struggled to detect much, if any, economics in her approach. It pains me to hear people I like and respect, who happen to support her, describing her as having a credible plan for growth.

There is no such plan, save from returning one part of the tax burden to where it was in 2019, when the UK was a weakly growing economy. Income tax is still scheduled to rise, thanks to the four-year freezing of allowances and thresholds, as will the national insurance (NI) burden for similar reasons from April next year even if the NI rate rise in reversed.

Using the expression “supply-side” is not a strategy for growth, and neither are unfunded tax cuts. I hate to say it, given that there was so much wrong with everything else he proposed, but Jeremy Corbyn’s “green new deal” was a more coherent growth plan than anything she has yet come up with.

Vague noises about revisiting the Bank of England’s mandate or establishing a new economic unit in 10 Downing Street, do not cut much ice. Changing the Treasury’s mission to one of growth is also very familiar territory.

Truss is fond of criticising her opponent for “Gordon Brown economics”. Brown made the Bank independent 25 years ago not just to improve the trade-off between inflation and growth/unemployment, which for most of the past quarter of a century it has done, but also so the Treasury could become more of an economics ministry, focused on improving the UK’s long-term performance.

He, the last chancellor to preside over a growth rate for which his successors would give their eye teeth, concentrated on productivity even when it was not obvious that we faced a crisis. On his watch, the productivity gap between the UK and competitor countries narrowed.

Truss, I have to say, comes over a novice on these matters. We can only hope that it is deliberate, and that she is not as economically challenged as she sounds.

Sunak, her rival, has however also been a disappointment during this contest. The economy should have been his strongest card, but he started on the back foot. Before his spring statement in March, I and others urged him to delay the NI rise because of the cost-of-living crisis but, having secured agreement from Boris Johnson to do it, he was determined not to lose the moment.

His claim that the furlough scheme helped limit the pandemic rise in unemployment is certainly true. But many older voters, including some Tory members, did not like the idea of people being paid by the government to sit at home doing nothing, as I know from my email inbox. Hence, I presume, Truss’s clumsy “no handouts” comments in respect of the intensifying cost of living crisis.

Sunak has managed to snooker himself during the campaign, and not just by thinking it was sensible for his wife to maintain her non-dom tax status while he was chancellor..

When inflation is already here, warning that Truss’s tax policies will mean yet higher inflation, which it only marginally might, was not clever. Citing Professor Patrick Minford, a Truss-supporting economist, saying that her tax policies would lead to a 7 per cent Bank rate, was not very clever either. Many older voters would love higher rates on their savings. As it is, Minford has strongly denied to me, and in a letter published in The Times, that he said any such thing.

His attack on the Truss tax policies should always have been on affordability and the magic money tree aspects of it, not inflation. Truss’s Johnson-like “cakeism”, simultaneously promising to cut taxes and increase public spending, and debt, something that normally would resonate to Tory members and the wider electorate, should have been his focus. Public spending will have to be increased furthers, as the Institute for Fiscal Studies points out, to avoid unintended austerity arising from the effects of inflation on departmental cash plans.

As it is, if she were to win, we could find ourselves in a worse position than under Johnson. Though he had to go for repeatedly demanding the office of prime minister, his cakeism was at least balanced by Sunak’s steadying hand at the Treasury. The loyalist that Truss appoints as chancellor, assuming she wins, is unlikely to show such resistance.

It has not just been Tweedledum and Tweedledee in this leadership contest. Both are guilty of one of the oldest deceptions in the book, that that there is a bonfire of red tape, most of it emanating from the EU, to set alight. The Daily Express wrote that “Brexit wonder woman” Truss was going to do so.

You may think that this sounds rather familiar, because it is. Boris Johnson, holding a kipper aloft, as in a fish, promised a bonfire of red tape three years ago and such a pledge was embodied in Queen’s speeches under his government. He was following a tried and trusted route, favoured by many politicians, but such conflagrations never happen.

The EU is a rule-maker, often setting global standards, so businesses wishing to trade often have to abide by those rules. The chemicals industry is currently having to grapple with the much higher cost and inconvenience of adopting home-grown red tape, the UK’s version of the so-called Reach system, knowing that it will also have to meet EU standards to trade. The reality for most businesses, and certainly those that export or import, is that Brexit has resulted in a significant increase in red tape. Both candidates have failed the honesty test over the costs of Brexit.

Both are also guilty of supporting something which fails every test on effectiveness and cost, but which is popular with voters, including Tory members. The policy of sending asylum seekers to Rwanda, if any are ever sent, was the desperate act of a beleaguered home secretary, not a policy for a new prime minister.

Both have also been remarkably insouciant about the economic meteorite heading our way this autumn in the form of a further huge increase in energy prices and the prospect of inflation running at between 13 and 15 per cent over the winter. Consumer confidence has fallen again to a new low, according to GfK, and Truss’s tax cuts are about as useful as a flimsy umbrella in a hurricane in this context.

Sunak has reversed his opposition to a temporary, but untargeted, cut in VAT on fuel, plus another £5 billion in help for low-income household, making £10 billion enough. But he has been constrained by his own edicts on responsible public finances.

Perhaps the one crumb of comfort for him, if the contest goes the way the polls suggest, is that this may not be a great election to win, given the scale of the problems the new prime minister will inherit.

Sunday, August 07, 2022
Looking for a light at the end of a very dark tunnel
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

There was a time when “not for those of a nervous disposition” was the standard warning on particularly scary films, often starring the late Vincent Price, or even books. It could easily have been applied to the Bank of England’s latest projections, or maybe Edvard Munch’s The Scream. The Bank’s latest monetary policy report, published alongside its decision to raise Bank Rate from 1.25 to 1.75 per cent on Thursday, was a horror story.

The rate rise, the biggest in 25 years of independence, was expected, and anticipated here last week. The new news was the Bank’s deep gloom about the economy, with inflation peaking at more than 13 per cent later this year and still being at 9.5 per cent in roughly a year’s time, the economy entering a five-quarter recession at the end of this year and the unemployment rate rising from 3.8 to 6.3 per cent over the next three years.

This would be as the Bank made clear, a Putin recession, brought about by a near-doubling of wholesale gas prices since May, because of Russia’s restriction of gas supplies to Europe, with the threat of more to come.

A recession is not inevitable, a I discussed here last week, and the Bank has different scenarios depending on what happens to energy prices. But another big price shock is inevitable this autumn.

The Bank does not do gloom on this scale lightly. Out of interest I looked back to what it was saying in its quarterly reports in 2008. In May and August, it expected a slowdown, but not a recession. Only in November, after the collapse of Lehman Brothers and the bailout of much of the UK banking system, did it recognise the inevitable.

As the Bank said on Thursday, things could turn out either worse or better than it now expects. Though it does not use the phrase, “slumpflation” has become a better description of the outlook it expects than stagflation. Though he would not be drawn on the Tory leadership contest, the noises off from the Truss campaign about Bank independence do not make the job of Andrew Bailey, the governor, any easier. More on that soon.

It would be very easy at this stage to get overwhelmed by the gloom. But, as plausible as the Bank’s forecasts of very high inflation later this year and well into next, so are its predictions that in a couple of years inflation will be at or below its 2 per cent target and in three years below 1 pe cent and skirting close to deflationary territory; falling prices. This was why one member of the Bank’s monetary policy committee (MPC), Silvana Tenreyro, favoured only a quarter-point rise last week.

I do not diminish the problems that we now face, particularly low-income households and energy-intensive firms. Each day brings new horrors when it comes to the likely path of energy bills in the autumn, and the cost-of-living crisis is bearing down on the economy. The decision to allow the holidaying Boris Johnson to continue as prime minister until his successor is chosen has created a vacuum in government at a time of intense domestic pressure on the economy and worrying international tensions.

But, looking as I always do for reasons to be cheerful, one thing that the Bank has been worried about is inflation expectations. But, despite the surge in inflation to 9.4 per cent (so far) and 11.8 per cent retail price inflation, such expectations appear to be, in the jargon, “well anchored”.

Bank of America’s “Consumer Whisperer” survey suggest that, while people expect higher inflation over the next year, their expectations for inflation over the next five years have come down from the peak of a few months ago and are not much different from normal. Other surveys show a similar picture.

The Bank of America survey also suggests a small rise in consumer confidence, while the longer-running GfK measures suggests that it has stabilised, in each case at very low levels. This may reflect government cost-of-living support kicking in, or that, having weathered the April energy price and tax increase storm, people think that it could have been worse.

Business confidence also edged up slightly last month, according to the Institute of Directors, though its chief economist, Kitty Ussher, notes that “risks in the macroeconomy continued to drive the behaviour of business leaders in July, with concerns around inflation, our relationship with the EU and political instability causing investment intentions increasingly to be put on hold.”

We are not, either, seeing a wage-price spiral. Average earnings growth of 4.3 per cent for regular pay looks like a model of restraint. And, while 6.2 per cent growth in total pay is too high for the Bank’s comfort, some of that reflects that fact that some businesses are offering their own cost-of-living support in the form of one-off bonuses, which are not being embodied in basic pay. The Bank’s agents expect pay increases to average 6 per cent over the next year.

All this could, of course, go badly wrong in the autumn, when the energy price shock enters a new phase. Confidence could tumble, inflation expectations rise and workers demand much more compensation for surging costs. Things will undoubtedly become more difficult and require additional government support, which is not built into the Bank’s recession forecast. It is not, though, as if any of this should come as a surprise, in a way that the spring surge in inflation caught many out.

It is in the autumn that, in the absence of further support, the Bank expects the economy to embark on a recession similar in scale to that of the early 1990s, with a drop in gross domestic product of more than 2 per cent in its baseline projection and the hangover continuing into 2024, when annual growth in the economy is expected to be negative. That early 1990s’ recession was relatively mild in GDP terms but devastating for the housing market, though interest rates were much higher then than now, reaching 15 per cent just before the recession.

There are plenty of reasons to fear the worst, though nothing like that for interest rates. Amid the gloom, we can only hope for the best. The prospect of a significant future fall in inflation is a reason to hope.

Sunday, July 31, 2022
The Bank walks a tightrope - can it avoid falling off?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

It will not be a huge shock if the Bank of England raises interest rates on Thursday. It will, in fact, be a big surprise if they do not do so. After a long period in which you could safely write off any action from the Bank’s monetary policy committee (MPC), which was happy not to raise (or lower) rates for most of the period between the global financial crisis and the Covid-19 pandemic, rate rises have been coming thick and fast.

Thursday’s will be special for three reasons. It will be the sixth rate rise in a row, something which has never happened before. There have been plenty of occasions in the past when official rates have risen more in one fell swoop than the “little and often” changes of recent months.

In January 1985, for example, the then equivalent of Bank rate rose by 4.5 percentage points in an effort, which was successful, to stop the pound from falling to less than a dollar. But the nearest thing to what we are seeing now was in the early period of Bank independence, when the rate rose from 6 per cent in May 1997 to 7.5 per cent in June 1998. This period of tightening, which began last December, is quicker.

The second reason is that, following a broad hint earlier this month from Andrew Bailey, the governor, markets expect an increase this week of half a point, or as they would describe it, 50 basis points. Bank-watchers among economists, I should say, are split on whether it will be 25, a quarter, or 50, a half, with the majority favouring the latter. If it is 50, it will be the first time this has happened in the post-1997 independence era, though you only have to go back a couple of years before that, to early 1995, for the last time it happened.

Thirdly, this should be the week in which the MPC signals its intention to actively reverse its quantitative easing (QE). Bear with me a second on this. I am used to people’s eyes glazing over when I talk to them about QE. A short talk on the subject could usefully double up as a sleep aid.

The transition from QE to QT, quantitative tightening, is even more of a challenge, but it is quite straightforward. QE is the creation by the Bank of money, in the form of reserves, which it uses to buy assets, mainly UK government bonds, gilts. At its peak, QE amounted to £895 billion, with most (just) done since the start of the pandemic. The process of reversing this through QT has already started, through the passive route of not reinvesting the proceeds of maturing gilts, reducing the QE total to £867 billion.

Simply doing this would be a very slow process, however, It would take four or five decades to fully unwind QE in this way, which is why the Bank is about to move to active gilt sales, as well as running down the £20 billion of corporate bonds in its portfolio to zero. Bailey has signalled that combining the passive and active approaches will lead to QT of between £50 billion and £100 billion in the first year. The significance of this is that it complements rising interest rates. It is another way of tightening policy.

I have tried your patience enough. On another occasion, when I have time and space, I will deal with the old and barmy chestnut – why don’t they just cancel the government debt that the Bank has bought? But not now.

For now, let me deal in anticipation with two sets of emails that I know I will get on Thursday, when the Bank does raise rates. One set of emails will be querying vociferously why the Bank has to act at all, and risk tipping the economy into recession, when all the inflation that we are experiencing is international.
The other will be questioning whether the piddling rate rises we are seeing from the Bank can possibly do anything about an inflation rate that is already 9.4 per cent (11.8 per cent for retail price inflation) and heading higher.

I did not want to mention the Tory leadership contest but both candidates should be criticised for scaring people and potentially making a difficult situation worse, Liz Truss has talked of Rishi Sunak’s tax increases inevitably driving the economy into recession, while the former chancellor has been highlighting comments from Patrick Minford, the Truss-supporting economist, that Bank rate, currently just 1.25 per cent ahead of this week’s move, could have to rise to 7 per cent.

A recession is not inevitable. In fact, a range of indicators, including the closely watched purchasing managers’ surveys, retail sales, and the labour and housing markets, suggest that the economy is holding up better than feared. There may be a small fall in gross domestic product in the second quarter, but that would have as much to do with the extra bank holiday for the Queen’s platinum jubilee as underlying weakness.

If there is a proper recession, it will not be driven by Sunak’s tax rises, or the Bank’s interest rate hikes, but the threat from Vladimir Putin of cutting off gas supplies to Europe this winter, a threat which is already producing scary figures for the energy price cap this autumn and underlines the point made here last week that more targeted help for those hardest hit will have to be announced, not across-the board tax cuts.

As for the Bank being too timid, it was last year in persisting with QE when it should have stopped, but since it began to raise rates, it has acted quickly. The idea of a 7 per cent Bank rate being needed is for the fairies. Rates will rise further after this week, but 3 per cent, or 3.5 per cent at a stretch, is the likely endpoint.

For, while gas prices will push up headline inflation, encouraging things are happening below the surface. I can bore about petrol prices almost as much as about QE but in recent days I have seen independent garages dramatically undercutting the supermarkets and selling for as little as 168p a litre, prices not seen since the spring. Oil prices have settled well below levels in the immediate aftermath of the Russian invasion.

It is not just petrol. “Core” inflation, excluding mainly food and energy, looks to have peaked at 6.2 per cent in April and was down to 5.8 per cent in June. Inflation in clothing and footwear has decelerated, as have some other components of the consumer prices index. Inflation is still too high, and will go higher, but there is evidence that policy is starting to work on those parts it can influence. Sterling has also staged a small recovery after the dethroning of Boris Johnson, which will help.

The Bank is treading a tricky tightrope, and it will not keep everybody happy. Its target is a softish landing for the economy, scraping close to but just avoiding recession, though its forecasts this week will be downbeat, and a big fall in inflation, starting next year. It may fall off the tightrope, which is always a risk, but it is right to give it a try.

Sunday, July 24, 2022
Not much headroom for fantasy Tory tax cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Yes, I know you are fed up of the Tory leadership contest already but, if I can be allowed one more go, I have a public service to perform. You will be hearing a lot about tax cuts in coming weeks from Rishi Sunak (not now but later) and Liz Truss (both now and later). And you will be hearing, in that context, about the “headroom” for such cuts.

So what is this headroom? Does it exist, and can it be used now? Or is it a version of the sunlit uplands, something that might or might not exist in the future?

The starting point, and stay with me on this, is that the government has fiscal rules, for which it has legislated. The first is that in the third year from now, which happens to be 2024-25, the last year of the current parliament, government debt needs to be falling as a percentage of gross domestic product.

To meet its rules, the government should also only be borrowing to invest by then, which in the jargon means eliminating the current budget deficit; so not borrowing to fund day-to-day spending. There are a couple of other rules, but I won’t detain you with them.

According to the Office for Budget Responsibility (OBR), those rules will be met with room to spare in 2024-25, by £27.8 billion on the debt rule and £31.6 billion on the current deficit rule. There will, in other words, be a current budget surplus of that amount then, on official projections.

Those projections include the 1p cut, to 19p in the pound, in income tax that Sunak announced in his spring statement. They suggest on the face of it that the next prime minister could order his or her chancellor to cut income tax by a further 4p or 5p in the pound, or VAT by 3 or 4 percentage points, just before the next election.

Those are the numbers, but they raise questions. The first is, why wait? Struggling households and businesses would love tax cuts now, not wait for them.
The answer to that is that the headroom does not exist now. The government will still be borrowing for day-to-day spending this year, 2022-23, to the tune of £42.7 billion, within an overall budget deficit of £99.1 billion.

Figures on Thursday, showing public borrowing of £22.9 billion last month, £4.1 billion more than a year earlier and £15.6 billion bigger than the “normal” month of June 2019, suggest that both measures are heading for a significant overshoot compared with the OBR’s forecasts. The public finances are very far from being fixed. Some of this reflects the impact of higher inflation on index-linked gilts, the bill for which will have to be paid in the future.

The second problem is that the headroom only exists because of Sunak’s tax increases. That is why, on the OBR’s projections, a current budget deficit becomes a small surplus next year, 2023-24, and a bigger one in 2024-25. Take away the national insurance increase, the four-year freeze on income tax allowances and thresholds and next April’s increase in corporation tax from 19 to 25 per cent and the rules would be broken I shall come in a second to whether that should matter for a new prime minister.

These are not the only issues. The headroom identified by the official forecaster in 2024-25, roughly £30 billion taking an average between the two calculations, would have been half as much again, if not for the additional cost-of-living help announced by Sunak in recent weeks. It is unlikely that he will ever return as chancellor but his successor, whoever that be, is likely to have to return to this in the autumn, when the cost-of-living squeeze is set to intensify, with a frighteningly large increase in the energy price cap in prospect in October. It would not take many more of these interventions, or as the OBR has warned, further shocks, to use up the headroom, which it says could be wiped out by relatively small changes in the economic outlook.

Not only that, but public services face a further squeeze. The public sector pay settlements announced last week, averaging 5 per cent, will eat into what is left for public services, unless topped up by the government.

Ben Zaranko of the Institute for Fiscal Studies says that this could require “painful” cuts, and a recognition that, in the face of economic shocks there will be less available for public services. Boris Johnson was very keen to avoid the impression that his government was returning to the austerity of the David Cameron/George Osborne years. His “offer” was of more money for public services, paid for in large part by additional taxes on business. Any top up for the public sector, in response to the pay awards, would further eat into the headroom.

Where does this leave us? Many businesses I talk to are hostile to next year’s planned corporation tax increases and would love it to be scrapped. Tax increases are his Achilles’ heel among the Tory membership, but he will hope that what used to be traditional values of fiscal discipline will trump them.

Truss’s unfunded tax cuts are problematical, an almost Pavlovian response to what she thinks Tory members want to hear. There is form on this. Johnson, in his successful leadership bid in 2019, pledged to raise the higher rate threshold – the point at which people start to pay the 40 per cent rate of tax – to £80,000. Even without the pandemic, that was never going to happen.

The affordability of tax cuts is a bigger issue than whether they will add to already-high inflation. They might, but not by much. Truss, who insists she is not modelling herself on Margaret Thatcher, cited the veteran economist Patrick Minford in support of her view that they would not. This brought to mind the time, in 1981, when Thatcher was asked by Michael Foot to name two economists who agreed with her on austerity. She said: “Alan Walters and Patrick Minford.” And, in the car afterwards: “It’s a good job he didn’t ask me to name three.”

As a new prime minister, Truss could rewrite the fiscal rules, or hope that the OBR has been too gloomy, particularly on the balance of the impact of higher inflation of tax revenues, government spending and debt interest. But markets could be very wary, and Citigroup has already warned that her economic approach presents the greatest risk to UK economic stability.

One thing we should be wary of is that there is a promised land of lower taxes ahead of us. Even if the roughly £30 billion of headroom was used to reduce taxes, the tax burden at the end of this parliament would still be the highest in decades. That headroom, as noted, can easily be used by then. It may be a mirage.

The new prime minister has to be honest about this, particularly after the repeated deceptions of the past three years. You can cut taxes, but only if you are prepared to reduce the size of the state or borrow more. Both candidates know this. They need to admit it.

Sunday, July 17, 2022
Economic supremacy? Not if our population is falling
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Population does not get as much attention as it deserves in economic discussions. So, to tear your attention away from the Tory leadership contest, let me try to fill the gap. A few days ago, the United Nations came out with new global population projections for China and India. They showed, not only that the world’s population will reach 8 billion on November 15 this year, which is scarily precise (and on its way to 10.4 billion by the end of the century) but that India will soon overtake China as the world’s most populous country.

This will happen, according to the UN, next year. The writing has been on the wall for China’s population for some time, mainly but not entirely because of the now-relaxed one-child policy. The country’s population will start to fall very soon, while India’s will continue to grow. By the middle of the century, on current trends, the UN estimates that India will have a population of 1.67 billion, China 1.32 billion. India will not close the economic gap with China immediately but, thanks to stronger population growth, will soon start to do so.

There is also some population news at home. The Office for Budget Responsibility (OBR), the government’s economic and fiscal watchdog, published its new ‘Fiscal risks and sustainability’ report earlier this month. There was a lot of interest in there.

For me, one striking finding was that the UK, like China, is heading for population decline. Before explaining why, we should remember how much this matters. The size of the future population is vital for civic planning, including how many new houses, school places, hospitals, and so on, we will need. It is a key metric for many businesses. It matters for the public finances and it matters for he economy’s ability to grow.

Three factors are weighing down on future population growth. The first is a declining birth rate. You may remember a couple of years ago, some people predicted a lockdown baby boom. The opposite, however, occurred. The UK’s total fertility rate fell in 2020 to a record low and appears to have settled there. The OBR now assumes a birth rate of 1.59, compared with 1.84 in its previous long-term assessment four years ago. A smaller number of births means that that the so-called young-age dependency ratio – those aged 15 and under as a proportion of 16-64 year-olds – will drop from 30 to 25 per cent, with implications for education, children’s services and businesses selling children’s products.

The second factor is a slowdown in the improvement in life expectancy. We have had features in this newspaper about babies born now routinely expecting to live beyond 100, but for a while now this has been going in the opposite direction. The OBR, for example, used to assume that women born in the 2040s could expect to live to an average age of 96. Now, based on changes already occurring, it is less than 93. The effect of low life expectancy, apart from reducing population growth, is to reduce the old-age dependency ratio in the short-term but raise it over time.

The third factor is, of course, migration, an important driver of population growth. The OBR now assumes net migration of 129,000 a year, compared with a previous forecast of 165,000 and the current assumption of 205,000a year used by the Office for National Statistics.

These are important changes and, as the OBR notes: “Taken together these three changes reduce population growth from an average of 0.3 per cent a year over the next 50 years in our 2018 projections to minus 0.1 per cent a year in these latest projections. 5 Indeed, the population peaks in 2044 at 68.4 million and falls to 65.9 million by 2072, the first time our projections have been based on a declining population.”

This is important. A few years ago I wrote a book, in one part of which I looked at this topic.I don’t want to seem like a desperate book plugger, so I won’t mention the title. When I wrote it, just ahead of the EU referendum, the UK appeared to be on course to become the biggest economy in Europe, driven by population. Projections then, from both the UK’s official statisticians and the United Nations.

The UK’s population was on course to reach 73 million by 2050 and 77 million by 2100, outstripping France and Germany by enough to compensate for this country’s productivity gap with our main competitors.

That, it seems, will no longer happen. Taking the OBR’s projections and combining them with new ones from the UN, Germany will continue to have a larger population this century. The UK’s dreams of population-driven economic supremacy in Europe look to be over, for this and other reasons.

There will be some people reading this whose response to the prospect of a gently declining UK population will be one of delight. We live on an overcrowded island, parts of which are sparsely populated but in others we live cheek by jowl.

It is a point of view, but it has to be set against the economic impact of a low birth rate and a reduction in the inflow of working-age migrants to top up the labour force and maintain the economy’s flexibility. Some would say that we have passed the point of no return on that already.

Meanwhile, though they might not live as long as previously expected the proportion of older people will grow. The old-age dependency ratio – the percentage of people aged 65-plus relative to the 16-64 population – is current just over 30 per cent. It is projected to rise to 50 per cent over the next half century.
Politicians would love the UK to be more like America or the faster-growing Asian economies in the future. The demographic outlook means that the UK risks “Japanification” and being more like Japan, with its ageing and declining population and slow growth.

It means, more than ever, that the next prime minister, whoever it may be, must have a relentless focus on productivity and growth.

Sunday, July 10, 2022
PMs and chancellors change - but economic reality remains
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

I do not expect much sympathy but spare a thought for those of us who must write an economics column, with a deadline, in current circumstances. Every few minutes I have had to pop away from my desk, not to see what is happening in the tennis, but to see whether the person just appointed chancellor is still chancellor and, if so, how long that is likely to be the case.

Rishi Sunak is definitely no longer chancellor, having resigned a few days ago after two years and just under five months in the job. In his resignation later, he said he was leaving what could be his last ministerial job, though it would not be a huge surprise if he were back at some point, possibly even as chancellor under a new prime minister, if he does not get the top job himself.

That would be no bad thing. Two years or so is not long enough to create a legacy as chancellor. His great hero Nigel Lawson, who also resigned having found it impossible to work with 10 Downing Street, was chancellor for more than six years. Sajid Javid, Sunak’s predecessor, had an even shorter time, never even presenting a budget. Neither should be lost to the country.

I found Sunak to be engaging, outgoing, intelligent, hard-working and with a curiosity and hunger for new ideas. He was very keen on something I wrote, explaining how cuts in the corporation tax rate had not prompted an increase in business investment, which helped him with the argument for increasing the tax.

His response to the pandemic, including the furlough scheme, something we had never seen before, was swift and sure-footed. It was no accident that this response was put in place at a time when Downing Street was preoccupied by the health challenges of the pandemic.

It was only later that the “fundamentally different” approaches Sunak referred to in his resignation letter came through. His aim was to fix the public finances first and cut taxes later, taking his leaf out of the Thatcher government in the 1980s. The tax burden rose for its first few years but fell later.

It was not illogical. The Office for Budget Responsibility (OBR), in its latest ‘Fiscal Risks and Sustainability’ report, thinks government debt will edge lower relative to gross domestic product in coming years. The former chancellor, in the OBR’s view, had some room to cut taxes later in this parliament, roughly £30 billion. He had reason to think that he could go well beyond the promised 1p cut in the basic rate of income tax.

The trouble with his strategy was that it involved raising taxes substantially now, lifting the tax burden to new highs. And the trouble with that, as the OBR pointed out, is that cancelling tax increases that were already in the bag for the future public finances more than removes that room for manoeuvre. Sunak’s big three tax hikes: raising corporation tax from 19 to 25 per cent next year, freezing income tax allowances until 2026 and raising employee and employee national insurance, will between them be raising more than £50 billion a year in additional revenue by 2024-25.

As it is, for now at least, Sunak leaves the Treasury as the instinctive tax-cutter who, largely because of the pandemic, become a big tax-hiker. Every chancellor leaves office with regrets, with a huge amount of unfinished business, but his bulging file of unfinished was bigger than most. His resignation was pivotal to the unseating of a terrible, chaotic prime minister, who was never suited to high office, but that may not be comfort enough.

His successor for now, Nadhim Zahawi, is somebody I know, but not as a politician. Before he ventured into more controversial oil businesses, he was one of the two founders of YouGov, the polling organisation. The other was Stephan Shakespeare. There is a certain neat symmetry in the fact that Zahawi’s parliamentary constituency is Stratford-upon-Avon.

Both worked for Lord (Jeffrey) Archer, when he was running to be London mayor in the late 1990s, before scandal intervened. The business that became YouGov, internet polling, was originally intended to provide instant democracy, with Archer testing his ideas on the public. The Sunday Times began to use YouGov in the early 2000s, at a time when many people were sceptical of internet polling, and I was responsible for it on the paper. Times have changed. Out initial polling was to gauge whether there was public enthusiasm for the UK joining the euro, at the time the hot political topic of the day.

Zahawi did well with YouGov, and he has done well politically over the past couple of years, first as vaccines minister, then education secretary, now chancellor.

Interviewers have been desperate to get him to commit to early tax cuts, but he has been commendably guarded on that. He has got out of, I think, having to deliver a big economic speech alongside Johnson shortly, though you never know. In theory there should be no big political announcements during the period when the Tory party is selecting a new leader, particularly if Zahawi enters the contest himself, but you never know about that either.

The problem for the new chancellor is the same as the problem for the old chancellor. Inflation is at a 40-year high and is going higher. For the next 12-18 months there will be no growth in the economy, at best, and there is not much that can be done about that.

Tory MPs and party members want tax cuts, but they also want fiscal disciple – control over government borrowing and debt – and extra spending on the NHS backlog, new hospitals, levelling-up infrastructure, and so on. They would rather teachers and other public sector workers did not go on strike and that the country worked better than it is now.

Economics is sometimes defined as the allocation of scare resources and there is a strong element of that in the job of chancellor, which is to try to reconcile competing and apparently irreconcilable demands. The new chancellor could make himself popular with the Tory faithful by scrapping all Sunak’s planned tax increases and, for good measure, announcing a temporary cut of 5 percentage points in VAT or income tax.

Temporary broad-based tax cuts would, however, add to and prolong the UK’s inflation problem and be poorly-targeted. Not proceeding with the announced tax increases, including corporation tax, may have appealed to an innumerate prime minister but should not be contemplated by a chancellor, unless there are alternative ways of funding it. “Cakeism”, wanting to have your cake and eat it, should be out of the door too.

The more borrowing and the more debt there is now, the more that the country will run into the demographic and other pressures which, as the OBR highlighted, face this country over the next 50 years, and which will push up government debt to what is says are unsustainable levels.

As for Sunak, his best moment was probably his Mais lecture at City University in February. It provided a diagnosis of the many weaknesses in the UK economy that he hoped to fix, including lower business investment and much less spending on skills than competitors.

He was also clear on tax, saying: “I am disheartened when I hear the flippant claim that ‘tax cuts always pay for themselves’. They do not. Cutting tax sustainably requires hard work, prioritisation, and the willingness to make difficult and often unpopular arguments elsewhere. And it is hard to cut taxes at a time when demands on the state are growing.”

It is a quote to be pinned up on every chancellor and MP’s wall.

Sunday, July 03, 2022
One crisis killed off productivity - will this one resurrect it??
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Anybody who has travelled by plane recently, as I have, or waited on the phone for a customer services department, or seen the many notices around cafes, bars and restaurants screaming out for staff, will know that the country is beset with labour shortages, of the kind we have not seen for a very long time. The question for today is whether this will bring about something that is essential for our long-term prosperity, a productivity revival.

Before trying to answer that question, some background, courtesy of the Productivity Commission, established by the National Institute for Economic and Social Research (Niesr), as part of the Productivity Institute. It published its evidence review recently, and the results are striking.

For three decades after the Second World War, during the so-called golden age for the world economy, productivity measured by output per hour worked grew by an average of 3.6 per cent a year. In the next three decades, it was 2.1 per cent a year, on average, a figure we have come to associate with long-term productivity growth for the UK.

But then, around the time of the financial crisis, the lights went out. Productivity growth over the 2008-2020 period average just 0.5 per cent a year, or 0.2 per cent from 2007 to the pre-pandemic year of 2019.

For those who are interested in economic history, this is quite something. Productivity growth in the period since the financial crisis has been weaker than at any time since the dawn of the industrial revolution well over 200 years ago.

The Productivity Commission deliberated on whether to date the start of the slowdown to the crisis. One theory was that US productivity began to slow about two years before 2007-8, so on the catch-up theory the UK may have experienced a slowdown anyway. But it settled on the financial crisis as the point where reasonable growth in productivity was replaced by near-stagnation.

All countries experienced a productivity slowdown after the crisis, but the UK’s slowed more than others. Some of that may be because of the fact that the post-crisis recovery in business investment, necessary for lifting productivity, was snuffed out by the referendum, and stagnated for more than three years, long before it took a further hit as a result of the pandemic. Business investment in the first quarter of this year was at its lowest for eight years.

This matters. Niesr calculates that, has productivity growth since the crisis grown in line with that 2 per cent average since the crisis, workers in the UK would be an average of £5,000 a year better off. As it is there has been a prolonged squeeze on real wages. Official figures show that regular and total pay in real terms is barely above, at best, the early 2008 level.

The Productivity Commission would admit, I think, that there was no lightbulb moment in the evidence it gathered. The UK’s weak productivity is due to low business investment, inadequate infrastructure, insufficient innovation, low skills and one of the most centralised economies in the world.

There are provisional recommendations of what needs to be done. It calls on the government to support more collaboration and business networks “to help firms develop new products, processes, and organisational methods that result in productivity growth”. This is sometimes called open innovation.

Meaningful regional devolution and a decentralisation of decision-making away from London and the southeast could address “weak institutional capacity to improve productivity in other regions and cities”. The same is true of the private sector, where financial institutions which could promote investment and innovation are also heavily concentrated in the capital. Government short=termism, evident in this government’s decision to abolish its industrial strategy council, is a problem.

Much more needs to be done on skills, where UK spending, public and private, lags well behind competitor countries and women, in particular, are not encouraged or incentivised to acquire the skills they and the economy needs. We also need a coherent long-term plan for infrastructure investment and, as the chancellor would agree, lift business investment to similar levels as in other countries.

That brings me on to the question I asked at the start. Will labour shortages prompt the investment, including automation, that could raise productivity? It needs to happen. Latest official figures show that output per hour fell by 0.7 per cent in the first quarter and, while it was 1.9 per cent above pre-pandemic levels, the statisticians said, “no fundamental change in productivity behaviour resulting from the coronavirus pandemic is yet visible in these data”.

Something may be stirring. A timely survey of 670 firms to be published by HSBC UK tomorrow will show that a third of them have investing in automation as a priority, because of staff shortages. Not all the businesses in the survey are experiencing such shortages, though some 40 per cent are.

The survey is reasonably positive about investment, with 45 per cent expecting to increase capital spending this year, up from 36 per cent who did so last year.
That becomes the key question. Do businesses invest in response to staff shortages or do they hang on in the expectation that such shortages will ease? Will they invest in general at a time when business confidence is very weak and cost pressures are biting hard? Forecasts for the growth of business investment have been revised down sharply this year because of the uncertainty, cost pressures, and those labour shortages. It should be remembered that recruitment and investment are not usually alternatives but go hand in hand.

That said, there is still considerable scope for automation and new technology to substitute for scarce workers. This has long been the case in industry and should spread across the service sector.

Before long, manned checkouts at supermarkets will become a rarity. Famously, ATMs, cash machines, did not result in a drop in the number of bank staff, but banking automation may now be doing that. The solution to a chronic shortage of HGV drivers will eventually be driverless lorries and, strikes permitting, a shift in freight back to trains. More robots will be used on warehouses, and even to care for the elderly.

All these things are likely. The question is whether they will happen quickly enough to lift us out of the productivity doldrums.

Sunday, June 26, 2022
Six years on, there's no plan to deal with the Brexit damage
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

I can remember vividly June 23 2016, the sixth anniversary of which we have just passed. During the afternoon I gave a talk to some schools in Guildford in Surrey, after which the heavens opened in a storm of Biblical proportions. Perhaps somebody was trying to tell us something. The short train journey back to Waterloo took hours, because of the rain not strikers, though I did get back in time to vote in the referendum.

Damage was done that day, with widespread flooding. Today I want to start by reviewing the damage done to the economy by the decision voters took that day. Polls show that they now think by a significant margin it was a mistake, though it is a little late for that.

Then, in the spirit of constructive engagement, I want to examine what we should do about it. It is not, spoiler alert, about rejoining the European Union, though it was a massive economic policy error to leave. The Labour Party is as scared about saying anything positive about the EU as it is about being caught offering support for striking railway workers. That ship has sailed and will not come back into port for many years.

The experience of the past six years is gratifying for economists, including me, because they have panned out as expected. Apart from an explicitly political Treasury forecast commissioned by George Osborne, most economists did not expect a post-referendum recession. That Treasury short-term forecast, of the mildest recession ever, was wide of the mark.

Other forecasts had two central features. One was that sterling would suffer a sharp fall, which it did, the biggest short-term drop of any major currency in the floating era. The other was that the economy would suffer from many years of attrition as a result of the Brexit vote, slow-burn damage, in other words.

I wrote once that there was a danger that people would lose sight of that damage as other things intervened. Other things have indeed intervened, notably the pandemic and the Russian invasion of Ukraine, so it is important that we do not lose sight. And before anybody says it, while the editor of this newspaper at the time backed Brexit, I and many of my colleagues strongly took the opposite view.

How do we measure the damage? An intriguing and widely accepted method, which has been used by the Bank of England among others, is the doppelganger approach. If that sounds a bit sci-fi, it is quite straightforward. The average performance of advanced economies similar to the UK, but which did not Brexit, is the control. Doppelganger UK reflects what would have happened had we not decided to leave, against which the performance of the actual UK can be compared.

The doppelganger approach has been used extensively by John Springford, deputy director of the Centre for European Reform. His latest update, covering the period to the end of last year, was published earlier this month, and the results are striking.

The headline is that actual UK GDP in real terms was 5.2 per cent smaller at the end of last year than doppelganger UK GDP. The economy has lost 5 per cent as a result of the Brexit vote on this calculation, equivalent to a quarterly GDP loss of £31 billion, or an annual loss of more than £120 billion.

The UK has done worse than its doppelganger in investment, which is 13,7 per cent lower, and goods trade, down 13.6 per cent. The only exception is services trade, in both directions, which is 7.9 per cent up on the doppelganger, but this only offsets a fraction of the declines elsewhere. I shall come back to exports in a moment.

There is a neat symmetry between the 5 per cent GDP loss since the referendum and the Bank’s calculation, revealed ion a recent speech by the monetary policy committee member Catherine Mann, that price levels in the UK are 5 per cent higher than in doppelganger UK. Brexit is not mainly to blame for current high inflation, caused by supply-chain difficulties, the monetary response to the pandemic and the Russian invasion of Ukraine, but prices in the UK are 5 per cent higher than they would have been.

This kind of effect, together with the damaging effect on productivity of Brexit, informed a Resolution Foundation/London School of Economics study last week, which said that real wages will be £470 a year lower, on average, than in the absence of Brexit.

Higher UK prices are partly a function of the dampening of competitive forces as a result of the UK becoming a more closed economy, but have a lot to do with sterling, which has again been coming under pressure recently. Sterling’s average value against the dollar since the referendum, $1.31, compared with $1.57 in the previous six years, and $1.66 in the 10 years leading up to the vote. The represents a devaluation of 17 and 21 per cent respectively.

Against the euro, where the post-referendum average has been just €1.146, the equivalent declines are 8 and 9 per cent respectively, or 17 per cent if we take the period since the euro came into being at the start of 1999.

This big sterling devaluation has not supercharged UK exports, as noted, far from it, but there is a curiosity. Non-EU exports have been weaker than EU exports, just as non-EU imports have been stronger than EU imports. Some of the weakness of non-EU exports may be due to the fact that many exporters, particularly smaller ones, have only a certain amount of bandwidth, and that dealing with the red tape of exporting to the EU has diverted them from the task of exporting elsewhere. There may also be still an echo of the old Rotterdam effect, in which exports destined for the rest of the world go via the Dutch port, though there is not good reason for doing that anymore.

Even so, there is no room to relax about exports to the EU. Official statisticians reported that, in cash terms, UK exports of goods rose to record levels in April. Digging a little deeper, however, and the figure was flattered by Ukraine-inflated UK energy exports. Adjusted for inflation, UK exports to the EU in April remained below pre-pandemic levels.

This brief review has underlined the damage inflicted on the economy by the Brexit vote over the past six years. The question is how to halt the decline. Shortly after the referendum, on July 3 2016, I set out an agenda for doing that and, if I say so myself, it was rather prescient.

Long before anybody had started to use the phrase “levelling up” I said it had to include regional rebalancing, partly via infrastructure spending including the full HS2 but also via a new focus on high-value manufacturing rather than low-productivity services.

To compensate for the big disadvantage of leaving the single market, I suggested that this country could attract inward investment by adopting a 10 per cent corporation tax rate, undercutting even Ireland’s 12.5 per cent. Low tax rates are not the only reason businesses invest in countries, but they help. The UK had to rediscover the secret of being a low-tax, dynamic economy.

We needed a close post-Brexit trading relationship with the EU. And, amongst other things, and this one has really come into its own, there had to be an energy strategy, including replacing the ageing nuclear stations that were coming to the end of their lives.

Some of those suggestions were heeded. There is a regional approach of sorts, though the government has been better at announcing large amounts of infrastructure spending than implementing game-changing projects.
Mostly, though, things have gone backwards. There is no industrial strategy anymore. Corporation tax is already higher under this government than it was intended to be, a cut from 19 to 17 per cent having been abandoned, and a rise to 25 per cent due next year, the exact opposite of what was needed. Foreign direct investment into the UK has not collapsed but little has been done to encourage it. The trade desal with the EU is think and flawed, The government is desperately trying to play catch up on energy.

More than that, in leaving the EU we have paradoxically become more European, with higher sustained levels of public spending and the tax burden heading for its highest since the late 1940s. Instead of low personal taxes, which made the UK attractive in the 1980s, they are rising. There is no plan, no strategy, just a government flitting from one headline to the next and struggling in the face of economic forces it cannot control. The Brexit hangover, sadly, will last.

Sunday, June 19, 2022
The UK's 'no mates' economy is down, but not quite out
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

The sun may have been shining but some of the lights have been going out all over the UK economy. There have been many falls from grace over the years, but the one that has occurred over the past few months has been particularly sharp.
Not so long ago, around the turn of the year, the UK looked well set. The government, preening itself on getting through the Covid-19 crisis, boasted of the strength of the recovery, which was to be the strongest in the G7. That was the case last year, partly reflecting the UK’s bigger fall in 2020.

Then, reality struck. The big inflation shock that was already building before the Russian invasion on Ukraine, and which has been made worse by it, has exposed the UK’s vulnerabilities. The British economy is weak and skirting perilously close to recession. You can see it in the forecasts.

Last November the Bank of England was predicting a modest 1.5 per cent growth rate for 2023. Now it thinks the economy will instead shrink by 0.25 per cent, though that did not prevent it from raising interest rates again on Thursday, for the fifth time in a row.

Its quarter-point rate rise to 1.25 per cent, on a split vote, with three monetary policy committee members preferring half a point, was its way of balancing a weak economy – it expects the economy to shrink by 0.3 per cent this quarter - and high inflation, with a new predicted peak of 11 per cent. Scary.

The Organisation for Economic Co-operation and Development (OECD) thought last December that the economy would grow by 2.1 per cent next year. Now it predicts zero growth. Consensus forecasts for growth are being cut. The CBI has just cut its growth forecast for 2023 from 3 per cent to 1 per cent and warns that even that will require government action to boost business investment.

Even last year’s strong growth story was not quite what it seemed. The economy has not been particularly strong since the middle of last year. The “oomph” it got from the lifting of Covid restrictions after the third lockdown in early 2021 did not follow through.

Sterling, meanwhile, has become a “no mates” currency, trading at times below $1.20 in recent days, which is even weaker than it fell during its initial post-referendum slump in 2016, the biggest of any major currency in the floating rate era. Some of this is due to a strong dollar, but the pound, trading below €1.15 at times in recent days, before recovering some ground, has also been plumbing the depths against the euro. Foreign holidays beckon for many people but they will cost.

A weak currency tells us something. International investors do not like what they see about the UK economy or British politics. Breaking international law in a way that threatens a trade war with your biggest set of trading partners to shore up a deeply flawed leader is a “sell” signal. Whatever the results of confidence votes among Tory MPs, there is not much confidence out there in this government.

Tony Danker, the CBI’s director general, said that government “grandstanding” over the Northern Ireland protocol was making international businesses think it was maybe not the time to invest in the UK right now. The money flowing into the UK may take the form of foreign buyers snapping up British firms at bargain prices as a result of low valuations and the weak pound.

What happens to the pound matters a lot, particularly at present. The weaker it is, the bigger will be the cost-of-living crisis and the pressure on business costs. Global oil prices have been higher than now than in the past but, priced in dollars as they are, the weaker the pound, the higher the sterling price, which has hit £100 a barrel in recent days. That is why petrol has been touching and in some cases exceeding £2 a litre. The UK is uncomfortably close to the top in one league table, that for the highest petrol and diesel prices in Europe.

Some of the economy’s woes were brought out into the open by the latest monthly GDP (gross domestic product) figures, published a few days ago. An unexpected 0.3 per cent fall in monthly GDP in April, with services, industrial production and construction all falling for the first time since the grim lockdown month of January 2021, told of an economy struggling to stay afloat.

Though the fall was distorted by an unwinding of NHS Test & Trace activity following the end of mass free testing, it still spoke of an economy that will stagnate, at best, for the rest of this year and most of next. Growth appears to have deserted us for the moment. The pandemic and Russia-Ukraine, two of my four horsemen of the Apocalypse, have inflicted damage at a time when we could have hoped for something better.

Even when the figures are not bad, markets appear to have such a downer on the UK that they decide they are. The latest labour market figures a few days ago showed rising employment, both in aggregate and on payrolls. Unemployment ticked up fractionally, though there was a small reduction in economic inactivity. The labour shortages that have plagued the economy may be starting to ease and there was even a small rise in self-employment.

Markets, however, focused on a big fall in real wages; regular pay adjusted for inflation. That is important, though is not news. And it would be worse if there was evidence that pay was chasing inflation higher, echoing the wage-price spirals of the past.

I am going to say here, and this may be controversial, that the gloom over the economy looks overdone. We have entered a period in which growth will be hard to come by and the risk of a technical recession – two consecutive quarters of falling GDP – are real. Compared with the wild swings we have seen over the past couple of years, however, including a phenomenal 21.4 per cent slump in GDP over two quarters in the first half of 2020, a technical recession, if there is one, will be small beer.

Other countries are facing similar pressures, even if so far they are not suffering such a bonfire of growth expectations. And I still think that we will see inflation falling over the course of next year, for several reasons, which will mean that we will eventually start to view some of our current problems through the rear-view mirror.

But if there is too much gloom around about the economy, fixing perceptions about British politics may be a harder task. We have never seen anything quite like this government, and not in a good way. But that is another story.

Sunday, June 12, 2022
With tax cuts, you can't have your cake and eat it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

There is a lot of talk of tax around. Boris Johnson, having scraped through a confidence vote among his own MPs, is being urged by some of them to repair relations with his party by pushing through big tax cuts. Tax Freedom Day – the point in the year when according to its inventors we stop working for the government and start working for ourselves – was marked on June 8, a week later than last year, and the highest it has been for 40 years.

The OECD – the Organisation for Economic Co-operation and Development – said in an updated Economic Outlook that the UK will have the slowest growth next year not just in the G7 but in the wider G20 group of countries, except Russia. In fact, the OECD says the UK will have no growth in 2023, which brings to mind the Monty Python election night sketch and the candidate who polls no votes at all and is asked: “Are you disappointed with this performance?” The candidate’s response is a rendition of Climb Every Mountain. I don’t think we will see that from ministers, but you never know.

According to the OECD, UK growth will be a victim of the Russian invasion of Ukraine but also the combination of a monetary and fiscal tightening; higher interest rates and higher taxes. The higher personal taxes this year, increases in both income tax (through freezing allowances and thresholds) and national insurance (NI), will be followed next April by the big rise in corporation tax, from 19 to 25 per cent.

I have described these before as the most ill-timed tax increases in recent history, particularly in the context of the cost-of-living crisis. Some of them are already in place, despite next month’s softening of the NI rise by increasing the threshold at which it starts to be paid. The corporation tax increase next year could be delayed, though I suspect the government would think the optics of that would be terrible against the backdrop of struggling families.

The freeze on income tax allowances and thresholds, which brings more people into paying income tax of paying it at a higher rate, could also be suspended. It is intended to last until 2026. There is a difference, however, between delaying or suspending the planned increases in tax - which will take the tax burden to its highest since the late 1940s - and actively cutting tax. That is the red meat some Tory MPs are pressing for.

The confidence vote revealed that the prime minister is held in low regard by more than two-fifths of Tory MPs. He is not going down a bundle with the public either, 60 per cent of whom wanted Tory MPs to remove him last week, and with a popularity rating plumbing new depths.

In an important respect however, the prime minister and Tory MPs and party members urging tax cuts are at one. They all want to have their cake and eat it. They want the government to recreate the tax-cutting spirit of Margaret Thatcher, but without replicating the conditions which allowed those tax cuts.

Public finance is not that complicated. If you want lower taxes you can either borrow more – which does not look like a sustainable long-term position – or you can spend less. Rishi Sunak, the chancellor, has done us all a favour, though not necessarily his own political prospects, by pointing out that there is no magic money tree here. Tax cuts do not pay for themselves.

Many Tories who know no economics think that the Laffer curve, invented in the 1970s by the American economist Professor Art Laffer, is gospel. It showed that above a certain level raising tax rates will generate lower rather than higher revenue. But real-world examples of this are hard to find, and the downward slope of the curve, when this effect kicks in, is likely to be at much higher tax rates and tax burden than anything in prospect now.

How did the Thatcher government cut tax? The answer is that it did not, at least initially. The first Thatcher term, 1979-83, was characterised by a higher tax burden, and higher public spending. Her government inherited public spending of 41.5 per cent of gross domestic product and fought that 1983 election with that having risen to 43.3 per cent of GDP. My figures are from the Office for Budget Responsibility’s invaluable database.

Then things changed dramatically. Public spending fell from 43.3 per cent of GDP in 1982-83 to just 34.5 per cent by 1988-89, a huge change helped by a booming economy. In real terms, public spending was barely higher in 1988-89 than in 1982-83 and was 2 per cent lower than in 1983-84. This period of tight spending control was tighter, though not by much, than in the austerity years under David Cameron and George Osborne after 2010.

The contrast, and this is where the cake-and-eat-it point comes in, is with now. The current government inherited public spending of 39 per cent of GDP. It surged to a record 51.9 per cent in 2020-21 as the pandemic struck and is expected to be more than 43 per cent this year, eventually settling at over 41 per cent. That assumes the government sticks to its plans and that unwinding some of the support announced this year will be straightforward.

This government has embraced higher public spending, which is intended to be 12 per cent higher in real terms in 2024-25 than in 2019-20. Some of that is higher infrastructure spending. Public sector net investment, which accounts for only about 6 per cent of government spending, is intended to be 44 per cent higher in 2024-25 than in 2019-20. But other government spending is also going up, by 11 per cent in real terms. Unveiling his comprehensive spending review last October, the chancellor hailed “the largest increase this century” in real-terms departmental spending.

You can’t have it both ways and have your cake and eat it. The reality is of a rising tax burden, in which any token tax cuts before the next election will be exactly that, mere flesh wounds to coin a phrase. The differences between this government and Thatcher’s are much greater than the similarities.

Sunday, June 05, 2022
Northern lights have dimmed as the South powers ahead
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The big picture is important when it comes to looking at what is happening. But an economy is comprised of many smaller parts, and for the UK those smaller parts are its regions and nations. It is, of course, possible to drill down even further, to local level.

Staying with those regions and nations, though, the Office for National Statistics (ONS) has just published some new figures. They are not as up to date as the national figures, but they tell an interesting story.

In the latest quarter for which figures are available, the July-September period of last year, the London economy grew strongly, up by 2.3 per cent, even as most other regions stagnated or shrank.

In the Armageddon year of 2020, the latest annual figures, when the economy overall recorded its biggest slump since 1921, the smallest annual falls were in London and the southeast, the biggest was in the northeast, followed by the West Midlands.

The recession pushed London and the southeast, unusually, into having budget deficits – normally they are in surplus – though these deficits were much smaller than in other parts of the country, particularly when adjusted for population.

This is quite interesting, because it runs against the general perception, which is that London was hardest hit by the pandemic, knocked by a plunge in commuter numbers and a loss of city centre activity. But London and the southeast may have adapted more quickly to working from home and local town centres appear to have thrived even as the centre was struggling.

It is part of a longer-term pattern. If we take the period since the financial crisis, when people also thought that London was badly wounded, its economy, measured by gross value added, grew by more than 35 per cent to the end of last year, compared with just 1.4 per cent for the northeast.

Measured from another recent big event, the EU referendum, it is notable that three of the regions which voted most heavily and enthusiastically for Brexit, the West Midlands, the East Midlands and the northeast, had economies at the end of last year which were smaller than at the time of the vote. So was the northwest. Scotland, which did not vote for Brexit, also had lower output at the end of last year than in 2016, though London was well up.

The West Midlands has suffered particularly because of the woes of the motor industry. Globally, the industry is in trouble because of supply-chain problems, particularly for microchips. But the UK appears to have particular problems, and a debate and a battle is under way over whether Jaguar Land Rover will manufacture its electric vehicles in the UK or in Slovakia.

A few years ago, UK-based car manufacturers were hopeful of surpassing the all-time record for vehicle production, 1.92 million cars, which was achieved as long ago as 1972. In 2016 the total was 1.7 million. But it has been downhill pretty much all the way since then, even before the pandemic. The latest 12-month rolling total is just 752,612. Engine production is also weak, down 19 per cent so far this year on last year’s depressed levels though, not to overdo the gloom too much, commercial vehicle manufacture in holding up better.

The West Midlands has always fascinated me, and not just because I come from there. Students of UK regional policy, which is going through another iteration as we speak, though with the “levelling up” label attached to it, will know that there was a time when parts of the UK were regarded, for policy purposes, as too successful. Regional policy actively discouraged industrial development in London and the southeast and the West Midlands. Things have changed.

Indeed, with a further nod towards this weekend’s Jubilee celebrations, regional changes during the Queen’s 70-year reign have been striking. I only have firm figures from 1966, but the trend has been clear. If we take “the South” as London and the southeast, the southwest and what used to be called East Anglia but is now Eastern England, in 1966 these regions accounted for 44.7 per cent of the UK’s gross domestic product.

By 1990, that share had increased, partly reflecting the manufacturing devastation of the 1980s, to 47.4 per cent. In the intervening 30 years it has gone up again, to an extraordinary 54 per cent. Given the trend, I would estimate that it was just over 40 per cent in 1952. These days London and the southeast, on their own, are 38 per cent of UK GDP.

There is manufacturing industry in London and the southeast, quite a lot of it. But it is part of a more diversified economy. It is hard, indeed, not to see the story of the UK’s regional inequality, which is extreme, and the concentration of economic activity in the South, as being closely linked to the relative decline of manufacturing industry.

In 1952, manufacturing accounted for nearly 36 per cent of GDP, and there were whole regions, including the West Midlands and the northeast, where industry entirely dominated mainly male employment. By the end of the 1980s, manufacturing’s share of GDP was down to less than 20 per cent. Now it is under 10 per cent and may be heading for another downgrade. While the service sector is back above pre-pandemic levels, manufacturing is yet to do so.

It is entirely right that the government is trying to respond to the UK’s regional inequalities, though its recent levelling up white paper was long on elegant analysis and well-designed graphics but thin on new ideas.

Rishi Sunak has been posting photos of himself at the government’s new Darlington economic campus and I am sure that those who work there will find it rewarding to do so, not least if it allows them to escape London house prices. The challenge, however, will be to stop this becoming just another regional branch office, as has happened with so many of these civil service outposts in the past.

Otherwise, the government appears to be as gimmicky now as when Lord Hailsham, as Tory minister for the north in the 1960s, donned a cloth cap for a visit to the northeast. A whippet may not have been available. The latest gimmick is to suggest relocating the House of Lords to Stoke, or York. If that happens, I would be prepared to eat a cloth cap.

The government has got some things right, by promising a big increase in infrastructure spending, though, as a forthcoming report from the Northern Policy Foundation is expected to say, the key will be turning those promises into timely and efficient delivery.

There is also, and this is not a new point from me, a pressing need for more private sector businesses. Each of the four regions that make up the South have more than 1,100 businesses per 10,000 population, with the peak London’s 1,460. Every other region has fewer than 1,000, with the lowest in the northeast, 700, Scotland, 752, and Wales 796.

Businesses and government have to work together if we are to reverse decades of rising regional inequality. Not wishing to spoil anybody’s weekend, the omens are not good.

Sunday, May 29, 2022
A different Jubilee story - 70 years of roaring house prices
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

There is a war on, and inflation has risen to uncomfortably high levels, having gone from less than 2 per cent to more than 10 per cent in the space of a couple of years. Households feel badly squeezed and are having to penny-pinch to make ends meet. People were looking forward to the sunlit uplands, but times are very tough.

This is not, though it could easily be, a description of where we are now but of the economy at the start of the Queen’s reign, in 1952. The war was in Korea and 60,000 British troops were involved, 1,100 of whom lost their lives, alongside 37,000 US troop losses and 227,000 South Korean deaths.

As we mark the Queen’s Platinum Jubilee, a length of a reign which will surely never be repeated, the economics of that 70-year period are fascinating. In 1952, according to modelled estimates of the current consumer prices index (CPI) by official statisticians, inflation peaked early in the year at just over 12 per cent, though ended the year below 7 per cent and during 1954, after the end of eh Korean War, dropped below 1 per cent. The Treasury and Bank of England would love a repeat performance now.

The Queen’s reign has been bookended by high inflation, and inflation has also in many ways been the story of her reign. For a long time, the UK was thought to be the most inflation-prone of the big economies. Today, with the highest inflation rate in the G7, that label is back, though this time it is to be hoped only temporarily.

Over the 70 years, again on the basis of the CPI, prices overall are more than 18 times what they were in 1952. For inflation, it has been roughly a game of two halves. From 1952 to 1988, consumer price inflation averaged 6.4 per cent. Since 1989, the average has been 2.5 per cent. That includes the period since Bank of England independence in 1997 in which the average, despite the current surge, is still clinging on to 2 per cent.

The difference between the two periods shows the power of compounding. A 6.4 per cent inflation rate, sustained over 35 years, would leave prices at the end roughly nine times where they were at the start. If inflation after the current episode was to settle at 3 or 4 per cent rather than 2 per cent, the implications would be significant.

In the 1950s, people really could enjoy a night out with a ten-shilling note; to remind younger readers, that was the pre-decimal half of £1. But ten shillings then is equivalent, in real terms, to about 2.5p now, and even I would struggle for a night out on that.

You will ask, as you should, what has happened to earnings over this long period when inflation has eroded the purchasing power of money so much. The answer required some statistical detective work since the official series for average earnings only goes back to 2000. But piecing it together using the Bank of England’s millennium of data, I estimate that average weekly earnings were £6.04 in 1952, compared with £605 in the second quarter of this year.

In cash terms, total average pay, admittedly boosted this year by exceptional bonuses, is 100 times what it was. If regular pay, excluding bonuses, is used for the comparison, earnings are more than 90 times what they were. The precise magnitudes can be debated but the broad conclusion is clear; wages have risen a lot faster than prices.

Again, this is a game of not-quite-two-halves. Until the financial crisis struck in 2008, real wage increases, alongside rising productivity, were guaranteed. Since then, neither has been. Real wages are falling quite sharply now on the back of more than decade of stagnation. Wage growth in cash terms, incidentally, was more than 8 per cent in 1952, 29 per cent in 1975 – the peak inflation year – and 22 per cent in 1980, Margaret Thatcher’s first full year in office.

Pay has not, it should be said at this point, kept up with all prices. The Nationwide Building Society’s house price index dates back, thankfully, in 1952. Then the average UK house price was just £1,891. Prices had to be pulled up by earnings. Otherwise, people would now be able to buy a house with a month’s average pay after tax.

The extent of that pull increased over time, however, exacerbated by the greater availability of mortgages and inadequate new housing supply. In the 1950s and 1960s, people did not need mega City salaries to live in some style. Teachers, civil servants and other professionals could do so. Then housing pulled away.

The highest rate of house-price inflation recorded by the Nationwide was 42 per cent during the Barber boom (after the Tory chancellor Anthony Barber) at the end of 1972, though house price inflation reached 32 per cent in the spring of 1979 and early in 1989. That last boom, named for Nigel Lawson, was followed by six years of falling prices, until the mid-1990s.

Even so, the rise in house prices over the period as a whole has been remarkable. The latest average for the Nationwide, £260,771, is 139 times the 1952 level, outstripping other prices and whichever measure of the growth in wages and salaries you choose to use. The Nationwide’s measure of “real”, that is inflation-adjusted, house prices only goes back to 1975 but it estimates that the are 2.4 times what they were then.

The story of the past 70 years is not just about inflation. The period is bookended too by tax, with the tax burden on course to return to the high levels last seen in the late 1940s and early 1950s.

It is a story of economic progress, something we probably take for granted and, because it is incremental, unlike the great surges in inflation, probably do not notice that much. Despite the current squeeze, living standards are much higher than they were. The UK’s gross domestic product, adjusted for inflation, is more than five times what it was in 1952. It has increased by 430 per cent.

Population has also increased, but by a smaller amount. In 1952 it was 50.6 million, compared with the latest official estimate of 67.1 million, a rise of 33 per cent. That is consistent with GDP per capita rising by nearly 300 per cent over the Queen’s rein and being almost four times where it was. John Major once promised to double living standards, measured by GDP per capita, over 25 years. That has never quite been achieved, though it has sometimes come close. A quadrupling over 70 years is not bad.

There have been other big economic changes. The female employment rate, 35 per cent in 1952, is now 72 per cent, though the male employment rate, 79 per cent, is lower than it was, partly due to young people spending longer in education. But that is probably enough for now, and maybe the changing labour market is a topic to return to.

Sunday, May 22, 2022
The Bank's problem is not being independent enough
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The last time inflation, measured by the consumer prices index, was higher than last month’s rate of 9 per cent, revealed a few days ago, was in March 1982, more than 40 years ago. Things were different back then, when inflation was 9.1 per cent. The unemployment rate was more than 10 per cent and its level was on the way to more than three million. Inflation, though, was on its way down from more than 20 per cent.

Perhaps that is why consumer confidence, as recorded by the long-running GfK survey, was higher than now. On Friday GfK announced that its consumer confidence index has fallen to a record low of -40 as this inflation squeeze bites. In March 1982, despite the uncertainty and rising unemployment, the reading was -18.

There are other differences. These days the unemployment rate is just 3.7 per cent, although that low rate is partly due to the shrinkage of the workforce, and employment is lower than before the pandemic. Most strikingly, while an official interest rate of more than 13 per cent was regarded as necessary to fight inflation in March 1982, these days Bank Rate is just 1 per cent.

One big similarity, though, concerns the Bank of England. In 1982, under the governorship of Gordon Richardson, later Lord Richardson, the Bank was at loggerheads with the government. It never bought into the Thatcher government’s monetarist experiment and relations were not good. The Bank only needed to bide its time. Even then the writing was on the wall for the experiment. But the writing was also on the wall for Richardson, who the following year was replaced by Robin Leigh-Pemberton, former chairman of NatWest Bank and Tory leader of Kent County Council.

These days the Bank is again at loggerheads, if not with the government as a whole, certainly with many Tory MPs and some unnamed cabinet ministers. The jump in inflation to 9 per cent and the current governor’s admission a few days ago the Bank feels “helpless” in the face of the current inflation surge and that “apocalyptic” food price rises are in store, has focused attention on the Bank, and not in a good way.

The 25th anniversary of Bank independence was not supposed to be marked by mutterings from the governing party that it might be no bad thing to take back control, so to speak, of interest rate decisions. They are only mutterings, but we should remember that, under the Bank of England Act, the Treasury has reserve powers to direct the Bank on monetary policy in “extreme economic circumstances” if that is deemed to be in the public interest.

The Bank, as is clear, should not be immune from criticism. It has got some things seriously wrong, including its inflation forecasting. But we should be very wary of moving beyond criticism into a change that would be seriously economically damaging. There is another example of this happening, though I can’t quite put my finger on it.

The Bank’s defence is that even it had acted earlier last year in raising interest rates and halting quantitative easing (QE), as many, including me, urged, it would have made no significant difference to the current inflation surge.
We cannot know whether that is the case, although it is reasonable for the Bank to point to the lags in monetary policy, and the difficulty of tightening it when we were still in the depths of the pandemic, in the second half of 2020 or early 2021.

A more telling criticism is that the Bank, along with other central banks, were prey to “groupthink”. No two crises are the same, but the playbook adopted by the Bank and other central banks was straight out of the one adopted for the global financial crisis in 2008-9. That playbook, slash interest rates and launch large amounts of quantitative easing (QE), was right when the economy faced a demand shock and a damaged banking and financial system more than a decade ago. But when the problem was a supply shock, which would be exacerbated as the world economy recovered from the pandemic, it was much more questionable. Lord (Mervyn) King, the former governor, is among those who have made this criticism recently.

Had central banks not done this, it is likely that we would still have had a post-pandemic inflationary shock, exacerbated by the Russian invasion of Ukraine. But the inflation peak would probably have been closer to the 5 per cent that we saw in 2008 and 2011, than the 9 per cent now. It is only fair to say that this is with the benefit of hindsight. It seemed to be the right thing to do at the time.

That is water under the bridge and if it is of any comfort, so incidentally is the big surge in inflation, which has seen the rate jump from 1.5 per cent to 9 per cent over 12 months. Inflation will be helped in coming months by so-called base effects (prices were already rising strongly a year earlier) and by some of the oddities returning to normal. Second-hand car prices, for example, are now falling. And, while inflation may go a little higher later this year, it will not be much above current levels, if at all, and is still on course for a fall next year.

If we look at the Bank, it seems to me that the problem is not that it is independent, but that it is not independent enough. The decision to launch an aggressive QE programme in March 2020 was, at least in part, to improve the functioning of the gilt market, and to make it easier for the government, which had an unprecedented deficit to fund, to do so. The Bank has found it hard to kill the criticism that its pandemic QE programme was for the convenience of the Treasury. There is a question about whether its softly-softly approach on interests was driven in part by concerns over the government’s debt interest bill.

Bank of America’s London office, in a critical note on the Bank, warned of its “growing concerns” about its approach. Markets struggle to work out its “reaction function” – when it will raise rates and why - together with “a building impression we have that monetary policy may appear more politicised”. To avoid upsetting the government, the Bank has been “reluctant to talk recently about one of the key supply shocks hitting the UK, Brexit.”

These things can be improved. The convention that the Bank cannot make any assumptions about changes in government policy, as other forecasters do, should be dumped. Its forecast of inflation topping 10 per cent later this year assumed there would be no further government action in response to the cost-of-living crisis.

In the meantime, we should forget any talk of reversing the Bank’s independence. That would be the surest way of adding a sterling crisis to the cost-of-living crisis and generating a “buyers’ strike” for the bonds (gilts) the government has to sell to fund the budget deficit. It would, in other words, make a difficult situation much worse.

Sunday, May 15, 2022
The drivers of growth risk going into reverse
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The mood has darkened, even as the days are getting longer. The economy is not so much falling off a cliff as entering a kind of deep freeze, which unintentionally rhymes with one of the main causes, the cost-of-living squeeze. Recent surveys showing sharp falls in business and consumer confidence show that the wisdom of crowds works. People and businesses knew instinctively that something was up, and they were right. The pound’s weakness is becoming quite a thing too, so the foreign exchange markets are also on to the story.

At times like this, it is useful to go back to first principles, and what I describe in my book Free Lunch as “the most useful equation in economics”. This tells us that the economy, gross domestic product (GDP), consists of consumer spending, plus investment, plus government spending, and plus exports, though minus imports.

On the face of it, the figures we had a few days ago, for the first quarter of the year, were not that bad. GDP rose by 0.8 per cent on the quarter, which is better than it does in normal times. Over 12 months the economy grew by a hefty 8.7 per cent, reflecting the comparison with a very weak first quarter of last year, when the country was in lockdown. That 8.7 per cent figure means that, while we have undoubtedly seen the best of the year already, it would be statistically very difficult, if not impossible, for the economy to show an annual fall this year, in the sense of 2022’s GDP being lower than in 2021.

I hate using the expression “the devil is in the detail” but on this occasion it really is. One bit of detail which was widely reported is the slowdown in GDP during the quarter, from a rise of 0.7 per cent in January, to no growth at all in February and a fall of 0.1 per cent in March.

When the February figures were published, I was able to offer the reassurance that, without a sharp fall in NHS test and trace activity, there would have been decent growth on the month. No such reassurance is available for March, sad to say. The weakness was genuine and bodes badly for the second quarter, which we are now in the middle of, and which will suffer from the twin effects of the intensification of the cost-of-living squeeze and the extra bank holiday for the Queen’s Platinum jubilee. To remind you, the economy shrank slightly in the second quarter of 2012, when there was an extra bank holiday to mark the diamond jubilee.

Going back to my equation, the March GDP data, in combination with the first quarter figures, tell us something useful about consumer spending, the biggest component of GDP, accounting for just over 60 per cent of it in normal times.

Consumer spending rose by 0.6 per cent in the first quarter, which again was not bad, but even before the intense phase of the cost-of-living crisis was 0.5 per cent lower than in the pre-pandemic period in the final quarter of 2019. There was also, as the monthly figures show, a lot of the weakness as the quarter went on, particularly affecting spending on cars. So-called consumer-facing services are 6.8 per cent down on where they were in February 2020 before the pandemic struck.

Consumers are now under the cosh, thanks to the biggest squeeze on real incomes – after allowing for taxes and inflation – since records began in the mid-1950s. The questions is whether the other elements of GDP can come to the rescue.

I have focused quite a lot recently on business investment, not just because it is necessary to lift productivity but because it has become a focus for Rishi Sunak. A few days ago, the Treasury put out a consultation asking for ideas on the permanent reform of capital allowances. The chancellor has acknowledged that the UK spends significantly less on business investment relative to GDP than competitors. As well as wanting to reform the system because it needs reforming, he is keen to head off the feared slump in investment when corporation tax goes up from 19 to 25 per cent.

Before then it was expected that there would be a boom in business investment as firms took advantage of the 130 per cent corporation tax “super deduction” announced by the chancellor last year, which expires next April. I have to tell you that, even as we move into choppier waters for the economy – with the Bank of England predicting a small contraction in GDP next year and the National Institute of Economic and Social Research saying that we will meet the standard definition of recession this year, with two consecutive quarters of falling GDP – there is no sign yet of that boom.

Business investment fell by 0.5 per cent in the first quarter and is 9.1 per cent below pre-pandemic levels. Over the next few months we will find out whether businesses invest for tax reasons or because of other factors. Some increase may still occur to take advantage of the super-deduction but talk of a mini boom has gone away.

What about government, which came to the rescue during the pandemic, with spending on a scale never seen before? Day-to-day spending is now falling back, as exceptional pandemic spending, such as on NHS test and trace, is reduced. Government spending thus fell by 1.7 per cent in the first quarter, and will be an engine of growth no longer.

The other government element, investment, is still firing on all cylinders, rising by 23.6 per cent in the first three months of the year, reflecting additional outlays on “buildings and other structures”. There is more to go on this, reflecting one of the government’s priorities, as set out in an otherwise lacklustre Queen’s Speech. But you cannot grow an economy on infrastructure alone.

I have left the worst until last, and it is something of a horror story. Export-led growth is the holy grail, the golden ticket, for the economy. But it is not happening. Exports fell by 4.9 per cent in the first quarter and are 19.9 per cent down on pre-pandemic levels. Some of the recent weakness is because of change sin recording procedures. Most of it is genuine. Brexit is, of course, the main factor, along with some others.

Whatever you think of Brexit, and I have made clear over the years what I think of it, we should be able to agree that this was a terrible time to do it, let alone threaten a trade war now, to compound one of the great policy errors of our time.

Import volumes, by contrast, rose by 9.3 per cent in the first quarter and were 2.3 per cent above pre-pandemic levels. They, remember, subtract from growth. The trade deficit in goods and services in the first quarter was £32.5 billion, easily a record.

To sum up, consumers are squeezed, businesses are not yet investing, the government is spending on infrastructure but reining back pandemic outlays. The trade story is not for the fainthearted. Those are the drivers of growth and we are not going anywhere fast.

Sunday, May 01, 2022
£450bn and counting - the cost in debt of the pandemic
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

There was a time, not so long ago, when it was impossible to get away from Covid-19, which dominated the news agenda for nearly two years. One day we will be able to tell our grandchildren that we were there when Professor Chris Whitty said: “Next slide please”. The pandemic, of course, had a huge human cost, which continues.

Latest estimates from the Office for National Statistics are that there have been 174,413 deaths involving Covid since March 2020 in England and Wales, and 126,619 “excess” deaths. For the latest reporting week, to April 15, there were 1,003 deaths involving Covid, in 644 of which it was the underlying cause. Other figures, from the government’s coronavirus dashboard – now of less interest because mass testing has ended – suggest 2,297 UK deaths within 28 days of a positive test in the latest seven days.

As well as the human cost, there has been a significant economic cost. You might think that is all behind us. Now that the unemployment rate is slightly below pre-pandemic levels, at just 3.8 per cent, and gross domestic product has recovered to where it was on the eve of the pandemic, it would be easy to conclude that we have quickly returned to normal. But there are still nearly 600,000 fewer people in work than there were, and some of the other economic effects are enduring.

That includes the impact on the public finances, and this is a good time to be looking at that. A few days ago, official figures covering the 2021-22 fiscal year were published. They showed that, while the budget deficit came down sharply compared with 2020-21, when most of the damage to the public finances was done, it was both above official forecasts and historically high.

The deficit fell from £317.6 billion in 2020-21 to £151.8 billion in 2021-22, thus dropping from the highest to the third highest on record (the second highest was during the financial crisis). For once the official forecaster, the Officed for Budget Responsibility (OBR) was too optimistic, the deficit coming in a hefty £24 billion above the forecast it made only last month, though the gap should narrow as later data comes in.

The latest figures also provide a running score for the effect of the pandemic, and the economic measures brought in to counter it, on government debt. At the end of March, roughly the wend of the 2021-22 fiscal year, public sector net debt was £2,343.8 billion, more than £2.3 trillion, and equivalent to 96.2 per cent of gross domestic product.

Two years earlier, at the end of March 2020, the debt was £1,793.1 billion, nearly £1.8 trillion, or 82.8 per cent of GDP. I could have started the comparison earlier, given that the first lockdown started in March 2020, as did the furlough scheme, but there was only a small increase in government debt between the end of February and the end of March then.

Both sets of numbers are large and the later ones are considerably larger than those earlier. Government debt at the end of March this year was £551 billion bigger than two years earlier. Relative to GDP it went up from just over 80 per cent to knocking on the door of 100 per cent.

Most of this increase in debt was due to the pandemic, both the effects of a profound economic shock on public expenditure and tax revenues, and the cost of the measures introduced by the chancellor in response to that shock. There was also, embarrassingly for the Treasury, as the guardian of the public purse, widespread waste and fraud. Purchases of unusable personal protective equipment and tales of suitcases of money at airports containing Bounce Back loans do not suggest a tightly run ship.

The debt in cash terms would have gone up anyway, but not by nearly as much. In February 2020, the consensus among economists was the public borrowing – the deficit – would be between £50 billion and £55 billion in both 2020-21 and 2021-22. The debt would have risen by £100 billion or so even if there had been no pandemic.

That leaves about £450 billion as the cost of the pandemic to the public finances, in terms of the addition to government debt. It is a significant sum. It is not as much as a war, to which the pandemic has sometimes been compared. The Second World War increased government debt from 137 per cent to 252 per cent of GDP, roughly equivalent in today’s prices to an increase from £3.3 trillion to £6.1 trillion.

There were, however, clear routes to reducing the debt burden after the war, through demobilisation, lower defence spending and economic growth. The debt fell from 252 per cent of GDP to just 22 per cent over the next 45 years. These days there are no such mechanisms. We face a future of unfavourable demographics and, it seems, low growth.

It is, of course, too soon to close the books on the pandemic. There will be costs for a number of years in clearing the NHS backlog, which ostensibly is the main reason for the National Insurance hike. There will also be costs in the catch-up for pupils, though much less has so far been allocated to that.

In the meantime, one of the chancellor’s big fears, that a combination of high debt and rising borrowing costs will mean a soaring debt interest bill. It was one reason why, in his spring statement in March, he chose not to splash the cash, even at significant personal political cost.

A standout number from the latest official figures was that debt interest rose to a record £69.9 billion in 2021-22, almost double its level a year earlier. The OBR, which got this one pretty much right, predicts a further rise to £87 billion this year, 2022-23.

Most of the increase reflects the impact of higher inflation on index-linked gilts, on which the return is tied to the retail prices index. And, while the money does not have to be paid out until the bonds mature, it still reflects the cost of servicing government debt. This year’s even higher bill is also largely an inflation effect, though also embodies higher interest rates.

The inflation effect will subside if inflation drops back, as the official forecasters expect it to do. But the public finances remain vulnerable to higher borrowing costs and new economic shocks. It is not that long ago, under Gordon Brown’s 1997-2007 chancellorship, that 40 per cent of GDP was thought to be the safe level of government debt and embodied in Labour’s fiscal rules. In very many respects, we are now in a different era.

Sunday, April 24, 2022
A groggy global economy has lost its mojo
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is a while since I have done it but there was a time when no year was complete without two pilgrimages to Washington for the annual meetings of the International Monetary Fund and World Bank, the “twins” which owe their existence to the Bretton Woods conference of 1944, the 80th anniversary of which we will soon be marking.

The spring and autumn IMF/World Bank meetings were where the world’s financial movers and shakers gathered, and mainly still do, not just finance ministers and central bankers but also a huge private sector contingent.

These gatherings used to move markets, particularly the smaller G7 meetings of finance ministers and central bankers, but it is a while since they have done so. It means that a lot of the interest is generated by the IMF’s new view of the world economy, published a few days ago.

IMF forecasts are often mocked for their accuracy, as are most economic forecasts. But there is no document as comprehensive in its analysis of the global economy as its World Economic Outlook, published twice a year, in April and October, with updates in January and July.

The big stories of the IMF’s new forecast are well known. Had the UK government not made such a thing of its “fastest growth in the G7” boast, I do not suppose this aspect of the new forecast would have got as much attention as it did.

But the new forecast shows that the UK’s growth of 3.7 per cent this year is pipped by Canada and equal to America. I pointed out last week that, thanks to lockdown quirks, the UK can get 3.7 per cent growth in 2022 even if the economy flatlines for the rest of the year. Next year, with predicted growth of 1.2 per cent, the UK is at the bottom of the G7 league. From hero to zero. Those who live by the IMF sword die by it.

That, while embarrassing, was not the big story. It was that, thanks to the Russian invasion of Ukraine, the global growth outlook has deteriorated. In January the IMF expected 4.4 per cent global growth this year. Now it is 3.6 per cent, a big revision in matter of weeks. The growth prediction for advanced economies is revised down from 3.9 to 3.3 per cent, and that for emerging and developing countries from 4.8 to 3.8 per cent.

At the heart of the conflict, Ukraine’s economy is predicted to contract by 35 per cent this year and Russia’s by 8.5 per cent. The impact on the rest of the world is “worldwide spillovers through commodity markets, trade, and financial channels” and “even as the war reduces growth, it will add to inflation”. Governments, having spent heavily fighting the pandemic, have limited room to spend to offset these effects, according to the IMF. Rishi Sunak would concur with that.


I do not want to focus today on the UK’s fall from IMF grace, or the negative economic impacts of the Russian invasion. What struck me most about this new set of forecasts was how downbeat they are. The IMF predicts out to 2027 and, when the dust settles following all the pandemic distortions, a muted picture it is.

We used to think of 4 per cent annual growth for the world economy, on the IMF’s measure, as something like the norm. Now it is expected to settle down at about 3.3 per cent. From 1990 until the mid-2000s advanced economies grew by an average of 2.7 per cent a year, perhaps partly on a diet of unsustainable finance.

But advanced economy growth is predicted to settle at just 1.6 per cent a year on average. You do not need many years stuck at this lower growth for the cumulative effects to be significant. The world economy, it seems, has lost its mojo.

There are some notable underperformers among G7 economies, notably Italy and Japan, which settle down to growth at no better than 1 per cent in the medium-term, and well below that according to the IMF. The UK has its own problems because of Brexit, though the IMF’s projections have an odd bounce in growth in 2025 for the UK, which may be a reaction to the weak growth of the previous two years. But the slow-growth malaise is also expected to affect America, which is expected to settle at just 1.7 pe cent over the medium-term.

These projections may be too downbeat, a bit like long range weather forecasts, though economists are better at assessing medium and long-run growth prospects than short-term shifts. What is going on?

There are three factors at work here. Global growth never got back properly to previous levels after the global financial crisis, which morphed into the eurozone crisis. And if one crisis was hard to take, two more, the pandemic and the Russian invasion of Ukraine have made things worse. We have yet to see the full impact of a potential Russian default, which at one time was enough to make financial markets shudder. The global impact of higher US interest rates, increased in response to the inflation shock, could be significant, particularly for emerging market economies, where there is talk of a new crisis. A groggy world economy is reeling under a series of blows.

Second, a particular weakness, since the first of these crises, has been world trade. World trade growth, which during the high watermark for globalisation in the 1990s and early 2000s often grew at double the rate of global GDP, now struggles to match it. Protectionism, favoured by populist, nationalist politicians like Donald Trump, pared back globalisation and has helped to make the world poorer. No longer is world trade the engine of growth it used to be.

Related to this is a third factor, the loss of momentum from China. China, having grown by an average of nearly 10 per cent a year since the late 1970s is now, at best, a 5 per cent growth economy. The IMF expects 4.4 per cent this year 5.1 per cent next. Part of this is due to the resistance China now faces, including the Trump trade barriers that have been retained by the Biden administration, but much of it is due to the internal contradictions of the Chinese growth model and a surely futile attempt to pursue a zero-Covid strategy.

India, which Boris Johnson has been visiting, fares better and can sustain growth of 7 or 8 per cent a year. But it is a much smaller economy, and instinctively protectionist.

We cannot easily turn the clock back to a time of stronger global growth but that does not mean nothing can be done. Rolling back protectionism would be a start. That includes this country, which has increased trade barriers with its biggest trading partner.

Sunday, April 17, 2022
Don't expect a recession, but don't bank on much growth either
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

We have got used to very odd things happening in recent years and another would be if, so soon after the biggest recession for nearly a century – 2020 was the worst year since 1921 – another was to come hard on its heels. This would be the classic “you wait ages for a bus and two come along at once” situation.

It would also be highly unusual, certainly in recent times. You may recall that, after the global financial crisis of 2008-9, official figures suggested that the UK was experiencing a “double-dip” recession and was on the verge of a triple-dip. But the figures implying that were revised, so the economy grew from 2009 to 2020. Before that the economy recorded an unprecedented 63 consecutive quarters of growth, from the spring of 1992 to early 2008.

The worry now arises from a combination of two things. The first is that the economy slowed to a crawl in February according to monthly GDP (gross domestic product) figures, growing by just 0.1 per cent. This was before the full impact of the second factor, the cost-of-living crisis which will result in one of the biggest squeezes on real incomes on record.

This combination of factors had some economists, if not predicting outright recession, at least flirting with the R-word. Ruth Gregory of Capital Economics said the weak figure “increases the risk of a contraction in GDP in the coming months as the squeeze on household real incomes intensifies”.

Samuel Tombs of Pantheon Macroeconomics predicts a 0.4 per cent fall in GDP in the second quarter which, on the now traditional “two successive quarterly declines” definition, would take us halfway to a recession. Thomas Pugh of RSM UK, a tax, audit and consulting firm, said that it would not take much more of a rise in oil prices or disruption to supply chains to push the economy into recession.

Today then, I have good and bad news for you. Let me start with the good news. That disappointing 0.1 per cent rise in GDP in February, which apparently showed the economy teetering on the brink, was not quite what it seemed.

Not for the first time over the past two years the figures were distorted, in this case by NHS Test and Trace and the vaccination programme. There was a 47 per cent fall in NHS Test and Trace activity between January and February and a 65 per cent drop in vaccinations as the booster programme wound down.

Having been boosted by these activities in December and January, their unwind subtracted 1.1 percentage points from the economy’s monthly growth rate in February. Yes, without that factor, GDP would have risen by a robust 1.2% on the month.

Not everything in the garden was rosy. Industrial production and construction both slipped in February under the impact of higher energy prices and supply-chain difficulties. But private sector services were strong and showed little sign of an economy succumbing to the cost-of-living crisis. There was a 0.7 per cent rise in consumer-facing services, driven by big increases in travel and tourism, hotels and hospitality.

This picture of private sector services growing strongly is consistent with the purchasing managers’ index (PMI) for February and, indeed, for March, once the Russian invasion was under way. Indeed, in its commentary on the March service-sector PMI, Markit, which produces the data, said: “UK service providers signalled an exceptionally strong increase in business activity during March and the rate of expansion accelerated to its fastest for 10 months.”

The big picture for the economy, admittedly before the most intense phase of the cost-of-living crisis, is thus one in which services are doing well, offset by the impact of a further winding down of NHS Test and Trace and vaccinations, and stagnant, at best industrial production. Construction, according to its PMI, is doing OK.

I said there was good news and bad news. A typical growth forecast for this year is between 3.5 and just over 4 per cent. The latest official forecast, from the Office for Budget Responsibility (OBR) was 3.8 per cent. That sounds very good. With the exception of last year’s 7.4 per cent bounce, it would be the fastest since 1997.

The figures are, however, deceptive. If the economy turns out to have grown by about 1 per cent in the first quarter, as seems likely, then as Philip Shaw of Investec points out, it would still show annual growth in 2022 of 3.7 per cent or so, even if the economy were to flatline for the next three quarters.

Such is the magic, and indeed sometimes the maddening nature, of statistics. Because the economy was depressed by lockdown a year ago, its annual growth in the first quarter of this year is likely to have been more than 9 per cent, thus doing most of the heavy lifting for this year. If GDP were then to stay at its first quarter level for the rest of the year, its annual growth over the subsequent three quarters would be 3.3 per cent, 2.3 per cent and 1 per cent.

It could even take one or two small quarterly GDP falls, in the spring and autumn, and yet record what looks like a very robust annual growth rate. Sorry for so many numbers, but did anybody say “lies, damned lies and statistics”?

This, I think, is the way to look at what is in prospect. Just as last year’s “strongest growth in the G7” was something of a statistical mirage, largely reflecting what happened in the second quarter of the year, so the best of this year’s growth is already behind us.

That fits better with a narrative in which households and businesses are suffering a multiple-whammy hit, from rising costs and prices, particularly for essentials, and rising taxes. You would hope that the economy can do a little better than flatlining for the rest of the year but you would not want to bet on it.

It fits better too with the way the economy impacts on people and firms. Most, understandably are more concerned with growth through the year, in other words from now on, than the annual growth rate thrown up by the statistics. Growth through the year looks like being subdued, though will vary from sector to sector.

We can avoid recession and should do so. But it won’t feel very much like the sunlit uplands.

Sunday, April 10, 2022
A very unhappy anniversary for the Bank of England
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Timing can be very cruel. In just over three weeks the Bank of England will be celebrating the silver anniversary of independence; 25 years in which it has been responsible for the setting of interest rates and other aspects of monetary policy. I can remember as if it were yesterday, within days of his becoming chancellor, the press conference at which Gordon Brown made his bombshell announcement.

Had this anniversary happened a year ago, it would indeed have been a cause for celebration. Inflation this time last year was a touch below the official 2 per cent target and, in May 2021, was almost exactly on it, at 2.1 per cert. The Bank’s actions during the pandemic had helped steer the economy through a period of disruption and uncertainty and, in the spring of last year, the economy was growing robustly, without a care in the world.

Things look rather different now. The country is gripped by a cost-of-living crisis and businesses are reeling under the impact of sharply rising costs. The Bank itself expects inflation to hit 8 per cent very soon and warned last month that it could be even higher by the end of the years. It may nudge 10 per cent.

This makes it the worst kind of anniversary, one of badly missed targets and an inflation cat that is not only out of the bag but is cocking a snook at the Old Lady of Threadneedle Street. This, though uncomfortable for everybody, may be no bad thing. It means that questions can be asked, rather nodding through the current monetary policy framework as an unalloyed success.

One thing should be said at the outset. There should be no return to the days when chancellors set interest rates, often for political reasons. While the Bank’s mandate was clumsily drafted – no central bank could be expected to exactly hit its target “at all times” – the 25-year inflation record has been a good one. Even including the current surge, inflation has averaged exactly 2 per cent over the past 25 years.

Independence also broke the British pattern of panicky interest rate hikes, usually in response to a falling pound. Official interest rates have been low, perhaps too low for some, averaging just 2.6 per cent over the past 25 years, compared with 10.4 per cent over the previous quarter-century. That was not all as a result of independence, but it was a big factor.

Independence was not all about monetary policy. The Bank lost its role in supervising the banking and financial system in 1997, and almost lost its governor, the late Sir Eddie George, in protest over the manner in which it was done. It got it back after the financial crisis and the system has been robust, through Brexit and the pandemic, since.

I cannot, however, ignore the elephant in the room, the fact that in this anniversary year inflation will peak at several times the official 2 per cent target. Some think the target to be changed, say to 4 per cent, while others think that there should be a different target, perhaps for the price level rather than the rate of change of prices, or for money GDP (gross domestic product), the combination of growth and inflation.

None of these, it seems to me, would offer a better policy guide. An inflation target, set at 2 per cent, an inflation rate which does not distort economic decisions, is the least bad choice. When the UK first adopted an inflation target, in the aftermath of the ERM (exchange rate mechanism) debacle of September 1992, some questioned its economic legitimacy. Could you really target something that was at the end of a process, rather than at the beginning?

To do so, the Bank required good and accurate inflation forecasting, something that has deserted it recently. In November 2020, which is when it might have been acting to head off inflation given the lags in monetary policy, the Bank’s forecast was that inflation in the second quarter of 2022, in other words now, would be below 2 per cent even if Bank Rate stayed at 0.1 per cent. That is why the Bank spent much of the pandemic adding negative interest rates to its “toolkit”.

Had the Bank known what was going to happen to inflation, perhaps it would not have responded, deciding instead to “look through” a period of high inflation rather than raise interest rates during the pandemic. This, indeed, is the get-out clause which can mean that hitting the inflation target is something of a fair-weather friend. In extreme circumstances, or when high inflation is due to an external shock, the Bank is allowed the leeway of not acting, when to try to bring inflation back to target would be at a prohibitive economic cost.

That is fair enough, but there is nevertheless room to criticise its recent actions. From about this time last year, when it was clear that there was gong to be a significant post-pandemic inflation problem, the Bank could and should have halted its quantitative easing (QE) programme, as many of us argued. But it carried on, easing monetary policy while inflation was rising, until the end of last year.

That was symptomatic of a wider problem for the Bank and its MPC, one of inertia. It continued with eh QE programme because it had announced that it would do so at the end of 2020. Operated flexibly, a sensible policy would have been to halt it.

That lack of flexibility can also be seen on interest rates. In the first half of its 25 years of independence, the MPC operated a “little and often” policy on rates, changing them 45 times in 12½ years, on average nearly four times a year. In the second phase of independence, lasting until now, the official rate has been changed just eight times, and that includes hikes in each of its last three meetings. It is almost as if the Bank came to regard interest rates as a dangerous weapon, one to be used infrequently if at all. But if monetary policy loses its flexibility, it loses one of its big advantages.

The current members of the MPC are all eminently qualified, and the selection process for external members is rigorous. But the mavericks of the early days of the MPC, when members were chosen by Ed Balls and Gordon Brown, with advice from officials, are no more. There is more “groupthink” on the MPC than there should be.

That and the impression it sometimes creates of being an ivory tower institution with too little awareness of what is happening in the world and in financial markets (which have been recently wrongfooted by the Bank’s communications) is not healthy. The Bank should engage more in the debates that are happening outside its four walls, including whether the massive QE programme it launched in response to the pandemic compromised its independence. I do not think it did, but others do.

These are problems that can be fixed and as noted, there should no question of going back on independence. It has mainly served us well over 25 years. It can continue to do so.

Sunday, April 03, 2022
UK exporters are struggling - and it isn't hard to see why
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Trade is often the poor relation in discussions of the UK economy, though it is one of the most requested topics among readers, some of whom have a memory of the time when the trade figures were the number one economic indicator, often leading the news.

There are a couple of reasons for the Cinderella status of trade statistics. One is that these days they are published on the same day and at the same time as a clutch of other figures, including monthly gross domestic product, a relative newcomer which grabs most of the attention.

A second reason is that, in these days of huge capital flows, trade figures no longer move the markets in the way they used to. The era when a bad set of trade figures could, by putting pressure on the pound, force interest rates up and, in 1970, may have cost Harold Wilson, then then Labour prime minister, the general election, are long gone.

They still tell us something, however, and that something can be quite important. Lost in the statistical flurry last month was the news that the UK’s trade deficit in January was easily the biggest on record, at a huge £26.5 billion for goods, and £16.2 billion for goods and services taken together.

These were not figures for those of nervous disposition. The deficit in goods is usually about £12 billion, while the overall deficit is normally well below £10 billion.

A new method introduced by HM Revenue & Customs at the start of the year for collecting data on imports and exports from the EU may have played a part. HMRC thinks that the figures for imports have not been much affected but that some of the sharp fall in exports to the EU will have been due to the change.

Even so, the figures were a reminder that, when it comes to the balance of payments, the UK is pretty unbalanced. After a temporary break in 2020, when there was a rare surplus in total trade, of £2.9 billion. Normal service was resumed last year, with a deficit of £28.8 billion. Last year’s current account deficit was £60 billion, 2.6 per cent of gross domestic product, and it is officially predicted to widen.

The deficit in trade in goods, £129.4 billion even in 2020, widened to £155.4 billion last year, 10 times what it was a quarter of a century ago. Forty years ago, the UK ran a trade surplus in manufactured goods, and had always done so. The last time the UK had an overall surplus on trade in goods also was in the early 1980s, thanks to North Sea oil.

Which brings me to one of my points today. The UK’s oil surplus lasted until the early 2000s but now that trade too is in deficit, to the tune of £4.4 billion last year and a record £1.6 billion in January. Given the surge in oil prices, and those for imported gas, that deficit is only going to get bigger, probably very significantly so.

The other worry, recently highlighted by the Office for Budget Responsibility (OBR), and mentioned here a couple of weeks ago, is the UK’s disengagement from international trade.

Trade is good, it drives productivity and other improvements. It is no accident that politicians of the past lauded export-led growth. “Export or die” used to be a slogan.

In the run-up to the 2016 referendum the Bank of England highlighted how the UK had become a more open economy, with trade comprising a high proportion of gross domestic product (GDP) during the long period of EU membership.

That this has now gone into reverse was described by the OBR. While every other big economy member of the G7 has seen a recovery in trade intensity – trade as a proportion of GDP – from the low point of 2020, the UK’s trade intensity is now even lower than it was at that low point.

The OBR is sticking to its view that Brexit will result in a 15 per cent drop in the UK’s trade intensity. The EU trade deals rolled over by the government, and the new deals being negotiated and in prospect, will only compensate for a tiny fraction of the losses as a result of Brexit, according to the official forecaster.

Rishi Sunak, who supported leaving the EU, like many who work or worked for hedge funds, reluctantly conceded in evidence to the Commons Treasury committee last week that Brexit was inhibiting UK trade. Boris Johnson, asked the same question by the Commons liaison committee, suggested it was because exporters were not trying hard enough. I know which one of them I would believe on anything to do with economics.

The UK’s disappointing recent trade performance goes deep. World trade in goods and services grew by a hefty 9.3 per cent in volume terms last year, according to the International Monetary Fund. Yet the UK’s exports of goods and services fell by 1.2 per cent on a balance of payments basis.

Exports of goods fell by even more last year, by 2 per cent from depressed 2020 levels. A couple of years into his chancellorship, George Osborne set out his ambition for doubling UK exports. Well, the volume of exports of goods and services last year was the lowest since 2014, while exports of goods were last lower in 2010, when the economy was recovering, bleary-eyed, from the financial crisis.

You might say that 2021 was a year when the economy was recovering from the pandemic, so some disappointment was inevitable. Certainly, manufacturers were beset with supply shortages and some service sectors, notably travel and transport, were a long way below normal levels, depressing service-sector exports (though this is an area in which UK imports traditionally exceed exports). Imports have also been depressed.

On the same basis that saw UK exports fall last year, and end 2021 with exports 15.7 per cent below the pre-pandemic levels prevailing at the end of 2019, however, France’s exports grew by 9.2 per cent last year, while Germany’s were even stronger, up 9.9 per cent. You would expect Germany to have been even more hobbled by the impact of supply shortages on industry.

I do not blame Britain’s exporters for this malaise. We have some superb exporting businesses, but they are operating with one hand tied behind their backs and with notably less government help and support than competitor countries. I don’t think a new royal yacht, which the government is proposing to use as part of future export drives, will change that.

It is too late to do anything about the main cause of this malaise, an economically damaging Brexit done in such a way that little, or no thought was given to the consequences. As far as trade is concerned, things are panning out in the way once stupidly dismissed as “project fear”. And we will be poorer as a result.

Sunday, March 27, 2022
Our firefighting chancellor tinkers while inflation burns
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is a few days since Rishi Sunak’s Spring Statement and, if it registered, you have probably forgotten most of it by now. That, without being unkind, is probably no bad thing, The crisis chancellor, for that is what he has been since being unexpectedly elevated to the job in February 2020, is still firefighting.

For those of us with long memories, his latest effort was steeped in nostalgia. Alan Greenspan, the former head of America’s Federal Reserve once successfully nominated for an honorary knighthood by Gordon Brown, but whose reputation suffered in the financial crisis, once described low inflation as “that state in which expected changes in the general price level do not effectively alter business and household decisions.”

During a low inflation era, in other words, people and firms do not constantly have one eye on inflation when they are deciding what to do. The same is true of chancellors. It is a very long time since a chancellor has stood up in the House of Commons to confront high inflation and a cost-of-living crisis. It last happened more than 25 years ago, before Bank of England independence.

One of the big reasons for independence, indeed, was because Brown did not want to spend his chancellorship inflation firefighting, freeing himself up make the Treasury an economics ministry, charged with the task of improving the economy’s long-run performance.

Sunak, although his hero as chancellor is Nigel Lawson, has a similar ambition. He genuinely wants to improve the UK economy’s performance. He wants to get British businesses to invest more and spend more on research and development (R & D).

It offends him that the UK does so much worse than competitor countries on investment and R & D and that the best the Office for Budget Responsibility (OBR) can offer for the medium-term is productivity growth of 1.3 per cent a year, two-thirds of its long run average. The OBR, it should be said, has an optimism bias when it comes to its productivity forecasts.

Our supply-side chancellor, who I think is the only holder of the post to possess an MBA, a Master of Business Administration from America’s Stanford University which he studied for courtesy of a Fulbright scholarship, wants to change this. He would love nothing more than to spend his time absorbing the evidence and research and talking to businesses about what they need from him to improve their investment and R & D game.

There will be some of this over the next few months in the run-up to the autumn budget but, while it would be wrong to pre-judge, it is probably not wise to hold your breath for anything genuinely transformational, particularly with a big increase in corporation tax, from 19 to 25 per cent, due in April next year.

How did the chancellor respond to the cost-of-living crisis? One thing they teach you at business school is the importance of focus. Concentrate hard on the matter in hand and try to resolve it.

This was not Sunak’s only stab at dealing with the cost-of-living crisis, He has been responsible for more fiscal “events” outside the normal run of budgets, statements and spending reviews than any of his predecessors. Last month he announced a £9 billion package, consisting of a £150 council tax reduction for bands A to D properties and a scheme to cut £200 off energy bills in the autumn, paid for by users over the following five years.

That may have persuaded him that he had done enough, in which case he made a significant miscalculation. When a Labour MP shouted “is that it?” after he unveiled his latest measures on Wednesday, he echoed my sentiments. A 5p cut in fuel duty and making household investments in green technology VAT free did not cut it.

For those facing big real cuts in benefits and state pensions, who get around by bus rather than by car, and for whom spending thousands on solar panels is about as likely as a trip to the moon, there was nothing. The most striking number in the Office for Budget Responsibility’s latest assessment was that living standards will suffer their biggest annual fall, more than 2 per cent, since records began in 1956-7. This was on the back of an expected peak in inflation of 8.7 per cent later this year, and an average of 7.4 per cent, together with the reality of higher taxes.

It is too late now to do anything about the real cut in benefits and pensions and the reality of that drop in real incomes in coming months, though it is perfectly possible that the chancellor will be back to offer more help, as he surely must, which would fit the pattern of his chancellorship,

There was, it should be said, a very welcome announcement in the spring statement, which was the equalisation of the starting threshold for national insurance (NI) with that of income tax, £12,570 from July. This is a long overdue reform, and the chancellor should be congratulated for doing it, even if that threshold is due to be frozen for the next four years, along with that for income tax.

Unfortunately, the timing of this welcome change was clouded by everything else happening around it. Next month’s NI increase, 1.25 percentage points for employees and a similar hike for employers, was meant to be essential to pay for the NHS post-pandemic catch-up, including in the coming year. But the chancellor has just handed 40 per cent of it back by raising the threshold, which makes a mockery of the hypothecation (a tax rise for a specific purpose) it was meant to be. And, as economists would point out, the 1.25 point rise in NI for employers will ultimately be paid for by employees, in the form of lower wages than would otherwise be the case.

The other big tax oddity was Sunak’s announcement of a 1p cut in the basic rate of income tax in 2024. He would say that, having pre-announced tax increases, as he did last year, it was fine to pre-announce a cut. But that small cut in income tax, if it happens, will come alongside an increase in income tax as a result of the freezing of allowances and thresholds, and the increase in NI, which will be renamed the health and social care levy from April next year. What it does, frankly, is make a messy tax system even messier.

The second most striking number was that, even with the chancellor’s gimmicky promise of a 1p cut in income tax to 19p in the pound in 2024, the tax burden is on course to rise to its highest level since the late 1940s. That is the wrong kind of progress; in the autumn the OBR thought it would only be the highest since the early 1950s.

To be a genuinely low tax chancellor, Sunak would have to abandon some of his planned tax hikes and cut income tax to 15p, not 19p. I am not advocating that, and I do not expect. Higher public spending means a higher tax burden, and it looks as though we are stuck with it.

Sunday, March 20, 2022
Lessons from the 1970s on when policy goes wrong
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is the chancellor’s spring statement on Wednesday and, according to an authoritative report by my colleague Tim Shipman in this newspaper last week, Rishi Sunak has been preparing for it, in part, by studying the oil shocks of the 1970s, and being briefed by officials on them. That is no bad thing for, while the oil price has come down in recent days – though not much so far at the petrol pumps – it is always good to be prepared.

Neither the chancellor nor I suspect the officials who briefed him had been born at the time of the first oil shock in the 1970s, the decision by member of Opec (the Organisation of Petroleum Exporting Countries) to suspend oil exports to America in October 1973 and the subsequent quadrupling of the oil price.

But, while there are parallels between the threat of an energy supply and price from Russian oil and gas, the differences between the current situation and the 1970s are greater than the similarities. The old cliché about the 1960s was that if you remember them, you weren’t there. That was always a bit of an exaggeration, though that may be because the swinging sixties never made it West Bromwich.

If you lived through the 1970s, which through the prism of history looks like a grim parade of runaway inflation, strikes, the three-day week, IRA bombs and impossibly flared trousers, you will know that it was not as bad as that, and it was a Technicolor time of cultural awakening, particularly for music. There was also, though nobody used such a crass term as levelling up, a bit of unintended regional rebalancing.

London in the 1970s was on the ropes, crime-ridden, polluted and suffering population decline. Its subsequent revival was far from guaranteed.

The important thing about the first Opec oil shock is that inflation was already high when it happened. Retail price inflation, the measure of the time, rose to more than 10 per cent in 1971 and was around 9.5 per cent during 1973, in the months before the oil price shock. That pushed inflation up into the mid and upper teens during 1974. But the full extraordinary inflation peak, 26.9 per cent in August 1975, came well after the surge in oil prices.

That it did so was because the inflation of that period was the result of a cocktail of factors, and not just the oil price. The inflation of the very early 1970s was partly a follow-though from sterling’s November 1967 devaluation. The pre-Opec inflation in 1973 was a consequence of the Barber boom, after the then chancellor Anthony Barber, the economy in that year growing at its fastest rate in the post-war period, at least until last year pipped it. 1973’s growth was not, however, preceded by a pandemic slump in activity and the biggest drop in gross domestic product for a century.

The very high inflation of 1975, after the oil price shock, was due to what economists call second round effects. Wages and salaries grew by 29.4 per cent in 1975, according to a now discontinued official series. The wage-price spiral was alive and well and living in Britain.

In economic terms, perhaps the biggest impact of the inflation of the 1970s was that it brought about a fundamental change of policy. Monetarist economists such as David Laidler and Alan Walters made their names by predicting that the rapid money supply growth of the early 1970s would bring about very high inflation.

Those predictions, together with the Labour chancellor Denis Healey’s failed attempt to expand the economy out of recession caused by the oil shock, led directly to the monetarist revolution. James Callaghan, the Labour prime minister, buried post-war Keynesianism with his famous “you can’t spend you way out of recession” speech in 1976, written by his son-in-law and former Times economics editor Peter Jay.

When Labour was forced to turn to the IMF for a bailout that same year, the Washington-based Fund insisted on the adoption of targets for the money supply. These were willingly embraced, at least for a while, by the Thatcher government elected in 1979. The economic policy landscape was never quite the same again.

There are, as noted, more differences between now and the 1970s than similarities. There will be no wage-price spiral this time. Higher petrol prices, and even more gas prices, make us wince and will make life very uncomfortable for many people, starting next month. But the economy is less sensitive to changes in energy prices, and less critically dependent on energy for economic growth, than it was, because of the decline of heavy industry – and industry in general – and improved energy efficiency.

The energy ratio, or energy coefficient, measures how much more energy is needed to produce a 1% increase in GDP. In the 1970s it was roughly one to one; every 1% GDP rise required a 1% increase in energy consumption. Now it is a quarter of that, perhaps less. Even since 1990 the energy ratio has more than halved. The old rule of thumb, that an energy price shock guaranteed recession, no longer applies.

You should not, as somebody once said, let a crisis go to waste. In the 1970s, the crisis led to a fundamental rethink of economic policy. Fiscal fine-tuning could not work in an environment of much bigger economic changes.

The current crisis is bringing change too. Germany is revisiting her energy and defence policy and all countries are aiming to reduce dependence on Russian energy.

But, after a week in which both the Bank of England and the Federal Reserve have announced modest increases in interest rates, it is time to ask whether monetary fine-tuning works either.

In a couple of months, the Bank will mark 25 years of independence. The anniversary will occur with consumer price inflation not only above the 2 per cent official target but decisively so, by several percentage points, and at 8 per cent on its own projection.

For the first of 10 years after independence, inflation was extraordinarily well behaved. When inflation is more than 1 per cent away from the official target, the Bank governor has to write an open letter to the chancellor to explain why, and what the Bank is doing about it. For 10 years there were no such letters. Since 2007, by my calculation, there have been well over 20 such letters. Given that they have only to be written every three months that inflation is off beam, that is a lot of missed targets.

The inflation overshoot in coming months will be easily the biggest in the period of independence. Questions will be asked about the Bank’s credibility and whether peashooter increases in interest rates can be effective. The Bank would argue that it was caught in a trap and that, to head off the inflation that we are now seeing, not only would it have had to raise interest rates during the worst phase of the pandemic, but that it would have seriously hampered the economy’s post-Covid recovery.

It is legitimate to ask, however, whether the framework established a quarter of a century ago is still fit for purpose. As in the 1970s, it may be time for a rethink. That should not mean abandoning Bank independence. It does mean conceding that, when the economy is faced with a global inflationary shock, and the trade-off between growth and inflation has worsened, it is fantasy to think that the Bank’s monetary fine tuning can keep everything under control.

Sunday, March 13, 2022
When war is raging, it isn't the time for big tax hikes
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

In 10 days times Rishi Sunak will deliver his spring statement or, as the Treasury prefers to describe it, his spring forecast statement. Much has changed since the date for this event was announced just before Christmas last year.

What was intended to be a victory roll for the chancellor – celebrating the economy’s robust emergence from the pandemic, the success of the furlough scheme in holding down unemployment and the fact that the public finances are on the mend – has turned into something rather different.

The Russian invasion of Ukraine has hit business and consumer confidence, will push inflation even higher and intensify the cost-of-living crisis. Back in December, when the spring statement date was announced, the most recent forecast from the Bank of England, made in November, was that inflation would peak at about 5 per cent in the spring and then fall back quickly. If only.

It is now clear that we are in a very different situation, one in which inflation will peak at more than 8 per cent and in which the government’s vainglorious “fastest growth in the G7” boast will only work if other countries are hit even harder.

The big issue, of course, is what will happen to what have become some of worst-timed tax increases in history, next month’s increases in national insurance (NI) for both employees and employers and the freezing of income tax allowances and thresholds. Not only that, but the chancellor is under pressure to offer more direct help to households and businesses, and beef up defence spending.

More on that in a moment, first a little context. The spring statement occupies a curious place in the fiscal calendar. It is not intended to be a budget or a mini-budget and the Treasury has been unusually keen this time to make the distinction. It is to meet a legal requirement dating back to the 1970s, that two official economic forecasts are published each year. The actual budget will be in the autumn.

The previous spring statement was by Philip Hammond, the last chancellor but one, who was determined to have only one major fiscal event – the budget – each year. His was in March 2019, a year in which because of Brexit and the general election, there was, unusually, no actual budget.

Hammond’s March 2019 spring statement was his last hurrah as chancellor. In what now seems like a time of extraordinary calm, the then chancellor made announcements, particularly on extra public spending. These things come full circle. One highlight was the government’s strengthened commitment, with money attached, to the Oxford-Cambridge Arc, Britain’s Silicon Valley.

Latest reports, however, suggest the Arc is no longer ascending, with plans for an expressway linking the two ancient university cities and 1 million new homes put on the backburner.

What about this month’s spring statement? The government was criticised by the House of Commons Treasury committee because so many of the contents of the budget and spending review last October leaked out. I am not going to knock that but we shall have to see how much comes out this time.

There are, as noted, two questions. One is whether the chancellor presses ahead with his planned tax increases. The second is whether he introduces further specific measures.

I imagine last week’s announcement by the Irish government that it is making hefty cuts to the duty on petrol and diesel was greeted with less than joy in the Treasury. Fuel duty is a totemic issue for many Tory backbenchers, who would like to see their constituents similarly cushioned from the worst of the fuel price increases.

The cuts, the equivalent of 17p a litre off petrol and 12.5p off diesel, effective until the end of August, would not come cheap in the UK. By my calculations, they would cost more than £3 billion if implemented for only six months. Even for a chancellor who has persisted with the freeze in duty that has been in place since 2011 that is expensive.

A temporary cut in petrol and diesel duty would face a significant “re-entry” problem, with the motoring lobby arguing for new lower duties to be made permanent. It would also be impossible to do without further assistance for households.

It is wise not to pay too much attention to what Boris Johnson says, particularly on economic matters, but in prime minister’s questions a few days ago he was lauding the chancellor’s interventions so far, notably the £9 billion package announced last month, of a £150 council tax reduction for most households and a planned £200 energy price bill reduction in the autumn, to be paid back over the next few years. Mind you, he also defended the government’s shambolic response to the plight of Ukrainian refugees.

You have to feel some sympathy for the chancellor. He is under intense pressure to further ease the impact of the energy shock on the economy and may have made something of a rod for his own back by the effectiveness of his interventions during the pandemic. As well as this, the Institute for Fiscal Studies says the defence spending would need to rise by a quarter for the UK to remain the second biggest spender in Nato. The war in Ukraine makes last year’s integrated review of defence, security, foreign and development policy already look badly out of date.

That may also be the case for the new forecast from the Office for Budget Responsibility (OBR) which is what the spring statement was intended to be all about. Forecasting in the current situation of high but seesawing energy prices is like catching a falling knife. All around, independent forecasters are halving their growth predictions, with some predicting that growth will peter out completely by the end of the year. For the OBR, the need to meet deadlines, and show the Treasury its workings, probably means that the forecast has been pretty well put to bed by now.

Having said all this, the fundamental question for the chancellor is whether he would be raising taxes in these circumstances if not for the legacy of the pandemic. The answer to this, I think is a firm no.

Next month’s NI increase, which adds up to 2.5 percentage points, combining the employee and employer increases, a £12.7 billion tax hike, is mainly about funding he NHS’s post-pandemic catch-up. The freeze on income tax allowance and thresholds, which is intended to continue until 2026, is all about repairing the public finances after the costs of the pandemic.

Neither would suffer from a one-year delay, particularly as we emerge from another year in which the budget deficit has significantly undershot official forecasts. The NI increase has been constructed in a such a way that a one-year delay would be neater. From April 2023, NI will revert to previous rates, with the increase being labelled as a separate health and social care levy.

Will it be delayed? So far, the chancellor looks to have dug in, but external circumstances are changing by the day. This does not look like a good time to be inflicting a big tax increase on the economy. And one thing is clear. We will need to see more than just a statement on March 23.

Sunday, March 06, 2022
Britain is dire at investing - and now there's an energy shock
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

If it was not clear a week ago, we can now see that, in addition to the horrors unfolding in Ukraine, a big price shock is unfolding. The oil price, having risen and then dropped back in the immediate aftermath of the Russian invasion, has nudged $120 a barrel. The gas price, even more in focus at present, has followed a similar pattern and tested last year’s highs.

The immediate impact of this, and of Europe’s efforts to reduce dependence on Russian oil and gas, will be to intensify and prolong the cost-of-living crisis. Inflation is heading higher than the Bank of England’s predicted peak of 7.25 per cent later this spring.

More significantly, an important part of the inflation story had been that the second half of this year would see energy prices settling down after their winter surge. That way, as well as the easing of non-energy supply shortages and other temporary factors, there was a clear path to lower inflation. Forecasters surveyed by the Treasury last month expected inflation to end this year at between 4 and 5 per cent.

Now, however, the energy shock has emerged as a risk to that. The renewed rise in gas prices threatens another big rise in the energy price cap in October, something that was not incorporated in the forecasts. Though these are early days – the October cap will be set in August on the basis of forward wholesale gas and electricity prices over the previous six months – the omens are not good. Energy prices need to come back down quite soon to save consumer from another, potentially eyewatering, increase in energy prices.

There is another aspect to this, which I wanted to focus on today. Ten days ago Rishi Sunak set out some big thoughts on the economy, in his Mais lecture at London’s City University. He was treading a familiar path, previous chancellors having used the same platform for important speeches describing their economic philosophy. Sunak’s, delivered just as the Russian tanks were starting to roll into Ukraine, did not get as much attention as it might have done in other circumstances. The chancellor has himself been preoccupied with Russian sanctions.

One of his central messages was the need for the UK to increase business investment. One comparison that has stayed with me was from the Office for National Statistics a while ago. It showed that, taking public and private investment together, over the period 1997 to 2017, the UK invested less as a percentage of gross domestic product (GDP) than any of the 30-plus members of the Organisation for Economic Co-operation and Development, the advanced economies’ club.

Nor was it close. The UK’s average over that period, 16.7 per cent of GDP, was three percentage points lower than the next lowest, Italy, and only just over half the highest, South Korea. Since then, at least s a far as the private sector component of investment is concerned, things have got worse rather than better.

The EU referendum, and the vote for Brexit, brought the recovery in business investment after the financial crisis to a halt. The pandemic drove it down again and it is yet to properly recover. Last year business investment in real terms was down by more than 12 per cent compared with 2016. Over the previous five years it had grown by 34 per cent.

There are two questions that arise now about business investment. The first is the extent to which ti recovers this year. The second, raised by Sunak, is whether it can be lifted to match competitor countries.

On the first, I noted recently that, channelling Elvis Presley, this year is now or never for business investment. Firms have just over 12 months to take advantage of the chancellor’s 130 per cent “super deduction” against corporation tax, after which the tax will rise from 19 to 25 per cent and, on present plans, the additional incentive will disappear.

This is why the energy price shock is so unfortunately timed. History tells us that such shocks are toxic, not just for consumers, but for businesses, who respond by cutting back on their investment plans.

There is a caveat. Much of the evidence and research on the impact of energy shocks dates from the Opec (Organisation of Petroleum Exporting Countries) oil price hikes of the 1970s and early 1980s. This was a time when industry, and in particular heavy energy-using industry, played a much bigger role in the economy. The impact of energy shocks may be less in a service-based economy.

The jury is out on this. Even before the Russian invasion forecasters had scaled back their prediction for business investment this year, though still expected a significant increase. The British Chambers of Commerce, however, in a new forecast, has revised down its prediction for business investment growth this year to just 3.5 per cent. It remains to be seen what the Office for Budget Responsibility (OBR) will come up with in its new forecast later this month. In late October last year it predicted a business investment boom this year, with a predicted rise of 15.7 per cent.

In some respects, firms remain in expansionary mode. The latest picture from the Recruitment and Employment Confederation (REC) showed a strong increase in advertised jobs in the final week of February. There were, it said on Friday, 1.82 million active job adverts, with a 224,000 increase in the latest week, the biggest since early December.

We can hope that willingness to recruit extends to willingness to invest. Purchasing managers’ surveys show that, in the UK and elsewhere, February was a month of bounce-back from the Omicron variant of the coronavirus. Now that Covid has been pushed off the news bulletins and front pages, it has been replaced by a new uncertainty.

That will pan out in coming months. What about lifting the UK’s investment over the medium and long term, which is the key to raising productivity?

In his Mais lecture, Sunak pulled no punches. Business investment in the long run in Britain averages 10 per cent of GDP, he said, compared with an OECD average of 14 per cent. And, anticipating, what some see as an excuse for the UK’s poor record, he was clear.

“The lower level of capital investment we see by UK businesses is not primarily driven by the sectoral composition of our economy, or by differences in firm size, and is observed across all regions,” he said. “This is a pervasive economy wide issue, it has been persistent for decades, and we must fix it to improve productivity, growth, and living standards. Indeed, we need the private sector to invest to level up this country.”

The government, through increased infrastructure spending, is playing its part by raising public investment. But what about businesses? His diagnosis is that the tax treatment of investment is less generous than in other countries and that that needs to be fixed. Cutting corporation tax did not provide a spur to investment, as pointed out here before.

What kind of tax incentives would work? That is what the chancellor will be examining in the next few months, leading up to potential action in his autumn budget. The CBI has already set out a marker, by calling for a version of the super-deduction, but pared back to 100 per cent tax relief on investment, to be made permanent.

That, though, looks too expensive, costed by the Treasury at £11 billion a year, the cost of a more politically appealing 2p reduction in the basic rate of income tax. Whether meaningful incentives can be introduced at much lower cost is something Treasury officials will be scratching their heads over in coming months.

It is not all about tax incentives. New technologies such as artificial intelligence (AI) offer opportunities for investment, as does the transition to net zero. But that applies to other countries too. Sunak has identified the UK’s investment problem. Whether he can cure it is another issue.

Sunday, February 27, 2022
War will slow our recovery but shouldn’t finish it off
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

How many shocks can we take? After the two “once in a lifetime” shocks, the financial crisis and pandemic, Russia’s invasion of Ukraine has led to many warnings of the biggest war in Europe since `1945. You will have seen and read many accounts of this, including in this newspaper. My task today is to try and assess where it leaves the economy, and it is far from straightforward.

When, last month, forecasters published their predictions for the global economy in 2022, their expectation was for relatively strong growth, though weaker than last year, alongside higher inflation. The International Monetary Fund (IMF) predicted 4.4 per cent global growth alongside inflation averaging almost 4 per cent in advanced economies (and nearly 6 per cent in America).

The effect of Russia-Ukraine will be somewhat slower growth, though not a world recession, and somewhat longer-lasting inflation. That inflation effect will come through higher and more prolonged increases in oil and other energy prices, including crucially, gas, and higher process for food commodities, notably what. The oil price, which has already moved back above $100 a barrel, is unlikely to reach the all-time high of almost $150 it reached in 2008 but could easily hit the $120s.

For the UK economy, this means that two essential questions will again be asked. The first is whether consumers will continue to spend when faced with an even more intense cost-of-living squeeze.

Even before news of the invasion, consumers were getting gloomier. The latest GfK consumer confidence index, for this month, published on Friday, showed a seven-point fall to -26, its lowest since January 2021, when the country was in lockdown and the vaccination programme was in its infancy.

Disturbingly, the biggest fall in confidence, of 12 points, was in people’s expectations for their personal financial situation over the next 12 months. This, rather than more general fears over the economy, is what drives people’s spending decisions. There was also a drop in the major purchase index.

With inflation set to peak this spring rather higher than the Bank of England’s 7.25 per cent forecast, and even higher on the retail prices index (where inflation is already well above 7 per cent), this drop in confidence is not surprising. Letters and emails are arriving informing people how much their gas and electricity direct debits are going to eb rising and they are pretty eyewatering. Petrol is the most visible price in the economy and we will soon get used to well over £1.50 a litre.

What all this means for consumer spending is that the heavy lifting will be done by two things: the strength of the labour market and the large stock of savings, almost £200 billion, that households built up during the pandemic. Before the latest developments, economic forecasters surveyed by the Treasury thought that these factors would be enough to lift consumer spending by between 5.5 and 6 per cent this year.

Some of that reflects what economist would call base effects, and the comparison with a weak first quarter of last year, when spending fell. Most of it reflects the view that many people will save less, borrow more and spend some of their accumulated savings, thus looking through the cost-of-living squeeze. It would be a huge shift to go from that kind of prediction to a fall in consumer spending, so we should still be looking for a rise, but a smaller one than was expected. Retailers and other consumer-facing businesses will find it tougher.

Part of the calculation about consumer spending will be that it depends on what businesses do. We have entered this crisis with the labour market tight, vacancies high and employers competing, in some sectors, for scarce labour. As long as firms want to recruit, and the evidence is that they do, any fallout for the job market should be limited.

The other question, and it is my second one about the outlook, is whether the uncertainty will deter businesses from investing. Business investment is more than 10 per cent below pre-pandemic levels and, though investment intentions are strong in business surveys, those surveys tend to be dominated by rising cost and price pressures. There should eb a rise in investment this year, but the jury is still out on how strong it will be.

If all this sounds a bit gloomy – a recovery but not as good as hoped – is there a light at the end of the tunnel? If we look at the oil price, most comparisons show that is at its highest since 2014, which was when Russia annexed Crimea. The history of the oil price is that it spikes and then falls, though some of those spikes can last for a time.

After the 2024 highs, oil prices then recorded one of their biggest falls in history, falling by 70 per cent in 2015-16 and delivering the UK its lowest inflation rate – zero in 2015 – its lowest since the early 1960s. High prices had the effect of bringing forward more supply and prices fell in consequence.

Will history repeat itself? A fall after a spike is likely but not guaranteed. One of the countries which responded to higher prices by increasing supply in 2015-16 was Russia, and it may have its own reason for not doing so this time. Members of the Organisation of Petroleum Exporting Countries (Opec) are currently increasing output to pre-pandemic levels and debating whether to go further in response to high prices.

The other complication is gas, which normally gets a lot less attention than oil, but not now. It had some down from last autumn’s highs but has increased. Whether it will also follow the spike pattern and move lower, to the considerable relief of households and businesses, remains to be seen. The only honest answer is that the outlook for gas prices is highly uncertain. Futures prices suggest a fall but they may not be a reliable guide.

Adding all this up, even with potential lights at the end of the tunnel, the outlook has plainly darkened. Russia is a rogue state, and its actions should not drive us into recession, and indeed are unlikely to do so. But they will damage growth prospects, at a time when we need all the growth we can get.

Sunday, February 20, 2022
Private sector lags behind in our unbalanced recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

For as long as I can remember, people have observed that the UK economy is unbalanced. Many chancellors have taken office promising to restore the economy’s balance. None, I would suggest, has yet succeeded.

Usually, the imbalance was described in terms of an economy too reliant on consumer spending, and on too much money going into property rather than productive investment, The pandemic was supposed to be followed by a period of, as they say, “building back better”.

That remains an ambition, and it is a laudable one, but it is important to recognise that the starting point is an economy more unbalanced than ever. Economic nirvana is an economy driven by exports and investment, moving productivity growth – the ultimate driver of prosperity – higher.

Economic reality is rather different. The good news recently was that the economy is almost back to pre-pandemic levels, with gross domestic product in the final quarter of last year just 0.4 per cent below its level two years earlier.

Though that still means two years of lost growth it represents a rebound which is quicker than a typical recession-recovery cycle, which usually takes three years and, after the financial crisis, took five.

The nature of that recovery is, however, nevertheless a cause for concern. Consumer spending has done OK and, like GDP as a whole, is a mere 0.4 per cent below pre-pandemic levels. But exports, hit by Brexit as well as the pandemic, are a huge 18 per cent down. Business investment, which had stagnated after the EU referendum in 2016, is down by more than 10 per cent even on that underwhelming pre-pandemic level.

So if exports and business investment remain depressed, where has the growth been coming from? The answer is that it has been coming from the government. Samuel Tombs, chief UK economist at the consultancy Pantheon Macroeconomics, separated private sector and public sector GDP.

Spending by the government, in the form of public spending and public investment were 10.9 per cent higher, in real terms, in the fourth quarter of last year compared with two years earlier. In contrast, private sector GDP was down by 3.2 per cent. The private sector is not back to where it was before coronavirus and may take some time to do so. Its performance is more like a typical recession and recovery.

You may remember that in 2020, when the UK’s economic performance was worse than others, with the biggest drop in GDP in the G7, ministers and government supporters made much of the fact that the treatment of the public sector by the official statisticians artificially depressed this country’s GDP in comparison with others.

Well, what the public sector took away then, it is giving back now. In the final quarter of last year, according to the Office for National Statistics ONS), the largest contributors to the rise in quarterly GDP “were from human health and social work activities driven by increased GP visits at the start of the quarter, and a large increase in coronavirus (COVID-19) testing and tracing activities and the extension of the vaccination programme”. The private sector was some way behind.

The UK’s export performance is quite disturbing, though perhaps not that surprising. After falling very sharply in 2020, along with everything else, exports dropped again last year, by a little over 1 per cent. This was quite an achievement in a year in which, according to the International Monetary Fund, world trade volumes in goods and services rose by a very strong 9.3 per cent. In the context of these figures, global Britain looks like a sad joke.

You do not need to be Hercule Poirot to work out that Brexit, and a trade deal put together by the negotiating equivalent of Inspector Clouseau, has damaged Britain’s overseas trade, in both directions, whatever the new minister for Brexit opportunities says. I admire what successful exporters do, but they are operating with a ball and chain attached to their ankles.

A survey last week of 1,000 firms by the British Chambers of Commerce (BCC) showed that nearly three-quarters of businesses, 71 per cent, say the deal has been bad for them, standing in the way of their ability to grow. Small and medium-sized firms have been worst affected with the majority citing additional costs, paperwork and delays. The deal, they say, has put the UK at a competitive disadvantage.

A recent survey showed that a high proportion of MPs struggle with simple statistics. Those who voted for the UK’s deal with the EU have an even bigger struggle with basic economics. The BCC has put forward a five-point plan for improving on the deal but it is not clear that anybody in government is listening.

As for business investment, we have arrived at the point that Elvis Presley might have described as now or never. Businesses have until April 2023 to take advantage of Rishi Sunak’s “super deduction” in which they will be able to offset 130 per cent of their investment spending against their corporate tax liability. It is not as generous as its sounds, allowing firms, in the Treasury’s own description, to cut their tax bill by up to 25p for every £1 they invest in plant and machinery. But it is an incentive, and unless firms choose to take advantage of it, we may have to write off a meaningful investment recovery.

After that, the corporation tax rate will in any case go up from 19 to 25 per cent and all bets will be off, with forecasters expecting investment to weaken after April 2023.

Investment intentions surveys are, it is true, quite strong, suggesting that this could indeed be the year when business investment finally kicks in. But firms have a lot on their plate, including sharply rising costs, a coming national insurance hike and recruitment difficulties. As I have pointed out before, investment and recruitment are complementary, not substitutes for each other. If you are investing in new plant and machinery you need to be sure that you have the people to operate it.

The Office for Budget Responsibility (OBR), the official forecaster, predicted in late October, its most recent forecast, that this year would be a bumper one for business investment, with a rise of 15.7 per cent. But forecasters have become more downbeat since then, with the latest average of new independent forecasts compiled by the Treasury suggesting a rise of just over 5 per cent.

How will the UK’s economic imbalance resolve itself? Government support of the kind unveiled during the pandemic cannot be permanent and, indeed, will be greatly reduced in coming years. The private sector will have to resume its position as the driving force of the economy.

Economists fear that the resolution to the imbalance will be slower growth and that, having seen growth taken down several notches after the global financial crisis, the pandemic and Brexit will have taken it down even more. That does not have to be the case if it were possible to be more optimistic about exports, investment and productivity. But something would need to happen soon to justify such optimism.

Sunday, February 06, 2022
Rampant inflation lets the Bank's hawks take flight
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Super Thursday has many meanings. It is used to describe those occasions when several important elections take place simultaneously, or when people like me try to analyse a bunch of official statistics published at the same time on that day, some of which get missed in the rush. In the publishing industry there is a Super Thursday each autumn, when more new books are published than on any other day of the year.

We had a different sort of Super Thursday last week, though most people would say there was nothing very super about it, and that Black would be a more appropriate description. First off was the announcement of a huge 54 per cent increase in the energy price cap to within a whisker of £2,000 a year - £1,971 – by Ofgem, the energy regulator.

Then came Rishi Sunak’s measures to ease the energy burden, yet another significant fiscal announcement made separately from a budget or other formal occasion, as has been the pattern during the pandemic.

Finally, the Bank of England stepped up, raising the official interest rate to 0.5 per cent, as had been widely expected, but also revealing more hawkishness than anticipated. This was both in the fact that four of the nine members of its monetary policy committee (MPC) voted for a bigger increase in rates, to 0.75 per cent.

Not only that, but as I suggested last month it would, the Bank has shifted from quantitative easing (QE) to quantitative tightening (QT). The massive QE it has undertaken since the depths of the financial crisis, will be gradually reversed. Again, this went a little further than expected.

There are two elements to QE. Most, £875 billion of the £895 billion total, is in UK government bonds, gilts. The Bank’s decision not to reinvest the proceeds of these gilts when they mature, which it has been doing up to now, will reduce QE by nearly £28 billion next month, by a total of £70 billion over 2022 and 2023 combined, and by a further £130 billion during 2024 and 2025.

That would still leave the stock of gilts held by the Bank at £675 billion at the end of 2025, though the Bank could go further to reduce it by actively selling gilts back to the markets. It could begin to do that, on its own rule, when Bank rate reaches 1 per cent. Markets have in mind a 1.5 per cent rate, later this year or next. Whether it does so or not, Thursday’s decision gives the lie to the very many people who have told me over the years that QE would never be reversed. This is even more the case with the £20 billion corporate bond element of QE, which will be fully unwound by the end of 2023 through a combination of not reinvesting maturing bonds and active sales.

What do the first back-to-back interest rate increases for 17 years, QT, and the chancellor’s response to high energy bills tell us? Does raising interest rates make a bad situation worse, as some would say?

Thursday’s flurry of monetary and fiscal announcements tells us, first and foremost, that policymakers have been badly caught out by the surge in inflation. There was an element of panic in these moves. As I discussed last week, most economic forecasters were caught out by the inflation surge.

The particular problem for the Bank, as its governor Andrew Bailey discussed in the press conference after the rate hike, was that, given the lags between changes in monetary policy and its impact, it would have been necessary to raise rates before there was any sign of the danger and in the middle of the pandemic, at a time when the chancellor, through fiscal policy, was providing extensive support. There is never a good time to raise rates, but that would plainly have been a bad time.

As for the chancellor, giving with one hand while taking away with another is not a good look, and reflects the danger of pre-announcing tax hikes. He was right to resist calls for abandon the National Insurance hike, as I argued last week. Some of those pre-announced tax hikes, most notably the potentially painful freezing of income tax allowances and thresholds in April, date back to the budget in early March last year, when it was reasonable not to foresee the extent of this spring’s inflation.

But in September, when the NI increase was announced, it was already clear that inflation was soaring, as were energy prices. I suspect that the Treasury was focused on getting the NI hike agreed, as it was last Sunday in this newspaper, ensuring that Downing Street was fully on board for the increase with a joint piece confirming it from the chancellor and prime minister.

The chancellor’s moves – a £150 council tax reduction on most properties and a £200 reduction in energy bills in October, paid back in five £40 instalments in future years – aim to soften for the majority about half of the £693 increase in the energy price gap. They will leave in place most of a two-year drop in real incomes, which the Bank says is the biggest for decades.

These are not the sunlit uplands people might have expected, if not after Brexit, then after the pandemic. They are also indicative of the start of a tougher time for the chancellor, assuming he stays where he is. The debt interest bill is rising, with both bond yields and official interest rates set to rise further and, despite last week’s announcements, the Santa of the pandemic has been replaced by the Scrooge of the recovery, as he seeks to repair the public finances.

Could the Bank have made life easier for people by not raising interest rates? This is the oldest question in the book, though given the rarity of rate rise in recent years, it has lain dormant for a while. I used to get asked all the time why the Bank, or in pre-independence days the chancellor, was adding to inflation by raising interest rates. Those were also mainly the days when the standard measure of inflation, the retail prices index, included mortgage interest payments.

The answer is that higher rates reduce inflation, and this was well put the other day by Catherine Mann, a newish member of the MPC. As she put it: “I know that here has been a lot of talk already about the cost-of-living squeeze. And to be clear, it is not my goal to make this worse than it already is – to the contrary, I aim to bring inflation back down to target such that workers can enjoy real wage gains from their labour.”

An interesting real-life experiment is under way. The European Central Bank is much more reluctant to raise rates, leaving it later, though it admits the inflation risks are tilted to the upside. It would have been hard for the Bank to do that, given its forecast of 7.25 per cent inflation in the spring. We will see which approach works best.

Sunday, January 30, 2022
Why economic forecasters missed the surge in inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

The table accompanying this piece, and to be read in conjunction with it, is also available on www.thetimes.co.uk

Looking back can be a useful way to look forward. We learn from our mistakes, or we should do. In a moment or two I shall offer a brief look forward. In the meantime, delayed from its usual appearance around the turn of the year but benefiting from more information, it is time to see how economic forecasters did last year. It provides an opportunity to see for whom the bell tolls, and this time it tolls for the forecasters.

When I last did this exercise just over a year ago, covering how economists did in 2020, bad forecasts were entirely forgivable. Nobody knew at the start of that year that a pandemic was coming, or what the response to it would be. Even if we had done, there would have been a debate about the economic impact. Most of the simulations that had been done, admittedly for flu pandemics, suggested something milder. As it was, the UK experienced its biggest fall in economic activity for 99 years.

Missing that, as I say, was understandable. Only when the pandemic began could economists begin to assess its effects, and many of those assessments were very good. But there was another big error a year later, in January 2021. This time last year forecasters did a poor job predicting the recovery, which should have been much more straightforward.

Those of you who have followed these annual exercises over the years will know that separating the winners from the losers is normally a precise exercise, drilling down to who got closer in percentage points to the outturn. In normal circumstances forecasters do pretty well. The wild swings of the past couple of years have, however, meant a change in my scoring system to something much more broad brush and, even with the help provided by that, forecasters did not cover themselves with glory.

The big story, which I shall come on to, is the failure of economists to predict the surge in inflation. The Bank of England has been criticised for being asleep at the wheel on inflation, by not anticipating its rise. But it was in good company. This time last year most economists thought inflation by now would be close to the official 2 per cent target. Many thought it would be below it. The highest forecast was for an inflation rate of close to 3.5 per cent, compared with the 5.4 per cent we saw at the end of last year.

To explain why forecasters missed the rise in inflation, it is necessary to look into a little more detail at what was expected. Growth last year will have ended up at more than 7 per cent, though it did not feel like it and we do not yet have the final figures.

Most forecasters thought it would be less than that, with an average forecast of 4.5 per cent. But there was a reason for that, and it is only fair to say that they were unlucky. This time last year, the UK was in its third lockdown and there was uncertainty about how rapidly the vaccine programme, then in its infancy, would be rolled out. One particular reason for the low growth forecast was the expectation that the economy would be a hit a lot harder by the third lockdown than it was, thereby dragging down growth for the year. As a result, forecasts for growth in January last year were a lot lower than, say, in the previous September, when the average forecast for growth in 2021 was a very respectable 6.7 per cent.

The other thing forecasters got wrong was unemployment. The consensus was that the end of the furlough scheme would reveal the true condition of the labour market and be followed by a rise in the jobless total. This also fitted the narrative of an economy only slowly getting back on its feet after a third lockdown. But instead of the unemployment rate ending last year at 6.5 per cent, the average forecast, it was only just over 4 per cent. Forecasters did not fully allow for the extent of the shrinkage of the workforce during the pandemic. Higher unemployment might have been expected to bear down on inflation but it did not transpire.

The big rise in energy prices, particularly international gas prices, a significant element of the rise in inflation – energy accounted for about a quarter of inflation at the end of last year – was yet to come.

The unemployment error, in turn, fed through to another error. Would the Bank of England raise interest rates in the context of a big post-furlough increase in unemployment? Most forecasters thought not and, indeed, this was the reason the Bank gave for not raising interest rates in November before, reassured by the labour market data, it did so last month. It is widely expected to do so again this week, its first opportunity to do so since inflation hit 5.4 per cent, though these things are never guaranteed.

Some people did warn of higher inflation on the back of the money supply boost from the huge quantitative easing (QE) undertaken by the Bank and others in response to the pandemic. The most prominent to do so was Tim Congdon of the Institute of International Monetary Research, who said in December 2020: “Our central expectation has to be that the annual increase in consumer prices in one or all of the USA, the Eurozone and the UK exceeds 5 per cent before the end of 2022.”

Interestingly, the highest inflation forecast in the annual comparison from last year was from Economic Perspectives, run by Peter Warburton, a former colleague of Congdon, with a broadly similar monetarist approach. He tops the league table. Patrick Minford’s Liverpool Macro Research group, which also adopts a monetarist approach, though a narrow rather than a broad one – I will not take up space here explaining the difference – was second, though his growth forecast was a lot better than his prediction for inflation. Both have experienced periods near the bottom as well as close to the top of the league table.

What does the record of last year tell us about the outlook for 2022? The average growth forecast for this year is similar to that made for last year in January 2021, 4.5 per cent. There has been a bit of softening of that forecast since the autumn, though not to the same extent as a year ago.

Forecasters think the worst of 2022’s inflation will be in the first half of the year and that, after perhaps reaching 7 per cent, it will end the year at 3.5 per cent, well above the official target. Bank rate is expected to rise to 0.75 per cent, though some think it could go a little further, to 1.25 per cent. Unemployment is predicted to stay around current levels at just above 4 per cent.

Will things turn out exactly lie that? Almost certainly not. But forecasters will be hoping to get a lot closer than they did last year. There is a decent chance that they will.

Sunday, January 23, 2022
Sterling shows that traders are relaxed about a change of PM
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Markets can be very cruel. I always think that it adds insult to injury when, after a boardroom struggle, a long-serving chief executive is forced out and the share price responds by rising, in a “resignation rally”.

There is no national share price but the performance of the pound can be a reasonable proxy, The currency markets have made some big calls in recent years. Sterling fell sharply during the financial crisis, on the argument, which was both logical and largely borne out by events, that the UK was more vulnerable to it than most other countries.

It fell again after the EU referendum in 2016 – the biggest short-term fall of any major currency in the floating rate era – on the view that Brexit would be damaging to the UK economy and British politics, again largely borne out by events.

In recent weeks something else rather interesting has been happening into the pound, as measured by the sterling index, its average value against other currencies. You might think that a prime ministerial crisis, with Boris Johnson hanging on by his fingernails, would be bad for sterling. But, as his woes deepened, and the revelations kept coming, the pound has been going up, a rally that began in early December.

You might say that many things can affect the currency, and you would be right. The Bank of England surprised many by raising interest rates in December and that could have boosted the pound. But sterling’s rally started before that, and the latest figures, showing inflation at a three-decade high of 5.4 per cent and cementing expectations of a rate rise next month, did not push the pound higher.

Nor does it look to be about Omicron and the response to it. Only very lately, with cases coming down and restrictions being lifted, has that been a factor.

The pound has been rising because, according to currency analysts, markets are either neutral about whether the prime minister is forced from office or think it would be good news for the country if his chaotic leadership were replaced with something more sensible and, yes, prime ministerial.

Though it would depend on who succeeded him, Johnson could find himself in the position of the ousted chief executive, in the sense of his departure being followed by a rise in the pound. When last week he appeared to have headed off the pressure to go for now sterling softened a little.

The succession question may have been postponed for now but one clear frontrunner would be Rishi Sunak. I have not, I should stress, spoken to him about this but I can only imagine what it must have been like living above the shop in Downing Street with parties spilling out into the garden, some of them involving drunken late-night revelries and broken children’s swings.

Anybody who has lived next to a student house will know the kind of thing. The chancellor is teetotal, which probably makes it worse, even apart from the rule-breaking, though he is a self-confessed Coke addict – Coca-Cola I should quickly add.

You might think that the short step from 11 to 10 Downing Street is an easy, even automatic one, but it is rarer than you would expect. Only four chancellors since the Second World War have become prime minister, though others have had the ambition to do so. Denis Healey is sometimes described as the best prime minister Labour never had, while George Osborne thought he was a shoo-in to succeed David Cameron until the Brexit vote intervened.

The four who did make it were Harold Macmillan, James Callaghan, John Major and Gordon Brown. Their records in office were mixed.

Callaghan, who moved aside as chancellor in 1967 after implementing a devaluation of the pound he had previously promised not to do, becoming home secretary, was prime minister from 1976 to 1979, losing to Margaret Thatcher. He ticked off all four great offices of state; chancellor, foreign secretary, home secretary and prime minister.

Brown, a 10-year chancellor whose many achievements included independence for the Bank of England, took over as prime minister in mid-2007, just as the financial crisis was breaking out. Within weeks he was faced with the run on Northern Rock, the first significant run on a British bank since the 1860s.

Both Callaghan and Brown suffered from not calling general elections when they should have done, Callaghan having lined everybody up for an election in the autumn of 1978 and then deciding not to do it and Brown repeating history in the autumn of 2007 with “the election that never was”. They would both have probably won the elections they decided not to hold and modern British history. As it was, Callaghan’s hopes were killed off by the 1978-79 winter of discontent of strikes and disruption, and Brown’s by the full extent of the financial crisis and recession.

Of the two Tory ex-chancellors who became prime minister, Macmillan and Major, both also served as foreign secretary, though only briefly in Major’s case. Macmillan, known for reassuring voters that they had never had it so good – “let us be frank about it, most of our people have never had it so good” – and won a general election in 1959. But his second term was more difficult, with the economy in difficulty, and he resigned in 1963, citing ill health.

Major, who as chancellor had taken sterling into the European exchange rate mechanism (ERM) was also an election winner, winning in 1992 when, following a recession he was widely expected to lose. But the next five years were troubled, characterised by Tory divisions over Europe and sleaze, before his loss in a landslide to Tony Blair in 1997.

If that tells you that moving from chancellor to prime minister is harder than it looks, that would be a fair assessment. The current chancellor, whose political rise has been meteoric, is competent, well-liked and has great attention to detail, and you would not apply all, or most, of those qualities to the prime minister.

The question in coming months will be whether his tax rises become a political millstone for him. Having presided over a big and necessary increase in the size of the state during the pandemic, some of which will persist, in any leadership contest he would face competition from a small-state, low-tax opponent. The question would be whether his reassurances that he is a tax cutter at heart and only implemented the post-pandemic tax hikes out of necessity would convince the sceptics.

He probably thought that would be a question for much later, perhaps after he has delivered the pre-election tax cuts he wants to do. Sunak, like many people, will have been surprised by the speed of Johnson’s descent into the mire.

We shall see. In the meantime, keep an eye on the pound

Sunday, January 16, 2022
The big squeeze is on - and Sunak's tax hikes add to it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Inflation is all around us. While this week’s UK figures may only show the annual consumer price inflation rate treading water at around 5 per cent, America has shown where it is heading this spring. Its latest 7 per cent rate the highest since 1982.

Britain has a more chequered inflation history than America, and if the rate gets to 7 per cent as energy and other price increases come through, it will merely be the highest rate since 1992. But that was five years before the Bank of England was given the task of meeting an inflation target, now 2 per cent, “at all times”. That will not happen for quite some time.

Part of the reason for high inflation is the effect of switching the economy off and on again. Figures on Friday, showing a 0.9 per cent rise in gross domestic product in November, and the economy regaining the pre-pandemic levels of output of early 2020, confirmed the unusual nature of this cycle. Normally it takes three years to get back to where we were and after the financial crisis it took five. Even if Omicron now causes some slippage, this was a rapid rebound.

It will be painful news for some that Greggs, the bakery chain, intends to raise prices by 5p or 10p across a range of items. Food prices more generally are rising strongly. Next, meanwhile, says its spring and summer ranges will rise in price by an average of 3.7 per cent, while prices for autumn and winter products will go up by 6 per cent compared with 2021. Clothing prices have been a drag on inflation for many years but, it seems, no longer.

Chris O’Shea, the chief executive of Centrica, which owns British Gas, giving a BBC interview while dressed as if about to go out and service a boiler, warned that high energy prices were likely to last for the next two years, and called on the government to scrap VAT on energy bills and move environmental levies off bills and into general taxation.

One interesting question is what car manufacturers will do when chip shortages ease and new cars become more generally available. They have seen used car prices rise rapidly – up by 31 per cent between April and November last year – and might be tempted to revisit their new car price lists when supplies come back on stream. Some second-hand vehicles are selling for more than the list prices of new ones.

A useful set of projections from economists at BNP Paribas shows that, while inflation in the eurozone should be back below 2 per cent in a year’s time, it will take longer in the UK. The Bank will release new forecasts on February 3, when it is also expected to raise the official interest rate from 0.25 to 0.5 per cent. Its last forecast, In November, merely promised that inflation will be “close to our target in around two years’ time”.

Inflation has been cropping up in unusual places. Germany, normally regarded as the anti-inflation bellwether, saw inflation hit 6 per cent, on a comparable basis, late last year, higher than the UK’s 5.1 per cent, though some of that reflected the unwinding of a temporary VAT cut, which the German government instituted in the second half of 2020, as part of its pandemic response.

It looks on the face of it as if the “Anglo Saxon” inflation problem will last longer than the eurozone’s. That would fit in with the warnings of monetarist economists like Tim Congdon, who warned of the inflationary consequences of huge quantitative easing (QE), for both America and Britain, but also others, like Larry Summers, who warned that Joe Biden’s huge post-pandemic economic stimulus would be inflationary.

It also fits with the responses of central banks. The Bank of England, which announced an unprecedented December interest rate rise last month (unprecedented in the independence era), even in the face of fears about the economic impact of the Omicron variant, has become noticeably more hawkish, as has America’s Federal Reserve. Some say that the European Central Bank, which has not, is falling “behind the curve”. It is still mainly sticking to the line that most of the inflation rise in temporary, or “transitory”. It will eventually tighten policy but take its time to do so.

The question for the UK is how long-lasting this inflation surge is likely to be and what, if anything, the government should do about it. That there will be a squeeze on incomes is not in doubt. The Institute for Studies points out that, with most working-age benefits set to rise by 3.1 per cent next April, the poorest will see their incomes falling well below the expect inflation rate then, which could be nudging 7 per cent. The same is true of the basic state pension.


Abandoning the “triple lock” for the basic state pension, thus breaking a manifesto commitment, and replacing it with a 3.1 per cent increase, seemed sensible last year, when the alternative could have been to raise it in line with distorted average earnings figures. But 3.1 per cent will condemn pensioners to a fall in the real value of their incomes.

The government is under pressure to do something about that, as it is to scarp VAT on domestic energy bills, if only temporarily. April’s tax hikes, similarly, look to be particularly ill-timed, with National Insurance and income tax both due to rise, the latter via the stealthy route of not indexing allowances and thresholds. That will bite at a time of high inflation. The chancellor is under pressure to postpone or cancel some of these hikes.

I think we can safely assume that, having warned Tory MPs a few days ago about the consequences for the government’s debt interest bill of rising inflation and interest rates, Rishi Sunak will be very reluctant to do any of this.

Shielding benefit recipients and poorer pensioners from the inflation surge would cost a few billion, while scrapping VAT on domestic energy for a year would cost roughly £2 billion. Moving environmental levies into general taxation would add to a tax burden that is already on course to rise to its highest since the Attlee government was in power in the early 1950s.

Delaying the NI and income increases would lift the cost of protective action by the government from the billions into the tens of billions. Those increases are baked into the official projections for the repair job on the public finances that the chancellor has embarked upon.

Sunak is also aware that temporary actions can all too easily take on an air of permanence. He faced a battle over ending the £20 a week temporary uplift to universal credit. If April’s tax increases were postponed would the time be ripe for reimposing them a year later, with an election becoming ever closer? The same goes for VAT on energy bills.

So, while there may be some limited help for people, particularly lower income households, to get them through the inflation squeeze, the chancellor is unlikely to bring out the fiscal bazooka, which he used effectively during the pandemic.

Mostly, we will have to grin and bear it, and hope that the worst of the squeeze is over by the middle of the year. That is what economists expect and there is a good chance that it will happen. Some of the increase in inflation will indeed be temporary. Even gas prices, the main cause of the energy price surge, have fallen, though too late to affect the big increase in the energy price cap due in April.

Figures provided to official statisticians by the National Grid show that the seven-day system average price for gas fell to just over 6p per kWh last week, half their pre-Christmas level. Energy prices are highly volatile, but it would be surprising if the kind of increases we saw last year were to be repeated.

Sunday, January 09, 2022
How WFH averted a bigger economic catastrophe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

We have reached an interesting point in the pandemic, with huge case numbers and a high proportion of infected people in the population, though alongside more reassuring data on the most seriously ill with Covid.

We have also reached the point where one of the most important economic and practical impacts is absenteeism as a result of illness or positive tests. Covid is not flu, but this calls to mind previous flu pandemics, such as the Hong Kong flu which hit the UK in the late 1960s and early 1970s.

That flu pandemic was serious, killing up to four million people worldwide and many tens of thousands in the UK. But one of its most notable effects was on the workforce. When you contracted the flu it was not possible to work, so bus and train timetables had to be reduced to accommodate driver shortages, deliveries were delayed and the NHS had to cope with flu admissions with many of its own clinical staff laid up with it.

There were no lockdowns in flu pandemics, including Hong Kong flu, and the absenteeism it caused did not register in the economic data for the period, unlike Covid-19, which broke statistical records, including the extent of the slump in the economy when it first hit in the spring of 2020.

Fifty years ago, when we were grappling with a nasty flu pandemic, a workplace was a workplace for the vast majority of people, whether it was in a factory, office, shop, building site or train cab. Working from home was unusual and would probably have been regarded as a euphemism for skiving. Some older folk have not moved beyond such attitudes.

Not everybody can work from home even now. The Office for National Statistics suggested that the proportion got close to 50 per cent in periods of 2020 and 2021 but never beyond it.

People have mixed attitudes to working from home. Some people got heartily sick of it. Those running sandwich shops, cafes, wine bars, restaurants and dry cleaners in city centres, as well as public transport operators, cannot wait to see the back of it, though I suspect that now the box has been opened it will not easily be closed.

We are not in lockdown in the UK and I am sticking to my pre-Omicron and pre-Tory rebellion forecast that we will not see another one. We are, however, in “Plan B” in England, with slightly different restrictions elsewhere in the UK, and part of that plan is that people should work from home when they can. As I know from personal experience, some people are working from home even when they have tested positive for Covid. The extended Christmas and New Year break clouds the data but the evidence from rail and Tube use, both of which dropped sharply after the government moved to Plan B, is that many people have adopted the official guidance.

A new research paper points out that, despite its drawbacks, working from home has been of significant economic benefit. The economic declines of 2020 were massive, but they would have been bigger, in some cases much bigger, in the absence of working from home.

The paper, ‘”Potential Capital” - Working from Home, and Economic Resilience’, by Janice Eberly. Jonathan Haskel and Paul Mizen, is published by America’s National Bureau of Economic Research (NBER), and highlighted in its latest research digest. Haskel is a member of the Bank of England’s monetary policy committee.

“The Covid-19 pandemic caused a widespread decline in recorded GDP [gross domestic product],” the paper says. “Yet, as catastrophic as the collapse was, it was buffered by an unprecedented and spontaneous deployment of what we call “Potential Capital,” the dwelling/residential capital and connective technologies used alongside working from home.”

People had homes from which they could work, in other words, their “residential capital”, and they also had home computers and laptops and broadband, which enabled them to carry on working. In most cases, certainly in the early stages of the pandemic, this equipment was provided not by employers but by workers themselves, having been acquired for non-work purposes such as entertainment, online shopping, or children’s homework. Had this not been the case, and we were still living in a pre-broadband world, much working from home would have been difficult, if not impossible.

The concept of potential capital is an interesting one. Before the pandemic and working from home, much of the equipment we have at home was under-used. A classic example of under-used capital is the private car, which spends most of the time parked, and is typically used for only 5 per cent of the time.

As it was, the effects of using this potential capital by working from home were dramatic. The paper examines America, the UK, Germany, France, Japan, Spain and Italy. The biggest negative effects of the pandemic were in the second quarter of 2020. In the case of America, working from home almost halved the drop in GDP, with similar effects in several other countries. In the UK, the record 19 per cent fall in recorded GDP in the second quarter of 2020 would have been at least a third larger without home-working.

In the spring of 2020, when lockdowns were new and very strange, we were just finding our feet when it came to working from home. We got better at it, the technology improved, including improved ability to hold online meetings and conferences, and firms moved to fill the technology gaps faced by some of their workers. Working from home was a significant contributor to the milder economic effects of subsequent lockdowns.

We should give credit where it is due. Working from home is not for everybody, and impossible for many, as noted, but it was an example of successful adaptation in difficult circumstances.

It is also, in all probability, here to stay. The paper points out that firms may want to bring more workers back when the pandemic eases as do the costs associated with it; distancing in offices, screens, testing and sanitisers. But there is unlikely to be a full substitution of home-working for workplace-working, the authors conclude. Remote working, at least for part of the time for many people, looks to be here to stay, and will be a legacy of the pandemic. Production “at home” will never be fully reversed. That, given its positive effects may be no bad thing.

Sunday, January 02, 2022
The rise and fall of inflation - and other 2022 stories
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

At this time of year, it is necessary to look forward, but I also find it useful to look back. In the equivalent column to this one 12 months ago, I gave you my version of the 5:2 diet, five reasons to be cheerful, and two to be a little worried.

The 5:2 diet was, as its name suggests, a weight loss programme once favoured by George Osborne, the last Tory chancellor but two, whose political career ended soon after the EU referendum, and who is now becoming something of a historical figure.

The reasons to be cheerful, despite what was then a grim start to the year, were vaccines, that growth would bounce back strongly with the removal of restrictions, that Donald Trump was no longer around to make a bad world trade situation worse, that the thin trade deal with the EU was better than no deal, and that households had built up a stock of involuntary savings to spend.

The reasons to worry were the virus and its potential variants, and the state of the public finances. On the deficit, hand on heart, I thought the chancellor would wait longer rather than announce, as he did, some humdinger but deferred tax hikes in his early March budget.

I do not have diet analogy to share with you today, though I am quite tempted by the idea of the Paleo, or Paleolithic diet, eating like our caveman ancestors. Mind you, I am not going to be wearing the outfits.

The big picture is not, however, so different to what it was a year ago, though the start of 2021 was quite a bit gloomier than where we are now, and the third lockdown during the winter weeks of January and February was grim.

I will return to this when I do my annual forecasting league table soon but growth forecasts for 2021 were too low – the average was 4.5 per cent, with a high of 6.1 per cent, compared with a likely 7 per cent outturn – because economists were too gloomy about what would happen in the early months of the year. Lockdown 3 was expected to reduce gross domestic product (GDP) by 4 per cent in the first quarter. Had it done so, 2021’s growth would have been much lower. In the event, there was only a 1.3 per cent first quarter fall.

The average new forecast for growth this year, 4.7 per cent, is similar to a year ago, and the same dilemma presents itself. Wil Omicron have only a marginal impact on economic activity in coming weeks, having already led to something of a hit last month, or could it be bigger? On present indications, it looks contained.

Though some sectors are being hammered, in economic terms we are getting better at living with the virus.

We are still worried about the virus and its mutations of course, as we will be for some time, despite encouraging evidence about Omicron. The latest variant, which we can hope but not be sure will be the last, made a fool of those predicting that Covid was on its way out.

We can be a little less worried about the public finances. Though the numbers remain very large by normal standards – the consensus among independent forecasters is that the public borrowing will be £193 billion this fiscal year, 2021-22, and just over £100 billion in 2022-23 – the budget deficit is clearly past its peak. The deficit in 2020-21 was £322 billion, or 15 per cent of gross domestic product, the highest relative to the size of the economy since 1946.

£100 billion is still a big budget deficit by past standards. The Office for Budget Responsibility (OBR) will revisit its forecasts for debt, currently £2.3 trillion or 96 per cent of GDP, and the deficit on March 23. Its recent forecasts have overshot the outturns for government borrowing, though independent forecasters do not expect a repeat of that this year. It is just possible that an improvement in the public finances would allow Rishi Sunak to rein back some of his already announced tax increases, particularly with a cost-of-living crisis underway. But I judge that he would rather keep any spare cash in reserve for eye-catching tax cuts later, were they to be remotely possible.

The big issue in coming months will be inflation. We started last year with an inflation rate of less than 1 per cent and ended it at 5.1 per cent. The extent of the rise took some, including the Bank of England, by surprise. We have nasty months ahead as far as inflation is concerned and, depending on what happens to energy prices in the spring, the next time the cap is lifted, could easily see a rate of 7 per cent. Retail price inflation, regarded as a flawed measure by official statisticians, is already at 7.1 per cent.

After that, while prices might not come down very much, inflation, which measures their rate of change, should do so, a distinction lost on many people. The big increases of recent months will start to drop out of the 12 -month comparison. Whether we get down to just over 3 per cent by the end of the year, the consensus forecast, we shall see. But inflation should come down noticeably in the second half and be lower at year-end than it is now.

Even if inflation is scheduled to rise but then fall, this should be a year when the Bank reimposes an element of normality on interest rates. Markets do not expect that much of a rate hike, expecting 0.75 or 1 per cent for Bank Rate by the end of the year, from 0.25 per cent now. But it would be good if the Bank were to break out of the low range for interest rates which has been in place since the financial crisis, and that the rate was to go up to at least 1 per cent. Since early 2009 the official rate has never been above 0.75 per cent.

The Bank has an opportunity to take advantage of the relatively strong growth in prospect this year, by raising rates. Leave it too long, until the economy settles back into its post-Brexit torpor, and there will always be an excuse not to raise rates.

What about shortages, of workers and supplies? The problem of worker shortages is one that arose because of the interaction of the re-opening of the economy, the furlough scheme and the government’s cackhanded approach to immigration. Labour shortages are not normal in a properly functioning economy, let alone one which has more than 1.4 million people unemployed and nearly 700,000 young people not in employment, education or training (Neet).

The good news is that unemployment is expected to stay roughly where it is, rather than rise. Labour shortages should ease, albeit alongside a squeeze on real wages, though it would be helpful if the government had some kind of employment policy.

There is a risk of continued supply shortages and much of that risk lies in China, where the pandemic started. The ports are clogged, factories are subject to closures and there are doubts about the effectiveness of China’s Sinovac vaccine. Until those supply shortages ease, we will not be able to say the economy has returned to something like normal. Though there are reasons to be cautiously optimistic, the strange times are not yet over.

Sunday, December 26, 2021
The figures tell of a boom year - but it never felt like it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

We will not remember 2021 with great fondness I suspect. A year in which we were supposed to shake off the coronavirus and return to something like normal turned out rather differently. We end the year almost as we began it, amid great uncertainty.

When future historians look back on it, certainly economic historians, there will be a curiosity. Looking at the latest official figures published a few days ago and assuming only very modest growth in the economy in the current quarter, growth this year will be roughly 7 per cent, give or take a decimal point or two.

In any normal circumstances that would be regarded as a boom. Indeed, in 20 or30 years’ time, when people are looking at the gross domestic product (GDP) data, it will look very much like the fabled V-shaped recovery, and a pronounced one at that.

Context is important. 2021’s growth comes after the slump of 2020, when the economy, we now know, shrank by 9.4 per cent; huge but a bit smaller than earlier estimates. Even so, 2021’s growth looks on the basis of the figures, like boom time for the economy. So why did it never feel like it?

One reason is statistical. If we look back on 2021 then, on the quarterly growth numbers, there was only one really strong three-month period. The year started with a 1.3 per cent quarterly fall in GDP, during the third lockdown, bounced back strongly with a 5.4 per cent expansion in the April-June quarter, ss things re-opened, then slowed to 1.1 per cent in the third quarter, and has probably slowed further in the fourth, under the impact of Omicron.

The growth story of 2021, just like the slump story of 2020, was all about the second quarter. In the second quarter of last year, GDP plunged by 19.4 per cent, and largely explained why 2020’s GDP fall was the biggest in a very long time. This year’s second quarter bounce, which translated into a 24.2 per cent increase compared with a year earlier, is now quite a long way behind us but guaranteed that the final tally for 2021 would be very strong.

There was, however, more to it than this. It never felt like because we always had one eye on Covid, and its recurrence, and one on soaring inflation, together with supply chain problems and shortages of workers in some sectors. Recoveries can bring stresses and strains, but this one brought more than most.

You can perhaps see this best when it comes to business investment. Businesses were given an almighty incentive to bring forward investment by Rishi Sunak in the first of his two budgets this year, back in early March. The 130 per cent “super deduction” against corporation tax was that incentive, and it provided a bridge to the time, in April 2023, when the rate of corporation tax will shoot up from 19 to 25 per cent.

Give it time, perhaps, but the incentive is a long way from producing an investment boom. Figures published just before Christmas showed that business investment fell by 2.5 per cent in the third quarter and was lower than at the end of 2020, before the incentive was introduced. It was a hefty 11.7 per cent below where it was at the end of 2019, before the pandemic struck.

To be fair to business investment, and to the chancellor, some of the latest fall reflected what the official statisticians described as “large decreases” in investment in transport equipment, which probably reflects chip shortages and shortages of new cars and commercial vehicles. But there was also a drop in investment in intellectual property, partly offset by stronger spending on ICT (information and communication technology) and other equipment.

The point still stands, however. Businesses have never been sure this year that the worst was over. They have had to cope with as well as the fear and reality of Covid and inflation, a chaotic and business-unfriendly government which has loaded it with hefty additional taxes, even if most of them are yet to come.

We are not, either, trading our way to success. Net trade is currently subtracting from economic growth and, in the three quarters of 2021 for which we have figures, annual growth in imports exceeded that for exports.

There is a way to recover for both exports and imports, as a result of the pandemic, supply chain problems and Brexit. It looks as though the volume of exports this year will have fallen by around 16 per cent compared with 2019 levels, while imports are down by about 14 per cent. It will take longer for trade to get back to pre-pandemic levels than most areas of economic activity.

I don’t want to end on too downbeat a note. I always say that you write off the British consumer t your peril but for much of this year, households seemed to be about as cautious as businesses when it came to spending. The re-opening of non-essential retail in the spring was followed, not by a runaway boom, but several months in which retail sales fell, which was never part of the script. Even allowing for the diversion of spending to hospitality and holidays, this was disappointing for shops.

The latest figures tell us, however, that before Omicron, consumer spending was bouncing back, narrowing the gap compared with pre-pandemic levels.
One of the most interesting economic variables over the past couple of years has been the household saving ratio, saving as a percentage of disposable income. In the spring of 2020, when people were unable to spend on a lot of things they usually do, the ratio rose to an all-time high of 23.7 per cent. Most of this was “involuntary” saving, but some was precautionary.

The ratio fell in the second half of last year, but remained well above normal level, before jumping to a high 18.4 per cent in the first quarter of this year. Now, however, it has come down quite sharply, to just 8.6 per cent in the third quarter. That is higher than immediately before the pandemic but lower than, for example, in the mid-2010s.

I suspect that this saving story is now over. Consumer confidence has faltered in the wake of Omicron but it has not collapsed. Households, moreover, are facing a cost-of-living squeeze, which will intensify with the huge increases in energy bills, alongside tax increases, due in April. People will not have the luxury of putting so much aside. Whether or not the great British consumer can be relied on to spend through adversity will be one of the big questions for 2022.

Sunday, December 19, 2021
Awful timing from the Bank - let's hope it's not a futile gesture
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It never rains but it pours. Just as we are trying to get to grips with the Omicron variant of Covid, along comes inflation. We knew we were experiencing an inflation shock, but the latest figures, showing consume pic inflation at 5.1 pe cent, and retail price inflation two percentage points higher at 7.1 per cent, were a shocker. “Not now, inflation,” was a reasonable response when there was already so much bad news around.

I have hesitated to use the word “stagflation” to describe the current situation, not least because it Is an insult to the great stagflations of the past, some of which had inflation at more than 20 per cent alongside recession.

But this upsurge in inflation has occurred at a time when growth was stagnating even before the Omicron variant came onto the scene and has been pushed into reverse by the economic effects of that variant. If the cap fits, and we should at least acknowledge that we have a mini stagflation on our hands, notwithstanding strong job market and retail sales data.

It was into this environment that the Bank of England raised interest rates on Thursday, from a record low 0.1 per cent to 0.25 per cent. Until the release of the inflation data, most people would have regarded even this modest hike as a non-starter because of Omicron. But to be fair to the Bank, it stuck to its guidance in November, which was that if the labour market held up well after the end of the furlough scheme on September 30, it would hike rates. The inflation figures, embarrassing for a central bank tasked with keeping inflation at 2 per cent, tilted the balance.

Being fair to the Bank only goes so far, however. Though some of us have urged the Bank to tighten policy for many months, initially by reining back its quantitative easing (QE) programme, and more recently by raising rates, this was not a great time to start. The country is reeling under the Omicron wave and the latest surveys, notably the purchasing managers’ survey, shows a sharp weakening of the service sector this month, for understandable reasons. Many businesses ill see this as a kick in the teeth, on top of the other pressures they face. As well as “not now, inflation,” they would say “not now, interest rates”.

When the hike was announced, which according to the Bank will not prevent inflation averaging 5 per cent over the winter and hitting 6 per cent in the spring, it brought to mind a famous comedy sketch.

This was the Beyond the Fringe sketch – younger readers ask your parents or look it up – in which Peter Cook, as a senior RAF officer, tells Jonathan Miller, his junior, to “pop over to Bremen” on a suicide mission, because the war wasn’t going well “and we need a futile gesture.

The Bank would say that while the war on inflation has not been going well, its gesture was not futile. By raising rates at a difficult time, it may have won back a little hawkish credibility. It is, after all, the first major central bank to do so. Last week’s rise, moreover, should be seen as the first in a sequence, which could see several more increases. The Bank was behind the curve, and his was a bit of a catch-up.

Covid is the big uncertainty. The Bank was briefed by Professor Chris Whitty, the government’s chief medical adviser. Economists are not epidemiologists and some who have tried to model the course of the virus have fallen spectacularly flat on their faces. Mind you, epidemiologists have not always covered themselves with glory, far from it. Faced with the uncertainty of the moment, economists are resorting to a familiar tool, and one which is used widely in business, scenario planning.

Continuum Economics, an independent macroeconomics and financial markets research firm, has devised four scenarios. They apply to the world economy but can be easily adapted for the UK.

Under the first, Omicron has higher transmissions but is similar in severity to Delta. Many countries impose further restrictions and lockdowns, and people shift their consumption patterns back to goods and away from services such as hospitality. Growth is adversely affects in the first half of next year, but then picks up. The inflation impact is mixed; stronger in goods but weaker in services. The firm puts a 40 per cent probability on this outcome.

At the other end of the scale, also with a 40 per cent probability, is that Omicron has higher transmission but is milder and vaccine effectiveness if not seriously compromised. There is a modest effect on growth in the next few months, but there is also a bigger inflation risk. Growth does not slow enough to bear down on inflation and there is a greater danger of second round effects, in which, for example, higher inflation feeds through into wage settlements.

There are two other scenarios. One, with a 15 per cent probability, is when fast-spreading Omicron seriously reduces vaccine effectiveness. Growth takes a bigger hit, and this takes some of the steam out of inflation.

The final scenario, with just a 5 per cent probability, is if Omicron turns out to be a damp squib, less transmissible and less severe than Delta. The growth and inflation effects are marginal. We may already have enough evidence to reject the idea that Omicron is less transmissible.

People and businesses will have their own ideas about the likely path of the virus in coming weeks and whether Boris Johnson’s government would be able to introduce new restrictions even if it wanted to. It could be too that the changes in behaviour that we have seen in response to warnings about Omicron will fade and that people, taking precautions, decide it is a risk we have to live with. Omicron delays the return to normality but does not take us back to square one.

There are, nevertheless, some striking things about all this. Never before has a single issue, Covid, dominated the outlook as it does now. The uncertainty seems greater than this time last year.

On most projections, however, the growth effects of continuing Covid appear to be quite modest. This is because, as we saw with the three UK lockdowns (so far), their effect diminished, from massive in the spring of 2020 to modest. The Bank picked up on this in the minutes of its latest meeting, noting: “The experience since March 2020 suggested that successive waves of Covid appeared to have had less impact on GDP, although there was uncertainty around the extent to which that would prove to be the case on this occasion.”

If the growth effects are modest, that adds to the fear that inflation will be a problem for longer and raises the question of whether the Bank’s actions will impact on some of the structural factors creating it, including supply chain problems and labour shortages. I suggest a couple of weeks ago that the Bank might be a bystander in the inflation process. It has elbowed its way in. Mainly, however, if inflation falls it will be due to factors outside its control.

Saturday, December 11, 2021
As gloom descends, can house prices continue to defy gravity?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Things have moved quite quickly, and the jolt of uncertainty I described last week has increased in intensity. Suddenly, the run-up to this Christmas seems as uncertain as last, if not more, and the country appears rudderless.

New restrictions will have a more discernible impact on the economy and will combine with the changes in behaviour I described last week. It will be surprising if there is not a fall in gross domestic product this month, and a weaker fourth quarter than previously expected.

Rishi Sunak, who spoke out against the new “Plan B” restrictions in cabinet, is concerned not just about the potential economic cost but because there will be pressure to bring back some of the Covid support that he thought he had seen the back of.

The pound, which some analysts had down for a strong 2021 revival, has been suffering. It has been weaker than now in recent years but is now back below the levels it slumped to immediately after the Brexit referendum in June 2016. The vaccine rollout is still going pretty well, but sterling’s vaccination boost has faded fast.

Markets still expect the Bank of England to raise interest rates in time but would be very surprised if it were to happen this week, which at one time was regarded as a near certainty. The decision on rates at one time appeared heavily dependent on what happened to the job market after the end of the furlough scheme. Now there are a wider range of economic considerations.

One interesting question is how this will affect the housing market. Its story has been an extraordinary episode in an extraordinary period. It has boomed even as other parts of the economy have been on their knees. When the 2020 slump loomed with the first lockdown in March 2020, during which the housing market was temporarily closed, a plunge in house prices and activity might have been expected.

In fact, any effect, which was minor, was temporary. Soon, people were using their spare screen time to hunt for houses on the property portals. Helped by record low interest rates and the chancellor’s stamp duty cut, prices and activity were soon surging.

It continues. The official house price index from the Office for National Statistics has house-price inflation at 11.8 per cent. The average UK house price has risen by £28,000 to £270,000 over 12 months.

The Halifax house price index showed that prices in the latest three months, September-November, were up by 3.4 per cent, the strongest quarterly rise since 2006, the eve of the financial crisis. This was significant, in that prices continued to rise even after the stamp duty reduction came to an end on September 30. It suggested that the market, or at least house prices, had enough momentum to see it through the removal of the tax incentive.

One reason for that was provided by the latest survey from the Royal Institution of Chartered Surveyors (RICS), in its latest residential market survey. The great obsession in housing commentary is with new-build supply, and it matters. Even more important as far as the day-to-day market is concerned, however, is the number of existing homes becoming available for sale.

According to RICS, the number of new instructions to sell has fallen fro eight months in a row, even as buyer demand continues to increase. This can only have one outcome. As RICS puts it: “This constrained supply backdrop is also underpinning price growth, which has shown no sign of easing over the latest survey period.”

When does the housing market succumb to gravity? The economic news is downbeat and consumer confidence has weakened. That, however, was also the case when the market started booming last year. One of the new restrictions is that the advice on working from home where possible, effective from tomorrow, has returned. This was one of the factors that encouraged people to focus on housing, and to seek properties further away from their workplaces with gardens and nearby countryside.

The new working from home advice will make anybody who did this even more comfortable in their choices. It will reinforce this aspect of housing demand. Even when things settle down, a hybrid model of working, part-home, part-office, will become the norm for many people.

There is another change which, if it occurs, will have a positive impact on the housing market, albeit a marginal one. The Bank will publish its financial stability report tomorrow, though the accompanying press conference has just been switched online because of new official guidance. It has been widely speculated that the Bank will relax the mortgage affordability rules introduced seven years ago, which have had the effect of making life tougher for first-time buyers. High house prices are the biggest barrier, of course, for first-time buyers.

Sooner or later, the steam will come out of the housing market. Transactions fell after the end of the stamp duty holiday even if prices remain strong, and activity will be softer in 2022 than this year. Supply shortages push up prices but they also reduce the volume of sales.

We should always remember in all this that while soaring house prices are often reported as good news, particularly by certain newspapers, this not necessarily true. Not only do they make life difficult for new buyers but they dramatically widen the country’s wealth divide.

A report by the Resolution Foundation, ‘Home County’, in conjunction with the Financial Fairness Trust looked at the house price gains of the past 20 years, which add up to an astonishing £3 trillion (£3,000 billion) addition to wealth and examined how they were distributed. The answer was very unevenly.
The average property wealth gain for the richest 10 per cent over this period was £174,000 per adult, compared with less than £1,000 for the poorest third of the population. Average wealth property gains in London were three and a half times those in the northeast.

Property wealth thus reinforces the regional divide and is cumulative in its effects. The children of those in London and the southeast benefit most from inherited property wealth, while those in many other regions barely do so. The government’s proposed social care reforms will lock in these wealth inequalities, with people in areas with lower prices more likely to have to sell up to fund their care.
What to do about it? The Resolution Foundation suggests that a 28 per cent capital gains tax on main residences could bring in a useful £11 billion a year. A smaller £4 billion a year could be raised with a threshold of £75,000.

This is not the first such suggestion. Dame Kate Barker, the former member of the Bank’s monetary policy committee and expert adviser to the last Labour government on housing supply, also recommended capital gains tax on main residences. I doubt, however, that even this high-taxing government would dare to go there.

In the meantime, we await signs that house price inflation is coming back to earth. Like inflation in general, it may have further to tun.

Sunday, December 05, 2021
A rollercoaster year ends with a jolt of uncertainty
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is at this time of year that I feel sorry for economic forecasters. They have to put together a coherent story for 2022 and yet, as 2021 draws to a close, a significant new uncertainty has emerged. I feel a bit sorry for myself, because I will soon be doing “year ahead” pieces, though I have plenty of opportunities from week to week to nudge things in one direction or another as events unfold.

The uncertainty is the Omicron variant of the coronavirus. It may be, as some early evidence suggests, that its effects are mild and that vaccines remain effective against it, but we do not yet know.

The dilemma was summed up by the Organisation for Economic Co-operation and Development (OECD) in presenting its new Economic Outlook. Its central forecast was positive on both the global recovery and on the UK. Its prediction of UK growth of 6.9 per cent growth this year and 4.7 per cent next, would make this year the strongest in the post-war period. 2021 and 2022, taken together, would also be the best two-year run in the post-war era. We’ll gloss over 2020, when the economy suffered its biggest fall since 1921.

But the OECD also talked of two possible Omicron scenarios. “One is where it creates more supply disruptions and prolongs higher inflation for longer,” said Laurence Boone, its chief economist. “And one where it is more severe and we have to use more mobility restrictions, in which case demand could decline and inflation could actually recede much faster than what we have here.”

The uncertainty has already affected market expectations about what the Bank of England might do next. Before Omicron, a rate rise at the monetary policy committee’s next announcement on December 16 was regarded as a near-certainty. Now it is seen as less than 50-50, despite an intensification of inflationary pressures.

The Bank will not want Omicron to damage the recovery but will not mind too much if it dampens inflation, though it may not be possible to have one without the other. Omicron uncertainty has pushed oil prices lower, with Brent crude falling from more than $80 a barrel to $70 or less.

The emergence of the new variant re-opens one of the great economic debates about the pandemic. Were the enormous falls in economic activity we saw last year mainly as a result of lockdowns and other restrictions? Or did they arise from behavioural changes by people and businesses, as individuals sought to keep themselves safe, and businesses tried to protect their employees, customers and reputations?

The answer is that the economic effects resulted from a combination of the two, with the debate being about how much weight to put on each. It was clear that behaviour was changing quite dramatically before the first UK lockdown began in March last year, though that might have been because it was widely anticipated. When restrictions have been eased it has taken time for activity to return to normal, and in some cases it has never done so.

Restrictions introduced so far in response to Omicron will only have a limited impact on economic activity, though it will have a further significant effect on the travel sector. Lockdowns introduced elsewhere in Europe will slow but not stop its recovery, as noted last week.

So we have to look at the behavioural changes. They are apparent in a flurry of cancellations of events, including Christmas parties, and it seems in people pulling out of restaurant and other bookings. Tentative evidence from Google trends and elsewhere that people’s appetite for going out for entertainment and hospitality has already waned.

The Office for National Statistics reported OpenTable data showing that, relative to its pre-pandemic average, the number of seated diners in the week to November 29 (last Monday) was the lowest since May 17. That covered a few days after the new variant was first reported. Tim Rumney, chief executive of Best Western Hotels, reported widespread cancellations of Christmas parties, dinners and room bookings and warned that, as in 2020, this Christmas could be a write-off.

Business confidence has also weakened and, according to one survey, half of smaller businesses fear a further lockdown. Tony Danker, director-general of the CBI, said in a speech the other day that the optimism of the summer among firms had given way to firefighting over shortages of people and supplies, rising costs and Covid.

With this particular variant, as I say, it may be a fuss about not very much, though it may not, and we do not yet know. The bigger point, however, is that it has reinforced expectations that Covid is going to be around for some time yet. The great worry, that a variant will emerge on which existing vaccines are ineffective has been brought into focus by this one.

The government’s ordering of 114 million additional doses of vaccines that can be tweaked against variants is reassuring but is also a reminder that the official view is that the public will need protecting for quite some time yet, and that booster vaccines may become an annual event.

Gauging these confidence and uncertainty effects is not easy, although some economists are already pencilling in a drop in monthly gross domestic product (GDP) for this month, ending the year on a sour note. “At present we could be looking at a decline of between 1 and 2 per cent this December, before hopefully the economy recovers again,” says David Owen of Saltmarsh Economics, who successfully monitored the economy from the start of the pandemic using real-time data.

These uncertainty effects are hitting hardest those sectors which have suffered most during the pandemic, notably travel and hospitality. They come at a time when most coronavirus support, including the furlough scheme, has been wound down. It is not only economic forecasters who could do without this sting in the 2021 tail.

Sunday, November 28, 2021
Fix our cities first, or we'll never level up this country
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

People, including the leader of the opposition Sir Keir Starmer, have taken to asking the prime minister whether everything is OK. I can’t answer that, though after a sequence which has included Kermit the frog references in a speech to the United Nations’ General Assembly and the Peppa Pig interlude to a bemused CBI audience, you do have to wonder.

I am more concerned about whether the levelling-up agenda, the government’s one signature policy, is OK. The government’s integrated rail plan for the north and the midlands, which involved scrapping the eastern leg of HS2, has gone down like a bus replacement service on a wet Wednesday in Wigan.

The “landmark” white paper on levelling up, promised by Boris Johnson a few months ago for this year, has yet to appear. I asked the Department for Levelling Up, Housing and Communities – yes there really is a department called that, under Michael Gove – when we might see the promised white paper and was told that it is “forthcoming”. So far, we have had to make do with a prime ministerial speech which, while it did not contain any references to children’s TV characters, was also content-free in other respects.

There are reasons to hope that we will get something. Gove has a reputation for shaking things up and getting them done, and he turned to the services of an expert, the former Bank of England chief economist Andy Haldane. He, in his capacity as chairman of the now disbanded industrial strategy council, threw himself into the levelling up agenda, which predated the Johnson government.

So we wait. In the meantime, I have become interested in one aspect of levelling up which has probably not received the attention it deserves. We tend to think that the “left behind” problem is concentrated in smaller communities which have lost their livelihood, such as former pit villages.

Bringing prosperity to these smaller, left-behind communities, which are not all in the north, is important. However, as Paul Swinney, director of research and policy at the Centre for Cities argues, the nub of the problem is the poor performance of the UK’s regional cities.

In evidence a few days ago to the Productivity Commission, which is being jointly run by the National Institute of Economic and Social Research (Niesr) and the Productivity Institute, he set out the position clearly.

“The UK’s largest cities outside the Greater South East are principally responsible for both the North-South divide and the UK’s poor productivity,” he said. “While the UK lags other Western European countries in terms of productivity, the Greater South East is one of the most productive parts of Europe.

“The UK’s low productivity is a result of the poor performance of the rest of the country. The principal driver of this is the underperformance of large cities such as Birmingham, Manchester and Glasgow.”

Analysis by the Centre for Cities shows this very clearly. The UK’s regional cities compare very badly with their counterparts elsewhere in Europe. Even in France, which like the UK is dominated by its capital, regional cities make a far bigger contribution to the economy and to productivity than the UK’s regional cities.

Looking at regional cities with a population of between 600,000 and 3.5 million, the UK’s big regional cities are all the wrong end of the productivity table, competing for the wooden spoon, compared with their European counterparts. If you think some cities are missing from the table, it is because they are too small to make the cut.

The underperformance of regional cities outside the Greater South East explains almost 60 per cent of the economy’s lost output, which the Centre for Cities conservatively estimates at 4 per cent of gross domestic product (GDP) a year, or more than £83 billion. It could be a lot more.

Some people will be puzzled by this. Many of the UK’s regional cities have had a makeover to what the planners call their central business districts and look a lot better than they used to. Some have diversified their economic bases.

The problem, however, persists. One cause, according to the Centre for Cities, is that cities have not been successful in attracting high productivity, exporting businesses, firms in so-called “tradable” sectors. “These are the businesses that bring money into an economy by selling beyond its borders, and are able to absorb new innovations,” it notes.

Instead, cities have attracted low productivity “non-tradable” businesses and activities, such as hospitality, the arts, entertainment and leisure. These bring a liveliness to city centres but they do not bring innovation and lasting prosperity.

Other countries in Europe do better because there is more genuine regional autonomy, as opposed to the UK government’s branch office mentality to relocating bits of central government to regional cities. This applies to the private sector too. Banks locate their high value-added investment banking activities in London, because that is where the skills and knowledge are, but put their lower productivity data-processing and call-centre operations in regional cities.

The underperformance of regional cities is frustrating because it should be easier to fix than achieving catch-up for thousands of smaller places. Many of these smaller places, which are quite close to cities, would in any case be lifted if their local cities did better.

Cities exist to accrue the benefits of “agglomeration” – bringing people and businesses to foster innovation, skills and economies of scale – but too many of the UK’s cities are not doing this enough. As Swinney pointed out: “These large cities are punching well below their weight and aren’t playing the role that the likes of Munich and Lyon play in their respective national economies … Manchester’s productivity looks much more like Cumbria’s than Bristol’s, and trails far behind Munich’s.”

The good news is that if other European countries can do it, there is no reason why we should not be able to do it in the UK. Regional cities have to be made more attractive for the private sector to invest in.

The Centre for Cities makes six recommendations for starting to fix the problem. They include: spending on skills needs to be increased; the austerity squeeze on local government should be ended to improve day-to-day public services; local areas should be given more devolved powers over services and spending; transport services needs to be improved, particularly buses, but also to focus transport infrastructure spending on big cities.

Government also needs to invest in struggling city centres through a City Centre Productivity Fund to make them more attractive places to do business, and target R & D (research and development) spending in places that are currently underperforming, it says.

There is no magic wand to be waved here and lifting the performance of the UK’s regional cities will take time. But there is no reason not to try, without which there will never be any meaningful levelling up.

There is also, without wanting to end on a downer, a sting in the tail. We have got used to London’s productivity performance, and that of the Greater South East, being superior to the rest of the country, as pretty much it always has been. But London’s productivity growth, like that for the rest of the economy, has been dismal for the past decade or so, since the financial crisis. Let us hope that is not a harbinger of levelling down.

Sunday, November 21, 2021
The Bank may simply be a bystander as inflation rips
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

What a difference a month makes. Four weeks ago, when official figures showed a drop on consumer price inflation from 3.2 to 3.1 per cent, there was quite a lot of scoffing directed at the inflation warriors. That temporary fall was, though, an aberration. The jump in inflation to 4.2 per cent last month, announced a few days ago, was more reflective of the story.

Inflation is going up, and the warriors were spoiled for choice in the latest figures. Retail price inflation rose to 6 per cent, its highest for 30 years. Factory-gate inflation, measuring industry’s output prices, rose to 8 per cent which, like consumer price inflation, was the highest for 10 years. And, for good measure, the official house-price index showed an annual increase of 11.8 per cent.

When these figures were released, I wondered what the market reaction would have been if the Bank of England had raised interest rates on November 4, as the City expected it to do. Would markets have judged that the Bank was right to act ahead of a bad set of inflation figures? Or would the reaction have been much the same as it was, in other words that the Bank is under pressure to raise rates next month, breaking a December duck that has survived nearly a quarter of a century of independence? Even the Bank does not want to be portrayed as the Grinch that stole Christmas.

The point is that when inflation is rising markets are unlikely to be satisfied unless interest rates are raised every time the central bank remains a decision. Had rates been increased in November, the markets would have been looking for another increase next month, and in February. By not raising rates this month, the Bank delayed that lift-off.

There is another question I wanted to address this week, however, and it is whether faith in central banks, and their ability to control inflation, is misplaced. A 0.1 per cent Bank Rate looks inappropriate when set alongside inflation of more than double the official target and heading to 5 per cent or more. But would a 0.75 per cent rate, which is where it may be heading in coming months, be any more appropriate? When inflation was 5 per cent in the period before the financial crisis, back in the early 1990s, typical levels for official interest rates were 5, 6, 7 or 8 per cent.

The subversive thought I have is that central banks like the Bank, far from being the masters of the universe, the controllers of inflation, are mere bystanders in the process. The fact that they have presided over generally low inflation over the past three decades is good news for them, because that is what they are supposed to achieve, But it may just be a happy accident.

Consider the last time consumer price inflation was as high as now, eventually topping 5 per cent 10 years ago in 2011. What did the Bank do to bring it down?

The answer is absolutely nothing. Bank Rate, which had been 0.5 per cent since March 2009, stayed at that level until August 2016. The Bank “looked through” the rise in inflation by looking away. Inflation’s fall, which was not complete until the end of 2013, when it came down to the target rate of 2 per cent, happened of its own accord.

There were, to be fair, some votes for higher interest rates on the Bank’s monetary policy committee (MPC) during this period, and it is possible that these led the markets to do some of tis work for it by tightening monetary conditions.
Inflation came down, however, because of factors outside the Bank’s control; a fall in world oil prices and the chilling effect of the eurozone crisis on the UK’s economic growth.

Today we stand at another inflation crossroads. The most likely outcome is that the 2011-13 story repeats itself. Some of the factors pushing inflation higher now are clearly temporary. A 27.4 per cent increase in second-hand car prices between April and October reflects the limited availability of new cars as a result of chip shortages and is highly unusual.

The increases in household electricity and gas prices over the past 12 months, 18.8 and 28.1 per cent respectively, are the biggest for 13 years. There is more to come on household energy, next spring, but you would not expect increases of this size to become the norm in future years.

There is a reason why inflation should come down even if prices stay high, which sometimes passes people buy. It is quite possible that we have moved to new higher levels of energy prices, and that petrol and diesel at close to 150p a litre becomes the new norm. But there is a difference between higher price levels and higher inflation. Only if the components of the consumer prices index rise at a faster rate than now will inflation go on rising beyond next spring.

Inflation will not come back down as quickly as the Bank first hoped. Its latest projections suggest we will not see a return to the 2 per cent target until the spring of 2024, in two and a half years’ time.

But when it does come down, and after the Bank has raised rates only modestly, perhaps to only 0.75 per cent (the rate prevailing before the pandemic) or 1 per cent over the next 12 months, it will pat itself on the back for not having been panicked into bigger rate rises. The fall in inflation, though, will have been mainly due to factors outside its control; international energy prices and the shortages resulting from the rapid reopening of the world economy easing.

To be fair to the Bank, it would argue that the monetary game has changed since before the financial crisis. The “neutral” level of interest rates is much lower than it was, implying that small changes in rates at these very low levels can have big effects. It may be, though, that these small changes do not have much effect, and that inflation largely comes down of its own accord.

There is another possibility in all this, of course, which is that inflation becomes more ingrained and that 4.2 per cent is just the taste of things to come. In the past, the combination of labour shortages and falling real wages – which most people will experience in coming months – would have been enough to generate big pay increases.

That was part of the alternative scenario sketched out by the Office for Budget Responsibility (OBR) in its budget assessment on October 27, and which had the Bank being forced to hike interest rates to 3.5 per cent. The Bank does not want that to happen, and neither does the Treasury, worried as it is about the debt interest bill. Neither will many borrowers.

The Bank favours a softly-softly approach on rates. Just let us not give it too much of the credit if and when inflation comes back down again.

Sunday, November 14, 2021
No boom, this is a recovery - but not as we know it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

One of the big questions for people like me is whether the economic measures we write about, like gross domestic product (GDP), actually relate to the experience of people and businesses. One of the quotes that has stayed from the Brexit referendum is the one in which an expert is in Newcastle explaining the negative impact of leaving that EU on GDP and a woman in the audience heckles: “That’s your bloody GDP. Not ours.” It would be nice if she were not anonymous, because she deserves to be up there alongside Brenda from Bristol, the lady who bemoaned the frequency of UK general elections.

You will know that we now have a new reading for GDP, which showed that it is getting closer to pre-pandemic levels. We are not quite there yet but should be relatively soon. That will make the recession and recovery as a result of the pandemic both the deepest and the shortest in the modern era. It normally takes three years to get back to where the economy was before the recession, and after the financial crisis of 2008-9 it took five.

I have explained before that there are different tests on regaining pre-pandemic levels depending on whether monthly or quarterly GDP figures are used. The monthly figures for September showed that GDP is now only 0.6 per cent below where it was in February 2020. That, coincidentally, followed a 0.6 per cent rise in September.

On a quarterly basis, after expanding by 1.3 per cent in the third quarter, down from 5.5 per cent in the second, GDP was 2.1 per cent below where it was in the final quarter of 2019. That is a bigger shortfall than most other big economies, reflecting the UK’s bigger slump last year.

In both cases, however, GDP should be back to pre-pandemic levels at or around the two-year mark; sooner in the case of the monthly figures, maybe slightly longer on a quarterly basis. When we look back on this period in the data, it will shine out as a dramatic V-shaped recession and recovery, of the kind I used to talk about in the darker days of the pandemic. It has been driven by restrictions and voluntary changes in behaviour and the easing of them. It was an abnormal recession, driven by a health emergency, and it is an unusual recovery.

That is why, despite the views of Nora from Newcastle – until we have a proper name – the GDP figures tell a story that probably fits the experience of many people and businesses. The story not to be taken from this is that we are experiencing a boom that will put the Barber boom of 1973 in the shade.

That is because this year’s elevated growth rate of around 7 per cent, is largely a product of comparisons with weak data a year earlier. So, after falling in the first quarter, GDP in the second quarter was up by 23.6 per cent on a year earlier, followed by a 6.6 per cent increase in the third. With numbers like this it is not hard to get a big annual growth figure, and for it not to read as if it were a boom. Similarly, next year’s growth will be boosted by comparisons with this year’s weakish first quarter.

A better picture is provided by the quarterly and monthly profiles for GDP. Growth of 1.3 per cent in the third quarter was weaker than expected. September on its own showed a 0.6 per cent rise, after the economy essentially stalled in July and August, though September was boosted by a big increase in “human health activities”, apparently because of a big increase in face-to-face appointments at GP surgeries. Plenty of things make up GDP.

The picture that many people are familiar with is there within the details.

Consumers are not very confident and consumer spending in the third quarter was 4.4 per cent down on pre-pandemic levels. Households increased their spending in the third quarter on eating out and hotels, and on transport (partly due to the petrol panic) but reduced it on quite a lot of other things, including clothing and footwear. Consumer-facing services have a way to go, more than 5 per cent, to get back to where they were before the virus struck.

There is also a more familiar picture, given all the headlines about shortages in recent weeks, when it comes to industry. Manufacturing output in September was marginally lower than in November last year, before the first ever Covid vaccination, and industry has been flatlining, in aggregate, for many months. Chip shortages have been a factor bearing down on vehicle production, but other sectors are also finding it hard to make progress through the headwinds.

Business investment, meanwhile, despite the massive encouragement provided by the chancellor’s “super deduction” tax incentive, edged up by only 0.4 per cent in the third quarter.

There are three other reasons why, while we should celebrate the fact that Covid did not send us into a new great depression, the GDP figures are a cause for only muted comfort.

The first is that the recovery is bringing pain with it in the form of higher inflation, the central reason for weak business and consumer confidence, and a story that is going to stay with us for some time.

The second is that while returning to where we were before the pandemic might seem like paradise as far as normal life is concerned, it was no economic nirvana. We had a slow-growing economy in which the damage from Brexit was already apparent. The government has appeared ready to add to that damage and trigger a trade war with the EU, because it is unhappy with the deal it negotiated, though I suspect after Downing Street’s recent blunders, the prime minister will be keen to avoid that.

Finally, of course, we should properly compare where we are now, not with where we were, but where we should have been. If the pandemic had not occurred, the economy would have continued growing. Not strongly, but growing nonetheless. Consensus forecasts in February 2020 had the economy growing by 1.1 per cent last year and 1.4 per cent this year, before the pandemic struck. If we take those as our guide, the economy is still 5 per cent or so down on where it might have been. Some of that shortfall, the scarring, will remain. It’s a recovery, but not as we know it.

Sunday, November 07, 2021
The big squeeze on incomes is not just for Christmas
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

There are some questions that are bigger and more important to most people than whether the Bank of England nudges interest rates up a little. As it happens, the dog did not bark on Thursday and the Bank left interest rates unchanged, as I suspected it might. The 0.1 per cent rate lives to fight another day.

The bigger issue is that, as a nation, we have stopped getting better off. Prosperity, which at one time we got used to being on a rising trend, has stalled. The cost of living crisis and subdued or falling real income growth are not just for Christmas. They are, as a flurry of analyses in recent days shows, the new reality. I shall come on a little later to what we might do about it.

The Resolution Foundation think tank came up with the striking finding that we are heading for the weakest growth in real household incomes in this Parliament than in any since the data became available in 1955. Compared with a long-run average of 2 per cent a year real income growth, though less than 1 per cent a year since 2010, the prospect is for a mere 0.1 per cent a year over the 2019-2024 Parliament. This is a close to stagnation as you can get.

The strongest growth in real incomes, incidentally, an annual rate of 3.8 per cent, was in Harold Wilson’s truncated first term, from 1964 to 1966, although income growth slowed sharply after he was returned to power in 1966 until his defeat in 1970, just 0.9 per cent a year.

Margaret Thatcher’s last period as prime minister, though she was forced to step down in favour of John Major just over halfway through produced surprisingly strong real income growth, 3.7 per cent a year over the 1987-92 period, though much of that occurred in the late 1980s’ boom. That reading may help explain why, against expectations, Major won the 1992 general election.

There are three reasons why the outlook now is so poor, according to the Resolution Foundation. For all the talk of a high-wage economy, prospects for real earnings growth – after allowing for inflation – are poor. Taxes, including next April’s national insurance hike and the freezing of income tax allowances and thresholds, will take a big bite. The employment rate is also expected to remain lower than before the pandemic.

It is more than a week since we had a flurry of analyses, official and unofficial, on the economy as part of the information overload that accompanies the budget. Quite a lot has stayed with me from the flurry, but one thing has really stuck in the mind. This is that, as far as most people are concerned, the economic good times came to an end 13 years ago, and they show no sign of returning.

This was the consistent story from the Office for Budget Responsibility (OBR) and the Institute for Fiscal Studies, as well as the Resolution Foundation. Three shocks to the system; the global financial crisis, Brexit (the self-inflicted one) and the pandemic have left us poorer than we could have reasonably expected to be, and it is only when you stand back and look at it that you realise the extent.

As Xiaowei Xu of the IFS pointed out in her analysis, real household disposable incomes rose by 2.3 per cent a year, on average, over the period 1989-2008. Incomes in real terms at the end of the period, in other words what people could afford to buy, were strongly higher. Given that the period included one significant recession and took us to the brink of another, it was quite an achievement.

Now consider the period since 2008, up to the end of the OBR’s forecast period in 2026. Real income growth is expected to average just 0.8 per cent annually, a third of its previous rate. On another measure, real average earnings, they would be 42 per cent higher than they are if the trend prevailing before the financial crisis had continued.

What is the impact of this very slow growth in incomes? As you might expect if people have not got the money they cannot spend it. In the 13 years leading up to the crisis consumer spending rose by 52 per cent in real terms. In the 13 years since it has grown by a shade under 10 per cent. That may be a slightly unfair comparison because spending has not yet recovered to the pre-pandemic level but, compared with that level, it rose by 17 per cent. Income growth slowed to a third of its previous level, and so did spending growth. Consumer-facing businesses have been finding it tougher.

Can we hope for anything better than income stagnation in coming years, or is the die cast? The financial crisis and the pandemic cannot be undone and, judging by the state of relations between the UK and France, there is not a lot of entente cordiale around at the moment.

The key to rising prosperity is, of course, rising productivity. On the output per hour measure, it rose by 26 per cent in the 13 years leading up the crisis and has increased by just 6 per cent since, somewhat less than a third of its previous performance.

The Productivity Institute, based at Manchester University, has some good ideas for raising productivity, which I shall discuss soon. So did the Industrial Strategy Council, set up under Theresa May, but abolished by this government. I have not seen many good productivity ideas coming out of the government, including in the budget.

Business investment, a key to raising productivity, was flattened by the Brexit vote and, while it may undergo a short period of growth to take advantage of the chancellor’s “super deduction” incentive, will be held back by rising business taxes. The official approach to raising skills is a piecemeal one. It is not clear whether the green obligations on business flagged at the Cop26 summit will boost or limit productivity growth.

Maybe technology will come to the rescue and lift us out of our productivity and prosperity malaise. Rishi Sunak suggested in his Tory conference speech that artificial intelligence (AI) could provide a £200 billion annual boost to the UK economy, though he did not show his workings.

Something is needed. The living standards’ malaise has already been around for a long time, taking on an air of permanence, and it appears to be getting worse, not better.

Sunday, October 31, 2021
A scary Halloween story on inflation and interest rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Amid the avalanche of information we get at times like this, which nobody normal can possibly make sense of, let alone the MPs patiently sitting through Rishi Sunak’s slightly surreal budget speech a few days ago, one thing jumped out at me. As the Bank of England contemplates what to do this week – amid frenzied speculation about an imminent rise in interest rates, either this week or next month – it concerned inflation, the issue of the moment.

It was from the Office for Budget Responsibility (OBR), the official forecaster. People of a nervous disposition may wish to look away now. Even on Halloween it is a bit scary.

The OBR set out what is its central forecast for inflation, which has it rising to 4.4 per cent by the spring of next year, and averages 4 per cent for the year. It then comes down, though it is not predicted to get down to the 2 per cent official target, as an annual average, until 2025. Retail price inflation, important for the public finances, student loans and many people, is forecast to rise to 5.4 per cent in January.

On this, its central forecast, the Bank raises official interest rates to 0.75 per cent very soon – a nudge to the Bank – and they stay there. The rise in inflation will be uncomfortable, and it will mean that real wages (earnings adjusted for inflation) barely rise over the next three years.

That high-wage economy the government keeps talking about is a distant prospect. But the rise in interest rates foreseen by the official forecaster would keep the cost of borrowing within the bounds it has been in since the financial crisis. Bank rate has not been above 1 per cent since early 2009, and a steady 0.75 per cent would maintain that and should not unduly frighten the horses, or anybody else.

It is the alternative scenario, or scenarios, set out by the OBR that would indeed frighten the horses and be a profound shock for the economy and for every business and household that has come to regard the ultra-low interest rates of the past 12-13 years as the norm. The OBR looked at two sets of circumstances in which inflation would be significantly higher than in its central forecast.

One was if prices, particularly but not exclusively energy prices, rise more than it currently expects, as businesses increase margins and seek to recover their higher costs. The other is if higher wages result in powerful echo the wage-price spirals of the past. The two have different implications for the economy. In the first, higher prices without a compensating increase in wages intensifies the squeeze on real earnings, leading to a big fall.

The two add up to the same broad message for inflation, however, which is that it would go up a lot, and the Bank would be required to respond aggressively. Inflation would rise to 5.4 per cent and still be 4 per cent in 2023 and 3 per cent in 2024. Based on what the OBR describes as “a simple monetary policy rule” the Bank would have to put up interest rates to 3.5 per cent.

You may say that inflation of 5 per cent or so is not terrible, so the Bank could afford to “look through” the rise, as it has done before. But the official forecaster estimates that without a response by the Bank, the inflation peak would be two or three percentage points higher, so 7.5 or 8.5 per cent. What it describes a “vigorous monetary tightening” would prevent prices at the end of the forecast period being 8 per cent higher than otherwise.

This is not, it should be said, a bunch of economists in Whitehall opining on inflation and monetary policy. This aspect of the OBR’s assessment was overseen, in his final forecast exercise as a public servant, by Sir Charlie Bean. He was chief economist and deputy governor at the Bank, attending 166 meetings of its monetary policy committee (MPC) from 2000 to 2014, so he knows a lot about setting interest rates.

I suggested this was not for the squeamish, and that has to be right. A Bank rate of 3.5 per cent before the financial crisis was unremarkable. When it happened in 2003, for a few months, it was the lowest official interest rate in more than half a century. Such a rate now would, however, crash the housing market and, most likely, push the economy into recession. We have been flirting with mild stagflation for some months. This would be the real thing.

It may not happen, and we have to hope it does not, though some reading this are no doubt yearning for significantly higher rates. But to the cocktail of factors pushing up inflation, which include a 0.1 per cent Bank rate, £450 billion of quantitative easing, the effects of global opening-up on energy and other prices, we have to add the budget. Was it wise at this juncture to unveil a post-pandemic splurge in public spending and highlight measures like a 6.6 per cent increase in the national living wage?

The chancellor, of course, took advantage of lower borrowing forecasts from the OBR. In some ways we have returned to the fiscal picture first envisaged by the official forecaster when the coronavirus pandemic first began last year. This was that there would be a short, sharp shock to the public finances, followed by a fairly rapid return to normal. That return to something like normality for the public finances, though public borrowing will still be £83 billion in 2022-23 and £62 billion in 2023-24, after £183 billion this year, prompted the relaxation.

As for the growth outlook, we should not get too excited by that. The new forecast for this year, 6.5 per cent, up from 4 per cent, is largely a reflection of the fact that the OBR expected the economy to shrink more in the first quarter, during the third lockdown, than it did. Its forecast for next year, 6 per cent, is actually lower than the 7.3 per cent in predicted in March.

Growth will soon slow to normal and rather disappointing quarterly rates. The OBR expects a gradual improvement in productivity growth, though only to 1.3 per cent a year, below the long-run average of 2 per cent. It has made such predictions before and the outcome has disappointed.

The chancellor was dealt a tough hand when he took over as the pandemic was breaking. He has dealt well with the challenges. But this is not an outlook which meets his description of “an economy fit for a new age of optimism”.

Sunday, October 24, 2021
Sunak prays that the pandemic's economic scars are healing
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The budget, which will be unveiled by Rishi Sunak on Wednesday, alongside the government’s comprehensive spending review, is usually one of the biggest occasions of the year for people like me. Wednesday’s announcements will, it should be said, be important.

We have, however, been rather spoiled this year. There was a big tax-raising budget in March, with the announcement of an increase in corporation tax from 19 to 25 per cent and a freezing of income tax allowances and thresholds. Both are delayed but that does not make them any less real for that.

Then last month, we had the manifesto-busting announcement of a 1.25 percentage point increase in both employee and employer National Insurance (NI) contributions, together with some other tweaks. All these hikes added up to a big increase in taxes, equivalent to between £35 billion and £40 billion extra when fully implemented by the end of the parliament.

So, this is the second budget this year, breaking what previous chancellors had hoped would be the convention of one big fiscal event a year. The NI increase announced in September, supposedly to pay for both a National Health Service catch-up and fixing social care, continued the pandemic pattern of big fiscal announcements being made outside budgets. The September increases were thought to be worth around £13 billion a year out of this year’s tax-raising total, though the costings have been left to the Office for Budget Responsibility (OBR).

The broad shape of the spending review looks to be set in as much stone as is possible with this government. The NHS will be getting more, partly thanks to the new levy, and the chancellor will recommit to a big increase in infrastructure spending as part of the government’s levelling-up agenda. For much of the rest of government, and for local government, it looks like thin gruel. The challenge for Sunak is to try to ensure that this thin gruel does not get labelled Austerity II – the sequel.

Inevitably, budgets get noticed for the small stuff, not the big numbers. George Osborne still has the scars on his back from the 2012 “omnishambles” budget, which included the ill-fated pasty (as In Cornish) and caravan taxes, as well as some other horrors. None would have raised much money, but they came to be seen as symbolic of a government struggling to get things right.

Talking of scars, if that is not too clumsy a link, one of the big questions for the budget and spending review, the answer to which has been keenly awaited by the Treasury. This is the extent to which the OBR, the official but independent forecaster, believes that the economy will be permanently damaged by the pandemic.

The extent of such scarring is far more important for the outlook for the public finances than individual tax changes. The smaller the extent of it, the better the prospect, though this has to be put in context. After the huge shock of the pandemic on the public finances, the outlook for government debt and deficits is worse than it was to be expected to be before the coronavirus struck.

The latest public finance figures, published a few days ago, showed that public sector net borrowing last month was £21.8 billion, £7 billion less than a year earlier but the second highest on record. Borrowing in the first six months, £108.1 billion, was huge, but £101.2 billion lower than in the corresponding period of 2020-21.

A significant undershoot is in prospect compared with the OBR’s deficit forecast for 2021-22 of £234 billion, made in March. The average of new independent forecasts is a shade over £200 billion but the Institute for Fiscal Studies, in collaboration with Citi, the investment bank, estimated £180 billion in its “green” budget, published earlier this month.

This should be the last of the really big budget deficits, assuming that the current high number of Covid-19 cases in the UK does not necessitate further significant restrictions. Borrowing should fall quite sharply in coming years, though government debt, currently more than £2.2 trillion, will remain permanently higher.

There are two measures of debt. One includes the Bank of England and is 95.5 per cent of gross domestic product, compared with just over 80 per cent before the pandemic. The difference is equivalent to around £400 billion. The Bank’s contribution is not, by the way, the full cost of its quantitative easing (QE) programme but the notional losses on it, plus its term funding scheme.

The other debt measure, excluding the Bank, is currently £1.98 trillion, 85.2 per cent of GDP, compared with 74 per cent before the pandemic.

Now back to scarring. In March, the OBR, while stressing the uncertainties, estimated that the long-term damage to the economy from the pandemic would be 3 per cent of GDP. That’s about £70 billion using this year’s GDP as a basis.
The chancellor has not made life easy for the OBR in the run-up to this week’s budget, requiring it to cut off its economic forecasts on September 24 and its fiscal forecast on October 1, so it has not been able to take account of the latest news, including some upward revisions to GDP, announced by the official statisticians on September 30.

Even so, it is expected to revise down its scarring forecast, and this matters. Every percentage point reduction in the amount of scarring means a £10 billion or more reduction in the annual budget deficit in the medium term.

There are good reasons for the OBR to revise scarring lower. The furlough scheme has worked even better than the Treasury hoped, and the risks of a surge in unemployment – assuming Covid remains under control – are low. Others have revised down their scarring estimates. The Bank, in its August monetary policy report, said that “longer-lasting scarring effects” would be only 1 per cent of GDP.

The OBR may not go that far. The Resolution Foundation, in a pre-budget report, suggested a new scarring assumption for the OBR of 2 per cent of GDP. The IFS and Citi, in the green budget, suggested 2.5 per cent, though that also included some additional Brexit damage.

The chancellor is, then, set for some good news; a borrowing undershoot for this year and a drop in the extent of scarring. It would be a mistake though, I think, to conclude that all this is about getting the government into a position in which it can deliver tax cuts before the next election.

Sunak’s focus is on repairing the public finances, and the pressures have not gone away. The IFS estimates that, in order to properly fix social care, the health and social care levy will have to rise from 1.25 per cent (on both employee and employer NI) to 3.15 per cent over the source of this decade to “fix” social care. Debt is high, and the government is still borrowing a lot, neither of which is comfortable for any chancellor.

Sunday, October 17, 2021
Global Britain badly needs to improve its export game
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Trade is in the news again. Felixstowe has been clogged up with tens of thousands of uncollected containers and big ships have been diverted elsewhere to ports within the EU. There are said to be similar strains at other ports, caused in part by a shortage of HGV drivers. Global Britain’s window on the world has not closed but it is barely ajar.

There have been faint rumblings of a trade war between the EU and the UK over the Northern Ireland protocol, adding to the restrictions put in place by the government’s thin trade deal, though those rumblings have faded in recent days.

There is a wider issue about trade that I wanted to discuss today, however, and it has long-term relevance for the government’s global Britain ambitions. The latest figures for the economy as a whole – the monthly gross domestic product figures – suggested that a return to pre-pandemic levels, those prevailing in February 2020, is getting closer.

The official statisticians suggest monthly GDP is now only 0.8 per cent below where it was in February 2020. I have mentioned before that there is a slightly tougher test, based on quarterly GDP data, but progress is being made there. The number of employees on payrolls is above pre-pandemic levels, though the number of self-employed people is not. There is a pattern here.

It is not, though, a pattern that applies to trade. The trade figures tell the story. In the three months to August, UK exports of goods, at £80.3 billion, were more than 13 per cent lower than in the corresponding period of 2019, before the pandemic. Adjusted for inflation, the fall was even bigger, 14 per cent.

There was an even bigger fall in exports of services, the dominant sector of the UK economy, which dropped by 14 per cent in cash terms and more than 20 per cent in real terms.

This is, on the face of it, very odd. This is a year of strong recovery in world trade, with the International Monetary Fund a few days ago predicting a rise of 9.7 per cent in global trade volumes this year, more than making up for the 8.2 per cent fall last year.

The weakness in exports of services is, for now, best kept in the pending tray. There was an even bigger slump in UK imports of services, roughly 30 per cent. Coronavirus restrictions have severely impacted trade in services. Travel and transport are important components of trade in services and are only slowly returning to normal. The absence of foreign tourists in Britain, and British tourists travelling abroad, helps explain the data.

There are also some temporary factors in trade in goods. When a shortage of microchips means fewer cars are rolling off production lines, for example. Exports of machinery and transport equipment in the latest three months were down by 17 per cent on two years’ earlier, while imports showed a fall of 15 per cent.

Caveats aside, however, there is still something rather worrying about the UK’s trade performance. The trade deficit in goods, £163 billion over the past 12 months, looks set to break new records this year. The biggest annual deficit on record was £142 billion in 2018. And, while exports of goods have slumped compared with two years ago, imports are down by a mere 1 per cent.

As with so many things happening at present, a combination of Brexit and Covid is at work, and it is difficult to disentangle the two. Indeed, the figures suggest that this combination is throwing up some odd effects.

Exporters are finding it tougher to sell into the EU but you would not necessarily know it from the figures. In the latest three months, exports of goods to the EU, £40.2 billion, accounted for just over half of all goods exports, £80.3 billion. The share of exports going to the EU, indeed, is higher now that it was when we were a member, even though such exports are down by a couple of billion on a quarterly basis on where they were two years ago.

The rise in the EU export share reflects a slump in exports to the rest of the world. Non-EU exports are down by a huge 21 per cent compared with two years ago. These are the markets that, according to the government, we left the EU to exploit.

Where there has been a shift, curiously, is in where we source imports from. Many importers report difficulties in getting imports from the EU, while some EU firms no longer see the UK market as a priority, and the figures bear this out. Imports from the EU are down by 13 per cent in cash terms over the past two years. Imports from the rest of the world, in contrast, are up by 13 per cent. It has been hard, unsurprisingly, to detect any benefits of Brexit. If there are some, it appears they may be accruing to non-EU exporters wanting to sell into Britain. I don’t remember that on the side of the bus.

The statistics will evolve as we return to normal. But the question, as with so many aspects of the current government’s policy, is whether it has a strategy. A new report from the Resolution Foundation, in collaboration with the Centre for Economic Performance at the London School of Economics, published a few days ago, suggested that it does not.

With a lot of talk around at the moment about our “national economic model”, the report, Trading Places, notes that the model was fundamentally altered by entry into the European Economic Community nearly half a century ago. Membership resulted in faster trade growth with EEC/EU countries than with the rest of the world. By making the UK a magnet for foreign direct investment (FDI), this country was able to reduce the productivity gap relative to France and Germany.

Increased openness within the EU was good for services, with service exports growing twice as fast as the OECD average, but bad for industry, with the decline in manufacturing employment bigger than in comparable economies.
Britain’s exit from the EU is likely to result in similarly big changes, the report says.

“Brexit represents one of the most significant shifts to international trade and investment policy across the world,” it says. “It is also highly unusual in that Brexit will increase barriers to trade with the UK’s largest trading partner.”

The government, is says, has been “fixated on the nuts and bolts of the individual trade deals that may be possible after Brexit”. But most of those deals, the majority of which rolled over existing EU deals, have been done, and there is little prospect for the foreseeable future of a deal with America.

A future UK trade policy has to recognise the reality of a world that is dominated by America, China and the EU. Throwing our lot in with America, and allowing trade relations with the EU and China to deteriorate does not make a lot of sense in this world.

“It is important to recognise that the UK will not be setting its policy in isolation, rather it must set its post-Brexit course in the emerging new era of global geopolitics,” the report says. “The UK is leaving the EU during an era of trade defined by the actions of three highly connected but increasingly competitive superpowers – the EU, the US and China.”

Another big question in what happens to productivity when one of the drivers of it, economic openness, is reduced. “A less open economy means that the strategy of driving increases in productivity and prosperity through EU competition and FDI inflows will no longer be available to the same extent,” it says. That is very true. Global Britain cannot turn into a low-productivity closed shop.

Sunday, October 10, 2021
Sunak on tenterhooks over a rise in borrowing costs
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

In the elegant Court Room of the Bank of England’s Threadneedle Street headquarters, there ls one of the most famous weathervanes in the world. Installed more than two centuries ago, its function was to tell the Bank which direction the wind was blowing, and thus when cargo ships were likely to arrive at the Port of London. This was information vital to controlling the supply of credit.

I am not aware of such a weathervane at the Treasury, though it sometimes employs a hawk to keep the pigeons at bay. Its electronic equivalent, however, monitors closely what is happening in the markets; the financial wind blowing from the east, the City and Canary Wharf.

For Rishi Sunak, who has racked up more debt for every month of his tenure than any of his predecessors – an average of nearly £24 billion a month since February last year - what happens to the east of SW1, in the financial markets, is crucially important.

The Bank, if it raises interest rates, will add to the cost of servicing that debt. It currently stands at £2.2 trillion (£2,200 billion) and is at its highest relative to gross domestic product – 97.6 per cent – since 1963, when it was still coming down after the war.

Even if the Bank does not act in the face of the inflationary shock the economy is facing, the gilt market may do so. Indeed, the reaction in the gilt market – the market for UK government bonds – could be greater if traders were to perceive that inflation was being allowed to get out of control.

There was a taste of this a few days ago, when gilt yields – the market interest on them – spiked higher in response to a surge in international gas prices. Yields, and thus the cost of borrowing, remain remarkably low, however. The yield on 10-year gilts, roughly 1.1 per cent, sometimes a little higher, is above the 0.1 per cent last year, but lower than typical levels of between 3.5 and 4 per cent in the early 2010s when David Cameron and George Osborne embarked on their austerity programme, fearful of what the markets might do it they did not.

In his speech to the Tory conference in Manchester, the chancellor took a rhetorical hard line against debt. “I believe in fiscal responsibility,” he said. “Just borrowing more money and stacking up bills for future generations to pay, is not just economically irresponsible. It’s immoral.” He sounded, rarely at the Manchester gathering, like a traditional Tory, and even praised his Tory predecessors.

His big fear is not just what he sees as the immorality of high debt. It is the cost of servicing that debt. Current very low interest rates, and the Bank’s extensive quantitative easing (QE), mean borrowing is cheap. By the end of the year significantly more than 40 per cent of the gilt market will be owned by the Bank, and that is as close as it can be to free borrowing for the government.

In 1963, when government debt was last this high relative to the size of the economy, the government’s debt interest bill was 3.2 per cent of GDP. Now it is 1.1 per cent. Were it now to rise to that 1963 level, it could add nearly £50 billion to the government’s debt interest bill.

Could that happen? Bank rate was 4 per cent in 1963, and it has not been above 1 per cent since early 2009, though these things can change.

The chancellor, in his budget on October 27, is likely to set out some revised fiscal rules. These were promised in the March budget, “provided economic uncertainty recedes further”. He may surprise us, but I would expect the new rules to be quite conventional. The government will be only borrowing to invest by the end of the parliament and that, by then, debt will be falling as a percentage of GDP, though it is likely to be above 100 per cent.

Fiscal rules are, recent history tells us, made to be broken, and all have been, so they alone will not do much for market confidence.
What will help is that the Treasury appears to be winning most of the battles over tax and spending. I did not like the national insurance (NI) hike announced last month but the fact that it was done in the run-up to a Tory conference, when it could have been left until the budget, showed a certain determination to grasp the nettle.

Had we got to this point in the year without any sense of how the government was intending to repair the public finances after the pandemic, the markets might have had reason to panic. But this has been a record year for tax hikes from a supposedly low tax political party. Corporation tax is going up a lot, from 19 to 25 per cent, and income tax is increasing by the stealthy route of freezing allowances and thresholds for four years from April.

When you see tax increases like this, you get an insight into Treasury thinking. My sense is that the official Treasury did not much like toe policy of continually raising allowances to “take people out of tax” and that money could have been better spent than by cutting corporation tax.

I shall return to the October 27 budget soon, but will a new set of fiscal rules and the announced tax hikes be sufficient to persuade markets that the government has a grip on the public finances? They may well be, though there are battles yet to fight, particularly over a levelling-up agenda that so far appears to be little more than an infrastructure programme. It sounds, however, that despite an absence of squeals emanating from Whitehall, that the spending round will be quite a tight one.

The Treasury, then, looks to be doing its best to reassure the markets. As was a common theme at the “don’t blame us” Tory conference, however, some of these things are outside its control. The only way is up for interest rates, even if the Bank is not itching to do so. In recent days Poland’s central bank has raised official rates for the first time since 2012, and rates have also been raised in New Zealand, which has not happened for seven years.

More than that, as we have seen in recent days, a surge in international gas prices, and in energy more generally, has the scope to spook the markets and push up the cost of borrowing. The future of them is in the hands of Vladimir Putin and international markets, not the UK government.

High inflation used to be of benefit to a government sitting on large debts, allowing them to be inflated away. But times have changed, and a high proportion of the debt stock is index-linked, and thus inflation pushes up borrowing costs. This is going to be a nervous autumn for the chancellor.

Sunday, October 03, 2021
As pandemic support ends, get ready for the hard yards
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

There was some good news on the economy a few days ago, which you may have seen. The economy grew by 5.5 per cent in the second quarter, up from an initial 4.8 per cent estimate of the rise in gross domestic product. It meant that the UK’s inferiority complex in relation to other big European countries is over.

UK GDP in the second quarter was 3.3 per cent below the pre-pandemic level in the final quarter of 2019, which sems like a very long time ago. This was exactly the same as Germany, fractionally worse than France but better than Italy. America got back to pre-pandemic GDP levels in the first quarter and China did so last year.

The GDP rise in the second quarter was driven by consumer spending, which rose by 7.9 per cent as restrictions were lifted. The saving ratio fell quite sharply, to 11.7 per cent of disposable income, and the statistics point to a slightly smaller wall of savings money waiting to be spent than previously estimated. There was also a big rise in government spending, by an upwardly revised 8.1 per cent.

Businesses have yet to respond to the generous investment incentive unveiled by Rishi Sunak in his March budget, the so-called super deduction against corporation tax. Though on the face of it there was healthy 4.5 per cent rise in business investment in the April-June period, official statisticians point out that much of this was in buildings, which do not qualify for the incentive. Investment in equipment and machinery, which does qualify, was flat.

For those who are captivated by historical comparisons, we may have to drop the “worst in 300 years” label for last year’s plunge in GDP. I quite liked that label, so it is a pity.

The latest revision, a drop of 9.7 per cent last year rather than 9.8, means that the appropriate comparison is with the tumultuous year of 1921, when GDP also fell by 9.7 per cent, rather than the Great Frost of 1709.

In 1921 the Irish war of independence was raging, culminating in the Anglo-Irish treaty at the end of the year, which paved the way for an independent Ireland, initially the Irish Free State, and the creation of Northern Ireland. Among other things to happen in 1921 was the Chequers became the prime minister’s official residence, England suffered a whitewash in the Ashes in Australia and Agatha Christie’s first novel was published in England.

That is looking back a long way. And, while the second quarter news was better, it too is a little historic. We have now reached an interesting, perhaps pivotal moment. Having been given an enormous amount of support during the pandemic, the economy is on its own.

The furlough scheme ended at midnight on Thursday, and Friday saw an increase in VAT on hospitality and one or two related areas from 5 to 12.5 per cent. The cut in stamp duty, extended to September 30 in the March budget, also came to an end on September 30. Most controversially, the £20 a week universal credit uplift will end this Wednesday.

On this, perhaps the most controversial aspect of winding down Covid support, the government is offering targeted support of £500 million to replace a universal credit uplift which costs £6 billion a year. It is not hard to do the maths.

Pandemic support, it should be said, did an excellent job, though it cost a lot. The National Audit Office puts that cost at £370 billion, equivalent to more than 17 per cent of last year’s GDP. Not all the support, of course, came and went in 2020.

The end of the furlough scheme should not result in a big rise in unemployment, which has remained remarkably low in the face of a massive shock. The Bank of England thinks there will be little impact on the jobless rate, currently just 4.6 per cent. There is a decent chance that the rate will stay below 5 per cent, though the economic clouds have darkened.

Given where unemployment might have been – there were fears and forecasts of four million unemployed and a rate of 12 or 14 per cent in the spring of last year – this has been a formidable achievement.

Universal credit provided a lifeline for many people during the pandemic, and still does. Not everybody was in the kind of job in which they could comfortably work from home and build up their stock of savings.

The cut in VAT in hospitality, part of a package of measures which included the now somewhat notorious Eat Out to Help Out, may have been more important in supporting the incomes of beleaguered pubs, restaurants and cafes. As it is, consumer spending on restaurants and hotels rose by more than 60 per cent in the second quarter, having slumped by 30 per cent in the first. For those who like big numbers, it rose by 360 per cent in the third quarter of last year, when we were being encouraged to eat out to help put.

As for stamp duty, the full cut came to an end on June 30, and September 30 marked a return to pre-pandemic rates. This is an element of support which may have worked too well, contributing to an increase in house price inflation which, according to the Nationwide building society, was 10 per cent last month.

We now enter an interlude period between the end of most pandemic support and the start of the tax increases to help pay for it, and for the NHS backlog. In just six months’ time, individuals will face two tax increases, the freezing of income tax allowances and thresholds – a stealth tax increase - and the 1.25 percentage point in the national insurance (NI) rate. Firms will also face a 1.25 percentage point hike in employers’ NI, before the bigger increase in corporation tax, to take effect in April 2023. The chancellor, having handed out a lot of money, will be clawing some back.

There was a time when this interlude was expected to be, if not the lull before the storm, a welcome return to normality. But households are now facing a squeeze from rising energy bills and an increase in inflation which the Bank expects will take it to 4 per cent or more and take longer to recede. Consumer confidence has fallen, even before the tax hikes come through, amid fears of a cost-of-living crisis.

Businesses, meanwhile, are beset with supply and labour shortages, of the kind discussed here last week. It remains to be seen whether, in these circumstances, they will convert investment intentions into actual investment.

Andrew Bailey, the Bank governor, talked in a speech the other day about the “hard yards” of a recovery that is far from complete, and suggested it might take a little longer to get back to pre-pandemic levels of GDP than previously thought.
So we should think of the 5.5 per cent jump in GDP in the second quarter as one of the statistical curiosities thrown up by the peculiarities of the pandemic. Much more modest rises are likely from now on as government support programmes come to an end, and we await tax increases. Harder yards indeed.

Sunday, September 26, 2021
Amid chaos, this recovery is starting to look very messy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The story so far. Energy suppliers are dropping like flies and millions of households and businesses face higher bills. The government has just paid an American-owned fertiliser manufacturing firm tens of millions of pounds to keep production going and head off a crisis in the availability of carbon dioxide, vital to food supplies.

There are empty shelves in supermarkets and warnings that many products will not be available for Christmas. Fresh produce is rotting in fields because a lack of pickers. Panic buying of petrol is resulting in huge traffic jams.

It never rains but it pours, and this looks like a perfect storm. “Events, dear boy, events,” is the most overused phrase in politics but these are the kind of events that can make any government look incompetent, and this government has less of a journey to make than many.

They remind us that in normal circumstances the economy, which is a highly complex mechanism, works pretty well, even if some of those workings are below the surface. Many people will have been surprised both by the widespread need for carbon dioxide and that you need to be making fertiliser to produce it.

What has gone wrong? What has happened to post-pandemic, post-Brexit sunlit uplands, made possible by a successful vaccination programme? Why is there a level of chaos that was avoided during previous crises? Why does it start to feel a bit like the 1970s?

Let me introduce a new analogy into the discussion. I have an old sports car, as well as a sensible vehicle. It is not a vintage model, though when I can get petrol it will fall foul of the expanded London ultra low emission zone, which comes in next month. I think I cut quite a dash in it with the top down - the car's not mine - though others disagree.

At 50 mph, the car goes along smoothly. At 60 it starts to rattle and at 70 I hear it saying: "What do you think you are doing?" At much more than 70, not only would I risk a speeding fine but I would expect the attentions of the national society for the protection of cruelty to cars.

For Britain's economy, one or two per cent growth is the equivalent of 50 mph. We are comfortable pootling along at this unremarkable speed. Three per cent growth is achievable, perhaps equivalent to 60 mph. It used to be a regular occurrence but we have not had growth of three per cent or more since 2005.

Now, how about the 6.7 per cent growth for this year for the UK predicted a few days ago by the OECD? It is not the highest growth prediction for this year but is the most recent. It is the kind of growth rate, even as a bounce from last year's near 10 per cent slump, which in motoring terms would have bits falling off and a screaming engine threatening to explode on the carriageway.

A growth rate of 6.7 per cent has never been achieved in the post-war period. The nearest was 6.5 per cent in 1973, the peak year of the Barber boom. Younger readers and some older ones may need reminding that this was when a Tory chancellor pumped up the economy to such an extent that high inflation was inevitable, even without the additional factor of a sharp rise in international oil prices.

Why is this recovery proving so troublesome when, after all, the economy is only getting back to where it was before the pandemic, having suffered a once in 300 years slump in 2020, and has not yet done so?

There are a few reasons. One is that strong growth is not confined to this country. The world economy will grow by 5.7 per cent this year, its best performance for decades, while G20 economies should expand by 6.1 per cent, the OECD says. That is putting pressure on energy supplies (though crude oil prices are no higher than they were in the spring), as well as shipping capacity, materials and components, and the availability of certain types of labour.

Second, the pandemic, and the restrictions introduced in response to it have reduced the supply capacity of the UK economy. We can be thankful as we approach the end of the furlough scheme this week that unemployment is low.

But, as the Institute for Employment Studies points out, the labour market is more than half a million people smaller that before the pandemic, the biggest contraction since the recession of the early 1990s and may end up being a million smaller as furlough unwinds. Two-thirds of this contraction is due to higher economic inactivity, among students, the long-term sick and others, and one-third is due to fewer foreign workers, particularly EU workers.

Supply capacity has been reduced in other ways. Many people work in sectors that are still operating at well below normal levels, such as aviation and parts of hospitality. The shock of the pandemic and its aftermath has yet to fully work through and may take time to do. Spare capacity in some sectors cannot be easily used by those experiencing rapid demand increases now.

Third, the crisis has exposed a lack of resilience. I learned my lesson on this during the financial crisis when, after the run on Northern Rock, the Treasury put out a lot of material on how resilient the UK’s economy and financial system was. Then we were hit hard by the crisis and discovered that there was not so much resilience in the system after all.

When the pandemic hit, we saw that there was a lack of resilience in the NHS, which was soon overwhelmed. Adding capacity, via the Nightingale hospitals, foundered because there were not enough people to staff them. The UK has fewer hospital beds per 1,000 people than the vast majority of advanced economies and operates at a higher level pf capacity, even in normal times.

A lack of spare capacity, and an emphasis on “just in time” is evident elsewhere. The UK has insufficient gas storage and an energy strategy which is not worthy of the name. The vulnerability of vital carbon dioxide supplies has been a shock. It may well be replicated elsewhere.

Worryingly, but perhaps unsurprisingly, the chaos is beginning to have an effect. The closely watched GfK consumer confidence index has slumped by five points to -13 this month, it was announced on Friday.

“On the back of concerns about rising prices for fuel and food, the growth in headline inflation, tax hikes, empty shelves and the end of the furlough scheme, September sees consumers slamming on the brakes as those already in economic hardship anticipate a potential cost of living crisis,” said Joe Staton of GfK. “All measures have declined this month and consumers are clearly worrying about their personal financial situation and the wider economic prospects for the year ahead.”

The latest “flash” purchasing managers’ survey for the UK showed a drop to a seven-month low to 54.1 amid rising inflationary pressures, signalling some loss of economic momentum. There was also a fall in the eurozone, for similar reasons, though to a higher level of 56.1.

It is much too soon to call a halt to the recovery, because of shortages and higher prices, but they are taking some of the steam out of the economy. In leaving interest rates unchanged at 0.1 per cent on Thursday and maintaining quantitative easing at £895 billion (though with two votes against), the Bank of England’s monetary policy committee also revealed a downgrade to third quarter growth from 2.9 to 2.1 per cent, which will leave the economy 2.5 per cent below pre-pandemic levels. This is turning into a very messy recovery.

Sunday, September 19, 2021
There's a real risk that the inflation cat is out of the bag
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

As inflation shocks go, the one unveiled a few days ago was quite a big one. The jump in consumer price inflation from 2 to 3.2 per cent in August was, according to official statisticians, the largest ever recorded increase in the rate, though the data only goes back to January 1997.

For those who still follow the retail prices index, and I know from my mailbag that many do - though the Office for National Statistics would rather they did not - inflation on this measure rose to 4.8 per cent, from 3.8 per cent. The RPI is still widely used, including for student loans (RPI inflation plus 3 per cent).

There were temporary factors in the rise in inflation. August this year compared with the Eat Out to Help Out price cuts of a year ago, courtesy of the chancellor. A rise of 18.4 per cent in used car prices since April is very odd and reflects supply shortages of new vehicles.

There are, on the other hand, many reasons to think inflation will go higher. Food prices rose by 1 per cent last month alone and while the increase over 12 months was a mere 0.3 per cent, that annual rate seems bound to rise. Similarly for household energy prices. Gas prices last month were 4 per cent down on a year earlier. They are now on the up

“Pipeline” measures of inflation, meanwhile, are also increasing. Industry’s raw material and fuel prices last month were 11 per cent up on August 2020, up from 10.4 per cent. Output or “factory gate” prices were up 5.9 per cent, from 5.1 per cent.

Other countries are experiencing high inflation. In America there was reassurance that consumer price inflation dipped, but it only fell to 5.3 per cent from 5.4 per cent and remains high. The UK’s inflation rate was the highest since March 2012, but Canada’s rose to an 18-year high of 4.1 per cent.

Some of the influences are global, though we have we or two special factors of our own, but the effects of inflation are local. And despite a long list of temporary factors, including the fact that higher prices are concentrated in a few areas rather than across the board, the question of whether the inflation cat is escaping from the bag is a live one.

What does the Bank of England do? Its monetary policy committee (MPC) meets this week and has a decision to make. I got quite excited earlier this month when the governor, Andrew Bailey, told the House of Commons Treasury committee that the committee was split 4-4 last month on whether the conditions had been met for a rise in interest rates.

You may be puzzled by that, for a couple of reasons. Firstly, are there not nine members of the MPC? Usually, yes, but at the time the Bank was awaiting the appointment of its new chief economist, Huw Pill, following the departure of Andy Haldane. Pill will be voting this week. Catherin Mann also joins the committee, replacing Gertjan Vlieghe.

Secondly, if you think you do not remember a 4-4 split vote on whether to raise interest rates last month, which would have shocked financial markets, you are right. This is because what the governor was talking about was the Bank’s policy guidance.

This, first set out a year ago, was that the MPC will indicate whether the “necessary” conditions have been met for a rise in interest rates, before deciding whether those conditions are “sufficient”. Four members, including Bailey, thought the necessary conditions had been met last month, and that could increase further this week.

Getting to “sufficient” is another story. The Bank is expected to raise rates but not for some time. Financial markets have priced in an increase from 0.1 to 0.25 per cent, but not until the first quarter of next year. A rise to 0.5 per cent is priced in by the end of 2022, at which point the process of reversing quantitative easing (QE), by not reinvesting the proceeds of maturing gilts, could begin. If you think that’s a snail’s pace, snails could reasonably complain that they are never that slow.

The inflation shock is one thing for the MPC to consider, but it will also have the weak July gross domestic product figure and the tax hikes announced last week to take into account.

The decision this week will be whether to proceed with the remaining QE voted on in November last year, with a promise that it would continue until the end of this year. That final tranche, of £150 billion in all, with perhaps £50 billion to go, should certainly have been stopped two or three months ago. One MPC member, Michael Saunders, voted to cease last month. If the others did so now, and market expectations are that they will not, it might signal that they had been shocked into a change. That, in turn, could make them reluctant to shift.

We should not be too harsh on the Bank. In America, where inflation is higher than in the UK, markets are waiting the Federal Reserve’s decision on tapering its QE purchases, not stopping them entirely. There is a similar picture in the eurozone, where inflation rose to 3 per cent last month, and the European Central Bank is trimming but not halting its asset purchases. For some reason Christine Lagarde, its president, does not want to call this tapering.

“The lady isn’t tapering,” she said earlier this month, channelling Margaret Thatcher. Whether or not the Bank of England completes the current QE programme, it is unlikely that there will be any more in this bout of monetary support.

It may be, of course, as many would argue, that central banks are collectively making an error, by operating ultra loose policy even as inflation starts to take hold. Capital Economics, the consultancy once known for declaring the death of inflation, has been running a series of research notes on the issue, and will soon publish a research note, “The rebirth of inflation?”

Its verdict is that for most countries the current inflation upturn will subside. But, it warns: “A new era of higher inflation is most likely to emerge in the US and perhaps the UK.” This will not be a re-run of the 1970s but, rather sustained inflation of 3 to 4 per cent. That would be getting close to double the official target of 2 per cent and also double the average since Bank independence in 1997. It would be a significant problem. These are choppy waters.

Sunday, September 12, 2021
After this dog's dinner. can we sustain record taxes?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

We have had some momentous announcements in the past week, dwarfing most budgets, though without the red box, the choreographed photo opportunities and the usual theatre. There are a couple of big questions I want to try to answer about these announcements, but first let me offer a quick assessment.

The policy package unveiled by the government to “fix” social care, and which included a big 2.5 percentage point in national insurance contributions – 1.25 points from employees, 1.25 from employers – was a dog’s dinner. So much of a dog’s dinner was it, in fact, that Pedigree, for years the manufacturers of Chum, could legitimately sue for breach of copyright. It may prolong this government’s active life, to recall a successful canine advertising slogan, but otherwise there was little to be said for it.

It was dog’s dinner because, even with a couple of minor tweaks, national insurance (NI) was the wrong tax to increase, as I pointed out a couple of weeks ago. The alternative to raising £12 billion a year (and we even had the triple counting horror of calling it £36 billion) would have been a two-percentage point increase in income tax.

The government chose not to do that, even though it would have been fairer, partly because all governments hate raising the highly visible income tax rate, preferring the more mysterious and widely misunderstood NI, which does not affect most pensioner incomes. Not only that, but as most taxpayers are probably unaware, income tax is already due to start going up from next year, through the stealthy route of freezing the personal allowance and higher rate threshold for four years. That will mean 1.3 million more taxpayers, and 1 million more on the higher rate, as well as higher taxes for all income taxpayers relative to indexing those allowances.

Even if NI was your chosen tax, there were better ways of doing it, as a useful London School of Economics/Warwick University report pointed out. It estimated that removing existing NI exemptions and earnings limits could raise considerably more than £12 billion a year, making room for a cut rather than an increase in the NI rate. As it is, last week’s announcement has further complicated our ludicrously complex tax system and introduced an even bigger discrepancy into the tax treatment of the employed and self-employed.

It was also a dog’s dinner because the extra money, overwhelmingly for the NHS, was not accompanied by any meaningful reform to ensure that the money is well spent, or even that it achieves its aim of eliminating the Covid backlog of treatments. Social care, the poor relation of the announcements, will remain a creaking and largely unreformed system, staffed by poorly paid but dedicated workers who are now in short supply. Anybody who thinks last week’s announcements have fixed social care has swallowed a lot of snake oil. When the elderly and infirm and their families get stung with the hotel costs of residential care, they will realise that the prime minister’s promises did not add up to very much.

It was a mess, and no way to make policy because, as we have seen quite often during the pandemic, we have a fiscal watchdog, the Office for Budget Responsibility (OBR), but it remains chained up at key moments. There has been some sterling work by the Institute for Fiscal Studies and Resolution Foundation, but the OBR has not been allowed a growl, and the package was nodded through the House of Commons without proper scrutiny.

I know why it happened like this. To introduce some more animals into the discussion, a camel is a horse designed by a committee, and this policy package was designed by a small committee with different aims. Boris Johnson wanted to be able to say he had fixed social care; Sajid Javid, the former chancellor turned health secretary needed many billions extra to try to clear the NHS backlog, and Rishi Sunak, overcoming the Treasury’s traditional objection to hypothecated taxes, wanted to make sure that the extra largesse would not be borne by government borrowing.

Now for those two big questions mentioned earlier. You will know that, under these plans, the tax burden will rise to around 35.5 per cent of gross domestic product by the end of this parliament. That is the highest since the immediate aftermath of the Second World War, when the wartime economy was being demobilised.

The overall tax burden does not represent the totality of government receipts. A broader measure, public sector current receipts, is set to rise to just under 40 per cent of GDP.

The interesting question that arises from this is whether the economy can sustain a tax burden of this size. The late time the tax burden was nearly as high as this, outside of wartime and its aftermath, was in 1969-70, when Roy Jenkins, Labour chancellor in the wake of sterling’s November 1967 devaluation, out up taxes in his “two years of hard slog” period.

The point about these peaks in the tax burden is that, unlike the one that is projected now, they are never sustained. There are a number of reasons for this. A change of government often brings a change in tax policy, though it is hard to see where the low tax alternative to the Tories might come from now.

More usually, the tax burden falls because the economy gets into difficulty. Most of the troughs in the tax burden over the years are associated with slowdowns or recessions. Often, chancellors have cut taxes, if only temporarily, to help the economy out of those recessions. Plans for increasing the tax burden, of the kind we have seen this year, are usually not achieved. A little bird told me that before he was chancellor, Sunak gave a speech on the limits of the tax burden in the UK, so he is familiar with the issue.

This brings me on to my second question. This year, as noted, has been a huge one for tax increases. The £12 billion a year NI rise is on top of the March budget announcements, which included the freezing of income tax allowances and the rise in corporation tax from 19 to 25 per cent. Those increases will build up to an annual £24 billion of extra tax, making £36 billion in all.

The tax rises are delayed, but they are still real. Increasing employers’ NI will mean fewer jobs and lower wages than otherwise. The taxes on individuals will reduce spending. Higher corporation tax makes the UK a less attractive location, and could affect employment, wages, investment and dividends.

How much will this damage the economy? Higher taxes will not cause a sudden stop, but the analogy of boiling the frog is a useful one. You can raise the temperature without any apparent adverse effects, but then they kick in dramatically. Poor frog. That is the tax experiment the government has embarked on, and it is a risky one.

Sunday, September 05, 2021
Sunak turned on the spending taps - can he turn them off again?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

One of the encouraging signs that things are returning to some kind of normal is the extent of the jousting ahead of the Treasury’s comprehensive spending review, which is expected at the end of October. Rishi Sunak has asked the Office for Budget Responsibility (OBR) to prepare a forecast for publication on Wednesday October 27, which is significant clue to the timing.

The jousting includes a demand for £10 billion extra for next year for the National Health Service in England to deal with the Covid backlog of treatments and operations. The demand, from the NHS Confederation and NHS Providers, is on top of plans already outlined.

For similar reasons – the Covid backlog – head teachers and some academy chains want £6 billion extra, which is significantly more than the government has committed.

Meanwhile, 100 organisations have written to the government calling for the £20 a week universal credit uplift introduced last year to be extended or made permanent. And an army of pensioners is ready to march on Downing Street – some of them having got in a bit of practice during the Extinction Rebellion protests – in defence of the triple lock for the state pension.

The chancellor faces a challenge. Having turned the taps full on during the pandemic, during which money sometimes seemed to be no object, he now has to resort to a more traditional Treasury posture. Public spending in 2020-21 reached the equivalent of 52 per cent of gross domestic product, by some margin a peacetime high. When the UK was forced to turn to the International Monetary Fund in 1976 for a bail-out, spending was 46 per cent of GDP.

A couple of these battles appear to have been resolved, though you can never say for sure until the ink is dry on the documents. The £20 a week universal credit uplift was, like the furlough scheme, a pandemic measure. And, unless the coronavirus has more shocks in store for us over the autumn and winter, it will go. The government will argue that it is better to target help on those most in need of it, rather than through a blanket increase in universal credit.

Similarly, the government seems prepared to risk the wrath of pensioners by not increasing the state pension in line with the Covid-distorted average earnings figures, which in the latest figures showed an annual rise of 8.8 per cent. The increase over two years, unaffected by the furlough distortion, was 7.1 per cent.

Both of these decisions, assuming they remain decisions, are right, though they will be met with protests. Universal credit worked very well as an emergency top-up during the pandemic, and it followed a four-year freeze on working-age benefits but targeting makes sense. It would be wrong, too, to provide state pensioners with a windfall as a result of distorted average earnings figures.

What about the bigger picture? The chancellor stands to benefit from the fact that the OBR’s forecasts for the budget deficit are turning out to be too high. In the first four months of the current fiscal year, April-July- borrowing was hefty £78 billion, but this was £26 billion below the OBR’s projections.

A useful briefing note from the Institute for Government (IfG) points out that the chancellor will find himself with more scope than the OBR expected in its March forecast, as a result of faster growth and the borrowing undershoot. It puts his additional room for manoeuvre at £12 billion, though also notes that the March projections were based on tight spending assumptions. Most of that £12 billion would be used up if, against expectations, the triple lock was honoured in full and the universal credit uplift maintained.

It points out a string of additional pressures, including “coronavirus-related costs beyond this year (such as continued test and trace, and vaccination programmes), backlogs created by the pandemic and the prime minister’s ambition to ‘fix’ social care”. The cost of the latter is at least £10 billion, and that is unlikely to provide a full fix.

Sunak’s position will be that even with an undershoot, this year’s budget deficit will be the second biggest on record, and close to £200 billion. Any improvement in the position in comparison with the OBR’s forecasts is relative. The pandemic effect on the public finances has not yet gone away and, indeed, will not do so for years.

On this, any chancellor awaiting the OBR’s verdict does do with a certain amount of trepidation. There is one particular issue that the OBR has to decide on in the coming weeks, which will be important. This is the amount of “scarring” or permanent damage inflicted on the economy as a result of Covid, for example as a result of sustained higher unemployment. In March, the OBR put the amount of such scarring at 3 per cent of GDP. Since then others, including the Bank of Englad, have revised their estimates down, in some cases to zero. A similar move by the OBR would make a difference to medium term outlook for the public finances.

It would not, however, relax the Treasury’s determination to achieve tight spending settlements this autumn. Public spending ratcheted higher during the pandemic, and it will remain higher in the long-term than previously expected. Total spending in real terms in 2024-25 is on course to be 11 per cent higher than in 2019-20.

That compares with a zero real rise during the austerity years 2010-11 to 2018-19. Some of the increase in due to a 52 per cent rise in public sector net investment, including infrastructure, which was planned before the virus struck. Much of it reflects the pandemic overhang.

Relative to GDP, public spending is projected to be a whisker under 42 per cent of GDP in 2024-25, 41.9 per cent, and staying around that level, compared with 39.5 per cent in 2018-19. In the past, the Treasury would seek to bear down on spending when it reached such levels. Though it may be that we have arrived at a permanently larger size of the state.

Either way, however, the chancellor and his Treasury officials are unlikely to want it any larger than that. Cheap government borrowing cannot be guaranteed for ever. It makes sense to turn off the spending taps.

Sunday, August 29, 2021
A Brexit headwind the UK recovery could do without
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The script for the economy’s post-pandemic recovery did not include a sequence in which a series of economic indicators started pointing downwards, and yet that is what we have been seeing. Why is it happening, and how serious is the threat to the upturn?

To rehearse some of the evidence, official figures a few days ago showed a surprise 2.5 per cent fall in retail sales last month. Though some diversion of spending from shops to hospitality had been expected, this was not the opening-up spending boost retailers had expected. The volume of sales fell back in May after April’s re-opening of non-essential retail, trod water in June and then fell last month.

You write off the British shopper at your peril and the CBI’s latest distributive trades survey, covering part of this month, was buoyant, though also reported very low retailer stocks and mounting supply problems. There is no doubt, however, that this period is proving to be a lacklustre one. The latest Springboard footfall data, monitored on a weekly basis by the Office for National Statistics, showed that footfall in the week from August 15 to 21 (inclusive) was 80 per cent of equivalent levels in 2019, and down by two percentage points on the previous week.

Housing transactions also fell back sharply last month, as the industry paused for breath following the rush to benefit from the full stamp duty reduction, which was extended by the chancellor to June 30 in his March budget. Though a fall was expected, July’s 62.8 per cent drop between June and July was heftier than anticipated.

Then there was the headline-grabbing announcement from the Society of Motor Manufacturers and Traders (SMMT), that only 53,348 cars were made in the UK last month, the lowest since 1956 and 37.6 per cent down on last year, when the industry was coming out of the first lockdown. July is usually an important month for production, in the run-up to the September registration change, though most cars built in Britain are exported, and most sold here are imported.

The immediate weakness of car production was the result of global chip shortages and the “pingdemic” which kept workers away from factories. Overlaying it, though, is the impact of Brexit. In the run-up to the EU referendum, strongly rising production suggested that the industry was on course to beat the all-time high of 1.92 million cars, achieved as long ago as 1972. But the industry has lost capacity as a result of Brexit, as was inevitable, and even before the pandemic struck rolling 12-month output had slumped by nearly half a million to 1.3 million.

The closely-watched purchasing managers’ surveys tell the story well. Taking manufacturing and services together, the “flash” composite output purchasing managers’ index (PMI) has fallen to 55.3 this month, its lowest for six months, and down from 59.6 last month and recent levels above 60.

So what is happening? The UK economy is being affected by a cocktail of factors, some of them global, some very much local. The global factors are well known. Supply bottlenecks, sharply rising shipping costs and microchip shortages are affecting industries the world over, though they not sufficient to prevent a strong global economic recovery.

The Delta variant of the coronavirus is also a global factor which is affecting some countries, including America, more than others, and has seen lockdowns reintroduced in parts of the world. The UK has very high case numbers but, thanks to a successful vaccination programme, only a fraction of the hospitalisations and deaths of previous Covid waves.

But the UK’s vaccination advantage, which earlier provided a springboard for recovery, has faded. The share of the population fully vaccinated in the UK is now exceeded by about a dozen countries, including several in Europe, and others are closing fast.

Then there is Brexit, our very own millstone. While the UK’s PMI fell last month, the eurozone equivalent held up well at 59.5, “close to a 15-year high”, according to IHS Markit, which is responsible for the data.

There remains a dispute about precisely how many EU migrant workers left the UK last year, and we may never know precisely, though people in the haulage, hospitality and construction industries have a pretty good idea. All this was both predicted and predictable.

There are labour shortages in other countries, it should be noted. Covid seems to have resulted in a reduction in the effective supply of labour, particularly for certain jobs, for a variety of reasons Brexit is one reason for the shortages in the UK but it is not the only one.

The government, in response to pleas from various industries to ease migration rules for EU workers has said, in effect, that people voted for this and will have to lump it. With retailers already warning of disruptions to Christmas supplies that is an approach that Yes Minister’s Sir Humphrey Appleby would describe as “brave”. Boris Johnson already has one Christmas debacle under his belt. Steve Murrells, chief executive of the Co-operative Group, says “Brexit and issues cause by Covid” are causing the worst supermarket shortages he has ever seen.

Even before post-Brexit rules have been implemented, the UK’s single market exit is exacerbating supply shortages in the UK. Many firms complain of the difficulties of accessing supplies from the EU. Official figures show that, even after a sharp recovery in the second quarter of the year, imports from the EU in cash terms were 16 per cent down on their 2019 level. The full picture will only emerge when all the distortions drop out of the figures but the omens do not look good.

So what does this all add up to? Has the recovery been stopped in its tracks? If we take the PMIs as a starting point, we should remember that in normal circumstances a reading of 55.3 would be regarded as reasonably strong. Levels above 50 are consistent with growth.

Other measures, such as the timely activity indicators monitored by the ONS, show a mixed picture. Job adverts appear to have flattened out, as have restaurant reservations and credit and debit card spending, though flights are now on a rising trend.

Jefferies, the investment bank, which has monitored activity using real-time data since the start of the pandemic says its activity radar has now flatlined for five weeks in a row. It still thinks the economy is on course for a decent third quarter rise, following a 4.8 per cent expansion in April-June. Whether that rise is as strong as the 3 per cent the Bank of England expects remains to be seen. Jefferies has concerns about a Covid “headwind” in the fourth quarter, if the return of schools brings a big rise in infections. The Brexit headwind will last rather longer.

For now, a range of factors, including Brexit, have slowed the recovery. They have not, however, stopped it, nor should they. But recent events have been a reminder that we should never take upturns for granted. They can be more fragile than they look.

Sunday, August 15, 2021
A V-shaped recovery - but not yet a Heineken one
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is not every Sunday that I get to comment on figures which show that the economy grew by 4.8 per cent in a single quarter and was more than 22 per cent bigger than a year earlier. In fact, I can confidently predict that I will never do so again.

Yet, as you may know, that is what the Office for National Statistics has just told us happened in the second quarter in the latest gross domestic product (GDP) figures. This was good news, and we should not look a gift horse in the mouth. Remember the debate about the shape of the coronavirus recession and recovery?

Would it be a V-shape, with a rapid bounce back, or a depressing “L”; down sharply and then flatlining, which some feared? How about a “U” or bath shape, with a fall, a prolonged period of dragging along the bottom, before recovery.

As a V-shaper, always expecting a pronounced recovery as restrictions were lifted, I am pleased to say that that is what we mainly appear to have. It is a bit messy, thanks to a lockdown-induced 1.6 per cent GDP fall in the first quarter, introducing elements of a square-root shaped cycle. But we will look back on it as an even more pronounced “V” than is typical.

You can see this in the quarterly figures, which have GDP now 4.4 per cent below pre-pandemic levels at the end of 2019, and on course to get back there over the next two to three quarters. Or you can find it in the monthly GDP figures, which in June were just 2.2 per cent below the monthly definition of the pre-pandemic level, in February 2020. On these figures, three months of rises in line with June’s 1 per cent increase would get back to that level.

The quarterly figures are probably the ones to use, given that most countries do not yet publish monthly GDP data. More on international comparisons in a moment.
Before that, it is worth dwelling for a second on how we should define recovery from the pandemic. Getting back to pre-pandemic levels is the least demanding test. The other two tests are getting back, when things settle, to the long run rate of growth we had before the pandemic. Given that this was rather subdued, particularly since 2016, I would hope that we can do better than that.

That then takes us to a second test. Can we get back to where we would have been had the pandemic never happened? Most forecasters think there will be some permanent scarring - and of course we will be living with the larger government debt – but estimates of the extent of such scarring have been coming down.

The recovery, as noted above, is something to be celebrated. Last year the government’s view was that comparisons with the UK and other countries should not be made, because of different ways of measuring the public sector. Now they are quite keen to do so, even though these effects remain. GDP was boosted in the second quarter by the return of schools, and it was boosted in June by a big increase in GP visits, as well as the re-opening of hospitality. I don’t think the two were related.

Even so, the UK still has further to recover than other big economies. America’s GDP is already above pre-pandemic levels and the other G7 countries – Japan, Germany, France, Italy and Canada – are closer to getting there. Much will depend on the course of recovery, and in the UK’s case the “pingdemic” of forced self-isolation, from now on.

There are three other things worth noting, which are potentially troubling. The first is business investment. In his budget in early March Rishi Sunak announced an important incentive to boost investment, the so-called 130 per cent “super deduction” against corporation tax. It is early days, but so far the response has been underwhelming.

Business investment picked up by a modest 2.4 per cent in the second quarter and was 15.3 per cent below pre-pandemic levels, which themselves were too weak for comfort. Business investment fell by 10.2 per cent last year and will have to go some in the second half if it is to avoid another annual fall, which would be disappointing in the context of the chancellor’s tax incentive. The good news is that investment intentions are strong - but they have to be delivered.

Second, anybody looking for a post-pandemic rebalancing in the economy will struggle to find it in the figures. This is developing into a services-led recovery. Manufacturing is described by the statisticians as “broadly flat”, which it is. Manufacturing output in June was barely higher than last November, when the economy was in lockdown.

Some of that reflects volatility in sectors like pharmaceuticals but vehicle manufacturing is also struggling. This could be purely the effect of microchip shortages or it might reflect a wider malaise. Honda’s factory in Swindon closed at the end of July. Manufacturing recovered faster than services last year, being less affected by restrictions, but it appears to have been flatlining since.

Finally, talking about imbalances, both exports and imports remain below normal levels; those of 2019. There are Brexit and Covid effects at work here, though recent weakness in exports has been to non-EU countries. The disruption in EU trade in the early part of the year appears to have faded, though exports of goods to the EU in the first half of the year were down by 14.5 per cent on the corresponding period of 2019, while imports from the EU were down by 23 per cent. That might explain some of the shortages we are seeing.

Normality has returned in one respect. In June there was a monthly trade deficit of £12 billion in goods, and of £2.5 billion in total trade, including services. That total trade deficit was £26.2 billion over the latest 12 months, suggesting that the surplus of £14.6 billion over the previous 12 months was an aberration.

So what should we make of it all. It is certainly a recovery, and a strong one, driven by the removal of restrictions. But it is not yet, by a long way, a Heineken recovery, reaching the parts that others do not reach. Slogans like building back better remain just slogans, for now at least. There is plenty of work to be done.

Sunday, August 08, 2021
Northern productivity powers up - but can it last?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

I am going to start today with a prediction. It is that when we get the next official estimate of productivity growth, it will be a strong one. Let me explain. The main measure of productivity is output, or gross domestic product (GDP), per hour worked. The next GDP figure we will get is for the second quarter and, in line with the opening up of the economy, expectations are for a rise of 5 per cent or so compared with the depressed first quarter.

The question then becomes what has happened to hours worked. On this, we know roughly where things are heading. In the March-May period, hours worked were 2.4 per cent up on the previous three months. A similar figure for the second quarter as a whole would tell us that GDP rose at more than twice the rate as hours worked. It would translate into something like a 2.5 per cent rise in productivity in the quarter.

That may not mean much to you but, given that in recent years productivity has struggled to grow by more than 0.5 per cent a year, it would suggest that the post-pandemic recovery - if calling it that does not jinx it – has got off to a good start. I will come on in a moment to whether it can be sustained. We will get the figures on August 17. If I am right, you read it here first. If not, there is plenty of time to expunge it from the memory.

I mention productivity because we have just had some interesting new figures on it from the Office for National Statistics (ONS). The new figures reveal what happened to productivity in 2020, the year the coronavirus struck.

The backdrop to this is that if you wanted the clearest evidence of a North-South divide in the UK, productivity is the place to look. Before the pandemic, in 2019, output per hour in London was 32.8 per cent above the national average, followed by the southeast, 8.2 per cent above the average. Every other region or nation was below the UK average and only Scotland, 1.2 per cent, below that average, broke southern dominance.

So the East of England was 5.1 per cent below the UK benchmark and the southwest 9.1 per cent below. Thereafter, it fell away quite quickly, with Northern Ireland the worst performer (80.4 per cent of the UK average) and no other region above 89 per cent.

As has been pointed out many times, if you could increase the productivity performance of the worst performing regions to match the best, the UK would not have a productivity problem. This is what makes the 2020 figures interesting.

The region with the strongest productivity growth last year, 4.6 per cent, was the northwest of England, followed by Northern Ireland, 3.5 per cent. Only then came “the South” – London, the southeast, eastern England and the southwest, followed by a more familiar line-up. Weakest last year was the West Midlands, with a 1.4 per cent drop in output per hour. By my calculations, the northwest’s better performance last year was enough to nudge its productivity levels above those of the southwest, putting a northern cat among the southern pigeons.

Last year was a difficult on for collecting statistics, with working from home and other changes, but what appears to have driven the better performance of the northwest, which includes major cities like Manchester and Liverpool, was the greater resilience of its economy. The northwest’s GDP fell by 7.9 per cent last year, less than the national average, with only London experiencing a smaller fall, 7.1 per cent. In contrast, the East Midlands suffered a 10 per cent slump, the northeast 10.3 per cent and the West Midlands a huge 13 per cent.

Explaining this is quite difficult. The northwest suffered more enduring Covid restrictions than many other regions, while the London story is difficult to square, on the face of it, with the huge drop in activity in the centre of the city, though maybe the diversified London economy was better able to adapt to working from home.

Even a couple of swallows do not make a summer, so the prospects of a good second quarter national reading for productivity will not mean that we have turned a corner. Neither does last year’s productivity bounce in the northwest tell us that the northern powerhouse initiative, initially focused on the region, has paid off. It is, as they say, too early to say.

There is work to be done to raise productivity and an interesting new Institute for Government paper from Giles Wilkes, a former adviser to Vince Cable when he was business secretary, and to Theresa May’s Downing Street, has some interesting thoughts.

After a week in which Boris Johnson and Rishi Sunak have written to pensions funds and other long-term investors urging them to increase their investment in Britain, including in infrastructure – something that George Osborne tried unsuccessfully – Wilkes makes two essential points.

The first is that a focus by government on high-value sectors and on technology, something prime ministers have been obsessed by since Harold Wilson talked of its “white heat” in the 1960s, will not work. Nor will a “batting average” approach, reducing the economic contribution of lower-productivity services, work. The UK’s productivity malaise came long after the decline in manufacturing’s share in the economy. The need is for a range of actions, across the whole economy.

As he writes: “Productivity is not a problem that can be solved with a laser focus on the right, high-technology sectors: if the aim is to help the bulk of the economy, efforts need to be much broader. Problems including weak management practices, slow adoption of technology, a lack of skilled staff, patchy infrastructure and access to finance need to be addressed across the economy, not just the cutting-edge parts.”

Wilkes’s other main point is one that is often ignored; the role of demand in driving up productivity growth. The weakness of productivity growth since the financial crisis has been against a backdrop of weaker overall economic growth. In the 60 years to 2008, UK GDP growth averaged 2.8 per cent a year. From 2010 to 2019, inclusive, it was 1.8 per cent, and even weaker after the 2016 Brexit referendum.

“The state of aggregate demand is one variable that might be overlooked,” he writes. “A broad productivity crisis hit many developed countries at the same time as the financial crisis damaged global demand and confidence.” We are there still, and we need to break out of it.

Sunday, August 01, 2021
Low rates seem here to stay - thanks to older savers
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

The Bank of England’s monetary policy committee (MPC) will on Thursday announce its latest decision on interest rates and it is fair to say that it would be regarded as an economic and financial earthquake if it was to vote for an increase from the current record low Bank rate of 0.1 per cent.

There is another interesting decision for the MPC to make, which is whether to proceed with the full amount of quantitative easing (QE) it agreed on last November, or whether to hold back on the final £50 billion.

Following recent comments by several of the nine members of the MPC, expectations are for a split vote, so it would be a much smaller surprise if the Bank decided to call a halt now, though the consensus view in the City is that the MPC will stick with the programme, in spite of above-target inflation and a strongly recovering economy.

We shall see. But, returning to interest rates, the monetary weapon that people most notice, you will recall that the official rate was reduced to 0.1 per cent, in two steps, in March last year as the pandemic hit. The pre-pandemic rate was 0.75 per cent, which also happened to be the highest since early March 2009.

You read that correctly. For more than 12 years, official interest rates have been below 1 per cent. For younger readers this will seem like the norm. Older readers, who recall interest rates well into double figures, including Bank rates of 16 and 17 per cent just four decades ago, may still be rubbing their eyes in disbelief.

There have been periods when Bank rate has been becalmed before, at 5 per cent between 1720 and 1821 and 2 per cent over 1932-50, though never at levels as low as now. In fact, until the financial crisis more than a decade ago, Bank rate which has been around since 1694 had never been below 2 per cent. The view at the time was that this was, in the jargon, its lower bound, because of the potential damage an even lower rate would inflict on the banking system.

Financial markets do not expect the current low interest rate regime to end soon. Economists at Deutsche Bank in London have just brought forward their expectation of the first post-pandemic rise in rates, but they do not expect it to happen until August next year, with an increase to the heady heights of 0.25 per cent.

Thereafter, Deutsche Bank expects two quarter-point hikes in February 2023 and May 2024, taking the rate to 0.75 per cent, which you will recall is the highest it has been since early 2009. That will mark the end of the tightening cycle, they say, with the rate then close to the “neutral” rate, with no need to hike more to keep inflation under control.

For those of us brought up in an era in which interest rates could go up by two percentage points or more in a single day, this kind of upward progress on interest rates seems painfully slow. Compared with the mountains of the past, a molehill is in prospect.

It is also painful for many older people. In the debate over honouring the triple lock on pensions, despite this year’s hugely distorted average earnings figures, many pensioners have contacted me to point out that low interest rates mean that they have lost out on most of the savings’ income they used to rely on.

Low interest rates benefit borrowers, who tend to be younger households. They hurt savers, who tend to be older. Low bond yields benefit the government, by reducing the debt interest bill, but also hurt pensioners, because they are linked to annuity rates.

To add insult to injury, perhaps, one member of the MPC, Gertjan Vlieghe, in his final speech as an external member of the committee, argued that the combination of an ageing population and the tendency of older people to keep their growing wealth in safe, or risk-free assets, is a significant factor bearing down on interest rates. This process began 30 years ago and, he argued, has further to run.

“We are only about two thirds of the way through a multi-decade demographic transition that is affecting interest rates,” he said. “Absent policy changes, there is no prospective reversal in this particular driver of interest rates: downward pressure from demographics either continues further or remains where it is.”

There has often over the years been a focus on household debt, but it is outweighed many times over by household wealth. At the latest official count, aggregate household wealth in Great Britain (so excluding Northern Ireland), net of borrowing, was £14.63 trillion, £6.1 trillion of which was in private pensions, £5.09 trillion in property wealth and £2.12 trillion in financial wealth.

Wealth is plainly not evenly distributed but it works out at more than £540,000 per household. It is skewed towards older households. And, as Vlieghe observed, the old life-cycle assumption that people build up wealth in the run-up to retirement and run it down when retired does not work, “the higher saving of the middle-aged outweighs the modest dissaving of the retirees”.

The wealth and savings of older households are not the only factor pushing down on the neutral rate of interest but they mean that current ultra-low rates are not just the consequence of a cautious MPC being unwilling to take a risk with rate hikes. The implication is that even if the Bank wanted to hike aggressively, it would soon find itself with interest rates above the levels necessary to hit the 2 per cent inflation target and maintain economic growth.

These things can never be set in stone. In the 1950s and 1960s, few would have thought that interest rates in double figures would soon become the norm. We will hear more from the Bank this week but it is set to confirm its view that the current inflation shock, which could push the consumer price measure up to 4 per cent later this year, is temporary.

Were that not to be the case, higher inflation became embedded, and the Bank was forced to raise interest rates more than it and the markets expect, that would open up a new dilemma. Every increase in interest rates would add to the government’s debt interest bill. An independent Bank, sitting on £895 billion of government bonds thanks to QE, assuming it sticks to the programme, could be responsible for adding tens of billions a year to that interest bill.

A new paper from the National Institute of Economic and Social Research, ‘Quantitative tightening: Protecting monetary policy from fiscal encroachment’, by its director Jagjit Chadha, together with Wiliam Allen and Philip Turner, addresses this issue.

As it points out: “The vulnerability of the central bank’s balance sheet (and thus government finances) to lower bond prices and higher policy interest rate is therefore now greater than at any time during the QE decade.” Some have suggested that, to limit the impact of higher interest rates, the Bank should stop paying the banks interest on their reserves at the Bank.

The paper proposes a different solution. It is somewhat technical but it should start, the authors say, with the Treasury swapping out some of the long-dated gilts (UK government bonds) it holds as a result of QE for shorter-dated paper. This process should start now, “to protect the independence of the central bank”.

Low interest rates and QE have changed the monetary landscape. Both can be changed and there is arguably more scope for running down the vast amounts of QE the Bank has undertaken than there is for raising interest rates too aggressively. The Bank has found itself in a position that those running it in the past could never have envisaged. Getting out of it will be a tricky task.

Sunday, July 11, 2021
A hefty bill to achieve net zero - who will pick it up?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Follow the money, they say, and these days quite a lot of money is going into responding to climate change. Two big recent motor industry announcements, Nissan’s battery gigafactory and Vauxhall’s decision to built electric vans at Ellesmere Port are both responses to the challenge of shifting towards a net zero economy.

People are shifting too. The new car market remains below pre-pandemic levels but in the first half of this year 41.2 per cent of vehicles sold were alternatives to full diesel or petrol, mostly hybrids, up from 21.6 per cent last year. More than a tenth, 10.7 per cent, of new cars sold in June were battery electric vehicles, up from 6.1 per cent a year earlier.

People and businesses are voting with their feet, or their wheels, and that shift is happening more quickly than expected. But it is important to recognise that this is one of the easier bits of responding to climate change, though it is not without its costs.

Those costs and others, particularly to the public purse, were one of the focuses of the latest Fiscal Risks Report, published by the Office for Budget Responsibility (OBR), the fiscal watchdog, a few days ago. There is a sting in the tail of its assessment, which I shall leave until the end.

The OBR, drawing on the work of the Climate Change Committee and the Bank of England, has looked at the fiscal costs of getting to net zero by 2050, the government’s ambition. These are, of course, not the only costs. Households and businesses will separately incur bills running into hundreds of billions.

Climate change and getting to net zero are complicated issues. The UK has on the face of it, a good record, with greenhouse gas emissions down by 44 per cent on 1990 levels, not least because coal usage has largely disappeared. We have also outsourced some of our emissions to China, a point often made by Greta Thunberg. The UK’s “consumption” emissions, based on what we buy and use, have fallen by a smaller 29 per cent.

It gets harder from now on, according to the OBR. “Getting the rest of the way to net zero by 2050 will require us to find ways of overcoming both the technological obstacles to delivering cost-effective carbon removals at scale, and the delivery challenges associated with upgrading insulation and installing low-carbon heating systems in more than 28 million homes,” it says.

To cut through the complexity, there are three simple points that can be made. The first is that, far from scaring us off the sums involved in tackling climate change, the two “once in a lifetime” shocks of the past decade or so – the financial crisis and the pandemic – may instead have taught us that these things are more manageable than we thought.

The OBR’s big number is that the fiscal costs of achieving net zero will add 21 per cent of GDP to public sector net debt by the middle of the century, £469 billion in today’s prices. That, the OBR says, is “somewhat smaller” than the debt increase resulting from the pandemic. The fat that it will happen over a much longer period should be reassuring.

Second, the early you act, the better it will be. The OBR notes that its “early action” scenario, or at least the one it has borrowed from the Bank, will cost more in the short-term but significantly les in the long run. Under a late action alternative, debt would be 44 per cent of GDP higher by 2050, 23 percentage points higher than from acting early.

Third, and this is also a pandemic point, you cannot leave climate change unaddressed. If it were allowed to continue unchecked, or “unmitigated” then the negative effects on the economy would be much greater, as would be the additional government debt. The coronavirus was a risk that the country was not properly prepared for. There would be no excuse for repeating that with climate change.

That said, this is still the trickiest of issues. There will be people who look at the charts in the OBR’s report and conclude that while plucky little Blighty is the fifth or sixth largest economy in the world (there’s a battle going on with India), this country is a minnow when it comes to greenhouse gas emissions, just 1 per cent of the total. The big ones are China, America, India, Russia, Indonesia and Brazil.

The biggest increases in emissions in recent years, unsurprisingly, have been in China and India. This creates a political problem, rooted in the economics of net zero. As the OBR puts it, the physical risks from global warming are “largely exogenous”, in other words coming from outside this country, while the costs and risks are “endogenous”, and have to be borne at home.

That is what makes it a challenge. It is one thing for the government to take on its share of the cost of decarbonisation, it is another to persuade the public to do so without very large incentives. Let me take a couple of examples.

We have an old and energy inefficient housing stock, with most heating provided by gas boilers. Achieving the kind of insulation programme needed to address that and persuading people to install what Boris Johnson described the other day as “10 grand a pop” heat pumps looks like something that any government would prefer to leave to its successor.

Or, returning to cars, where I started. Carbon taxes will be needed to shift people and businesses away from traditional energy sources. Fuel duty is a kind of carbon tax, albeit one that chancellors have been too timid to increase for the past 10 years.

Eventually, however, these receipts will be lost, a natural consequence of decarbonisation. If they could be replaced with other course of revenue, the fiscal costs of moving to net zero would be greatly reduced. The OBR says that if the tax burden on motorists was maintained, the debt would be 24 per cent of GDP lower than it expects by the middle of the century. How do you maintain the tax burden on motorists, either by ramping up the road fund licence to very high levels or by road pricing? Would governments which have been fearful of raising fuel duty do that? You tell me.

What about that sting in the tail I mentioned earlier? Climate change is one of three fiscal risks analysed in detail by the OBR in its latest report, the others being the legacy of the pandemic and the danger of a rise in the cost of government borrowing, pushing up the debt interest bill.

These are only three of 87 risks identified by the OBR and, to simplify the analysis, it isolated each of these in terms of their impact on the public finances. When the OBR looked at the long-term outlook for the government’s finances a year ago, in its Fiscal Sustainability Report, its central projection was for public sector net debt to rise above 400 per cent of gross domestic product over the next 50 years, largely driven by demographics and the ageing population. In the long run, we have a problem.

Sunday, July 04, 2021
The story has changed, but the productivity puzzle remains
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

You may not have noticed it, but we have had some important figures on the economy in recent days. They change the economic story of the past 20 years or so, and they have a bearing on the all-important productivity puzzle.

The figures I am referring to were not the revised gross domestic product (GDP) figures for the first three months of the year, the quarterly economic accounts, though they also told us something. The first quarter is quite recent, though the second has just come to an end, and it is easy to forget how grim it was. The fall in GDP in the first quarter was revised down from 1.5 to 1.6 per cent, leaving it a chunky 8.8 per cent below its pre-pandemic level at the end of 2019.

Some of the individual numbers in the first quarter would have been record-breaking had it not been for the fact that even more spectacular records were set last year. Thus, restrictions led to a 4.6 per cent slump in consumer spending in the first quarter, leading to a surge in the saving ratio – gross savings as a proportion of disposable income – of 19.9 per cent, the second highest on record.

There was also a disturbingly large slump in business investment, 10.7 per cent, another second largest on record, which left it 17.3 per cent lower than before the pandemic. For a country that needs all the investment it can get, this was not good news.

If you are a glass half full person, you will see good news among the bad. The mere act of households saving less will support consumer spending, and indeed has already started to do so. Since the low point of the first quarter, which was in January, monthly GDP is already up by more than 5 per cent.

For those who see the glass as half empty, the fact that UK GDP in the first quarter was further below pre-pandemic levels than any other G7 country was troubling. There are also tentative signs, and they are only tentative, that the recovery has been losing some momentum in the past 2-3 weeks.

The debate will continue. We remain on course for a very strong growth number this year, the only question being how strong.

On which note, let me turn to the more significant official figures. The Blue Book, for those who do not know it, is the “bible” for the UK’s national accounts, produced every year by the Office for National Statistics (ONS).

In preparation for this year’s edition, the ONS has been looking back nearly a quarter of a century, and it is rather interesting. For the period 1997-2007, leading up to the financial crisis, average annual growth has been revised down from 2.9 to 2.7 per cent. This makes the period leading up to and including the crisis even more “a bust without a boom” than it was. Pre-crisis growth of 2.7 per cent was only a little above what was thought at the time to be the economy’s trend, or underlying, growth rate.

The revisions have not changed the picture of the crisis itself very much. Last year’s collapse in GDP remains nearly two and a half times the drop in the worst financial crisis year, 2009. Post-crisis growth leading up to the pandemic is now, however, slightly stronger, at 2 per cent a year on average from 2010 to 2019, up from 1.9 per cent before.

These changes have implications for productivity. The ONS now has a better picture of what is happening in the financial sector and has adjusted the figures for what it describes as “double deflation” (don’t ask). Well, if you do ask, then to quote the ONS: “Double deflation is a method for calculating value added by industry chained volume measures, which takes separate account of the differing price and volume movements of input and outputs in an industry’s production process.”

The ONS has also transformed the picture for the telecommunications sector, which on the previous measure had shown weak to declining productivity in recent years but in the new data has a big increase.

That is not true for most parts of the economy, sadly. Productivity growth in many service industries is revised down for the 20 years from 1997, only partly offset by upward revisions for manufacturing and some others. Manufacturing industry, sadly only 10 per cent of the economy, remains a key driver of productivity. For public services, incidentally, productivity was poor during the Blair-Brown years of plenty in the 2000s but improved during the austerity years. Make of that what you will.

What all this tells us is that, just as growth was weaker than previously thought before the financial crisis, so was productivity. That means that the level from which the productivity disappointment of recent years began was lower than previously thought.

To be specific, productivity growth, measured by output per hour, was 2 per cent a year over the 1997-2007 period, rather than the 2.2 per cent previously thought. So, when we compare recent performance, which is slightly stronger, against the previous trend, that previous trend is weaker than was thought.

The result is that the productivity gap – where we are compared with where we should be – is now though to be about 15.6 per cent, compared with the 19 per cent estimated before.

That sounds like better news than it is. The main reason for this, as I say, is that productivity was weaker before the financial crisis. Its growth since the crisis, while marginally better than before, is still feeble. The productivity puzzle remains.

It is indeed a puzzle. We know what the drivers of productivity are – investment, innovation, infrastructure and skills – but nothing changed after the crisis for any of these to produce the abrupt productivity slowdown we have seen, even in the new data. The statisticians need to keep digging.

Sunday, June 27, 2021
As inflation jumps, the Bank risks falling behind the curve
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It may not have been obvious to everybody but the decision of the Bank of England’s monetary policy committee (MPC) on Thursday lunchtime was actually quite a bold one. When I say decision, I should say non-decision. The committee stuck with its previous policy.

Why bold? Nobody expected the risk-averse MPC to contemplate an increase in official interest rates from the current all-time low of a mere 0.1 per cent, though some would have liked to have seen it, or at least a signal that it could happen before long.

No, the boldness was to persist with the latest tranche of quantitative easing. This, agreed last November, was for an additional £150 billion of asset purchases, mainly UK government bonds, to be completed by the end of this year, taking the total up to a huge £895 billion.

Early last week I chaired an online seminar, a webinar, organised by the Spinoza Foundation, featuring two former members of the MPC, neither of whom would be regarded as particularly hawkish. They were agreed, however, that in the context of a strong recovery and rising inflation, the QE agreed last November should be immediately halted. There is still £72 billion of the £150 billion agreed last November yet to go, according to the Bank, so in their view that should not happen.

A similar view was expressed by The Times shadow MPC, all nine members of which voted to call a halt to QE. This view did not go entirely unheard on the actual MPC, with the Bank’s departing chief economist Andy Haldane, voting for a second month in succession – at his final meeting – to cut the QE total by £50 billion. If the other members gave him a leaving present, which I am sure they did, it was not this. The other eight voted to stick with the programme.

This, to me, while not at all unexpected, was nevertheless a bit of a puzzle. Stopping some of the QE, if not immediately then very soon, would have been an easy way for the Bank to show that it was concerned about the rise in inflation now coming through. Growth in the economy has been coming through more strongly and inflation is higher than the Bank expected. In the dark days of November, during the second lockdown, when this QE decision was taken, nobody had even yet received a Covid vaccination. When the facts change, as the saying goes, you can change your mind, and without any loss of face.

By sticking to its dovish guns, the MPC majority runs two risks. The first is to fall “behind the curve” as inflation comes through. Monetary policy is supposed to be flexible, but sticking with a QE programme that will run for more than a year is inflexible and displays a lack of concern over an inflation rate that it now expects to rise above 3 per cent later this year.

The second danger, which Bank insiders always play down but many outsiders regard as a serious issue, is whether the Bank, in persisting with QE even as the economic arguments for doing so weaken, is helping the government out a little too much with its purchases of gilts (UK government bonds). It rejects the charge of what is known as monetary financing but others are not so sure.

When does inflation become a problem? As I have written here before, there are plenty of reasons to think that some of the current upturn is temporary, or “transitory” as central bankers like the Bank to say. It will, in other words, fade. Base effects – comparisons with very weak levels a year ago – are driving some of the current increase. The MPC majority, it should be said, is betting heavily on this being the outcome and that inflation will soon return to 2 per cent.

The Bank also takes comfort from the fact that inflation expectations are, in the jargon, “well anchored”. Its latest survey of public views on inflation, carried out by TNS, and released earlier this month, showed that while people had a median expectation for inflation of 2.9 per cent in the coming year, this came down to 1.9 per cent in the year after that.

In five years, people think inflation will be 2.6 per cent. That is above the official 2 per cent target but, significantly, below the 3.4 per cent five-year view that the public had in February. Most of the survey results, carried out in May, were below those in February. It remains to be seen whether those views stay the same when people are asked again after the rise in inflation over the summer and autumn.

People sometimes ask why it is important to keep inflation low – which the Bank’s survey shows the public supports – and whether there is anything magical about a 2 per cent target. Indeed, a debate has been raging since the global financial crisis more than a decade ago about whether central banks should target a higher inflation rate, say 4 per cent.

The traditional argument for inflation targeting, and indeed for choosing a target of about 2 per cent, is that at such a level it does not distort economic decisions. When inflation is higher, people and businesses start taking action to avoid it. That distorts economic behaviour and can damage economic growth.

We have not reached anything like that point yet, with inflation only a smidgeon above the official 2 per cent target, though I know from my mailbag that many people think it its higher, but inflation worries may already be starting to affect behaviour.

The latest consumer confidence index, published by GfK and released on Friday, showed that confidence stalled at minus 9 this month, breaking its rising trend. Some of that may have reflected uncertainty about the coronavirus and the Delta variant but GfK also uncovered worries about rising inflation. Forecasts of rising inflation, if realised, could dampen confidence further, it warned.

Bank of America, in its “consumer whisperer” report, noted that after rocketing between March and May, consumer confidence on its measure had slipped over the past fortnight, not because of the delayed removal of restrictions but, rather, because higher inflation is starting to squeeze real incomes.

For businesses, the reality of rising costs, and the necessity of passing them on in higher prices, is even more pressing. According to the latest “flas” purchasing managers’ index from IHS Markit: "The rate of input cost inflation accelerated for the fifth month running and was the joint-fastest on record, equal with that seen in June 2008. While inflation continued to be led by the manufacturing sector, service providers also posted a marked increase in input prices. In turn, the rate of output price inflation hit a fresh record high for the second month running.”

This is something to be watched. The Bank may be relaxed. Many are not.

Sunday, June 13, 2021
A red hot housing market adds fuel to the inflation fire
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

There was a time, before everything went a bit bonkers, when an article about house prices was guaranteed box office. Maybe it is time to relive those days, at least for a while, because the housing market is showing plenty of signs of exuberance, which some see as dangerous.

Most measures have the rate of house-price inflation close to or above 10 per cent. Halifax has the rate at 9.5 per cent, Nationwide 10.7 per cent, and the official measure from the Office for National Statistics 10.2 per cent. Stay with me and I shall reveal that parts of the country are experiencing even more spectacular price rises.

This is not just about a particular sector of the economy. Andy Haldane, who will be stepping down shortly as the Bank of England’s chief economist, described the housing market recently as “on fire” with price rises generating further inequality, including inequality between the generations. Haldane sees roaring house prices as part of a more general inflation problem, which risks allowing the inflation genie to get out of the bottle.

He is not the only one to worry. Lord (Mervyn) King, the former Bank governor, writing for Bloomberg, worries that central banks, including the Bank, have “painted themselves into a corner”. As he put it: “Support for monetary policy as the way to combat inflationary risks is declining. Over the next few years, governments will probably want to spend more, but won’t want to increase taxes on most citizens. Higher interest rates, or a shrinking of central-bank balance sheets, will make it more difficult for governments to finance their deficits. Inevitably, there’ll be political pressure on central banks to respond slowly to signs of higher inflation.”

More on that in a moment. But what about house prices themselves? Some of those regional increases are spectacular. The e.surv-Acadata monthly index, which uses Land Registry data, had annual house-price inflation at 11.7 per cent, or 15 per cent excluding London and the southeast. The biggest annual increase over the past three months was in the northwest, up 15.7 per cent.

RICS, the Royal Institution of Chartered Surveyors, noted in its latest residential market survey, for May, that the disparity between housing demand and supply was driving prices higher, with no sign of an easing up. Estate agents are suffering from a lack of new instructions to sell alongside strong demand from buyers.

The house-price boom is testimony to the power of government intervention. Rishi Sunak’s stamp duty cut, first announced in July last year and extended in his March budget, has significantly boosted both prices and activity. The furlough scheme, now winding down, appears on course to achieve its central aim, of preventing a big surge in unemployment. Home buyers, meanwhile, have little fear of sharply rising interest rates.

Lower transaction costs (the stamp duty cut) a benign unemployment outlook and cheap borrowing have provided a potent brew. Respondents to the RICS survey reported “frenetic” efforts to beat the stamp duty deadline and a “pressure cooker”, though some are already getting ready for an easing in the second half of the year.

This is because one of these elements is soon to come to an end. The full stamp duty cut (no duty for most on purchases up to £500,000) only lasts until the end of June and will be phased out in reduced form by September 30.

At one time, housing market analysts thought that the combination of the end of the stamp duty reduction and a post-furlough rise in unemployment would lead to a fall in house prices. I never thought that, but it is reasonable to expect that house-price inflation will start to come back down to earth when the stamp duty cut stops providing an incentive to bring forward purchases. That does not mean falling prices, but it should mean an easing of the pace at which they are rising.

Is housing part of more general inflation problem? As I have written before, inflation is going up, the only question is by how much and for how long. The next few months will be a time of great nervousness for inflation worriers.

Apart from a rise in consumer price inflation to above the official 2 per cent target, and perhaps to 3 per cent before the end of the year – US inflation last week hit 5 per cent - there will be further evidence of price pressure in raw material and fuel prices. Crude oil prices this time last year were off their lows but Brent crude now, at more than $70 a barrel, is nevertheless up by 74 per cent over the past 12 months.

Those who are worried about a wage-price spiral, and that includes Haldane, will have ammunition in the expected jump in annual average earnings growth to 7 or 8 per cent very soon, something we have not seen this century. The calculations on this are straightforward. Even if average earnings were just to stay at their January-March level in the current April-June quarter, they would show an annual rise of 6.8 per cent. It will not take much to push annual pay growth above 7 per cent.

Most of that will reflect base effects – comparisons with depressed year-ago levels – and furlough distortions, which should drop out over time. There is a good chance, using similar arithmetic, that by September, annual growth in average earnings will be back down to 2 or 3 per cent.

For average earnings, for house prices, and in time for consumer price inflation, the prospect is for a temporary or “transitory” boost, followed by a return to more normal levels. This, in other words, is a “don’t panic” moment.

That is not as comforting as it sounds, however. As King noted, there remain plenty upside risks to inflation over the medium-term, which central banks should be concerned about. There was case for proceeding cautiously after the global financial crisis just over a decade ago, when growth was fragile and often tentative.

But there is no case for that now. The post-pandemic party has started and the Bank and other central banks should be giving serious thought to removing some of the emergency support, including record low interest rates and the lashings of quantitative easing (QE) they provided during the pandemic. Whether they will do so is another matter.

Sunday, May 30, 2021
We mustn't begin to think yet of scrapping tax hikes and more public spending
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

We are past the peak in the pandemic, if that is not too many hostages to fortune, and we are past the hump in public borrowing, the budget deficit. This time last year, we reeled from monthly government borrowing figures that were off the scale in terms of previous experience. Now we are in a run of numbers that are just very large indeed.

When I talk about the hump in public borrowing, I am aware that this does not really do justice to a budget deficit that jumped from £57 billion in 2019-20 to more than £300 billion in 2020-21. That is not so much a hump as a high and jagged mountain peak, which you would need the help of a team of sherpas to think about climbing.

And when I talk about still very large monthly figures, April’s borrowing of £31.7 billion was not much below the annual total just over two years ago in 2018-19. Then, public borrowing was 1.8 per cent of gross domestic product. In 2020-21, the fiscal year just ended, it was 14.3 per cent, with more to come from write-offs on pandemic loan schemes, officially estimated to be about £27 billion, which will take it up towards 16 per cent.

It is right to talk about the pandemic and public borrowing peaks in the same sentence, as it is for other economic variables. While some people are getting very excited about another “roaring twenties” as the recovery gathers strength, there is nothing more remarkable happening than an economy that was turned off being turned on again, just as happens to the computer on which I am writing this.

As far as the budget deficit is concerned, its fall is a product of the economy firing up and returning to growth. Compared with April 2020, the month of maximum lockdown, tax receipts last month were sharply higher, with income and capital gains tax revenues up by 31 per cent and VAT by nearly 9 per cent, even though non-essential shops were not open for the full month. The government’s day-to-day expenditure, in contrast, was down by an annual 15.6 per cent.

The pandemic analogy is also appropriate in another sense. Just as the government and public health professionals cannot afford to drop their guard because of the risk from known and potential future Covid-19 variants, so the chancellor cannot afford to drop his guard on the public finances.

Last month’s borrowing, while large, was only two-thirds of the April 2020 figure. That and the fact that it undershot the Office for Budget Responsibility (OBR) budget forecast has led to a bit of an outbreak of deficit optimism.

Some say if things go on like this Rishi Sunak might be able to cancel the tax increases that he announced two months ago, the two main ones being a freeze on personal income tax allowances and thresholds, starting in April next year, and a hike in corporation tax from 19 to 25 per cent a year later.

Others are looking towards the chancellor’s second budget of the year, which is expected in November, and advocating some chunky increases in public spending, made possible by an undershoot in government borrowing.

To both of these suggestions I say, hold your horses. The public finances have been through an enormous shock, from which they will take years to recover.

The OBR, which a year ago was faced with the enormous task of trying to assess the public finance implications of a public health crisis which had met with an unprecedented economic response, initially suggested (in April 2020) that the budget deficit for 2020-21 would be a jaw-dropping – at the time - £273 billion.

It went even higher three months later, with a forecast of £322 billion. This, allowing for the losses on pandemic loans still to come through in the figures, looks like being close to the outturn. Its worst forecast, made during the November lockdown, was for a deficit of £394 billion. That and its March budget forecast, £354 billion, were conditioned on the effects of the second and third lockdowns on the economy being bigger than turned out be the case.

The point is that these are all very large numbers, and playing the game of “undershooting the forecast” in this context is a bit like debating whether the gale that just blew your roof off was a force 9 or 10. The black hole is still a very dark grey.

As it is, the excitement about a borrowing undershoot last month was overdone. While a superficial reading suggested that the deficit had come in £7.3 billion below the OBR’s March forecast, some of this reflected a change in the official treatment in, of all things, the timing of payments under the Brexit divorce bill. The actual undershoot was £1.8 billion, big to you and me, but small change in public finance terms.

The OBR predicts that this year’s budget deficit will be £234 billion, which would be the second biggest on record after 2020-21, and still significantly larger than borrowing in the worst year of the global financial crisis, £158 billion in 2009-10.

Independent economists surveyed by the Treasury this month think it will come in a but lower than that, but that it will nevertheless be very large at £217 billion. They also fear it will come down more slowly subsequently than the official forecaster expects.

We should remember too, that borrowing from now is likely to be in an environment in which there is rather less aid from the Treasury’s helpful friends at the Bank of England. The Bank’s quantitative easing (QE) over the past 14 months has been of enormous assistance to the government in getting the debt away. But that process is coming to an end and, in the light of rising inflation, the Bank may be looking to reverse some of the QE that it undertook during the pandemic.

As it is, even if the economy gets back to pre-pandemic levels quite soon, which it should, the public finances will not. The OBR expects public sector borrowing in 2025-26 to be 2.8 per cent of GDP; higher than in 2018-19 and, for that matter, part-pandemic affected 2019-20.

The central point is a straightforward one. There has been a massive shock to the public finances. We will be lucky if the tax increases already announced provide enough of a repair to the public finances and if the chancellor can restrain other ministers and the prime minister and stick to the relatively tight public spending plans sketched out in his March budget. Talk of relaxation is misplaced.

Finally, and it is a little early for a curtain raiser, the OBR will publish its fiscal risks report in early July. That will set out some of the longer-term challenges for the public finances, including from an ageing population. It may not make for comfortable reading.

Sunday, May 23, 2021
Furlough worked. Now it will be hard not to make it a habit.
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is a mere 14 months ago, but it seems like longer, as have a lot of things over the past year or so. On March 20 2020. Rishi Sunak stood at the Downing Street podium and announced an economic intervention “unprecedented in the history of the British state”. It was a big moment, so much so that I wrote a commentary about it on the front page of this newspaper at the time.

The young chancellor, only five weeks into the job, was announcing the coronavirus job retention scheme, otherwise and more generally known as the furlough scheme. As you will recall, it provided for the government paying 80 per cent of the wages of furloughed workers, up to £2,500 a month, with an associated and more controversial scheme for the self-employed.

The scheme was designed quickly and with the expectation that employers would pay the remaining 20 per cent although, as Sunak said at the time, firms could choose to do this or not. There would be no limit on the amount of funding for the scheme, something you do not hear very often from the Treasury. It would be backdated to March 1 2020, and was initially intended to last until the end of May, a mere three months, though the chancellor said that he would extend it for longer if necessary.

You do not often hear either a Tory chancellor thanking the Trades Union Congress, as well as the CBI, for its constructive contribution to the putting together of the scheme from a standing start.

The initial three months for the job retention scheme turned into 19 as a result of further lockdowns, assuming that it is fully phased out in line with current plans at the end of September this year. It has, as promised, been a hugely significant intervention in the economy.

Figures from Her Majesty’s Revenue & Customs (HMRC) show that a cumulative total of 11.5 million jobs have been supported by the scheme at various times during the pandemic, and at its latest count, the end of March, 4.2 million “employments” were furloughed. To put that 11.5 million in perspective, it is equivalent to more than 40 per cent of the number of employees in the UK before the pandemic struck.

The chancellor said at the outset that there would be no funding limit, which was perhaps just as well. Had we known in March last year that the scheme would have cost a cumulative £61.3 billion by April 14, many would have gulped. In his March budget, the Treasury costed the extension to the end of September at £6.9 billion, adding up to a total cost of not far short of £70 billion.

No scheme is perfect, particularly one put together as quickly as the furlough scheme was. A minority of furloughed workers were able to take on other jobs, perfectly legally, and enjoyed a double income at taxpayers’ expense. Some say that the scheme could have been more carefully targeted and less expensive. Some also warn that the cushioning effect of the scheme may hamper the necessary adjustment of the job market to the country’s post-pandemic future.

The self-employment income support scheme, on the other hand, about which I know I will get emails, has been criticised for being too targeted and too restricted in its eligibility. Its extension in the budget, incidentally, was costed by the Treasury at £12.8 billion, more than the cost of extending furlough.

According to the Institute of Employment Studies (IES), drawing on official figures, the share of self-employment in the total number of people in work, 13.3 per cent, is now at its lowest since 2009. Most of the fall in self-employment, however, has been as a result of a shift from self-employment into becoming an employee, perhaps into some of the jobs that cropped up during the pandemic, such as test and trace and delivery work. Even actors were forced to turn their hands to other roles.

The furlough scheme was intended to provide a bridge back to normality for the job market. There have been one or two false moves – last September the scheme was due for the scrapheap and a new one, including a £1,000 job retention for firms – but it has succeeded.

Figures last week showed that the unemployment rate edged down to 4.8 per cent in the first three months of the year, despite lockdown. The rate has never been above 5.1 per cent during the pandemic. After the 2008-9 financial crisis, it took until well into 2015 to get down to that level, the rate having peaked at 8.5 per cent after that recession. Previous post-recession unemployment peaks were much higher than that.

A recovering economy is, meanwhile, bringing renewed optimism on jobs. Officially recorded vacancies slumped to 341,000 in the spring of last year but have now recovered to 657,000. Every survey of employment intentions is very strong.

Forecasters, who feared a post-furlough surge in unemployment, are revising their expectations. The Bank of England now thinks the peak will be as low as “just under” 5.5 per cent. Given the scale of the recession that would be an extraordinary achievement. As Tony Wilson, director of the IES, puts it: “The single most important reason why unemployment is now below half where we thought it’d be last summer is because of the furlough scheme protecting jobs. We’ll have the lowest post crisis peak in unemployment since the mid-1970s, despite a fall in output greater than any in living memory.”

The furlough scheme is now winding down gracefully. From 20 per cent of employees furloughed in January, the latest official snapshot suggests a figure of 10 per cent in late April and early May.

Its success, however, will post a challenge for future chancellors. In normal circumstances recessions result in rises in unemployment, sometimes very large ones. It is part of the normal order of things and, indeed, part of the economic adjustment that occurs. Other countries have long had schemes to limit the rise in unemployment during and after recessions but, as the chancellor noted when launching the job retention scheme last year, in UK terms his intervention was unprecedented.

The precedent he has now set, though, will make it hard for his successors not to intervene heavily too. If a significant rise in unemployment could be prevented during the worst recession for more than 300 years, why not during a “normal” downturn. A near doubling of unemployment was the norm in the four recessions that preceded the 2021-21 pandemic recession, and that may no longer be acceptable. Success brings its own challenges.

Sunday, May 16, 2021
Growth's back - and so is the great debate over inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

In all the great battles of our time, including the culture wars, one thing you might not have expected is for conflict to be fought out over the GDP (gross domestic product) statistics. Last week the official statisticians gave us both monthly and quarterly versions of these important figures.

If you are a glass half full, Britain is bouncing back fast type of person, then you are likely to focus on the monthly figures. According to the Office for National Statistics (ONS), monthly GDP jumped by an impressive 2.1 per cent in March, its biggest rise since August last year. This lifted it to just 5.9 per cent below its level in February last year, before the pandemic struck.

The two lockdowns since last autumn have taken their toll, so that GDP in March was 1.1 per cent below where it was in October. But, however long last winter may have felt, the economic impact of the later lockdowns was much smaller than the first, a year ago.

If you are of a more cautious disposition, and plenty of people are, you might prefer to concentrate on the quarterly GDP figures. These showed a first quarter fall of 1.5 per cent, dragged down by a bad January, and left GDP 8.7 per cent below its pre-pandemic quarterly peak, which was in the final three months of 2019.

If you are curious about why one peak was in February 2020 and the other 2-3 months earlier, it is because when the pandemic hit it resulted in a big GDP fall in March, which was enough to mean that the economy shrank by 2,8 per cent in last year’s first quarter.

Depending on whether you are a monthly or quarterly fan, it makes a difference to how quickly the economy gets back to pre-pandemic levels. On the monthly figures, three more growth rates like March’s 2.1 per cent would get you there as early as June. It could happen. On the quarterly figures, GDP needs to rise by a little more than 3 per cent each quarter – which in normal circumstances would be regarded as extraordinarily strong – to reach pre-pandemic levels by the end of the year. That could happen too.

I do not have an axe to grind. Both sets of figures tell us a lot. The monthly figures show how growth was recovering as the first quarter progressed, and is consistent with the story I have long told here, which is that whatever else was happening, the easing of restrictions would result in a rapid recovery. The quarterly statistics will be the ones that future economic historians look at to gauge the recession and recovery, as well as last year’s worst fall for more than 300 years.

There is another story here, however, and another battle, and it relates particularly to the construction industry. It has been less affected by the pandemic than any other sector. On the monthly figures it is the only part of the economy in aggregate to be above pre-pandemic levels, manufacturing and services still having some ground to make up, particularly services. On quarterly figures, construction is still a little below where it was before the pandemic, and in a similar position to manufacturing, both doing a lot better than restrictions-affected services.

Every silver lining has a cloud, and for construction it is that cost pressures are intensifying. The latest purchasing managers’ index (PMI) for the construction sector published earlier this month, covering April, showed a pronounced recovery continuing but also the strongest cost pressures since the survey was first conducted in 1997.

According to IHS Markit, which produces the survey: “Higher prices paid for a wide range of construction items contributed to the fastest overall rate of cost inflation since the survey began in April 1997. Steel, timber and transportation were among the most commonly reported items up in price.”

Construction is not the only sector experiencing rising costs, and it has opened up an interesting split. The markets are jumpy about the return of inflation, and their jumpiness was reinforced by figures showing that America’s consumer price inflation rate rose to 4.2 per cent last month. That was before the full effects of the Biden stimulus and the release of pent-up demand come through.

Businesses, many of which are experiencing the kind of cost increases highlighted by the construction PMI, are also worried. They see inflation on the way and, among the cost increases coming through as well as materials and fuel, are significantly higher wages, at least according to the official figures.

Most economists, in contrast, are relaxed about inflation. The latest compilation of independent forecasts by the Treasury showed that the average prediction for consumer price inflation at the end of this year is 2.1 per cent. That, incidentally, is also the average prediction for the end of next year.

The National Institute of Economic and Social Research, whose latest quarterly review was published a few days ago, sees inflation rising from its current very low 0.7 per cent, but only “reaching 1.8 per cent in the final quarter of 2021, before falling to 1.5 per cent at the end of 2022 and settling just below its 2 per cent target between 2023 and 2025.”

The Bank of England is not quite as optimistic but also does not see a problem. Inflation will rise to around the target rate of 2 per cent by the end of the year, reach 2.3 per cent next spring but then subside to around the 2 per cent target, it predicts.

Not all economists are so relaxed about inflation. Tim Congdon and his fellow monetarists think inflation is heading noticeably higher, and that we will see a 5 per cent figure soon. I don’t think it was deliberate trolling but the Bank did not mention the money supply at all in its latest monetary policy report.

The standout inflation forecast in the Treasury’s compilation, mainly because it is so much higher than everybody else’s, is from Economic Perspectives, run by Peter Warburton, a former colleague of Congdon’s. He sees inflation at 3.7 per cent at the end of this year, and 5.2 per cent at the end of 2022.

Most economists, in contrast, think that current inflationary pressure is exaggerated by comparisons with the weakness of a year ago, so-called base effects. They are sceptical about the monetary arguments for higher inflation, and also point to the poor track record for rising raw material prices feeding through into sustained rises in price more generally.

The debate is on. Which of these views is right will do much to determine the economic outlook. And the markets are not ready to stop fretting about inflation, nor will be for a while.

Sunday, May 09, 2021
The makers are on the march - but can it last this time?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is not often I get a chance to say this, but manufacturing industry is on a roll. Surveys show that manufacturing is bouncing strongly. The numbers for manufacturing are more positive than for a very long time, and this is not just a UK phenomenon.

The purchasing managers’ index (PMI) for manufacturing came in a few days ago. Levels above 50 indicate expansion, and vice versa. At 60.9 in April, it was at a 27-year high, beaten only once in the survey’s history, in July 1994. There was, according to IHS Markit, which produces the survey, “a further acceleration in the rate of expansion of the UK manufacturing sector”, with growth in output and new orders at their best for years and a “solid” increase in employment.

The service sector also showed a strong recovery last month, its PMI rising to 61, the best for 7½ years, but we are more used to it being upbeat in our service-dominated economy.

Manufacturing hopes were supported by other evidence. The CBI’s quarterly industrial trends survey showed that manufacturing optimism in the three months to April increased at its fastest pace since April 1973. That was not unsurprising, given the deep gloom into which we were all thrust in January, but the survey also showed that investment intentions for plant and machinery were at their strongest since July 1997.

That looked like a rapid endorsement of Rishi Sunak’s policy of trying to ensure that investment plays its part in the post-pandemic recovery. The chancellor’s innovative budget announcement of a 130 per cent “super deduction” allowance for investment for the next two years is making a difference, though manufacturers would not be investing if they were not confident.

A separate CBI survey for small and medium-sized manufacturers showed optimism rising at its strongest rate for seven years and predictions for output growth at their best since 1988.

Things are looking up in the beleaguered motor industry. Though the vast majority of cars sold in the UK are imported, the industry will take comfort from the fact that new car registrations so far this year are up 16 per cent on last year’s depressed levels. Fleet buyers are contributing most to the increase, so the industry will be waiting to see how much of their savings private buyers are prepared to splash on a new motor.

Separate figures from the Society of Motor Manufacturers and Traders (SMMT) showed strong year-on-year rises in car, commercial vehicle and engine production, though car production in the first quarter was down on a year earlier.

Manufacturing revival is not, as I say, just a UK phenomenon. The eurozone manufacturing PMI last month was even stronger, at 62.9. European lockdowns have pegged back service sector activity in many countries but have had only a marginal impact on manufacturing. The Netherlands is at a record high of 67.2, Germany on 66.4.

Globally, manufacturing output is rising at its strongest rate since April 2010, when it was recovering from the financial crisis. The makers, it seems, are on the march again.

Can it last? As with all readings for the economy this year, a pinch of salt is required. Economies are bouncing back from their worst downturn in decades – in the UK’s case in more than three centuries – and the comparison will tend to flatter. When you have been through something as dramatic as the lockdowns, restrictions and collapse in output and sales of the past 14 months, a return to something like normality can seem like nirvana.

And, while many sectors are still subject to restrictions, which are gradually being lifted, this has not been the case for manufacturing. In many countries, starting China, industrial output is well above pre-pandemic levels.

In the UK, industry was never required to shut down and the instruction to work from home where possible was never practical for many people working in factories. Thus, while on the latest official figures the service sector was 8.8 per cent below February 2020, pre-pandemic levels, the gap for manufacturing was much smaller at 4.2 per cent and should be made up very soon.

I am aware that writing something positive about manufacturing, particularly UK manufacturing, carries a serious risk of jinxing it. MakeUK, which represents manufacturers, is not yet putting the champagne on ice, let alone breaking it open.

Stephen Phipson, its chief executive, warns that a strong UK manufacturing sector needs a world-class steel industry. Everybody knows the travails currently being suffered by Britain’s steel industry and the concerns about its viability.

MakeUK’s prognosis for the industry is for only a partial recovery this year. It predicts 3.9 per cent growth in 2021 and 3 per cent in 2022, following 2020’s 9.9 per cent slump. It welcomed the strong bounce in the PMI but noted that industry faces “growing challenges around the supply-chain and soaring input prices”.

Its caution is justified by experience. Potential revivals in manufacturing have come and gone but have never been sustained. If we take the 25 years to 2019, before the pandemic struck, the economy as a whole grew by 68 per cent. Within that, however, manufacturing grew by just 3 per cent, so growth was dominated by the service sector. Last year’s slump, which one hopes will be made up very soon, saw manufacturing output reduced to its lowest level since 1992, two recessions ago.

There are also the elephants in the room, as highlighted by IHS Markit and the Chartered Institute of Purchasing and Supply, in their commentary on the PMI. As CIPS said: “The still significant delays in the delivery of goods due to the pandemic, Brexit and the Suez blockage in some sectors hampered further progress on two counts.

“The slow delivery of goods motivated supply chain managers to increase their order numbers and try to build up recently unravelled stocks leading to further hold-ups, and the injection of more inflationary pressures into the economy. Price rises were amongst the highest in the last three decades and shortages in some essential materials intensified.”

We should not look a gift horse in the mouth. The revival of manufacturing we are now seeing is good news for a government seeking to level up. Wales has the biggest proportion of GDP in manufacturing, or did before the pandemic, 17 per cent, followed by the East Midlands, West Midlands, North East and North West.

The most likely outcome, in the UK and to a lesser extent globally, is that manufacturing is just the first to revive after the pandemic, and the service sector will quickly make up lost ground, as it appears to be already starting to do. But it would be good if this could give way to something more sustained. I do not yet see much of a strategy for achieving that.

Sunday, May 02, 2021
There is no economic silver bullet, but every little helps
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Every so often people start to think great thoughts about improving the performance of the British economy. Nearly 60 years ago, there was a flurry of such thinking. We would give our eye teeth for the UK’s absolute performance in those days, but relatively speaking it was weak, particularly compared with the big European economies.

So, in 1962, the National Economic Development Council (NEDC) was established, bringing together the “three sides of industry” - government, business and the unions. Three years later the Labour government set up the Department of Economic Affairs (DEA) which, taking it leaf from successful French planning, launched a national plan for the UK.

Then, as now, there was a lot of excitement about new technology, Harold Wilson revelling in the “white heat” of the technological revolution. But these efforts were not successful. The DEA was short-lived, always overshadowed by the Treasury, in whose building it operated. The NEDC and the “little Neddies” it spawned, covering individual sectors, were finally put out of their misery in the 1990s.

The problem of relatively weak growth and persistently high inflation in the UK was instead tackled by entry into the European Economic Community (EEC) in 1973, the Thatcher revolution, the “Big Bang” in the City, the single market and Bank of England independence.

Toady we are at another of those crossroads, and plenty of people are thinking big thoughts about how to improve the UK’s performance in a post-pandemic, post-Brexit world. Some of that thinking is going on within government, though it tends to emerge in ambitious and eminently missable targets from the prime minister. You don’t get the impression that a huge amount of strategic thinking is going on.

Others are doing so, however. The CBI is undertaking its own exercise, and the Resolution Foundation think tank is combining with the London School of Economics for its Economy 2030 inquiry, which will be formally launched later this month. “The country lacks a clear sense of its path to prosperity,” the think tank says.

The first of these exercises, the final report of the Covid Recovery Commission, was published a few days ago. Set up in July last year, and chaired by John Allan, chairman of Tesco and Barratt Developments, this business-led commission consisted of 10 leading business figures, including the chief executives of Vodafone and Heathrow, and the chairs of Shell UK, Admiral Insurance and Babcock International and the managing partner of McKinsey in the UK, It was advised by a 23-strong advisory group and a 19-strong policy panel. It was an impressive line-up.

The UK, it concluded, needs a “national prosperity plan” led by business, government and civic society, to address longstanding problems of weak productivity and inequality. It uses the example of the speedy development of the Oxford/AstraZeneca vaccine as an example of the kind of thing this country can do when the chips are down One of its commissioners is UK president of AstraZeneca.

The commission addresses the UK’s key weaknesses, on skills, infrastructure, investment, competitiveness, regional inequality and income inequality. It will be necessary, it says, to build on the UK’s strengths: “our leading universities, world-class innovation and R&D, our businesses and financial system, our democracy, our institutions and governance”.

To this end it has a five-point programme., or five national “imperatives”. The first aim is to create at least one globally competitive industry in every region and nation of the UK by 2030. Regulators should focus on competitiveness as well as immediate consumer protection, it says, and catapult quarters – a bit like supercharged enterprise zones – should be established.

Second, lifelong learning should be made a reality rather than a slogan, with the aim of halving the skills gap by 2030. The apprenticeship levy, hated by many businesses, should be replaced. Third, government should spend at least 1.2 per cent of GDP on infrastructure each year. It thinks there should be a new government consulting service, among whose tasks will be to create “the Great British supply chain”.

Fourth, there should be a “national deal for net zero homes”, what it describes as a 15-year pathway for the decarbonisation of the housing stock. A green homes bond would provide access to the funds for retrofitting buildings, with the return coming from a share of the energy savings. Finally, an imperative is to “close personal and community resilience gaps in mental and physical health, finances and wellbeing in each year over the next decade”.

As is often the case with these exercises, in it there is a lot that is good, some questionable, and quite a lot of motherhood and apple pie, in other words things that we would very much like to happen but it is not clear how. I like the idea of having at least one globally competitive industry in each region. Some regions already have more than one, others none at all.

The government is responding to the infrastructure challenge, and the report’s well-described UK shortcomings in this area, though we have not seen much yet apart from the announcements. Infrastructure takes time. Full-fibre gigabit capable broadband could provide a significant boost, and featured in both the Tory election manifesto of December 2019 and Boris Johnson’s leadership bid. But the government has scaled back its plans, from offering 100 per cent coverage by 2025 to 85 per cent, and the Commons digital, media, sport and culture committee warned recently that even that scaled-down target risked being missed.

The idea of a Great British supply chain, which has had some coverage, looks like a bit of a knee-jerk response to issues that arose around component supplies from China early in the pandemic, delays at the ports around the turn of the year and the more recent Suez Canal blockage.

Businesses will decide where best to source their supplies. For government to seek to influence those decisions, and push businesses to Buy British, smacks of protectionism.

There is great potential for jobs, and growth, from decarbonising the economy and the commission is right to push it. But this is a policy which, too often, again lacks follow-through from announcement to realisation. If there is an army of home insulators and heat pump installers out there, I have yet to spot them.

The commission’s conclusion, that there is no “silver bullet” but that growth and innovation are the key to future success, is hard to disagree with. Its report is a good effort but falls short of being comprehensive. Perhaps, when the other exercises currently being undertaken are complete it will be possible to combine them into a workable plan.

Sunday, April 25, 2021
The Covid debt isn't going away. We will have to live with it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Cast your mind back a couple of years, if you can, to the spring of 2019. At that time, most of the indicators relating to Britain’s public finances were flashing green. The budget deficit, which for the 2018-19 fiscal year came in at less than 2 per cent of gross domestic product, had ceased to be a source of major concern.

It had been a painful process, and some of that pain, such as the freeze on most working-age benefits, was still in place. But the public finances, to all intents and purposes, had been fixed. There was a small current budget surplus, on day-to-day spending, in 2018-19. Public sector debt, at £1.77 trillion, was high, but it was no longer rising very much in cash terms, and is was falling relative to GDP, to a shade over 80 per cent by the end of March 2019.

Maybe we should have known then that something nasty was about to come along to shock us out of what was a false sense of security. It was known that Brexit would damage the public finances, but that was built into official forecasts that showed debt continuing to fall as a percentage of GDP, the deficit falling further and current budget surpluses becoming the norm.

Nobody could have predicted, however, quite how dramatically things would change, as a result of the pandemic and the government’s response to it. Figures on Friday showed that the budget deficit for 2020-21 came in at £303 billion and, while this was lower than the £355 billion projected by the Office for Budget Responsibility (OBR) alongside the budget early last month, a big undershoot, roughly £27 billion of that undershoot reflects expected government write-offs on pandemic loan schemes that have not yet been incorporated into the figures.

The debt, meanwhile, is £2.14 trillion, 97.7 per cent of GDP. And, while it will increase at a slower rate from now on as the deficit comes down, it will increase nonetheless. The OBR predicts that it will peak relative to GDP at just under 110 per cent in 2023-24, but continue to rise in cash terms, reaching £2.8 trillion by 2025-26.

What to do about it? The chancellor had a first bash in last month’s budget, including an increase in corporation tax from 19 to 25 per cent in April 2023 and a freeze in income tax allowances and thresholds from next year. He has also set out some reasonably tight public spending numbers. Those are incorporated in the OBR figures.

A new report from the National Institute of Economic and Social Research, Niesr, funded by the Nuffield Foundation, ‘Designing a New Fiscal Framework: Understanding and Confronting Uncertainty’, should be read by anybody interested in UK fiscal policy.

It includes contributions from two former chancellors, Lords Lamont and Darling, two former chief secretaries, and current and former central bank and government officials, including the government’s chief economic adviser.

As a general point, it argues that Rishi Sunak was right to let the public finances take the strain in response to the pandemic. As Martin Ellison and Andrew Scott, two leading economists, put it in a chapter called “the debt vaccine”: “Debt has done exactly what economic theory tells us it should do – act as a buffer in response to unexpected negative shocks. In a sense, government debt acts as an economic vaccine - protecting a weakened economy from shocks to economic health.”

They make the interesting point that, on the basis of the market value of gilts (UK government bonds) debt is higher than appears, at 133 per cent of GDP. But, while there are risks attached to high government debt, notably an increase in borrowing costs, the chancellor was right to act first and think about how to pay for it later.

As a former chancellor at the helm during the global financial crisis, Lord Darling argues that many countries are in the same boat and should work together. He likes the US proposal for a minimum global corporation tax rate to help pay for the pandemic. With debt set to be more than 100 per cent of GDP in coming years, it is worth recalling that one fiscal rule he was forced to tear up during the financial crisis was that it should be kept below 40 per cent of GDP.

Lord Lamont, chancellor during the 1992 ERM (exchange rate mechanism) crisis, notes the very different interest-rate environment now compared with then. When he became chancellor in 1990, Bank rate was 14 per cent and remained in double figures for most of his tenure. Today it is 0.1 per cent and the “bond vigilantes”, who traditionally punish governments running up debt, are quiescent. He fears they will not always be so.

To keep them at bay, the government needs to have a credible fiscal framework, which is the nub of the report, as summarised by its editors, Jagjit Chadha, Niesr’s director, Hande Küçük and Adrian Pabst. They preface their chapter with a quote from Ernest Hemingway: “How did you go bankrupt?" Two ways. Gradually, then suddenly.”

Fiscal rules have been frequently changed by governments, they point out, and are often set for political reasons, not economic ones, and tied to parliamentary timetables which the economy does not follow.

They propose a five-pronged approach. First. the dates of fiscal events like budgets should be known and fixed well in advance, like meetings of the Bank of England’s monetary policy committee, not sprung on people for the convenience of the government. They should also be subject to greater parliamentary scrutiny.

Second, the OBR should publish reports ahead of these events, addressing the key issues and numbers. Currently it only does this privately to the Treasury. Third, the chancellor should outline what it describes as “fundamental fiscal choices” under different scenarios, to be assessed by the OBR.

Fourth, the government should set up a body of independent fiscal experts, in addition to the OBR and, finally, there should eb more joined-up fiscal strategy across the regions and countries of the UK, looking at a range of measures, including distribution, productivity, wellbeing and the environment.

The chancellor is drawing up a new set of fiscal rules. They did not see the light of day last month because of continued uncertainty but it will be surprising if they do not include some or all of the suggestions in the Niesr report.

There is no magic or easy way of dealing with the extra debt the country has taken on as a result of the pandemic. Its legacy will be higher public sector debt for years to come. Maintaining the confidence of the markets in this will be crucial.

Sunday, April 18, 2021
Pluses and minuses of the return to business as usual
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Things are changing, and not so imperceptibly. If you have ventured out to the shops in recent days you will have noticed that there are people around. Not necessarily madding crowds, at least in the ones I have visited, but certainly what retailers would call decent footfall.

There is also another change underway. The talk is of a return to the office, even for people for whom over the past 12 months, a daily commute, sitting at a desk and face-to-face meetings have seemed about as likely as a trip down the Amazon.

Indeed, there are hard facts to back this up, The Office for National Statistics (ONS), in its latest weekly assessment of coronavirus and its impact on the economy and society, found that the proportion of the workforce at their normal place of work rose to 49 per cent in the two weeks to April 4 and is clearly on a rising trend.

All of which is rather interesting. Both of these examples of a degree of normality returning have pluses and minuses. The opening up of non-essential retailing is an undoubted plus for the retailers concerned, particularly those which have eschewed an online presence. It is great news for high streets and shopping malls, which have taken on an eerie feel over the past year.

Similarly, the return of people to offices will transform city centres, particularly the centre of London, restore the viability of public transport and allow the tens of thousands of businesses dependent on legions of office workers, and busy offices, to get back on their feet.

All these are undoubted economic and social benefits, along with restoring all the other things missing from our lives during three lockdowns and other restrictions over the past year, including pubs, restaurants, cinemas, theatres, travel and, perhaps most of all, freedom to do more or less what we want.

But, and there has to be a but, it is also important to recognise that there are minuses in the return to business as usual. One of these could be in the most important driver of prosperity, productivity; the amount we produce per worker, or – a better measure – per hour worked.

A few days ago the ONS published data for productivity in last year. They showed that it was a volatile year, with sharp movements from quarter to quarter and a different picture depending on which measure is used. But output per hour across the whole economy rose by 0.4 per cent last year, during the deepest recession for more than 300 years. This was in sharp contrast to the experience of the last recession, when output per hour fell in both 2008 and 2009.

The simple reason for this was that hours worked fell even more sharply than gross domestic product. Behind this, however, something else important was happening. Productivity held up because of what statisticians call the allocation effect. It means that if you take out the least productive parts of the economy, average productivity improves. You can explain this by reference to batting averages. If you don’t play the three weakest members of the team, or they never get to bat, the average of the team as a whole improves.

This is what happened last year, fairly spectacularly. What is known as the food and beverages services industry – pubs, cafes, coffee shops, restaurants – is a low productivity sector, a dramatic 54 per cent below the average. Lockdowns and restrictions took these players out of the economy for much of last year. In contrast, the share in hours worked rose of high productivity service industries, including legal services, accounting and computer services.

A lot of non-economists have difficulty with the idea that service sector productivity exists and can be measured. But it does, and can be improved – or lese management consultants would be out of a job – and has been important in recent years. The service sector has been the driver of the productivity improvements we have had in recent years, excluding financial services, which has been weak in contrast to the period before the 2008-9 crisis.

One of the elements of improved service sector productivity, which was supercharged last year, has bene the shift to online retailing. Online retailing is more productive than face-to-face. Getting the shop to come to you is more productive than getting you into the shop. Anybody who has worked in a shop during the long, lonely hours when there is nobody in knows this. There are only so many times you can refold a jumper. I make no judgment here on the quality of the shopping experience.

The other big question, which is not yet captured explicitly in official statistics, is the productivity effect of working from home. A study last month by Shivani Taneja and Paul Mizen of Nottingham University, and Nicholas Bloom of Stanford University, based on interviews with some 5,000 full-time UK workers, found a strong preference for continued home-working after the pandemic, for at least two days a week.

Asked about the impact on their own productivity, the most popular answer, from 49 per cent, was that it had made no difference. But some, 29 per cent in all, though their productivity had improved, in some cases substantially so. This exceeded the 21 per cent who thought their productivity had gone down. Controlling these results for the special circumstances of lockdowns is not easy – some will have had to combine home-working with home-schooling – and the results could also reflect people’s preference for working from home.

Another way of looking at it is from the perspective of employers. The Chartered Institute of Personnel and Development (CIPD) did this in a report earlier this month. It found, in a survey of 2,000 employers, that 33 per cent thought working from home had boosted productivity. This was an increase compared with a June 2020 CIPD survey, in which 28 per cent of organisations reported improved productivity. In the most recent survey, 23 per cent reported a productivity decrease from home-working, pointing to a net benefit. In June last year 28 per cent thought productivity had decreased, so the two balanced out.

This tells us, or tells me, that there were potential productivity improvements that were discovered, almost by accident, during the pandemic. They include, as above, a likely future model of hybrid working, partly at home and partly at work. They should not mean that the share of online shopping goes back to where it was.

Many pubs, restaurants, cafes and coffee shops will not re-open and neither will some retail outlets, as we have seen from John Lewis, and countless others on a smaller scale. This is the creative destruction that results from serious economic shocks. We will see whether it helps lift us out of our long productivity malaise.

Sunday, April 11, 2021
The virus cost trillions, but the world is bouncing back
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Every six months by tradition, to coincide with its spring and autumn meetings, the International Monetary Fund provides an update on the outlook for the global economy. In recent years it has supplemented that with world economic outlook updates in January and late June or July.

Many things have changed as a result of the pandemic. The meetings these economic assessments are intended to inform have moved online, as has a lot else. Time will tell whether such gatherings resume, and in what form.

Nonetheless, these world economic outlooks provide a useful framework for analysing the enormous economic impact of the pandemic. In January 2020, when the IMF’s outlook provided the backdrop for the world economic forum in Davos – the last such meeting – people had begun to be aware of a new and potentially dangerous virus in China, but few thought it would have much of an economic impact.

In the IMF’s January 2020 world economic outlook, neither coronavirus nor Covid-19 merited a mention, the latter unsurprising because it had not yet been named. At that time, the IMF thought the world economy would show a modest acceleration compared with 2019, with global growth of 3.3 per cent in 2020 and 3.4 per cent in 2021 after 2.9 per cent in 2019.

The IMF saw risks to that outlook, most notably from the US-China trade war, but also climate events such as fires and flooding. Prospects for America were dull, with 1.6 per cent growth predicted in both 2020 and 2021, not much better than the weak growth then seen in prospect for Britain, 1.4 and 1.5 per cent respectively, continuing the poor post-2016 trend.

Advanced economies, including the US and the UK, would grow only slowly, 1.6 per cent a year. The world economy would be pulled along by emerging and developing economies, growing by 4.4 and 4.6 per cent respectively, and in particular by emerging Asia, with growth of nearly 6 per cent a year.

Things have changed, and the point here is not to attack forecasters, but to show the impact of a pandemic that, even 15 months ago, few saw as a big short-term risk to the economy.

So, according to the IMF’s latest economic outlook, published a few days ago, the world economy shrank by 3.3 per cent last year, easily its worst performance since the second world war, and a mirror image of its forecast growth rate in January 2020.

America’s economy contracted by an estimated 3.5 per cent last year, the eurozone by 6.6 per cent and the UK, on latest estimates, by 9.8 per cent. The UK’s slide would have been bigger than either the US or the eurozone even allowing for differences in measuring health and education output, including as it did a 10.6 per cent drop in consumer spending and a 10.2 per cent fall in business investment.

That is the bad news. Global gross domestic product in 2019 was roughly $88 trillion (£64 trillion). Replacing a 2020 growth rate of 3.3 per cent with a fall of a similar amount carries a cost in lost output of nearly $6 trillion. That is £4.4 trillion, £4,400 billion, equivalent to taking two economies the size of the UK, plus a bit more, out of the world economy altogether.

Now for the good news. Though the data on Covid-19 is far from uniformly good, and in some parts of the world downright worrying, economic prospects are improving fast. The IMF’s new global economic forecast is for a 6 per cent expansion this year, almost double what it expected in January 2020, followed by 4.4 per cent next year.

This is, most definitely, a US-led global recovery, boosted by Joe Biden’s $1.9 trillion (£1.4 trillion) stimulus package and successful vaccine rollout, with an extraordinary growth forecast of 6.4 per cent this year, followed by 3.5 per cent in 2022.

The UK does well too, with growth predicted at 5.3 per cent and 5.1 per cent respectively. Some economists think this is too cautious, given the smaller than feared drop in monthly gross domestic product in January and evidence in the purchasing managers’ surveys and other data of a significant upturn since then, even with most lockdown measures still in place.

Given the size of the fall in GDP last year, this country needs all the growth it can get. Though the UK is expected to outpace the eurozone, with predicted growth of 4.4 and 3.8 per cent in 2021 and 2022 respectively, it will take longer to make up lost ground. China got back to pre-pandemic levels of GDP last year and America, on IMF forecasts, will do so this year, followed by the eurozone next year. But on IMF forecasts, the UK will not get back to 2019 GDP levels until 2023. Spain, which had an even bigger fall in GDP last year, 11 per cent, is scheduled for a stronger recovery but is in a similar position in terms of getting back to where it was before the pandemic.

I should say at this point that economists have different ways of measuring the recovery to pre-pandemic levels. There is the one outlined above, but it can also be done on a quarterly basis, in other words in which quarter does the economy get back to where it was in the final quarter of 2019, before the pandemic struck. There is quite a debate about this. Some think it will happen before the end of this year, the Bank of England early 2022 and the National Institute of Economic and Social Research not until late 2023.

There is another interesting aspect to the outlook. We have got used to the world economy driven by emerging economies, including China, the biggest of all. Indeed, this was what the IMF envisaged ahead of the pandemic. But, while emerging economies are set to grow well over the next couple of years, by 6.7 and 5 per cent respectively, the gap between their growth and that of advanced economies will be smaller than for many years.

There is another way of looking at this, which the IMF does, and that is by looking at medium-term losses in GDP. Comparing what it now expects for 2024 with what it thought would happen in January 2020, America is a clear winner; its economy being about 0.5 per cent bigger by then. Advanced economies as a whole do not fare badly, on the assumption that, eventually, all successfully roll out vaccine programmes. They are down on what was previously expected, but only by 1 per cent, while China is 2 per cent smaller than previously anticipated.

The big losses, in contrast, are in the emerging world, with overall GDP losses of more than 4 per cent for them as a whole, the largest in sub-Saharan Africa, 5.5 per cent, Latin America, 6.5 per cent, and emerging Asia excluding China, a hefty 8 per cent. The pandemic has changed the world and tilted it back in favour of the West.

Sunday, April 04, 2021
Will Britain's consumers splash their stash of cash?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Many conversations about the UK economy involve consumer spending, which is not surprising. In normal circumstances – counting 2018 and 2019 as normal – it accounts for 62 per cent of the country’s gross domestic product. Most of those conversations, over the years, have been about whether consumers are over-exuberant, and are taking on too much debt to fuel their spending habit.

Today, the situation is rather different. The health warning I have to provide at this point is that not everybody had the opportunity during the pandemic to build up savings – some have had a very tough time – but in aggregate this has been what happened.

Official figures last week showed that the final quarter of 2020 completed a trio of very high saving ratios, gross savings as a proportion of disposable income. It ended the year at 16.1 per cent, having leapt to 25.9 per cent in the second quarter, and come in at a still high 14.3 per cent in the third quarter. For last year as a whole it averaged 16.3 per cent, a record high, up from 6.8 per cent in 2019.

To put some numbers on this, household gross saving last year was £238 billion, compared with £99 billion in 2019, a jump of £139 billion, or nearly 7 per cent of last year’s GDP. Most of these savings were, in the jargon, involuntary. People could not spend on the things they normal spending on; transport and travel, leisure, entertainment, eating out, and so on, so they put the money aside instead.

There are some figures on this too. Last year consumer spending fell per cent in real, inflation-adjusted, terms by 10 per cent. The fall included an 11.8 per cent drop in spending on clothing and footwear, 33 per cent in transport, 5.8 per cent in recreation and culture and a huge 42.1 per cent on restaurants and hotels.

All these things are interlinked. Not going so much to the office, and maybe not at all, reduces spending on transport and office wear, while not going out so much at all means that people did not need to buy as many new clothes. Some elements of spending did rise, with food and drink up 7.7 per cent, alcohol and tobacco by 7.9 per cent and household goods and services 4.5 per cent higher.

As for debt, the past year has been anything but debt-fuelled as far as consumer spending is concerned. While households have been taking on more mortgage debt, reflecting the surprisingly strong pandemic housing market, levels of outstanding consumer credit have been falling. In February they stood at £197 billion, nearly £28 billion lower than a year earlier.

What happens now? It is the key question for very many businesses. It will determine the strength of the post-lockdown bounce for hospitality, travel and tourism and high streets, as physical retail resumes. It is key to whether private new car registrations, down in the first two months of the year by 38 per cent on a year earlier, recover. It is, given the importance of consumer spending in the economy, central to the strength of the recovery.

There are three possibilities. The gloomiest in terms of spending would be if households not only hang on to all the savings they have accumulated during the pandemic but also extend their new prudence into the post-lockdown period. We will not know the answer to this for a while because, when we get figures for the first quarter in a few weeks, it is likely that the saving ratio will have remained high because of the lockdown.

The second possibility is that households retain most of the savings of the past year but return to a more normal saving ratio of 6.5 to 7 per cent of income from the current quarter onwards. This would assume that the excess savings during the pandemic were involuntary rather than precautionary.

The third and most bullish would be that people blow most of the savings they have accumulated, as well as returning to normal savings levels (which traditionally have been regarded as too low).

Ruth Gregory, an economist with Capital Economics, has looked at how this might pan out. Capital assumes that the saving ratio will not remain elevated for long, in contrast to the period after the financial crisis. This time, people will have less reason to worry about unemployment, with the rate set to peak at a much lower level than after previous recessions.

As for dipping into the accumulated savings, which as I say will have accumulated some more over the past three months, if households spend a quarter of the near £140 billion of the past year, it will boost consumer spending by 2.8 per cent and GDP by 1.6 per cent. If they spent half, we would soon be talking about a huge pent-up demand boom.

What will happen? The pandemic has broken new economic ground, and the question is whether the traditional evidence, that households do not typically go out and spend most of an unanticipated build-up in wealth still holds. A lot of the extra savings have been in better-off and retired households, and night clubs may wait in vain for the latter to turn up and party the night away.

The Bank of England has taken a very cautious approach to this, assuming that only 5 per cent of pandemic savings are spent over the next three years. The Office for Budget Responsibility (OBR), the official forecaster, expects a quarter to be spent, but only over five years. Capital, while expecting the saving ratio to return to normal levels, does not expect any splurge of the accumulated savings.

Perhaps that is no bad thing. Even without most or all of those savings, the Bank has 5 per cent growth this year, 7.25 per cent next; the OBR 4 per cent and 7.3 per cent respectively, and Capital 5.6 per cent and, also, 7.3 per cent.

Much more than this and you might worry that the economy, which has been hit hard by the pandemic, soon overheating, with inflationary consequences. Households, in aggregate, have built up a stash of cash. It is probably best that they do not splash too much of it too quickly.

Sunday, March 28, 2021
Europe's third wave will not derail the recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Boris Johnson is famously said to be an admirer of the mayor in the Jaws, who kept the beach open despite the shark, though that has not been reflected in his lockdown strategy. And, as the promotions for that film said, just when you thought it was safe to go back into the water … something big and scary looms into view.

The third wave of coronavirus in Europe, or more properly the second wave seen in the UK in recent months, with the “English variant” running amok across the Channel, is the new danger. The prime minister, in words reminiscent of previous change of strategy, has warned that “previous experience has taught us that when a wave hits our friends, I'm afraid it washes up on our shores as well”.

Taken together with the fact that, while deaths and hospitalisations as a result of Covid are still falling sharply, daily case numbers appear to have plateaued or are increasing slightly. Is this a reason to worry? Could the roadmap be torn up, hampering this year’s expected strong economic recovery?

There have been false dawns before. Lockdowns 2 and 3 came after reassurances from the government that it would do its best to avoid further lockdowns. Such reassurances probably delayed action last September, to deadly effect. This time, however, it is different.

It is different this time because the vaccination programme makes it much more difficult to justify another lockdown. If vaccines are effective in preventing hospitalisations, which they appear to be, and if those most likely to be hospitalised are inoculated, as they will be quite soon, it will be hard to use the “protect the NHS” slogan again to justify another lockdown.

The only circumstances in which it could be justified would be the emergence of a variant that vaccines do not protect against. In the absence of that, further lockdowns look politically very difficult and, while you can never say never, unlikely.

This is not to say I have any sympathy with lockdown sceptics, still less the sad characters who go on anti-lockdown marches. Yes, lockdowns have damaged the economy and disrupted lives, but the damage would have been far greater had the virus been allowed to run out of control. I have even less time for the innumerate loons who question Covid-19 deaths and try to argue that it has been a fuss about nothing.

Even with social distancing, restrictions and lockdowns, more than 148,000 people have died in the UK with Covid-19 on their death certificate and more than 133,000 where it was the main cause of death. The coronavirus has reversed, temporarily we hope, many years of declining mortality. The crude mortality rate last year was 14 per cent above its average for the past 10 years, while the age-standardised rate was eight per cent up on its 10-year average.

The 608,000 total for UK deaths last year was the highest since 1918, another pandemic year, when the population was a lot smaller, and only one of two years to break the 600,000 level. Al this would have been a lot worse without restrictions as, most likely, would have been deaths from flu. Covid deaths, sadly, did not stop at the end of 2020.

Though further lockdowns are unlikely - even if some restrictions will remain in place, including on international travel, for quite a long time – the likely absence of lockdowns is not the only reason to be optimistic about recovery.

We have, as I have noted before, got better at adapting to restrictions. The falls in gross domestic product (GDP) in November and January were a fraction of what we saw in April last year. We also adapt during lockdowns. The latest rapid indicators from the Office for National Statistics, covering the period until a few days ago on everything from debit and credit card payments to traffic and job advertisements, show a continued recovery from the lows of January.

The Recruitment and Employment Confederation (REC) says that the two latest weeks have seen the largest number of new job adverts being placed since the start of the pandemic, a combined total of more than 300,000 over two weeks.

This upward economic momentum, absent in January and February last year, when the economy was limping even as we went into the coronavirus, is important. It is most evident in the latest “flash” purchasing managers’ surveys, which measure business-to-business activity and track GDP pretty well.

The flash UK purchasing managers’ index (PMI) for March showed a jump to 56.6, from 49.6 in February, with both services and manufacturing posting index levels well above the 50 level which marks the difference between expansion and contraction.

As Chris Williamson, chief business economist at IHS Markit, which produces the data, put it: “The UK economy rebounded from two months of decline in March, with business activity growing at its fastest rate since last August as children returned to schools, businesses prepared for the reopening of the economy and the vaccine roll-out boosted confidence. Companies reported an influx of new orders on a scale exceeded only once in almost four years, and business expectations for growth in the year ahead surged to the highest since comparable data were first available in 2012.”

This bodes very well but what about the plight of what the prime minister calls “our friends in Europe”? Will not renewed restrictions in our biggest trading partner, including an Easter lockdown in Germany and partial lockdowns in large parts of France, inhibit the UK recovery.

Here again, the message from the purchasing managers’ surveys was reassuring. Germany, with a flash PMI of 56.8, showed services doing well and manufacturing powering ahead, with the highest reading on record. The eurozone as a whole returned to growth last month.

France was slightly below par, with a PMI of 49.5, though the official business climate index, from the French statistical agency INSEE, showed a strong improvement. Across Europe, as In the UK, consumer confidence has risen strongly, in spite of the slow vaccine rollout.

Just as this has been anything but a normal recession, as discussed here last week, so it will not be a normal recovery. There were 4.7 million people on furlough at the end of February, and their re-entry will be a challenge, but the latest labour market statistics were encouraging, showing the unemployment rate slipping to 5 per cent.

The recovery in prospect is, of course, all about making up the lost ground of the past year as restrictions are lifted. There is no reason to believe it will not happen.

Sunday, March 21, 2021
The deepest recession, but also easily the weirdest
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This time last year, give or take a few days, I was giving a talk in Birmingham. I had arrived late the night before and had not been out that morning. A couple of members of the audience remarked, however, on how eerily quiet the streets were. A lockdown had not been announced but people had already started to change their behaviour. Little did we know as we exaggeratedly bumped elbows – something I have not done much since – how strange the next 12 months would be.

What was on the way, of course, were more than 125,000 Covid-19 deaths, tens upon tens of thousands of stories of personal tragedy and loved ones unable to see each other even at times of serious illness, death and severe mental strain. What followed were the most onerous restrictions on everyday life and normal business activity that most of us have ever seen and would hope not to see again. Lives were blighted, particularly the lives of the young in education.

For the economy, what followed was, frankly, off the scale. A year ago, the economy was sliding into recession, even before the first lockdown. Gross domestic product fell by 7 per cent in March 2020, contributing to a 2.9 per cent fall in the first quarter of the year, the biggest drop since the three-day week of 1974.

That was just the appetiser. In April, GDP plunged by a further 18 per cent as the economy locked down. That was the main contributor to the 19 per cent slump in GDP in the second quarter of last year, easily the biggest on record. If this is the first draft of history, economic historians will be marvelling at these numbers for decades to come.

But then something rather different happened as restrictions were lifted. Starting in May, the economy grew for six months in a row. It slipped back in November, by 2.3 per cent, grew in December and managed to eke out 1 per cent growth in the fourth quarter, before falling back again by 2.9 per cent in January. We thus got very much better at handling lockdowns compared with the first.

The result of this is that, in the worst recession since the Great Frost of 1709, measured by GDP, there was monthly growth in seven of the 11 months for which we have data. This quarter will see at most a modest fall in GDP. As fort hat “worst since 1709” comparison, which I have used extensively, there are questions whether it its appropriate to compare with a time before the industrial revolution, when the harvest-related swings in economic activity were huge, in both directions, and nearly two and a half centuries before GDP was invented in the way we know it today.

Though the “worst recession for a very long time” label is likely to stick, it may be that the current estimate of a 9.9 per cent GDP fall last year will be revised lower as more data comes in. The Office for National Statistics has said that its estimates are subject to greater than usual uncertainty because of the pandemic.

That is not the odd thing about the past 12 months. Despite all the despair and tragedies I described above, and the severe setbacks for many individuals and businesses, on many measures it did not seem like a recession at all. Corporate and individual insolvencies have, as the Insolvency Service notes, remained low since the first national lockdown. Last month company insolvencies were 49 per cent lower than in February 2020, while individual bankruptcies and debt relief orders were down 42 per cent.

Weekly company incorporations – new business formations – are also showing significant year=on-year gains, as they have been for most of the period of the pandemic. Some say businesses are being established to qualify for government support, but I doubt that is the main explanation.

There are other odd aspects to the recession. You do not expect incomes to rise strongly at a time of economic pain but this is what has happened. In the final quarter of last year wages and salaries in aggregate, the biggest component of household incomes, were up by 2.8 per cent on a year earlier at a time of very low inflation. For 2020 as a whole aggregate wages and salaries showed a rise in real terms.

The big question for the recovery is not whether beleaguered consumers have money to spend, but how much of the £148 billion of deposits, mainly involuntary savings, they built up during the first three quarters of last year - £100 billion more than the previous year – will be spent.

Unemployment, at 5.1 per cent of the workforce, is at a level that many past politicians would have given their eye teeth for, in terms of it being so low. It will rise but probably not by very much, and the Bank of England will soon revise down its prediction of a 7.75 per cent unemployment peak. The Office for Budget Responsibility predicts 6.5 per cent.

The common thread here, as you may have discerned, is the unprecedented extent of government intervention in the economy. Government spending in the current fiscal year, 2020-21, will be the equivalent of 54 per cent of GDP.

The Treasury puts the scale of its Covid-19 support for the economy at £280 billion this fiscal year, and for a total of more than £350 billion this year and next combined. A significant part of those ages and salaries described above will have been provided by the government via the furlough scheme. The government could not prevent the hit to GDP largely but not entirely caused by its own lockdown restrictions, but its actions greatly limited the impact

We are now, one hopes, on the way out of that, and into a period in which the economy can stand on its own feet, though in a webinar I was doing the other day, businesses taking part were not so convinced. Nearly half thought there would yet be another lockdown and roughly 90 per cent believed some restrictions would return next autumn and winter. The champagne corks are not yet popping. Most were also sceptical about the pace of recovery and did not see the economy as the “coiled spring” beloved of Andy Haldane, the Bank’s chief economist.

For consumers, things are now looking up after this extraordinary, and very weird time. Though the survey was done before news emerged of delays in vaccine suppliers, Friday's consumer confidence index from GfK showed a notable bounce of seven points. It has now shown a considerable recovery since the gloom of January, and an even lower point in November, the second lockdown, though it is still quite a bit lower than a year ago.

Consumers, the guardians of those savings that are waiting to be spent, think the past 12 months have been terrible for the economy but the next year will be a lot better. They are more upbeat about their personal financial situation over the next 12 months than they were a year ago. They, like the rest of us, will be hoping for something that is not as weird as the past 12 months have been.

Sunday, March 14, 2021
Now the economy braces for the shock of the new normal
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Normal life is slowly resuming, with the return of schools in England a few days ago and their partial return elsewhere earlier. Schools are not the economy, but they are clearly hugely important to the economy. It is possible to see the light at the end of the lockdown tunnel, with all the usual caveats.

The January gross domestic product figures, released on Friday, which showed a monthly drop of 2.9 per cent, will with luck be the last such fall, though the drop in UK-EU trade that official figures also showed revealed a more enduring brake on the economy.

It cannot come soon enough for most people, least of all parents with school-age children, though I wonder how long it will be before we see an outbreak of lockdown nostalgia; a yearning for the days when there was no early morning commute and online meetings meant you could wear what you like, at least from the waist down.

The question is what kind of economy will we return to? How much of what has changed during the pandemic will become permanent? It is a big issue, and I cannot cover it in its entirety today, but let me make a start.

A few days ago, Andrew Bailey (I am sure impeccably dressed from head to toe), gave a speech to the Resolution Foundation think tank on this very theme. The Bank of England governor was speaking from his office in Threadneedle Street and revealed, among other things, that this was his first day working in the office this year.

The Bank has been looking at different aspects of the recovery from Covid. One key element is the extent of the recovery in demand, in particular what proportion of the involuntary savings built up during the pandemic will be spent by consumers. And, crucially, how much of the economy will get back on its feet to meet that demand, and how much will have been lost on the way.

Another, on which something of a consensus is emerging, is future patterns of work. I have pointed out before that working from home is not available to everybody. In its latest weekly assessment of the impact of coronavirus on the economy, Office for National Statistics’ data suggested that only 36 per cent of people worked exclusively from home in the week to March7. Most people are either still attending their normal place of work every day, because it is the only way they can work, or in combination with working from home.

It is this “hybrid” model of working that, it seems, will survive the pandemic. The Bank’s decision maker panel survey takes the temperature of chief financial officers of small, medium and large firms every month. The latest, carried out last month, showed that 49 per cent of full-time employees were working at least one day a week from home, compared with 14 per cent in 2019, before the pandemic.

For 2022 and beyond, the expectation was that 34 per cent of employees will be working from home for at least a day a week, with the most common form of hybrid working two to three days a week working from home. Surveys by Deloitte, the accountants and adviser, show a similar picture.

Mark Dixon, chief executive of IWG, known for its Regus serviced offices in the UK, suggests a variation of the hybrid model, in which people spend some of their time at home, some in a city centre location and some at a local office near to where they live. He may have bene talking Regus’s book but it was an interesting angle.
Businesses, meanwhile, are carrying higher costs as a result of the pandemic.

Measures to make premises safe and contain Covid added 7 per cent to unit costs last year according to the Bank and will be adding 5 per cent in the spring of this year, with a permanent addition to unit costs of 2 per cent. It is one reason why most firms are relaxed about employees working from home; the greater the attendance, the higher the costs.

This is one change, then, that looks like being permanent. Another permanent shift is to online retailing, up from 20 to 35 per cent of the total, which is unlikely to be full reversed with the shift back to “normal”. It was happening anyway but has been accelerated by the pandemic. This is bad for high streets but, as the governor noted, online retailing is more productive and contributes to keeping prices down.

Things will change. Hospitality, business travel, events and commuting into city centres will not go back to where they were. Trains and the Tube will be less crowded, and more in need of public subsidy, though firms may have to manage astutely to ensure that not everybody adopts Mondays and Fridays as their working from home days, straddling the weekend.

Even when things recover, some ground will have been permanently lost. I doubt if many people will take twice as many journeys, holidays or meals out to make up for the ones they have missed over the past 12 months.

This poses two challenges, and they fall under the broad headline of reallocation, of both capital and labour. It is hard to repurpose an aircraft, as Bailey noted, but there is a lot of talk about repurposing city centre offices and high street stores.

Some of that space, plainly, can be used to address housing shortages, and projects are under way to change the usage of retail and office premises. But there is a bit of a contradiction in some of this. The appeal of city centre living, for many, has been closeness to work. If work is no longer mainly in the city centre, that appeal diminishes.

What about labour, and changing what people do? The Bank’s view this time is that it will be easier to “reallocate” labour this time than after the great manufacturing shakeout of the 1980s under Margaret Thatcher, but harder than after the financial crisis.

This makes sense. It took many years before former industrial workers and miners were absorbed back into the service-based workforce in the 1980s and, indeed, many never were. After the financial crisis the UK witnessed something of an employment miracle, with the numbers in work rising by 4 million, or 14 per cent, between the low point of the 2008-9 recession and the eve of the pandemic, though some would say that this was accompanied by a rise in insecure forms of working.

This time, the challenge is to avoid so-called scarring. The Office for Budget Responsibility, the official forecaster, does not expect a “roaring twenties” for employment or a repetition of what happened after the crisis, predicting that employment levels in 2025 will only be slightly above pre-pandemic levels, and that unemployment, while peaking at quite a low level of 6.5 per cent, will not get back to pre-pandemic levels.

Any shake-up of the economy is painful. I doubt that people who worked on the beauty counter at Debenhams will be comfortable driving a fork-lift truck around a warehouse. But we have a flexible labour market and people are adaptable. The coming months and years will be a test of that flexibility.

Sunday, March 07, 2021
Sunak's budget judgment was right - but the economy still needs fixing
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Budgets are a bit like Christmas, a huge amount of anticipation followed by the event itself, which can be a bit of a let-down, particularly if you know beforehand most of what you are going to get. Christmas, of course, is not all about presents. Four days on, however, the kids have got bored with or broken their toys, and I have to try to conjure something up from the leftovers.

Fortunately, there is plenty to say. This was a big budget, a big moment, and the first thing to say is that I have to applaud a budget that precisely met the central recommendation set out here in recent weeks. Last Sunday’s column had the headline “Sunak must support us now and make us pay later” and that is exactly what the chancellor did.

There was plenty of pre-briefing about corporation tax rises and freezing personal income tax allowances and some of it implied that it would happen immediately. Delaying the tax allowance freeze for a year and the corporation tax hike for two years made perfect sense, though in the case of corporation tax, the expectation was of a gradual rise over time, not that the rise from 19 to 25 per cent would be done in one fell swoop.

Meanwhile, we should note the tax dog that did not bark. Tory donors, entrepreneurs and landlords, some of whom fell into all three categories, got very excited in the run-up to the budget about an increase in capital gains tax. It did not happen and, indeed, it was not mentioned. Sunak may have had it in mind to do something but he was persuaded against it, though he will say something more on tax reform on “tax day”, March 23.

The general shape of the budget was, therefore, one that I have no hesitation in applauding. The chancellor did not repeat the prescription of Geoffrey Howe in 1981 and raise taxes immediately with the economy in recession. His support for the economy went further than expected, with the furlough scheme extended to the end of September, not June, and more self-employed people brought into the support net. The budget judgment was right. I’ll come on to the other big support measure in a moment.

Second, and I don’t think this is generally appreciated, if all goes according to plan, the chancellor will have at a stroke set in train a process that will fix the public finances. By 2025-26, according to the Office for Budget Responsibility (OBR), the current budget deficit will have been eliminated. It is a huge 13.3 per cent of gross domestic product (GDP) this year.

The current budget deficit, to explain, is the difference between day-to-day government spending and tax revenues. It means that the government, which intends to devote nearly 3 per cent a year to capital spending, would only then be borrowing to invest, a long-held ambition of chancellors.

Fixing the public finances is a relative term. In five years public sector debt will still be more than 100 per cent of GDP, £2.8 trillion, and public borrowing, in cash terms, will be around £74 billion, according to the OBR. But it would still represent considerable progress.

“If all goes according to plan” is doing quite a lot of work in the paragraphs above. There are serious questions about whether the future tax increase announced in the budget can deliver the expected revenues and whether the economy can sustain a tax burden which has only been achieved once, and very briefly, over the past 70 years. The Institute for Fiscal Studies points out the “sad truth” that it will require the highest sustained tax burden in UK history.

There is also a question of whether the chancellor, whose future plans depend on tight control of public spending after pandemic support is withdrawn, can constrain a fiscally incontinent, big spending prime minister. Already the government is embroiled in a row over a 1% recommendation for the increase in NHS pay. That is one of the many challenges ahead.

Third, I have to try to answer the question about whether the budget addresses any of the issues about Britain’s future economic performance and, in particular, productivity. Will it raise our game?

Exactly a year ago, drawing on hints from the former chancellor Sajid Javid about what he would liked to have done had he remained in office and research led by Professor Peter Spencer at the University of York, I wrote about “full expensing”, allowing firms to immediately deduct the entire cost of new investment from their tax bill.

Sunak, as you will know, went further, announcing a “super deduction” which will allow firms to deduct 130 per cent of the cost of investment in eligible plant and machinery from their tax bill. It will last for two years, starting next month, 2021-22 and 2022-23, and be quite expensive, £12 billion a year.

It should stimulate business investment, on which the UK’s record has been pretty terrible, and this contribute to a revival in productivity, the holy grail of the economy’s supply side. The OBR predicts that after a small fall this year, business investment will jump by 16.6 per cent in 2022.

Unfortunately, however, it is a flash in the pan. Business investment then tails off and falls as the stimulus ends and higher corporation tax kicks in. The incentive’s effect is merely to bring business investment forward, not raise it overall. The supply-side signals being sent out by the government are all over the place. Kwasi Kwarteng, the new business secretary, is scarring the industrial strategy council chaired by the Tiggerish Andy Haldane, the Bank of England’s chief economist, which has been doing good work.

We are left with a familiar picture. Brexit will reduce the UK’s long-run productivity by 4 per cent, according to the OBR. “Scarring” as a result of the pandemic will leave the economy 3 per cent smaller than it otherwise would have been by the end of the parliament. After a strong bounce this year and next, with growth of 4 per cent and 7.3 per cent respectively, the economy slows to a dull rate of growth of just over 1.5 per cent a year.

The story is also a familiar one on productivity. It will also be lower than feared before the pandemic. It will be lower than expected before the pandemic over the medium term, and its growth will average just 0.9 per cent a year over the next five years according to the OBR. Normally these forecasts are too optimistic. Sunak could not do everything in a single budget. Fixing productivity is still on his “to do” list.

Sunday, February 28, 2021
Sunak must support the economy now and make us pay for it later
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is worth remembering, as we await Wednesday’s budget, that it was not supposed to be like this. A few months ago, Rishi Sunak, basking in the warm glow of his Eat Out to Help Out scheme in August, was looking forward to presenting his second budget in November. By then, the Treasury hoped, Covid-19 would be in retreat, and the spring 2020 national lockdown would be a fading memory, and it would be time to embark on the task of paying for the pandemic.

Things have turned out differently. Two more lockdowns have happened and the current one is not over and will not be by the time of this week’s delayed budget. Eat Out to Help Out is viewed a little differently these days, though there is talk of a re-run.

This will not, either, be the budget that the Treasury had in mind for last November, for which we may have to wait until November this year.

The delay, however, has been no bad thing. The last update from the Office for Budget Responsibility (OBR), in November, predicted a budget deficit this year, 2020-21, of £394 billion. With two months of the fiscal year to go, the running total is £271 billion. By now, the OBR thought it would be a shade under £340 billion.

There is a complication, in that the OBR is expecting a £29.5 billion write-off of the government’s Covid-19 business loans which do not feature in the monthly figures. Even so, it will be a disappointment if this year’s deficit does not come in below £350 billion, still clearly a massive number, but probably £50 billion – a sizeable budget deficit in a normal year – below what was feared even a few weeks ago.

The other positive, of course, is that the vaccine rollout and the government’s roadmap for the easing of restrictions offers the prospect of a really strong recovery. The Bank of England is not at the top end of economists’ expectations but its latest forecast, published early this month, provides an insight of what we might expect.

In the second quarter, April-June, it expects a rise in real gross domestic product (GDP) of more than 5 per cent, followed by an increase of nearly 5 per cent in the third quarter. To put these in perspective, they would represent the second and third biggest quarterly increases in GDP on record, the biggest (16 per cent) having been in the third quarter of last year. They will also translate into some spectacular year-on-year gains. Second quarter annual growth will be around 18 per cent.

All this is likely, but not guaranteed. We do not yet know if the coronavirus has anything more t throw at us. And, while the GDP statistics point to a very robust growth, for businesses in many sectors it will feel like blearily stepping out into the sunlight and it will take time to adjust.

That is why, looking at all the things that have been said and written in the run-up to this budget, it looks to me very much like a case of continued short-term support for the economy, combined with the beginning of a plan for medium-term fiscal consolidation, in other words tackling the budget deficit.

Some of that short-term support seems very well-judged. It makes sense to persist with the furlough scheme beyond the end of April, and indeed until restrictions are lifted, as with business rate relief. It makes sense too to continue with the VAT reduction for hospitality for now, even if people may not need much encouragement to hit pubs, cafes and restaurants when they are allowed to.

There is less of an argument for extending the stamp duty reduction beyond March 31, given the strong revival in the housing market in recent months. Sunak appears to have decided that a cliff-edge tax increase while the economy is still operating under restrictions is not a good idea, so the new deadline will be the end of June.
He may find that he faces a backlash against increasing it even then. Temporary tax cuts have a habit of becoming permanent.

That leaves the question of tax increases, and the timing of them, on which I wrote last week. The most obvious here is the widely mooted increase in corporation tax. When the Treasury let it be down it was considering that last summer, the talk was of an increase, over time, from 19 to 24 per cent. More recently, two versions have emerged, with end goals of either 23 or 25 per cent, with the additional suggestion of an announcement now but implementation in the autumn. That leaves open the question of whether the first percentage point increase will come in 2021-22 or 2022-23.

Interestingly, Lord Wolfson, chief executive of Next, said the other day that higher corporation tax was a reasonable price to pay for the government huge support during the pandemic.

Every percentage point increase in corporation tax raises around £3 billion, according to the government’s latest tax ready reckoner, published last month. Four increases would net around £12 billion, not that much for losing a reputation as a very low business tax country, and only a fifth of the £60 billion of tax increases the Institute for Fiscal Studies thinks will be needed over the medium term to stabilise the public finances. Those will be for later.

A pandemic budget – even if the route out is now clearer is not the time for decisions that will constrain the government in future. Sunak had hoped by now to unveil a new set of fiscal rules, partly to reflect the government’s infrastructure investment priorities, but the word is that there is still too much uncertainty to do that now. Once again, the Treasury is looking towards a November budget.

There is also a question of whether the chancellor wants to be remembered as a reformer, or just as somebody who stepped in with a very large chequebook when the chips were down for the economy.

There is a lot to be done. Andrew Sentance, an adviser to Cambridge Econometrics, in a blog for the firm says that the government’s green recovery plan needs beefing up. Britain is hosting the Cop-26 climate conference later this year.

There is scope for tax reform across a range of areas, including property taxation – taking in now delayed decisions on reforming business rates – and stamp duty, described by the IFS as a “particularly damaging tax”, which should be abolished. Sentance also suggests that Brexit offers scope for reforming VAT in a way that better reflects UK priorities.

We shall see, and we will probably have to wait. For now, Sunak has not finished firefighting the pandemic. He has provided a lot of support, and a further £55 billion is earmarked for the 2021-22 fiscal year, starting in April. Continued support now, pay for it later, has to be the message.

Sunday, February 21, 2021
Sunak shouldn't even think of doing a Geoffrey Howe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This is a time for momentous anniversaries. It is ancient history now, particularly for younger readers, but a few days ago we market the 50th anniversary of decimalisation. It is surprising, unless I have missed it, that we have not had a campaign to bring back pounds, shillings and pence, not that I am suggesting it would be a good idea.

And, while we have embraced metrication – not the same as decimalisation but part of the family – we still measure distances in miles, fuel consumption in miles per gallon, height in feet and inches (well I do) and beer, when we used to be able to drink it in pubs, in pints.

It is, however, another anniversary I wanted to remind you of today. Forty years ago next month a Tory chancellor presented a budget in difficult circumstances. Government borrowing was high, though at 4.3 per cent of gross domestic product (GDP) in 1980-81, it looks like small change these days, but the economy was in its deepest recession since the Second World War
.
The consensus was clear on what that chancellor, Sir Geoffrey Howe, should do, and it was not to raise taxes, which you did not do in the teeth of a recession. But he did, aggressively, with a new tax on North Sea oil, a one-off windfall tax on the banks, which were benefiting from the government’s high interest rate policy, and big increases is excise duties, including those on petrol. Toughest of all, for a supposedly tax-cutting government was a freeze on allowances at a time of very high inflation, increasing income tax on everybody.

The budget produced the now famous or infamous reaction in the form of a letter from 364 economists, including a much younger Lord (Mervyn) King, warning that it would deepen the recession. Margaret Thatcher, challenged by the Labour leader Michael Foot to name two economists who supported her policies, snapped back Alan Walters and Patrick Minford, before saying in private in the car taking her back to Downing Street: “It’s a good job he didn’t ask me to name three.”

The letter from the 364 has been much mocked because the spring of 1981 marked the start of the long 1980s’ recovery, though unemployment continued to rise for years and was more than three million six years’ later. The 364 had failed to spot that Howe’s fiscal tightening masked a big monetary relaxation, including a two percentage point cut in interest rates; chancellors could do that in those days.

Anyway, forty years on, Rishi Sunak is facing a dilemma similar to his predecessor, except that all the magnitudes are so much bigger. The budget deficit this fiscal year, 2020-21, will be not far below 20 per cent of GDP, a figure that would have been unimaginable to his predecessors, though figures on Friday suggested that the deficit will come in well below the feared £400 billion.

The economy has had the deepest recession, not since the Second World War but since before the War of Jenkins’ Ear. Not for more than 300 years have we seen anything like last year’s 9.9 per cent slump in GDP. And, while the worst of it is behind us, and happened in March and April last year, the economy is back in a period of declining GDP in the current quarter.

Even as the economy pulled back from the worst at the end of last year, the economy was 7.8 per cent below pre-Covid levels, with consumer spending down 8.4 per cent and business investment 10.3 per cent
.
Some of the old tunes from 1981 have been playing. There has been talk that Sunak, like Howe, could announce a stealth increase in income tax by freezing allowances, though at a time of low inflation the impact would be a lot less now than then.

A windfall tax has been mooted, this time on businesses that have done well out of the pandemic, as have increases in corporation tax, capital gains tax (by aligning it with income tax) and pensions’ taxation, by reducing or reforming higher rate pension tax relief. An online sales tax, also unimaginable for Sunak’s predecessor 40 years ago, has been mooted. So have green taxes.

One thing, however, has not changed. Economists are just as certain now as they were then that this would be a very bad time to raise taxes. This applies across the spectrum, from those who think tax increases are always a bad idea, to those who think they will be necessary in time, but that this would be a terrible time to do it.

The Institute for Fiscal Studies (IFS) in its pre-budget assessment a few days ago, fell into the latter category. While it thinks hefty tax rises - £60 billion – will eventually be needed to put the public finances on a sustainable footing, it also believes that is something for later.

As it put it: “Sizeable net tax rises – to help meet likely demands for additional public spending and make-up for any enduring weakness in revenues, while keeping inflation low – will be needed at some point. But substantial tax rises should not be part of the coming budget. Mr Sunak should only commit to permanent spending rises (or for that matter tax cuts) if he is sure of an appetite for larger subsequent tax rises.”

Neil Shearing, chief economist at Capital Economics, in a paper for Chatham House, the international affairs think tank, says that the priority for governments, including the UK, is to “stay the course” and not engage in premature fiscal tightening, including tax hikes. Countries should also better co-ordinate their response to ensure a sustained global recovery, he argues. Such co-ordination, absent in the Trump era, has a better chance now.

And, while the chancellor has understandable concerns about the record government borrowing on his watch, he can be reasonably relaxed about that for now, Shearing argues. “The key point is that with interest rates kept low by ultra-loose monetary policy, bond yields are likely to stay below the rate of nominal GDP growth in most major economies over 2021–22,” he writes. “In these conditions, it is unlikely that public debt ratios will spiral out of control.”

Will Sunak ignore the advice of economists and “do a Geoffrey Howe” in his budget on March 3? He would not be the first Tory chancellor to follow in his predecessor’s footsteps. George Osborne incurred the wrath of many – not all – economists in embarking on austerity in 2010.

I suspect that the current chancellor will, though, continue in the vein he has pursued since taking on the job a year ago, that of supporting the economy, and jobs, during a difficult time. That has to be right. People are beginning to look at the sunlit uplands that lie beyond the lockdown. The latest GfK consumer confidence index, published on Friday, showed a five-point increase, albeit to a still quite weak -23. People have become less gloomy about the economy over the next 12 months and in net terms are positive about their own personal financial situation.

The optimism is still fragile and should not be snuffed out by premature tax hikes. Sunak says he wants to be honest with people about the state of the public finances and the need to restore them over the medium term. That is fine. But now is too soon.

Sunday, February 14, 2021
Not Project Fear - but Brexit reality for firms and the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It takes something to break through the blanket coverage of the pandemic, on which the news is not as encouraging as it might be. I don’t think, a year ago, that many people would have been anticipating the introduction this month of the harshest travel restrictions so far, or for there to be a debate about whether even staycations will be possible this summer. I think they will, but I am an optimist on these things.

What is clear, I think, is that even with a successful vaccination programme there is not going to be a “with one bound we are free” moment. Restrictions should be less than now in the April-June period, but they will not have been removed completely. That says something about the nature of the coming recovery. While we are still on course for some big year-on-year gains in economic activity, after last year's worst-for-300-years plunged of 9.9 per cent, for many businesses it will seem like slow progress and a long haul.

One thing has broken through the blanket coverage, however, and that is the UK’s new trading arrangements with the EU. The penny appears to be dropping. Peter Cowgill, the chairman of JD Sports, spoke for many when he said that Brexit was turning out “considerably worse than feared”. He is considering establishing a new distribution centre within the EU as a result of trade frictions and red tape costs running into “double digit” millions. The UK’s deal with the EU was “not properly thought out”, he added.

A survey by the British Chambers of Commerce (BCC) found that nearly half, 49 per cent, of exporters were finding trading difficult. They outnumbered the proportion finding it easy by more than three to one.

“Trading businesses – and the UK’s chances at a strong economic recovery – are being hit hard by changes at the border,” said Adam Marshall, director general of the BCC. ““For some firms these concerns are existential and go well beyond mere ‘teething problems’. It should not be the case that companies simply have to give up on selling their goods and services into the EU.”

The government has found itself in a battle with the Road Haulage Association (RHA), a non-political members’ organisation, over its estimate that exports going via British ports to the EU last month were 68 per cent lower than a year earlier, and that between 65 and 75 per cent of lorries coming to the UK from the EU are returning empty. We have to wait a while for the official figures for exports to the EU in January. Informal government figures, briefed to the BBC, suggested that trade has recovered this month.

These are not the only impacts. Quite a few people pointed out, perfectly fairly, that last week I left the Brexit deal, with its higher costs and red tape, off the list of factors that will push inflation higher in coming months.

None of this is particularly surprising. The UK-EU trade deal was concluded late and in the middle of a pandemic and it was struck by politicians and negotiators with little or no experience of business and the damaging impact of red tape, non-tariff barriers and tariffs on products imported into the UK and re-exported to the EU. When the focus was on sovereignty, it was not surprising that the economy took a back seat.

It is not, of course, the only effect of Brexit. Though the City of London is comfortably Europe’s largest financial centre, and is set to remain so, it has lost its place to Amsterdam for share trading – which was a symbolic blow - and there is uncertainty about future mutual recognition and equivalence arrangements.

These are not the only problems for business since January 1. Trade between Great Britain and Northern Ireland remains problematical as a result of the trade border in the Irish Sea. This is no longer attracting the headlines that it did but persists.

As I say, none of this is surprising. It is not a “project fear” forecast, but it is the new reality. The Bank of England estimates that the disruptions to EU trade will reduce the UK’s gross domestic product by 1 per cent in the January-March period.
That is not nearly as much as the fall resulting from this lockdown, but accounts for about a quarter of the drop in GDP the Bank expects this quarter.

Many businesses will, over time, have to absorb the new red tape and get on with it or, as JD Sports has suggested, take action by relocating some activities within the single market to minimise some of its effects. Others, mainly smaller firms, will stop trading with the EU altogether.

As businesses adjust, so some of these short-term effects will fade. That still leaves the long-term, however. A Downing Street spokesperson was asked last week whether the government would be publishing an impact assessment on the UK-EU trade deal and the answer was that it would not be. There was a time when even modest policy changes warranted such an assessment.

Fortunately, other assessments are available from reputable sources. The Bank has estimated that the economy is roughly 2 per cent smaller than it would otherwise have been as a result of the 2016 referendum result. Business investment, even before the pandemic, was 20 per cent lower than it would have been.

As for the future, in this month’s monetary policy report, the Bank said that, in comparison with frictionless trade, the government’s deal will leave UK trade around 10.5 per cent lower, and productivity and GDP some 3.25 per cent period. Most of these effects will come through over the next three years.

An assessment by the UK in a Changing Europe think tank came up with similar, though slightly larger, estimates. It sees a big hit to UK exports to the EU, down 36 per cent compared to membership after 10 years, with imports from the EU also down, by a hefty 30 per cent. Overall, it sees UK trade 13 per cent lower. GDP takes an overall hit of around 6 per cent, as do per capita incomes. The UK’s already weak growth rate is reduced by around 0.5 per cent a year.

Does it have to be like this? The optimistic view, that the Christmas Eve deal was just a framework which could be improved upon over time is having to fight against a deterioration in relations between the two sides, for which both are to blame. It is a pity but that may pass over time. We could do with some damage limitation.

Sunday, February 07, 2021
Negative rates? No, the Bank should be starting to think of when to raise
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Many is the Thursday lunchtime I have waited with bated breath for the Bank of England’s interest rate announcement, and many is the time when it has been much ado about nothing. So it seemed last week, when the eight men and one woman on the Bank’s monetary policy committee (MPC) left official interest rates at a record low of 0.1 per cent and opted not to increase its quantitative easing (QE) total from an already massive £895 billion, including corporate bonds.

The announcement was not without its moments, however. The Bank wants to add negative interest rates to its toolkit, but the banks will need six months to prepare, so that probably kicks it firmly into touch, which for me is good thing. It is also examining how it might reverse some of that massive QE and has asked Bank staff to investigate. Its position used to be that this could not happen until Bank rate had risen to 2 per cent (later reduced to 1.5 per cent). It may be that its future position will be that it can happen at any time, which would also be a good thing.

If all goes to plan, or at least according to the Bank’s new forecasts, the next few months will see both a powerful growth bounce and an upturn in inflation. The only debate, on both counts, is by how much.

Recent history suggests that there could be a rise in inflation as the impact of this crisis fades. Inflation rose to 5.2 per cent in September 2011 after the financial crisis. Some of this was due to the rise in VAT to 20 per cent at the start of 2011, but most of it reflected other factors, including a recovery in oil and commodity prices.

The Bank of England’s survey of public opinion on inflation, conducted by the market research company Kantar, shows an expectation that prices will be rising by more than the official 2 per cent target in 12 months’ time.

The latest survey, carried out at the end of last year, showed a median expectation of inflation of 2.7 per cent a year on. Nearly a fifth, 18 per cent, think inflation will be more than 5 per cent. Two-fifths, 39 per cent, think inflation will be 3 per cent or more.

A significant proportion of economists also think that a period of above-target inflation is on the way, either because the Bank will allow it to happen, or because it is unable to prevent it. The Centre for Macroeconomics of the Centre for Economic Policy Research recently carried out a survey.

Of those surveyed, 22 per cent thought the Bank would allow inflation to exceed the target, while 19 per cent said it would be unable to prevent an overshoot. The combined total, 41 per cent, exceeded the 37 per cent who expected the target to be met.

Some prominent economists have been warning of higher inflation for some time. Tim Congdon of the Institute of International Monetary Research has long argued that the big increase in the money supply as a result of aggressive quantitative easing (QE) by central banks will push inflation to 5 per cent or more. He has also pointed to the recovery in commodity prices and other “early warning signs” of rising inflation.

Commodity prices are recovering – the Bloomberg commodity index is up by more than 35 per cent from its low point last March – and the Bank is more optimistic than the consensus about growth. It predicts that the economy will grow by 5 per cent this year and just over 7 per cent next. This year’s recovery, which is subject to the speed of the vaccine rollout and the extent to which people feel confident enough to spend again, sees the economy “projected to recover rapidly towards pre-Covid levels”.

It is quite a punchy forecast and it removes one of the arguments for inflation staying very low. It currently just 0.6 per cent. How much inflation goes up is essentially a tug of war between two sets of factors. One set comprises the huge economic shock from the pandemic and the spare capacity it leaves in the economy, bearing down on inflation. The other consists of the impact of the Bank’s huge monetary stimulus – a 0.1 per cent Bank rate and lots of QE – and a big post-pandemic economic bounce.

On the first, the Bank expects unemployment, now 5 per cent, to peak at 7.75 per cent in the middle of this year (equivalent to nearly 2.7 million people) but it thinks this will be short-lived and that it will be back to 5 per cent next year. This means, on its broader measure of spare capacity, that there is some this year but that it will have disappeared by next year. All of which leaves the other set of factors, the monetary stimulus and the rebound, to push it higher.

There is, then, no serious debate about whether inflation will go higher, merely a question of degree. For the Bank going higher means hitting the 2 per cent official target and staying there, or slightly above it. For others it will be a much bigger overshoot.

The question is whether the Bank will do anything about it. It has bought itself enough time to avoid a move to negative interest rates, but its forecasts are conditioned on continued ultra-low official rates.

There are good reasons why it should be preparing the ground for return to some kind of normality for interest rates and for beginning the gradual unwind the massive QE it has undertaken this year. When it “looked through” the rise in inflation after the financial crisis, it got stuck with record low interest rates and a greatly expanded balance sheet as a result of QE.

It should not do so again. A year ago its position was that “a modest increase in interest rates” would probably be needed over time to keep inflation on target. As the effects of the pandemic on the economy ease and the nightmare subsides it should return to that position. The Bank, it should be said, is not thinking this way yet. When the emergency is over the sirens can be switched off.

Sunday, January 31, 2021
Can this stuttering recovery still pick up the pace?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The International Monetary Fund’s January world economic outlook is always interesting. It normally coincides with the annual Davos jamboree in the Swiss mountains. This year, like many things, Davos took place virtually. But, having not been invited to attend the real thing for a while – it is a long story – I did not take part in the online version either, but I did devour the IMF’s new assessment.

It provides an interesting update on how the world’s economies fared during the pandemic last year, and how they are expected to do this year and next. The big picture is that the world economy shrank by 3.5 per cent last year, which means it was a big recession. It compares with a fall of just 0.1 per cent in 2009, the big negative year during the global financial crisis.

This year, according to the IMF, the global economy will grow by 5.5 per cent. You do not need a calculator to tell you that this means that the world economy will get back above its pre-pandemic level this year, implying a deep but short-lived world recession.

I have mentioned before the performance of China, the world’s second largest economy, which grew by 2.3 per cent last year, is expected to expand by 8.1 per cent this year, before settling down to a more normal (these days) 5.6 percent in 2022.

America, the world’s biggest economy, did not have a bad year in 2020, its economy contracting by “only” 3.5 per cent, despite Donald Trump’s mishandling of the coronavirus crisis, or maybe because of it. Joe Biden’s first year should see 5.1 per cent growth the IMF says, followed by 2.5 per cent next year.

China and America, in fact, will see much less economic “scarring” than other countries, the IMF believes, with GDP next year in these countries only a little bit below where it would have been in the absence of the coronavirus crisis.

The world economy’s other two big players, Japan and Germany, suffered falls of 5.1 and 5.3 per cent in 2020, the IMF says. They will recover but will not get back to pre-pandemic levels until next year.

Now let me bring it right back to home. The IMF thinks the UK economy contracted by 10 per cent last year. This matters for those interested in historical parallels. If the economy shrank by less than 9.7 per cent, it would merely be the worst since 1921. If it is more than that, it takes us back to 1709, and the Great Frost.

If you think that the IMF is being unduly gloomy, the latest assessment of independent forecasts from the Treasury has a fall last year of 10.6 per cent.

One of the big debates at the moment is whether the statisticians at the Office for National Statistics (ONS) have made the UK GDP figures look worse by applying a “gold standard” of measurement to the output of the public sector, which other countries do not.

I hesitate to remind parents who are tearing their hair out at this very moment, but unpaid home tutoring, like housework, does not count towards gross domestic product (GDP), though online teaching by teachers does. Measured activity in the National Health Service is suffering, despite the extraordinary pressure created by the coronavirus crisis, because of all those cancelled operations and non-Covid treatments.

That the UK had a big recession last year is not, however, in doubt. Even in the third quarter of last year, when the economy enjoyed a strong but short-lived bounce, consumer spending was 10 per cent down on pre-pandemic levels, while business investment showed a 19 per cent fall.

The safest thing to say is that the UK was among a clutch of poorly performing European countries, along with France, Italy and Spain.

What goes down, should of course go up, and some favour the trampoline theory of economic recoveries. All of which makes the UK’s projected recovery, 4.5 per cent this year and 5 per cent next – not quite making it back to where we were on a calendar year basis – disappointing. It is in line with independent forecasts.

Why so disappointing, particularly in comparison with Spain and France, which are projected to grow more strongly, in spite of the EU’s terrible vaccination imbroglio?

One reason, as we are discovering, is that the UK’s successful vaccine programme is not, yet, delivering liberty, and will not for a while. The current lockdown is turning into the longest of the three and, though it will not have anything like as big an impact as the first, which started in March last year, it has clearly scuppered the first quarter.

Another factor is Brexit, which I will not dwell on today, but which is creating serious trade frictions that are providing an additional dampener on growth.

There is another reason, and it carries echoes of the financial crisis. Then, you recall, the government spent a lot of money bailing out the banks and had little left over to provide a fiscal stimulus to help the economy on its recovery path.

This time the government has spent hugely – at least £280 billion – fighting the pandemic and supporting the economy and employment through it, and there is little official talk of providing a post-pandemic fiscal boost. In fact, the thoughts of the chancellor and his Treasury officials are turning to how to raise taxes to reduce the budget deficit, as discussed last week.

This is in contrast to America, where the new president is trying to push through a $1.9 trillion (£1.4 trillion) stimulus plan, and the EU, where the main debate about its €750 billion (£665 billion) recovery fund is whether it is big enough. The evidence is that fiscal boosts are most effective when, as now, interest rates are close to zero.

Rishi Sunak would o doubt say that the best stimulus any government can offer now is an easing of Covid-19 restrictions and it is correct to say that this provides the best hope of a return to strong growth in coming months. Other countries are adopting a belt and braces approach, giving their economies an additional shove to help them on their way. Time will tell which approach is best.

Sunday, January 24, 2021
Tax rises aren't easy, so Sunak will have to proceed with stealth and reform
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

There are some traditions that, even in a pandemic, are being maintained. When March budgets were the norm, it was traditional at this time of year for tax ideas to be run up the flagpole to see whether they would fly. While gardeners can measure the approaching spring by the appearance of crocuses and daffodils, economy-watchers could see it in the form of budget stories.

Last Sunday this newspaper reported that government sources were still indicating that a corporation tax hike was still on course for the March 3 budget. The story was widely followed.

This, you may recall, was part of a trio of tax rises that the Treasury was reportedly considering last summer, in order to bring the public finances back under control after the pandemic. Another was to more closely align the taxation of capital gains and income, as recommended by the Office of Tax Simplification (OTS), which was asked by Rishi Sunak to look at it. The third was an old favourite, reforming higher rate pension tax relief.

There are some serious sums to be raised in these areas. Every percentage point increase in corporation tax, currently 19%, raises an eventual £3.4bn a year, so a phased increase of five percentage points, which has been suggested, could bring in an additional ££17bn a year. The government has already turned against the corporation tax mantra of George Osborne and Philp Hammond, cancelling a planned cut from 19% to 17% last April.

The OTS pointed out that capital gains tax raised a relatively small amount, just over £8bn, in comparison with income tax, and covered a relatively small number of taxpayers. Its proposals, if adopted, would widen the net and bring in significant additional revenue.

Pension tax relief costs £21.2bn a year, with most of that going to higher rate taxpayers, with an additional £18.7bn of relief on employer contributions.

The idea that corporation tax could begin to rise in the March 3 budget has already drawn a frosty response. It looks like no way to treat businesses emerging from the worst recession in centuries and, as is likely at the time of the budget, still subject to significant restrictions. The chances of the current lockdown being lifted by then look slim.

Not only that, but only a few days ago the prime minister assembled the great and good from British business to advise him on the post-Covid recovery. I doubt that any of them would say that the best way to do that would be to whack up business taxation. It is hardly a welcome sign to international businesses to invest in the UK, when set against the disadvantages that Brexit will impose. “Global” Britain would look as if it was pulling up the drawbridge.

Some of the attacks on the suggested corporation tax hike, is from the usual suspects, like the Taxpayers’ Alliance and Institute of Economic Affairs, which tend to oppose any increase in tax. But some of it comes from business advisers aware of the signal it would send, not to mention the reality of paying more tax.

Nobody should underestimate the challenge faced by the chancellor. In his budget he will want to persist with his them of supporting jobs, as he has done since the start of the pandemic. On question will be whether the furlough scheme needs to be extended beyond the end of April. He will also want to set out an economic vision for the country beyond the pandemic, some of which he has already touched on in declaring that the City of London can enjoy a second “Big Bang”.

Understandably, too, he will want to show that his concern about returning the public finances to health is not just a political slogan; he means it. It is understandable. The Treasury has just published its latest compilation of independent forecasts. The average new forecast for public borrowing this year, 2020-21 – the budget deficit - is £399bn, with a high of £450bn. More troubling for the chancellor is that the average new forecast from next year, 2021-22, is just over £200bn, with the gloomiest £275bn.

These are big figures but three things act as constraints. The first is timing. Osborne was widely criticised for announcing a big tax increase, VAT up to 20% from 17,5%, in his June 2010 budget, alongside the austerity cuts in public spending. But that budget was a year after the economy had started to recover and the VAT hike did not take effect until the start of 2011. Any tax hike announced in March would be while the economy was still in recession.

Second, no tax hike is easy, as the backlash against the corporation tax suggestion shows. There should be plenty of low hanging fruit, like the ability of a government committed to net zero being able to raise the duty on petrol and diesel. But any Tory chancellor who tries it is guaranteed a huge backbench revolt.

Third, the Tories committed not to raising any of the three main taxes – income tax, National Insurance and VAT – in their manifesto for the December 2019 election. Plenty of people say to me that there is no need, political or otherwise, to respect a manifesto drawn up in a pre-Covid period. The overseas aid commitment, which was also in there, has been abandoned. I agree, but the government appears to want to stick to it.

What can a chancellor do? The answer, it seems to me, is to unveil a series of reforms that will raise revenue in the medium and long term, without getting in the way of the recovery – which will be driven by an easing of restrictions – later this year.

On corporation tax, the chancellor could do a “reverse Lawson”. When Lord (Nigel) Lawson was chancellor in the 1980s he cut the rate of corporation tax decisively, partly funding it by also getting ride of the many reliefs that could be set against the tax. Instead of this, short-term reliefs in the form of more generous investment allowances could be announced to lift a feeble business investment outlook, alongside an intention to gradually raise the rate of corporation tax later. There are some good ideas in the OTS’s capital gains tax proposals.

There is talk too of a reform of property taxation, which makes a lot of sense. The current system of council tax, stamp duty, business rates and inheritance raises a lot of money but is messy and inefficient. Stamp duty, reduced by the chancellor last July, has been described as the worst tax in Britain and the Mirrlees Review, under the auspices of the Institute for Fiscal Studies, called for its abolition, while the IFS itself has recently described council tax as “out of date, regressive and distortionary”. There has not been a property revaluation for council tax purposes for 30 years.

There is no silver bullet when it comes to property taxation. But any chancellor who wants to leave his mark should be looking at it.

Finally, there is taxation by stealth. As a simple example, the personal income tax allowance and higher rate threshold do not have to be raised every year, as was the case even during the austerity years after 2010. After a national emergency there is nothing wrong with bring more people into the income tax net. Raising the personal allowance was a tax cut by stealth. Freezing it would be opposite.

Sunday, January 17, 2021
In a post-Covid world, the UK can't be a tech also-ran
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It has always struck me as hugely impressive that even as the Second World War was raging, serious thought was being given to the post-war economy. The Beveridge report, which provided the foundations of the modern welfare state, was published in 1942. The Bretton Woods conference, which provided the template for the post war international financial system, including the International Monetary Fund and World Bank, was in July 1944.

The question is whether we are planning similarly, for the post-Covid world, or just trying wearily to get over the line to some kind of normality. The pre-Covid world, to remind you, was one in which Britain had suffered a decade of productivity stagnation and, since the 2016 EU referendum, very weak business investment.

To know what needs to be done, you have to be aware of where you are starting from. If you asked a lot of people in Britain, they would probably take the view that when it comes to science, technology and so-called knowledge-based industries, we do pretty well.

This has been reinforced by the successful development of the Oxford/AstraZeneca vaccine, though other countries have also developed vaccines. Cambridge, also sometimes known as Silicon Fen, stands out as hugely successful, as does London’s fintech (financial technology) sector.

Boris Johnson, in his foreword to the latest Tech Nation annual report, described the UK as “Europe’s number one tech nation” Tech Nation is the body that provides a “growth platform” for UK tech companies and leaders. The prime minister’s boast appears to be based on the fact that there was more than £10bn of inward investment into UK technology businesses in 2019.

We should be optimistic about things that this country is good at, but how close to reality is this boosterish assessment of the UK?

Richard Jones, professor of materials physics and innovation policy at Manchester University, came to prominence last year when one of his papers was quoted approvingly by Dominic Cummings, Johnson’s former chief of staff, last year.

In a blog on his website, Soft Machines, ‘How does the UK rank as a knowledge economy?’, he draws on data from the science and engineering indicators published by America’s National Science Board. It looks at five high R & D (research and development) intensive industries, aircraft; computer, electronic, and optical products; pharmaceuticals; scientific R&D services; and software publishing.

It also includes, as Jones notes, eight medium-high R&D intensive industries: chemicals; electrical equipment; information technology (IT) services; machinery and equipment; medical and dental instruments; motor vehicles; railroad and other transportation; and weapons, as well as some knowledge-intensive services. The UK’s performance relative to other countries is a bit of a jolt for those who believe the “number one tech nation” boast.

“From this plot we can see that the UK is a small but not completely negligible part of the world advanced economy,” Jones writes. “This is perhaps a useful perspective from which to view some of the current talk of world-beating ‘global Britain’.”

The alarming thing is the extent of the UK’s drop in global market share in these knowledge-intensive sectors since the mid-2000s. While all countries have lost knowledge-intensive market share as a result of the rise of China, the drop in the UK’s market share, 46%, is bigger than that for America, 19%, and the rest of the EU, 13%.

There is another measure, cited by Jones, which provides even more cause for concern. This is Britain’s ranking relative to population, in value-added in knowledge and technology intensive industries. In 2002, the UK’s ranking was 12th in the world, behind Ireland, whose ranking may be swelled by multinationals taking advantage of its low corporate tax regime, but also below Switzerland, Singapore, Finland, America, Japan, Sweden, Israel, Taiwan, Denmark and France.

By 2018, the latest figures, the UK had dropped to 17th place, behind these but also behind Germany, Belgium, Norway, Australia and South Korea. On this measure, Britain is a very long way from being the number one tech nation in Europe, let alone the world. We are, sad to say, an also-ran.

What can be done about it? For decades R & D spending in the UK has been too low, in spite of efforts, such as the R & D tax credit, to boost it. Not since the early 1980s has this country spent 2% of gross domestic product (GDP) on R & D. The latest figure is 1.7%. The government has a target of raising it to 2.4% by 2027, though it is not entirely clear how this will be achieved, and that would merely take it to the current average of OECD advanced economies. Germany spends 3.1% of GDP on R & D, America 2.8% and France 2.2%.

Jones’s strong point, in other papers, is that it is only by addressing Britain’s low level of R & D spending can we address the country’s poor productivity performance. He also believes that it is the key to reducing the country’s regional imbalances.

In a paper last year for Nesta, formerly the national endowment for science, technology and the arts, co-written with Tom Forth, he argued that the UK needs not just more R & D spending, but a better regional spread.
As the report, ‘The Missing £4 Billion, how to make R & D work for the whole UK’ put it: “There are two economies in the UK. Much of London, South East England and the East of England has a highly productive, prosperous knowledge-based economy. But in the Midlands and the North of England, in much of South West England and in Wales and Northern Ireland, the economy lags behind our competitors in Northern Europe.”

It is hard to argue with that, or its conclusion that: “The UK’s research base has many strengths, some truly world leading. But three main shortcomings currently inhibit it from playing its full role in economic growth. It is too small for the size of the country, it is relatively weak in translational research and industrial R&D, and it is too geographically concentrated in already prosperous parts of the country, often at a distance from where business conducts R&D.”

Can this be turned around? The first requirement is a tilting of the balance of government R & D spending toward the regions. Nearly half of it at present is in the “golden triangle” covered by Oxford, Cambridge and London. The second is a more general boost in such spending, which probably does more good than most expensive infrastructure projects. The final requirement, always difficult for politicians, is a realistic assessment, not just of our strengths, but also our many weaknesses.

Sunday, January 10, 2021
With every lockdown we lose some more of our economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Normally at this time of year not much happens and, during the period of limbo when most of the data refers to last year, it is sensible not to draw too many conclusions about what is going on. This year, however, not much is happening for a different reason. Lockdown 3 has followed hard on the heels of Lockdown 2, with only a few short weeks of tiers in between.

Nobody wants this third lockdown but this is not to deny its necessity. Indeed, the main criticism of the government should be that it has been too slow to grasp the nettle, not trigger-happy. Governments in all parts of the UK have made errors. The Welsh government followed its 17-day October-November firebreak with a big relaxation of restrictions and, as a result, at one stage recently had the highest infection rate in the world. The Johnson government’s lurches before and after Christmas did nothing for confidence and may be only belatedly successful in bringing down infection numbers.

Lockdowns remain controversial. There were restrictions in earlier pandemics but on nothing like this scale. But some of the people arguing that Covid-19 is a hoax, or that lockdowns do not work in limiting its spread, are like those arguing that, despite his heavy defeat and appalling behaviour Donald Trump really won the US election. Indeed, there is often a crossover between these groups.

The misuse of statistics by the coronavirus and lockdown sceptics is as irritating to the statisticians as their other antics are to frontline NHS staff. Nick Stripe from the Office for National Statistics (ONS) tweeted some interesting facts about what happened last year, up to December 25.

The year started with “excess” deaths below the average of the previous five years but that quickly changed with Covid-19 in March. In total there were 73,000 excess deaths in England and Wales last year. From late March to Christmas Day, the excess was more than 78,300.

There were more than 600,000 deaths in England and Wales last year, for the first time since 1918, when the Spanish flu pandemic began. Adjusted for population, there were more excess deaths than in any year since 1940, when the country faced a different kind of threat. We know that without restrictions and social distancing, these figures would have been much higher.

The first lockdown had a crunching impact on the economy, not least because a lot of things closed, including factories and construction sites, which did not need to. The second, in November was milder. This one will be closer to November than March-April, the main uncertainty being how long it will last.

That has shifted some analysts, who normally focus on economic and financial data, to try to come up with vaccination and case number scenarios. David Mackie of J P Morgan is using a matrix of vaccination numbers – under which low would be 200,000 a day, high 300,000 – infections and lockdown compliance. He concludes that while at first blush it looks as if a nine-week lockdown, to March 10, looks likely, the situation could be better than that, allowing the toughest restrictions to be lifted in six weeks, on about February 12. The government is suggesting a longer haul but that is better than overpromising on the timing of exit, as is its wont.

What about the economics of this? There was a lot of excitement about double dip recessions in the aftermath of the global financial crisis but, though it was close, we never quite had one. That means the last one was nearly half a century ago, in the 1973-5 period; three consecutive quarters of falling gross domestic product in 1973, followed by another two in 1975.

The recent picture for UK GDP is dispiriting. The economy was doing badly in 2019, with successive quarterly growth rates of 0.1%, 0.5% and zero from the second quarter. It then shrunk by 3% in the first three months of this year (at the time the biggest fall in the post-war period) then that enormous 18.8% slump in the second quarter. As things stand, the 16% jump in GDP in the third quarter looks like the aberration, and raises the question about whether, after such a short reprieve, we should call it a double-dip recession at all.

We have to wait a little longer, until Friday, to know what happened to GDP in November, let alone the final quarter of 2020 as whole. But the consensus is that GDP will have fallen by up to 2% in that quarter (though some think there will be no fall at all), and by up to 4% in the current quarter. The longer the lockdown, the bigger the fall.

Some people have been getting very exercised about what this third lockdown will mean for the public finances. There are suggestions that this year’s budget deficit will come in at half a trillion pounds, £500bn, rather than the £394bn predicted by the Office for Budget Responsibility in November. I never expected to be arguing about whether the budget deficit would be £400bn or £500bn, but borrowing would really have to go some to get from the cumulative £240bn in the April-November period, the first eight months of the fiscal year, to anything close to £500bn for the year as a whole.

There are many imponderables, the speed of the vaccine rollout, the extent of this lockdown and the adjustment to Britain’s post-Brexit future, with some smaller exporters giving up the ghost already.

What we should remember in all this, however, is that each of these episodes takes out thousands of businesses, some bad but many good, and leaves the economy smaller and its capacity for recovery impaired. There was a time when plenty of people said that the economy could survive one lockdown but not two. Now we are into number three and for many businesses, particularly smaller firms, survival is now the key. Let us hope that, for most, it will be possible to look beyond mere survival quite soon.

Sunday, January 03, 2021
Five reasons to be cheerful - and two to worry about
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Rarely, as we start a new year, has the gap between hope and reality been so wide. The reality, as far as the economy and business in concerned, is the prospect of weeks, maybe many months, of lockdown or near-lockdown restrictions. It makes it, by my reckoning, the worst start in the very many years I have been following these things.

You may ask, what about the start of 2009, when the economy was reeling from the collapse of Lehman Brothers the previous autumn and the teetering on the edge of much of the banking system? But gross domestic product (GDP) fell by “only” 1.7% in the first quarter of 2009, one of its two biggest quarterly falls during the financial crisis, and we will be lucky to get away with anything as small as that during the coming quarter.

The gap between hope and reality struck me most when looking at some of the absurdly hyperbolic tabloid “boom” headlines which followed the EU-UK trade deal and the rolling over of most of the EU’s trade deals with other countries, the latest big one being Turkey.

But, without going down that daft road, let me offer some reasons for hope. In fact, let me offer you my version of the 5:2 diet, which some people may be needing just now. In my case, it is five reasons to be optimistic, and two to be still concerned.

I shall stick with Brexit for my first. However thin the EU-UK trade deal is, and it is, it is better than the short-term chaos of a no-deal Brexit. There is a view that a deal was done because Boris Johnson convinced the EU that he really was mad enough to contemplate a no-deal Brexit.

But a basic free trade agreement was always on offer, and the EU has many more reasons to be happy with it than Britain. Its comparative advantage is in goods, particularly manufactured products and food, the UK’s in services, particularly business, professional and financial services. The deal preserves that advantage, albeit with a but more friction, while doing nothing for the services that make up the vast bulk of the UK economy.

Alongside that, Liz Truss, the international trade secretary, has got on, quietly for her, in rolling over those EU deals. The Brexit deal will still damage the economy in the medium and long-term but avoiding most of the short-term chaos of a no-deal Brexit and a schism in Britain’s trade relations with other countries has to be better than the alternative.

Second, while Covid-19 still stalks the earth, this will be a good year for the global economy, and when it does well, the UK should not be too far behind. The global economy shrunk by between 4% and 4.5% in 2020 and leading forecasters expect it to grow by 4% or 5% this year, led by China.

We should put that in perspective. 2020 saw the biggest downturn in the global economy in living memory. The 2009 recession saw global GDP drop by 1.7%, on World Bank figures, and that was followed by a brisk 4.3% recovery in 2010, though it did not necessarily feel like it. But a global rebound is better than stagnation, or worse.

Third, there will be no Donald Trump to mess up the global recovery. A bad, protectionist president, who undermined America’s institutions, including the Federal Reserve, its central bank, turned out to be a very bad loser. Joe Biden will approach his presidency as he approached his election campaign – cautiously – but we won’t have to be looking out for disruptive tweets in the early hours.

Fourth, to look at a couple of UK-specific factors. There have been two striking things about the economic numbers in 2020. The first is the build-up of involuntary savings, as restrictions limited people’s spending. The saving ratio – saving as a proportion of disposable income – rose to a record 27.4% in the second quarter and stayed at a high 16.9% in the third, even as the economy recovered.

What this means, according to the Resolution Foundation think tank, is that “social spending” – hospitality, entertainment, travel, physical retailing, etc – will bounce back “very quickly indeed …. once a semblance of normality returns”.

A related development, which also offers reasons for optimism, is that the peak in unemployment will be lower than feared. Government measures, including the extension of the furlough scheme until the end of April, should mean that the jobless total peaks at well below 3m, some 7% of the workforce, lower than after previous milder recessions.

Fifthly, there is the vaccine. The very good news in the past week was regulatory approval for the Oxford-Astrazeneca vaccine. That offers the very real prospect of a sustainable way out of this crisis. And, while everybody is focusing on the spring, it should at least guarantee that the second half of the year is better than the first.

So, five reason to be moderately cheerful. I would not be doing my job, however, if I did not mention a couple of reasons for caution, things that might temper some of that optimism.

One is this pesky virus, the new variant of which is more transmissible than the first, as I know from direct experience in my own family. I, like Rishi Sunak, was too optimistic about the course of the pandemic during 2020. Though I feared a second wave in the winter, its scale surprised me. We don’t how many more surprises it will throw at us.

The other is how the Treasury deals with the fiscal hangover from this crisis. With a budget date set for March 3, quite a few people have got in touch with me to ask whether there will be tax increases then. I have said not, though the chancellor might provide some signposts, but we shall see. We shall also see whether the current very unusual combination of record public borrowing and very low borrowing costs can last. And whether the Bank of England will provide more quantitative easing (QE) and/or negative interest rates. Those are for future columns.

Adding all this up, what kind of growth can we expect for 2021? The Office for Budget Responsibility, in its late-November forecast, had a central forecast of 5.5% growth this year, after last year’s 11%-plus decline. The Resolution Foundation suggests that first quarter restrictions will knock that down to about 4.3%, which seems reasonable. Let us hope so, anyway.

Sunday, December 27, 2020
A dire year for the economy - and for forecasters
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The forecasting league table referred to in this piece is also available alongside my column on www.thetimes.co.uk

This extraordinary year is ending with as much to be worried about as at any time during it. People like me often bandy around words like uncertainty but in normal times, there is nothing like the doubt that we are experiencing at the moment. We worry about the health implications of the new Covid-19 strain, and we worry about the economic implications.

The Brexit deal finalised on Christmas Eve was better than a catastrophic no-deal and should be welcomed for that. But businesses were exasperated and damaged by its last-minute nature. There will still be disruption. And the adverse effects of this narrow deal will occur over the medium and long-term.

This has been a year of extraordinary numbers, including the worst-in-300-years recession which will see gross domestic product (GDP) fall by around 11%, and some quarterly lurches, the likes of which I hope will prove to be a one-of; down nearly 19% in April-June, and up 16% in a July-September period for which I am already feeling nostalgia.

To set this year’s 11% fall in context, it is roughly equivalent to the sum of annual growth rates for the previous six years. This year’s budget deficit, put at nearly £400bn by the official forecaster, is equivalent to more than the previous six years combined.

Rishi Sunak has set himself two dates for 2021. The first is March 3, when he hopes to deliver his second budget, a year after his first. The second is the end of April when, on current plans, the furlough scheme is due to start being wound down. That suggests a budget while the labour market still requires significant government support. At one time or another the government has directly supported more than 12.5m jobs, including the self-employed.

Before coming on to my forecasting league table – brace yourself – a couple of honourable mentions from me for what they have done this year. David Owen and his colleagues at the investment bank Jefferies International, were quicker than anybody at using informal indicators to track the economy during the course of the Covid-19 crisis. His assessment of what was likely to happen to gross domestic product (GDP) during the first crucial lockdown phase and the third quarter recovery was remarkably accurate.

I’d also mention Howard Archer of the EY Item Club, not so much for his forecast, but for his tireless monitoring of the data. Not a day goes by without him picking up on and analysing new statistical information on the economy and it is extremely useful.

I should also single out the Office for National Statistics (ONS), which provides much of that data. It has adapted what it does, providing timelier indicators on both the economy and the course of the pandemic, in very difficult circumstances. It has dome a great job, and I can even forgive it releasing important statistics at 7 am.

Now to the forecasts. I did consider scrapping the league table this year but it is a tradition that stretches back a quarter of a century, and I did not want to break the sequence. We have had, as the former chairman of the Office for Budget Responsibility said, two once in a lifetime shocks in the space of little more than 10 years.

The financial crisis was kinder to forecasters than Covid-19, at least as far as my competition is concerned. It was clear by January 2009 that something terrible was amiss. In contrast, nobody in the UK knew about the coronavirus when economists prepared their forecasts for publication in January this year. Even when the news began to emerge it was not clear how big the impact would be. As late as March, economist were still on average expecting some growth this year and even in April, the average forecast for this year’s GDP decline was less than 6%, about half the likely outturn.

Normally, under my scoring system, most forecasters score seven, eight or nine out of 10. This year, even with some generous amendments to the system, it is no disgrace to have scored zero or one. A big negative economic shock came along, the timing of which nobody could have reasonably foreseen.

The best forecasts, in that context, were the gloomiest, though nobody got close to being gloomy enough. Top of my league table were the economists at Bank of America/Merrill Lynch, who were downbeat on growth, unemployment and interest rates. They would be the first to concede that it was something of a Pyrrhic victory, though in this game you take any wins that you can.

Next week I shall look forward to 2021. A decent recovery is generally expected. The question is how much of a shadow will be cast by the very gloomy end to 2020. And whether the world has more nasty surprises in store.

Sunday, December 20, 2020
Inflation is back - but so far only for house prices
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.

For those fearing that inflation will be one of the economic consequences of the pandemic, and the extraordinary measures introduced to combat it, the latest figures showed that it is not happening yet. Far from it. Consumer price inflation fell to just 0.3% last month, admittedly during the second national lockdown, when non-essential shops were closed.

Is this the lull before the storm? Will the economy’s post-Covid bounce, coupled with the inflationary effects of this year’s huge public borrowing and quantitative easing (QE) bring higher inflation? This would not be the first government to inflate away debt.

Before coming on to this question, it is worth noting that the drop in inflation, from 0.7% in October, is producing a significant boost to real pay. When the coronavirus crisis broke, it first looked as if wages were taking a big hit and that people were taking pay cuts to hold on to their jobs. Annual growth in average earnings turned negative in the spring.

That now looks to have been purely a feature of the furlough scheme, when many private sector workers had 80% of their wages paid by the government and their employer did not top up the rest. Overall pay growth has now picked up to 2.7%, with regular pay up 2.8%, both in the August-October period compared with a year earlier.

The public sector is leading the way, with pay growth of 4.1% on a year earlier but the private sector is catching up fast, at 2.3% and rising. In each case, the growth in earnings comfortably outstrips inflation.

Back to inflation. What is going to happen? The most prominent inflation worrier is
Tim Congdon, the veteran monetarist economist, and his Institute for International Monetary Research (IIMR). He says a “reasonable forecast” is that this year’s exceptional growth in the money supply, driven by quantitative easing (QE) will see inflation above 5% in Britain, America and the eurozone at some stage over the next two years.

Annual growth in the UK#s M4 broad money supply measure was 13.1% in October. The annual inflation (deflation) rate in the eurozone last month, by the way, is -0.3%.

Earlier rounds of QE did not lead to higher inflation but this year’s efforts have been bigger and more concentrated. And there is a better prospect of a strong bounce in economic activity than for example after the financial crisis.

The latest consumer confidence reading from GfK, released on Friday, showed that people want reasons to hope, and perhaps that they are ready to spend when they can do so freely again. Though the fuss about the Christmas relaxation of restrictions may have dampened the mood since the survey was conducted, GfK’s consumer confidence barometer showed a seven-point rise, with consumers more upbeat on both the outlook for the economy and their own personal finances.

“It’s safe to say that consumers are looking for good news and they have found it in the form of the UK’s Covid-19 vaccination programme getting underway, which has lifted the mood,” said Joe Staton of GfK.

One ingredient for a potential rise in inflation, the eventual release of pent=up demand, thus looks to be there. The consensus among economists is for growth of more than 5% next year, the strongest since 1988, admittedly after this year’s weakest performance for more than three centuries.

There is quite a wide range of predictions around that consensus, it should be said, with optimists expecting an even stronger bounce and pessimists a recovery from the crisis that will be in low single figure percentage terms. Parts of the country, it is clear, will limp into 2021, amid new tougher restrictions announced in recent days.

The best way to think of the inflation outlook is as a tug of war. On the one hand we have had a huge monetary stimulus whose aim, after all, is to push inflation higher. When it is all hands to the monetary pumps, as it has been this year, it is hard to calibrate whether enough or too much has been done. This is not an exact science.

Without wanting to sound like the famous two-handed economist, on the other hand we will have spare capacity bearing down on inflation. Unemployment will rise further and be a lot higher than before the coronavirus crisis for some time. The “output gap” – economy-wide spare capacity – will be there for a while.

Who will win the tug of war? Inflation forecasts for the coming year do not suggest that most economists are unduly worried about a surge in inflation. The latest compilation of independent forecasts by the Treasury shows that on average the expectation is for inflation of 2% by the end of 2021, in line with the official target. There are a range of views within that, however, with the lowest inflation forecast 0.8% and the highest 3.7%.

The Bank of England, for its part, sees a climb back for inflation to the 2% target, and that it will then stay there. Predicting that inflation will stay at 2% is part of the Bank’s DNA, so there are no surprises there. On Thursday the Bank left interest rates unchanged, though warning that it might spring into action in the event of a no-deal Brexit. “CPI inflation is expected to rise quite sharply towards the target in the spring, as the VAT cut comes to an end and the large fall in energy prices earlier this year drops out of the annual comparison,” it also predicted.

One thing everybody should be able to agree on, however, is that an exceptional monetary stimulus does boost asset prices. It helps explain why, even with the treat of unemployment hanging over them, house prices have recovered so strongly. The Halifax says annual house price inflation last month was 7.6%, the highest since June 2016. The official house price index has prices rising at their fastest rate since the autumn of 2016.

The hand of QE can also be seen in stock markets that have done a lot better that they should have done in the face of the Covid economic shock, in high government bonds prices and ultra-low yields and I am sure in a range of other assets, from art to fine wines and vintage cars. I have been reading that puppy price inflation has soared, though that may be a consequence of lockdown-related demand.

The jury is out on whether inflation for most of the things we buy will rise to high levels, leaving aside the fading possibility of tariffs on imports from the EU, which would be the ultimate exercise in shooting ourselves in the foot. It is quite hard to see a big rise in inflation while the economy remains in the throes of the pandemic and its after-effects, and while it is operating below capacity. The question is whether we are building up problems for the future that lies beyond that.

Sunday, December 13, 2020
Now investment prospects go from bad to worse
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.

When it comes to Brexit, definitions of what is last minute are pretty flexible. As I write this, we are still waiting to see whether it will be a no deal or the thin deal the two sides have been trying to negotiate. The pendulum has been swinging towards the former, though it is always capable of swinging back.

Brexit has now re-emerged as the main risk to recovery. Figures a few days ago showed that gross domestic product rose by a modest 0.4% in October, its smallest increase since the recovery began in May. That left it 1.9% above its third quarter average, which would normally be a good basis for growth in the current quarter.

Since then, however, we have had the November lockdown. It was always the case that its impact would be small compared with the March-April lockdown. Professor Costas Milas of Liverpool University notes, in addition, that data on the UK-wide stringency of restrictions, from the Blavatnik School of Government at Oxford and others suggests that last month was not that much different in terms of restrictions than October.

To that can be added the fact that some economic activity has been stepped up in anticipation of Brexit. UK exporters have been getting their products into the EU and vice versa, hence some of the damaging congestion at ports.

Netting all this out, the economy may suffer only a small setback this quarter, if it
does so at all. Brexit, though, represents a significant risk in the early months of next year, when it is likely to be combined with further post-Christmas Covid restrictions. The sunlit uplands provided by coronavirus vaccines will still be there, but probably not until the spring.

Even when we get into the sunshine, though, it is unlikely to shine on business investment. A strong investment revival still seems like a distant prospect. The EU referendum in June 2016 killed off a decent recovery in business investment, leaving it 20% below what it would otherwise have been on the eve of the pandemic, according to the Bank of England, since which time the situation has gone from bad to worse.

The Office for Budget Responsibility (OBR), the official forecaster, predicts that after a pandemic-related 18.1% fall in business investment this year, next year’s “recovery” will be a mere 1.2%. That compares with figures of 15.1% and 7.5% for consumer spending. Consumers will get their mojo back a long time before businesses do, it thinks. Only in 2022 will there be a reasonable pick-up in business investment, the OBR suggests. It will, however, take until 2023 before business investment gets back to depressed 2019 levels, and that is on the assumption of a smooth Brexit.

This is even with the incentive, which should be very important for small and medium-sized firms, of a £1m annual investment allowance, a temporary measure which has been extended by the Treasury until the beginning of 2022.

The OECD, which recently released an updated global economic outlook, is even more downbeat about UK business investment, warning that “feeble investment” will weigh on the recovery and that “business investment will remain weak due to spare capacity and continued uncertainty”. Business investment next year will be running at 80% of pre-Covid levels, it says, and warns of “high risks of rising trade barriers, reduced labour mobility and lower foreign direct investment”, particularly in the context of leaving the EU without a deal.

Foreign investment is important for the UK, and crucial to productivity. Surveys and official figures show that foreign-owned firms have consistently higher productivity than their domestic counterparts, for a variety of reasons. Now, however, a lot of chickens are coming home to roost.

Brexit has made it a struggle to hold on to the existing foreign direct investment in Britain, some of which was made with the explicit aim of accessing the EU single market. Some of this investment was key to Margaret Thatcher’s remaking of the economy in the 1980s, which was why she was so enthusiastic about the single market. Attracting new foreign investment in the context of the UK’s new trading arrangements with the EU will be even harder, and I feel sorry for those who are asked with trying to do so, as some of us warned repeatedly in the run-up to the referendum.

It all comes back to productivity, the fundamental driver of prosperity and living standards. Some hope that the coronavirus crisis will have provided the “creative destruction”, the expression of the economist Joseph Schumpeter and provide the basis for a sustained productivity revival and string and sustained long run growth.

For this to happen, however, you need not just the destruction of old and inefficient firms going out of business, but also the phoenixes rising from the ashes, buoyed by the “animal spirits” of another great and, in his own words, defunct economist, John Maynard Keynes.

Those animal spirits are, however, lacking. Business investment traditionally leads the cycle, as firms spot new opportunities and look to exploit them, rather than lags it badly, as now.

A combination of weak business investment and stagnant productivity is an unhappy one. Britain’s businesses should be able to do a lot better than that. But when they have to deal with the destructive actions of politicians, it is hard.

Sunday, December 06, 2020
If the Scots want independence, they'll have to pay a lot for it
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.

These are heady days for supporters of Scottish independence. Fifteen polls in a row have shown net support for independence among those likely to vote, the latest from Ipsos-Mori for STV showing 56% support for Scotland breaking free from the rest of the UK.

Support for Scottish independence has risen as a result of the Covid-19 crisis. It could have gone either way. Scotland’s death rate per million people from the coronavirus in recent weeks has been higher than in England, although the cumulative total is slightly less, as it is lower than in Wales, though higher than Northern Ireland’s.

Scotland has benefited massively from the UK’s ability to borrow vast sums to fund its crisis response, with the help of the Bank of England, and has gained massively from UK schemes. As its own independent economic and fiscal forecaster said in September: “The largest increase in spending in Scotland has been through UK-wide schemes.” Separately, the Scottish budget has been boosted by 14% since the projections set out in February, “largely driven by extra funding from the UK government”.

Despite all this support for independence has grown, because of the perception that Nicola Sturgeon, the Scottish first minister, has had a good crisis, while Boris Johnson has had a bad one. Even the Scottish Tory leader concedes that she has the better communication skills. Johnson’s jovial old Etonian schtick does not work north of the border. He was toxic even before he described devolution as “a disaster”.

It is Sturgeon, however, who has again exposed the Achilles heel of independence; the economics of it. Her announcement of a £500 bonus for “Scotland’s life-savers and care-givers” – all NHS and care home workers - together with her plea to the UK government to waive tax on it, has again highlighted the weakness of Scotland’s public finances. The Scottish government describes the bonus as an “investment of around £180m”.

Every country is borrowing hugely this year because of the pandemic. The official forecast for the UK budget deficit this year, 2020-21, is £394bn, 19% of gross domestic product. But Scotland went in this crisis with a budget deficit of 8.6% of GDP, compared with 2.5% for the UK as a whole, according to its own GERS (government expenditure and revenue Scotland) exercise, published in the summer.

Scotland’s budget deficit this year is likely to be a sky-high 26% to 28% of GDP, according to calculations by David Phillips of the Institute for Fiscal Studies, and it will stay above 10% of GDP for years even when this crisis is over. If anything, this year’s deficit could be even higher, because of recent additions to spending. As the IFS pointed out: “Under full fiscal autonomy or independence, the deficit would be the Scottish government’s responsibility, and the need for tax rises or spending cuts would be starker.”

The arithmetic behind this is straightforward enough. Even leaving aside the £500 one-off bonus and this year’s boost, public spending per head in Scotland, £14,829 in 2019-20, was more than 12% higher than the UK average of £13.196. Taxation, meanwhile, brings in less per head than in the UK as a whole, even including a geographical share of North Sea revenues, £12,058 versus £12,367. You don’t have to be Mr Micawber to know that this is a recipe, if not for misery, then for a big budget deficit. Scotland’s budget deficit per head last year was more than three times the UK average

Supporters of independence, though not yet the Scottish government or its fiscal watchdog, have tried various devices to escape from this economic and fiscal reality. Some say an independent Scotland would not be obliged to assume its share of UK debt on independence and, indeed, the former SNP leader Alex Salmond said in the run-up to the 2014 referendum that Scotland would renege on its share of the debt if the UK government did not allow continued use of sterling. Some on the wilder wings of the independence movement say that an independent Scottish government should adopt the modern monetary theory (MMT), dealt with here a few weeks ago. That is never going to happen.

Independence supporters are fond of drawing a parallel between Scotland and successful smaller economies, particularly Scandinavian countries. A common feature of them is that they have higher levels of taxation, around 43% of GDP in the case of Sweden and 46% for Denmark. That compares with a pre-crisis 37% of GDP for the UK as a whole and less than 35% of GDP for Scotland. If the Scottish people want fiscally credible independence and the public services they currently enjoy, they and their businesses would have to pay for it with higher taxes.

Scotland’s public finances are not the only issue. The noted US economist Barry Eichengreen, who has taken a close interest in Scottish independence, writing recently, was happy to describe the prime minister’s EU negotiations as “shambolic” and a reason for rising support for Scottish independence.

But he also lamented the lack of any plan for post-independence currency arrangements. This has become more, not less, difficult since the 2014 referendum, he pointed out. The plan suggested by some a few years ago, that an independent Scotland could enter into a monetary union with the rest of the UK and continue to use the pound, would not work now if Scotland wanted, as it does, to join the EU. A country in a monetary union with a non-EU country, which the UK now is, cannot join the EU.

Scotland could try to start a currency from scratch, with its own central bank, but it takes time to establish the credibility of a new currency and an independent central bank in what he described as a “politically charged environment”. Or, continued use of sterling on a temporary basis. Either would be staging posts on the road to euro membership. None of the options are palatable, which is perhaps why we have not seen a currency plan.

Stranger things have happened than people voting for what they think of as independence even though it will damage the economy and make them poorer. Look at Brexit. The economic challenges faced by an independent Scotland would be even greater.

Sunday, November 29, 2020
Sunak's talk of emergency can only knock confidence
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.

You may have seen a report a few days ago which highlighted people’s lack of understanding of basic economic concepts. The report, based on a survey by the Economics Statistics Centre of Excellence and the National Institute of Economic and Social Research, showed that fewer than half of people knew what gross domestic product (GDP) was when presented with a range of definitions.

Most, 67%, knew that the government was running a budget deficit – I don’t know what the other one-third has been doing during this year – but only 40% knew that that meant government spending was higher than tax revenues.

Welcome to my world. This is meat and drink for those of us who think basic economic understanding should be part of the school curriculum and made available to every adult. Perhaps it helps explain some of the things that have been happening in the past few years.

Though people who have made it this far into the Business section are much more economically aware than most, some of the emails I get show there is still work to be done. Among the public at large, budget deficits and trade deficits are commonly confused, as is government debt and international debt. And don’t get me started on the difference between real-terms changes – those adjusted for inflation – and changes in cash, or nominal, terms.

This brings me on to Rishi Sunak. Chancellors have a duty to explain, and this chancellor has won plaudits for his clarity and the speed of his response to the crisis. I defy even the most economically aware member of the public, however, to have followed his jargon-filled and statistics-heavy spending review statement when it was delivered in the House of Commons last Wednesday, without benefit of the accompanying documents.

That was not my main concern. In rehearsal, the chancellor’s opening burst – “Our health emergency is not yet over. And our economic emergency has only just begun” - may have sounded suitably Churchillian. But it jarred, and it jarred badly.

I know what was meant, that the economic effects of this crisis will be around for years, and there will be bills to pay in future, though Sunak has been noticeably coy about saying anything about future fiscal policy. But as a description it was a strange one, and if his aim was to undermine confidence, this was how to go about it.

The “economic emergency”, which it has been, began in March and, as far as the economy is concerned – our old friend GDP – reached its low point in April, seven months ago. A 23% recovery from that low point by September and a 15.5% rise in GDP in the third quarter show the extent to which that recession low is in the past, not something to be suffered in the future.

This month’s lockdown will have represented a hiccup in the recovery, not an end to it. The 11.3% drop in GDP for this year as a whole, if it occurs, is indeed spectacular, but it is mainly a historical artefact.

As for the new official forecast from the Office for Budget Responsibility (OBR), it is disappointing that the “V” of this recovery will take longer than initially hoped, because of the coronavirus second wave, but if the economy gets back to where it was in late 2019 by the end of 2022, as its main forecast suggests, that will be in line with three of the past four recessions since the 1970s, and shorter than the five years it took after the global financial crisis.

On unemployment, while every lost job is painful, the OBR’s first guess in the spring was that unemployment would hit 10% almost immediately. In July, in another forecast, its Fiscal Sustainability Report, it suggested a peak next year of 12%, equivalent to more than 4m people. Its new forecast of a 7.5% rate, half that experienced in America as a result of the pandemic, is in relative terms quite reassuring. Not for the 2.6m people who will be unemployed if the prediction is right, but for the many others who could have suffered.

The messaging around these things should be simple enough, particularly when the new tier system announced on Thursday, to be introduced in the wake of the second lockdown, has produced another dollop of gloom. It is that while the economy has suffered a huge economic hit as a result of Covid-19, the worst is behind us, and there is every reason – backed by the new official forecast – to expect a strong recovery over the next two years. Jobs will continue to be lost, and some businesses will not make it, but it could have been worse.

That still leaves the not so small matter of a £394bn budget deficit this year and the fiscal challenges to come. I am intrigued to see whether we get to that huge figure, given that borrowing in the first seven months of the year has been “only” £215bn. After that, borrowing initially falls faster than it did after the financial crisis, though remains high at around £100bn even at the end of the parliament.

The chancellor how suggested that this is not sustainable. It remains to be seen how he addresses a tax gap estimated by the OBR to be around £27bn; that amount needed to balance day-to-day spending and tax receipts. To put that in context an increase in VAT of 2.5 percentage points, as announced by George Osborne in 2010, would raise an additional £18bn a year.

An increase in VAT, along with rises in income tax and National Insurance, are officially off limits because the Tory manifesto last December ruled them out. But it also ruled out a cut in the overseas aid budget from 0.7% to 0.5% of gross national income (a close relative of GDP).

There was, it should be clear, no need to do this and, as several former prime ministers have pointed out, it sends the wrong signal at a time of global need and when the UK wants to demonstrate global leadership. Our contribution would have been smaller anyway because GDP has been hit by the coronavirus crisis. But the chancellor appears to be as guided by polls and focus groups, as are the prime minister and his advisers. Cutting overseas aid, on the “charity begins at home” mantra, is popular, as is freezing public sector pay.

The result was that a chancellor who is spending record amounts of money, in a government which it should be said is presiding over record amounts of waste, managed to sound mean and mean-spirited. If universal credit is cut next April, which on current plans it will be, he will add to that impression. Non-Covid spending is also due to be cut from previously expected levels.

Finally, there is the dog that did not bark, Brexit. The chancellor did not mention it in his speech and he does not appear to be taking much of a lead on it in a government that still mainly wants to have its cake and eat it. The official forecaster is clear that the free trade agreement the government is pursuing will hit the economy; in the long run it will be 4% smaller than otherwise. A no-deal Brexit would add to that hit, pushing growth significantly lower and unemployment higher next year, and adding to the long-term damage. It is a risk perhaps, that would justify a more downbeat tone.

Sunday, November 22, 2020
In a deep fiscal hole - and the government is still digging
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.

November can be a cruel month for chancellors. The last thing Rishi Sunak wanted was a second national lockdown and on Wednesday we will all find out what the additional measures he has been forced to put in place, including the extension of the furlough scheme until March, will cost.

On Wednesday the chancellor will announce the results of his one-year public spending review, covering 2021-22, the fiscal year starting next April. Shortly after that the Officer for Budget Responsibility (OBR) will unveil its latest fiscal assessment and economic forecast.

There is plenty to consider on both fronts. On the face of it, the spending review will process has been a gain for the often wasteful defence budget and a loss for overseas aid and for public sector workers, who face a one-year pay freeze. The chancellor could yet surprise us and not cut overseas aid from the 0.7% of gross national income the government delivered even during the austerity years, or not freeze public sector pay, but both have been briefed. So the Ministry of Defence has been celebrating what Sunak himself has described as the biggest defence boost in nearly 30 years. I shall come back to that.

More attention, I suspect, will be devoted to the latest assessment from the OBR. Its last assessment, in its fiscal sustainability report in July, set out three scenarios. Even in the most optimistic it expected gross domestic product (GDP) to drop by more than 10% this year, which would mean the biggest annual fall since 1709, which as you will know, was the year of the Great Frost. This month’s national lockdown will have tilted the balance towards a bigger rather than smaller hit to GDP.

I read a headline the other day saying that the chancellor faces the worst hit to the public finances since the war. That was hardly news. In August, the OBR updated its central scenario to take into account Sunak’s July economic measures, to predict a budget deficit of £372bn this year.

Nothing like that has ever been seen before in peacetime, either in comparison with its cash level – the previous peak was £158bn during the financial crisis – or as a percentage of GDP, which is the high teens.

This week’s OBR exercise will take into account the chancellor’s many variations in his winter economic plan, originally announced in September with a new and less generous job support scheme but later modified to include the extension of the furlough scheme, initially for this month and subsequently until the end of March.

It is not all one-way traffic. While the monthly public borrowing figures have broken records this year, they have come in below what the OBR feared. Figures released on Friday showed that public sector net borrowing was £22bn last month, for a cumulative total of £215bn so far this fiscal year. That is lower than the cumulative figure of £291bn for the first seven months of the fiscal year consistent with the OBR’s projections. This week’s figures will be horrible but they might not be as horrible as they could have been.

Dealing with the deficit will not be easy. On the face of it, we have a typical 10 and 11 Downing Street relationship, in which a chancellor tries and mainly fails to restrain a spendthrift prime minister. But the relationship between these two is hard to work out. I would like to bet that cutting overseas aid, which saves a few billion for the loss of a large amount of international reputation at a time when poor countries need help, has proved popular with focus groups.

Sunak, despite being opposed to a review of defence spending lasting more than a year, was quick to make the best of a bad job, sending out a signed tweet with the message: “We’re providing a record £24bn for the defence budget over the next four years.” More defence spending tends to be popular with Tory voters.

What should be unpopular, with all voters, is the terrible waste of public money during this crisis. The Treasury has provided a blank cheque and plenty of people have been cashing it, including friends, and friends of friends, of the government. Comparisons have been made between this crisis and wartime. In one respect, the emergence of an army of spivs and profiteers, it has been like the war.

How do we get down from all this? Most of the emergency support the chancellor has offered will come to an end by the start of the next fiscal year in April, though there many have to be a gradual winding down of the furlough scheme and government losses on bounce back and business interruption loans could be a feature of the public finances for many years to come.

The Centre for Policy Studies, a right-of-centre think tank, says that public sector workers have done well relative to their private sector counterparts during the crisis (public sector employment has also increased). A three-year freeze on public sector pay from now, and not just the planned one-year freeze, could save a cumulative £23bn, it suggests, with spending in year three down by nearly £12bn. The chancellor hinted after the most recent public sector pay settlement that he would be seeking to restore the balance between public and private sector workers.

I doubt, however, that he would want to go as far as a three-year freeze. This is a government with a huge fiscal hole to fill but which is also committed to avoiding a return to austerity. It does not take much for a Tory government to be accused of a return to austerity. A public sector pay freeze would certainly do so.

Then there is tax. The Office for Tax Simplification, at the chancellor’s request, has suggested that a shake-up of capital gains tax, unifying it with income tax and reducing allowances, could bring in an extra £14bn a year, though it might also lead to big behavioural changes. Other tax increases being considered by the Treasury include an increase in corporation tax from 19% to 24% and cutting higher rate pension relief.

The Resolution Foundation, in a report Unhealthy Finances, agreed that capital gains tax and corporation tax should be increased but also proposed a 4% health and social care levy “to raise significant revenue, improve our tax system and deliver badly-needed resources for social care”.

It would apply to incomes above £12,500, be combined with National Insurance changes to ensure that anybody earning under £19,500 would be net gainers, and make a big contribution to the £40bn a year in extra taxes the group deems to be needed.

None of this is for now. The Resolution Foundation suggested that tax increases should not come before 2023. This week will give us a better idea of the size of the fiscal hole. How to fill it remains mainly a question for the future.

Sunday, November 08, 2020
After another handout from Sunak, how do we pay for it?
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.

Like a lot of other people, I am finding that there is something missing in my life at the moment. It is not just that, thanks to the second lockdown, I can’t browse in a non-essential shop, sit in a pub or restaurant, have a haircut or beauty treatment, or play tennis or gold. I haven’t played golf for a while but in my case it was always socially distanced, most of the time trudging through undergrowth in search of lost balls.

No, apart from all those, I am missing the budget. For people like me the run-up to the budget always provides plenty of material, whether it is speculation of tax changes that may or may not happen, or trying to guess the rabbit that the chancellor will pull out of the hat.

Sadly, however, the November budget has, like the other things I mentioned, fallen victim to the coronavirus. The two big “fiscal events” planned for this autumn, the budget and a three-year comprehensive spending review, have been replaced by one tiddler, a one-year spending review due on November 25.

There is much anguish in Whitehall over the cancellation of the three-year spending review. Many hours have been wasted in government departments preparing for it, at a time when there have been plenty of other things for them to be getting on with. It has also created new uncertainty about medium and long-term strategy.

The Treasury would say that, instead of a proper budget this month, we have had a series of mini budgets. They have come thick and fast, sometimes at a rate of one a month, and we had another on Thursday.

That, however, creates a sense in which policy is rudderless. Rishi Sunak is being forced to provide more and more support for the economy, either by the coronavirus, or by Downing Street, or a combination of the two. He had hoped by now to have said farewell to the furlough scheme. Indeed, as a I wrote last week, he hoped to have done so many months ago.

Now, in the mother of all rushed U-turns he has extended it and the self-employment scheme until the end of March, meaning that it will be around – depending on a January review – for more than a year. There is good news and bad news in this. The good news is that many people who would have become unemployed will stay on company payrolls. The bad news is that it could be seen to imply that serious restrictions, if not lockdown, will be in place until the spring, with no guarantee that there will not be another U-turn then.

The chancellor’s U-turn has gone down badly with experts. Paul Johnson, director of the Institute for Fiscal Studies, said nothing had been learnt since this spring: the new package was “wasteful and badly targeted for the self-employed”, with no effort to target sectors and viable jobs for employees.

The chancellor did not have a budget, but in short statement in the House of Commons he handed out tens of billions. We cannot be sure how much. The Treasury estimates that extending furlough costs between £2bn and £10bn a month; the self-employment scheme £7.3bn and money allocated to the other nations of the UK under the Barnett formula £2bn. Against this, the job retention bonus he announced for employers in September, which was dependent on the furlough scheme ending, ahs been scrapped. A conservative assessment was that the furlough extensions (for lockdown and beyond) and the other measures will cost a further £35bn to £40bn.

The question, and it is one I get asked a lot, is how to we pay for all this. £5 million was an important sum for the Treasury when it was at loggerheads with Greater Manchester over Tier 3 support, and money may have been at the heart of the government’s refusal to provide meal vouchers to underprivileged children during half-ter. Suddenly, however, whether Sunak wanted to or not, the taps have been turned on full. What can and will be done to repair the public finances?

The chancellor could, of course, do nothing on the assumption that the Bank of England will always be around to make things easy for him. Britain has won praise for the co-ordination of fiscal (the Treasury) and monetary (the Bank) policy during the pandemic. On Thursday the Bank not only provided a further £150bn of quantitative easing (QE) but helpfully moved its announcement forward to 7am, to leave the airwaves free for the chancellor at lunchtime.

The Bank’s purchases of government bonds (gilts) make even a huge budget deficit – which could hit £400bn or 20% of gross domestic product this year – easier to fund and keeps the cost of doing so low. The Bank, coincidentally, has announced £400bn of additional QE.

This is not, however, a permanent solution. One of the Bank’s deputy governors, Sir Dave Ramsden, said recently that the Bank was getting closer to its self-imposed limit for QE. Thursday’s £150bn announcement ahs taken it much closer to that limit, leaving only £100bn or so to go. It has already become the dominant holder of gilts. There would still be demand for gilts after the Bank stopped buying, from pension funds, insurance companies and overseas buyers, but that is not limitless either, and investors might well require a higher return, pushing up the government’s cost of borrowing. When the Bank is buying, the cost of borrowing is zero.

The chancellor could raise taxes and/or restrain public spending. Neither is easy. On public spending, the government is keen to avoid being branded with a return to austerity. Sunak is similarly hobbled when it comes to tax, because of the government’s manifesto commitment not to raise any of the main taxes; income tax, VAT and National Insurance.

That is why the summer speculation, emanating from the Treasury, was about raising taxes on business, including lifting the corporation tax rate from 19% to 24%, equalizing the treatment of capital gains and income and abolishing higher rate pension tax relief. The corporation tax hike could bring in £15bn or so, when fully implemented – which would take some years - capital gains tax a few hundred million. Replacing higher rate pension tax relief with a flat rate of, say, 30% would be revenue neutral. Limiting the relief to the basic rate of 20% would bring in some revenue but act as a powerful disincentive.

We come aback to a familiar dilemma. Closing a large fiscal hole with taxation requires higher taxes for everybody, which is why the International Monetary Fund, in its latest assessment of the UK economy, suggested in coded language that it will be necessary to raise some of the main taxes. There are ways of doing this by sticking to the government’s promises, for example by freezing the personal tax allowance and higher rate threshold and extending the range of goods and services subject to VAT. You would still struggle, however, to raise the £43bn a year in extra taxes that the Institute for Fiscal Studies says is necessary to stabilize government debt at 100% of GDP, a figure once considered to be too high for comfort.

Can we grow our way out of it? After all, after this year’s huge plunge, the economy should show its best growth for nearly half a century next year. The key, however, is not a short-term bounce but sustainable recovery, and that means reviving productivity growth. Successive assessments of the public finances by the Office for Budget Responsibility have stressed the importance of productivity growth for the public finances.

Talking about reviving productivity and actually doing so are, though, two very different things. Adding to government debt to help the economy is but the work of an afternoon, as the chancellor demonstrated the other day. Tackling it afterwards is a job for the long haul.

Sunday, November 01, 2020
Sunak's bridge to normality proves to be a rickety one
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.

Who would be a chancellor? As the second wave of the coronavirus intensifies, and national lockdowns are unveiled in France and Germany, albeit less strict ones than before, the direction of travel in the UK looks clear. Last night, as people will be aware, the prime minister announced a government U-turn and another national lockdown.

For the Treasury, this can only mean that the bill for responding to the crisis, which was already breaking records, goes up further, as does the challenge of restoring the public finances to health in the medium to long term.

Sometimes I think back to February, when Rishi Sunak was happily carrying out his duties as Treasury chief secretary, deputy to the then chancellor Sajid Javid. Sunak was a cabinet new boy, having only been elected as an MP in 2015, and having been a junior local government minister until late July 2019.

Javid, in contrast, was on his fifth cabinet role and, after less than seven months as chancellor, and fully committed to the government’s “levelling up” agenda – which is looking a bit lopsided at the moment – and looked to be at the Treasury for the long haul.

It did not happen. Javid resigned, Sunak got the call, giving rise to a conversation with Boris Johnson which might have gone something like this. “Rishi, the good news is that you are going to eb chancellor. The bad news is that the coronavirus pandemic is going to give us the biggest recession in a century and a budget deficit two and a half times the previous annual record.”

It did not happen. On February 13, the date of his appointment, the UK had had nine reported cases of coronavirus but the prime minister had not then woken up to the danger. Sunak’s first budget, nearly a month later on March 11, including a response to the emerging Covid-19 crisis but this was only a taste of what was yet to come.

As poisoned chalices go, this one competes with that of Alistair Darling’s appointment of chancellor at the end of June 2007, weeks before the financial crisis came to Britain with the run on Northern Rock. Sunak, however, had even less time to get his feet under the table when his crisis hit.

That he has handled it with aplomb is a credit to him. He is the most competent and popular member of what, admittedly, is a dysfunctional government. The unprecedented furlough scheme was announced on March 20, days before the national lockdown and only nine days after the budget.

This was a time of all hands to the economic pump. One the previous days, March 19, the Bank of England had announced a record low of 0.1% for interest rates and a further £200bn of quantitative easing. While other parts of the government’s response to the coronavirus were struggling, and in some respects continue to do so, the economic response was fast and formidable.

The furlough scheme has so far prevented an unemployment tsunami. The unemployment rate at the latest count, June-August, was 4.5%, from a pre-Covid low of 3.8%, though roughly 700,000 payroll jobs were lost between March and September.

But it was due to end yesterday - before last night's month-long extension - and the normally surefooted Sunak stumbled last month when he announced the first iteration of his winter economic plan in September.

Now, he is getting what chancellors should perhaps expect in difficult circumstances, criticism from many sides. Some of it, like a video doing the rounds on the internet, is an attempt to get a class war going because he is personally rich and can be put to one side.

He is also getting blamed, however, for cancelling the planned three-year spending review, instead of which there will be a one-year only review, covering 2021-22, to be unveiled on November 25. The Ministry of Defence is very unhappy with this, saying it has scuppered plans to conduct an integrated review into defence and security, and left the armed forces facing new uncertainty.

It has gone down like a lead balloon in Downing Street, which wanted the spending round to reinforce the government’s commitment to its levelling-up agenda. In what may also be a default position, there is increasing tension between 10 and 11 Downing Street.

This comes at a time when, even though the furlough scheme has been spared the immediate axe, we are moving into a period of significantly higher unemployment. Sunak’s revised job support scheme will, like furloughing, reduce the peak in unemployment when it comes in in December, but it has gone down badly, particularly in areas facing Tier 3 restrictions, with pretty well every TV vox pop saying that people employed by firms forced to close cannot be expected to survive on two-thirds of pay, possibly for months on end.

No chancellor can escape criticism, trying as this one is to balance supporting the economy with what he has described as his “sacred duty to future generations” to manage the public finances. Most economists would say that there is no trade-off between short-term support for the economy and the public finances in the long-term – helping people stay in employment will be good for the economy in the long run – just as they do not see a trade-off between lockdowns and sustained recovery.

They are right, but they are not the ones presiding over an official forecast of a £372bn budget deficit this year. And they are not the ones who will have to respond if the government is, like France and Germany, forced into a national lockdown over the winter.

If there has been a persistent error in Sunak’s approach it has been over-optimism about the course of the virus. When the furlough scheme was announced in March, it was originally intended to run until the end of May. When the virus and the associated restrictions were extended, so was the scheme. The chancellor saw his emergency measures as a bridge back to normality. Normality has, though, proved to be elusive.

In August, basking in the success of his Eat Out to Help Out scheme, which was intended to provide a bridge to normality for the hospitality sector, the chancellor let it be know that he was pondering tax-raising ideas, some of which could be set out in his November budget.

But the budget was cancelled when the second wave emerged, and higher taxes will have to wait. His first iteration of the winter economy plan and the job support scheme acknowledged the risks from a resurgence of the virus but said that there were reasons to be cautiously optimistic. That resurgence, however, and the restrictions it triggered, forced the chancellor to revise the job support scheme and make it more generous. No official costings have ben released for those changes. Further changes may be needed in a new lockdown. Some argue that the original furlough scheme should be fully reinstated, and not just for a month. The Treasury’s Covid response is far from over.

It is better to have an optimistic chancellor than one who despairs. There will be a time when the virus is genuinely in retreat and Sunak’s bridge to normality will be the right analogy. But not for a few months yet.

Sunday, October 25, 2020
Consumers will stay wary as long as the virus stalks us
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.

We enter a new period of uncertainty, in response to which the chancellor, Rishi Sunak, has announced another set of job support measures, which is becoming a regular occurrence. The Bank of England is heading for a Bonfire Night announcement of another £100 billion of quantitative easing (QE), which will mean almost as much of this kind of help for the economy this year as in the previous 10 years combined.

A month ago here, I wrote about the importance of confidence in driving the economic recovery. This was after Boris Johnson had announced new restrictions, including the closure of pubs and restaurants ay 10pm, following hard on the heels of the so-called “rule of six”. The confidence killer was the messaging that surrounded the new rules, that they would probably be around for six months.

Since then evidence of the Covid-19 second wave has become clearer and we have had a bitter North-South battle over the confusing three-tier restrictions, as well as a new set of support measures from the chancellor. A growing proportion of the UK population, though not yet the majority, is operating under more severe restrictions, including those introduced in Wales, Scotland and Northern Ireland.

These new restrictions came too late to affect the September retail sales figures, released on Friday. They showed a robust rise 1.5% rise in sales volumes in September, up 5.5% on pre-Covid levels in February, and 4.7% up on a year earlier. More than a quarter, 27.5%, of sales were online in September, compared with 20.1% in February. The key question, however, is what happens next.

I was right to worry about confidence, though. While not all of the latest measures will have been reflected in the surveys, consumer confidence has taken a battering. The closely watched GfK consumer confidence index, released on Friday, showed a drop of six points to -31, almost down to its levels during the national lockdown in the spring.

And, according to Joe Staton of GfK: “The prospect of rising unemployment is severely depressing our outlook. Worryingly, this data was collected before the new round of COVID-19 restrictions came into force and the end of the furlough scheme, so this will negatively impact the Index in the run-up to Christmas and the months beyond. Expect the autumn chill to give way to much stormier conditions.”

If the GfK measure is almost down to its lockdown lows, another consumer confidence indicator, from Bank of America’s UK team is even gloomier. The 28-day moving average of its index has hit a new low, thus falling below where it was in March-April this year. People are wary of making major purchases, and gloomy about pay, jobs and the impact on them of Covid-19.

Robert Wood, its UK economist, highlighted what is an important feature of the coronavirus crisis, and a shortcoming of attempts to isolate parts of the country with low infections from the economic damage. As he puts it: “This consumer reaction is larger than consistent with the direct effects of government mandated business closures.”

We all watch the same news on television and read the same newspapers, whether we are in high infection Merseyside, Nottingham and Lancashire, or low-infection Cornwall, Isle of Wight and Somerset. We all see the same downbeat Downing Street briefings and see the same national figures for rising coronavirus infections and cases.

The direct effects of even Tier 3 restrictions on the economy are small, even if they are devastating for the hospitality sector. Estimates by J P Morgan suggest that these direct effects are equivalent to 1% or less of gross domestic product. But it also cites the downside risks to this assessment as a result of changes in behaviour.

This has become one of the most important aspects of the economic effects of the pandemic, as highlighted by Gertjan Vlieghe, a member of the Bank of England’s monetary policy committee, in a thoughtful speech a few days ago.

Looking at evidence and studies on the impact of restrictions, some of it dating back to the Spanish flu pandemic of a century ago, most more recent, Vlieghe argued that the typical pattern is one in which governments introduce restrictions, but only after virus cases have started to increase, by which time people have already started to respond to the danger by reducing their spending.

“The overall conclusion that I take away from this rapidly growing literature is that the bulk of spending reductions are due to restrictions that people voluntarily impose on themselves, not due to government imposed restrictions,” he said. “People react strongly to actual or perceived virus risk, and government measures that reduce the spread of the virus are good for public health as well as for the economy, relative to a counterfactual where the virus is allowed to spread more widely.”

That probably give the government too much of a free pass, in the sense that some restrictions that have been introduced in response to Covid-19 have had a limited effect, at best, on the spread of the virus. Countries with the best public health records have combined restrictions with effective test and trace systems.

There may also be strong feedback effects, so when the government announces restrictions that makes people even more worried about the virus, so more likely to change their behaviour. This could particularly be the case when new restrictions are accompanied by scary extrapolations from the government’s scientific advisers.

He is surely right, however, to conclude that changes in behaviour are the key driver of changes in the economy, particularly now when restrictions in most of the country fall well short of the lockdowns in late March and April.

Behaviour adapts, and it may be, as Vlieghe suggests, that people and businesses will respond in a different way to the second wave of the virus than they did to the first, though he remains downbeat, and likely to vote for more QE next month. We have to hope behaviour does change. We are entering a period when consumer spending will not longer benefit from the release of pent-up demand suppressed during the spring lockdown.

You can see that in new car registrations. In July, private new car sales were up by 20.4% on a year earlier, reflecting a combination of pent-up demand and purchases that would have happened anyway. But in both August and September private sales were down on a year earlier as this effect faded, and so far this year, private new car sales are down by nearly 29% on the equivalent period of 2019.

Can anything be done to boost confidence and thus maintain spending over the winter? After all, while the crisis has brought many people close to the edge, and suffering both a substantial drop in income and the prospect of unemployment, others are sitting on the involuntary savings accumulated during the pandemic.

For the moment, however, they are worried, and it does not help that, at the latest count, 9% of employees were on the furlough scheme that comes to an end this week. According to the Office for National Statistics, 74% of people say they are very or somewhat worried about the impact of the coronavirus on their lives, the same proportion as at the end of April.

This is where public health and economics come together. Only when the numbers and the messaging on Covid-19 are more reassuring will people feel more confident. Otherwise, it looks like a difficult winter for businesses relying on the consumer.

Sunday, October 18, 2020
How the 'China virus' hurt China less than most others
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.

As we approach the end of this Covid year, with new restrictions popping up all over the place, cast your mind back nine months to January, when we had barely heard of the coronavirus, and it had yet to be christened Covid-19, let alone SARS-Cov-2, its current scientific identifier.

Nobody at that time expected a world recession. The UK economy was set merely for weak growth. The International Monetary Fund (IMF), which has just released a new world economic outlook, predicted in January that the world economy would enjoy a slightly better year in 2020 than in 2019, 3.3% growth versus 2.9%.

Its main worries then were rising global geopolitical tensions, and what it described as a further worsening of relations between the United States and its trading partners. Those issues remain important but they have been put in the shade by the coronavirus.

The time of deepest gloom about the global economy was in the spring and early summer, and again that can be tracked by the IMF’s forecasts. In June it predicted a huge 4.9% contraction in the global economy this year; a negative swing of more than eight percentage points compared with January. Advanced economies were predicted to slide by 8%, while a double-digit decline was forecast for the UK economy.

All these things are relative, but the latest position in slightly less gloomy than it was. This is because downturns in the April-June quarter in America and the eurozone were less extreme than feared, and in some cases recoveries have been stronger. It now expects a 4.4% slump in the world economy this year, followed by a 5.2% recovery next year.

The big difference is for advanced economies, now predicted to shrink by “only” 5.8%, followed by growth of 3.9% next year, which will leave some ground to be made up before getting back to 2019 levels. The UK numbers have been shaded slightly less than most; a 9.8% drop this year followed by a 5.9% recovery next.

The IMF was not the only body to have a look at global economic performance in a time of Covid in recent days. Citi, the investment bank, also did so as part of the Institute for Fiscal Studies’ annual green budget.

It found, perhaps unsurprisingly, that countries with the most effective lockdown and containment strategies had the best economic and political outcomes. In this respect, Britain is part of a cluster of poorly performing European countries along with France, which has just also introduced new restrictions, along with Spain and Italy. Japan, Germany and, in economic terms, America, have done much better.

One interesting aspect of this, highlighted by Citi is that, despite the heroic efforts of NHS workers, the UK entered the crisis with an underpowered health service. There were seven intensive care beds per 100,000 people, compared with 29 in Germany and 35 in America. Health spending as a proportion of gross domestic product, 10.3%, was among the lowest.

As Citi’s economists put it: “The UK had the worst starting point among the G7 countries and Spain.” That may be marginally better than having a good starting point and still getting it wrong. As they also point out: “The US had the best starting point but has had the worst pandemic, while Japan had one of the worst starting points but the best outcomes [in the G7] so far.”

Perhaps the most remarkable story is that of China. Back in January, when we were only dimly aware of this new and deadly coronavirus, to the extent that anybody thought much about the economic impact of this mysterious disease, it was that China would bear the brunt of it.

There was talk of shifting global supply chains away from production-disrupted Chinese factories and of China’s four-decade growth miracle coming to an abrupt end, with serious consequences for the Chinese president Xi Jinping.

Well, it has not quite turned out like that. China has certainly suffered a hit to growth as a result of Covid-19, but it has come through it a lot better than other big economies. The coronavirus may have originated with an outbreak in a wet market Wuhan, in China, having got there from a bat cave,but its economic impact has been deadlier elsewhere.

China, as both the IMF and Citi’s economists say, will be the only significant economy to record growth this year. While everybody else has been mired in deep recessions, some the deepest for decades, China will have a positive number for growth; 1.9% this year according to the IMF, followed by an impressive 8.2% recovery next year.

China stands out not just in comparison with advanced economies but also with the emerging world, with those economies expected to experience an average 3.3% contraction this year.

While other countries will have to wait to get back to pre-Covid levels of GDP, China has already done so, a big drop in GDP in the first quarter being recovered in subsequent months. And, though a note of scepticism is justified regarding Chinese health and economic information, this short, sharp shock appears to have been achieved through a combination of very tough lockdowns – tougher than anything in the West – and robust testing.

China’s bounce has ramifications, many of which some will regard as entirely undeserved. What Donald Trump described as the China virus, before it became his virus, will mean that China closes the economic gap with America. Over 2020 and 2021, China will have grown by more than 10 percentage points relative to the United States.

China’s great emerging economy rival, India, has had a coronavirus crisis which in economic terms is more like the worst-hit European countries, including the UK, with a big 10.3% drop in GDP this year, followed by an 8.8% rise next. Like America, it will have done slightly worse than standing still over two years, while China has continued to grow.

The Covid-19 crisis has thrown up big changes, and a lot of economic pain. It’s an ill wind, however, that does not blow somebody some good. Many will think it very unfair that that ill wind has favoured China.

Sunday, October 11, 2020
There's no quick fix for Britain's deep productivity problem
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.

One of the topics I get asked a lot is about productivity. People don’t necessarily put it this way, but is this crisis unleashing the “creative destruction” that will propel us out of more than a decade of productivity stagnation? Is the working-from-home revolution and other changes that businesses have adopted, which in other circumstances could have taken years, good or bad for productivity?

What about the nature of the shakeout in jobs that we are seeing? Is the very bad news for the UK’s hard-hit hospitality sector, and the people who work in it, good news for economy’s overall productivity?

These are big questions and I cannot promise definitive answers on all of them. Before I try, let me give you another in the series of extraordinary statistics this crisis is throwing up. The Office for National Statistics (ONS) has just published figures for productivity in Britain’s public services. The measure used is slightly different from the way we typically measure productivity for the economy as a whole, which is on an output per hour or output per worker basis. Public services productivity is measured by the amount of inputs going in – public spending – versus the outputs emerging in return.

On this basis, productivity in public services plunged by 35.7% in the second quarter, compared with a year earlier. This was comfortably the largest fall since it was first measured on this basis, the previous record being the 3.8% annual drop in the first quarter.

It happened because inputs into public services, mainly health and social protection (benefits, free school meals, etc), increased sharply, while outputs fell. School closures hit the output of education, while non-Covid work in the NHS also dropped. No public sector workers were furloughed even when they were unable to work. The drop in the output of public services was a contributor to the 19.8% second quarter fall in gross domestic product.

These huge falls in productivity should not be taken as evidence that the public sector can never deliver productivity gains. Between 2010 and last year productivity in public services rose by more than 5%, with the biggest gains occurring during the period of maximum austerity. Old Treasury hands used to say that putting the squeeze on spending was the only sure ay of delivering such gains.

The official statisticians are still working on final productivity data for the whole economy in the second quarter, which will be published shortly. We will have to wait even longer to see how much productivity bounced back in the third quarter, if it did, as the economy recovered from its second quarter slump. Friday’s monthly GDP figures were a touch disappointing, showing only a 2.1% rise in August, but they left the economy on course for a 16% third quarter rise.

In the meantime, we have the ONS’s “flash” estimate for second quarter productivity, which showed a 19.9% quarterly fall in output per worker and a more modest 2.5% drop in output her hour. The output per worker fall was so large because furloughed employees were counted as still being in jobs, even when they were not working. The drop in output per hour was smaller, though it was still the biggest on record.

These figures will be revised, not least because the revised second quarter drop in GDP was marginally smaller than first estimated, but they will confirm that any productivity recovery will start from a low base. What are the prospects for such a recovery?

As far as the public sector is concerned, and productivity in public services, one feature of this crisis is that a lot of money has been poured in, the “inputs”, often without due diligence. Contracts have been hastily signed and the services not delivered. That is not unusual – there was a lot of such wastage in the second World War – but it does not bode well for public services’ productivity.

For the private sector, there are two big questions. One is whether productivity gains will result from changes in working practices. We should not exaggerate such changes. The latest ONS coronavirus business impacts survey, showed that in the period from September 7 to September 20, 9% of employees were furloughed, 28% were working remotely but 59% were at their normal place of work.

Looking to the future, only 19% expected to use increased homeworking as a permanent business model in the future. Of these, improved productivity was only the third most popular reason, cited by 34%, behind improved staff wellbeing (60%) and reduced overheads (55%).

This will be the test of changes in working practices – whether firms can point to productivity gains – and so far the evidence is thin. I am aware of many surveys showing that employees believe they are more productive when working from home, as well as an improved lifestyle when you cut out commuting. But for salaried workers, getting a set amount done in a shorter time so that you can take the dog for a walk does not increase measured productivity. Only when more is done in each working day does productivity improve. I note that some firms are keeping a remote eye on their employees, to make sure they are working.

Any productivity gains from changes in working practices, meanwhile, have to be set against other losses. Sir James Dyson may have been speaking for many when he said that businesses need the interaction of people working closely together. “I’m 73 and when I come into work I’m learning all the time, we’re learning from each other,” he said. “You can’t train people and learn when you’re sitting at home”.

The jury is out on this. What about the changes in the economy resulting from Covid-19, which the chancellor, Rishi Sunak, has described as a “permanent adjustment”? All sectors have their productivity leaders and laggards but a labour-intensive industry like hospitality has much more of a challenge in delivering productivity improvements than, say, manufacturing. Many hundreds of thousands of hospitality jobs are at risk.

Economists sometimes talk about the “batting average” approach to productivity, which is that if you eliminate low-productivity firms, indeed large parts of low-productivity sectors, the economy’s average productivity will be higher.

That may happen but it is probably not a good thing. Hospitality and other domestically focused services may drag down the productivity average but they have generated huge numbers of jobs and they have a minimal impact on the UK’s ability to compete in global markets. At this time in particular, we need those hospitality jobs.

The keys to raising our productivity game are the same as before; more investment, more innovation and better infrastructure, together with skills. This crisis is very unlikely to come to the rescue.

Sunday, October 04, 2020
This nation of unexpected savers has money to burn
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.

Extraordinary things have been happening during this coronavirus crisis, and it is throwing up some extraordinary numbers. I could give you second quarter gross domestic product, now revised down slightly to show a fall of 19.8% (from 20.4%), still more than seven times its previous biggest recorded quarterly fall, 2.7% during the three-day week in early 1974.

I could also give you the plunge in the number of people on payrolls, 695,000 between March and August, or anything related to the public finances, where the official projection, a £372bn budget deficit this year, is nearly two and a half times the previous peacetime record, £158bn in 2009-10.

Let me however today focus on another number, the saving ratio. For as long as I have been following these things, which is a very long time, the worry has been that people in the UK do not save enough. We are a nation of spenders not savers, unlike some other countries, and the worry has traditionally been that we leave ourselves unprovided for emergencies, reductions in income and retirement.

Well, for three months this year, all those worries were turned on their head. Typically, the saving ratio, the amount saved as a proportion of disposable income, is low. There are technical arguments about the definition of savings, but we can put them aside. Typically, the saving ratio shows that we put aside between a twentieth and a tenth of income, and usually closer to a twentieth.

In the second quarter, however, things changed dramatically. The saving ratio shot up to nearly a third of income. To be precise, it rose to 29.1%, from 9.6% in the previous quarter, 7.7% in the final “normal” three months of last year, and a recent low of just 4.7% during 2017.

Most of that exceptional increase in saving was involuntary. People saved because they could not spend, including the period when most non-essential shops were closed. Not everybody is able or willing to shop online. During this period of involuntary saving, there were also four consecutive months in which households repaid past borrowings in the form of consumer credit.

Not all of it was involuntary. One of the traditional motives for saving is the precautionary motive; people save because they fear tough times ahead, including unemployment, and the Office for National Statistics (ONS) detected some increase in voluntary saving “in response to the higher levels of uncertainty around their future employment prospects”.

The balance between the involuntary and voluntary motivations for the second quarter surge in saving is an important one. If it was mainly involuntary this would suggest that we ended the period of lockdown earlier in the year with a reservoir of unspent money. If it was mainly voluntary then you might fear that households will be battening down the hatches for some time to come. This would be Keynes’s paradox of thrift in which, by virtue of their saving, people make things worse for the economy and for their employment prospects.

The evidence is that it was largely involuntary. That is what the ONS thinks was the man reason for the surge in the saving ratio. Supporting evidence is provided by the fact that the last time people were really worried about unemployment, during the financial crisis, the saving ratio also rose, but only to 12.2%.

Have people already spent their involuntary savings? It is now more than three months since the end of the second quarter and in that time retail sales have shown a strong and, dare I say it, V-shaped recovery. In August, the volume of retail sales was not only 4% above February’s level, before Covid hit the economy, but 2.8% above August 2019.

If you are wondering why high streets are not putting out the bunting, it is that online sales have increased from less than fifth to at times nearly a third of all sales. The latest share was in the high 20s. Food retailers and DIY stores have also done well.

Does this mean that households have blown the lot, and all that extra saving in the April-June period has now been spent? No. Many people equate retail sales with consumer spending, but that is a mistake. Retail sales account for less than half of consumer spending.

People are still involuntarily not spending on things they would normally spend money on, for good reason. In many cases official restrictions mean that they cannot do so.

Visa data monitored by the Bank of England shows that while spending on food is up by an average of 25.7%, year-on-year, since March, most other categories of spending are well down. That includes clothing and footwear, down 18.2% on the corresponding period of last year, but also transport, down 35.4%, recreation and culture, down 11.2%, and hotels and restaurants, down by 41.8%. Not going out, and not travelling to city centre offices, has a big impact on people’s spending.

Thus, while the saving ratio in the third quarter should show a big drop compared with the second, though we will not get the figures until January, quite a bit of this additional saving has carried over. It isn’t necessarily a wall of money but it suggests that, just as retail sales benefited from the release of pent-up demand, so will other sectors, once they are able to open up safely.

Sadly, it looks as though will not be in time for the panto season this year. The question is how much will be left of the hardest-hit sectors, once restrictions ease; the things that people like to spend money on when they are able to do so. Otherwise, the saving habit that we saw forced on people during the spring could become permanent, and for all the wrong reasons.

Sunday, September 27, 2020
A question of confidence as we face a long six months
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.

Weeks like the one just gone do not come along too often. For economy watchers, the cancellation of the planned November budget and the scaling back of the comprehensive spending review was big news, as was their replacement by another emergency economic package.

Rishi Sunak’s winter economy plan, which we cover in greater detail elsewhere, was modest, probably costing no more than a few billion pounds compared with the £190bn plus the government has already spent.

The chancellor stuck to his promise of ending the furlough scheme, replacing it with a UK equivalent of Germany’s Kurzarbeit, under which workers employed for at least a third of their normal hours (paid by their employers) will have a third of their remaining hours paid for by the government, and a third by their employer. The maximum monthly cost to the government is just under £698 per employee.

It has drawn both praise and fire but seemed to me to be pretty well-judged, as was the extension of the temporary cut in VAT to 5% for the hospitality sector to the end of March. Involving both the TUC and CBI was politically astute, the former describing it as a “lifeline”, while the employers’ organisation said it will save hundreds of thousands of jobs over the winter.

It should, but it is hard to say how many. The chancellor has left it to employers to determine which are “viable” jobs and is under no illusions that there will, in spite of his efforts, be a substantial rise in unemployment this winter. The chancellor has left incentives to retrain and recruit until later. This was very much a firefighting operation, in response to a Covid-19 second wave that the government did not expect. Only weeks ago, after all, the talk was of autumn tax hikes.

How much unemployment rises depends on several factors. High amng them is the fact that the winter now looks, in economic terms, a lot colder.

I am not the first to say it, but the worst thing about the announcement last week from Boris Johnson, and the warm-up provided by Professor Chris Whitty, the government’s chief medical officer, was not the measures themselves but that they will have to remain in place “for perhaps six months”.

For half a year, unless things turn out a lot better than the scientists fear, not only are these latest restrictions unlikely to be lifted, but stricter measures may be introduced. This was a new and, for the economy, a damaging piece of messaging. When lockdown was introduced on March 23, there was always a hope that it would be lifted.

The prime minister said of the restrictions announced then: “We will look again in three weeks and relax them if the evidence shows we are able to.” It was not false hope; there was a progressive relaxation of the lockdown in subsequent weeks.

This time, no such hope was offered, only the threat of tougher measures. Maybe it would have been false hope; in March there was the warmer weather to look forward to, which offered the hope of naturally suppressing the spread of the disease. But the six-month timeframe was a serious blow, letting the tyres down on an economy that was still not properly motoring. You could almost hear the spirits drop.

What does it do for the recovery? As I have explained before, the path in and out of this recession is easy to describe. The precipitous fall in gross domestic product started around mid-March, even before formal lockdown, as people and businesses started changing their behaviour. It accelerated with lockdown and reached its nadir in April, the month of maximum lockdown.

The recovery since then, tentative in May, stronger in June and July, owed everything to the easing of restrictions and the re-opening of the economy. August should be fine as far as monthly GDP is concerned, helped by the success of the chancellor’s Eat Out to Help Out scheme, which has now given way, oddly, to “go home early to stay safe”.

The economy should also have continued to grow this month, despite the latest announcements, and a small slippage in the “flash” estimate of the closely watched purchasing managers’ index. One reason for September’s growth should be the return of schools. School closures had a big negative effect on measured GDP in the second quarter. I do not want to upset any parents tearing their hair out trying to understand their children’s schoolwork and attempting to teach it but home tutoring does not count towards GDP. Neither does housework.

The factors that helped push GDP down by a record-breaking 20% in the second quarter, including a large fall in measured educational output, will have reversed themselves. We remain on course for a big jump in GDP in the third quarter. By my calculations, GDP at the end of September – the monthly GDP figure for the month – will be around 5% lower than in February, before Covid-19 hit the economy. This would leave a crucial last lap to be completed before the economy got back to where it was before the crisis hit, in GDP if not in employment and how it feels for many businesses.

This is what makes the new restrictions, and the messaging around them, so concerning, and so unfortunately timed. The latest consumer confidence index from GfK, released on Friday, showed a small improvement to a historically still weak -25, continuing its recovery from the April low point. People remained very gloomy about the economy, though less than they were, and slightly more willing to make major purchases. The survey was carried out before the latest announcements.

Another positive sign was from the Recruitment and Employment Confederation (REC), which reported 129,000 new job adverts in the period September 14-20, the highest weekly total since lockdown. Again this came before the new measures.

It is the fourth quarter we have to worry about and, as I say, it is not the measures themselves but their impact on confidence that matters. The new restrictions will reduce monthly GDP by a mere 0.2 percentage points, according to Oxford Economics, but beyond that “are likely to damage sentiment and encourage more consumer caution”.

GfK, which prepares the consumer confidence index, asks of the modest improvement in recent months: “Can this fragile improvement last, or is it about to come to a grinding halt?”

The last lap of recovery to pre-Covid level of GDP has suddenly become more uphill. Robert Wood of Bank of America, having expected some growth in the next two quarters now predicts stagnation.

Capital Economics, warning that “these new restrictions will set back the economic recovery” also predicts a flat fourth quarter. Economists at ING, the bank, think the rot will set in with the October monthly GDP figures, which are likely to show a fall. Further measures, including the two-week “circuit break” which has been talked of, could turn that fall into a large one.

So is it time to give up on the recovery and accept that the economy will limp into next year, still smaller than it was, until there is better news, or a vaccine, or both, in the spring?

That is now becoming the consensus view, though I have not quite given up yet. If the trajectory of new cases and deaths follows anything like the path described by the government’s chief scientific and medical advisers a few days ago, then the next few months do indeed look difficult. We can hope that it is not so bad, though the government did not give us a lot of reason for any such optimism.

Sunday, September 20, 2020
For Britain, Covid has been the worst of all worlds
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.

The Covid-19 crisis has seen the return of the public information broadcast, often accompanied these days by public information tweets. For those of us of a certain age, this brings back many memories, the broadcasts not the tweets. Public information films used to tell us to put seatbelts on in cars – “clunk, click, every trip” – though they were presented by Jimmy Savile. We were also told that “coughs and sneezes spread diseases”, a campaign that might be worth reviving now.

I say this because this is going to be a public information column, on the coronavirus pandemic and its impact. So get ready for some cold, hard facts. There are, I know, a lot of misunderstandings out there, and not just from the deluded anti-vaxxers, and their fellow travellers, who insist that Covid-19 is a myth. Fortunately, they are a tiny and nutty minority.

Let me start with Covid-19 itself. Many people will be aware of the daily figures for UK deaths from coronavirus, measured by people who have died within 28 days of having a first positive Covid-19 test. The cumulative total now stands at a little under 42,000. Even on the basis of this narrowest definition of Covid deaths, Britain has the fifth largest global death toll, after America, Brazil, India and Mexico.

Most people will also be aware, I hope, that this underestimates the true total. The Office for National Statistics’ weekly comparison, of numbers where Covid-19 is mentioned a cause of death on the death certificate, gave a total of 56,840 in the period to September 4. It is “a” cause of death for a reason; most victims – not all – had underlying health conditions. 56,840 is equivalent to a town the size of Macclesfield or Aldershot.

How does the death toll for Covid-19 compare with other causes of death? The answer is that many more people have died from other causes during the period of the pandemic, including dementia and Alzheimer’s disease, cancer, heart disease and strokes. Since late June more people have died each week with influenza and pneumonia – which often takes away the elderly - mentioned as a cause of death than Covid-19.

Overall, between the start of the pandemic – the first deaths - and September 4, 16.9% of deaths were attributed to Covid-19, the rest to other causes.
Before moving on, it is worth also mentioning another important figure, which is for excess deaths; those above the five-year average for this period. There were 57,793 excess deaths in England and Wales until September 4 and scaled up for Scotland and Northern Ireland gives a figure of around 65,000.

Shocking though these figures are, each representing a family tragedy and in many cases a lonely death, I hope it is not too callous to say that the economic consequences of the crisis are, when expressed in hard numbers, even more striking.

At the start of this year, the consensus among independent economists, as sampled by the Treasury in its monthly compilation of independent forecasts, was that the economy would grow by a modest 1.1% this year. It was not looking like a good year, the slowest since the financial crisis, for an economy beset by Brexit and other uncertainties.

Little did we know. Now the consensus among economists is that the economy will contract by a huge 10% this year. “Contract” is too mild a word for that, as is shrink. Plunge would be better. Taking 2019’s gross domestic product as a starting point, and ignoring inflation, the difference between an economy growing by 1.1% and one plunging by 10% is £246bn.

In round numbers, the economy has taken a £250bn hit this year, and that is not the end of the story. There will be a cumulative loss of GDP in future years. Bouncing back is not just a question of getting back to where you were. It is also making up the lost ground with a period of stronger growth than was previously expected and that looks unlikely. Even in five years, the economy will be several percentage points smaller than previously expected.

To the human cost of the crisis in deaths and illness can be added the human cost in unemployment. At the start of the year, the consensus among economist was that the unemployment rate would end the year at 3.9%. It is already higher than that, as the latest figures show, and is now forecast to rise to 8.3%. The difference is equivalent to more than 1.5m additional people becoming unemployed, taking the total to just under 2.9m.

The Office for Budget Responsibility (OBR) in its central scenario sees unemployment rising to 3.5m total this year, which implies that more than 2m people will have become unemployed as a result of the pandemic.

Its numbers for the public finances are even more eyecatching. This year government borrowing – the budget deficit – will be £267bn more than it expected before the pandemic, and £87 billion more next year, 2021-22. By the end of this parliament, government debt will be £600bn higher than it previously predicted. That is more than £9,000 for every man, woman and child in the country.

What do we conclude from these numbers? Many people will look to the example of Sweden, which did not have the same kind of lockdown as the UK, relying on voluntary social distancing, restrictions ion gatherings of more than 50 people, table-only service in bars and restaurants and limits on care home visits (where, as in this country, the coronavirus problem was worse). Sweden will suffer a smaller fall in GDP this year, 7.8% according to the OECD, and Covid-19 deaths there per 100,000 people are lower than in Britain.

No two countries are the same but one assumption early in the crisis was that Sweden was a different country and British people could not be trusted to abide by voluntary rules, so more draconian measures were needed. That still informs the government’s approach, though the vast majority of people in Britain have followed voluntary guidelines, and probably could always have been trusted to do so.

Most economists would say there is no trade-off between dealing with a health emergency and the economy, and that tackling the disease was essential to a sustainable recovery. We should remember that the economic damage began even before lockdown was imposed.

That general principle should not, however, give a free pass to governments in their response to a public health emergency. We were unfortunate that this pandemic landed on Boris Johnson’s watch, when we needed focus and a grasp of detail. This newspaper has catalogued the many missteps the government made in response to the crisis under his leadership. Six months on from the imposition of the lockdown, the government is struggling particularly on testing, and its rationale, which once was to prevent the NHS from being overwhelmed, has become fuzzy.

The economy, meanwhile, has suffered one of the biggest hits in the world. The OECD’s interim economic outlook, published last Wednesday, showed that the UK’s projected 10.1% fall in GDP this year compares with 3.8% in America, 7.9% in the eurozone, 5.4% in Germany and 5.8% in Japan. Of the G20 countries highlighted by the OECD, only Argentina, Italy, India, South Africa and Mexico do worse, marginally, than the UK this year.

We will only know the full Covid-19 scoreboard after this winter and beyond. On current data, the UK has suffered the worst of both worlds, a deadlier health crisis than most and one of the biggest economic hits. We will see whether this remains the case.

Sunday, September 13, 2020
We priced ourselves into jobs last time. Can it happen again?
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.

We are just coming up to the end of the first two weeks of September and you would have to say that the autumn has not started too well. On Covid-19, it has been a case of one step forward – the overwhelming majority of schools returning – and at least one back; new national restrictions on people gathering, the so-called rule of six, that could be in place for many months.

These lurches do nothing for confidence. One minute the talk is of a return to work, the next is the threat of a national lockdown – something I thought had been ruled out by the preference for local responses – if these restrictions do not work.

One minute the chancellor is musing openly about how he might go about the task of repairing the public finances, the next Downing Street is talking of a “moonshot” of 10m tests a day, which could cost £100bn. The only comfort for the Treasury is that there is about as much change of this non-existent technology delivering as there is of Britain landing a man or woman on the moon next year.

It reminds me, painfully, of how non-existent technology was going to solve the problem of the Irish border, and the state of the Brexit negotiations and the government’s deliberate breaking of international law is another sorry start to the autumn. It seems like a long time since we could have our cake and eat it and the German car manufacturers would appear on the horizon and come to our rescue. They won’t. The head of the BDI, which represents German industry, said that the British government “is losing credibility on a huge scale”. I will write about the Brexit mess, but not just yet.

Instead, amid all this gloom, I wanted to try to offer just a tiny glimpse of optimism. A sharp rise in unemployment later in the autumn and over the winter would compound what the government’s chief medical officer, Professor Chris Whitty, has predicted will be a “difficult” few months for Covid-19.

It is quite hard to be optimistic about unemployment. I have written before that keeping the total below 3m (from 1.34m now) would be an achievement. Gordon Brown, the former chancellor and prime minister, has warned of a “tsunami” of mass unemployment, said that pleas for help are falling on “deaf ears” at 10 and 11 Downing Street, and urged a package of measures

The Office for National Statistics will provide an update on Tuesday, though covering a period under furlough, which has held down recorded unemployment. Rishi Sunak and Boris Johnson have both ruled out an extension of the furlough scheme, though the Johnson premiership has characterised by U-turns.

The House of Commons Treasury committee said on Friday that the chancellor could carefully consider a targeted extension of the furlough scheme. It also warned that his job retention bonus, paying employers £1,000 for every furloughed employee they keep on until the end of January, was not effectively targeted and unlikely to be good value for money.

So where is the glimpse of optimism I promised? It comes in two parts. The first, while it may not be enough when set against the tsunami to come, is that we are seeing some job creation announcements amid the gloom. We know which sectors are suffering, notably city centre hospitality, transport and travel, and so on, and tomorrow’s restrictions will not help.

Other sectors are, however, doing well, and announcing new jobs. Tesco has announced 16,000 new permanent jobs, Morrisons that it will convert thousands of the 45,000 temporary jobs it has created since the coronavirus crisis hit to permanent ones. Iceland, the store not the country, is creating 3,000 jobs. Amazon, a clear online beneficiary, will create 7,000 more permanent jobs and 20,000 temporary ones.

The Recruitment and Employment Confederation (REC), which represents the recruitment industry, reported a sharp rise in the hiring of temporary staff last month, alongside an increase in permanent placements, which it suggested could mark a turning point for the job market.

“A return to growth in permanent placements and temporary billings is good news – though it is also expected, given we are comparing activity now with the lockdown,” said Neil Carberry, REC’s chief executive. “Temporary work is critical in any recovery - businesses turn to temps to help them ramp up and meet demand while the future looks uncertain. At the same time, it enables people to find work quickly. Past recessions show that temporary work bounces back more quickly – it is one of our job market’s biggest strengths and that’s really showing now.”

Figures from Eurostat, the EU’s statistical agency, showed that Britain’s labour market has so far held up well. Most countries have furlough schemes, or equivalents, but the average fall in EU employment in the second quarter was 2.7%, compared with 0.7% in the UK. Compared with a year earlier, UK employment rose by 0.3%, while the EU average was down by 2.9%.

There are, then, some stirrings in the job market. The second element is pay. In the aftermath of the global financial crisis just over a decade ago, many people feared a huge rise in unemployment. I won’t name names but one prominent economist predicted 5m unemployment. The post-crisis peak was actually 2.71m.

An important reason for that was pay restraint, which started during the crisis with pay freezes and cuts and which continued with a much lower level of wage and salary increases after it. Collectively, people priced themselves into jobs.

In the eight years leading up to the crisis, average earnings growth averaged 4.2% a year. In the eight years after recovery from the crisis began, it averaged 1.8%. This lower post-crisis pay growth was, of course, accompanied by stagnant productivity.

The question is whether something similar is happening again. Average earnings growth has turned negative. Total pay in the second quarter was down by 1.2% on a year earlier, while regular pay showed a 0.2% fall. Some of that, perhaps much of it, is a furlough effect. Furloughed workers had 80% of their wages paid by the government, and some employers did not top them up to 100%.

But it probably goes beyond this. The REC survey reported a drop in starting salaries and temporary workers’ pay for the fifth month in a row in August. People want work, the survey reported that the rise in candidate availability was the second sharpest on record, and are prepared to accept lower salaries to do so. The sharpest increase, another throwback to the last crisis, was in December 2008.

All recessions and recoveries are different, and this one is highly unusual. After the financial crisis, workers were able to price themselves into jobs because those jobs existed and were expanding, particularly in sectors like hospitality. This time, the risk is that not enough of the jobs will be there.

But the experience after the financial crisis is a reminder that it is easy to get too gloomy about unemployment. This will be a test for Britain’s labour market flexibility and the ability of employment to adapt to new circumstances. Let us hope that it can pass it.

Sunday, September 06, 2020
Sunak's toxic tax problem as spending hits wartime levels
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.

It is easy sometimes to forget what an extraordinary period we are living through. There are many ways to capture it with statistics but let me today provide you with just one. What will public spending be this year as a proportion of the economy? What will the state’s share be?

The answer, according to the government’s fiscal watchdog and forecaster, the Office for Budget Responsibility (OBR), is no less than 54% of gross domestic product. That is on the basis of its central scenario. If things turn out worse than it expects, the spending share could be as high as 58%. Even in its optimistic take it is 50%

Let me put that in perspective. In 1976, the peak spending share when Britain had to turn to the International Monetary Fund for a humiliating bailout was much lower, 46.4%.

It was also lower in 2009-10, when high levels of spending and borrowing prompted the coalition government’s austerity programme. Then the peak level of spending was 46.3% of GDP.

The level of spending we are seeing this year is normally only witnessed during wartime, when the state mobilises the private sector to pursue the war effort. Indeed, to add to the comparison, this year’s 54% would be the highest since 1946, at the start of post-war demobilisation.

There has been a flavour of wartime mobilisation during the Covid-19 crisis in the quickly negotiated (and in some cases very bad) personal protection equipment contracts, schemes to quickly make ventilators and to buy up future vaccine supplies and, most notably, in policies like the job retention scheme. The government paid people’s wages, not in this case to fight the enemy, but to stay at home on furlough.

This Covid-19 version of the war effort has so far resulted in £178bn of additional public spending this year, out of £192bn of fiscal support, the rest in the form of tax measures. That is unlikely to be the final bill, So, when we are looking at the public spending share of the economy, the numerator has gone up a lot.

At the same time, of course, the denominator, GDP, will show a fall this year of a magnitude that we have not seen for a century. The OBR predicts a 12.4% drop in GDP this year, slightly more than the 10% drop which is the average among independent forecasters. Either way, a large contraction in the economy and a big increase in public spending can only mean one thing: a substantial rise in the state’s share of the economy.

It helps explain why the chancellor’s thoughts are turning to tax increases, as revealed by this newspaper last weekend, and in the speaking notes for a meeting with Tory MPs he inadvertently gave us a glimpse of last Wednesday.

I have argued here before that a one-off increase in the spending share and in public borrowing need not result in tax hikes. Yes, the crisis means more borrowing and higher debt, but if the extra borrowing is short-lived, that need not be a problem.

The context for that view was the OBR’s first look at the impact of the coronavirus, back in April. Then it expected that the impact of Covid-19 on the public finances would be sharp but temporary, with the path of public borrowing quickly returning to what it had expected before the crisis.

Things have changed. The OBR, like other forecasters, no longer expects a short, sharp fiscal shock. The hangover for the public finances will last for some years. Even in 2024-25, it thinks the budget deficit will be nearly 5% of GDP, compared with a pre-crisis prediction of just over 2%. The deficit then is expected to be double in cash terms what was previously expected. That is why, in his own words, Rishi Sunak wants to “correct our public finances” and re-establish the Tory reputation for “sound finance”.

Whichever of the many tax hikes currently doing the rounds makes it into the chancellor’s autumn budget, and when they are introduced, there is something that would worry me if I were him.

This is that it is one thing to announce higher taxes, quite another to actually achieve the higher revenues needed to reduce borrowing. One reason for this is that recessions and their aftermath depress revenues. Typically it takes time. That was a particular issue during the recovery after the recession of the early 1990s.

The other issue is whether it is possible to increase tax revenues to the kind of level that would allow the chancellor to claim that he had brought borrowing under control. The OBR’s Fiscal Sustainability Report, published over the summer, from which my number today are largely taken, projected that after this year’s surge spending will still be 42.5% of GDP by 2024-25, the final year of this Parliament.
That is high for a Tory chancellor, I remember a time when the debate between Tory ministers and would-be ministers was whether spending should be as low as 35% of GDP, or as riskily high as 40%.

Those days are gone but, unless the spending share can be reduced – and in the absence of austerity, faster growth (and thus a higher level of GDP) offers the main hope there – tax revenues would have to be more than 40% of GDP to, say, run a budget deficit of about 2% of GDP.

It is a long time, however, since government receipts have been above 40% of GDP, as long ago as 1982-83 in fact. Then, receipts were boosted by North Sea oil revenues and privatisation proceeds. Income tax rates were far higher, with a basic rate of 30% and a top rate of 60%.

In recent years receipts have typically been between 36% and 37% of GDP. The OBR thinks they will be a little higher by the end of the Parliament, 37.9%, but this still implies a hefty budget deficit, £116bn, or 4.6% of GDP. You can increase tax rates but the behavioural response and other factors may mean that revenues do not respond as expected.

The other thing that would worry me is that 2024-25 is not seen by the OBR as a staging post on the road to ever lower deficits bur, rather, the jumping off point on the road to ever larger deficits, as the ageing population and other factors kick in. Within a couple of decades, without action, the levels of borrowing relative to GDP that we have seen this extraordinary year would become the norm.

As the OBR says: “In reality, no government could attempt to run the public finances along the paths implied by these scenarios for any length of time without running into financing difficulties. At some point, policies would need to change in order to bring the public finances onto a nonexplosive trajectory.”

The chancellor is well aware of this. His dilemma is when to start raising taxes, with every economist saying this is not the year to do it, and whether, when he does, he can make meaningful inroads into the deficit.

Sunday, August 23, 2020
A post-lockdown housing boom. But will it turn to bust?
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.

There are many things you might have expected to happen as lockdown was eased but I suspect that a housing boom was not one of them. At a time when it has been harder than expected to get people out of their homes, it was not obvious that the first thing on the minds of many would be moving to a new one.

That there has been a burst of housing activity and a jump in prices is not in doubt, and I shall come onto some of the evidence in a moment. It is possible, of course, that some of this has been stimulated by the experience of lockdown itself, and the prospect of permanent changes in working arrangements.

Who would not want to work from home in a thatched cottage in St Mary Mead, rather than slogging in on the 7.32 to Waterloo, followed by a sweaty Tube journey? Other cities will have their variations on this.

Some estate agents say this has been an important factor, though they are pretty good at talking their own book, and I doubt that it has been the key influence. Even in the strange world in which we are living, most house moves are local.

So what is driving a market that, according to the Nationwide building society saw prices rise by 1.7% last month, with the Halifax only fractionally behind at 1,6%, pushing prices to record levels and annual rates of house-price inflation higher?

The Royal Institution of Chartered Surveyors (RICS) suggested that the easing of lockdown – the housing market reopened three months ago – lifted buyer enquiries out of their post-referendum torpor. According to the RICS’ residential market survey, a net balance of 75% of surveyors (those reporting a rise rather than those reporting a fall) saw a rise in in new buyer enquiries last month.
Surveyors also had something to sell, with a net balance of 59% recording an increase in instructions to sell. In the past few weeks the market has come back to life with a bang.

The first and most obvious reason for the strength of the market in recent weeks has been the bunching effect from a combination of stalled pre-lockdown purchases and pent-up demand. Some of the activity that would normally have occurred in the period between late March and mid-May has instead happened since.

There has been a second factor, supported by traffic figures from Rightmove, the property portal, and its rivals. When Brits were at home, they did not just watch Netflix, bake bread and grow beards. Many scoured the property websites. To this can be added the fact that the normal housing market summer lull, as people disappear to foreign parts, has not really happened this year.

A third factor is, of course, that the chancellor, Rishi Sunak, could not rely on these natural forces to continue lifting the market, so in his summer economic update last month increased the stamp duty threshold in England to £500,000. Some other parts of the UK have lower thresholds, reflecting lower house prices. He was worried that the housebuilders were reluctant to start work on new sites and wanted to provide the additional boost to consumer spending that stronger housing market activity provides. When people move, they spend, on furniture, furnishings and other things.

There is, it seems, a definite stamp duty effect. Knight Frank, the estate agent, reported that the number of offers accepted in the UK market between July 8 and August 3, after the stamp duty announcement, was 146% above the five-year average for that period. Not all of that was the impact of the stamp duty cut, but much of it was.

There is, then, a mini-boom under way in the housing market, for prices and for activity. The question is whether it is just a bit of summer madness, which will fade like the flowers when the days get shorter.

There are two significant concerns. One is mortgage availability. Some lenders are making life tougher for first time buyers, as this newspaper has reported. Nationwide has led the way in tightening the rules on how much help young people can get from their parents, the legendary Bank of Mum and Dad.

Across the market as a whole, mortgage rates have gone up on high loan to value mortgages, in spite of the Bank of England cutting official interest rates to a record low of just 0.1%. Bank data shows that the average five-year fixed rate mortgage on a 95% loan to value advance rose from 3.28% at the end of February to 4.11% at the end of July.

Lenders are nervous, as are most other housing market observers, because of what is yet to come for the economy. A year in which most people experience falling real pay and in which unemployment is bound to soar in the autumn is a pretty toxic combination for the housing market. The shoe of widespread joblessness has yet to drop.

These concerns are justified, and it is quite possible that a combination of restricted mortgage availability and rising unemployment kills off this mini-boom and turns it into a bust. Those would be the circumstances in which predictions of significant house-price falls, which usually happen in recessions, would come to fruition.

There are, however, a couple of caveats. The surprise strength of the housing market at present may reflect the fact that people are buying blind, unaware of the horrors that are to come. Or it could show that housing is more resilient, more of a safe haven, than we think.

Life is unfair, and it may be that the shakeout in jobs that we are seeing is also unfair. In a piece on housing for ING, the bank, one of its economists James Smith, notes that the sectors with the highest levels of furloughed workers, who may be most vulnerable to unemployment, tend to be young and lower-paid. The typical first-time buyer is older these days, in their early 30s. Covid-19 may have made it harder for young people to get close to the housing ladder, without necessarily harming the prospects of those who were ready to buy.

At the other end of the age scale, early official evidence also points to a big fall in employment among the over-65s, who are beyond normal home-buying age. I am casting no aspersions here – I am no spring chicken myself – but it may be that some older workers have found it more difficult to adapt to working from home and are more reluctant that younger colleagues to return to the workplace, so have decided this is time to stop. A fall in employment among older workers does not have much of a housing market impact.

These are caveats, and may not be enough to offset the negative impact of a really big rise in unemployment. But, having thought that a significant fall in house prices was a Covid-19 certainty, I am no longer convinced. Whether that is right or wrong I shall report back.

Sunday, August 16, 2020
Worried about debt? Not in a world running on MMT
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.

Today, something slightly different. This is in the nature of an economic version of a request show. I have had many requests to write about what is known as modern monetary theory (MMT) and this is my response. MMT has been around for some time, decades or even centuries according to its advocates, but it is relevant now.

My reluctance to write about it has been partly because its true believers, like some true believers in Brexit, can get very exercised when faced with criticism, even it is constructive. Actually, there is an overlap between supporters of MMT and Brexiteers. If MMT works for anybody, it plainly does not work for countries which have joined the euro because they do not have monetary sovereignty. It would have been of no use to Greece during the eurozone crisis

But I am getting ahead of myself. The reason for writing about MMT now is the recently published book by Stephanie Kelton, professor of economics and public policy at America’s Stony Brook University, and one of MMT’s leading advocates. She advised Bernie Sanders, who ran Joe Biden close for the nomination as Democrat challenger for the US presidency. Her book, the Deficit Myth: Modern Monetary Theory and How to Build a Better Economy, is published in this country by John Murray.

It is proving popular, for good reason. Not only are plenty of people interested in MMT but it is written in a non-technical, accessible, even folksy style. It is being read by non-economists, as all the emails I have received urging me to write about it attest, as well as being on the summer reading lists for many economics’ students. Last time I looked it was Amazon’s bestseller in macroeconomics and within sight of the top 1,000 among all titles.

It is arranged as a series of myth-busting chapters, though I do not know if people who are aware of conventional economics believe many of these myths. The first “myth” is that there the government’s budget is not the same as a household budget, something that I thought had been buried many years ago. The same goes for most of the other myths.

The central idea of MMT is simple. It distinguishes between currency issuers and currency users. The only currency issuer in America is the US Treasury, and the Federal Reserve acting as its agent. Everybody else is a currency user.

As a currency issuer, the government has the ability to print as much money as it needs. The budget deficit itself is not a constraint, and neither is government debt. Some claim, wrongly I think, that MMT has already been adopted, in effect, in response to the Covid-19 crisis.

In the world of MMT the government can print enough money to cover a deficit of any size and in extremis to pay off all the accumulated debt of the past. The only tests of whether a budget deficit is too large or too small are inflation and unemployment. If inflation is low, the budget deficit cannot be too high, and if there is unemployment, the budget deficit must be too low.

Many people will be catching their breath at this point, not least because Kelton claims that this is not just a theory but an explanation of how the world works. But that then requires us to be taken down a rabbit hole of implausibility.

If deficits can be costlessly funded and managed by the simple device of issuing currency, why do governments need to raise taxes? In perhaps the least plausible explanation of the way incentives work, people apparently need to work to meet their tax obligations. If they did not have to pay tax, they would not need to work. I rather think they would, to satisfy their wants. Another reason provided for taxing to redistribute wealth and income, does not wash either. You can redistribute wealth and income within the tax system without raising any net revenues, by taking from the rich and giving it to the poor in tax credits.

Taxation exists in the real world to raise revenue. And borrowing by governments also plainly exists. Her explanation is that this is not to raise money, because governments do not need to, but “to offer people a different kind of government money, one that pays a bit of interest”. Try telling that to American and British governments in the past, which have paid a lot of interest to fund their borrowing and have sometimes struggled to do so.

There is plenty more in the book. Some of it, like the policy of a job guarantee for everybody, is not so much part of MMT but an add-on, though at a time of high unemployment possibly a popular one.

MMT is misnamed because it is not monetary at all but almost entirely fiscal. As Kelton puts it: “MMT requires us to demote monetary policy and elevate fiscal policy as the primary tool for macroeconomic stabilization.”

So what should we think about this? MMT has drawn robust criticism from some of the world’s most eminent economists. Kenneth Rogoff, a former chief economist at the International Monetary Fund, writing last year under the headline Modern Monetary Nonsense, described its central idea as “just nuts”. An exasperated Paul Krugman has described trying to debate with MMT advocates as like playing Calvinball, a game in which players make up the rules as they go along.

Larry Summers, the notable economist and former US treasury secretary, has attacked the “ludicrous claims” by “fringe economists who hold them out as offering the proverbial free lunch: the ability of the government to spend more without imposing any burden on anyone”.

In response to Kelton’s book Julian Jessop, an independent economist, has written: “MMT is simply a repackaging of some old ideas to appeal to a new audience. There really is no such thing as a free lunch – even from a magic money tree.”

I am going to be polite. We always need new fresh ideas and nobody wants to kill off ideas which are clearly in a state of gestation and are in no way workable in their present form. Some, like the economists above, might say it is necessary to kill off MMT because it is dangerous. There is, however, little chance of it being adopted as real-world policy. Even Jeremy Corbyn and John McDonnell did not embrace MMT, despite being urged to by some of their supporters.

They were wise not to do so, because there are fundamental problems with MMT, which it would take another book to fully address. Kelton has some fun with Margaret Thatcher and what she describes as Thatcher’s backward dictum, because of her tendency to describe the government’s finances in the way you would describe a household’s finances.

But Kelton has more in common with Thatcher than she thinks. In the early 1980s, when the Tory government launched its monetarist experiment, Thatcher thought the key driver of inflation was the budget deficit. Government borrowing had to be reduced to reduce growth in the money supply and bring down inflation. It is why people associated monetarism with “cuts”. Kelton is looking at it from the other end of the telescope but applying the same principle.

The causes of inflation are many and varied, particularly when you do not use the simplifying assumption of a closed economy. Dylan Grice, whose review of Kelton’s book was recently republished by Albert Edwards of Societe Generale, is not unsympathetic but points to the “preposterous” idea that getting the Congressional Budget Office in America, or equivalent bodies elsewhere, to predict inflation will take care of the inflation risk from large budget deficits. Given the forecasting record on inflation, it plainly will not. As he puts it: “In short, MMT is a recommendation that policymakers press hard on the accelerator without knowing where the brake is.”

He is right, and while advocates of MMT like Kelton see it as two-way street, in which spending would be reined back in inflation took off, politicians might see it differently. Would it be a recipe for huge instability in the provision of public services, with public spending cut back in a way that would make George Osborne’s post-2010 austerity look like a tea party? Or would the government decide it could live with a lot more inflation. Either way, it would not be pretty.

Sunday, August 09, 2020
V, W or Aargh? It depends on the virus - and on jobs
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.

When the economy has been hit by as profound a shock as Covid-19, and the unprecedented lockdown measures adopted to limit its spread, we should take comfort where we can. The Bank of England, which gave us its latest forecast on Thursday in its quarterly monetary policy report, offered a modicum of such comfort.

On the basis of its new forecast, we no longer have to look at the early 1700s, the time of Queen Anne, the War of the Spanish Succession of 1706 and the Great Frost of 1709. If the Bank is right, and the economy shrinks by “only” 9.5% this year, it will merely be the worst since 1921, when it shrank by 9.7%. Anybody who talks about the roaring twenties, as some over-enthusiastic tabloids did not so long ago about the 2020s, has to remember that they did not roar last time in Britain.

The Bank, which in an “illustrative scenario” in May suggested that gross domestic product (GDP) could fall by 14% this year, hence the early 1700s’ comparisons, is not yet putting out the bunting. The UK’s recession this year is predicted to be worse than that of the eurozone, down 8%, and America, down 5.75%.

It also provides a health warning that would grace any cigarette packet or box of pills, noting that the outlook “will depend critically on the evolution of the pandemic, measures taken to protect public health, and how governments, households and businesses respond to these factors” and that its “projections assume that the direct impact of Covid-19 on the economy dissipates gradually over the forecast period”.

Those are the key assumptions for the Bank, and for other so-called V-shapers like me. It does not help when people talk about a second wave of Covid-19, because that is usually associated with flu outbreaks, which are more severe in the winter. This coronavirus, currently raging in very hot countries, does not appear to be weather-dependent. Even so, if easing lockdown means a return of the infections and deaths, to the point where lockdowns have to be reimposed (and if there are enough local lockdowns you get many of the effects of a national lockdown) that is bad news for the recovery.

On the assumption of a gradual dissipation of Covid-19, as has happened with previous pandemics, the recovery is both rapid and dramatic. After a huge 21% GDP fall in the second quarter, the Bank predicts an extraordinary 18% in the current third quarter. Both represent record-breaking quarterly changes, by a very large margin.

Similarly, after this year’s 9.5% fall, the economy grows by 9% next year, according to the Bank, and gets back to where it was at the end of 2019, before we knew what was coming, by late 2021. That, as Simon French of Panmure Gordon points out, would represent the most rapid recovery in 50 years.

It would also underline the highly unusual nature of this recession and recovery. We have the deepest recession in nearly a century but the downturn happened in just two months, March and April, as lockdown was imposed. Assuming the June GDP monthly GDP figures this week show a rise (the Bank expects a 9% increase on the month), the economy’s journey out of the low point will be confirmed.

Whether it continues depends, as noted, on the virus and the avoidance of a disruptive Brexit. That deserves a piece on its own but most observers expect a compromise, if limited, trade deal in the autumn. I shall return to that.

It also depends on the labour market, and here the Bank has done some invaluable work. The furlough or job retention scheme has been a huge government intervention but the Treasury and Her Majesty’s Revenue & Customs (HMRC) have little information on how many people are currently covered by it, as opposed to the cumulative 9.6m total of employees who have benefited from it at some stage.

The Resolution Foundation think tank has done some useful digging, and now so has the Bank. It estimates that, on average, 6m people were furloughed at any one time during the April-June quarter, and that numbers peaked at over 7m in May. This quarter, July-September, it thinks that the average number of people furloughed will come down to 2m, dropping further to 1m in October, the scheme’s final month. The Bank’s decision maker panel, the latest results of which were also out on Thursday, revealed that at 18% of employees were furloughed in July, down from 30% in June.

That informs the Bank’s view of unemployment, which is less scary than others. It sees unemployment peaking at 7.5% later this year, equivalent to about 2.6m people. There have been projections which suggest that the jobless total could reach 3.5m or 4m.

Bad though a near-doubling of unemployment would be, it would be better than it could have been. I have written before that success for Rishi Sunak’s furlough and other schemes will be keeping unemployment below 3m. Any loss of jobs is unwelcome, but if the Bank is broadly right the rise in unemployment will probably not trigger a big downturn in spending, which would undermine the recovery, later in the year.

There was a lot in the Bank’s new report. It is considering whether there may come a time when it should adopt negative interest rates, as other central banks have done, but appears sceptical, suggesting that there are reasons to doubt their effectiveness in the current situation. They might not work as effectively as a traditional cut in interest rates and they could hit household and business confidence.

This produces a curiosity in its forecasts. While the Bank’s steer was against negative interest rates, though not entirely ruling them out, the market interest rate assumptions it uses to prepare its projections has Bank rate going marginally negative, by 0.1%, next year and for the following two years.

Is the Bank trying to have its cake and eat it, as one analyst suggested? A little, but as you might expect, the difference in the economic outlook between an interest rate of 0.1% and one of -0.1% is very small. The Bank’s V-shaped recovery does not depend on it.

But the debate over negative rates has not gone away. Were the Bank to adopt them at some stage it would be an indication that the other tools in its kit, notably quantitative easing and ultra low but positive interest rates, were not doing enough. They would also be an indication that the economy was not bouncing back as strongly as the Bank currently expects.

Sunday, August 02, 2020
We have to say farewell to the furlough scheme
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.

The idea that we have experienced two “once in a lifetime” shocks in little more than a decade is now becoming pretty well established. Both the global financial crisis and the Covid-19 pandemic share one thing in common. Nobody, despite many claims to the contrary, really predicted either.

Some warned about the unsustainability of the global economy, the build-up of debt and the dangerous reliance on risky financial derivatives in the run-up to the financial crisis but these general warnings did not add up to a prediction of the crisis in the way it panned out.

Similarly, from the time of the SARS (SARS-Cov-1) outbreak in 2003-4, plenty of people warned that there would in time be an even deadlier virus, in the sense of more infections and a higher death toll. Bill Gates, the Microsoft founder, did a few years ago. But these general warnings could never have told us about the extent of the economic impact, the lockdowns, and the timing of SARS-Cov-2, or as it is usually known Covid-19. I doubt that at the start of the year anybody had a global pandemic at the top of their list of risks for 2020.

Whether predicted or not, these two momentous shocks have had an enormous impact on the economy. The National Institute of Economic and Social research (Niesr), in its latest quarterly review, published a striking comparison of the UK economy’s pre-financial crisis trend, its pre-Covid trend and what the economic think tank now expects over the next few years.

We had got used to the idea that, in general, the economic cycle was rather like a laundry cycle, and that it all comes out in the wash. What was lost in recessions was made up during recoveries, which were usually strong, particularly in the early stages. The pre-recession trend was regained, with little or no overall loss. Between 1955 and 2005 the real level of UK gross domestic product almost quadrupled.

These two shocks are different. They have been big enough to knock the economy hugely off kilter, and to result in a permanently large loss of GDP. So, according to NIESR, real GDP in 2025 will be around £536bn a quarter. That compares with a projection in February, before the scale of the Covid-19 crisis was known, of around £584bn. It compares with a trend figure for 2025, if neither of these shocks had occurred, of around £743bn.

These are huge impacts. In the absence of these two shocks, the economy in 2025 would be nearly 40% larger than it looks like being. It will be almost 30% - 28% - smaller than it otherwise would have been. These shocks make us all poorer and reduce the size of the economy, and that may not have yet fully sunk in. For simplicity’s sake I have for now left out the Brexit shock, which also reduces the size of the economy relative to what it would have been.

It is in this context that I now turn to employment and unemployment. An economy that is not as big as it otherwise would have been cannot sustain as many jobs.

The National Institute also made the case, in this context, for the chancellor’s job furlough scheme to be extended beyond the end of October, to limit the rise in unemployment. Unemployment is on course to rise to nearly 10%, more than 3m, by the end of the year, from under 4%, it warned, and to average 7% next year. Extending furlough would be a “relatively inexpensive” way of keeping the rate to 5% or below and save more than a million people from unemployment. Uts calls for an extension was backed by the Trades Union Congress.

“The planned closure of the furlough seems to be a mistake, motivated by an understandable desire to limit spending,” said Garry Young, Niesr’s deputy director. “The scheme was intended by the Chancellor to be a bridge through the crisis and there is a risk that it is coming to an end prematurely and this increases the probability of economic scarring.

“The scheme has been an undeniable success in terms of keeping furloughed employees attached to their jobs. The incentives offered to employers by the Job Retention Bonus look too small to be effective given the uncertainty about the economic outlook ─ a one-off payment of £1,000 per employee compared to an average wage of £530 per week.”

The Treasury sees it differently. In his summer economic update last month, his Plan for Jobs, Rishi Sunak, described the idea of endless extensions of the furlough scheme as “irresponsible”. It would, he added, give people false hope that the jobs they had been furloughed from would still exist when many will not. Keeping people on furlough indefinitely would see their skills fade and hold them back from taking advantage of new job opportunities.

Nothing is set in stone but there is no reason to think that he has changed his mind. The Treasury also defends the £1,000 job retention bonus. The typical employee still on furlough is paid relatively modestly, and well below average earnings. The bonus payment to employers will cover roughly a fifth of earnings in the November-January period, after furlough ends, and is thus more generous than it looks.

It is a close call. Friday saw Boris Johnson’s announcement that casinos and bowling alleys, which were due to open, can no longer do so. Weddings are being postponed and local lockdowns spreading. Yesterday brought a change in the furlough scheme, so firms have to start to pick up some of the bill.

But I think Sunak is right. The job market has to clear, in economists’ language, and maintaining the furlough scheme is preventing it from doing so. True unemployment is far higher than the official figures are showing, for that reason.

Some sectors will never again employ as many people as before. Retailing employment has been declining for some time and jobs in hospitality look set to suffer a similar fate. Much of this reflects the impact of the Covid-19 crisis, but some sectors went into it with clear over-capacity. We have had big shakeouts in employment before, notably in manufacturing in the 1980s. This time consumer services look likely to bear the brunt, and a longer furlough scheme will not prevent that. This is the creative destruction you get, or should get, in recessions, though we have to hope that there are new phoenixes to rise from the ashes.

We should remember how unusual the furlough scheme was. While previous governments had put in place employment subsidies and other support measures, none had paid people 80% of their previous salary to be idle but still notionally attached to their jobs.

It is, a I say, a close call and the situation would change if the government were to change its Covid-19 guidance again, which is entirely possible. The furlough scheme emerged because the government had, in effect, stopped many businesses from operating. Boris Johnson has said there will not be another national lockdown but that does not rule out reversing the easing measures for pubs, cafes, restaurants, cinemas and gyms if there were to be a second spike in infections, as has happened locally. In that situation, the chancellor would have little option but to extend furlough for the affected employees, however much he wants to avoid it.

Sunday, July 26, 2020
Austerity's off limits, but Sunak will try to squeeze spending
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.

There have been many tricky public spending reviews over the years. Some even informally revived the historic star chamber to resolve bitter disputes between Whitehall departments and the Treasury. This year’s review, announced by Rishi Sunak a few days ago, is perhaps the trickiest yet, however.

The chancellor’s task in providing support to an economy hit hard by Covid-19 is not yet over. During the crisis he has been handing out money hand over fist. Never before has the Treasury played Lady Bountiful to the extent it has in recent months. Her Majesty’s Revenue and Customs (HMRC), which is normally good at extracting money from firms and individuals, has proved surprisingly adept at handing it out. In the right circumstances, it seems, even tax officials have a soft spot.

Now, however, Sunak has to begin to pivot to a more traditional Treasury position, that of restraining and in some cases reducing public spending. The taps, he is already arguing, cannot be left on forever.

In launching the review, he said there would be “tough choices” and that departments have been asked to identify savings and ways of reprioritising their spending. Though he announced pay rises of up to 3.1% for 900,000 key workers, including doctors, teachers and police officers, he also warned of future pay restraint for the public sector.

This year, with public sector workers not having been furloughed, their pay has risen even as pay for most in the private sector has fallen. Sunak said it was important for the future that there was parity between the public and private sectors.

There are some who would say that the chancellor should carry on regardless with whatever spending the economy and public services need, now and in the future, regardless of a budget deficit which, according to a new EY Item Club forecast, will hit £335bn or 17% of gross domestic product this year, with a risk it could be higher.

This is not just conventional economists who believe that a repeat of post-2010 austerity would be disastrous. I have received many reader requests to write about modern monetary theory (MMT), which I promise to do. One of its most prominent advocates, Stephanie Kelton, has written a book called The Deficit Myth, which provides an indication of where MMT enthusiasts are coming from. More on this soon.

The Treasury does not quite see it like that, and does not regard the deficit as a myth, which will not surprise you. As a bit of background, there is a lot of unfinished business in this year’s spending review.

It was supposed to happen last year but was postponed because of uncertainty over Brexit. Some would say it is brave to hold it his year amid the uncertainty over Covid-19 and Brexit but that is what the government has decided to do.
It will cover everyday spending, current spending, from 2021-22, next year, to 2023-24, three years in total, and capital spending, infrastructure, for one further year, to 2024-25. The unfinished business is mainly on current spending, infrastructure having been a prominent feature of the March budget.

On the face of it, there will be no return to austerity. Sunak has promised that departmental spending, boh capital and current, will rise in real terms over the review period. This sounds more generous than it is.

Torsten Bell, chief executive of the Resolution Foundation think tank, points out that the chancellor has “given himself more flexibility to reduce the size of public spending increases over the coming years, rowing back on significant increases announced as recently as March”.

“The planned 2.8% real terms growth a year has now become a far vaguer promise of some growth in real terms. This could mean very tough times for some public services in the years ahead,” he added.

Indeed, public spending did not fall in real terms during the austerity years from 2010 to 2018, though even holding it constant while giving the National Health Service and some other aspects of spending real increases meant savage cuts elsewhere.

The government will want to avoid that, particularly when Boris Johnson has promised no return to austerity and the government has ambitious targets for the recruitment of nurses and police officers - the numbers of which were cut during the austerity years - as well as a big infrastructure programme.

Projections from the Office for Budget Responsibility (OBR) show how a combination of this year’s emergency spending and weaker future growth in the economy will mean that public spending, which is on course to hit roughly 55% of gross domestic product this year, almost wartime levels, will remain higher than previously expected relative to GDP in future years.


This year’s spending review was meant to be the time when other government departments caught up with some of the generosity shown to the NHS, which received its 70th birthday present from Theresa May’s government in 2018. That now looks harder to deliver, and some departments will continue to feel squeezed.

As it is, following this crisis, the NHS is likely to get more money and, while it no doubt deserves it, will look even more like a cuckoo in the nest. From taking 10% of spending on public services in the mid-1950s, the NHS was up to 26% by 2018-19, and is on course for 40% in coming years. That looks very lopsided but may be hard to avoid.

So this is a hard one. It is one thing for a chancellor to be parsimonious when he already has a reputation for being Scrooge-like. But Sunak, in his short period as chancellor, has only known generosity, on a scale that none of his predecessors could have imagined.

Not only that, but the government has to show a commitment to its new supporters in the North and Midlands in a way that was hard to do along austerity and which will not be achieved simply by its announcements on infrastructure projects. At the same time, the prospect of a surge in unemployment later this year will require additional government spending, some of which has already been announced.

Engraved on every finance minister’s heart is Jean-Baptiste Colbert’s famous quote that “the art of taxation consists of plucking the goose as to procure the largest quantity of feathers with the least possible amount of hissing”.

For this spending review, for the Treasury the art will be to achieve the maximum amount of restraint, to start to repair the public finances, with the minimum number of headlines about a return to austerity.

Sunday, July 19, 2020
How COVID and Brexit put the kibosh on business investment
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.

So far during this crisis there has been a lot of emphasis, understandably, on what it means for the economy in general, for unemployment, and for the public finances. We know that the economy suffered a record fall in March and April, and only a modest bounce in May, so is 24.5% below pre-crisis levels.

We also know that the unemployment dog has yet to bark in the official figures, where the rate is still, miraculously, below 4%, but that it surely will in coming months. As for the public finances, the question is whether government borrowing this year will be nearer to £300bn or £400bn, both previously unimaginable figures.

There has been little focus so far, however, on something that will drive future prosperity, productive business investment. Without it, there will be no recovery in productivity, and no sustained rise in living standards.

Rishi Sunak eschewed measures to boost business investment in his March budget, perhaps because he thought it would be like trying to put up an umbrella up in a hurricane, and his summer economic update was all about encouraging consumers to spend and firms to retain workers.

But there is a crisis for business investment, both actual and looming, and it has three causes. The first is the direct effects of the crisis and the economic damage it has caused. A few days ago the Office for Budget Responsibility, in its fiscal sustainability report, set out three scenarios for the economy.

All start from a 40% collapse in business investment in the second quarter, as projects were cancelled and firms hunkered down. Only in its upside scenario, which has a rapid recovery in the economy, does business investment quickly get back to where it was pre-crisis, attaining that level in the second quarter of next year.

In both its central and downside scenarios, in contrast, it takes years before business investment gets back to pre-crisis levels and the damage is significant. In the central scenario, business investment is a cumulative 6% lower than previously expected, and its downside scenario, as the OBR puts it,“none of the lost business investment is recovered and cumulative business investment is 10% lower over the whole period”.

The second issue is the distinction between business spending and productive business investment. The Covid-19 crisis has forced firms to spend in ways that they would have had no expectation of doing a few months ago.

Spending on making premises safe, whether offices, factories, shops or other premises is considerable. Businesses are having to invest in safety, just to do what they were doing before, or in many cases a scaled-down version of what they were doing before. Forced spending alongside reduced turnover is a pretty deadly combination.

For many businesses, the calculation is straightforward. This extra spending, which also in most cases increases operating costs, crowds out productive business investment.

The third factor is a familiar one, Brexit. The 2016 referendum snuffed out a promising recovery in business investment and, even before this crisis, left it 20% below what it would otherwise have been, according to the Bank of England.
For business, the Brexit process has gone from bad to worse, from a government ambition to achieve an exit from the EU with minimum disruption to existing trading links and supply chains, to one where such disruption has become central to the Brexit that the current government is aiming for.

Vast new customs processing centres, huge lorry parks in Ashford and a massive increase in paperwork for exporters and importers are part of the grim and bureaucratic future that form the government’s vision.

Indeed, a good rule of thumb, as some of us warned, is to take the claims of pro-Brexit politicians, and this Brexit government, and turn them on their head. Instead of less red tape, there will be a lot more, for trade and employing foreign workers. Instead of a global Britain, it is closing before our eyes. Where they claim to offer certainty, there is only uncertainty.

Though a no-deal Brexit is the worst outcome, the government’s limited ambitions for a post-Brexit trade deal with the EU are not much better. The European Commission has published a list of what will change, even if a trade deal is negotiated this year.

For trade in goods there will be customs controls, tariff controls, VAT and excise payments and checks on conformity with regulatory standards. For trade in services, UK firms will have to demonstrate compliance with service standards, there will be a loss of current rail, air and road transport licences and an end to recognition of UK professional qualifications. The settlement for financial services is up in the air.

UK travellers will need a visa to stay in the EU for 90 days or more in any 180 day period, will lose the right to work in the EU and UK driving licences will no longer be recognised. Use of the EU pet passport will end, as will the guarantee of no roaming charges for mobile phones.

If all that happens in the event of what the government would describe as a good deal, you have to wonder. You do not have to wonder that this gives businesses another good reason not to commit to productive investment in Britain.

A no-deal Brexit would be worse. The OBR, in its scenarios, assumed that the UK and EU would “move in orderly fashion” to a “conventional free trade agreement”. If not, it said, leaving without a deal “would pose downside risks to short-and medium-term growth prospects on top of the economic challenges created by the pandemic”.

No government would want to inflict this on their economy, and on businesses which want to rebuild and invest, would they? It is a depressing fact that this government, which is far from business-friendly and has taken plenty of wrong turns in its short life, may well do so.

Sunday, July 12, 2020
Rishi to the rescue, but we'll have to live with the debt
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.

Hindsight is a wonderful thing but I can honestly say, listeninging to Rishi Sunak’s plan-for-jobs statement last Wednesday, the words “deadweight cost” kept coming into my mind. This was except when he announced his “eat out to help out” 50% reduction in restaurant food bills on some days in August, when the word was “gimmicky”.

I am not going to criticise the saintly Sunak too much because he is more popular than any economic journalist is ever going to be, and because he is doing his best in very difficult circumstances. He is also refreshingly aware of the pros and cons of his policies and, unlike others, is not given to bluster.

The two obvious deadweight costs in his announcements were firstly, the £1,000 per worker job retention bonus, which could cost over £9bn, and which the permanent secretary to HMRC (Her Majesty’s Revenue & Customs) did not think was good use of public money. The second was the six-month cut in VAT for much of the hospitality sector from 20% to 5%.

The bonus will be paid to employers who furloughed staff only briefly and have had them back at work for some time. The VAT cut will benefit people who would have eaten out or visited attractions anyway. There may have been method in both, however. Refining the bonus would have taken too long and the VAT cut may be intended to funnel money to a troubled sector of the economy as much as persuading the reluctant to venture out.

The gimmicky “50% off” Treasury-backed restaurant promotion reminded me of those “buy one get one free” offers that are said to have contributed to the country’s obesity problem. The behavioural response to this will be interesting. When you halve the price of a burger, do people eat twice as many?

That is in the detail of what was another big announcement from this chancellor. City economists think the cost of last week’s package will be closer to £20bn than the “up to £30bn” costed by the Treasury. But this is on top of the £158.7bn of direct fiscal support already provided by the Treasury in response to Covid-19.

The appropriate way to think of the Covid-19 response, of course, is akin to that of fighting a war. You do what the chancellor has described as “whatever it takes”, lifting a line from the former European Central Bank president, and think about how to pay for it afterwards. In fact, the government is probably less constrained in its ability to borrow than its wartime predecessors, given the Bank of England’s large-scale quantitative easing (QE) purchases of UK government bonds, gilts. Its £300bn of additional QE this year is in the same territory as the likely budget deficit.

Debt has not always fallen after wars. In the 1920s and 1930s government debt averaged 170% of gross domestic product (GDP) after World War One, before pushing sharply higher during the Second World War. Its drop then from 250% of GDP or more reflected a combination of post-war austerity, demobilisation and financial repression; the government being able to fund its borrowing at sub-inflation rates. By the late 1970s debt was down to less than 40% of GDP.

Many people will say that, in response to this crisis, we should not worry too much about debt. The Resolution Foundation think tank expects public sector net debt to stay above 100% for the remainder of this parliament. That in itself is not worrying, though it is worth recalling that at one time, under Gordon Brown, the safe level of debt was thought to be 40% of GDP.

To put some numbers on this; official figures show that public sector net debt is currently £1,950bn, nearly £2 trillion, that government borrowing in the first two months of this fiscal year exceeded £100bn, and that the rise in debt over the latest 12 months, £173bn, is the biggest on record.

There are two things that make this situation unusual. One is the combination of high levels of debt and large-scale government borrowing. You may think this is always the case but it was not in the interwar years. Budget deficits were modest relative to GDP.

One lesson from the past decade is that, once borrowing is big enough, it takes time to get it down to “normal” levels. This year’s borrowing will certainly be big enough, between 15% and 18% of GDP, roughly between £300bn and £350bn.
When the Office for Budget Responsibility (OBR) looked at this three months ago, it concluded that a big budget deficit this year would be followed by a speedy return to normality next year, as temporary measures like the furlough scheme are wound down.

On Tuesday the OBR will publish an updated fiscal sustainability report, which will provide a more nuanced view in three scenarios. One will be optimistic, predicting a very rapid bounce, with no medium-term economic scarring. The others will show significant economic and fiscal hangovers.

The Institute for Fiscal Studies set out three such scenarios last month, ahead of the chancellor’s economic update. Its central scenario had the government still borrowing £130bn a year in 2024-25. That implies a bigger fiscal hangover than after the global financial crisis. In the five years after that, the government borrowed just over £650bn. This time, on the IFS’s projections, which may have to revised in the light of further action by the chancellor, the total will be around £860bn.

The second point is that there is no obvious way of reducing debt, even if the government wanted to do so. Two years ago, the OBR’s fiscal sustainability report showed that ageing populations and other factors would push government debt significantly higher over the next 40-50 years, if unchecked, to some 280% of GDP. The OECD has come to similar conclusions, and not just for Britain. This Covid-19 related debt surge means that these increases will start from a higher base.

It is not clear that Boris Johnson understands what austerity was but he has said that there will be no return to it. Tax increases on the scale needed to deal with the borrowing in prospect – many tens of billions - are not feasible, not least because of the damage they would do to the recovery, whether introduced next year or later. A wealth tax, now apparently not Labour party policy, would make barely a dent, which would mean raising one or all of the big taxes; income tax, VAT and national insurance, all of which the Tories are committed to not doing.

“Over the medium-term, we must, and we will, put our public finances back on a sustainable footing,” Sunak said in his statement. It is not clear whether he, or anybody else in the Treasury, yet knows how.

A strong recovery would, of course, help, and we should probably avoid the post-financial crisis obsession with how much of the budget deficit was “structural” and thus permanent, and how much cyclical. Beyond the bounce as lockdown is eased and the economy returns to something like normality, it is not clear that the economy is capable of doing better than its subdued, Brexit-constrained growth rate of recent years. Given the way the negotiations are going, it may do a lot worse, something I shall return to soon.

The Covid-19 crisis has resulted in a step-change for government debt. We may have to live with this higher debt, or even higher, for the foreseeable future, hope that we can continue to fund it cheaply, and pray that it does not bite us.

Sunday, July 05, 2020
Sunak has to spend now, and he will have to spend later
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.

On Wednesday, straight after prime minister’s questions, when Rishi Sunak stands up to address the House of Commons, it will feel like a budget. And expectations are probably higher than ahead of most budgets, particularly after Boris Johnson’s ‘no big deal’ speech last week, dressed up as his version of Franklin D Roosevelt’s New Deal of the 1930s.

The chancellor has been the undoubted star of the Covid-19 crisis and he will want to ensure that his crown does not slip this week. In some important respects this will not be a budget, however, but merely an economic statement. There will be no accompanying economic forecast or assessment from the Office for Budget Responsibility (OBR), and thus no formal assessment of the impact of this week’s announcements on the economy and the public finances.

The tension in the Treasury leading up to this week’s statement is between those who think the chancellor should act immediately and those that think he should keep most of his powder dry until the next formal budget in the autumn, when there will also be a spending review.

Sunak knows, however, that expectations are high and that politically, neither he nor the government can afford a damp squib. So, despite the unusual nature of this week’s statement it will be meaty.

There are reasons for holding some of the Covid-19 response back. Yesterday saw the reopening of much of the hospitality sector in England, so-called Super Saturday, and other parts of the UK will either follow or, in the case of Northern Ireland, got there slightly faster.

Last week also saw changes in the furlough scheme. From July 1, last Wednesday, employers have been allowed to bring back previously furloughed workers on a part-time basis. Firms will be required to pay for any hours worked, with the government still covering the proportion of usual hours that employees are not worked.

Further changes will take effect from August 1, when businesses will be required to may the National Insurance and pension contributions of furloughed workers. In October, at the end of which the scheme is due to come to closer, firms will pick up 20% of the pay of furloughed workers, the government 60%. The tapering in the scheme is intended to provide firms with an incentive to gradually bring back furloughed workers.

The great unknown, to the Treasury and everybody else, is how much unemployment this will leave us with. It should have better information than is publicly available on how many workers who benefited from the furlough scheme are still furloughed now. It is less than the cumulative 9.3m figure recorded by Her Majesty’s Revenue & Customs (HMRC), probably quite a lot less, but it is hard to be sure.

XpertHR, the employment consultancy, surveyed nearly 200 employers and found that one in 10 furloughed workers are set to lose their jobs by the end of August. Two-thirds will have returned to work by then. The Recruitment and Employment Confederation (REC) recorded nearly a million job postings in the last week of June, many of them in the hospitality sector ahead of reopening. Capital Economics has just revised down its forecast of the likely peak in the unemployment rate from 8.5% to 7%. That would be regarded by the Treasury as a great outcome, amid fears of much higher unemployment.

The economy is also in a state of considerable flux, not quite like trying to catch a falling knife but clearly changing by the day. Andy Haldane, the Bank of England’s chief economist, provoked a sceptical reaction a few days ago when he said he was become more confident of a V-shaped recovery in the economy, which was bouncing back more rapidly than feared. As a V-shaper myself, who has also countered scepticism, I naturally agreed with him.

Scepticism about a V-shaped recovery is unsurprising, particularly in the context of large-scale job losses, including more than 10,000 in the space of little more than 24 hours last week.

The explanation is straightforward enough. According to the Bank’s decision-maker panel of firms, sales in the second quarter, which has just ended, were 38% below normal, and in the current quarter will be 26% below normal, in the fourth quarter, 16% down, and in the first quarter of next year 10% below normal. That will not translate directly into GDP, which in the second quarter is likely to have been about 20% below normal, but it gives you the idea. After a spectacular fall in the second quarter, there should be some record rises in subsequent quarters. That is the “V”.

An economy that remains below normal even in the early part of next year, with some sectors like airlines and hospitality a long way below normal, cannot sustain as many jobs as a normal economy. Much of this year’s lost sales and output is lost for ever, hence the high levels of corporate distress.

What will happen? Annelise Dodds, the Labour shadow chancellor, has called for a “Back to Work budget, focused on jobs, jobs, jobs”. She is pushing, I think, at an open door.

There are some big ideas around. The Resolution Foundation think tank will this week call for a £30bn voucher scheme, as used in countries like Taiwan and China, to get people to spend in the hardest-hit sectors. It has also called for a £17bn jobs’ package, including a £5bn job protection scheme to evolve out of the job retention or furlough scheme. That is small in comparison with the estimated £60bn cost of the furlough scheme.

Reform, another think tank, has called for a £3.2bn package aimed at helping those for whom there is no job after furlough, including direct support and enhanced advice on assistance with skills and retraining for career changes out of those sectors which will not return to normal.

The focus will be on jobs. While there are scary numbers around on the coronavirus drop in employment (600,000) and nearly 3m universal credit claimants, the furlough scheme has been successful so far in preventing a surge in unemployment, notwithstanding those job loss announcements.

When the furlough scheme was first unveiled on March 20 this year, it was originally intended to cover three months of employment; from March 1 to the end of May. Now it will last until the autumn, as the Treasury has revised its expectations of the return to normality. They may have to be revised again but we cannot know that for sure now. That is why the chancellor has to come forward with measures to protect jobs this week, for the people already falling out of furlough and into unemployment. It is also why he needs to keep something in reserve for later.

Sunday, June 28, 2020
After the bailout, Bailey plots the Bank's exit strategy
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.

When Andrew Bailey became governor of the Bank of England in March, the usual description of this Threadneedle Street veteran was that he was the ultimate safe pair of hands and a model of discretion. Mark Carney, his predecessor, had developed a reputation for generating headlines, and was happy to wander beyond his brief. Bailey, it seemed, would keep himself within the Bank’s solid walls.

This theory suffered a rather big blow a few days ago when the new governor generated headlines suggesting that Britain almost went bust in March but was saved by the Bank’s exceptional actions. At a stroke, Bailey out-Carneyed Carney and knocked his predecessor but one, Lord (Mervyn) King, out of the park.

The suggestion that the country could have gone bust a few weeks ago has produced an outbreak of harrumphing from economists, Bank veterans and others. Was the Bank doing in March 2020 what the International Monetary Fund did in 1976, bailing out the British economy at a time of great difficulty?

No, but I do not blame journalists for running with the story. You do not look a gift horse in the mouth and the governor’s remarks, in an interview with Sky News, were hard to resist. There was, he said, a “pretty near meltdown” in core financial markets and, had the Bank not announced more quantitative easing (QE) and other measures: “I think the prospects would have been very bad. It would have been very serious.”

It would also have been serious, he suggested, for the government because “we would have a situation where in the worst element, the government would have struggled to fund itself in the short run”.

Critics have pointed out that, ultimately, governments can always fund themselves, the question being at what price. The markets, in other words, would have soaked up whatever gilts (UK government bonds) the government needed to issue to fund its borrowing, if there terms were attractive enough.

This, however, rather spectacularly missed the point. If the government was only able to get its funding away at a high interest rate then that high interest rate would have percolated through to rest of the economy, scuppering the efforts of the authorities to keep short, medium and long-term interest rates down. It would have sent out a confidence-sapping signal and increased the damage to an economy already facing a significant hit.

The Bank’s additional QE, the £200bn in March and a further £100bn this month, has been timed to coincide with the period of maximum pressure on the public finances as a result of the furlough scheme and other emergency measures to support the economy. Those who get twitchy about Bank apparently working so closely with the government and worry that it might be compromising its independence should note, as Bailey did in a letter to the chancellor on Thursday, in his capacity as chairman of the Bank’s financial policy committee, that “the committee attaches great importance to its secondary objective of supporting the government’s economic policy, and will continue to have regard to the impact of its policies on the government’s economic objectives”. You can be independent and still very helpful.

As it is, thanks to the Bank, the government has had no difficulty funding its extraordinary borrowing, which will break all records this year, even managing to do so on occasion at marginally negative interest rates.

It has been hard to keep Bailey own in recent days, and of more importance in the long run than the fuss over whether the government could have funded itself or not were his comments in an article he wrote for Bloomberg, the financial news and information service.

Headed ‘Central Bank Reserves Can’t Be Taken for Granted’, and with a sub-head ‘The current scale of central bank balance sheets mustn’t become a permanent feature’, the article set out the case for unwinding this year’s emergency QE once the crisis is over.

This, you will recall, has not happened before. The Bank announced its initial £200bn of QE in March 2009, with further tranches later, including in the aftermath of the Brexit vote in 2016. None has ever been reversed, and this year’s additional £300bn takes the running total up to £745bn, equivalent to between 35% and 40% of Britain’s annual gross domestic product.

The Federal Reserve, America’s central bank, did embark on a process of unwinding some of its QE but had to stop, even before the coronavirus crisis, because of the damage inflicted on the economy by Donald Trump’s trade wars.

Now, however, Bailey is looking for a way to reverse it. He, and presumably other members of the Bank’s monetary policy committee (MPC) are starting to feel uncomfortable with the size of the Bank’s balance sheet.

As he put it: “The current scale of central bank reserves mustn’t become a permanent feature. As economies recover, it’s likely that some of the exceptional monetary stimulus will need to be withdrawn, including by reducing reserves. This wouldn’t take us back to the very low levels of reserves before the financial crisis, which sometimes failed to recognize the role they play in ensuring the stability of the financial system. But elevated balance sheets could limit the room for manoeuvre in future emergencies.”

One thing that has held the Bank back from unwinding any of its QE is that it had applied a rule that reversing QE should only begin when interest rates had risen. The initial target level of Bank rate for this process to start was 2%, later reduced to 1.5%. At a 0.1% Bank rate, we are a long way away from that.

This rule always seemed to me to make unwinding QE unnecessarily difficult. I have argued here on a number of occasions that the Bank should adopt a “last in, first out” approach. QE was undertaken only after interest rates had been cut to what were regarded as rock-bottom levels. Unwinding it should have been the first step on the road back to normality.

That, it seems, will now be the Bank’s approach. “When the time comes to withdraw monetary stimulus, in my opinion it may be better to consider adjusting the level of reserves first without waiting to raise interest rates on a sustained basis,” he said.

That makes a lot of sense. We can debate how much the Bank’s intervention saved the country from a much worse fate. I hope most can agree that unwinding some of this year’s large-scale actions will be an essential step on the road back to normality.

Sunday, June 21, 2020
The floor's the limit - we must avoid negative interest rates
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.

As widely expected, the Bank of England announced additional quantitative easing (QE) on Thursday, pumping in a further £100bn. The Bank’s monetary policy committee (MPC) did not cut its main interest rate below zero, leaving it at 0.1%, despite some suggestions that it might do so, and hints from some members that negative rates are part of its armoury.

I shall come on to negative rates in a moment. It may seem a little odd, when the Bank announces a further £100bn of QE, to describe the decision as hawkish, but it was. Instead of a unanimous decision in favour of expanding the asset purchase programme, one member, the Bank’s chief economist Andy Haldane, voted against because “the recovery in demand and output was occurring sooner and materially faster than had been expected at the time of the previous MPC meeting”.

In general, while noting that the risks in the labour market were on the downside, the MPC said that emerging evidence pointed to a less severe Covid-19 downturn than it had set out last month in its May monetary policy report. The Bank, it seems, has moved from the gloomy end of the spectrum into the pack.

It has the same evidence to look at as the rest of us, but it also has a little more, in the form of the reports from its network of regional agents around the UK and from its decision-making panel (DMP), which consists of 8,000 chief financial officers from small, medium and large businesses. It is run from Nottingham University.

The latest survey, carried out last month, showed that businesses expect sales in the current quarter to be 42% lower than they otherwise would have been, and investment 43% down. This is very gloomy but marginally less so than in April, when the expectations were for second quarter falls of 44% and 50% respectively.

The survey also shows the impact of the chancellor’s furlough scheme, with firms now expecting a 6% drop in job numbers this quarter, down from 18% in April.

Perhaps most interesting was what the survey showed about the shape of the recovery. As noted, firms expect sales to be around 40% below normal in the current quarter; 30% below in the July-September quarter; 20% down in the final quarter of this year and 10% in the first quarter of next year. This is the economic “V” I have often referred to; the economy picking up quarter by quarter as activity returns.

What is also clear, however, is that there will be lasting negative effects elsewhere. Business investment will lag the recovery in sales and will still be 20% below normal in the first three months of the year. The employment shakeout, meanwhile, will be most intense in the post-furlough period at the end of the year, when firms expect a hefty 10% drop in job numbers.

It is a very plausible recovery scenario, but we are not out of the woods yet, and we are not beyond the point at which the Bank will have to consider further QE or negative interest rates. If the economy were to suffer a further setback, say from a second wave of Covid-19 in the autumn, all options would be back on the table. Negative rates have been avoided so far, but the story may not yet be over. I hope it is, but we shall see.

If you think that negative interest rates do not feel right, I agree. They turn the basics of finance on their head. An interest rate is the reward for deferring consumption from now until later. By the same token, borrowers have to pay an interest rate to spend money now they did not have. Only if there is an overwhelming case for bring forward consumption from the future is there an argument, though negative rates may or may not achieve this. Nor, to bring it to the current debate, would cutting interest rates on commercial bank reserves at the Bank necessarily make much difference to the amount that banks lend into the economy.

A better case for negative interest rates would be if current and expected inflation was itself heading below zero, in other words into deflationary territory. A Bank rate of 0.1% with inflation at 2% means that official interest rates are negative, in real terms, by almost two percentage points. A 0.1% rate with -2% inflation, falling prices, represents a significantly positive real interest rate.

Though inflation is currently low, at 0.5%, and set to fall further over the summer, it is expected to rise again as lockdown eases further and a degree of normality returns. Some, like the veteran monetarist economist Tim Congdon, suggest that current very high levels of money supply growth point to a significant inflation shock to come. The inflation outlook does not offer an argument for negative interest rates.

There are two further points. The first is that one thing we have discovered from recent experience is that once a new level of interest rates is established, it is very hard to get out of it. When the Bank cut rates to a record low of 0.5% in March 2009, most people, and all members of the MPC, expected it to last for no more than 12 months or so. In fact, it lasted for more than seven years, until August 2016, at which point there was a cut to 0.25%. Not until August 2018 did the rate move back above 0.5%, and then only to 0.75%, and temporarily.

Forecasters do not expect Bank rate to rise above 0.1%, the current rate, for perhaps 3-4 yeas. Were the Bank to cross the Rubicon and move to a negative rate it could take a very long time to get out of it.

The final point is that, for the most vocal advocates of negative rates, like the US economist and former International Monetary Fund chief economist Kenneth Rogoff, it is no use interest rates being a little bit negative, say by 0.25%, they need to be “deeply” negative.

This really does turn finance on its head. It calls into question the continued existence of cash, which holds its value, against deposits, which would lose value. Rogoff is the author of The Curse of Cash, published four years ago. One of his arguments was that phasing out cash, beginning with large denomination notes, would leave more room for negative rates.

It may be that the danger has passed, and that, if the Bank’s more optimistic noises on recovery are anything to go by, it will not need to contemplate negative interest rates. Let us hope so, anyway. They are a bad idea, and we do not need them.

Sunday, June 14, 2020
We need imaginative ideas on the long road back for jobs
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.

Some things are worth getting up early for, and Friday’s 7am clutch of official figures on the economy fell into that category. I can safely say that I never expected to see anything like a drop of more than a fifth in the UK’s gross domestic product in a month.

Even more surprising, perhaps, was that the figures were not surprising. Roughly speaking, the lockdown has taken out a quarter of Britain’s GDP, April’s 20.4% drop being preceded by a 5.8% fall in March. Almost two decades of growth were wiped out in two months. The OECD says the UK is heading for an unenviable record; the worst recession among leading economies.

An economy that had shown no growth since Boris Johnson became prime minister last summer began to totter in February and toppled over the edge when the lockdown started on March 23. Services fell by 19% in April and 24% between February and April; manufacturing by 24% and 28% respectively, and construction by 40% and 44%.

Some weeks ago, as you may remember, I wrote that the lockdown would have shut down nearly a third of the economy, so a 25% lockdown fall was not a surprise. It could have been worse; the Office for Budget Responsibility’s scenario had a 35% fall in GDP in the second quarter, though that was based on the assumption of a full three-month lockdown, and that the impact would not begin until April.

And, extraordinary though Friday’s figures were, they represent a time, albeit a recent one, of maximum weakness for the economy, a full month of lockdown. I have long argued that this will represent the low point of the recession, a view supported by Jonathan Athow, deputy national statistician for economic statistics, on Friday. The next set of monthly GDP figures will be as interesting, because they will provide the first indication of how rapidly the economy is lifting off the bottom.

Before that, on Tuesday we will get another set of official figures, those for the labour market; employment, unemployment and pay. These, in contrast to the GDP figures, are unlikely to give the full picture of the consequences of this crisis.

Rishi Sunak’s job retention scheme now covers 8.9m furloughed employees, while its self-employment equivalent encompasses 2.6m people. When I wrote on the front page of this newspaper on March 22 about this unprecedented peacetime government intervention in the economy, the consensus was that the number of people furloughed might reach 4m or 5m. It is more than double that and, to put it in perspective, 11.5m represents nearly 42% of all private sector employment in Britain.

How do we prevent a jobs’ bloodbath when the furlough scheme begins to wind at the end of July – when employers will be required to pick up a small part of the bill and employees will be allowed to work again – and comes to an end completely at the end of October?

Clearly, if this unprecedented intervention is to have worked, then most of the furloughed employees will need to have returned to work and the self-employed currently being helped will also have to see a return to something approaching business as usual. The schemes, after all, were never intended to be permanent but to provide a bridge back to normality.

The biggest and most significant employment scheme the government can deliver is thus a further easing of the lockdown. That is why the chancellor is urging people to spend when non-essential shops open tomorrow. It is also why he is said to be keen on the two metre social distancing guidance being reduced to one metre, which will make the difference between a quarter of pubs re-opening next month and three-quarters doing so.

The delays in full primary school re-openings, together with continued uncertainty over whether a full return will be possible for primaries and secondaries in September, was a disappointment. Previous studies of pandemics have shown that school closures are a key factor in their economic and labour market impact.

Even with an easing of the lockdown, Sunak is said to fear that 3.5m more people could be left unemployed when the dust settles later in the year. To put that in perspective, it would imply more than 4.8m people unemployed, or 14% of the workforce. We have never had an unemployment level above 4m, and 14% compares with the unemployment rate peak of 11.9% in the 1980s, 10.7% the 1990s and 8.5% after the financial crisis.

What can be done about it? We know where the vulnerabilities lie. Most of the jobs that have been furloughed, 1.6m, are in retailing, including cars, followed by hospitality, 1.4m, manufacturing, 831,000, and construction, 680,000. The biggest take-up on the self-employment scheme has been in construction.

Tony Wilson, director of the Institute for Employment Studies (IES), argues convincingly that an immediate priority should be to cut the cost of employment for firms. A temporary suspension of employers’ national insurance contributions (Nics), levied at 13.8% on pay above £8,788 a year, equivalent to £2,400 annually for an employee on the average wage, would help enormously. As an alternative to full suspension, Wilson suggests raising the threshold to £18,000.

The IES, in its report, Help Wanted: Getting Britain Back to Work, put together with other expert organisations, has set out a five-point plan. It includes targeted support for furloughed workers who lose their jobs between August and October; an £800m scaling-up of job support, including more Jobcentre Plus work coaches; £2.4bn of additional support for the long-term unemployed and disadvantage; an education, training or job guarantee for school leavers; and the launch of a long-term plan for improving employments prospects and skills, particularly for young people.

I am also intrigued by a scheme, called Toupay, designed by the fintech entrepreneur David Brown, which has attracted interest and participation among business software firms, is being examined by the Commons Treasury committee, and has been submitted to the Treasury.

It builds on an existing government guarantee of eight weeks’ pay arrears for workers in firms that fail, and would use that guarantee to enable businesses, or banks on their behalf, to raise long-term payroll finance in the markets. It suggests that up to £86bn of working capital could eb released to help businesses recover and retain.

All of the above suggests that a range of responses will be required. There is no magic bullet. No modern government has faced an unemployment crisis on the scale that could occur later this year, though a much bigger jobless surge than happened was feared after the financial crisis. The Future Jobs Fund, aimed at young people, was launched in 2009, but abolished in 2010, though a 2012 assessment concluded that it had brought significant net benefits to participants, employers and society. Imaginative thinking like that will be needed again.

Sunday, June 07, 2020
A groggy recovery is under way but the real test comes later
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.

On Friday, the Office for National Statistics (ONS) will publish its monthly estimate of gross domestic product for April. That may not sound like the most momentous event but stop all the clocks, cut off the telephone, it will be, reflecting a month in which the economy was almost dead to the world.

The crash in GDP in April will put the previous monthly record, March’s 5.8% plunge, in the shade. It will generate many headlines. But it is, if not old news, a reflection of how the economy was at time of maximum lockdown, not as it is now.

What we have seen since then is a gradual, if sometimes groggy, pick-up from those extremely depressed April levels. The latest purchasing managers’ surveys, for services, manufacturing and construction, show that activity, while still below normal, is less depressed than it was. The composite purchasing managers’ index rose from 13.8 in April to 30 last month.

The ONS, which has responded well in this crisis, is producing faster indicators on its effects. In businesses surveyed over the period to May 17, a quarter of those which had temporarily ceased trading intended to start again over the following four weeks, so many will done so, and a further 30% intended to restart after four weeks.

Shipping arrivals in UK ports, a new favourite of mine, are now on an upward trend, while one phenomenon at the start of the crisis – shortages and price rises for products that people were desperate to buy for the lockdown - has now pretty much disappeared. Things are not normal, but they are more like normal than they were.

Hudson Contract, a firm which provides payroll and other services to the construction industry, estimates that demand for labour fell by 70% in April, before rising by 40% last month as sites reopened. More generally, there are early signs of an uptick in advertised job vacancies.

In some cases, the revival between April and May was modest. The Society of Motor Manufacturers and Traders (SMMT) reported that new car registrations last month were down by 89% on a year earlier. In normal circumstances that would be regarded as dreadful, but it was better than April’s 97.3% fall (including a 98.7% fall among private buyers). And, given that car showrooms were closed in May, even achieving sales a tenth or so of normal was an achievement. The picture will improve a lot this month.

Economic revival from the April low-point is not rocket science, or even medical science. Lockdowns combined with people’s maximum fears of contact were bound to shut down large areas of activity. Both are easing, though people seem keener to relax for social gatherings and shopping than to return to work, and activity will thus recover.

This is not, of course, just a British phenomenon and, if anything, the UK is a laggard in easing the lockdown. Economists at UBS estimate that, of 42 countries they monitor, the number imposing severe restrictions on mobility has dropped from 33 to 11 over the past five weeks and mobility is up from 38% to 55% of normal. The world is waking up from its coronavirus-induced coma.

What is the biggest risk to the economy’s gradual, if groggy, emergence from this shock? A second wave of the virus as we move into the autumn and winter is the obvious danger. I have written before that, if the justification for the lockdown was to prevent an unprepared NHS being overwhelmed, it would be hard to justify a second lockdown, given that there has been time to add to capacity, including currently unused Nightingale hospitals.

But this is a jumpy, erratic and inconsistent government, driven as much by the polls – as in the case of quarantine policy for overseas arrivals – as by the science, so anything is possible. And a second wave, if it occurred, would see individuals, businesses and sporting bodies take action that would replicate the lockdown in their impact.

The other big danger is that the ending of the job retention scheme for furloughed workers, and its equivalent for the self-employed – now covering a combined 11m people, will be followed by a surge in unemployment. The schemes have done a good, it seems, in preventing much higher unemployment – latest ONS figures for universal credit claims show they are down from very high peaks, including a daily total of nearly 150,000 claims in late March, to near-normal levels.

But two looming cliff-edges, at the end of July, when full government support ends, and at the end of October, when all support stops, underline the danger.
How can an unemployment surge be prevented? The blanket nature of the furlough scheme has made it easy for many individuals to survive the lockdown, and even enjoy it. Most people are not despairing. The latest GfK consumer confidence reading, published on Friday, is at a weak -36, but people are much gloomier about the general economic situation over the next 12 months, where the reading is a very gloomy -57, compared with expectations about their own financial situation, where it is -10.

This suggests, rightly or wrongly, that most people are not worried about their jobs when furlough ends. Interestingly, the Office for Budget Responsibility (OBR), revised down its estimate of the cost of the job retention scheme from £84bn to £60bn on Thursday, based on new evidence that employers using the scheme had concentrated it on lower-paid and part-time workers, thus with a lower cost per worker than had been assumed.

It is these workers, perhaps, who should be worried. The sectors that will be slowest to come back after lockdown, like pubs, restaurants, hotels and travel, including airlines, are likely to need job support beyond the end of October. Selective job support is better than mass redundancy. Boris Johnson has suggested an apprenticeship guarantee for young people, and other schemes are being examined by the government.

The Treasury is working on a stimulus package, partly to show that the significant “levelling up” infrastructure spending Rishi Sunak announced in March remains on track. Other countries are doing so too. Germany has just announced a £115bn stimulus package, including a temporary cut in VAT from 19% to 16% and new incentives to buy electric vehicles.

My own view is that a VAT cut is not particularly needed now, because plenty of pent-up demand will be coming through as lockdown eases. Nurturing this recovery means preserving jobs and providing incentives for battered businesses to invest. There is a lot of talk of a green recovery, which should also be part of the mix. More on this soon.

Sunday, May 31, 2020
Levelling up has become even more of an uphill task
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 long time ago, though not in a galaxy far, far away, we were in a different world. I am talking about early March in this country, less than three months ago. When, on March 11, Rishi Sunak presented his first budget, the economic costs of this coronavirus outbreak were starting to become clear.

The chancellor announced a small package of measures, intended to help hardest hit firm and, by the time he stood up on budget day, the Bank of England had cut interest rates from 0.75% to 0.25%, unveiled a new term funding scheme for small firms and relaxed the countercyclical capital buffer for banks.

Most of the budget, indeed most of the debate in government at that time, was, however, about the so-called “levelling up” agenda. Sunak had made it clear before the budget that he was not going to miss the opportunity to try to deliver on that agenda, mainly through a substantial boost to infrastructure spending. I do not blame him for that, even though his efforts have bene subsequently overshadowed. Budgets had become rare events – there was not one during the whole of 2019 – so he had to seize the moment.

What is clear, however, is that levelling up to improve the situation of “left behind” towns and regions presents an enormous challenge. This is partly, of course, because of Brexit. Every credible analysis, including the government’s own, shows that the biggest negative effects of leaving the EU will be on the regions. The government’s own assessment saw the northeast hit hardest, followed by the West Midlands, Northern Ireland and the northwest.

It is also because the trends firmly point in the other direction. On Thursday EY, the accountancy giant, published its 2020 UK Attractiveness Survey. The survey has for more than two decades recorded inward investment, foreign direct investment (FDI) projects, and ranked this country against competitors.

There was good and bad news in the survey. As an EU member, the UK was successful in attracting FDI, both from the rest of Europe and the rest of the world. Lighter-touch regulations, particularly in the labour market, helped, as did the English language and other factors. For many firms, a UK location was an attractive proposition for accessing the EU single market.

The bad news in the survey is that, while inward investment has continued, the UK lost top spot in 2019, for the first time since 1997. And, to add insult to injury for those who have little time for the entente cordiale, it was lost to France. Our near neighbour had 1,197 projects, the UK 1,109.

The good news, for those looking to the future, is that this country appears to be establishing a new comparative advantage in digital technology. Last year the UK secured 30% of all European FDI in digital technology, with 432 projects, which was more than France and Germany combined. Since 2013, digital technology has accounted for the biggest number of UK inward investment projects.

This, as I say, is good news, and it is logical. Digital technology is much less reliant on single market membership, or existing patterns of trade. The UK suffers from a lack of competitiveness in many sectors, but not in digital technology, including areas like fintech, financial technology.

This success, however, highlights the challenge in levelling up the economy. For foreign investors, digital investment mainly means London. It is London, by and large, where there is a successful tech cluster, with the right people, infrastructure and business climate. It meant that last year, 69% of digital projects were in London, and most of the rest was in or close to the UK’s so-called core cities; Birmingham, Bristol, Cardiff, Edinburgh, Glasgow, Leeds, Liverpool, Manchester, Newcastle, Nottingham and Sheffield. Small-town Britain barely got a look-in.

It also meant that last year, 538 inward investment projects were in London, 48.5% of the total. Yes, almost half of all FDI projects were in the capital, and its rising share of the UK total suggests that it will not be long before London has more than half of the FDI projects coming into the UK.

As Mark Gregory, EY’s chief economist, notes, the UK has “has struggled to spread the benefits of FDI beyond the larger urban centres. There’s a similar and even more concerning trend in terms of digital tech investments with 83% of FDI located in the major cities and a further 10% in large towns. Digital rebalancing is a prerequisite for successful levelling up in the UK.”

The Centre for Towns collaborated with EY on the survey. Its director, Ian Warren, also expressed concern. “Whilst we welcome a small increase in FDI projects overall, we are still worried that investment is concentrating in London and our core cities, he said. “81% of foreign direct investment to the UK took place in our Core Cities or within 30km of one. Our coastal towns in particular have seen their levels of investment plummet over the last two decades, and in the last two years the number of FDI projects has halved in our university towns. “

In the heady days of the 1980s and 1990s, much of the FDI attracted to the UK was in manufacturing, and it contributed to regional revival. Nissan in Sunderland, Toyota in Burnaston in Derbyshire and Honda in Swindon were the most high-profile examples but there were plenty of others.

That has not come to an end. Honda is closing in Swindon, but troubled Nissan has spare capacity at its Sunderland plant as a result of cancelled models and is keeping it open for the time being, despite closing a plant in Barcelona. The Derbyshire economy is reeling from Rolls-Royce’s announcement of big job cuts.

Jaguar Land Rover, the mainstay of the West Midlands economy, and important for Merseyside, is looking for government help. The latest Make UK survey shows that a quarter of manufacturers plan redundancies over the next six months.

What will happen next? If early March represents a different time, 2019 is eons ago. FDI this year will be extremely depressed, as will business investment generally. Collapse might be a better way of describing it.

Have we learned anything during the crisis that offers hope? Working from home, and distance working in general, has proved itself. Many businesses have done things in 10 weeks what they were planning to do over 10 years. Could cheaper locations come into their own. When it comes to digital can you do in Stourbridge, South Shields or Stockton-on-Tees what at present you only think of dong in Shoreditch?

It would be nice to think, too, that the crisis has ushered in a new era for Wakefield, Wigan and West Bromwich. We have, however, to be realistic. Levelling up was always a huge challenge. Now it is even more of an uphill task

Sunday, May 24, 2020
Signs of life start to flicker in our lockdown economy
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.

When, a few days ago, Rishi Sunak warned of “a severe recession, the likes of which we have not seen”, the surprise was that nobody was surprised. He was also able to say it without facing criticism. Among the many changes brought about by this crisis, the old rule that chancellors should always be upbeat, even when standing on the burning deck, appears to have been shelved.

I could not help contrasting it with the fate of Alistair Darling, a month before the collapse of Lehman Brothers in 2008. The then chancellor, now Lord Darling, told an interviewer that the economic times were “arguably the worst they’ve been in 60 years” and the situation was going to “be more profound and long-lasting than people thought”.

He was pulled up for his comments, partly because there was a more economically aware prime minister in Downing Street – Gordon Brown had been chancellor for 10 years – and partly because there was at least some room for doubt about what would happen; the big bank failures were yet to happen.

This time, with both the official forecaster (the Office for Budget Responsibility) and the Bank of England setting out scenarios which envisage the deepest recession since the early 1700s, a chancellor who tried to pretend that the economy was just suffering from a little scratch would risk his credibility.

Jim Callaghan, Labour chancellor in the run-up to sterling’s 1967 devaluation, once described the deeply disconcerting feeling of seeing Britain’s currency reserves pouring away in a vain attempt to defend the pound. Sunak is experiencing the domestic equivalent; bucketloads of money flowing out of the Treasury to support the economy during the crisis and tax revenues only trickling, partly as an element of that support.

The fiscal consequences of the crisis are becoming clearer. Figures on Friday showed that the government borrowed £62bn last month, more than the £55bn officially predicted in March for the whole of 2020-21. Retail sales volumes slumped by 18% last month.

The monetary consequences are also pretty clear. For the first time in its 326-year history, the Bank of England is contemplating negative interest rates; charging commercial banks to keep their reserves at the Bank. We are in a world, it seems, in which even a 0.1% Bank rate is not low enough, even alongside an expected additional £100bn of quantitative easing (QE) next month. Already the government has sold some debt, gilt-edged securities, at a negative interest rate.

I think the Bank should hold off from crossing this particular rubicon. The economic effects of marginally negative interest rates would be tiny, at best, and there are other things the Bank can do first, including that extra QE.

Whether the Bank can hold off from negative rates depends of course, on how the economy does. There is some evidence from economists that, even in the absence of a lockdown, economies would have suffered a significant hit, as people adopted voluntary social distancing and businesses responded to customer and employee concerns.

The lockdown legitimised such concerns, however, and the government’s behavioural advisers, having thought that the most difficult thing would be to get people to abide by the lockdown, now finds it is harder to get them out of it.

In some ways that is not surprising. Behind Sunak’s candour on the economy, you can sense a Treasury frustration about the lockdown and its economic effects. The furlough scheme, which was put together impressively quickly, was more widely adopted than expected; giving some employers the easier option of shutdown when they could have continued operating but under more difficult conditions. It has also made lockdown more comfortable for many people than they might have thought possible.

The question now is for how many people the furlough or job retention scheme has been a bridge back to normality, as was intended, and for how many an expensive way – for taxpayers – of smoothing the path to unemployment. We will know part of her answer to that at the end of July, when the full 80% scheme ends, and the full answer in late October, when partial support coms to an end. The furlough scheme was the right thing to do, though should perhaps have allowed employees to continue part-time, but may have contributed to a more complete lockdown than would otherwise have been the case.

There is a glimmer of light in the latest survey evidence. It has always been the case, as noted here, that last month was likely to represent the low point, the nadir, of the UK and global lockdown recession. This was when most of Europe and America were locked down for a full month. The easing this month could be expected to lift us off the bottom, if only marginally.

Sure enough, this is borne out by the latest purchasing managers’ surveys, which measure business-to-business activity. For the UK, the “flash” purchasing managers’ index (PMI) for services and manufacturing, which slumped to 13.8 last month, bounced back to 28.9 this month. It does not mean everything is hunky dory, far from it. Levels below 50 on the index are consistent with falling gross domestic product. But the rate of decline has eased and can be expected to ease further.

There is a similar picture in the eurozone, where the flash PMI has recovered to 30.5 this month, from 13.6 last month. These are stirrings, and they are not uniformly felt, but they could be quite important ones.

The Bank has been monitoring a series of real-time indicators, as has the Office for National Statistics (ONS). Some of the Bank’s indicators remain flat, but motor vehicle traffic has turned up, as have Google searches for cars.

The ONS found that of the businesses trading in its latest two-week period, 6% had started trading again in that period, including nearly a fifth in accommodation and food services. It also found that ship arrivals at UK ports, which had fallen sharply to mid-April, have steadied, and averaged 283 a day in the week to May 17.

I am also impressed with data from Quartix, a leading supplier of vehicle tracking systems, software and services, which looks at commercial traffic mileage by sector and compares the early-lockdown period – the week beginning March 30 – with the middle of this month. Every sector has seen a recovery though only one, mining and quarrying, is back above pre-lockdown levels. Most are down on normal, but by less than they were, notably construction, down half of what it was. Manufacturing is also a lot better than before, according to vehicle usage for the sector.

These are straws in the wind, some more significant than others, but they are important. They show that, even as many lockdown measures remained in place this month, there were signs of recovery.

There is, plainly, a long way to go, and the economy remains significantly below normal. But these are modest signs of revival. Sunak will be hoping his next pronouncement will be an economy gradually recovering from a profound shock

Sunday, May 17, 2020
There's no need for tax rises now, and maybe not later
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.

In a moment I shall have something even more interesting to say on the economics of this pandemic, but first let me deal with the great lumbering elephant in the room. This is the extent of the government’s support for the economy during the crisis – including Rishi Sunak’s extension of the furloughing scheme last week – and how we will pay for it.

It is a question I get asked a lot. How much will taxes have to go up to pay for this and, whether Boris Johnson uses the A-word or not, will it mean a new round of austerity, or the cancellation of previously announced “levelling up” infrastructure spending?

That there is a lot more money sloshing around is not in doubt, though it is important to distinguish between different kinds of government supports. Some of the most eye-catching numbers, for example, the £330bn of loan guarantees announced a few weeks ago, are contingent liabilities.

That there has been actual spending is not in doubt. The Office for Budget Responsibility, the fiscal watchdog, updated its estimates on Thursday. It now thinks that the policy response to the crisis will cost £123billion this year, of which the bulk, £118bn, is extra spending.

It estimates that the addition to borrowing will be more than that. Its new estimate for the budget deficit this year, public sector net borrowing, is £298bn, up from £273bn in its first coronavirus scenario in April. That is roughly 15% of gross domestic product and compares with a March forecast, prepared before the extent of the coronavirus crisis and lockdown were clear, of just under £55bn. £298bn is almost double the maximum annual deficit, in cash terms, in the financial crisis.

The increase in borrowing goes beyond the direct effect of government measures because of the recession’s impact on tax revenues and the effect of significantly higher unemployment on the welfare bill.

It is a very big fiscal hole. What should the chancellor do about it? This year’s deficit has to be regarded as a sunk cost, an emergency increase in borrowing, for entirely understandable reasons, that cannot and should not be recovered.

That still leaves the question of what happens beyond this year. How quickly does the deficit come back down again, or has this crisis opened up a permanently much larger gap between government spending and tax revenues? And, as well as this, do the fiscal rules still matter, or has this crisis provided a cast-iron excuse for abandoning them? Before he was diverted on to other things, the chancellor said he would review the rules in his autumn budget.

Nobody sane would suggest that tax rises are the right thing to do when the economy is emerging from its deepest recession in modern times, so in the short term, talk of higher taxes should be safely put one side.

The question is what happens later, say after two or three years, and here the latest projections from the National Institute of Economic and Social Research (Niesr) provide a useful way of thinking about it.

The Niesr projections suggested that there will be a longer-term impact on the public finances from this crisis. So, in 2-23-24 and 2024-25, government debt is more the 90% of GDP – the permanent addition from around 80% as a result of this crisis, and the budget deficit is about 3% of GDP, higher than it has been recently; in 2018-19 it was less than 2%

Most importantly, in terms of the existing fiscal rules, the current budget deficit, excluding public investment, settles at about £20bn a year. The government is committed to borrowing only to invest, in other words balancing the current budget. This £20bn, rather than £300bn or even £500bn, provides a guide to the kind of extra revenues the government might want to raise in the medium term. It is a lot of money but in fiscal terms a drop in the ocean. We should not worry unduly about big tax rises to come.

Nor should we worry that this crisis will mean that the government’s infrastructure programme will have to be scrapped. The rules specifically allow investment spending, up to 3% of GDP and, as long as the government can borrow, this should not be threatened.

Whether it can continue to do so depends, at least in part, on the length of this lockdown-induced recession. Last week I bemoaned the fact that, while scientists have been greatly involved in the decision-making process around the coronavirus, economists have not.

Today I can offer the best of both worlds, an economist, Professor David Miles, a former member of the Bank of England’s monetary policy committee, working with an Oxford scientist, Oscar Dimdore-Miles, who happens to be his son. Their joint paper, “Assessing the spread of the novel coronavirus in the absence of mass testing”, is published in a new Covid Economics collection from the Centre for Economic Policy Research.

Their paper addresses a key problem in assessing the spread of the virus. There have not been enough tests, and there may not be for some time. In the absence of such testing, however, there is another way, which is to use a so-called SIR model (susceptible-infected-recovered), coupled with actual data on cases, and the fact that many people will the virus will be asymptomatic, to try to work out the spread.

Without wanting to blind you, or myself, with science, the paper suggests that many more people have been infected, perhaps 200 times more than we know about, in Britain and in other countries (the model was also tested on the data for America, Italy, Spain and Sweden).

It raises the fascinating possibility that at the end of April, 60% of the population may have been infected, the overwhelming majority of them asymptomatically, compared with an official estimate of well under 1%. This is entirely separate, by the way, from earlier research by Oxford epidemiologists.

And, when we look at the UK’s success in flattening the infection curve, the paper offers a choice. It could as a result of the lockdown, as the government would claim, but it could also be, as the authors say, “that the infection has spread so far that new infections naturally slow down”. In their study, as they point out, “in all of the countries whose data we analysed, the best fit to that data favours the second explanation”.

They are careful not to overstate it and admit that we are dealing with “a fog of considerable uncertainty”. But their work says that the evidence supports a further easing of lockdown restrictions and that this can occur alongside a continuing fall in the number of new cases.

If that occurs it will come as a relief to the chancellor. The extension of his unprecedented (in the UK job retention scheme – fully to the end of July and then in partnership with employers until October 31 – is consistent with most sectors of the economy getting back to normality over the summer, with a further recovery in activity by the autumn. If the science and the economics can agree on that, it will be a very good thing.

Sunday, May 10, 2020
Wartime lessons on deficits, debt and the role of the state
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.

On Friday we marked 75 years since VE Day, and the end of the Second World War in Europe. Will we still be talking about this coronavirus crisis in 75 years’ time? Whether it becomes one of the great pandemics, in terms of the global death toll, remains to be seen, but if its economic effect is anything like the 14% fall in gross domestic product (GDP) this year sketched out by the Bank of England on Thursday, we will remember it for a very long time.

It could be, of course, that we are moving into an era in which very dramatic swings in GDP become the norm, as they were in the agricultural era, when harvests were all-important, though there is no good reason to think that. Normal service, in which annual changes in GDP are measured in low single-figure percentages, should be resumed in a year or so.

The Bank’s scenario, which according to its own database would represent the biggest fall in GDP since 1706 has had us scratching our heads. When the Office for Budget Responsibility (OBR) suggested a drop of just under 13% this year, the biggest since 1709, the year of the Great Frost, that was easy. But in 1706, the Act of Union (England and Scotland) was signed and there was the War of the Spanish Succession, but no obvious economic hit.

I shall leave that one for now but will return to the Bank later. However, as suggested by this weekend’s VE Day anniversary, it is another piece of history I wanted to draw on today. Now I know you are all pretty fed up of wartime analogies about the coronavirus crisis. And, to paraphrase a well-known political putdown, I didn’t know Winston Churchill and Boris Johnson is no Winston Churchill. There isn’t an obvious John Maynard Keynes around at the moment either.

But for somebody who grew up on Sunday afternoon black and white war films, the myth and reality of the Dambusters’ raids and had family members directly involved in some of the war’s great episodes, the Second World War has always been fascinating. And it is also fascinating that we are still finding out new things about it.

A new book from VoXEU.org and the Centre for Economic Policy Research, The Economics of the Second World War: Seventy Five Years On, edited by Stephen Broadberry and Mark Harrison, provides fresh insights. There is a lot in it but, in the context of the current crisis, I wanted to highlight just a few points.

At a time when we are seeing the economy transformed, if only temporarily, the much bigger transformation in the 1939-45 period is worth dwelling on. As the chapter by Broadberry points out, the UK went from being a small-state economy in the pre-war period, with public spending accounting for roughly 15% of GDP, to a large-state economy, with government spending around 50% of GDP, as the war effort was cranked up.

Some of hat increase was funded by taxation, including an excess profits tax, a device that was also employed during WW1. Mostly, the government borrowed, mainly domestic long-term debt, which covered two-thirds of the debt, including patriotic savers, but also short-term borrowing and an expansion of the money supply. The country was also, of course, left with external debts at the end of the war, mainly to America and Canada. These debts were not fully paid off until 2006, more than 60 years after the war’s end.

The economy grew strongly in WW2, by 27% or nearly 5% a year, Broadberry points out, though within that, consumer spending dropped from a pre-war GDP share of 78.8%, to just 51.9% in 1943, a drop of more than a third in its share of GDP. Then as now, if now only temporarily, consumers were limited in what they could spend. The war effort was extraordinary. In another chapter, David Edgerton notes that the UK outproduced Germany in the war years in production of planes, warships and tanks.

What lessons can we draw from that period? There are three, I think. One is that, when governments do exceptional things, and the current economic intervention is exceptional, they have to know when to let go, to have an exit strategy. At the end of WW2, letting go proved to be hard for policymakers to do, even if they wanted to. Rationing remained in place until the summer of 1954.

A larger role for the state was also accepted. The private sector had not covered itself in glory in the 1930s and a state-run economy had won the war. So, as Broadberry puts it: “Britain may have learned the lessons of the war economy too well, with the state too ready to accept restrictions on the operation of market forces, with adverse effects on Britain’s post-war productivity performance.”

Second, the Treasury is worried about the debt consequences of the current crisis, but set against the situation at the end of the war, things would have to go very badly wrong to come close to that. The Office for Budget Responsibility looked at this recently. At the end of WW2 government debt was 270% of GDP but it then fell sharply, so that by the late 1970s it was below 50% of GDP.

Some of that fall reflected the demobilisation of the economy in the immediate aftermath of the war, reducing the number of people in the armed forces, and so on. There was also post-war austerity, albeit alongside a huge nationalisation programme. Mostly it reflected what is known as financial repression. The government was able to issue debt, gilt-edged securities, at interest rates below the rate of inflation. Exchange controls and limits on bank lending forced financial institutions to buy and hold government debt, even when the returns were negative in real terms. The effect was striking. In the 30 years after WW2 the economy expanded by more than 1,200% in cash terms. The cash value of government debt, in contrast, grew by only 137%, so it fell sharply relative to GDP. The interest on government debt is below inflation again now but there are plenty of other factors pushing the debt higher.

There is a third lesson to be drawn from the war. Economists were instrumental in the war effort. Some of the greatest names in economics were closely involved in developing the data, policies and planning framework that contributed significantly to victory. They included not just Keynes, but James Meade and Richard Stone, and economists like Wassily Leontief in America.

Economists have not been much involved in the decisions made during the current crisis, during which the government has insisted it is guided by the science, not the economics. Maybe, given the scale of the economic damage now unfolding, they should have been.

Sunday, May 03, 2020
We'll have a different economy - but will it be a better one?
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.

The extent of the economic shock from the coronavirus crisis and government-imposed lockdowns is becoming clearer by the day. China led the way in reporting a slump in gross domestic product in the first quarter and now other countries are following suit. These are just the appetisers, if that is the right word, ahead of much bigger falls in economic activity in the current April-June quarter.

America’s 4.8% annualised drop in gross domestic production the first quarter (1.2% in the way we would measure it) was milder than France’s 5.8% fall (in the way we do measure it), Italy’s 4.7% drop and the eurozone’s 3.8% fall. We will have to wait until May 13 for the first quarter GDP figures for the UK, though the eurozone’s record quarterly drop provides a pointer.

Today, I wanted to deal with a couple of things. The first is a question I get asked a lot, which is why a temporary lockdown in the economy, lasting a matter of weeks or months, has such a devastating impact on the economy, the effects of which will last for years. After all, the economy goes into something like a lockdown every year for a couple of weeks over Christmas and New Year.

The second question is whether we can improve on the dull post-crisis outlook envisaged by economists, in which the loss of output during this recession is never fully made up and productivity continues on its weak, pre-virus path. Could the forced changes in the economy lead to the “creative destruction” that gives us a better balanced and more productive economy?

The economic effects of the lockdown will have been at their most intense last month, April, with gradual easings mainly happening this month in Europe, as well as a modest private sector easing, including housebuilding sites and some DIY chains, in Britain. That will not prevent huge second quarter GDP declines, of which the Office for Budget Responsibility’s 35% drop provided a template.

Even if this is followed, as is likely, by some spectacular quarterly and annual gains in GDP – imagine the percentage growth between a Q2 2020 economy severely limited by lockdown and a much less affected Q2 2021 – the impact will linger. This is because, thanks to this year’s slump, which takes a big chunk out of GDP, any future gains will be from a much lower base.

The National Institute of Economic and Social Research set this out well in its latest quarterly review, which has just been published. It predicts a smaller annual fall in GDP than the OBR’s coronavirus scenario, 7.2% rather than 12.8%, and a GDP recovery from the third quarter onwards, which delivers 6.8% growth next year. But the economy does not get back to its level at the end of last year until late 2021, implying that the coronavirus has cost two years of growth. Even by 2024 the economy is nearly £60bn smaller than was expected before the crisis hit.

Some people have looked longingly towards the idea of a “roaring twenties” for the UK economy as we come out of the crisis. But the 1920s, which we associate with the flappers and the jazz and radio ages in America, did not roar much for Britain, as another article in the institute’s review points out. After the slump at the start of the decade, we had Winston Churchill’s blundering return to the Gold Standard in 1925 and the General Strike of 1926.

If not necessarily roaring, the economy will certainly change. CIL, the consultants, carried out a consumer pulse survey among more than 2,000 people in the last week of April. They found that the things that people were looking forward to least after the lockdown that they cannot do now was going to restaurants, cafes, cinemas, entertainment and non-essential shopping. Apart form seeing family and friends, going to the gym, playing sport, and haircuts were the top priorities.

These may be temporary effects, but it feels as if something significant is happening, and social distancing is likely to be with us for a long time. The economy and employment have been supported in recent years by the strength of consumer services; the rise of the coffee shop, eating out and experiences. Retail employment has been falling for some time, and will take a further hit as a result of the high street casualties of this crisis, the list of which is growing.

Other things that we have come to regard as normal, like low-cost and convenient air travel, will look very different in future. British Airways is cutting 12,000 jobs and pondering its future at Gatwick for a reason. It will work both ways for the tourism sector. More British people will take staycations but the number of overseas visitors will decline. You would not want to be in the airline or travel industries.

All this could be balanced, to an extent, by “reshoring” of some manufacturing activities, made necessary by a reduction in airline traffic and the weaknesses of global supply chains and just-in-time manufacturing processes exposed by the crisis. Manufacturing is currently in a state of deep gloom, as a survey by Make UK on Friday pointed out. It described the sector in a state of “freefall”, with a likely drop in output in the second quarter of more than the 55% the OBR suggested for the sector in its scenario. It is hard to think of post-crisis revival when the numbers are so grim.

These are very early days. A decade ago, some people not only looked for a demonstration of the “trampoline” theory of recovery; the bigger the drop, the more convincing and sustained the bounce. They also looked for the “creative destruction” memorably described by the great economist Joseph Schumpeter, in which economies reboot for the better, as the weak and uncompetitive are driven out.

Neither happened. The trampoline lacked enough spring, and too many zombie firms survived the crisis. Will it be different this time? It might be. Consumer services have given the UK economy record levels of employment but alongside stagnant productivity. The rebalancing that may be forced on the economy in the post-crisis period may be associated with stronger productivity growth but persistently higher unemployment. A few months ago the unemployment rate was just 3.8%, its lowest since 1974. It could be a very long time before we see the likes of that again. The economy will be different. We have to hope that, in changing, it will be better.

Sunday, April 26, 2020
Lockdowns are different, and getting out of them is the hard part
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 pandemic which originated in the Far East is sweeping across the country, leading to many thousands of deaths and putting the National Health Service under intense pressure. Aspects of normal life are significantly interrupted. The fear among experts is of a second wave even deadlier than the first.

I am not, for once, talking about the current coronavirus pandemic, which I shall come on to shortly, but about an earlier one, employing the technique used by the very good Radio 4 programme The Long View. This is the pandemic that affected Britain half a century ago, Hong Kong flu, and I have become a little obsessed with it.

Hong Kong flu hit Britain in two waves, the winters of 1968-9 and 1969-70. It caused some 80,000 deaths in those two waves, according to estimates in the government’s recent coronavirus action plan, out of what the World Health Organisation says was up to four million deaths worldwide.

It did have an impact. Nicholas Timmins, chronicler of the welfare state in his excellent book The Five Giants, recalls some of that impact on the website of the King’s Fund, the health think tank.

“For a briefish period, everything stopped for tea, so to speak, “ he writes. “There was no email in those days, and much of the post stopped being delivered, or was very late. The milk – almost all of it delivered to the door in glass bottles – stopped arriving. Trains and buses ran to heavily reduced timetables: not because of the sorts of decisions being taken now, but because drivers had the flu. Clinical staff, of course, also caught it, and for a period the NHS was overwhelmed.”

Hong Kong flu was serious. Ed Conway, Sky’s economics editor, who has been diligently tracking death tolls from the coronavirus in Britain and elsewhere, a few days ago highlighted a new dataset from the Office for National Statistics, providing weekly death tolls from the beginning of 1970.

The biggest weekly death toll in the period, bigger than has been experienced so far in this coronavirus crisis, was in the first week of 1970, with the second week not too far behind. This was during the deadlier second wave of the Hong Kong flu pandemic, when more deaths occurred than during the first.

I too lived through the Hong Kong flu pandemic and have written about the economics of the period extensively in books. One striking thing, however, in comparison with what we are currently going through, is that a public health emergency did not also become an economic emergency. Unless we all missed it, the government did not even contemplate a lockdown. Sporting fixtures, with spectators crowded onto terraces, continued.

The economic preoccupations in the 1968-70 period were the aftermath of the November 1967 devaluation of sterling - an economically necessary humiliation for Harold Wilson’s Labour government – and that government’s battles with the unions, which included Barbara Castle’s In Place of Strife proposals to limit their power.

The economy grew by a strong 5.5% in 1968, boosted by devaluation, slowed to 1.9% in 1969 as the government imposed post-devaluation austerity measures, but picked up to 2.7% in 1970. Growth over the three-year period exceeded its long-run average.

In his King’s Fund piece. Timmins rightly draws the contrast between flu and Covid19, which appears to be both more transmissible and result in a higher proportion of severe respiratory problems.

It is nevertheless worth asking the question about the response we have seen, and how lockdowns became the international norm, in a way we have not seen before.

Even a decade or so ago, in 2009, when Simon Wren-Lewis and Marcus Keogh-Brown wrote their paper, ‘The possible macroeconomic impact on the UK of an influenza pandemic’, they saw the main negative impact on the economy through the impact of school closures, though also through a reduction in “social consumption”, pubs, restaurants, hairdressers and so on, as people sought to reduce social interaction to minimise their chances of catching it.

That same year, 2009, when the swine flu pandemic hit, there was no question of a lockdown, though there was a rush to spend a lot of money acquiring doses of vaccine.

When China introduced its lockdown in Wuhan province in January, it initially seemed like something that only an authoritarian regime could do. Even when the lockdowns spread, including to countries like Italy, there was an element of “it could never happen here”.

But it has. Covid19 is not flu and perhaps for this reason earlier pandemics do not provide much of a template. But, while Hong Kong flu barely registered as an economic event, this one clearly has, with a bigger recession this year than during the global financial crisis, and possible since 2009. A new forecast from the EY Item Club, using the Treasury’s model of the economy, says that the economy will not get back to 2019 levels of gross domestic product until 2023.

The purchasing managers’ survey and the CBI’s industrial trends showed an economy pounded by the coronavirus lockdown. The Treasury and the Debt Management Office revealed the mountain of government borrowing that will be required to deal with the crisis, with £382bn of gilt issuance over the next 12 months, £225bn of it over the April-July period. The longer the lockdown persists, the more that mountain will grow.

The government, while its response to the crisis was slow and uneven, and lacked focused leadership, lurched from complacency to lockdown. It ended up in the same place as other countries, and this is not to criticise ministers for eventually putting public health first, almost whatever the cost.

Its approach, however, may have had unintended consequences. The lurch into lockdown successfully put the fear of God into people, as do the daily news reports from intensive care units. But it also went further than intended. Some of the businesses which have announced that they will be recommencing operations next month, such as DIY chains and building sites for new houses, were never required to close under government guidance and rules.

The Treasury’s coronavirus schemes have so far had a decidedly mixed record, particularly the business interruption loans, but some aspects of them, such as the job retention scheme which provided 80% of normal pay for furloughed staff, may have encouraged a bigger shutdown than would have occurred, while rightly trying to save as many jobs as possible.

There is also tentative evidence that the peak in deaths and new infections, which appears to have happened around April 8, came before the effects of the lockdown, and reflected the voluntary social distancing that happened before it.

The trouble with lockdowns, as we will see, is that though it is a huge step for any government to impose them, it is even harder to get out of them. The only thing that has changed so far is that the fear of the NHS being overwhelmed in this wave has diminished. It is why the task of weaning the country off it will be a delicate one.

There are plenty of good ideas around, some of which are being studied in Whitehall, such as the “traffic light” system proposed by the economists Gerard Lyons and Paul Ormerod. In the “red” phase starting next month, small and local shops would re-open, while maintaining safe social distancing, while schools would be allowed to open, at their discretion, for pupils at a vital stage f their education, for example Year 10 and 12. The amber phase would see all schools reopen and unlimited private car journeys, but masks required on public transport. The green phase, which they say could be as early as mid-June, would see a return to normal
.
It is a plan, though the timetable looks very ambitious, particularly in the light of the chief medical officer’s observation that significant social distancing measures will have to remain in place all year, and the government’s reluctance to go against scientific advice. We have never seen anything like this lockdown, or its economic effects, before. We may have to live with it for a time yet.

Sunday, April 19, 2020
How to avoid the scars from a deep and nasty recession
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.

Anybody who was shocked by the scenario drawn up by the Independent Office for Budget Responsibility (OBR) a few days ago, the one that suggested that Britain’s economy could shrink by a massive 35% in the second quarter of the year, should perhaps not have been.

Huge though the OBR’s numbers were, which included a rise to 3.4m in the level of unemployment and a budget deficit of £273bn, or 14% of gross domestic product, this year, they were the natural consequence of something I described here exactly a fortnight ago.

My piece then, “Despatches from an economy at two-thirds of normal”, informed by some ingenious work the Centre for Economics and Business Research (CEBR) had carried out on my behalf, likewise had an economy down by more than 30% as a result of the lockdown.

I want to talk about some of the longer-term effects of this medical recession, known in the jargon as scarring. But let me first share some dirty little secrets of these assessments, scenarios and forecasts.

The main reason why the OBR came up with such a big second quarter drop in GDP – 35% is 10 percentage points above the biggest private sector assessment I was aware of - is that it assumes the lockdown announced on March 23 lasts for a full three months. That takes in all but a week of the second quarter, with a gradual lifting over the following three months.

Other economists have assumed shorter lockdowns, which may or may not a correct assumption, and have also built in quite a sharp drop in first quarter GDP because parts of the economy were already shutting down before the formal lockdown. Their second quarter falls thus start from a lower base.

A second thing worth saying, or in my case reiterating, is that it is perfectly possible, indeed likely, that the statistics will show a very sharp bounce in activity, as lockdown measures ease. Suppose, to take an example, the economy goes from 65% of normal in the second quarter to something approaching 85% in the third, it does not mean that things are back to normal. It does mean you get the kind of numbers the OBR has in its scenario, a 27% rise in GDP in the third quarter, and a further 21% in the fourth, as the lockdown lifts entirely (its assumption), and GDP returns to its pre-crisis path.

You may ask, if this is so temporary, concentrated in the current quarter, why the OBR also has GDP for 2020 as a whole falling by 12.8% this year. This is one time when I can say this would be biggest fall in living memory. It is three times the drop in GDP in 2009, when the global financial crisis gave use the worst year in the post-war era. Nothing like it has been seen since the Great Frost of 1709.

The answer is that we measure growth, not from the beginning of the year to the end but comparing this calendar year with the previous one. The big loss of GDP in the second quarter, and a smaller on in the third, is enough to give this very dramatic result.

Though it was not intended that way, the 35% figure is quite useful to Rishi Sunak, the chancellor, in the internal government debate about the length of the lockdown. It describes starkly the extent of the economic hit, some of which – more than £40bn over three months according to the OBR – is being funded by the furlough scheme for employees.

Further food for thought, and potential ammunition for the Treasury, is provided by the Resolution Foundation, a think tank, in a new report “Doing whatever it takes”. Its estimates are slightly different from the OBR scenario but say that a three-month lockdown would lead to a still very hefty 10% drop in GDP this year, while six months would see the economy down by 20%. A 12-month lockdown, some of which would spill over into 2021, would see the economy contract by 24% this year. For perspective, that would wipe out nearly two decades of growth, taking GDP back to where it was in the early 2000s.

The longer the lockdown, the longer it takes to get back to normal. A 12-month lockdown would result in a permanent loss of GDP of 7%, and it would take five years to get back to where we started. It would also see unemployment reaching 7m, or 21% of the workforce, next year.

The longer the lockdown, too, the bigger the scars from this episode. What economists call “scarring” is, apart from the sheer scale of the downturns that we are seeing at present, the key issue.

What is scarring? Scarring after the recessions of the recessions of the early 1980s and early 1990s was mainly in the form of prolonged high unemployment. Scarring after the global financial crisis showed itself in prolonged productivity stagnation. Austerity, many would argue, also produced its own significant scarring effects.

And this time? The OBR says it has not attempted to quantify any scarring effects, though notes that the government’s measures to support businesses and individuals are intended to minimise them. There is a kind of scarring in its scenario, however, in that unemployment remains significantly above pre-virus levels this year, next year and beyond. Its scenario also has government debt in five years’ time 10% of GDP, or well over £200bn, above its pre-virus forecasts.

How much scarring will there be? It is the big question, and it is also one of the most difficult to answer. In an ideal world every worker furloughed under the government’s job retention scheme will back to normal when the lockdown eases and every viable business, big and small, will survive this crisis. In the real world, things might be different. There will be changes in the way people and businesses behave, some of them for the better, some for the worst.

The Resolution Foundation is relatively optimistic, because of the government’s anti-scarring measures, as long as the lockdown is relatively short-lived. Severe though it is, this is not like the recession of the early 1980s, which resulted in a restructuring of the economy away from manufacturing, or the early 1990s, when the housing market hangover lasted many years. Damaging long-lasting impacts should be less of a danger if the lockdown only lasts a few months.

There is room for debate on this. Capital Economics says that the economy will struggle to get back to full health and be 5% below where it would have been without the virus by the end of 2022.

There are many moving parts, many imponderables. We do not know how long this lockdown will be, or whether it will be followed by a second if the infection rate heads higher. We cannot know with any certainty what the behavioural effects of all this will be. The aim is to avoid permanent scarring from this unprecedented recession. We can only hope it is successful.

Sunday, April 12, 2020
Even as we dive into recession, some worry about the return of inflation
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.

At this time, indeed at all times, I am conscious of not wanting to add to the mood of concern, to put new bricks in the wall of worry. But it would be remiss of me not to address something that some people are worried about, which is that this modern great plague that we are seeing will be followed by a great inflation.

I say worried. Some would say that for governments racking up a lot of additional debt in their efforts to fight the coronavirus and trying to limit its economic impact, higher inflation would be no bad thing. It was part of what became known as financial repression is the period after the Second World War, when inflation reduced the real value of debt and governments were able to borrow at negative real interest rates.

For most people, however, inflation is unwelcome, particularly when the outlook is for wage growth, in cash terms, to remain subdued, and for official interest rates, and those most savers can expect, to stay close to zero.

Should we be worried about inflation? There was a flurry of concern on Thursday when the Bank of England and the Treasury announced, in effect, that the Bank was increasing the government’s overdraft facility. The Ways and Means facility, normally around £400m, will be increased, as during the financial crisis, when it reached £19.9bn.

When people and businesses have to increase their overdraft facilities it usually shows that they are in trouble. The government is not in financial trouble, but it does need cash to finance the crisis measures it has announced, smoothing the amount it can raise by selling gilts (UK government bonds).

That is how the announcement should be seen, rather than the so-called monetary financing – the Bank directly funding government spending – that the new governor, Andrew Bailey, has publicly set his face against. When the Bank creates money, as it is doing by expanding its QE (quantitative easing) programme by £200bn, and purchasing gilts, it is ensuring that it is doing so via the market. The government, via the Debt Management Office, issues gilts into the market. The Bank buys gilts, not necessarily the same ones, from the market. People may think this is convoluted, but it keeps things honest.

Despite this, some fear that the combination of ultra-low interest rates and other central bank measures, including QE, together with an explosion in budget deficits, is sending a big inflation warning signal.

Tim Congdon, once economics correspondent of The Times, then a much-followed City economist, now chairman of the Institute if International Monetary Research (IIMR) at the University of Buckingham, has had a commendably consistent view since the 1970s, when he helped shift economic policy towards monetarism.
He believes that the key to the outlook for inflation is the growth of the broad money supply, M4 I the UK, and one follows the other as sure as night follows day.
As he put in an IIMR note a few days ago, referring to the new governor: “Bailey needs to be told – like his predecessors – that the rate of increase in the UK price level depends on the rate of increase in the quantity of money relative to the rate of increase in the quantity of goods and services.”

Congdon’s particular worry at the moment is America where, he says, as a result of the exceptional measures being taken, this year may see the biggest increase in the broadly-defined quantity of money in peacetime. He does not blame the authorities for taking exceptional action, because they could not obstruct governments wanting to save lives. But: “The policy response to the coronavirus pandemic will be followed by an inflationary boom.”

In Britain, meanwhile, he foresees an inflation rate “closer to 10% than we have seen for many years”. The many years thing is correct; on the current measure of consumer price inflation, inflation has not been in double figures for more than three decades.

He is not the only one to be concerned about monetary trends. David Owen, an economist with Jefferies International, the investment bank, expects UK broad money growth to be 10% or more by the end of the year.

Michael Howell, who runs CrossBorder Capital, a consultancy, warns of “an inflation tsunami”. As he puts it: “The huge monetization of deficits planned by Central Banks, culminating in a one-third jump in the size of their balance sheets, could lead to 15-20% monetary growth in 2020. With velocity already depressed and real GDP growth slow, this surely must lead to faster inflation of circa 5-10% in the US from 2021. Bonds beware.”

How worried should we be about moving into an era of high inflation or what Congdon describes, more benignly, as a one-off shock to the price level – higher prices – as coronavirus measures wash through the system? He is right to say that broad money growth, and concerns about inflation, are secondary at present.
Is inflation on the way? Many will remember high-profile warnings about inflation in 2008-9, when central banks launched their QE programmes. And, while inflation in Britain rose to more than 5% in 2011, some of that was due to George Osborne’s hike in VAT from 17.5% to 20%. Inflation soon subsided.

The money created by central banks then replaced that destroyed by the crisis and the damage to the financial system but did not result in exceptional money supply growth. The annual growth in M4 has averaged 3.9% over the past 10 years and is only a little above that now.

This time may be different, in that after the crisis banks were being encouraged to rebuild capital, while they are now being encouraged to lend. But there are other forces that will bear down on inflation. UK inflation is currently below the 2% official target and set to fall further when new figures are released in 10 days’ time. The short-term drivers of inflation, including the oil price, and thus the price of petrol, which nobody is much buying, are sharply down.

Five years ago, in 2015, consumer price inflation averaged zero, its lowest since the early 1960s, and there were some months in which the annual rate was negative; statistical deflation. It will not be entirely surprising, with the lockdown enforcing a sharp drop in demand, if we see a repeat of that in coming months.
Beyond that, it depends. In both Britain and America we are seeing a sharp rise in unemployment; probably towards 10% in Britain and towards Great Depression levels in America. It would be a super-stagflation indeed if, alongside that, we were to see the rapid emergence of high inflation.

Beyond that, and beyond the immediate crisis and the return to some kind of normality, however, there is a debate to be had. Part of it arises from crisis measures, and the big boost to money supply growth they threaten. But it could also arise from the combination of a rapid, post-crisis rebound in the economy, alongside supply shortages as international borders only gradually open. We do not need to worry about inflation for some time. We may have to worry eventually.

Sunday, April 05, 2020
Despatches from an economy operatng at two-thirds of normal
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.

It is a big and difficult question. How much is the economy being shut down by the lockdown? Is very little happening, as it can easily seem, or is quite a lot of activity happening alongside social distancing and a huge increase in the number of people working from home? How much below normal are we?

And, as importantly, which I shall come on to, is it possible to increase the amount of economic activity that is taking place? Let me be clear, I am not about to join the ranks of the irresponsible, and advocate that we ignore the virus and carry on as normal for the sake of the economy. But there may be room for a bit of nuance in this debate, to gradually bring on stream some activities that have been suspended as a result of the government’s measures.

Let me start with the first question. How much below normal is the economy operating at? It is a question where the usual visual aids do not work. If you looked at the station car park not far from my home, you would conclude that normal activity has slumped by 90%, with just a handful of cars where it is normally packed out.

There are, of course, good reasons for that, as there are for the slump in all forms of transport in recent weeks. So I am indebted to the economists at the Centre for Economics and Business Research (CEBR) for an innovative attempt to estimate just how much is being lost at present.

Gradually in coming weeks more statistical information will emerge, though it will be harder for the Office for National Statistics (ONS) and others to collect the normal run of data as a result of shutdown measures. We know the second quarter of the year, which has just started, will be awful for the economy, but it will be a while before we know just how awful.

The CEBR’s approach, carried out by economists Daryn Park and Owen Good, was to look at the nearly 100 detailed sectors of the economy, on the basis of the standard industrial classification, and assign each a score. For some, economic activity was continuing as normal, with most employees still in work. For many others, most workers had been sent home and were still working, and were reckoned to be "producing" at 90% of normal. A final category was where workers had been sent home and, by nature of their job, were not producing anything.

After looking at whether the sectors could produce, they then did a separate analysis of whether at present there was likely to be any demand for the sector’s products. Their final estimate of the sector’s lost output took both production constraints and the likely change demand into account.

The results showed sharp differences in the scope for different sectors of the economy to carry on at anything like normal. Most sectors are on track to lose a significant proportion of normal output, though a small number; healthcare, pharmaceuticals and food retail, will do more than usual.

The broad results, taking aggregated sectors of the economy, are that during the lockdown the percentage of output lost will be 14% in agriculture, 60% in mining and quarrying, 69% in manufacturing, 10% in electricity and gas supply, zero in water and sewerage, 50% in construction, 58% in wholesale and retail, 39% in transport, 79% in accommodation and food services, 7% in information and communication, 18% in finance and insurance, 20% in real estate, 10% in professional and scientific activities, 46% in education and 81% in arts, entertainment and education.

Adding all these up, and weighting by sector, produces the result that the economy is currently suffering a loss of output of 31%, and is thus operating at 69% of normal levels. That does not mean we will see a 31% drop in gross domestic product in the current quarter – most forecasts are for around half that – because some of the weakness had already set in during March. But it gives a good idea of the kind of economy we have now.

Though the streets are quiet and most people are staying at home – National Express will suspend all its coach services from midnight tonight – something is still happening. But that something is well below normal, to an extent that none of us have seen before. Even in the three-day week in the early weeks of 1974, the economy did not operate this far below normal.

Interestingly, the CEBR results are similar to those produced by INSEE, France’s national institute for statistics and economic studies, which estimates that its economy is operating at 65% of normal because of coronavirus lockdowns.

That something highly unusual is confirmed by other evidence, including nearly a million new universal credit claimants since the lockdown began. The Bank of England’s decision-maker panel, based on responses from 2,500 businesses from a panel of 8,000, showed that 71% expect lower sales over the next 12 months as a result of Covid-19, with most of these expecting a drop of more the 10%. The results of the survey, carried out last month, got progressively gloomier as the month progressed.

The ONS, for its part, surveyed more than 3,600 businesses during the first three weeks of March and found that 27% were planning to cut staff and 45% were experiencing lower than expected turnover. The British Chamber of Commerce’s business impact monitor found that 44% of firms which responded were planning to “furlough” at least half of their staff, taking advantage of the government’s job retention scheme, which will pay 80% of salaries, up to £2.500 a month.

This is where it gets interesting. As a new collection of essays from the Centre for Economic Policy Research shows, not be confused with the CEBR, the chancellor’s approach to the crisis is a textbook one. We are, as the collection’s editors, Richard Baldwin and Beatrice Weder di Mauro write, in a recession that is “a medical necessity”. The key is to prevent a medical emergency that should be temporary into a longer-lasting economic emergency, a depression. The answer to this is to prevent as much “economic scarring” as is possible. A rise in unemployment is inevitable, the question is whether it cam be contained and then reversed as the economy recovers.

This is where policymakers will have to box clever. If we look at the amount of economic activity that has been shut down, much of it, in hospitality, retailing and entertainment, is inevitable for public safety. But garages and DIY stores were allowed to stay open under government rules, though many have closed, including the bigger chains

For years we have observed the rising trend of online sales and the threat to the high street. This crisis has proved, however, that high streets were necessary all along and that, faced with a sudden surge in demand, online retailers could not cope. Some did not try.

Many firms which have stopped operating and furloughed their employees would say they are doing it with the interests of their workers uppermost. I am sure this is true for many. Others, however, will have seized the government’s job retention scheme with open arms. The Institute of Economic Affairs, a free market think tank, suggests that the Treasury scheme may give some businesses the wrong incentives, making it too easy for the government to pick up their pay bill.

The response, led by the chancellor Rishi Sunak, is the right one. What it must not do, however, is prevent the economy from getting back to normal. Social distancing measures will need to be in place for a long time, as will a far higher proportion of people working from home.

There is, however, plenty to be learned from the successful social distancing methods used by the supermarkets and other food retailers, and by businesses which are making a success of distance working. The lockdown will have to be eased, as the former Bank of England governor Lord King said the other day, and the economy cannot operate on two-thirds of normal for too long. A gradual return to some kind of normality will be needed, though not for a few weeks yet. It is important that policy does not get in the way of that.

Sunday, March 29, 2020
Whatever it takes - but with an eye on the public finances
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.

For those of us who were not around at the time, one of the most impressive things that happened during the Second World War was that, even when the outcome was highly uncertain, planning for a post-war future took place. The Beveridge report, which formed the basis of the post-war welfare state, was published by the wartime coalition government in December 1942. The Bretton Woods conference in America, which put into place the post-war architecture of the international economic and monetary system, notably the International Monetary Fund and World Bank, was in July 1944.

The coronavirus crisis is not a war, though it has been widely described as our biggest peacetime challenge since then, including by the prime minister. It has not yet reached its peak.

The view of most economists is that there is a path to the other side and that this year’s terrible numbers will be followed by a strong bounce next year, partly a statistical effect arising from year-on-year comparisons with the very weak numbers in prospect for coming months.

Some, it should be said, are gloomier. Nouriel Roubini, who made his name during the global financial crisis, and became known as Dr Doom, warned last week of “persistent depression and runaway financial market meltdown” as a result of “uncontained pandemics, insufficient economic-policy arsenals” and other risks.

We shall see. But to return to my theme, you see the hand of post-coronavirus or at least post-crisis planning in the way the Treasury has approached its response. Though the chancellor, Rishi Sunak, has repeatedly promised to do “whatever it takes” and the government has been urged by many people to spend big now and ask questions later, the Treasury is keen to avoid doing now what the country, and the public finances, will regret later.

The chancellor has been criticised for the fact that his 80% income support for the employed will not be available until next month, and for the fact that the generous 80% support scheme for the self-employed will not be available until early June. That delay, which is understandable, together with a hint that the tax treatment of the self-employed will change in the future, predictably met with a very mixed response.

Sunak and his officials resisted what many urged on him, to introduce a universal basic income (UBI), even on an emergency basis. A UBI, a guaranteed weekly sum payable to everybody, has had many advocates, including Silicon Valley billionaires – as a response to artificial intelligence, not the coronavirus – for some time.
Its flaws in normal times have been pointed out here before. Welfare systems are complicated for a reason; people have different needs. Providing a UBI to everybody would discriminate against those with needs and provide free money to those that do not need it. Setting the UBI at more than a very low level would require punitive taxation. And, crucially is the current situation, there is no obvious way of delivering it, particularly to low-income people without bank accounts.

So the Treasury is right to resist it, and I hope that resistance continues. Similarly, while exceptional times require an exceptional response and justify a ballooning in government borrowing and a sharp rise in public sector debt, care has to be taken, not just to avoid saddling us with bad policies, but also an unnecessary burden.

There were strong expectations last weekend of a big rescue package for the airlines, including the possibility of the government taking equity stakes in them. But the Treasury remembers the last time it took equity stakes, in the banks, and how long it has taken to get rid of them.

The Resolution Foundation is a think tank devoted to improving the lot of those on low incomes. But, in a paper published a few days ago Richard Hughes, a research associate at the Foundation, also stressed the importance of keeping the public finances sustainable. Hughes, a former senior Treasury and International Monetary Fund official, looked at the experience of previous pandemics for his paper, “Safeguarding governments’ financial health during coronavirus; what can policymakers learn from past viral outbreaks?”.

As he puts it: “During all of these past outbreaks and even more during the current coronavirus pandemic, governments played a central role in not only treating the sick and containing the spread of the virus, but also in mitigating its impact on people, businesses, and the economy as a whole. To do so, however, governments have to keep their own finances in good health in the midst of unprecedented pressures on their expenditure, revenues, and traditional sources of financing.”

The economic lessons of past crises are that the falls in gross domestic product (GDP) we are likely to see could be in double digits or high single digits, that the longer social distancing measures have to be kept in place, the more protracted the downturn, and that we can also expect high single digit or double-digit budgets deficits as a proportion of GDP. This translates into big numbers. Paul Johnson of the Institute for Fiscal Studies suggests that we could be looking at a deficit of £175bn for the coming fiscal year, 2020-21, bigger than the financial crisis peak of £158bn, though slightly smaller as a percentage of GDP.

Hughes sets out six rules that governments should adopt to ensure that the public finances are sustainable after the crisis. They are that they should target financial support and avoid universal or open-ended offers; should avoid fiscal policies which unnecessarily exacerbate supply disruption (for example providing people with short-term incentives to spend); and that their spending priorities should be focused on funding healthcare systems and supporting individuals and firms.

He also says that governments should examine how they should finance themselves during long periods when expenditures will exceed revenues and, in this context, if markets are illiquid, the central bank, the Bank of England, may have to directly buy government debt with newly created money. This, monetary financing, normally brings shudders for governments and central banks, and would be a last resort measure. But It may have to be done.

Hughes also calls for governments to avoid introducing capital controls to protect their funding sources and for there to be more international economic and monetary co-operation is responding to the crisis.:

The last is one example where the wartime spirit has been lacking. Central banks have been working together but there has been nothing like the government-level co-operation and co-ordination we saw as recently as the financial crisis. America and China have been engaged in a trade war and, when G7 foreign ministers cannot issue a communique because the US secretary of state Mike Pompeo insists on calling it the “Wuhan virus”, you know we are a long way from the spirit of 2008, let alone 1944.

The Treasury under Sunak is by and large following Hughes’s rules, though some of its commitments, with a promise to roll over 80% support for incomes beyond the initial three months, if necessary, could become open-ended. The longer the crisis goes on, the more difficult it will be even for strong businesses to keep most staff on, on existing pay. One way or another, either through paying 80% of normal wages for employees, or 80% of profits for the self-employed, or through universal credit for the unemployed, the government could find itself with a very hefty and long-lasting wage bill, and without the revenues to pay for it. It has to hope, as we all do, that the shutdown is short-lived.

There are other things we should be thinking about post-crisis, beyond the sustainability of the public finances. They will, I hope, provide themes and food for thought in coming weeks, as we see how this plays out.

Sunday, March 22, 2020
The deeper the dive, the longer the way back
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.

If you can keep your head when all about are losing theirs, to paraphrase Rudyard Kipling, then you are the right person for a crisis. Britain has gone into this one with a new chancellor and a new Bank of England governor and it is only fair to say that both deserve congratulation for both keeping their heads and their speed of response.

Rishi Sunak is having a good crisis and has shown a sure touch in extraordinary circumstances. When he says “whatever it takes” he means it. He and the Bank’s Andrew Bailey, some of whose emergency measures were done with outgoing governor Mark Carney, are safe hands and bring confidence.

It is important to see the Treasury and Bank’s measures working in tandem. Friday’s huge commitment by the chancellor, to meet 80% of the wages of staff - from March 1 - if employers agree to keep them on, up to £2,500 a month, and in theory £30,000 a year, will be costly. It is a gamble worth taking, to limit some of the inevitable rise in unemployment that we will see in coming weeks and which, indeed, is already happening. The more that the rise in unemployment can be contained, the better the economy will recover once the public health emergency eases.

Sunak also announced a boost to universal credit, direct help for renters and other measures adding up to a further £7bn.

His actions need to be seen in the context of Thursday’s announcements by the Bank of England. The least important bit of that announcement, though historic, was the cut in Bank rate to 0.1%. The most important was the £200bn of additional quantitative easing (QE), mainly in the form of purchases of gilts (UK government bonds) and probably front-loaded.

The significance of this, at a time of jittery financial markets, is that the Bank will buy from the markets the extra gilts issued by the government to fund the substantial extra borrowing that its measures will require. And this is effectively interest-free borrowing for the government, because any interest due to the Bank on gilts is returned to the Treasury.

It would be easy to get punch drunk with the speed and size of the Treasury and Bank announcements. As well as the rate cut and extra QE, the Bank announced an expansion of the newly created term funding scheme for smaller firms, and a scheme of large-scale commercial paper purchases by the Bank, intended to support larger firms.

Even in the financial crisis, interest rates were not cut this low, the lowest ever, while the extra £200bn of QE is the same as the inaugural amount announced during the crisis in March 2009. This is big stuff.

It is worth remembering, amid these historic moves by the Bank, how quickly all this has come about. At the end of January the Bank’s monetary policy committee (MPC) voted 7-2 to keep Bank rate on hold at 0.75%. Since then there have been two emergency packages and rate cuts. The new governor’s first scheduled MPC meeting was not supposed to be until this Thursday.

As for the Treasury, it is true that its response has been done in stages, and as with designing direct income support for workers forced to stay at home and suffering a loss of income, has sometimes appeared slow-footed. But there is no point in announcing schemes until the details have been worked out, and some of these things are easier said than done.

With so many big numbers around, and they genuinely are very big - a monetary and fiscal bazooka – a word of explanation might be useful. There is tendency to confuse apples and pears when describing some of the actions that Sunak has announced.

Many newspapers reported his second coronavirus package (the first being in the budget, the third on Friday) as a £350bn lifeline, or rescue, for the economy. I do not blame them. But £20bn of this was an additional short-term fiscal boost, to be added to the £12bn announced in the budget, and which will be added to further. The bulk, £330bn, was in the form of loan guarantees. Things would have to go really badly wrong for these guarantees to eventually cost the government anything more than a tiny fraction of that, though anything is possible..

People can debate whether the measures announced by the Bank and the Treasury are the right ones, though they seem to me to press the right buttons, but it is worth setting out what the aim of it all is.

The Bank described what is happening as “an economic shock that could be sharp and large but should be temporary”. The shock has three components; the initial supply disruptions from the first outbreak in China, the reduction in activity resulting from the government’s actions in shutting down or discouraging normal activities; and decisions by businesses and individuals, some of them arising from government advice, some independent of it.

The result is a dive in economic activity, gross domestic product, which will show through first in the surveys and official data for this month, but which will be particularly pronounced in the second quarter. In a briefing call with journalists following the Bank’s move, Bailey said the decision was driven by the risk that the markets were becoming disorderly, including a rise in the yield, or interest rate, on gilts (UK government bonds). But the authorities also want to provide a “bridge” to more normal times, preventing the lasting damage that would be done by the failure of fundamentally strong companies, and by a surge in unemployment.

The governor appeared to accept that there is not much that can be done about the short-term drop in economic activity, some of which is a direct consequence of government actions to increase social distancing.

Limiting the scale of the immediate decline, however, if that is a side-effect of the Bank and the Treasury’s actions, could be very important. The arithmetic of sudden declines in economic activity can be very challenging, leaving aside the practical effects on businesses struggling to survive a period of indeterminate length and unprecedented severity.

That arithmetic means that if GDP were to fall by 20% in a quarter, it would take a 25% rise to get back to where we started. Capital Economics does not have a 20% drop but it is expecting GDP to fall by 15% in the April-June period compared with a weak first quarter. It expects a recovery thereafter, with quarterly GDP rises of 5%, 8.5%, 2% and 1% over the following four quarters. But that still means it takes more than year – beyond the middle of 2021 – to get back to where we were. The good news is that that is a lot shorter than after the financial crisis.

It is reassuring to hear the Bank and the Treasury say that the shock to the economy will be temporary, a view shared by most economists. But we will be talking about this period for years to come, even after the virus has been brought under control. It will change the way businesses operate and it will change the way that people think about health, and their vulnerabilities to it. The hangover for the public finances will also be a lasting one.

What will be the lasting economic effect? Neil Shearing, Capital’s chief economist, offers a choice of three scenarios. The first and most optimistic is that the spending not being done now is fully made up for later, with no overall loss. It is also unlikely, some of what is being foregone now is lost forever. We will not make twice as many commuter trips to make up for the ones not being done now.

More realistic is the idea that, come next year, or later this year, we will do what we have always done, in terms of visits to pubs and restaurants, holidays, leisure, and so on. This year’s fall in GDP is not repeated; growth returns to what it would have been.

Finally, there is the gloomy view, that even when the public health crisis is over, there is lasting economic damage from a further retreat for globalisation, skills atrophying because of a rise in unemployment, the actual or feared return of the virus and, possibly, the need for governments to introduce new austerity programmes to deal with the fiscal costs of this crisis.

We have to hope that, while the economy should recover much more quickly than after the financial crisis, the lasting effects will not be as damaging. That is the real test for the interventions we have seen from the Treasury and Bank.

Sunday, March 15, 2020
The chancellor places his bets on a £1 trillion gamble
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.

It is always a challenge writing about a budget a few days after the event, particularly when the ensuing period has included a further big slump in the stock market – making this bear market very grizzly - the government’s response to the coronavirus outbreak moving into a new phase and Donald Trump’s ban on travel from most European countries to America.

There is the bigger question of whether the impact of Covid-19, on public health, society and the economy, will be so severe as to make the budget irrelevant. I do not want to be alarmist about this, and have not been, but the dangers cannot be ignored and a recession now looks very likely. It is not every week, after all, that you get a 7 am announcement of an interest rate cut and other emergency measures from the Bank of England.

But let me draw you in. Once upon a time I used to write about budgets in terms of millions. Then we moved on to billions. Now, we can talk about trillions, in other words thousands of billions, as will be explained in a moment.

Let me draw you in also with a couple of bits of history. When I saw a headline “Stonehenge scheme gets go-ahead”, my first thought was that they had finally got some ancient Britons to drag some more bluestones from the Preseli Mountains in Pembrokeshire to finish it off. But no, it was another bit of ancient history, a two-mile tunnel for the A303 near Stonehenge which, as the former chancellor Lord (Alistair) Darling revealed, he had given approval for when transport secretary nearly 20 years ago.

There is a bit more history. The government’s fiscal watchdog, the Office for Budget Responsibility (OBR) said that the plans announced by Rishi Sunak on Wednesday represented the largest budget giveaway, in the form of higher public spending (the government is raising taxes overall) since March 1992.

I remember that episode well. When I wrote a piece pointing out the extent of the Tory government’s spending largesse, it was picked up and written about by William Rees-Mogg, father of Jacob.

Things changed. Michael Portillo was appointed Treasury chief secretary after the April 1992 election and was irked to find that he was presiding over a spending splurge. That and the Black Wednesday crisis a few months later, when the markets forced sterling out of the European exchange rate mechanism (ERM), brought a big change. Instead of a big spending boost, the Tory government adopted plans that, in the words of Kenneth Clarke, the then chancellor, were “eye-wateringly tight”. It remains to be seen whether anything like that is the fate of this government’s plans.

I promised some trillions in the context of the budget, so here they are. In two years’ time, on the new plans, overall government spending, total managed expenditure in the jargon, will reach £1 trillion for the first time ever in 2022-23.

That is up from £851bn in 2018-19, the last full year for which we have data. It represents a more-than-doubling in less than 20 years compared with 2003-4, when spending was less than £500bn. Adjusted for inflation this is more than a 40% real rise.

Government receipts, mainly taxes, are also on track to top £1 trillion, although not until a couple of years later, 2024-25. The tax burden – and the government is raising taxes overall – will be its highest since the late 1960s.

The other trillion-pound number is for government debt, currently just under £1.8 trillion, and predicted to reach £2 trillion within five years. That is another big number. The budget added £125bn to debt.

The government, incidentally, no longer has ambitions to reduce government debt in relation to gross domestic product. The OBR describes it as “essentially flat” in the later years of its forecast, at around 75% of GDP. Adjusted for the Bank of England’s term funding scheme it rises slightly.

With so many big numbers around, it was a pity that Sunak, in a polished first outing as chancellor, decided to exaggerate some of his budget numbers. He claimed a £30bn fiscal stimulus to support British people and British business “through this moment” but the coronavirus crisis response is only £12bn, though comprehensive in tandem with the Bank’s moves. The rest comes mainly from adding Sajid Javid’s spending boost, announced last September, when this coronavirus was yet to reveal itself.

The chancellor also talked about providing a £175bn increase in infrastructure spending, a figure which you can only get to by using the multiple counting method which was discredited when employed by Gordon Brown more than two decades ago. Properly measured, on the Treasury’s own scorecard, that addition to capital spending over the next five years is just over £80bn. That is big enough to need no exaggeration.

Also on the Treasury scorecard is the fact that, though most of the emphasis in the budget was on levelling up via infrastructure spending. Most of the increase in spending by the end of the parliament, however, roughly 56%, is on day-to-spending. No wonder the Treasury is examining changes in the fiscal rules that will enable some education spending to be defined as human capital spending and thus be included in the definition of capital expenditure.

How risky is all this? Before the budget the OBR could look forward to a period in which public borrowing headed down from just over £47bn this year to £30bn by the end of the parliament. Now it is predicted to rise, reaching a peak of nearly £67bn in 2021-22 and still close to £60bn by the end of the parliament. Serious coronavirus effects on the economy will add to borrowing, certainly in the short term.

This shift from austerity and fiscal responsibility to Lady Bountiful largesse has had a sobering effect on the free-market think tanks in Westminster. Most have concentrated on individual measures, which they can welcome because in a long-forgotten paper they have recommended them, rather than the big picture. But the Adam Smith Institute broke cover by accusing Sunak of “spending like a drunken sailor” on “vanity projects” which will not make us better off, while the Institute of Economic Affairs was concerned about a chancellor who “seems to think the only best way to boost growth is through public spending”.

For the moment, that battle has been lost. The Tories are content merely to stabilise debt and to allow spending to settle at nearly 41% of GDP, compared with the sub-35% level when Margaret Thatcher left office 30 years ago.

More than the concerns of the think tanks, Sunak was probably stung by the comparison made by Robert Chote, the outgoing OBR chairman, between the chancellor now and Gordon Brown in the run-up to the global financial crisis. When the tax revenues are coming in and when, as now, governments can borrow very cheaply, spending a lot more public money looks like the sensible thing to do. Things are “priced for perfection” But when any of this changes it starts to look very risky. The chancellor has taken a £1 trillion gamble.

Monday, March 09, 2020
Get businesses to invest or you can forget about levelling up
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.

It is beginning to look a lot like the curse of the budget. This time last year the last chancellor but one, Philip Hammond, unveiled his spring statement for the economy, having had a budget the previous October.

In it, he looked forward both to an autumn budget and a three-year public spending review, which would conclude at the same time. Neither happened. Sajid Javid, his successor, having only managed a one-year spending review in September, was all ready to roll with a budget in November but the election was called instead.

Now, unless the Treasury or Parliament is put into lockdown, it looks as if we will get a budget on Wednesday, one of what officials describe as the new chancellor Rishi Sunak’s “three bites of the cherry” this year, to include a summer spending review and an autumn budget.

The task for this week is to ensure that the government’s planned big “levelling up” announcements, which the Treasury is still planning to deliver – a few days ago it proclaimed in a tweet, “we’re going to level up opportunity across the country” – are not overshadowed by coronavirus and the response to it. At the very least, the health emergency will provide the chancellor with cover for relaxing the fiscal rules.

Important though coronavirus is, it would be a pity if it overshadows everything else. When a chancellor makes big announcements, particularly on infrastructure spending, and the expected additional £100bn over five years, the announcement part of that policy is important.

Infrastructure projects take years to deliver, and are subject to delays and cost overruns. It is an important part of the strategy, therefore, that those who stand to benefit from this part of the government’s levelling-up agenda know that it is on its way. Otherwise, “levelling up” might soon be in danger of becoming as mocked as David Cameron’s “big society” programme.

Infrastructure announcements have also become more complicated, following the recent court decision on the Heathrow third runway. They have to be zero carbon compliant, which is why, as the BBC has reported and the Treasury confirmed, the full detail of the government’s national infrastructure strategy will not be published this week.

An additional problem, identified by the Resolution Foundation think tank, is that it is no use investing in shiny new infrastructure when existing facilities are crumbling. As it puts it: “The legacy of three decades of relative underinvestment has been a decline in the quality of our stock of infrastructure assets relative to other advanced economies, particularly in areas like health, social housing, prisons, and transport links outside of London. Future increases in investment need to focus on reversing this legacy as well as equipping the country to meet new challenges.”

There is another key challenge, which is to ensure that infrastructure investment in the regions is accompanied by business investment by firms. When, last weekend, Javid the former chancellor gave an interview outlining what he would like to have put in the budget. Most of the attention focused on an apparent plan to cut the basic rate of income tax from 20p to 18p in the pound. Though anything is possible these days, briefing in recent days suggests that this is unlikely to see the light of day.

Less noticed was another part of the Javid plan, which was to reduce the tax burden on business and introduce “full expensing”, allowing firms to immediately and entirely deduct the cost of investment from their tax bill. Such a move “could make a difference quite quickly” particularly to productivity.

As it happens, there is an oven-ready plan to do this, devised by Professor Peter Spencer, himself a former Treasury official, and colleagues at York University. It was sent to Dominic Cummings, Boris Johnson’s chief adviser, two months ago.

The proposal, “How to align the UK’s corporate tax structure with national objectives”, takes as its starting point corporate tax reforms dating back to Nigel Lawson in the 1980s, under which rates of corporation tax have been lowered, but so too have the tax breaks for investment and other expenditures by business.

The result of these reforms, says the York paper, has been to remove a bias towards investment and replaced it with a strong bias towards debt finance, because the interest on debt is allowable against tax. The reforms “have favoured service industry at the expense of capital-intensive manufacturing industry and so added to the imbalances in the economy caused by globalisation”.

The government has already tentatively reversed one aspect of the previous policy, by not proceeding with the corporation tax rate cut from 19% to 17%. The York paper says it should go further, neatly dovetailing with the government’s levelling-up agenda.

More generous investment allowances, it says, would benefit manufacturing industry, which has “positive spillovers” for productivity and high-wage jobs and for regionally rebalancing the economy in favour of the north. It might also narrow the UK’s very large trade gap in manufactures.

Currently, the depreciation rate on investment in plant and machinery is 18%. The York economists would raise that to 40% and say that there is a good case for 100% relief, “if the government really wanted to deliver a big investment boost”, and as Javid hinted at. The upfront costs are high but fade rapidly over time. Something like this should be in the budget.

It is not the only thing. In a paper for the think tank Onward, “Levelling Up: rebalancing growth-enhancing spending”, released on Friday, the Tory MP and former adviser to George Osborne and Theresa May Neil O’Brien argued that productivity-enhancing spending has favoured Britain’s already productive regions.

This applies to transport spending, as is well known, where spending in London per head has averaged nearly three times that in the rest of the country in the past decade. It applies to culture, where London has received five times the average per head spend as the rest.

It applies, crucially, to what O’Brien describes as innovation, a buzzword for this government. As he puts it: “Taking direct government spending and university research funding together, London saw R&D funding per head of nearly twice the UK average - £3,900 compared to a national average of £2,300 over the period 2001 to 2017. The next highest spending was seen in other high productivity regions: the East, South East and Scotland. The share of the core research budget spent in just three cities, Oxford, Cambridge and London, rose from 42.1% in 2002/3 to 46% in 2017/18.”

How to spread this out better? O’Brien notes that some regions combine low R & D spending by business with low spending by government and that funding for such regions should be ring-fenced. The innovation budget should also be devoted to funding streams which are more industrially focused, he argues, and the research spending that flows through universities should be judged on its regional as well as its overall economic impact.

There are plenty of good ideas around. The challenge is to deliver.

Saturday, February 29, 2020
A nasty shock - but only if we panic about the pandemic
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.

Once it would have been easy. People like me would have looked at the deadly effect of the coronavirus Covid-19 outbreak on the stock market, concluded that it must be telling us something important and worrying, and wheeled out our recession predictions.

Times have changed. The FTSE 100 and other markets have taken a very nasty tumble and, as I write this, London’s main index has not only wiped out all its post-election gains but is quite a bit lower than it was a year ago.

But the mechanism through which falling stock markets were traditionally supposed to feed through to the economy, notably wealth effects on households as they saw their financial wealth battered, is very weak. Business investment is adversely affected by a very weak stock market, but in the case of the UK it was very weak anyway.

The old joke about stock markets having predicted five of the last two recessions also applies. The stock market matters a lot to Donald Trump, who regards what happens on Wall Street as a key measure of US economic success, but it does not matter so much to the economy.

There was a big fall in global stock markets at the end of 2018 and, while it was followed in 2019 by the weakest year for the world economy since the global financial crisis, which is interesting, it was not followed by recession.

Stock markets are telling us something, which is that many people, and many businesses, are worried about the impact of this coronavirus. Goldman Sachs says that earnings growth for US companies will be knocked down to zero by it. But markets are not telling us everything.

What else is driving the economic impact of Covid-19? Last year was a poor one for world trade, which fell by 0.4% according to the CPB think tank in the Netherlands, the recognised source for monitoring trade.

The OECD, which released its latest trade update for G20 countries last week, noted that merchandise trade “continued its downward path” in the final quarter of last year and added: “Evidence of significant disruption to Asian (in particular) supply chains related to the Covid-19 outbreak suggests that this downward trend is likely to continue into the first quarter of 2020.” Hopes that the small thaw in trade relations between America and China would lift trade have been dashed by the virus.

There is also the impact of cancelled events, including Six Nations’ rugby games and business conferences and exhibitions. Having been in Barcelona when the Mobile World Congress was taking place in past years, I know how big it is. It was cancelled last month after a number of big firms pulled out. Other events will follow.

The question here on the economic impact is whether events like these are cancelled for this year or merely postponed. In the case of the latter, there will only be a temporary loss of economic activity. If events are cancelled outright, the loss is permanent, even if some of the costs are covered by insurance.

The biggest economic impact of the outbreak, interestingly, is likely to be from changes in behaviour from people who do not fall ill