David Smith's other articles Archives
Sunday, July 24, 2016
Bank will fight the economic downturn, not the upturn in inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

2015 was an unusual year, though not as extraordinary as 2016 is turning out to be. Last year was strange because for the first time in more than half a century there was no inflation at all. Inflation, which in one way or another has dogged most of our lives, disappeared.

Indeed, there were three months last year when Britain experienced technical deflation; consumer prices lower than a year earlier. Before anybody writes in, not all inflation disappeared; there was still plenty of it in the housing market. But the overall price level stabilised.

That brought direct benefits to households. Even modestly rising average earnings of 2% to 3% looked good when set against zero inflation, delivering solid gains in real incomes and boosting consumer confidence.

Inflation remains very low now. The latest figures, for June, showed a rate of just 0.5%, up from 0.3% in May. We have, however, said farewell to the days of zero inflation, and of flirting with deflation. From here, the direction is up.

Some of this was going to happen anyway, as a result of the recovery in oil and commodity prices, and their earlier falls dropping out of the year-on-year comparisons. It has been given an additional boost, of course, by the pound’s post-referendum fall.

The extent of that inflation boost is a matter of some debate. The consensus in the new independent forecasts assembled by the Treasury since June 23 is that the economy will experience mild stagflation next year, with growth of just 0.5% and inflation by year-end of 2.5%.

Mild, however, is the operative word. After all, 2.5% inflation is only a smidgeon above the official 2% target. Some forecasters, it should be said, see a much bigger pass-through from the lower pound, and predict 4% inflation next year, but that is not the majority view.

Even so, the coming rise in inflation has two important implications. One is that, unless there is an accompanying increase in the pace of pay rises, there will be a return to at best stagnant growth in household real incomes, at worst falling living standards. In the latest official figures, for May, total pay was only up by 2.1% on a year earlier. A squeeze on real incomes will have implications for consumer spending and consumer confidence.

The second, which is as interesting, is what it implies for monetary policy and, in particular, interest rates. Not for the first time in recent weeks I have felt a lot of sympathy for Mark Carney. In contrast to the dithering and confusion that marked the response to the onset of the global financial crisis nine years ago, his has been a textbook central banker reaction.

He offered reassurance – and a promise of £250bn of additional liquidity – in the early morning of June 24. Six days later, in a speech at the Bank, he pledged that the Bank would do its utmost to “support growth, jobs and wages” during this time of uncertainty.

Carney was not the only one to offer reassurance. So, once he got over the shock of the referendum result, did George Osborne, the former chancellor. The rapid coronation of Theresa May as prime minister, also helped to settle nerves.

One response to Carney’s success in helping to calm market nerves, which is that he was wrong to warn of the economic dangers, can be easily dismissed. He has done exactly what everybody is supposed to do: accept the result, deal with the consequences, and move on.

What is also clear, however, that the calming of nerves has revived a debate within the Bank of England. In May, when the Bank published its last inflation report, it talked of a “challenging trade-off” between the inflation and growth impacts of a vote to leave the EU. Should the Bank, in other words, respond to the threat of high inflation or the risks of a prolonged period of weak growth?

We know now that different members of the monetary policy committee (MPC) have different views on this. One, Jan Vlieghe, had already seen enough by July 14 to vote for a rate cut. Carney, in his June 30 speech, said “some monetary policy easing will likely be required over the summer”.

Andy Haldane, the Bank’s chief economist, said just over a week ago that he would “rather run the risk of taking a sledgehammer to crack a nut” and said “a package of mutually-complementary monetary policy easing measures is likely to be necessary”.

But not everybody agrees. Martin Weale, whose final MPC meeting will be next month, struck a cautious note, saying he would need to be sure that weakness in the economy will be large enough to “more than to compensate for any overshoot in inflation”.

Kristin Forbes, another MPC member, wrote in the Daily Telegraph that until there was more hard evidence, her instincts were to “keep calm and carry on”. She also pointed out that there are costs as well as benefits to cutting rates, and not just for savers.

So what does all this mean? Will the Bank cut on August 4, or not? One thing the current debate has done is kill the idea that the Bank is Carney’s fiefdom, and that the rest of the MPC is just there to carry out his instructions. That was said a lot, including by former Bank insiders, in the run-up to the July 14 meeting at which the MPC surprised the markets by holding rates. We should hear less of it now.

I still think, however, that there will be a cut on August 4, probably of 0.25 points, along with other measures, including more quantitative easing and a rebooting of the funding for lending scheme. The justification will come from a sharp downgrading of the Bank’s growth forecast and the argument that it is right to “look through” the temporary effects on inflation of the pound’s fall.

Will it be the right thing to do? Until Friday, and the release of an alarming new purchasing managers' survey, there was a debate to be had. The Bank's own agents had found little evidence of a sharp post-referendum slowdown. The composite purchasing managers' index plunged from 52.4 to 47.7, however, with its services component recording its sharpest reversal in its 21-year history. How long this very deep gloom lasts can be debated. For the moment, however, the MPC has little choice but to respond aggressively.

Sunday, July 17, 2016
Osborne: much better than his critics said, but plenty of unfinished business
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

So no more George Osborne. Hello Philip Hammond. But 0.5% Bank rate, the record low rate that lasted for the whole of Osborne’s chancellorship, lives to fight another day. I’ll come on in a moment to the question of whether the Bank’s decision not to cut on Thursday was the right thing to do.

On Osborne, the game was up for him in the early hours of Friday June 24, though he made a spirited effort to demonstrate he was irreplaceable in the days that followed. Sadly, none of us are.

I’d like to say I’ll miss my fireside chats with the former chancellor at No.11. I’d like to say it but I can’t. They never happened, and they won’t now.

I do, however, feel quite a lot of sympathy for him. The referendum was David Cameron’s idea, not his. No chancellor, and certainly not Osborne, would have taken the risk. As it is, Cameron left office with the cheers of the House of Commons ringing in his ears, while Osborne left by the back door of 10 Downing Street.

Now it is over, how should we view the Osborne supremacy? Was he a good chancellor? There have been few recent chancellors who have divided opinion more. My view is that he was not as bad as his critics alleged, nor quite as good as he and his supporters thought.

His own parting shot, that he hoped he had left the economy in a better state than he found it, can be answered in the affirmative. The recovery got stronger – latterly becoming the strongest in the G7 – and the employment rate rose to record levels. Never before has a higher percentage of the 16-64 workforce (74.2%) been in work. In 2010 Labour said the private sector would never replace the public sector jobs being cut. It did, several times over.

The strength of employment was in contrast to the weakness of wages, damagingly so during the bouts of high inflation, notably in 2011, during his chancellorship. Collectively, people priced themselves into jobs. Osborne’s last big announcement, the introduction of the national living wage, was an attempt to break that low-wage cycle.

Despite weak wages, Osborne presided over a post-crisis decline in inequality – not that you would notice from the debate – and an increase in the share of income tax paid by those at the top of the scale.

His big ambitions have, however, mainly been unachieved. The budget deficit, public sector net borrowing, was £75bn, 4% of gross domestic product, in 2015-16, his last full year as chancellor. That is better than the level of borrowing he inherited, which was more than 10% of GDP, but is a long way from job done. The budget surplus he coveted will not even be a target any more.

His “march of the makers” – a recovery built on manufacturing – did not happen; industry remains below pre-crisis levels. His ambition of doubling exports by 2020 will not happen; it will be missed by a huge margin. The Northern Powerhouse is still a work in progress. Pension reform is incomplete.

But Osborne was more pragmatic than his critics allow; some of his missed deficit targets were unintended, but some of it was because, as an austerity chancellor, he also prioritised cuts in personal and corporate taxes. It would have been possible to eliminate the deficit but the past few years would have been far grimmer. As it was, he managed to maintain the confidence of the markets while presiding over a slower pace of deficit reduction than he intended.

Reducing the deficit was, however, important, and lesser chancellors would have been diverted from the task much more than he was. A deficit of 4% of GDP is still too high, but entering this period of post-Brexit economic uncertainty with it much higher would have increased Britain’s vulnerability. Even so, Britain’s sovereign debt rating has been downgraded since the referendum.

His was, however, a very messy chancellorship. His last budget, in March, contained more individual measures than anybody can remember, and was followed by the forced abandonment of its two headline announcements; disability cuts and turning all schools into academies. His own joke about the 5:2 diet, that in two out of every five budgets he had to eat his own words, was a little too close to the truth. Having mocked Gordon Brown for making the tax system much more complex, he leaves it even more so. History will remember him as a chancellor who took over in a crisis and helped steer the country out of it. It is unlikely to remember him as a great reformer.

How will history judge Mark Carney’s period as Bank governor? Thursday’s decision to leave rates on hold, albeit with what looks like a pretty clear promise to make a move next month, was a sensible one. The monetary policy committee (MPC) fears that that the problems in commercial property and what looks like a sharp slowdown in the housing market presage a wider slowdown in the economy.

But it wants to have a new, fully-worked forecast before deciding on its course of action, and it will have that in three weeks’ time. MPC members have discussed “various possible packages of measures”, which they are ready to unleash next month. It will be surprising if that does not include a cut in rates.

And what about Philip Hammond? Had the Tories won an outright majority in 2010 he would have been Treasury chief secretary, the post he had shadowed in opposition. He would have been responsible for controlling/cutting public spending.

As it is, his route to the Treasury has been a circuitous one, via transport secretary, defence secretary and foreign secretary. In all those roles he has been quietly competent, never making too much of a fuss; the archetypal safe pair of hands.

That is not a bad quality for a chancellor, though the same was said of Alistair Darling when he was appointed in June 2007, and his stint at the Treasury over the following three years was anything but quiet; it was one of the scariest for decades, though Darling did well with the hand he was dealt.

The challenges faced by Hammond will be different ones. And, while most people I have come across have greeted his appointment without a huge amount of enthusiasm, an important part of any chancellor’s duties is to offer reassurance. He will probably be quite good at that.

It may also be that, partly as a result of Brexit and the need to negotiate new arrangements for Britain, and partly because of the new prime minister’s declared intent to pursue a wider economic agenda, run from Downing Street, that the Treasury is less powerful than in the recent past.

In the days of Gordon Brown, and more recently in the case of Osborne, the Treasury has called all the shots. It will still be one of the biggest beasts in the Whitehall jungle but it may have to get used to a slightly more truncated role. That may be no bad thing.

Sunday, July 10, 2016
Why we should all mind Britain's very large gap
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This continues to be a record-breaking time, though the records being broken are not necessarily those you would want. So, the pound’s peso-style two-day fall in the wake of the referendum was the biggest in the post-Bretton Woods era, in other words for four and a half decades.

Consumer confidence has also taken a tumble, according to a snap assessment published by GfK on Friday. Having been very high – last year was the best year for confidence in the more than 40 years GfK has been surveying it – the post-referendum dive was the sharpest for over 20 years. People may be more worried about their jobs. Another firm, CEB, which monitors online job postings, says they almost halved in the week after June 23.

These things will, as I noted last week, take time to fully reveal themselves. The problems in commercial property which have led to the suspension of withdrawals in several property funds may be the isolated difficulties of an overextended sector or the canary in the coalmine. It is reassuring, I hope, that banks have been stress-tested against a 30% fall in commercial property values.

This week I want to concentrate on what is potentially both a short-term and long-term problem for Britain. I had planned to look at the current account deficit regardless of the referendum outcome. It is timely to do so now.

Just to be clear on terminology, because I know some people get confused, I am talking here of the current account of the balance of payments, which comprises the trade deficit/surplus on goods and services, primary income (mainly investment income) and secondary income (including transfers such as payments to and from the EU).

That something unusual has been happening to the current account is not in doubt. In the final quarter of last year the deficit reached £34bn, a record 7.2% of gross domestic product. It narrowed in the first quarter, but only slightly, to £32.6bn, 6.9% of GDP. The last time we really worried about the current account deficit was in the late 1980s, at the end of the Lawson boom. Its peak then was however smaller, at 4.8% of GDP.

Why has the current account deficit widened so dramatically? Five years ago, the deficit was close to being eliminated, if only for a couple of quarters. Its widening to record levels is not mainly due to the usual culprit, the trade deficit. Though bigger than is healthy, at 2.5% of GDP, it is pretty close to its average of the past decade and a half, 2.4% of GDP.

The problem, instead, lies on the income side, mainly investment income. Just over a decade ago, during 2005, Britain had a surplus on primary income of 3.1% of GDP. Now there is a deficit of a similar among; exactly 3.1% of GDP in the first quarter. It is the turnaround on investment income which has put the current account into a parlous state.

Why the turnaround? It mainly reflects a substantial drop in the investment income that British residents, and British businesses, are getting from their investments abroad, while foreigners’ earnings on their investments in Britain have held up.

Some of that – about half – is directly related to weak oil and commodity prices. Energy and mining companies have seen their overseas earnings slump. Some of it reflects the fact that Britain’s economy has been growing more rapidly - generating more investment income – than most other advanced economies.

Does a big current account deficit matter? The balance of payments has to balance, as every student is taught. A current account deficit has to be matched by capital inflows.

The Bank of England’s financial policy committee, in its twice-yearly financial stability report last week, put the current account deficit at the top of its list of concerns. As it put it: “The current account deficit is high by historical and international standards. The financing of the deficit is reliant on continuing material inflows of portfolio and foreign direct investment.

“During a prolonged period of heightened uncertainty, the risk premium on UK assets could rise further and overseas investors could continue to be deterred from investing in the United Kingdom. Persistent falls in capital inflows would be associated with further downward pressure on the exchange rate and tighter funding conditions for UK borrowers.”

Incidentally, there is a strand of bonkers criticism around about the Bank and its governor, Mark Carney. Having warned against the consequences of Brexit, he and his colleagues have been quick to take action to minimise those consequences. The Bank’s actions may extend to a cut in interest rates this week. Yet all this, according to some economic illiterates out there, is merely an extension of pre-referendum scaremongering.

Will the risks from Britain’s gaping current account deficit diminish, or will they crystallize, to use the Bank’s phrase, in an even lower pound than we have seen so far? The balance of payments, as noted, has to balance, the question is at what exchange rate it does so.

On the current account itself, there are reasons to believe that over time the deficit will narrow rather than widen to, say, 10% of GDP. The fall in the pound so far will help, though not in the way most people expect. The drop in sterling has a direct translation effect on Britain’s overseas investment income, boosting receipts on assets denominated in foreign currencies. This is the main mechanism the Bank sees through which the deficit will narrow.

The trade deficit may respond to sterling’s weakness. The usual way this would happen is through the so-called “J-curve”, whereby the deficit initially worsens as imports become more expensive but then improves as Britain’s exports become more competitive. It could happen, though as I noted last month, sterling’s 25% fall in 2007-9 was notable for its disappointing impact on exports. Foreign tourists will find Britain cheaper, while British tourists will see the cost of their foreign holidays rise. The Brexit vote could thus see more foreigners flocking to Britain.

The current account could also improve if there is a further recovery in oil and commodity prices, boosting the overseas earnings of firms in this sector. There has been a recovery in prices from the lows of earlier this year, though so far it has only taken us back to where we were in the final months of last year.

Finally, the deficit could narrow if the hit to growth in Britain both reduces demand for imports – already we have seen the first signs of a weakening in new car registrations – and results in lower investment income for foreigners with British investments. This, of course, would be the least desirable way in which the deficit becomes less of a problem.

Will the current account deficit narrow by enough to take it off the Bank’s list of critical risks for the economy? That is the big question. To do so it probably needs to be no more than half its present level of nearly 7% of GDP. Getting there may take some time.

Sunday, July 03, 2016
Carney in a battle to head off a post-Brexit recession
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What an extraordinary time it has been. During the worst of the global financial crisis I wrote that we had 10 years of big economic and financial stories crammed into about 10 weeks. Something similar has been happening in the past few days.

Even leaving aside what is going on at the top of British politics, which is completely barking, this is an action-packed time. Remember all that agonising about whether Britain’s AAA sovereign debt rating would be downgraded? On Monday, the last remaining AAA rating, from S & P, vanished with a big downgrade and Fitch, another agency, also took us down another notch.

Sterling has tumbled but not yet collapsed, though has hit a 31-year low, while the stock market has almost been a caricature of itself; despair followed by euphoria. I would like to take some reassurance from the euphoria bit though, thinking back to the crisis, I recall that the FTSE-100 was still surprisingly buoyant in the late spring of 2008 and gave little sign of the horrors to come.

Meanwhile, as if on cue, official figures reminded us of one of Britain’s important sources of vulnerability. The current account deficit in the first quarter – the red ink on the balance of payments - was a worryingly large 6.9% of gross domestic product, only marginally down on the record 7.2% of the final quarter of 2015.

So what is going to happen? We are still in a state of limbo in terms of the economic impact, short and long-term, of the referendum decision. There is some preliminary evidence that consumer confidence has taken a hit and a lot of talk of cancelled investment projects but very little hard evidence.

That will be the case for some time. Even the June purchasing managers’ surveys, normally a good indicator of what is currently happening, are based mainly on data collected before June 23. For most surveys, and even more so for the official statistics, we may have to wait until August for hard evidence, and that will only be for the initial impact.

In the absence of that, however, economists have been busy adjusting their forecasts downwards. A sample assembled by Consensus Economics gives an idea. Before the referendum the expectation was for 1.9% growth this year, 2.1% next. Now the numbers are 1.4% and 0.4% respectively. That does not sound too bad, but it implies a technical recession – two or more quarters of declining gross domestic product – between now and next summer.

And, if the consensus is right then, for those nostalgic for one of the high spots of the referendum campaign, it implies that GDP per household will be about £1,450 lower by the end of next year than it otherwise would have been.

Some are even gloomier. The Economist Intelligence Unit, which topped my annual forecasting league table in 2012, predicts an outright recession, with the economy shrinking by 1% next year on the back of a big fall in investment and weaker growth in consumer spending. GDP by the end of next year will be 4% lower than it otherwise would have been. Unemployment will rise, it says, and the budget deficit go back up to 5.5% of GDP (from about 4%) and public sector debt rise to 100% of GDP in coming years, from 84% now.

Why should we go into recession? Business investment, which was falling earlier this year on pre-referendum uncertainty, seems likely to be very weak for some time to come. Consumers, apart from feeling unsure, will be hit by the rising prices that result from sterling’s fall.

And, if you really want to be depressed, listen to the respected John Llewellyn, former OECD chief economist, and his team at Llewellyn Consulting. In a note to clients the firm said: “We are more worried - for the UK, though importantly not for the world - than we were in 2008 or any other post-WWII crisis. And between us we have been present for every one of them. The scale of all this will start to unfold in coming weeks.”

The challenge for the authorities is to turn this gloom around. And, in the state of political limbo in which we find ourselves, that for the moment means the Bank of England. On Thursday I, along with other journalists and a large invited audience from the City, assembled in the Court Room of the Bank of England to hear Mark Carney. There was a frisson when, talking about jobs, the governor asked: “Will I keep mine?” He was putting into words the concerns ordinary people have when times are uncertain but he also faced questions about whether he would survive in a post-Brexit government. My view is that the worst thing you could do for confidence is get rid of the Bank governor, but anything is possible amid the current madness.

Carney, as you will have read, had one important message. The Bank’s monetary policy committee (MPC) had been expecting to raise interest rates over the next 2-3 years. Now it is likely to cut them, even from the record low of 0.5%, starting on July 14. Before August is out interest rates could be zero, and another round of quantitative easing (QE) is a possibility. I do not see negative interest rates but other policy tweaks are possible, including so-called credit easing, with the Bank buying assets other than gilts, and action on the Funding for Lending scheme.

Such moves will help ease the shock to the economy but we should not overstate their potency. A cut in rates from 0.5% to zero does not take us very far. QE may be of limited use when long-term interest rates are already very low. Carney himself made the point that there are limits to what monetary policy can do, and that – even when it is effective – its impact is not immediate.

The best the Bank can do may be to reassure. When Mario Draghi, the president of the European Central Bank, promised to do “whatever it takes” to hold the eurozone together, it helped do so. Carney’s “all the necessary steps” message is in a similar vein. The Bank, like the rest of us, has to hope it helps stop some of the nastier outcomes now predicted by economists from becoming a reality.

Sunday, June 26, 2016
I'm not going to sulk - we have to make the best of a bad job
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

For many people reading this, Friday morning will have dawned as a moment of triumph, of liberation. That was not how I saw it, as you might have gathered from my series of pre-referendum pieces. But, admittedly after a dishonest campaign, the voters decided otherwise. Democracy does not always throw up the outcomes we would like, or think sensible. We face a poorer and more uncertain future.

Despite his “no regrets” statement in Downing Street on Friday, I doubt if David Cameron now thinks that of the referendum that is bringing an end to his prime ministerial career. You only ask a big question of voters if you are sure of the answer. Downing Street thought it was sure of the answer as late as Thursday evening but it was wrong. As it is, a Tory prime minister Sir Edward Heath is most remembered for taking Britain into Europe 43 years ago, and Cameron will go down in history as the prime minister responsible for taking us out.

The Cameron-George Osborne double act, meanwhile, does not have much further to run. As with the referendum outcome, people will have mixed feelings about this. The chancellor has had more than his fair share of setbacks, particularly since last year’s election. As he joked himself, his version of the 5:2 diet is one in which in two out every five budgets he has to eat his words.

Osborne wanted to be remembered as the chancellor who took over at a time of crisis and, while courting unpopularity, fixed the public finances, alongside some long-term reforms, including pensions. Now, the abiding memory will be of the warnings on the economy that he commissioned or co-ordinated not being enough to persuade voters. Indeed, if the evidence of the polls is anything to go by, those warnings backfired with many voters. It is not hard to think who might succeed Cameron as prime minister. A successor to Osborne is rather harder to think of.

Osborne’s efforts were not enough, and neither were those of the overwhelming majority of economists, including highly respected bodies such as the Institute for Fiscal Studies (IFS). Businesses, big and small, were much less influential than expected, even locally. Nissan’s presence was not enough to prevent a big vote for Brexit in Sunderland, nor Honda in Swindon, nor Airbus in Flintshire.

I noted last week that economic arguments would not be enough to prevent a big vote for leave and a very close outcome on Thursday, and so it proved.

Many have said that those of us inside the “bubble” were unaware of the anger out there from the economic have-nots, some of which pre-dates the global financial crisis. I was well aware of such anger, particularly in Wales, the poorest part of the UK, where most local authority areas voted for Brexit. But the Brexit vote, as I also know, included many usually non-political, comfortably-off middle-class voters in the south-east.

One thing I do not have the slightest regret about is setting out the strong economic case for staying in the EU. I doubt it swung a single vote but I would have felt permanently guilty if I had not done so, particularly towards the young, many of whom feel they have just had part of their future snatched away by leave-supporting older voters. The baby boomers have done it again.

Many divides were thrown up by the referendum, but the inter-generational one is perhaps the most regrettable. Many young people, including those in my family and their friends, were almost inconsolable after the result became known.

The other thing that my series of pieces did was to provide a road map for the kind of post-EU response we should have. The first response to calm the market reaction, from Mark Carney on Friday morning, managed to make a nasty situation somewhat less toxic without saying all that much, other than that the Bank of England is prepared for all eventualities.

There will be important decisions from the Bank in the coming weeks. In one sense, it is good that Carney and his colleagues have the experience of 2007-9 to draw on, a period in which the authorities’ reaction was less than surefooted.

Whether the Bank needs to cut rates (or raise them to support sterling) and whether it needs another round of quantitative easing (QE) will become clearer in the coming weeks. The Bank’s preferred response will be to content itself with supporting financial stability, riding out the storm without adjusting rates or engaging in another round of QE, which was why there was no knee-jerk reaction on Friday.

What about the fiscal policy response? One campaigning line which Osborne was unwise to pursue was the idea of putting up taxes or slashing spending in the wake of a Brexit vote. That was when he departed from economic logic. If your economy takes a hit, as Britain’s will do, the sensible response to it is not to amplify that hit. Deficit-reduction is appropriate, when needed, in a growing economy, not one that has just been hit by a sock.

The public finances will have to take the strain. Osborne’s deficit targets were slipping anyway, partly because of the pre-referendum slowdown in the economy. His successor will have to decide whether to aim for a budget surplus. There will be downgrades of Britain by the ratings agencies, because of Britain’s record current account deficit, as well as the budget deficit, but that is probably one of the least of our worries.

More important than the short-term monetary and fiscal response are the decisions that need to be taken in the coming months to limit the long-term economic damage from Brexit. Despite silly attempts to disparage it by Vote Leave campaigners, the single market is hugely important to Britain’s economy. It is important for goods, and it is important for services, including financial services.

It is too much to hope for a deal in which Britain could be fully part of the single market while being outside the EU but something as close to that as is feasible has to be the aim. The UK, like Norway and Iceland, will need to be in the European Economic Area but with enhanced arrangements for the City. There will be a price to be paid in terms of what will effectively be a contribution to the EU budget but that would be a small price compared with significantly restricted access to our most important market.

What can be achieved on the single market will be key to Britain’s ability to continue to attract foreign direct investment (FDI). This will be the test in the coming years. Will multinationals automatically choose to access the single market from EU locations, or will it be possible to neutralise the impact of exit by replicate as close as possible existing arrangements? FDI does not come without a huge effort, and those trying to attract it to Britain will fear they have one hand behind their back.

The final area is immigration. We have a system for non-EU migration which does not work well, and an apparent plan to apply that to EU migration as well. In all the debate over immigration, and “taking back to control”, it is often forgotten that it is not just doctors and engineers we need but also in many sectors, unskilled workers.

So, this was not a result I wanted but congratulations to those who did and I am not going to sulk. The task now is to make the best of a bad job.

Sunday, June 19, 2016
A hard pounding - and with so very little to show for it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The moment is nearly upon us. Like the Scottish referendum in September 2014 but with even more at stake, a nerve-racking few days lie ahead. Either way, we will wake up to a different world on Friday morning , a very different one in case of a vote to leave.

One point is worth making. It is that economic models tend to underestimate the impact of shocks, as we saw in 2008. Some people say leaving the EU will be a little like leaving the European exchange rate mechanism (ERM) in September 1992. Apart from the fact that both narratives involve a plunging pound, the similarities end there. In 1992 we left a currency arrangement after 23 unhappy months having joined, as was said then, at the wrong rate, the wrong time and for the wrong reasons.

Leaving allowed an overvalued pound to come down to earth, and made room for big cuts in interest rates, which are simply not an option this time. As for sterling’s fall providing us with the elixir of export-led growth, it did not happen after the pound’s 25% fall in 2008-9, and there is no reason – with world trade depressed – it would be any different now.

Voting to leave the EU after 43 years in which our economy has become increasingly intertwined with the rest of Europe, and done well out of it, would be a very different proposition to being kicked out of the ERM. Even leaving the ERM made the Tory economic brand toxic for years. Apart from the economic and financial fallout, the political instability that would result from a Brexit vote would be much bigger. Whether this would be helped or hindered by George Osborne’s threatened £30bn emergency austerity budget – and whether it would happen - is one of the many questions that would arise.

It would be foolish to deny that any of this will prevent a big vote for leave and a close outcome on Thursday, and that those expecting “it’s the economy stupid” to have clinched it were wrong. A minority probably believes in the “project fantasy” of a seamless transition to a world waiting for British goods and services if only the EU were not holding us back, and the mythical pot of fiscal gold and bonfire of red tape beyond Brexit.

Rather more believe much more important is to “claim back our country”, which for most means sharply reducing immigration, even if there is an economic sacrifice. For some, where the pressures on local services are acute, and where there has been a sudden increase in the migrant population, such concerns are valid.

But there is also something more visceral happening elsewhere, the fear that hordes of Syrians, Iraqis, Turks, Libyans and those who use Libya as a jumping-off point are about to hit our shores, as well as legitimate economic migrants from the EU. They are not and politicians will regret stoking up the immigration issue. If there is a vote to leave, we will replace one set of politicians who unwisely promised and predictably failed to reduce net migration to the tens of thousands with another, unless the labour market is so badly affected it ceases to be a magnet.

Non-EU net migration from the Commonwealth but also China (mainly students), Russia and America, has averaged more than 200,000 a year this century. As for EU migration, over the long run it might be reduced but it would not stop.

But there are other pro-Brexit views out there, not specifically related to immigration, some of which I received in response to last week’s piece, which should be addressed.

The first is the eurozone. The argument here is straightforward. Why should we stay in the EU when the eurozone, its centrepiece, is heading for disaster? I wrote here on April 24 about the need for further eurozone reform. The much-misinterpreted Five Presidents’ report of last summer (the presidents of the Commission, Council, Central Bank, Eurogroup and Parliament) is about precisely that, rather than creating a “superstate”.

Its aim, to ensure that the single currency works for all its members and avoids being caught out as it was in 2008, is laudable. It wants member states to establish more flexibility in their economies and to build fiscal buffers so they can cope with future downturns. It is an agenda Britain should support. The worry is that, because of other issues, including the migration crisis and, yes, the referendum, it is not being implemented rapidly enough. But it is lazy to assume another eurozone disaster is looming. Lessons have been learned.

The eurozone’s experience demonstrates that, far from being a superstate, its members are not integrated enough. The European Central Bank had less freedom than other central banks to engage in unorthodox monetary policy, which is why it came to quantitative easing so late, because it had to deal with national sensibilities. That was also why its rescues of troubled eurozone countries were so fraught. Is the eurozone clear of the crisis? No, but as I noted last week, Britain is also in a state of convalescence.

The second strand is a familiar one. It is that, even if there is an economic price to be paid for Brexit, it is worth it to be freed from the yoke of the “unelected bureaucrats” in Brussels, restore our sovereignty and stop the EU making all our laws. In short, why should we stay with an imperfect EU? Space is limited, and these are big issues, but briefly.

It would be foolish to deny there is a democratic deficit in the EU, but it is worth digging into. European Commissioners are proposed by democratically elected national governments. The Commission president, chosen by the European Council (leaders of member states) by qualified majority voting, has to be approved by the European Parliament.

In Britain, moreover, we have a curious attitude to European democracy. If we wanted better scrutiny of the European Commission we would take European Parliament elections more seriously. But two-thirds of us do not bother to vote and we do not mind sending Westminster rejects and anti-EU oddballs there.

You could have direct elections for the Commission and its president (last time there were primaries) but that would be seen by critics as a step towards the superstate they fear.

On sovereignty, no country is truly sovereign in the modern world but we have independent economic and monetary policy, independent foreign and defence policy. Talk of an EU army – if Britain stays - should rightly be taken with a large pinch of salt. Steve Peers, professor of EU law at Essex University, pointed out in a recent article that Britain has vetoes in all the important areas, including defence, transfers of power, enlargement, taxation, non-EU immigration, asylum and criminal law, the single currency (including participation in bailouts and Britain’s opt-out) and the EU budget rebate.

Where there is qualified majority voting, future British governments can and should build alliances. People who think Britain can bestride the world, striking deals left, right and centre, strangely fear we are either incapable, or too timid, to stand up for ourselves in Europe.

These issues deserve a lot more space, as does the idea that most of our laws come from the EU; they don’t and most of those that do are the legal detail of single market rules. Old prejudices die hard, however, Since the days of Jacques Delors, some people have chosen to believe that Brussels only exists to do Britain down. It doesn’t. In this mad campaign, however, some people will believe anything.

Sunday, June 05, 2016
Leaving the single market risks a world of pain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Judging by the many ideas I have had for post-referendum subjects – keep them coming – I sense that June 23 cannot come too soon for most. Are we nearly there yet? Yes.

Soon there will be no more of the Brexit camp’s bogus £350m figure, or its fantasy pledges of spending £100m a week more on the NHS or cutting Vat on fuel, which are an insult to voters’ intelligence.

Next week I shall pull all this together and the following week I shall clear up some important loose ends, but today’s piece is a reminder of how far we have come.

When, seven months ago – before we even had a date for the referendum – I wrote that if we left the EU we would lose the single market, the reaction from many Outers was that we would do nothing of the sort. The rest of Europe would be so keen to trade with us that they would allow us to leave while staying in the single market.

Time has moved on. Vote Leave’s position is clear on one thing; that a post-Brexit Britain will not be in the single market. What it will be in is not clear. The small group known as Economists for Brexit has suggested no trade deals at all and the unilateral removal of all trade barriers by Britain. I shall come back to that.

It is important in this debate to know what the single market is. It is not just a trade deal. It is one of the most important ways in which Britain has influenced the EU. When Margaret Thatcher took up the idea of the single market in the mid-1980s, and set Britain’s European commissioner Lord Cockfield the task of pushing it through, it was against the protectionist instincts of some other EU countries.

The single market is still a work in progress but it has come a long way. By setting the same regulatory standards, state-aid regulations and other rules across the 28 members, it guards against unfair competition. Those same standards mean that firms do not have to go through the rigmarole of complying with different sets of rules, including product and safety standards, to sell in different European countries.

The single market has created an integrated European economy, taking advantage of the economies of scale of a 508m population grouping of countries. Supply chains operate across borders. Within a business, some components will be made in one country to be combined with others made in another. Dismantling these supply chains, or putting tariff and other barriers up within them, would be both time-consuming, costly and a recipe for inefficiency.

Most importantly, as far as Britain is concerned, progress is being on a single market in services. When EU leaders such as Donald Tusk talk of deepening the single market, it is an agenda we should enthusiastically embrace. British exports of services to the EU have almost doubled in a decade and trebled in 15 years. The passporting regime, as the Bank and England and others have noted is important for Britain’s financial services sector. In its absence, some activity and employment would be relocated to inside the single market.

Much of the debate on the single market is stuck in the world of 40 years ago. When the Brexit camp say a way would be found for Germany to sell its cars or the French to sell their cheese in Britain, they are reflecting that world. Perhaps the strangest recent comment – in a crowded field - was from Steve Hilton, David Cameron’s former “blue sky” thinker, who said: “The US is not a member of the EU, but the last time I checked, General Motors had no problem selling cars there.”

GM, of course, exports very few cars from America to the EU, but is part of the integrated single market, with local manufacture at Vauxhall in Britain, Opel in Germany, and extensive operations in Spain, Hungary, Poland and Austria.

As for a deal to sell German cars in Britain, maybe. But most of the 80% of British cars built for export are sold elsewhere, including elsewhere in the EU, and a deal to maintain access could be difficult. No wonder Britain’s Society of Motor Manufacturers and Traders reports that 77% of its members favour continued EU membership and only 9% want to leave.

The single market, named by 79% of inward investors in Britain as a key driver of location decisions in the latest EY attractiveness survey, clearly matters for both trade and investment.

It is also a dynamic process. When the rules evolve – and in the case of Brexit without any British influence on those changes – firms selling into the EU would have no choice but to abide by them. Without Britain at the table to push for further liberalisation, and with new barriers erected, our strongly-growing services to Europe would languish.

What about the fact that fewer than half of our exports now go to the rest of the EU? This tells me two things. One is that EU membership is not preventing us exploiting other markets. The other is that it is an inevitable consequence of the rise of China and other emerging economies. As the share of the older industrial economies in the global economy has declined, so their share of UK exports has fallen.

But the EU remains crucial. We sell almost as much to the 450m people in the rest of the EU, as to the 6.5bn or so people in the rest of the world. Making it more difficult to do that does not look like an obviously sensible strategy.

What about the idea, associated with Professor Patrick Minford of Economists for Brexit, of no trade deals at all, and a unilateral removal, by Britain, of all trade barriers? I know Minford well, but I think he is onto a loser with this one. He himself has said it would probably mean the elimination of manufacturing industry in Britain.

An assessment of his proposal by the Centre for Economic Performance at the London School of Economics, using up-to-date trade models and empirical evidence, says the negative impact on living standards in Britain would be similar to the so-called WTO (World Trade Organisation) option. The WTO option is, in any case, quite problematical, as its director-general has pointed out. Whatever future Britain had outside the EU, it would involve extensive and painful negotiation to get there, generating significant uncertainty.

But, as I say, one thing is clear. If we were to vote to leave on June 23, it would be a vote to leave the single market. Some will not mind that. Many, including many in business, will be deeply worried.

Sunday, May 29, 2016
Plenty of migrants - but plenty of jobs for UK workers too
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The economic debate over EU membership rages on, with the heavy weaponry overwhelmingly on one side. I can only hope there will be a ceasefire on June 24 but I cannot promise it.

So in the past few days we have had the Institute for Fiscal Studies confirming the conclusion of this column on May 1st, “There’s no pot of gold at the end of the Brexit rainbow”, and that there will not be the Leave campaign’s dodgy £350m a week figure to spend on the National Health Service or anything else.

Because the public finances will suffer in net terms from Brexit, on all plausible assumptions, there will be less to spend on services, not more. The IFS, for pointing out this simple truth, got accused by the teenagers who run the Vote Leave campaign of being a propaganda arm of the European commission or, even more absurdly, by Nigel Farage – EU-funded for the past 17 years – of being biased because it gets some funding from the EU.

The IFS’s great achievement over decades has been to rise above politics, informing the debate. Its intervention on the likely consequences for the public finances of a Brexit vote maintained that tradition.

What about the Treasury’s prediction of a short-term Brexit shock of between 3.5% and 6% of gross domestic product, and up to 820,000 fewer jobs than under a Remain scenario? Given that it probably did not need to do it, or be asked to do it, did the Treasury lay it on a bit thick?

Perhaps. Confidence effects are hard to measure, and they could be smaller or bigger than the Treasury assumes. In the political chaos that would follow Brexit, a rapid handover to a government composed of prominent Brexiteers would put the wind up many in the markets and in business. And hte direction of travel of the Treasury's assessment is similar to other, independent analyses.

One criticism of the Treasury exercise I would defend it against is that it did not take into account the monetary policy response to a Brexit vote. If interest rates were cut, in other words, it could mitigate some short-term confidence effects. The reason the Treasury was right not to include such a response is that Mark Carney has made clear it could go either way; interest rates could rise or fall. Even if they were cut from 0.5% to zero, I doubt there would be much of an impact on the economy or confidence. It could even be seen as a panic move.

Anyway, all this is grist to my mill. I shall pull together the economics in a couple of weeks’ time. For now, let me focus on a topic of the moment, one on which Vote Leave feels more comfortable, immigration.

Immigration is subject to more deliberate misreporting and scaremongering than any other subject. If there’s Project Fear on one side on the economy, there’s more Project Fear on the other on immigration. Anti-immigrant sentiment is stoked up as aggressively now as at any time I can remember. Partly because of this immigration, as I wrote when last in this territory in February, is economically beneficial but has become politically toxic, even in areas where there is not a large immigrant population.

This was the context in which the Office for National Statistics released its latest migration statistics. They showed net migration of 333,000 in the 12 months to last December – in other words 2015 – up a little, 20,000, though not in a “statistically significant” way, on the figure for 2014. Net migration, which measures the difference between long-term arrivals and departures, rose compared with 2014 because of a drop in emigration.

As before, and as has always been the case since we joined the European Community in 1973, non-EU net migration exceeded EU migration, though only slightly. EU net migration into the UK was 184,000, non-EU migration 188,000. The 333,000 number for overall net migration arises from 39,000 of net emigration by British citizens.

The ONS also provided some useful information on short-term migration. A couple of weeks ago, many newspapers ran stories about “hidden” migrants, people who come to Britain for between one and 12 months. They do, and always have, some for seasonal work, some for study, some for other reasons. But British people travel abroad for these reasons too. In the year to June 2014, there were on average nearly twice as many short-term emigrants – people from Britain leaving for between one and 12 months (420,000) – as short-term immigrants (241,000). The effect of short-term migration was to reduce not add to the population.

When people have a problem with immigrants that is not simply dislike of foreigners it usually arises from two sources. One is the additional pressure they impose on public services. The figures are, however, clear on this. HMRC data show that migrants who arrived in the past four years paid £2.5bn more in taxes in 2013-14 than they received in tax credits and benefits. That money is currently being used, at least in part, to reduce the budget deficit. But it is also as available as anybody else’s taxes to pay for public services.

The other problem people have with immigration is the “they’re taking our jobs” objection. David Davis, the former shadow home secretary, who I normally have a lot of time for, described the EU as “a job transfer machine – switching employment from British workers to those on the continent”. He is not alone. Many people think that the jobs created in Britain in recent years have mainly gone to eastern Europeans.

Leaving aside the fact that this is also an area of regular misreporting – new jobs and a net increase in employment are not the same thing – the true picture is very different. Since January-March 2010, the post-recession low-point for employment, the number of UK-born workers in employment has risen by 1.1m to a new record level of 26.25m. Not only was the number a record, but so, in 2015, was the proportion of UK-born people aged 16-64 in employment, 74.3%. In the six years to the first quarter of this year. there was a rise from 70.7% to 74.6% in the UK-born employment rate.

There was, it should be said, also a net rise of 633,000 in the number of EU migrants from the new eastern European member countries in work - more than 80% of those of working age do so - and one of 309,000 in those from long-standing EU counries in western Europe. But this rise occurred alongside, not instead of, a sustained increase in UK-born employment.

Employment among UK nationals rose even more, by over 1.5m, in the six years to the first quarter accounting for two-thirds of the overall rise in employment It has also never been higher as a percentage of the 16-64 workforce.

Could there have been a bigger increase in UK-born or UK nationals' employment? Maybe a little, but probably not by much. Given that a significant proportion of the 16-64 workforce is in full-time education and not working, or looking after children and other family members, or unable to work for other reasons, the current UK-born employment rate is probably quite close to the maximum.

What about the kind of migrants we have? Would not we do better with the much-vaunted points-based system, based on the Australian model, promoted by Boris Johnson and Michael Gove, as well as Ukip? Well, we have such a system for non-EU immigration, and even its best friends would say it is not working that well.

As for applying such a system to immigration from Europe in the event of Brexit, even Migration Watch criticises it for its extreme complexity and for the fact that it is a system intended to encourage immigration; Australia’s net migration per capita is roughly three times that of the UK. It is, it says, “thoroughly unsuitable” for Britain.

The majority of EU migrants to Britain would still qualify under skilled-labour criteria under a points-based system. But this additional layer of bureaucracy, whether the onus would be on workers or those seeking to recruit them, would make it harder for firms to fill gaps in their workforces. Those who say they would reduce red tape would merely tangle business up in more of it. And Britain’s labour market would become more inflexible.

Sunday, May 22, 2016
We hate EU red tape - but others are tied up more than we are, and there'll be no bonfire of it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A few weeks ago I came across a woman who told me that she was voting to leave the European Union because it had stopped her buying traditional light bulbs. She was, pun intended, incandescent.

I suggested that this was not a very sensible basis on which to base a decision but she was having none of it. The EU had gone too far. I tell the story because it illustrates a wider theme, the perception that Brussels is foisting things on us that, were we to leave, we would no longer have to do; that it is strangling us in its unnecessary red tape.

In the case of incandescent light bulbs, the position is clear and entirely the opposite of that perception. Hilary Benn, environment secretary in the Labour government, announced in 2007 an agreement with retailers to phase out the sale of incandescent light bulbs by 2011. Britain, he said, was “leading the way”.

His initiative came two years before an EU agreement to phase out the bulbs. In this, as in many things, the EU was going with the flow. Most countries have plans in place to phase out old-fashioned energy-inefficient bulbs. In Britain, I should say, nearly a decade after Benn led the way in banning them you can still buy them if you know where to go.

It would be unfair to blame my light bulb lady. For years, blaming Brussels for most things has been the default position of a significant proportion of the media and, it should be said, quite a lot of politicians. The EU provides good cover.

Nor will this stop. The Arthur Daleys abound in the referendum debate. I heard one the other day giving a ludicrous figure for the cost of EU regulation, repeat the now discredited £350m a week figure we “send” to Brussels and claim most businesses in Britain favour Brexit. They don’t. Every credible business survey, covering firms from the large to the very small, show a net position in favour of staying in the EU, apparently in spite of all that red tape.

Red tape is an important issue. None of us like it and for some firms it goes beyond being a mere irritation. There is often a sense among firms I talk to that Britain obeys the rules, and even “goldplates” them, while other EU countries adopt a more relaxed attitude.

But it is also important to be realistic. Some red tape simply represents the fact that things that were acceptable on health and safety or other grounds in the past no longer are. Like lower-energy light bulbs, they have would have happened whether or not we were in the EU. Some may yearn for the days when every new electrical appliance was supplied with bare wires, for the householder to fit the plug – not always successfully – but those days are not coming back.

Not only that, but much red tape is home-grown. Her Majesty’s Revenue & Customs has been trying to reduce the administrative burden on business – hard when you have had successive chancellors addicted to tinkering with the tax system – but it is still a work in progress.

It is also the case that, far from EU rules being foisted on an unwilling Britain, successive governments have often initiated them - as we initiated the single market – or been perfectly happy to go along with them. In Facts, a group which seeks to promote accuracy in the referendum debate, points out that of nearly 2,600 EU votes since 1999, Britain has voted no only 56 times and abstained 70 times. On more than 95% of occasions, in other words, we have been quite happy.

Just because ministers are happy does not, of course, mean business is happy but there are two essential points in this debate. The first is that, however bad it may seem, Britain is less regulated than our EU competitors. This is not that surprising; it is one reason why inward investors have favoured Britain as their location of preference within the EU single market. It is confirmed by Britain’s high ratings in the World Economic Forum’s international competitiveness league table and the World Bank’s “ease of doing business” rankings.

It is quantified in successive studies from the Organisation for Economic Co-operation and Development (OECD). These have the virtue of showing, not only that some EU countries are more regulated than others – look at the French, German, Italian, Dutch and Belgian labour markets – but also that Britain is among the least regulated advanced economies, in or out of the EU.

For product market regulation, Britain is the second least regulated of 34 OECD countries, and marginally less regulated than America. For employment legislation, Britain is the fourth least regulated. However bad the red tape burden seems, it could be a lot worse. The think tank Open Europe points out that even at EU level there has been some progress in reducing red tape over the past two years.

In a letter last week organised by Vote Leave, some 300 business people said that “Britain’s competitiveness is being undermined by our membership of a failing EU”. Now, there are many reasons why Britain is not more competitive, ranging from shortcomings in education and skills, low productivity, a failure to invest enough, including in infrastructure, and lack of innovation is some sectors.

Blaming it on the EU, however, seems to me to be the worst kind of bleating, given that our regulatory burden is lower than the vast majority of our competitors. When we look for failings, we should look in the mirror.

This brings me to me second point. Would there be a bonfire of red tape if Britain left the EU? Open Europe, which is strong in this area, estimates the annual cost of EU red tape to be £33bn a year. There is, it should be said, a parallel estimate of the benefits to Britain of EU regulations of £58.6bn a year, also based on official impact assessments.

How can there be benefits of red tape? The Treasury, in its assessment of the costs and benefits of EU membership, lists some of them, such as the fact that a single testing regime for cosmetics reduces costs, that there have been significant gains to both operators and consumers in the transport sector, and so on. The public benefits from measures to protect the environment while, in the field of labour market regulation, one firm’s burden is its employees’ workplace protection. Estimates of the benefits of EU regulation, to be fair, include those from rules not yet fully enacted.

Staying with the costs, however, Open Europe calculates that a politically feasible maximum for the amount of red tape that could be reduced is £12.8bn out of £33bn, most coming from scrapping some labour market and environmental regulation, some from easier regulation of financial services.

It is a reasonable stab, but I think it is likely to be a significant overestimate. Think of the climate that we have been in, in which a majority Conservative government has had to backtrack on plans to cut tax credits and disability benefits. Think too of the continued debate over zero hours contracts and claimed exploitation of workers, or of the row over diesel emissions, where EU regulations have been attacked for being too lax, rather than too tight.

The idea that a post-Brexit Tory government, facing significant opposition from within its own side as well as from Labour and the Scottish Nationalists, could push through a programme of scrapping workers’ rights, reducing environmental legislation and adopting a softer-touch regulatory regime for the City, seems to me entirely unrealistic.

There is v ery unlikely to be any bonfire of red tape. Given that that has been a significant plank in the case for leaving the EU, this is a big flaw in that case.

Sunday, May 15, 2016
Amid all the referendum excitement, the long wait for a rate hike goes on
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Thursday’s Bank of England inflation report press conference was, by my calculation, the 29th since interest rates last changed. I may have missed one or two but sat though most.

If you think that’s a burden, think of the members of the monetary policy committee (MPC) itself. The latest “no change” verdict from their May monthly meeting was the 86th in a row. The personnel have changed along the way, and MPC members would not doubt say there was nothing they would rather have been doing. But no wonder, perhaps, the Bank is reducing the number of MPC meetings from 12 to eight a year.

There was a time when the Bank was expected to be the first of the big central banks to hike rates. Then, when it became clear that America’s Federal Reserve would be the first-mover, which it was last December, that the MPC would follow soon after. Now, it is fair to say that there is more speculation about a cut than a rise.

Part of that, of course, arises from the part of the Bank’s inflation report that Mark Carney, its governor, described as “the elephant in the room”. Its view that a decision to leave would have “material economic effects”, including weaker growth, higher inflation and rise in unemployment, was explicit.

Sterling would fall, “perhaps sharply”, and: “Aggregate demand would also likely fall, relative to our forecast, in the face of tighter financial conditions, lower asset prices, and greater uncertainty about the UK’s trading relationships. Households could defer consumption, and firms could delay investment. Global financial conditions could also tighten, generating potential negative spillovers to foreign activity that, in turn, could dampen demand for UK exports.”

The Bank’s frankness has provoked predictable fury from the Leave camp. My tip for them would be not to challenge the Bank’s independence or its governor’s integrity – these verdicts were unanimously agreed by all nine members of the MPC and the 10 members of the financial policy committee – but to argue that a bit of short-term pain would be worth it for what they see as the long-term gain. I doubt if they will take that advice.

The referendum is the latest obstacle to a return to some kind of normality for interest rates, adding to a very long list. The Bank held rates at their record low to help the economy cope with George Osborne’s fiscal tightening, and kept them there and unleashed another round of quantitative easing when the eurozone was mired in its deepest crisis. It passed up an opportunity to raise them in 2014 when growth was strong and unemployment falling far faster than it expected, and well below the 7% rate cited by Carney in his forward guidance the previous summer.

When rates were first reduced to 0.5%, in March 2009, MPC members did not think they would stay there long, probably less than a year. Now, according to the markets, it will be touch and go whether they go up before the 10th anniversary of that cut, in 2019.

Andrew Sentance, the former MPC member and long-time hawk has promised to assemble a live band outside the Bank to celebrate the first hike. I think it will take more than that, maybe a streak down Threadneedle Street. Either way, according to the markets, it looks a long way off.

Is that a reasonable expectation? Let me take two scenarios, Brexit and non-Brexit. The Bank’s response to big events usually has the virtue of being clear-cut. In the global financial crisis cutting rates was a no-brainer.

In the case of Brexit, as Carney and his colleagues made clear, the decision would be more balanced. The slump in sterling and the consequent rise in inflation would argue for higher rates, while the hit to growth would make the case for a cut. A cut would not do much – I am pretty sure the Bank will not want to follow other central banks and opt for negative rates, so from 0.5% to zero would be as far as it goes. A half-point cut in interest rates would not do much to offset a growth shock. As the governor said, there is only so much that monetary policy can do.

Which way would it go? The Bank is not saying. If it thought the rise in inflation resulting from Brexit was temporary, then it could “look through” it, as it has done before, and cut to try and keep growth going. If, on the other hand, a post-Brexit slump in sterling turned into a rout, the Bank might have no option but to raise rates to prop it up. After two decades in which sterling has not been a driver of interest rate hikes in Britain, it could make an unwelcome return. This is the kind of nostalgia we can do without.

The other point about interest rates post-Brexit is that even if policy rates were cut, actual rates in the economy might well rise, because of the increase in bank funding costs. Carney told me that the Bank would do its best to mitigate such effects by providing liquidity, but even that might not do the trick.

What about interest rates under a Remain scenario? That is easier to address, because it is the assumption on which the Bank has based its new forecasts. There is a view that, once the referendum uncertainty is out of the way, the Bank will feel liberated enough to give serious thought to raising rates. Not immediately – August would be too soon – but perhaps as early as November.

A post-referendum bounce in economic activity would provide the context, while the Bank’s forecast that inflation in two years will be back above 2% would give the justification. Quite a few economists in the City subscribe to this view. Add in one or two more rate rises between now and November from the Federal Reserve and the Bank could see itself as going with the flow.

On the other hand, as noted above, there have bene plenty of opportunities to grasp the nettle on rates in the past few years, and it has gone ungrasped. In its inflation report, the Bank devoted a large panel to the effects of uncertainty, and how they can linger even after the event that has caused the uncertainty has come and gone. The post-referendum bounce in the economy would have to be big and very obvious for the Bank to move. And 2016, for all its other excitements, would go down as another year in which nothing happened on interest rates. In which case, maybe next year?

Sunday, May 08, 2016
Housing: a simple story of supply and demand
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Let me take a break from the heat of the Breferendum debate this week and enter the calmer but only slightly less contentious waters of the housing market. Another set of elections have passed, amid ambitious promises to sort out the problems of housing. I think I can guarantee that when these elections are next held in a few years’ time those problems will still not have been sorted out.

Britain’s housing problem is easily described. There is plenty of housing demand but not enough supply. And, while it has been possible to comfort ourselves in recent years with the fact that supply, while inadequate, was moving in the right direction, it now appears that it no longer the case.

In such a situation there is only one outcome, prices will rise and housing will become more unaffordable. It is not unaffordable to the vast majority of existing home owners, most of have substantial equity in their properties and continue to benefit from very low mortgage rates. If housing was unaffordable to the majority, prices would fall.

But the problem of unaffordability impacts particularly on new entrants, the first-time buyers faced with a dauntingly large first step to get on the housing ladder. Hence the renewed interest in the leg-up role of the Bank of Mum and Dad, which according to Legal & General is part-funding at least a quarter of mortgages this year. And hence the return of the 100% mortgage from Barclays, an idea which had apparently perished in the ashes of the banking crisis, though this one comes with more strings attached (in the form of parental support) than was the case then.

Let me start with housing supply. One of the best indicators of supply is provided by NHBC, the old National House Building Council. It provides building guarantees, and all but a fraction of new homes being built are registered with it.

Its latest numbers show that in the first quarter of the year, 36.566 new homes were registered, which sounds reasonable enough but represented a drop of 9% compared with the first quarter of 2015, when 40,144 new homes were registered. There were declines in both private registrations, down 7% on a year earlier and in social housing, down 15%.

That first quarter fall was enough to bring an end, for now at least, in the upward trend of housing supply. For the 2015-16 financial year, a total of 152,329 new homes were registered, virtually unchanged on the 2014-15 figure of 152,262. Mike Quinton, NHBC’s chief executive, said the supply of new homes was “consolidating”, though also pointed to an 80% rise in registrations compared with the lows of 2008-9. It is consolidating in spite of continued support from, for example, the government’s Help to Buy equity loan scheme for new homes. We should, remember, be building around 250,000 new homes each year.

In London, where the housing shortage is most acute, and where the mayoral candidates battled among other things over the provision of 50,000 new homes a year, separate figures from Stirling Ackroyd, estate agents, showed that London boroughs approved just 4,320 new homes in the first quarter, down 64% on a year earlier. Those who are quick at mental arithmetic will have noticed that 4,320 new homes in a quarter represents barely a third of an annual target of 50,000.

New housing is not the only source of supply, as I often point out. What existing homeowners do is also very important. The cycle of trading up as families expand and downsizing when they have flow the nest is part of the essential ebb and flow of a properly functioning housing market. But that cycle, if not broken, is severely damaged.

According to Rics, the Royal Institution of Chartered Surveyors, “lack of supply is still an overriding feature of the market”. While the number of people putting homes on the market is better than it was a few months ago, it remains well below normal. I put a lot of that down to high transaction costs – stamp duty and other fees provide a significant deterrent to move – but there are other factors. Older people wanting to downsize also complain of a shortage of suitable properties.

What about demand? Latest Bank of England figures show that mortgage lending is strengthening. In March lending was up by 3.4% on a year earlier, while its annualised growth in the latest tree months was a robust (by recent standards) 4.7%. A year ago mortgage lending was trundling along at less than 2%.

Some of its recent strength, it should be said, reflects a buy-to-let and second home rush ahead of George Osborne’s imposition of a 3% stamp duty premium on such purchases, which took effect last month. But part of it reflects the underlying growth in demand you would expect in a rising population, and the gradual normalization of the mortgage market. Housing supply, in all its forms, is inadequate to meet housing demand.

We see the consequences of that, of course, in prices. The Halifax, part of Lloyds Banking Group, will provide an update on prices tomorrow but its last bulletin had prices rising at an annual rate of 10.1%.

The official house price index, from the Office for National Statistics, has prices growing at a 7.6% annual rate, but that is still more than three times the growth in average earnings. A glance at the ONS’s long-run chart shows that prices are currently more than 120% higher than in 2002, the base-date for the index, and 20% above their pre-crisis peak. As time goes by the crisis will come to look like barely a blip on the house-price radar.

I said this was a non referendum piece but it would be wrong to ignore the impact of the forthcoming vote on housing. Brexit uncertainties are weighing on the economy, and thus on the housing market. Rics, to quote them again, says that we should look to commercial property for the biggest effects, but that housing will also be affected, with prices pushed lower “in the immediate to short term”.

In the long run, however, it is the fundamentals that will determine what happens to housing. The problem of inadequate new housing supply pushing up prices was, after all, quantified by Kate Barker in her review for the Labour government in 2004. This was before the surge in migration from the rest of the EU and it is a verdict that will survive the end of that surge. Leaving the EU might moderate the long-term upward pressure on house prices but would not remove it.

The problem of unaffordability for those wanting to get on the ladder – and the difficulty of saving for a deposit while renting – will remain. Many people say the housing market is not working. In one key respect, however, it is. When supply is weak and demand strong, prices will tend to rise. That’s what happens in all markets.

Sunday, May 01, 2016
There's no magic money tree if we leave the EU
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

There are two things that even the most casual observer of the EU referendum debate will have heard. One is that we “send” £350m a week to Europe. The other is, in a pattern familiar in politics, those who favour Brexit have come up with various ways in which this money could be better spent, the latest being to settle the junior doctors’ dispute.

If there is one thing I can impress on you as we approach our date with destiny on June 23, it is to expunge that £350m figure from your mind, because it is wrong. That is not an easy thing to do because it is so often said. But ignore any politician who says we send £350m a week to the EU. Tear up any leaflet that makes that claim.

A second thing I would urge is to reject what I would call the crude accountancy approach to Britain’s contribution to the EU budget, or others might term a reductio ad absurdum about this debate. In other words, the effect on Britain’s public finances, or for that matter the balance of payments, will be dwarfed by the wider effects of a decision to leave the EU. The analogy is not perfect, but it is a bit like deciding whether or not to buy a prestigious car on the basis of the cost of replacing the wiper blades. There is a lot more to it than that.

Let me start with the contribution itself. The odd thing about the £350m figure is that it is widely used by many Brexit campaigners who profess admiration for Margaret Thatcher, while conveniently ignoring the EU rebate she successfully negotiated at Fontainebleu in 1984 and which for three decades has reduced Britain’s budget contribution before anything is “sent” to Brussels.

The rebate has outlasted her, and it will outlast the current generation of politicians should Britain remain in the EU. The rebate was worth £4.4bn a year in 2014, the latest full year for which data is available, and averaged of £3.5bn over the period 2010-14. It is deducted from the £17.4bn annual gross contribution over that period.

That is not the only necessary deduction. An average of £5bn a year flowed back to Britain’s public sector during 2010-14, reducing the net contribution to £8.9bn, or £170m a week. Roughly £2bn a year comes from the EU to the private sector in Britain. On this basis, the net contribution over the latest five years averaged £7.1bn a year, £135m a week. In 2014 alone, it averaged £110m a week; less than a third of the claimed £350m.

These figures, I should say, come from correspondence between Sir Andrew Dilnot, the head of the Statistics Commission, the independent statistical watchdog and Norman Lamb, the Liberal Democrat MP who had complained about the use of the £350m figure. Sir Andrew agreed that it was “potentially misleading”, which means it should not be used.

The method in the Brexiteers’ madness may be that, even though they know £350m is misleading, any figure which runs at more than £100m a week is still a very large number. They, in other words, do not mind a debate about it. £110m or £135m a week is a lot of money to most people.

It is, however, small in relation to government spending; well under 1%. Could that money, small though it is in terms of the public finances, be used instead for domestic priorities? The answer to that comes in two parts.

The first is that any post-Brexit trade deal with the EU comes with a bill attached. Both Norway and Switzerland have deals which give them less favourable access to the single market than Britain has now, and no influence over the way single market rules are made. Norway pays only a slightly smaller per capita contribution as Britain.

Switzerland pays less, but misses out on, amongst other things, the financial passporting scheme that Mark Carney, the Bank of England governor, has said is very important for London’s role as a global financial centre. Switzerland would dearly love to have it. Nobody can say what the bill to access the single market would be but it is not impossible that it would be larger than now. The budget rebate would, after all, die with the end of Britain’s EU membership.

Even more important than this is the second key point, which is that any savings on the budget contribution would be dwarfed by the wider economic effects. As foreshadowed here last week, the Organisation for Economic Co-operation and Development (OECD) added its voice to the many warning of the economic costs of Brexit.

Angel Gurria, its secretary general, said Britons would pay a “Brexit tax”, equivalent to a month’s salary by 2020, adding that it would be “a pure deadweight loss, a cost incurred with no economic benefit”. It was an odd way of putting it but I think we know what he meant. Gross domestic product would be 3% lower than under a remain scenario by 2020 and between 2.7% and 7.5% lower by 2030.

As he put it: “While no one knows precisely what the costs would be, what is striking about our estimates and those produced by most others is that all the numbers under a Brexit case are negative. The best outcome under Brexit is still worse than remaining an EU member, while the worst outcomes are very bad indeed.”

On the budget contribution, the OECD’s assessment noted that “net transfers to the EU budget are relatively small, at 0.3% - 0.4% of GDP per annum in the years ahead, and the saving from a reduction in these transfers would be more than offset by the impact of slower GDP growth on the fiscal position”.

Like the assessments of the International Monetary Fund, the Treasury and the London School of Economics, the assumptions used in coming to such verdicts can be challenged. But all are remarkably similar and, in the case of the Treasury like the OECD, imply that far from Brexit helping the public finances by reducing budget contributions, the net effect would be “higher government borrowing and debt, large tax rises or major cuts in public spending”. Tax receipts by 2030 would be between £20bn and £45bn lower.

Some economists are attempting a fightback against what is becoming the prevailing wisdom. Three I know very well – Patrick Minford, a long-term “better off out” campaigner, Roger Bootle of Capital Economics and Gerard Lyons, economic adviser to Boris Johnson – are part of Economists for Brexit, which launched on Thursday. They are in a small minority against the economic mainstream but I shall take their views into account in my overall assessment.

Oxford Economics, which has no axe to grind in the debate, says that even the most benign Brexit outcome - one that does not harm the economy over the medium to long-term - would produce a “negligible” dividend for the public finances.

So the Brexiteers should stop pretending that leaving the EU would suddenly free huge sums to spend on what we like. There is no magic money tree. It is an insult to voters’ intelligence to suggest there is.

Sunday, April 24, 2016
In or out of the EU, we need a euro with stronger foundations
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

There are now just two months to go (two months!) to the referendum and as promised another instalment in my series on the economic issues. So this week, the euro. Do the single currency’s flaws mean we would be better off leaving the EU?

A few days ago the Treasury produced a comprehensive and rather impressive 200-page assessment of the impact of EU membership and the alternatives, taking the economic debate to a new level. I suspect most of its critics either have not read it or did not understand it. This week the Paris-based Organisation for Economic Co-operation and Development (OECD) will be the latest heavy-hitter to warn of the consequences of Brexit.

Even the most sophisticated economic modelling cannot, however, either product or sufficiently allow for disaster and crisis, as we saw in 2008. What if the subsequent near break-up of the euro was just one of a series of damaging convulsions that will be the norm for the eurozone in coming decades?

The euro and I go back a long way. Two decades ago, with my former colleague Andrew Grice, we had the world exclusive on the single currency’s name. Like all great stories, it did not make it onto the front page.

In 1999, my book Will Europe Work? was published, which concluded that the euro, as it had been set up, could not. The euro lacked the conditions of a so-called optimal currency area and would struggle. When it was published I encountered a small army of enthusiasts for early UK membership of the euro. They included Adair Turner, now Lord Turner, when he was director-general of the CBI. He has since admitted that he was wrong to advocate membership. Most of the others have airbrushed it from their memories.

Perhaps the euro advocates were not as out of step as it looks now. In the early 2000s, we started regular polling on the issue with the new (at the time) firm of YouGov. Throughout 2002, the year euro notes and coins were introduced, a majority of British people thought we should either join immediately or when conditions were right.

It is intriguing that, a decade or so after a time when joining the euro, or not, was the hottest topic in British politics – 2003 was the year of the Treasury’s famous five tests exercise – voters should be deciding on whether to leave the EU, something few thought was even the remotest of possibilities back then.

So what of the euro and its flaws and dangers? It is fair to say that the eurozone has been held together, sometimes against the odds, by the extraordinary actions of the European Central Bank. Since Mario Draghi, its president, said in 2012 he would do “whatever it takes” to save the euro, the ECB has run through its armoury of weapons, including most recently negative interest rates and quantitative easing. It has resulted in a return to modest growth and falling - though still very high - unemployment. The euro has held together.

Lessons have been learned. I would be surprised if a crisis of the kind that hit the eurozone in a series of waves between 2010 and 2015 were to repeat itself exactly. That was the time when its banking, sovereign debt and competitiveness crises came together. These were special and unusual circumstances. Glib forecasts of another big impending crisis should be taken with a large pinch of salt.

Even the euro’s best friends would admit, however, that much more needs to be done to make the eurozone secure, and turn it into a monetary union in which more than modest growth is possible.

Some things have been done since the crisis, of which the move towards banking union is the most impressive. But some initiatives, such as the so-called euro plus pact agreed at the height of the crisis, have foundered. Last summer’s “five presidents” report, Completing Europe’s Economic and Monetary Union, set out an ambitious programme, including fiscal union (one of the conditions for an optimal currency area).

But the attention of Europe’s leaders has wandered, to the migration crisis and even Britain’s referendum. Reform of the eurozone still has a very long way to go.

What does that mean for Britain? Both sides of the EU debate would agree on one thing; this country cannot be moved to another part of the world. Proximity is important. When the eurozone slid into a second recession in the 2011-13 period, Britain was affected, despite the attempt of some to portray the slowdown in that period as entirely home-grown.

But Britain’s growth over that period, 2%, 1.2% and 2.2% (2011, 2012 and 2013) was better than the achieved by Switzerland, a non-EU country, and Sweden, like Britain in the EU but not in the euro. I have mentioned before that being inside the EU but sensibly outside the euro has been good for Britain’s relative growth performance. Since January 1999, Britain’s economy has grown by twice as much as Germany and France and 10 times as much as Italy.

Are there enough safeguards to prevent Britain being dragged into future eurozone crises, as and when they occur? As a European country, Britain would be affected, but one key element of David Cameron’s now largely forgotten renegotiation is that the rights of non-euro countries have been given enhanced protection. Britain will never have to participate in eurozone rescues, except as a member of the International Monetary Fund (which would continue to be the case outside the EU).

And, according to last week’s Treasury assessment: “The new settlement provides the basis for stable and sustainable economic governance arrangements. It puts in place a set of legally-binding principles, supported by a new safeguard mechanism, that will ensure the UK is not penalised, excluded or discriminated against by EU rules because it is not part of the euro area. The new settlement recognises that not all member states have the euro as their currency and that the UK should not be forced to participate in measures designed for euro area countries. “

It would be better, of course, if Europe’s leaders were able to move on from the migration crisis and focus on strengthening the euro. Its existence makes life easier for British businesses, while Britain’s non-euro status provides us with the most important freedom in this debate; freedom to pursue an independent monetary policy. And we should not be too gloomy. The euro is here to stay. One way or another, we have to live with it.

Saturday, April 16, 2016
Let's hope it's just fear of Brexit hitting growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The sun has been shining, the birds singing and the days getting longer. But if the economy has a spring in its step it is keeping it well hidden. That squelch you hear underfoot is a soft patch.

The National Institute of Economic and Social Research, which uses official data and other information to calculate gross domestic product a monthly basis, reckons growth slowed to just 0.3% in the first quarter, half its rate in the final three months of last year, and its slowest since late 2012.

The British Chambers of Commerce, in its latest quarterly survey a few days ago, reported that growth had softened in the first quarter, “with most key survey indicators either static or decreasing”.

A similar message has been emerging from the monthly purchasing managers’ surveys compiled by Markit, the information services provider. As Chris Williamson, its chief economist, put it: “Survey data indicate a slowing in UK economic growth in the first quarter, with the suggestion that the pace is more likely to ease further rather than recover in coming months as business confidence remains unsettled by worries at home and abroad.”

In fact, though these things can change, it has been hard to find very much of cheer in the recent numbers. Even consumers appear to have been letting the side down. The British Retail Consortium reported that the value of retail sales in March was flat compared with a year earlier, with so-called like-for-like sales down by 0.7%. It ascribed this “relatively disappointing” picture to the timing of Easter, though in the past Easter has often provided a spending boost.

In some ways, weaker growth is not a surprise. Though the storm has now passed, the first few weeks of the year were characterised by a mood of deep gloom, and some deeply gloomy reporting of it, with markets plunging, the oil price apparently tumbling towards $10 a barrel (it is now in the mid-$40s) and George Osborne warning of a dangerous cocktail of risks. I am not suggesting your average Primark shopper keeps a close eye on the daily gyrations of the FTSE 100 but these things do percolate through to the mood.

Fortunately, too, we have another ready explanation for this period of weaker growth. I am not sure how wise it was for the International Monetary Fund to enter the Brexit debate a few days ago. At a time when at least some British voters are fed up with unelected supranational institutions throwing their weight around, another one sticking its oar in was not necessarily very deft.

I am not sure either that the chancellor should have celebrated that intervention so enthusiastically. The IMF is saying “heightened uncertainty” about the referendum is already hitting the economy and that Brexit itself would be a significant economic shock, with the potential for “severe regional and global damage”, according to Maurice Obstfeld, its chief economist.

But this apparently growth-damaging, risk-enhancing event has been created by the prime minister, with the full support of a chancellor whose long-term economic plan was supposed to take Britain away from danger. In this respect at least, you might argue, the economy would have been safer with Ed Miliband and Ed Balls.

The idea that Brexit uncertainty is to blame for the current period of weaker growth is not confined to the IMF. The Bank of England’s monetary policy committee (MPC) left interest rates unchanged at 0.5% for the 86th month in a row on Thursday.

In detailing that decision the MPC both outlined its view that “a substantial proportion of the recent fall” in the pound reflected referendum uncertainty, and that nervousness about the vote was weighing on growth.

As it put it: "There had been signs that uncertainty relating to the EU referendum had begun to weigh on certain areas of activity. Media references to uncertainty had jumped, though the impact of this on household spending was unclear. The likelihood that some business decisions would be delayed pending the outcome of the vote was consistent with the easing in survey measures of investment intentions, reports of the postponement of IPOs and private equity deals and a softening in corporate credit demand. The fall in commercial property transactions in Q1 had been particularly striking. Thus, there might be some softening in growth during the first half of 2016.”

It will surprise nobody that the Bank will be doing nothing between now and June 23. Whether it has to do anything afterwards, and particularly in the event of a vote to leave, it says it will “use its tools” to respond to what might be “an extended period of uncertainty about the economic outlook”. Osborne has talked about rate hikes but it could include interest rate cuts, even from 0.5%, reluctant though the Bank is to do that, and more quantitative easing, as well as emergency liquidity and other measures.

The EY Item Club, in its latest forecast out tomorrow, is also strong on the Brexit uncertainty point. As its chief economist Peter Spencer discussed here last week, it expects consumer spending to be less buoyant next year. Fortunately – on its assumption of continued EU membership – the cavalry will arrive in the form of stronger business investment.

“With the recent drag from uncertainty assumed to fade, companies are likely to resume their investment drive, putting their healthy balance sheets and high profits to good use,” he says. “This bounce back in business investment should more than offset the slowdown in the consumer sector.”

So we have a story here. The economy has slowed but a large part of that slowdown is due to pre-referendum uncertainty. Once that uncertainty is out of the way with a vote to remain, there will be other things to worry about, including the US presidential election, but growth should rebound.

It is a decent story, but it is not one we can be certain about. There is plenty of anecdotal and survey evidence that referendum uncertainty is having an impact but very little hard data. Recent weakness in manufacturing, exemplified by the problems in the steel industry, reflects fundamental rather than temporary factors, and is not just affecting Britain. Britain, as the IMF reminded us, is still in the process of fiscal consolidation – deficit reduction – with Osborne still hoping for that budget surplus. Global growth prospects, as the IMF also reminded us, have deteriorated a little in recent months.

We should not be too gloomy, but we should also not assume that with one bound we will be free to grow more strongly if there is a vote to remain. Ahead of the Scottish referendum in September 2014 there was a lot of talk of referendum uncertainty weighing on growth. But if there was a post-referendum bounce it was short-lived. In a picture admittedly complicated by oil weakness, the Scottish economy grew by just 0.9% between the fourth quarters of 2014 and 2015. All I can say is it would have been a lot worse with a vote for independence.

Is there a bigger uncertainty effect weighing on UK growth now than there was in Scotland then? We have to hope so, but it is by no means guaranteed.

Sunday, April 03, 2016
Britain would struggle to maintain inward investor appeal after Brexit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The referendum on Britain’s membership of the EU is still more than two months away, though the campaign seems to have been going on forever. Given that most election campaigns do not get properly in their stride until the final weeks, I cannot offer any early relief.

Instead, as promised, I will continue my series on the economic aspects of Leave and Remain. Shortly before the referendum, all these will be pulled together in a single piece and a verdict.

So far I have done five pieces. I began last November with trade, pointing out if you leave the EU then, unless you replicate the conditions of membership (including free movement of people and a budget contribution) you lose the single market. There is a lot of misunderstanding about that, mainly because many do not appreciate the difference between a trade agreement and the single market.

At the start of the year I warned, even when talk was of global risks to the recovery, that the referendum represented the biggest threat to Britain, a theme that has since been widely taken up. In February I looked at migration, under the heading economically beneficial, politically toxic.

I also examined in February at how Britain’s relative economic performance had improved since we joined the European Economic Community (EEC), the EU’s forerunner, in 1973. Mark Carney, the Bank of England governor, got into trouble with some Tory MPs for making a similar point. Finally, ahead of the budget, I wrote about how the chancellor would be seeking to emphasise the economic dangers of Brexit, while presenting a safety-first budget to minimise referendum risks. Whether or not he succeeded with the first, he failed with the second.

Today, let me examine another aspect of the economic debate, inward investment into Britain. The starting point, overwhelmingly supported by the evidence, is that EU membership has been good for inward investment, particularly foreign direct investment (FDI), for entirely logical reasons. The question is whether Britain’s attractions for inward investors could be maintained outside the EU.

Foreign companies have been attracted to invest in Britain, over decades, because of the combination of a less regulated and taxed economy and access to the European market. The phenomenon goes back at least as far as the 1970s, and decisions by American multinationals to increase investment when this country joined the EEC.

It accelerated in the 1980s with Japanese car manufacturers – starting with Nissan in Sunderland - establishing operations in this country. It has increased further since the single market began in 1993.

Over this period Britain has regularly been the biggest European recipient of foreign direct investment from outside the EU, though often vying with Germany for top slot. A process that began with America, then shifted to Japan and Korea, has moved more recently to the new economic giants of China and India.

The ‘voice of Indian business and industry’, the Federation of Indian Chambers of Commerce & Industry (Ficci), put it straightforwardly last month. “Britain is considered an entry point and a gateway for the EU by many Indian companies,” its secretary-general said.

Inward investment from distant nations like India creates a lot of attention, and in examples like Tata and Jaguar Land Rover, and much more challengingly in recent days in steel and Port Talbot, deservedly so. But, importantly, about half of the stock of foreign direct investment in Britain is from closer to home: the rest of the EU. Britain is integrated with the EU economy via investment as well as trade.

Let me make one thing clear. EU membership is not the only reason why there is foreign direct investment in Britain. Britain’s attractions include openness, a flexible labour market with pools of particular skills, the English language and the English legal system.

In many cases, such as much-needed foreign investment in Britain’s energy or transport infrastructure, it is hard to see that there would be very much difference whether we were in or out, except to the extent that Brexit reduces future growth prospects.

But it would also be folly to deny that EU membership is an important determinant of inward investment. EY, the accountancy and professional services firm, provides the most comprehensive annual survey of FDI. In its 2016 survey, to be published next month, it will look specifically at the potential effects of Brexit.

In the meantime, we have last year’s survey to go on. It showed a record 887 inward investment projects in Britain in 2014, up 11% on the previous year, and an increased European market share of 20.4%. It also found that 72% of inward investors cited access to the single market as important in their decision.

The question can be asked why, with the referendum on the horizon, inward investment in 2014 was so strong. The answer is that at that time business put a very low probability on Brexit.

What impact would Brexit have? We will await EY’s verdict next month but its rivals PWC had a stab in its work for the CBI, predicting that there would be an overall negative effect on inward investment even if a free trade agreement for trade in goods were to be swiftly negotiated. Service sector inward investment would still be “negatively affected”. The Bank of England, while stressing the many reasons why there has been foreign investment in financial services in Britain, also highlighted the importance EU’s “passporting” regime for banks.

Do we need inward investment? Yes. It makes for a more successful and dynamic economy and, while we are now in the middle of a period of productivity disappointment, foreign-owned businesses have made an important contribution to Britain’s economic performance over decades.

Could steps be taken to maintain Britain’s appeal to inward investors after Brexit? Yes, though some of them would involve a possibly tortuous renegotiation in order to try to re-establish what we already have, and at a cost. Whatever was negotiated in terms of access to the single market would probably not be as good as now. Impressions count, and the impression from afar – let alone from the rest of the EU – would be that Britain had moved from being semi-detached to being detached from the rest of Europe.

In my younger days I used to enthuse about the idea of Britain as the Hong Kong of Europe, free of eurosclerosis, with low taxes and with the most deregulated economy. As I have grown older I have become more realistic. Britain already has among the most deregulated product and labour markets in the advanced world, according to the OECD. There is red tape but much of it is home-grown. Her Majesty’s Revenue & Customs does not get its instructions from Brussels.

As for tax, George Osborne is already aiming for the lowest corporation tax rate, 17%, in the G20. He could aim to reduce it to 12.5%, matching Ireland, but the public finances are still not fixed, and voters – already pretty fed up with what they see as sweetheart tax deals for multinationals – would look askance at tax cuts intended to make life even easier for them.

As well as this, inward investors know that business tax cuts or supposed bonfires of red tape are prey to shifts in the political wind – the next government could reverse them at the drop of a hat – but EU membership and access to the single market have been regarded as permanent. If it ceases to be so, it seems inevitable inward investment will suffer.

Sunday, March 27, 2016
A big rise for the low paid - will it cost jobs?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

On Friday this week, the biggest government intervention in wage-setting since the introduction by the Blair government of the minimum wage in 1999 will occur.

The national living wage of £7.20 an hour for the over-25s will come into force. It is, curiously, exactly double the original minimum wage of £3.60 an hour of April 1999. More importantly, it is 50p an hour, or 7.5%, above the existing minimum wage of £6.70 an hour.

It seems a long time since George Osborne announced his version of the living wage in his post-election budget last July. Iain Duncan Smith, who had apparently not been told in advance, celebrated with some energetic fist-pumping on the floor of the House of Commons. It was probably the moment of maximum togetherness between the chancellor and the former work and pensions secretary.

Incidentally, there has been far too much excitement about the supposed “black hole” in the public finances following the abandonment of the disability cuts that supposedly provoked Duncan Smith’s departure. £4.4bn between now and the end of the parliament and £1.3bn in 2019-20 does not constitute even a pale grey hole. There are many much larger challenges on the chancellor’s rocky road to a budget surplus, not least the questions of whether he will ever raise fuel duty and the cost of further raising the personal tax allowance and higher rate threshold.

But back to the living wage. It was, in many ways, a curious policy announcement from a Tory chancellor. At the time I noted that had the election turned out differently, and the living wage had come from Ed Balls in an Ed Miliband government, the response might have been quite different. Many in business, and many commentators, would I suspect have said that it was an intervention that showed how little Labour understood how the economy really worked.

Politically, too, what some saw as Osborne’s masterstroke – seizing the centre ground from a wounded Labour party – can now be seen as jumping the gun. At the time, most thought that Jeremy Corbyn’s candidacy for the Labour leadership was a curiosity and that one of the mainstream candidates would win. It was not, so Labour left the centre-ground of its own volition. The chancellor had no need to muscle in to push it aside.

The other thing about the national living wage announcement, which speaks to some of the recent criticism of Osborne’s approach, is that it was deliberately intended to shock and awe. This was the rabbit out of the budget hat. There was thus little consultation ahead of it. Anybody who has read the Low Pay Commission’s deliberations on the minimum wage will know the careful analysis that goes into them, including detailed assessments of the impact on different sectors of the economy.

No such detailed analysis preceded the living wage announcement. Some sectors, including care homes, domiciliary care, cleaning, and parts of retailing, catering and the hotel trade are exposed. Others, except to the extent that they use the services of some of these exposed sectors, are not much affected. When governments have intervened in pay-setting, way back to the wages councils that were eventually abolished in 1993, they have taken into account these sectoral differences.

Even within the affected sectors some will be more exposed than others. Certain employers have taken steps to trim elements of pay, such as overtime rates, ahead of the introduction of the living wage, in order to control the pay bill. Others have embraced it. Whitbread, for example, says it will pay above the national living wage to all its Costa and Premier Inn employees, even those aged under 25 and apprentices. The British Retail Consortium (BRC), on the other hand, cited the living wage as one of the factors in its prediction of 900,000 retailing job losses by 2025.

The most vulnerable employers (and employees) are probably those in the care sector, caught between rising wage costs and squeezed local authority budgets.

So what will happen? One certain effect is that the living wage will provide a significant boost for the lower-paid. A Resolution Foundation analysis, out today, shows that, in combination with October’s rise in the minimum wage, people on the lowest rung of the pay ladder will have seen a 10.8% rise in pay once the living wage comes in this week. That is four times the increase in pay for workers as a whole, and it is not a one-off.

Resolution expects the lowest-paid to enjoy a 5.7% average annual pay rise between now and 2020, compared with a 3.7% workforce average (which looks optimistic). The living wage will, says Resolution, provide an immediate boost to 4.5m workers and “make significant inroads into tackling Britain’s low pay problem”.

Will it cost jobs as the BRC and others fear? The issue came up at the Royal Economic Society’s annual conference at Sussex University last week. If I were to sum up the position among economists who have researched this, always a tricky thing to do, it would be that the adverse employment consequences of minimum wages have been overestimated in the past – job losses were expected to be bigger – and that the same will probably be true of the living wage. The Bank of England, for example, expects it to add only 0.1 percentage points to overall pay growth; not enough to cost many jobs.

But this is an uncertain area. A new survey of economists carried out by the Centre for Macroeconomics, which I take part in and which encompasses the universities of London and Cambridge as well as the Bank and the National Institute of Economic and Social Research, is on this very subject.

It shows that by two to one, 57% to 33%, economists do not expect the living wage to lead to significantly lower employment. More convincingly, by 76% to 11%, they believe it will have only a muted effect on wages and prices across the economy as a whole.

We should not, however, be too complacent. The fact that many economists do think the living wage will lead to sizeable job losses is a worry. So is the fact that, while researchers agree that introducing a minimum wage at an appropriate level and increasing it gradually does not have a big employment cost, the chancellor may be testing that theory to destruction. A 10.8% pay rise for the lower paid at a time of zero inflation is big in anybody’s book.

So Friday sees the start of an experiment. The hope has to be that employers can absorb the increase in wage costs, or neutralize it by achieving productivity improvements. It will be good for everybody is that is also the reality. But that is not guaranteed.

Sunday, March 20, 2016
Why two Osbornes and one Duncan Smith don't mix
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

My initial reaction to Wednesday's budget was that, apart from being the fiddliest I could recall, it would not stay long in the memory. That was before it exploded on Friday evening with Iain Duncan Smith's resignation.

We are four days on from a budget that included 77 separately costed measures – more in a single budget than anybody can remember – as well as some of most obvious and ungainly fiscal gymnastics.

So, I was fully geared up to hold forth on a chancellor more addicted to unnecessary tax tinkering and more prone to using smoke and mirrors to meet his fiscal rules than that legendary exponent of the art, Gordon Brown.

And I was all ready to weigh in an assault on George Osborne for failing so soon in this parliament on two of his fiscal targets; the so-called welfare cap (breached in November and still breached now) and reducing debt as a percentage of gross domestic product every year, which is breached now according to the Office for Budget Responsibility. If this, his eighth budget, were also to be his last because of a Leave vote in the EU referendum, it would not have been a great swan song. It wasn’t even the safety-first budget the referendum had apparently required.

Then, two things happened. One was that plenty of other people immediately weighed in with a similar critique of the chancellor, so there was no point in repeating what is already out there. The other was the surprise resignation of Duncan Smith as work and pensions secretary on Friday evening, ostensibly about cuts to disability benefits. In leaving, he attacked Osborne’s entire approach.

Before coming on to that, I do not want to add to the unjustified gloom that surrounded much of the budget coverage. True, there is a significant referendum risk to growth, described here last week. Otherwise, however, Britain does not look like an economy in all that much trouble.

On the morning of the budget official figures showed a rise of nearly half a million in the numbers of people in work over the latest 12 months. A record percentage of people are in employment and growth in wages has ticked higher.

The biggest surprise in the OBR’s projections was a downward revision of its prediction for government borrowing this year, 2015-16. Instead of the £73.5bn of borrowing it projected in November, and a near-unanimous view among outside economists that there will be a sizeable overshoot, the OBR expects the number to come in at £72.2bn.

It is quite likely too that Osborne’s debt rule, having been broken in 2015-16 on this occasion, will be subsequently found to have been met. The rule was broken, not because of higher debt – it is a little lower than expected in November - but because of lower nominal, or cash, GDP. As the official statisticians get round to revising the GDP figures, most likely upwards, so this apparent failure could revised away.

Similarly, the almost universally downbeat view on growth and productivity – the biggest single economic change underlying the budget – should be taken with an appropriate quantity of salt The OBR responds to the latest data at its disposal. The productivity numbers in the final quarter of last year were thoroughly gloomy, so the OBR gave up the ghost on its previous productivity expectations.

But these are murky waters. Sir Charlie Bean’s independent review of official statistics, the recommendations of which were fully accepted by Osborne, pointed out the challenges of measuring both output (GDP) and labour input (hours worked) in a changing economy and labour market. Productivity growth has undoubtedly slowed since the crisis but the extent of that slowdown is complicated by measurement challenges.

Why is productivity so important for the public finances? As the OBR says: “Lower productivity growth means lower forecasts for labour income and company profits, and thus also for consumer spending and business investment. In aggregate this reduces tax receipts significantly.” If the OBR is right and, as I wrote a couple of weeks ago we should learn to live with weak productivity, we may also have to learn to live with weaker tax receipts than we would like.

This brings me on to my big point. When Osborne misses his fiscal targets, and has to perform contortions with the timing of corporation tax changes and infrastructure spending to keep his target of a budget surplus alive, some of that is due to factors outside his control, including the performance of the global economy. If Britain’s productivity performance has deteriorated then anything that has been done since 2010 to try to fix it – and there is a legitimate debate about whether it should have been more – will not show through until long after this chancellor has moved to pastures new. Supply-side reforms take time.

Some of the missed targets are, however, entirely deliberate. There are two Osbornes; the Jekyll and Hyde of the Treasury. There is Osborne the deficit cutter, harsh and unbending in his determination to slow and eventually eliminate the rising tide of debt. Osborne the deficit cutter wanted to get rid of most (not all) of the deficit by the end of the parliament.

Then there is Osborne the politician who, like all politicians, wants to be loved. He is not, as we have seen in recent days, necessarily all that good at it. This Osborne developed his economic philosophy in the years of plenty. “Sharing the proceeds of growth” between tax cuts and spending was the Osborne and David Cameron call when Labour was in office. It has survived into the era of austerity and big deficits.

A good example is fuel duty. Wednesday marked the sixth successive year in which fuel duty has been frozen. The chancellor is proud of the fact that pump prices are 18p a litre lower than they would have been if the pre-2010 duty escalator had been maintained, and that the average motorist spending £450 a year less on fuel than five years ago (not just because of duties). The cost of this admittedly popular freeze compared with the alternative is at least £6bn this year and cumulatively several times that, according to the OBR. Assuming the freeze continues, that cost will continue to rise. Deficit-cutting Osborne would have had no truck with this; for politician Osborne it was second nature.

Or look at the details of last week’s budget. Faced with a £56bn underlying deterioration in the public finances, the deficit-cutter would have bent over backwards to squeeze more revenue and cuts out of the system, eschewing any giveaways.

Politician Osborne, in contrast, found room for reducing business rates, corporation tax and capital gains tax, and for generous increases in the personal tax allowance to £11,500 next year and in the higher rate threshold to £45,000. Every tax-raiser, such as the sugar levy, was immediately spent. As I sometimes remind people, in his austerity budget of 1981 Lord (Geoffrey Howe) froze allowances and thresholds at a time of high inflation. Osborne prefers to increase them at a time of no inflation.

Politician Osborne may be right. Most voters do not follow the finer details of the public finances. Many do not know the difference between debt and the deficit. They do know when the cost of filling up the car goes up. Holding out the ambition of a surplus is an important signal, drawing the distinction between the Tories and Labour. Achieving that surplus may be less important.

But the Duncan Smith resignation has also exposed the weakness of the “two Osbornes” approach. Had the chancellor stuck to deficit-cutting, eschewing giveaways, the former work and pensions secretary would not have had much of an argument, leaving aside the obvious differences over Europe. Welfare cuts and deficit cuts need to go hand in hand. Because Osborne did not, preferring to splash some of the welfare savings around, he left himself open. It remains to be seen how quickly he can recover.

Sunday, March 13, 2016
Osborne skates on thinner ice as Brexit fears hit growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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When George Osborne started thinking about his eighth budget a few weeks ago he probably knew that by the time March 16 came around the EU referendum battle would be in full swing. That did not, however, stop him pushing ahead with ambitious plans to reform the way pensions are taxed, with his preference for a wholesale switch to a so-called pension ISA (individual savings account).

We know now that this will not happen, or at least not this week. Fear of doing anything potentially unpopular in the run-up to the referendum, as changing the existing system of tax relief would have been, led to the plans being shelved. There had been murmurings from Tory MPs.

Chancellors are supposed to do unpopular things in the interests of the longer-term good of the country. Osborne is finding it difficult to do so, particularly since the election. We may look back on the 2010-15 coalition as a model of stable government, certainly in comparison with what has followed.

Tory MPs have discovered their power. It only takes 30 or so of them, sometimes less, to force a retreat. That, more than the chancellor’s political opponents, forced the U-turn on cuts to tax credits last November. Tory MPs, by voting against the government, helped defeat plans to relax Sunday trading laws. There is a gathering revolt against a fuel duty rise this week, a rise that is counted in the government’s fiscal calculations. With dozens of Tory MPs openly campaigning against the EU stance of the prime minister and chancellor, this is turning out to be a chaotic government.

Osborne is quite good at pulling rabbits out of the hat, even if often on closer examination they turn out to be tiny kittens, so do not discount the possibility of a populist surprise or two this week. Even if there are, however, the chancellor will not want to let the moment pass without issuing stark warnings against the dangers of a vote to leave the EU.

Saying anything that suggests leaving the EU will have negative consequences and that membership has benefited Britain is tricky territory, as Mark Carney discovered a few days ago. The Bank of England governor can look after himself but when faced with attacks by oddball Tory MPs and an out-of-control “big beast”, the former chancellor Lord Lawson, there must have been moments when he wished he was back in Ottawa.

Jacob Rees-Mogg, the Tory MP for North East Somerset, accused him of making “speculative” pro-EU comments that were “beneath the dignity” of the Bank. Peter Bone, his Wellingborough colleague, said Carney should consider his position and drew the contrast between the Bank governor and John Longworth, the “Brexit martyr” who resigned as chief executive of the British Chambers of Commerce (BCC) after speaking out at its annual conference.

MPs have sunk low in recent years but this really was scraping the barrel. Carney was not speculating but accurately reflecting the view of his institution, as set out in its carefully-researched report last October, EU Membership and the Bank of England, which provided extensive evidence that trade openness with the EU, inward investment to access the single market and free movement of labour “reinforces the dynamism of the UK economy”. Longworth, in contrast, deliberately went against the agreed position of the BCC, the organisation he was paid to run.

Lord Lawson was even worse. Suggesting in a BBC interview that Carney was driven by the desire to curry favour with Goldman Sachs, his former employer, and get a good job there when he steps down from the Bank, was beneath the dignity of a former holder of the office of chancellor.

Fortunately for Osborne, one accusation that was levelled at Carney, that he was guilty of wading into politics, cannot be legitimately directed at him. The chancellor is meant to be knee-deep in politics, though sometimes he is up to his neck in it.

The chancellor has promised a full Treasury analysis of the costs and benefits of leaving versus staying in the EU, though the only guidance on timing is that it will be published between now and the referendum. One thing that would help frame the debate, an Office for Budget Responsibility forecast showing the outlook for the economy and the public finances on “In” and “Out” is, officials say, outside the OBR’s terms of reference. It can only forecast on the basis of government policy, which is to stay in the EU.

It is, however, generally accepted that Brexit would be a negative shock for the economy. The long-term consequences or leaving can be debated. In the short-term it would, as the prime minister put it in a speech last week, cost growth and jobs.

As a report last month, London: The Global Powerhouse, commissioned by Boris Johnson, the pro-Brexit mayor of London, put it: “Leaving the EU would be an economic shock. Most, if not all, economic shocks depress economic activity. Thus economic forecasts that focus on, say, a couple of years ahead would tend to show that leaving the EU is always worse than the alternative.”

How big a short-term negative shock might there be? Kevin Daly, UK economist at the aforementioned Goldman Sachs, says that there would be “a damaging uncertainty shock for the UK” which could be prolonged. “Business investment accounts for 10% of UK GDP,” he writes in a special report. “A collective decision to pause a significant share of this spending would be materially negative for UK output.”

ABN-Amro, another investment bank, says Brexit would push Britain’s GDP down by between 1% and 3% next year. An effect at the upper end of that range would push the economy back into recession. Societe Generale, in a new report, says Britain’s growth would be reduced by between 0.5% and 1% for a period of 10 years.

A bigger concern than these effects on GDP, which can never be precisely measured, would be if things really got out of control. That is why Carney announced measures to see the financial system through a Brexit shock, if it occurred. Even that might not be enough. Berenberg Bank warns that a crisis in the second half of the year would follow a vote to leave. Neil Williams, chief economist at Hermes, the investment managers, thinks the Bank of England would be forced into another round of quantitative easing, last undertaken four years ago.

This is where it gets interesting, and where useful anti-leave ammunition for Osborne could turn into something more dangerous. The public finances, as the chancellor often reminds us, are still not fixed. He is likely to announce further action this week to restrain spending over the medium-term.

Even without a Brexit vote he is heading for a £50bn borrowing overshoot over the next five years compared with the OBR’s November forecast, according to a new analysis published today by PWC. It will not be surprising, given the downward revision of so-c alled nominal GDP since November, if the OBR has presented the Treasury with similar numbers.

With Brexit, borrowing could easily shoot up to more than £100bn annually, creating powerful echoes of the crisis of a few years ago, and fatally undermining Osborne’s efforts to restore the country to fiscal health.

The chancellor has been steering a fine line between keeping the markets and international investors happy with deficit reduction and not killing the recovery with excessive austerity. A Brexit vote, or even the heightened fear of it, could mean that he has been skating on very thin ice.

Sunday, March 06, 2016
Let's relax and learn to live with low productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

We all need a break from the referendum this week, so I will provide one here. The only thing I will mention in passing is the question of whether Brexit fears are already weakening the economy as they have weakened the pound.

Brexit uncertainty is one factor cited by Markit, which produces the monthly purchasing managers’ surveys, all three of which (manufacturing, construction, services) weakened last month. If Brexit is indeed a factor in what looks to be a slowdown, it plays both ways.

The Remain camp will say it shows anticipation of how the economy will suffer if we leave. The Leavers will argue that it is not Brexit fears hitting growth but wider worries about the global economy. The rest of us might conclude that a government that says we should not take risks with the economy has itself introduced risk by holding the referendum.

Anyway, it is another area of weakness I want to address this week; productivity. Britain’s poor productivity performance has been one of the stories of the post-crisis period. Productivity – output per hour or output per worker – is the lifeblood of the economy, the source of all our prosperity. In the famous phrase, “productivity isn’t everything but in the long run it is almost everything”.

But if productivity is almost everything, in recent years it has not been very much at all. Output per hour across the whole economy has crept above its pre-crisis level, but only just. In the latest figures last year it was 1.6% higher than in early 2008. That, however, was nothing to celebrate. The Office for National Statistics points out that had it kept up with the pre-crisis trend it would be 13% higher than it is.

I should say at the outset that plenty of business people dispute the extent of the productivity gloom. My colleague Dominic O’Connell encountered such scepticism at a high-level dinner a few days ago. The EEF, the engineering employers, published a major report on productivity recently which found that for many in industry, official measures of productivity are poorly specified and poorly measured. Economists at Legal & General, in a new report, say official statisticians are “failing to capture the revolution in distributed networking and cloud computing”.

But, staying with the official numbers, a large chunk of potential productivity growth has been lost, apparently never to be regained. Even now, while output per hour is rising, it is doing so at barely half the rate that was the norm before the crisis. The picture for output per worker, another productivity measure, is, if anything, even more muted as a result of the strength of employment growth. The latest figures had it just 0.7% up on pre-crisis levels. If it had grown as fast as in the seven years leading up to the crisis it would be 14% up.

If you want to get really depressed about productivity, meanwhile, look at the comparisons with other countries. Official figures last month showed that output per hour in Britain in 2014 was 18 percentage points below the average for the rest of the G7 (America, Germany, Japan, France, Italy and Canada).

Worse, Britain appears to be doing appallingly badly in comparison with our near neighbours. French output per hour is 31% higher than Britain’s. In the case of Germany, the gap is a whopping 38%. The British disease, once characterised by too many strikes and tea breaks, appears to be back. How worried should we be?

In terms of the international comparisons, there is not a lot to the proud of, but the picture is not as black as it first appears. German and French workers have much shorter average working weeks than their British counterparts, 26.4 and 28.3 hours respectively, compared with a British average of 32.3.

Some of that is explained by legislation, some by the part-time, full-time split. But it means that if we take an alternative measure, output per worker, then Germany is a more manageable 11% higher than Britain, and France 15%.

There is another comparisons produced by the Office for National Statistics. This, a constant price productivity measure, suggests that Britain achieved significantly stronger growth in output per hour in the 10 years leading up to the crisis, and somewhat weaker since. Britain is behind, but on this measure by only a few percentage points.

The bigger question is how worried we should be about the weakness of productivity which, in the post-crisis period, has not been just a British affliction. The point has often been made in recent years, including by me, that strong employment growth has been a price worth paying for weak productivity but that it cannot go on forever.

Now I wonder, both whether lower productivity is temporary and also whether we should be that worried about it, a suggestion that is almost sacrilege in economic circles.

Many years ago, in the 1980s, when the world was looking to Japan, both as a tough competitor and a model economy, international productivity comparisons showed up something very curious. Despite its fearsome reputation Japan’s productivity was lower than the other big industrial countries, including Britain.

Japan, in those days and indeed now, combined high levels of productivity in the export-facing sectors it needed to compete, including manufacturing, with low productivity across large swathes of the rest of the economy, including much of the service sector and agriculture. Japan combined a high degree of competitiveness with a high employment, indeed virtually full employment and a lifetime system of job security.

Japan is no longer a model to follow in a general sense, but its productivity approach has a lot to be said for it. Combine high productivity in export-facing sectors such as manufacturing and internationally-traded services with low productivity across a whole range of domestic service industries and you end up with something that, if not ideal, is not bad. Having the most productive hairdressers in the world will not necessarily help Britain compete.

Low-productivity services, of course, imply low wages, or else there would be an inflationary threat. But they also imply high employment.

What about the sectors in which we need to compete? The EEF notes that manufacturing productivity has grown at twice the rate of the rest of the economy, and of services, over the past 20 years. Its chief economist Lee Hopley, noting that good data is hard to come by, cites figures showing that Britain’s manufacturing productivity grew faster than Germany, France, Italy and the Netherlands in the five years straddling the crisis. But there is work to be done – a lot of it – to make manufacturing more productive.

As for internationally-trade services, the picture is mixed. Productivity growth in financial services has gone into reverse since the crisis, while business services continue to perform pretty well. Across the services where Britain is strongest, there is no reason for complacency but none for deep gloom either.

Productivity matters, but it matters more in some sectors than others. It is those sectors in which government should direct its efforts. And it is in those sectors – not everything – we should worry when we fall behind.

Sunday, February 28, 2016
Inside the EU, we whistled a happier tune
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

History does not necessarily repeat itself, but it is a long way from being “more or less bunk” as Henry Ford famously put it. History looms large in the politics of the EU referendum. Now, as 40 years ago, we have a prime minister trying to sell his renegotiation to voters, while presiding over a divided cabinet. For David Cameron, read Harold Wilson.

There is also useful history in the economics of Britain’s relationship with Europe. Campaigners for Brexit look to a future in which Britain is disentangled from the constraints of the EU and free to forge new and stronger economic relationships with the rest of the world. I shall have a look in more detail what this might mean between now and June 23rd.

Before that it is worth reminding ourselves of that tangle-free world, because Britain has been there before. In the 1950s and 1960s, while the original six members of the EU were forging ever closer economic relationships, beginning with the coal and steel community and then the European Economic Community (EEC), Britain ploughed a very different furrow.

By staying out of the talks leading to the establishment of the coal and steel community in the early 1950s because, in the words of Herbert Morrison, Labour’s deputy prime minister (and Peter Mandelson’s grandfather), “the Durham miners won’t wear it”, Britain had already demonstrated a hostility to European integration. It was no great surprise when the EEC, created as a result of the Treaty of Rome of 1957, and starting in 1958, did not include Britain among its original members (Germany, France, Italy, Belgium, the Netherlands and Luxembourg).

While Europe was busy integrating, the world was Britain’s oyster. Where there had once been the Empire, on which the sun never set, now there was the Commonwealth. There was the special relationship with America. There were opportunities well beyond the narrow confines of the EEC.

The world, however, was not enough. Commonwealth countries such as Australia and South Africa, far from being happy to be easy markets for British exports, wanted to develop their own industries and imposed tariff barriers against the mother country. India was heavily protectionist from the time of independence in 1947.

As a result of this and other factors, Europe’s grass started to look a lot greener. Britain’s economic performance in the 1950s and 1960s, while reasonable in comparison with later decades, was poor in relation to the EEC pioneers. Germany and France had a lot more catching up to do after the devastation of the war but, even allowing for this, achieved growth well in excess of Britain.

In the period 1950-73, sometimes known as the golden age, gross domestic product per head rose by an average of 2.4% a year in Britain, 4% in France and 5% in Germany. By 1960, Germany was once again producing more cars than Britain and had secured a bigger share of world trade.

Having sampled life outside, successive British governments wanted in, and desperately. Having tried a smaller alternative to the EEC, the European Free Trade Association (EFTA), established in 1960, Britain applied, and was rejected for EEC membership, in 1963 and 1967, before being finally admitted at the start of 1973. Envy of Europe went deep. The 1964-70 Labour government, under Wilson, consciously and unsuccessfully tried to imitate France’s successful experiment with economic planning.

The politicians of the 1960s and early 1970s were not daft. Having lagged behind growth in the EEC prior to membership, Britain caught up and then overhauled the original six. Their growth became no longer a cause for envy. Growth rates slowed everywhere after the golden age, but Britain’s relative performance improved. Plainly not all of this was due to being in the EEC. Clearly, some of it was.

Joining the EEC was a considerable economic success, according to a new paper The Growth Effects of EU Membership for the UK: A Review of the Evidence, by the noted economic historian Professor Nick Crafts of Warwick University.

“Membership has raised UK income levels appreciably and by much more than 1970s’ proponents of EU entry predicted,” he writes. “Joining the EU raised the level of real GDP per person in the UK compared with the alternative of staying in EFTA. The deeper economic integration EU membership entailed increased trade substantially and this had positive effects on income.” His calculations suggest that the positive economic effects of membership have outweighed the cost of Britain’s EU contributions and red tape by a factor of about seven to one.

The world was different in 1973 when Britain joined the EEC, and 1975, when we had a referendum, comfortably won, on whether to remain in. Many people who did have a vote in 1975, and some who did not, claim that the country was conned, that we voted to join a common market and ended up with ever closer union, migration and a single currency on our doorstep.

It is true that at the time of the 1975 referendum the government chose to emphasise the trade aspects of membership to the exclusion of almost everything else. But freedom of movement and equal treatment of people were part of the Treaty of Rome, though in the 1970s most people expected the flows to be from Britain to Europe, not the other way around. The subsequent TV series Auf Wiedersehn Pet was about British migrant workers in Germany.

As for the single currency, when Ted Heath began his successful entry negotiations, the EEC was still officially on course for monetary union, the Werner Report of October 1970 having set the target of achieving it by 1980. It took a further two decades but Europe’s intentions were pretty clear.

A stronger point is that Europe has changed in 40 years. No longer do we envy our European partners their growth, although I find that many people I talk to still have a lot of envy for Germany, and even France. The world has changed too, with the rise of China and other emerging economies. Trade is freer, for goods, if not yet enough for services, though Britain is making great strides: service-sector exports doubled between 2006 and 2014.

The question which I will address in the coming weeks is whether things have changed enough for life to be better outside. Does our EU membership prevent us taking full advantage of the wider world, or is that an escapist fantasy? Germany has been a notable success, from within the EU, in selling to the world. Only China and America, with much larger populations, export more. A few decades ago we found that life outside Europe was cold. The question is whether it would be any warmer now.

Sunday, February 21, 2016
EU migration: economically beneficial, politically toxic
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is the biggest and most toxic issue in the referendum debate, central to the deal concluded by David Cameron late on Friday. It is the one in which emotions run highest. I am talking about immigration, safe in the knowledge that whatever I write today plenty of people will disagree with me.

Immigration from the rest of the European Union to Britain has got caught up in the public mind, wrongly, with the EU migrant crisis; the flood of asylum-seekers from Syria and elsewhere making their way across Europe and threatening the EU’s open borders, the Schengen agreement. Britain, of course, is not part of that agreement and never likely to be.

But figures this week will confirm that “normal” net migration into Britain – the number of immigrants minus the number of emigrants – is at or close to all-time highs. Thursday’s figures, covering the period to September last year, are set to show a rolling total similar to the 336,000 for the 12 months to June 2015, which was a record.

The figures will provoke a row, again making a mockery of David Cameron’s always unachievable 2011 “no ifs, no buts” pledge to reduce net migration to the tens of thousands. Before getting into the arguments, let me provide a little more detail on the previous set of numbers.

The 12-month total to June last year comprised 636,000 immigrants and 300,000 emigrants (many previous immigrants). Of the 636,000, 294,000 came to work, 192,000 to study, and 80,000 accompanied or joined other family members.

Just as there is confusion over migration and the asylum crisis, so there is a widespread assumption that immigration into Britain is overwhelmingly from the rest of the EU. That is not the case now, nor has been true at any time in the 43 years of Britain’s EU/EEC (European Economic Community) membership.

In the 12 months to June 2015, EU net migration to Britain was 180,000, non-EU migration 201,000. If you think that does not add up to the 336,000 net migration total you would be right. The circle was squared by 45,000 of net emigration by British citizens (much of it to the rest of the EU). That continued a long-term trend. In only one year in the past 40, 1985, has there been no net emigration by British citizens.

Immigrants from the EU tend to come to Britain to work. They accounted for at least 162,000 of the 294,000 migrants coming for work reasons. Non-EU migrants, in contrast, are more likely to come to study – 131,000 out of 192,000 – or for family reasons; at least 45,000 out of 80,000.

What about the impact of EU migrants on the job market? Separate labour market figures released last week showed there are now 2.04m non-UK nationals from the rest of the EU working in Britain, about double the number from the rest of the world. In the latest 12 months (between the final quarters of 2014 and 2015) there was a 215,000 rise in employment for EU migrants – two-fifths of the total rise in numbers in work. These were the figures that caused apoplexy on some front pages on Thursday.

Is immigration from the rest of the EU good or bad from the economy? As a thought experiment imagine what the impact would be of waving a magic wand and increasing the working population by hundreds of thousands of mainly young, mainly skilled and mainly educated people. You would expect the economic effects to be beneficial and you would be right.

Studies have consistently found that EU migration provides a fiscal boost, not a fiscal drain, including a much-quoted November 2014 University College London study. EU migrants, on average, pay more tax than they receive in public services or benefits. Notwithstanding a central aspect of the prime minister’s EU renegotiation, migrants mainly come to Britain to work, not to claim benefit. If there is a problem with in-work benefits, including tax credits, the fault lies with the design of the system.

A Home Office review of the evidence two years ago found that EU immigration does not adversely affect native employment during normal times. Only when the job market is weak, such as in 2008-9, is there an adverse effect.

What about pay? A Bank of England working paper last year by Steve Nickell and Jumana Saleheen found that immigration has a small negative impact on average wages, though there was no difference in the impact on earnings of EU and non-EU migrants.

Though other studies have suggested no impact on wages, that conclusion does not seem logical. The effect of immigration is to provide an ongoing boost to labour supply. That means more slack in the job market and at the margin less upward pressure on wages.

But such effects should not be overstated. The overlap between the jobs EU migrants do and those British workers want to do is much less than commonly thought. As Jonathan Wadsworth of the London School of Economics put it in a recent paper, new migrants are much more likely to be close job market substitutes for existing migrants than native-born workers.

I wouldn’t want to use the Pret A Manger close to our offices as typical of the labour market as a whole, but it appears be entirely staffed by young, largely EU, migrants. The availability of migrants for work almost certainly increases employment, currently a record 74.1% of the workforce.

We do not know is what might happen in the long-term if EU migrants stay permanently rather than returning home. Younger workers who stay eventually get old, and the positive contribution they make to the public finances evens out over time. One indicator of that would be if EU migrants were choosing to apply for UK citizenship in large numbers. So far that does not appear to be happening. Poles are remaining Poles: there are 853,000 people of Polish nationality in Britain.

There are swings and roundabouts in EU migration but the evidence points to the economic benefits comfortably outweighing the costs. Why then is migration such a politically toxic issue, the big potential swing factor in the referendum?

One factor, plainly, is the speed of change. Until the mid-1990s there was virtually no net migration from the rest of the EU. Since then there has been lots. In 10 years from 2004 to 2014 the number of EU nationals in Britain rose from just over 1m to nearly 3m. From 1997 to 2015, the proportion of employment accounted for by non-UK nationals rose from 3.8% to 10.2%, driven by EU migration.

Another factor is the uneven concentration of EU migrants. In some areas migrants put intense pressure on schools and public services. Across much of the country migrant-driven population growth exacerbates the housing shortage. Add to that the fact that the losers from migration, perhaps from being squeezed out of housing provision or low-skilled job opportunities, feel those losses much more keenly than those who benefit from economic gains spread across the population.

But those who oppose immigration should not be played for fools. If we left the EU tomorrow there would still be large-scale net migration to Britain. Non-EU migration, which is substantial, would be unaffected. Some EU migration would continue. But business would find it harder to recruit the skilled and productive workers it needs, and gaps in the job market would go unfilled. EU migration both reflects and contributes to Britain’s flexible and successful labour market. Economically, we would lose out.

Sunday, February 14, 2016
Osborne's budget surplus starts to look like a distant dream
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Every recording artist is familiar with the idea of the difficult second album – the tricky follow-up to a successful debut – as is every author of a bestselling first novel. Now George Osborne is experiencing the equivalent, in what so far is proving to be a difficult second term.

To be fair, not all of the chancellor’s first term ran smoothly. The low point was 2012 and the “omnishambles” budget, and there were others. But, as he prepares for next month’s budget, his fourth big set-piece event in 12 months (three budgets and an autumn statement/spending review), even his best friends would admit that things are not going that well. What might have been his golden age – a Tory chancellor in a Tory-only government – is proving a bit of a headache.

Osborne’s U-turn on cuts to tax credits in his autumn statement may have been politically necessary, but it was embarrassing. Another U-turn may be looming over planned reductions in the amount of public money, so-called Short money, opposition parties receive.

Tumbling stock markets, which have taken on a slightly more sinister turn with the sell-off in banking shares, have forced the postponement of the sale of the government’s remaining stake in Lloyds Banking Group, a sale once intended to recapture some of the privatization spirit of the 1980s.

Growth forecasts are being revised down. Both the CBI (down from 2.6% to 2.3% for this year) and the Bank of England (down from 2.5% to 2.2%) predict continued recovery, but at a slower pace. A 1.1% drop in industrial production in December, announced last week, owed much to the effect of exceptionally mild weather on electricity and gas demand but added to the softer growth tone. The chancellor’s “dangerous cocktail” of risks he referred to last month is having an impact. There is also a tricky EU referendum to negotiate.

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The biggest question, perhaps, arises over what is central to Osborne’s chancellorship, his aim of eliminating the budget deficit and leaving a legacy of permanent surpluses. Having planned to eliminate most of the deficit in the last parliament and not succeeded, he moved on to the more demanding target of achieving a budget surplus by the end of this one, and keeping it there.

Recent days have seen one of the biggest events in the fiscal calendar that does not involve the chancellor, the Institute for Fiscal Studies’ annual green budget. The IFS, which is always fair, warned that Osborne is “boxed in by his own rule” (that of achieving a surplus) and “has to pull off a precarious balancing act”.

The all-party House of Commons Treasury committee, which will shortly publish its assessment of the autumn statement and spending review, is also set to criticise Osborne’s fiscal rule, while pointing out that the tax burden in rising as a result of measures such as the apprenticeship levy and the tax attack on buy-to-let landlords. Ahead of the election the chancellor had promised to finish the job of deficit reduction by restraining spending, not raising taxes.

The IFS is right to say that budget surpluses are rare – there have only been eight in Britain over the past 60 years – but wrong to point to a £7bn “black hole” in forecasts for the public finances over the next five years, caused by weaker project growth in earnings and the recent stock market fall.

Its economists know as well as I do, that £7bn in the context of the public finances at the end of the decade is the equivalent of loose change. The path of the budget deficit over the next few years will not be determined by what has happened to the stock market over the past few weeks.

Where the IFS is right is to point to the difficulties of achieving a budget surplus while simultaneously reducing some significant taxes. Osborne aims to increase the personal income tax allowance to £12,500 (from £10,600 now), while also increasing the higher rate threshold. These pledges are so far unfunded. The sums on which the official public finance projections are based assume fuel duties will rise in line with the retail prices index – not the more gently rising consumer prices index – something that the chancellor last did five years ago. Our business-friendly chancellor is bent on cutting the main rate of corporation tax to 18%, the lowest in the G20, even though the main challenge with this tax is getting companies to actually pay it.

This, perhaps, is the nub of the problem. There is nothing wrong with setting a target of achieving a budget surplus in normal times, rare while that might have been in the past. It does not mean starving the country of necessary infrastructure spending: that depends on how much you raise in tax and how you divide up public spending. It does mean you reduce the public sector debt burden more quickly, which after the huge budget deficits of recent years is no bad thing.

Where there is a problem, particularly if you have a chancellor with a populist eye on succeeding David Cameron as prime minister, is trying to combine expensive and supposedly popular pledges, including raising the inheritance tax threshold on family homes to £1m, with the hard job of eliminating the budget deficit. The two may be incompatible.

A few days ago we had a rare speech from Sir Nick Macpherson, the outgoing Treasury permanent secretary, its top official. Normally those in his position adopt a Sir Humphrey-like vow of silence.

He was responding to criticism that the Treasury should have been more Keynesian in its approach in recent years, and less obsessed with getting the deficit down. I agreed with most of his speech, particularly what he described as the “asymmetry” of policy by governments, which find it much easier to relax fiscal policy than tighten it, and to run budget deficits rather than surpluses. I also agree that most economists underestimated what a tightrope Britain was running with the very large budget deficits of a few years ago, and how close the country was to a full-blown fiscal crisis. Sir Nick was weaker on the absence of “shovel ready” infrastructure projects which the government could have spent money on. A government determined to spend more on infrastructure should by now have overcome planning and bureaucratic delays.

In 2009 and 2010, some of Sir Nick’s Treasury colleagues were worried that Gordon Brown, if re-elected, would not have the stomach or the desire to push through the necessary measures to get the deficit down.

Now, they are entitled to wonder whether the same is true of Osborne, or whether populism will win out over eliminating the deficit. A test will come next month. With oil prices hitting new lows, there has never been a better time to start increasing excise duties on petrol again, albeit in the knowledge that it would certainly generate negative headlines for him. Osborne should forget popularity, which may in any case be a lost cause, and do the right thing.

Sunday, February 07, 2016
Britain should never join this negative interest rate club
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Negative interest rates are in vogue. The Bank of Japan a few days ago joined a club which includes Switzerland, Denmark, Sweden and the European Central Bank (for one of its key rates) in pushing the interest rate dial below zero. Three of the world’s biggest central banks have negative rates. I shall come on to the Bank of England in a moment.

After a long period in which interest rates have been close to zero and central banks have engaged – and in some cases are still engaging – in large-scale quantitative easing, it appears that it is still not enough. At least five central banks think negative interest rates are now necessary. Could they ever become the norm?

Negative interest rates are still a strange phenomenon. The idea that anybody should pay for the privilege of depositing funds runs counter to the normal rule of “time preference”, that any rational person, or business, would rather spend now than later. The usual way of dissuading them from doing so, in other words encouraging them to save rather than spend, is an interest rate incentive. We will defer consumption if it is worth our while. That is how it works.

Central banks are different. The interest rate they typically set is on the reserves commercial banks hold with them. In most cases, commercial banks have to hold at least some of those reserves, for prudential and other reasons. They are, in that sense, a captive audience – up to a point.

As Paul Sheard, chief economist at Standard & Poor’s puts it: "Central banks can do this because they get to determine the total amount of liabilities they issue, giving them the unique ability to set both quantity and price. In the real economy, borrowers can't usually force lenders to lend to them.”

So, even in countries which have adopted negative interest rates, ordinary savers are unlikely to have to pay for the privilege of putting their money in the bank, though that may be of small comfort to those who have been enduring near-zero returns for years.

What is the point, then, of negative rates? When the Bank of Japan, or another central bank reduces rates below zero, it is trying to do two things. It is sending out a signal to the markets that whatever expectations they may have of future interest rate rises, they can revise them down. And, by penalising commercial banks – effectively taxing them on their deposits at the central bank – it is hoping that they will use any excess reserves (those above what are required by the regulators) will be used more productively; lending them into the real economy.

Negative rates are, as I say, still a strange idea. In the crisis, and in the post-crisis period, we have, to paraphrase Lewis Carroll, got used to believing many impossible things. This is just the latest.

It is perhaps not so strange when we think about the “real” interest rate; the interest rate adjusted for inflation. A negative “real” rate has been the norm for many years. Rates set by central banks have been well below inflation since the crisis hit.

In Britain in the period since Bank rate was reduced to 0.5% in March 2009, consumer price inflation has averaged 2.4%, implying an average negative real interest rate of almost 2%; -1.9% to be precise. At its worst, during 2011, real interest rates were negative by almost 5%.

Logic would suggest that if a negative real interest rate averaging nearly -2% has been needed to generate recovery over the past seven years then, at a time when inflation is close to zero – and set to remain so for some time – real interest rates might currently be too high.

So, while inflation of 2% or so allowed the Bank to pursue a negative real interest rate strategy by stealth, zero inflation could mean it has to do so in an upfront way. Actual, or what economists would call nominal interest rates, might also need to be negative, perhaps significantly so.

Logic can only take us so far in this, however. There are important practical and symbolic differences between a negative real interest rate achieved when both rates and inflation are positive, and a negative real rate that can only be achieved by cutting below zero. Even then, as noted above, a reduction in general rates throughout the economy would provide a powerful incentive for everybody to keep everything in cash. This was the conundrum addressed by Andy Haldane, the Bank’s chief economist, when he mused a few months ago that negative rates might require the abolition of cash.

So what of the Bank? It, and its governor Mark Carney, tried to be both dovish and hawkish on Thursday, with the publication of the quarterly inflation report. The dovish signal was that the only member of its monetary policy committee (MPC) to have been voting in recent months for a rate rise, Ian McCafferty, has thrown in the towel, for now at least.

The hawkish signal was that the MPC think markets have got ahead of themselves. Ahead of Thursday they were pricing in a 30% chance of a cut in rates, with no increase until 2018. The MPC, Carney said, has not even discussed the possibility of negative interest rates, and believes rates will need to rise to hit and maintain inflation at the 2% target. Not yet, but they will go up. Pressed repeatedly on rate cuts, the governor batted the suggestions away.
This is, as Bank-watchers know, no guarantee but it looks to be a pretty firm stance. The Bank is not even flirting with joining the negative interest rate club. It does not intend to turn Japanese.

That is good news. Britain’s economy is strong enough not to need further monetary help, even with the Bank’s modest trimming of its growth forecast. And, having argued a couple of weeks ago of the dangers of leaving rates too low for too long, I am not now going to argue that they should be cut, let alone go negative. To reprise one of the arguments then, a good way or persuading people and businesses that something must be badly wrong, thereby hitting confidence, would be a negative interest rate. This a club to which we do not want to belong.

Sunday, January 31, 2016
Confidence and a brighter eurozone argue against a Brexit vote
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

We do not yet have a date, and we do not yet have much of a campaign, but the referendum on Britain’s membership of the European Union is slowly looming into view. Moreover, it is already starting to affect the markets.

An opinion poll a few days ago which appeared to offer a greater probability of “Brexit” weighed on the pound. City economists, responding to requests from clients, are busy penning notes both on the effects of referendum uncertainty on the economy and the consequences of a vote to leave if it were to happen.

There will be time to consider these things in the coming weeks. Today, however, to continue my planned programme of pre-referendum pieces, let me address another aspect to the European question.

The euro is the pinnacle, so far, of European integration, and it is the fault-line on which many of the continent’s problems rest. Badly designed, open to too many countries too soon, it brought Europe to the brink of a crisis a few years ago that could have been at least as big in its impact as the banking crisis of 2008-9.

That should have been a wake-up call for Europe’s leaders. So far, however, they have been content mainly to kick the can down the road rather than pick it up and redesign it. The fundamental problem of the eurozone remains. It is not what economists call an optimal currency area. There is no central Treasury, or properly co-ordinated fiscal policy, to offset the power of the European Central Bank. Eurozone labour markets, and wages, are inflexible. And, contrary to what you might think from your TV screens, there is not enough mobility of labour within Europe.

There is a second issue about the eurozone, and it is one that troubles George Osborne, when he can drag his thoughts away from Google. There are 19 members of the euro, out of the EU’s 28 members. 337m people, two-thirds of the EU’s population, live in euro member countries. More countries are likely to join, despite its flaws, in the next few years, though Britain never will.

The danger is that the euro “outs”, comprising a diminishing minority within the EU, gets outvoted and outmanoeuvred by the rest. Ensuring this does not happen, which will be difficult, is arguably the most important aspect of the government’s renegotiation.

For some people, the flawed euro and the risks of being repeatedly turned over by the euro majority in the EU are sufficient grounds for a “leave” vote. As I have said before, I will hold fire on my verdict until nearer the time of the referendum.

In terms of how the economics of the referendum vote will play out, however, and trying to cut through the noise from other issues, let me offer a view of how voters may see things.

Most people do not think too deeply about the euro. They certainly do not trouble themselves over whether the eurozone is an optimal currency area or not. A perhaps disturbingly large number of people in Britain thought – and may still think – that euro membership would be good for us because it would cut out the inconvenience of having to exchange currencies when holidaying elsewhere in Europe.

But people do know when things are going badly. Three years ago, when all the talk was of a double-dip recession in Britain (it never happened), the eurozone had a proper one. It lasted for over a year and it coincided with talk, not just of Greece leaving but of a complete dismantling of the single currency. Eurozone unemployment stood at more than 12% and in Spain and Greece was more than 25%.

This, to not quite paraphrase Groucho Marx, was a European club that we wanted nothing to do with. Polls at the time showed a lead of 20 points or more for the exit camp.

How we feel about Europe matters. How we feel about ourselves also matters. 2012-13 was the time of the squeezed middle, the squeezed bottom, and the squeezed just about everything else. Growth was tentative and the rise in employment, while happening, was weaker than subsequently became the case. Prices were rising faster than wages. Consumer confidence was very depressed. We felt miserable. We probably blamed the eurozone crisis for some of that misery.

There has been a turnaround. The euro’s fundamental flaws have not disappeared but the eurozone has come through its crisis. You would not rule it out indefinitely but Grexit, the departure of Greece from the euro, has ceased to be an imminent threat. It was a close-run thing, but the eurozone has held together.

It has also returned to modest growth. The eurozone started growing again in the spring of 2013 and has continued to grow since. Its current growth rate of 0.3% or 0.4% a quarter is nothing to write home about but it is better than the alternative. The unemployment rate has come down to 10.5%. No longer does Europe appear to be in economic crisis.

As for consumer confidence in Britain, figures on Friday showed it has maintained its strength of last year this month, in spite of tumbling stock markets. Last year was the best for consumer confidence in Britain in the more than 40 years GfK, which surveys the public on behalf of the EU, has been assembling the data. This month has seen a two-point rise in its overall measure of consumer confidence, on the back of continued strong employment growth and rising real incomes. Britain’s consumers are “resiliently bullish” says GfK. They are no longer feeling miserable and they are no longer looking for somebody else to blame.

If these two things persist – a crisis-free and modestly growing eurozone and heightened levels of consumer confidence in Britain – the leave campaign will have its work cut out in trying to persuade voters that change is either necessary or desirable.

That does not, of course, preclude non-economic factors coming to the fore, though people tend to vote with their wallets and purses. The economic backdrop to the referendum is more favourable for a “remain” vote than David Cameron could have imagined when he pledged an in-out vote three years ago this month.

Sunday, January 24, 2016
The dangers of leaving rates too low for too long
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Mark Carney has spoken, in a speech to celebrate 50 years as a professor of economics at London’s Queen Mary University of Lord Peston (Robert’s dad). I don’t think he will have the gall to pop up again this summer and warn us be on the alert for a hike in interest rates at the end of this year.

For the Bank of England governor, who has the ability to generate headlines, being twice-bitten (he gave such warnings in both 2014 and 2015) should mean that this year he will choose to be a little shy.

He could, of course, generate plenty of headlines by starting to drop hints of interest-rate cuts. The Bank’s chief economist, Andy Haldane, appears to be genuinely agnostic about whether the next move in interest rates should be up or down. The Bank has said there are no technical barriers to cutting even from a record low 0.5% rate. Haldane has even talked about the possibility of a negative interest rate.

Carney and most of the other members of the Bank’s monetary policy committee (MPC) continue to insist that they fully expect the next move in rates to be up. Looked at logically and in the context of the governor’s speech, however, it is clear that there are circumstances in which a rate cut could occur.

His three conditions for raising rates were: growth being above its long-run trend, which in practice means quarterly growth of at least 0.5%-0.6%; evidence of a firming of cost (particularly wage) pressures, and a rise in core inflation consistent with getting back to the 2% target.

It is a reasonable set of conditions, but it also opens the way to a possible rate cut. What if quarterly growth were to slow to 0.1% or 0.2%, alongside a further weakening of wage growth and a few more months of inflation being stuck at close to zero, or even going significantly negative on the back of a new round of energy price cuts?

I do not expect it to happen, and I don’t think it would be a good idea, but it is not impossible. There is perhaps a 10% chance of a cut. Earlier this month George Osborne said that a rise in rates would be a sign of strength in the economy. If there were to be a cut he would need another script.

The remaining probabilities I would say are for no change at all this year, maybe 50% (some would put it a lot higher), with a 40% probability still clinging to a very late move this year, though not until November.

The governor’s speech, which was preceded by the MPC’s 82nd consecutive monthly decision to leave interest rates on hold, was unremarkable in its conclusions. With global markets plunging and the oil price slumping, the dust needed to settle. Most of those 82 decisions have been unremarkable.

If you were looking for an ideal time to raise interest rates, with every duck lined up in a row, such times have been in short supply. And, to the extent the MPC is waiting until a decision to raise rates is incontrovertible, a “no-brainer”, the longer we will have to wait for a move.

But, just because each decision to hold rates is defensible, is there a bigger picture danger, which is that ultra-low rates for too long, apart from depriving savers of returns, become dangerous?

Some would see those dangers in the housing market, where the latest Rics (Royal Institution of Chartered Surveyors) survey points to a further acceleration in house prices. For much of the period of very low interest rates, limited mortgage availability has offset the boon provided by low rates, though low rates have also encouraged investors to move into buy-to-let property. Now mortgage availability is improving fast there is a danger that low rates are stimulating the housing market – and pushing up prices – too much.

This is part of a wider point. Early last week I attended and spoke at a conference organised by the Spinoza Foundation in Geneva. One of the other speakers was Bill White, the Canadian former chief economist of the Bank for International Settlements, the central bankers’ bank.

White, who genuinely warned of the crisis before it happened (unlike many who claimed to do so) says central bankers made the mistake of pursuing excessively easy money policies before the crisis, and are making the same mistake again, supplemented by policies such as quantitative easing. Very low rates have had only a limited (and I would say diminishing) effect in boosting growth, while storing up other problems.

Indeed, as he put it in another recent speech, easy money policies may have had the opposite effect of that intended. “Much of what has been done recently smells of panic,” he said. “Arguably, by increasing uncertainty, it might even have encouraged people, both companies and households to hunker down and spend less rather than more.”

The BIS, which presciently warned of the “uneasy calm” in markets last month, thinks central bankers – including the Bank – are collectively making a big mistake. As it put it in its annual report last year: “Low rates are the most remarkable symptom of a broader malaise in the global economy: the economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited. The unthinkable risks becoming routine and being perceived as the new normal.”

The fact that there is even a possibility of a rate cut in Britain from 0.5% would meet the BIS’s definition of “unthinkable”. So would the fact that we are fast approaching the seventh anniversary of a cut to 0.5% in March 2009 that at the time was regarded as emergency and short-term.

The common theme between the pre-crisis period and now is inflation. Before the crisis, central banks focused too much on inflation and missed the dangerous credit bubble that was building. Since the crisis, the Bank ignored above-target inflation for some years, but now sees itself as constrained from raising rates by very low inflation.

Whether these post-crisis easy money policies will ultimately prove to have been dangerous and damaging is hard to say. But there is at least a risk that we will come to regret having near-zero interest rates for so long.

Sunday, January 17, 2016
When world trade struggles. so do Britain's manufacturers
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Another year is now in full swing. Alongside all the other things sent to try us, including weak and volatile stock markets, a plunging oil price and worries about global growth, manufacturing is in the doldrums.

Official figures last week confirmed the gloomy message of industry surveys. Manufacturing output fell by 0.4% in November and was down by 1.2% on a year earlier. Whatever things happened last year, a rise in factory output was not amongst them. And there is, sadly, nothing very new in this.

In the past four years there have been up years like 2014, when manufacturing output rose by a healthy 2.7%, and there have been down years like 2012 and 2013, when it fell by 1.4% and 1.1% respectively.

Broadly speaking, however, and allowing for the fact that there have been winners and losers within the overall numbers, Britain’s manufacturers are now producing what they were in 2011.

That was the year, of course, when George Osborne, in his March budget, talked about “A Britain carried aloft by the march of the makers”, for which he has been much lampooned, the latest in a series of politicians to see a bright future in manufacturing, only to see a grimmer reality kick in.

To be fair to Osborne, he thought in March 2011 that he was simply riding the tide. With parts of the service sector, most notably financial services, reducing activity, there did appear to be a genuine shift back to making things. Manufacturing output rose by a very healthy 4.5% in 2010 and Britain’s factories looked to be set fair.

That, unfortunately, was that. If every part of manufacturing had done as well as transport equipment (including cars), output up 38% since 2010, the chancellor would be hailed as a great sage. Well, he might. But other parts of manufacturing have either not prospered or fallen back sharply, for example in the case of sectors such as basic pharmaceuticals and textiles. Overall, the makers have not marched.

Why is this? Every time we get a disappointing set of manufacturing numbers, industry experts come up with a range of explanations, from skill shortages and high energy costs, through to lack of investment and Britain’s anti-industrial culture. All have a part to play in the long-run story of British manufacturing.

The manufacturing disappointment of recent years has a simpler and more straightforward explanation, however. When world trade does well, British manufacturing does well too. When world trade struggles, so will Britain’s factories.

In 2010, on the back of which Osborne chose to highlight industry, world trade boomed. Having dropped by more than 10% in 2009, the annus horribilis for the global economy, world trade volumes bounced back even more strongly in 2010. For a while it seemed as if normal service was being resumed for the global economy after the crisis, with Britain’s manufacturers playing their full part.

It was a false dawn. One of the missing ingredients of the post-crisis recovery has been world trade. 2011 saw a slowdown, 2012 and 2013 the equivalent of trade being becalmed in the Sargasso Sea. 2014 was better, hence a relatively good performance for manufacturers that year. That last 12 months have, though, seen trade growth fall back.

The CPB Netherland Bureau for economic policy analysis, which records world trade growth, says that it dropped back to just 1.4% in the autumn. As it put it: “Export momentum was down in both advanced and emerging economies.”

I have written before about the post-crisis weakness of world trade, suggesting a combination of lack of availability of export credit, some re-arranging of global supply chains and subtle protectionism.

Trade weakness is plainly not just affecting British manufacturers. The CPB Bureau also produces data for global industrial production, which shows a remarkably similar pattern to that of Britain. In Europe, Germany stands out as the only major economy which has increased its manufacturing output in this period of weak, post-crisis trade growth, with a rise of around 8% since mid-2010.

France, like Britain, is becalmed, while Spain and Italy are down. It is a tough world for manufacturers, and particularly tough in Europe. Maybe, also, something more profound is happening.

I don’t get invited to the Davos World Economic Forum these days but I notice that its theme for this week’s gathering in the mountains is the “fourth industrial revolution”, what it describes as the “ongoing transformation of our society and economy” by various technologies, ranging from robotics to artificial intelligence.

It is easy to mock Davos and its pretensions. Its themes have sometimes been spectacularly mistimed. But technology does change the nature of trade. This may seem an odd point to make when car sales in Britain have just had a record year of more than 2.6m new vehicles registered. We still eat and drink.

But the rise of a new kind of consumer intangible, the most obvious example of which is electronic downloads, is having an effect on trade. It means that, in the case of Britain, exports of services are fast closing on those of goods. As recently as 2010, service-sector exports were less than 70% of the value of exports of goods. In November last year, the figure was just under 90%. Soon Britain will be exporting more services than goods.

Even that may not fully capture the effect of intangibles but the net result will be that there will be a smaller increase in the output of manufacturers, and probably measured trade, for a given increase in gross domestic product and consumer spending in Britain and other advanced economies.

Does that mean we will never see a “march of the makers”? One would hope, despite some of the structural shifts that we are seeing in world trade, that it is not permanently in the doldrums. Some exporters will take comfort from the fact that sterling has come down from last year’s highs, particularly against the euro. At the margin, that will provide a boost for manufacturers.

But it would be unwise to expect too much. Some of Britain’s manufacturers are indeed marching, and long may they do so. Some, equally, are only going backwards.

Sunday, January 10, 2016
Don't drink too deeply of Osborne's dangerous cocktail
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Such is George Osborne’s reputation for political cunning, the natural reaction to anything he does is to look for the true meaning behind the message. Prince Metternich’s observation on the death of Talleyrand – “What did he mean by that?” – springs to mind.

The chancellor is in good health but his warning three days ago, that Britain’s recovery faces “a dangerous cocktail of new threats”, provoked similar thoughts.

When, in November 2014, David Cameron talked of the “red warning lights … flashing on the dashboard of the global economy”, and was quickly backed up by Osborne, it was pretty obvious what they were up to. With the election less than six months away, they wanted to remind people not to risk handing over the economy back to Labour.

As I put it back then, the world was not about to go pop but they wanted voters to think it might, and that only they could be trusted to shield voters from the damage.

This time, some of the chancellor’s motivations are fairly clear. The government has faced criticism over cuts to flood defence spending, as Osborne did last year over his planned – and eventually abandoned – cuts to tax credits. Hence his emphasis on the work still to be done on the budget deficit.

There are two things to say about spending on flood defences. One is that given the scale of the rainfall in recent weeks, the overwhelming majority of the flooding problems we have seen would have occurred with or without the spending reductions of the coalition government’s early years. Spending was cut by 16.5% in real terms in 2011-12 and maintained at the new lower level (which was roughly what was being spent in 2007-8) for two more years.

But we are not talking about billions of pounds here – the 2011-12 cut was less than £100m in cash terms – and even some defences that were considered state of the art proved inadequate. If extreme weather events are becoming the norm, spending on flood defences by all recent governments has been significantly too low.

The second point is that the benefits of good flood defences and related infrastructure improvements far exceed the costs. The fact that those benefits may be intangible – when flooding does not occur it is a non-event – should not matter. Preventative medicine also brings large benefits. That rethink everybody is now talking about on flood defences is necessary. A government that goes on a lot about security must be aware of the insecurity of having your home or business flooded out, or being under threat of it.

But, and this was one of the aims of Osborne’s speech, the public finances are a long way from being fixed. Splashing out on flood defences, no pun intended, will require compensating cuts elsewhere if the chancellor still intends an eventual budget surplus. Six years after it peaked at more than £150bn, public sector borrowing is officially predicted to be more than £70bn this year, and there are pressures on that forecast after a couple of disappointing recent monthly figures.

Was Osborne responding to disappointing pre-Christmas growth figures and getting his retaliation in first ahead of a sharp slowdown this year? As I said at the time, previous experience suggests we should take the late-December data revisions from the Office for National Statistics with a pinch of salt. Most economists expect similar growth this year to last and they are not known for viewing the world through rose-coloured spectacles.

That said, a few things have changed for the worse in the past few weeks. There have been downward revisions to global growth forecasts, particularly for emerging market economies. The World Bank, for example, has just revised down its prediction of global growth this year from 3.3% to 2.9%, and for next year from 3.2% to 3.1%. Both would be better than last year’s estimated growth of 2.4%, which is important to bear in mind, but weaker than hoped.

The World Bank still thinks Chinese growth, at 6.7% this year after 6.9% last, will be with within touching distance of 7%. Investors who have been panicking about China’s prospects in recent days would be more than pleased with that.

It is hard to say whether the Chinese stock market panic reflects genuine concern about the country’s growth prospects or whether it is mainly a response to cackhanded interventions by the authorities. But it has ensured a dreadful start to the year for world markets, including our own FTSE-100, and it has been accompanied by a further plunge in the oil price to a 12-year low of under $35 a barrel.

That further fall in oil prices, when in the past an escalation of tension between Iran and Saudi Arabia might have been expected to push them higher, shows what a changed world we are in. Traders have decided that this oil glut is not going away, and that Iran-Saudi tension means co-operation within the Organisation of Petroleum Exporting Countries to make it do so is even less likely than it was.

So how worried should we be by these recent developments? The stock market’s grim start to the year is not good news but the correlation between what happens in the markets and the real economy is weak, and even more so in China than Britain.

The fall in oil prices is in danger of turning from a helpful boost to growth to a damaging rout which could set back energy investment for years. It looks as if we are now firmly in overshoot territory for oil prices, but without any indications of when prices might start to bounce. The predicted cold snap should help retailers still trying to offload winter clothing lines, and it could help the oil price.

There is nothing wrong, of course, with a chancellor keeping people apprised of the risks that face the economy. But there is a danger, coming after a year in which consumer confidence in Britain has had its best run for more than four decades, that people and businesses overreact to such warnings and they become a self-fulfilling prophecy. The hope has to be that they do not drink too deeply his dangerous cocktail. If they do, 2016 will be “mission critical” for the economy, to use the chancellor’s words, for the wrong reasons.

One thing that should be knocked on the head is the idea, which emerged from some interpretations of Osborne’s speech, that an early rise in interest rates from the Bank of England is inevitable, and that he was preparing the ground for it.

As noted last week, a rise in rates this year is marginally more likely than not but could still very easily not happen. The Recruitment and Employment Confederation said on Friday that pay growth for permanent jobs, crucial to the Bank’s thinking, has slowed to a 26-month low.

More than that, the more that Osborne’s fears about the global economy come to fruition, the significantly less likely a rate rise. If the backdrop remains one of volatile stock markets, weakening global growth and a plunging oil price, the Bank will not be raising rates.

Sunday, January 03, 2016
EU referendum is the biggest cloud on the horizon
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The easiest thing to do when looking ahead is to assume more of the same. That, to let you into a dirty little secret, is how economic forecasting generally works and it is why economists are not bad at identifying trends but not good at predicting turning points.

It also keeps forecasts within realistic limits. Having ended the year at close to zero, you would put a very low probability on inflation rebounding to 10% over the next 12 months. Britain’s twin deficits – the red ink on the budget and current account – are not going to turn to surplus between now and the end of 2016.

The Bank of England’s monetary policy committee (MPC), similarly, will continue to adopt an ultra- cautious approach. After nearly seven years pondering whether the time was right for a quarter-point rise in interest rates, it will not suddenly start jacking them up as if there was no tomorrow.

Things do change in unexpected ways, however, even when they are flagged in advance. Britain’s continued membership, or not, of the European Union will come into focus this year. Even that, of course, is subject to some uncertainty.

We do not know for sure whether the EU referendum will be held in 2016, even though a summer vote appears to be David Cameron’s clear preference.

Assuming the referendum is held this year, we do not know whether it will be an economic non-event or the biggest challenge for Britain’s economy since the global financial crisis. Swap opportunity for challenge and you have both sides of the debate encapsulated. More on that in a moment.

As for the world beyond Britain, the world’s two biggest economies will, unsurprisingly, have the biggest influence. It may be that America’s presidential election is just a bunch of unelectable Republicans providing entertainment before Hillary Clinton’s stately passage into the White House but it cannot be ignored.

The Federal Reserve will raise interest rates further, perhaps as many as four times this year. Markets celebrated last month’s first Fed hike for nine years.

They might not do that every time, though if the Fed feels confident enough to continue the process of “normalizing” rates, it shows it is reasonably sanguine about the US and global economies.

As for China, its landing was hard enough last year to hit commodity and stock markets but in recent weeks the numbers have looked rather better. If you believe the official figures of growth of slightly below 7%, Chinese growth should stabilise around that level this year. That will provide a little support for oil prices. I cannot see a sustained drop in oil to $20 a barrel though I would be surprised to see a recovery to much more than $50.

America and China are not the whole of the world economy but they suggest a picture of reasonable growth; not as good as strong as the 4% trend rate of global expansion but 3.5% is achievable.

What about Britain? Before returning to the EU and the referendum, two things. The first is the argument that this recovery is so long in the tooth that we should be ready for the next downturn. We are now into the seventh year of a recovery that began in the middle of 2009. It sounds like a long time but the recovery that preceded it, from the early 1990s to 2000, ran for more than 16 years. The one before that, in the 1980s, lasted for over nine years. Given how far the economy fell in 2008-9, it is far too early to be calling time on the recovery.

The second thing is to deal with the end of year flurry of nonsense about Britain being in the middle of some kind of debt-fuelled consumer boom. In the national accounts released just before Christmas, the Office for National Statistics reported that aggregate wages and salaries in the third quarter were 4.6% up on a year earlier, pushed higher by both pay rises and employment growth, at a time of zero inflation. Real household disposable incomes were up by 4%. Consumer spending growth of 3% over the same period looks modest by comparison.

And, while household borrowing has picked up a little, it remains remarkably restrained. Overall borrowing has risen by less than 5% over the past seven years, and is significantly lower in real terms and relative to income than it was before the crisis. Unsecured borrowing is 15% lower in cash terms than before the crisis.

So what is in prospect? The big question about the EU referendum is not just the result but whether the uncertainty leading up to it has a significant impact, for example postponed or cancelled investment projects. My judgment is that there will be a little of this, but not too much. Despite the closeness of some polls, most businesses are assuming that the status quo will continue, and that voters will not choose Brexit. If that assumption, which I tend to agree with, turns out to be wrong, then the EU will be the big story for Britain’s economy in 2016. And, whatever your view of the long-term consequences of EU exit, the short-term effects would be significant, and negative.

In the absence of that, what is the outlook? If you took the pre-Christmas gross domestic product figures at face value, which suggested a slowdown, you would expect even slower growth in 2016. But, as I said last week, I did not, so growth of around 2.5% is on the cards for this year.

Inflation, having surprised everybody on the downside last year, should rise very slowly, as some of the helpful “base” effects drop out. But We may still be below 1% at the end of the year. I shall go for 0.75%.

Does that mean the Bank of England will leave interest rates unchanged? I am tempted to say so, conscious of the fact that for the past six years at this time the Bank has been expected to raise rates over the course of the following 12 months, only to do nothing of the sort. But, while fearing another error, there is a limit to the extent to which the Bank can ignore rate hikes by America’s Federal Reserve without at least a token move. So, with trepidation, I will say one move, to 0.75%.

Unemployment should continue to fall, to 0.7m on the claimant count, and just under 5% on the wider Labour Force Survey measure. The current account deficit will still be with us, as noted, but should drop to around £60bn, from nearly £80bn last year.

All that assumes that the economy in 2016 will not be hugely different from the economy in 2015. Meanwhile, the big issues, including productivity, the budget deficit, the EU and trade will continue to exercise us, or certainly me, in the coming months.

Sunday, December 27, 2015
A year in which China slowed, Greece survived and Britain soldiered on
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk, as is the forecasting league table which accompanies the piece This is an excerpt.

So that was that. A year in which plenty happened, and plenty more might have happened. A year in which Greece did not leave the euro but came close to doing so. I predicted Greece would stay in, including to some people worried about their holiday bookings, but it was touch and go for a while.

The Greek crisis quickly gave way to deep worries about China; one of the factors behind the collapse in oil and commodity prices and this year’s exceptionally low inflation. People got a bit too bearish about China, and indeed about the global economy, which has shown tentative signs of strengthening in the final weeks of the year.

Most of what we saw in respect s of China was the necessary slowdown and rebalancing of an economy that had grown for almost 10% a year for three and a half decades. The China story, including its continued emergence as a global player in the international financial system, will continue to fascinate us in 2016.

At home by now, had things gone differently, we could have had a Labour government, perhaps with the support and veto of the Scottish Nationalist Party, with both a budget and a spending review from this strange alliance. But voters decided differently, particularly cruelly in the case of Ed Balls, who went from being chancellor in waiting to ex-MP in the space of a few hours.

The Tories’ electoral position was stronger than it seemed. Indeed, David Cameron secured the support of a higher proportion of overall electorate than Tony Blair in 2001 and 2005. So the euro survived an d the Tories survived, and indeed strengthened their position, with the first Conservative outright majority in a general election since Sir John Major in 1992.

In 1992, as this year, voter doubts about Labour’s economic credibility swung the result. Labour’s further loss of credibility since the election makes the party’s uphill task all the steeper.

The curious economic consequence of the Tory victory was that George Osborne, rather than taking a harder line on public spending when freed from the Liberal Democrat yoke, instead adopted a gentler approach.

The deepest spending cuts offered by the chancellor came in his March budget, when the coalition was still in place. Progressively, in his summer budget and his November autumn statements and spending review, things then got milder. Both of his big post-election set pieces also featured tax increases, significantly in the case of the apprenticeship levy and a tax clampdown on buy-to-let landlords. You would have looked in vain for much hint of these in the run-up to the May election.

Not only that, but Osborne introduced the national living wage, to take effect at £7.20 an hour next April. Some businesses, in care, retailing and catering, will find this difficult, though most in business swallowed their doubts and welcomed the move. As I wrote at the time, the response might have been different had this been introduced by Balls and Ed Miliband in a Labour government.

What was the story of the economy in 2015? One continued theme has been the very slow progress towards normalization. In the case of monetary policy, things are very abnormal indeed or, if this is the new normal, it is a strange one. As I wrote a couple of weeks ago, I expected a token rise in interest rates late in the year. Many forecasters expected more. But we are still stuck with the emergency settings of 0.5% Bank rate (since March 2009) and £375bn of asset purchases under quantitative easing sitting on the Bank’s books.

The other bit of slow progress is on the budget deficit. There were two surprises in the autumn statement from the Office for Budget Responsibility. One was that it found a very useful £27bn down the back of the sofa which was very useful for a chancellor needing to dig himself out of a hole on tax credits. The other was that it took an optimistic view on the public finances for this year, when most economists were looking for a £10bn overshoot.

It remains optimistic, despite last week’s official figures showing that the chancellor has already borrowed £66.9bn in the first eight months of the fiscal year, close to the OBR’s full-year forecast. But I would not dismiss the chances of meeting the forecast. The OBR’s recent record on the deficit has been pretty good.

The other late-breaking pre-Christmas story was the Office for National Statistics (ONS), and its downward revisions of recent growth numbers. How worried should we be by this? Not remotely. I do not know why the ONS does this, save to complicate my annual forecasting league table.

This time last year, when the economy had been on course for 3% growth, the ONS gave us similar revisions which pushed the implied expansion down to 2.5%. Since then, it has spent its time revising the numbers back up, so we now have almost 3% for 2014 again.

This time, an economy that seemed set for roughly 2.5% growth has been pushed down to 2.2% or 2.3%. I have chosen 2.25% for the purposes of the league table, but those who predicted something stronger have every reason to feel miffed. I have no doubt that in the fullness of time growth in 2015 will have been shown to have been at least 2.5%.

The other pre-Christmas ONS highlight was the release of figures showing a current account deficit of £17.5bn, 3.7% of gross domestic product, in the third quarter. The good news is that the deficit has stabilised and is below last year’s peak. The bad news is that at just under £80bn this year (on present trends) it is still very large.

That is a worry, to be examined further next year, Britain’s exceptionally strong labour market and non-existent inflation add up to the very good news of 2015.
Who did best at predicting this? All my top forecasters expected low inflation but none got quite as low as we got. The nearest was the EY Item Club, with just 0.2% inflation in the final quarter. Those who predict ted little or no change in interest rates benefited. Overwhelmingly, forecasters were too optimistic on growth though, as I say, the numbers there are a movable feast.

In the end, it was a very close fought contest between Ross Walker of RBS and Peter Dixon of Commerzbank, both long-time followers of the British economy. Both scored a very creditable nine out of 10, with Walker shading it by the tiniest of margins on the forecasting equivalent of goal difference. But both deserve hearty congratulations.

How did I do, I hear you say? Well, 2.5% growth, 1% inflation, 0.7m claimant unemployment and a £70bn current account deficit was enough for a fluky eight out of 10. It could have been nine if I had not expected that tiny quarter-point rate rise, but that would have been even luckier. I wish all the forecasters success with their predictions for 2016, some of which have already landed.

Sunday, December 20, 2015
Britain heads for another pay rise in 2016
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Pay, the final frontier, or am I getting my Star Trek and my Star Wars mixed up? Anyway, what happens to pay over the next 12 months is important, in many respects.

At its most basic there is the question of whether most people can expect a pay rise, by which I mean the increase in their wages and salaries outstripping inflation, in 2016. There is the issue of how fast pay needs to rise to persuade the Bank of England to follow the Federal Reserve in raising interest rates.

There is also the question of whether Britain is a higher pay country than we often assume, even at the national minimum wage, which has important implications for David Cameron’s efforts to limit immigration from the rest of the European Union.

By happy coincidence, I took part in a Resolution Foundation (RF) discussion on the pay outlook a few days ago, chaired by Linda Yueh, featuring the RF’s Laura Gardiner, George Magnus and Michael Saunders.

We all took the view that there would be a real-terms rise in pay in 2016, which was encouraging, the differences of opinion being mainly whether it would be larger or smaller than in 2015.

At the end of last year average earnings were growing at 2.2% and inflation was 0.5%, so real wages rose by 1.7% over the course of 2014. That was a comfort. At a similar RF event nearly two years ago, I and others said there would be such an increase.

We do not yet have the figures for pay at the end of this year. The latest figures, showing a 2.4% rise in total pay, represented a deceleration compared with recent average earnings growth of 3%, though some of the numbers which make up the calculation. A sharp slowdown in pay growth in business and financial services, to just 1% in the latest month, may for example represent the lull ahead of the bonus season storm.

But let us say that average earnings will have risen by 2.5% in the final three months of the year. Inflation is likely to average precisely zero, so real wages have also risen by 2.5%. 2015 was better than 2014. Will 2016 be better again?

If you wanted evidence that the skill shortages emerging as a result of strong employment growth (up more than half a million over the past year) are pushing up wages, you could look at construction, where pay in the latest three months was 6.1% up on a year earlier. Outside that sector, however, despite reports of skill shortages elsewhere in the economy, there is scant evidence that the traditional Phillips curve relationship – the lower the level of unemployment, the higher is wage inflation – is exerting itself.

Pay settlements, while less important than they used to be, look to be stuck at around 2%. Allowing for drift and factors like the new national living wage, that suggests to me that wage growth over the course of next 12 months will be 2.5% to 3%. Some will get more some, particularly in the public sector, less. If that is the case, how much will real earnings rise? That depends on inflation.

For the second year in a row, the consensus among economists on inflation looks too high. The average prediction this month for inflation at the end of 2016 is 1.5%. That is higher than the Bank of England, 1.1%, and higher than I would expect. Inflation of between 0.5% and 1% at the end of 2016 would translate into a 2% real wage increase, not quite as good as this year but not bad. It would be a little above the prospective growth in productivity, which is running at just over 1.5%, but not excessively so.

What would it mean for the Bank and interest rates? Pay matters a lot for the Bank’s monetary policy committee. Minouche Shafik, one of the Bank’s deputy governors, is the latest to say so, highlighting the fact that pay growth has failed to accelerate as it expected, and has even gone into reverse.

If pay evolves as I suggest over the next 12 months then, alongside recovering productivity, it will give the Bank little reason to raise rates. Of course pay could be stronger, and of course there are other reasons why the Bank might want to follow the Fed. But on the evidence we have, and on the Bank’s signals, you would have to say it looks later rather than sooner.

Before I close on pay, a couple more things to say. One is whether the official figures are giving us anything like a realistic picture. Simon Briscoe, an independent economist and statistician, is particularly exercised by this and has written an extended blog on his website: https://simonbriscoeblog.wordpress.com. The Bank might find it interesting.

Weak average earnings have dominated the debate in recent years, he says, with pay apparently still well below pre-crisis levels. But, as he puts it: “This does not (by and large) reflect falling wages for individuals. The great majority of people in employment have seen wage increases year on year. The average wage is low because millions of low paid jobs have been created …. When the dust has settled and the truth about the statistics emerges, there will be a rewriting of history.”

In similar, though not quite the same vein, it is not generally realised that Britain is, relatively speaking, a high-pay economy, even at the lower end. Britain’s draw, for workers from the rest of the EU, is usually thought to be because more jobs are available. Relative pay is, however, also important.

Michael Saunders of Citi points out that the existing national minimum wage is, when converted to euros, more generous than in any EU economy with the exception of Luxembourg. It is higher than Germany and France, double that in Spain, and roughly four times the level in Poland and most other eastern European EU members.

George Osborne does not intend to let it rest there. The new national living wage will be set at £7.20 an hour next April (the minimum wage is £6.70) and rise progressively to more than £9 an hour by 2020.

David Cameron has been trying to reduce the “pull” factor of Britain for EU migrants in his efforts to renegotiate the terms of Britain’s membership. Meanwhile his chancellor is busy increasing it by raising the statutory minimum employers have to pay. A case, it seems, of the right hand and the left hand not being very well coordinated.

Sunday, December 13, 2015
Cheap oil is a bonus, but not a bonanza
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The drop in oil prices to $40 a barrel, and now to a couple of dollars below that level, resonates a lot with me. Readers with very long memories may recall that when the oil price soared well above $100 a barrel, even coming close to $150, I used to say that the sustainable price was $40.

If you are patient, most forecasts will come right in the end, however eccentric they seem at the time. Oil dropped below $40 a barrel, but only briefly, in 2009, and may have further to fall in the current rout.

There are two aspects of the further drop in oil prices, and in other commodities, that I wanted to discuss this week. The first is what it means for inflation. The second is whether, given the extent of the fall, we should be disappointed about its impact on growth.

On inflation, it seemed likely until recently that the fall in oil prices would soon drop out of the inflation numbers. What I mean by this is that once you get to the point at which prices now are the same as a year ago, there is no additional downward pressure on inflation. And, once we had got to that point, it would be reasonable to expect the inflation rate to start gradually moving higher as underlying inflationary pressures re-exert themselves.

That will still happen, but it will not happen for a while. This time last year crude oil prices were close to $60 a barrel, well above current levels. The average petrol price used by the Office for National Statistics in calculation inflation was 120p a litre in December last year, falling to 109p in January. Now the RAC is talking of an imminent reduction to 103p a litre, with supermarkets already charging less than £1. For most of this year, the average price has been above 110p a litre, often significantly so.

So the fall in prices will keep inflation lower for longer, and may produce more “deflation” readings in coming months. There are many reasons why the Bank of England is not ready to follow America’s Federal Reserve in hiking interest rates, and this provides another.

Bigger than this perhaps is the question of why the fall in oil and commodity prices has not done more for growth. We should be wary of concluding that growth in Britain has definitely slowed this year. The latest figures have yet to undergo much of the revisions process that we have come to know and love. As things stand, however, growth this year is running at closer to 2.5% than last year’s 2.9%.

At a global level, the International Monetary Fund estimates 3.1% growth this year, down from 3.4% last year, and the weakest since 2009, the height of the crisis. What has happened to the oil bonus, the beneficial effects of the good deflation I wrote about this time last year?

At a global level it is not too hard to explain. There are gainers and losers from falling oil and commodity prices. The gainers – every industry in the world which benefits from cheaper fuel and raw materials – will respond by investing more but may take time to do so. The losers will respond by cutting investment sharply, and are doing so. There is an overall benefit from cheaper oil, in other words, but it is complicated by timing differences. You see that in microcosm in the stock market’s poor performance this year, spectacularly so on Friday, where falling share prices for oil and mining firms have outweighed any gains elsewhere.

To take an example, according to IMF calculations, export revenues in the Gulf Co-operation Council countries (Bahrain, Kuwait, Oman, Saudi Arabia, Qatar and the United Arab Emirates) will be $275bn (£182bn) lower this year than last and, of $40 a barrel holds, even lower in 2016. Their combined budget deficit, 12.7% of gross domestic product, is bigger than that of Britain, or for that matter Greece, at the height of the crisis. The Gulf states are close to agreeing on introducing VAT in the region to raise some much-needed non-oil tax revenues.

The global story is thus essentially a tale of two types of economy, rather than a dramatic slowdown or the harbinger of something worse. For emerging and developing economies, including a huge swathe of oil and commodity producers, the fall is mainly bad news. Russia and Brazil, two of the Brics (Brazil, Russia, India and China) are in recession. South Africa is in trouble. China has not been a net oil exporter since the 1990s but its slowdown to growth of less than 7% a year has been the big factor on the demand side of the oil equation. Overall, emerging economies will have grown by around 4% this year, down from 4.6% in 2014 and 5% in 2013.

For advanced economies, the opposite has occurred. Their growth has followed the expected pattern, picking up as the benefits of cheaper oil feed through. Advanced economies should have seen 2% growth this year, up from 1.8% last year and 1.1% in 2013.

What about Britain? In many respects the economy is following the script. Consumer spending, current rising at a 3.1% annual rate, is stronger than last year, when it rose by 2.7%. Business investment, despite North Sea cutbacks, is up by 6.6% over the past year, compared with a rise of 4.6% last year.

The problem lies elsewhere. Another disappointing set of trade figures came out last week, with the overall trade deficit rising from £3.1bn in September to £4.1bn in October, as a result of a surge in imports. Net trade subtracted significantly from growth in the third quarter and may do so again in the fourth.

For this, for once, the blame lies outside the European Union. The volume of exports of goods to the rest of the EU has increased by 12.1% over the past 12 months, nearly four times the 3.2% growth in non-EU exports. Imports from non-EU countries have jumped by 10.2%, against 6.9% from the rest of the EU.

In certain cases, such as China, the fall in UK exports has been spectacular; 36% over the past 12 months. Just as exporters were being encouraged to diversify to emerging economies, which in the long run they should, some have seen the rug pulled from under them

The big fall in oil prices has put more money into British consumers’ pockets, encouraged businesses to invest more and delayed the first hike in interest rates. But it has been disruptive, and it has not necessarily made the world a more comfortable place.

Sunday, December 06, 2015
Low long rates - for as far as the eye can see
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is time for a confession. In my first piece this year, on January 4, while admitting that I was torn on the issue, I predicted a “token” quarter-point rise in Bank rate, to come late in the year.

To be fair to myself, it took me only about three weeks to decide that it was probably not going to happen, after inflation lurched downwards and the two “hawks” on the Bank of England’s monetary policy committee (MPC) withdrew their vote for a rate hike.

There was a brief flurry of excitement in the summer, when Mark Carney warned that a decision to raise rates would come into sharper focus around the turn of the year. But that came to nothing and, barring an enormous surprise this week when the MPC meets, this will be the sixth full year in which there has been no change in rates. The seventh anniversary of the cut to 0.5% comes in March.

The debate about whether or not the Bank should raise rates has been running for so long that most of the arguments are very familiar, though Jan Vlieghe, the MPC’s newest member, brought some fresh perspective when I interviewed him for last Sunday’s paper.

On the question of whether the Bank should follow the Federal Reserve’s likely rate hike later this month, his argument was that what the Fed’s move may tell us about the American economy has to be weighed against what the European Central Bank, which eased again on Thursday, is telling us about the eurozone.

Growth in Britain’s economy is pretty reasonable; expectations following the latest purchasing managers’ surveys are for a 0.6% fourth quarter rise in gross domestic product. But the economy is not racing away, and has slowed compared with last year. Above all, as foreshadowed at the start of the year, there is no inflation and oil prices dropped again last week.

All these are straightforward reasons why the MPC has not pushed the button on interest rates this year. But there is another factor, which is also weighing on the Bank’s decision-makers; the sustained downward pressure on long-term interest rates.

Bank research on it has been described in one of the Bank’s “Underground” blogs and featured in speeches by Carney and Andy Haldane, the Bank’s chief economist. It should be published as a working paper soon under the not so snappy title ‘Secular drivers of the global real interest rate’, by Lukasz Rachel and Thomas Smith. I should declare an interest; one of the authors is my son.

The traditional view of long-term interest rates – such as the interest the government pays on the bonds (gilts) it issues – is that they are determined by the outlook for short rates and the credibility, or creditworthiness, of the issuer.

The traditional view also is that you expect long-term “real” rates – the interest rate less expected inflation – to be positive. Investors do not lend to governments or other bond issuers for nothing; they expect a real return. Three decades ago, that real rate was around 5%

But not now. Though real rates have picked up a little with this year’s very low inflation, the trend has been firmly downwards; if not to zero (though they have been there) to something under 1%.

The Bank’s research looks in detail why this has happened and finds that most of it can be explained by a series of economic factors. It claims to identify why a fall in long-term real interest rates of 4 percentage points, or 400 basis points, is justified by these factors. 50 basis points of the total fall of 450 is unexplained.

The factors are demographics – principally the slowing of global population growth and ageing in advanced countries – which has reduced real rates by 90 basis points; higher inequality within countries, 45 points, and higher savings in the emerging world following the 1997-8 Asian crisis, 25 points.

Other factors include a drop in private investment, 50 points, and a reduced emphasis by governments on public investment, 20 points. Another technical factor is what the authors describe as an increase in the spread between the risk free rate and the return on capital, 70 points. On top of these, which together account for around 300 basis points of the drop in real rates, another 100 is explained by a worsening outlook for trend, or long run, growth in the world economy.

There is no need to get hung up on the precise numbers. The essential point is that long-term interest rates are not just low because central banks have been operating with near-zero short-term rates. They are low because of a range of factors bearing down on them, and most of those factors were in place well before the crisis.

And this is where it feeds back importantly to MPC thinking and the outlook for interest rates, if long-term interest rates are permanently low, there is a limit to how much, when the time comes, the committee can push up short rates. A 5% Bank rate would, for example, be inappropriate in the context of 10-year gilt yield of under 2%, as they are now, or even if they were to rise into the 2% - 3% range, but no more.

That is why those on the MPC who say they are in no rush to raise rates genuinely mean it. If it were a case of having to get rates up from 0.5% to 5%, they might be more impatient to get started. If it ends at 2%, they see time as on their side. It is also why, despite a lot of scepticism about such guidance, it seems reasonable to accept the Bank’s line that interest rates will peak at much lower levels than in the past. If the past seven years have been a nightmare for savers, the next few might not be much better.

Finally, that wait for the Bank to unwind its £375bn of quantitative easing will be a long one. We know now that it will not happen until Bank rate reaches 2%. Not so long ago that would have been a mere staging post for interest rates. Now it starts to look like the final destination.

Monday, November 30, 2015
A interview with the MPC's Jan Vlieghe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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A version of this interview appeared in The Sunday Times

In his job as an economist for one of the world’s biggest and most aggressive hedge funds Gertjan “Jan” Vlieghe tried to second-guess what the Bank of England would do.

Now, as a member of the monetary policy committee (MPC), he offers a pretty clear signal to the markets. As far as he is concerned, interest rates in Britain are going nowhere for some time.

In his first newspaper interview since joining the MPC in September, he reveals himself to be firmly in the dovish camp. While some have speculated that a raising of interest rates by America’s Federal Reserve next month could push the MPC into an early hike, he says he is in no rush at all.

For Vlieghe, who has joint British-Belgian nationality, his MPC appointment marked a return to the Bank, having worked there from 1998 to 2005, latterly as Lord (Mervyn) King’s economic assistant. After that he moved into the City with Deutsche Bank and then Brevan Howard, the hedge fund run by Alan Howard, Britain’s wealthiest hedge fund boss, according to the Sunday Times Rich List.

“In financial markets there is more pressure to be fast, to get there first,” Vlieghe said. “But the fundamental questions are the same. The analysis is the same.” What does his analysis tell him now?

People have been puzzled by the weakness of productivity. But it was only a puzzle, he argues, in the context of a normal recession — 2008-9 was not normal. “Once you realised it was a financial crisis, it really wasn’t that surprising,” he says.

As for what is happening now, he thinks productivity growth has picked up to 1%-1.5%, from about 0.5% 18 months ago but it is still weaker than before the crisis, and may stay weaker from some time.

On what will persuade him that it is time to start thinking about higher interest rates, he cites two factors. Growth in the economy, he points out, has slowed over the past 18 months, from about 3% to 2.3% in the third quarter. “We need to see it stabilise, or even pick up a bit,” he says.

The other factor is wages, which he would want to see rising more strongly — perhaps decisively above 3% a year — before pressing the button, “We’ve seen a little bit of disappointment on wage growth,” he says. He would want to see a much clearer “direction of travel” towards higher pay growth.

Underpinning his view on interest rates is a belief that two forces — the debt overhang and demographics — are weighing down on the global economy, which will mean permanently lower interest rates. Even when rates rise, in other words, there will not be that far to go and so: “I am relaxed about waiting a little longer before we start.”

In fact, the longer you talk to Vlieghe, the more reasons he provides for delaying a rate rise. He snorts at suggestions that central banks might want to start to “normalise” interest rates so they have ammunition to fight the next downturn. Such a strategy would “create the slowdown” they worry about.

A hike in rates by the Fed might tell the MPC that the Fed is more confident about America’s economy but if it coincides with further loosening by the European Central Bank, that would tell you that there is compensating weakness in Europe. Sterling’s rise in the past two to three years is also a factor. “We’ve had a huge tightening from the exchange rate,” he says.

And, while stressing that he expects the next move in rates to be up, like the Bank’s chief economist Andy Haldane he is not afraid to talk about the possibility of further cuts, even a negative rate. “If you had asked me five years ago whether the ECB or SNB [Swiss National Bank] would have had negative interest rates, I would have said no,” he says. “You have to think of it in the context of what other people are doing.”

So, if there was what he describes as an “economic disappointment”, would he favour cutting interest rates or more quantitative easing? “Probably rates first,” he says. The wait for a rate hike could be a long one.

Sunday, November 29, 2015
Osborne keeps the ball rolling on public spending
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is five days since the autumn statement and spending review but it is not too late to give credit to the man who made it possible. Sometimes we do not praise enough.

I refer, of course, to Robert Chote, chairman of the independent Office for Budget Responsibility (OBR). He and his team, by uncovering a £27bn underlying improvement in the public finances over the next five years, drove last week’s announcements.

Most of the improvement was due to a more optimistic view of future tax revenues. Without it, George Osborne would have been in some difficulty.

I should also single somebody else out for a mention: Mark Carney, governor of the also independent Bank of England. When, earlier this month, the Bank clarified its position on quantitative easing, saying that there would be no reversal until interest rates hit 2%, I don’t suppose many people considered the implications for the public finances.

But the OBR did. The £375bn of gilts – government bonds - the Bank holds on its books are effectively an interest-free loan to the government. The longer they are held, the lower the government’s debt interest bill. For complicated reasons, extending the period the Bank holds these gilts adds to government debt. But it reduces borrowing, which was more important in the context of last week’s announcements, by about £6bn over the next five years.

I am not suggesting for a moment that either the OBR or the Bank of England are anything other than independent. Chote and his team made life much easier for the chancellor this time but during the last parliament often made things more difficult. There are swings and roundabouts.

As for the Bank, it would be shocking if the Treasury had suggested that the QE clarification would be very helpful – a clear breach of the independence of monetary policy – that I cannot believe it could have happened.

What is a little disturbing about all this is that the changes announced by the OBR are essentially technical in nature, and they are forecasts. Forecasts, we know, are often wrong. Even this year, in which the OBR is predicting a small fall in the budget deficit compared with its summer forecast even though the monthly numbers point to an overshoot, the forecast could be wrong. The chancellor’s £27bn windfall could evaporate as quickly as it arose.

Would he respond by cutting spending harder or raising taxes further? I think we know the answer to that. This time four years ago the OBR had bad news for Osborne. It took a gloomier view of the economy’s potential and revised up its projections of future borrowing by much more than £27bn over five years. The chancellor could have responded by doubling up on austerity but chose not to do so.

So he is pragmatic, perhaps sensibly, about these things. When the OBR offers him a windfall, he goes out and spends it. When it lands him with a large bill, as it did a few years ago, he chooses to ignore it.

The OBR – set up to adjudicate on but not determine the policy stance – has been the tail that wagged the dog this time. It may do so again, but probably only if it comes up with good news.

Osborne was the lucky recipient of a windfall, although he made some of his own luck, while riding roughshod over his earlier promise to achieve all his deficit reduction through lower spending. He will raise £28.5bn in additional taxes over five years, £11.6bn from the apprenticeship levy, £6.2bn from higher council tax bills and £3.8bn from additional stamp duty on buy-to-let properties and second homes.

What we are left with as a result of this is chancellor who before the election gave us a roller-coaster for public spending – deep cuts in the early years followed by a sudden increase in the run-up to 2020 – with something much smoother. Osborne has done the opposite of what chancellors are supposed to do. For those worried about public spending cuts, he kept the good news back until after the election. Next year, 2016-17, there will be a £6.2bn net fiscal giveaway as a result of the autumn statement, according to the OBR, with a similar figure for 2017-18. There has been a lot of talk recently about the new politics. Post-election giveaways certainly are the new politics.

Osborne, of course, is political to his fingertips. He did not need to be told that he had a problem with tax credits. The losers, as I wrote here, were losing too much too quickly. But he thought it was a good idea to rein back the tax credits bill in July, and he thought it was essential to remain within his welfare cap. Jettisoning both may have been essential in political terms, and the OBR provided him with the means to do it, but it was a lurch, a screeching u-turn.

And we may not have seen the last of it. The Institute of Fiscal Studies and Resolution Foundation have pointed out, rightly, that it is a case of pain postponed for many recipients of the credits, who will face similar cuts with the switch to universal credit later in the parliament. But the chancellor has form. If he was prepared to scrap six months after the election, he will presumably be even more likely to defer or cancel the pain in the months leading up to the next one, even if it were to mean missing his target of achieving a budget surplus.

The big picture is that, while some government departments, and some public services, face further cuts, the squeeze has eased. Osborne is happy to talk about the £4 trillion, £4,000bn, he intends to spend over the next five years as funding “the things we want the government to provide in the modern world”.

In five years’ time, though he may not then still be chancellor, overall public spending will be 1% higher in real terms than he inherited in 2010, and 3% higher than now. Day-to-day spending will be up by 2.5% in real terms over the period.

Spending will be down to 36.4% on gross domestic product, it is true, from a recent peak of 45.7% in 2009-10. But this will have been achieved after more than 10 years of decent economic growth and will be higher, relative to GDP, than in the early 2000s. When the next downturn comes, spending will head back up to 40% of GDP or more.

Maybe Osborne’s bark was always worse than his bite. Maybe he has adjusted to the fact that he no longer has to be so tough on public spending to draw out Labour’s lack of fiscal credibility. Under the party’s new leadership it is on open display.

Or maybe, fiscal fatigue has set in. There were reforms in the spending review. Including devolving decisions to local level and transforming the prison estate, but there were not that enough of them to guarantee a permanently smaller state. Osborne is accused by his critics of wanting to destroy the state. He has just demonstrated, once again, that he means to preserve it.

Sunday, November 22, 2015
It isn't just the deficit where Osborne is struggling to hit his targets
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Though it is easy to dismiss such things as pieces of political theatre, Wednesday’s announcements from George Osborne – an autumn statement and a spending review – are rather important.

Autumn statements, it is true, come round once a year. If you think of them as mini budgets, which the headline writers often do, we have a budget or a mini budget every few months. Spending reviews are rarer. There was only one proper one in the last parliament, five years ago, and Wednesday’s is the big one for this parliament. It is big in more ways than one. As Osborne observed a couple of weeks ago, it will set out how the government will spend an eyewatering £4 trillion - £4,000bn – over this parliament.

What should we be looking for from the chancellor this week? I would say he has four targets. He has to detoxify the tax credit changes he announced in his summer budget, which were subsequently voted down by the House of Lords.

He has to demonstrate that his deficit reduction strategy is on course in this parliament, having been blown off it in the last one. That target will only be achieved if a third one, credible plans for reducing public spending, are in the spending review. Finally, there is a fourth target. Having talked up his commitment to infrastructure spending, and tempted Lord Adonis away from Labour to chair his new national infrastructure commission, Osborne has to match words with deeds.

Let me take these in turn. On tax credits, the chancellor will soften the blow of the cuts announced in the summer, while sticking with his £12bn of welfare reductions, which he needs to remain within his self-imposed cap. I suspect he knows he will take a political hit on this, in that no amount of tinkering or phasing will change the fact that there will be losers from the changes. Wednesday will, be about limiting the damage.

Interestingly, a report from the Institute for Fiscal Studies last week found that the tax credit changes, in combination with the new national living wage, will have one desired effect – apart from reducing the welfare bill – which will be “on average, to strengthen incentives to move into work and to work more if in work”. The trouble with averages, however, is that they can conceal problems. For some, such a single parents, the changes will reduce incentives to work.

Whether tax credits grab the headlines this week, or whether the chancellor comes up with an alternative headline-grabber, which is likely, the budget deficit will be an ever-present, as it has been during his chancellorship.

Indeed, irritated by the fact that some people are starting to argue that it is job done on the deficit – including some who argue that there was never a job to do even when it was more than £150bn – the chancellor and his officials have taken to talking up. Osborne spoke recently of this year’s deficit, predicted by the Office for Budget Responsibility to be just under £70bn – a figure that the latest data (released on Friday) suggested it will be hard to achieve - as adding to the “mountain of debt”. Treasury officials are happy to say that Britain’s deficit is bigger than Greece’s as a percentage of gross domestic product.

What this means is that the aim of achieving a budget surplus and maintaining it “in normal times” remains set in stone. Osborne has listened to the arguments of economists who say you should take advantage of ultra low interest rates and deliberately borrow more, and rejected them.

That means hitting his third target, further sustainable cuts in public spending. The IFS, again, has done the sums on this. In the July budget the chancellor set out plans to cut departmental spending by £11.3bn, or 3.2%, in real terms between 2015-16 and 2019-20. That sounds relatively painless.

Drill down into the numbers, however, and capital investment – infrastructure spending – is planned to increase by £4.9bn, or 11.5%. That increases the cuts to day-to-day spending, so-called resource spending, to £16.2bn, or 5.1%.

Drill down again and take out of that the planned increases of £7.6bn in spending on the NHS, defence, overseas aid and a freeze on schools spending, and the reductions on everything else increase to £23.7bn, or nearly 19%. By the end of the parliament, spending by these unprotected departments will have been cut by 39% in real terms compared with 2010.

Can it be done? The problem with the 2010 spending review was that it contained cuts but not much reform. This week’s effort is intended to include both. It aims to show that government can be smaller, in terms of what it spends, if it is also smarter. The template is the recent announcements on prisons, in which old Victorian prisons will be sold off, some of them to provide bijou apartments for hipsters, and replaced with modern institutions. As well as saving money, the intention is to provide better rehabilitation, saving money by reducing reoffending. Expect more such policies, as well as an outcry when the cuts are announced.

What about infrastructure? For the reasons set out above, Osborne is not going to tear up his deficit reduction plans and engage in a borrowing splurge to pay for a big increase in public investment. He says the government will spend £100bn on infrastructure during this parliament (small in relation to £4 trillion of overall spending). Broader OBR figures are for public sector net investment of £144bn in the next five years.

This will be supplemented by private infrastructure investment, including from abroad. Osborne tweeted approvingly a survey last week from Nabarro, the international law firm, showing Britain to be the top destination in the world for foreign infrastructure investment. Some will applaud that, while some will worry that too much of our infrastructure will be foreign-owned, and not just in the nuclear industry. Whether, even with that foreign input, Britain is spending enough upgrading our infrastructure will be questioned by many.

So four targets: sort out the tax credit mess, convince on deficit reduction, unveil achievable spending cuts and increase infrastructure spending. Whether Osborne can hit them will not be fully resolved this week. It certainly won’t be easy.

Sunday, November 15, 2015
Leave the EU and you lose the single market
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The battle over Britain’s membership of the European Union is now officially joined. It could be all over by next summer, though it could drag on for the next two years.

I presume that if, as is likely, David Cameron decides that the EU has not turned a deaf ear to his fairly modest renegotiation demands, Downing Street will choose a referendum timing which offers the best prospect of a yes vote. That probably means waiting until the refugee crisis has subsided.

Anyway, there is a long way to go, and a lot of areas to cover, between now and even an early referendum. But let me focus on just one today: the issue of trade and access to the single market.

Last week I quoted projections from PWC which demonstrated that, though the share of exports of Britain’s goods and services going to the rest of the EU is in decline – from 55% in 1999 to 45% last year and a projected 37% in 2030 – it will remain, assuming continued EU membership, the key trading partner.

The EU is important even if you adjust for the so-called Rotterdam effect; exports destined for the rest of the world which are shipped via Rotterdam in the Netherlands, and imports from the rest of the world which come in the same way. Exclude all exports to the Netherlands from the numbers and it would still be the case that more than 40% of Britain’s overseas sales are to the rest of the EU.

The EU is even more important when it comes to imports: 53% of the total last year, up from a recent low of 50% in 2011. Britain had an overall trade deficit with the rest of the EU of £62bn last year, compared with a non-EU trade surplus of £28bn.

It is this that has led some in the “leave” camp to conclude either that we would be better off without EU trade – because we have been in long-term deficit with the rest of Europe – or that if there is a vote to leave, Brussels will be desperate to quickly put in place a deal to allow EU exporters to continue to access the British market.

The first can be easily dismissed. Though the far left and extreme right have periodically argued for blanket controls on imports, basic economics tells us that countries gain from trade even when running a deficit.

The serious issue is whether Britain and the EU would rush to negotiate a market access deal even after an exit vote. The answer, provided a few days ago by Lord Mandelson in a speech to the EEF, the engineering employers federation, was a firm no.

The Mandelson speech, delivered at the Royal Society, was interesting. Though the EEF is as broadly pro-EU as the CBI, the event did not attract a silly Vote Leave stunt. There were no students dressed as business people holding up placards.

And, while there is inevitably a strong “he would say that wouldn’t he” element about the former EU commissioner’s remarks, they struck a chord. Whatever else he learned in Brussels as trade commissioner, he quickly discovered that negotiating new trade and market access deals is a thankless task. Such negotiations typically drag on for years, if not decades. Mandelson’s verdict was that, even in the event of a deal, it would not give Britain’s exporters anything like the access to the single market they enjoy now.

These days any such deal would not be mainly about tariffs; industrial tariffs between advanced economics are very low. They are about common product, regulatory and safety standards. For Britain, they are also about completing the single market in services, in many of which we excel; which is proving challenging to negotiate while we remain in the EU, and would be impossible if we were no longer members.

In a recent paper, Brexit: The impact on the UK and the EU, Global Counsel, the strategy advisory firm chaired by Mandelson, looked at the options for Britain outside the EU. The paper, written by Gregor Irwin, former chief economist at the Foreign Office, examined a Norwegian-style European Economic Area (EEA) agreement; a Turkish-style customs union; a free trade area; Swiss-style bilateral trade accords for different sectors, and a so-called most favoured nation approach giving Britain preferential access to the EU but on less advantageous terms than now.

Of these, only the Norwegian option would give Britain full access to the single market, but at the cost of continuing to pay into the EU budget and losing any influence over the regulations and directives British business would be required to adopt to gain access to that market. A free trade agreement would mean that British exports would escape the EU’s common external tariff but not much else. Full access to the single market would be lost.

As for it being in the EU’s interest to quickly negotiate a comprehensive deal to preserve its trade surplus with Britain, that is not how it works, as became clear at the EEF event. For some countries and for some industries, such as the German car manufacturers, it would clearly be of benefit to do so. Getting approval from the remaining 27 member parliaments of the EU, and from the European parliament itself, would be tough in an environment in which there would be little goodwill towards Britain.

Some voters will say that some loss of access to the single market is a price worth paying for, say, regaining control of over our borders (though non-EU net migration is larger than migration from the rest of the EU). Some businesses, particularly those that do not trade elsewhere within the single market, will agree with them. After all, we sell to plenty of countries with whom we do not share a single market, though largely under trade deals negotiated by the EU.

The single market issue is not, on its own, decisive, but it is important. And it is just one of many areas in which, as things stand, a vote to leave the EU would be a step into the unknown.

Sunday, November 08, 2015
Risks start to rise as rates get stuck again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Forecasts are always risky, but if I wanted to venture a couple, it would be these. At some stage next summer Mark Carney, the Bank of England governor, will make a speech warning that interest rates could be going up, perhaps around Christmas.

Then, at roughly this time next year, when it becomes clear they are not, the markets and the Bank will between them push out their expectations of the first rate hike into late 2017 or beyond.

This is not, I should say, some bold leap into the dark, though it could still turn out to be wrong. Friday's strong US jobs report put the Federal Reserve's on-off December rate hike back on again again, showing that these things can change quickly. But expecting a hint next summer from Carney that rates could soon be on the up merely assumes the governor will follow the pattern of the past two years.

In the summer of 2014, at the Mansion House in the City, and in the summer of 2015, at Lincoln Cathedral, Carney put markets, households and businesses on alert for higher rates. And, while he pointed out on Thursday that we have not yet reached the turn of the year, which is when he said the decision on rates would come into sharper relief, the tone of Bank’s latest inflation report was that everybody can stand down; rates are going nowhere.

My other prediction is not particularly bold either. All it assumes is that the history of the past few years will repeat itself and that the Bank’s monetary policy committee will continue to find more reasons not to raise interest rates than to do so. For added comfort, the market assumptions on which the Bank’s latest growth and inflation forecasts are based are for no change in rates next year.

Thus continues an extraordinary period. If, it is indeed the case that interest rates are on hold until 2017, this will be the missing decade, perhaps even the lost decade, for rate hikes. The last change in interest rates – the cut to 0.5% - was in March 2009 but the last hike was as long ago as July 2007. The last time we went so long without a rate hike was in the period which included the Great Depression and the Second World War. Bank rate was at 2% from 1932 to 1951. The last time before that was when Bank rate remained at 5% for over a century, from 1719 to 1821. I don’t think we will beat that one but these are early days.

If rates were still at 0.5% in 2018, Carney would return to Canada as that rarest of modern-day governors; never presiding over a change in rates. He still seems personally keen on getting one under his belt next year, even though the inflation report suggested otherwise. Many City economists also still have a rate hike pencilled in for 2016, though they were surprised by the dovishness of the Bank’s inflation report.

The other extraordinary thing is that the Bank, having never done quantitative easing (QE) before the crisis, is in no hurry to unwind it. Electronically creating money to purchase assets was novel in 2009. By the time the Bank gets around to reversing it, it will be old hat. A few weeks ago I suggested that the Bank might want to run down its QE to take the temptation away from politicians to launch much dodgier versions of it.

Instead, the Bank has hardened its commitment to maintaining QE. Until last week the understanding was that, as soon as interest rates started to rise, it could quietly start the process of running down its QE, by not reinvesting the proceeds of maturing gilts it has on its books. Now it says it will not do that, let alone start the process of actively selling the gilts back, until Bank rate is up to 2%, which might not be until 2020. As well as a decade without rate hikes, we would by then have had a decade or more of large-scale QE.

Does it matter? You could say it does not get much better than this. While savers have been deprived of the return on their savings they would normally have expected, borrowers are continuing to enjoy the bonus of low rates. Indeed, to be charitable to Carney, his 2014 and 2015 warnings were both scuppered by what the Bank regards as an “unforecastable” plunge in oil prices. Indeed, the latest inflation report includes a useful comparison of what the Bank expected in August last year and what subsequently happened. The halving of oil prices since then meant that instead of inflation being just below the 2% target now, as it projected, it is running at -0.1%.

You could also say that consumers have had a double-bonus from cheap oil: the fall itself and the postponement of possible rate hikes. So these are good times for households: real post-tax household incomes will rise by 3% this year and more than 2% annually for the three following years. They are also good times for businesses, with the Bank projecting a 5.5% rise in investment this year, followed by 7.5% t0 8.75% rises for the following three years. Growth is good, inflation is benign, what could possibly go wrong?

Three things. One striking thing about inflation in recent years has been how much it has been driven by factors outside the Bank’s control; the rise and fall of commodity prices, and the fall and rise of sterling. Those factors are currently blowing in a favourable direction. There is no guarantee that will continue, particularly given instability in the Middle East.

Secondly, the longer that interest rates stay low, the greater the danger of risky behaviour. House price inflation is back within a whisker of 10% according to the Halifax and consumer credit is picking up strongly. The intention of low rates is to encourage households to spend and businesses to invest. But spending can turn to splurge and judgments can become very clouded when the risk of higher interest rates appears to have been removed from the table.

Finally, the Bank’s new forecast, in which consumer spending grows by an average of 3% a year and the growth of imports comfortable exceeds that of exports each year, is one that could be expected to exacerbate Britain’s already parlous balance of payments position. In the past we would have worried about that because of the impact on sterling, and the knowledge that a plunging pound has usually meant higher interest rates. This time, so far at least, it has been different. But this time is different does not usually work as a long-term plan.

Sunday, October 25, 2015
A fine mess: How Osborne can dig himself out of his tax credit hole
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

George Osborne, it seems, is on a three-year cycle. Much of the time he gets a pretty good press, given that he has presided over some unpopular policies, and he has had the last laugh over his austerity critics.

Every three years, however, something goes badly wrong. Three years ago it was his “omnishambles” budget, which combined the brave move of cutting Labour’s 50% top rate of tax to 45% with some unwise tinkering with the tax privileges of Cornish pasties and caravan owners.

Now it is his “toxic” cuts to tax credits, which are in danger of joining a long list of policies which look elegant and logical on a Whitehall computer screen are disastrous when implemented. They include Gordon Brown’s abolition of the 10p tax band, the bedroom tax and Osborne’s own child benefit cuts, which penalised higher-paid single-earner families, while letting two-earner couples with high household incomes off the hook. Some are even drawing comparisons with the poll tax, the policy which more than any other brought down Margaret Thatcher.


The chancellor, political to his fingertips, will be aware of all these precedents. But when he presented his summer budget in July, his second in the space of four months, he was perhaps still in the first flush of excitement after the Tories unexpected majority in the May election. As in the early months after the 2010 election, when he was in the first flush of excitement of becoming chancellor, things were done that on reflection might have been done differently.

Let me start, however, with praising Osborne on tax credits. Having inherited a system that was becoming ruinously expensive, and which benefited nine in 10 families with children in 2010, the reforms the chancellor steered through in the last parliament, largely without fuss, went a long way towards putting things right.

The proportion of families with children receiving tax credits has been reduced to six in 10 and the tax credit bill, rather than rising to £37.8bn this year and £40bn in 2016-17 in cash terms, has been stabilised at around £29.5bn, before the summer budget changes kick in. Spending on tax credits has been cut in real terms, and cut dramatically compared with unchanged policy, with the minimum of fuss.

The other essential point to make is that, despite savings such as these, there is a long way to go on the deficit and debt. The September public borrowing figures were “good”, in that they were lower than the markets expected, but the government still spent £9.4bn more than it brought in on taxation. Borrowing so far this year is £7.5bn lower than last year but analysts still think it touch and go whether the official forecast of £69.5bn will be met. Public sector net debt has risen by £70.5bn in the past year.

The question is why Osborne’s latest push on tax credits, which will reduce the number of eligible families with children from six to five in 10 and produce additional saving of less than half what has been saved so far, has caused so much trouble.

The answer is that the tax credit cuts these will usher in from April are large, and people on low incomes hard. So a single-earner household with two children on £6,420 (the old threshold for withdrawing tax credit) will see their tax credits drop from £10,885 to £9,651, a drop of £1,234, or more than 7% of their combined income from earnings and tax credits. Somebody earning the new national living wage, which for a full-timer on 35 hours a week will be £13,100 a year from April, will lose £1,701, cutting their combined income by 8%. A household on roughly double those earnings, £26,530, will lose all their tax credits, currently £2,640 a year.

Given the nightmare complexity of the tax credits system, these things are never straightforward. Osborne, like many before him, may find that what he saves in one part of the welfare system costs him elsewhere. Press down hard in one place and up something pops elsewhere. Paul Ashton, an independent economist, has a plausible example of a single mother getting back much of what she loses in tax credits from higher housing and council tax benefits. It is quite likely that some of those worried most about the cuts to tax credits are not the biggest losers, or even losers at all.

Even so, there are big losers, and they are among the “hard-working families” the Tories want to encourage, and they happen suddenly. So if this threatens to be Osborne’s poll tax moment, how can he escape it?

The first option is to phase in the changes. A 7% or 8% drop in income is a big hit; 1.5% to 2% annually spread over four years is more manageable. People’s circumstances change (admittedly something the tax credits system is not great at dealing with), but with the cuts spread people would have a better chance of working their way through them. This process would be helped by rising wages, notwithstanding the Institute for Fiscal Studies’ (IFS) point that the national living wage will not on its own come close to compensating for the cuts.

The second option is to keep the overall tax credit cuts but push them up the income scale, as suggested by Frank Field, the former Labour welfare reform minister. Under his proposals, which he claims would save as much as Osborne intends, nobody would lose anything on earnings below £13,100, all the losses being above that level.

Field is always worth listening to but his alternative reform would impose unacceptably high marginal rates of tax and benefit withdrawal. David Phillips of the IFS calculates that they would mean a 97% effective marginal rate on earnings above £13,100, once the loss of tax credits, income tax and national insurance are taken into account. If households are on housing and council tax benefit, that marginal rate rises to 99%.

There may be a third way. I would suggest a combination of phasing in the changes and Field’s suggestion of shifting the burden of the cuts to higher income families, but with a crucial addition. This crucial addition would be using higher taxes to reduce the amount that credits have to be cut.

What taxes? It is a pity that the new £1m inheritance tax threshold on family homes passed to children has been announced and is being implemented. That will cost nearly £1bn a year by 2020 and, apart from buying the Tories a few votes in the election, is hard to justify.

Also increasingly hard to justify, however, is the obsession with increasing the personal tax allowance; the amount that people can earn before paying income tax. Raising it to £11,000 next year in the July budget was at a cost of more than £1bn a year, a tax cut that has long ceased to be of benefit to the very lowest paid.

Most obvious of all, at a time of low inflation and low petrol and diesel prices is to push up fuel duty. The chancellor’s “fair fuel stabiliser” four years ago ruled out duty increases when oil prices were above $75 a barrel. They are currently under $50. A 2.5p increase in duties would raise over £1bn and take some of the rough edges off the tax credit changes. It would be unpopular. But not as unpopular as the raw changes in tax credits Osborne seems determined to inflict.

Sunday, October 18, 2015
How Osborne's dreams of a surplus could backfire
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Outside the narrow confines of what is sometimes called the Westminster village, most people will have been getting on with life, rather than following the progress of the government’s Charter for Budget Responsibility; its new set of fiscal rules.

To sum up, for those who missed it, Labour decided that the charter was a very obvious political trap set by George Osborne to demonstrate that the opposition could not be trusted with the public finances. Then, having identified this very obvious trap, the party’s new leadership tried to get all its MPs to hold hands and jump into it. Some sensibly resisted by abstaining on the vote.

John McDonnell, the new shadow chancellor, has made a fool of himself. There was something very odd about his interview with The Guardian on September 25, when he said he would support the charter – which commits the government to an overall budget surplus – while also saying Labour would borrow to fund investment; the party’s position under Ed Miliband.

It looks like he did not understand what he was saying and the illogicality of his position was pointed out to him. That is more convicing than his story, that he had a Damascene conversion when visiting the families of steelworkers in Redcar, should be taken too seriously.

I hope this is the last time McDonnell will feature here for a while. Ed Balls, for all his faults, was 10 times more suited to the job of chancellor than his successor and I did not devote many column inches to him during the last parliament. It would have been very different if the general election had turned out differently for Labour and for Balls.

Just because the new shadow chancellor has been a fool does not, of course, mean Osborne is a genius. The fiscal charter is not, as its opponents suggest, a stunt – he means it - but the highly political way in which it has been used makes it easy to make that claim. Sometimes the chancellor can be too political for his own good. You might have needed a fiscal charter vote to convince voters that a Miliband-Balls Labour party lacked fiscal credibility. You do not need it with a Labour party led by Corbyn; people know that already.

This should be a golden time for Osborne. Though he got on reasonably well with Danny Alexander, the Liberal Democrat Treasury chief secretary, during the coalition, those days are over. The Treasury these days is peopled by like-minded Tory ministers, including Alexander’s successor, Greg Hands.

The economy is doing well. Though there is evidence of a slight slowdown in the third quarter, Osborne can bask in the glory of an economy growing faster than G7 competitors, and the recent upward revisions in gross domestic product which have vindicated his approach.

The labour market is doing extraordinarily well, a recent pause in employment growth giving way to another good rise. In the latest three months employment has grown by 140.000; in the last year by 359,000, and overwhelmingly traditional full-time employee jobs. The unemployment rate has dropped to 5.4%, its lowest since May 2008, and could soon threaten to drop below its lowest point during the long upswing from the early 1990s to the global financial crisis.

Average earnings are growing by 3% - 3.4% in the private sector – at a time when inflation has turned marginally negative, by 0.1%, again. Real wages are rising strongly and, though the path will be bumpy, productivity should also recover. The economy is in a sweet spot.

Instead of basking in this, and the political gift of a chaotic and divided opposition, the Tories are in danger of creating rods for their own backs. The fiscal charter is badly designed and hard to defend, and the cuts in tax credits, which have become the lightning conductor for austerity in this parliament, are being badly handled.

The problem for the charter is not that it aims for an overall budget surplus, and then to keep it there, although Osborne could easily find, like most of his predecessors, that this is a triumph of hope over experience. He came up with his surplus ambition only after his deficit targets had slipped.

After a big increase in government debt before, during and after the financial crisis, it is reasonable to aim to reduce it, if only slowly. Treasury projections produced at the time of the budget showed that, even assuming an economic shock every eight years that pushes public sector debt up by 10% of gross domestic product, a rule that required a small surplus would reduce it from just over 80% of GDP now to just over 50% of GDP by the mid-2030s. Borrowing to invest – running an overall budget deficit - would leave debt close to current high levels.

Nor is it the case that running a small overall surplus means starving means starving the country of much-needed public investment, as is sometimes claimed. There have been times when budget surpluses coincided with near-record lows for public investment, as under Gordon Brown from 1988-99 to 2000-01. But there have also been times when surpluses ran alongside very strong public investment, as in 1969-70 and 1970-71, when public investment averaged well over 6% of GDP, more than four times current levels.

The problem is the way the charter is designed. It aims for an overall budget surplus by 2019-20, which would be the first for nearly two decades, and a reduction in debt as a percentage of GDP each year until then. That overall surplus would then be maintained each year “in normal times”, the requirement only being abandoned if there is a “significant negative shock” hitting the economy, defined as an assessment from the Office for Budget Responsibility (OBR) either that growth has dropped below 1%, or that its forecasts show it doing so.

The problem with this, as Jonathan Portes, former director of the National Institute of Economic and Social Research points out, is that it could lead to mistakenly tight fiscal policy. If growth averaged 1.5% a year rather than 2.5% over a four-year period, the cumulative loss of GDP, and tax revenues, would be considerable but the charter’s get-out clause would not be triggered. Osborne, or his successor, would be required to target a budget surplus even in a period of slow growth.

This would deprive Osborne of flexibility he himself has taken advantage of. The OBR, in its latest forecast evaluation report, just published, looked at why borrowing last year, 2014-15, was more than £50bn more than it predicted in 2010. The problem was a shortfall in economic growth, and the weakness of wages, which meant tax revenues came in £60bn lower than expected. But we now know that growth never fell below 1% during the last parliament. Had the charter applied, Osborne would have had to cut spending more deeply, or raise taxes, to compensate for the shortfall in revenues. It is a problematical piece of legislation.

The government is also getting itself into an unnecessary bind over tax credits. There are plenty of things that need fixing about tax credits. Everybody talks about their positive effects on work incentives but they also operate in the opposite direction. I recently quoted a Low Pay Commission report which found that many lone parents were unwilling to work more than 16 hours a week, and single adults more than 30, because it affected their entitlement to tax credits and other in-work benefits.

What you do not want in any reform are large numbers of seemingly deserving cases, who will lose out significantly from the tax credit changes, in some cases reducing or removing their incentive to work. Chancellors are at their best when following the dictum of Jean-Baptiste Colbert, Louis XIV’s finance minister, of plucking the largest amount of money from the goose “with the smallest possible amount of hissing”.

There is plenty of hissing over the tax credit changes, which strongly suggests they could be done in a better and fairer way.

Monday, October 12, 2015
Geoffrey Howe, exchange controls and the 1981 budget
Posted by David Smith at 01:00 PM
Category: David Smith's other articles

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An extract from my book, Something Will Turn Up

The 1979 budget was big and bold. Rarely has a government set out its stall, and its philosophy, so clearly. The argument was that if these big changes had been delayed, they might never have happened, once events intervened. As significantly as the income tax cuts and the big shift from direct to indirect tax was another section in Howe’s speech.

Exchange controls had been the cross that British individuals and businesses had had to bear through sterling’s long period of vulnerability. During the worst of the country’s ‘sick man of Europe’ period in the 1960s, before and after the 1967 devaluation, a £50 ‘foreign travel allowance; operated, this being the limit on the amount of money British travellers could take abroad. That was probably the least important though most visible aspect of exchange controls. Partly to hold the Bretton Woods system together, most countries operated controls on the amount of capital that could flow in and out. For countries with vulnerable balance of payments positions, which could be exposed by flows of ‘hot’ or short-term money, such controls had come to be seen as very important. All that changed for Britain in the space of just a few months in 1979. In his budget speech, Howe said it was now ‘an appropriate time to start dismantling our apparatus of controls on outward capital flows’.

In his budget speech, Howe suggested that his approach to the removal of exchange controls would be a cautious one. It would be a ‘progressive dismantling’, he said, and determined by the strength of sterling among other factors. In the event, the chancellor was able to proceed a lot more rapidly than he thought. Just four months after his budget he announced to a surprised House of Commons that all the remaining exchange controls were to be abolished. This was quite a moment. Nothing better illustrated the commitment of the Thatcher government to free markets than this bold move to allow people and businesses to decide for themselves how to money across Britain’s borders.

It set the standard for the rest of Europe, which eventually followed suit by removing national exchange controls, though in some cases not for a decade or more. The Labour Party complained that it would cost British jobs, as firms used their new freedoms to invest overseas, although in subsequent years Britain was a net beneficiary of such flows, as inward investment increased sharply, particularly from the Far East. It also signalled to the world that the Thatcher government meant it when it said it would be radical and reforming.

The removal of exchange controls was one of the most important reforms of the Thatcher era, alongside other financial liberalisation including freeing the banks to enter the home loan market, the removal of hire purchase controls and the Big Bang reforms of 1986; which opened the City up to foreign ownership and brought the phenomenon of investment banks to Britain. A controlled financial system became a liberalised one, with both good and bad consequences.

Sir Geoffrey Howe, Margaret Thatcher’s first chancellor, was also the first chancellor I got to know on a personal basis. I was working for Financial Weekly, a now-defunct City newspaper. It had been launched, in 1979, by the then owners of the Daily and Sunday Express, with some fanfare. Money was spent on it, and high-profile columnists hired at considerable cost, including Harold Wilson, the former Labour prime minister. Later I was deputed, with a colleague, to take him to lunch in Westminster and tell him that we could no longer afford to carry his column, news he was able to avoid, on that occasion at least, through the simple expedient of not turning up.

Financial Weekly had failed to live up its founders’ expectations. When I joined in the spring of 1981 it was already clear that neither circulation nor advertising made it a viable proposition. A year later the original owners closed it and everybody received a redundancy cheque. It was a short-lived period of idleness. Two weeks later the title was bought by Robert Maxwell, the flamboyant Czech-born businessman and one-time Labour MP, today remembered for appropriating funds from his companies’ pension funds and dying, in 1991, after apparently falling overboard after a heart attack from his yacht, the Lady Ghislaine, which was cruising off the Canary Islands. That was much later. I remember him as a huge presence, literally, with a domineering manner. Anybody on the receiving end of Maxwell’s bullying, which I fortunately never was, did not forget about it in a hurry. As almost a comic-character magnate, he was also the subject of a lot of gentle mockery. One story about him, which I do not think was apocryphal, was of him coming across a member of staff in one of the corridors in Maxwell House (yet it was called that) on the north side of the City, smoking a cigarette while reading a notice board.

Maxwell, for some reason, took an instant dislike to the person, called him into his office and in his booming voice asked what his annual salary was. He them wrote out a cheque for the amount and told him never to appear in the office again. The man, it turned out, was not a member of staff but a visiting sales representative from another company, who had just enjoyed a large and unexpected bonus. In the meantime, a new proprietor meant a relaunch for the newspaper. We asked the Treasury if Sir Geoffrey Howe would agree to an interview, and he did.

Over the years, Howe has acquired a reputation as one of the most downtrodden political figures of recent times. In 1978, when he was shadow chancellor, he was famously the subject of one of the cruellest House of Commons putdowns of all time. Following an assault on his economic policies by Howe, Denis Healey, the chancellor, said that being attacked by his opponent was like being ‘savaged by a dead sheep’. Once in government, stories began to emerge of Howe being humiliated by Thatcher in cabinet meetings, and later some of those humiliations came out in some of her public utterances. It was no secret that she used her personal economic adviser, Alan Walters, and Sir John Hoskyns, head of the Downing Street policy unit, to bolster her chancellor’s resolve. At a time when the Treasury was resistant to the new government’s policies, she always feared that Howe would go native. One explanation of Howe’s devastating Commons’ resignation speech in 1990, which triggered the leadership contest that brought down Thatcher, was that it was his revenge for years of humiliation. He later denied that strongly, saying his speech was a matter of conscience. When I met him in 1982, it struck me that people had perhaps sometimes confused his courteousness with weakness. He was certainly courteous. When I said we were very pleased to have the interview for our relaunch, he said: ‘Do you think it will get on the front page?’ There was of course never any doubt that it would. The story, a variation on the theme that the economy was decisively on the up, fitted perfectly. That he was able to say in 1982 was far from guaranteed.

This was a year after Howe’s most dramatic moment as chancellor, his 1981 austerity budget. In the depths of the 1980-1 recession, he had turned the conventions of post-war economic policy on their head. Unemployment had risen above two million and was increasing by 100,000 a month. Though there was some tentative evidence that the pace of decline was easing, nobody could be sure that the economy was near a turning point. It was a moment when most governments would have trod carefully, for fear of making a bad situation worse. Instead Howe, egged on by Thatcher and her advisers, unveiled a budget that even with the passage of time looks bold, to the point of foolhardiness. Had it gone wrong, it could have been the end of the Thatcher government.

Though Keynesian economic policies had been abandoned by the Callaghan government in 1976, they were buried by Howe in 1981. His budget raised taxes, mainly by freezing personal tax allowances at a time of high inflation, raising employee National Insurance contributions and announcing big increases in excise duties on petrol, alcohol and tobacco. Popular it was not, even though there was a one-year windfall levy on the banks, which were benefiting from the very high interest rates that were part and parcel of the government’s monetarist experiment. Most notoriously the budget produced a response from 364 economists, a round-robin letter circulated around university departments which was published in The Times, which condemned the government’s approach. The letter, initiated by Frank Hahn and Robert Neild of Cambridge University, two of Britain's most distinguished professors of economics, attracted the signature of four former chief economic advisers to the government, and one future governor of the Bank of England, Mervyn, later Lord, King. ‘There is no basis in economic theory or supporting evidence for the Government's belief that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment,’ it warned. ‘Present politics will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.’

The letter could have been an epitaph for the Thatcher government’s economic experiment. The story goes that when Michael Foot, the Labour leader, asked her in prime minister’s question time to name two economists who agreed with her policies, she was able to say, quick as a flash, Walters and Patrick Minford. But in the car back to Downing Street she turned to an aide and said: ‘It’s a good job he didn’t ask me to name three.’ 1981 was certainly the government’s toughest year. Just a month after the austerity budget the first of the inner-city riots broke out. The riots, in Brixton in London, Toxteth in Liverpool, Chapeltown in Leeds and Handsworth in Birmingham, appeared to be a direct response to high and fast-rising unemployment, though subsequent investigations showed that the causes were more complex. For several months the austerity budget appeared to be a gamble that had failed. Though it is now seen as one of the episodes that were the making of the Thatcher government, it did not look like that for some time. Figures now show that the 1981 budget did mark the low-point of the recession, and that the 364 economists were wrong. By focusing on fiscal policy – the budget measures – they had failed to spot that the purpose of the budget was to make space for a relaxation of monetary policy. Howe was able to announce a two-point cut in interest rates in the budget and in subsequent months it became clear that the government had moved away from its initial very tough monetarist approach, which Healey had christened ‘punk monetarism’. The pound came down in response, easing some of the pressure on industry. Inflation also began to fall sharply, easing the pressure on living standards. Monetary policy revealed itself to be more powerful than fiscal policy, establishing a pattern for economic policy that was to become the norm.

Sunday, October 11, 2015
China sneezes: Is the rest of the world catching a cold?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

How worried should we be about the world economy and, by extension, Britain’s recovery? Is it time to batten down the hatches or is this just a pause for breath?

Should there be emergency action to boost global growth which, with the monetary levers already turned up to maximum can only mean a massive Keynesian fiscal boost, as advocated a few days ago by Larry Summers, the former US treasury secretary?

Concern over the global economy has been building for some time, most notably in worries over China and even America, where the majority on the Federal Reserve’s decision-making committee is keen to get on with raising interest rates but has so far been thwarted by global developments and disappointing US data.

That concern has been brought into sharper focus, however, by the latest forecast from the International Monetary Fund. The IMF’s forecast for world economic growth this year is just 3.1%; and given how much of the year has gone it is as much an assessment as a forecast.

Growth of 3.1% does not sound that bad. A growth rate in Britain of 3.1% would be very acceptable indeed. But for the world economy it is not good. The normal or “trend” growth rate of the world economy is 4%, or at least it was before the global financial crisis. The IMF’s definition of a world recession is when growth drops to 2% or below. So the current situation sees the world perched, perhaps precariously, halfway between a normal expansion and recession.

Not only that, but after three unspectacular years from 2012, in which the world economy has grown by 3.4%, 3.3% and 3.4% respectively, this year’s 3.1% is the worst since 2009, when there was no growth at all; the weakest in the post-war era. Growth this year is reckoned to be the same as in 2008, when the world was succumbing to the crisis and for the latter part of the year was clearly dragged down by it.

And, for once, it is easy to see where the problem lies. Advanced economies – North America, Western Europe, Japan and a few other parts of the world – are gradually picking up. This year’s 2% growth for advanced economies is nothing to write home about, and weaker than in the years leading up the crisis, where the average was close to 3%. But it is better than we have been used to. In 2012 and 2013, growth was barely above 1%, largely because of the eurozone’s woes.

Britain, incidentally, had its best year for growth last year, according to the IMF, which it puts at 3%, followed by a forecast/assessment of 2.5% this year and 2.2% for 2016. Having beaten the advanced countries’ average for a while, Britain’s growth next year will be exactly in line with it, according to the IMF. It sees advanced countries picking up from this year’s 2% to 2.2%.

Rather than the advanced economies, it is the emerging world where the problem lies. China is slowing and two of the four Brics (Brazil, Russia, India and China) are in recession this year and are expected to stay in recession next year. The IMF has Russia shrinking by 3.8% and 0.6% in 2015 and 2016 respectively, and Brazil by 3% and 1%.

For emerging economies as a whole, growth this year is put at 4%. That is the weakest since 2009, but that does not tell the full story. In 2009, emerging economies carried the world through the crisis. While advanced countries saw their economies dive – gross domestic product plunging by 3.4% (including a 2.8% fall in America and 4.3% in Britain) – emerging economies grew by 3.1%, including a remarkable recession-busting 9.6% expansion in China.

Growth then accelerated in emerging economies, to 7.5% in 2010. That, perhaps unsurprisingly, was the high watermark. Growth in the emerging world has slowed every year since, and this year’s 4% is barely more than half what was achieved four years ago.

Even that, however, does not tell the full story. If we look at the past decade and a half, emerging economy growth has always significantly exceeded growth in the advanced world. Sometimes emerging economy growth has been three times advanced-economy performance, sometimes more.

It was this that led me, and others, to conclude that we had moved into a new era for the world economy. In the 20th century two-thirds of global growth came from advanced economies, one-third, and often less, from the emerging world. In the 21st century, it seemed, those positions had been reversed, with emerging economies the new locomotives, responsible for two-thirds of the world’s growth.

Has that come to an end? Even the more muted growth in emerging economies this year, 4%, is twice the 2% expected for advanced countries. But that is the narrowest gap since 2000. Andy Haldane, the Bank of England’s chief economist, has talked of the emerging market crisis from 2015 onwards as part three of a trilogy that began with the “Anglo-Saxon” financial crisis of 2008-9 and transmuted into the eurozone crisis of 2011-12. Though the Bank’s minutes on Thursday were a little more guarded in their language, when interest rates were left unchanged at 0.5% for the 79th successive month, the emerging market slowdown is clearly a factor weighing on it.

Does it mean that we are going to return to the global economy of the 20th century, in which the West once again calls all the shots?

There is no doubt that emerging economies face challenges. In some ways they are victims of their earlier success, in that some of the international capital that flowed in in anticipation of strong growth forever is now flowing out again. This is similar to what gave us the Asian financial crisis of 1997-8. Investors seeking safer havens in the West have pushed up interest rates – bond yields – in emerging economies and this will affect growth.

In some respects, however, the story is a simple one. As long as China was growing very strongly, it produced a rising tide that lifted a lot of boats. Neither Brazil nor Russia can remotely be said to be well-run economies, and that applies to much of Africa, but as long as China was pushing up oil and commodity prices, growth in these commodity-rich economies was guaranteed.

The China slowdown has exposed underlying weaknesses. When China sneezes, many coountries catch a cold.

Some will fail to adjust but we should not be too gloomy. I am with Capital Economics, which headlines its new report on emerging economies: “One extreme to the other”. “Having been too optimistic on the outlook for the emerging world over much of the past five years, the consensus has now shifted too far in the other direction,” it says.

I’m also with the IMF. It thinks this year will be the low point for the emerging world, with growth picking up to 4.5% next year, building up to 5.3% by 2020, the latter alongside a slowdown in advanced economies. Something like normal recent service will eventually resume.

That, of course, is not guaranteed. And the one thing that looks odd in this context is an early rise in US interest rates. Even if the US economy were racing away, which it is not, there would seem to be a strong case for holding fire because of what is happening outside America. We shall see.

Sunday, October 04, 2015
Those green shoots were always stronger than we were told
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

History has been rewritten. What we were told was happening to the economy two or three years ago was not happening. Growth was stronger than the official figures of the time told us it was. Hundreds of “flat-lining”, “double-dip” and even “triple-dip” headlines were written in vain.

Nor is the process over. The revisions a few days ago to the growth numbers for 2011-13, foreshadowed here last week, are not the end of the history rewriting process. Indeed, we are still very close to the beginning. It will go on for many years.

Long after the figures have ceased to be of interest to anybody other than economic historians, they will carry on changing. There is nothing wrong with that. It is good that the Office for National Statistics (ONS) does not close the books. As new information comes in, or new methodology is adopted, the numbers are revised.

It is important to recognise, however, that these things matter. As I have pointed out before, comparisons between the current recovery and its predecessors are meaningless, because the data on previous recoveries has been through many more revision cycles than recent figures. One day, maybe in a couple of decades, we will know for sure whether this recovery was weaker than its post-war predecessors. We cannot know that with any certainty yet.

It also matters for the decisions that were taken at the time. Rupert Harrison, George Osborne’s former right-hand man, tweeted after the gross domestic product (GDP) revisions were released that they showed that Britain had enjoyed exactly the same growth since the first quarter of 2010, the last quarter before the coalition took over, as America.

He was right. Both Britain and America’s GDP have grown by 11.8% since then, better than the G7 average of 9.1% and the European Union average of 5.8%.

Harrison knows what it was like to be on the inside when the criticisms were raining down on the chancellor and even the International Monetary Fund’s chief economist said he was playing with fire. He had to put up with austerity critics unfavourably comparing Britain’s growth performance with that of America and attributing it all, not to Britain’s proximity to the troubled eurozone but to apparently misguided austerity. Well now we know, and in time we will know more.

Osborne did not bow to the pressure and abandon his deficit reduction strategy, but other chancellors might have done so. Instead, the new figures show that growth was stronger in 2011 at 2%, perhaps the year of maximum austerity, than in 2010, 1.5%.

When history is rewritten, it also reminds us that other decisions might have been different. Andrew Sentance, who was on the Bank of England’s monetary policy committee (MPC) at the time, reminds us that a 6-3 decision to leave interest rates on hold in February 2011 could have gone the other way had the MPC know then what we know now.

Though three MPC members voted to hike rates, others were deterred by the ONS’s initial estimate of a 0.5% fall in GDP in the final quarter of 2010. I know this was the case, from talking to some of those who voted for a hold at the time. It was known that exceptionally bad weather had depressed GDP by 0.5% but the expectation was that the overall number would still be flat. The fall spooked some MPC members and, of course, we are yet to see a rate hike more than four years later.

The new figures show, however, that GDP rose by 0.1% in the final quarter of 2010. There was no fall. Some would say the ONS saved the Bank from an error, in that any hike in early 2011 would have been reversed a year later when the eurozone crisis intensified. Maybe, but it would have re-established the principle that rates can go up as well remain stuck at just above zero.

History is history. What do the figures tell us about what is happening to the economy now? There is some evidence of a slight slowdown in growth in the third quarter but the broad picture is encouraging.

The caricature of Britain’s recovery presented by the new Labour leader and his shadow chancellor at their party conference last week was just that. In the past 18 months more growth has come from net trade (exports minus imports) and investment combined than from consumer spending.

There has been no debt-fuelled splurge. Real household incomes have risen by more since early 2014 than consumer spending. Even the current account deficit, Britain’s Achilles heel, has improved; the deficit in the second quarter, 3.6% of GDP, being just over half the alarming 6.3% of GDP gap recorded in the final quarter of last year.

We may also be moving beyond the productivity crisis. As had been suggested by the GDP and employment figures, output per hour rose by 0.9% in the second quarter, hitting a new record but – more importantly - showing decent growth.

Instead of strong employment, weak wages and stagnant productivity, the new phase looks to be one of slower employment growth, bigger pay rises and a return to something like normal productivity growth. The figures also suggest that inflation will not be at zero for too long. The rise in unit wage costs over the past year, 2.2%, was the strongest for three years. Much more of this and the MPC will start to think a lot more seriously about higher interest rates.

There remain challenges. The current account and budget deficits may be down but they are still too big for comfort. Productivity is 15% below where it would be had it followed its pre-crisis path, even after the latest improvement. Manufacturing is going through a stagnant phase.

The rewriting of history by the official statisticians reminds us, however, that even when things appear grim, they are often better than they seem Some of us knew this. Everybody should know it.

Sunday, September 27, 2015
Bank frets that is has run out of ammunition
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The economic news is generally good, particularly in Britain. Growth has decent momentum, zero inflation is bringing strong gains in real wages, business investment is rising, and consumer and business confidence are high. There are even signs of a productivity revival.

Not only that but this week official figures will show that the recovery was stronger than initially thought, as is often the case. The Office for National Statistics (ONS) will revise growth in 2011 up from 1.6% to 2%, 2012 up from 0.7% to 1.2% and 2013 from 1.7% to 2.2%. The 3% growth number for 2014 will probably stay the same.

These revisions will be a reminder that conclusions drawn about the state of the economy on early ONS data are often misleading. Britain was never “flatlining” during the last parliament. Average growth over 2011-14 was more than 2% a year. Quarterly growth on the new figures was stronger on a number of occasions than in the second quarter of 2010, when the coalition took over and before most deficit-reduction measures were introduced.

I’ll return briefly to those revisions in a moment. The point about the generally good news about Britain’s economy is that it stands in sharp contrast to the fears stalking the world’s stock markets. The Greek crisis gave way to worries about China, which continue. There are now concerns that the Volkswagen scandal could drag down Germany. In a world of worry, it never rains but it pours.

My view is that most of this is overdone. Greece was about as messy as it could have been, given the Syriza government’s hamfisted brinkmanship. But the crisis is now on the backburner. Reaction to China’s necessary slowdown has been overdone.

Willem Buiter, the former Bank of England monetary policy committee member who is now global chief economist at Citigroup, recently generated headlines by warning that China could drag the world into a new recession. Yet Citigroup’s new forecasts for global growth, published a couple of days ago, show a relatively small downgrade compared with what it expected in the spring: growth over the next four years will average 3.2% rather than 3.5% a year. It also expects China to grow by between 6% and 7% a year. Britain, by the way, is predicted to grow by an average of 2.8% a year.

The circle is squared by Citigroup’s belief that Chinese growth is significantly overstated by official figures, so 6% to 7% growth is actually 4%. Adjust for that and global growth next year could be only 2.5%, the firm says, with a 40% chance that it drops to 2%; the usual definition of a world recession (at least until the much bigger one we experienced in 2008-9). We shall see.

As for Germany, while it is tempting to see the VW scandal as the Federal Republic’s Northern Rock moment, or its Libor, or even its version of the financial crisis, that looks like a gross exaggeration. Holger Schmeiding, chief economist at Berenberg Bank, points out that the car industry only accounts for 2.7% of German gross domestic product. “Even a heavy drop in diesel car production and exports would probably not subtract more than 0.2% from German GDP,” he says.

The worries and warnings are not confined to stock market investors. Central bankers, and those who hang on their every word and deed, are also fretting. When the Federal Reserve passed up on the opportunity to raise interest rates 10 days ago, saying “recent global economic and financial developments may restrain economic activity somewhat”, it underlined the difficulty central banks have had in escaping from the so-called zero bound.

More than six years on from the trough of the 2008-9 global recession, no major advanced-economy central bank has raised interest rates and kept them up. Some of the smaller ones, like the Swedish Riksbank were forced to reverse dramatically post-crisis rate hikes. Its main interest rate is negative, -0.35%.

The Fed’s non-hike has pushed out market expectations of the first rate hike in Britain until well into next year, a shift more or less endorsed by Ben Broadbent, the Bank’s deputy governor for monetary policy, who said in an interview with Reuters that the reaction of the markets was “entirely predictable”.

The trouble with interest rates is that there is never a good time to raise them. In the very many years I have been covering these things the number of times when a rate hike has not been met with at least some howls of protest and dire warnings of the damage it would do. The fact that rates have been near-zero for so long means there is now a powerful air of permanence about it.

This, in turn, means that when the downturn does come, central banks will have much less ammunition to fight it than usual. As Andy Haldane, the Bank’s chief economist, pointed out in a recent speech, the average loosening cycle – the amount rates have been cut – has been five percentage points since 1970 and nearly three points even in the period of generally lower rates since the mid-1990s. If you start at 0.5%, achieving anything like that is impossible without moving to what I would regard as unfeasibly negative interest rates.

Similarly, if the Bank goes into the next downturn with £375bn of assets purchased under quantitative easing still sitting on the its books, there is at least some constraint on its ability to do more. "Helicopter" money - the Bank creating money to hand ouit to households - would be a dangerous step on a slippery slope.

There is, as I say, never a good or popular time to raise rates. Had the Bank known for certain that the economy was stronger than it thought, maybe it would have happened some time ago. Had Mark Carney stuck to his summer 2013 forward guidance, and rates had begun to rise when the unemployment rate fell to 7%, we would be now be a few notches above 0.5%. I suspect, however, that the governor was more interested in giving people and businesses reassurance that rates would not go up for some considerable time (in 2013 the Bank did not expect 7% unemployment until 2016) than pinning the decision on a specific number.

There is a lesson here from fiscal policy. Though it would have been easier to postpone tough fiscal decisions until later, and though the latest figures were a touch disappointing, George Osborne’s actions in reducing the budget deficit mean that there is a decent chance that it will have been eliminated by the time of the next downturn. That, in turn, will allow for the possibility of a temporary fiscal stimulus – tax cuts and spending increases – as happened in 2008-9.

Unless the Bank and other central banks give themselves more room to cut interest rates and if necessary embark on a new round of quantitative easing – by reversing some or all of what they did in response to the crisis – fiscal policy will be on its own. Central banks would be spectators, out of ammunition when the battle begins. No wonder they are fretting.

Sunday, September 20, 2015
Even at low rates, infrastructure's not as easy as it looks
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Even without going as far as Churchill – “If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions” – we expect economists to disagree. Consensus is rare, debate and disagreement the norm.

If there is one thing on which you would get something close to consensus, however, it is that the current period of very low interest rates presents an ideal opportunity for governments to borrow and spend on essential infrastructure.

After all, there is no country in the world, not even China after its public investment boom, which could not improve its infrastructure. Britain could certainly improve her roads, railways, schools and hospitals. There is a pressing need for new investment in power generation. The economic effect of building new infrastructure is to generate more employment and economic activity directly, as well as improving the economy’s performance over the long run.

Not many sensible economists would agree with Jeremy Corbyn’s “people’s quantitative easing”, if it ever becomes a policy – and it was good to see Mark Carney put his head above the parapet to attack it – but plenty think there should be more infrastructure spending.

Fiscal multipliers associated with infrastructure spending are higher than for other public spending; in American parlance you get more “bang for your buck”. It looks like a win-win. So why is it not happening?

The first thing to say is that more is happening than has been the norm in recent decades. Taking what was achieved in 2010-15 and what is planned for 2015-20, public sector net investment this decade, averaging £31bn a year in real terms (2014-15 prices), is about a fifth higher than under the Blair-Brown Labour governments from 1997 to 2010, where it averaged just under £26bn a year.

Public sector net investment was much lower in the 1980s and 1990s than now and, while it rose strongly in the late 2000s in the run-up to the London Olympics and in response to the crisis, this was always seen as temporary. Had Labour been re-elected in 2010, it was with a plan to cut public investment even more aggressively from those temporarily high levels than the coalition ended up doing. Not since the period from the mid-1960s to the mid-1970s, when it was swelled by investment by the then nationalised industries (now private sector investment) has it been consistently higher than in the current decade.

Even so, previous governments did not have the benefit of current very low borrowing rates. The yield on 10-year gilts is currently just under 2%, while the 30-year yield is just over 2.5%. Factor in 2% inflation, the official target, and borrowing is very cheap indeed.

So why is there not more of it to fund higher levels of infrastructure spending? The first reason, I think, is that borrowing is borrowing. The budget deficit, while falling, is still large; £88bn or 4.9% of gross domestic product last year. Even if the payback from public investment is larger than for other government spending, the initial effect would be to push the deficit higher.

At times in recent years, when the deficit was barely coming down at all, that was a luxury the Treasury did not think it could not afford. It is still wary. Markets are more concerned with the overall numbers for the deficit and debt than the composition of it.

There is also the political reality of infrastructure versus other government spending. More infrastructure may be good for us, and indeed is essential in the long run. But it is often fraught with political difficulties. Indeed, it is often unpopular. Look at the row over HS2 and the pressure to abandon it, or the third runway at Heathrow, or new nuclear power stations. Anybody who has trundled through miles of coned areas while a “managed motorway system” is being installed is not filled with love for infrastructure.

Though complicated by the issue of nuclear weapons, George Osborne’s announcement of a £500m investment at the Faslane submarine base on the Clyde, guaranteeing jobs, was met with this response from Nicola Sturgeon, the Scottish first minister: “If the chancellor's got £500m to spend then I think he'd be better advised to spend it on health, education, giving young people the best start in life and reversing some of his cruel attacks on the most vulnerable.” Politically, £12bn of welfare cuts and tiny public sector pay rises alongside a huge increase in infrastructure spending would be a tough sell.

Treasury officials are meant to worry about debt and they will never be as relaxed about the prospect of adding to it as economists who do not have to carry the can if things go wrong. Long-term interest rates are very low now, and Britain is fortunate in that the average maturity of government debt is longer than in most other countries. But even under existing plans, more than £500bn of gilts will have to be rolled over in the next five years; new ones issued to replace those maturing. It may be that this can be done on terms as favourable as now but nobody can be sure of that.

Perhaps the strongest argument against turning on the infrastructure taps is that, while we may have got a bit better at these things, the history of massive cost overruns and public sector project disasters is a sobering one. Just because infrastructure spending is cheap to finance does not mean it will be value for money. White elephants and unplanned budget-busting outlays are part of the territory.

A new study by professors Bent Flyvbjerg of Oxford and Cass Sunstein of Harvard, looking at more than 2,000 big projects around the world, found that four-fifths of them “get tripped up by a malevolent hand that hides the true costs of and benefits, resulting in massive economic losses to taxpayers and businesses”.

None of this means things could not be improved. I still like the proposal of the LSE Growth Commission two years ago for an infrastructure strategy board, planning commission and bank to take the politics out of infrastructure and ensure it can be funded in partnership with the private sector. A big disappointment in recent years has been the failure to get more pension fund and insurance company money into infrastructure.

There is also scope to do a lot more on housing. The government is in something of a battle with housing associations at the moment. But they, rather than councils, will deliver the social housing Britain needs. If that means guaranteeing more borrowing by them, the public finance rules should not get in the way of that.

Even housing runs up against Nimbyism, planning delays and lack of skills, of course. There are, or should be, imaginative ways of tacking all these things. But we should not pretend it is easy. We discovered during the crisis that “shovel-ready” infrastructure projects are not a tap waiting to be turned on. Like many apparently easy things, it is a lot more complicated than it seems.

Saturday, September 12, 2015
The Great Escape: How Scotland dodged a bullet
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A year ago this Friday the Scottish people voted on whether to remain part of the UK. It was a big moment, more important because of its irreversibility than this year’s general election. Maybe more important than the coming referendum on European Union membership.

The Scots, of course, voted no, by 55.3% to 44.7%, to my considerable relief and I hope theirs. In doing so, they gave us a Scottish version of The Great Escape. They dodged a bullet. Had Scotland voted for independence, its economy would be in deep trouble. Nicola Sturgeon, its first minister, would not be attacking George Osborne’s austerity but announcing more of it in an effort to prop up Scotland’s chronically weak public finances.

But, and this is not purely a backward-looking exercise, these issues have not gone away. After rejecting independence in September last year, Scottish voters flocked to the Scottish National Party in the May general election, its 50% vote share being enough to give it an astonishing 56 out of 59 Scottish Westminster seats.

Buoyed up by this, some in the SNP have been talking up the prospect of a second referendum, with its former leader Alex Salmond saying it is “inevitable”. A vote to leave the EU would be seen by the SNP as one reason to hold a second referendum but there could be others.

Even if another referendum is avoided, Scotland is getting more fiscal powers under the enhanced devolution promised in the run-up to the referendum. Though the SNP has gone a bit quiet on full fiscal autonomy, the economic stepping stone to independence, it remains a possibility.

Why was it such a lucky escape for Scotland? The main reason, and the biggest change since the independence vote, has been for North Sea oil. The Scots were promised a future of high oil prices and rising production. The reality has been plunging prices and a crisis in the North Sea. The Scots were told that Westminster was keeping secret from them the true picture of future North Sea riches. If anything was being kept secret, it was how bad it would be.

A few numbers illustrate the point. In June the Office for Budget Responsibility (OBR) issued its latest long-term “fiscal sustainability” projections. As far as North Sea tax revenues are concerned, their conclusion was that it would be wise to plan for nothing from 2020 onwards. Total North Sea revenues will be just £2.1bn in the 20 years from 2020, it said, equivalent to a single year’s revenue in a bad year now.

Ahead of the referendum, the OBR’s projections were frequently criticised by nationalists as too pessimistic. In fact, by comparison with its current revenue forecasts, the OBR was looking at the North Sea through rose-tinted spectacles. In 2014 it though revenues in the 20 years from 2020 would be more than £36bn. In 2011 it thought they would be more than £130bn.

Forecasts, like oil prices, go up and down. What about if we saw a big recovery in oil prices closer to home? The OBR had an answer to that. As it put it: “Even an assumption of higher production and oil prices reaching around $210 a barrel leaves revenues as a share of GDP (gross domestic product) at a fraction of the levels seen in the past 10 years.”

As for keeping the good news back, the Scottish government’s own revenue projections from North Sea oil and gas have come down dramatically. In May 2014, a few months before the referendum it said that revenues for the next five years would range between £15.8bn and £38.7bn. In June, updating those projections, it said they would be between £2.4bn and £10.8bn. Taking the mid-point of those ranges, and the mid-point of the latest range looks generous given the oil price, the post-referendum projection is less than a quarter of what it was.

Nor is there any sign of things getting better. Oil & Gas UK, in a report a few days ago, said that 65,000 jobs have been lost in the North Sea since 2014. Exploration is at its lowest since the 1970s and investment is plunging. Even last year, when the plunge in prices was not complete, “more was spent on UK offshore oil and gas operations than was earned on production”.

The response of the Scottish government to this has followed a well-worn path. The North Sea was only ever a “bonus” for Scotland, not the lifeline. The trouble is, at least as far as the public finances are concerned, it is not true. The latest official figures, Government Revenue and Expenditure Scotland (GERS) show that without North Sea revenue, Scotland had a Greek-style budget deficit of 12.2% of GDP in 2013-14. With that revenue, the deficit came down to 8.1% of GDP, still higher than the overall UK deficit of 5.6% of GDP.

Since then, according to the Institute for Fiscal Studies, Scotland’s public finances have gone backwards. After the March budget, the IFS’s David Phillips used OBR figures to calculate a budget deficit for Scotland of 8.6% of GDP this year, 2015-16, the same as in 2014-15. This year’s forecast is more than double that of the UK as a whole (4% of GDP). According to Phillips, events since March will have tended to widen Scotland’s deficit, both in absolute terms and relative to the UK as a whole.

Oil and the deficit were not the only factors a year ago. The SNP went into the referendum on a wing and a prayer, hoping against all the denials that Westminster would allow it to be part of a sterling currency union and threatening to renege on its share of UK debt. An independent Scotland, I wrote then, would be “poorer, unstable and fiscal weak” and, if it carried out its debt threat, a pariah in international markets. There would have been an exodus of big employers.

As I say, these things have not gone away. Angus Armstrong of the National Institute of Economic and Social Research points out that greater fiscal autonomy for Scotland poses huge challenges. The Smith Commission’s proposals for greater devolution will give Scotland control over 60% of spending and 40% of revenues, which he says will make it “one of the most powerful sub-central governments in the OECD”.

Such is the weakness of Scotland’s public finances that it is a very long way from the balanced budget Armstrong says it would be required to follow. Allowing Scotland to borrow on the markets to give it more flexibility would, because of its fiscal weakness “and clear intention to borrow and spend more” attract the attention of the ratings agencies and possibly affect the UK’s credit rating as Scotland’s ultimate backstop.

Scotland may have dodged the bullet on independence. The challenges of its weak fiscal position remain.

Sunday, September 06, 2015
An incoherent lurch to the left
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Next Saturday, if the polls and most of the pundits are right, Jeremy Corbyn will be elected leader of the Labour party. There has to be an “if” there because we have had recent experience of the polls and the pundits not being right. It could yet be that this will be another outcome that is different from the one we have been led to expect.

If that is the case, then this will be my last opportunity to write about “Corbynomics” before it retreats back into obscurity. Even if he is elected leader (though with about as much chance of becoming prime minister as I have), somebody would have to get on with the job of turning vague ideas into workable policy.

But for now, let me work with what we have got and start by praising a round-robin letter from 55 economists published in the Financial Times on Thursday. Such letters have had a bad name since 364 mainly academic economists, including former government chief economic advisers and a future Bank of England governor (Lord King), had one published in 1981 warning that the Thatcher government’s policies would deepen the recession. The letter, of course, coincided with the start of the long 1980s’ upturn.

Lately, such letters have been an outlet, and not a very effective one, for academic economists opposing austerity.

This one, however, was spot on. Corbyn’s economic policies, if ever implemented, would be “highly damaging”, had not been “seriously thought through” and included elements that were “almost unbelievable” it said. The 55 economists, from across the political and economic spectrum, and including some opponents of austerity, were stung into action by suggestions from Corbyn supporters that his ideas represented the economic mainstream.

Those ideas include energy and rail nationalisation, “a national investment bank”, not just to invest in infrastructure but in “the hi tech and innovative industries of the future”. “People’s QE” – quantitative easing forced on the Bank rather the decided on by it – to buy the bonds issued by this new bank.

National Insurance (NI) contributions for anybody earning more than £50,000 – thus including many public employees, including senior teachers and doctors – would go up by 7 percentage points and corporation tax by 2.5 points to pay for the abolition of university tuition fees. £93bn of “corporate welfare” and £120bn of uncollected taxes would apparently provide a pot of gold to pay for replacing public spending restraint with the return of state largesse.

A lot of this is easy to dismiss. The idea that governments, desperate for revenue, have turned a blind eye to £120bn of uncollected taxes annually is laughable.

Renationalising the energy sector would be a hugely expensive folly, costed at £185bn by Jefferies, the City firm. Money spent on that would be wastefully diverted from more productive use. Taking control without full renationalisation would fall foul of the rules. Renationalisation without compensation would be the kind of thing Third World dictators do and destroy Britain’s reputation as a place to do business. Renationalising the railways by the backdoor – not renewing existing franchises but keeping them in the public sector – would take very many years.

Much more than this, renationalisation would harm consumers. Many of Corbyn’s supporters are too young to remember how bad most of the nationalised industries were, and how much better service has been since privatization. The privatized utilities have not been perfect but they have been infinitely better than what went before. This is not the Attlee era, when bombed out sectors needed to be nationalised to ensure their survival.

As for “people’s QE”, forcing the Bank to buy the bonds issued by a new national investment bank, which I touched on a couple of weeks ago, not only would this put an end to the most successful economic policy innovation of the past two decades – central bank independence – but it is entirely unnecessary.

If a future government wants to increase infrastructure spending it can do so. If it did so through a new investment bank, that would also increase spending and debt. But if the new bank was soundly-based, and its bonds guaranteed by the government, financial institutions would queue up to buy them. If, in a subsequent downturn, the monetary policy committee did more QE, it could buy some of these bonds if it chose to do so.

Forcing the Bank to be the exclusive buyer of such bonds in all circumstances, suggests that they would be too dodgy for investors and leave the Bank saddled in way that would risk insolvency (requiring the government to step in and prop it up). Leaving the QE tap permanently turned on would mean higher inflation and interest rates. This is a policy whose time should never come.

There is more. In a mixed economy such as Britain’s what should governments do? Certainly they should provide incentives to encourage business to invest, spend on research and development and export. It should at least ensure that these incentives do not put British business at a disadvantage relative to those in competitor countries. Capital allowances are particularly important for Britain’s manufacturers.

For Corbyn, however, these are part of the £93bn “huge tax reliefs and subsidies” which would be much better used in “direct public investment”. Some of this “corporate welfare” offers no scope for saving at all, such as ensuring all government work is done internally. Most of it would result in a net cost to the Exchequer from the corporate exodus that followed. Business employs the people and generates the revenues to pay for the public largesse the Labour leadership candidate craves.

Scrapping tax reliefs is one way of putting up taxes. Increasing corporation tax and putting up individual taxes, not only with higher NI but by making the tax system “more progressive” would be another. All those French people who came over to Britain to escape the high taxation of Francois Hollande would soon be on the way back again.

Those who ignore the lessons of history are condemned to repeat them. The sad thing about all this is that we have been there before and it failed. Killing off the private sector with high taxation and renationalisation, blind faith in the wisdom of the public sector to make the right decisions on everything else, political control of the central bank and a cavalier attitude to the public finances brought us to our knees before, most notably in the 1970s. We will not go there again, but the fact that so many people appear to think it would be a good idea to do so is rather depressing.

Sunday, August 30, 2015
The world struggles when the trade winds don't blow
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It has been a nasty scare, and it is not yet over. Though I think they are overstated, the doubts about China will persist. Though the sell-off appears to have reduced the ardour among central banks in America and Britain to raise rates – as was suggested in these pages last weekend – that bridge will still have to be crossed at some stage, and Mark Carney said at Jackson Hole yesterday that the rate decision will come into sharper focus around the turn of the year, an unchanged message.

Inevitably, there were fears that we were going back into a huge financial crisis. Larry Summers, the former US treasury secretary, helpfully tweeted that there were echoes of August 1997 (the start of the Asian financial crisis), August 2007 (the start of the global financial crisis) and August 2008 (just before the Lehman collapse).

If that was the equivalent of shouting fire in a crowded theatre, I thought a more sensible parallel was with August 2011. That was the month when the eurozone crisis escalated, America was downgraded following fraught debt ceiling negotiations in Washington and, by the by, riots broke out across England.

That sell-off did not presage a new global crisis and recession – most do not – but it ushered in a period of uncertainty and weaker growth, including a second recession in the space of four years in the eurozone, albeit one that was milder than the first.

It has been a while since markets have been quite so panicked as in recent days. Underpinning the uncertainty among investors, over and above Chinese growth worries, Greek exit fears and rate hike concerns, is the fear that something is not right about the global economy. The world was knocked off balance by the financial crisis and it is yet to recover its stability.

Are such worries justified? On the face of it, global growth is not too bad. The International Monetary Fund, in its latest world economic outlook update, published last month, sees 3.3% global growth this year, 3.8% next.

This year’s forecast is slightly below the 3.4% achieved in both 2013 and 2014, and all four years will see growth weaker than the pre-crisis world norm of 4% a year. But this is a long way from a growth crisis. The IMF, for what it is worth, shares my view of China, which is that we are seeing an adjustment, though a tricky one, to slower but ultimately better balanced growth.

There is something missing from the global economy, however. The Paris-based Organisation for Economic Co-operation and Development (OECD) calls it a “B-minus” world economy. I would call it a world lacking one of its key drivers.

That driver is world trade. A few days ago CPB Netherlands, the Dutch think tank which is a centre of expertise for monitoring world trade, reported that despite a rise in June world trade in goods in the second quarter was down by 0.5%, following a drop of 1.5% in the first quarter. According to CPB: “Import momentum was negative or zero in all major regions. Export momentum was positive in advanced economies, but negative in emerging economies.” Unless the June figures signal a sustained upturn, which looks unlikely given everything, this looks like a weak year for world trade.

CPB monitors trade in goods. Services are also important. But taking goods and services together, we are seeing a prolonged period of weak growth in trade. Alongside the IMF’s estimate of 3.4% economic growth in 2013 and 2014, world trade in goods and services expanded by 3.3% and 3.2% respectively.

For most of the post-war period world trade grew significant faster – often twice as fast – as global gross domestic product. If we take the period 1990-2007, world trade grew by an average of nearly 7% a year, despite a recession at the start of the period and a slowdown at the turn of the millennium.

In contrast, even leaving aside the collapse and rebound in world trade in 2009-10, trade growth in recent years has averaged only 4% a year and – as noted – has often struggled to achieve that.

That is reflected in Britain’s trade figures. Though exports had a good second quarter, helping to boost gross domestic product, until then export volumes had only grown by 1% a year over three years. Import volumes did a little better, though not spectacularly so.

Why the weakness in world trade? In the case of Britain, weak growth in the eurozone has been an important factor. Indeed, Europe’s slow growth has removed an important source of world trade growth.

But there are other factors. Exporters blame the failure of trade credit to get back to pre-crisis levels, even when governments are on hand to help out; some more than others. Risk aversion on the part of businesses may also have undergone a long-term shift as a result of the crisis.

Protectionism has not obviously increased but it may have done so discreetly. Certainly, the momentum for trade liberalisation, which was a key driver of global growth in the second half of the 20th century, has faded badly.

The Doha round, under the auspices of the World Trade Organisation, was launched as long ago as 2001 and shows no sign of reaching the finishing line. Initiatives like the Trans Pacific Partnership (TPP) and TTIP (Transatlantic Trade and Investment Partnership) have run up against a coalition of protectionists, vested interests and left-wing protest groups. Politicians seem to have decided they have enough on their plate without fighting the good fight on free trade.

The result is that the world economy is not firing on all cylinders. It is missing the trade winds that have blown us to prosperity in the past. What that means is that countries are having to generate growth under their own steam.

That is true in Britain, where net trade has made virtually no contribution to the recovery in recent years, though the latest figures were rather more encouraging. It is true in China, notwithstanding this month’s small devaluation of the renminbi.

When world trade is weak, adjustments to domestically-generated growth like those the Chinese authorities are trying to achieve become more abrupt, and more challenging. Recoveries like those in Britain are almost bound to be unbalanced. We would all benefit from stronger world trade. Sadly, it does not appear to be on the horizon.

Sunday, August 23, 2015
QE or not QE? A slippery slope to breaking the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is more than six years since the Bank of England launched quantitative easing (QE) and more than three years since it last actively did any. But QE opened up a Pandora’s box, and it may be only now that we are seeing the consequences of that.

The Labour leadership candidate Jeremy Corbyn has talked of a “QE for the people”, in which the Bank would print money to pay for infrastructure and other projects. Some economists have picked up on an idea, “helicopter money”, originally attributed to Milton Friedman but floated again by Lord (Adair) Turner a couple of years ago, in which in the event of a downturn – or even in the absence of a downturn – the Bank would print money in an open-ended way to finance the budget defciit, and perhaps to hand out to households.

It was perhaps inevitable that a policy which appears to magically conjure up money out of thin air, which can then be used to boost the economy, risked being the first step on a slippery slope. The Bank, in my view, could and should have done more to prevent that from happening.

Let me elaborate, starting with a brief account of what the QE undertaken by the Bank QE is and what it was meant to achieve.

QE was launched in March 2009, the moment the MPC reduced official interest rates to an all-time low of 0.5%. That was when it launched its asset purchase programme (its name for QE); buying assets, overwhelmingly British government bonds – gilts – using newly created “money”. “Money” in this case means, not cash, but central bank reserves. The new “money” is not costless. Interest has to be paid, at Bank rate, on the reserves created.

Over a 10-month period in 2009-10, the Bank created £200bn of such reserves and used it to purchase £200bn of assets. This was not, as is often wrongly thought, part of the bank bailout programme. The assets were largely bought from pension funds and insurance companies, as well as foreign investors in gilts.

QE in 2009 was hard not to support. I certainly did. This was an emergency “all hands to the pumps” period, when the economy needed rescuing. The institutions which sold assets to the Bank used the proceeds to buy corporate bonds, equities (shares) and other assets. This ensured that businesses, particularly larger ones, could access capital markets to keep going, and fund growth.

The key effect of QE was to reduce long-term interest rates. Cutting Bank rate to 0.5% had reduced short-term rates. Asset purchases reduced long rates – significant for investment – and also lowered the spread between government bond yields and those on other long-term investments. Not only did QE make it possible for larger businesses to raise money, bypassing the banks, but it made it cheaper for them to do so.

There were other routes QE boosted the economy, boosting confidence, signalling to the market the Bank was prepared to do whatever was necessary and improving liquidity. It may have helped keep sterling down. The effects of that first £200bn were significant. The Bank estimated it boosted GDP by between 1.5% and 2% and, when there were worries about “bad” deflation – falling prices due to weak growth – it pushed up inflation by 0.75 to 1.5 percentage points.

There were two important things about 2009’s QE. It was fully reversible. The gilts the Bank bought meant that it has assets alongside the reserves it created. When the gilts are sold back into the markets, or allowed to run off as they mature, the “money” created – will also be wound down.

The other is that it was undertaken very much in emergency circumstances, which was why I was less enthusiastic about the second wave of an additional £175bn of QE, which began in the autumn of 2011 and lasted well into 2012. You could argue that with the euro apparently on the brink of falling apart, hitting confidence and growth in Britain, this was also an emergency. But it was less pressing than in 2009.

So what about Corbyn’s “People’s QE” and helicopter drops? I am not sure how serious the Labour leadership candidate is about the policy. It may be a way of diverting discussion from some of his other policies, which I will look into in more detail in coming weeks. Certainly, he does not seem to know a lot about it.

Responding to questions on Radio 4’s World at One a few days ago, he described QE as a £325bn (sic) “loan” to banks, and suggested part of that loan instead should go towards the setting up of a new National Investment Bank, promising to establish a commission to investigate.

In his speech The Economy in 2020 he talked about People’s QE as “one option, under which the Bank would “be given a new mandate to upgrade our economy to invest in new large scale housing, energy, transport and digital projects”. The other option was to slash what he described as £93bn of “huge tax reliefs and subsidies” and fund infrastructure spending that way.

There is nothing new about what some of Corbyn’s supporters think of as a slightly different kind of “People’s QE”. A few years ago I used to get lots of e-mails from advocates of “Green QE” who said the Bank should invest in green projects rather than in the banks. I pointed out to them that QE was not about the banks and that to work, these green projects would need to be funded by the issue of government-backed bonds, which the Bank could buy if it chose to. Issuing these government-backed bonds to fund spending would, of course, add to government debt.

The twist in the People’s QE debate, from Corbyn’s supporters if not yet from him, is that the Bank would be compelled to buy bonds issued by a National Investment/Infrastructure Bank, and not just in emergencies. Compelling the Bank to undertake this kind of QE would kill Bank independence, one of Labour’s proudest achievements. Unless there was a commitment to sell these bonds back, the policy would be irreversible. It would be a strange and roundabout way of doing things, destroying the Bank’s reputation on the way.

Helicopter money would have a similar effect. Handing out cheques to households would clearly be irreversible. The Bank would not take any assets in return. It would have huge liabilities on its balance sheet, but no offsetting assets, requiring the Treasury to keep it keep it solvent. As David Miles, the outgoing MPC member, put it to me last week: “When people say helicopter drop, what they mean is, why doesn’t the government run a larger fiscal deficit?”

An article by Fergus Cumming, a Bank official, on the Bank’s new “blog” site says any extra boost from helicopter money “is either non-existent or comes with a sky-high price tag”. If Lord Turner was suggesting it in his interview to be Bank governor ahead of Mark Carney’s appointment, I can understand why he did not get the job.

That said, you can see why these ideas are around. When the Bank launched QE in 2009, it did not expect to be stimulating a debate six years later. In my view it could have done more to head it off. While the MPC’s reluctance to raise interest rates has been clear, there was no strong reason why it could not have begun to move away from “emergency” policy by selling off in the past couple of years some of the gilts it acquired in 2009-10 and 2011-12.

Had it done so even passively, not reinvesting the proceeds when the gilts it has on its books mature, then including its latest decision it could have run down the stock of gilts it has by around £52bn. But it has decided not do so before raising interest rates.

As for rates, the longer they are kept at 0.5%, the more the clamour will grow for experiments such as People’s QE and helicopter money in the event of the next downturn. The common feature of these is the belief that you can have money for nothing. Sadly, it is not true.

Sunday, August 16, 2015
Productivity lift-off will keep pushing up pay
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

I did wonder if this was the week when, in the light of Corbynmania, and what appears to be the Labour party’s longest suicide vote in history, I should tackle Corbynomics. But, though a victory for Jeremy Corbyn in the Labour leadership contest is confidently predicted, I note that some of those making the predictions also assured us that Ed Miliband would now be prime minister. So I’ll hold off for now.

Fortunately, there’s plenty of other things going on. Greece is not yet out of the woods and China, as I discuss below, has grabbed the markets’ attention. We have also had some interesting job market numbers which, on the face of it, suggest the election came not a moment too soon for the Tories. Before it, employment growth in jobs was powering ahead and unemployment falling.

Since it, the figures show employment falling and, as every new bulletin told us, unemployment rising for two months in a row, something that has been as rare as hen’s teeth in recent years.

Worse, for a government committed to reducing immigration, most of the reporting of the figures suggested that the lion’s share of the new jobs is going to foreigners, particularly foreigners from the rest of the European Union.

A bit of clarification is in order. The labour market numbers can be confusing and as a result are prone to misreporting. The Office for National Statistics (ONS) takes three-month periods as its basis for the employment and unemployment numbers. The latest three-month period is April-June. The three-month period reported in July was March-May. The unemployment number for April-June, 1.852m was slightly lower than the 1.853m for March-May, not higher. Employment, 31.035m, was just over 50,000 up on the 30.982m figure reported for March-May; higher not lower.

So where did the rising unemployment-falling employment story come from? This is because the ONS compares the latest three months with the previous three months, in this case January-March. On that basis, employment was down 63,000 and unemployment up 25,000, but that is different from saying the jobless total rose for a second successive month. Indeed, unemployment on the old claimant count measure – people on jobseeker’s allowance – has fallen every month this year.

As for those jobs going to migrants, having decided to publish the numbers a few years ago, the ONS has been fighting a losing battle since to persuade people not to confuse new jobs with net jobs. It is quite possible, indeed highly likely, that most new jobs are going to natives, because they – UK nationals – account for almost 90% of people in work (for UK-born the figure is 84%).
But it is also true that when it comes to net jobs – jobs added minus jobs lost – most of the gains over the past year have gone to non-UK nationals (61%), or non-UK born (75%), overwhelmingly from the rest of the EU. The distinction is important but does not defuse the tricky politics in this debate.

Having said all that, what is the bigger picture? It is that the job market recovery is maturing, so that in the past year there was an increase of 422,000 in the number of full-time employees, easily outweighing the 63,000 rise in the number of part-timers. Self-employment, which has risen strongly in recent years, has fallen by 95,000 over the latest 12 months. That tells us that there is a shift within the job market back towards conventional full-time employee jobs and away from part-time work and self-employment.

That is important, but arguably more important is that, alongside a recovery in pay, we may finally have arrived at productivity lift-off. It has to be a tentative claim at this stage but the prolonged weakness of productivity, which has puzzled economists for years, may have come to an end.

So in the second quarter, overall employment fell by 0.2% while gross domestic product rose by 0.7%, suggesting a healthy rise of around 0.9% in GDP per worker. Compared with a year earlier, GDP was up by 2.6%, employment by 1.2%.

A similar picture emerges when we look at GDP per hour, another way of measuring productivity. Hours worked fell by 0.2% in the second quarter, when GDP rose 0.7%. Hours worked in the past year were up by 1%.

One swallow does not make a summer but if productivity is indeed reviving, why is it happening? In an important sense, it is happening because it had to. There was a limit to how much unemployment could continue to fall and employment rise without running into serious bottlenecks – in spite of the EU migration safety valve – and skill shortages. The BBC had a nice example last week of a firm which had invested in a machine and doubled a worker’s output. Most productivity-enhancing investment is not so straightforward, but it is happening.

What will rising productivity mean? Two things. The first is that the turbocharged rise in employment we have seen over the past three years will be replaced by a gentler upward trend and that, peering through the latest numbers, may be what we are already starting to see. Unemployment can fall further, though also at a slower pace than we have been used to. Do not forget that when Mark Carney took over as Bank of England governor in the summer of 2013, the Bank did not expect the unemployment rate to fall to 7% until 2016. It is now 5.6%.

The second implication is that the growth in wages will become both more entrenched and, for employers, justifiable. Indeed, many will be looking at ways of pushing through productivity improvements ahead of the introduction of George Osborne’s new national living wage of £7.20 an hour next April.
As it is, the latest figures show total pay rising at an annual rate of 2.4% (2.8% in the private sector) and regular pay by 2.8% (3.3% private sector). Most of Britain is enjoying a meaningful pay rise. Rising productivity should mean that continues.

Sunday, August 02, 2015
Another milestone on the road to normality
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

An economic recovery is all about barriers and milestones. It is a story of getting over the barriers and counting off the milestones as you pass them. Britain has just passed an important milestone. It is one which suggests that at the very least talk of a lost decade for the economy, which was once very common, was misplaced.

It is two years since gross domestic product (GDP), adjusted for inflation, surpassed the pre-crisis level achieved in early 2008 but is only now - or more accurately in the April-June quarter - that GDP per head has regained its earlier peak.

These milestones do move around. As GDP figures get revised, it is quite likely that both will be seen to have occurred earlier than the current numbers suggest. We should not expect miracles, however. The economy was left weak and groggy by the crisis and was always going to take time to get back on its feet.

The barriers to recovery in recent years – from outside Britain – have been several. High global oil and commodity prices gave us high inflation in 2011, intensifying the squeeze on real incomes, a factor that did not dissipate until about 18 months ago.

The eurozone crisis, at its height three years ago, affected Britain’s economy directly through trade, and indirectly by spilling over into renewed concerns about the banking system. What may or not be its last gasp, the Greek crisis of recent months, is no longer critical, but one of its side-effects has been to push sterling up to €1.40-plus heights against the euro, which is hurting exporters.

Now China has emerged as a potential barrier to recovery, though my sense is that any negative effect from China’s stock market woes will be balanced by its effect on oil and commodity prices. Sometimes, as with last year’s sharp fall in oil prices, which has not been significantly reversed, external forces can be more of a springboard than a barrier.

Now that the GDP per head milestone has been passed, what other milestones are there? One is the length of recovery. If we define a recovery as a period of growth unbroken by two successive quarterly GDP falls, this one has now lasted almost six years. It is still in the foothills compared with the 16-year growth marathon between the autumn of 1991 and early 2008 but is catching up on the Thatcher 1981-90 nine-year recovery.

The biggest milestone of all would be if growth in coming years were strong enough to eliminate the “lost” years, in other words to make up for the ground lost as a result of the recession of 2008-9 when GDP fell by 6%.

The five years it took for GDP to get back to pre-crisis levels (seven years on a per capital basis), meant those years of potential growth – when the economy might have been expected to expand by 2.5% a year – were lost. Though growth is now above its long-run average, it is not enough above it to make up that lost ground other than at a snail’s pace. Those years of potential growth, and the rise in living standards associated with them, were largely lost for ever.

That’s enough milestones. Two questions arise. One is whether there is anything to suggest growth will become better balanced than it has been. The other is whether strong growth – the second quarter rise of 0.7% made it six out of the past eight when the economy has grown by that much or better – will be enough to persuade the Bank of England to hike interest rates.

That the recovery could do with being better balanced is not in doubt. The service sector bounced back quickly, getting back to pre-crisis levels of output as long ago as 2011. But manufacturing has yet to do so; it is 4.9% below its early-2008 levels, while construction is still 3.2% down.

Though both sectors disappointed in the latest quarter, perhaps a more nuanced picture is provided by the performance of the three sectors from their recession low points. Construction and manufacturing fell further, so had more to make up. From their respective recession low points, the service sector is up by 11.9% and manufacturing by 8.8%. Construction is actually the strongest of the three, up by 16.8% from its recession trough. But manufacturing could and should be doing a lot better.

What about interest rates? Every quarter of 0.7% growth is a quarter in which a little more spare capacity is used up. We will hear a lot more about this on “super Thursday” this week when the Bank publishes its quarterly inflation report, interest rate decision and monetary policy committee (MPC) minutes simultaneously. In the past these three events were been spread over three weeks.

Will the Bank, while acknowledging the strength of recovery, tone down its language on rate hikes because of the renewed weakness of oil and commodity prices? Brent crude oil is back in the low $50s, while broader commodity price measures dropped to a 13-year low last week.

We will see what happens. But I would be surprised if some MPC members do not vote for a rate hike this week and if the Bank’s broader message is not that people and businesses should be prepared for the start of a gradual rise in rates in the coming months.

When oil and commodity prices were high, the Bank “looked through” the temporary boost they provided to inflation, deciding instead that the economy was not ready for a hike in rates. Now prices are low, they are likely to take the opposite view; that they cannot postpone indefinitely the process of “normalising” interest rates. The new normal will, of course, be lower than the old normal.

Starting to raise interest rates will, when it comes, be a milestone in itself after more than six years in which there has been no change. It will be a milestone of the road back to normality.

Sunday, July 26, 2015
Cuts: the big bad wolf's howl is worse than his bite
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Sometimes I think that when George Osborne looks in the mirror each morning, he thinks: “Now how can I put the wind up the Labour party today?” Then, while holding that thought, he goes on to: “And how can I put the fear of God into people working in the public sector?”

A few days ago, the Treasury produced a 24-page document called ‘A country that lives within its means: Spending Review 2015’. Signed by the chancellor and his Treasury chief secretary, Greg Hands, this was not the spending review itself; that will not be published until November 25.

No, it was the Treasury’s opening gambit in the coming negotiations between it and the spending departments. Unlike in 2010, when the coalition’s first and most important spending review was a bit of the back of the envelope affair, the chancellor does not want to be accused this time of not following proper procedure.

Actually procedure has become a lot more formal during the time I have been following these things. There was a time when to extract from the Treasury, or more likely from disgruntled Whitehall departments, what the mandarins were demanding was gold dust. Now it is set out in black and white in an official document.

Osborne and Hands have asked “unprotected” departments to model two scenarios, of 25% and 40%, for real-terms reductions in their so-called resource budgets. Even in an official document, that is big news. The BBC led on it all day.

Does it mean, as some have suggested, that the Treasury is setting a target for cuts that can never be achieved? Does it mean an ideologically driven plan to shrink the state beyond recognition, so people have no choice but to use the private sector?

I suspect it means neither of those things. There is an interesting question to be asked about what kind of spending review we might have had, if the budget deficit had come down as much as expected in the last parliament. It is falling, but at £88bn in 2014-15 was some £50bn more than Osborne intended in 2010.

Even if the deficit had come down by more, however, there would have been a case for a proper look at public spending, the Canadian-style review the Tories used to talk of fondly before the 2010 election. Time and manifesto commitments have, however, taken their toll.

The government is committed to raising NHS spending in England by £10bn in real terms by 2020-21, to protecting per-pupil funding for schools, and to increasing the Ministry of Defence budget by 0.5% a year in real terms. The overseas aid commitment of spending 0.7% of national income will be met.

Being inside the ringfence, as this spending is, does not preclude efficiency savings, indeed the NHS will be required to deliver significant ones. But it is the non-ringfenced departments – all the rest – which will be bearing the brunt. Will they be cutting by 25% or even 40%? No, the resource budget only encompasses some Whitehall spending, excluding for example capital spending, which is significant for some departments. The Institute for Fiscal Studies estimates that the actual real-terms cut for non-ringfenced departments will be 12.6%. Whitehall should not be as afraid of the big bad wolf as the headlines might have suggested.

This is even more the case if we look at the overall numbers for public spending. According to the Office for Budget Responsibility, it has come down from 45.7% of gross domestic product in 2009-10 to an estimated 39.6% this year. The task for the next five years is to get it down to 36.3%.

How much will overall government spending be cut over the next few years? Not at all. In real terms – 2013-14 prices – it will rise from £724bn this year to £746.5bn in 2020-21, an increase over and above inflation of 3%. Public sector current expenditure rises by more than 2.5% over the same period. We can argue over the composition of spending, and whether the ringfence is in the right place. Some bits of government will see their budgets reduced but in most cases this is a long way from savage cuts. I can understand why Osborne wants to play the big bad wolf but his howl is a lot worse than his bite.

There is another fiscal issue to be touched on here. After the budget I bemoaned the absence of serious tax reform, in particular the failure to mention merging income tax and National Insurance. Since then, though I would not claim cause and effect, it has emerged that the chancellor has commissioned a Treasury study into the integration of income tax and NI into a single “earnings tax”.

The name earnings tax, if it happens, is important. Merging tax and NI and applying it to all incomes would create a large swathe of losers among pensioners, who do not pay NI.

Michael Johnson of the Centre for Policy Studies, who wrote a report last year on NI, called The End Should be Nigh, argued for a single earnings tax with three rates, 32%, 42% and 47%. The lowest rate would kick in at the existing personal allowance, £10,600, which is well above the NI lower earnings limit (£5,824) and the more relevant primary threshold (£8,060). The change would thus help lower earners.

One reason why chancellors have been reluctant to merge income tax and NI is because the latter preserves a semblance of the Beveridge contributory principle, though the Mirrlees review commissioned by the Institute for Fiscal Studies declared in 2010 that NI “is not a true social insurance scheme; it is just another tax on earnings”. Another is that NI is a good stealth tax. Under the last Labour government the basic rate of income tax – which people are more aware of - went down but NI went up.

There is the bigger question of what to do about employers’ contributions, which are responsible for a substantial chunk of the £109bn NI brought in last year. Johnson suggests that these could be replaced by higher corporation tax, though that would go against the grain for a government bent on reducing the corporation tax rate to 18%. The easiest thing would be just to rename employers’ NICs as an employer earnings or payroll tax.

Osborne will not be the first chancellor to have considered merging income tax and NI. Let us see if he will be the one to do it.

Sunday, July 19, 2015
Bank ponders a rate rise as job market changes gear
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Things are getting rather interesting. In the past few days we have had what looks like a concerted attempt by the Bank of England to prepare people for an interest rate rise in the coming months, coupled with an equally explicit effort by Janet Yellen, chairwoman of the Federal Reserve Board, to say America’s rates will also soon be rising.

Mark Carney, the Bank of England governor, travelled up to Lincoln to tell the world that the decision on interest rates would move into sharper focus around the turn of the year, which most people interpreted as signalling the first rate rise since 2007 and the first move in any direction since 2009.

And yet, on the face of it, the numbers have been going against the idea of a rate rise, certainly in Britain. Inflation, having popped up to a heady 0.1% in May, subsided to zero in June. “Core” inflation dipped slightly and British Gas has announced the start of what might be a new round of energy price reductions with a 5% cut in gas prices. Though inflation will rise as we get towards the end of the year, it is not about to race away.

Even more tellingly, the latest job market figures were a lot softer - at least as far as employment and unemployment were concerned – than expected. Could the Bank, having held off from raising rates when jobs were booming possibly do so when employment is slipping and unemployment going up?

The answer is that it depends, and it depends on two things: whether the latest figures were a temporary blip and whether, if they were not, they signal a change of direction we should celebrate, or be worried about.

The headlines from the job figures were that the number of people in employment fell by 67,000 to 30.98m in the March-May period, which was the first quarterly fall since February-April 2013. That, to remind you, was when the air was thick with worries – misplaced as it turned out – that Britain was sliding into a triple-dip recession. As we now know, there was not even a double-dip.

The fall in employment coincided, perhaps unsurprisingly, with a small rise in unemployment, up 15,000 in the March-May period, with the unemployment rate ticking up from 5.5% to 5.6%. This was the first quarterly increase in unemployment since early 2013.

Was it a blip? The quarterly falls in unemployment have been getting smaller in recent months, even as employment growth was continuing quite strongly. That would suggest that the obvious blip factor, uncertainty over the general election, was not entirely to blame. The fact that the claimant count, a narrower measure of unemployment, edged higher in June, supports that verdict. So election uncertainty may have played some part in the unemployment rise but it is far from the full story.

What is also happening, very clearly, is that as the economic recovery matures, so the job market is evolving. In the latest three months there was a 45,000 increase in employees working full-time, alongside a 40,000 drop in part-time employees and a 55,000 fall in the number of self-employed.

We should be wary of reading too much into quarterly changes like these but they are part of a longer-run trend. So over the past 12 months there has been a hefty 382,000 rise in the number of full-time employees, while the rise in the number of part-time employees has slowed to a crawl, up just 46,000 in a year. The number of self-employed people, meanwhile, dropped by 131,000.

So we are seeing a shift from self-employment into employment and from part-time into full-time work. As I noted recently, some people who opted for self-employment as a stop-gap are moving pack into working for somebody else as opportunities become available. Though you would not want this to run alongside rising unemployment and falling employment, it is a healthy development.

The other part of the non-blip story is what is happening to wages and, it appears, productivity. Average earnings growth has been accelerating for some time. Last summer, total pay was up by less than 1% on an annual basis. Now it is rising by 3.2%, with private sector pay in the latest three months up 3.8% on a year earlier. That will settle down a little in the coming months but we appear to have moved back into a world in which private sector pay – the best guide to underlying labour market pressures – rises by 3% or more.

A quick verdict on the latest numbers might be that the old relationship between wages and unemployment, the Phillips curve, is reasserting itself; as wages go up, employment goes down. I am not sure that is the correct verdict because, alongside the uptick in wages – and thanks to zero inflation real wages are now growing very rapidly indeed – there has been an upturn in productivity.

We will not know the official productivity figures for some time, but looking at what we do know in terms of hours worked, it looks like output per hour was up about 0.8% in the second quarter and by at least 2% on a year earlier. That is starting to look like more like normal productivity growth, which is another healthy development.

It will be healthier still, of course, if rising productivity can be combined with rising employment and falling unemployment, albeit with both occurring at a slower pace than we have become accustomed to in the past 2-3 years. So, instead of strong employment growth alongside weak productivity and stagnant or falling real wages, employment rises more modestly but real wages and productivity also increase. That would be a more normal state of affairs.

It would also be consistent with a gradual “normalisation” of monetary policy. David Miles, who is nearing the end of his six years on the Bank’s monetary policy committee (MPC), was if anything more interesting than Carney. He has yet to be part of a vote to change interest rates in either direction. But even he, known to be one of the most “dovish” MPC members said last week that waiting too long to raise rates would be “a bad mistake” and that “the time to start normalisation is soon”. That is unlikely to mean before he leaves the MPC at the end of August but, if the Bank’s reading of the labour market squares with mine, it may not be many months after that.

Sunday, July 12, 2015
Osborne gambles on a pay rise to cushion the cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Five days on from any budget is always a bit of a challenge, particularly one that has been picked over more intensely than most. Fortunately there is still a lot to say on George Osborne’s first budget of the new parliament.

Let me first give thanks for a measure that was not in the budget. Three weeks ago I wrote that a cut in the very top 45% tax rate alongside welfare cuts would send out the worst possible signals. The chancellor was being urged to do it by some senior Tories but fortunately resisted the temptation.

The other omission, which was much less welcome, was sensible tax reform. There was nothing about merging income tax and National Insurance but instead a continuation of the coalition policy of lifting the personal income tax allowance, combined this time with raising the higher rate threshold. Merging tax and NI would help the lower-paid more, while messy aspects of the income tax system remain, including the 60% marginal rate that kicks in at £100,000.

The tax changes that were in the budget, including the new £1m inheritance tax threshold for couples on homes (though not until 2020) and restricting mortgage interest relief for buy-to-let landlords to the basic rate, added to the complexity of the tax system rather than reduced it. Neither the Institute for Fiscal Studies’ Paul Johnson nor me are champions of buy to let, but he is right when he points out that owner-occupation has tax advantages over being a landlord, and will have even more now.

So what was the budget all about? Three things. The budget, rightly, got rid of the roller coaster that the chancellor found himself with after his March budget, because ahead of the election he wanted to rid himself of the silly charge that he planned to cut spending to its lowest since the 1930s.

Though the Treasury was keen to keep that as a surprise, it should not really have come as a surprise that we now have a more measured pace of deficit reduction. I wrote as much on the Sunday after the March budget.

The planned budget surplus, of £10bn, does not arrive until 2019-20, rather than 2018-19, and spending is significantly higher in three years – 2016-17, 2017-18 and 2018-19 – than set out in March. But this is overwhelmingly a story of smoothing rather than largesse. At the end of the parliament overall government spending is just £7.1bn, or 0.8%, higher than under the previous “savage cuts” scenario.

The second thing of note was that, for a government that said fiscal adjustment would come through spending restraint, there were some significant tax increases in the budget. Overall, according to the Office for Budget Responsibility tax policy changes will be raising a net £6.5bn a year more by the end of the parliament.

The new dividends tax will eventually raise more than £2 billion a year, vehicle excise duty reforms nearly £1 billion and increasing insurance premium tax from 6% to 9.5% £1.5 billion. Most of the burden of adjustment will still be on spending, together with the clampdown on tax evasion and avoidance, but these are big revenue raisers and rather stealthily done. If he could bring himself to admire anything Osborne does, Gordon Brown would be proud.

I have left the biggest budget change until last. With his reduction in tax credits and the new national living wage - £7.20 from April, rising to more than £9 (£9.35) by 2020 – Osborne has given us a variation on traditional Tory philosophy: reduce the size of the state, not by assuming the private sector will move into the gap, but intervening to make sure they do so.

The new national living wage is a kind of super minimum wage. I remember when Labour introduced the minimum wage alongside tax credits in the late 1990s Ed Balls telling me that it was essential to have a wage floor so employers could not exploit the new system. Osborne has just raised that floor.

Just as the BBC is taking on some of the welfare bill by funding free TV licences for the over-75s, so business will take on some of the costs of welfare, particularly tax credits, by paying its workers more.

What should we think of this? It is a fair question for people to ask what the response to this might have been if it had been introduced by an Ed Miliband Labour government. It would probably have been dismissed, including by me, as an anti-business, job-destroying intervention by a party that does not understand how the economy works.

This, indeed, is the response of some in business, including the low-wage sectors that will bear the brunt of this, such as care homes and catering. The minimum wage has not been a destroyer of jobs, but only because its level has been carefully calibrated each year by the Low Pay Commission.

Labour, on the other hand, would not have accompanied a proposal to force wages up with welfare cuts on the £12bn scale Osborne announced. Politically, and perhaps economically, the pill needed to be sweetened.

The IFS is perfectly correct when it says that the national living wage will not, on its own, compensate for welfarte cuts. The numbers, £4bn extra from the living wage versus £12bn of welfare cuts, demonstrate that clearly. Some welfare losers will not gain from the living wage.

There will be losers from the welfare cuts, whatever happens to wages and employment. That is inevitable, as is the fact that most of the losses will be for households on lower incomes. What the Treasury has in mind, however, is a more dynamic process than that implied by the raw numbers, in which the living pushes up pay at higher levels and employment grows even more strongly than the 1m over the next five years expected by the OBR. Osborne expects 2m. More, in other words, could be lifted off welfare.

I am still not sure this was the best way of doing it. One of the consequences of the welfare cuts will be that the “why work?” syndrome gets worse. Some people on low incomes will face marginal tax/benefit withdrawal rates of nearly 80%. The issue I have touched on in recent weeks, that what needs to be freed up are the restrictions on the hours people are willing to work under current welfare arrangements, has not obviously been tackled. The new national living wage may make employers less willing to offer more hours. It is in danger of being seen as a sledgehammer to crack a nut

What we are seeing, to use a word that appeared frequently in Osborne’s speech, is a bold experiment. It is intended, not just to raise wages at the bottom but to have knock-on effects right up the pay scale. The aim is indeed to give Britain a pay rise.

Whether this forces the rise in productivity that will justify higher pay is one aspect of the experiment. Whether it leads to bigger job losses than the 60,000 assumed by the OBR – hugely offset by the 1m net new jobs it expects over the next five years – is another. Let us hope so. Boldness is good. But fortune does not always favour the brave.

Sunday, July 05, 2015
Syriza dreamers snuffed out growth and made a difficult situation worse
Posted by David Smith at 12:00 PM
Category: David Smith's other articles

From The Sunday Times, July 5 2015

At the start of this year, things were looking up for the beleaguered Greek economy. Economists polled by Consensus Economics predicted growth of 2% this year, following last year’s modest 0.8% expansion. Unemployment, while still sky-high, had edged lower. There was a flickering light at the end of the tunnel.

That has now been blown out. The latest Consensus Economic assessment is that Greece will experience a small outright recession this year, a consensus forecast that could get a lot worse in the coming days and weeks. Nor can this be blamed on what is happening in the wider eurozone. Forecasters have become more optimistic about eurozone growth in recent months, raising their 2015 forecast from just over 1% to 1.5%.

The gloom has a single explanation. The election of the Syriza government in late January, and the chaotic months of negotiation with Greece’s creditors that followed, plunged the economy into uncertainty and snuffed out the embryonic recovery. The closure of the banks last week, inevitable once the Greek government announced a referendum for today on a bailout package that has since expired, was the final chaotic act by a government that has set new standards of incompetence.

The battle between Alexis Tsipras, the Greek prime minister, and his country’s creditors has been seen in some quarters, including in Britain, as David versus Goliath, dignity versus dictatorship, growth versus austerity, democracy versus the faceless bureaucrats. It could have been all of these things. When Syriza won power it brought with it to the negotiations with its creditors a lot of goodwill. It immediately won a fourth-month extension on its €240bn (£170bn) bailout, which dwarfs the other eurozone rescues, for Ireland, Portugal and the Spanish banking system.

The problem has been that if Syriza wanted to negotiate seriously, it showed little sign of doing so. A competent left-wing government, which built alliances and elicited sympathy for the pain the Greek people have suffered, could have won substantial concessions. Instead, Greece’s creditors were driven to distraction by negotiating positions that appeared to change with each meeting.
Elected on an anti-austerity programme, it has come to accept it, while simultaneously disowning it. It first opposed and promised to reverse privatization before changing its view.

It reversed some reforms previous Greek governments had agreed to, before partially reversing its reversal. It has flipped and flopped; within a few hours last Wednesday Tsipras was apparently willing to accept most of the creditors’ proposals, before going on TV to condemn them. TV images last Sunday showing a smiling Yanis Varoufakis, taking to the streets to join a protest march hours before the country’s banks were shut, told their own story.

If Greek voters say “no” in the referendum today, it will be the second time in six months that they have backed Syriza on a false promise. In January it was the false promise that there would be no more austerity and that the reforms insisted upon by creditors could be reversed. This time it is that a no vote will mean a better deal. It will not. A no vote would mean a return to the negotiating table for a Syriza government that the creditors have already decided they cannot deal with. Even the normally diplomatic Christine Lagarde, the managing director of the International Monetary Fund, has talked of the need for “adults” in the room. If a no vote does not mean a Greek exit from the euro, it is hard to see what would.

Though a “yes” vote should mean the end of Syriza, and its replacement by an alternative government, perhaps a government of technocrats, who would then negotiate with the creditors, Greece’s problems would be far from over. Its six-month experiment with a dysfunctional government of academics and dreamers have set the Greek economy back some years. It has also been expensive.

The IMF, in a “debt sustainability analysis” released last week said that “very significant changes in policies and in the outlook since early this year have resulted in a substantial increase in financing needs”. Having thought Greece would need no further debt relief, it now thinks it will need €50bn (£35bn) of support over the 2015-18 period, €36bn (£27bn) of it from Europe. The Syriza bill is a large one.

Osborne must press the right buttons on tax and productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Given the sheer unpredictability of events in Greece we cannot be sure that George Osborne’s first post-election budget, his seventh in all, will be the biggest economic story this week. But it will be important for all that.

One thing is clear. A budget that merely fills in the details of where the welfare axe will fall will not get the parliament off to a good start. As I wrote last week, there is plenty of scope for savings but they must be in the context of weaning people off welfare and into work, or into working more hours.

There are two other priorities. One is tax reform. Paul Johnson, director of the Institute for Fiscal Studies, is always worth listening to and his proposals for a tax reform programme for this parliament, beginning this week, make a lot of sense.

So the chancellor should begin the process of integrating income tax and national insurance, tackle absurdities such as the 60% marginal rate on earnings between £100,000 and £121,200 (tricky when the beneficiaries of any change are high earners) and reintroduce sensible indexation into taxation.

Johnson points out that we have a hotch-potch of indexation arrangements, with some parts of the system using the consumer prices index and others the now discredited retail prices index. More often, I would add, the decision to index or not, for example in the case of fuel duty, has become highly political. I have lost count of the number of times this chancellor has decided to “be kind to motorists” by not indexing fuel duty. Over time, these things add up to a lot of lost revenue.

The biggest failure to index, as the IFS director points out, is in the council tax system, where the system is based on valuations of nearly quarter of a century ago. This is bonkers.

The chancellor would make his life a lot easier if we were to return to the days when indexation, using a sensible inflation measure, was the normal thing to do. And there is no better time to do that when inflation is very low. If Osborne is to embark on sensible tax reform, not something that stood out in his first five years, now is the time to start. I am not clear that raising the inheritance tax threshold on main homes to £1m, paid for by reducing pension tax relief, is the kind of reform I would have in mind.

What else? Most chancellors, even those like Gordon Brown who introduced his own productivity agenda, have not had to worry overmuch about weak productivity growth.

New figures from the Office for National Statistics show that productivity – output per hour – rose 0.3% in the first quarter and is 1.3% up on a year earlier. They also show, however, how far there is to go.

In the first quarter productivity was just 5% up on its level 10 years earlier. The period straddles the crisis and recession but, even so, for productivity growth to average a little under 0.5% a year over a decade is remarkably weak. It was slowing even before the crisis hit.

For comparison, productivity rose by 22% in the previous decade; 1995-2005; 26% from 1985 to 1995, and 28% from 1975 to 1985. Roughly speaking, we have had a fifth of the productivity growth over the past decade that we should have had.

There are, as noted before, some special factors in that; the shift in the financial services sector from productivity driver to productivity drag and the decline of North Sea oil. Some sectors have bucked the trend. Manufacturing productivity has been up and down recently but is 18% higher than 10 years ago.

But productivity is a bigger problem for Osborne than for his predecessors. Hence the “productivity plan” we will see unveiled this week around the time of the budget.

There is no great mystery about what should constitute a productivity plan. Politicians cannot wave a wand and boost productivity though they can create the conditions under which the private sector can deliver improvements.

That means tackling the usual suspects, the productivity "drivers", though Osborne also appears to have in mind the dynamic drivers of productivity, the cities and other clusters in which those productivity drivers can trhive.

Of the traditional drivers, business investment has been improving recently but the single biggest explanation for why the output of British workers is below that of competitor countries such as France is that they invest more. So expect some modest investment incentives, notably an increase in the annual investment allowance.

A productivity plan means boosting education and skills, incentivising training and apprenticeships. Plenty is being done on this, though governments can probably never do enough.

It should also mean investing in and updating the infrastructure in a timely way and it is here that you realise that this productivity thing is not so easy. In presenting the findings of his Airports Commission Sir Howard Davies fired the starting gun, not on the diggers breaking ground for Heathrow’s third runway but on a prolonged period of argument, dithering and uncertainty.

The announcement a few days earlier of delays in what had been billed as the biggest rail investment programme since the Victorian era, including the postponement of at least one project pivotal to the chancellor’s northern powerhouse, confirmed that we do not do these things well. Anybody waiting for Transpennine electrification to deliver productivity improvements will be waiting a long time.

There is, of course, nothing new in Britain being bad at infrastructure, in business tending to under-invest and in more work being needed to improve education and skills. None of this, however, prevented good rates of productivity growth being achieved in the past.

If you were to put your finger on one big difference since the crisis, it is finance. Availability of credit, of funding for business growth is a factor most people can agree has significantly held back productivity. The process of creative destruction long ago identified by the Austrian economist Joseph Schumpeter has been held back. Banks have kept bad businesses alive while failing to finance new, creative and productive firms. It remains the case that bank lending to business is falling in year-on-year terms, six years into the recovery.

There have been plenty of initiatives in this area, and there are sources of finance, but it is still a problem. Osborne’s current priority is to get Lloyds and Royal Bank of Scotland back into the private sector. Maybe that will deliver stronger lending to business but probably it will not.

It is good that the chancellor has a productivity plan. It has some good elements as well as some familiar ones. But if productivity improves it will probably do so because of an easing of the effects of the crisis and a return to some kind of normality, not because of what will be announced in the next few days. If Osborne is lucky, his plan will coincide with an improvement in productivity. If not, it will be back to the drawing-board.

Sunday, June 28, 2015
Cut tax rates at the bottom, not at the top
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

There is more than a touch of déjà vu about George Osborne’s summer budget on July 8. In June 2010, when Osborne presented his first “emergency” budget, Greece dominated the headlines, having agreed to its first bailout package amid deadly riots and a flurry of ratings downgrades.

Then as now, Britain had a substantial budget deficit which had to be tackled. And, while it has fallen by more than half as a percentage of gross domestic product, at 4.9% of GDP or nearly £90bn in 2014-15 (though falling this year) it remains too high for comfort. Hence, one of the sounds you hear from the Treasury is that of knives being sharpened.

True, this is the first budget in a Conservative-only government since Ken Clarke’s last outing nearly two decades ago in November 1996 (at that time the spring budget had been abolished). And true, the fact the chancellor no longer has to get everything past coalition partners will change the character of next month’s budget. In other respects, however, things are rather familiar.

Let me address three aspects of the upcoming budget: the economic backdrop, whether welfare cuts can be achieved and whether in the context of such cuts, the first Tory budget for almost 20 years should include a cut from 45% to 40% in the top rate for very high earners.

The economic backdrop to the budget is one of a strong job market, low inflation and rising real wages. Independent forecasters expect 2.5% growth this year and, in forecasts published since the election, 2.4% next. Though the talk is of tough, front-end loaded austerity, forecasters do not expect this to have a significant impact on growth.

If so, this would follow the pattern of the last parliament. Though there is a view around that growth stopped as soon as Osborne embarked on austerity (in addition to that he inherited from the previous Labour government), and only started when deficit reduction was relaxed or even abandoned, it is a myth.

Growth in 2010-11 was 2.3% and 1.4% in 2011-12, even as austerity was biting hardest (reducing growth by 1.1 percentage points each year according to the Office for Budget Responsibility). Non-oil growth, which adjusts for sharply falling North Sea oil production, and is a fairer measure of underlying economic activity, was 2.7% and 1.9% respectively. Though tax increases and spending cuts hit growth, as did several other factors, low interest rates and quantitative easing by the Bank of England boosted it. With Bank rate at 0.5% for more than six years, monetary policy remains loose now.

What could hit growth is what happens in the eurozone. Growth slowed to 0.7% (1% excluding oil) in 2012-13, when euro break-up fears were at their height and the eurozone was in a full-blown recession, its second in the space of three years. Currently growth in the eurozone is picking up, which is good. The hope has to be that that continues, notwithstanding a Greek saga that has lurched into new uncertainty this weekend, with the Syriza government's decision to call a referendum next Sunday on a deal which may well have evaporated by then.

The two solid elements of the budget are the planned £12bn of welfare cuts and £5bn of savings from curbing tax avoidance. Nobody will argue with the latter. Plenty will criticise the former.

On welfare, as was made clear in the joint piece in this newspaper last Sunday from Osborne and Iain Duncan Smith, the work and pensions secretary, and a speech a few days ago by David Cameron, the aim is not just to cut but to reform, improving incentives to work and ending what the prime minister called the “merry go round”. Essentially, the more that people receive in pay, the less they will need from working-age benefits.

Is this feasible? There is little evidence that employers deliberately play the system of tax credits by paying the minimum they can get away with (usually the minimum wage), knowing that the government will top it up with tax credits.

There is plenty of evidence, however, that benefit and tax credit rules do affect the hours that people are willing to work, and their willingness to receive bonuses. A Low Pay Commission report earlier this year, the Minimum Wage, Taxes and Benefits, found that over half of employers found that employees did not more hours, because it would affect their entitlement to in-work benefits. This was particularly the case among lone parents at 16 hours, and single adults at 30 hours, in each case the threshold for receiving tax credits and other benefits.

This is because of a longstanding flaw in the system, that higher earnings can result in a marginal effective tax rate of more than 100%. Unsurprisingly, people respond to such disincentives. The system can act as a trap. The switch to universal credit will help, though the Low Pay Commission report notes that effective tax rates of over 70% will remain. Osborne, Duncan Smith and Cameron have the right aim, to reduce welfare dependency, and it seems there is demand from employers to increase working hours – shifting the burden from taxpayers to business – but it is ambitious. Taking £12bn out of a £94bn working-age welfare bill means taking some prisoners.

Whatever the chancellor announces on welfare, it will be greeted as draconian by many, the more so if he were to combine it with a cut in the top rate of tax. This was the intriguing possibility raised by the Financial Times a couple of days ago, citing the fact that Lord Lawson, the former Tory chancellor, is urging Osborne to do it.

Lawson, of course, cut the top rate from 60% to 40% in his penultimate budget in 1988. The current chancellor announced a cut in the top rate from 50% to 45% in 2012, a budget that for a variety of reasons was not his finest hour.

Is there a case to go further, taking it back down to the level that prevailed for 22 years after Lawson’s historic announcement? He did it in the first budget of a new parliament, so there is precedent. The closer you get to an election, the harder it is. Combined with a package of measures that hit higher earners – further limiting pension tax relief and abolishing non-dom status for anybody born here – it could be presented as a fiscally neutral. It would delight many Tory backbenchers.

But, while I am normally as much in favour of lower taxes as anybody, it would look terrible. A tax cut for those earning more than £150,000 alongside significant welfare cuts would confirm very stereotype about the Tories. Getting the top rate down to 40% is a laudable aim. It should wait until the public finances are closer to being fixed.

Sunday, June 21, 2015
Booming job market gives Britain a pay rise
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Apart from a Greek crisis that is in danger of giving a whole new meaning to the term brinkmanship – the usual idea is to stop before you go over the edge – the past few days have brought some other interesting developments.

Though the latest figures show that Britain has edged out of deflation after just a month, the combination of negligible inflation and a strengthening of pay growth means real wages are growing at their fastest since 2007; before the crisis hit home.

Some said this would not happen for a very long time, or that the return of real wage growth last year was merely a product of very low inflation. But the latest rise in average earnings, 2.7%, is enough to outstrip inflation even when it returns to the 2% target.

It runs alongside what the Office for National Statistics says is the longest spell of sustained retail sales growth since records began almost two decades ago. In May, retail sales volumes were 4.6% up on a year earlier. Low inflation has certainly helped here. A drop in petrol prices of more than 10% over the past 12 months has had the predictable effect of increasing the volume of spending, not just on fuel but on other products as well.

The earnings figures provide me with a peg to address three things. One is that the job market is changing as its recovery matures. The second is the sustainability of stronger pay growth when overall productivity is weak. The third is what the numbers tell us about the consumer recovery.

Let me take these in turn. Though the average earnings figures were the most eye-catching element of the latest labour market numbers, they were not the only information of note.

We have an economy which has generated a rise in employment of 424,000 and a fall in unemployment of 349,000 in the past year. There are more than three-quarters of a million unfilled vacancies, which is why many employers complain of problems in recruiting.

Behind these headline figures, something rather interesting is happening. One of the refrains of recent years has been the casualization of employment; the rise of self-employment, part-time jobs and zero hours contracts.

This has been a caricature for some time. Over the latest 12 months there has been an increase of 453,000 in the number of employees working full-time. Sharp-eyed readers will notice that this exceeds the overall rise in employment over the period. This is because, as well as a smaller increase in the number of part-time employees (92,000), there have been falls in self-employment (91,000), unpaid family workers (14,000) and people on government schemes (15,000).

The death of the traditional full-time job - working for somebody else - was greatly exaggerated. Over the past two years, to offer a slightly longer comparison, three quarters of net new jobs created have been for full-time employees.

Some will bemoan the decline of self-employment over the past year, and it is too early to declare it as a trend, but it seems likely that at least some people who were going it alone have been lured back to the security of being a full-time employee as opportunities became available. There is still plenty of scope for entrepreneurs but we may be seeing the beginnings of a decline in involuntary self-employment.

Companies do not recruit, of course, unless they have jobs for people to do. And in general they do not pay higher wages unless they need to do so to recruit and retain staff or because it is justified by higher productivity. Though there is clearly an element of the former in what is happening at the moment, we should not ignore the latter.

This brings me on to my second point. Though the overall numbers for productivity remain weaker than they should be, something is stirring. I have noted before that the sectors and sub-sectors in which jobs are strongest are typically those where output is also rising strongly.

The construction industry increased employment by 1.3% in the year to the first quarter. Earnings growth has also started to pick up quite strongly in the building industry. But output, we now know, showed a hefty 4.4% annual rise in the first quarter, suggesting productivity is on the up. The same is true for wholesaling and retailing – employment up 2%, output 4.7% - real estate, 0.3% and 1.7% respectively; transport and communications, 1.4% and 4.7%, and several other parts of the economy.

The process clearly has further to go, indeed a long way to go. The productivity numbers are still weighed down by North Sea oil and financial services, and by the fact that availability of finance continues to inhibit the growth of younger, high-productivity businesses. But there are signs of change. Even with these factors, the aggregate figures point to productivity growth of between 1% and 1.5%, which is a step in the right direction.

Finally, the latest earnings figures offer an opportunity to bury a myth I often hear repeated, which is that the British economy has been carried along by “debt-fuelled consumption”. The remarkable thing about the past few years is how little household debt has risen, not how much.

Bank of England figures show that household debt stands at £1,434bn, overwhelmingly in the form of mortgages. It has risen by £43bn, or just 3%, from its pre-crisis peak just ahead of the collapse of Lehman Brothers in 2008. In the previous seven years, for comparison, it rose by £602bn, or 76%. Unsecured credit has fallen by nearly a fifth from pre-crisis levels.

And, while lending to households has picked up recently, it is running at a modest 2.5% growth rate, compared with 15% or more at times in the pre-crisis period. For its effects on consumer spending, it is dwarfed by rising incomes.

Tucked away in the official GDP (gross domestic product) figures is a series for compensation of employees, overwhelmingly wages and salaries. It picks up both the growth in earnings and the effects of rising employment. What matters for spending power in the economy is not just the pay rises received by individual workers but the number of people in receipt of wages.

In the first quarter, compensation of employees was up by 4.2% on a year earlier, having risen by 3.2% in 2014 and 3.1% in 2013. Though some of this – a diminishing proportion – was eaten up by inflation, most provided the basis for the growth in consumer spending, which has been running at around 2.5% recently. When incomes are rising, people still need to borrow to move house, and many choose to take out finance to buy cars and other big-ticket items. Overwhelmingly, however, spending is out of rising incomes.

Sunday, June 14, 2015
First get your budget surplus, then try to keep it there
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Neither will welcome the comparison but George Osborne since the election reminds me of Gordon Brown in the weeks after Labour’s 1997 victory. Both hit the ground running, with a flurry of announcements and initiatives while their cabinet colleagues were getting used to being in office or, in the case of the Tories, back but with an overall majority.

For Osborne, it is like a weight has been lifted. Though I am sure he enjoyed the company of Danny Alexander, his former Liberal Democrat Treasury chief secretary, and all those “quad” meetings with Nick Clegg and Alexander as well as David Cameron, the sense of liberation is palpable. The sometimes Eeyore-ish presence of Vince Cable at the business department might have meant slower progress on selling the rest of Royal Mail and embarking on the disposal of RBS. No more.

The chancellor’s biggest offering, however, is what he described in his Mansion House speech as his “new settlement” for the public finances, “a permanent change in our political debate and our approach to fiscal responsibility”.

That new settlement, to legislate for future governments to run a budget surplus “in normal times”, “to bear down on debt and prepare for an uncertain future”, has been widely greeted as a political trick, intended to kick Labour when it is down, by forcing the main opposition party to commit to a fiscal rule it is probably not comfortable with.

There is some truth in that, as there is in the fact that fiscal rules, even those enshrined in law, are made to be broken, and that no government can bind the hands of its successors. On the latter, however, the chancellor may be aiming for the kind of consensus there is now on Bank of England independence. Just as it is hard to see any new government reversing that, it could be a very big deal if future politicians decided to abolish the proposed fiscal law.

Let me leave the politics aside and take the proposed surplus rule at face value. While some see it as a return to the Victorian era, there is much later experience, if not with permanent surpluses, then at least with far tighter public finances than the recent norm.

Reliable figures for the public finances go back to 1948 and, while it is true that there have only been 12 years in that period when the government has run a budget surplus, the deficit over the period 1948-72 averaged just 0.6% of gross domestic product. This, remember, was the period of fiscal activism, Keynesian demand management.

The current budget – excluding public sector investment – was in surplus in every year from 1948 to 1974, that surplus averaging 3.8% a year. The figures, incidentally, give the lie to the suggestion that tight public finances mean governments cannot undertake necessary investment in the economy.

In the three decades from 1948, when the average overall budget deficit was a tiny 0.6% of GDP, public sector net investment averaged 4.6% of GDP annually. That is roughly three times its average over the past 20 years, not least because much of that investment used to be by nationalised industries.

We are a long way from the golden age of the 1950s and 1960s. The budget deficit has averaged 3.6% of GDP since the early 1970s and, pending revisions, was 4.8% of GDP in 2014-15.

Budget deficits are the norm. Even Canada and Sweden, praised by the chancellor for their successful reforms of their public finances in the 1990s are running deficits, though admittedly lower ones than Britain. For those who believe in legislating for these things, Germany is the current poster boy.

In 2009 it initiated its Schuldenbremse or debt brake legislation, embodied in Article 109 of the country’s basic law, which required the federal government to run a structural budget deficit of no more than 0.35% of GDP. So far it is working.

Aiming for a small budget surplus in normal times –as long as that is not at the expense of an adequate level of public sector investment – is perfectly laudable. It produces a gradual fall in public sector debt and a much more rapid drop in debt as a percentage of GDP. The lesson of recent years, discussed last week, is that if you go into a crisis with a significant deficit the subsequent pain is much greater.

There would be battles between the politicians and the fiscal watchdog, the Office for Budget Responsibility, charged with determining what the public finances should be in a given year. For the Treasury this would be ultimately be a good thing; the OBR would be an ally in reining in the spending ministries.

The first big task, however, is to get to a surplus, the equally challenging second to is keep it there. Neither will be easy. Though official projections are for a small budget surplus of 0.2% of GDP in just three years’ time, there is a serious risk that this represents the triumph of hope over experience.

Now he has been liberated from coalition, Osborne has a chance to do what should have been done in 2010; a Canadian-style root and branch review of the role and limits of government, together with a mechanism for ensuring that the lower level of spending is permanent, not just the temporary low point achieved after a long squeeze. Though Canada is now running a small deficit, its public finances are far healthier than Britain’s.

There is a chance to do this in this autumn’s spending review, with the new Treasury chief secretary Greg Hands charged with achieving it. It may be the only chance. Public spending is the equivalent of roughly 40% of GDP, having peaked at nearly 46% of GDP in 2009-10. Tax receipts appear to be stuck at just over 36% of GDP. So spending needs to be brought down to 36% of GDP or less.

That will not be easy, and neither will be keeping it there. The OBR’s latest fiscal sustainability report, which looks at the public finances over the long-term, has some striking findings. Scottish Nationalists hoping to build an economic future on North Sea oil will have discovered that the cupboard is bare. The OBR expects only £2bn of North Sea revenues in the 20 years from 2020 – in total – down £37bn from the OBR’s assessment a year ago.

The ageing population, the biggest source of extra spending, will add 1% of GDP to public spending each decade on current policies. The OBR sees public sector debt falling as a percentage of GDP on current policies until the 2030s, assuming accidents can be avoided, after which it starts to rise strongly again.

In the long run, as Keynes said, we are all dead. But in the long run too there will be significant upward pressures on spending at a time when the outlook for some of the taxes to pay for it is at best uncertain, at worst dire.

It makes sense to try to prepare the public finances for such pressures. If, over the next 25 years, the result was a small budget deficit of the kind we saw from the late 1940s to the early 1970s, rather than the surplus Osborne aims to enshrine in law, it would still be a considerable achievement. But, as I say, it requires some hard thinking about the role and scope of the state. The election campaign, rich with promised giveaways on both spending and tax, was not notable for such hard thinking. Let us see what the next few months bring.

Sunday, June 07, 2015
After wasting five years, Labour will struggle to rebuild economic credibility
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The general election is becoming a fading memory but its implications will be with us for some time. For the Conservatives, there is the task of delivering the spending cuts necessary to complete the task of eliminating the budget deficit.

The Paris-based Organisation for Economic Co-operation and Development (OECD) has offered advice, suggesting to George Osborne that “evening out the profile of fiscal consolidation” would make sense. I don’t think this piece of OECD advice will be particularly unwelcome.

In his March budget, the chancellor left us with a “roller-coaster” public spending outlook; down sharply in the first two years of the parliament, then up dramatically at the end. As I have written before, it will be very surprising if, now he is safely back in 11 Downing Street, he does not take the opportunity, in his July 8 budget and the spending review later in the year, to indeed even out this profile. Thursday’s announcement of a £4.5bn package of cuts and asset sales, includingof £3bn of a £1.5bn sell-off of the government’s remaining 30% stake in Royal Mail, were part of the smoothing process.

To the victors go the spoils, however, and the challenges for the Tories are as nothing compared with those for Labour. Labour has now lost two elections, largely because of a lack of public trust in its ability to run the economy. The task for its leadership hopefuls is to rebuild economic credibility, and it will not be easy.

We will never know whether Labour was ever in with a shout of winning the election, or even being the largest party. One thing that helped guarantee it would not happen, even apart from Ed Miliband’s absurd “Ed Stone”, was the Labour leader’s refusal to concede that his party had overspent when in government.

In 2011, Miliband appeared to be on the brink of wiping the slate clean, apologising for the regulatory failures that contributed to the crisis. Given that London was at the heart of the crisis that was probably the least he could have done. And, given that politicians do not get themselves directly involved in financial regulation, blaming the failure of officials at the Financial Services Authority, Treasury and Bank of England was not too hard.

That same year Ed Balls, then the shadow chancellor, also appeared to be on the brink of truth and reconciliation, apologising both for regulatory failings and for the fact that “we didn’t spend every pound of public money well”. But that was it. The attitude then appeared to shift to blaming everything on the bankers and conceding nothing on the disaster that befell the public finances.

This was strange. While some Labour die-hards insist the party has nothing to apologise for, resorting to the absurd “spending increases did not cause the global financial crisis” the evidence is clear.

Public spending increased by a plainly unsustainable 51% in real terms between 1999-2000 and 2009-10, overwhelmingly ahead of the crisis. The OECD says Britain had an underlying or structural budget deficit of 5% of gross domestic product in 2007, behind only Greece and Hungary. Though its estimate at the time was lower, it believed and said at the time that Britain’s was the fifth largest structural deficit among its members.

The Office for Budget Responsibility’s measure of the underlying deficit, cyclically adjusted net borrowing, hit 4.1% of GDP in the mid-2000s. Between 40% and 50% of the record peacetime structural deficit was in place before the crisis hit. Incidentally, that underlying deficit is now back to where it was in the mid-2000s, suggesting the effects of the crisis have been eliminated, but not the overspending that preceded it. The OBR points out that Britain was one of a tiny number of countries to increase debt as a percentage of GDP from 2004 to 2007.

Overspending was recognised at the time. Martin Weale, the distinguished former director of the National Institute of Economic and Social Research, pointed out repeatedly that the government was bending its own fiscal rules. So did other bodies and commentators.

So, belatedly, did Labour. In 2007, Gordon Brown prepared the ground for a shift from public spending growing more rapidly than GDP to restricting its growth to less than rise in GDP. Spending would still rise, but by 2% a year in real terms, rather than 5%. Whether that slower spending growth would have been achieved in the run-up to a general election with Brown in 10 Downing Street, we will never know. The crisis intervened. The good things Labour did, including Bank of England independence, a strengthened competition regime and some of the increased spending on public services and infrastructure, got lost in the reputational collapse.

The pre-crisis deficit had two implications. One was that the size of the deficit meant the temporary fiscal stimulus introduced to limit the economic damage from the crisis – mainly a 13-month reduction in Vat – had to be small. The second was that roughly half of the austerity programme adopted by the coalition government in 2010 was necessitated, not by the crisis, but by Labour’s pre-crisis spending largesse.

How are the Labour leadership candidates doing in wiping the slate clean and trying to move Labour on? It is given added piquancy by the fact that two of them, Andy Burnham and Yvette Cooper, were Treasury chief secretaries, and so responsible for spending, though in both cases mainly after the damage had been done. Burnham did the job from mid-2007 to early 2008 and Cooper from then until June 2009, when the unfortunate Liam (“there’s no money left) Byrne took over.

Burnham has made an encouraging start. “If we are to win back trust we have to start by admitting that we should not have been running a significant deficit in the years before the crash,” he said recently. Liz Kendall, who should also make it on to the final ballot, has said bluntly: “We were spending too much before the crisis.” But Cooper, who is married to Balls, while shifting her position a little, appears most closely wedded to the line that helped lose Miliband the election. The deficit was small before the crisis, she has said, focusing on its narrowest definition, and it would not have made much difference if there was a small surplus. Voters, rightly, do not believe that.

Whether Labour can begin to wipe the slate clean therefore partly depends on its choice of leader. By 2020, of course, the 2010 legacy will be a distant memory, but these things have a habit of sticking. After the International Monetary Fund crisis of 1976 and the winter of discontent of 1978-9, a lack of economic credibility kept Labour out of power for 18 years, even failing to win in April 1992 when the general perception was that the economy was still in recession.

It required a combination of Tory self-inflicted economic wounds, including the September 1992 ERM (exchange rate mechanism) humiliation and the rebuilding of a Labour economic policy platform under Brown and Tony Blair, to tilt the balance decisively.

Something similar will be needed again, whether or not the Tories implode. Labour has to be trusted to spend prudently, tax sensibly and pursue pro-business policies. After wasting five years not doung any of that, it will be an uphill task.

Sunday, May 31, 2015
Trade is such a drag for Britain's economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A new government is in place and we have had its first Queen’s speech. As far as the economy is concerned, the two most important aspects of its programme are the referendum on European Union membership and the second-half of the deficit reduction programme.

On the first, of which much more no doubt in coming months, I still think it will be a story of some occasionally fraught renegotiation, followed by a yes vote, but we shall see.

On the second, the task for the Tories – given that many people seem to feel curiously cheated by the election result – will be to make deficit reduction seem fair. Without the cover provided by the Liberal Democrats, George Osborne will be under even greater pressure to demonstrate that we are all in it together. Anyway, more on that later too, in the run-up to and after the July 8 budget.

As always, what happens to the economy is not exclusively reliant on what politicians do. They can declare until they are blue in the face that they want to raise productivity but in the end the decisions by tens of thousands of private sector firms will determine whether it happens or not.

Similarly they can set a target, as Osborne has, for doubling Britain’s exports but, again, in a period of slow world trade growth, they cannot guarantee it will happen.

Trade is a big issue for Britain’s economy, as figures a few days ago showed. Against expectations of an upward revision in first quarter gross domestic product growth, the quarterly increase was left unchanged at 0.3%. Manufacturing and construction were stronger than first estimated but services a little weaker. Business services and finance appear to have had an unusually weak quarter.

In the detail of the figures, however, the standout drag on growth was what economists call net trade; exports less imports. Net trade, in fact, was not so much a drag as a giant millstone round the economy’s neck.

So, while there was a decent 0.5% quarterly rise in consumer spending, an encouraging 1.7% increase in business investment and even a small 0.1% upward tick in government consumption, exports fell by 0.3% on the quarter, while imports jumped by 2.3%.

Putting all that together gives you the extent to which our poor export performance and appetite for imports impacts on growth. In the first quarter net trade reduced the change in GDP by 0.9 percentage points. Had the contribution of net trade to the economy been merely neutral, in other words, the rise in GDP in the first quarter would have been more than 1%, rather than just 0.3%.

Or, taking last year as a whole, 2014’s growth of 2.8%, which was perfectly respectable, would have been a heady 3.3% without the 0.5 point drag on growth from net trade.

These things move around from quarter to quarter, and the net trade picture in the first quarter was particularly disturbing. But, while there is some evidence of rebalancing in the pick-up in business investment, the opposite is happening when it comes to net exports.

Is there are any reason to think this might change? After all, this is not just a question of growth being stronger if exporters were doing better (and importers rather worse). Britain’s large current account deficit, 5.5% of GDP, reflects weak investment income but also puts the onus on exporters of both goods and services to raise their game.

One source of hope is the eurozone. The stronger the growth bin the rest of Europe, the better Britain’s exporters should do. The eurozone crisis, and its 2011-13 recession, which followed the deep 2008-9 downturn, were a factor in Britain’s slowdown a couple of years ago.

The unfortunate thing about the first quarter numbers, however, was that they coincided with signs of stronger growth in the eurozone. Though I expect Britain’s first quarter figure to be eventually revised higher, as things stand the 0.4% rise in eurozone GDP in the first quarter exceeded Britain’s 0.3%.

Stronger eurozone growth could yet be threatened by the instability that would follow a Greek exit, though I do not expect that to happen. For the moment, however, even stronger growth in Europe is not helping Britain’s trade position. If anything the opposite is happening.

A pick-up in world trade would help. The odd thing about the post-crisis global recovery has been that, while the rise in GDP has not been that bad, the recovery in world trade – after an initial spurt in 2010 – has been muted. Normally world trade would grow at double or more the rise in global GDP. That has not been happening, perhaps because of the weakness of trade credit, perhaps because of discreet protectionism.

The upshot is that, to the extent that exporters have geared up for a global trade upturn, and refocused their efforts on faster-growing emerging markets, they have got all dressed up with nowhere to go.

What about the exchange rate? Many blame the strength of the pound for Britain’s disappointing export performance. But sterling is below its long-term average against the dollar and does not look fundamentally overvalued against the euro. The fact that exports did not respond well to sterling’s 25% fall between November 2007 and early 2009 suggests we should look elsewhere for the causes of the problem. Maybe a more stable currency would help, though attempts to stabilise sterling in recent decades have ended in tears.

There are two sides, of course, to net trade. Our appetite for imports continues unabated, not just because of consumers. Many manufacturers rely on imported components. Another aspect of disappointing trade performance has been the absence of import substitution among both consumers and business buyers. Again, this is not obviously in the gift of government.

It would be good to predict better times ahead for trade. If you wanted to be optimistic you would look at Britain’s service sector exporters, many of whom genuinely are world beaters. Even in a disappointing first quarter, Britain’s service sector exports totalled nearly £55bn and exceeded service sector imports by more than £22bn.

But if you wanted to be gloomy you would look at those first quarter GDP figures and conclude that one of our traditional Achilles’ heels is continuing to hold us back, and will continue to do so. The traditional complaint, that we do not make enough of what we want to consumer, has some validity.

Britain’s trade performance, like Britain’s productivity performance, needs to improve. As things stand, it is not obvious that it will do so.

Sunday, May 24, 2015
A little bit of deflation does you good
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Britain’s drop into deflation has produced a mix of curiosity, celebration and, in some quarters, alarm. The fact that the consumer prices index (CPI) last month was 0.1% lower than a year earlier (as distinct from unchanged in February and March) is of little practical significance.

But it has certainly provoked a lot of curiosity. Though the CPI was not even a twinkle in the statisticians’ eyes in 1960 – back then inflation was measured by the retail prices index – the Office for National Statistics (ONS) has managed to “backcast” the data to then. So we have been treated to comparisons which show this is the first episode of CPI deflation since Princess Margaret married the future Lord Snowdon, the skiffle artist Lonnie Donegan topped the charts and Wolverhampton Wanderers last won the FA Cup.

If the current deflation episode is as short-lived as many believe, it is a slightly sobering thought that in 55 years’ time somebody could be looking back and running comparisons to the quaintness of life in 2015, and which tunes we were all whistling from the charts. I should probably add a "not" there.

Mostly, the reaction to the drop into mild deflation has been to celebrate it. This has to be right. When I wrote about “good” deflation last year, I think I was one of the first, if not the first in this episode, to do so.

Good deflation in when prices fall in response to a favourable global price shock, in this case a sharp fall in oil prices. Bad deflation is when prices are dragged down by a lack of demand in the economy and is associated with stagnation.

Though the supermarkets might argue there are elements of bad deflation in the current picture – they are fighting like cat and dog for the consumer pound – it is overwhelmingly good. Mark Carney, the Bank of England governor, says that we should enjoy it while we can and he is right. An oil glut has delivered a welcome boost to household incomes and energy-using businesses. Good indeed.

For evidence of good deflation, look no further than the latest retail sales figures, which showed a 1.2% increase in spending volumes last month, for a rise of 4.7% up on a year earlier. A 3.2% drop over 12 months in what the ONS calls shop prices, but in practice was largely driven by a big fall in petrol prices, was a big reason for what is a mini consumer boom.

Some, of course, will always look a gift horse in the mouth and worry that we are about to return to the 1930s, though there was less of this this time than I might have feared.

But the fact that inflation is temporarily sub-zero, and will fluctuate around this rate for the next few months, raises an interesting question; one I have been asked a lot over the past few days. If inflation at close to zero is such good news why do we not make zero the permanent aim? Why do politicians and central bankers talk about price stability and then adopt a 2% inflation target? After all, after 20 years of 2% inflation, prices at the end would be nearly 50% higher than at the start.

Governments do not go for zero inflation targets for a variety of well-known reasons. Sometimes, as often over the past six years, they want a negative real (inflation-adjusted) interest rate, in other words an interest rate that is lower than the inflation rate, to boost the economy. If zero is the target and the norm, the only way that can be achieved is through negative actual interest rates, which are not generally to be recommended.

Aiming for zero would also run the risk of prolonged periods of deflation. At any time there would be an equal risk of inflation being negative and positive. Given the wayward inflation forecasting record of the Bank since the crisis, overshoots into deflationary territory could be prolonged. That would bring into play some of the dangers economists tend to emphasise about deflation, notably the fear that households and businesses will delay purchases until prices are lower. Deflation also raises the real value of debt; not something you want when you have a lot of it.

Because of these and other effects, economists caution against aiming for zero inflation. Almost 20 years ago a group of economists led by George Akerlof, did research for the Washington-based Brookings Institution, and calculated that a zero inflation target would lead to a permanent loss of gross domestic product and jobs of 1% to 3%. The big reason they cited was that zero inflation makes it hard for wages in different parts of the economy to adjust; pay cuts can be as awkward as negative interest rates. Real wages end up too high, and employment too low. Akerlof, as well as being a Nobel laureate, is the husband of Janet Yellen, chairman of America’s Federal Reserve Board.

In all likelihood this period of “noflation”/mild deflation will be short-lived. A one-off price shock will drop out of the inflation comparison by the end of the year. The last time we were briefly negative, all those years ago, inflation rose quite sharply afterwards.

There is a possibility, however, that very low inflation becomes entrenched. Fathom Consulting points out that core inflation, excluding energy, food, alcohol and tobacco, is at a record low of 0.8% and falling. Service sector inflation, which normally outstrips overall inflation, has come down to 2%.

Meanwhile, so-called pipeline inflation pressures are very low. “Factory gate” prices for manufactured goods last month were 1.7% down on a year earlier, or zero excluding energy and food. Raw material and fuel prices, down 11.7%, are still reflecting sharp oil and commodity price falls.

It may be, as noted last week, that rising wage pressures compensate for some of these deflationary impulses, though one of the reasons why both the Treasury and the Bank are keen to emphasise the temporary nature of the current episode is that they do not want employers to respond to zero inflation with zero pay rises.

One thing is reasonably clear. We are now in a prolonged period – 16 months so far – in which inflation has been below the 2% target. It pre-dated the sharp fall in oil prices. It was preceded by 48 months in which inflation was above the target, exceeding 5% at times.

If that tells you we should be sceptical of the ability of central banks to keep inflation on target, whether that target is 2% or zero, it is a good lesson to draw. If it tells you we should expect big inflation swings in the coming years, in both directions, that is a good lesson too.

Sunday, May 17, 2015
Crunch looms as pay picks up but productivity struggles
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The dust has settled, though the politicians – on the winning side at least – have not yet paused for breath. George Osborne, when he has not been trying to turn the north into a powerhouse, has been laying the groundwork for renegotiating the terms of Britain’s membership of the European Union.

These are early days for both of those, so I shall leave them for this week. More interesting is whether the economy has been given a post-election splash of cold water. The Bank of England, whose praises I was singing last week, left it until the new government had its feet under the table before unveiling a downgrading of its growth forecasts.

Had the Bank told us that during the election campaign, say some, it could have eroded the Tory “stick with us for a stronger economy” message. The post-election shock was not a rise in interest rates – that is still perhaps 12 months off – but a gloomier growth outlook.

Hand on heart, I do not think we should get too excited about this. Until Wednesday, the striking thing about the Bank’s growth forecasts was how upbeat they were. Growth of almost 3% a year this year and next – 2.9% in each year - was perkier than almost all other forecasters.

Its new forecast of 2.5% growth this year (an inevitable downgrade following a weak first quarter) and 2.6% next brings the Bank more into line with the consensus. The Treasury’s latest compilation of independent forecasts has an average prediction of 2.6% growth this year, 2.3% next. There was no drama in the Bank’s downgrade. Nothing to see here.

In other respects, however, the combination of the latest very strong labour market figures and the Bank’s inflation report has exposed a dilemma for the British economy. A crunch may be looming, partly as a result of what John Hawksworth, PWC’s chief economist, describes as Britain’s “incredible job creating machine”.

Let me explain. The latest labour market numbers continued what has been an extraordinary story. In the most recent three months, January-March, there were 202,000 more people in work than in the previous three months, with the new total 31.1m. The proportion of 16-64 year-olds in work rose to 73.5%, the highest since records began in 1971, and no mean feat when 200,000 of the 1.25m rise in employment over the past two years has been among those aged 65 and over.

In the first three months of the year we were collectively working 20m, or 2.1% more hours than a year earlier and 84m more than five years before. Unemployment over the past year has dropped by 386,000 to a new post-crisis low of 5.5% of the workforce. Job vacancies, 736,000 in the latest three months, are close to their highest since records began in 2001.

The labour market is tightening quite rapidly; slack is disappearing, and the really interesting thing about this is that it is now starting to be reflected in the pay figures. The first three months were expected to be difficult for average earnings comparisons, because of a tax-related surge in bonus payments in the first quarter of 2014.

If there was a difficulty, however, pay has sailed through it. In March, total pay – including bonuses – was 3.3% up on a year earlier. The latest three months, a better comparison, showed an increase of 1.9%. The figures for the private sector, not subject to government-imposed pay limits, were 4.3% and 2.4% respectively.

For regular pay, not subject to bonus distortions, there was a 12-month rise of 2.7% across the whole economy in March, and 2.2% in the January-March period. The private sector figures were 3.3% and 2.7% respectively.
One swallow does not make a summer. Pay has ticked up before, only to slip back again. But if this is the start of stronger pay growth, which would fit the picture of a tightening job market, it opens up some interesting possibilities.

The Bank’s inflation report, and the fact that it once again downgraded its productivity forecasts, has put the focus again on this important issue. As I have pointed out before, the productivity picture is more nuanced than is usually reported. Some sectors, such as motor manufacturing, have recorded good productivity growth in recent years and output per job across the whole of manufacturing is 14% up on its recession low point in 2009. Across services the rise is 4.9%.

What is not in doubt is that productivity is a lot weaker than it should be. Had output per hour increased over the past seven years by as much as over the previous seven it would be 15% higher than it is.

For most of that seven years, weak productivity was unfortunate but not hugely problematical. It was the counterpart to strong employment growth, and thus preferable to strong productivity and weak employment. It was also accompanied by weak wages. Indeed, low productivity growth was the usual economic explanation for non-existent growth – and often falling real (inflation-adjusted) wages.

But what happens when wages pick up but productivity does not? This is when a benign combination starts turning malign. Rising real wages – and thanks to zero inflation they are rising strongly now – in combination with weak productivity means that unit labour costs go up. Unit labour costs are the key determinant of competitiveness. The risk is that they now start rising quite rapidly.

Economists would say that firms will keep a lid on pay if productivity growth remains weak. Sometimes, however, theory and practice diverge. In a tight labour market with skilled workers in short supply, businesses may have no option but to pay up.

There is, of course, a safety valve for the labour market in the form of immigration. The tighter the job market, the more employers will turn to foreign workers. Of the 576,000 rise in employment over the past year, 294,000, or 51%, has been among non-UK nationals. No wonder firms are not keen on a clampdown on net migration.

So we have reached an interesting point. Productivity remains weak but pay is picking up. Net migration and other ways of increasing the effective supply of labour – older workers and existing workers doing longer hours – can ease the pressure, as the Bank pointed out. But sooner or later something has to give. And the hope has to be that finally, it is the meaningful acceleration in productivity growth the Bank has been predicting for the past few years.


Sunday, May 10, 2015
A victory for common sense - and the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This time last week, when you could still get very good odds on a Tory majority, I missed out on yet another good investment opportunity. In other respects, however, the election showed that, outside Scotland at least, the wisdom of crowds works.

The election, and the unexpected Tory majority, was a victory for economic common sense, though I was sorry to see the Liberal Democrats so badly punished. Whatever voters thought about the future fiscal plans of the parties, they had enormous doubt about putting Labour back in charge of the economy.

Had Ed Miliband conceded when he became leader in 2010 that Labour both messed up on banking regulation and overspent, he would have endured flak but could have had a clean slate. Denying overspending right up to election day, when the numbers show it clearly with hindsight, was a fatal error.

As it is, George Osborne now faces having to accommodate a series of campaign pledges – right to buy for housing association tenants, a law not to raise any of the main taxes and £8bn more for the NHS by the end of the parliament – into a tight fiscal framework. Whether these pledges made any difference is hard to say, but compared with the alternative of defeat, these are headaches the chancellor will regards as the most minor of ailments.

What was most encouraging for me was that voters did not fall for Labour’s populist interventions. I do not want to revisit the columns of recent weeks but there was something fundamentally wrong about an agenda of price freezes and rent controls, a return to “government knows best” interventions in business and the attempt to persuade people that pain could be avoided by soaking the rich, preferably the foreign rich. I have no doubt that all this would have harmed the economy. It is good that voters recognized that.

The other encouraging thing was that the markets never panicked about the election, even when a hung parliament looked likely. For this, we should pay some tribute to the strength of Britain’s institutional set-up, and in particular the independent Bank of England.

The Bank has been a quiet place, a haven of tranquility, amid the pre-election political uncertainty. Mark Carney, no doubt enjoying a quiet cup of Nespresso with his lieutenants, was able to keep a calm eye on what looked like a close race for power in Westminster.

When Gordon Brown announced independence for the Bank five days after the May 1997 election (alongside a rise in interest rates) he perhaps did not have events of the past few days in mind.

Ed Balls, who did much to initiate and design Bank independence back then, certainly would not have expected the outcome he suffered early on Friday morning.

Had things turned out differently, he would have been chancellor this week (I don’t think we would have had an easy relationship). He almost was before the 2010 election. Now I suspect he never will be.

But the independent Bank Brown and Balls forged proved its worth in the run-up to the election, and it will do so again now.

Markets approached the election, if not in a state of serenity, then a long way from panic. The pound’s average or trade weighted value, measured by the sterling index, stood at 89.1 on the eve of the election, 1% up on its level at the start of the year, and 2.5% up on 12 months earlier. The pound is lower against the dollar (though it jumped when the election result became clear) but higher vis-à-vis the euro.

That stability, which also applies looking forward, has much to do with the fact that the Bank has control of the monetary levers.

The markets no longer wait with trepidation for a post-election rise in interest rates. Rates increased soon after the polls of 1979, 1987 and 1997. They did not after the three post-independence elections, in 2001, 2005 and 2010. They will not now.

The Bank’s nine-member monetary policy committee (MPC) deliberated on Thursday and Friday about interest rates and will announce its decision at noon tomorrow. It is fair to say that it will be the shock to end all shocks if it announces a rise. The most we can expect from Carney this week is another open letter to explain why inflation is more than a percentage point below the official 2% target.

There will be a few more “no change” meetings if the markets, which do not expect a rate rise for the next 9 to 12 months, are right. Bank independence takes the pressure off the politicians.

Where do we go from here? Osborne did not like to be reminded a few days ago that Britain has a bigger budget deficit than Greece; 4.8% versus 0.8% of gross domestic product, according to the International Monetary Fund. More comfortable for him, perhaps, is the fact that Britain’s deficit is smaller than Japan’s, 6.2%, and only a bit above America, 4.2%.

But it was a reminder that there is work to do. In contrast to Greece’s brutal austerity, most of which is complete, deficit reduction in Britain has been milder. Though much of the low-hanging fruit has been plucked, and though there are those campaign pledges to accommodate, I think it can continue to be milder than people fear, though getting from 4.8% to zero will require grit and imagination.

The interaction of weak productivity and weak wages of recent years is another challenge. It is clear from the latest US figures, weak productivity is a problem afflicting most advanced economies.

In the end, higher productivity requires an economic climate that encourages business investment and innovation.

This should be the time when it can occur, with post-crisis pressures on funding and credit availability easing. I do not think there is a serious prospect of EU exit, so there are good post-election reasons to be optimistic on productivity and investment. Let us hope so. Finally, politicians from all parties — except perhaps the Greens — talk a good game when it comes to streamlining the planning system and pushing through infrastructure and housing projects, but nothing much happens.

There is a crying need for more airport capacity in London and for investment in transport and energy infrastructure around the country. There is a similar need for much more housing. Planning is the sand that gets into the cogs and stops the economy operating efficiently. It needs fixing, and there is no reason now to delay.

Sunday, May 03, 2015
Deja vu - but the choice is starker this time
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The election is upon us, the party leaders’ voices are getting hoarser, and I don’t suppose many people would mind if they never heard a “cast-iron pledge” aimed at “hard-working families” again.

You will have heard pundits say we have never seen anything quite like this election before. Certainly the rise of the Scottish National Party, and to a lesser extent Ukip, makes it different.

In other respects things are quite familiar. To confirm my sense of déjà vu, I looked back to what I wrote on the Sunday before the May 2010 election.

All three parties were on the receiving end of a battering from the Institute for Fiscal Studies (IFS), then run by Robert Chote, now chairman of the Office for Budget Responsibility, for not coming clean about their policies. Opposition parties took their lead from the government; Labour’s refusal to spell out how it would cut spending (Alistair Darling, under pressure from Downing Street, postponed his spending review). Change the names and not much has changed.

It looked then, as now, that we were heading for a hung parliament, though the Tories were well ahead in the polls. While not then knowing there would be a full coalition, I wrote of a first budget for a new Tory government with Liberal Democrat input and the “obvious” a rise in Vat to 20%. I also warned of a post-election hangover for the economy, whoever won. The eurozone crisis was intensifying, the banking system had not been fixed and deficit reduction was just getting going.

How has the past five years gone? Just in case the LibDems do not make it into government again – and it will be a surprise if they do not lose half of their current parliamentary seats – let me praise them.

All politicians have their eyes on power but the LibDems entered coalition with the Tories in the national interest and have mainly made a positive contribution. The coalition has been more stable and less argumentative than many majority governments.

Nick Clegg has been a calming influence, Vince Cable a solid business secretary and Danny Alexander, who I remember as a young press officer for Britain in Europe, a capable Treasury chief secretary. The LibDems deserve better than the punishment voters appear likely to inflict upon them.

For Labour, the timing of the 2010 election was unfortunate. It presided over the crisis but had no time to clean up afterwards. Even so, the party has been a disappointment in opposition. The great achievement of Tony Blair was to turn Labour into a pro-business left-of-centre party.

Under Ed Miliband that achievement has been junked and, as well as “the cost of living crisis” we have had a string of policy interventions, from price freezes to rent controls, whose common theme is that they never worked in the past. It can only be a matter of time before we have a prices and incomes policy.

The Tories, and George Osborne, deserve credit for not bending under extreme pressure, particularly when the economy almost stalled in 2012. The chancellor has one big reform under his belt, the liberalisation of pensions that took effect last month, and deserves credit for recognising the importance of regional regeneration with his northern powerhouse.

In other respects it has been a bitty chancellorship, with too many initiatives and too little tax simplification. The initiatives may have been there to distract attention from the overriding need to get the deficit down or, as Treasury economists argue, it was necessary to try a series of different things, particularly to get credit flowing.

In the end, it is the overall record that matters and the coalition, under Osborne’s economic leadership, has a good story to tell. The first quarter gross domestic product figures, a 0.3% rise, were disappointing but should be taken with a pinch of salt. Their equivalent five years ago, for the first quarter of 2010, were initially reported as a 0.2% rise but now show a 0.5% increase.

There was no “sharp slowdown” in the first quarter. Non-oil GDP in the final quarter of last year was initially reported as a 0.5% rise. Last week’s preliminary reading for the first quarter was 0.4%.

Even after those figures, Britain’s gross domestic product has risen by more than 9.5% in real terms over the past five years. Non-oil GDP, which is a better measure of underlying activity, is up almost 11%.

The job market story has been astonishing, with a record 31m, or 73.4% of working-age people in jobs, unemployment falling, and private-sector job creation, almost 3m over the past five years, comfortably exceeding the near-1m public sector job cuts. It has been a long time coming but inflation at zero has restored growth in real wages.

Most of all, though deficit reduction has been slower than hoped, because of weak tax revenues, it has ceased to become a crisis issue. Britain has been brought back from the edge of an abyss which, whatever some say now with the benefit of hindsight, was real in 2010.

What about all that we have heard in the past few weeks? A positive economic story has been in danger of being drowned out by the negatives. What should have been a straightforward “sound money” approach to pushing on with eliminating the deficit has too often come over as austerity for its own sake.

As for all the gimmicks and giveaways that the parties have been showering around in recent days, the intelligent voter should ignore most of them. David Cameron, in promising to legislate against any rise in major taxes, is trying to close off the Labour charge that if re-elected he would put Vat up again. It would not have happened anyway, but the fear must have been picked up in focus groups. Like Labour’s silly pledge to reduce the budget deficit every year, there would be a get-out clause. No chancellor could deprive himself of the right to raise tax in all circumstances.

Similarly, the main parties have been trying to outdo each other by throwing money at home-buyers, whether it is the Tories’ planned very large right-to-buy discounts for housing association tenants or Labour’s stamp duty holiday on purchases up to £300,000. None of this addresses the problem of housing supply. Given capacity in the industry I will eat my hard-hat if 1m new homes are built over the next five years.

The big issues affecting the economy: productivity, improving export performance and the current account deficit, rebalancing are not in the gift of politicians. As Osborne discovered, it is one thing to talk about the “march of the makers”, another thing to deliver it.

That said, there is more of a choice this time, though the prospect of a hung parliament makes it a difficult one. Even the most expert of tactical voters could not plan their vote in a way that ensures the continuation of a current coalition. Labour voters may hate the idea of a government propped up by the SNP but may end up getting it. So might Ukip voters.

The choice, in the end, comes down to whether people favour a return to greater interventionism, and policies aimed at taxing the rich more which could make Britain a less attractive location for inward investment, together with higher levels of government debt. We will know in a few days which way the dice has fallen.

Sunday, April 26, 2015
The budget black hole still matters in this election
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It was a big week for the public finances, both where we have been and where we might be going. We can now make a judgment on the past five years and say something meaningful about the next five, though through the murk that passes for serious political debate on debt and the deficit.

Let me start with the record of the past five years. Though the numbers for the public finances are prone to revision – usually downwards in the case of the budget deficit – the Office for National Statistics’ latest figures, released on Thursday, tell the story reasonably well of the past five years.

Public sector net borrowing in 2014-15 was £87.3bn, £3bn less than was expected in last month’s budget. In five years the deficit has come down from £153.5bn, the 2009-10 figure the coalition inherited. That is a drop of 43%, though relative to gross domestic product it has fallen from 10.2% to 4.8%, a fall of more than half.

What about the debt? Public sector net debt at the end of March – the end of the 2014-15 fiscal year – was £1,484bn, 80.4% of GDP, compared with £956bn at the end of 2009-10.

It has thus increased significantly under the coalition, as it was bound to do; you cannot eliminate a £150bn-plus deficit overnight. Nigel Farage keeps saying that debt has doubled under this government, which is wrong; the rise is 55%, though it did more than double in the previous five years under Labour, rising from £448bn in 2004-5 to £956bn in 2009-10, an increase of 113%.

This measure of debt, incidentally, excludes the public sector banks, mainly Lloyds and RBS. Include them and the debt is larger, £1,796bn, but has fallen by £449bn under the coalition.

How much more has George Osborne borrowed than he planned? The official Office for Budget Responsibility (OBR) forecast in June 2010 was for borrowing of £37bn in 2014-15, so the outturn was £50bn higher than intended.

Interestingly, that June 2010 forecast envisaged that debt would rise by more than £500bn over this parliament, and it has done so. Definitional and other changes suggest, however, it is fair to say that Osborne has borrowed around £100bn more than planned.

Why has this happened? If you want a rare example of an astonishingly accurate five-year forecast, look at what the OBR was saying about spending back in 2010. It predicted £737bn of overall government spending in 2014-15 and its latest estimates suggest spending was precisely that. There was no relaxation on the spending side: the government stuck to its plans.

Where the extra borrowing has occurred has been because of the weakness of revenues, some £50bn in the latest year below what was expected five years ago. Some of that was deliberate, reflecting the aggressive raising of the personal income tax allowance to £10,000 and now £10,600. Most of it was accidental, reflecting weak earnings growth; now starting to unwind.

When you hear opposition politicians claiming that they would not have presided over such weakness in pay, treat it with the contempt it deserves. We are many decades from the era of the “going rate” and the idea that politicians can determine what employers choose to pay. What we have had over the past five years – very strong growth in employment alongside subdued pay rises – has been infinitely preferable to the alternative.

What does the recent history of the public finances tell us about the outlook for the next five years? The differences between the parties on deficit reduction are fairly clear, even if some are doing their best to obscure them. Labour, for example, wants to have its cake and eat it; selling itself to voters as the party of significantly less austerity than the Tories but not wanting voters to realise that its definition of “balancing the books” will mean borrowing £25-30bn a year in normal times, as the Institute for Fiscal Studies pointed out in a typically useful analysis last week.

Though some economists, who I would call the Martini set, strangely dismiss the need for austerity any time, any place, anywhere, there is a sensible debate to be had over whether governments should continue to borrow to invest – eliminating only the so-called current budget deficit – or whether they should go the whole hog and aim for an overall budget surplus.

The coalition, after all, had the aim of getting rid of the current deficit, not the whole lot. Gordon Brown’s golden rule was borrowing only to invest over the economic cycle. The lower the interest rates on government debt, the stronger the argument for borrowing to invest in infrastructure and other projects.

There are, however, problems with it. Politicians tend to miss their deficit targets, as we have seen. Brown’s golden rule creaking well before the financial crisis hit, and was destroyed by it. We know now that a supposedly fiscally responsible government was running a structural, or underlying, overall budget deficit of roughly 5% of gross domestic product in 2007.

The coalition followed suit. It probably never would have been credible to eliminate an overall budget deficit of more than 10% of GDP in a single parliament – and that was never the government’s aim – but even getting rid of the current deficit has proved too challenging.

Another difficulty, although I would not overstate it, is that “borrowing to invest” could cover a multitude of sins, allowing governments to boost what they define as investment without limit, although there official checks and balances on this.

The other is the opposite one: some things that should properly be defined as investment these days, such as spending on training and skills, are generally not.

The problem I have with this goes deeper, however. The IFS did its best with the thin gruel the parties provided, but was obliged to take at face value their broad promises. On their stated plans Labour will cut less than the Tories but borrow £90bn more over the next parliament.

The difficulty I have is imagining Labour cutting at all, particularly if it is reliant on Scottish National Party (SNP) support. Labour’s record on cuts is, frankly, almost non-existent. It did so after the International Monetary Fund bailout in 1976, though only under extreme duress. When Labour took office in 1997 it stuck to Tory plans for two years, temporarily earning Brown the sobriquet “iron chancellor”.

In the run-up to the 2010 election, aides and cabinet colleagues found it almost impossible to get Brown the words “cuts” at all. That was why there never was a Labour plan to deal with the deficit, merely a sketch, an artist’s impression.

Not much has changed. When pressed on the cuts Labour would make Ed Miliband mentions a couple of small-scale privileges for better-off pensioners, which would save peanuts, and then moves swiftly on. You could say the Tories and to a lesser extent the Liberal Democrats are not much better but at least they have a track record.

Labour does not. If a minority Labour government did indeed require the support of the SNP, which is committed to ending austerity even if its policies do not imply that, it is hard to see tough decisions on spending getting through the House of Commons. The deficit, which is still closer to £100bn than zero, could easily get becalmed.

After two successive five-year periods in which Britain has added more than £500bn to government debt, a sizeable black hole remains which has to be dealt with. Whether or not that matters to most voters, it should. And it matters to me.

Sunday, April 19, 2015
Parties obsess about "costings", while ignoring the elephants in the room
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

I would not want anybody to think a theme is developing here but, having warned last week that we should take economists’ views on austerity with a pinch of salt, this week I have another warning about this kind of thing.

When you see the words “fully funded” or “properly costed” attached to the plans of political parties, take great care.

Be also sceptical about fake precision. I know why it made the headlines but the difference between an International Monetary Fund forecast that there would still be budget deficit of £7bn in 2020 and the Office for Budget Responsibility’s prediction of a £7bn surplus is margin of error territory.

The IMF predicts a deficit of 0.3% of gross domestic product in five years’ time, the OBR a surplus of a similar amount. This is small change, even when you factor in the possibility that we may have a government in place which is not even aiming to eliminate the overall budget deficit.

The IMF produces its fiscal monitor every six months. The 0.6% of GDP difference between it and the OBR’s projections is not untypical of the size of the IMF’s six-monthly forecast revisions for Britain’s deficit –in either direction – not for five years’ time but for the coming year. Until they have quite a lot of monthly data to go on, forecasters struggle to get within £10bn of the deficit for the current fiscal year, let alone what it will be in 2020. The difference between a small surplus and a small deficit in five years is, as the IMF managing director Christine Lagarde has pointed out, fake precision.

This is not to say that we should just allow the political parties to say what they like, without any nod in the direction of fiscal reality. This may be good enough for those at the fantasy end of the spectrum, like the Greens and the Scottish Nationalists, but neither are going to form a government and, it is to be hoped, will have little influence on the government that is formed.

But there is also a danger in going too far the other way, in which the parties fight over a tiny amount of fiscal territory, ignoring what really matters. In this environment, the political accountants take over. So Labour was keen to show that, as Ed Balls put it: “Every policy fully costed, fully funded, fully paid for with no additional borrowing.”

The Tories followed suit with some things, explaining how they would pay for raising the inheritance tax threshold on homes to £1m and enhanced childcare (reducing pension tax relief for £150,000-plus earners) and the right to buy programme for social housing tenants (sell expensive council properties), while not spelling out how they would pay for £8bn of extra health spending, or how they would fund raising the personal allowance and higher rate threshold.

A looser approach has something to be said for it when you look at some of what else is on offer. So Ukip accompanied its manifesto with a costing exercise produced by the Centre for Economics and Business Research.

The CEBR dutifully looked at the savings from reducing overseas aid, cancelling HS2, the absence of EU contributions (when Britain exits) and scrapping the Barnett formula, and set them against the cost of Ukip’s proposals, including income tax cuts and the abolition of inheritance tax.

What it could not look at, however, was the elephant in the room. What would be the effect on the economy, and on the public finances, of Britain leaving the EU? I cannot tell you precisely what that effect would be, but it would be bigger than all Ukip’s measures combined and overwhelmingly negative for growth and tax revenues, at least in the early years. It is the elephant in the room.

There are other elephants. In December the OBR set out three different scenarios for the economy and the public finances, based on what it described as low and high assumptions for productivity – output per worker - alongside its central forecast or some recovery in productivity growth.

The differences were striking. If productivity growth stays low, essentially the deficit stays high, and government debt rises. But in a high productivity scenario, growth is stronger, the deficit comes down more sharply, and debt falls smartly as a percentage of GDP. The differences were enormous. On a high productivity scenario debt at the end of the decade would be more than £600bn lower than if productivity is weak.

But, while we should be sceptical about the ability of governments to wave magic wands and boost productivity, have we heard anything in this campaign on this subject which is remotely convincing?

Or, when it comes to the outlook for the public finances for the next few years, the oil price is hugely important. In March 2014 the OBR expected the oil price to average $100 a barrel over the next five years. Now it expects $70 a barrel.

The drop in prices was the equivalent of a tax cut that no government could have afforded. As the Ernst & Young Item Club will say in its new forecast, to be published this week, the boost to real incomes from cheap oil, weak commodity prices and supermarket price wars will trump political uncertainty as far as the economy’s performance this year is concerned. If the oil price were to rise, reversing that effect, growth would suffer, and vice versa.

To a certain extent I am saying that Harold Macmillan’s “events, dear boy, events” are more important influences than the relatively things the political parties are arguing, and often deliberately obfuscating, about but there is more to it than that.

What matters is the supply-side of Britain’s economy can be invigorated, delivering the productivity growth that would reduce the need for further fiscal pain and put government debt on a decisive downward track. Labour has proposals that for the most part would damage the supply-side by increasing government intervention, reducing Britain’s appeal to inward investors and making the labour market more flexible.

But the Tories, as noted, have done little to suggest they have taken hold of the productivity issue. And they worry many people in business with the fear, though it is exaggerated, that they will take Britain out of the EU, and by worries that they will indeed clamp down in immigration. For many in business, this is a Tory policy they hope continues to fail.

Maybe there are no votes in the supply-side, when set against the “fully costed” promises the politicians matter. But it is the supply-side rather than those which will determine our future prosperity.

Sunday, April 12, 2015
On austerity, take economists with a pinch of salt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Should you listen to economists during this election campaign? I say that in the full knowledge that it may encourage some to stop reading now, and that the excellent work done by economists at the Institute for Fiscal Studies and other bodies is rightly used as a check on the claims and counter-claims of the parties.

No, I ask because of a survey of mainly academic economists published a few days ago by the Centre for Macroeconomics, which is based at the London School of Economics but which also encompasses researchers from the Bank of England, Cambridge University and other institutions.

The survey asked two questions. One was whether the coalition’s policies had been good or bad for growth over the past five years. The second was whether the outcome of the election would make any difference to growth and employment over the next five years.

The answer to the first question was clear-cut. Two thirds of the economists questioned said that coalition policies – “austerity” – had been bad for growth. The answer to the second question was slightly less clear but the majority view was that the slower the pace of deficit reduction – the less the austerity - the better it would be for economic activity.

I know this survey because each month I take part in it, on a range of different questions. This one got noticed more than usual because of the timing and because it was picked by Robert Peston of the BBC. It was quoted during the televised party leaders’ debate.

I disagreed with the majority verdict. The coalition had been for good growth, I said, because it had pulled Britain back from the abyss and away from a fiscal crisis that could have been hugely damaging.

Sometimes it is said that fears of such a crisis were artificial and that a country with its own currency and central bank should not worry about such matters. But Britain has had more than here fair share of past crises. Attempting to spend our way to growth gave us the IMF crisis of 1976.

As for the next parliament, the most important question is not the relatively small differences in the pace of deficit reduction between the main parties but what the next government can do for the supply-side, for incentives, and for productivity.

I was not alone in saying the coalition has been good for growth. Several distinguished economists, including Patrick Minford of the Cardiff Business School, Nicholas Oulton of the LSE, Costas Milas of Liverpool and Jagjit Chadha of the University of Kent took the same view, and for similar reasons.
Minford argued that the coalition had achieved a balance between deficit reduction and destabilising the economy, Oulton that “austerity has been greatly exaggerated” and Chadha that “sound money” deficit reduction had created the room for aggressive quantitative easing by the Bank of England, alongside low long and short-term interest rates. Milas pointed to Britain’s respectable growth performance in recent years, particularly on IMF figures.

Indeed, the pattern of growth during this parliament was not, as is often said, that growth stopped as soon as the coalition started implementing austerity, roughly two-thirds of which it inherited from Labour. Growth in non-oil gross domestic product, the best undistorted measure of economic activity, exceeded 2% in both 2010 and 2011, only slowing to 1% in 2012 – the height of the euro crisis – before picking up again.

If I am honest, however, I would admit that in my response I was aiming off, as a counter to the inevitable large majority on the other side. If you ask a group of British academic economists whether austerity has been good or bad for growth, whatever the circumstances, the majority answer will be as predictable as if you asked them whether there should be more or less university funding. In that respect, most academic economic opinion has not moved much since 364 economists signed a round-robin letter in 1981 warning that Margaret Thatcher’s policies would deepen the recession. The letter famously coincided with the start of a long upturn.

The correct answer to the first question in my view, though it would not have made for an interesting survey, would have been for respondents to adopt the classic two-handed economist – “on the one hand, on the other hand” – approach. The coalition might have been good for growth, but it might not have been. It depends, and it depends on things we cannot possibly be certain about.

I cannot say for certain there would have been a fiscal crisis if austerity had been abandoned in 2010 but neither can the critics of austerity say there would not have been. We do not know what would have happened to long-term interest rates, or what the Bank would have done. Would sterling have succumbed, pushing inflation even higher and exacerbating the squeeze on living standards? Possibly, but we do not know.

Fortunately, you do not have to take just my word for this. Wouter den Haan, co-director of the Centre for Macroeconomics, who took the neutral view, put it well. “I think the macroeconomics profession doesn’t have the evidence to answer this question,” he said.

Charlie Bean, the former Bank deputy governor, another neutral, also put it well. Coalition austerity was not undertaken in the belief “it would boost demand directly but rather that it would reduce the likelihood of a loss of market confidence in the UK government's economic policies, which - had it occurred - would have necessitated a much sharper consolidation.”

Just as economists cannot really know what would have happened in the absence of austerity, so we should take with a pinch of salt their recommendations on future austerity. Indeed, for some, there should be none at all, even though Britain is running a £90bn deficit.

On this I would give some credit to Ed Miliband and Ed Balls. Though their version of “balancing the books” means running a permanent deficit of around £30bn a year, at least they recognise the need for further deficit reduction.

Both Miliband and David Cameron have found themselves up against other leaders from the smaller parties, most of whom blithely wave away the need for austerity, knowing they will not have to carry the can if Britain goes into the next downturn with the deficit still large and government debt rising. The SNP’s Nicola Sturgeon is the worst but not the only offender in this.

In 2010, the coalition took a judgment that the deficit had to be reduced to bring Britain back from the fiscal edge. Whether or not the net effect of that was to reduce or ultimately boost growth, we cannot know but it gave Britain stability in what could have been a very rocky period..

As things stand now, with the economy growing well and interest rates still low – they have not increased for the whole of this parliament – it is hard to argue that this is not the right time for further deficit reduction, alongside supply-side policies to boost long-run growth. Sensible politicians know this. They have to live in the real world.

Sunday, April 05, 2015
The economy's doing better - have voter memories of past chaos faded too?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A landmark has been passed, and sooner than expected. Living standards, measured in the conventional way, are higher than they were than the coalition took office, as George Osborne was quick to pick up on a few days ago.

Now, the last thing you want to read is somebody slapping themselves on the back but it has long been my expectation – rehearsed here on a number of occasions – that this parliament would not see the first fall in living standards in living memory, as some repeatedly said, but a rise.

The danger was that we would not know about this rise until after the election – had the recovery in real household disposable income per head to spring 2010 levels come in the first quarter of the year rather than the final quarter of 2014 the figures would not have been available until June – so it would have been a forecast rather than a cat. It is now a fact.

Of course, based on current data, the rise since May 2010 – the second quarter of 2015 – is minuscule, just 0.2%. In the circumstances, however, even that is a considerable achievement. It was always the case that the financial crisis was going to make us poorer, as was the task of tackling a record peacetime budget deficit that resulted from a combination of crisis-induced recession and the public spending splurge of the 2000s.

One of the mechanisms for supporting living standards, aggressive cuts in interest rates, had already happened when the coalition took office. Bank rate was cut to 0.5% in March 2009. In May 2010 there was little or no room to cut further. Add commodity price rises (now reversed), negligible credit growth, and the eurozone to the necessary deficit reduction measures and even a modest rise in living standards is much better than it might have been.

The real household income figures came with the latest gross domestic product numbers, which saw growth revised up last year to 2.8%, from 2.6%. Before too long 2014 growth will be shown to have been 3% or more, which is what most of us thought anyway.

We have got so used to this being described as the slowest recovery on record – which we will not know for sure until we have had years of data revisions - and to certain politicians saying there was no growth at all in the coalition’s first three years - that it is worth reminding ourselves of the numbers.

Growth in 2010 was 1.9%, 2011 1.6%, 2012 – when the euro seemed on the verge of break-up – 0.7%, 2013 1.7% and 2014 2.8%. That is an average of 1.75% a year on current data; slow growth but not no growth, at any time.

Take sharply declining North Sea production out of the figures (Scottish Nationalists please note), and you get a better picture of underlying growth. The numbers there are 2.3%, 2.2%, 1%, 1.7% and 2.9%, an even more respectable average of just over 2% a year. Not bad in the circumstances. The mistake was to think normal service could be resumed quickly in the aftermath of the biggest crisis in a century.

Not only are the official economic numbers looking better but so are measures of consumer confidence. The GfK-NOP consumer confidence index has been running since the 1970s and last month rose to its highest level for nearly 13 years.

Nick Moon, the veteran pollster, head of social research at GfK, had thought consumer confidence had hit a plateau at the end of last year after one if its strongest rises on record. In fact it has risen by eight points over the past three months. Much of this reflects public perceptions of the economic situation, up 16 points in the past year, and willingness to make major purchases, up by a similar amount.

The reason I highlight these numbers is that, as well as being a source of fierce debate among the political parties, they have the potential to be an important determinant of the way people will vote on May 7.

The usual narrative on this is that the Tories should be doing a lot better than they are in the polls given the state of the economy, to which the usual counter is that they would be doing better if only most people felt the recovery, which they are not. It takes time, in other words, for an upturn to filter through.

There has to be some truth in that. Real household disposable incomes per head are a mere 0.2% up on the spring of 2010. That average conceals a lot of falls, as well as rises. Most analysis suggests the rises have been particularly concentrated among older voters, who my mailbag and e-mails tell me are inclined to be a little curmudgeonly about it, and do not regard the past few years as a cause of great celebration.

Even so, most people do not, either, ask themselves the Ronald Reagan question – am I better off than four or five years ago? They look at how they are doing now, and here the numbers are rather good. Real disposable incomes per head are up 1.9% over the latest 12 months. Aggregate wages and salaries have risen by 5.3% at a time of virtually no inflation. A rise in employment is included in that but it is still a hefty increase, the biggest for seven years.

All of which raises a second possibility, supported in particular by the consumer confidence index but also by some of the other numbers. This is that, for many voters, the fear has gone. Falling unemployment and low inflation make for a very low misery index but they also make people worried less about the future.

The days when the banks were collapsing are a long time ago. The period when Britain was running a budget deficit which caused the then head of Pimco, the world’s biggest fund manager – which counts Ed Balls’s brother among its senior employees – to say Britain was sitting on “a bed of nitroglycerine” is also a long time ago.

A Labour government may well be chaotic – I cannot remember an opposition less prepared for government – but the potential descent into national chaos under Labour evoked by David Cameron and George Osborne is a hard sell to people who are generally upbeat. People may not think ‘crisis, what crisis?’ but the extreme conditions of 2007-9 have faded in the memory.

Governing parties face a dilemma on this. They want living standards to be rising and for recovery to seem secure, and both those conditions are currently met. The risk for the coalition is that they have also made the economy safe for Labour in the eyes of some floating voters.

It has to be better to have rising confidence and a strong economy to sell to voters than the alternative. It should pull votes back to the Tories and the Liberal Democrats and there is some evidence of that in the polls. But the better people feel, the less they may fear change. That is why this election is far from plain sailing.

Sunday, March 29, 2015
Don't forget asset prices. Cutting rates is not the right response to zero inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A big fat zero. No inflation at all. Though it is not guaranteed, a run of deflation – prices lower than a year earlier – seems highly likely in the next 2-3 months.

For many people this is uncharted territory. Though retail price inflation fell to zero in February 2009, and was negative for the following eight months, this reflected the sharp reductions in interest rates of the time. Inflation measured by the consumer prices index (CPI) remained positive throughout.

No, you have to go back 55 years, I suspect before many readers were born, for anything like this. The Office for National Statistics (ONS) has usefully modelled the current CPI back to January 1950. It shows that inflation last fell to zero in December 1959, and was negative by 0.5%-0.6% for three months.

Zero inflation is proving to be good news for the economy. Retail sales volumes rose by 0.7% last month and were a booming 5.7% up on a year earlier. As far as retailing is concerned, deflation is not merely on the way. It has been with us for some time.

So what the ONS describes as average store prices fell by 3.6% in the 12 months to February, a record. Stores include petrol stations, so much of this reflected the drop in fuel prices over the past year. But prices were also modestly lower for both food and non-food stores. Falling prices genuinely are putting money into people’s pockets.

At this point it is customary to warn that, while a temporary bout of deflation is a good thing, you would not want to make a habit of it. Indeed.

There are, however, a couple of other aspects to this. History rarely repeats itself but if we look at what happened when inflation last fell to zero and turned negative, it did not usher in prolonged deflation.

By the end of 1960, inflation was heading back up towards 2%. By the end of 1961 it was 4% and by the middle of 1962 it was 5.6%. The 1960s were not a particularly high inflation period, but even with a very low start, prices rose by an average of 3.4% a year over the decade.

Not only that, but it is easy to forget how recent this experience of ultra-low inflation is in Britain. After four years above the 2% official target, inflation only dropped below it at the beginning of last year. As recently as September 2011, Britain had an inflation rate of 5.2%, and as recently as last 2013, the country’s “natural” or normal inflation rate seemed to be 3% rather than 2%. It is far too early to say whether anything fundamental has changed.

The bigger danger is that this brush with deflation will take central bankers’ eyes off the ball. Before the crisis, the criticism was that the obsession with inflation targets allowed a toxic build-up of risk in the financial system and a huge rise in asset prices, particularly house prices but also financial assets.

There is a powerful echo of that today. At exactly the same moment the ONS released the latest inflation numbers a few days ago, it also published figures showing house prices up by 8.4% on a year earlier. Though this is slightly off the pace of last year, the juxtaposition neatly encapsulated the question I get asked very often: How can inflation be so low when house price are rising so fast? Housing, after all, is a significant component of most people’s expenditure.

Inflation measures do not deal particularly well with housing costs. But those that do incorporate housing, the ONS’s CPIH measure and the old retail prices index, while not showing zero inflation, have it very low; 0.3% and 1% respectively.

Nor is housing the only asset price which has been rising strongly. The stock market had a touch of the wobbles last week but is well up on its level of a year ago. Government bonds, gilts, show a 12-month rise of more than 15% on average.

The Bank of England would say some of this is deliberate. Keeping long-term interest rates low has been an aim of policy, and the counterpart to that is rising gilt prices. The housing market has been part of the recovery story, and a deliberate policy target, and a by-product of that is higher prices. Whether or not there is a government bond bubble remains to be seen but there is not a housing bubble yet, and the parts of London where there was the greatest risk of it has been gently deflating.

The risk, however, is that leaving interest rates too low for too long inflates new bubbles. Already the sharp drop in inflation has persuaded the two hawks on the Bank of England’s monetary policy committee (MPC), Martin Weale and Ian McCafferty, to drop for now their call for higher rates.

Mark Carney, the governor, having tried to pull the markets back from the view that rates were never going to go up, has in recent speeches pushed them out again, citing not only the threat from “persistent external deflationary forces” but also the pound’s rise against the euro. Andy Haldane, the Bank’s chief economist, reckons that “policy needs to stand ready to move of either foot”, and that in his view the next move in rates is as likely to be down as up.

That worries me. Kristin Forbes, another MPC member, rightly pointed out in a London Evening Standard article that most domestically-based measures of inflation are stable. Service-sector inflation, which is above 2%, has actually edged up in the past two months.

To be fair, Carney, along with Ben Broadbent, a deputy governor, made clear on Friday that they will not over-react to the drop in inflation, and that they expect the next move in rates to be up.

The one-off effects of the big fall in oil prices will drop out over the next 6-9 months, though second-round effects could last for a little longer. Even so, the right response for the Bank to either high or low oil prices is, to quote Rudyard Kipling, “to treat those two impostors just the same”.

That means preparing the ground for a gradual “normalization” of interest rates over the next 2-3 years, in other words slowly raising them starting later this year or early next, and forgetting talk of further cuts. After all, nobody would forgive the Bank for squandering the gift of low inflation it has been given, and repeating the experience of the early 1960s. And nobody would forgive it for allowing dangerous bubbles to inflate again. Inflation at zero is a happy accident, it should not be allowed at develop into an nasty accident.

Sunday, March 22, 2015
No roller coaster - but the tail wagged the dog in a curious budget
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This is a strange world, and we have just had a rather strange budget. There was some jam today, though it was spread pretty thinly. There was also less austerity tomorrow, as suggested here last week. But the overall impression was odd.

George Osborne had two aims: to demonstrate that only he can be trusted on the deficit and debt, and to kill the silly idea that he was planning, if re-elected, to cut public spending to the levels of the 1930s.

The fact that achieving both of these aims means, at this stage, merely ensuring consistency with the forecasts of the independent Office for Budget Responsibility (OBR) – which even its best friends would say has a forecasting record that leaves a lot to be desired – added to the Alice in Wonderland quality of all this.

We have policy driven by forecasts which will almost certainly turn out to be wrong and, perhaps even worse, we have a fiscal watchdog, the OBR, which has produced a “rollercoaster” projection for spending by government departments over the next few years (down very steeply then up), which no sane person thinks is remotely likely.

How did it come to this? How did the forecasting tail come to wag the policy dog? Why did the OBR, having given us that 1930s’ comparison after the autumn statement in December, give us the rollercoaster this time?

For Osborne, having determined that he would not fight the election with a giveaway but by reinforcing his reputation as the man who brought Britain back from the fiscal brink, it was necessary to resort to a few gimmicks to achieve his original aim of having public sector debt falling as a percentage of gross domestic product by the end of the parliament.

This, you may remember, was one of his original 2010 aims, but appeared to have been pushed out well into the next parliament in 2012. Wrenching it back again was a coup, though lewss of one than it looks.

I imagine the conversation between Osborne’s team and the OBR went along the lines of; Treasury: “What do we need to get debt falling in 2015-16?” OBR: “Quite a lot because that is not what our forecasts are showing.” Treasury: “What if we sold some assets?” OBR: “That could do it.”

So debt is coming down, from 80.4% of GDP this year, 2014-15, to 80.2% in 2015-16, if the new forecasts are right. To achieve it, Osborne has raided the piggy bank. £13bn of Northern Rock and Bradford & Bingley assets acquired in the crisis will be sold off, as will £9bn of Lloyds Bank shares. Nothing wrong with that – their place is in the private sector – but if the timing of the sales is simply to meet a debt target there is a real danger that taxpayers will not get value for money.

The other imperative, to get away from the charge that he was cutting spending to 1930s’ levels as a percentage of GDP, produced even stranger outcomes. I thought I had been pretty hard on the silliness of this comparison, but the eminent economic historian Professor Nick Crafts took me to task for not being even harder. In the 1930s, he points out, public spending was typically 25% of GDP. Spending on social services – education, health, welfare, pensions and housing – was 9% of GDP, compared with 28% now. Overall public spending by 2020 will be at least nine times what it was in real terms in the 1930s.

Nonsensical or not, Osborne felt obliged to respond to it, hence the bizarre lurch at the end of the parliament, when the projected budget surplus of £23bn for 2019-20 (1% of GDP) is slashed to £7bn (0.3% of GDP). Public spending, having fallen, suddenly starts rising strongly, simply to get the ratio of public spending to GDP up from 35.2% - that 1930s’ comparison – to 36%, Gordon Brown in 2000 before the splurge. The tail, again, is wagging the dog.

Because of this, which I suspect happened very late in the budget process, and because of what in the end seems to have been a serious breakdown in relations between the Treasury and the OBR, we now have little idea about public spending in the next parliament. The OBR will not take account of Osborne’s planned £12bn of welfare cuts and £5bn of savings from reducing tax avoidance and evasion because the former are not coalition policy and have not been detailed, and the latter have not been detailed.

The result is a bit of a mess. I am sure that, as the always reliable Paul Johnson of the Institute for Fiscal Studies put it: “We won’t be on the OBR’s rollercoaster” - whoever is in charge. But the OBR could only work with the material it had and the upshot is that, even with an independent fiscal watchdog and work by bodies such as the IFS, we know precious little about the main parties’ plans. I criticised Labour in 2010 for ducking a comprehensive spending review. It is little better now.

Which is a pity. Even on the OBR’s cautious forecasts, it is quite likely that the lion’s share of austerity is already behind us, given the positive effects of lower inflation and lower interest rates on government debt. Osborne’s claim in the budget that Britain is “walking tall again” chimes with most of the data.

For two years the economy has been growing well, even as deficit reduction has continued. Britain compares well with her G7 peers.

The labour market has been a particular success, with the employment rate a record 73.3%, a near 2m increase in employment in this parliament in the context of public sector job cuts, and the growth in jobs concentrated in full-time roles; 85% of the net new jobs created over the past two years.

Real household disposable incomes per head are an appropriate measure of living standards and, as I have frequently pointed out here and the OBR confirms, will be higher at the end of this parliament than at the beginning. This year should see the sharpest rise in living standards since 2001.

It is a good electoral platform. Osborne’s very obvious message was that all this and more would be put at risk by a change of government. Repeated often enough, it should move the Tory dial up in the polls. It is a pity, however, that the budget, and it should be said Labour’s response, merely reinforces the impression that politicians are playing games with the voters. Transparent, it is not.

Sunday, March 15, 2015
Osborne: some jam today, will there be less austerity tomorrow?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

George Osborne’s sixth budget may not go down as his most memorable – the expectation is that it will be a political rather than an economic event – but it will be no less important for that.

The backdrop to the budget is better than the chancellor might have hoped, and not just the “feelgood” effects discussed here last week. The public finances are also looking a little better.

Price Waterhouse Coopers (PWC) predicts that the fall in oil prices and lower gilt (government bond) yields will reduce the budget deficit in each of the next five years compared with the Office for Budget Responsibility’s autumn statement forecast. The cumulative undershoot, £32bn, is not huge but it not to be sneezed at either.

Goldman Sachs predicts a deficit undershoot of £8bn for this year alone, followed by £13bn next year, 2015-16. Its prediction of £83bn of borrowing this year would take Osborne close to halving the deficit in cash terms, in addition to as a percentage of gross domestic product. Next year’s £63bn prediction would take us closer to normality; in the five years leading up to the crisis, the last government borrowed an average of £45bn a year in today’s prices.

The improving public finances should allow Osborne to sprinkle around a few sweeteners; some jam today. They should include a further raising of the personal income tax allowance, now and next year, as reported by this newspaper last week, as well as populist measures on beer, wine and petrol duty. I think we can safely assume that the chancellor will not take advantage of the fall in oil prices to push up petrol duty.

He is constrained by the fact that the deficit, while falling, is still very large, and that this will still be a coalition budget. But Osborne may still give us some old tunes, such as inheritance tax, if only as an ambition if re-elected rather than hard action.

Though pre-election budgets are often holding operations – Alistair Darling’s 2010 effort did not stick long in the memory – there is nothing to stop Osborne being bolder, and I am sure he will try to be. Setting out a series of announcements that will only be implemented if you are returned to office has a certain appeal.

Can Osborne combine jam today with less austerity – or at least a less austere image – in the next parliament? He has a good recent record of wrongfooting Ed Balls, his Labour opposite number, on the deficit and the recovery. He is helped by the fact that his opponent rarely resists the temptation to exaggerate.

The Balls’ approach is often to think of a number and double it. Balls is intelligent – in a New Statesman profile the former cabinet minister Peter Hain says he has the best economic brain in parliament – and affable. But he comes over as a bulldozer and, perhaps because he is intelligent enough to know when he is laying it on too thickly, never entirely convincing.

So in a speech last week he said Osborne had borrowed “a staggering £200bn” more than he planned in 2010. The true figure, confirmed last month by the Institute for Fiscal Studies, is £100bn.

Balls said wages after inflation are down by more than £1,600 a year since 2010. The true figure, using the consumer prices index he was instrumental in making the main measure of inflation, is £700 a year. Adjusted for the old retail prices index, no longer regarded by the Office for National Statistics as being worthy of national statistic status, the fall is bigger but well under £1,600 a year.

As for public spending, and Balls’s “unprecedented” £70bn of cuts, the figures are clear. In cash terms overall public spending will rise by £43bn between now and 2019-20; the duration of the next parliament (assuming it lasts five years). In real terms there is a planned cut, though less than £20bn. To get to £70bn, or anything like it, you have to add up all the areas where the coalition is planning to increase spending, including public investment, and subtract the rest. It is, to say the least, an odd approach.

That said, as I wrote here on February 8, Osborne has got himself into a less than ideal position on public spending. Spending has been cut by much less than most people think (day-to-day spending has not been cut at all in real terms) yet the chancellor is in danger of being seen as a mad axeman, determined to slash the state for ideological reasons.

The Office for Budget Responsibility (OBR), by saying after December’s autumn statement that Osborne’s plans implied the lowest public spending to gross domestic product (GDP) ratio since the 1930s, 35.2%, gave Labour an economic lifeline. It is an almost meaningless comparison. But it has political force.

Part of the chancellor’s task, therefore, is to convince voters, and sceptical financial markets, that his fiscal plans are credible, and can be delivered without extreme pain. Part of the reason Goldman Sachs is more optimistic than the OBR about the budget deficit over the next 2-3 years but not over the longer-term is because, as its UK economist Kevin Daly puts it, it doubts the spending numbers outlined in the autumn statement will be delivered. If there is another coalition after the election, they may never have to be.

Will the public finances improve by enough to allow Osborne to say that he can meet his ambition of delivering a budget surplus while running higher levels of spending than OBR projections suggest?

Those projections suggested spending would need to fall to 36% of GDP to generate a small budget surplus; slightly higher than when Gordon Brown was chancellor in 1999-2000. But to get a surplus of 1% of GDP, it would need to fall to 35.2%.

Can Osborne cast off those comparisons with the Neville Chamberlain era? He could, though it should be said that the Treasury is playing down the extent of any improvement in the public finances since the autumn statement.

They probably would say that but officials say there are swings and roundabouts: lower oil prices hit North Sea revenues first and may or may not boost other revenues later. Low inflation and gilt (government bond) yields produce some savings on debt interest but the effect should not be overstated.

Even so, the budget this week looks like being a combination of some jam today coupled with a little less austerity tomorrow. Whether it works, and whether it is even noticed by voters, will become clearer in the next few weeks. Depending on what the election throws up it may not, of course, be the only budget this year.

Sunday, March 08, 2015
The feelgood factor's back - will it work for the Tories?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The feelgood factor is often elusive. But it is back. Consumer confidence is riding high, wages are once more outstripping inflation and unemployment continues to fall.

The misery index, invented by the American economist the late Arthur Okun, is arrived at by adding the country’s unemployment and inflation rates together. Currently, with an unemployment rate of 5.7% and inflation of just 0.3%, it is at its lowest level since the late 1960s, according to Capital Economics. Both Capital and Oxford Economics expect further falls – a lessening of misery – as inflation and unemployment fall further.

If misery is in retreat, confidence is strong. The GfK-NOP measure of confidence, which has been running for more than three decades, has risen by 30 points over the past two years, is well above both its long-run average and pre-crisis levels and has not been higher for more than a decade.

The Institute for Fiscal Studies attracted a lot of coverage a few days ago for its report that living standards – real household incomes – are broadly back to pre-crisis levels. In fact that was not news; the Office for National Statistics said as much last year on the basis of its real household disposable income per head measure.

There was, though, plenty of interest in the IFS report. One surprise was that the fall in real incomes as a result of 2008-9 recession, the deepest in the post-war period, was at 4% smaller than the 5.7% drop in the early 1980s. That is testimony to The Bank of England’s alacrity in cutting interest rates hard, Alistair Darling’s temporary fiscal stimulus and the fact that benefits were protected until well into the coalition’s period in office.

The IFS also noted that real incomes are now increasing, if not at a riproaring pace, with some of the fastest increases coming through for young people, who were disproportionately hit by the fall in real wages.

The rise in real incomes now under way should mean this will not, as Labour sometimes claims, the first parliament in living memory in which living standards have fallen. The ONS real income per head measure is still a little lower than it was when the coalition took office in May 2010. In the third quarter of 2014, the latest data available, it was 0.8% lower than in the second quarter of 2010. When the numbers are available for the second quarter of this year, which unfortunately will not be until late September, it should confirm an admittedly small rise in living standards.

Labour appeared to switch in recent days to a safer claim, which is that real wages will fall during this parliament. That is still more likely than not. Since May 2010 average earnings have risen by 8.9% while consumer prices are up by 11.1%. But the gap is smaller than many think, and it is closing, though official earnings growth may be adversely affected in the next couple of months by bonus distortions a year ago.

Even so, the Recruitment and Employment Confederation, in its latest report on jobs, published on Friday, noted that permanent and temporary employment is increasing strongly, and that salaries are rising at a “marked” pace across a range of sectors. Engineering, construction, medical and executive and professional roles are where staff demand is strongest and running up against skill shortages.

Nothing will change the fact that the rise in living standards now coming through compares unfavourably with previous recoveries, as the IFS noted. That is part of the price the economy has paid for the cushioning of the fall in real incomes when the crisis hit. It is also a reflection of weak productivity.

It is mainly, and politicians on both sides should be honest about this, the consequence of the permanent loss of prosperity inflicted upon the economy by the crisis. We lost a chunk of gross domestic product that we will never get back, and weak living standards have been a part of the economy’s adjustment to that.

What we do not know, of course, is whether the improving feelgood factor showing through now will translate into votes. Though there is tentative evidence that the Tories are edging up in the polls, they have yet to decisively break away from Labour. In Britain’s electoral system, where the existing boundaries favour Labour, neck and neck is not good enough for the Conservatives. George Osborne’s March 18 budget, of which more next week, may provide a trigger for stronger Tory support but that remains to be seen.

Though the default position for many pollsters is that elections come down in the end to the wallet and purse, what are known in America as “pocketbook” elections, there are important exceptions to the rule. In 1997, Labour won a landslide victory in spite of the fact that real household disposable incomes per head rose by more than 9% in the three years leading up to polling day.

In 1979, astonishingly, real incomes per head rose by more than 15% in just two years leading up to the May poll of that year but voters rewarded Labour by electing Margaret Thatcher.

In both cases there were extenuating circumstances. For Kenneth Clarke, chancellor in 1997, it was an uphill struggle against public perceptions of a Tory party fractured on Europe, tarnished by sleaze, and living with the embarrassing legacy of Britain’s exit from the ERM (exchange rate mechanism) in 1992. For Labour in 1979, there was the humiliation of the International Monetary Fund bailout of 1976 and, more importantly, the winter of industrial relations’ discontent of 1978-9.

This time, the Tories cannot hope to match the pre-1997 and pre-1979 rises in real incomes, still have issues with Europe and have a harsher image with many voters than the actual austerity the coalition has imposed justifies. Labour has the legacy of being in charge when the economy crashed in 2008-9, a leader who does much worse than his party in the polls and a perception, which even many of its best friends would agree with, that it is not ready for a return to government.

It is better for a governing party to be fighting an election against a backdrop of strongly rising employment and rising real incomes than the alternative. Whether the latter has come too late, and will be enough to overcome voter scepticism, remains to be seen. Either it will be a pocketbook election, or another exception to the rule.

Sunday, March 01, 2015
If Europe keeps growing, Brexit won't happen
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Greece’s negotiations with its creditors have provided us all with an entertaining glimpse into the dysfunctional family that is the eurozone. So we have had Wolfgang Schauble, Germany’s finance minister, playing the part of the stern, unbending father figure, almost taking it beyond caricature.

Yanis Varoufakis, his Greek counterpart, has won admirers for his style and his straight-talking approach, the antithesis of most professional politicians. But ultimately he has been cast in the role of the rebellious teenager who insisted over and over again that he would never tidy his bedroom but has now got the vacuum cleaner out.

It remains to be seen where the Greek episode goes next. Syriza’s tactics have alienated many of its eurozone partners and the “deal” (or no deal) it achieved – which if not nothing was not far from nothing – has led to understandable disillusionment at home. Maybe Greek voters always took their new government’s promises with a pinch of salt but Syriza has made the mistake of over-promising and under-delivering, the opposite of what good governments try to do.

There are further episodes in this family struggle to go but, in a curious way, and despite its dysfunctional aspects, it has probably strengthened the euro. The chances of Greece leaving are smaller than they were, and the risks of other governments seeking to overturn austerity – which in many cases has already run its course – are quite low. Germany may not have won many friends but it has prevented what it would see as fiscal anarchy. “Grexit” – Greek exit – is off the agenda for now, and the 19-member euro lives to fight another day.

Less noticed amidst all this is that the eurozone economy, having looked like something of a basket case just a few months ago, has been quietly gaining strength. Maybe most people and businesses in Europe never took the prospect of Grexit seriously, or if they did were not troubled by it, but the eurozone is looking better, even before this month's bond-buying quantitative easing programme from the European Central Bank.

It began with the official figures for growth in the final quarter of 2014, published earlier this month. Though eurozone quarterly growth of 0.3% was weaker than Britain’s 0.5% expansion, it represented an improvement from the 0.1% and 0.2% increases of the previous two quarters. Some eurozone members, notably Germany and Spain, both of which saw a 0.7% rise in gross domestic product, outperformed Britain.

That improvement has carried through into this year, according to the purchasing managers’ index for the eurozone produced by Markit. Its composite measure for February showed a third successive monthly rise, was at its highest for seven months and showed the fastest pace of job creation since 2011.

Germany’s official unemployment figures showed a 20,000 fall for February, with the jobless rate of 6.5% remaining at a record post-unification low. With two of Germany’s biggest industries – metals and electronics – having struck a 3.5% pay deal, Oxford Economics predicts that this year will see the biggest rise in real household incomes since 1991.

Even France, which seemed to be in real trouble, is looking up. Unemployment fell by more than expected in January, admittedly from a record high of 3.5m, and consumer confidence is rising. Italy, judging from its purchasing managers’ survey, is growing. Ireland, Spain and Portugal are looking better.

Eurozone unemployment remains much too high, at 11.4% of the workforce, but is coming down. Growth in the money supply M3, a necessary precondition for continued economic growth, perked up to a perky 4.1% in January.

Nobody is suggesting, of course, that the eurozone is enjoying anything other than a modest recovery. If it grows by 1.5% this year, a percentage point or so below Britain, it will have done well. The eurozone is benefiting from a similar “good” deflation boost to spending power as Britain, though with a bigger risk that deflation becomes entrenched. But a weaker euro may help head off that danger, while also boosting exports.

Though we sometimes take pleasure in the eurozone’s dysfunctional family tearing itself apart, stronger growth in Europe is good for Britain. Much of the growth disappointment in Britain in the early stages of recovery was down to the eurozone’s woes. The better it does, in general, the better we do too.

The performance of the eurozone also has another important British dimension. If Labour policies worry business, the prospect of an in-out EU referendum is the big concern for many of them about the Conservative agenda.

I think fears of “Brexit” – Britain leaving the EU – are overstated. A few days ago a YouGov showed record support of 45% for staying in the EU (in a question that has been asked since 2010), against 35% of people who would vote to leave. The 10-point margin in favour of staying in was also the highest since 2010.

Attitudes to remaining in the EU reflect two things. One is the state of Britain’s economy. The better that people feel about the economy in Britain, the less they will be inclined to take a risk by voting to leave the EU. The second is the state of the eurozone economy. Support for staying in the EU was just 28% during 2012, at the height of the eurozone crisis, and head of Mario Draghi’s “whatever it takes” commitment to holding it together.

A situation in which Britain’s economy is doing pretty well and the eurozone growing slowly but surely is one in which voters in Britain are likely to opt for the status quo, as they did in Scotland when faced with a similarly big decision last September. Open Europe, a think tank, puts only a 17% probability currently on Brexit.

Things could change, of course, between now and 2017, though other polling evidence suggests that voters will not casually vote for EU exit. When people are asked whether they would want to remain in a renegotiated EU, support is around three to one in favour.

That could change if current evidence of a eurozone upturn proves to be a false dawn, and the euro lurches back into crisis. Those who want Britain to stay in the EU have a vested interest in Europe doing better.

Sunday, February 15, 2015
'Good' deflation boosts growth - will it bring forward rate rises?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It is easy to get depressed about deflation. Deflation and depression are linked in the mind for good reason. In what economic historians call the first great depression, which lasted from 1873 to 1896, prices fell by a fifth. In the more familiar second great depression, in the 1930s, prices in 1934 were 12% lower than in 1928.

So why, when these gloomy associations are so powerful, has the Bank of England’s response to the prospect of deflation in Britain in the coming months been something close to hanging out the bunting?

Mark Carney, the first Bank governor to predict deflation (though he prefers to call it “temporarily negative inflation”) since Montagu Norman in the inter-war years – and back then the Bank did not do anything so vulgar as issuing a public forecast – was positively upbeat about the “stronger underlying dynamics” affecting the British economy.

The halving of oil prices over the past six months, the main factor pushing inflation towards negative territory is “unambiguously positive” for the global economy, he said. It is also, according to the Bank, manna from heaven for Britain.

Three months ago it expected real post-tax household incomes to rise by just 1.25% this year. Now it expects a 3.5% increase, which Carney reminded us will be the best for a decade. The difference, by the way, is equivalent to a boost to spending power of roughly £25bn.

Some of this will be familiar territory to those of you who have followed my recent pieces on this theme. This, the Bank is saying, is “good” deflation with knobs on, a gift from America’s frackers and the Organisation of Petroleum Exporting Countries to every oil-consuming economy, including Britain.

It is a very far cry from the “bad” deflation of the late 19th century and the 1930s, when falling prices were the product of economic weakness. Bad deflation which becomes entrenched is dangerous for many reasons, not least because the real burden of debt increases, which further hampers growth. A vicious cycle of stagnation and deflation can develop.

The surprise about the Bank’s “good deflation” assessment is not that it is upbeat but that it is quite so upbeat. Britain will enjoy three more years of overall economic growth of close to 3% (2.9% 2015, 2.9% 2016, 2.7% 2017), driven by strongly rising consumer spending but also robust business investment.

Consumer spending will grow at 3.75% this year and 3.5% next, without a meaningful drop in the saving ratio. Households will be spending out of their strongly rising real incomes, with inflation close to zero for most of this year, and set to drop below zero for a month or two in the spring.

Unemployment will continue to fall. Export growth will outstrip that of imports this year. The members of the monetary policy committee (MPC), far from reading from the depression script, are overcome with optimism. Economic spring has sprung early. Had the Treasury produced such a forecast less than three months before a general election, it would have been accused of producing politically-driven predictions. The independent Bank is, of course, above such things.

There are two questions about this. One is whether the Bank may have overdone the optimism, and is at risk of overdosing on happy pills. The other is whether the net effect of a bout of temporary deflation will end up bringing forward the first hike in interest rates.

Is the Bank over optimistic? In its last published minutes, some MPC members fretted about the response of employers to an inflation rate that will fluctuate either side of zero in the coming months. If workers are experiencing no inflation, or a month or two when prices are lower than a year earlier, why award pay increases? Could pay settlements follow inflation down, notwithstanding David Cameron’s plea to firms to boost wages?

The risk is there but the Bank’s central forecast has chosen to ignore it. Currently, average earnings are rising by less than 2%. This year, it predicts, they will accelerate to a 3.5% growth rate – more than it expected three months ago – rising further to 4% in each of the following two years. Such increases, which imply real wage increases running well ahead of productivity, are central to the Bank’s upbeat forecast.

I don’t think there will be an outbreak of pay freezes as a result of the zero inflation/deflation in coming months. If there was it would elevate the risk of prolonged deflation. But it also looks a bit of a stretch that in this environment earnings will soon be rising at double their current rate. The mechanism is that a tightening labour market – falling unemployment – will leave employers with little option but to be more generous on pay. But it is a big uncertainty.

The other is whether the impact of cheap oil on the global economy will be quite so unambiguously good. There is no doubt that it will be beneficial. The question is whether it is beneficial enough to offset other dampening factors, including the continuing uncertainties in the eurozone.

To take my second question, and assuming the Bank is right to be so upbeat, could this bout of temporary deflation bring us closer to the first interest rate hike since 2007, and the first move in any direction since 2009? Some of the headlines generated by the Bank’s inflation report suggested that it was ready to cut interest rates further and unleash another bout of quantitative easing if the temporary dip into deflation proves to be more enduring.

Though that is true, it is not the message the Bank wanted to convey. It thinks its main response on those circumstances would be to keep interest rates at 0.5% for longer.

The broader message was that this year’s zero/negative inflation will pave the way, not only for stronger growth now but for higher inflation and interest rates later, as that stronger growth feeds through to higher prices. Though this was the first inflation report to allow for the possibility of deflation, it was also the first in a long time to suggest that inflation in just over two years will be above the official 2% target.

That does not mean the MPC is going to shock us with sudden and dramatic interest rate hikes; “gradual and limited” are still the watchwords. It does mean, on this forecast at least, that by the time Carney leaves the Bank in the summer of 2018, he expects to have a few rate hikes under his belt.

Sunday, February 08, 2015
Osborne needs to be careful with that axe
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

George Osborne has, in spite of everything, a pretty good story to tell on the budget deficit. The scale of the borrowing problem the coalition inherited in 2010 was huge, and was subsequently discovered to be even bigger.

Yet the deficit has come down significantly. Depending on which measure you choose, and where the final destination for borrowing is, between 55% and two-thirds of the necessary action has been taken. Getting there requires a bit more than one more heave but looks far from impossible.

The question is why the chancellor is choosing to present the task ahead in quite the way he does. Stay with me is his message, and there will be years more of spending cuts. Not only will taxes not be used to help achieve the remaining reduction in the deficit but they will be cut. Merely eliminating the deficit, meanwhile, will not be enough. The aim will be to achieve a permanent surplus. I shall return to this curious pre-election message in a moment.

First, the record, and I draw on the Institute for Fiscal Studies’ always excellent annual green budget, which has been published for more than three decades, and is often more interesting than the budget itself. There is also an interesting new report on debt from the consultancy McKinsey.

What has been the story of fiscal policy on Osborne’s watch? Many people think that in 2010 he pledged to eliminate the budget deficit by the May 2015 election. That is not the case. The aim was to get the so-called cyclically-adjusted current budget deficit down to zero (and beyond), but public sector net borrowing – the overall deficit – was predicted to be 2.1% of gross domestic product this year, 2014-15.

There has been slippage, quite a lot of it, so the overall deficit is officially predicted to be 5% of GDP this year. But that slippage is rather less than often portrayed.

Borrowing over this parliament has been higher than Osborne hoped but, as the IFS points out, the true figure for the cumulative overshoot compared with the coalition’s 2010 plans is £100bn, rather than the £200bn Labour is using in its election literature.

Had the plans sketched out by Labour before it left office been followed, the IFS says there would have been “significantly more borrowing”, which would have deferred but not avoided “the need for greater fiscal consolidation”.

The other misunderstanding about fiscal policy is that the chancellor, worried about a stagnating economy, somehow abandoned deficit reduction in 2012, thereby paving the way for recovery.

Again, that is not the case. What actually happened, as the IFS points out, was that official estimates of the size of the “structural” budget deficit – that which is not dependent on the economic cycle – increased between 2010 and the end of 2012. Osborne could have tried to compensate for that underlying deterioration but chose instead to defer the additional deficit reduction needed until the next parliament.

There are therefore three components to Britain’s deficit problem. There was the structural deficit Labour was running before the crisis, estimated to be between 3.9% and 5.3% of GDP. There was the increase in that deficit as a result of the crisis, and there was the further deterioration when it became clear that the supply-side of the economy – and productivity growth – had been damaged.

How much of the deficit has been eliminated? The IFS, noting Osborne’s aim of achieving a budget surplus of 1% of GDP by 2020, calculated that 55% of the tax has been completed, with 45% still to go. It is worth noting, however, that on the original aim of merely eliminating the current budget deficit (in other words continuing to borrow to invest), the chancellor is rather closer to finishing the job.

The IFS also used figures from the International Monetary Fund to compare Britain with other countries. They show that the scale of underlying deficit reduction in some countries has been staggering. In Greece it has been 20.3% of GDP, Iceland 17%, Ireland 9.9%, Latvia 8.2%, Portugal 8.1% and Spain 6.7%.

Underlying deficit reduction in Britain has been 6.6% of GDP, with 3.5% still to go. That ranks only seventh among advanced economies to date, a far cry from the idea that some kind of mad Frankenstein austerity experiment has been carried out. Another myth, that America under Barack Obama has eschewed austerity, is confounded by the figures. America’s deficit reduction has been 5.8% of GDP, not a million miles from Britain’s.

Indeed, figures I highlighted last week showing Britain is further above its pre-crisis level of GDP than all but two other G7 countries – Canada and America – give the lie to the argument that austerity has been to blame for weak growth. Germany, France, Japan and Italy have all had much less action to reduce their budget deficits, typically less than half that in Britain, and much weaker growth.

The other encouraging part of the story is provided by McKinsey, in their report Debt and (not much) deleveraging. Government debt has risen in Britain, as everybody knows. But Britain is rare in that corporate and household debt have fallen in relation to GDP. The result is that the increase in overall debt – leveraging – has been much smaller in Britain than in most other advanced economies.

So Britain is in 13th place overall in what McKinsey describes as real-economy debt, well below Japan, and below France, Italy, the Netherlands, Sweden, Denmark and others. That is a big change.

So there is much to commend about what has been achieved. Why then, to return to the question I posed at the start, is Osborne risking that he will not be around to finish the job by parading the hair shirt?

If more than 1% of voters know the difference between eliminating the cyclically adjusted current budget deficit and achieving an overall budget surplus, I would be surprised. Even if they do, many would share the scepticism of a good proportion of economists that it will ever be achieved.

If there is private polling showing that people want further deep cuts in public services, it runs counter to all the public polling I have seen. Instead, the chancellor’s commitment to achieving his budget surplus through such cuts has opened him up to the dishonest but potentially potent charge that he is taking the state back to the pre-NHS 1930s.

The tax cuts that the Tories are promising, notably raising the personal allowance to £12,500, are mainly more of the same. Many people would like to see the higher rate threshold raised but are likely to take the promise that it will happen with a pinch of salt. Increasing the inheritance tax threshold was a vote-winning move in 2007 but times have changed.

So I am genuinely puzzled. Osborne has a pretty good story to tell on deficit reduction and Labour has very little credibility on the issue. It would have been enough to say that he was sticking to his original plan (eliminating that cyclically-adjusted current budget deficit)- which is now Labour and Liberal Democrat policy - but that it is taking a couple more years to achieve it, allow us to finish the job, etc. Then, if the wind is fair, you can press on with trying to achieve that overall surplus.

Instead, he in danger of being portrayed as a mad axeman shrinking the state for ideological reasons, and he has allowed Ed Balls, his Labour shadow, as well as his coalition Liberal Democrat partners, to claim that they occupy the centre ground on deficit reduction.

There may be method in what looks like a bit of madness. As I say, I can’t quite see it.

Sunday, February 01, 2015
Consumers are buoyed by the 'feel-better' factor
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A month into the year and questions about the recovery are already being asked. Growth slowed at the end of last year, with the smallest quarterly rise in gross domestic product for a year.

Are these the “red warning lights” David Cameron warned about coming into sharp focus? Is the recovery past its sweet spot? And what happened to that boost from lower oil prices that we have all been talking about?

The answer is to the last question is that it is still there. As Professor Peter Spencer, chief economic adviser to the EY Item Club puts it, if you put money into the hands of the British consumer, you can safely assume that he or she will spend it.

This is not just conjecture. Figures on Friday showed that the main measure of consumer confidence in Britain, produced by GfK-NOP, rose strikingly in January, by five points.

Every measure of the index rose, with people’s perception of their financial situation over both the past 12 months and the next 12 months each up by four points, their perception of the general economic situation over the past 12 months up by 5 points and over the next 12 months by four. Their willingness to make major purchases rose by six points on the month.

Even more dramatic are the comparisons with a year ago. People’s assessment of how the economy has been doing is up 15 points, while perceptions of their own financial position have shown a 10-point improvement. As Michael Saunders, an economist at Citi, puts it: “The ‘feel-better’ factor is back.”

There is a similar message in the Markit household financial index. Though launched only in 2009, the depths of the crisis, its January readings were the best in six years.

Nor is this just a theoretical “feel better” factor. The CBI, in its latest distributive trades survey, said retailers enjoyed “robust” sales growth in January, even after an exuberant Christmas. Not only did 39% more retailers say sales were up compared with January last year than reported falls, but they were also optimistic about prospects for this month. “Consumers have a bit more money in their pockets,” said Rain Newton-Smith, the CBI’s director of economics. “We expect to see this translate into strong sales growth in the months ahead.”

This, it should be repeated, came after a very strong festive season. Retail sales volumes rose 2.3% in the final quarter of last year, their strongest for 12 years.

Why is it happening? None of this should be too much of a surprise. The most visible price in the economy is for petrol, displayed in big letters outside every service station. Petrol prices have come down from an average of 131p a litre to an average of 106p.

To update a calculation I did in December, the fall is equivalent to a substantial tax cut. Had the chancellor achieved a 25p a litre cut in the price of petrol through duty reductions, it would have cost roughly £13bn. Add cuts in diesel and household gas tariffs, and the indirect effects of cheaper energy on other prices, and it is huge.

A report last April by the Treasury and HM Revenue & Customs, entitled “Analysis of the dynamic effects of fuel duty reductions”, suggested lower fuel prices have lasting growth-boosting effects, for both firms and households. It is not the only boost.

Employment growth continues to be strong, though its pace has slowed a little in recent months. Nevertheless, it is up more than half a million in the past year, overwhelmingly for full-time roles.

Nor is the usual dampener for consumers — higher interest rates — looming as a worry. Andy Haldane, the Bank of England’s chief economist, visiting north Wales, suggested in an interview with the Daily Post that the Bank is in no hurry to raise rates, as noted here last week, but that when they do rise they may do so at no more than half a percentage point a year.

That is his personal view rather than the collective view of the Bank’s monetary policy committee but, if correct, it suggests higher interest rates are not going to get in the way of growth for several years.

The big reason why people are more optimistic, and converting that optimism into higher spending, is that the cost-of-living crisis is over. The Labour party’s narrative is that this is a miserable recovery accompanied by falling living standards. The evidence from the surveys is that this kind of thing will increasingly fall onto deaf ears. Combine falling unemployment with low inflation and rising living standards and you have a recipe for optimism.

All this is good news for the government, though the Tories are inching rather than racing up in the polls and the Liberal Democrats have yet to emerge from the political doldrums.

There are those who say, despite George Osborne and Cameron’s claim this is all due to their “long-term economic plan”, it has nothing to do with it. The coalition is a lucky beneficiary of events outside its control. There is some truth in that, but those who live by the cost-of-living sword must also die by it.

Much of the squeeze on real wages in recent years came from price changes in global energy and commodities outside the government’s control. You cannot blame them for one and expect them not to claim credit for the other.

What about those GDP figures, which showed that while 2014 was the best for growth since 2007, the economy expanded by “only” 0.5% in the fourth quarter?
Apart from the fact that not so long ago 0.5% growth would have been regarded as a cause for celebration, the usual health warning applies. Part of the reason for weaker growth was a drop in the volatile construction sector. If that figure does not get revised I am prepared to eat a very large hat.

Similarly, energy production was hit by the mild weather in the first half of the winter. That is not a meaningful loss of momentum.

Meanwhile, the figures also showed that Britain’s recovery compared with where the economy was before the crisis now ranks behind only Canada and America in the G7. Not so long ago, people bemoaned the fact that we were not doing as well as Germany and France. No longer.

Of course, we want stronger growth in exports, though here we are reliant on the European Central Bank’s quantitative easing injecting some life into the eurozone economy and Greek contagion not spreading. And of course we want businesses to respond to rising domestic demand by investing more.

But if consumers are more optimistic, more than half the battle is won. Their spending accounts for 62% of GDP. There was not much of a growth pause at the end of 2014, and it should not last.

Sunday, January 25, 2015
Near-zero rates and QE look to be here to stay
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It has been a big week for monetary policy, led of course by the European Central Bank’s €1 trillion-plus quantitative easing (QE) programme but also here, with the two hawks on the Bank of England’s monetary policy committee having unexpectedly flown into the dovish nest.

The only big central bank that seems to be on track to raise interest rates this year is the Federal Reserve, with the markets expecting a move from the summer onwards. Even that may be a movable feast, however. On Wednesday the Bank of Canada, admittedly managing monetary policy in an economy vulnerable to oil price falls, surprised markets by cutting its main interest rate from 1% to 0.75%.

If you needed evidence that we are in a highly unusual period for monetary policy, there has been plenty of it in the past few days. This is becoming the near-zero decade for interest rates, even leaving aside the unusual and controversial tool of QE. Not since the period covering the 1930s, the Second World War and the few years after it have we seen anything like it, and Bank rate was higher back then than today’s 0.5%. And we did not have QE.

Will we ever see the return to anything like normal as far as monetary policy is concerned? Let me start with the European Central Bank’s QE “bazooka”, before coming closer to home.

There are a few things you need to know about eurozone QE, announced on Thursday by the ECB president Mario Draghi. The headline announcement of €60bn (£45bn) a month of asset purchases from March until at least September next year was a bit bigger than the markets were expected. The total size of the programme announced is €1.08 trillion, but about a third of that will be in assets other than eurozone government bonds, mainly private assets such as covered bonds and asset-backed securities.

Only 20% of the programme is what you might call unconstrained or pure QE, in which Europe collectively covers the losses if the assets bought fall below their purchase price. The rest will be undertaken by national central banks and any losses will be the responsibility of the taxpayers of the countries concerned. This was to meet German concerns that the citizens of Hamburg or Heidelberg should not be responsible for losses on Italian or Spanish bonds.

Will it work? It goes without saying that the eurozone’s problems go deep, and that supply-side reforms. Including more flexible markets, are essential, as well as infrastructure investment and growth-friendly tax policies. It may be that no amount of QE can rescue a flawed system.

Eurozone QE is late, six years after America and Britain, and is not as big as it looks. The bazooka is roughly twice the size of the UK’s QE programme but for a eurozone economy five times the size. “Too little, too late” – and compromised - was what characterised Japan’s QE programme in the early 2000s. The risk, as with other things, is that Europe repeats Japan’s experience.

I would not be entirely negative. The announcement of QE has pushed down the euro, which will help eurozone exporters. In a short time Draghi has established a reputation for pulling the eurozone back from the brink. Eurozone QE is a necessary but not sufficient condition for making things better. The question is whether there is rapid follow-through on the other necessary things.

What about Britain, where the latest developments were more of a hand-gun than a bazooka? The news last week was that the two rate-hikers on the Bank’s monetary policy committee (MPC), Martin Weale and Ian McCafferty, who from August to December last year had been voting to increase the cost of borrowing, this month changed their view.

Having previously argued that the MPC should “look through” the temporary weakness in inflation caused by falling oil and commodity prices, the scale of those falls finally persuaded the two to blink. With Bank staff saying it is 50-50 whether inflation, currently 0.5%, goes negative at some stage in the coming months, they feared that raising rates now could lock Britain into permanently very low inflation; well below the 2% target. They have not necessarily become doves for ever, but it is hard to see either voting for higher interest rates for many months.

It means that, as we approach the sixth anniversary of 0.5% Bank rate in March, there can be no solid expectation that we will see a hike this side of the seventh, in March 2016. Some analysts have already stretched out their expectations until 2017. Near-zero starts to look like the new norm.

Those who follow what the Bank does are entitled to be a little puzzled. Less than 18 months ago Mark Carney, its governor, set out his original forward guidance on rates. This was that the MPC would consider rate hikes when the unemployment rate, then 7.8%, fell to 7%, which the Bank did not then expect to happen until 2016.

Well 7% has come and gone. The latest figures, also out last week, show unemployment has dropped to 5.8%. Job vacancies, at 700,000, are at a record level. Pay growth is picking up, which at a time of very low inflation is translating into real wage increases.

True, there is tentative evidence that job creation has slowed from its previous breakneck pace. Yet this is, by any measure, a labour market which is tightening, alongside an MPC which has become more dovish. To the extent that we were being guided by the governor, we were being guided in the wrong direction.

Would I be raising rates now? No. But there have been times over the past few years when I would have done, notably when inflation was above-target. Had it been premature to do so, at least it would have established the principle that rates can go up as well as stay low. Rates would have risen to a level at which they could have been cut. As it is, the longer they stay the same, the higher the hurdle for a move. As things stand, the circumstances in which the MPC would raise rates are hard to see. High inflation did not do it and neither did strong growth. Very low inflation rules it out.

Though most of the attention has been on Europe, the likely delay in any interest rate increase has implications for the Bank’s £375bn QE programme. I do not think we will get more QE from the Bank but until rates begin to rise it will continue to reinvest the proceeds of any of the maturing gilts (government bonds) in its portfolio. Until rates have risen quite a lot, to a level from which they can “materially” be cut. QE, like near-zero rates, looks to be here to stay.

Sunday, January 18, 2015
How to prevent good deflation turning bad
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

How unusual is deflation? The Office for National Statistics has an inflation measure which goes back to 1800, mainly based on the retail prices index (RPI). In nearly 70 of those years, prices fell -Britain experienced deflation - though the closer you get to today, the rarer the phenomenon is.

So in the 19th century, slightly more than half the years, 52, had annual deflation. This dropped to 15 out of 50 in the first half of the 20th century, including much of the 1920s and the early 1930s. From 1950 onwards, however, deflation has been very unusual. In only one year, 2009, did prices fall on the ONS’s measure, by 0.5%, and this only because it was distorted by the very sharp reductions in interest rates. Other measures showed modest inflation even in the depths of the crisis.

To add a bit more historical perspective, prices at the end of the 19th century were 34% lower than that at the start. Some of that reflected developments in commodity prices, but much of it reflected technical progress and lower prices for industrial products.

The story of the 20th century was very different. Prices at the end were 73 times those at the start, 72,000% higher. Most of that occurred in the second half. While prices in 1950 were 3.5 times their level in 1900, in 2000 they were 20 times their 1950 level. Most of us have only known inflation, and often very high inflation.

Did the deflation of the 19th century inhibit economic growth? I only have numbers going back to 1830 – the Bank of England’s “three centuries of data” series - but they show that real gross domestic product in 1900 was more than four times its level 70 years earlier. Mostly it was good deflation.

I write this because, as everybody will have noticed, Britain’s inflation rate fell to just 0.5% last month. On this measure, based on the consumer prices index which is not directly influenced by interest rate changes, inflation in 25 years has only been this low once, in May 2000. Nobody took any notice of this particular measure back then. Only when it became the Bank of England’s target measure a few years later did we pay attention.

It seems certain that records will be broken in the coming months. Petrol and diesel prices have further to fall, as do household energy bills. Inflation should fall to zero, and may even temporarily dip below it. It is unlikely that we will get deflation for the year as a whole, but perfectly possible that inflation this year will be the lowest in more than a quarter of a century. To do that it needs to get below 2000’s annual inflation, which was 0.8%.

We will never again see the wild harvest-related swings from inflation into deflation we saw in the 19th century – one year prices could be up 12%, the next down 23% - but there is an echo of that in what is happening now. At a time of low inflation, big swings in commodity prices can tip economies from a modest rise in the price level into deflation.

A few weeks ago I wrote here about “good” and “bad” deflation, a distinction which many have taken up. Good deflation arises from a favourable international price shock, the kind we are seeing with the sharp fall in the price of oil and other commodities. Bad deflation arises from weak demand.

Back in 2000 Britain was also benefiting from “good” influences, which bore down on inflation, most notably the so-called China effect which reduced the prices of manufactured goods, even while service-sector inflation remained quite high.

Today, as then, Britain does not have deflation, and may not do so, but it has “good” low inflation, again mainly arising from international influences. The EY Item Club, in a forecast to be published tomorrow, says that inflation will average close to zero this year and by boosting real disposable incomes – it predicts a very strong rise of 3.7% this year – the fall in inflation will help deliver growth of close to 3%; 2.9%. It is, it says, a timely boost, given that the economy was losing some momentum at the end of last year.

I agree with that. The right way to view the drop in oil prices is as the equivalent of a tax cut. “It will provide a major boost to disposable incomes and consumption in 2015 and help stay the hand of the MPC (monetary policy committee) on interest rates,” says Item. “It should also stimulate our European and American export markets and support business confidence and investment.”

Is there a risk that good deflation, or good low inflation, could turn bad? As one who wrote some years ago that the sustainable price of oil was closer to $40 a barrel than $100 or $150, I have an interest in the current low price. But there is a danger that for oil and other commodities, the fall becomes a rout. In some respects it already has, hitting the stock market. If oil falls too far now, it guarantees that it will be higher later, because exploration and development will be cut back sharply.

There is also a risk that those who benefit from falling oil prices and very low inflation do not use it. In microcosm in Britain, we now have BP cutting back and it and other North Sea producers crying out for help, while most non-oil businesses are in rude health, official figures showing that their profitability in the third quarter of last year was the highest for 16 years. But if they sit on that cash rather than invest it, the benefit will be lost.

Similarly, if employers were to use the opportunity of zero inflation to drive down pay increases, the real income boost to demand would be muted, if not lost, a point taken up by David Cameron on his trip to Washington.

What is true of Britain is also true globally. The World Bank does not usually cause much excitement with its economic forecasts but its downgrading of global growth prospects did sent a frisson through the markets. It still expects world growth to accelerate this year, from 2.6% in 2014 to 3%, but not as much as it did. It made the point that the beneficiaries of lower oil prices – most countries – use those benefits to more than offset cutbacks by the oil producers.

John Llewellyn of Llewellyn Consulting makes a similar point, and warns of the danger that while the first effects of the falling oil price are to boost consumer spending in the West, the second will be to hit exports to countries hurt by it.

Those effects must be counteracted, in Britain and elsewhere. In Europe it means building on the benefits of the lower oil price with some aggressive quantitative easing. We must not look this gift horse in the mouth.

Sunday, January 11, 2015
Why politicians struggle to even trim the size of the state
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It may already be too late, given that the election campaign is already in full swing and the claims and counter claims about the public finances and public services will be flying thick and fast for many weeks to come. If you are not confused now, you very soon will be.

But, just in case there is still time to offer some context, let me attempt to do so. All of my figures come from the independent Office for Budget Responsibility. Some of them may surprise you.

Let me start with the numbers for overall government spending, total managed expenditure. George Osborne is accused of wanting to take Britain back tom the 1930s, while the Tories, for their part, say Labour would take us back to the fiscal irresponsibility of the Blair-Brown era.

In inflation-adjusted terms, 2013-14 prices, there was a massive increase in total managed expenditure over the 2000-2010 period. Spending in real terms in 2009-10, £737.3bn, was 51% higher than it was in 1999-2000, £488.5bn.
Think about that for a second. In a decade, the size of the state increased by just over a half. It was the biggest sustained increase in public spending in British history.

Some may say that the comparison is unfair, because spending was skewed sharply higher at the end of the period by the economy’s dive into crisis and recession. That, however, is not true. The increase in spending in the last 2-3 years was not out of line with its average in the rest of the 2000s. The rise in spending was overwhelmingly deliberate.

Now, using those same OBR figures, updated following last month’s autumn statement, what is in prospect? This is what might surprise you. Osborne’s overall aim over the 10 years 2010-2020 is to reduce total managed expenditure from £737.3bn in 2009-10, again in real terms, to £703.7bn in 2019-20. That is a reduction of 4.6% over 10 years, less than a single year’s increase during the splurge years.

How much of this has already been done? Slightly more than half. Total managed expenditure in 2013-14, £719.9bn, was 2.4% down on its 2009-10 level.

That is also broadly the message from the deficit numbers. There has been a slightly odd debate about whether the budget deficit has halved or not. As far as most economists are concerned, it has, public sector net borrowing having fallen from 10.2% of gross domestic product in 2009-10 to an estimated 5% of GDP this year. Adjusted for the cycle, it has dropped from 8.1% to 4.2% of GDP. So we are halfway there to eliminating the deficit, or slightly less than half to meet Osborne’s ambition of running a budget surplus of 1% of GDP

What would happen under Labour to overall spending? Nobody in British politics has a copyright on fiscal credibility but Labour has more work to do to convince voters after leaving office with a record peacetime budget deficit. Its softer ambition of just eliminating the so-called current budget deficit, in other words continuing to borrow to invest, would allow it a real level of public spending some £45bn higher than the Tories in 2019-20.

That is quite a big difference, though it does not mark a return to the years of irresponsible plenty. Total spending in real terms would be about 4% higher than now, compared with 2% lower under the Tories.

Why, if the numbers suggest either a modest real cut in overall spending – to take it back to 2007 levels - or a small increase under Labour, is the air so thick with talk of savage cuts, of a return to the 1930s? Why are NHS accident and emergency departments creaking so badly, just a few years after the health service – which did disproportionately well in the Blair-Brown era – received a near-doubling of real resources?

The answer, and it is a depressing one, is in three parts. The first is that, for the most part, once government spending is spent, it is spent, gone for ever.
Gordon Brown used to talk about investment in public services but the overwhelming majority is here today, gone tomorrow. You can talk about infrastructure spending and, perhaps, investment in education. But, even in health, where it should, spending more now does not spend you can spend less tomorrow.

In fact, and this is my second point, spending more now means you probably need to spend at least as much tomorrow. Public spending is subject to a ratchet effect. Once it has been increased, to whatever level, it becomes curiously hard to cut. New entitlements quickly become established provisions, over which fierce battles are fought. Increasing spending is the easiest thing in the world for any politician, cutting it much harder.

The third reason is that, perhaps because of this, politicians do not like to cut. Osborne has got a reputation as the most savage wielder of the axe since Margaret Thatcher was in office, despite the fact that day-to-day spending has not been cut. There was remarkable unity between Labour and the Conservatives on cutting public capital spending – government investment – the coalition ran with the plans it inherited from Labour.

But public sector current spending is in real terms a little (1%) higher than its 2009-10 level, and has been flat over the past 3-4 years. On the assumption that public investment will not be cut further, day-to-day spending has to take the strain.

I should say that even a steady level of current spending has required spending cuts – deep for local government and some departments and mainly without an adverse effect on services – because debt interest has risen by around £20bn and welfare spending is up.

Even so, the fundamental question remains. Why is it so easy to increase government spending, even enormously as happened in the 2000s, and so hard to cut it?

My e-mail inbox is not necessarily typical of the population as a whole, but a constant theme of it is that people are uncomfortable with high and rising government debt, currently £1,457bn, and want to see it reduced. Treasury projections in the autumn statement suggested that you could only get debt back to 40% of GDP in a reasonable timeframe (it is currently 79.5%) and reduce it in cash terms by running the kind of budget surplus (1% of GDP - if it is not used for tax cuts) Osborne has as his ambition.

If there is an appetite for reducing government debt, is there one for cutting public spending, even relatively modestly in overall terms? I am not sure. People tend to approve cuts except when they affect them. The problems in the NHS are a walking advertisement for more public spending. Amid the dossiers of uncosted spending commitments and claims of a return to the 1930s, you will struggle to find a sensible debate on spending in the coming months.

We need such a debate, over what the priorities should be for spending and how non-priority areas can be cut back. Without it, the public finances will never be properly repaired and we will lurch from one crisis to the next. It can be done. The question is whether it will be.

Sunday, January 04, 2015
Election and the current account will weigh down on sterling
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It would be nice not to have to look ahead into the reminder of 2015 at this point. Barely have we got over thinking about 2014 when another year comes along.

Nor, just a few days in, do we yet have much of a feel for how 2015 is doing. How much better, and potentially much more accurate, this piece might be if I were able to postpone writing it until after the May 7 general election or, even better, until November.

But needs must – it has to be written now - and I mention the election for good reason. There are some general election years which pass without much direct impact on the economy. These, it should be said, are usually the predictable ones.

So the elections of 1983, 1987 (Margaret Thatcher’s second and third victories) , 1997, 2001 and 2005 (Tony Blair’s three wins) all coincided with periods of strong growth and saw no significant post-election slowdowns.

John Major’s surprise April 1992 victory probably gave the economy a boost: it only really started growing after it, while Gordon Brown’s defeat in May 2010 was followed by slower growth as the eurozone crisis and austerity (Labour’s delayed measures and the coalition’s new ones) kicked in. I note, however, that the infamous snow-affected drop in gross domestic product at the end of 2010 has now been revised away by the official statisticians.

That is now water well under the bridge but, as readers often remind me, these downbeat initial estimates for GDP do have a wider effect on confidence. That late 2010 GDP estimate was no exception.

This year’s general election will have an effect, I think. Those effects could be profound if Labour were elected and proves to be as anti-business in practice as some of the party’s rhetoric currently suggests. But the Conservatives also have work to do to demonstrate that deficit reduction can be both fair and effective, and also to convince voters that they are doing the right thing. Voters and markets tend not to fret too much about the deficit as long as it is coming down.

The bigger short-term worry is over the economic impact of political uncertainty. There is a good chance that the outcome of the May election will be inconclusive. There is a possibility that there will have to be a second election within the year, something that has not happened since 1974.

Last September’s Scottish referendum provided a glimpse into the economic impact of political uncertainty. Though cause and effect cannot be conclusively proved, a 1.4% drop in business investment in last year’s third quarter could have been driven by fears of a break-up in the UK.

A more visible effect could be for the pound. Sterling’s fall in the second half of last year, from $1.70-plus to the mid $1.50s was more of a gentle trickle than a rout. But political uncertainty, in combination with a current account deficit running at £27bn a year (6% of GDP) and the prospect of the Federal Reserve hiking interest rates before the Bank of England could put significant pressure on the pound. I am normally wary of joining the pack and predicting dark days for sterling. But I would be surprised not to see it drop decisively below $1.50 over the next few months, though it could rebound after the election, depending on result.

Sterling should rise against the euro, into the 1.30 to 1.35 range I have long predicted, though that may not compensate for its dollar fall.

How will growth survive the politics? The growth numbers were thrown into some disarray by pre-Christmas revisions, as noted last week. It seems likely that 2015 will see slower growth than in 2014, though not by too much. Against the political uncertainty there are positives, including the prospect of real – after-inflation – wage rises. The consensus growth forecast for 2015 is 2.6% and 2.5% is a nice round number.

One of the lessons of last year was not to over-estimate inflation, which dropped to 1% by November and spent the whole of 2014 below the 2% target. Economists expect it to be heading back towards the target by the end of the year – around 1.7% - though this may not have fully factored in the recent weakness of prices, particularly oil prices.

I expect oil prices to fluctuate in a $50-70 a barrel range and, in spite of the risks to sterling, inflation is likely to start the year very weak – quite a bit below 1% - and end it close to 1%. Continued low inflation will, of course, help deliver real wage rises. Forecasters expect nominal wage increases – pay rises in cash terms – of around 2.5% this year. That will provide decent support for consumer spending. Business investment may weaken around the election but the hope has to be that this is temporary.

Does the prospective weakness of inflation mean the Bank of England can stand down on interest rates and leave it another year before adjusting a Bank rate that has been stuck at just 0.5% since March 2009? This is a tough one. There is no question of a big interest rate hike in 2015. The question is whether there will be a small one. Most economists think there will be, with the highest end-year prediction for a 2% rate.

I am torn on this one but think if there is a move it will be a token one, in anticipation of higher inflation to come later. So, just a quarter-point hike in 2015, to 0.75%.

Will the job market continue to perform minor miracles? As we moved towards the end of 2014 there were subtle changes in labour market performance, including what we can hope is the start of a sustained rise in productivity in the third quarter. I doubt we will see employment growth of close to 600,000, as in 2014, though 300,000-400,000 is quite likely. The wider measure of unemployment should drop from 6% to 5.5% while the claimant count, currently 900,000, should come down to 700,000.

That leaves the question of the twin deficits. Even while the budget deficit has been gradually improving – and we should see firmer signs of this when the January tax numbers are published next month – the current account deficit has been getting worse.

At one time I thought that sterling’s 25% depreciation in 2007-9 would bring a big improvement in Britain’s external position. In fact it is getting worse. The current account of the balance of payments was in deficit by £62bn in 2012 and £77bn in 2013. The £27bn deficit in the third quarter of last year puts Britain on track for a £100bn deficit in 2014. The fact that trade is less to blame than a deterioration in investment income does not make it easier to bear. There has to be an improvement in 2015, though perhaps only to a deficit of £70bn, but even that is more in hope than firm expectation.

The one thing one can say with certainty about 2015 is that there will be surprises, not all of them nice ones.

Sunday, December 28, 2014
A better year than most expected
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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The table to accompany this piece is available on www.thesundaytimes.co.uk

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

What did we make of that? Whether we should lay it down and save it for later (rather than lay it down and forget it, as for some recent years) , there is no doubt that 2014 was a good year for the economy. It started well and ended better. A year ago there were doubts about whether the recovery starting to build would last. Now we know it did.

The job market continued to perform minor miracles, with the latest figures showing a rise in the number of people in work of 588,000 over the past year, 95% of them full-time roles. Unemployment has dropped by more than 450,000.

The icing on the cake was provided by the drop in oil prices in the final months of the year and the consequent weakness of inflation. Strong growth and low inflation are an unusual combination. At the end of the year Britain has an economy growing by 3% alongside inflation of just 1%.

That November inflation rate of 1% will not mark the low point for inflation in this cycle; Mark Carney has his inkwell filled ready to write that letter of explanation next month when it drops further. It is also one reason why real wages – earnings adjusted for inflation – have begun to rise in recent months.

I took part in a debate organised by the Resolution Foundation in January in which there was unanimity that 2014 would be the year of the real wage rise. All the panellists have been saved from red faces. Eventually 2014 was the year of the real wage rise.

On interest rates, things blew a little hot and cold. This time last year we were still in the early phase of Mark Carney’s forward guidance, which pointed to no rate rise until 2016 (conditional on unemployment no falling too fast).

Though markets were sceptical about the Bank of England’ forecasts given the pace of the fall in unemployment even 12 months ago, few expected an early move in rates. That changed in June, the Bank governor’s Mansion House speech, in which h he appeared to point the way towards a hike before the end of this year. Things move on from that, but only as far as an early 2015 hike by the start of autumn. Now are close to coming full circle to the original guidance.

Who successfully steered their way through all these hurdles? Regular readers will know that for very many years, going back to the 1990s, I have been running an annual league table for forecasters, based on their ability to get closest to the outcomes – or what we current believe to be the outcomes – for the traditional four goals of economic policy; growth, inflation, unemployment and the balance of payments, together with one of the instruments of policy – interest rates.

People have asked me why I do not include other important variables like the budget deficit. This is not due to Ed Miliband-style amnesia but simply because, while the deficit is clearly very important, the timing is wrong. We do not get a decent handle on the outcome for the budget deficit for the fiscal year until almost the middle of the calendar year.

A word on the data used in this year's comparison. Two days before Christmas the often-exasperating Office for National Statistics had one of its periodic bouts of revision madness, just a few weeks after a huge shake-up of the gross domestic product figures.

Its revisions, going back to 2013, will initially make 3% growth for 2014 more difficult to achieve though I and the Bank of England have no doubt that in the fullness of time 2014 growth will be at least that. As last year, when the revisions were in the other direction, it is unfair that forecasters are judged on the whims and timing of the official statisticians' revisions. We have been a 3% growth economy for many months.

That was the Office for Budgets Responsibility's December number, and the consensus among independent economists two weeks ago. So it is the number I use for the comparison.

Similarly, while the pre-Christmas balance of payments figures will probably push up the current account deficit for 2014, I have stuck with the December consensus figure (few were close to even the smaller deficit anyway).

Anyway, who got the economy right in 2014? This year’s clear winner was Capital Economics. Many years ago Roger Bootle, its founder, wrote a book called The Death of Inflation. Forecasting that inflation would have another near-death experience was one of the reasons for Capital’s triumph.

It is not its first success. It topped the table in 2005, came second in 2011, and has done well in other years, interspersed with the occasional off year.

Mention should also be made of Peter Spencer and his colleagues at the EY Item Club, sponsored by the accountants formerly known as Ernst & Young. Item stands for independent Treasury economic modellers, named because when the Treasury model was made available to outside users many years ago, a group of businesses got together to use it to forecast the business climate.

Things have changed. The Office for Budget Responsibility is now the official forecaster and Item has had to adjust. But it is still turning out good forecasts.

I must also mention Kevin Daly and his team at Goldman Sachs and Michael Saunders at Citigroup, third and fourth. Goldman topped the table last year, which can sometimes be a prelude for a slump to the bottom of the table next time. To stay close to the top shows skill and tenacity. The same is true for Citigroup, and regular strong performer over the years.

Where did forecasters go wrong? Mainly by overestimating inflation. At the start of the year most forecasters expected inflation to stay above the official 2% target, in some cases significantly so. Some thought Carney would have to write an open letter explaining an inflation overshoot. In fact, inflation dropped below the official target in January and has stayed below it all year. For once, it surprised on the downside.

How did I do? My forecasts, published on January 5, were for 2.75% growth, 1.75% inflation, 1m unemployment and Bank rate staying at 0.5%. The one I got wrong was the current account, which I expected to narrow to £42bn rather than widen further.

That forecast would have been enough for eight points, enabling me to share the glory with Capital Economics. But that would be unwary. You cannot be judge, jury and winner at the same time.

So congratulations to Capital, and to the forecasters who ran them close. Next year promises to be just as challenging, if not more so.

Sunday, December 21, 2014
Don't be too afraid of the big bad wolf of deflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A few days ago something happened which I have not experienced for a very long time, if ever. Inflation fell to just 1% and will surely go even lower when the figures for December are published next month.

This will mean that Mark Carney will be obliged to write an open letter to George Osborne to explain why inflation has deviated by more an a percentage point from the 2% target. This will also be, for now at least, a unique occasion.

There have been 14 such Bank of England governor letters since Gordon Brown announced Bank independence in 1997. All of them were written by (Lord) Mervyn King, and all of them were to explain an inflation overshoot; a rate of more than 3%. This will be the first undershoot letter and, while Bank governors are meant to be neutral on these things, Carney wouldn’t be human if, with interest rates already at record lows, he will find this one easier to write.

Why is 1% so unusual? After all, the Office for National Statistics said last week that this was merely the lowest rate of consumer price inflation for 12 years. Twelve years ago, however, we did not know much about the consumer prices index. It was promoted by Brown in 2003 – and became the Bank’s target – ostensibly to make it easier for Britain to join the euro, which may surprise you. This was because, as a “harmonised” inflation measure, it was used by other countries in Europe.

In the early 2000s, we still used the retail prices index, and its close relative, the retail prices index excluding mortgage interest payments (RPIX). Both fell very sharply in the crisis in 2009, but by that time we had moved on. Until then the RPIX measure had never been as low as 1% and you had to9 go back to 1960 for the last time RPI inflation was 1%. Even I wasn’t following these things closely then.

The great inflation that followed means that prices now are 21 times what they were in 1960. For most of the past half century or so, a 1% inflation rate would have seemed like a fantasy.

If there is a rule about these things, it is that as soon as inflation falls to low levels, people start screaming about deflation; a sustained fall in prices. Thanks to one silly comparison, we are supposed to be heading for the lowest public spending since the 1930s. It is not a giant leap, for some, to imagine that we are heading for the deflation of that decade.

People should calm down, for three reasons. The first is that, while it is possible if oil prices were to collapse to, say, $40 a barrel, inflation could go negative, it is unlikely to stay negative. Even in the highly uncertain conditions of 2009, a sharp fall in oil and commodity prices passed through only into temporarily low inflation. What economists call “base effects” – you can only benefit from a one-off price shock once – are likely to push inflation higher as we move into the latter part of 2015.

Second, it is very clear where the downward pressure on prices is coming from. Food and non-alcoholic drinks were 1.7% lower last month than a year earlier, reflecting lower commodity prices and supermarket competition. Fuels and lubricants for cars were 5.9% lower, as a result of the drop in world oil prices, with more to come.

There has also been a drop in so-called core inflation, excluding food, energy, alcohol. But, even more than the consumer prices index, it is unlikely to go negative for any sustained period of time.

A better measure of domestically-generated inflation is service-sector inflation. Last month this was running at 2.4%. In June it was 2.5%. This does not point to an economy sliding into deflation.

The final point is to elaborate on what I wrote last week about the eurozone, and the idea of good and bad deflation. Bad deflation is that which results from chronically weak demand. Nobody could pin that on Britain. In November, helped by Black Friday madness, we bought 6.4% more goods than a year earlier. Exclude petrol and diesel and the rise was an even more heady 6.9%.

We will have to wait to see whether there is some payback this month, but these were boom-like numbers of Klondike proportions, the best for more than decade.

Good deflation, by contrast, is when prices fall because of a beneficial price shock. The plunge in oil prices and the weakness of commodity prices is delivering a gift to the economy that we should seize with both hands. Good deflation is good news.

We can see that with the latest average earnings figures. Though these were not strong – more of an uplift might have been expected with the 3% rise in the national minimum wage in October – the growth in regular pay of 1.6% and in total pay of 1.4% in the latest three months compared with a year earlier is outstripping inflation.

The details of the numbers suggest there is more of this to come. Since the spring, regular pay has been rising at an annualised rate of more than 3%.

The Bank’s monetary policy committee noted this in its latest monthly minutes, published on Wednesday, which maintained the 7-2 split on interest rates, with the same two members, Martin Weale and Ian McCafferty, continuing to vote for a quarter-point rate hike.

For the rest, the prospect of what it described as a “significant period” ahead of below-target inflation, one senses that they will take some shifting. The pick-up in pay, which is “promising”, will have to go a lot further even to be consistent with the 2% inflation target.

It may be that the Bank will hike rates, late next year, even when inflation is running below target, if it believes that the only way is then up. But that will be a challenge. After what will then be more than six years of a record low 0.5% rate, the Bank might be accused of responding to phantom fears.

Weale and McCafferty argue that the Bank should “look through” the current weakness of inflation, just as it looked through earlier post-crisis overshoots. But the Bank will want to be sure of tis ground. Low inflation pushes out the timing of the first hike. This time next year we may still not have seen a move.

Sunday, December 14, 2014
Relax: lower oil prices will be good for growth
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Rejoice. That is my normal response to lower oil prices. Filling up the car ranks second only to paying gas and electricity bills as the kind of spending you would rather not do. Anything that brings down the cost of such spending has to be good news.

The average price of a litre of petrol has dropped below 120p a litre, compared with more than 131p in the summer, with a similar reduction in the price of diesel. Had the reduction so far been achieved through cuts in excise duty, the cost would have been £6bn.

With the oil price having fallen by more than 40% to under $65 a barrel, and with analysts predicting that petrol could drop to just over £1 a litre, there should be more of this to come. By the time the process is done, consumers will be benefiting from the equivalent of a tax cut of £10-15bn, much more than in any recent budget.

That is not the only effect. Falling oil prices are cutting industry’s costs. In the past 12 months raw material and fuel costs have fallen by 8.4%, driven by the fall in oil prices. Cheaper oil is cutting inflation directly – it is now just over 1% - and will keep it low in coming months as these very weak pipeline pressures (no pun intended) feed through to energy bills and the price of goods in the shops.

Lower oil prices are helping narrow Britain’s trade deficit, which in October fell to £2bn, half its level a year earlier. Britain is a net oil importer, and has been for many years.

The drop in the cost of crude will also boost the global economy. Oxford Economics, which has a global economic model to estimate the effects of oil price changes, estimates that every $20 a barrel fall in the crude oil price boosts global growth by 0.3 to 0.4 percentage points, sustained over several years.

The benefits are heavily skewed to oil consuming nations. Growth in the Organisation of Petroleum Exporting Countries (Opec) is reduced by around 0.7 percentage points a year by the effect of a $20 oil price fall.

For Britain, according to the Oxford simulations, growth will average 2.6% a year in 2015-16 if oil averages $84 a barrel, but close to 3% if it comes down to $40, which many in the industry are talking about (with some talking about even lower prices). Cheap oil is a growth booster.

As Rob Wood, UK economist at Berenberg, the bank, puts it: “What a Christmas present. Thank you oil men of Dakota. Cheap oil, cheap food, and cheap money give us all the reasons we need to forecast continued strong UK growth and low inflation. We cannot know how permanent the fall in oil prices will prove to be but the further Brent falls, and the longer it stays low, the bigger the upside risks to UK growth in 2015 become.”

So why is there a sense of nervousness about the plunge in the oil price, a worry that it may be not such good news? Why did the FTSE-100 fall by 2.5% on Friday, and 6.6% in the past week?

Some people – including Scottish Nationalists – still see Britain’s North Sea oil as a huge cash cow that pays for public services and will be hard hit. That horse had already bolted, even before the latest fall in oil prices and well before the Scottish independence referendum in September.

The Office for Budget Responsibility noted in its latest assessment, published alongside the autumn statement, that North Sea revenues have dropped by 75% to £2.8bn a year since 2008, on the back of a 50% drop in production and tax changes that allow oil companies to offset more of their capital spending against tax. A lower oil price may knock a few hundred million more off North Sea revenues but that is small beer when set against the benefits.

As it is, the Nationalists’ economic case for independence has been further undermined. Nicola Sturgeon, the Scottish first minister, stands out among political leaders – with the possible exception of the Greens – in praying for the oil price to go back above $100 a barrel.

What are the other fears? The last time oil prices fell this fast, culminating in a drop to just over $30 a barrel (from a high of $147) was in 2008, when the banks were in meltdown and the global economy falling off a cliff. Some argue that if the oil price is a proxy for the strength of the global economy, in which case it is looking like a seven-stone weakling.

No. The oil price does partly reflect weaker demand but most of that is a combination of greater efficient in energy use in the West, coupled with a slowdown in emerging economy growth – including China – from the turbocharged rates of the 2000s. Most of the price fall, of course, reflects greater supply; America’s shale oil and gas revolution coupled with Saudi Arabia’s refusal to perform its traditional role as Opec swing producer by slashing output.

The International Energy Agency, in its latest oil market report, released on Friday, noted that non-Opec supply has risen at a record rate this year and predicts a continued supply surplus in 2015.

Should we worry that the fall in the oil price will batter the budgets of oil producers to the extent that it leads to instability, not just in the Middle East but in countries such as Venezuela and Russia? I think we should limit such concerns. The oil price did not rise above $40 a barrel on a sustained basis until 2004. These countries have enjoyed a 10-year bonanza on the back of an oil price that has usually been well over $100 a barrel. If they squandered it, more fool them. We should also not shed too many crocodile tears for the oil companies.

What about the spectre of deflation? Will not a falling oil price push many countries, and perhaps even the eurozone as a whole, into outright deflation? It might. A $40 a barrel oil price would, according to Oxford Economics, push 21 of the 45 economies it monitors into deflation next year, including many members of the eurozone and the eurozone itself, and Britain.

There is, however, good and bad deflation. Falling prices as a result of domestic deflation are bad. Falling prices as a result of a correction in global energy prices are good, because they boost real income growth.

The oil price, remember, has come part of the way back down to earth but remains significantly higher than it was. We did not pay more than £1 a litre for petrol and diesel in Britain until the autumn of 2007. The fall in prices is a relief, and a welcome boost. Enjoy it for that.

Sunday, December 07, 2014
Eliminating the deficit: hard work but not impossible
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Has the world changed? We knew before Wednesday’s autumn statement that George Osborne would be forced to concede that the budget deficit remains uncomfortably close to £100bn, so there would rightly be no room for a meaningful pre-election giveaway.

We knew that the growth numbers would be better but that it would be hard to generate too much of a political lift out of essentially rearranging the deckchairs.

So how was it? The budget deficit is uncomfortably large but Osborne wrong-footed Labour, and most commentators, by announcing that this year’s borrowing total, £91.3bn, will be below last year’s £97.5bn. That is still an overshoot of nearly £5bn compared with the official forecast in the March budget but it is still on the way down.

The Office for Budget Responsibility (OBR), which slightly encouraged the idea that borrowing this year would be up rather than down in its monthly commentaries, might turn out to be wrong. But a good rule of thumb is that this chancellor will find always a way of announcing that his deficit reduction plan has not gone into reverse.

Similarly, by deft footwork involving debt interest and a few other factors, Osborne managed to avoid the prolonged deficit overshoot confidently predicted by many economists. Again the OBR may be wrong but the big picture is that a slightly higher deficit this year and next is balanced by lower deficits later. That does not mean, of course, that the public finances are in any sense healthy.

As for growth, the OBR was over optimistic early on in its existence but has become too pessimistic since. Its forecast of 3% growth for this year, 2.4% next, was indeed revised up but looks downbeat compared with the Bank of England’s 3.4% and 2.9% predictions. The official forecast is also cautious on long-term growth, just over 2% a year.

In terms of content, Osborne did manage a small political gain. Stamp duty was sold as a tax cut for most homebuyers but in reality it was a sensible and long overdue reform of a clumsy “slab” tax, which had no place in any tax system. A few other Labour foxes were wounded, if not killed outright, and it is probably the case that the chancellor just about reinforced his reputation as a responsible custodian of the public finances, which is no mean feat when you are running a £91bn deficit.

Today, however, I want to look to the future, and in particular the big question that has arisen since the autumn statement. Have we reached the point where the chancellor is obliged to offer what many economists are calling “fantasy” ideas about eliminating the budget deficit, based on unspecified and undeliverable future cuts in public spending? Osborne accused the BBC of “hyperbolic” reporting of future cuts, which to be fair to him it sometimes is. But if he thought that was bad, he had not seen my e-mail inbox, full to the brim of commentary which, if not hyperbolic, was certainly highly sceptical.

I sense a little tension between the OBR and the Treasury. The OBR was not told in time of Osborne’s plan to spend more on the NHS, while its observation that to achieve a budget surplus public spending will have to be cut to its lowest for 80 years (the sub-text of which is “not a chance”) has not gone down too well with the chancellor, provoking some of that hyperbolic coverage. The Treasury thinks the OBR may be overstating the extent to which deficit reduction has to come through spending cuts.

Is it all fantasy? The first thing we should do, I think, is get away from that 80-year figure. Even if it were useful to use it, it would mean that, since the economy is six times the size it was in the 1930s, the government is aiming for a real level of public spending which is also six times what it was then.

That figure, total managed expenditure, is 40.5% of gross domestic product this year, having come down steadily from 45.3% in 2009-10. According to the OBR it needs to come down to 36% of GDP by 2018-19 to eliminate the budget deficit and give a small – 0.2% of GDP – surplus. It needs to come down to 35.2%, which we have not seen since before the war, to produce Osborne’s ambitious goal of a 1% of GDP budget surplus.

The reason why the 80-year comparison is a bad one is that for most of the period in question, capital spending by government, on roads, hospitals and schools (the building of) and other infrastructure was a lot higher than it is now, gross investment reaching 10% or more of GDP at times in the 1960s and 1970s. Currently it is just over 3.5%. In a pre-privatization era, the nationalised industries swelled public sector investment.

So a better measure of the squeeze on day-to-day spending is public sector current expenditure, which is mainly the spending on public services. This also needs to come down, to 32.7% of GDP to eliminate the deficit and 31.9% to achieve a 1% surplus. You also have to go back into history for times when this measure of spending was this low. It was 32.4% in 1973-4 and 31.1% in 1972-3. The economy, by the way, is roughly 2.5 times the size it was then.

Is it pie in the sky to think such numbers can be achieved? Does it mean, as Paul Johnson of the Institute for Fiscal Studies says, “spending cuts on a colossal scale” and the smallest state for generations?

I bow to nobody in my respect for the IFS but I think that is overstating it. Public spending on this measure has come down from its peak of 40% of GDP in 2009-10 to an estimated 36.9% this year and a projected 36% in 2015-16. Reducing it further, by just over three percentage points of GDP to eliminate the deficit, will be very hard but it is not impossible.

It would be a lot easier, of course, if the government did it properly, and freed its own hands. The more spending that is ringfenced – the National Health Service, schools, overseas aid – the more the burden of cuts is shifted to local authorities, and other non-ringfenced departments, as well as welfare.

We are, unfortunately, in a an environment in which every party is desperately scrambling to ensure it is in power, without thinking what it will do when it gets there. Labour, to be fair, talks of a zero-based spending review but it is hard to see that breaking too many eggs.

A proper review of spending is, however, needed. The coalition is still running on the basis of the rushed spending review it carried out in the summer of 2010. What was needed then, and what is needed now, is a fundamental review of the size and scope of the state, including a full public debate, with no sacred cows, including health, education and pensioner benefits.

If that were to happen, and if tough but realistic decisions were taken, total government spending of 35% of GDP and current spending of 32% of GDP is perfectly possible. If not, the public finances will be on a wing and a prayer.

Why not, to finish, just raise taxes to ease the burden on spending cuts, as favoured by Labour and the Liberal Democrats? There may be a small role for higher taxes in cutting the deficit but it would be wrong to think there is much. One lesson of the past 25 years is that it is hard to get tax receipts much above 36% of GDP. If you want to eliminate the deficit you have to get spending down to that level. The question is whether there is the appetite to do so.

Sunday, November 30, 2014
Osborne confronts his failure on the deficit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The autumn statement, George Osborne’s fifth and possibly final one, is on Wednesday and it is hard not to feel a sense of déjà vu. I have previewed very many of these over the years, and I can count on the fingers of one hand the times when I have expected a chancellor to stand up and announce that the budget deficit is coming in lower than he expected.

On Wednesday, the chancellor will do the opposite, as is often the case, and confront his failure. This year the budget deficit will be close to £100bn, with the independent Office for Budget Responsibility (OBR) set to revise up the prediction it made in March by around £10bn. It is touch and go whether the deficit will be up or down this year compared with last. It was, of course, supposed to fall, by 12% or nearly £12bn.

So it will be another miss, and an even bigger one compared with Osborne’s original June 2010 plan. The definitions have changed, making precise comparisons more difficult, but this year the deficit was supposed to be below £40bn, with all the hard work of deficit reduction completed ahead of the election. At £100bn, there is another parliament’s work to be done, if politicians and voters have the appetite for it.

Osborne’s deficit failure is not, as I say, untypical. We have had autumn statements since 1976, though there was a time under the Tories in the 1990s when they were known as single unified budgets (the March budget was scrapped) and Gordon Brown called them pre-budget reports. ‘Chancellor to miss borrowing targets’ is usually a pretty safe headline for these events.

It matters more now though, and not only because the deficit is still so big. Deficit reduction was central to the coalition government’s programme; its main purpose. It has not been achieved. Theresa May, the home secretary, admitted the other day that David Cameron’s target of reducing net migration to the high tens of thousands would not be met, by a mile.

The autumn statement will confirm that for the budget deficit. Both the things Ed Miliband forgot to mention in a party conference speech widely regarded as a disaster – immigration and the deficit – are not going well for the government. Yet stewardship of the economy, if not Britain’s borders, will be central to the Conservative May 2015 election campaign. Can it possibly work when the deficit is still £100bn?

Osborne has a good story to tell on growth, jobs and inflation. The recovery in real wages is late in the day but it will help. Depending on what the OBR says about the amount of spare capacity in the economy, he might be able to claim that the underlying, or structural budget deficit, has been brought down to Labour’s pre-crisis figure, as a percentage of gross domestic product.

That is true on the International Monetary Fund’s estimates, which suggest that Gordon Brown was running a structural deficit of 5% of GDP in the pre-2008 good times. So he could say he has dealt with the damage from the crisis but still needs to deal with the damage from Labour.

But there’s still the matter of a £100bn deficit, which makes playing the fiscal responsibility card difficult, as does the prime minister’s promise of unfunded tax cuts after the election. The idea of enshrining in law a commitment to eliminating one definition of the deficit (the cyclically adjusted current budget deficit), which Osborne is set to announced, has the smack of desperation about it. Labour pledged a similar legal commitment to halve the deficit in 2010. Voters know such laws are made to be broken.

In general, as I have noted before, the problem has been with weak revenues rather than missed targets on public spending. Even on spending, however, where debt interest payments have been lower than expected, helping the totals, the coalition could have done better.

This week we will almost certainly hear of more spending for the National Health Service. When Ed Balls suggests something in the run-up to an important announcement – using the recent fines on the banks to pump £1bn more into the NHS – it is often because he has got wind of what the Treasury has been working on.

It is elsewhere, though, that the evidence of largesse during austerity has been most notable. There is a protected species in Britain, and they are called pensioners. Paul Johnson, director of the Institute for Fiscal Studies, wrote in a piece for The Times last week that by 2018-19 spending on pensioners will be £12bn higher than in 2010-11. This is partly because there will be more of them: a 2m or 20% increase in the number of over-65s in 2020 compared with 2010.

But it is also because the coalition, as Johnson noted, “those currently retired and hitting the state pension age over the decade have been spared most of the effects of austerity”.

That includes those reliant on the state pension, pension credit and handouts such as the apparently sacrosanct winter fuel allowance. But it also includes those receiving public sector pensions. The government will spend £36bn on these this year which, as Johnson put it, “are hugely more generous than almost anything in the private sector”. In a different era, Osborne used to talk about sharing the proceeds of growth. In this era he has distributed the pain to the extent that some people are not experiencing it.

We should look after pensioners, particularly at a time when their savings income has been hit by years of ultra low interest rates. But the largesse looks excessive and has hampered deficit reduction. And if it was intended to pay political dividends, so far it is not working.

According to a You Gov poll a couple of days ago, though 35% of over-60s back the Tories, against 29% for Labour, it is in this age group that support for Ukip – 22% - is strongest. Only 6% support the Liberal Democrats. Pensioners have responded to the coalition’s largesse by shifting their support to other parties. Ungrateful, or what?

That is not the only way in which Osborne has made deficit reduction more difficult for himself. Tory MPs and supporters love tax cuts. The only issue for them about the increase in the personal tax allowance to £10,000 was whether they or the LibDems should take the credit.

As it is, as I have written, in combination with weak growth in wages the allowance has made deficit reduction much harder. So did the repeated postponements of duty increases on petrol and diesel, which the chancellor easily acceded to under gentle pressure from his own backbenchers and white van man.

The deficit could and should have been brought down more. Slow progress is better than no progress at all, and maybe part of Osborne’s calculation is that if the deficit had been eliminated voters might have concluded that the country was safe again for Labour. But that’s too subtle. On deficit reduction , the chancellor has failed.

Sunday, November 23, 2014
Risks aplenty - but the world isn't about to go pop
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The Cassandras are out in force, from the prime minister down, predicting doom and gloom for the world economy and by extension a knock-on effect for Britain.

If China sneezes, Japan starts going backwards and Germany is forced to retire to bed with a warming glass of gluhwein, then surely the world will catch a cold. Britain’s plucky consumers, who in October bought 4.3% more than a year earlier, cannot after all keep us going on their own.

Is the world economy about to lurch downwards? Even more worrying, looking at some of the headlines generated by David Cameron’s “red warning lights … flashing on the dashboard of the global economy” are we about to have a re-run of the global financial crisis?

Nobody doubts that there are risks out there. The Russia-Ukraine crisis, unspeakable Islamic State murders in the Middle East and the Ebola epidemic in parts of Africa are all things we could do without.

Japan, the world’s third biggest economy, has gone back into recession. Germany, fourth biggest, is barely keeping its head above water. China, probably still the second biggest although the world’s largest on some measures, may never see a 10% growth rate again and has plenty of problems, including fast-falling property prices. France, fifth biggest, is stagnating.

The slowdown in China, and a disappointing performance by other emerging economies, explains the big fall in commodity prices and the fact that Brent crude oil is now less than $80 a barrel. A little bit more of a fall and oil will be half the level reached in the middle of 2008, on the eve of the worst phase of the financial crisis.

So how bad is it? Let me start with what forecasters are saying about the global economy. Consensus is always a dangerous thing but the consensus among leading forecasters is that global growth prospects for 2015 and 2016 are not looking as good as they were a few months ago but that the global economy will do better in both years than in 2013 and 2014.

So the Paris-based Organisation for Economic Co-operation and Development (OECD), in forecasts prepared for the recent G20 meeting in Australia, predicts 3.7% global growth in 2015 and 3.9% in 2016, after 3.3% this year and 3.1% last year. America will be a star performer, with growth rates of 3.1% and 3%, but even eurozone growth will pick up a little, it says, while China will grow at close to 7%, with India not far behind and Brazil picking up.

The Bank of England also sees stronger global growth, 3.75% and 4% respectively for 2015 and 2016 as, with slightly different numbers, does the National Institute of Economic and Social Research.

Forecasts are forecasts, and they could all be wrong. All the forecasters emphasise that there are risks, particularly in the eurozone. But if we look at the detail of what is happening, it suggests we should not be too pessimistic.

Japan’s surprise slip into recession was, for example, not quite what it seemed. A sharp drop in business inventories – stocks – led to the 0.4% quarterly drop in GDP and gave the prime minister Shinzo Abe an excuse for a snap election to seek a mandate to postpone next year’s planned increase in the country’s sales tax. Economists at Barclays expect growth to bounce back sharply in the current quarter, by around 1%, as the inventory drop unwinds. The outlook for Japan is more or less as it was before Abe embarked on his “three arrows” strategy, with annual growth of around 1%.

That is also the outlook for the eurozone, but it is important to distinguish between the current growth weakness, centred on France, Italy and Germany, and the earlier pronounced weakness of the so-called peripheral economies – Ireland, Portugal, Spain and Greece – which threatened to break up the system. There is much less risk of euro break-up, which would have given us a second global financial crisis, then than now.

As for China, we should get used to it being a 7% growth economy rather than it being a 10% one. That was inevitable and is largely intentional. China's central banks cut its main interest rate from 6% to 5.6% on Friday to prevent that slowdown going too far.

The bigger China got, the more it was bound to experience a moderation of growth; extrapolate 10% for too long and you get world domination. There are strains in China but there is nothing to suggest imminent collapse now, any more than at any time over the past 35 years.

The world economy is not perfect, and the eurozone is a long way from perfect. World trade, which bounced back strongly in 2010, has disappointed since, barely growing at all. The global recovery is uneven.

There is, however, nothing to suggest an imminent second financial crisis and there are positives. The fall in the oil price is the equivalent of a tax cut for most Western countries (remember all those expensive deferrals of duty increases on petrol by George Osborne). Cheaper oil will boost growth and makes it easier for central banks to maintain cheap money.

As for Britain, the recovery now looks a lot better. Chris Williamson of Markit points out that Britain’s GDP is now 3.4% above pre-crisis levels, better than Germany (3.1%), France (1.4%), Spain (-5.8%) and Italy (-9.4%). America and Canada do better, though their 2008-9 recessions were milder.

The one thing Britain’s recovery does not need is bloodcurdling warnings from the prime minister, for his own narrow political reasons, which suggest, intentionally or not, that another crash is looming.

Some damage may already have been done. A YouGov poll a couple of days ago showed that of people now expect another global financial crisis over the next 12 months. Business and consumer confidence need to be nurtured. Frighten too many people for electoral reasons and we will all suffer.

Sunday, November 16, 2014
The Bank conjures up a sweet spot for Osborne
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The Bank of England’s latest quarterly inflation report has attracted a lot of comment, mainly because it confirmed the Bank’s “lower for longer” view on interest rates and because of an upbeat assessment of prospects for wage inflation.

What has received rather less attention is that, even apart from its views on wages, the Bank has set out an economic scenario which any chancellor would die for. If the Bank is right, the main risk of the sweet spot it sees for the economy in election year is that it will be too sugary.

Consider the evidence. The Bank’s forecast for growth next year is 2.9%, close enough to 3% to make no difference. Unemployment, now 6% of the workforce, will continue its fall, to 5.4%, on its way down to a near-normal 5% rate.

Inflation, after a period in which Labour has based its pitch to voters on the so-called cost of living crisis, will run at close to 1% over the next year, the Bank expects, with Mark Carney, the governor, saying it is “more likely than not” that he will have to write an open letter to George Osborne, explaining why it has dropped below 1%.

This will be a significant moment. There have been 14 open governor-chancellor letters, all of them from Mervyn (now Lord) King, during the 2007-2012 period. All of them were to explain why inflation was more than a percentage point away from the 2% target on the upside; an overshoot.

Never has a governor had to explain an undershoot, because consumer price inflation has never been below 1% in the time it has been the official target. Food and petrol prices are falling and household energy inflation has slowed to a crawl.

The Bank cannot do anything about the eurozone crisis, Carney’s “spectre of economic stagnation” but it does expect a continued strong recovery in business investment; up 10% next year.

Productivity, the dog that has not barked so far in this recovery, will not exactly be howling. The Bank expects a rise of only 0.75% next year, similar to this, followed by 1.5% in 2016. But it is heading in the right direction.

And then there are those wages. 2% wages growth alongside 5% inflation, which we had not so long ago, was a Micawberite recipe for misery. Wage growth of 3.25% alongside inflation of roughly 1% is the macroeconomic equivalent of Mr Micawber’s recipe for happiness.

And, of course, though two members of the Bank’s monetary policy committee have been voting to raise interest rates, most seem set to sit on their hands until autumn of next year. Carney’s original forward guidance of August 2013, which pointed towards 2016 as the most likely date for the first interest rate hike, may end up coming good. Mind you, it has been a bumpy ride.

The Bank would not, of course, accept for a moment that either its forecast or the fact that interest rates now seem to be on hold until after the election have anything to do with politics. One way to rile its occasionally tetchy governor is to suggest that his forward guidance has not been an unalloyed success. Another is to accuse him of political motives.

Forecasts are forecasts, and the Bank’s forecast, that the recovery will be supported by rising real wages, buoyant consumer confidence and strongly rising investment may turn out to be wrong.

Nor would I suggest for a moment that this pre-election sweet spot for the economy reflects Osborne’s pinpoint planning. This is more of an accident than a master strategy. The chancellor did not expect or want real wages to be depressed for so long, or for the economy to be so slow to get into its stride.

Indeed, over the next few months we may find out something useful about the lags between economic change and public perception. The default position of voters is to be curmudgeonly. Even when times are good people are reluctant to concede it. Our YouGov polls show that most people think the economy is in a bad way and that the recovery has yet to lift the Tories’ poll rating, though it may have knocked Labour’s. It will take a long time before the so far tiny recovery in real wages starts to feed through to public perceptions. It should gain strength, but it may have come too late.

Osborne also has a tricky hurdle to negotiate on the budget deficit, though it is not something that keeps many voters awake at night. Official figures this week for the public finances will be important. They are the last before the Office for Budget Responsibility does its calculations for the December 3 autumn statement, and they will show whether the Exchequer is getting a boost from corporation tax revenues.

I think the coalition has a pretty good story to tell about deficit reduction. According to the latest International Monetary Fund fiscal monitor, the cyclically-adjusted deficit has come down from 10.3% of gross domestic product in 2009 to 4.1% this year, a big reduction. One reason is that there is still a lot left to do is that Osborne toughened his own target, aiming for an overall budget surplus in the next parliament rather than just eliminating the current deficit.

As for reports that Treasury officials are unsettled by the tax promises made by David Cameron and others, I should tell you that the Treasury always gets unsettled at this stage in the political calendar. Last time some of them were very troubled by fears of a Gordon Brown victory.

Even so, the budget deficit remains worryingly close to £100bn and, like the Tory poll rating, is not being moved much by economic recovery. Stronger growth in wages will help but low inflation will depress other tax receipts, notably VAT.

Osborne will still have a good economic story to tell in his autumn statement on December 3. The sweet spot contained in the Bank’s forecasts is, as I say, better than he could have expected. His message will be that the sacrifices have been worthwhile and the economy is reaping the benefits, His message on the deficit will be that there is still a lot of work to be done, and that only he can be trusted to do it.

Whether it works politically remains to be seen.

Sunday, November 09, 2014
In many ways, business in Britain has never had it so good
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Is Britain a good place to do business? It is, in the end, the most fundamental question for the economy. If not, then we are condemned to a future of low growth and stagnant living standards.

We need a successful private sector to provide the tax revenues to get the budget deficit down and provide public services. We also need private sector businesses to generate jobs, as they have been doing pretty effectively recently.

On Tuesday, as part of the events marking 50 years of the Sunday Times Business section, I will be chairing a debate on precisely this subject. Organised in conjunction with the London Business School, it promises to be a very good one, featuring Lord (Terry) Burns, chairman of Santander, Carolyn McCall, Jim Ratcliffe and Sir Martin Sorrell, chief executives of easyJet, Ineos and WPP respectively.

They will have their own views, which I am keen to hear. As it happens the 50th anniversary is an interesting moment for me; I have been economics editor of this newspaper for exactly half that time, 25 years. I don’t think we marked the 25th anniversary of the section back in 1989, so I had no idea that I was joining at a historic moment.

Let me give an economic perspective on the question. It will not surprise you to learn that it has been a story of ups and downs for business, given that we are just getting over the biggest “down”, the 2008-9 recession, in the post-war period.

In general, though, it has been a game, if not of two halves, then at least an improving picture. For the 25 years I have been at The Sunday Times, and for a few years before, the business environment has been generally good and, I would argue, improving. The contrast with the 1960s and in particular the 1970s, when free enterprise was in retreat a, profit almost a dirty word and the trade unions all-powerful, has been stark.

In those days business wanted low and stable inflation and, in the main, that is what it has got. Low-inflation re-emerged during the 1980s, was temporarily lost at the end of the decade, but has been the story, excepting one or two blips, during my time. At just over 1% now, inflation is, if anything, a little too low, and unimaginable in the dark days of the 1970s.

Business wanted industrial relations peace, and it has got it. Last year there were just 443,600 working days lost as a result of industrial disputes, fewer than 20% of them in the private sector. That compares with an average of nearly 9m working days lost annually between 1964 and 1989 and a post-war peak of 29.5m in 1979.

Business wanted to end the damaging wage-price spirals of the 1960s and 1970s and that has happened, partly as a result of low inflation itself, but also trade union reform and other measures to improve labour market flexibility.
Again, if anything, this has gone too far, with the current prolonged period of falling real wages. But the days when firms were held to ransom by pay demands are long gone.

Business’s ability to hire the workers it needs, meanwhile, is arguably greater than ever. Though there are some complaints about some aspects of the government’s immigration policies, and though the conclusions of last week’s UCL study on migration were accepted too uncritically – there are huge uncertainties about the costs and benefits in this area – firms have a larger pool of labour on which to draw than ever before.

Remember the days when Britain’s businesses were some of the most heavily taxed in the world? No longer. The main rate of corporation tax has come down from 52% just over 30 years ago to the current 21%. Next April the rate will drop to 20%, equalling the lowest in the G20.

The main rate of corporation tax will have been cut from 28% to 20% in an era of fiscal retrenchment in this parliament. Though corporation tax is far from the only tax paid by firms – many of which say business rates are a bigger burden – this is a powerful signal.

The climate has improved. Interest rates are at record lows and business investment is rising quite strongly. The share of profits in gross domestic product has risen. The environment for setting up, expanding and financing a business took a big knock during the crisis but is on the mend.

Is it all good? Of course not. The long-term problems that have dogged the British economy: skills, inadequate infrastructure and under-investment, remain. In the case of infrastructure there is a serious risk that a lack of investment in new energy capacity will leave industry, and the economy more generally, facing uncertain supply and high prices, at a time when America, through its shale gas revolution, is doing much better.

There is political risk, most notably in the anti-business rhetoric of the Labour party under Ed Miliband. Oppositions tend not to be as scary if and when they get into government but as things stand, businesses regard the prospect of a change of government with trepidation they did not feel when Tony Blair was Labour leader.

Even then, it is not all one way. Many in business also fear divorce from the EU, and worry that David Cameron is being pushed to a point of no return on the EU. I think the fear - hope for some - of EU exit is greatly exaggerated, but that does not prevent it being an issue.

There is also a tendency to load business with more red tape and cost, not all of it from the EU. Last week’s employment appeal tribunal ruling on holiday pay was another straw in the wind on this, possibly a significant one. The default position of bureaucrats, and often the courts, is to increase bureaucracy.

There was never a golden age in which Britain was a red tape free zone for business, though we probably came closest to it in the mid-1990s. Since then, despite pledges from politicians to ease the burden, it has increased.

We should never take business for granted. In most respects, as I say, Britain has become a better place for doing business. In several respects, businesses have never had it so good. But these things can change, and they can do so quickly, particularly if anti-business sentiment is allowed to gain traction.

Sunday, October 26, 2014
Eurozone starts to look a lot like Japan
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

How worried should we be about the eurozone? Is the single currency area, the weakest link in the global economic chain since the crisis, about to enter its third recession in the space of little more than six years? Worse, are those fears of euro break-up, which paralysed business and consumer confidence, returning?

The Bank of England is clearly concerned. Though two members of the monetary policy committee (MPC), Martin Weale and Ian McCafferty, continued to vote for higher interest rates this month, most MPC members were concerned, among other things, about the impact of the eurozone on Britain’s economy.

“There was mounting evidence of a loss of momentum in the euro area, including in Germany, where growth appeared to have stalled and industrial production had fallen sharply,” the MPC’s October minutes said. And: “Further downside news in the euro area had increased the risks to the durability of the UK expansion in the medium term.”

Today is quite a big day for the eurozone. The results of the Asset Quality Review (AQR) for the eurozone’s banks will be published, ahead of the European Central Bank taking responsibility for euro area banking supervision on November 4.

Though these stress test exercises have been criticised in the past for being too soft, there have been reports that up to 10% of the 130 banks covered will fail. The aim of the exercise is to demonstrate that the eurozone’s banking system is secure. At the margin, however, some banks will have to raise additional capital and this will depress bank lending.

The big picture in the eurozone, which the Bank of England was responding to, is one of desperately weak growth and very low inflation. Eurozone gross domestic product was flat in the second quarter and up by just 0.7% on a year earlier. The best that can be hoped for in coming quarters is growth of 0.1% or 0.2%. The fear is that GDP will turn negative again, following the recessions of 2008-9 and 2011-13.

Unemployment, while down from its highs is nevertheless 11.5%, 18.3m people, with a rate of 23.3% for young people.

Inflation is down everywhere but it is down particularly in the eurozone, averaging just 0.3% last month. Five of its members, Greece, Spain, Italy, Slovakia and Slovenia, have negative inflation; deflation. Several others are very close to it.

So how bad is it? I always have mixed feelings writing about the eurozone. On the one hand this is a system which, as some of us warned repeatedly, combines the worst of all worlds. Europe’s politicians over-reached themselves in launching and expanding a system which defied economic logic. The eurozone’s problems were entirely predictable.

A grouping of a small number of similar economies might have worked but once the euro became effectively open to all trouble was inevitable. As it is the long-term future of the eurozone rests on creating the conditions for what economists would call an optimal currency, which means some kind of central Treasury or properly co-ordinated fiscal policy, wage flexibility and genuine geographical mobility of labour. Incidentally, free movement of people is much more important for euro members than for non-euro EU countries such as Britain.

All that will take a long time, if it can ever be achieved. It means supply side reform, and it means institutional reform, and it will mean individual euro members accepting a loss of control of fiscal as well as monetary policy. Many are unwilling to do that.

I do not in any way celebrate the eurozone’s problems. It was the biggest single factor holding back Britain’s recovery, and it remains the biggest factor preventing a rebalancing of the economy towards exports.

The eurozone’s current woes are, however, slightly different to those of a couple of years ago, when Europe was staring into the abyss. Ireland, after its harsh austerity programme, is now showing remarkable growth, with GDP up an astonishing 7.7% over the past year. Spain is also picking up as, somewhat more patchily, is Portugal. Greece remains a problem but may also be ready to return to modest growth.

The problem is in the eurozone’s core, with France at best stagnant – no growth at all over the latest six months, Italy already in its third recession in the space of a few years and Germany on the brink after a disastrous August and a 0.2% drop in GDP in the second quarter.

These “core” eurozone economies are not going to leave the single currency, which was the big fear with Greece and some of the other peripheral economies. But their weak performance will weigh down on the rest and, as long as it continues, make it hard for the eurozone as a whole to stage a decent recovery.

What can be done? The European Central Bank, having cut interest rates to rock bottom and then reduced them further, is running through its unconventional “whatever it takes” monetary policy options, to include purchases of covered bonds, asset backed securities and perhaps eventually full-blown quantitative easing, involving government bond purchases.

What about fiscal policy and the infrastructure spending recommended to boost the eurozone by the International Monetary Fund and others? This should be looked at, though we should be realistic about the hurdles.

The eurozone’s budget deficit last year was 2.9%, about half that in Britain, according to Eurostat data based on the new methodology, the so-called ESA2010 data. The trouble is that the deficits were unevenly spread. Greece, for example, still had a deficit of more than 12% of GDP. France’s was 4.1%, still above what the EU authorities regard as acceptable. Italy’s deficit is 2.8% of GDP, but alongside debt of 128% of GDP, compared with a high eurozone average of just over 90%.

A few countries have scope for a fiscal boost. Germany has a budget surplus of 0.1% of GDP, beaten only by Luxembourg with 0.6%. Some others, such as Austria and the Netherlands, have relatively small deficits.

Germany, however, appears to be an immovable object on relaxing fiscal policy and boosting infrastructure spending, insisting on protecting a balanced budget which is now enshrined in law.

An infrastructure boost in Germany would, in any case, while generating some extra growth in the Federal Republic, have a limited effect elsewhere. The eurozone crisis has evolved. Its slow growth, which is starting to look rather like Japan, is here to stay.

Sunday, October 19, 2014
Bank may eventually rue leaving rates low for too long
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Even before the stock market had an attack of the vapours, other factors — a sharp fall in Britain’s inflation rate, renewed weakness in the eurozone, and doubts about the strength of the job market — had led some in the City to push out their expectations of when the Bank of England will begin to lift interest rates.

Some, having thought the Bank would begin raising rates early next year, now think it will not happen until the second half of 2015, or possibly not even then.

Sure enough, on Friday morning Andy Haldane, the Bank’s new chief economist, offered plenty of succour to the “lower for longer” school on interest rates. Haldane, who said in June he marginally favoured being on the front foot on rates – raising them earlier – said he had now shifted to the back foot, mainly because he was on balance gloomier about the economic outlook.

Though his comments could be taken to mean that he thinks the peak for rates will be lower than he thought, they have been universally interpreted as signalling a delay in the first rate hike until later. And, while he is only one vote on the MPC, it is likely that his view is close to others in the Bank, including Mark Carney, the governor.

I shall return to the Bank in a moment. First, let me look at some of the other elements. The drop in inflation from 1.5% to 1.2% in September, its lowest for five years, was welcome. We should be wary, however, of concluding that Britain is about to join parts of the eurozone in experiencing deflation — falling prices.

Core inflation in Britain, excluding the more volatile energy, food, alcohol and tobacco components, is running at 1.5%. Service sector inflation, a better guide to domestic inflation, is running at 2.4%. Retail price inflation is 2.3%. Deflation is some way away.

Britain’s inflation rate is likely to run at close to 1% for the next two to three months. Next year, however, it is much more likely to rise than fall, pushing back up toward 2%.

Is the job market weakening? There has been a record annual fall in unemployment of 538,000 over the past year, taking the level down to 1.97m and the rate to 6%, a full percentage point below the earlier 7% forward guidance threshold (for considering rate hikes) which, a year ago, the Bank did not expect to be hit until 2016.

The weakness was that in the latest three months (June to August) employment rose by only 46,000, its smallest quarterly increase for more than year. Annual growth in total pay was only 0.7%, below even the lower 1.2% inflation rate.

The small rise in employment looks, however, to be misleading. The monthly numbers show there was an unexplained drop in employment in June, followed by strong increases in July and August. When June drops out of the three-monthly comparison in the next set of figures we should see stronger employment growth, and this concern will subside.

As for pay, something odd is happening there too. We expected weakness in bonus payments in April and May because a year ago people shifted their incomes to take advantage of the cut in the top rate of income tax from 50% to 45%. Even in August, however, with the exception of public sector bonuses (which for some reason showed a 75% annual rise), bonuses continued to fall. A better guide to wages is regular pay, which in August was 1.2% up on a year earlier. The big picture remains one of a strong job market, alongside weakish wages.

Where there is cause for concern, apart from the risk that market turmoil could become self-feeding, is in the eurozone. We knew the eurozone’s growth problems had transferred themselves to its three big “core” economies, France, Germany and Italy (which, to be fair, has long been weak) — but what also emerged in recent days were what could be the first murmurings of a re-run of the eurozone’s sovereign debt crisis, centred initially on Greece again. That should be watched closely.

So what should the MPC make of all this? A 2014 rate rise has been off the agenda for some time. The question now is when, or if, the Bank will start to hike in 2015.

On inflation, you will remember the MPC decided to “look through” the high inflation of recent years, which at one time hit 5%, because it was mainly due to global rather than domestic factors. Logic suggests it should do the same for the current low rate of inflation, explained by weak energy and commodity prices and the earlier strength of sterling.

As for the labour market, the key issue is that the further unemployment falls the less slack there will be in job market. The unemployment rate, as noted, is already well below the level at which the MPC had said it would consider rate rises. On wages, there is nothing in the latest figures to change the Bank’s view that a recovery in wage inflation — mainly next year — is still on the cards.

So I have some sympathy with the views of Weale, one of the two rate-hikers on the MPC in recent months. He put it well in a lecture a few days ago. He would, he said, consider what was happening in the eurozone and the wider international economy in deciding on his MPC vote. But his main focus domestically would be on the rate at which spare capacity was being used up in the economy because this provided a good guide to what would happen to wages. “The best indicator of this is probably the rate at which unemployment is falling,” he said.

Of course the MPC should not be raising rates if markets are in turmoil, or if the eurozone returns to its darkest days. Though the dangers of the latter are clearly there, I still think we have moved beyond fears of euro break-up and a re-run of the sovereign debt crisis.

But I also think the MPC should, as Weale says, be thinking about the fundamentals of a tightening labour market and the fact that the current weakness of inflation is likely to be temporary.

In the end, there are always reasons to delay raising rates, particularly when they have been low for so long. But, having prepared the ground for rate hikes in the first half of next year, the Bank would be unwise to kick things too far into the long grass. That would make the eventual decision harder but could also mean bigger increases will be needed when the time comes. The Bank may regret leaving rates low for too long.

Sunday, October 12, 2014
Time to join the dots on infrastructure spending
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

How do we build the infrastructure the economy is crying out for and the new housing a growing population sorely needs?

Through the haze of the party conferences, I got that Labour and the Liberal Democrats want to borrow more to fund additional public investment in infrastructure – roads, railways, energy, schools, hospitals, flood prevention, etc - and social housing, with the LibDems rather bolder on this than Labour.

Superficially this makes sense. Government borrowing costs – gilt yields in Britain’s case - are very low, so why should the government not go directly to the markets to fund such spending?

The International Monetary Fund, concerned about the slowdown in the eurozone’s already anaemic growth, has called for debt-financed infrastructure spending – even in countries with debt and deficit problems – to generate activity.

Of course Britain’s government, like others, already directly funds infrastructure spending. Net capital spending will be around £28bn this year, just over 1.5% of gross domestic product (GDP). The trouble with adding to it significantly would be that borrowing for investment is not ringfenced; to the markets it would be indistinguishable from borrowing for everyday spending.

It would be seen, in other words, as weakening the commitment to deficit reduction. Nor, as recent experience shows, can we rely on governments not to cut capital spending when the public finances come under pressure.

So it is probably not sensible to think of the public purse, which will be severely constrained for many years to come, for a big increase in infrastructure and housing investment. Nor is it sensible to think of the banks, which were active in this area, and were an important source of funding for housing associations which build most of Britain’s social housing. The banks too are severely constrained.

There is another way, and on the face of it looks like a no-brainer. Globally there are hundreds of billions of pounds of institutional money anxious to find a home in infrastructure investment. Britain’s financial institutions – the pension funds and insurance companies – want long-term investments with stable returns, not sky-high ones.

Six of Britain’s insurers – Prudential, Aviva, Legal & General, Standard Life , Friends Life and Scottish Widows – a few months committed an initial £25bn to invest in UK infrastructure over the next few years. The National Association of Pension Funds has set up a pensions’ infrastructure platform, with the aim of directing pension fund money into the infrastructure.

I have been thinking about this. A couple of weeks ago I chaired a seminar on the issue at the Tory conference in Birmingham, organised by the think tank Reform and sponsored by Prudential, one of the insurers keen to do more infrastructure investment.

I have also had a long dialogue with Nigel Wilson, chief executive of Legal & General, who is a passionate advocate of institutional investment in infrastructure. What we need, says Wilson, is what he describes as “slow money investment”; housing and urban regeneration.

“Economic growth is created by modern efficient cities - we should be discussing how we build these cities instead of spending all our time discussing the timing of interest rate increases,” he says. “Urban regeneration requires slow money (20-year plus) and a lot of institutional support.”

Most of the insurers can point to some progress in increasing investment in infrastructure, including student accommodation and affordable housing. None would say there is enough. At the Birmingham event William Nicoll, head of fixed income at M & G, which is owned by Prudential, bemoaned the fact that too much institutional money in search of infrastructure investment ends up going overseas.

Priti Patel, the Exchequer Secretary representing the Treasury, took note. Lord Deighton, her Treasury colleague, its commercial secretary, is charged with driving additional infrastructure spending.

The situation is not completely dire. The Construction Products Association predicts that infrastructure spending as it directly affects the construction industry will rise from £14.6bn this year to £20.3bn in 2018. On this measure, while infrastructure spending has been flat over the past four years, it has been significantly higher in real terms than over the previous 15 years.

But it could be a lot better. A report by Scape, a construction procurement company, notes that construction output is currently 26% lower than if it had followed pre-crisis trends. Even after its recent recovery, we are building half the number of houses we need.

Why is it proving so difficult to join the dots between a government and an economy in need of more capital spending and institutions with the funds to make it possible?

One perennial issue is planning. The government has an infrastructure pipeline, just updated, with a huge number of projects and a combined value of hundreds of billions. But many projects are stuck in the pipeline and planning is usually the culprit. There is no better way to deter even long-term investors than to sink them in the planning morass.

Bureaucratic inertia is a problem. Civil servants are rightly risk averse but that risk aversion often extends to deep suspicion of the private sector. Not only that but the public sector rarely takes advantage of its economies of scale; it is highly fragmented.

Insurance companies will tell you of a social housing or other project they have successfully undertaken in one local authority, often for a low return, in the expectation that it will serve as a template for similar projects elsewhere. But each bit of central and local government does things in its own way, and each project has to expensively start from scratch.

It would be wrong, too, to pretend that everything is hunky dory on the institutional side. MPs at my Birmingham meeting pointed out that many pension funds, particularly local authority pension funds, are too small to undertake meaningful infrastructure investment. It is a point that has been taken up by Boris Johnson; combining these funds would allow them to scale up their investments.

But, with one or two exceptions, there is also institutional caution, sometimes forced on them by actuaries, trustees or shareholders. We have nothing yet comparable with the Ontario Teachers’ Pension Plan, which has substantial stakes in Birmingham, Bristol, Brussels and Copenhagen airports; HS1; Scotia Gas Networks; and energy, container ports, desalination and other projects across the world.

We are, then, missing an opportunity. Every serious long-term report on the British economy says we need much more infrastructure. The money is there. We need to make it happen.

Sunday, October 05, 2014
Don't forget the budget deficit's ugly sister
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

We have had the two main party conferences and the big revisions to Britain’s economic numbers. We now know the economy’s pre-crisis peak was exceeded in the third quarter of last year rather than in the second quarter of this one. This is not, of course, the end of the story.

I want to try to draw these political and economic themes together. At the party conferences the biggest announcement, of course, was David Cameron's pledge to raise the personal tax allowance to £12,500 and the higher rate threshold to £50,000 by 2020. The cost of doing so, over and above the normal indexation of allowances, will be some £7bn.

This policy, as I wrote last week, does not in combination with weak wages growth make deficit reduction easy. In fact it seriously hampers it.

But some of the reaction to this pledge from economists and commentators is overdone. The prime minister clearly did not want to do a Roy Jenkins: emulate the 1967-70 Labour chancellor whose hairshirt stewardship of the public finances probably helped Labour lose the 1970 election.

And, if a £7bn tax cut, just over half the £12-13bn the coalition has spent raising the personal allowance during this parliament, is the worse that we will get between now and May - it may not be - we should relax.

As it is, the Tories are calculating that because Labour is perceived to have very little fiscal credibility, fairly or not, they can afford to lose some, and still remain well ahead in the credibility stakes. In fact, we can put a number on that. Labour's plans imply about £28bn less fiscal tightening than the Tories - becaused it has a less demanding deficit goal - and £7bn is a quarter of that. Despite the Cameron pledge, the Tories will continue to be seen by the markets and the public as more credible on deficit reduction.

Not that the rest of what we have seen during the party conference season was very encouraging on that score.

Ed Balls, for Labour, announced that he would limit the rise in child benefit to 1% a year until 2017, to demonstrate he means business about cutting the deficit.

George Osborne went much further. While the Balls plan would save a small amount – he estimates £400m, others less – the chancellor’s proposed two-year freeze on most working age benefits would save £3bn, part of £25bn of proposed spending additional spending cuts in the next parliament.

I have to say I was not very impressed with all this. Protecting the NHS, and in the case of the Tories anything involving pensioners, is seriously distorting the balance of public spending. Labour’s mansion tax will be a nightmare to introduce, and is a clumsy attempt to pull off the old political trick of offering the majority more while getting somebody else to pay for it.

Osborne, meanwhile, is determined to demonstrate only he can be trusted on the deficit, and that the best way to do this is to clamp down further on benefits, however harsh this sounds, not least because polling and focus groups show this to be popular. Those who would never vote Tory anyway will hate it but those who have been flirting with Ukip may be encouraged.

There has to be a better way. It is good that deficit reduction will be a theme of next year’s election – even if Ed Miliband forgot to mention it – but on the evidence of the last two weeks we may get more heat than light.

On benefits, for example, the chancellor has allowed himself to get way behind the curve. In the coalition’s first 2-3 years, welfare recipients, including many working people, benefited from the high inflation that squeezed wages hard. To make freezing them a pledge for the next parliament merely confirms how much work on the deficit Osborne has left himself to do.

There is still no sense that either party is thinking sensibly or strategically about the size of public sector the economy can afford. Before the 2010 election, the Tories looked and apparently learned from Canada’s experience in the 1990s, when a 20% reduction in the size of the state was achieved, affecting the majority of government functions. But in government the coalition’s approach has been piecemeal.

Labour promises a zero-based spending review, in which every item of spending will be up for grabs. I am not holding my breath, and this has already been partly over-ridden by the party’s commitment to put more into the NHS.

On budget deficit reduction, the parties will fight it out in the coming months over relatively small amounts of territory. We should take both parties’ plans – the Tories’ to achieve an overall budget surplus and Labour’s a so-called current surplus (excluding public sector capital spending) – with a pinch of salt until we get more detail. Osborne will probably win the credibility battle, though may lose some floating voters who find his approach too harsh.

I said I would bring this back to the new economic numbers. They were generally good news, particularly on investment, which is now seen to have been much stronger than previously thought. This stronger trend is continuing, with business investment up by 11% in the year to the second quarter.

Overall investment, up 9.1%, has made a much bigger contribution to growth over the past year, twice as much in fact, as consumer spending. This is encouraging, even if the continued disappointing performance of productivity – 0.3% lower in the second quarter than a year earlier – was not.

But there was another aspect of the latest slew of numbers that was also worrying; the balance of payments. Britain has its own extreme version of the “twin deficits” made famous by Ronald Reagan’s America in the 1980s.

Alongside a big budget deficit, we have a very large current account deficit. In the second quarter that widened to £23.1bn, from £20.5bn in the first quarter. It increased from 4.7% to 5.2% of gross domestic product. In fact it has averaged 5.2% of GDP over the latest 12 months, which is more red ink than we have ever had before, in records that go back to the mid-1950s.

Why is it so bad? Britain’s stronger growing economy attracts imports and export performance has been weak, but for once the trade deficit is not the explanation. It has been improving and was only 1.4% of GDP in the second quarter.

No, the reason was what is starting to become a familiar one. Britain used to have a surplus on investment income – we earned more from overseas investments than foreigners earned in Britain – but now it is the other way around.

Whether this is now the permanent state of things can be debated, though the current account deficit may turn out to be harder to eliminate than the budget deficit.

Whether we should be worried about it can be questioned. Ben Broadbent, the new deputy governor of the Bank of England, suggested in the recent speech that we should not worry overmuch. As long as Britain has what he described as hard-won credibility, the current account should not “pose some independent, existential threat to UK growth”. As long as capital can be attracted to Britain to offset the current account deficit things will be OK.

Let us hope so. But the twin deficits mean that the economy is reliant on investors to fund the budget deficit and capital inflows from abroad. Hard-won credibility can easily be lost. In a time of political uncertainty that threat is a real one.

Sunday, September 28, 2014
Osborne's deficit plan gets lost in the statistical fog
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Maybe Ed Miliband should have talked about the budget deficit, and not just for the obvious reasons.

Had the Labour leader done so he could have provided George Osborne and David Cameron with a bit of discomfort ahead of their conference this week. As far as we can tell, the budget deficit so far this year is up rather than down, and the chancellor is in danger of missing his deficit reduction targets. The “long-term economic plan” will look more than a little tarnished if the deficit starts going up again.

I shall return to that in a moment. I say “as far as we can tell” because the figures for Britain’s public finances have just been put through the statistical mill. The Office for National Statistics (ONS) has redone the numbers to comply with the new European System of Accounts (ESA10) requirements, which apply to all EU member states, and it has introduced a new measure of the budget deficit.

These changes have had even the experts scratching their heads. The independent Office for Budget Responsibility said the new figures make it “more difficult to draw inferences from the latest data for performance against our latest forecast".

The Institute for Fiscal Studies was a little more willing to look through the “significant methodological changes” – which include increasing the level of public sector net debt by £130bn to £1,432bn – but conceded that there were uncertainties about what will happen in the rest of the current fiscal year.

This process of methodological upheaval for the statistics will get even more attention this week, when the ONS updates its GDP (gross domestic product) figures to meet the new ESA10 standard.

Though the ONS has warned against extrapolating the GDP re-estimates it has done so far – to 2012 – on the face of it, this week’s figures will show that the economy surpassed its pre-crisis peak last year rather than this, and is currently some 3% above it.

They may also show that this is no longer the slowest recovery since the dawn of time. Though they will still show that it took longer to get back to where we were before, a big reason for this is the scale of the 2008-9 downturn. When it comes to how fast the economy has recovered from its low point, there is a good chance that this week’s figures will show that the current recovery is slightly better than the 1970s.

Though these revisions are necessary – ONS officials will say they are required to implement these changes and that it would be wrong not to incorporate the latest thinking into their estimates – they are also infuriating.

Much of the debate about the recovery over the past 3-4 years will in time be seen to have been hot air, blown away by statistical revisions. Those initial underestimates of growth did affect business confidence and could easily have resulted in self-fulfilling gloom. The lesson, set out here on many occasions, is to take early unrevised data with a pinch of salt.

When it comes to the budget deficit and government debt, it so happens that the data changes are less welcome than the GDP revisions, in the sense that the headline numbers are higher than before. But, by making comparisons more difficult, they also make it harder to scrutinise the government’s progress against its fiscal targets. The goalposts have moved.

What do the figures for the public finances tell us through the fog? In most respects the story is a familiar one. Borrowing on the new definition (the public sector excluding banks) in the first five months of the current fiscal year, the April-August period, was £45.4bn, compared with£42.8bn in the corresponding period of last year.

That increase in borrowing is, as I say, embarrassing for a government engaged in deficit reduction, though both the OBR and IFS cite factors that will help the public finances as the year progresses.

These temporary timing factors, most notably depressed income tax receipts compared with a year ago – when bonuses and some regular pay were shifted from 2012-13 to 2013-14 to take advantage of the top rate cut from 50% to 45% - will gradually unwind. It remains more likely than not that the 2014-15 budget deficit will turn out to be lower than 2013-14.

Something else is happening in the public finance numbers, however, which suggests that when it comes to deficit reduction the government has inadvertently shot itself in the foot.

If you listen to the chancellor’s critics on the Tory right, you might think that the slow pace of deficit reduction is entirely due to the fact that the government has not been tougher on public spending. What Osborne should have done, they say, is slash spending harder, and use the leeway both to cut taxes and reduce borrowing faster.

In fact, public spending is coming in around £10bn a year lower than the chancellor intended in his June 2010 emergency budget, partly as a result of additional measures to cut spending and partly because departments have underspent. Spending is down in real terms, and some departments and much of local government have faced very big cuts. Public sector employment has fallen by more than 7%, excluding classification changes.

The problem, instead, is on the tax side, and it may lie with one particular tax change. More than 30 years ago in 1981, Geoffrey Howe introduced his austerity budget, as I describe in our special Fifty Years of Business supplement today. The centrepiece was a freeze in the personal income tax allowance, at a time of high inflation. The effect was to increase income tax for the majority of people, hastening the process of deficit reduction.

The coalition, as a result of the deal between the Conservatives and Liberal Democrats, has done the opposite. Instead of an austerity freeze on the personal allowance, we have had a big income tax cut, as it has been raised in large steps to its current £10,000.

It is laudable to take people out of tax and increase the incentives for those at the bottom end of the income scale. But it is also expensive and, it appears, has made it harder to reduce the budget deficit.

The interaction of subdued wage rises and the relative shift from high to lower paid jobs means that the £10,000 allowance costs much more. In an unchanging labour market and something like normal pay rises relative to inflation – which not so long ago official forecasters expected – a smaller share of people’s earnings would have been tax-free. As it is, the tax-free proportion – which higher earners do not benefit from – is one reason why tax receipts are depressed.

We should keep an eye on this. It is, as I say, more likely that we are still in a situation of gradual deficit reduction than not. But the chancellor has deprived himself of quite a lot of tax. The tax take is at least £12-13bn a year lower than it would otherwise have been. He should not be too surprised that it is taking longer to get the deficit down.

Sunday, September 21, 2014
Weak pay and low inflation mean no rate hikes just yet
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

After all the excitement - and for me the right result - time to return to some normal but rather interesting fare. While we have been preoccupied with other things, there have been developments. The question is which way they are pointing.

On the face of it the job market continues to roar away. The unemployment rate, now just 6.2%, is at its lowest since October 2008 – just as the financial crisis was starting to do really serious damage – and is down from 7.7% a year ago.

Without rubbing salt into old wounds, a year ago the Bank of England though it would take until 2016 just to get down to 7%, let alone to be knocking on the door of 6%.

The fall in unemployment over the past year, the fastest for 25 years, takes the wider jobless total down to just above 2m (2.02m), while the narrower claimant count has dropped below the symbolically important 1m level; it is now 966,500.

Add the rise in employment, an extraordinary 774,000 over the past year, with a record 30.61m people in work, and a near-record 73% of the workforce, and it looks like a job market on steroids.

Nor is this without its wider economic effects. Another set of official numbers, for retail sales, showed that spending last month was an inflation-adjusted 3.9% up on a year earlier.

For those thinking we have an economy a little too strong for comfort, all this was ammunition. Martin Weale and Ian McCafferty, two members of the Bank of England’s monetary policy committee (MPC) voted for a second consecutive month for a hike in Bank rate.

They, according to the Bank’s minutes, think the economy is flying high on the stimulus of ultra-low interest rates and while policy remains so “expansionary” spare capacity will be used up, wage pressures will increase and inflation will rise. Modest rate rises now will help cut that danger off at the pass.

For all the strength of these numbers, however, there is another side to the story. Inflation, at 1.5%, is below target and still falling, according to new figures last week. The growth in average earnings has turned positive again, rising by 0.6% in the latest three months compared with a year earlier, or 0.7% for regular pay.

While the unemployment and retail sales numbers look very strong indeed on the surface, some other bits of evidence suggest an economy in which growth is moderating. The National Institute of Economic and Social Research estimates that growth in the June-August period was 0.6%, slower than its recent quarterly growth rate of 0.8%.

Even in the labour market figures, and even apart from the weak pay figures, there were one or two signs that things were not as strong as they have been. The latest three-monthly rise in employment, 74,000, was the smallest since the spring of last year. Though it is too soon to call a break in the trend, the number of people characterised as economically inactive rose by 114,000 in the latest three months, its biggest increase since late 2009/early 2010. It had been falling.

On the face of it too, the figures for pay are going nowhere. Manufacturing is the only significant sector of the economy in which pay in the latest three months outstripped inflation but not by much (2% versus 1.5%). One area where pay was doing well – the large wholesaling, retailing, hotels and restaurants sector – has seen pay growth slow to just 0.6%; in line with the national average increase. It could be that pay increases in this sector are being delayed until the minimum wage goes up from £6.31 to £6.50 an hour next month but it will be a long time until we see this in the figures.

Some of this weakness in pay is hard to square with on-the-ground experience. Last week I helped chair the Countryside/What House? new homes debate at Molineux, Wolverhampton, where the talk was of skill shortages driving pay higher, and materials shortages doing the same for other costs. It may be that we are seeing the first inklings of this in the numbers. For one month only, July, the official statistics showed construction pay up by a hefty 4% (by recent standards) on a year earlier. But again, too early to call a trend.

Similarly, there are the first stirrings of a revival in productivity in the fact that the rise in employment, and the total number of hours people are working, was smaller than the increase in economic output. But we need more data to be sure that faster productivity growth is finally kicking in.

So the economy is genuinely quite hard to read at the moment. Growth has been very strong, as has the job market, but both are showing tentative signs of softening. Inflation is below target, and likely to remain so. We may be looking at a low point of just above 1%, with no return to the 2% target for a long time.

As for pay, its weakness was a puzzle when the job market was so strong. It may become less of a puzzle if the growth in employment really is weakening.

What does this mean for interest rates? Though I have some sympathy for Weale and McCafferty on the MPC, and though they are correct to say that the MPC has to anticipate, not merely respond, I would not vote for a rate rise at the moment.

One reason is the uncertainties about the data, outlined above. The other is that the first hike in rates since 2007 (and the first move from 0.5% since March 2009) would have to be clearly explained to households and businesses.

Mark Carney had a go in his recent speech to the Trades Union Congress but more will need to be done. Raising rates for the reasons set out by the two hikers in the MPC minutes – the concern that spare capacity will be used up rapidly, generating inflationary pressures, does not quite do it.

It may be that come early next year, the evidence is coming through strongly on rising pay. And it may be that recent tentative evidence of slowing growth turns out to have been a false signal. Under those circumstances, a rate rise would be fully justified. Doing it now would look premature.

Sunday, September 14, 2014
Don't go, but Scotland needs the UK a lot more than the UK needs Scotland
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

With days to go, it it is still not clear whether Scotland will avoid the economic car-crash that would follow independence. It could still, as Deutsche Bank's chief economist puts it, be on the brink of a historic economic and political mistake.

The fact that independence will be bad for Scotland’s economy is so clear that it surprises and rather saddens me when some business people north of the border either say there will be little difference whichever way Thursday’s vote goes or that Scotland will be better off.

For a sensible business view of independence, I would look to Terry Scuoler, the Glaswegian chief executive of the EEF, which represents Britain’s manufacturers. As he wrote in The Times on Thursday: “A ‘yes’ vote would be deeply damaging for the Scottish economy, and thereby the living standards of ordinary Scots, for decades to come.”

That’s enough on that, without reprising all last week’s arguments. Let me move on to a different tack. Last week’s dash up to Scotland my the prime minister and the other Westminster leaders, together with the general air of panic about the risks of a “yes” vote, have led to some nationalists making an interesting claim. The reason the rest of the UK is so worried, they say, is because it has been exploiting Scotland all these years.

There are three things wrong with this argument. The first is that it is hard to claim exploitation when Scotland’s income per head – measured by gross value-added - is the highest in the UK outside London and the south-east, even without allocating it a geographic share of North Sea oil. Wales, Northern Ireland and the north-east of England, with income per head on this measure less than 80% of the Scottish level, are entitled to feel hard done by. Scotland is not.

Second, the UK is an economic and monetary union that works. The sum really is greater than the parts. The rest of the UK can regret the loss of Scotland, not because it exploits it, but because if you remove part of any integrated economic system it leads to short-term dislocation – and in this case the short-term could mean several years – and significant adjustment problems.

Separation has economic consequences. When retailers and other companies warn of higher prices in an independent Scotland, they are not bluffing. Once you remove the benefits of an integrated system, and a genuine single market, Scottish consumers will be hit by higher distribution costs and the loss of economies of scale. The greater the currency uncertainty, the bigger such effects will be.

Thirdly, and most importantly, in the long-term the rest of the UK would do very well without Scotland. If there has been a criticism from readers about my take on Scottish independence, it is that I have not emphasised the benefits of separation to the rest of the UK.

We are already seeing some of those effects. A “yes” vote on Thursday will see a substantial migration of Scotland’s banking and financial services industry southwards. Royal Bank of Scotland, desperate to try to please both sides, has said a shift of head office need not mean a reduction of operations and jobs north of the border.

That, however, is an untenable position. The Bank of England is not going to provide lender of last resort facilities and regulatory oversight to a bank that remains substantially Scottish in the event of independence. There will be a large-scale and meaningful migration.

Other businesses are also likely to shift. The problem for England’s northern regions, and for Wales, has been competing with the inducements on offer to invest in Scotland. Veterans of UK trade promotion tell of Scotland, with the support of UK taxpayers, paying perhaps three times per job in investment inducements as the English regions.

Those days will be over, or such inducements will be balanced by the disadvantage for Scotland of being outside the UK. Over the long-term, England’s regions, Wales and Northern Ireland will benefit both from the outflow of investment from Scotland and a greater share of inward investment from overseas.

Britain’s or rather the rest of the UK’s fiscal position will also benefit. As my piece a week ago pointed out, Scotland has run a bigger budget deficit than the UK as a whole for the past 25 years. Oil revenues are in long-term decline. In future, as a result of this, the subsidy from taxpayers in the rest of the UK to fund Scotland’s higher per capita public spending will increase. Removing this liability will benefit the rest of the UK’s public finances, not hugely, but it will benefit them.

Surely, however, Independence would expose the fundamental weakness of Britains’s trade position. In July, the trade deficit in goods was £10.2bn, reduced to £3.3bn by the surplus on services. Last year North Sea oil exports were £39bn. Scotland’s “geographic” 90% share of that would be £35bn. That is a lot of exports for the UK to lose.

It is, but it would be offset by Scotland’s £12bn trade deficit with the rest of the UK, the fact that around £20bn of North Sea profits are currently remitted abroad and, over the long-term, by the shift in activity southwards. An independent Scotland would lose a substantial chunk of her financial services exports, and probably other exports as well. In any event, Britain has to adjust to declining North Sea production and exports. This would merely hasten that adjustment.

In trade, as in everything else, Scotland needs the UK a lot more than the UK needs Scotland. Nearly half of Scotland’s exports go to the rest of the UK. The end of three centuries of economic and monetary integration would hurt the smaller economy moving away a lot more than it would the larger one staying. Losing Scotland would take the UK’s population back to where it was in 2000.

The economic tail, if it does patter off into the distance, would not wag the dog.
None of this should be taken to mean that I want to see a vote for independence this week. This is no time for economic and financial disruption.

At a time when an unsuccessful economic and monetary union is being held together in Europe, it would be bizarre to break up a successful one in the UK. The question is whether voters in Scotland see the sense of that.

Sunday, September 07, 2014
An independent Scotland would be poorer, more unstable and fiscally weak
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

In 11 days, voters in Scotland will decide on whether their country should go it alone. The latest Sunday-Times YouGov poll shows a two-point lead for the "yes" camp. The outcome is now too close to call.

The closeness of the polls has been matched by a shift in the tone of some economic commentary on independence. Some say it would be a close-run thing whether an independent Scotland would be better or worse off than if it remains part of the UK. If this is the case, then Scots are free to vote with their emotions, their hearts.

Such talk is dangerously misleading. The economics of independence are not close at all. Scotland will be worse off in the short-term, in the medium-term and in the long-term if it votes for independence.

A vote for independence will be a vote for a Scotland that is poorer, more unstable, and will require deeper cuts in public spending than if it remains part of the UK.

In the short-term, a vote for independence would be followed by turbulence. Goldman Sachs has warned of a euro-style currency crisis within Britain, with the break-up threat providing investors with “a strong incentive to sell Scottish-based assets and households with a strong incentive to withdraw deposits from Scottish-based banks”.

Robert Wood of Berenberg, the private bank, warns of a yes vote being followed by “serious short-term pain”, in the period of uncertainty over Scotland’s future currency arrangements and EU membership. The UK authorities, including the Bank of England, would be obliged to step in, but as the experience of 2008 showed, financial panics can be hard to contain.

These uncertainties, in the transitional period, have the potential to hit Scotland hard. They could mean that the independence vote is followed by a recession in Scotland and a significant slowdown for the rest of the UK. The longer-term challenges are arguably even greater.

To understand why, we need not get bogged down for the moment in questions about the currency, which many people appear to regard as too confusing, though I shall return to it.

Instead, let me start with the two fundamental economic forces arguing against Scottish independence. The first is declining North Sea production and revenues.

This year the North Sea will produce around 830,000 barrels a day of oil, just 28% of the peak of 2.92m barrels in 1999. Oil and gas production together will be some 75m tonnes of oil equivalent, 31% of the 1999 peak of 243.7m.

There is no doubt at all that North Sea oil and gas production, while far from exhausted, is in long-term decline. That decline has averaged 7.8% a year since the 1999 peak. Production has fallen particularly sharply since 2010, mostly as a result of a sharp drop in production efficiency.

The costs of extracting the remaining oil have increased sharply. The days of big fields being operated by the big oil companies have given way to a situation in which production is from some 300 fields mainly operated by smaller businesses.

According to the Wood Review, chaired by Sir Ian Wood and published earlier this year, development costs per barrel have risen five-fold over the past decade. Oil and Gas UK, the industry body, says exploration activity is at an all-time low.

The result of all this is that oil is ceasing to be a significant revenue-raiser for Scotland. In 2012-13, The North Sea brought in £5.6bn of revenues for Scotland, assuming an independent Scotland would get a “geographic” 90% share of revenues. This was less than half the £11.6bn of 2008-9.

For last year, 2013-14, Scotland’s oil and gas revenues appear to have dropped further, to £4.2bn. The independent Office for Budget Responsibility (OBR) forecasts for North Sea revenues imply further falls over the next few years, to £3.3bn this year, £3.4bn in 2015-16, £2.9bn in 2016-17, £3.1bn in 2017-18 and £3.2bn in 2018-19.

Nor do things get any better after that. Robert Chote, the OBR chairman, recently wrote to the Scottish parliament to explain why he was revising down projected North Sea receipts over the period 2019-20 to 2040-41 from £51.9bn to £39.3bn.

There were predictable cries of foul from the nationalists, though Chote patiently explained how North Sea production and revenues had persistently disappointed. Nor was the OBR taking a gloomy view on output; the assumption is that it will be flat until the end of the decade before resuming its decline, but at a slower 5% a year rate. The OBR’s forecasts imply that Scotland’s North Sea revenues in the 2020s and 2030s will average a modest £1.6bn a year.

Surely, however, any oil revenues are better than no oil revenues? Alex Salmond, the Scottish first minister repeatedly says that no country ever got poor by having oil.

The trouble for Scotland, however, is that its public finances can only be made to add up if it is has significant oil revenues. This is where Scotland falls foul of the second fundamental force; high and rising public spending.

Scotland spends much more than the rest of the UK. Spending per head in Scotland is between 12% and 16% higher than the UK average. Part of the reason Scotland is relatively well off (income per head excluding oil is around 94% of the UK average) is that it is boosted by this higher level of public spending. The pressures for higher spending, not least from the country’s ageing population, will intensify.

In 2012-13, the latest Scottish government figures, public spending in Scotland was £65.2bn. Taxation, excluding North Sea revenues, was £47.6bn. The gap was equivalent to 14% of GDP; bigger than the UK deficit at the height of the crisis. Only by including North Sea revenues was Scotland’s budget deficit brought down to 8.3% of GDP; bigger than the 7.3% for the rest of the UK.

This, in fact, has been the position for the past 25 years. Even with a geographic share of oil revenues, and even in a period when North Sea production was at a peak, Scotland has run a bigger deficit than the whole of the UK.

Its position can only get worse as North Sea revenues decline. The Scottish government, taking what appears to be an unrealistically optimistic view of oil revenues, predicts a budget deficit for Scotland in 2016-17 of 3.2% of GDP, compared with 2.4% for the UK as a whole. Independent assessments from the Institute for Fiscal Studies, Citibank and others suggest a deficit of between 5% and 6%.

It could easily be much worse. If, as feared, the uncertainties following independence hits the Scottish economy hard then this, in combination with weak oil revenues, could easily push the deficit to 10% of GDP or more. Scotland would start independent life on the shakiest of fiscal footings.

Every independent assessment of Scotland’s fiscal position points to the need for bigger spending cuts than the UK government’s austerity programme and tax hikes. “If an independent Scotland wanted to achieve a sustainable medium and long-term fiscal position, further tax increases and/or spending cuts would be needed after independence,” the IFS says.

To replace the falling oil revenues and achieve a manageable budget deficit, Scotland will either need its own austerity – over and above the planned £400m in defence cuts – and higher taxes. The IFS suggests that over the medium term tax increases equivalent to 10 points on the basic rate of income tax and an eight-point hike in the main rate of VAT.

The Scottish government’s response to its fiscal problem has been to pretend it does not exist. Its white paper in the summer proposed net giveaways of more than £1bn. John Swinney, its finance secretary, has promised to end the Westminster government’s austerity. Salmond, astonishingly, has won support by pledging to protect an NHS he already has control of form privatisation and cuts.

Politicians say a lot of things before votes. When fiscal reality hits home, things will look very different.

THE FISCAL DEBATE is not the only issue for an independent Scotland. Its voters have been subjected to the spectacle of businesses lining up on both sides of the debate. “Yes” supporters in the business community have in general been more vocal and willing to nail their colours to the mast, while those backing maintaining the union have been more circumspect, and in many cases have emphasised that they are only expressing a personal position.

If there is a pattern to these declarations it is the smaller firms operating mainly within Scotland appear keener on independence, while larger firms do not want it. The Scottish government is offering a 3% cut in corporation tax to stop firms from leaving, and to attract new ones.

Scotland’s problem, however, is that it does not have enough private-sector businesses now, and independence is likely to result in a loss of big taxpaying firms, notably but not exclusively in financial services.

Scotland has 740 private businesses per 10,000 adults, lower than any UK region apart from the north-east of England. Most businesses will worry that, behind the prospect of a small cut in corporation tax, there is the bigger danger of other taxes going up. Post-independence, those who want access to the market of the rest of the UK would be able to do so from Ireland, with a corporation tax rate of 12.5%.

In his Gresham lecture earlier this year, Professor Douglas McWilliams predicted that much of Scotland’s financial services industry would migrate to London, with a consequent loss to Scotland of high-paying jobs and tax revenues. Scotland’s banks, in particular Royal Bank of Scotland, will have little option but to re-domicile. What Scotland may gain in a few entrepreneurs emboldened by a yes vote it will more than lost in the departure of large businesses.

That will be compounded if the Scottish government carries out its threat not to take on its share of UK public debt, if it is not allowed to be part of a currency union with the rest of the UK.

Such a move would make a newly independent Scotland a pariah in the financial markets – a country that reneges on its debts once can do so again – and a pariah in the rest of the UK. A country that walks away from its debts deserves to be condemned. In the latest five years alone, the Scottish government’s figures show Scotland has run up debts of £88bn, or more than £51bn if its ‘geographic’ oil revenues were backdated.

Scotland’s currency arrangements threaten to be its biggest problem of all. Westminster’s insistence that it would not allow Scotland to be part of a formal currency union is taken seriously by all but the nationalists, mainly because it would not be the rest of the UK’s interest.

Salmond’s insistence that the rest of the UK would want to be in a currency zone with Scotland because the two form an “optimal currency area” is either extreme ignorance or a deliberate attempt to mislead. Once Scotland left the UK and established its own fiscal policy with its own Treasury, the optimal currency area would have ceased to exist.

As it is, Scotland’s lack of currency preparation is shocking. It took Europe decades to prepare the ground for a single currency that nevertheless had significant launch problems. The Scottish first minister’s throwaway insistence that all options are open for an independent Scotland does not deserve to be taken seriously.

As it is, the only option on the table, taking the Scottish government’s statements at face value, is the worst of all worlds; use of the pound but without any influence on it (sterlingisation), accompanied by a reneging on past debts. There would be no lender of last resort for what remained of the Scottish banking sector. That is the policy of a banana republic, not a proud nation

FOR SUPPORTERS of independence, all of the above will be dismissed by what has been the problem for the “No” campaign; how do you enthuse people by pointing out the risks. People want to vote for positive reasons and they are also tempted to vote for a change. Is there a positive message among the many negatives that would be associated with independence?

Yes. Capital Economics, in a report, says that a no vote would lead to an economic resurgence in Scotland, at least in the short term, as uncertainty fell away. Scottish firms quoted on the stock market have suffered an uncertainty effect, depressing their share prices relative to the rest of the market and, while Scotland’s economy has been growing, its unemployment has fallen more slowly than the rest of the UK.

Longer-term, Scotland has been pledged greater powers even in the event of a rejection of a no vote. Scottish voters will get a version of “devo max”, greater devolution but without the huge risks and economic damage associated with independence. A canny Salmond will even be able to present that as a victory.

And if the Scots were to use these extra powers to build a stronger economy, without its current fiscal vulnerabilities and with a workable currency plan, they might even be able to make the economic case for independence in the future. There is no case for it now.

Sunday, August 31, 2014
French lessons in how not to run an economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Britain and France are two nations separated by just 21 miles of sea but sharply divided by their economic performance. France, economically stagnant, is experiencing rising unemployment and disagreements over policy which last week forced a serious cabinet shake-up.

Britain, in contrast, is growing well, unemployment is tumbling and, against the predictions of many when the coalition government was formed more than four years ago, has kept policy disagreements to a minimum.

This is not a “what I did on my holidays” piece. I did not contribute to the roughly 9m annual visits by Britons to France this year. But what is happening in France is interesting, and in some respects a warning; it could have happened to Britain.

The French economy did not grow in 2012, managed just 0.2% in 2013, and has growth by just 0.1% in the past 12 months, with little better in prospect for the rest of the year. That is what you really do call flatlining.

Britain did not grow much in 2012, 0.3%, but picked up to 1.7% in 2013 and has grown by 3.2% in the past 12 months.

Britain’s unemployment rate has dropped to 6.4%, a fall of 437,000 in the past 12 months to just over 2m. French unemployment, by contrast, is 10.2% of the workforce, has risen for 36 months in a row and stands at more than 3.4m. Business and consumer confidence in Britain is strong; in France it is weak.

France’s problems go deep. It suffered a milder recession in the crisis than Britain and, with a smaller financial sector and budget deficit, initially recovered more quickly. But that soon faded and the government’s efforts to foster stronger growth with economic reforms look doomed to disappoint.

Fitch, the ratings agency, published an assessment following President Francois Hollande’s dismissal of ministers opposed to his economic programme and appointment of a new cabinet.

“The impact of recent reforms is unclear but in our view they do not look sufficient to reverse the decline in long-term growth and competitiveness,” it said. “We think estimates of long-term growth potential around 1.5% are plausible. A weak labour market will constrain private consumption, while an uncertain economic outlook and low profit margins will subdue business investment.”

Britain has three big advantages over France. Reforms of the kind the French government is trying to introduce were implemented in Britain 30 years ago, though France’s are more timid. France’s supply-side reforms are not only late but there is little political support for them and they are being introduced against the backdrop of a stagnant economy.

Indeed, there was an echo in last week’s French cabinet shake-up, and the removal of anti-reform ministers, of the wet-dry battles in Margaret Thatcher’s early years. She got rid of most of the “wets” and stuck to it. You would not want to bet on Hollande doing the same.

The second factor is the euro. Britain, very sensibly, stayed out of the euro. Though euro membership has not been as big a constraint on France as it has been for the eurozone’s peripheral economies, it inevitably limits the government’s room for manoeuvre. France, like other eurozone countries, is finding life tough in a German-dominated currency union and, with an inflation rate of just 0.6%, is flirting with deflation.

Most importantly of all, France’s problems show the danger of policy lurches, even if they are in a sensible direction. Hollande was elected on a ticket of defying austerity, hitting the financial services industry hard and soak-the-rich tax policies. Ed Miliband, the Labour leader, should be embarrassed by his open admiration for the French president’s then programme.

Hollande has now moved to a programme of spending cuts to pay for tax reductions alongside measures to reduce the costs of doing business and employing people, as set out in a major speech in January. Any sinner who repents is to be welcomed but the effect is to breed uncertainty.

Britain’s coalition government, in contrast, has mainly stuck to what it said it would do on the economy. Policy certainty breeds confidence. The policy has been steady deficit reduction policies alongside loose monetary policy. This is not always well understood by those who should know better; I was astonished to hear John Longworth, director-general of the British Chambers of Commerce, say on the radio the other day that there has been no austerity in Britain.

How much should we worry about what is happening in France and the rest of the eurozone? Can Britain carry on growing while there is stagnation so close to home?

From the middle of 2011 to the spring of 2013, when the eurozone’s double-dip recession coincided with fears of imminent euro break-up, Britain was significantly affected. Falling demand for Britain’s exports and, more importantly, the confidence effects of a eurozone apparently on the brink hampered growth.

The eurozone overall is not quite as weak as France but is weaker than is comfortable to support Britain’s recovery. In the latest 12 months the eurozone has grown by just 0.7%. It needs to be rather stronger, and the European Central Bank will almost certainly need its version of quantitative easing to bring that about and head off the danger of system-wide deflation.

We should not, however, expect strong growth in the eurozone, or in France, any time soon. A couple of weeks ago I pulled out some figures for growth in Italy, Germany and France since the launch of the euro in 1999; all of them much weaker than Britain.

The same is true of the eurozone as a whole. Its economy has risen by 18% in real terms since 1999, compared with 30% for Britain. Britain can grow at a decent pace when the eurozone is merely growing weakly. Achieving good and sustained growth in Britain when the eurozone is stagnating, as exemplified by the problems in France, is possible. But it is more of a challenge.

Sunday, August 17, 2014
Baby-boomers take some of the rap for falling pay
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Strange things are happening. Pay should not be falling at a time when employment is booming – up by 820,000 over the past year – and unemployment is tumbling.

Yet it is. As most people will have noticed, the latest average earnings figures showed that total pay, including bonuses, was down 0.2% on a year earlier in the April-June period. This was not the first time this has happened – there was a bigger, though temporary, fall in pay in the depths of the crisis and recession in the early part of 2009.

This one will also be temporary. When the Office for National Statistics reports the next set of labour market numbers in a month’s time, I think I can guarantee that pay growth will have turned positive again. This is because part of the big distortion in the figures – both bonuses and regular pay were boosted in the spring of last year to take advantage of the cut in the top rate of tax from 50% to 45% - will have dropped out.

Most of this effect was in April, when total pay on a single-month basis was down by 1.5% on a year earlier, though some carried through into May and June.

That is the good news. The bad news is that, even as the pay picture turns positive, it will remain subdued. Getting back to 1% pay growth will take a while. Getting back above inflation, currently just below 2%, will take even longer.

I thought pay would slightly outstrip inflation this year, giving us modest real earnings growth. It did in the first quarter, when pay growth of 1.9% moved just ahead of average consumer price inflation of 1.7%. But this unwound in the second quarter, partly because of the bonus distortion, but partly because of other factors.

So what is happening? Why is pay apparently weakening when the job market is getting tighter? It would be easy to blame the official statistics, and the contrast with other surveys, notably from the Recruitment & Employment Confederation, which point to rising pay pressures.

It is important, though, to dig a little deeper into the figures. The average weekly earnings figures are affected, not just by the timing of bonus payments, but by two so-called compositional factors.

One is the fact that pay in some high-earning sectors, notably financial services, has been falling, dragging down the average. The other is changes in the mix of employment, with the strongest growth in lower-paid jobs.

The Office for National Statistics adjusts for this second effect deep in the entrails of its statistical releases. So in June, for example, wages were up by 1.5% on a year earlier in total, with regular pay up 1.2%, but in both cases the average was dragged down by this employment effect. These figures give a better idea of the wage increases people actually receive.

But they are still very weak by past standards. On this same measure, wage increases of between 4% and 5% were the norm before the crisis, and you do not have to go back too far for a time when they were very much higher. I don’t suppose anybody in the 1970s would have ever imagined that we would one day worry about too low a rate of wage inflation.

The many explanations of why it is happening include immigration- discussed here two weeks ago - the collapse of union power, the possibility that pay settlements have not yet adjusted to fast-falling unemployment and welfare reforms pushing people more effectively off benefit and into the job market. It is interesting that the claimant count, which measures the number of people claiming jobseeker’s allowance, is now just over 1m, compared with 2.08m for the wider Labour Survey measure of unemployment.

I quite like another explanation. As a baby boomer I am used to being blamed for many things, from destroying the planet to pushing house prices up to unaffordable levels and keeping them there. Now, it seem, we may also be to blame for weak wages.

There was a time, in the relatively recent past, when Britain’s occupational pension system was the envy of the world and the Saga generation retired in their fifties to travel the world or potter in their sheds.

No more. I am not saying age discrimination has disappeared from the job market – no letters please – but older workers are on the rise. In the 50-64 age group, 68.5% of people now work, compared with 60% in the year 2000. The proportion of 65-plus people working has doubled from 5% to 10% over the same period.

Now, 26% of those in employment are aged 50-plus, compared with 24% immediately before the crisis and 22% in 2000. Overall employment trends are up but those for older workers are particularly strong.

Why? The Bank of England, which had a look at this in its inflation report, cited several factors, including the rise since 2010 in the state pension age for women, the abolition of the default retirement age and – perhaps most importantly – in an era of ultra-low interest rates on savings and lousy pension returns, many people have no option but to carry on working.

The more people in work, whatever their age, the more incomes are generated, and the more growth there is. But older workers staying in the job market probably spend less of their income, are less likely to be less demanding when it comes to pay and dampen down on pay pressures, like immigrants, by increasing the pool of available labour.

If I wanted to really controversial I would say they may also be less productive than younger workers, though while that may have been true in an age of manual labour, where muscles mattered, there is no good research evidence that it is true now. Older office workers are less technologically adept than their younger colleagues but spend less time on Facebook.

I am not suggesting for a moment that older workers should carry the can for all the weakness of wages. But they are part of a phenomenon in which rising labour demand creates additional supply, whether that supply is from overseas or from changes in working patterns at home. Nor, given that government policy involves increasing the number of older workers in work, and getting them to do so for longer, is this going to fade. Ultimately it is a good thing.

So where is pay headed? In September last year I did a piece headed ‘This squeeze on pay is not about to go away’, citing research by Bill Wells, a labour market expert at the Department of Business. His theory was that pay increases were “shocked” into a 1% to 3% range by the crisis and – were likely to stay there until something new came along to shock them out of it.

At the moment pay rises are at the lower end of that range. They could move to the top of it in time, as the Bank and others expect, allowing modest rises in real wages. But modest is the word. The forces weighing down on pay are not going away.

Sunday, August 03, 2014
It can get sticky when you're a honeypot for migrants
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Immigration is an issue it would be easy to file away in the “too difficult” drawer. Is it one of those where good economics – most economists would say it brings net benefits for the country – can never be good politics? Or is it a bit more complicated than that?

A few days ago the International Monetary Fund, in its annual assessment of Britain’s economy, was generally supportive of the coalition government’s policies but warned that “restrictive immigration policies could have a negative impact on productivity growth”.

It called for a relaxation of immigration restrictions in areas where there are labour shortages, as well as a loosening the visa regime for foreign students, which it said “could contribute to expanding the skilled labour force and to improving the prospects of higher education exports”.

The Office for Budget Responsibility (OBR), the government’s fiscal watchdog, in its latest assessment of Britain’s long-term fiscal sustainability, demonstrated that the lower the level of net migration, the higher the level of future government debt. Migrants tend to be of working-age and pay more in taxes than they take out in benefits.

In 50 years’ time, in 2063-64, public sector net debt will be just over 40% of gross domestic product in a “high migration” assumption; net migration continuing at 225,000 a year, similar to its recent rate. If, however, net migration was reduced into the “tens of thousands” as suggested by ministers – the OBR uses a figure of 90,000 a year – net debt in half a century will be closer to 90% of GDP. Migration is good for the public finances.

I can hear some harrumphing as I write that sentence, about the inability of anybody to predict the state of the public finances in half a century, about the assumption that the economic benefits of migration outweigh the costs and about the fact that it is easy for bodies with three-letter acronyms to ignore the politics of immigration.

Those politics were exposed about the time the IMF published its recommendations. Following up on a newspaper article and broadcast coverage, David Cameron invited me (by e-mail) to “share the facts” on an “immigration system that puts Britain first”.

The Conservatives, he said, were closing bogus colleges, cutting benefits for EU immigrants – reducing the time they can claim them from six to three months – and outlawing the practice of advertising British jobs in other countries but not here.

The prime minister’s announcement that he was cutting benefits for immigrants drew much mockery, while his apparent claim that it would save £500m over the next few years brought a clarification from the OBR. Its chairman, Robert Chote, pointed out that the £500m referred to a series of measures unveiled in the March budget, for which the costings were uncertain. The measure to limit benefits from six to three months will affect only a few thousand people.

There is a tendency among the chattering classes to dismiss any measures that target the benefits immigrants receive, or the use by foreigners of the National Health Service. Most migrants do not come here to receive benefits but to work, and heath tourism is a bigger issue in the tabloid newspapers than it is in reality.

Perceptions are important, however, and though neither benefit nor health tourism are not huge, there is some of each, and no government in the current climate could get away with ignoring it.

Cameron’s problem, of course, is that he can tinker around the edges of immigration but he is competing against two fundamental difficulties. One is that he there is very little he can do about EU migration. The other is that the more successful the economy and job market, the more that Britain becomes a honeypot for migrants.

Net migration to Britain, which for many years was negative or insignificant, has fluctuated between 150,000 and 300,000 for the past decade. Last year’s figures of 212,000 (up from 177,000 in 2012) was roughly in line with its recent average.

Most people, I suspect, think that recent migration is all about the enlargement of the European Union to the east in 2004 and the Labour government’s decision to admit the EU’s new citizens. In fact, while EU migration to Britain – 124,000 last year – is important, it was exceeded by non-EU migration, 146,000, though this was the lowest since 1998. The other key fact was that there was net migration of 57,000 by British citizens moving overseas.

If we take the last 10 years, there was 900,000 of net migration into Britain from the rest of the EU, less than half the 1.98m of non-EU net migration. Over the same period, there was net outward migration of 780,000 by British citizens. So, net migration of 2.1m over 10 years. The proportion of non-UK born workers in Britain, now just over 9%, is almost three times its 1997 level, though is probably not as high as most people would guess.

What has been the effect of this migration? In surveys of the evidence produced by the Department of Business, Innovation and Skills and the University of Oxford’s Migration Observatory, there has been some negative impact on employment for British workers, though this effect is mainly when the economy is weak. Immigration has also reduced the wages of lower-paid workers, including earlier migrants, because they tend to compete most in the job market with new migrants. It is quite likely that higher levels of migration have contributed to the weak growth in wages of recent years.

The other big effect is on housing. Though not every migrant worker requires their own house or flat, met migration is running at roughly twice the level of new housebuilding. More than 2m of net migration puts a lot of pressure on available housing. The IMF is right to say, as it also did in its report, that Britain needs a lot more new housing. But we know this is far easier said than done, and for the moment, its encouragement of more immigration will add to housing shortages and the upward pressure on prices.

I said this was difficult. Immigration brings long-term fiscal benefits and probably does raise growth more than population (it boosts per capita GDP as well as GDP itself). But it also produces short-term losers in the job market and adds to pressure on available resources including housing, as Bob Rowthorn pointed out in a report for the think tank Civitas on Friday.

It also leads to political responses that take us close to the worst of all worlds. The prime minister is obliged to oversell policies that make little difference, and fail to satisfy those, including the UKIP tendency, who want a clampdown on migration that they only think can be achieved by leaving the EU.

Meanwhile, though non-EU migration remains high, businesses and universities complain that the restrictions that have been introduced make it hard for them to attract key employees and the best students. The result is a policy that satisfies nobody. It is all a bit of a mess.

Sunday, July 27, 2014
The black hole's still huge - but Osborne's slowly filling it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The latest figures for Britain’s public finance a few days ago produced an interesting reaction. Either Britain’s budget deficit is soaring, and George Osborne’s strategy for reducing it is in tatters, or it has stopped falling, which is hardly any better.

Neither of those verdicts is correct, as we will see in the coming months. But they are part of a wider problem when it comes to assessing Britain’s fiscal policy. Those on the right of the chancellor – there are some – say he should have cut spending harder in the face of disappointing deficit reduction, claiming that he has left all the hard work, two-thirds of it some say, until the next parliament.

Those on the left, meanwhile, accuse Osborne of inflicting untold misery on large sections of the population with his unremitting austerity, while some economists – mainly on the left – say the only reason Britain’s economy is recovering is because he abandoned that austerity.

Let me guide you through this minefield, starting with the latest figures. They showed that the budget deficit, public sector net borrowing, was £11.4bn last month, up £3.8bn on June 2013. The figures a year ago were, however, artificially helped by a £3.9bn payment from the Bank of England to the Treasury of interest it receives on its holdings of gilt-edged securities under the quantitative easing (QE) programme. Adjusting for that, borrowing last month was marginally (£111m) down on a year earlier.

That does not sound like much of a deficit reduction programme and borrowing in the April-June period, the first three months of this fiscal year, was £36.1bn, £2.5bn up on a year earlier.

Again, however, there were special factors at work. In the spring of 2013, as noted here before, both wages and salaries and income tax receipts benefited from income being shifted into the 2013-14 tax year to benefit from the cut in the top rate of tax from 50% to 45%. The silver lining for this year, as the Office for Budget Responsibility (OBR) pointed out, will be that self-assessment receipts due in January will be similarly boosted.

This “end-loading” to tax receipts, coupled with the strong revenue growth in June – Vat up 5.5% on a year earlier, corporation tax 17.6%, stamp duty 43.1%, National Insurance contributions 3.3% - should mean that the borrowing overshoot of the first three months turns into an undershoot. Borrowing this year in line with the official forecast of £95bn, after £105.8bn in 2013-14, remains in prospect. This is better, incidentally, than the OBR expected in March 2013, when it thought borrowing would be becalmed at £120bn for three years and only slip to £108bn this year.

But £95bn is still a big number, and is a lot bigger than the OBR expected when it published its first forecast alongside Osborne’s first budget, back in June 2010, when it predicted a deficit of only £37bn for this year. Doesn’t this tell us that the critics are right, and that the chancellor has soft-pedalled on austerity, kicking the can down the road?

No. If we take public spending, which is where the chancellor gets it in the next from his right-wing critics, the striking thing is not that that spending has been relaxed but that it has been tightened – cut – relative to the 2010 plans.

According to those plans, the government intended to spend £722bn in the 2013-14 fiscal year, that one that ended this spring. In fact it spent £714bn.

Spending has been lower each year than set out then. Public sector current spending was originally intended to be £679bn in 2013-14. In fact it was £668bn. Unusually, for any government, spending has come in comfortably within budget. There has been no slippage.

Where there has been slippage is in tax receipts, which have been weaker than expected. A small amount of that was due to deliberate policy choices – not raising fuel duty and increasing the personal income tax allowance to £10,000 more quickly – but most of it was not.

The weakness of the recovery until 2013, due in part to deficit reduction but mainly weak credit, the squeeze on real wages and the eurozone crisis – hit tax receipts. As long as growth persists, and the International Monetary Fund last week revised its forecast for Britain up to 3.2% this year and 2.7% next, and with figures on Friday showing GDP back above pre-crisis levels, tax receipts will continue their comeback, reducing the deficit more quickly.

Did Osborne abandon his austerity? No, of course not. The always excellent Institute for Fiscal Studies, in an analysis by Gemma Tetlow, one of its economists, sets out the numbers clearly on its website. Starting in 2010-11, there was a discretionary fiscal tightening of 1.6% of gross domestic product, followed by 2.4%, 1.4%, 1% and a planned 0.6% this year. The pace of tightening has slowed, but that “front-loading” was always intended. Over the course of the parliament the coalition will have tightened by 7% of GDP, slightly less than the 7.9% originally planned because of the tax changes described above, but only slightly.

Why is there still so much to do? By the end of this year, says Tetlow, 55% of the planned tightening will have occurred, leaving 45% to the next parliament. It is important to be aware, however, that the goalposts have been moved.

They were moved in November 2011 when the OBR changed its view on the economy’s productive potential, so more of the deficit was deemed to be structural – and thus requiring tax hikes or spending cuts – and less of it cyclical, in other words disappearing with the recovery.

The second goalpost shift was by Osborne himself, when he set himself the goal of achieving a sustained budget surplus, rather than merely getting the deficit down to zero. Between them, these moves increased the amount of work to be done, so there is more to do. But a lot will have been achieved. By 2018-19, according to the IFS, a deficit reduction programme equivalent to 11.5% of GDP will have been achieved. Apart from in the special conditions of moving from war to peace, I do not think that has ever been done before.

It is disappointing more than four years after Britain’s budget deficit hit a record £157bn, that it is still closer to £100bn than it is to zero. But progress is being made. It has to continue.

Sunday, July 20, 2014
An independent Scotland risks a Greek tragedy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This will not be my last look at Scottish independence between now and the September 18 referendum but it will keep us going for now. I urge readers in other parts of the UK not to switch off now. It matters, and it matters rather a lot.

Independence is not all about economics but if the economics does not work it will be a pyrrhic and ultimately damaging victory for its supports.

My focus today is on Scotland’s fiscal and financial position, not least because voters are not in my view getting the true picture. Of course this piece, along with pretty much everything else produced south of the border, will be dismissed by the nationalists. But it is accurate.

So, I have two aims. The first is to briefly set out a few basic facts on Scotland’s fiscal position. The second, more substantive aim is to introduce a rather interesting forthcoming report from Fathom Consulting, a firm which has no political axe to grind on independence, one way or the other, but which has a new take on it.

Let me begin with those fiscal facts. You may get the impression from listening to some Scottish politicians that Scotland is in a healthy fiscal position. Most nationalists have stopped claiming that Scottish taxpayers pay more into the UK Exchequer than they take out but nonetheless give the impression of rude fiscal health.

It is not true. The latest Scottish official figures, taken from Government Expenditure and Revenues Scotland (GERS), show that if calculated on the same basis as the rest of the UK, a so-called per capita basis – with oil revenues shared equally across the UK - Scotland had a budget deficit of 13.3% of gross domestic product in 2012-13, the latest year for which figures are available. That compares with 7.3% for the UK as a whole; the Scottish deficit is nearly twice as large.

The Scottish deficit, on this same basis, peaked at 16.5% in 2009-10, when the whole of the UK deficit was 11% of GDP. Edinburgh has a fiscal problem. High levels of public spending are not matched by the onshore tax base.

But surely, you will say, Scotland has North Sea oil. Yes it does, and it might be allocated 90% of it post-independence. But every reputable forecast, including the most recent from the Office for Budget Responsibility, shows a future decline in output and revenues from the North Sea. Even with 90% oil, Scotland’s budget deficit in 2012-13, 8.3% of GDP, was bigger than that for the whole of the UK. It has been bigger on that basis for the past 25 years.

It will get even larger if John Swinney, the Scottish finance secretary, follows through on his recent suggestions that an independent Scottish government would deliberately borrow more to boost public spending.

That is the backdrop, now for that Fathom Consulting report, ‘Economic consequences of independence for Scotland and the rest of the UK’, written by Florian Baier and Erik Britton, in response to requests from clients – some of them north of the border – for an assessment. I shall return on another occasion to the implications of independence for the rest of the UK.

Fathom’s report is a balanced one. It sets out the conditions under which an independent Scotland could succeed. But it also describes a scenario, one that it is in danger of following, in which an independent Scotland would be seen by investors as being as risky as Greece.

Fathom’s sovereign fragility index shows that the government bonds of an independent Scotland without a geographic (90%) oil share would be so far into junk status as to be beyond Greece. Those very large (13.3%) budget deficits on a per capita basis would scare investors.

Even if Scotland gets a geographic share of oil, however, it would not be out of the fiscal woods. Fathom estimates that it would still be as fragile as Greece, not because its budget deficits are a bit larger than the whole UK but because it would carry too much banking risk.

As things stand, Scotland’s banking assets – in practice the potential liabilities of an independent Scottish government in the event of independence – are a staggering 1,100% of GDP. Scotland has a potential banking liability of Icelandic proportions, and much bigger than those (700% of GDP) which almost bankrupted the Irish economy.

To be viable, Scotland has to get rid of its banks, or at least their domicile, and keep a much smaller level of banking operations and assets. Some would say this process will happen anyway, or is happening; RBS’s Gogarburn headquarters on the outskirts of Edinburgh, otherwise known as Fred’s folly, as in Goodwin, is said to be a shadow of its former self in terms of the numbers employed there. But the nationalist position appears to be that they can hold on to their banks, and the rest of the financial services industry. Even if that could be achieved, it would be a fatal error.

A Scotland with geographic oil and a greatly shrunken banking sector would still not be financially viable, according to Fathom. The other ingredient is an independent currency. Having been rebuffed on monetary union by the three main parties in Westminster, Alex Salmond, the Scottish first minister, insists an independent Scotland will continue to use the pound. That would be the worst of all worlds.

The case for an independent currency is simple. Though North Sea oil is diminishing it would still be disproportionately important for an independent Scotland. When oil prices are strong, that would boost the Scottish economy, and vice versa when they are weak. Stuck in an unofficial currency zone with the rest of the UK, or an official one at some later date as a member of the euro, Scotland would lack the currency flexibility needed to respond to these shifts. It needs its own independently floating currency, a petrocurrency.

Could an independent Scotland work? Yes if it allows the banks to leave, establishes an independent currency and takes tough but gradual fiscal action – spending cuts and tax hikes – to make its public finances healthy. Unfortunately, none of these three policies appears to be on the Scottish government’s agenda.

That could be very bad news. According to Fathom: “Any other settlement … could make it impossible for Scotland to borrow, forcing the government into a severe tightening of fiscal policy and Scotland into recession. Scotland would face a situation worse than the one that has been facing Greece for the last few years.”

I don’t know what effect that conclusion will have on floating independence voters but it would certainly scare me.

Sunday, July 13, 2014
Don't blame Superpound for Britain's export woes
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Official figures a few days ago for industrial production in Britain produced a surprise. And, for once, it was not a pleasant one. Overall industrial output fell by 0.7% between April and May and within that manufacturing recorded a hefty 1.3% drop.

It was not the only disappointment. Britain’s trade deficit widened from £2.1bn in April to £2.4bn in May on the back of a meagre £0.1bn monthly rise in exports, more than offset by a bigger rise in imports. In the latest three months exports of goods have risen by just 0.1% to £72.6bn, while imports are up 0.5% to £98.9bn.

The industrial figures appear to be an aberration and are at odds with much stronger survey evidence. Manufacturing output in the latest three months was up by 1.1% on the previous three and, this – annual growth of around 4% - is a better guide to what remains a pretty robust industrial recovery.

But the trade figures tell a familiar and more believable story, which is that the great export revival that was going to be an important driver of growth and rebalance the economy, is still eluding us. Total exports in the latest three months in cash terms were 3.6% down on a year earlier. The volume of goods exports was 2% down. It is a strange kind of revival when exports are falling.

The question is whether this is due to the strength of the pound. Sterling Is flavour of the month among currency traders, At $1.71 it is more than 20 cents up on where it was a year ago, and at more than €1.25, it has gained roughly 10 euro cents.

Why is the pound so strong, will it last, and is it the thing holding back our exporters? Simon Derrick, BNY Mellon’s currency strategist, and “a big fan of sterling” says that there is a simple interest-rate story to tell about the pound’s strength.

The Bank of England, while it left interest rates unchanged again last week, is paving the way for the start of a series of hikes, beginning in the next few months. The European Central Bank, in contrast, is still cutting rates – though it has probably now cut them to rock bottom – and is contemplating other ways of relaxing monetary policy.

Reading what America’s Federal Reserve plans to do under its chairman Janet Yellen is far from easy, but two things should be remembered about the Fed. The first is that, while the Bank has not done any quantitative easing (QE) since July 2012, the Fed is still doing it. Though it is tapering its QE asset purchases, it will not stop them until later this year, probably October. The second is that it will not raise rates before the Bank.

Britain’s economy is surprising with its strength and the Bank has suddenly become the muscle man among the seven-stone weaklings. That’s exaggerating it but, when other central banks are bending over backwards to be dovish, even a sparrow can look like a hawk.

CrossBorder Capital, which monitors liquidity flows between different economies, offers another reason for sterling’s strength. Mike Howell, its chief executive, says the interest-rate explanation is important but so too are private sector cash flows, which have rebounded. “British firms are generating sizeable cash flows and this is providing major support to the currency because it signals a robust domestic economy and a strong rebound in corporate profitability,” he notes.

Will it last? In time the Fed will move from relaxing monetary policy to hiking rates, though that is unlikely to be for several months after the Bank has begun to raise rates. Higher interest rates in Europe are a very long way away.

The biggest threat to the pound may be political rather than economic. Derrick notes that sterling’s volatility is unusually low given that we are into the 12-month run-in to the election, normally a period when markets start to factor in some political risk.

He thinks there is not much danger to the pound from September’s Scottish independence referendum, given the state of the polls, but that there is from next May’s general election. For this and other reasons, the pound is unlikely to repeat its rise of the past 12 months. Against the dollar, the story of sterling’s climb may be coming to an end, though it probably has further to rise against the euro.

Is the pound harming industry and exports? We should put its recent rise in perspective. What is the current sterling-dollar rate? $1.71. What is its average for the past 10 years? Also $1.71. For the euro the figures are €1.26 and €1.28 respectively. Before the pound began its slide in 2007, it traded at $2.11 and a fraction under €1.50. Exporters are still benefiting from a significantly lower pound than in the past.

Vince Cable, the business secretary, put it well in a speech to the Social Market Foundation last week. While he acknowledged industry’s concerns about the strength of sterling, he also noted that there was evidence that Britain’s exports were less price-sensitive than in the past and that “there has been a weaker connection between sterling’s crisis-driven depreciation and the strength of UK exports than we might have expected and hoped for”.

Exports depend on whether markets are growing or stagnant and having the right products, services and trade support. They depend on quality, reliability and timely delivery and, as Cable pointed out, British industry raising its productivity game.

We should not blame the pound, which is not in the grand scheme of things particularly strong, for a disappointing export performance.

Sunday, July 06, 2014
Inequality: always with us but less than it was
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Inequality is always with us and it never loses its power to provoke debate. This year, of course, we have had a bestselling book on it, Thomas Piketty’s Capital in the 21st Century.

The politics of inequality will feature in the run-up to the next election. Though official estimates suggest a 50p top of income tax will raise no additional net revenue compared with 45p, Labour is pledged to reintroduce it if re-elected.

The default position of the comfortably off, whether they are Church of England bishops, Bank of England governors, academics or think-tank researchers, is that “something must be done”.

Often, of course, that something would end up damaging those on low incomes, whether it is requiring all employers to pay a co-called living wage, or paying over-generous benefits that trap people on welfare.

I quite liked the formulation used by Tony Blair and Gordon Brown, which was that governments should strive to improve equality of opportunity but accept that inequality of outcomes are inevitable. Such inequalities can be and are reduced by the tax and benefits system but take that too far and you destroy incentives and growth.

Enough preamble, what do the numbers tell us about inequality? Let me bring in some evidence. Hottest off the press is an analysis by the Office for National Statistics of wage trends in recent decades; UK Wages Over the Past Four Decades.

Though there is probably too much of an obsession with the top 1% and 0.1% in this debate, it shows that the top 1% of earners (strictly speaking those at the 99th percentile) earned 11 times as much per hour as the bottom 1% (those at the 1st percentile) in 2013. That sounds quite a lot but it is down from almost 13 times in 1998. The minimum wage has supported people on low wages, while higher earners have suffered the biggest drop in incomes since 2011.

Exhibit 2, also from the ONS, is a report The Effects of Taxes and Benefits on Household Income, published a few days ago. The ONS has a measure called equivalised income, which is income adjusted for both inflation and the size of household.

The striking result in this report was that since 2007-8 – when the crisis first hit – the richest 20% of households have seen a drop of 5.2% in this measure of real incomes. The poorest 20%, in contrast, have seen a rise of 3.5%.

I should say in the interests of completeness that the poorest fifth of households have done well largely thanks to the pensioners among them, whose real incomes have risen by 14% since the crisis (pensioners in general have seen a 7.9% rise). But, because benefits were initially better protected than wages, the smallest fall in real incomes among non-retired households – 2% since 2007-8 – was among this bottom 2%. Inequality has fallen as a result of the crisis.

This is also the message from another piece of official analysis, called Households Below Average Income, published a few days ago. It found that income inequality in 2012-13 was little changed from 2011-12, but again was well down on where it was. It takes two income measures; before and after housing costs. The former showed inequality down to where it was in the mid-2000s, the latter preferred measure down to mid-1990s’ levels.

As the Institute for Fiscal Studies put it, describing the squeeze on earnings and the fact that benefits were protected: “Benefits account for a relatively large share of household income towards the bottom, whereas earnings account for a relatively large share further up. After almost two decades in which inequality had changed little, this was enough to return it to its lowest level since 1996-7.”

That last IFS point is worth noting. We should not celebrate overmuch if it takes a massive financial crisis and huge recession to produce a drop in inequality, which may be reversed as the recovery proceeds.

What we should note, instead, is that contrary to most people’s impression, income inequality in Britain, on ONS data, has been remarkably flat for almost a quarter of a century. Among retired households, it peaked in 1991 and has been declining gently since. Among non-retired households it has been broadly stable.

Income inequality has moved around in the past. It fell in the 1960s and 1970s, rose under Margaret Thatcher in the 1980s but since then it has largely been a case of much ado about nothing.

You do not, by the way, have to take my word on this, or that of the ONS. Professor Tony Atkinson of Oxford University, Piketty’s great collaborator, noted in his chartbook of economic inequality, published in March, that while income inequality in Britain is higher than it was in 1980. “most of the increase took place in the 1980s”.

There have been significant income increases over time for all households. On ONS data real incomes for the top 20% were 2.53 times their level in 1977, while for the bottom 20% the multiple was 1.86. People move in and out of these groups, of course, but the top 20% mainly pulled ahead in the 1980s.

What about wealth inequality? Wealth is less evenly distributed than income. The latest ONS data shows that the top fifth of households own 44% of Britain’s wealth, while the bottom 20% have 7%.

However, the distribution of wealth is, like the distribution of income, stable. Again, not just my words or those of the ONS, but also Atkinson: “Downward trend in top wealth shares from 1923 to end of 1980s; now levelled off.”

There is a debate about whether the distribution of wealth should be properly measured by a survey, as the ONS does, or by data from estates. But both show a broadly stable pattern. Britain, taking the evidence together, has a more even distribution of wealth than most countries, including those normally thought of as more equal such as Sweden.

This is because of the nature of wealth in Britain, the vast bulk of which is in property and private pensions, rather than “capital” or financial wealth. That, by the way, is the fundamental flaw of Piketty’s book, that it confuses wealth and capital.

That is for another day. The big picture in Britain is that inequality is with us and always will be. But it has gone down, if only temporarily, in the past few years, and has been broadly stable for more than two decades. Not that you would know it.

Sunday, June 29, 2014
Global winds can blow us to a long-haul recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Britain’s economy is expanding at a healthy rate. This month, for the first time, the average growth prediction for 2014 has hit 3% among the independent forecasters surveyed each month by the Treasury.

With half the year gone, you may say that this is not a particularly bold forecast. The numbers and the surveys are heading that way, with no sign yet of the feared slowdown in the second half of the year. If anything, growth is looking stronger.

It is, however, a milestone. This year see the strongest growth since 2007, the year when the crisis began to wreak havoc but before its economic impact was felt. This year’s growth is a powerful sign that the crisis’s deadly grip is weakening.

Not only that but I began to fear that growth numbers beginning with a “3”, normal in past recoveries, were going to be denied to us this time. Maybe those banking and fiscal hangovers had left us so groggy that the last thing we could do was run faster.

So this is good news. The question is whether this is the only 3% year we see, a bit of a flash the pan, or whether there can be more of them. In other words, is this stronger recovery sustainable?

The Office for Budget Responsibility is typically cautious. Though it thinks the upturn will last, its March forecast had not a single year of 3% growth, including this one, and a slowdown to 2.3% next year.

The Bank of England is much more upbeat, with a 3.4% growth forecast this year slowing only slightly (to 2.9% and 2.8%) in 2015 and 2016. Though it would be nice if that 2.9% was a tenth of a percentage point higher, nobody would complain too much if its prediction proves correct.

For some, however, the flash in the pan argument is a powerful one. Even the Bank of England governor says the economy is unbalanced and over-reliant on consumers whose incomes are squeezed. The balance of payments, though improving, is in a sorry state and productivity is becalmed at pre-crisis levels. So what hope is there for a sustained recovery?

For reassurance I turned to a perhaps surprising source. Capital Economics, the consultancy founded by Roger Bootle, is not known for an excessively sunny disposition. But its latest economics focus report seeks to answer the question: “Is the recovery sustainable?”

The answer it comes up with is a positive one. “Providing that interest rates rise only gradually over the years ahead, the UK economy looks set for a prolonged period of strong growth which mends rather than exacerbates its existing imbalances,” it says.

Capital points out, as I have here, that the recovery so far has often been unfairly labelled. The contribution of consumer spending over the past year or so, for example, has been low by historic standards and smaller than its share of the economy. Now investment has started to increase it is punching above it weight in the recovery.

Capital also notes that the recovery is broad-based by sector. Of the 20 main sectors of the economy, 16 are growing significantly, a similar proportion to the long upturn in the 1990s and 2000s.

How about those imbalances? Though they do not expect a return to the pre-crisis norm for average earnings growth of 4% to 5%, Capital’s economists see a gradual strengthening of real income growth alongside a recovery in productivity. They think the business investment upturn, now it has begun, is likely to continue.

Revised first quarter GDP figures, released on Friday, confirm the "better balanced" story. Business investment rose by 5% in the quarter, for an increase of more than 10% on a year earlier. Investment is much smaller as a proportion of GDP than consumer spending but over the past year it has made as big a contribution to growth.

Capital also believes that, while export performance has disappointed so far, it is likely to pick up. British exporters are diversifying, they say, and world trade weighted by Britain’s export markets should pick up “significantly” over the next couple of years.

What could derail the recovery? The Bank of England, with last week’s move to limit high (4.5-plus) loan-to-income mortgages, has taken modest action to head off what it sees as the main internal danger; housing boom turning to bust.

The biggest risk – and the biggest potential – comes from outside Britain. Whether or not exports grow is one big way in which the world economy affects Britain’s economy but it is far from the only one.

A research paper in the latest Bank of England quarterly bulletin - How have world shocks affected the UK economy? – concludes that Britain has been malignly affected by global influences in recent years.

In the long upturn that preceded the global financial crisis the world economy provided a leg-up to Britain. Not only did the China effect push down prices, lifting real incomes, but there were big growth benefits through trade, confidence and international capital flows. Policymakers in Britain took a lot of credit for riding helpful global waves.

Since then, according to the Bank’s research, global influences have worked the other way. Two-thirds of the weakness in Britain’s economy since 2007 can be attributed to them, both in the 2008-9 recession and the slow upturn in 2011-12. Part of that negative influence comes through trade but it is mainly via what the Bank describes as the financial and uncertainty channels.

Those who blame Britain’s austerity for the disappointing recovery usually fail to allow for these global factors. At most, home-grown austerity has been responsible for part – and probably not a large part – of a third of the economy’s weakness, in other words not much at all.

That is why, according to Capital, the economy can grow through the austerity that is yet to come. But it is also why, ultimately, the question of whether the recovery is sustainable will not be decided in the Treasury or Threadneedle Street.

Britain’s economy, as always, is buffeted by international events. If you were looking for trouble you might look in Iraq and the wider Middle East, or America’s weather-affected first-quarter slump (followed by a decent second-quarter bounce).

If you were looking for reassurance, it could be in the fact that international forecasters like the Organisation for Economic Co-operation and Development expect the global recovery to strengthen. What we should not do is ignore what is happening beyond these shores. As far as the economy is concerned, Britain is not an island.

Sunday, June 22, 2014
Enough 'will they, won't they?' - time for the Bank to act
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The Bank of England has got itself into a terrible tangle over interest rates, which is threatening to make it look rather foolish.

The big question for monetary policy was how, after more than five years with Bank rate at a record low of 0.5%, the Bank would approach the tricky task of managing the first of what will be a sequence of hikes.

We have become so used to announcements of unchanged rates each month from the Bank that the first move was always going to be a very big story. Maybe not on the scale of the moon landing but big nonetheless.

So far at least, the Bank has botched the job of preparing the ground for that first hike. And I am afraid the buck for this has to stop with Mark Carney, the big-bucks earning Bank governor.

In August last year Carney launched forward guidance, which tied the point at which the Bank’s monetary policy committee (MPC) would begin considering rate hikes to the unemployment rate. The MPC would not necessarily hike rates when unemployment hit 7% but it would think about it. But, because unemployment was unlikely to fall that much until 2016, people and businesses could relax.

We all make mistakes and, though the outgoing deputy governor Charlie Bean disagrees, it was a mistake to link rate decisions to so wayward a mistress as the unemployment rate. As it is, figures this month showed it has already dropped to 6.6%.

But the policy had its heart in the right place; allowing the recovery time to breathe before the Bank started to withdraw the exceptional stimulus implied by a 0.5% Bank rate. That, at least, was the right thing to do.

The problems came this year. In February, when it was clear that unemployment was falling more rapidly than the Bank expected, the original forward guidance was re-cast in the Bank’s inflation report. Interest rate moves would still be informed by spare capacity, but on the basis of a range of indicators rather than just unemployment. Most significantly, out of this fuzzier guidance, the Bank – and Carney – acknowledged that the market path for interest rates, a gradual rise starting next year, was not a million miles from what the Bank had in mind.

What should have happened then, as the economy strengthened, was a reinforcement of this message in May, the next inflation report. Growth had picked up strongly, the governor should have said, and this logically added to the case for raising rates.

Instead, we had the madness of May, when Carney appeared to bend over backwards not to endorse the market view on rates, even a rise in the first half of next year, and none of his MPC colleagues moved to correct him. As far as markets were concerned, the signal was clear. Howard Archer of IHS Global Insight said it “put to bed” the idea of a rate hike before the end of 2014. Capital Economics said it cooled expectations of a hike even in the first quarter of 2015.

After the madness of May came the lurch of June, starting with one sentence in Carney’s June 12 Mansion House speech, in which he said rates could rise sooner than markets expect and continuing with last week’s June minutes, in which the MPC said (for a second time) that the decision on rates was becoming more balanced and that the low probability attached in the markets to a hike this year was “somewhat surprising”.

To say I was flabbergasted to read that understates it. When the message in May rang loud and clear that markets should not get ahead of themselves in pricing in rate rises, why should anybody have factored in a 2014 hike? And if the 15% probability the markets were attaching to a 2014 rate rise when the MPC met two weeks ago was too low, what is the right probability now: 40%, 70%, 100%?

What will happen? Everybody has been looking for the first vote on the MPC for a rate hike, which will then pave the way for a gradual shift of opinion on the committee. Some in the markets were disappointed that Martin Weale, seen as the most likely to break ranks first, did not do so earlier this month.

We are more likely, I think, to see the MPC shifting en masse. Danny Gabay of Fathom Consulting notes, and not in an approving way, the fact that a remarkable “unanimity and harmony have reigned” on the committee “at a time when uncertainty over the UK economy is so high”.

Now, that unanimity appears to be extending to the question of when and by how much interest rates will rise. In the past few days we have heard from most MPC members, including Weale, David Miles, Bean, Ian McCafferty and Andy Haldane.

The view they are expressing is almost identical, though they have managed to find different ways of saying it, including what may be the most analogy-rich speech in the Bank’s history from Haldane. If we thought the sporting analogies had left the Bank with Mervyn King, Haldane’s “corridor of uncertainty” speech proved us wrong, which ended by saying it is probably better for the Bank to be on the front foot.

Even the newest recruit to the MPC, the American academic Kristin Forbes, who admits she has a lot to learn about the British economy (and worryingly says she will be talking to the International Monetary Fund to find out more) told MPs that the committee’s main challenge over the next three years will be “normalizing” monetary policy, Normalizing is Bank-speak for raising interest rates.

The view they are commonly expressing is no rate rise yet but, if we want to limit the eventual rise to 2.5% to 3%, better not to leave it too long. An early rate rise, a stitch in time, will help limit the eventual peak. That is this month’s view anyway.

When? All this “will they, won’t they” speculation is going to get very wearing very quickly. It feels like the MPC, unsure of its ground, is through minutes and speeches undergoing a collective public therapy session. By the time they do get around to raising rates – and November is the current favourite – we will all have been bored into submission.

I think they should put us out of our misery. If they think rates have to rise – and there seems to be no argument about that – and if they also think that an early hike will genuinely mean that rates can be held below 3% in the medium-term, why wait?

There are risks – the crisis in Iraq and the rise in the price of oil is one such risk now – but there are always risks. Having clumsily prepared the ground for higher rates, the MPC should get on with it. August, when the changes in MPC personnel will have fully taken effect, is probably the earliest it could happen. But August, when the Bank publishes its new quarterly inflation report, also fits in that respect. Don’t dither, do it.

Sunday, June 15, 2014
GDP revisions will give us a different picture
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Gross domestic product, which came into being in Britain just before the D-Day landings we were commemorating earlier this month, is about to undergo one of its periodic transformations, and this is one of the dramatic ones.

It may change the way we think about how the economy has done, and is doing. It may help solve the puzzle of strong employment growth and weak productivity. It will inevitably result in more flak for the Office for National Statistics (ONS), after the ribaldry it has endured for including the proceeds of illegal drugs and prostitution in GDP (as part of new international statistical conventions).

The context of this is that a few days ago the National Institute of Economic and Social Research declared to some fanfare that Britain's economy surpassed its pre-crisis peak - recorded in early 2008 - at the end of May. The economy, now 0.2% above that pre-crisis peak, has taken nearly five years to recover the 7.2% plunge in GDP it suffered in 2008-9 and – taking that plunge into account – more than six years to get back to where it started. If you can remember where you were in early 2008, on current figures you are back there now.

It has taken a long time, reflecting both the extent of the 2008-9 drop in GDP, which on existing figures was easily the worst in the post-war period, and the stop-start recovery that followed it. It is, the National Institute says, the slowest of any recovery in living memory, including those that followed the recessions of the early 1920s, early 1930s (in both cases for which the institute constructed GDP data), the mid 1970s, early 1980s and early 1990s.

We should savour comparisons like these, and not merely because they show that the economy has belatedly made it back to the recession's starting point all those years ago. No, it is also because they will soon come to be seen as a historical curiosity, rendered meaningless by data revisions.

I have argued before that it is unwise to compare recoveries based on largely unrevised recent GDP data with those from earlier decades. The latter have been through the statistical mill over and over again, to the point where revisions have fundamentally changed the picture as it appeared at the time.

The last recession before the crisis, in the early 1990s, looks for example about half as deep as was recorded at the time and ended much sooner. What looked like a tentative recovery in that period, which took an age to get going, in fact started quite soon and lasted for a very long time; more than 16 years. Though it is possible to argue that a couple of mild recessions over that 16-year period would have done some good by reminding people, businesses and banks that there was a downside, it was a reminder that lasting recoveries can start from unpromising beginnings.

Two things are under way in the numbers. The first is the normal process by which the ONS gets more complete information, often many years after the event, on what was really happening to GDP. Sometimes that means marrying different sets of data and ironing out inconsistencies. Sometimes it means discovering where growth was under-recorded.

The other process is more dramatic, and it will pan out between now and the end of September. Under changes known in the jargon as ESA10, where ESA stands for the European System of Accounts, what the ONS describes as “improvements” in the national accounts are being introduced. All European Union countries are making the changes, though so too are most other advanced economies, under System of National Accounts changes.

A few days ago, the ONS revealed that changes in the measurement of research and development (the biggest single change), pensions, weapons expenditure and other smaller modifications, will collectively add £65bn, or 4.6%, to the cash value of GDP in 2009. There will be an average GDP boost of 3.6% over the period 1997 to 2009.

On June 30, the ONS will tell us how these changes affect real GDP growth over the 1997-2009 period, and in July it will reveal how the revisions will affect the balance of payments and the different sectors of the economy. In August, new figures will be produced for recent growth, 2010 to 2012, culminating on September 30 with numbers on the new basis that will take us right up to the middle of this year.

The changes will be significant, though we should remember that we are talking mainly about revisions that affect the level of GDP. That is not insignificant. Though separate changes will affect the public finances, the new numbers should make magnitudes like debt to GDP and deficit to GDP ratios look a little better.

Where will the process end up in what it tells us about the economy? Nobody knows, I suspect including at this stage the official statisticians. My guess would be that the recession of 2008-9 will end up being milder than the pre-revised data shows, perhaps a 5%-6% drop in GDP rather than the current 7%-plus.

You may question this, and point to the sharp 2008-9 swing into record deficit in the public finances as supporting evidence. A budget deficit of 11% of GDP does not happen without a huge downward lurch in the economy. Remember, however, that the very mild recession of the early 1990s gave us a budget deficit of 8% of GDP, and the 2008-9 one hit the revenue-generating financial sector squarely between the eyes.

I think we will also see that the post-2009 recovery was stronger than it currently looks. Why do I say this? Because in the context of lacklustre GDP figures (until the past 12-18 months) we have seen exceptionally strong growth in employment and exceptionally weak productivity. Some productivity weakness is explicable, as discussed here on previous occasions. But the idea that the productivity switch was suddenly switched off in 2008 seems highly implausible.

In the 1990s, it took eight years for employment to get back to its pre-recession peak, in the context of 1993-98 GDP growth averaging almost 4% a year. This time it took just over four years – and employment has strengthened significantly since then – despite apparently much weaker growth.

We shall see. The revisions will not alter the fact that we suffered a big economic shock. But they may well mean that at least some of the wailing and gnashing of teeth over “flatlining” and non-existent productivity growth, was misplaced. Whether they will do anything for public and users’ confidence in the GDP figures is another matter. Moving the goalposts, as they say in Brazil, can ruin the game.

Sunday, June 08, 2014
Bank grapples with a strange kind of housing boom
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Even by the standards of Britain’s housing market, the announcement a few days ago of a 3.9% May increase in house prices was a humdinger. The Halifax house price index has recorded bigger increases in its 31-year history but not that many. This was its fourth biggest monthly rise, and you have to go back 12 years for anything bigger.

There are caveats. The Halifax index can be a skittish beast, prone to occasional lurches. May’s big rise was preceded by two (smaller) falls. The 2% rise in prices over the latest three months, which translated into an 8.7% rise on a year earlier, showed a lower rate of house-price inflation than some other measures.

Even so, there is exuberance there, which the Bank of England’s financial policy committee (FPC) will respond to later this month. Before coming on to my main theme – the fact that there is something very odd at the heart of this rise in house prices – I should do us all, and the Bank, a favour by opening the lid on the FPC.

The Bank appears to have realised, perhaps a little late, that it has a problem on its hands with the FPC. The monetary policy committee, now 17 years old, is pretty well understood by most people. It meets once a month, decides whether to adjust interest rates (or not for more than five years) or do more quantitative easing. To the extent these things can ever be straightforward, it is.

The FPC, however, is a shadowy body which meets on a quarterly basis. There is the cult of ther amateur about it. The fact that this shadowy body may be about to make decisions that could affect people’s ability to get a mortgage explains the flurry of activity from the Bank, including tweeting photos of the committee and a speech by Richard Sharp, one of its external members. The title of his speech, however, “An experiment in macroprudential management” did not exactly inspire confidence.

The FPC has 10 members, three of which it shares with the MPC – Mark Carney, Charlie Bean and Sir Jon Cunliffe, as well as two other Bank insiders, Andrew Bailey and Spencer Dale. Martin Wheatley of the Financial Conduct Authority is a member, as well as four external members, Sharp, Dame Clara Furse, Donald Kohn and Martin Taylor.

It may be that, by the end of the month, we will know quite a lot more about the FPC. It meets on June 17 and its recommendations, which are expected to include restrictions on high loan to income mortgages, as well as others, with be made public nine days later, when the Bank’s financial stability report is published.

The delay between meeting and announcement is said to be because it is dealing with more complex and nuanced decisions than whether interest rates should go up or down by a quarter of a point. It is, however, a recipe for uncertainty. The Bank can and should do better than this.

Anyway, after all the build-up, the FPC is almost honour-bound to do something on housing. It has, moreover, to get it right. The question is how it, and we, should be reading the market.

Everybody involved in prime central London housing says the market has slowed significantly. Knight Frank, the estate agent, attributes it to high prices and uncertainty over next year’s general election. Other parts of London and the south-east remain strong but are also likely to level off for similar reasons, and because some lenders – Lloyds and RBS – have decided to unilaterally impose constraints on £500,000-plus mortgages.

The really interesting thing, however, is what is happening to activity. Alongside its report of a 3.9% jump in house prices last month, the Halifax noted that transactions had recently fallen (though they were still up on a year earlier).

The monthly numbers for mortgage approvals suggest anything but a housing market awash with cash. The figures, from the Bank of England, showed approvals dropped to just under 63,000 in April, from almost 76,000 in January. Just as approvals were getting into their strike, they have fallen back, and they are an important lead indicator of housing activity. The long run average for approvals – 1993-2007 – was nearly 99,000 a month.

Some of that fall is due to the run-up to the mortgage market review, introduced at the end of April, which disrupted some lending. Some of it may have been the refocusing of the Funding for Lending Scheme away from mortgages, announced in November. The Office for National Statistics, in its latest economic review, notes that net mortgage lending is barely increasing.

A significant factor, also, is the lack of availability of property. This is not, for once, the traditional complaint about not enough new housing, at least not directly. An arguably more important factor, which is pushing prices up even as activity remains well below normal levels, is that existing homeowners do not want to sell.

RICS, the royal institution of chartered surveyors, reports “a dearth” of new instructions to sell, with nine of its 12 regions reporting a drop in properties coming on the market. The other day I saw an estate agents’ window with 40 properties displayed but all but two of them sold.

Why is it happening? Older people looking to downsize appear reluctant to do so, perhaps because the returns they can get on the savings they unlock are so abysmal, and cannot compare with the strongly rising price of the property they own. Instead of being a source of properties for sale, they have become the so-called “bed blockers” of the housing market.

High transaction costs, including stamp duty rates of 3% above £250,000, 4% above £500,000, 5% above £1m and 7% above £2m, may be taking their toll on transactions elsewhere in the market. Expanding families often find it easier, and cheaper, to extend.

The cumulative effect of too little new housing over many years is also a factor, says Simon Rubinsohn of RICS. The tightness of supply damages the market by severely restricting choice. If there is not enough out there to buy and move into, owners will not sell.

So, we have an odd challenge for the FPC. The London market, which has grabbed its attention, looks to be slowing. Elsewhere, the problems in the market do not appear to be driven by runaway mortgage growth but by supply shortages, for both new and existing homes. The Bank cannot do anything about them, as Carney has said. The question, unless it has evidence that the banks under its supervision are taking unwarranted risks, is whether it should be doing anything at all.

Sunday, June 01, 2014
No longer downhearted. A nation on happy pills
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

During the worst of the global financial crisis, people were fond of quoting Montek Singh Ahluwalia, deputy chairman of India’s planning commission. In his phrase: “Confidence grows at the rate a coconut tree grows but falls at the rate a coconut falls.”

Confidence rises only gradually but drops sharply. During the crisis business and consumer confidence collapsed. The edge of the abyss looked dangerously close. Many feared plunging over.

If you were looking for a single reason for the turnaround in the economy, you could do worse than look at confidence. Rising business and consumer confidence partly reflect stronger growth and rising employment but are also driving that growth.

Not so long ago we were stuck in a mire of weak growth and depressed confidence. Now it has turned into a virtuous circle of rising confidence and strengthening growth. It is hard to overstate the importance of the return of confidence.

The latest figures from the European Commission tell the story. The main economic sentiment measures, covering business and consumer confidence, rose in May in both the EU and the Eurozone and, perhaps surprisingly, are a little above their long-run (1990-2013) averages.

The picture for Britain was even more encouraging, indeed remarkable. Though the overall sentiment measure slipped a little in May, it was nevertheless at its second highest since 1988, the highest having been achieved in April.

The Commission’s consumer confidence figures for Britain suggest a nation on happy pills. Overall confidence is at its highest since the series began in 1985. The related GfK-NOP measure is rising at its fastest rate for 37 years. In the detail, as Michael Saunders of Citi points out, is the highest proportion of consumers who think the economy has improved over the last 12 months since 2000, the most optimism on unemployment since 1998 and the best time for major purchases since 2007.

Full-time employees are more optimistic than at any time since the question was first asked of this group in 1990, while for other workers optimism is at 16-year highs. Perhaps most surprising of all, optimism among young (16-29) people is also at its best since 1990.

Businesses are, if anything, firms even more upbeat than households. The longest running of all the surveys, the CBI’s industrial trends, has business optimism at its highest since April 1973.

All this is very encouraging, but raises three important questions. Why is it happening? Is this as good as it gets? And, for the politicians, why amid so much optimism is there so much discontent, as we saw across Europe in last weekend’s parliament elections?

Why is confidence so high? Households, we are told, have rarely been more squeezed and businesses are frozen into inactivity by caution, hardly the recipe for confidence at multi-decade highs.

As regular readers will know, I think the extent of the squeeze on households is exaggerated by the regular average earnings figures. Real household disposable incomes in aggregate only had one really bad year, 2011, and on a per capita basis recovered to pre-crisis levels in the second half of last year. Real take-home pay has being doing better than real earnings, because of the big increase in the personal income tax allowance. Wages and salaries data from the national accounts suggest a stronger real wage picture for some time.

I would accept, however, that compared with previous periods, this is not a time of strong growth in real incomes or wages. In the late 1980s, for a while, average earnings were growing by 7.5% against inflation of 2.5%.

Firms, meanwhile, have been building up cash in readiness to start spending and are doing so. The pick-up in investment, though not rip-roaring, stretches back five quarters.

In both cases, confidence is up so sharply because things have turned out better than expected. Confidence is all about expectations. When they are exceeded, it goes up. In the case of employment growth, which has been very strong, it has easily exceeded expectations.

Will it last? The fact that confidence is so high should make us cautious about predicting further big gains. Sometimes confidence soars just before something nasty happens, as in 1973 and 1990, both on the eve of recession. Mainly, confidence levels off or slips back because expectations are merely achieved rather than exceeded. That is not bad news: people come to expect stronger growth and their expectations are validated.

There may be a particular reason now why confidence is high, and why it will not go up much from here. The economy is in the sweet spot in which growth has come through strongly but the Bank of England has yet to respond with higher interest rates.

That will not last. With the monetary policy committee’s Martin Weale warning that rates will need to rise “sooner rather than later” the debate is hotting up.

He and some other MPC members are probably sceptical of the impact of financial policy committee measures directed at the housing market, echoing the scepticism expressed here last week. The first votes for higher rates could come in late summer or autumn. I still think the first hike will come next year, though some City economists are now targeting November 2014.

Higher rates need not derail the recovery, and I don’t think they will, but they are likely to create enough uncertainty to rein back confidence.
Finally, why when confidence is so high are elected politicians having such a tough time? In Europe, the return to growth and the end of the worst phase of the eurozone crisis did not prevent a surge in the Eurosceptical vote last weekend.

In Britain, with confidence high, the coalition parties might have expected to reap the benefits of recovery in the May elections more than they did. But while the Tories avoided collapse, the Liberal Democrats did not.

It may be that another year will do the trick but clearly more is happening than just confidence and recovery. While Labour is blamed for over-spending and failing to regulate the banks, the coalition parties get the blame for austerity and, in the case of the Tories, will always be seen as too close to the City. Curiously Nigel Farage, the only party leader who worked a long time in the City – more than 20 years – gets away with it. The coming general election could be one where a strong economy benefits the incumbents less than usual.

Confidence is very important. Its economic effects are seen in stronger growth in consumer spending and business investment, both of which should last. Its political effects are harder to judge.

Sunday, May 25, 2014
New-style corsets face old-style problems
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Unaccustomed as I am to delving into the subject of what used to be called ladies’ foundation garments the time has come to to talk about the corset.

The corset, to avoid any misunderstandings or hot flushes, was the nickname given to a Bank of England scheme of the 1970s, intended to control bank lending. Under the supplementary special deposits scheme, banks were required to operate within limits specified by the authorities, and faced penalties for not doing so.

It lasted from 1973 to 1980, in three phases, and was not the only mechanism for controlling credit. Hire purchase controls, scrapped in 1982, set the proportion of the purchase price people had to put up before buying on instalment.

Mortgage lending was controlled by the simple expedient of rationing. Until banks were allowed to enter the mortgage market in the early 1980s prospective borrowers queued. I was once told by a building society - now a bank - I would have to wait two years for a loan.

The point of reviving these memories now is that they were all examples of what we now call financial policy. There is very little new under the sun, and there is nothing new about seeking to restrict lending growth by direct means.

Indeed, given the Labour party’s current shift towards direct interventions to tackle the “cost of living crisis” - though shop prices and petrol were 0.6% lower last month than a year earlier - maybe we should all be studying the 1970s.

The history of the corset was not a glorious one. It coincided with one of the most turbulent periods, until the recent crisis, in Britain’s modern economic history. It ran alongside very high interest rates. It did what you would expect any system of direct controls to do, encouraging lending growth to shift into other, non-controlled channels.

When it was abolished in 1980, provoking a row which meant Margaret Thatcher never really trusted the Bank again - it failed to warn her of the one-off boost to her precious money supply - that seemed to be that for such policies.

The corset was rendered redundant because lending could then as easily flow into Britain from foreign banks, or overseas subsidiaries of British banks. The Bank’s own assessment, in 1982, was that the corset “exemplifies the difficulties of relying excessively on direct controls on the banking system as a means of influencing monetary developments”.

I raise it now because there is a danger of repeating past errors. The Bank is once more concerned about lending excesses in the housing market. Its financial policy committee(FPC) will meet on June 17, and is set to announce measures to seek to cool housing lending.

The FPC’s next scheduled meeting after that, September 26, means those measures will be given a little time to take effect, after which there could be more. Its final quarterly meeting of the year is on December 8.

In some ways it is odd that the FPC is considering action to restrain mortgage lending. Its own figures show net mortgage lending in the year to March was up only 1.1%. A decade ago this lending measure was rising 15% a year.

I accept it is concerned about new lending, so gross lending may be more important, and it was up 31% in March on a year earlier. After a long period of mortgage famine, however, this only took it to £16.8bn, half its pre-crisis peak of more than £32bn in June 2007.

Will such measures cool the London housing market? Foreign buyers, cash-rich buy-to-let landlords and people getting hold of their pension pots to put into property mean the main effect of curbing mortgage availability would be to further limit the chances of genuine owner-occupiers. Reducing the scope of Help to Buy would be in irrelevance in London.

The prospect of success looks more remote than in the case of the corset in the 1970s. The market may slow, but not mainly as a result of FPC actions.

The Bank probably knows this but that will not stop it trying and the dangers are twofold. The first is that it will disappoint on house prices. Rising house prices have effects that go beyond financial stability. They have social consequences and may ultimately be inflationary.

The second danger, and this is the biggest, is that financial policy - direct measures - comes to be seen as a substitute for monetary policy; higher interest rates.

Charlie Bean, the Bank’s deputy governor, is hard to characterise as either a hawk or a dove on interest rates, but he is the wisest owl on the monetary policy committee. He is also on the FPC.

In a speech at the London School of Economics ahead of his retirement at the end of next month, he set out both the role of direct measures, so called “macroprudential” policy, and the limitations.

As he put it: “Compared to the impact of changes in interest rates, we have relatively little experience of deploying macroprudential instruments. And there will often be scope for those affected to work out ways to circumvent them, including by moving activities outside the regulatory perimeter.”

The latter, of course, was what happened under the corset in the 1970s. “There may well be times when moentary policy is the only game in town,” he added, so that even at a time of below-target inflation - with no inflationary danger in sight - the Bank should “lean against the wind” by raising rates.

We may be moving towards that point. The minutes of this month’s MPC meeting, released last week, showed the first stirrings of discussion about hiking rates, with some members arguing that the decision was becoming “more balanced” and others arguing that raising rates early could be the best of ensuring that they do not need to rise too much.

The minutes, coming on the day when official figures showed the volume of retail sales last month nearly 7% up on a year earlier reignited the debate on rates, it having been kicked into the long grass by Carney a few days earlier. But with the MPC about to undergo a big shake-up of its membership, we do not know whether this month’s stirrings will turn out to be a false signal.

The Bank does not need to be precipitate. There is a case for waiting until the economy is back above pre-crisis levels and real wage growth is more firmly established. That does not mean a hike now, but should mean the process starts next year, ahead of the May election.

The risk is that the Bank leaves it too long, in to hope that financial policy takes care of it. Experience suggests it will not. Corsets, I gather, can be uncomfortable. But they rarely deal with the underlying problem.

Sunday, May 18, 2014
Carney goes back to keeping everybody guessing
Posted by David Smith at 08:00 AM
Category: David Smith's other articles

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

July 2007. Roger Federer won Wimbledon for the fifth time and Venus Williams the ladies’ title. Gordon Brown had only just become prime minister and spent much of the month dealing with devastating summer floods. The European Union nominated Dominique Strauss-Kahn as managing director of the International Monetary Fund, a nomination that did not end well.

It was also the last time interest rates in Britain rose. In July 2007, paradoxically just as the global financial crisis was rumbling into view, the Bank of England’s monetary policy committee(MPC) raised rates from 5.5% to 5.75%.

I would encourage you to savour that sentence for a moment, not only because it is so long since it happened but also because the level of rates at the time: 5.75% is so far away from the current Bank benchmark of 0.5% as to look like another world.

At the time, an rate rise was unremarkable, as was a 5%-plus rate. The MPC had raised rates in May, as it had on many occasions - 18 in all interspersed with cuts - since independence in 1997.

But that, as things stand, was that. The Bank raised rates repeatedly in its first decade of independence. For reasons we know only too well, it has not done so at all in the first seven years of its second decade. When will it do so?

Before answering that let me remind you what an unusual period we are in. Until it was cut to the current 0.5% in March 2009, Bank rate had never been as low as this, in a history stretching back to 1694, when the Old Lady of Threadneedle Street was a bouncing baby girl. The previous low was 2%. In 1694, by the way, Bank rate was 6%.

This is now, in addition, the longest period of unchanged rates since the Depression and Second World War. Then, there was a cut to 2% in 1931 and no increase until 1951.

There is another exceptional feature, which is that the MPC decided even a prolonged period of 0.5% rates did not provide enough of a monetary stimulus, so it undertook £375bn of purchases of gilts - UK government bonds - in its quantitative easing programme.

The Bank provided some new guidance last week on what it intends to do about that £375bn of gilts, which it still holds. Some will be run down automatically as they mature, though even that process will not begin before interest rates have started to rise.

Large-scale asset sales, and this was new, will not begin until interest rates have reached a level from which they can be “materially cut”. The MPC does not want to get itself into a position in which it sells gilts back to the markets but is forced to buy them back again because the economy weakens. As for the level of interest rates at which they can be materially cut, I judge that to be when Bank rate has reached 2.5% or 3%.

That is also the rate we are being encouraged by the Bank to think of as the new norm, implying it will be well into the Bank’s third decade of independence before we see an official interest rate starting in a 5. Normality is a long way away. For the next few years, on present thinking, we will go no higher than 3.

When will the Bank begin to scale that peak? When, in other words, will rates start to rise? Had you asked me that question a week ago, I would have had no hesitation. In its February inflation report the MPC, and its governor Mark Carney, seemed happy to endorse the market view that the first hike would come next spring. Martin Weale, the most hawkish member of a dovish MPC, said explicitly households and businesses should prepare for higher rates then.

Now, however, a terrible fuzziness has taken over. In presenting the Bank’s May inflation report, Carney was unwilling to endorse any view on rates, let alone the market view of the first hike occurring in a year’s time. Short of a magician-like flurry, producing some white birds from the lining of his jacket and releasing them into the room, he could not have been more dovish.

It was not just his sporting analogy - a reference to the World Cup - that this seemed like a return to the Mervyn King era. We appear to have returned to the pre forward guidance period in which the MPC takes one meeting at a time and the only determinant of when it decides to raise rates will be the data.

I still think rates will start to rise in roughly a year’s time but why the fuzziness? There are three possibilities.

One is that, with the MPC in a state of flux, Carney cannot pre-judge what his new colleagues will decide. Soon Spencer Dale, the Bank’s chief economist, Charlie Bean, deputy governor, and Paul Fisher, executive director for financial markets, will leave the MPC.

They will be replaced by Andy Haldane, Minouche Shafik and Kristin Forbes, an American professor of economics at the Massachusetts Institute of Technology, once a member of George W Bush’s Council of Economic Advisers. Haldane has made many speeches, though not on monetary policy. The others are unknown quantities.

A second reason may be that, the closer a rate rise gets, the less precise the Bank will want to be. If a hike were seen in the markets as set in stone and for some reason did not happen, the Bank could lose credibility.

Related to this, had the Bank provided an endorsement of a rate rise in the early part of next year then, markets being markets, it would not have rested there. Any strong data would be interpreted as bringing the expected hike forward into this year; speculation I judge the Bank does not want.

Finally, it may be that Carney has not quite given up on his initial forward guidance of last summer, which you will remember signalled that no hike was likely until 2016. The key question for the Bank is how soon it acts before spare capacity in the economy - which it estimates at 1% to 1.5% of gross domestic product - will be used up.

It thinks it will take three years for that to happen, but will not wait until that point before hiking rates. The question is how long in advance it decides to pull the trigger.

As I say, I think the first move will be in roughly a year, and the Bank’s own forecasts imply that. But instead of clear guidance, we now have a rather fuzzy interest rate outlook. Forward guidance was meant to provide clarity on interest rates to households and businesses. The current guidance is anything but clear.

Sunday, May 11, 2014
Bank must beware bubble hysteria
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Let me take you to the West Midlands, if not the land of our fathers then certainly the land of my father, the place I grew up. It has been through tough times but things are looking up.

Unemployment is falling and employment rising. Manufacturing is bouncing back. None of the West Midlands’ football teams got relegated this year - breaking the pattern of recent seasons - and one, Wolves, was promoted.

Why the West Midlands? Because Sir Jon Cunliffe, the Bank of England’s deputy governor for financial stability, chose to focus on it in his important recent speech on the housing market.

House prices in the West Midlands, he noted, fell 15% between 2007 and 2009, while transactions - sales and purchases - halved from 10,000 to 5,000 a month. After that, transactions recovered a little but prices were flat until spring last year.

Since then, as he also noted, prices in the region have risen just under 10%, while transactions averaged 7,000 a month. Prices are 7% below their 2007 peaks. He did not say it but in real terms - adjusted for consumer price inflation - prices are down a quarter.

Cunliffe’s choice of the West Midlands was for two reasons. One was to show the Bank is not overinfluenced by the bright lights of Mayfair, Kensington and Chelsea. It looks beyond the capital.

The other was to show that house-price inflation and rising transactions are not confined to London. The West Midlands, for house prices, is in line with the national average. It used to be the bellwether region of the British economy. Now, in at least one respect, it is again.

What does it, and the country as a whole, tell us about the housing market? We have seen an outbreak of housing hysteria, which I fear is far from over.

The Bank is thought to be readying itself for action on what Cunliffe described as the brightest warning light on the Bank’s dashboard. The Bank’s quarterly inflation report press conference, on Wednesday, will be dominated by housing questions.

Three ex chancellors, Lords Lamont and Lawson and Alistair Darling, have expressed concern about George Osborne’s Help to Buy mortgage guarantee scheme.

The Paris-based Organisation for Economic Co-operation and Development (OECD) has called for “timely prudential measures to address the risks of excessive house price inflation”, which it says should accompany monetary policy tightening, in other words higher interest rates. The clamour is growing.

We will learn more about the Bank’s interest rate intentions this week. On Thursday it left Bank rate unchanged at 0.5% for the 62nd successive month. How long can this go on?

For a while yet, I would think, unless it has had a radical change of heart. The message coming from the Bank in recent weeks was that its first port of call to dampen irrational housing exuberance would be the tools at the disposal of the financial policy committee (FPC).

Only if the FPC’s actions fail will the monetary policy committee (MPC) be called into action. That should mean the first hike in rates is some months away; I still think next year rather than this.

What are those tools? The Bank’s FPC, if it fears housing boom could turn to bust, has the power to direct banks to ensure they have the capital to weather the storm.

It could, as Cunliffe pointed out, make recommendations which directly affect lenders’ underwriting standards, as well as loan to value (LTV), loan to income(LTI) and debt-service to income ratios. It could cool the market by making mortgages tougher to obtain.

If it chooses to do so, and its deputy governor acknowledges it will be a “challenging judgment”, it may be curtains for the second phase of Osborne’s Help to Buy scheme; mortgage guarantees. It would look like a topsy-turvy world in which the Bank was at the same time reining back mortgage availability while implicitly endorsing a government scheme to increase such availability.

Should the Bank act? My favourite housing valuation measure, prices relative to their long run “real” trend has prices undervalued by almost 10%. That big fall in the West Midlands, and nationally, has not yet been fully recovered.

The only house price-earnings ratio worth considering is for first-time buyers (almost all existing homeowners have equity). This, according to the Nationwide, stands nationally at 4.7, 13% down on its pre-crisis peak. Only in London and the south-east is it up.

As for Help to Buy, there is a lot of misunderstanding. The first phase, equity loans to help buyers of new homes, will be with us until 2020. Since April last year, when it was launched, 19,394 Help to Buy 1 mortgages have been advanced, overwhelmingly (87.5%) for first time buyers, and overwhelmingly outside London and the south-east. NHBC, which monitors the new homes market, says 7% more were built in the first quarter compared with a year earlier.

Help to Buy 2, launched in October, was responsible for just 2,572 guaranteed mortgages in its first three months, again overwhelmingly to first-time buyers, and with an average house prices of £148,048. Scrapping it, or even reducing the limit from £600,000 to £400,000, might have a psychological effect but its practical impact would be close to zero.

The other possibility, which should not be ignored, is that the market is already self-correcting. The latest Halifax house price index showed a fall of 0.2% last month and has shown no tendency to accelerate in the past year. Mortgage approvals, a key driver, have fallen for two months in a row.

In the stratosphere of the top end of the London market, Grosvenor Estates has sold £240m of property in the belief the peak is nigh, while some agents report that the combination of sky-high prices and a strengthening pound has cooled the market.

These signs are far from uniform. The latest LSL-Acadata house price index, using Land Registry data, shows a 7.3% annual rise and price strength spreading around the country. The latest RICS (Royal Institution of Chartered Surveyors) survey was also strong.

But the Bank has to take things carefully. It has taken time to get housing going and to generate an upturn in housebuilding. Nipping it in the bud too soon, despite justifiable concerns about house prices in some areas, could backfire.

Professor Paul Cheshire, in a spirited piece for the London School of Economics' Centrepiece magazine estimates that between 1994 and 2012, between 1.6m and 2.3m fewer houses were built than were needed. More land in Surrey is devoted to golf courses than housing he points out, and more have been built in recent years in Doncaster and Barnsley than Oxford and Cambridge. Planning reform is desperately needed but it is also important to nurture the current upturn in activity and building, not slam the brakes on.

Sunday, May 04, 2014
Milestones that show the nightmare is over
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Milestones are either in sight or have been passed. The latest quarterly rise in gross domestic product (GDP), 0.8%, takes us within a whisker, 0.6%, of its pre-crisis peak.

“Onshore” GDP, excluding North Sea oil and gas, is already 0.4% above pre-crisis levels, because of the weakness in recent years of Britain’s offshore energy production (Scotland please note).

There are other games you can play with the figures. Exclude financial services where the whole thing started - but which has seen a 21% slump in activity - and GDP is 2% or so up on its peak.

Allow for the inevitable statistical revisions and we will discover, at some stage, that GDP recovered to pre-crisis levels some time ago, That is for another time.

The significance of these GDP milestones is that we are waking from the nightmare Britain entered almost seven years ago, when the financial crisis hit.

At times it has been a close run thing. In 2010, when the general election was inconclusive and eurozone collapse began to loom large, Britain teetered on the brink of a full-blown fiscal crisis.

The failure of recovery to take off prompted worries Britain was turning into Japan, lost decades of stagnation and high unemployment in prospect.

Even early last year, when the fear was of a triple-dip recession and an increase in the budget deficit, it was touch and go. There were a lot of worried people in the Treasury and Bank of England. But growth came through just in time, a strong 3.1% rise in GDP in the past year. The double-dip never happened, let alone a triple one.

It has taken time to get back to the pre-crisis peak. One reason for that was the depth of the recession: the 7.2% drop in GDP in 2008-9 was much bigger than America’s 4.3% fall.

After that, several factors came together to put a dampener on recovery. They included tax hikes and spending cuts, though these were no more of a factor than the eurozone crisis, the high inflation squeeze on real incomes and the sudden shift from easy credit growth to no credit growth at all, effectively cutting off the economy’s oxygen supply.

Perhaps as important as all these was the time factor. Carmen Reinhart and Kenneth Rogoff, the influential American economists who in their book This Time is Different examined previous financial crises, highlighted this.

Taking nearly seven years to get back to pre-crisis levels of GDP, and perhaps 10 years to return to pre-crisis levels of per capita GDP (population has grown since the onset of the crisis) is not untypical. We should perhaps have been a little more patient.

One of the effects of “balance”, as operated by the broadcasters, is if a report on an important economic number includes George Osborne, it also has to include Ed Balls, his Labour shadow.

So viewers and listeners were treated to the shadow chancellor’s view that the economic upturn was only working for the rich and that “most people are not feeling any recovery at all”.

I think I even heard him suggest that wages increases should be measured against the retail prices index rather than the consumer prices index. People may have forgotten that, as Treasury chief economic adviser and Gordon Brown’s right-hand man, Balls was instrumental in the 2003 Bank of England switch from an RPI-based target to CPI.

Is it true that for most people the recovery is a mirage and the cost-of-living squeeze is as intense as ever? A few days ago the latest GfK-NOP consumer confidence index, which has been running since 1974, was released.

It showed overall confidence at its highest level since June 2007. Optimists outnumber pessimists about their personal financial situation over the next 12 months and the country’s prospects. You would not get results like this if most were feeling as grim as Labour suggests.

The other important clue is in the labour market numbers. Apart from showing continuing strong rises in employment, they demonstrate that the benefits of recovery are not only well spread but that, if anything, the highest paid are lagging behind.

So private sector pay in the most recent three months was up by 2%, outstripping CPI inflation. The private sector accounts for 81% of employment.

Even more interesting was the breakdown, Manufacturing pay in the latest three months was up 3.2% on a year earlier, construction by 3.1% and “wholesaling, retailing, hotels and restaurants” - hardly bastions of high pay - by 3.5%. Not only were these increases comfortably ahead of CPI inflation (now 1.6%) but they also outstripped RPI inflation (currently 2.5%).

If you want to shed any tears, shed them for those in finance and business services, where pay was up just 0.1%, dragged down by falling earnings in financial services. This is a mirror image of the picture suggested by Labour.

Telling people they are squeezed and hard done by may be politically smart; few people are satisfied with their lot. I was always surprised during the long upturn from the early 1990s to the start of the crisis how much discontent there was. Consumer confidence is now higher than its average over that long upturn.

But we should also be honest. The rise in GDP is well spread between the different sectors of the economy and it is benefiting the majority of people. The longer the recovery in GDP goes on, the more those benefits will spread.

That recovery is not guaranteed. There are political risks, most notably next year’s general election. There is also the question of how the economy will respond when the Bank starts to raise interest rates. But the nightmare looks to be over. And that is worth celebrating.

Wednesday, April 30, 2014
The problems with Piketty
Posted by David Smith at 05:00 PM
Category: David Smith's other articles

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Everybody has had a go at the phenomenon of Thomas Piketty's Capital in the 21st Century. Here's a version of my Sunday Times piece of a few days ago.

Most people in Britain will never have heard of Thomas Piketty, a 42-year old professor from the Paris School of Economics, but that may be about to change.

If you believe the hype, Piketty is shaking capitalism to its foundations, and he is about to bring his message to Britain.

Piketty, an unassuming, softly-spoken Frenchman, has set the world of economics alight and taken America by storm. His book, a muscle-straining 685-page tome, Capital in the Twenty-First Century, published last month, is top of the Amazon bestseller charts in America, and has sold out its initial print run. His publisher, Harvard University Press, is busy getting the presses rolling again for what is likely to be easily its biggest seller in its 101-year history.

On his whistle-stop US tour a few days ago, Piketty wowed the chat shows, met the US treasury secretary Jack Lew and the White House’s Council of Economic Advisers and held forth at a seminar at the International Monetary Fund. New York magazine described him as the “rock-star economist”.

Though his book shows he is no admirer of America’s economics tradition, he appeared alongside two admiring US Nobel prize winners, Paul Krugman and Joseph Stiglitz. Krugman, one of America’s most influential economists, with a column in the New York Times, assessing Capital for the New York Review of Books, described it as a “magnificent, sweeping meditation on inequality”, which explained “why we’re in a new gilded age”.

“Capital in the Twenty First Century is an extremely important book on all fronts,” he concluded. “Piketty has transformed our economic discourse; we’ll never talk about wealth and inequality the same way we used to.” Robert Solow, another American Nobel winner, reviewed the book in New Republic under the headline “Thomas Piketty is Right”.

All this praise in the land of the free, the home of capitalism, is for a book that deliberately invokes Marx in its title and uses 300 years of data to claim that he has exposed the system’s fundamental flaw. Capitalism, according to Piketty, will always result in damaging and dangerous inequality that can only be corrected by taxes on wealth and sky-high income tax rates on the better-off of more than 80%.

Now he is about to bring his road show to Britain and word is starting to get out. The £29.95 book is seventh on Amazon’s UK list and the publishers, having expected to satisfy demand with copies imported from America, are now arranging a large print run in Britain.

On Wednesday Piketty will take the Eurostar from Paris, meeting senior journalists at The Guardian, hold a seminar at the London School of Economics, pre-record an interview with the BBC and give a sold out lecture on his book to an Institute for Public Policy Research event at King’s College. Prospect magazine has him at 27th in its list of 50 top world thinkers, with his long-time collaborator Emmanuel Saez.

He will be back again in June for more lectures and for a discussion in the House of Commons with Lord Stewart Wood, Ed Miliband’s senior adviser. Perhaps ominously for those worried about soak-the-rich policies under a Miliband-led Labour government, Wood says: “We must respond to Piketty’s challenge with ambition and imagination, not with pessimism.”

What is all the fuss about? Piketty’s appeal, certainly to US liberals, is that he has provided an intellectual framework for the challenge to capitalism that was expected in the wake of the banking meltdown and global financial crisis but never happened. The Occupy movement, which targeted the richest 1%, and claimed to speak on behalf of the remaining 99%, had a brief flurry, which in Britain included the occupation of St Paul’s churchyard. But it faded. Capitalism has picked itself up, dusted itself off and carried on more or less as before, though with the regulators keeping a closer eye on things, particularly in the banks.

Piketty, if he is right, has exposed a flaw in capitalism that existed before the crisis and will become increasingly evident as the 21st century progresses. The tendency towards greater inequality, to the rich becoming richer and the masses being left behind, may not bring about the collapse of capitalism – he insists he is not as “apocalyptic” as Marx – but it will put the system under increasing strain.

Measures to correct what he describes as “the fundamental force for divergence” and “the central contradiction of capitalism” will not only be needed on grounds of fairness but will also be required because they threaten democratic societies.

Part of the appeal of the book is that it is readable, despite its length, thanks to Piketty and his English translator Arthur Goldhammer. Frequent references to Jane Austen, Honore de Balzac and other classical novelists, show that this is one economist who has not spent all his life with his nose in economics texts. There is a grand sweep of history in his use of data stretching back 300 years, particularly French data on incomes and inheritances, but also statistics – carefully assembled by Piketty and his fellow researchers – for Britain and other countries.

He also has a nice self-deprecating touch, when he criticizes economists for being “all too often preoccupied with petty mathematical problems of interest only to themselves”. “There is one great advantage to being an academic economist in France,” he writes. “Here, economists are not widely respected in the academic and intellectual world or by financial and political elites. Hence they must set aside their contempt for other disciplines and their absurd claim to greater scientific legitimacy.”

There are two essential conclusions in Piketty’s book. Simon Kuznets, one of the giants of American economics in the 20th century – he lived from 1901 to 1985 – published a seminal paper in the 1950s to demonstrate what became known as the “Kuznets curve”. This was that, while societies had a tendency to become much more unequal during the early stages of industrialization, in which the rewards go to the magnates and landowners, there is a natural tendency towards greater equality in capitalist societies towards greater equality. The longer the process of growth goes on, in other words, the more that the masses will share the fruit of that growth. Capitalism survives by spreading its rewards.

For Piketty, however, Kuznets had identified what was a temporary and special case. Yes, there had been a tendency towards greater equality for much of the 20th century but that was “above all a consequence of war and of policies adopted to cope with the shocks of war”. Since 1980, capitalist economies have been reverting to their 18th and 19th century norms, faithfully recorded by novelists as well as the numbers, in which inequality widens. The rich get richer, the rest stagnate.

The reason why this is the second central claim of Piketty’s Capital, which could be summed up as money will always go to those who already have it. The wealthy will always grow wealthier – inequality will increase – because, according to Piketty, the rate of return on their capital or wealth, r, will always exceed the rate of growth of the economy, g. Most people are stuck in the slow lane, held back by the economy’s growth rate – which he thinks will be quite modest in the 21st century. The rich are in their own fast lane. Money begets money.

If he is right, we may only be seeing the opening skirmishes in the defining battle of the 21st century. When Vince Cable, the business secretary, writes to Britain’s FTSE 100 businesses telling them to curb executive pay, or when a sizeable minority of Barclays’ shareholders votes against higher pay and bonuses, these may just be the early rumblings of far bigger wars to come. If the future is one of ever greater inequality, the wealthy may need very large walls to keep out the dispossessed.

But is Piketty right? Before jumping onto the Piketty bandwagon, however, we should note that the recent history of economics bestsellers changing the world is decidedly mixed. In the 1990s, Will Hutton’s The State We’re In appeared to set the agenda but its theme of stakeholder capitalism was dropped by Tony Blair’s New Labour as quickly as it picked it up. Hutton, predictably, has been singing Piketty’s praises.

A few years ago another book The Spirit Level: Why Equality is Better for Everyone, by Richard Wilkinson and Kate Pickett, was widely attacked for its use of statistics, even prompting a book-sized riposte.

Though Piketty is basking in the warm glow of effusive praise, much of it unthinkingly effusive, the criticisms are starting to mount, even from some who might be expected to be sympathetic to Piketty. Tyler Cowen, the well-regarded professor of economics at George Mason University and co-author of the hugely popular Marginal Revolution website, finds serious flaws.

“Overall, the main argument is based on two false claims,” he wrote recently. “Firstly, that capital returns will be high and non-diminishing … Second, that this can happen without significant increases in real wages … I’m not convinced by the main arguments and the positive reviews I have read worsen rather than alleviate my anxieties.”

James K Galbraith, son of the legendary Keynesian economist J.K. Galbraith, and like Cowen an economist who has done a lot of work on wages and income distribution, has been even more critical. Writing in Dissent, a quarterly journal, Galbraith accuses Piketty of a “terrible confusion” between physical capital – the plant, machinery and buildings needed to make things – and financial wealth.

In straightforward terms, leaving aside academic niceties, Galbraith accuses Piketty of getting his understanding, and his facts, wrong. “In global comparison, there is a good deal of evidence, and (so far as I know) none of it supports Piketty’s claim that US income today is more unequal than in the major developing countries,” he writes. Branko Milanović identifies South Africa and Brazil as having the highest inequalities. New work from the Luxembourg Income Study (LIS) places Indian income inequality well above that in the United States.”

Piketty does not, he concludes, “provide a very sound guide to policy” and the book “is not the accomplished work of high theory that its title, length and reception (so far) suggest.”

Economists are meant to disagree and, though nobody would accuse Cowen and Galbraith of it, Piketty’s success is provoking more than a little professional jealousy. That said, there are three important flaws in the book. The first is that the idea that the rate of return will always exceed the economy’s growth rate is assertion, and most likely incorrect assertion, rather than fact. The period leading up the financial crisis of 2007-9, indeed the prime cause of the crisis, was the quest for a higher rate of return – the search for yield – in a world of low returns. That led to the taking of big and in the end highly destructive risks.

The second flaw is that Piketty is guessing. He is assuming, because it happened in the 18th and 19th centuries, and has been happening in the past three decades, that rising inequality is the new norm. Nobody knows whether that is the case or not. Inequality is diminishing between countries, thanks to the rise of economies like China and India, which is raising living standards in those countries. Inequality is rising in those countries, as happened in Britain, France and America after their industrial revolutions. But you would expect inequality to diminish in these countries, as Kuznets recorded in America, not least because mass production requires a mass of consumers.

The third flaw, as even Krugman concedes, is that Piketty’s model might explain why plutocrats are getting ever wealthier but does not explain the phenomenon of the past three decades, the rise of top salaries. Chief executives, in banks elsewhere, are paid sums relative to the average worker that their predecessors could only dream of. That reflects their bargaining power and persuading enough people – maybe in some cases wrongly – that their talent is in short supply and has to command premium international rates. You do not need three centuries of data, Austen and Balzac to explain it. And already there are signs of a self-generated backlash against some of these boardroom excesses.

Bigger than any of these problems, however, is when Piketty gets into policy recommendations. He would have been better advised to present his conclusions and left it to others to decide what to do with them. As it is, he proposes a global tax on capital – wealth – which he concedes is “a utopian idea” which “is hard to imagine the nations of the world agreeing on any such thing anytime soon”.

Worse, is when he gets on to income tax. In 2007 Piketty backed and worked with Segolene Royal, the French socialist and former partner of Francois Hollande, for the French presidency. She did not get it, but is now back in Hollande’s cabinet. Hollande went for a 75% top tax rate. Piketty thinks it should be 80%.

This is dangerous territory. Piketty refers with a hint of admiration to Britain in the 1970s, when the top rate of income tax – on earned and unearned income – reached a record-breaking 98%. Nobody, of course, paid it, and the effect was not just to kill the golden goose but to stuff it and cook it as well.

Perhaps he thinks 80% sounds modest in comparison with 98%. “The evidence suggests that a rate on the order of 80% on incomes over $500,000 or $1 million a year not only would not reduce the growth of the US economy but would in fact distribute the fruits of growth more widely while imposing reasonable limits on economically useless (or even harmful) behaviour,” he writes.

That does not just apply to America. “According to our estimates, the optimal top tax rate in the developed countries is probably over 80%, he adds. Such “confiscatory” rates are in his view the only way to stem the growth of high salaries.

This is bizarre. Have we learned nothing since the 1970s about the impact of very high tax rates on growth and incentives? Does anybody really think that the prospect of eye-wateringly high tax rates on success will not stop people striving for success, to take the necessary risks needed to stimulate innovation? The Levellers had nothing on Piketty when it comes to tax.

As it is, we have discovered in Britain that lower top tax rates both incentivised success and brought a bonanza for the taxman. The top 1% of income earners account for 30% of income tax revenues, compared with 11% in 1979. The main effect of high tax rates is to boost the tax avoidance industry.

Wealth is Piketty’s great concern. But it, according to Credit Suisse’s latest Global Wealth Report, is more evenly distributed in Britain than in Canada, Denmark, France, Germany, Ireland, Israel, Holland, New Zealand, Norway, Singapore, Sweden Switzerland and America. It is also more evenly spread in Britain than in most developing countries in Africa, Latin America and Asia, including China, India, Indonesia, Thailand and South Africa.

A glance at The Sunday Times Rich List, or lists of global wealth, shows moreover that the money begets money model does not fit. Yes we can envy the mega-rich. Or maybe not, but they are usually not the same mega-rich as 20 or 30 years ago. The main effect of sky-high tax rates would be to preserve differences in wealth, by killing entrepreneurialism and the rise of new wealth-creators at at birth, not eliminate them.

Piketty, the rock-star economist, has written a huge book, and sold more copies than he could have dreamt of. Mostly, it has been well-received, though it is flawed. But his conclusion, slap huge taxes on the rich, is as crude as it could be. And if politicians are tempted to take it up, they will find that it comes back and bites them. Piketty has been greeted as some kind of inequality messiah. The one way to guarantee the slow growth he fears is to take his advice and tax it out of existence.

Sunday, April 27, 2014
Self-employed may hold key to rate hikes
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Today I want to talk about a subject dear to the hearts of many millions in Britain, 4.5m to be precise. I am referring to self-employment, which is booming, and which, for reasons I shall explain, may hold the key to the timing of when interest rates rise.

The rise of self-employment is one of the big stories of the recovery in the job market, and the changing nature of employment. There are now 700,000 more self-employed people in Britain, a rise of 18% compared with early 2008, before the economy slid into recession.

The optimistic view is that the banking meltdown and recession have resulted in a flowering of the entrepreneurial spirit. Faced with uncertain employment opportunities and the appeal of being their own boss, hundreds of thousands of people chose to turn the financial crisis into an opportunity.

Or, less benignly, could it be that pride has prompted many to describe themselves as self-employed when, to all intents and purposes, they are not employed at all? Could self-employment be the equivalent of some zero-hours contracts, except in this case, people spend many hours doing zero work?

It is a big question and, before answering it, let me provide a few more numbers. Much of the increase in self-employment, roughly half a million, has come in the past three years, though self-employment held up far better than employment – which dropped sharply - during the 2008-9 recession.

To put the 700,000 rise in self-employment since the eve of the crisis in perspective, the number of full-time employees, though rising strongly, is still some 200,000 below pre-crisis highs. The overall number of employees, admittedly, is up, though that reflects a rise in the number of part-timers.

To add a bit more statistical colour, the 1.15m rise in employment over the past three years divides into a 515,000 rise in the number of full-time employees, that 500,000 increase in self-employment and the rest - between 130,000 and 140,000 – in a rise in the number of part-time employees. Full-time employment during the recovery phase has kept ahead of self-employment, but only just.

What do Britain’s 4.5m self-employed do? Pretty well everything. Around 850,000 are in construction and civil engineering. Other big categories include retailing, 256,000; education, 246,000, building services and landscaping, 225,000; washing and dry-cleaning, 218,000; transport, 215,000; “human health” (including personal trainers), 188,000; farming, 175,000; legal and accountancy, 136,000; creative arts, 130,000; social work, 118,000, and architecture and engineering, 104,000.

Why does self-employment matter for interest rates? The Bank of England’s monetary policy committee(MPC) minutes for this month, released a few days ago, were significant because they were the last under Mark Carney’s original forward guidance, linking future interest rate changes to the unemployment rate.

Since the MPC met earlier this month the unemployment rate has dropped through the 7% threshold, falling to 6.9%, thus ending that first phase of forward guidance (while not prompting the Bank to think about a rate hike yet).

When it will do so, as was clear from the minutes, has a lot to do with if we should interpret t he rise in self-employment optimistically or pessimistically.

“A key question was whether the amount of slack in the labour market was understated by measured unemployment, as might be the case if many of the self-employed were underemployed and searching for work as employees.” the Bank’s minutes said.

There was “a range of views” among MPC members about whether the rise in self-employment was genuine, or a form of disguised unemployment.

If you are a hawk on the MPC, thinking about when to swoop for a hike in interest rates, you are more likely to think that the rise in self-employment is genuine. If you are a dove, and I would put Mark Carney, the governor, firmly in this category, you are more likely to question the self-employment numbers.

Though there is a range of views on the MPC, it has been hard so far when it comes to hawkishness to spot a sparrowhawk, let alone a golden eagle.

What is really happening to self-employment? Talking to the Office for National Statistics, which admits there is more it would like to know about the self-employed, several things stand out.

Most people do not flit in and out of self-employment, in response to redundancy or anything else. Self-employed people tend to be older than the average worker and have been doing it for some time, typically 10-20 years.

Why, if most are in it for the long run, have we seen such a strong rise in self-employment over the past few years? The ONS has an interesting explanation for this, which feels right. It is that many fewer self-employed have been retiring, perhaps because of inadequate pension arrangements or other factors. So, in the jargon, there have been fewer outflows from self-employment into retirement.

Combine that with a steady increase in the number of people becoming self-employed - the inflows - and you have the reason for the rise in numbers.

There are three other reasons to think the rise is genuine. The strong revival of construction and house-building would be expected to lead to a rise in the number of self-employed, and it has. Numbers of self-employed in construction and civil engineering are up more than 100,000 over the past 2-3 years.

The recent overall rise, moreover, has been concentrated in full-time self-employed people, up 243,000 in the latest 12 months, compared with a 54,000 rise in part-time self-employed. If self-employment was disguised unemployment, you would expect the biggest rise to be among people declaring themselves part-time self-employed.

Not only that, but self-employment is rising strongly even as more jobs become available, with a 100,000 increase in vacancies in the past year alone.

So, it looks genuine, and I suspect the MPC will come to that view too. Does that mean interest rates are about to go up? Not yet. I think the unspoken deal on the MPC is for no rate hike this year but that forward guidance will have served its purpose if there are rate rises next year. The question is whether that will come to be seen as too late.

Sunday, April 20, 2014
Union blues: Would an independent Scotland honour her debts?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

There are still nearly five months to go until the referendum on Scottish independence but the debate is definitely hotting up. The polls are getting more interesting.

Buoyant is the default position of Alex Salmond, SNP leader and Scotland’s first minister but he is unusually buoyed up at present. He, after all, has a history of winning in Scotland.

Were I a Scot living in England I would be frustrated to the point of distraction by not having a vote in this, the most important decision for my country. For many Scots living in Scotland, I suspect, emotional arguments pull against the considerable economic risks of independence.

Recent evidence on the UK economy adds to those risks. Britain has turned into a formidable job creation machine, with nearly 700,000 new jobs created over the latest 12 months and an unemployment rate now below 7%, something the Bank of England said last summer it did not expect to happen until 2016.

Not only is the national labour market doing well, but Scotland is doing well within it. It has an unemployment rate of 6.5%, compared with 6.9% for the UK as a whole. Its employment rate, 73.3%, compares with a national rate of 72.6%.

10% of the new jobs created in the past 12 months have been in Scotland, bigger than its share in the UK economy. Would an independent Scotland do as well? Maybe, but there is a big risk it would not.

My last big piece on independence, ‘Separate Scotland will have to take the low road’, in September last year, described that and other risks. I will revisit it nearer the referendum but, without anticipating that entirely, the economic case has looked shakier even as support for independence in some polls has increased.

It was thought, for example, that Scotland’s budget deficit, assuming a geographical share of North Sea oil and gas, would initially be smaller than the rest of the UK, the big fiscal challenges coming later.

Now we know, from the Scottish government itself, it ran a budget deficit of 8.3% of gross domestic product in 2012-13, bigger than the 7.3% deficit for the whole of the UK.

Today I want to tackle a separate issue. When all three national parties (“Westminster parties” in SNP terminology) say they do not want Scotland to become independent, but if it did would not allow it to be in the currency union with the rest of the UK, there are three responses from the nationalists.

The first is that it is bullying of plucky little Scotland by the bigger boys in Westminster. I must say I’ve never seen Danny Alexander as school bully.

The second is that it is bluff, though it has to be said that it is a curious world in which the nationalists give greater weight to the off-the-record words of an unnamed minister than to the three parties’ economic spokesmen and the Treasury’s top official. If a future Westminster government opted for a currency union with an independent Scotland, it would do so against Treasury advice.

What about the third argument, which is that if the rest of the UK is so desperate to keep Scotland, this must show that Scotland is being exploited, either for her oil, or for other reasons?

Many English readers, I know, are entirely relaxed about Scottish independence. Some say the rest of the UK would be better off without Scotland. So why the keenness on the part of the Westminster political establishment to keep it?

One point can be dismissed. Salmond and his SNP colleagues insist that a post-independence rest of the UK would be desperate for a currency union for fear of losing the balance of payments support provided by North Sea oil.

This is a strange argument. Britain already runs a sizeable trade deficit in oil, and crude oil imports are between two and three times greater than exports. And, currency union or not, Scotland would have a separate balance of payments. That is what independence means. It would have a trade surplus in oil, partly offset by a deficit (including with the rest of the UK) on other goods and services.

The rest of the UK would have its own balance of payments and the level of sterling would be determined by that, not what was happening north of the border. There would be times when the right currency level for Scotland’s petro-dominated economy would be higher than that of the rest of the UK, and times when it would be lower. But the idea that an independent Scotland would provide balance of payments support for the rest of the UK does not wash.

There is, however, a genuine financial reason – among plenty of other reasons – why the rest of the UK wants to keep Scotland. This is the fact that an independent Scotland would almost certainly start life owing the rest of the UK a lot of money.

The latest paper from the National Institute of Economic and Social Research on independence, just published, suggests the negotiating range for Scotland’s share of UK debt will be between £102bn and £143bn, up to 86% of GDP.

The key point is that Scotland will not be able to pay off the rest of the UK immediately but is likely to be forced to issue an IOU.

This will have two implications. One is that until that IOU is honoured, gross public debt for the rest of the UK will be pushed up to more than 100% of GDP which, as the National Institute says, is likely to attract the attention of the ratings agencies.

The other is that the rest of the UK will be reliant on Scotland not reneging on her debts. Since some SNP politicians have warned that this is exactly what Scotland might to if not allowed to participate in a currency union, this would be a fiscal problem Britain could do without.

Sir Nicholas Macpherson, Treasury permanent secretary, has dismissed the nationalists’ warning that Scotland could renege on her debt as “not a credible threat”. The National Institute points out, though, that an independent Scotland would need to run tougher fiscal policy than the UK as a whole has had over the past four years to both take on her share of UK debt and bring it down to manageable levels.

There are many reasons why the rest of the UK wants to keep Scotland. But not being able to trust the Scots to take the tough fiscal decisions to honour her debts is one of them.

Sunday, April 13, 2014
Plenty of lessons for France in Britain's recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Being British means we are easily embarrassed even by modest success. The default position, when it comes to the economy, is to grumble. There is usually plenty to grumble about even in the good times, so that keeps us happy.

So how should we respond to the fact that the International Monetary Fund now predicts that Britain’s growth rate this year, which it thinks will be 2.9%, will be the fastest in the G7?

Should we celebrate, or worry that all too often in the past pride in our economic performance has come before a fall? Can it, in other words, last?

Actually we should celebrate a little. Olivier Blanchard, the IMF’s chief economist, went much too far a year ago, warning George Osborne that he was “playing with fire” with his policies and has been proved spectacularly wrong. Hence the chancellor’s upbeat “victory roll” speech to the American Enterprise Institute on Friday.

Blanchard was not alone - misreading Britain’s economy from the other side of the Atlantic (and sometimes from this side) proved to be an occupational hazard - but he was perhaps the most prominent.

There is also a delicious irony, against the French-run IMF, in that if you were looking for an economy with growth problems, look no further than France, predicted to grow by just 1% this year after 0.3% last year and zero in 2012.

Its new prime minister, Manuel Valls, has outlined a programme of spending cuts, tax reductions and labour market reforms that almost sound Thatcherite. Time will tell whether it will work.

What about Britain’s place in the economic sun? The IMF expects Britain to grow by 2.5% in 2015, second only to America. It expects inflation slightly below the 2% target and, to take up last week’s theme, a welcome narrowing of the current account deficit to just over 2% of gross domestic product next year.

That’s enough IMF. It was, after all, wrong in one direction a year ago, so could easily be wrong in the other direction now. Are there other reasons to be optimistic?

The answer to that is yes. Britain’s better growth performance reflects improved credit availability, reduced fears of new crises, rising business and consumer confidence and a strong labour market.

One paricularly positive development is that industrial production, having hit a post-recession low in 2012, is now on a firm upward trend, with manufacturing output up nearly 4% on a year ago.

Industry is being supported by stronger retail and consumer spending, rather than exports. Exports of goods and services in the latest three months were 1.7% down on a year earlier. There may, though, be some import substitution going on. The latest figures show that while exports have been disappointing, imports were even weaker.

Indeed, import substitution may be our best hope when it comes to the growth contribution from trade. Delta Economics, which specializes in analysing and forecasting trade, predicts that this year will be lacklustre, with just 1% world merchandise trade growth. Export success will be hard-won in this environment.

Much more positive, as the Ernst & Young Item Club points out in its new forecast, a distinct shift is happening in the labour market. So far it has been a case of strong employment growth balanced by weak wages.

The new Item forecast has both rising together, with employment threatening to meet Osborne’s full employment target, which he defined as the highest employment rate in the G7. Canny politicians know that you should never set yourself a target unless you believe you have a good chance of meeting.

Professor Peter Spencer, who runs the Item forecast, says Britain will challenge Germany for the highest employment rate in the G7. Alongside that, a combination of stronger wages growth and weak commodity prices should mean sustained growth in real wages, from now.

Item, like the Office for Budget Responsibility, sees plenty of a kick from business investment, with more than 9% growth this year followed by only slightly slower rates of expansion later.

2014 could turn out to the sweet spot of this recovery - though some economists think next year will be just as strong - but even the gloomy do not think there will be a return to the relapses the economy was prone to in the period from 2010 to 2012. The debate is over the strength of recovery, not whether it will last, and that has to be an improvement.

Could it be a case of pride coming before a fall? One worry, almost an ever-present in Britain, is housing. Prices, according to the latest LSL-Acadata index, are up by 7.2% in the past 12 months, with London up 13.3%. Other measures are even stronger.

A few days ago I took part in the HSBC great housing debate, organised by the Wriglesworth Consultancy. Though house prices are indeed buoyant, many at the debate saw reasons why they will cool, including the mortgage market review, which sets tougher tests for loan applicants, and which takes effect in less than a fortnight.

It is also the case that the contribution of the Help to Buy scheme to the housing market is greatly exaggerated. Fewer than 17,000 Help to Buy mortgages have been advanced since the first phase of the scheme was launched a year ago, and only just over 1,000 in London. The Help to Buy total, so far, is running at under 4% of all new mortgages.

Is everything perfect? No, there is still plenty to grumble about, and that will keep us happy. The recovery is better than it was but not as good as it could be. We may not even be top of the G7 growth league for too long. But things are a lot better than they looked a year ago. And that can’t be bad.

Sunday, April 06, 2014
Britain's balance of payments sinks in a sea of red ink
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

One question keeps coming back to me from readers. Why, when it was such a big issue in the past, does the balance of payments no longer seem to matter anymore?

And, related to this, are we now entering a period in which it may indeed start to matter again, perhaps quite a lot?

There has never been a better time to write this piece than now and it may help to start by defining terms. The trade deficit is the gap between exports and imports of goods and services.

Traditionally we used to talk about the visible trade deficit – the gap in goods (£108bn last year) - but now it is customary, and helpful to Britain, to include services (the goods and services deficit in 2013 was a more manageable £27bn).

The current account deficit - £71bn last year - is the trade deficit plus two other flows, income and transfers, of which more in the moment. The current account deficit is the one to watch. Because the balance of payments has to balance, as every economics student is taught, there are two other accounts, the capital and financial accounts.

Actually, when I was first taught economics, we always expected the capital account to balance any red ink we recorded on the current account.

But, as the Office for National Statistics (ONS) reminds us, the combined current and capital account has been in deficit since 1983. For three decades we have relied on the financial account – direct and portfolio investment and, perhaps scarily, financial derivatives – to keep our heads above water.

The current account was more important in the past, certainly in the 1960s, because current flows (trade and invisible earnings) were not then dominated by capital flows, and because it was an era of fixed exchange rates. Balance of payments pressures required a swift response from the authorities in the form of higher interest rates.

Now there are reasons why we should take note again. Not only were the numbers for last year awful, but they took a decided turn for the worst in the second half of the year.

When, a few weeks ago, the ONS released current account figures for the third quarter of 2013, showing a deficit of more than £20bn, my initial thought, given there was such a lurch into larger deficit from under £10bn the previous quarter, was that it must be an aberration and would probably be revised lower.

A few days ago, however, that third quarter figure was revised up, to £22.8bn, and the number for the fourth quarter came in at a high £22.4bn.

Moreover, the fourth quarter deficit was 5.4% of Britain’s gross domestic product, only marginally down on the 5.6% figure for the third. Add the two together and you get a deficit of 5.5% of GDP, the biggest for any six-month period in post-war history.

For once the problem was not with the trade deficit, which narrowed from £10bn to £5.7bn on the back of a record high for service sector exports.

No, the problem lay elsewhere, and in particular for investment income, which showed a deficit of £10.3bn in the final quarter and £17bn for 2013 as a whole, up from £3.7bn in 2012.

The turnaround in Britain’s investment income has been sudden. In 2008, there was a surplus of £33.2bn from this source. As recently as 2011 Britain was in the black to the tune of £22.7bn. Losing this source of balance of payments is like a star racehorse going lame.

It has happened, say official statisticians, because of losses abroad by British banks – or the realization of earlier losses – together with a drop in income on overseas investments by British firms.

Tied to this, there has been a turnaround in relative returns on investment. Michael Saunders of Citi points out that from 1998 to 2011 the annual rate of return on British investments overseas, 3.9%, exceeded the return on foreign-owned assets in Britain, 3.5%.

Since then, the position has been reversed. Both sides suffered as a result of the crisis but at the end of last year British investments overseas were only returning 1.7% annually while foreign-owned assets in Britain returned 2.2%.

It is possible some of this is temporary. It may, in part, be an aftershock of the financial crisis.

But these shifts can be long-lasting. Though we came in recent years to regard investment income as one of the sure things of the balance of payments, there was a deficit on it for all but a couple of years over the period 1977 to 1997, partly as a result of the income paid to foreign owners of North Sea oilfields. There was a trade surplus on North Sea oil most of that time, but an outflow of investment income.

This time, according to an interesting analysis by James Carrick, an economist with Legal & General Investment Management, the big shift has been in Europe. Depressed demand in the eurozone, coupled with strong export performance by countries such as Germany, led to a sizeable current account surplus.

In the final quarter of last year, that surplus was 66.8bn euros (£55bn), well over double Britain’s deficit. So Britain’s poor numbers for investment income partly reflect what is happening in the eurozone. British investors, and British businesses with operations in Europe, have been getting poor returns.

Europeans, however, have been happy to use their current account surplus to pour money into Britain, and not just into London housing. We are relying on the rest of the European Union to fund our current account deficit, a point it might have been worth Nick Clegg raising in his debate with Nigel Farage.

How risky is this? Britain’s current account deficit, Carrick points out, is in similar territory to the so-called “fragile five” emerging economies. The financial flows that have kept Britain afloat could be vulnerable to political uncertainty and change, such as a yes vote in September’s Scottish independence referendum and, even more, a vote to leave the EU in an in-out referendum.

The best long-term solution is to trade our way into a stronger current account position. Until then the pound, and ultimately interest rates, will be worryingly dependent on the willingness of others to fund our current account deficit.

Sunday, March 30, 2014
Falling inflation lifts the mood and helps the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Inflation has been below the official 2% target for two months in a row, something it has not been possible to write for a long time.

You have to go back to 2009, five years ago, when the economy was falling off a cliff, for the last time this happened.

Inflation at 1.7%, as it was in February, has come down from more than 5% in the space of less than two and half years. Even last autumn it seemed we were stuck at closer to 3% than 2%.

The fall is a feather in Mark Carney's cap though I am sure, given the lags in monetary policy, he would give some credit to his predecessor, Lord King.

One set of crossroads has been written about a lot. Is this the point when wages - average earnings - start to rise faster than prices, the consumer prices index? As regular readers will know, my view is that this has been happening for some but it will not be generally accepted until the monthly data from the Office for National Statistics confirms it.

The second set of crossroads, what it means for the Bank of England, is as important. The course of inflation over the next 12-18 months matters. Some, like Fathom Consulting think this is the briefest of below-target interludes.

Fathom thinks lack of spare capacity in the economy will, alongside stronger growth, push inflation back up to 3% by the end of the year. They have a bit of history on their side. Even in the deep recession of 2009 inflation was below target for just five months. Why should it be better during a period of recovery?

In the opposite camp are regular inflation optimists such as Capital Economics, who expect inflation to drop to 1% later this year. They see the pressure from global commodities, and thus food price inflation, continuing to ease.

Even more optimistic is David Owen, an economist with the City firm Jefferies International, who sees sub-1% inflation. Falling inflation is common in recoveries, he notes, and there is more evidence of price discounting by retailers, including supermarkets.

Energy price rises, which have pumped up inflation in recent years, are being replaced by freezes, led by SSE. Generalised energy price falls, like the recent drop in petrol and diesel prices, are a possibility.

Tellingly, as Owen points out, the proportion of goods and services in the CPI (consumer prices index) basket rising by more than 3% has come down sharply. That is reflected in the drop in inflation but may also be a sign of things to come.

The Bank of England is somewhere in the middle. Based on market interest expectations (which are for a mdoest rise starting in a year’s time), it expects inflation to go back above 2% shortly and stay there until the autumn, before dropping a little below it - in a 1.7% to 1.9% range - through to the early part of 2017.

Interestingly, if Bank rate were to stay at 0.5%, inflation would stay above 2%, though not by much, perhaps averaging 2.2% or 2.3%.

I know what you are thinking. Given the vagaries of the data, though inflation numbers are trusted more than most, this is dancing on the head of a pin.

Given Britain’s past inflation gyrations, the difference between 1.9% and 2.2% is small beer. So, in the grand scheme of things, is the difference between 1% and 3%.

But it matters. If inflation is 1% over the next 12 months, that guarantees a rise in real wages for the four-fifths of people who work in the private sector. Earnings in the private sector in the latest three months were up 1.7% on a year earlier and the trend is for faster growth.

We will soon reach the point in which growth in real pay for private sector workers is incontrovertible. The only thing that will stand in the way of it is a rise in inflation back up towards 3%.

Politically, rising real wages are important, neutering if not destroying the Labour party’s cost of living argument. But it is important for the economy too. Sustained real wage growth is the only sound long-term basis for rising consumer spending.

The evidence, from the national accounts and the annual survey of hours and earnings, is that real wages have been rising for a while now. The latest retail sales figures, showing a 1.7% jump in spending last month and a 4.3% increase in the latest three months compared with a year earlier, lend support to that view. But perception is important and risijng real wages need to be in the headlines, not the statistical detail.

What about public sector workers? We are in a time, unusual in recent years, in which private sector pay is rising faster than in the public sector, where the latest rise is a mere 0.5%. That, however, is dragged down by falling pay in the state-owned banks, Royal Bank of Scotland and (for now) Lloyds.

Take them out and public sector earnings are rising by 0.9% and the growth in pay is accelerating. Even public sector workers could find themselves with real pay rises if inflation drops to 1%.

Low inflation also matters for the Bank and its credibility. If inflation were to go back up to 3%, its process of beginning to raise interest rates, set to start next year, would be from a position of weakness.

It would also, given that under those circumstances it would probably coincide with a continued squeeze on real wages, be harder to do, adding to the pressure on hard-pressed households.

Raising rates at a time of below-target inflation, on the other hand, would be a good thing from every perspective. It would show the Bank was responding to the risks of future inflation, not reacting to existing inflation. Households would be better able to take it with real wages rising. Savers would love it.

When it comes to low inflation it is possible, of course, to have too much of a good thing. If inflation falls so much that deflation is seen as a risk, the Bank would be reluctant to embark on an even a gradual rise in rates. 1% inflation would be good. Too far below 1% maybe not so good.

Sunday, March 23, 2014
Export gloom rains on Osborne's parade
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

So, was it one of those budgets that will last about as long in the memory as the spring daffodils, or was it more enduring than that?

In the two pieces I wrote ahead of Wednesday’s budget, one said there should and could be no big giveways given the state of the public finances. The other, last Sunday, said the budget must be firmly focused on lifting Britain’s dismal productivity performance.

Though the Institute for Fiscal Studies rightly pointed out that the budget was not quite as neutral as claimed, because small giveaways now are funded by unspecified spending cuts later, my judgment is that Osborne passes the “no significant giveaway” test.

Not only that but, apart from the pledge to raise the personal allowance to £10,500, and maybe even including that, these modest adjustments (which added up to a net cost of just over £0.5bn in bother 2014-15 and 2015-16) fell into the “good giveaway” category.

You cannot be too hard on a budget which doubles the annual investment allowance to £500,000 and increase incentives for savings, with a new ISA limit of £15,000 and, as touched on here ahead of the budget, no limit within that on how much can be put into a cash ISA.

Some, like the shadow chancellor Ed Balls, argue it cannot have been a budget for saving because the Office for Budget Responsibility is predicting a drop in the saving ratio from 5% last year to 3% by 2018. But this misunderstands the saving ratio. It is falling, not because households are saving less, but because some are borrowing more. It was a budget for saving.

It was also, and this is where it should make it into the pantheon of memorable budgets, a big reform of pensions. Freeing people from the prison of annuities carries some risks, but these will be greatly outweighed by the benefits.

Was it a budget for productivity? The increase in investment allowances for firms, and the OBR’s prediction of annual rises in business investment averaging more than 8% over the next five years, will help lift productivity. There were bits and pieces on apprenticeships and other measures, dotted around the budget, that will help at the margin.

But this was not a budget for productivity in any meaningful sense. For the moment, the chancellor seems happier that employment is rising - and predicted to continue to do so - than that productivity rebounds.

Though the OBR predicts a gradual pick up in the growth of productivity, output per hour, as the economy strengthens, itr also warns that productivity growth “remains below the rate consistent with historical trends throughout the forecast”.

That forecast, which extends until 2018, may be wrong. But the OBR’s argument, that damage to the financial system is preventing the allocation of capital to more productive use, has merit, and was not seriously addressed.

What about the balance of the recovery? After a three-year interlude in which he was keener for growth, any growth, than the nature of that growth, the chancellor was able to return to his 2010 agenda of trying to secure a more balanced recovery.

I was gratified to see the Treasury, in its analysis, take up some of the themes and numbers that have featured in recent columns here. So it noted, as I did, that the annual survey of hours and earnings shows that people in continuous employment - around two-thirds of all employees - have seen above-inflation pay increases in most recent years.

It also picked up on, as I have done, the myth of a consumer-dominated recovery driven by debt. Consumer spending’s contribution to growth has been lower than its long-term share of the economy and similar to previous recoveries. Business investment has kicked in over the past year.

In my pieces on this I emphasised that the export shoe has yet to drop. The Treasury is a bit more circumspect, focusing instead on more generous export credits and lower tax rates on flights to some of the more promising export markets outside Europe.

But the OBR was clear. Not only has the export shoe not dropped, but it will never do so. the new official forecast is resolutely downbeat on the contribution of exports to recovery. This, if the OBR is right, is a home-grown recovery, and not in a good way.

The OBR has revised down its forecast for export growth this year from 4% to 2.6% since December. Even when export growth picks up to 5% from next year onwards, it will be slower than the growth in world trade.

One of the saddest charts you can draw, Britain’s share of world trade is stuck firmly in a downward trend. Britain’s trade share dropped by a fifth between 1998 and 2010, and will drop by a further tenth by 2019.

The contribution of net exports (exports minus imports) to growth will be negative by 0.2 percentage points this year and, in what looks like a decisive burying of the prospects for export-led recovery, the OBR notes that “net trade is expected to make little contribution to growth over the remainder of the forecast period, reflecting the weakness of export market growth and a gradual decline in export market share”.

This is all a bit depressing. It has been possible to put export disappointment in recent years down to the eurozone crisis and exporters choosing to widen their margins when sterling fell rather than chase market share. Now the pound has recovered some losses, providing another excuse for export weakness.

The export malaise goes deep if the official forecaster is to be believed, and the budget measures did little to address it. We have to hope it is too gloomy about Britain’s external trade. If not, we need a change of export culture. Until we have it, we will wait in vain for that export-led recovery.

Sunday, March 16, 2014
George, we need to talk about productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Wednesday's budget will be the latest in a very long line. I say that with enthusiasm even though I have covered enough to last a lifetime.

And were I to say how many of them were genuinely memorable, the answer would be a rather small number. I’m struggling, as I write, to remember much about George Osborne’s 2013 budget, and that was only a year ago.

My list of memorable budgets would probably include Sir Geoffrey Howe in 1979 and 1981, Nigel Lawson in 1984 and 1988, Norman Lamont in 1991 and again, with Kenneth Clarke, in the two tax-raising budgets of 1993.

Gordon Brown would make it with his 1997 budget and, possibly, 2002, when he raised National Insurance to pay for health spending, Alistair Darling’s 2009 budget, the one that included the new top rate of 50%, squeezes in.

Osborne’s memorable one was his June 2010 “emergency” budget, which set the parameters for the parliament and raised Vat to 20%, though his 2012 “omnishambles” sticks in the memory.

Just as budgets quickly fade in the memory, so it is important not to overstate their impact. Though there are exceptions, 1981 and 1988 particularly, economic policy is usually incremental. The chancellor as conjuror, waving a wand to transform the economy, is appealing but usually wrong.

There is, however, a central issue hanging over Wednesday’s budget. It is not, for once, the question of whether the economy is growing or the budget deficit coming down. As discussed last week, unless Osborne has a rush of blood to the head and is tempted into unaffordable giveaways, the public finances will slowly continue to mend.

No, the issue is productivity. Britain’s productivity, whichever way it is measured - the economic output produced by each worker, or each job, or each hour worked - is notoriously weak.

So, compared with its level in 2010, latest figures show that output per job across the whole economy is up just 0.5%, while output per hour is down 1.1%. This weakness is true of manufacturing, unusually, and it is true of services. Stronger economic growth has boosted the number of people in work but it has not yet boosted productivity.

Weak productivity matters because it matters. The only line I am likely to quote from the American economist Paul Krugman these days is “productivity isn’t everything but in the long run it is almost everything”. Raising productivity is the key to prosperity.

It matters too because the weaker productivity is, the sooner the Bank of England will decide spare capacity in the economy - 1% to 1.5% of gross domestic product - is used up. At that point, or before, interest rates will start to rise.

And it matters particularly for the public finances. Nearly three years ago, accompanying Osborne’s 2011 autumn statement, the Office for Budget Responsibility (OBR), taking a gloomier view of the economy’s supply potential, revised up its estimate of the underlying - or structural - budget deficit.

This is the deficit that will not permanently disappear even as the economy recovers and has to be dealt with by spending cuts and tax hikes.

The result was to kill the chancellor’s ambitions of “dealing with the deficit” in this parliament, forcing him to extend austerity beyond the election.

Some fear history is about to repeat itself. In December, in the economic and fiscal outlook published alongside the 2013 autumn statement, the OBR was quick to say that the upturn was cyclical, rather than reflecting any underlying improvement in growth potential.

It also noted that, because the weakness of productivity was unexpected, it was hard to say when, or if, it would return to past rates of growth.

Whether or not the OBR takes an even gloomier view now, with serious implications for the public finances, there is an imperative for the chancellor to try to do more to boost productivity.

What could it be? Some things being done, shifting people from traditionally low-productivity public services to the higher-productivity private sector should be helping more than it is.

There is talk of measures to boost business investment, perhaps through more generous capital allowances, building on the recovery we have seen.

One explanation for productivity weakness is that firms have preferred to recruit workers, who can be unrecruited if demand falls short, rather than make the bigger and less reversible commitment to new investment.

Britain’s low productivity in relation to Germany and France - where output per hour is 31% and 32% higher respectively - is in large part due to lower levels of investment in this country.

Another budget theme is expected to be boosting exports, perhaps via better-focused export credit. Again, this is a promising route to lifting productivity.

Export sectors tend to have higher productivity than sectors supplying only to the domestic economy, with Japan the most dramatic example of this.

There is much more. Another reason for weak productivity has been the lack of “creative destruction” in recent years - too few bad businesses going under and being replaced by dynamic, high-productivity start-ups.

That reflects what has been happening in parts of the banking system: keeping too many zombie firms alive while starving new ventures of the finance they need. That is changing, but it needs to change faster. The Funding for Lending scheme has been refocused towards small and medium-sized firms but lending to that key sector has yet to turn round.

Achieving high productivity requires more than pulling a few budget levers. It means changing the culture. But the budget must make a start. George, we have to talk about productivity.

Sunday, March 09, 2014
There's still no money left for tax cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Where is all the pre-budget speculation? In just 10 days George Osborne will deliver his fifth budget and there has been so little fuss you could be forgiven for thinking it had been cancelled. Even the Treasury seems reluctant to talk about it.

Actually, as I shall come onto, it might be no bad thing if the budget were to be cancelled but let me first set the scene. Anybody looking at Britain’s public finances is entitled to conclude that the crisis into which they were plunged six years ago is far from over.

This year, 2013-14, the Office for Budget Responsibility (OBR) predicts a budget deficit - public sector net borrowing - of £111bn. Monthly figures suggest it may come in a little below this forecast but still well above £100bn.

To put that in perspective, borrowing on this measure had never been higher than £100bn until the 2009-10 fiscal year, when it ballooned to £157bn. This year’s deficit, in other words, is the fifth biggest in cash terms on record.

We get used to big numbers, but only a few years ago a budget deficit of £60bn would have been regarded as a crisis, let alone one in three figures (and staying in three figures for five successive years).

To add another bit of perspective, the budget deficit this year is, according to the OBR, 6.8% of gross domestic product. That is only the merest touch lower than 1975-6, a borrowing level that helped trigger Britain’s 1976 rescue by the International Monetary Fund.

Public sector net debt, £1,239.6bn excluding the direct effects of support for the banking system, is two and a half times what it was before the crisis. A decade ago it was a healthy 30% of GDP. Now it is just under 75% and rising.

By the time it turns down as a percentage of GDP, in 2016-17, it will have hit 80% of GDP and more than £1.5 trillion. There is a lot of red ink still to flow.

A man from Mars looking at these numbers would be aghast that, to the extent there is budget talk around, it is about how much Osborne will be able to afford to give away in pre-election tax cuts.

I am as keen on tax cuts as anybody. The fiscal drag that means a record 4.4m people are paying the higher 40% rate of tax this year - up from 1.6m two decades ago - needs fixing.

So does the absurd anomaly in which people earning between £100,000 and £120,000 (from next month) pay a marginal rate of 60% (62% including National Insurance).

The coalition has raised the personal allowance to £10,000 and Osborne may move further, though this reform has gone beyond where it helps genuinely low paid. Better to raise the threshold at which people start to pay NI, just £111 a week, £5,772 a year, from April.

Business investment is improving but why not help it along with generous capital allowances, particularly for smaller firms? Actually we might see some of that. Why not help firms more with business rates?

Why not acknowledge we are in a low interest era by doubling the amount savers can put in tax-free cash Isas (individual savings accounts)? And why not help first-time buyers, complementing Help to Buy, by getting rid of stamp duty altogether on properties below £250,000?

There is much more, and not just on tax. Every housing gathering I attend - a few days I was at the National Housing Federation in Brighton - rightly bemoans the low level of housebuilding, and in particular social housing. The government complains about the squeeze on real wages but one easy way of easing it, given that the public sector acts as wage-setter in many areas, would be to lift the 1% cap on public sector pay.

Everybody will have their own wish list. Mine only scratches the surface. Some Tory MPs would like to see Osborne slash taxes across the board. Britain’s bishops are praying for hikm to ease up on the squeeze on welfare.

The point is that you do not need a man from Mars to tell you that most of the pre-budget wish list is pie in the sky. All you need is the man from the Institute for Fiscal Studies, its director Paul Johnson, who rightly points out that with so much fiscal adjustment still to come if the chancellor is to achieve a budget surplus, it would be inconsistent to have any kind of meaningful giveaway now.

The situation has not changed much since Liam Byrne, the outgoing Labour Treasury chief secretary, famously wrote a note for his coalition successor saying there was no money left.

Why has it taken so long to get the deficit down? Disappointing growth, until now, has been a factor. Weak productivity has raised official estimates of the strctural deficit.

Because of the constraints of coalition or for other reasons, Osborne has opted for gradualism in reducing borrowing. The short, sharp shock of, say, Sir Geoffrey Howe’s legendary 1981 budget in Margaret Thatcher’s first term, has been avoided.

To an extent this has given him the worst of both worlds - getting blamed for harsher cuts than he has delivered - and there may be more of this in the budget when he announces his 2015 cap on welfare spending in the budget.

Progress has been made. This year’s cyclically adjusted bugdet deficit is about half the 2009-10 record. In real terms about £60bn has been lopped off the deficit, with more to come.

But there is also much more the Treasury should be doing which does not involve opening the Exchequer purse-strings. We should not be hearing Nigel Wilson, Legal & General’s chief executive, bemoaning the fact that there are too few ready-to-go infrastructure projects for the insurer to invest in.

The bureaucratic delays that have prevented institutional money from filling the gap left by cuts in government infrastructure spending, including housing, are an appalling waste of opportunity. That, rather than tax wheezes for March 19, is where the chancellor should be directing his efforts.

For the budget itself, he should be busy doing nothing. It will be a long time, given the state of the public finances, before a chancellor’s spring thoughts can turn to big tax cuts.

Sunday, March 02, 2014
The recovery's better-balanced than you think
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

You hear it a lot. Britain has a recovery that is fragile and unbalanced. It is reliant almost exclusively on consumers spending money they do not have - or running down savings - and the government’s short-term boost to housing.

But it is wrong.

For those who never expected a recovery as long as George Osborne was chancellor, hopping onto its supposedly unbalanced and unsustainble nature has been highly convenient.

But this kind of thinking, oddly enough, is not confined to the government’s critics. Mark Carney, in presenting the Bank of England’s inflation report last month, talked of “a few quarters of above-trend growth driven by household spending”, which he said were “a good start but they aren’t sufficient for sustained momentum”.

Even the chancellor himself caught the bug during his recent stopover in Hong Kong. “I’m the first to say that the recovery is not yet secure and our economy is still too unbalanced.” he said. “We cannot rely on consumers alone for our economic growth, as we did in previous decades.”

There has been, it is true, some blurring of this interpretation since the release of revised fourth quarter gross domestic product (GDP) figures a few days ago. But this was mostly “one swallow doesn’t make a summer”. A quarter of better-balanced growth, in other words, changed nothing.

Let me be clear about one thing. It is possible to have an economic recovery without a rise in consumer spending but that recovery is likely to be very weak.

Consumer spending accounts for nearly two-thirds of gross domestic product, 62%. Expecting all growth to come from the remaining 38% is asking too much.

By the same token, to say that this recovery relies on consumers alone flies in the face of the facts.

Let us look at the evidence. In the year to the final quarter of 2013, GDP rose by 2.7%. Consumer spending rose by a reasonable 2.4% over that period - slower than overall GDP - and its rise was dwarfed by the increase in overall investment, 8.7%, and business investment, which rose by 8.5%.

Consumers played their part in the recovery. Of the 2.7% rise in GDP, 1.5 percentage points came from consumer spending. Their contribution to growth, just over half, was however smaller than their long-run 62% share of GDP.

Investment, meanwhile, accounted for a percentage point of the GDP rise, and there were also contributions from net trade (exports minus imports) and government spending. If there was a glitch it was that net trade only contributed 0.1 points to the 2.7% growth rate. Much of that, however, reflected an unusually bad third quarter of 2013, when for no obvious reason Britain’s trade lurched into much bigger deficit.

The story of a better-balanced recovery is also in the GDP breakdown by sector. All three of the main sectors of the economy grew over the past year; industrial production by 2.3%, services by 2.7% and construction by 4.3%.

What about the argument that, even if consumers are not driving the recov
ery, their spending should not be going up at all given the continued squeeze on real wages? Again, this is wrong.

In the year to the final quarter of last year the official figures for “compensation of employees” contained in the GDP data,showed a rise of 3.9%, faster than any measure of inflation.

Though employees’ compensation includes employer pension contributions they tend to rise in line with wages and salaries. Helped by rising employment, there has been a significant real increase in the amount of money being received by the household sector as a whole, and thus available to spend.

Does not the drop in the saving ratio, from 7.9% of disposable income in early 2012, to 5.4% in the latest reading (for the third quarter of last year), not tell us households are only able to spend because they are eating into savings?

No. The saving ratio fall mainly reflects the fact that some households are now able to borrow whereas previously they were not. Most of this borrowing is in the form of mortgages to finance house purchase, not current spending. The pre-crisis norm, using housing equity for holidays, cars and kitchens, went into reverse in 2008 and is still in reverse now.

That’s enough on the numbers. The pattern of recovery will evolve in coming months and years - very many years - to the point where the upturn we think we have now will look very different.

But I also think the recovery can get better. The investment shoe has dropped but the contribution of exports - net trade - can improve, and should. Sterling has risen but remains competitive.

The bigger picture is that the worries about this recovery being neither balanced nor sustainable are misplaced. No recovery is perfect but this one has been unfairly castigated.

When does the recovery become sustainable enough for a rise in interest rates? Some, such as former monetary policy committee member Andrew Sentance, think it has been for some time.

The MPC has, however, reached a compromise in which it can talk about eventual rate rises - committee member Martin Weale has been most explicit about the prospect of higher rates in about a year’s time, while maintaining the formula that there is no immediate need to act.

David Miles, another MPC member, thinks that when rates do rise, the neutral or equilibrium level of Bank rate will be at or below 3% for some time to come. That may be for his successors. He is due to leave the Bank after a six-year MPC term on May 31 next year, and may do so without ever having voted for a rate hike (the last was in July 2007).

That is all for the future. In the meantime, let us enjoy the recovery. It is healthier than you think.

Sunday, February 16, 2014
Carney's fuzzy guidance sets a path for higher rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

A few years ago I developed a theme, which I used more than once in books, and often in talks, called the seven ages of monetary policy. The story started in 1976, with the International Monetary Fund imposing monetarism on a reluctant Labour government and reached its seventh phase in the Eddie George/Mervyn King era of an independent Bank of England targeting inflation.

Seven different versions of monetary policy over 30 years or so suggests a very changeable picture, though each lasted for an average of four years or so.

So what are we to make of Mark Carney’s forward guidance, launched in August and abandoned a few days ago? Six months is barely a brief encounter, let alone an age. It may not even merit a footnote in future accounts of monetary policy.

I’ll come on in a moment to what I think is the significance of the successor to forward guidance, the best description of which is fuzzy guidance. But how did the Bank governor get himself into such a tangle?

This is not to condemn his intentions. When Carney arrived at the Bank last summer, the first stirrings of stronger growth were emerging but there had been false dawns before. He wanted a mechanism to be able to reassure firms and households that the monetary policy committee (MPC) would not be trigger-happy on interest rates and that it would give the recovery time to breathe.

There is some evidence, presented by the Bank in its inflation report, that the governor and MPC members saying this gave businesses more confidence to invest, though it appears to have gone over the heads of individuals.

But it is stretching things to breaking point to regard forward guidance 1, as we must now call it, as a success. A policy that was supposed to kick the question of rate rises into the very long grass quickly became one in which every bit of good news on unemployment was accompanied by a wave of speculation about the timing of interest rate hikes.

It is impossible to do a controlled experiment with these things but there has probably been more such speculation in recent weeks than there would have been in the absence of guidance. In the past, a few well-timed nods and winks would have been enough to dampen rate speculation – the legendary governor’s eyebrows – now the Bank is forced to use its full armoury to get across what should be a simple message.

How did it go wrong? Carney, an urbane and well-informed Canadian central banker, lacked expertise and experience on the British economy. His choice of a 7% unemployment rate as the threshold before which a rate hike would be considered reflected that, though Bank staff and other MPC members should have alerted him.

He rightly pointed out that the rapidity of the fall in unemployment took everybody by surprise. But it took the Bank, which did not expect it to happen until 2016, more by surprise than most.

Carney says he regrets nothing about the first phase of forward guidance, though he gave a broad hint that he wished he had chosen a lower unemployment rate, say 6.5%, for the threshold.

Had he done in August what he did last week, however, by linking future rate decisions to a range of measures of spare capacity, but accompanying it with the message that those measures pointed to a prolonged period of unchanged interest rates, he would have done himself a big favour.

So where are we now? Forward guidance 2 has had plenty of people scratching their heads. A rate rise will not be considered, it says, until more of the margin of spare capacity in the economy has been used up.

That spare capacity is, however, estimated at just 1% to 1.5% of gross domestic product. Taken in conjunction with the Bank’s punchy new growth forecasts, 3.4% for this year (up from 2.9%), and 2.7% for next year (up from 2.5%), it implies that rates could be rising very soon.

But not too soon. If forward guidance 1 was simple but flawed, its successor is complex. The Bank has released an array of assumptions and forecasts used to underpin its expectations about spare capacity.

Spare capacity, to complicate things further, is not the same as the “output gap”, which is conventionally used (including by the Office for Budget Responsibility) to measure the amount of headroom in the economy.

The Bank’s measure of spare capacity is a movable feast. At present the Bank thinks what it calls the medium-term equilibrium unemployment rate is between 6% and 6.5%. But it also thinks that, as the recovery progresses that equilibrium rate will come down. Business investment, which it predicts will rise 11.5% this year, 12.75% in 2015 and 13.75% in 2016, will add to the amount of capacity in the economy.

The result of this is that, on the Bank’s projections, which run through to the early part of 2017, spare capacity in the economy is not used up. Those forecasts come with a huge health warning, given the experience of recent months. But do they imply that we will see no rise in Bank rate from its historic low of 0.5% for another three years?

No. For me the most interesting aspect of the new guidance, and the inflation report, is that it has begun to look forward to the day when interest rates will rise. Yes, Carney was keen to stress that when rates do rise, they will only move to levels well below the pre-crisis norm of about 5%. And yes, he may be one of the last MPC members to actually vote for a hike.

But, in response to a question I asked, Charlie Bean, the deputy governor, said the MPC would begin to raise rates before spare capacity in the economy was used up, because to leave it until it was would be too late.

Carney, for his part, did not demur over the market path for interest rates, which implies the first hike in the second quarter of next year and a gradual rise to 2%-3%, where it sticks, over the next three years.

That looks like a sensible path. An emergency level of interest rates cannot last forever. Personally, I would like to see the first hike next year coming before the May general election. The Bank, after a bit of a battering, needs to reassert its independence. That would be a pretty good way of doing it.

Sunday, February 09, 2014
Pay and productivity are both due a rise
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Pay is of vital importance to most people in this country, productivity holds the key to our long-term prosperity.

So two vital questions. Will this be the year when real wages finally start rising again after a prolonged squeeze? And, closely related, is this when productivity shrugs off its post-crisis stagnation and starts growing?

The question of whether 2014 is the year of the real wage rise is a big one, economically and politically. On the most straightforward measure used by the Office for National Statistics (ONS), average weekly earnings adjusted for the consumer prices index, real wages began falling on annual basis in 2008, and they have not stopped falling yet.

This is highly unusual. The ONS has good data stretching back to 1964 and comparisons well back into the 19th century. A long run of falling real wages is rare and the cumulative scale of it, 6% or more, breaks all modern precedents.

The good news, to judge by a Resolution Foundation event I spoke at a few days ago, is that the squeeze may be over and we should see modest real wage growth this year. Before coming on to that, let me address one of the puzzles in the real wage story of falling real wages which has bothered me for some time.

People may be familiar with a regular finding about the US economy, which is that real earnings (measured by the real median wage) have been stagnant for decades. How could an economy grow, and benefit from rising spending, if people were not getting better off?

The answer is that they were getting better off. So, if we take the period 1980-2005, before the crisis, the US real median wage grew by a mere 3%, equivalent to stagnation. Within that, however, every group recorded much bigger increases: 75% for white women, 62% for non-white women, 16% for non-white men and 15% for white men.

How so? The composition of the workforce changed. In a period of rising employment, there was a big rise in the proportion of low-paid, many of them women, dragging down the median. In an apparent reversal of mathematical logic, everybody beat the average.

Something similar appears to have been happening in Britain. This is not to dispute that many have suffered a real wage squeeze, but the picture has been distorted by changes in composition.

The overall level of employment is just above where it was pre-crisis. Within that, however, there has been a significant rise in part-timers (with lower weekly earnings) - relative to full-timers. There has also been a fall in the proportion of public sector workers, who on average earn more, and a rise in the share of private sector jobs.

One striking result from the official annual survey of hours and earnings is that people who have stayed in work continuously (defined as more than a year in each survey) have done pretty well.

So, taking the 12 months to April in each case their pay rose by 6.8% in 2008, 4% in 2009, 4% again in 2010, 3.7% in 2011, 3.6% in 2012 and 3.3% in 2013. Their pay, and this is a large group, has mainly stayed ahead of inflation.

Does that suggest all the pain has been felt by everybody else, those new to employment or the job-changers? Possibly, though there may be other factors. One phenomenon in recent years has been the near-doubling, to almost 1.1m, in the number of over-65s working. For a variety of reasons, their pay requirements are lower than younger workers.

So what is the big picture? As I say, there was a real wage squeeze, though it may have been less intense than it appeared. Though this is not yet the message from the regular monthly data, I think that squeeze came to an end last summer, for reasons set out here before, notably broader wages and salaries data in the gross domestic product figures.

As for this year, the consensus at the Resolution Foundation - me, Nicola Smith from the TUC, John Philpott of the Jobs Economist and Ian Stewart from Deloitte, was that we should see modest real wage growth this year.

For me, the drivers were a tightening job market, with unemployment falling quite sharply and emerging skill shortages. Philpott saw the bargaining power of workers increasing as vacancies rise. Stewart attributed it to growing optimism in the corporate sector, while the TUC’s Smith attributed it to unions negotiating better terms for members.

What would turn modest real wage increases into the rises - averaging 2% a year - that used to be the norm? The answer is stronger productivity growth. The faster the growth in output per worker or per hour, the bigger the real pay rises that can be justified.

The ONS, in its latest economic review, points out how different the economy’s productivity performance has been this time. At this stage after the recession of the early 1980s, output per hour was 12.6% above its pre-recession peak. In the 1990s it was 19.9% up. This time it is 4.4% down.

Much of that reflects weak service sector productivity, down 6.9% on pre-recession levels, while manufacturing productivity is just 0.8% lower. Both, of course, should be well up.

“If recent reductions in labour productivity are reversed as the economy strengthens, the potential for more rapid and sustained economic growth without rising inflation may be greater,” the ONS says. The economy would shift out of the vicious circle of low productivity and weak real wages, into a virtuous circle as both move into a higher gear.

Can it happen? If it does not do so soon, it may never do so, and the productivity pessimists will have been proved right. I think it will, on the back of stronger growth in demand, rising investment and the scope for moving workers into higher-productivity roles. The tighter the labour market, the greater the incentives for managers to introduce productivity-enhancing measures.

That's the theory anyway. Let's hope it works in practice.

Sunday, February 02, 2014
Giving the regions a bigger slice of the cake
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Mark Carney has been up in Scotland, querying whether one part of the UK could split away from the rest, while retaining the pound.

The Centre for Cities, in a report, said London was attracting talent from the rest of the country, though also highlighted the return of growth and successful job creation in cities such as Liverpool, Manchester, Nottingham and Leeds.

So, as promised, the third and final part of my mini-series. I have written about London’s dominance of the economy and that, in my view, London’s success is, on balance, good for the rest of the country.

That leaves the question of how to improve the performance of the regions, which have seen their share of the UK economic cake decline, and which suffer from slower growth and higher levels of economic inactivity.

This is, of course, familiar ground. For many years I immersed myself in regional policy, with its two broad thrusts, taking work to the workers, or workers to the work. This had some success in the 1950s and 1960s but fell apart from the 1970s with the onset of high unemployment.

In some cases regional policy, by directing more public sector functions to less successful areas, backfired by making those areas more vulnerable to cuts.

So what do the regions need? It is a big subject with many answers but, fresh from visits to the North, the West Country and Wales, let me offer the three ‘i’s. The regions need more investment, more innovation and more infrastructure.

By investment and innovation I mean a more vibrant and entrepreneurial private sector. The figures are stark. In London official figures show there are 1,266 businesses per 10,000 adults, followed by 1,119 in the south-east, 1,061 in the south-west, 1,056 in eastern England, 844 in the East Midlands, 835 in the West Midlands and north-west, 820 in Yorkshire & the Humber, 785 in Northern Ireland, 740 in Scotland and just 633 in the north-east.

Figures from StartUp Britain for businesses created in 2013 showed that more than a quarter were in London, with a long, and in most cases very thin, tail spreading to the rest of the country.

The problems in generating more entrepreneurial activity are formidable. Often in the old industrial areas the culture passed through the generations was one in which people were accustomed to being employed — in shipyards, mines, steel or heavy engineering plants — rather than setting up in business themselves. Add to that the often deadening overlay of too big a public sector and the absence of entrepreneurial activity was unsurprising.

Efforts are being made to change that. The entrepreneurs’ forum in the northeast, chaired by Nigel Mills, brings together 400 private sector businesses, which offer example, encouragement and mentoring to new entrepreneurs. It is starting to make a difference.

In Scotland there is the Entrepreneurial Exchange, set up by the Kwik-Fit founder Sir Tom Farmer in the 1990s. Other examples are springing up.

Businesses in the regions can also use their cost advantage to grab business from London and southeast England. I came across two in the past few days who are doing precisely this. There is a danger, reflected in London’s sky-high house prices, that the capital could price itself out of the market.

Innovation and investment can come to the regions in other ways. Faced with a blank sheet of paper (and some regional investment incentives), many foreign firms chose their inward investment locations well away from London. One of the most successful, Nissan, has just launched an updated version of its Qashqai. Fears that these projects would bring no wider benefits were misplaced.

It may be that more British businesses, and not just in manufacturing, should adopt the blank sheet of paper approach when it comes to new investment. Inertia, and convenience, means firms tend to look for the location closest to them. If they and their executives are based in London and south-east England, that may mean less willingness to look for locations further afield. Breaking that pattern of inertia would help the regions hugely.

What would help massively in that is my third ‘i’, infrastructure. When I travel around the country I am often struck by how hard it can be to get a train back, even quite early in the evening, and the patchy nature of regional air services.

Anyone who has driven between Leeds and Newcastle will know how the A1 goes from fast-flowing motorway, the A1(M), to lorry-clogged dual carriageway.

The Institute for Public Policy Research, and in particular IPPR North, its northern arm, has identified what it says is a huge London bias in planned infrastructure expenditure, with roughly three-quarters of the spending due between now and 2020 in London and the south-east. HS2, which I support, will add to that bias, at least in its initial stages.

There is some dispute, it should be said, about the precise figures, with the Treasury and transport department querying the extent of the regional bias suggested by the IPPR. But the broad thrust of its analysis seems undeniable, despite the fact that suppliers outside London and the south-east benefit from orders associated with infrastructure projects such as Crossrail, in and around the capital.

The rest of the country needs a lot more infrastructure. IPPR is putting together a list of five infrastructure schemes (some of which will be collections of smaller schemes), which it says will bring easy economic wins for the north. Other parts of the country will have their ideas. Linking the regions with each other is as important as linking them with London.

So is it possible to see those three ‘i’s linking together in a way that brings sustained prosperity to the regions, reversing London’s increasing share of the cake? It is, but it will take a very big effort, so maybe not. But we can hope.

Sunday, January 26, 2014
Another fine forecasting mess you've got me into
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

When Mark Carney took up his job as Bank of England governor in July last year, he impressed everybody with how well he had been briefed, or briefed himself, on the British economy and financial system.

In two important respects, however, he could have done with a bit more briefing. The first was that he should have been more aware of the Bank’s recent very poor forecasting record.

The second, which is related, is that he should have been more cautious about using the unemployment rate as the basis for his forward guidance strategy.

As I wrote in August, when the policy was announced: “Is it the best-designed policy in the world? No. Frankly, it looks as if it was designed by committee, which it was. The unemployment rate threshold of 7%, at which point the monetary policy committee (MPC) will start thinking of higher rates, suffers from familiar flaws.”

Those chickens are coming home to roost, of which more in the moment. But let me first put in a good word for forward guidance, which I genuinely think helped the recovery along by reducing interest-rate uncertainty, if in the end only briefly, for households and firms. Carney said on Friday that the MPC will consider a range of options to update its guidance, which I think is the right thing to do.

The appeal of using the unemployment rate was its simplicity. The question about the updated guidance, which may have to feature a combination of indicators, is whether it will be possible to convey the Bank’s message – rates will not be raised until the recovery has had plenty of time to breathe – in as straightforward a way.

Let me also speak up for the labour market. It is a pretty rum state of affairs when a big fall in unemployment, and the strongest rise in employment on record (280,000 in the September-November period) is interpreted as bad news. The job market is strong across the board, from sharply rising working hours to a falling jobless total on all measures.

This is something to be celebrated and, to answer a question often put to me, is not mainly a reflection of government measures to clamp down on bogus benefit claimants. Such actions do not affect the wider, and fast-falling Labour Force Survey measure of unemployment.

We also appear to have reached the point where real wages are no longer falling. In fact, it appears to have happened at about the time when the Labour party switched from attacking the coalition’s austerity to focusing on the cost of living.

I base this not on the government’s analysis showing a rise in real take-home pay in 2012-13 for all but the top 10% but on the wages and salaries data in the most recent gross domestic product figures. They showed a rise in total wages and salaries compared with a year earlier of 3.7% in the second quarter of last year, and 3.3% in the third. Adjusted for rising employment they suggest earnings per employee were rising at an annual rate of around 2.6% during the two quarters, broadly in line with inflation. The big squeeze is over.

But what about the Bank’s terrible unemployment forecast? Carney was right to say that it is better to get it wrong in this direction than if the jobless total was going up. That does not, however, redeem it. The Bank’s forecast has given him exactly what he did not want, intense speculation about an imminent rate rise, which he has had to deal with, less than six months into his forward guidance strategy.

This is an interesting time to talk about economic forecasting. This year is the 50th anniversary of the launch of the Sunday Times Business section. One of the earliest innovations in the section was to introduce the regular London Business School economic forecast, prepared by such luminaries as James Ball, Terry Burns and Alan Budd.

As a very young reader, I remember being fascinated by these forecasts. How could anybody look into the future? There was a mystique about it which implied that forecasters were endowed with magical qualities. The Treasury, remember, did not publish its forecast until the mid-1970s, and the Bank did not do so until the 1990s.

Why have forecasts not got better? The old joke used to be that economists produced forecasts to make weather forecasters look good. Weather forecasts, however, have become significantly more accurate, thanks to satellite and computer technology. Why has there been no similar improvement in economic forecasts? The answer may be that there are too many aspects of economic behaviour which are simply unpredictable.

In the case of the Bank, Charlie Bean, one of its two deputy governors, took the issue of its forecasting record on the chin in a recent speech. The Bank, like most other forecasters, failed to spot the severity of the downturn in 2008-9. In 2010, it was guilty of being over-optimistic about both growth and inflation.

Growth, it predicted in 2010, would be supported by improved credit conditions and a reduction in uncertainty, boosting consumer spending and business investment, while exports would provide a “significant stimulus” as the pound’s big 2007-8 fall “worked its magic”. As for inflation, it would be boosted temporarily by George Osborne’s January 2011 VAT hike, but swiftly return to the 2% target.

It did not, as Bean ruefully admitted turn out like that. Growth was much weaker than it expected, and business investment has only just started to turn up. Net exports contributed to growth in the first half of last year, but have taken an age to do so. Inflation only belatedly returned to the target last month.

Why did the Bank get it so wrong? Bean’s explanation was a variation of Harold Macmillan’s “Events, dear boy, events.” Things intervened, like the eurozone crisis and soaring commodity prices to scupper the forecast. But forecasters are employed to at least keep an eye out for these things, and the Bank should have had more intelligence on them than it did.

You could argue that the Bank’s errors did not do great harm. Its optimistic forecast did not result in damaging interest rate hikes. Had it known what was really going to happen to inflation, maybe it would have done so.

Is there any point to forecasting? Yes. But forecasters have to be smarter and more aware than the Bank’s (and most other forecasters) have been in recent years. Providing alternative scenarios is one way of demonstrating the uncertainty.

As for Carney, wiping a little egg off his face for believing too much in the Bank’s unemployment forecast, he now has to ensure that his new forward guidance rules are as error-proof as they can be. Once- bitten, twice-shy.

Sunday, January 19, 2014
Inflation balloon starts to deflate
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Inflation is back at the official 2% target. Even though that news came out a few days ago, I was determined to write that sentence, not least because it is so long since I have been able to do so.

The last time inflation was at or below the 2% target was in November 2009, since which time we have been through the long nightmare of above-target inflation, at the very time when it was able to inflict maximum damage on a fragile economy.

That nightmare saw inflation at or above 4% through 2011, only partly because of George Osborne’s Vat hike that year to 20%. It peaked at 5.2% in September 2011, which hurt the public finances because that is the monthly inflation rate used for the annual pension and benefits uprating.

Even before then, in fact for the past 8-9 years, inflation was usually above target. In September 2008, when the banks were collapsing, inflation also hit 5.2%. For 85 of the past 100 months it has exceeded 2%.

Above-target inflation has been a key element in constraining recovery. I have cited before Bill Wells, an economist in Vince Cable’s business department, who points out that real take-home pay would not have fallen at all had inflation remained at the 2% target over the past few years.

Lord (Mervyn) King, the former Bank of England governor, argued that had the monetary policy committee tried to keep inflation at 2% in the face of international pressures, with higher interest rates, the consequences for the economy would have been much more severe.

His successor Mark Carney is proving, if nothing else, timing is everything. He would be the first to admit the combination of low inflation and strong growth is not all his doing. But it is far better than weak growth and high inflation.

I am obliged, before getting on to whether this is just a brief return to target before normal service resumes, to mention the retail prices index (RPI). Retail price inflation is higher than consumer price inflation and edged up between November and December, the latest month, from 2.6% to 2.7%, even as consumer price inflation dipped from 2.1% to 2%.

Many people regard the retail prices index as the only true inflation measure. I think this is a mistake. The independent Office for National Statistics has relegated the RPI to pariah status, saying it does not meet the standard required to be a national statistic. Its successor, using a different method of calculation, called RPIJ, is also at 2% and got there earlier than the CPI.

That’s enough of that. Consumer price inflation is back to target and raises three questions. Will it stay there, does it mean the end of the cost of living squeeze, and when do we start to worry, not that inflation is too high, but that it is too low?

On the first question, I do think I will be able to write my opening sentence many more times in the coming months. Inflation is set for a prolonged period of on-target, or even below-target inflation.

The Ernst & Young Item Club, in a new forecast to be published this week, predicts that inflation will average 1.8% this year and only inch back above 2% in the second half of 2015.

That looks right. Suddenly the air has gone out of the inflation balloon. From an inflation perspective, all that needs to happen for the rate to fall is for prices to stop rising, or at least stop rising so fast.

In the case of global commodity and energy prices, things have gone further. They have fallen significantly over the past year. One factor that was contributing to their rise was aggressive quantitative easing (QE) by the Federal Reserve in Washington. The Fed’s “tapering” of its QE will reduce the impetus from this source.

What about real wages and the cost of living? This is the big question, one I will discuss at a Resolution Foundation event early next month. Even with inflation back at 2%, it is running well ahead of average earnings growth, currently 0.9%.

There is a strong possibility this is understating growth in pay, as discussed here before. Even if that is not the case, however, we should see a combination of stronger growth in earnings alongside lower inflation.

The tide is turning. The chancellor says the government backs an above-inflation increase in the national minimum wage, currently £6.31 an hour. Rising demand for labour, and skill shortages, will support an increase in earnings growth.

You would hope that any increase in real wages is natural rather than artificial. The minimum wage is an artificial construct, and business groups and free-market think tanks warn that increasing it will rebound on the low-paid. It may, to an extent, but the effect is likely to be quite small. We do not want a return to the days when governments (and the unions) established pay norms. But as long as recovery brings stronger growth in productivity, higher pay should be both natural and affordable.

There will not be a sudden lurch from falling to strongly rising real wages. This year, however, should see pay at the very least keep up with inflation, giving way to meaningful real wage rises (conveniently timed for the election) next year.

When do we start to worry inflation is too low? Christine Lagarde, the managing director of the International Monetary Fund, warned last week of “rising risks of deflation” - falling prices - as “the ogre that has to be fought decisively”.

I see it a little differently. We have been through a period in which inflation was higher than warranted by domestic conditions, mainly because of strong rises in commodity prices driven by emerging-market demand.

We are now through that period, which means inflation is more in line with domestic realities. That means low inflation in Britain but it will not mean deflation. Nor will it in America, where inflation is running at 1.5%.

The eurozone, where inflation is running at 0.8%, is slightly different. But inflation in most of its “core” economies is running at between 1% and 2%. Where it is lower, in Spain (0.3%) or Portugal (0.2%) or where there is already deflation, as in Greece (-1.8%), it is in economies that need to boost their competitiveness with smaller increases in costs and prices.

We should celebrate lower inflation, and hope it lasts, which it should, not fret unduly about deflation.

Sunday, January 12, 2014
What's good for London is mainly good for Britain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Is London good or bad for the rest of the Britain? I posed this question a few weeks ago and since then, perhaps by coincidence. there has been quite a lot on it.

Most notable was Vince Cable, the business secretary, who last month said London “is becoming a giant suction machine draining the life out of the rest of the country”. For a cabinet minister who constituency is in a London borough, albeit one whose constituents do not want to see a Heathrow expansion, that was brave.

Is he right? As promised, my answer, and I want to be methodical. So it comes in three parts. Does London distort monetary policy by imposing higher interest rates on the rest of the country than it needs?

Second, on fiscal policy, does London prop up other regions or drain fiscal resources from them? And finally, what are the dynamic and supply-side effects of London’s dominance: does the business it generates for the rest of the country outweigh the talent it draws from them?

London’s dominance is not in doubt. Its population exceeds the next 14 British cities combined. The Greater London built-up area, as defined by the Office for National Statistics, has more people, 10m, than the next six (Greater Manchester, West Midlands, West Yorkshire, Liverpool, South Hampshire, Tyneside) put together.

How does that affect monetary policy? The late Eddie George (Lord George) got into trouble in the 1990s after Bank of England independence for implying high north-east unemployment was a price worth paying for low southern inflation.

Monetary policy has to balance the different economic performance of regions in the area in which it operates. That task is a lot more demanding in the eurozone.

In the case of Britain, however, it is a stretch to say that monetary policy over the past two decades (including the period immediately before independence) has been too tight because of the London effect.

Most economists would agree interest rates should have been higher in the period running up to the crisis to curb demand for credit and cool housing and commercial property. It is hard to argue that the ultra-loose monetary policy of the past five years would or should have been any looser.

So London is not guilty on the monetary policy charge, with a caveat. This was sterling’s strength from 1996 to 2007, which helped cut manufacturing’s share of gross domestic product from nearly 20% to 11%.

That strength, we now know, was directly linked to overseas flows into Britain’s banking system, as banks expanded at breakneck pace. This was a period, admittedly encouraged by the then government, when London’s role as an international financial centre was in conflict with the success of manufacturing.

What about London’s fiscal position? It may surprise some people to learn that spending on public services per head in London, £9,757 in 2011-12, is above both the English (£8,618) and UK (£8,877) averages. Wales, Scotland and Northern Ireland all have higher spending per head than London but no other English region does.

Fortunately, London typically pays more into the Exchequer than it gets out. Professor Tony Travers of the London School of Economics estimates that surplus of revenues over spending to be between £10bn and £20bn in normal times.

He chaired Boris Johnson’s London Finance Commission, which argued for greater fiscal autonomy for the capital, not least to provide greater local incentives for, for example, more housebuilding. His report fell a long way short of calling for “city-state” independence for London, though there is a far stronger fiscal case for that than Scottish independence.

What about the trickier question: the “suction effect” of the London economy versus its ability to generate growth elsewhere in Britain? Costas Milas of Liverpool University has just done an exercise comparing growth rates in London and the rest of the country from 1997 to 2012.

Though growth rates vary between regions, they are always positively correlated. Growth in London is not, in other words, at the expense of the rest of the country, to the point where the regions experience a decline in economic activity.

The Centre for Economics and Business Research, under Doug McWilliams, came up with similar findings a few years ago, concluding that London, by providing demand for goods and services in the regions, and fiscal transfers, was good for the rest of the country.

This positive London effect can be seen in detailed data. Most of the jobs and orders for London’s Crossrail project are outside the capital. In 2012-13 the project supported 13.800 full-time jobs, 8,310 of which were outside London, as are 62% of the firms which have won orders on the project.

A study by PWC for London First found central London office developments are worth £1.7bn a year of economic output and 34,600 jobs, £1.1bn and 22,400 of which are outside London. The capital is sucking in goods and services from the rest of Britain, and that is a good thing.

Even financial and professional services, often thought to be a London-only thing, are regionally well spread. Of the combined employment total of just over 2m, slightly fewer than a third, 663,600, is in London and 41% of gross value-added.

It is not all one way. The CEBR’s McWilliams wonders whether what looks like a straightforward economic message - what’s good for London is generally good for the rest - fully picks up dynamic effects. When does London’s advantage become so great, that other regions become starved of investment, drive and talent to the point that they can never keep up? When does London become the cuckoo in the nest?

It may happen. In more normal times London could become the equivalent of Germany in the eurozone, and impose too high interest rates and too high an exchange rate on the rest. The brain drain from the regions could do irreversible damage. Some say it already has.

None of this means we should embark on a process to restrain London’s growth. That was the failure of post-war regional policy. Levelling-down leads to disaster.

London’s success is Britain’s success. It does, on balance, benefit the rest of the country. The key is to increase that success, by improving growth prospects in the regions. I’ll address that very big subject in a couple of weeks.

Sunday, January 05, 2014
Looking for a pay, productivity and investment boost
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What are the hopes and fears for 2014? One fear is that economists are now generally now much more optimistic about the British economy, which is sometimes a dangerous sign.

Another is that the eurozone, the dog that didn’t bark in 2013, still has a few crisis woofs left in it. The shift of focus from Greece, Portugal, Spain and Ireland to troubled France means we cannot yet relax about Europe.

Paradoxically, given that the Franco-German axis is central to any EU project, and always will be, France’s difficulties may not pose the kind of terminal anxieties about the euro that the problems in the peripheral economies did. But we’ll see.

In terms of hopes, I hope the return of growth has seen off the stale debate about the impact of austerity, and in particular contributions from supposedly eminent American commentators and economists who just do not understand the data.

I also hope that the word “bubble” will be used sparingly and judiciously, particularly when applied to the housing market. Both may be too much to hope for.

Anyway, what about the outlook? 2013, as everybody now knows, exceeded most people’s expectations and, while we will not get a fourth quarter gross domestic product figure until January 28, looks to have ended on a strong note. We may not quite get there this month but 2% growth for 2013 is now within statistical reach.

Before I get on to this year’s numbers, let me pick out two themes: there wil be time for plenty more in the coming weeks and months. Both of them, unfortunately, are in areas where the statistics pose more challenges than most.

The first is pay and the so-called cost of living crisis. Monthly figures from the Office for National Statistics show that pay remains depressed, up just 1.1% in the latest 12 months, still significantly below even a falling rate of consumer price inflation, currently 2.1%.

A different message was offered by the ONS in its annual survey of hours and earnings (Ashe), which suggested that the squeeze on real wages more or less came to an end in the 12 months to April.

It is possible to reconcile the two sets of figures. Pay was boosted in the monthly numbers in April by bonus payments (some of them to avoid the 50% top tax rate that applied in the previous fiscal year) and the Ashe could have reflected some of that.

I suspect, though, that the earnings picture is genuinely more robust, despite tight controls on public sector pay. But on both measures we should be nearing the end of the squeeze. After a dismal four years, wages should move modestly ahead of prices this year, alongside a necessary improvement in productivity.

Will this end the cost of living debate? It will take some of the sting out of it. But it takes time before such changes feed through, and not everybody will benefit.

And even if wages do creep ahead of prices, John Philpott, a labour market expert who runs the Jobs Economist consultancy, thinks real wages will not achieve the kind of growth rates (roughly 2% a year) we used to think of as normal until the unemployment rate gets down to 5%. That will not happen this year. So better news on pay, but no bonanza.

Why has consumer spending been rising alongside the pay squeeze? One possibility, as I say, is that the earnings figures have exaggerated the squeeze. Another, a favourite of mine, is that households are spending their lower mortgage payment windfalls. Unrecorded incomes, as a result of a 20% Vat rate that is tempting to avoid, may also be contributing. But this has not been a credit-fuelled spending surge, and nor is it likely to be this year.

The other area where the statistics can be a challenge is business investment. It may be that we have to re-think what we think of as investment, given that even today’s depressed levels are not much different from the norm - apart from a brief pre-crisis flurry - for most of the 2000s.

It may be that once we moved beyond conventional manufacturing plant and machinery, investment just became too hard to measure. It may be that business investment in Britain will always be lower than it should be, though America is similarly afflicted.

That said, a business investment recovery in Britain does now appear to be under way, and should be reflected in a 5%-6% increase this year. That is no boom, but better than the alternative.

What other numbers are we likely to see this year? Growth should resemble something closer to a normal recovery, maybe not quite 3% but 2.75%. The unemployment claimant count, now 1.27m, should drop to 1m. Though not the preferred measure these days, a drop below 1m will be a significant moment.

The current account should improve from last year’s very provisionally estimated £55bn deficit, but perhaps only to £45bn, leaving plenty of room yet for proper export-led growth. Inflation should end the year below target, 1.75%.

Because of this, and finally, I think Bank rate will remain at 0.5% all year, despite growing speculation in the City that this year will see the first hike in interest rates since July 2007 as the unemployment rate drops below 7%, which it surely will.

Why will that not result in a rate hike? When Carney set out his forward guidance it was to give the economy time to breathe and to grow at an above-trend rate for some time, inflation permitting, before starting to apply the monetary brakes.

Growth will be stronger, barring accidents, this year, but not by enough to convinced him or the rest of the MPC that it is time to start raising rates. It will, after all, only just have got back to where it was before the great fall. I’m not even sure rates will rise in 2015 but that’s another story.

Monday, December 30, 2013
2013: a year that shone increasingly brightly
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What a strange year. Britain’s economy, this time last year, appeared to be on the brink of another huge disappointment. The Olympic growth boost had come and gone, leaving the outlook apparently very stodgy.

George Osborne’s deficit reduction strategy, it seemed, was turning into a deficit-increasing programme, predictions for 2012-13’s borrowing pointing to more not less borrowing compared with the previous year.

At the Bank of England, Mark Carney’s appointment had been announced but there was deep scepticism about whether a change of governor would also mean a change in policy. All the monetary levers had been pulled, it seemed, and most were not attached to anything.

The economy was moribund, as was the housing market. A eurozone collapse had been staved off, mainly by the actions of the European Central Bank, but nobody knew whether this was just the lull before another storm.

But things turned out better and, if recoveries are self-feeding, this one has gained legs as time has gone on. What was initially very tentative growth in the first quarter now looks quite convincing, giving way to stronger growth in the second and third quarters. The surveys suggest the year has ended on a strong note, providing a good platform for 2014.

People fret about the balance of growth, though the latest figures suggest net exports made a significant contribution to the economy in the first half of the year and that business investment began what will ideally be sustained upturn in the third quarter. Manufacturing, services and construction are all doing well.

Consumers have been spending more, a puzzle perhaps given the apparent continuing fall in real wages. Some figures (the Annual Survey of Hours and Earnings in particular) cast doubt on the extent of that fall, certainly this year. The squeeze on pay also looks less extreme when mitigated by the rise in the personal tax allowance.

It is also important to distinguish beween the wage experience of individuals and that for the economy as a whole. Thanks to rising employment, up nearly half a million in the past year, the overall amount being paid out in wages and salaries has been rising in real terms.

Most important has been the return of confidence, and of credit. Businesses and individuals are never cock a hoop but the current picture is less negative than for many years. The fear of falling has given way to renewed optimism.

Our view of 2013 will, of course, evolve as time goes on. And that brings me on to my annual forecasting league table, an Economic Outlook ritual for many years now, and one that was trickier than usual this year.

Let me explain. Until December 20, the consensus for growth in 2013 was 1.4%. That was the Office for Budget Responsibility (OBR) figure published alongside George Osborne’s autumn statement in December.

Then the Office for National Statistics (ONS) published a string of data revisions going back to the beginning of 2012, the effect of which will be to raise Britain’s likely growth rate this year to 1.8% or 1.9%. In the fullness of time, based on the usual pattern of revisions, 2013’s growth rate is likely to have been above 2%, and growth in earlier years will come more into line with the strong rise in employment.

For the moment, however, the question was whether to go with the stronger figure suggested by the revisions or the 1.4% we had before, and I have decided on the latter. Forecasters cannot be expected to predict the timing of the ONS’s revisions.

The other matter to clear up is about the forecasts themselves. We know that the strength of the recovery this year has taken economists by surprise - and some by complete surprise - yet in the context of 1.4% growth (if not 1.9%), forecasters did not do badly. The OBR, the official forecaster, predicted 1.2%.

Unfortunately, forecasters did not stick with the predictions they made at the beginning of the year. By spring the OBR had come down to 0.6% and the forecast consensus to 0.8%. This was the time of maximum pessimism, which gradually lifted as the stronger numbers came through.

As you will see, this year’s contest was a close-run thing. Kevin Daly of Goldman Sachs, who takes the trophy, did not join in with the general rush to downgrade in the spring, and his generally optimistic view of the British economy in recent years has achieved its just reward this year. He took the view that the economy could recover through Osborne’s fiscal tightening and was right to do so.

The only thing he did not get, and this was common to all but one of the forecasters in this year’s league table, was the strength of the job market. The majority view was that the piece of recovery would not be strong enough to make a serious dent in unemployment, but 2013 ended with both the main jobless measures falling quite sharply.

I should also mention four other forecasters who came very close this year. They are the CBI, ING Financial Markets, Oxford Economics and Lonbard Street Research. All missed out very narrowly in a photo finish. In other years, any would have won the top prize. Nine out of 10 is a formidable score.

I give an honourable mention to Patrick Minford’s Liverpool Macroeconomic Research, with its 2% growth forecast for this year, which is likely to be closer to the eventual outcome than any other forecast. Even if I had moved the goalposts to the higher growth number, however, Liverpool’s overall forecast performance would not have been quite enough to top the league this year.

Right now, we approach 2014 with forecasters much more optimistic about the outlook. 2% was a bold forecast for 2013 but is below consensus for 2014. More on this next week. Let us hope that optimism is justified.

Sunday, December 22, 2013
The fall and rise of the London economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

It has been a big week, with the Federal Reserve’s tapering decision, good news on inflation and unemployment, and the question of what the Bank of England does when the jobless rate gets down to 7%.

But let me this week tackle a subject which I know is of intense interest. I know this because when I dropped a small pebble into the pond last week, asking for input on whether London helps the rest of the economy or drains it, I was indundated.

Some have made up their mind. Vince Cable, the business secretary, said in a Today interview on Thursday that Lodnon sucked the life out of other parts of Britain.

We have had a London-centric few days, with Sir Howard Davies’s Airports Commission, set up to investigate the issue of UK airport capacity, publishing a short-list of London solutions. It is tempting, to coin a phrase, to say “I agree with Vince”.

What I want to do, however, given that this is a very big subject, is something slightly different. Today I want to set out the extent of London’s dominance, and the reasons for it. Then, events permitting, I will do two pieces next month.

One will try to answer the question of whether London is good or bad for the rest of the country. The other, without prejudging that answer, will examine what can be done to improve the performance of Britain’s regions, and the balance of the economy.

When I arrived in London in the 1970s, it was a city in decline. New York went bankrupt then and, while that does not happen in Britain, the capital was in a sorry state.

London’s population was falling - it dropped three-quarters of a million between 1971 and 1981, with good reason. It was dirty, strike-prone and, crime-ridden, its Victorian infrastructure crumbling. The swinging sixties had come and gone.

The comeback was, however, swift. The London School of Economics’ Growth Commission found there was a step-change in Britain’s economic performance around 1980 - GDP per capita suddenly began growing more rapidly than in the rest of the G7 - and there was a similar change in London. The sick man of Europe, and its sick capital, suddenly started to recover.

From 1980 Britain started to do better than other countries, and London started to do better than the rest of Britain. Population reversed its earlier decline and began to grow. By the end of the 1980s the north-south divide had re-established itself.

A book of mine published then, North and South, just republished as an e-book, chronicled that rise. As an aside it reminded me in 1982 the Monopolies Commission ruled against bids by HSBC and Standard Chartered for Royal Bank of Scotland (things might have been different).

Why did London revive? There have been three broad trends in recent decades, all of which have fuelled London’s growth.

The first is the rise of global cities, which some call modern city-states. Modern globalisation has benefited strategically-placed cities just as in an earlier era trade led to great prosperity for the ports.

The second is the shift from manufacturing to services, and the so-called knowledge-based economy. Though London was and is an important manufacturing centre, its great advantage during Britain’s deindustrialization was its economic diversity.

The third is financial services. Though it is easy to overstate the contribution of the City, it should not be underestimated, or the impact of Big Bang in 1986, which effectively opened up a closed and protected sector to the world.

There are other factors. When I wrote my book in the 1980s, the shift of regional head offices to London waa in full flood. Now very few top firms have head offices outside London. The civil service, despite waves of regional relocation, remains firmly London based. So does the media, despite the BBC shifting some activities to Salford. Regional newspapers are an endangered species. Last week saw the final edition of the Liverpool Daily Post.

The numbers for London’s domination are striking, as is the fact that the capital has prospered since the crisis. It is the smallest of the Office for National Statistics’ standard regions, accounting for just 1% of the UK’s land area.

It houses, within that, 13% of the country’s population and, as noted last week, has a 22.4% share of the economy, measured by gross value-added. That share is up from 18.5% in 1997 and 20.7% in 2007.

To put London’s 22.4% share of the economy in perspective, it is bigger than Wales, the northeast, Northern Ireland, Yorkshire & Humberside and the West Midlands combined. They have a combined population share of 29%, more than double that of London.

There are many other such indicators. London’s gross value-added per head, £37,232, is 75% above the UK average. Only four parts of the country: Scotland, the rest of the southeast, the east of England and the southwest, have a GVA per head more than 50% of the London figure.

Put like that London’s higher incomes - wages and disposable incomes are 25-30% above the UK average - look quite modest, though house prices, averaging £437,000 versus £234,000 in the rest of the country, put that in context.

London has the youngest population, a median age of 34 comparing with a 39.7 average. If you wanted evidence it sucks in young talent from the rest of the country (and the rest of the world), that may be it.

The question is whether it sucks in all the economic life. I think I know what my answer will be when I return to this early in the new year. I can tell you that most of the very large number contacting me agree with Vince. What everybody accepts is that, for good or bad, Britain has become regionally very lopsided.

London and the southeast combined account for 37% of the UK economy, a share that is rising inexorably towards 40%. It is not unthinkable it could reach 50% in this century, which would be a nightmare vision of an overcrowded corner pulling along an underdeveloped and unproductive economic tail. Would that be remotely healthy? Surely not. To be continued ...

Sunday, December 15, 2013
Carney looks on the bright side of life

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

Mark Carney, having been exposed to the British economy for six months (though he also lived in London in the 1990s) has emerged more optimistic about both the short and the long-term. Normally the opposite happens.

The new Bank of England governor's optimism is in sharp contrast to his predecessor. Lord King had many estimable qualities but nobody would accuse him of having a sunny disposition when it came to the economy in recent years. Colleagues on the Bank's monetary policy committee (MPC) learned that it was hard to out-gloom the governor since the crisis.

His successor set out his optimistic stall in a speech a few days ago to the Economic Club in New York, though he has been building up to it. Citing positive economic news, including a drop in inflation from over 5% to 2.2% in the space of two years and job creation of 60,000 a month, he declared that "the cumulative run of economic surprises has dwarfed those of the other major advanced economies". The news, in other words, has exceeded expectations more in Britain than elsewhere.

The recovery, he said, reflected an easing back of extreme uncertainty, successful repairs to a damaged financial system and an improvement in household balance sheets.

More importantly, Carney robustly challenged the idea, sometimes known in the jargon as "secular stagnation", that growth has somehow come to an end in advanced economies and the best we can look forward to is a never-ending series of lost decades. That idea, perhaps unsurprisingly, originated in the Depression years and is usually attributed to Alvin Hansen, an American economist and follower of Keynes.

In Britain, much of the pessimism is now about productivity, but also investment. Growth, in the pessimists' view, can be pumped up by repeated injections of debt but has no underlying supply-side strength. So it will always be fragile and unbalanced.

That view does not reflect what appears to be a broad-based upturn now in the economy, with manufacturing, construction and services all growing strongly and, within that, business-to-business spending and production of capital goods (normally associated with higher investment) leading the way.

Nor, according to Carney, does it reflect the outlook for Britain. Though the near-record deficit on the current account (of the balance of payments) is troubling, it largely reflects economic weakness elsewhere in Europe.

And: “Although the current account position underscores the need for the recovery to shift over time towards investment and export growth, it would be unreasonable to expect that to have happened already. Recoveries are seldom led by investment.”

He also has an interesting take on productivity, which is that workers priced themselves into low-productivity jobs when demand in the economy was weak, but will move into higher-productivity work as growth strengthens. The productivity switch was not, in other words, suddenly turned off in 2008.

“Given the flexibility of its labour market, the continued openness of the economy and the credibility of macro policy, it is hard to think of any reason why there should have been a persistent deterioration in the rate of potential growth in Britain,” he said.

So, a glass “more than half full” view of the economy. Carney's most telling blow against the pessimists, perhaps, was that they have always been wrong before. “There is a long history of pessimism in economics, from Thomas Malthus through Alvin Hansen to Robert Gordon,” he said. “Such worries have proven misplaced in the past and scepticism is warranted now. Don’t forget that the US economy is more than 13 times larger than when Hansen first formulated his ideas.”

Should a central banker be optimistic? As a breed, are they not supposed to be constantly looking in the dark corners for the risks and dangers, a job they failed to do very well before the crisis?

The role of a central banker, according to former Federal Reserve chairman William McChesney Martin’s much-quoted dictum, is to take away the punchbowl just as the party is getting going. Carney instead is a genial mine-host, not only filling up the punchbowl but lining up the glasses along the bar.

Should they not now be starting to withdraw the exceptional monetary stimulus - near-zero interest rates and quantitative easing - which has helped drive the upturn? Andrew Sentance, a former member of the MPC, argues that this is precisely the moment to begin edging interest rates up.

Carney sees it differently. His policy of forward guidance - a pledge to keep Bank rate at the current 0.5% at least until the unemployment rate gets down to 7% - is in the best sense of the word a confidence trick. The trick is to boost confidence.
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His MPC colleague Martin Weale used a speech to point out that the direct economic effects of forward guidance, in comparison with what the markets were expecting to happen to interest rates, is probably very small.

Weale’s scepticism was justified. The Bank’s latest forecast assumed the mere announcement of forward guidance would have a significant impact on growth but these things take time, particularly as far as the public is concerned.

The Bank’s own NOP survey of inflation attitudes, just published, shows that 34% of people think rates will rise over the nexct 12 months. Mind you, 22% believe they have risen over the past 12 months.

So Carney’s optimism is genuine, but it is also a deliberate attempt to build on his forward guidance policy by making it more effective. If people are worried that a housing bubble is on the way and will mean higher interest rates, they need not be, because the Bank will use other means at its disposal, targeting the lenders with so-called macro-prudential tools, instead.

Similarly, if households and businesses are reluctant to take advantage of ultra-low rates because they fear growth will not last, he is assuring them that historical precedent suggests that it will.

If pessimism has negative effects - evident in very low levels of business and consumer confidence until recently - optimism can have positive consequences as it gains traction. The governor is happy to be a cheerleader for this process.

Is this is a risky strategy? There is always a danger that interest rates are too low for too long. The MPC, according to Carney, believes the “equilibrium real interest rate” is currently negative, in other words that it is appropriate for Bank rate to be below inflation.

That will change as the economic evidence improves. The sooner the governor’s confidence is reflected in a stronger and more durable recovery, and the risks of a setback become much lower, the sooner it will be appropriate to raise rates.

That will not be for some time but the interest-rate worriers should not begrudge Carney his optimism. In the end, he will be on their side.

Carney looks on the bright side of life

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

Mark Carney, having been exposed to the British economy for six months (though he also lived in London in the 1990s) has emerged more optimistic about both the short and the long-term. Normally the opposite happens.

The new Bank of England governor's optimism is in sharp contrast to his predecessor. Lord King had many estimable qualities but nobody would accuse him of having a sunny disposition when it came to the economy in recent years. Colleagues on the Bank's monetary policy committee (MPC) learned that it was