David Smith's other articles Archives
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.
.
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

carneycheerful.jpg

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.
.
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.

Saturday, December 07, 2013
A stronger growth forecast: now to beat 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.

Set pieces like budgets and autumn statements are like selection boxes. There is a lot to choose from so you are tempted to try everything.

For George Osborne's fourth autumn statement, delivered on Thursday, there are many things I could dwell on, from measures to ease the burden on business - including rates - to action to encourage firms to take on young workers by abolishing employers’ National Insurance contributions for under-21s.

I could talk about fuel duty freezes that in a couple of years will be worth an average of £11 a tankful (compared with increases under the now-abandoned escalator) or the decision to hit foreign property owners with capital gains tax.

Let me, however, concentrate on just two aspects of the statement, the most important aspects: growth and the public finances. The upward revision to the Office for Budget Responsibility’s growth forecasts, taking this year up from 0.6% to 1.4%, was inevitable given the run of the quarterly gross domestic product numbers,

By normal standards, 1.4% growth would be a disappointing year and 2.4% - the OBR’s forecast for next year - merely middling. These are not, of course, normal times. Britain’s quarterly growth of 0.8% in the third quarter was good enough for a couple of hours to take Britain to the top of the G7 league, until an upward revision of America’s GDP figures took them to 0.9%.

Even so, the OBR’s upward revision of 2013 growth from 0.6% to 1.4% was, as Osborne pointed out, the biggest such in-year revision for 14 years. It also left room for further improvement.

Growth should exceed the new official forecasts of 2.4% in 2014 and just 2.2% in 2015. The OBR is quite cautious even in the short-term, predicting quarterly growth rates of just 0.5% through next year. There is scope for further pleasant surprises.

Not only would that be nice, it is essential. The striking thing about the economy over the past few years, which the OBR brings out well, is how much ground there is to make up. It is as if, five or six years ago, Britain went on a long detour, which has taken us a very long way from our destination. Indeed, we may never get there.

By the early part of 2019, according to the OBR’s new forecast, Britain’s gross domestic product (GDP) will be 15% larger than at the beginning of 2008, the eve of the 2008-9 recession. That does not sound bad, except 15% over 11 years averages out to little more than 1% a year.

That average is dragged down, plainly, by the economy’s 7.2% dive in 2008-9. But the big picture, of an economy hit extremely hard and only gradually getting back to its feet, remains even after last week’s upward revisions. Now contrast that, as the OBR does, with the economy as envisaged by the Treasury back in 2008. Projecting forward its assessment of trend growth, as the OBR does, gives you an economy 35% higher in 2019 than 2008.

The gap between the two estimates, nearly a fifth of GDP (roughly £300bn) explains why we do not just need growth, we need much stronger growth. Otherwise the damage that we suffered as a result of the crisis makes us permanently poorer.

Can it happen? Can we see a few growth numbers starting with a “3” rather than a 2? The answer is yes. The new official forecast assumes no export-led recovery. Through the period 2012-2018, the contribution of net exports to growth is negative.

Replacing that with a positive number would take us back to the kind of growth envisaged on the back of a competitive pound a few years ago, it would also help close the GDP gap. Some fear sterling’s recent revival will nip any export revival in the bud. It is a bit more complicated than that. Exports can do better.

Is there room for much faster growth? The OBR is downbeat on productivity and believes there is a relatively small amount of spare capacity in the economy, 2.2% of GDP. You do not know how much spare capacity you have until you reach its limit but that is too gloomy. In a service-based economy, capacity can be very flexible.

Let us hope so. It was the OBR’s gloomy supply-side view which, two years ago, pushed Osborne into abandoning his original hope of squeezing all the fiscal pain into a single parliament.

His measure of when the job was done - eliminating the so-called structural current budget deficit - was in June 2010 predicted to be achieved in the 2014-15 fiscal year. Now it will not be reached until 2017-18 and the path there is slightly slower than the OBR expected in March (stronger growth does not help cyclically-adjusted borrowing).

That may be no bad thing. Out of the adversity of a deficit taking longer to come down than he hoped, Osborne has forged an opportunity. Instead of a “Hey Presto” fiscal magician ready to hand over things over to the next set of politicians who want to spend taxpayers’ money, he has become a keeper of the Treasury keys, determined that his “responsible recovery” means responsible public finances.

So there will be an overall budget surplus by 2018-19, from a downward-revised (but still high) £111bn this year, which as the OBR says “suggests that underlying net borrowing will have fallen by 11.1% of GDP since 2009-10”. That, by the way, is equivalent to bringing the budget deficit down by £180bn. It may yet be that progress is a little quicker — I am still hoping for a deficit of less than £100bn this year.

There will be a strengthened Charter of Budget Responsibility, to be presented to parliament in a year’s time. There will be measures, notably bringing forward increases in the state pension age, to save significant sums in future (£500bn over 50 years in the case of pensions). And the government will aim for a budget surplus of 1% of GDP in the good years in the long term.

Politicians, and chancellors - including very political chancellors like this one - come and go. One extraordinary statistic from the OBR is that before the end of this decade, core government spending on services (excluding welfare, debt interest and other transfers) will be its lowest percentage of GDP since 1948.

The good news is that Osborne is trying to impose a discipline on spending that will tie the hands of him and his successors. The question is whether such constraints will be more effective than in the past. They need to be.

Sunday, December 01, 2013
Growth's back: now to rebalance it
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

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George Osborne’s autumn statement this Thursday could have been very different. The chancellor might even have been struggling to hang on to his job.

A few months ago the vultures were hovering over Britain’s economy, ready to swoop on the dead body of the recovery.

In what turned out to be one of the most poorly-timed interventions since 364 economists attacked the Thatcher government in 1981, just as recovery was getting going, Olivier Blanchard, the International Monetary Fund’s chief economist, warned Osborne he was “playing with fire”.

A year ago even respected bodies like the Institute for Fiscal Studies warned Osborne’s deficit-reduction strategy risked turning into a deficit-increasing strategy.

Public borrowing for 2012-13 of £135bn, which the IFS feared, would have been a huge setback. Instead it was £115bn. The deficit is falling and the Office for Budget Responsibility (OBR) will say it is falling a little more rapidly than it predicted in March.

I think this year, 2013-14, will see the first deficit in double instead of triple figures since 2008-9 (when it was £99.5bn), though the OBR may not go so far.

Had growth not materialised, Britain would have been the poster boy for the fashionable debate about whether Western economies are suffering “secular stagnation”. This, permanently weaker long-run growth, has been popularised by Larry Summers, former US treasury secretary.

We do not know yet what will happen to Britain’s growth over the long run, but quarterly growth rates of 0.4%, 0.7% and 0.8% so far this year, the latter confirmed in new gross domestic product figures, is a long way from short-term stagnation. The OBR will revise its growth forecasts higher.

Now the growth cavalry has arrived, just in time, what will Osborne do with it? The broad message this week will be the programme is workimg and that he intends to stick with it. It will also be to emphasise that there is a very long way to go.

That should mean two more things. One is that growth has to be nurtured. The other is that the coalition has not given up on achieving better balanced growth.

The latest GDP figures showed the scale of the challenge. Despite recent stronger growth, it will be well into next year before the gap between where we are now and where we were when the economy dived into recession in 2008, 2.5%, is eliminated.

On the question of balance, the recovery was always going to need consumer spending. So far it has needed it a bit too much. I have to mention business investment, which rose in the third quarter. But it was up a mere 1.4% on the quarter, and down 6.3% on a year earlier.

There are doubts about the reliability of the business investment numbers, as Mark Carney points out, but its fall contrasts sharply with a 2.4% rise in consumer spending over the past year. Business investment and net exports subtracted from growth. Consumer spending, helped by government and inventories, drove it.

Had exports and investment made a suitable growth contribution, we might have had 2.5% growth in the past year rather than 1.5%. Had they done so at the pace of the 1990s, growth could have topped 3%.

The announcement from the Bank of England, agreed with the Treasury, that in future the Funding for Lending scheme will focus on business rather than household lending, can with other tweaks be seen as evidence that lending to individuals can stand on its own feet, albeit it with the help of record low interest rates.

That can be tied with some Bank concerns about the housing market, reflected in its latest financial stability report. I would not bet on Help to Buy surviving for anything like its full three years.

But the move was also a recognition that business lending, to small and medium-sized firms (SMEs) still needs a lot of nurturing. On its own that will not give us an investment-led recovery but it will help. Lack of finance prevented some firms from exploring new export markets.

Lending to SMEs is still falling, according to Bank figures on Friday, so the shift of emphasis is welcome. We wait to see whether it works.

As for the decision to reduce implicit support for the housing market, we should not look for too much of an effect. Michael Saunders of Citi points out that of the 42 banks which signed up to use the Funding for Lending scheme (FLS), 14 have not used it at all, and use by the rest has been declining, from a peak of £9.5bn in the final quarter of 2012 to just £1.1bn in the second quarter of this year.

As he puts it: “Credit growth [to households] has picked up recently, but this seems to reflect the general improvement in banks’ health and the economic outlook, plus the Help to Buy (HTB) scheme, rather than the FLS.”

For this reason some dismiss Carney’s move as irrelevant but that is going a bit too far. It is the first explicit use of financial policy, in addition to the other weapons at the authorities’ disposal; monetary policy (interest rates and quantitative easing) and fiscal policy (tax and spending).

The two strongest messages we should take from the move is firstly, that the Bank does not intend to allow housing history to repeat itself, so there may be further more meaningful moves to calm the market if its financial policy committee deems it necessary.

The second is that Carney intends to be a financial policy activist while keeping rates low under his forward guidance. Indeed, this use of financial policy should be seen as pushing out the date when interest rates eventually rise

The trick for Osborne and Carney is to keep the consumer side of the economy growing - interestingly, taking the second and third quarters together, wages and salaries were 3.7% up on a year earlier - while boosting the contribution from exports and investment.

Some of that is outside Osborne’s hands - the latest eurozone numbers suggest the move away from the abyss has not resulted in the return of much growth - so Britain’s exports will continue to struggle.

Some of it is within his gift. Business thinks the government is moving too slowly on infrastructure, is deaf to its pleadings on business rates (bigger for many firms than corporation tax), and continues to load on costs and red tape. In this environment, it is unsurprising many firms have chosen to remain in their shells.

Businesses do not expect too much from politicians, and are wary of small changes trumpeted by chancellors as transformational. But they will be looking for something, amid the political pressure on the chancellor to respond to popular concerns about the rising cost of living.

The return of growth should not, under any circumstances, mean a big giveaway this week. Even if it sneaks down into double figures, public borrowing remains very high by past standards.

Growth provides an opportunity to ensure the deficit continues to fall and politicians, now and in future, are not tempted to spend or tax cut their way to popularity.

Two think tanks, Reform and Policy Exchange, set out proposals last week. Reform favours targeting pensioners and pensions, ending their exemption from National Insurance contributions and questioning the future of tax relief on pensions.

Policy Exchange called for new fiscal rules which would commit the government to reducing the public sector debt to GDP ratio every year, against the penalty of scrapping the annual indexartion of the personal tax allowance, benefits and any increases in public sector pay.

I doubt we will see too much of that this week, though the ball is in the chancellor’s court. At the Tory conference in September he pledged to deliver a budget surplus by 2020. We await the details of that, either this week or in the March budget.

In the meantime his task for the next 12 months is to enable growth that is not only stronger but better balanced.

Saturday, November 23, 2013
Cash has been king for long enough: now for some investment
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The figures for business investment do not get the same attention as those for gross domestic product, unemployment and inflation.

Business investment is, however, important and in three days' time we will get the figures for the third quarter. An investment-led recovery is the prize for policymakers. A recovery driven by investment and exports is the holy grail.

So far investment is not delivering and exports, while they have grown in recent years, have been neutralised in their economic impact by rising imports.

The Bank of England’s monetary policy committee, in its latest deliberations, said “a successful handover from household to business spending would play a crucial role in underpinning the recovery in the medium term”.

The previous set of official figures, for the second quarter, showed whatever else we have been having it has not been an investment-led recovery. Business investment was down by 2.7% on the quarter and by 8.5% on a year earlier. It was more than 25% below its pre-crisis peak.

Growth in the economy has surprised on the upside this year but investment has done the opposite, so much so the Bank questions the figures, pointing out initial estimates are “prone to large revisions”.

Even such revisions may not change the picture fundamentally because it is not purely a British phenomenon. The Paris-based Organisation for Economic Co-operation and Development (OECD) noted last week that “business capital spending has been subdued in recent years, even allowing for soft demand growth.”

This is not supposed to happen. We expect businesses to anticipate upturns, or respond quickly to them, turning a modest increase in demand into something stronger. Economists used to spend a lot of time analysing this accelerator effect.

In recent years, business has been happier to wait and see, to sit on its hands until the outlook becomes much clearer. In the past, that would have been a recipe for allowing competitors to steal a march.These days the game has changed.

I’ll return to that. But if you wanted reassurance the investment train had been delayed but not cancelled, you would draw on two factors.

One is that firms have been deterred from investing by economic uncertainty. The banking crisis, followed by the eurozone crisis, with any number of other crises running in tandem or threatening to break out, has been a powerful dampener on corporate investment ardour.

The other is that damage to the banking system (and its extreme lending caution) has deprived new and expanding businesses of the finance they need to expand.

Most investment is done by larger firms but to the extent smaller businesses have been deprived of funding, this has been a factor, not just in weak investment but also poor productivity growth. The “creative destruction” economies need after recessions has been held in check.

The good news is that both of these factors are easing. The Bank’s MPC cites evidence from its agents that economic uncertainty is fading fast as a constraint on investment. A year ago a net 50% of firms cited uncertainty as a factor dragging on investment plans. Now it is 5%.

The optimistic view would be that as the clouds of uncertainty lift, so will investment. Business confidence is up, as so is the outlook (the latest CBI survey showed the strongest growth in manufacturing since 1995), so investment should follow.

Availability of finance, similarly, is not what it should be but showing signs of improvement. We have just seen the first tentative rise in bank lending to small and medium-sized firms since 2009.

These are two good reasons to think we might start to see an upturn in business investment. We will see this week whether it is too early for that to show in the official figures. There are, though, gloomier views. One is that the incentive structures within firms are biased against investment.

Chief executives have relatively short time horizons. Most last longer than football managers but not that much longer, with an average tenure of 3-4 years. In that time they get plaudits from shareholders for increasing dividends or buying back their own shares. This, in turn, pushes the share price higher, on which the chief executive’s bonuses are usually based.

This is not to say chief executives undertake no investment. Plainly they do, even if the benefits will be felt by their successors, But they do not do as much as they should.

The other argument is that there are not enough good prospects for businesses to invest in. An influential paper last year by Professor Robert Gordon of America’s Northwestern University, asked the question “Is US economic growth over?”.

His deliberately provocative title was to discuss whether, temporarily or permanently, America - and by extension other advanced economies - were in a prolonged quiet phase for innovation.

The IT and telecommunications revolution, the latest of the innovation waves that date back to the industrial revolution, has on this view run most of its course.

As Gordon put it: “Many inventions that replaced repetitive clerical labour with computers happened a long time ago, in the 1970s and 1980s. Invention since 2000 has centred on entertainment and communication devices that are smaller, smarter, and more capable but do not fundamentally change labour productivity or living standards in the way electric light, motor cars, or indoor plumbing changed it.”

Many reading this will argue that we have barely begun to scratch the surface of the possibilities of new technology. Others would argue that the changing economy means we should think of investment differently. When manufacturing dominated, business investment was big and tangible: plant and machinery, new factory buildings and so on.

Now it is different, so we should think of investment as less tangible. The Office for National Statistics will next year incorporate intangible investment, including goodwill, into the GDP figures. We should also think of it as investment in people - recruitment and training - strong even as traditional investment has been weak.

We should not think, as some suggest, of government investment as an alternative to business investment. The two are fundamentally different. Government investment, in for example infrastructure, can help create the conditions under which the private sector can invest and grow. Rarely can it be a substitute for it.

Sunday, November 17, 2013
Carney won't be raising rates any time soon
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 Margaret Thatcher's famous words on becoming prime minister in 1979, when she quoted St Francis of Assisi, and adapt them to deal with interest rates and the Bank of England.

Where there was certainty now there is confusion. Where there was harmony, now there is discord. Will forward guidance, Mark Carney’s big idea, turn out to be one of the shortest-lived monetary policy experiments in history?

I shall come on to that. The big question, of course, is when interest rates will start to rise. In August, shortly after the new governor arrived fresh from the Canadian prairies, the answer as he launched forward guidance appeared clear enough.

The monetary policy committee (MPC) would not even contemplate a hike in Bank rate from its current record low of 0.5% until the unemployment rate got down to 7%, and it did not expect that to happen until the latter part of 2016 at the earliest.

Though dependent on the state of the economy, the clear message was that people and businesses could relax about a rise in interest rates for three years (savers, of course, are desperate for a rate rise but that is another story).

Now fast forward to last Wednesday and the publication, three months on, of the Bank’s latest inflation report. To say that the Bank has shifted its view on the economy is an understatement. To stay with the religious theme, there have been few bigger changes of mind since Paul was on the road to Damascus.

On the same basis that the Bank thought in August that unemployment would not get down to 7% until mid to late 2016 - the assumption Bank rate stays at 0.5% - it now thinks there is a 50-50 chance of getting there roughly two years earlier, in the fourth quarter of 2014, just a year from now.

Even assuming rates rise a little in line with market expectations (which seems a bit of a contradiction) the unemployment rate gets down to 7% in mid-2015.

In the space of three months, forward guidance has apparently moved from the MPC not contemplating a rate move for three years to it being firmly on its agenda in 12-18 months time. For a policy that was supposed to enable firms and individuals to plan for the medium-term, this looks worryingly skittish.

Let me try to interpret and adjudicate, starting with the Bank’s new forecast. Now I am as optimistic as anybody but I fear that the Bank may have had a little too much sun on that road to Damascus. It may have jumped too far into the optimistic camp.

Its growth forecast for next year on the assumption of no change in interest rates is 3.4%. To set that in context, the average new independent forecast for growth next year is 2.2% and the most optimistic is 3%. The Bank has gone out on a limb.

The Bank's growth forecast on the market interest rate assumption (in other words that rates gradually creep up to 1.7% by 2016) is just under 3%. Still very strong.

I hope it is right but, while most of the recent economic news has been gratifyingly upbeat, we should not assume it is plain sailing. Retail sales, for example, fell by 0.7% last month and were merely flat over the past three months. Eurozone gross domestic product rose by just 0.1% in the third quarter and in some leading economies, including France and Italy, it fell.

It is this very strong forecast that drives the Bank’s prediction of a much earlier fall in unemployment that it previously predicted. Here again, it is worth questioning the numbers.

The latest unemployment reading is 2.47m, 7.6% of the workforce. If you thought unemployment had been close to 2.5m for some time, you would be right. Despite strong growth in employment, 377,000 over the past year, the level of unemployment has barely moved from that 2.5m level. The unemployment rate has fallen over that period because the size of the workforce has grown, but only from 7.8% to 7.6%.

Now, if the Bank is right about 3.4% growth next year, it is possible that employment will rise even faster than its very big rise over the past year. Three large falls in the monthly claimant count, a different measure of unemployment, have increased optimism among forecasters about the pace of the fall in unemployment.

But it still seems to me to be what sports commentators call a big ask for the unemployment rate to get down to 7% in a year, or even 18 months. It could, if productivity growth continues very weak, which would endorse fears that there is not as much spare capacity in the economy as thought.

Equally, however, if we believe a record 1.46m people are working part-time but really want a full-time job and if some of the growth in employment continues to come from people beyond normal retirement age, the unemployment rate could be slow to fall.

It is complicated, and it is one reason why I said when forward guidance was launched in August that it was not the best-designed policy in the world, looking very much as if designed by committee, which of course it was. The Bank is now finding that out.

The debate will continue on when unemployment gets down to 7%. Whenever it happens it has to be said the Bank’s new forecast is a victory for the many economists who criticised it for stretching 7% too far into the future.

For everybody else, what matters is when interest rates rise. Carney’s mantra on this is a familiar one: that 7% unemployment is a threshold not a trigger. When it is reached the MPC will start thinking about whether to hike rates but is under no obligation to do so.

Though the Bank’s new forecast made the governor’s task uncomfortable last week, he was helped by a sharp drop in inflation, from 2.7% in September to 2.2% in October. If inflation is close to target, and predicted to remain so, there may be no reason to raise rates even if unemployment has fallen to the threshold level.

A better way of looking at it is to stand back from the unemployment numbers. This, by the way, is how I beliecve Carney looks at it.

The economy is still roughly 2.5% smaller than it was before the crisis. The gap relative to what it might have been if the economy had avoided crisis and recession (a big if) is even larger, perhaps 15%. Some of that gap will be permanent but the hope has to be that not all of it is.

So what is the Bank trying to do with forward guidance? To give the recovery time to breathe, not just until the level of gross domestic product gets well above those pre-crisis levels, but also to permit what could be a long period of above-trend growth to claw back as much of that lost output as possible. That process is still in its infancy, despite recent stronger growth. As a result, I would not be looking for any movement on interest rates for the next two years, and possibly quite a bit longer.

So is forward guidance still alive? The past few days have not helped it, though the policy was only ever going to tested when growth picked up. Carney says that households and businesses should have confidence that rates will stay low and “not just that the glass is half full, but that it will be filled”. He is still guiding us not to expect rates to go up.


Sunday, November 10, 2013
Calm down dears, this isn't a debt-fuelled 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.

One of the functions of this column is to separate myth from reality. One myth, that the economy could never recover as long as the government was pursuing a deficit-reduction strategy. is being comprehensively disproved.

The latest evidence from the purchasing managers’ surveys of construction, manufacturing and services is that growth is at its strongest since 1997 and gross domestic product is on course for a rise of more than 1% in the fourth quarter.

Nobody should be too surprised by the return of growth: every modern-day British recovery has occurred against the backdrop of action to cut budget deficits. This time is no different.

Now that myth is being replaced by another, which is that the economy is only recovering because of a debt-fuelled consumer and housing boom.

The myth was given added impetus by a reporting error by the Bank of England a few days ago. Having initially reported that unsecured consumer credit rose by £411m in September, it rushed out revised figures showing that the correct total was, in fact, £864m.

Cue headlines about Britain embarking on a credit card binge or, worse, repeating the excesses that led us into the financial crisis. Some people got very excited.

Michael Winner is sadly no longer with us, but the only response to all this is “calm down, dears”. If we take the credit card component of the £864m, £151m, it was actually the lowest for five months, and below the monthly average since the financial crisis took its most devastating turn in September 2008.

Compared with the pre-crisis period, when credit card borrowing sometimes topped £1bn a month, the plastic is barely being flashed.

As for the wider picture, unsecured borrowing of £864m sounds a lot, but September is one of the two peak months in the year for new car-buying; along with March it is when registration plates change.

In September last year, partly as a result of this, unsecured borrowing hit £1.1bn. This year’s increase was smaller. As for rates of change, the amount of unsecured borrowing outstanding showed an increase of 3.9% on a year earlier but that is a pale shadow of the 13%, 14% and 15% growth rates of the pre-crisis period.

As always when it comes to household borrowing, it is necessary to look at the bigger picture, and that means mortgages, which account for 89% of household debt. The bigger picture shows that lending to individuals, including mortgages, has risen by just 1% over the past year, so is not even keeping pace with inflation.

The amount owed by individuals, £1.43 trillion on Bank figures, is lower in cash terms than in September 2008, and 15% lower in real terms. Far from going on a debt binge, households have bene quietly deleveraging.

You can see this in a number of ways. Real household disposable incomes are nearly 4% above pre-crisis levels but consumer spending is more than 2% below. Housing equity withdrawal, the amount people take out out of the equity in their properties for other purposes, supported consumer spending in the run-up to the crisis. But it has been negative since 2008 and in the second quarter of this year hit £15.4bn, its biggest negative since the crisis.

When this turns around maybe it will be possible to talk about echoes of the pre-crisis era, but not before.

Or, if you are still not convinced, how about this from Chris Williamson, chief economist at Markit, which compiles the purchasing managers’ surveys. The very strong growth in services last month was driven by financial services, computing and IT and business-to-business services, he says. Consumer-facing services, ranging from hotels, restaurants and catering through to hairdressing, were the weakest components of the survey.

None of this is to dismiss the importance of the consumer or an improved flow of credit - for both households and businesses - to the economy. Too much credit is dangerous but too little stifles growth to the point of stagnation.

An important part of the recent recovery story, probably the most important part is that the years of ultra-loose monetary policy, coupled with Funding for Lending and Help to Buy, are finally gaining traction. Stronger money supply growth, and the shift from negative to modestly positive credit growth, is supporting a strengthening recovery.

At some stage, particularly as rising mortgage lending feeds through to the numbers, household debt will rise.

Unless you are a Russian oligarch, Middle East potentate or Chinese zillionaire, you need a mortgage to buy a property. People entering the housing market do so by taking on debt; those leaving it, either for the Sunnyside retirement home or that great suburb in the sky, have paid off their debt.

The normal condition is for overall household debt to rise, though we should never forget that household assets, at over £10 trillion according to the Office for National Statistics, are more than seven times the total of outstanding debt.

That is for later. But if recovery so far has not been driven by debt-fuelled consumers, what has it been driven by? To the extent consumers have contributed, and they have, the absence of new crises and strongly rising employment - which may be about to get stronger - have been important counterweights to the squeeze on real wages.

Even more improtant, I suspect, is the delayed impact of very low interest rates. The windfall from drastic reductions in monthly mortgage payments was not initially spent by many households, partly because their confidence was battered into submission and partly because they feared low rates would not last.

Thursday marked the the 56th month at which the Bank’s monetary policy committee has held Bank rate at 0.5%. On the same day the European Central Bank cut its key interest rate to 0.25%. Even without forward guidance, people had guessed that rates in Britain were not about to rise. With it, they have become more secure in that belief, hence stronger spending, without so far any meaningful rise in debt. Forget talk of a debt-fuelled recovery.

Sunday, October 27, 2013
Productivity versus unemployment: the new interest-rate battleground
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.

Friday’s gross domestic product figures, showing a 0.8% rise on the quarter, confirmed, instead of a triple-dip predicted by some earlier this year, Britain has has three consecutive quarters of pretty good growth.

This is still not the longest sequence in what has been a stop-start recovery. In 2009 and 2010 there were four successive growth quarters before the snow-affected GDP dip in late 2010. In 2011 growth resumed for three quarters in a row.

The expectation this time among policymakers is that this upturn will prove more durable. That explains George Osborne’s bullishness and Ed Ball’s decision to switch his attack on the government to living standards.

Members of the Bank of England’s monetary policy committee (MPC) are also notably more optimistic. They have moved from a position in which their growth forecasts were upbeat but they were not, to a more consistent recovery message.

Charlie Bean, the Bank’s deputy governor, last week contrasted its upbeat summer 2010 forecasts, based on “a steady improvement in credit conditions amd a gradual decline in uncertainty” with the much more subdued outturn. The uncertainty, particularly over the eurozone, increased rather than declined and credit conditions did not improve.

Now, both those headwinds have eased. Credit is coming through, even for businesses; September saw a rise in net lending to non-financial businesses according to the British Bankers’ Association. Fear of imminent eurzone collapse, with all the chaos that would bring, is greatly reduced, even if the single currency’s underlying problems have yet to be resolved.

So Bean is surely right to argue that this looks like a sustained recovery, unlike previous post-crisis episodes. I also agree with him that we should not expect it to continue at the searing pace suggested by some surveys over the summer.

Growth has surprised on the upside but that does not mean it is a 3%-plus expansion all the way from now on. The latest CBI manufacturing survey pointed to some easing in the pace of growth.

But growth it is, and with it comes the big question, or rather two related questions. Will it resolve the puzzle of exceptionally weak productivity? To remind you, output per worker was fractionally lower in the second quarter than in 2010: normally you would expect it to rise about 2% a year. Output per hour worked was even weaker, down more than 1%.

Related to this is the question of how growth will impact on unemployment. If productivity remains weak, stronger growth will be immediately converted into a faster rise in employment, and a sharper fall in unemployment.

If, on the other hand, productivity picks up as growth strengthens, all the extra workers taken on by the private sector over the past 2-3 years will have to earn their corn. Productivity will rise, reducing the need to take on more staff.
Employment will grow, but not particularly rapidly, and unemployment will take time to fall from its current 2.49m level, 7.7% rate.

This matters in its own right. We need an economy that combines a decent productivity growth with rising employment and falling unemployment. A rise in employment alongside weak productivity is neither healthy nor sustainable.

It matters also because of the Bank’s new approach to monetary policy under Mark Carney’s forward guidance regime. Everybody will know that 7% is the unemployment rate at which the MPC will start to think about raising interest rates.

The Bank is currently revisiting its forecasts ahead of its November inflation report. But the clear message from its last forecast, in August, was that everybody can relax about interest rates. Even after three years, the unemployment rate will not be down to 7% (the MPC’s “best guess” was 7.3%) and, subject to the so-called inflation and financial stability “knockouts” not being breached, rates will stay low. Built into that story was the expectation that as growth recovers, so will productivity.

Some disagree fundamentally. Fathom Consulting, which precedes each inflation report with its own monetary policy forum of ex-MPC members, thinks policymakers are whistling in the dark in waiting for a productivity upturn. Waiting for the productivity bounce is like waiting for Godot.

Its economists believe that Britain suffered a huge supply shock in 2008 from which it has yet to recover. That supply shock has inflicted permanent damage on the economy’s ability to generate productivity growth, with important short-term and long-term consequences.

The biggest short-term consequence is that stronger growth will be converted rapidly into falling unemployment. Far from waiting until 2016 or beyond to get down to a 7% unemployment rate, Fathom thinks it will happen next year.

There is support for its view in the most recent numbers for the unemployment claimant count, a narrower jobless measure. It fell 41,700 in September, its biggest monthly fall since the 1990s, after a drop of 41,600 in August. The unemployment rate on this measure has dropped from 4.7% to 4% in a year. If it is a harbinger of the wider measure, that could indeed race down towards 7% very quickly.

So what will it be? Growth, as noted earlier, may not persist at its very strong summer pace. Productivity, surely, must come back a bit. One prominent theory at the Bank about weak productivity is that it is due to the lack of credit supply to new, rapid growth start-up businesses. Another related argument is that we will see a strong upturn in business investment from now on, which will also help generate stronger productivity growth.

The other get-out is that 7% unemployment is, the Bank insists, a “threshold” not a trigger. Even if unemployment fell rapidly to 7% the MPC would not be impelled to hike rates, merely think about it.

It would, however, also have to issue a new form of forward guidance at that point. A policy that has already generated a lot of controversy would have to be redrafted, if Fathom are right, at an embarrassingly early stage. The Bank has to hope for a productivity revival.

Sunday, October 20, 2013
The inflation balloon's still up in 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.

Britain has become, once more, a high-inflation economy. Normally as a nation we like to top any European league. But when that league is for inflation rates across Europe, that is more than a little embarrassing.

New Eurostat figures, which the Labour party was quick to pick up on, show that last month Britain had the highest inflation rate in the European Union. Yes, of all 28 EU members states, Britain’s inflation rate was the highest.

Britain’s 2.7% rate last month was more than double the EU (1.3%) and eurozone (1.1%) averages. Previously high-inflation EU countries, which included Hungary, Poland, Romania and the Netherlands, have come back down to earth.While Britain’s rate is close to 3%, more than half of the members of the EU - 15 in all - have prices rising at an annual rate of 1% or less.

If we take a wider comparison, the advanced economies of the OECD (Organisation for Economic Co-operation and Development), only Turkey (8.2%), Mexico (3.5% and Iceland (3.8%) have higher inflation. In the G20, Britain’s rate is higher than China’s.

Some people are intensely relaxed about Britain’s 2.7% inflation rate based on the consumer prices index (inflation based on the longer-running retail prices index was 3.2%). There is, they say, nothing remarkable about 2.7% inflation. In this respect at least they are right.

Inflation has been 2.7% for seven of the past 12 months. It has averaged 2.7% over those 12 months. It is sticky, if not stuck. The inflation target, remember, is 2%.

Actually, 2.7% inflation over 12 months is better than the recent record. In the past 24 months it averaged 3%, over three years 3.4%, over four years 3.3%, over five 3.2%, over six 3.2% and over seven 3.1%. If Britain had a 3% inflation target, this would be acceptable. With a 2% target it is not.

Taking that seven-year average, the level of prices is 8% higher than it would have been had the Bank of England consistently hit the 2% inflation target. As noted here recently, real take-home pay would have held up if inflation had not overshot.

Why is inflation so much higher in Britain? It is easy to blame quantitative easing, though the weakness until recently of money supply growth would suggest that is not a huge factor, and it has not been confined to Britain.

Once it was possible to tell the story through the performance of the pound. Sterling’s weakness pushed up import prices, of food, energy and other globally-traded commodities. Higher inflation,, it seemed, was the price we had to pay for a competitive pound.

All that, however, is a long way behind us. Sterling’s fall was concentrated in the period from the autumn of 2007 to the early part of 2009. The pound is higher now than at its low-point then. To blame the sterling weakness of 5-6 years ago for high inflation since is a stretch too far.

Another explanation is that Britain never really had properly low inflation, even in the glory days of the first decade of Bank of England independence. In those days, indeed, there appeared to be a bigger chance of inflation undershooting.

Inflation then was, however, flattered by the China effect which produced falling prices for goods, before the rise of China began to put big upward pressure on commodity prices. Domestically-generated inflation, in particular service-sector inflation, was never brought to heel.

That remains the case now. Service-sector inflation last month was 3.4%. Some goods are barely rising in price - clothing and footwear inflation was 1.1%, furniture 0.7% - but overall goods prices were up by 2.1% compared witha year earlier. Result: the highest inflation rate in Europe.

At one time a ready excuse for high inflation was pay. But with official figures showing total pay in the latest three months up just 0.7% on a year earlier that is hard for anybody to argue, even bringing in the additional factor of weak productivity growth (which pushes up unit labour costs). Pay is the dog that is not barking.

So what is it, apart from the factors outlined above? For reasons that are not entirely clear, firms appear to be able to push through price rises in Britain in a way they find hard to do in other countries.

Let me give you, courtesy of Richard Ramsey, an economist with Ulster Bank, a couple of figures that I think will amaze. According to the Office for National Statistics the big contributors to Britain’s inflation over the past few years have been food and (non-alcoholic) drink; housing, water, electricity, gas & other fuels; and transport (including petrol and diesel).

So what has happened to food and drink prices? In the past six years they have risen by a hefty 35.6% in Britain, enough to make a huge dent in any household budget. We have come to believe, that this is the inevitable result of global factors.

In Ireland, however, which Ramsey is well-placed to monitor, the rise in food and drink prices over that period is, remarkably, just 1%. Irish people are paying the same for food as six years ago, while Britons are paying over a third more.

If we take gas and electricity prices, in the news again following British Gas’s announcement of hefty price hikes averaging 9.2%, the difference is also huge. British prices have gone up 61% in six years, Irish prices by 28%.

Unsurprisingly, Britain has had a lot more inflation than Ireland; a 20.7% increase in consumer prices over six years compared with just 3.2% in the Republic. Had Britain had Ireland’s inflation, households would never have had it so good.

How do we account for this? The supermarkets will insist they operate in a highly competitive environment, as do the utilities. So too will every other business. But price increases have become ingrained in the culture in Britain, in a way they are not in many other countries.

Of course 2.7% inflation is not particularly high by past standards, particularly for those of us who lived through a bout of near-27% inflation. So should we not chill out about a bit of an overshoot?

No. It it matters. Labour’s “cost of living crisis” is opportunistic but inflation is significantly too high for the current rate of earnings growth, when it is far from obvious what will push pay rises higher.

You would not, either, want to start from a position of relatively high inflation when moving into a period of stronger growth. There are scenarios in which stronger growth pushes inflation down but there are plenty more in which the opposiute occurs. Inflation is already too high. We cannot afford for it to go higher.

Sunday, October 13, 2013
Help to Buy will help lift housing transactions
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.

Many moons ago I suggested, drawing on Professor Nick Crafts’ research on the 1930s, that housebuilding was an essential route out of Britain’s post-crisis torpor.

Some disagreed, suggesting that housebuilding was somehow wasted spending, and only “productive” investment, in plant and machinery and the like, is worthwhile. The answer is that you need both, and the advantage of housebuilding is that it is a great job generator.

These days, however, every Tom, Dick and Harry calls for more housebuilding. It has become the panacea. Critics of George Osborne’s Help to Buy scheme say we do not want the government to boost the supply of mortgages but just to increase the supply of new housing.

That is a very odd. Ask any builder why housebuilding has been weak in recent years and they will put finance at the top of the list: the finance to develop new sites and the mortgage finance that enables customers to buy.

While there is case for more social housing, it is naive to expect even an echo of the post-war council housing boom. These days, when we talk about new housing supply we are mainly talking about private sector supply.

Why has housebuilding been so weak in the past few years? Immediately before the crisis, nearly 220,000 new homes were being built. When mortgage availability dried up in 2007-8, new building slumped by nearly 40%. The failure of housebuilding to recover after that, until very recently, was a direct product of the mortgage famine.

Social housing, these days almost exclusively the preserve of housing associations, has responded in a counter-cyclical way, filling some of the gap left by the private sector. But on the eve of the crisis in 2006-7, housing associations and local authorities only accounted for 12% of new homes completed.

That proportion has gone up to around 25% (and will probably go down again now) but we are a long way from the days, last seen in the early 1970s, when there was more social housing built - mainly then by local authorities - than by the private sector. This was in the context of nearly 380,000 homes being built a year.

The shift from mortgage feast to famine as a result of the crisis was dramatic. Bank of England figures show that in 2005 there was £91bn of net mortgage lending (gross lending less repayments), peaking at £110bn in 2006 before subsiding slightly to a still very strong £108bn in 2007. Even in 2008, the eye of the storm, net mortgage lending was £41bn.

For the next four years nothing happened. Net lending averaged less than £10bn a year, achieving less over four years what was achieved in the single annus horribilis of 2008.

Another way of looking at it is in the Bank’s figures for housing equity withdrawal, the amount extracted by homeowners from the housing market.

For most of the 2000s, housing equity withdrawal was huge, totalling £232bn between 2000 and the spring of 2008, when the economy dived into recession. Then the process reversed itself dramatically. Since then, households have collectively injected £209bn back into housing. There are many reasons why the consumer recovery has been weak but this is high on the list.

The key point is that boosting mortgage supply and increasing housebuilding are not alternatives; they are intimately related. The first phase of the chancellor’s Help to Buy scheme, which offers interest free equity loans of up to 20% of the value of a new home has, together with Funding for Lending, provided a decisive boost for housebuilding.

Official figures show housing orders are rising at their fastest rate since 2007, while the more timely construction purchasing managers’ survey from Markit shows housebuilding accelerating at its strongest since 2003. Help to Buy, as predicted here, is helping to build.

If so, why do we need the second phase, brought forward from January by George Osborne at the Tory conference? In this, the government will guarantee up to 15% of a property’s value, in return for a fee charged to the lenders.

The answer takes us back to where I started. New housebuilding is great but it cannot do everything. The read-across from new housing to the wider market is not perfect - you cannot newly-build Victorian houses with character (or large gardens) and the numbers will always be against new housing. Even in a good year, new housing will add less than 1% to the housing stock. It is, as I say, no panacea.

A proper housing recovery requires things to move in the market for existing homes. People who have hung on instead of selling because the market was dormant; perhaps older people contemplating downsizing. Younger households stuck in a home too small for their growing families need to be able to trade up. This too will feed through to more housebuilding in a way a stagnant market would never do.

Defending Help to Buy is a lonely task. The trite argument that it will only push up prices is too easy a soundbite.

Fortunately I have some company. The always-sensible Michael Saunders, an economist with Citi - not a mortgage lender - puts it well. Help to Buy is artificial but no more than the myriad schemes, including ultra-low interest rates and quantitative easing, introduced to lift the economy. This one has the merit that, in its first phase at least, it is working.

Peter Spencer, economic adviser to the Ernst & Young Item club, says the policy is “well timed and well targeted”. He adds: “The main benefits will be felt outside London, where they will help to restore a level playing field between first-time, first-move and cash-rich buyers,”

House prices have adjusted a lot. Saunders points out that they are 25% lower in real terms than pre-crisis. The house price-earnings artio, calculated by the Halifax, is 20% lower than it was.

The test for Help to Buy 1 was whether it would boost housebuilding. It has. The test for Help to Buy 2 is whether it results in a significant increase in transactions - currently barely more than half pre-crisis levels. I think it will.

Sunday, October 06, 2013
Osborne boldly goes for a budget surplus
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What is said in the conference hall, rightly, normally stays in the conference hall. The things politicians say to please the party faithful often do not easily translate into practical policies.

The question is whether George Osborne gave us something last week that will prove to be more durable and significant in terms of future economic policy in Britain.

It was not, in spite of its short-term appeal, the chancellor’s pledge to try to freeze fuel duty between now and the election. It was not, either, the bringing forward of the second phase of the Help to Buy scheme, on which more I hope next week.

No, it was his promise that “when we’ve dealt with Labour’s deficit, we will have a surplus in good times as insurance against difficult times ahead”.

“Provided the recovery is sustained, our goal is to achieve that surplus in the next parliament,” he added. “That will bear down on our debts and prepare us for the next rainy day.”

A couple of sentences in a speech does not amount to a fully-worked policy. But the chancellor’s advisers produced a four-page briefing note to accompany it and the aim is to work this up into fully-fledged fiscal mandate by the May 2015 election.

That new mandate will not necessarily appear in autumn statement or budget documents between now and the election. The constraints of coalition mean that, because this is so far only Tory policy, the Liberal Democrats would also have to adopt it for it to becoem government policy.

What does it mean? At its simplest, it means the Tories will go into the next election promising a budget surplus before the end of the next parliament. In 2019-20 or 2020-21 instead of public sector net borrowing, there will be a debt repayment.

Is that possible? Current projections from the Office for Budget Responsibility show that public borrowing, £115.7bn in 2012-13, will be £42bn by 2017-18. Osborne believes that, even without further real cuts in overall public spending, that trajectory will lead to a budget surplus in at least one of those two fiscal years around 2020.

That, in itself, is no great shakes. A temporary budget surplus, after years of austerity and in the context of a recovering economy is rarel but not unprecedented. It happened in 1969-70 and 1970-71, then again in 1988-89 and 1990-91 and, most recently, in 1998-99, 1999-2000 and 2000-01, the last one helped by £22.5bn of 3G mobile phone proceeds.

Temporary surpluses like this are, however, the political equivalent of a huge itch that has to be scratched. Even if chancellors do not necessarily think that a budget surplus is better spent in tax cuts or higher public spending, you can bet plenty of their colleagues will, particularly when there are elections looming.

Roy Jenkins, Labour chancellor during one temporary surplus period, was blamed by some colleagues for losing the 1970 general election.

Longer-term surpluses - prolonged periods of debt repayment - are much rarer. Successive governments reduced the debt overhang left after the Second World War mainly by allowing its real value to erode, rather than cutting it outright.

For a sustained period of falling debt you have to go back to the late Victorian era, and famous chancellors like William Gladstone, Benjamin Disraeli and Lord Randolph Churchill, as well as not so famous ones like Sir William Vernon Harcourt and Sir Michael Hicks Beach.

Can Osborne recreate those Victorian values? Fiscal rules do not have a great reputation. Gordon Brown’s golden rule (only borrowing to fund investment) and sustainable investment (keep debt below 40% of gross domestic product) disappeared in a puff of smoke when the crisis hit.

The coalition’s original rules, to eliminate the current budget deficit and have debt falling as a percentage of GDP by the end of the parliament, have had to be stretched out well beyond the election.

The fiscal rule, or mandate, Osborne has in mind this time is that, subject to economic cirumstances, the government will run a budget surplus, will repay debt. “Subject to economic circumstances” sounds woolly. The mandate could get around it by targeting cycically-adjusted borrowing, though that opens up the kind of can of worms that discredited Brown’s golden rule even before the crisis. Deciding where the economy is in the cycle is a matter of judgment and, even if that judgment is devolved to the OBR, there would be plenty of room for doubt and debate.

Instead we might see Osborne taking a leaf out of Mark Carney’s book. So just as there are “knockouts”, mainly relating to inflation, when the Bank of England’s forward guidance on interest rates will no longer apply, so there would be knockouts in which the government would no longer have to run a budget surplus.

So, if unemployment rises above a certain level, or growth drops below a certain rate, the chancellor would not have to run a surplus; the so-called automatic stabilisers of allowing spending to rise and revenues to fall would apply.

Is running a budget surplus a good idea? It depends where you start from. Brown’s 40% debt rule was not necessarily a bad one, though it proved fragile, and countries that went into the crisis with lower debt levels also found themselves in trouble.

But the fact is that, on almost any scenario, Britain in 2020 will have significantly higher government debt - both in absolute terms (perhaps £1.7 trillion) and relative to GDP (over 80%) - than was the norm for the 40 years leading up the crisis.

That leaves Britain with little room to cope with emergencies or face the pressures of an ageing population, which the OBR expects to push debt to 100% of GDP over the next 50 years. Aiming for a sustained surplus, given this, is a good idea. If you think of the crisis as the equivalent of a war, peacetime is when you unwind the rise in debt that occurred as a result of it.

Will it ever be achieved? 2020 is a long way away. Politics will change - the Tories might not be in government - and so will the economy. But there is a chance, at least, that we have just witnessed the launch of what could be a profound change in the way governments approach the public finances.

Sunday, September 29, 2013
The Bank trumpets recovery: now to lift investment
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Since Mark Carney took over at the beginning of July, most of the economic news has been significantly better than expected.

Not only that but members of the Bank of England’s monetary policy committee (MPC), including the new governor, are both sounding decidedly upbeat and stressing their collective role in driving recovery. It is not quite “the Bank wot won it” but there is an element of it.

Though in Tory conference week George Osborne would like to all the recovery credit to be directed at him, he will not be too troubled by the Bank’s new-found optimism. After all, he has long argued that his policy of fiscal conservatism alongside monetary activism would deliver recovery.

Revised figures last week confirmed that the economy grew by 0.7% in the second quarter, after rising by 0.4% in the first. City economists are looking for a 0.9% rise in the third quarter, which ends tomorrow. Though there was some less than welcome detail in the latest figures, which I shall return to, the economy appears to have come through its stop-start phase.

David Miles, an MPC member, certainly thinks so. “I would guess that right now we might have a rate of growth in the economy of between 2.5% and 3.5%,” he said in a speech, adding: “The recent rise in activity and confidence in the UK could be — I believe - sustainable and self-confirming.”

His MPC colleague Ben Broadbent, in a speech that required an equation-laden technical appendix, pointed to surveys suggesting the market sector of Britain’s economy “is expanding at an annualised rate of 5% or so”. And, while that could be an overestimate: “The economy has clearly picked up significantly faster than the majority of forecasts (including those of the MPC) made last year.”

Paul Tucker, the Bank’s outgoing deputy governor, joined the celebration. Recovery he said, was “finally underway” and it should not come as a surprise.

Why is it happening? While they could be accused of talking their own book, all three had a similar message, which is that monetary policy has started to work.

For Tucker it is “the massive amount of monetary stimulus of recent years”, including four and a half years of 0.5% Bank rate, £375bn of quantitative easing, Funding for Lending and huge liquidity provision.

While many - too many - economists argued that only a fiscal stimulus (a “Plan B”) would lift the economy, Tucker argues that what he perhaps mischievously calls the Bank’s “Keynesian” monetary stimulus is doing the trick.

Broadbent agrees, pointing out that while neither the Bank nor other central banks cut interest rates last year, their actions significantly reduced bank funding costs, which had a similar effect. Last year’s actions led to this year’s recovery.

The aim of the Bank now, and this was Miles’s central point, is to ensure that the monetary stimulus is given time to work to its full extent, which is what forward guidance on interest rates is all about. So stronger growth will not mean higher interest rates for a long time to come.

The role of a central banker, in the cliche, is to take away the punchbowl just as the party gets going. The MPC instead intends to keep it topped up, the more so because it believes what it is doing is working.

If anybody takes the punchbowl away these days it is the Office for National Statistics. I mentioned that there was some unwelcome detail in the latest figures and they were for investment. While overall investment rose by 0.8% in the second quarter, boosted by housebuilding and infrastructure, business investment dropped by 2.7%. Worse, it was down by 8.5% on a year earlier.

This was a surprise. Previous official figures showed a small rise in business investment in the second quarter, in line with business surveys. The British Chambers of Commerce, for example, said manufacturers’ investment intentions in the second quarter were their strongest since 2007. There was a similar message last month from the EEF, the engineering employers.

Business investment, it should be said, is a curious beast. The figures are subject to greater revision than most official numbers and will be revised even more extensively than usual next year when new estimates for so-called intangible investment are incorporated into the figures.

Business investment in Britain, moreover, does not behave as it should. Remember the 2000s before the crisis hit? It was an era of easy credit, growth and no return (apparently) to boom and bust. Was it also a time of booming investment?

Curiously no. After rising modestly (1.4%) in 2000, business investment fell every year from 2001 to 2004, by 8% in total. It burst upwards in 2005, by 14.9%, before falling by 14.4% in 2006. After that businesses got their investment timing spectacularly wrong. Investment got back into its stride in 2007, up 13.7%, even rising by 4% in 2008 as the economy fell into the abyss. That may help explain the caution now.

All that said, a healthy recovery, and as importantly a rebalanced economy, needs a sustained rise in business investment. One theory about why private sector employment has been so strong is that firms have been happier to commit to taking on more people than committing to a significant - and perhaps more permanent - increase in capital spending.

Though it is hard to quantify alongside the effects of weak business confidence, availability of finance has also been an issue holding back investment, particularly for smaller firms. But it is fair to say that the Bank, and the chancellor, will only really be able to pat themselves on the back when business investment takes up its rightful place in the recovery.

Investment intentions surveys suggest it will. The CBI predicts a strong 7.3% rise in business investment next year, after a 2.8% fall this year. The most recent official forecast from the Office for Budget Responsibility (OBR) was for 6.1% growth in business investment next year, and nearly 9% annually for the following three years.

Anything like that and it really would be a healthy and sustained recovery.

Sunday, September 22, 2013
Scotland will find it cold outside the UK
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 less than a year, on September 18 2014, Scotland will have a referendum on independence. Though polls currently suggest otherwise, more than three centuries of union between England and Scotland could end.

People have strong views on this and I don’t want to get into the politics. But with Tories perennially unpopular north of the border and a lacklustre Labour leadership making the case for continued union, it is good the Better Together campaign is in the safe hands of Alistair Darling.

Like many in England I don’t want the Scots to go but they have the right to decide. Independence wouldn’t mean border guards at Berwick on Tweed.

There is, however, a strong economic dimension to the debate - many Scottish voters say they will be swung by the economic arguments - hence this piece.

Several recent assessments have been published on the economics of independence, from the Institute for Fiscal Studies (IFS), the National Institute of Econokmic and Social Research (Niesr) and the Westminster government.

To sum these up: Scottish public spending per head is significantly higher than the UK average. Allocating Scotland a 90% geographical share of North Sea revenues would make it easier for Scotland to pay for this higher spending initially, but with those revenues set to decline, tough spending decisions would be needed.

Scotland’s need for spending cuts would be made greater by having to pay more to borrow, and by some revenue losers. Scotland could no longer discriminate against UK students by charging them tuition fees.

The central issue is Scotland’s higher public spending, £12,629 per head in 2011-12 (in today’s prices) according to the IFS, 11% higher than the £11,381 for the UK as a whole. On the basis of population, Scotland’s public spending in 2011-12 was 50.6% of gross domestic product, five percentage points above the UK average.

Proponents of independence will argue that if most of the North Sea is allocated to Scotland, public spending is lower, relative to GDP, than the UK average. But this does not get Scotland off the hook.

Under projections from the Office for Budget Responsibility, the IFS points out, “Scotland’s budget deficit may be 2.2% of GDP further into the red than that of the UK as a whole in 2017–18. To fill this hole would require a further £3.4bn of tax rises or spending cuts.” This is as well as the £2.5bn of cuts already planned.

The National Institute (Niesr) was no more comforting. In Scotland’s Currency Options it highlighted one important monetary consequence of independence, a Scottish economy dependent on oil would not be suitable for a one-size-fits-all monetary policy operated by the Bank of England.

An independent Scotland would also face the task of issuing a huge number of bonds to fund the share of UK government debt it would acquire on splitting. Such debt issuance would threaten market indigestion. Scotland’s borrowing costs would be between 0.72 and 1.65 points higher than for the UK, Their broad message is that, fiscally, it would be cold out there.

“Our baseline scenario ... indicates that a very tight fiscal adjustment would be necessary for Scotland to achieve a 60% debt to GDP target in 10 years,” it says. “The greater the share of debt and the smaller the share of assets (primarily oil and gas) which Scotland receives at independence, the greater the fiscal adjustment necessary.”

The government, quoting the Centre for Public Policy for Regions, also knocks down the idea that an independent Scotland could use oil revenues to establish a Norwegian-style sovereign wealth fund. Scotland will need all the revenues it can get, and more, to fund annual outgoings.

So the fiscal prospect for an independent Scotland looks grim, even compared with the less than rosy prospect for the rest of the UK. This should make Scottish voters pause. But so should what in my view is even more important.

In the end, the success of an economy depends on its ability to create wealth, through private sector businesses.

The Westminster government’s latest Scotland analysis has useful background on the border effect; how separation leads to a drop on bilateral trade. Prior to the split of Czechoslovakia 20 years ago, 22% of what are now Czech Republic “exports” went to Slovakia. Within five years it was less than 10%. The effect for Slovakia was even more dramatic, a drop from nearly 45% to 15%. Ireland saw a drop over decades from 90% of trade with Britain to around 25%.

So Scottish businesses will face the challenge of replacing a likely loss of trade with the rest of the UK. Nine in 10 customers of Scotland’s financial services industry are in the rest of the UK; as are 60% of its business services exports and a third of the exports of its key food and drink sector.

Behind these dangers lies what is perhaps a bigger challenge for Scottish businesses. There are not enough of them.

I am not disparaging Scottish entrepreneurial talent when I say Scotland is one of the least entrepreneurial parts of the UK. But, since the days of empire, many Scots have been entrepreneurial only outside Scotland. Scotland has long been the natural home of the public sector.

The number of private businesses per 10,000 adults is just 735 in Scotland, compared with 1,231 in London, 1,098 in the rest of the southeast, 1,096 in the southwest and 1,080 in the east of England. The Scottish figure is lower than in Northern Ireland (798), Wales (769) and every other region of the UK except for the northeast.

The yes lobby will say Scottish entrepreneurs have been held back by Westminster’s southern bias. I cannot think of a single reason why this should be. Scotland has enjoyed greater prosperity than most English regions, as well as Wales and Northern Ireland.

Would independence rekindle the entrepreneurial spirit in Scotland? Some pro-independence business people argue that it would but they are in the minority.

Certainly, if the intention of a Scottish government would be to keep public spending high, thus requiring high rates of taxation, on and offshore, it is hard to be optimistic about prospects for the country’s brave band of entrepreneurs.

It is hard indeed, in such circumstances, to be optimistic about the economic prospects for an independent Scotland.

Sunday, September 15, 2013
We had it so good - but this pay squeeze will last
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.

Thanks to Mark Carney’s forward guidance, the unemployment rate is the economic indicator of choice. We will see the great debate - when will the unemployment rate get down to 7% and how soon after that will the Bank of England raise interest rates? - twist and turn in coming months.

This month the pendulum has swung to those in financial markets who think 7% will be achieved well before the 2016 date implied by the Bank’s forecasts. In the past year the unemployment rate has dropped from 8.1% to 7.7%, suggesting 2015, or even before, is more likely.

But there will, as I say, be twists and turns. The more employers extract higher productivity from workers, the slower will be the growth in net new jobs (a strong 276,000 over the past year) and the more gradual the fall in unemployment.

The Bank would also stress that a 7% unemployment rate wlll not be the trigger for higher interest rates, but merely the point at which the monetary policy committee considers them. More on that in coming months.

This week I want to tackle a couple of puzzles. Why, when the job market has been so strong, is pay so weak? And why are people spending again when wages and salaries are apparently falling inexorably in real terms.

This is, of course, Labour’s new line of attack on government policy; that the recovery is not worth the name as long as living standards are falling. And the latest figures showed that the fall, which dates back to the onset of the crisis, persists.

Average earnings - total pay - rose only 1.1% in the 12 months to May-July. Regular pay, excluding bonuses, rose only 1%. There will be a new inflation number out on Tuesday but the last one was 2.8%. Prices are easily outstripping pay.

The weakness of pay has some puzzling aspects, Surveys of private-sector pay settlements show they average 2% to 3%. Public sector pay, it is true, has moved more into line with the government’s 1% limit; earnings in the latest 12 months were up by 0.9% (excluding the publicly-owned banks).

The earnings figures imply, however, that as well as the public sector, pay must be very weak in the hundreds and thousands of smaller firms not covered by formal agreements.

Assume the earnings figures are right. Why, apart from public sector pay policy, are they so low? The stock answer is that unemployment, and fear of it, is keeping a lid on pay. It seems the Phillips curve, a negative relationship between unemployment and wage rises, lives.

Bill Wells, an economist with Vince Cable’s Business, Innovation and Skills department (BIS) takes a different view. Wells, who digs deep into the labour market numbers, and has given a number of recent presentations, argues that wages have become less responsive to short-term economic signals, including unemployment and inflation.

The recent story of wages, according to him, is that they had settled into a 3% to 5% range before the crisis but were shocked down to between 1% and 3% by the crisis.

Most employers still award annual pay rises but few believe they need to award more than inflation, let alone make up for the drop in real wages of recent years. Until pay is shocked out of its range - and it is not clear what will bring this about - this may be the new normal for pay.

Real wages are not, however, the whole story. The broadest measure of money flowing into households, real household disposable income, has only fallen in one year, 2011. It rose by 1.4% last year. It held up during the 2008-9 crisis, and has fared better than, say, during the 1970s, when it fell for three years in four in the 1974-77 period. Households have sources of income other than pay.

Wells also draws the distinction between real wages, down by a around 7% since mid-2007, and real take-home pay, which has benefited from tax changes, most notably the coalition’s big increase in the personal tax allowance, which will reach £10,000 in April. Low pay is also being topped up by tax credits.

Though the drop in take-home pay is smaller than the fall in real wages - around 3% and it would not have occurred at all if the Bank had met its 2% inflation target - it is still a fall. Yet consumer spending has risen for six consecutive quarters and some areas are booming; such as 18 months of strongly growing private new car registrations.

Credit may be playing a part, though consumer credit remains weak. Some households may be responding to low interest rates and forward guidance by spending out of savings. I suspect, however, the next estimate of gross domestic product later this month will show a rise in the saving ratio.

Consumers are spending for a complex array of reasons. One, which I have noted before, is that households with large borrowings have only belatedly started spending the ongoing windfall they are getting from very low interest rates. Borrowers tend to be bigger consumers than the savers who are suffering from low rates. Other windfalls, such as payment protection misselling compensation, may have helped.

It may be, however, we have to get away from the idea that workers can expect pay rises that outstrip inflation, year-in, year-out. Wells points out that Britain is unusual in that workers came, over decades, to expect annual real wage hikes.

The result, and this is a statistic that will surprise many, is that on OECD (Organisation for Economic Co-operation and Development) figures, Britain’s average take-home pay last year the third highest among advanced economies.

Only Switzerland and South Korea ranked higher, while Britain outstripped America, Germany, Sweden, Japan, France and 26 other countries. The comparison with America is particularly striking. Since the mid-1960s Britain’s real earnings index has doubled while America’s has not risen at all. Maybe Britain will now become more like other countries.

The good news from all this is that the squeeze on real incomes has not been as intense as it appears, hence the fact that spending is rising modestly. The bad news is that the squeeze may not go away even as the recovery gathers strength. Whether that means the recovery lacks legs remains to be seen. At the very least, it cannot rely too heavily on the consumer.

Sunday, September 08, 2013
No more Plan B: Growth kills the fiscal stimulus debate
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 return of growth in Britain means the debate has moved into a new phase. The argument that has, often tediously, dominated over three years - whether or not George Osborne should abandon his deficit-reduction strategy and have a “Plan B” fiscal stimulus - now looks dead and buried.

I shall return to that in a moment, and I will return to the debate about whether Mark Carney’s Bank of England can or should keep interest rates low as the upturn gathers momentum has heated up.

First let me talk about growth. People may not realise how strong recent numbers have been, particularly surveys. The purchasing managers’ index (PMI) showed manufacturing output rising at its fastest since July 1994, and orders at their most rapid since August that year. Britain’s factories “are booming again” said Rob Dobson of Markit, which compiles the data.

The equivalent survey for construction, responsible more than any other sector for reducing growth last year, showed the fastest rise in construction output since September 2007. Construction, lifted initially by housebuilding, appears to be enjoying a broad-based recovery.

You cannot have a modern-day recovery without the service sector playing its part. Fortunately it is. Service sector activity in August rose at its sharpest pace since December 2006, with growth in new business its best for 16 years. It was, according to Markit, “a stellar performance”.

Adding these up gives an economy firing on all cylinders, with construction, manufacturing and services all growing, and at their fastest pace on record, or at least a record going back to 1998, when Markit’s composite PMI was first calculated.

The August surveys, which followed strong July readings, are consistent, say economists, with annual growth of 4% to 5% and a rise of at least 1% in gross domestic product in the third quarter (more than once expected for the whole of 2013), following 0.7% in the second.

Whether or not the Office for National Statistics endorses this, we shall see. Official industrial production and trade figures for July, released on Friday, were a touch disappointing. But the Paris-based Organisation for Economic Co-operation and Development sees 0.9% third quarter growth and and 0.8% in the fourth.

This will be the strongest period of sustained growth since the crisis, and is supported by other evidence. Retail sales and new car registrations are up, the latter for the 18th month in a row. Britain’s exporters have improved their performance and business investment is picking up. The economy has got back its mojo.

Why is it happening, and can it last? The absence of new crises, particularly the eurozone, has boosted business and consumer confidence. What I call the “sod it” factor and others would describe as the delayed effects of exceptionally stimulative monetary policy, is boosting spending. As long as these conditions hold, this stronger recovery will persist.

The effect, as I say, has been to kill the argument for a fiscal U-turn by Osborne. The International Monetary Fund, whose chief economist was among those urging a such a shift, now sees global recovery as being driven by advanced economies such as Britain, echoing last week’s piece.

Its briefing for the Russian G20 meeting, describing what governments should be doing on deficits - sticking to the plan but allowing so-called automatic stabilizers to operate - sums up Britain’s approach.

The argument for a fiscal stimulus in Britain always suffered from serious shortcomings. A country running its largest peacetime budget deficit and teetering on the edge of an extreme fiscal crisis, had little option in practice but to pursue a credible strategy for reducing borrowing.

Not only that, but within that deficit-reduction strategy, government spending has been supportive of recovery. Between the second quarters of 2010 and 2013, government current spending rose by 4.4% in real terms to £88bn (in 2010) prices, significantly faster than the rise in GDP.

Capital spending by government, infrastructure, has fallen but less than most people think. In the second quarter of this year it was £8.4 billion (in 2010 prices), less than £500m below its level three years earlier. The argument that weak growth was due to “the cuts” does not hold water.

One response to the stronger growth now, and you hear this from Ed Balls, the shadow chancellor, is that it barely compensates for three years of “flatlining”
That overstates it. The economy has grown under the coalition, by a little over 1% a year if you exclude the distorting effects of much weaker North Sea oil production, by a little under 1% if you include it. Employment has been strong.

The trouble with fiscal policy to achieve stronger growth than that is that it rarely gets its timing right. Infrastructure spending cannot be switched on and off at will. Had Osborne been persuaded the infrastructure cuts he inherited from Labour were a mistake and should be reversed, we might just be seeing some extra spending coming through now, just when momentum is building without it.

Infrastructure spending is needed. But as Sir John Armitt pointed out last week, echoing the LSE Growth Commission, it is for the long-term, and should be taken out of short-term political decisions by establishing an infrastructure commission. It is not a short-term fiscal fix. Given the experience of government with big projects, it can be a great way of wasting money for limited economic benefit.

The fiscal stimulus crowd will not lie down quietly. Lord Skidelsky, Keynes’s biographer, will no doubt continue to argue what he sees as his master’s case.

But as long as this stronger growth persists, the stimulus crowd will dwindle, leaving just a few like those Japanese soldiers encountered on Pacific islands in the years after 1945, still fighting the last war.

What about stronger growth and forward guidance? Will it not scupper Carney’s hopes of keeping rates low?

This is the wrong way of looking at it. Low rates, and the commitment to keep them low until recovery is well-established, are a means to an end, not an end in themselves If sustained growth is achieved sooner rather than later, and if forward guidance helped, nobody would be happier than the new governor

Sunday, September 01, 2013
Tortoises catch up on emerging-market hares
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.

Much attention is rightly being directed towards Syria and the risk Middle East turmoil poses to the global and British recoveries.

Certainly, the Middle East has taken over from the eurozone as the biggest economic threat. An oil price not far short of $120 a barrel, with predictions it could hit $150, is not what the world needs, particularly when something is happening which should be bringing the oil price down: a sharp slowdown in emerging economies.

It is this slowdown, which has evolved into full-blown currency crises in some countries, notably India, that I want to focus on today, and for good reason.

For years I have been telling anybody who would listen the future lay in the emerging world. A book of mine six years ago, The Dragon and the Elephant, looked at the two emerging-economy giants, China and India and predicted great things for them. Never before had we had two such populous countries, each with well over a billion people, growing so strongly and in tandem.

The emerging-economy story was strengthened by the global financial crisis which most of them sailed through. In 2009, the annus horribilis for advanced economies, which suffered a collective 4% fall in gross domestic product (Britain’s was more than 5%), emerging economies grew. Some, such as China with with 9% growth and India with 7%, almost boomed.

After the crisis, the advanced world seemed destined for two enduring hangovers: the financial hangover that meant their banking systems would need a prolonged period of convalescence and the fiscal hangover requiring tax hikes and spending cuts.

Emerging economies, mostly free of such constraints, were where exporters - and selectively investors - needed to be. The big criticism of Britain’s exporters was that they sold too much to sclerotic Europe and too little to the Brics (Brazil, Russia, India and China). Remember all those stories about Britain exporting more to Ireland than to the Brics? It has not been true for a while but it appeared to be a powerful indictment of British failure.

But now, with the Brics apparently crumbling, were exporters sold a pup? Was all that exhortation to go east, or elsewhere in the emerging world, a cruel trick?

Last year only China, which grew 7.8%, achieved the kind of growth associated with the Brics. Brazil, 0.9%, India, 3.2% and Russia, 3.4%, barely deserved to be members of the club. Emerging economy growth dipped below 5%, before the crisis of plunging stock markets and tumbling currencies this year. One emerging darling, Indonesia, is in a currency crisis. Another, Thailand, is in recession.

Advanced economies, on the other hand, have perked up, including Britain but also the eurozone, America and Japan. On one estimate advanced countries contributed more to global growth in the second quarter than the emerging world, the first time this has happened for years.

The pessimistic case on emerging economies is easily made. It is that they been beneficiaries of two developments made in the advanced world. The first was pre-crisis debt-fulled growth, which provided the demand to pull the emerging world along.

The second was the response of the big central banks to the crisis, particularly the Federal Reserve. The crisis in emerging economies has at least in part been driven by the big financial market event this year, indications from the Fed that it will soon begin “tapering” its asset purchases under quantitative easing.

Some emerging economies had become too dependent on a regular fix of the QE drug. Stephen Roach of Morgan Stanley cites International Monetary Fund research showing cumulative capital inflows to the emerging world of $4 trillion (£2.6 trillion) since 2009.

Add in to the pessimistic mix worries about rising Chinese debt and it is not hard to be concerned. If China falls it would drag other emerging economies with it. There are signs, evident in the trial of the ex political rising star Bo Xilai, the cast-iron grip of the authorities in Beijing has weakened.

So is it time to throw in the towel? No. Most emerging economies have years of strong growth ahead of them, including China. We are seeing an adjustment there from three decades of super-strong strong, averaging 9.5% a year from 1978 to 2008, to a more modest and sustainable rate of around 7%, with the balanced tilted towards domestically-generated growth. Such adjustments are not easy but predictions of Chinese downfall, ever-present since the late 1970s, have been wrong before and are likely to be wrong again.

India may be different. While the dragon can continue roaring, the elephant may be condembed to a lumbering existence, a far cry from the 10% growth its government was targeting not so long ago.

India is in some respects back to the crossroads it faced in 1991, when a chronic current account deficit (it is 5% of GDP now) and a run on the rupee was the wake-up call that led to the country’s successful economic reforms. The wake-up call is being sounded but it is not clear the country’s politicians have the appetite or ability to push through reforms. The prospects for India and her 1.2bn people, soon to grow into the world’s biggest population, are a lot cloudier than they were.

As for the rest of the emerging world. there remain plenty of bright spots, in Asia, central and eastern Europe, sub-Saharan Africa and Latin America. Even at 5% average emerging-world growth, some countries will achieve more than this, and this year that includes the likes of Vietnam, Indonesia ((despite the rupiah crisis), Ghana and Nigeria.

What we have learned, once again, is for these countries it can be a rocky ride. But for emerging economies, as a whole, the ride is far from over. Britain’s exporters should carry on boarding those planes.

Sunday, August 25, 2013
Growth's back - but the deficit's still huge
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 will we know the recovery is genuinely making a difference? A sustained increase in gross domestic product (GDP), taking it above and beyond pre-crisis levels, is one obvious test. A reduction in unemployment, which has remained stuck at about 2.5m in spite of record numbers in work, is another.

Both are very important. For George Osborne and the Treasury, however, one vital measure is the budget deficit.

Growth this year has come through in time to get many of the chancellor’s critics off his back. At the point when the International Monetary Fund appeared ready to join those calling for a major rethink of his fiscal strategy, the economy perked up.

Friday's figures showing an upward revision to growth to 0.7% in the second quarter, with that growth remarkably well balanced between sectors and the different components of expenditure, were very good news.

Osborne will not be off the hook, however, without firm evidence that the deficit is decisively on the way down. So far that evidence is more elusive than it should be.

Recent days brought news of a rare July budget deficit, with public borrowing, adjusted for the various special factors, of £0.5bn, compared with a surplus (a debt repayment) of £0.8bn a year earlier.

We should not make too much of that. Borrowing is the difference between two big numbers. July 2012 was initially reported as a deficit but later revised.

But the trend for the first four months of this fiscal year, April-July, did not suggest a deficit on its way down. Public borrowing so far in 2013-14 is £36.8bn, compared with £35.2bn for the corresponding period of 2012-13.
Growth has returned but it is not, it seems, reflected in the public finances.

In some ways this is a mirror image of the past three years. As the Office for Budget Responsibility (OBR) has noted, public borrowing - like employment - has been better than expected given GDP.

One explanation for that is that the GDP figures will be revised. Another is that the deficit is not as automatically linked to growth as we have come to expect.

In June 2010, at the time of Osborne’s June 2010 emergency budget, the OBR predicted £354bn of borrowing during the coalition’s first three years, partly on the back of a recovery strengthing from 1.2% growth in 2010 to 2.3% in 2011 and 2.8% in 2012.

In the event, the coalition borrowed a little more, £374bn, despite a big growth undershoot. The numbers we have at present for growth over that period are 1.7% for 2010, 1.1% 2011 and just 0.2% 2012.

True, the profile is different from that envisaged by the OBR. 2012-13 borrowing was predicted to be £89bn, rather than the £116.5bn currently estimated. That is likely to be revised, but only an extreme optimist would expect it to get down to £89bn.

So where do we go from here? Is this the recovery that does not get rid of the budget deficit? After all, five years of good growth was enough, alongside austerity, to move Britain from a very large budget deficit, 8% of GDP, to a surplus in the 1990s.

Treasury officials, responding to the latest figures, pointed out that tax revenues are consistent with the growth story, up 3.6% in April-July on a year earlier, against a 3% OBR forecast for the full year.

Some of that, however, is due to top rate taxpayers shifting income into the current tax year, so that it would be taxed at 45% rather than 50%. The explosion of bonuses in April, with some follow-through in May, was no accident.

Overall bonuses in 2012-13 were up by just 1% on the previous year. In April, however, with the new 45% rate in place, bonuses showed a 62% rise on a year earlier, followed by a 22% increase in May.

The Treasury also pointed out that borrowing may have been boosted by the timing of public spending, particularly by grants to local authorities, where there was a greater concentration of spending at the start of the new fiscal year, as well as health, education and overseas aid.

Whitehall’s current expenditure in April-July was £217bn, up 4.3% on a year earlier. That is a strange kind of austerity. For once this was not driven by benefits, up a modest 1.5%, but other spending.

Some of this spending is front-loaded, particularly grants to local authorities. It needs to be. The OBR forecast for full-year current spending, 2.2%, is barely half the rate at which it has risen so far this year.

So what will happen? There is a good chance that borrowing numbers will improve as the year goes on, as last year. Only a few months ago many predicted a borrowing outturn of £135bn or more for 2012-13, well above the £116.5bn outturn.

In theory, the deficit will rise this year if the OBR’s latest forecast is accurate. Its prediction, made in March, was for borrowing of £120bn. I think there is a good chance it will come in quite a bit below that, no more than £110bn, as stronger growth (the OBR expected only 0.6% this year) feeds through to revenues. Some City economists, including Philip Shaw at Investec, agree.

Osborne will be relieved that borrowing remains on a downward track, as it has each year so far he has been at the Traesury. What we are not seeing yet is a decisive reduction in the deficit of the kind we saw in the 1990s. Anything above £100bn for annual public borrowing is still enormous, around 6% of GDP, adding to the £1,193bn stock of public net debt.

There are reasons for that, beyond the fact that growth has yet to gain cruising altitude. Weak pay weighs down on income tax revenues and, via in-work benefits that top up people’s incomes, adds to public spending.

Corporate tax receipts are likely to remain subdued, because multinationals have become more adept at avoiding tax and because the cash cow of the financial sector has turned into a tiny calf.

We should not be too pessimistic, Some of these factors will fade over time. But the numbers confirm what we probably already knew. It is a lot easier acquiring a budget deficit than getting rid of one.

Sunday, August 18, 2013
Carney battles the markets - but no knockout 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.

Mark Carney has been Bank of England governor for just seven weeks but already we have had the first tiff on the monetary policy committee (MPC). His relationship with the markets, meanwhile, is approaching the plate-throwing stage.

The new governor is finding his eight colleagues on the MPC - all men - can be an argumentative bunch. His actions are subject to closer scrutiny in the cauldron of the City of London than when he was setting rates for Canada in gentler Ottawa.

Carney gave the first hint of his new policy of forward guidance on interest rates on July 4, when the MPC issued a statement saying the rise in market interest rates was unwarranted, and not justified by anything the Bank was planning to do.

The bells and whistles version of the new approach, unveiled at Carney’s first inflation report press conference on August 7, gave us the now familiar 7% unemployment threshold, at which point - barring accidents - the MPC will begin contemplating interest rate hikes. On the Bank’s forecasts that will not be until 2016.

That was not the end of the story. A few days ago we had the minutes of the August MPC meeting at which forward guidance was agreed. They showed one member, Martin Weale, unhappy with one whistle associated with the policy: one of the so-called inflation “knockouts”, which will override the 7% unemployment rate.

Instead of a Bank forecast of inflation above 2.5% in 18-24 months’ time, Weale would have preferred a more timely warning of above-target inflation, perhaps a year out. Not only that, but other unnamed MPC members did not think the markets, which are pricing in rate hikes well before 2016, were obviously out of line.

To add to the mix - some say the confusion - other MPC members, presumably ultra-doves Paul Fisher and David Miles, have not given up on quantitative easing. They think the case for adding to the Bank’s £375bn of QE remains “compelling” and may vote for it in the coming months.

All this did not go down too well in the City. Ross Walker of Royal Bank of Scotland said the forward guidance framework was “less robust or cohesive” than expected.

Rob Wood of Berenberg Bank called it “Undermining a policy the Bank of England way”. “Markets are unconvinced over the extent to which the MPC will commit to its forward guidance,” said Investec’s Philip Shaw. Harshest was Nick Beecroft of Saxo Bank, who said: “Forward guidance is hardly worth the paper it is written on.”

The markets, apart from pricing in the first rate hike sooner than 2016, have pushed up the yield on government bonds - 10-year gilts - to their highest since 2011 and a percentage point above where they were in the spring. Both amount to a tightening of policy at a time when the new governor is saying it will stay loose.

So is it all up for Carney’s forward guidance when it has barely begun? Despite saying that this is not the best designed policy in the world I do not think so.

Anybody relying on markets for rate guidance recently would have been caught out badly. From March 2009, when Bank rate was cut to 0.5%, the market default position has been to price in rate hikes. Those expectations never came to pass.

The current situation, in which strong economic data runs up against the Bank’s commitment to keep rates low, is exactly the one which will test the strategy. Carney’s arrival coincided with a sustained burst of activity but I do not think he will mind that. Had his launch of forward guidance come at a time of moribund activity, nobody would have paid much attention.

The battle between markets convinced it will not take much of an economic lift to force a rate hike and a governor saying it will take a lot to do so will be a fascinating one. For forward guidance to work it is a battle he has to win.

Though it is as important for firms and individuals to believe low rates are here to stay, rising market rates affect borrowing costs in the wider economy, so need to be nipped in the bud.

Some of that battle will be settled by the data. If inflation continues to fall, as last week, dropping to 2.8% in July, it will calm talk of higher rates. If the unemployment rate is slow to fall that will do so too.

While there are City economists who think 7% unemployment could be hit quite soon, that looks optimistic.. The Bank says even if 250,000 net new jobs are created a year, 7% will not be achieved until 2016.

Recent experience suggests it could be longer. In the past year a 301,000 rise in employment resulted in only a small drop in the unemployment rate, from 8% to 7.8%. With that kind of progress it could require 1.2m net new jobs, and at least four years, to get down to the threshold.

Only if productivity really has permanently collapsed, and it does not take much growth to get unemployment down, would 7% be reached much faster. In those circumstances, the Bank would be right to worry.

What about the MPC minutes and Weale’s dissent? Two things. The MPC, including Weale, will operate on the basis of the framework adopted 8-1 by the majority. As importantly, the discussion about the inflation “knockouts” shows the Bank has not abandoned its commitment to 2% inflation. That, given some of the initial worries about the new strategy, should be positive for Britain’s monetary policy.

As for rising 10-year gilt yields, the new governor is probably realistic about his ability to influence them. They partly reflect international developments, not least events in America. They also reflect the view that such yields, which have been exceptionally low, have to normalise at some time. I doubt the Bank thinks it can or should try to stop that happening.

The big picture is that the new policy is bedding-in, with some teething troubles, not that it has stalled or failed.

The possibility remains that Carney will only resolve his battle with the markets with actions as well as words. That could involve him joining ultra doves in voting for more QE, which I hope he does not do.

It could mean the Bank contemplating a Bank rate cut from 0.5% to 0.25%, to underline its dovishness, though it will be reluctant to do that for fear of upsetting the operation of the money markets.

More likely will be more words. So far we have only really heard from Carney on forward guidance with no strong sense of how genuinely committed the rest of the MPC is to the new strategy. A few speeches from them could help resolve the market doubts.

Sunday, August 11, 2013
Forward guidance aims to give the recovery time to flower
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

They may not be everybody's cup of tea but it has been my privilege to be present at some big Bank of England announcements.

In May 1997, I was among journalists invited to the Treasury for the announcement of Bank of England independence. Handing interest rate policy from the Treasury to the Bank was momentous.

Last week I was among journalists at the Bank for another momentous announcement, the forward guidance that Mark Carney has persuaded his monetary policy committee (MPC) colleagues to adopt. Not as big as independence but still a big deal.

The contrast with 1997, not to labour it, is interesting. Then, in response to a strongly growing economy, the Bank embarked on a series of interest rate hikes to establish its anti-inflation credibility.

This time, despite evidence recovery is gathering momentum, the Bank’s clear message was that rate hikes are a long way off. Indeed, on present plans the MPC will not even think about them for three years.

I will come on to recovery evidence but that, in a nutshell, is what the Carney-run Bank’s new policy is about. Growth is picking up and the first thing markets do when that happens is price in rate hikes.

The Bank’s clear message is that the recovery will be given time to mature, to achieve “escape velocity” from the doleful influence of the global financial crisis.

Is it the best-designed policy in the world? No. Frankly, it looks as it was designed by committee, which it was. The unemployment rate threshold of 7%, at which point the MPC will start thinking of higher rates, suffers from familiar flaws.

This week will almost certainly see a jobless rise because of the volatility of the monthly numbers. Since mid-2009 nearly 1m more are in jobs, yet the unemployment rate has only edged down from 7.9% to 7.8%. Older workers staying in jobs and inward migration could mean 7% unemployment is further than three years away. In the 1990s the rate only fell below 7% as the Bank hiked rates in summer 1997.

The three “knock-outs”, which could persuade the MPC to raise rates sooner, look like playful sparring. The Bank’s financial policy committee could declare that low rates threaten stability but it, like the MPC, is chaired by Carney and there is membership overlap.

The MPC itself could predict a “knock-out” inflation rate of 2.5% or more but its default position is to forecast 2%, in line with the target. Having seen inflation expectations move around a lot in recent years, the MPC is unlikely to shoot itself in the foot by suddenly concluding expectations were no longer “well-anchored”.

Without the knock-outs, of course, people might have concluded the Bank had given up on inflation. But they cloud the simple message that the Bank will seek to hold rates at 0.5% until recovery is well-established (making this the longest period of unchanged rates since 1939-51).

Will recovery become well-established? Since we had news in April that Britain had avoided a triple-dip recession, followed by the revising away of the earlier double-dip, surveys and numbers have been overwhelmingly stronger than expected.

So 0.3% first quarter growth gave way to 0.6% in the second and, to judge by the surveys, something even stronger in the third. Official figures for manufacturing showed an encouraging jump in June and retail sales showed a healthy rise in July.

The really striking evidence, however, is from the surveys. The July purchasing managers’ surveys showed manufacturing, construction and services all growing, as they did in the official data for second quarter GDP, but more strongly.

The manufacturing purchasing managers’ index showed its strongest growth in 28 months and construction output picked up to its fastest rate since June 2010. Most spectacular of all was the service sector, its July index reading of 60.2 pointing to the fastest increase in business activity since late 2006.

Another survey, the KPMG/Recruitment and Employment Confederation report on jobs, also from the information provider Markit, showed the biggest increase in permanent jobs since March 2010 and the strongest rise in vacancies for six years.

Why is it happening? We are seeing a frequently-made claim of recent years, that Britain could never recover alongside a fiscal tightening, disproved. More on that in coming weeks. Growth was held back by several factors and some are now easing.

So the eurozone appears to be coming out of its second recession in five years, with important implications for British exports and business confidence. The flow of credit to households and businesses, while still weak, is starting to improve.

Even the squeeze on real incomes is easing. The gap between wage growth and inflation is narrowing and individuals are benefiting from the coalition’s increases in the personal tax allowance. Consumer and business confidence has risen, a necessary precondition for stronger growth.

Does it matter what kind of recovery we have? Yes, but in the early stages beggars cannot be choosers. There is a lot of nonsense talked about lack of rebalancing - the trade deficit in the first half was down by a third on a year earlier - and even more about housing market bubbles.

After three years in which everybody has bemoaned lack of demand in the economy now some worry that - horror of horrors - some of it is coming from consumers. The bald fact is that if you do not have a recovery in consumer spending, two-thirds of GDP, you do not have a recovery. I believe the Bank when it says stronger investment will follow, and an apparent downward lurch in the saving ratio in the first quarter reflected distortions that will be reversed in the second.

None of this has much to do, yet, with forward guidance, but by heading off talk of higher rates, even when growth rises above 2.7% (on Bank forecasts) in the early part of next year, it will nurture recovery.

If growth accelerated much more than this, even if unemployment stays high, the Bank has to be alert. Forward guidance is just that. In an uncertain world the path of interest rates can never be set in stone. And a rise in rates can be good news, showing the economy is strong enough to take it.

Inflation also still matters and any repeat of the experience of recent years, when on two separate occasions it has breached 5%, would be fatal for the credibility of the new policy.

The oldest cliche about monetary policy is that central bankers have to be ready to take away the punchbowl just as the party gets going. Carney intends to leave that punchbowl in place for some time. At some stage he will have to take it away. Judging when to do that will be the hard part.

Sunday, July 28, 2013
Three cheers for dull 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.

At one time when you would struggle to get a 0.6% rise in gross domestic product to lead the business pages, let alone every news bulletin. A 0.6% GDP rise, which we had in the second quarter, is pretty dull.

These days, however, dullness is good. After the excitement of recent years, including quarters when the Office for National Statistics shocked with a figure nobody expected, it was nice not to be surprised.

Quarterly changes in GDP in recent years have ranged from plus 1.3% (the second quarter of 2007) - a modest boom - to minus 2.5% (the first quarter of 2009), a spectacular bust. So 0.6% was a steady, safe number, neither breaking the speed limit nor driving so slowly as to be dangerous.

Indeed, if you could be assured of 0.6% growth, each quarter, for the next few years, most policymakers, I suspect, would grab it with both hands.

It would mean the hole in the economy left by the crisis was mainly permanent; by now in normal circumstances we would expect to be 13% above early 2008, not 3.3% below. But it would also mean our ability to grow had not been damaged for good.

Growth of 0.6% a quarter, roughly 2.5% a year, is close to what most economists would think of as the trend, or normal, long-run growth rate. It is a lot better than the Japanese “lost decade” rate of closer to 1% Britain has been achieving, on currently-available data, since the economy turned up in the middle of 2009.

Perhaps it was because 0.6% was in line with expectations it sparked a frenzy of navel-gazing about the kind of growth being achieved. This is the charge that the authorities failed to rebalance the economy away from debt and consumer spending and towards exports and investment. Though it was predictable the debate would shift from the lack of growth to the composition of it, I still get a little irritated by it.

This is not, remotely, a recovery led by consumer spending or household debt. Household debt has fallen in relation to annual household income, from just under 170% to just over 140%. We have the slowest consumer recovery of modern times, with spending still 3% below pre-crisis levels

The performance of exports and investment is indeed disappointing. But the Bank of England and Treasury were happy to preside over a huge fall in the pound to stimulate exports. The fact exporters have not responded as well as hoped (or when they have importers have responded in kind) reflects longstanding structural weaknesses and the time it takes to switch to the faster-growing parts of the world.

As for investment, the government has done its bit to make Britain a more attractive location for inward investment, at a time of huge strains on the public finances, by cutting corporation tax. By 2015 the rate will be 20%. When Nigel (Lord) Lawson cut corporation tax in the 1980s, it led to an investment boom. This time businesses have preferred to hold on to their cash.

Governmments and central banks can provide the incentives but cannot make the private sector do things it is unwilling to do. To judge from some commentary, you would think these things were in the gift of the authorities. But we do not live in a centrally-planned economy. All policymakers can do is lead the horse to water.

Nor would a recovery driven by even more government spending do anything for the cause of rebalancing, in fact the opposite. I have said many times the government got the mix wrong between current and capital (infrastructure) spending - the latter cut harder than it should have been. That is now water under the bridge.

The question is where we go from here. Can we maintain a 0.6% quarterly growth rate, and can we hope for better from exports and investment?

Recent surveys, including a strong CBI manufacturing survey, the regular purchasing managers’ surveys for services, manufacturing and construction, and others for property, housing and retail point to momentum in the third quarter.

The anecdotal evidence I pick up, from readers and others, also suggests more confidence in recovery than for some time. The “sod it” factor I mentioned a couple of weeks ago - we can’t carry on doing nothing - may be kicking in.

There are also more tangible reasons for cautious optimism. Nobody pretends that the eurozone’s problems are solved. Currently it is Portugal, who knows who next of the eurozone’s 17 members will be casting doubts on the ability of the single currency to ride out the crisis?

But fear of imminent collapse has faded, a year after Mario Draghi, the European Central Bank president, pledged to do whatever was necessary to preserve the system.

Perhaps as significant as Britain’s growth figure, there are indications, after six successive quarterly declines, the eurozone is returning to growth. Its composite purchasing managers’ index jumped to 50.4 in July, from 48.7 in June. Levels above 50 are consistent with growth. The European Commission says consumer confidence is at its highest since August 2011.

What happens in the eurozone is important. Uncertainties there have undoubtedly been a factor holding back investment and weak demand from Europe has stood in the way of a rebalancing of the economy towards exports. One reason America has enjoyed a better recovery than Britain (though weak by its standards) is it does not have the drag of Europe on its doorstep.

There are other reasons for hope. The squeeze on real incomes is easing, as earnings growth edges up and inflation heads bumpily lower. By next year, real wages may be rising. The money supply, for so long apparently immune to the Bank of England’s ultra-loose policy, is growing. Simon Ward, chief economist at Henderson Global Investors, says this is the key factor in the recent stronger performance.

So there are reasons to take heart, for believing that the second quarter’s 0.6% growth was no flash in the pan. We don’t like flashiness when it comes to growth. Dullness is a virtue. Let us have more of it.

Sunday, July 21, 2013
What else is in the Bank's box of tricks?
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 early days but the Carney effect is already discernible at the Bank. Mark Carney, the new governor, took over three weeks ago today and has made a difference. The question is what else is in his box of tricks.

The first difference was the release of of a statement, after the first meeting of the monetary policy committee he chaired, on July 3-4, to hose down market interest rate expectations.

The markets had begun to discount a rise in Bank rate in less than two years’ time, in contrast to the position weeks earlier, when no hike was seen before late 2016. Nudged by its new governor, the MPC said this change of view was unwarranted.

The second change, which occurred at that same meeting but was not revealed until the publication of the minutes last week, was that the MPC, which had been split on the issue of quantitative easing since November, voted unanimously for unchanged policy this month.

Last month three of its number, David Miles, a long term enthusiast for QE; Paul Fisher and Sir Mervyn King, the former governor, wanted more asset purchases. This time, with King enjoying his retirement, the other two withdrew their call for more QE.

The new governor brought harmony where there was discord, to paraphrase Margaret Thatcher’s famous St. Francis of Assisi quote. His first meeting saw a 9-0 vote for no more QE - £375bn is the total so far - and no change in Bank rate, 0.5%. Neither he nor anybody else was outvoted.

Interesting though these developments were, they represented the appetisers to next month’s main course, to be unveiled on August 7. While many will be enjoying the beach, the Bank under its new governor will set the tone and parameters for Britain’s monetary policy over the next few years.

Does it mean we have seen the last of QE? Though I would not mourn its passing it is too early to conclude, as some have done, that there will be no more. The International Monetary Fund, in a comprehensive report on the British economy, its so-called Article IV consultation report, said the Bank should consider more QE, alongside other policies.

Even the minutes of the 9-0 vote left the door ajar for more QE, with those who had previously been enthusiastic agreeing that “an expansion of the asset purchase programme remained one means of injecting stimulus, but the committee would be investigating other options during the month, and it was therefore sensible not to initiate an expansion at this meeting”.

Having said that, QE will not be the focus next month. It will be the policy most associated with the new governor, forward guidance on interest rates.

In the March budget, having talked to Carney, George Osborne updated the Bank’s remit to make clear, as he put it, that the MPC “may wish to issue explicit forward guidance, including using intermediate thresholds in order to influence expectations on the future path of interest rates”.

There is a danger, in the language used by the chancellor, and talk of intermediate thresholds and “state-contingent” forward guidance, of complicating a very simple idea. That idea is that interest rates will not be raised until certain conditions are met, and the Bank is working on its formulation for what those conditions should be.

It could be the unemployment rate, the measure used by the Federal Reserve. The US unemployment rate is currently 7.6% and the Fed is looking for 6.5% before it tapers its QE programme (its additional asset purchases) to zero.

Britain’s unemployment rate is 7.8% and, according to the Office for Budget responsibility’s latest forecast, will be 6.9% as late as 2017, implying on a 6.5% rule no increase in interest rates before then.

An intermediate unemployment threshold is not perfect - you can have strong economic growth which is not reflected in a drop in unemployment if the workforce is expanding - but is likely to be part of next month’s guidance.

Other variables are being examined, including the “output gap”, the amount of spare capacity in the economy, which is hard to measure. Above-trend growth, and the number of quarters it is achieved (if and when), and the level of “money” GDP merit consideration.

I suspect, however, the Bank will want to keep it simple, finding the most straightforward way of conveying the message that rates will be kept low until such time as growth is properly established, as measured by unemployment. There will be caveats: an exchange-rate crisis or domestically-generated inflation surge could force the MPC to override its guidance. But that will be the aim.

Will forward guidance work? It is important to recognise that not doing something can still provide a stimulus. So even if there were to be no more QE, the £375bn already done, which will not be unwound until well after interest rates have risen, is still providing a monetary boost.

Similarly, and perhaps more obviously, not raising interest rates, or holding them down beyond the point firms and individuals might have expected them to rise, should stimulate some growth.

It will not be a panacea. The victims of low rates, savers and particularly pensioners, will shout even louder about the iniquities of indefinitely low rates. It will not prevent, say, 10-year bond yields from rising if, led by stronger US data, that is where markets want to take them.

The IMF, in its assessment, said forward guidance is unlikely “by itself” to instigate recovery, citing the need to boost the supply of credit. With the latest figures from the Bank showing a continued drop in len ding to small and medium-sized firms, even with the Funding for Lending scheme in place, it is a point well made.

Though this week’s figures should show growth picking up significantly in the second quarter - the Bank expects 0.6% - there is a long way to go. Forward guidance is definitely worth trying. But that box of tricks may have to be raided again.

Sunday, July 14, 2013
Exports becalmed on a sea of disappointment
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 no other way to describe Britain’s trade performance than as becalmed. Exports, which were supposed to drive Britain’s recovery, have mainly stayed at home. The question is whether they will continue to do so.

According to figures released a few days ago by the Office for National Statistics, Britain had a trade deficit in goods and services of £2.4bn in May, split between an £8.5bn deficit on goods and the traditional surplus on services, in this case £6.1bn.

If you were looking for progress on Britain’s external trade, you would not find it in these figures. A year earlier, in May 2012, the overall deficit was smaller, £2.1bn.

Looking for a trend in these numbers, in either direction, probably does not make sense. The trade deficit is flat, stuck or, as I say, becalmed. Rather than making the hoped-for big contribution to growth, net trade - exports minus imports - has effectively done nothing to boost the economy.

The only year it did, 2011, it added 1.2 percentage points to growth, the effect previous experience suggested was achievable over a sustained period. But 2011 was bookended by 2010, when net trade subtracted 0.5 percentage points from growth, and 2012, when it did so by 0.6 points.

This does not mean there has been no growth in exports since the low point of the recession in mid-2009. Exports of goods and services in volume terms are up by 13.3%. But imports, which are of course bigger, are up by 10.2%.

Exports are fractionally below their pre-crisis peak, recorded in the second quarter of 2008, though to be fair imports are down rather more. To the extent there has been any rebalancing, that is the extent of it.

Nor have things gathered momentum as the recovery has progressed. On a slightly different measure, the value of trade, the ONS notes “the value of both exports and imports has remained flat since mid-2011”.

The big picture is that in an age of instability, Britain’s trade deficit has been remarkably stable. Pencil in between £23bn and £24bn for the quarterly deficit in goods trade and you will not be far wrong.

Since the beginning of 2007, the quarterly goods deficit has moved within a narrow, £19.6bn to £27.8bn range, and between 5.6% and 7.2% of gross domestic product. The earth has moved but the trade deficit has not.

Were we wrong to expect export-led growth on the back of sterling’s sharp fall in 2007-8? The pound’s average value fell by nearly 30% between the middle of 2007 and the end of 2008 and remains roughly 25% below pre-crisis levels.

The template was the performance of exports after the rather smaller sterling devaluation when sterling plunged out of the European exchange rate mechanism in September 1992. Over the following four years, a sterling fall which reached a maximum of 17%, was enough to drive a 37% rise in the volume of exports.

Conditions have been different this time, of course. All advanced economies, which comprise most of Britain’s export trade, have been struggling to shake off the effects of the crisis and are experiencing slow growth.

For a time there was a clear distinction between Britain’s exports to the European Union, which were falling by roughly 10% a year, and the rest of the world, where they were rising at a similar rate.

That gap has narrowed. Over the latest 12 months, exports to the EU, in value terms, are down 1.1%, while non-EU exports are up a modest 2.6%. There are some bright spots within that; exports to China are up 18% and those to Japan by 8%. But there are not enough of them.

Weak growth in markets is one thing, though the Bank of England noted in its last inflation report that Britain’s share of world trade has also been declining.

What ails exporters? I go to a lot of meetings at which, with the encouragement of UK Trade & Investment (UKTI), the official body, exporters are urged to step up their efforts and given official help to do so.

There is no lack of enthusiasm, among companies large and small. Exploiting export markets, particularly new ones, is not an easy business, however. It requires investment, something credit-constrained smaller firms, in particular, are cautious about committing to. It involves taking risks. which risk-averse businesses are keen to avoid.

It also requires, for Britain’s economy, a significant change of emphasis. After the post-ERM export boost of the 1990s, Britain settled down to growth driven by domestic demand. Between 1998 and 2007 net trade substracted an annual average of 0.1 percentage points from growth.

Firms got out of the exporting habit and, in recent years when they needed to, have not priced to compete in overseas markets, despite the advantages of a low pound. Enthusiasm for exporting is not enough.

Can things change? Recent surveys have been positive on exports, including the British Chambers of Commerce quarterly survey which suggested service sector exports are at their best in the survey’s 24-year history.

The Ernst & Young Item Club, in a report to be published this week, suggests a 4.6% increase in export volumes next year, after a modest 1.2% this year.

“There are hopeful signs for the world economy, which will lead to a pick-up in demand from the UK’s key export markets,” says Peter Spencer, its chief economic adviser. “The US has successfully negotiated the fiscal cliff, the Chinese economy is beginning to rebalance away from investment to consumption, and there is also a move towards pro-growth policies in the Eurozone. If managed successfully these factors could be a real boon for UK exporters.”

Let us hope so. So far, however, waiting for export-led growth has been a triumph of hope over recent experience. It could stay that way.

Sunday, July 07, 2013
Carney tries to ensure lift-off won't be aborted by 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.

Two related events dominate the discussion this week. The first is the growing evidence that Britain’s recovery is strengthening. The second was the signal from the new Mark Carney-run Bank of England that stronger growth does not mean early interest rate rises.

There will be time a-plenty to analyse the Carney approach next month, when the new Bank governor sets out his approach to so-called forward guidance on interest rates. There may even be, though I hope not, more quantitative easing.

He has, however, already made an impact, the monetary policy committee’s statement that the recent rise in market interest rates was unwarranted sent the pound down sharply. This will help exporters, which is good, but push up inflation, which is bad.

Anybody who had doubts that Carney intends to give the recovery plenty of time to breathe, which was why George Osborne was so keen to appoint him, should have shed them at noon on Thursday. This is a governor who does not intend fears of higher rates to take hold for a long time.

When people at the Bank asked me about the value of forward guidance on rates - at a time a few weeks ago when nobody was giving any thought to rate hikes - I said it would be when stronger numbers were starting to make the markets think about higher rates.

So it proved to be and the explicit message from the Bank was that it will take a lot more such stronger data, sustained over a very long period to make the MPC raise rates. I would be surprised to see a rate hike over the next 2-3 years.

But what about that recovery evidence? What is it and is it likely to last? It has come with the monthly purchasing managers’ indices, which measure business to business activity, all of which have recently beaten expectations.

So the June manufacturing PMI rose from 51.5 to 52.5, construction was up from 50.8 to 51 and, most impressive of all, that for services rose from 54.9 to 56.9, a 27-month high. Chirs Williamson of Markit, which produces the data, says the PMIs are consistent with growth of at least 0.5% in the second quarter “with more growth to come”. The economy, in other words, has acquired a lot of momentum.

Alongside the PMIs the British Chambers of Commerce, in its quarterly survey, showed rising business confidence and increases in most of the key measures it monitors, for employment, orders and, in the case of manufacturers, investment.

Service sector exports rose to their best since the survey began in 1989, while export orders were at their strongest since 1994, when Britain was enjoying an export-led recovery.

Perhaps most encouraging was the rise in confidence. Confidence among manufacturers that turnover will improve rose seven points to +51%, while confidence in profitability rose six to 39%. Among service-sector firms the figure for turnover was up six to 46% and on profitability up 12 to 34%.

This is potentially very important. Everybody has heard the expression “animal spirits” and everybody also knows they have been depressed. Businesses need to have confidence to invest, and for the past few years it has been a case of one thing after another giving them reason not to. If that is changing it is a very welcome sign.

The same is true of consumers. Consumer confidence is depressed compared with “normal”, as in pre-crisis levels, but it is definitely on the up. Mostly, according to the GkK-NOP measure, it is because people are more optimistic about the wider economy. The pick-up in housing activity and prices is both a symptom and a case of greater consumer confidence.

The question is why the data and confidence measures are looking much better when, on the face of it, nothing has changed. All the factors apparently holding back recovery are still with us.

So George Osborne has not abandoned fiscal consolidation, and indeed has just announced £11.5bn of new cuts for 2015-16.

The squeeze on real wages continues, with inflation close to 3% and earnings growth roughly 1%. Eurozone surveys have been looking better but not by enough to prevent a seventh successive quarterly drop in gross domestic product in the April-June period. Bank lending to small and medium-sized firms continues to fall.

There are three possible reasons why things are looking up. The first is the absence of new shocks. After the big one in 2008-9, the subsequent period has been interspersed with worries about imminent collapse, particularly in the eurozone. Those fears have faded, largely thanks to the European Central Bank.

The second possibility is that the long years of very easy monetary policy - Bank rate has been 0.5% since March 2009 - are along with new measures to stimulate lending, particularly for housing, starting to have an effect. The lags in monetary policy are notoriously long I have used the analogy of trying to start a damp bonfire with copious amounts of petrol. Maybe this time the fire is finally getting going.

The third is what I would indelicately call the “sod it” factor. People and businesses have hung on for long enough, maybe expecting rates to rise, perhaps waiting for clearer signals that it was the right time to spend than they were ever going to get. At least some of them are now deciding to do it anyway.

You see it in new car registrations, particularly to private buyers, which in June were up by 21.3% on a year earlier, within a rise of 13.4% for the overall market. In the first half of this year private buyers have bought over 80,000 more new cars than they did in the corresponding period of last year, a rise of 17.1%. We may yet see the sod it factor reflected in stronger business investment as the year progresses.

Can the stronger upturn last? The better news means a second wave of revisions to growth forecasts. The first wave came after the better than expected 0.3% rise in GDP in the first quarter. The prospects of an even better number in the second quarter means forecasts are being torn up again.

So J.P.Morgan has revised this year’s growth forecast up from 1.2% to 1.6% and next year’s from 2% to 2.6%. That, if achieved, would be the best since 2007. Forecasters have been wrong before during this recovery, of course, but upward revisions make a welcome contrast with the relentless tide of downgrades of recent years.

There are plenty of risks. Events in Portugal remind us that the eurozone crisis is far from over. The military overthrow of the Egyptian government produced an unwelcome rise in oil prices. We are not yet out of the woods. Maybe, however, the path is getting a bit clearer.

Sunday, June 30, 2013
Osborne's slow march to a smaller 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.

Gathered in a single room were several former chancellors, as well as the current one and his shadow, the only surviving former Bank of England governor, and very many current and former Bank and Treasury officials, including most who have served on the monetary policy committee.

The occasion, of course, was Sir Mervyn King’s retirement, and if you wanted to put together a collection of people who have tried to manage the ups and downs of Britain’s economy over the past three decades, last week’s would be hard to beat, though Gordon Brown, surely invited, would have been a useful addition.

I feel I have lived with these people during the rollercoaster ride. We have held hands, though usually not literally, during the scarier moments. All the economic expertise assembled in that room would, however, struggle to explain fully the economy now.

New gross domestic product figures from the Office for National Statistics have deepened the puzzle. They showed the double-dip recession of late 2011 and early 2012 was revised away, as long predicted here. The bigger story, however, was that as things stand the economy is even further below pre-crisis levels of GDP than we thought.

The ONS now believes, thanks to what it regards as more accurate corporate data, the economy’s plunge off the cliff in late 2008 and early 2009 was even more dramatic than it seemed at the time.

So GDP fell by 7.2% from peak to trough (compared with the 6.3% previously estimated), and in the first quarter was 3.9% below its level in the first quarter of 2008, compared with the previous estimate of 2.6%.

Think about that 3.9% for a moment. Let us round it to 4%. The five years of deep recession and modest recovery from the first quarter of 2008 to the first quarter of 2013 have left the economy 4% smaller than it was. Though its composition has changed, employment is up by nearly 1% over the same period, hence the sharp drop in productivity: output per worker.

Had the economy grown in line with its 3.2% average in the 10 years before the crisis, it would now be 17% bigger than it was in early 2008. Had it grown at a more modest 2% rate, it would be over 10% bigger. It did not, and the gap between what might have been and what is - equivalent to as much of a fifth of GDP or more than £300bn - is enormous.

We are where we are, or at least until the next big set of ONS revisions, so what does it tell us? The people gatrhered in that room have seen pretty well all variations of economic policy. The current mix of very loose monetary policy and tight fiscal policy is not unprecedented, but the extent of it, on the monetary side at least, is.

George Osborne’s spending round did not contain anything that will affect the short-term economic outlook. It confirmed, however, that the road back to fiscal health is a long and difficult one.

The spending round, with its additional £11.5bn of cuts, covered only the 2015-16 fiscal year. Even that year, when public spending is set at £745bn, it will be the equivalent of 43.1% of GDP. The 40% of GDP target that any Tory chancellor would normally regard as the maximum acceptable level of spending, will not even be achieved, on present plans, by 2017-18, when the level will be equivalent to 40.5% of GDP.

By then, even on these figures (which will surely change), a decade of austerity will have only got us back to where public spending was in 2007-8, the eve of the crisis, 40.7% of GDP. For 10 years, Britain will have been spending more than, on any reasonable estimate of the tax base, the country can afford, hence the big rise in public sector debt. Some of that spending has been hard to avoid, but it is still a sobering thought.

How sobering is it? There were three things in Osborne’s statement that could make a difference over the long run: the annual cap on welfare spending, from April 2015, to be policed by the Office for Budget Responsibility; the merging of health and long-term care and the ending of automatic, so-called progression payments in the public sector.

Each of these provides the opportunity, in the next parliament rather than this one, to exercise proper long run control of spending, in the way that countries like Canada have done but Britain has so far failed to manage. The weakness of the welfare cap is that it excludes most pensioner benefits, but it still leaves the possibility that the failure in this parliament to make serious inroads into the overall level of spending will not be repeated in the next one.

There is another consequence of the latest decisions. They mean the government is already well on the way to achieving a smaller state in the non-ringfenced areas of spending: most departmental spending excluding health, schools and overseas aid. If a combination of stronger growth and the new welfare cap were to mean that this huge element of spending is controlled or cut, it is possible that Britain’s public finances could look healthy in a few years’ time, with a smaller and more affordable state and borrowing under control. There are a lot of “ifs” in that but it is something to hope for.

What about that loose monetary policy? Should it, under the new Bank governor Mark Carney, be even looser. Some City economists have seized on the new GDP figures as evidence that there is more room for the Bank to act with additional quantitative easing (QE) than was thought.

After all, an economy languishing 4% below pre-crisis levels has an enormous amount of catching-up to do, and a lot of spare capacity. The output gap, a measure of that capacity, is bigger than we thought.

Tie that to the fact that in the past three months, the yield on 10-year gilts (UK government months) has risen from 1.7% to roughly 2.4% - and the one proven effect of QE is to get those yields down. You could make the case, on these two factors, for restarting the QE programme this week.

It is possible but it would make me very uneasy. The ONS revisions represent a change in our view of economic history, not the pace of the current recovery, which is unaffected. A monetary policy change driven by a revised view of what happened 4-5 years ago would be odd, and we are many years away from the last official word on what is happening now.

As for the rise in gilt yields, I repeat what I said last week. That rise is due to the markets’ reaction to Ben Bernanke’s very broad hints that the Federal Reserve will taper its asset purchases in the coming months. Bond yields have to normalise at some stage. As long as it does not get out of hand, that process should be encouraged, not artificially halted.

Sunday, June 23, 2013
Bernanke adds to Mark Carney's challenges
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 Sir Mervyn (soon to be Lord) King took over as Bank of England governor 10 years ago, inflation was below target, the economy was more than a decade into a prolonged upturn and the banking crisis was not even a twinkle in anybody’s eye.

Today, as he hands over to Mark Carney, things are rather different. On July 1 2003, the latest published reading for consumer price inflation was 1.3% and, while the official target at the time was specified differently, inflation had not been above the current 2% benchmark in over six years.

Now, inflation is 2.7% and has not been at or below the 2% target since autumn 2009. Indeed, for 81 of the past 96 months it has been above target.

2003, with hindsight, was a year of very strong growth for the economy, 3.8%, though the Bank’s monetary policy committee still felt concerned enough to vote for a reduction in interest rates to the then daringly low level of 3.5% at King’s first meeting as governor in July 2003.

Now, while forecasts for growth this year are creeping higher, the consensus is only for 0.9% this year, even though Bank rate has been at the record low level of 0.5% for more than four years.

Worries about the banking system did not trouble King in his first four years or so. Up to the outbreak of the crisis in the summer of 2007, his publicly expressed view was that British banks were sound, and perfectly capable of weathering storms arising from bad US subprime loans.

Now, the banking system is still being repaired, with banks required by the new Prudential Regulation Authority (part of the Bank) to raise another £27bn of capital. The outgoing governor insisted in his final Mansion House speech on Wednesday that this will enhance their ability to lend.

The banks see it differently and, while mortgage lending is picking up - in May gross lending was at its strongest since the autumn of 2008 - business lending and overall credit growth remains very weak.

I am not suggesting these changes can all be laid at King’s door, or that he is handing over a poisoned chalice to his successor. The picture looks better than a year ago and, indeed, considerably better than the 2-3 years before that. When he took over in 2003 he was in some respects inheriting from himself, having been deputy governor and before that chief economist.

Even so, Carney faces some serious challenges and he has given himself only half the time; five years compared with the 10 years in office that has been the norm for recent governors. He is a man in a hurry.

The first challenge is the issue of the moment, quantitative easing (QE), or central bank asset purchases. Ben Bernanke, the Federal Reserve chairman, has ably demonstrated the markets’ addiction to QE by indicating when the Fed will reduce, or taper, its current $85bn (£54bn) of monthly asset purchases. He suggests the tapering will begin later this year and that QE will stop altogether by the middle of next year.

The turmoil this timeline has generated could, if it impacts adversely on economic activity, force the Fed into keeping QE going. In the meantime, however, it creates a dilemma for the new governor.

Though growth has a long way to go before it is anything like normal (and normal now is nothing like what the economy achieved in 2003), it has been picking up. Retail sales jumped 2.1% in May and purchasing managers’ surveys and other evidence point to stronger growth in the second quarter than the 0.3% rise in gross domestic product in the first. Official figures this week may nudge up some of Britain’s growth history.

Signs of stronger growth can be taken together with the fact that inflation rose from 2.4% to 2.7% last month, and seems certain to go higher when this month’s figures are released in July (the new governor would be forced into a letter to the chancellor if it goes to 3.1% or more). This should be enough to kill talk of an early resumption of the Bank’s £375bn QE programme.

When you add the fact that the Fed is starting to think about its exit strategy, it would be odd for the Bank to contemplate doing the opposite. The only argument for doing so, the rise in gilt yields (the interest rate on UK government bonds) that has resulted from the Fed’s exit talk, is surely no reason at all. It would be a bizarre world if one central bank felt obliged to ease policy in response to another’s attempt to begin the process of tightening.

Carney’s task, surely, should be to work with other central banks to find a painless way - if there is one - of weaning the markets off this extraordinary support.

His second challenge is to come up with policy that makes a difference. Here, the buzz-phrase is explicit forward guidance. A Carney-led MPC might say Bank rate will stay at 0.5% until the unemployment rate has fallen below, say, 6.5% from 7.8% now - similar to earlier Bernanke guidance on QE. Or it might say that there will be no change in rates until GDP - in either real or money terms - has reached a certain level. The new governor is known to favour this kind of forward guidance.

It is not, however, as straightforward as it sounds. Unlike the Bank of Canada, where the governor makes the final decisions on monetary policy, the nine-member, one person-one vote MPC is democratic. Carney no doubt knew this when he took the job, but that was before King was outvoted in each of his last five meetings. The culture shock could be considerable.

Even if he can get the rest of the MPC to agree on forward guidance, it may not be particularly effective, as Russell Jones, an economist with Llewellyn Consulting, points out. If the markets sense the Bank will not necessarily stick to its pledges, perhaps because future MPC members will not feel obliged to abide by them, they will see through them. “If a central bank lacks credibility, it is effectively powerless,” he says.

The third challenge is the biggest of all. Britain, for a time at least, was an economy that could grow by 3% a year alongside sub-2% inflation. Now it is a sub-2% growth economy alongside 3% inflation. The trade-off has worsened significantly.

The longer inflation persists at near-3% rates, the more firms, households and markets will believe the 2% target is a fiction. Carney’s biggest task in his five years will be to return to Britain to lower inflation and higher growth. It is not clear whether he as the tools, or the scope, to do so.

Sunday, June 16, 2013
Don't write off Britain's productivity 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.

The news on pay and productivity has been bleak. Britain, it seems, has become a lower-paid, faling-productivity economy, a land of squeezed incomes, low investment and declining ambition.

For those tempted to switch off now, stay with me for a while. Let me start some of those gloomy numbers. The Institute for Fiscal Studies (IFS), in a series of studies, reported that real wages at the end of last year were 6% lower than on the eve of the recession in early 2008.

Real wages have fallen more over the past five years than in any comparable period, the IFS noted, with large numbers of workers subject to pay freezes (at a time of rising prices) and cuts.

Nor, according to another IFS analysis, have households been making up this wage squeeze elsewhere. Depending on which measure of inflation you use, but based on official Department of Work and Pensions data, it demonstrated that median real incomes dropped by between 4% and 6% between 2009-10 and 2011-12.

The IFS was not the only organisation to highlight what has been happening to pay. The Trades Union Congress reported that total pay in 2012 was £52bn lower, in 2012 prices, than in 2007, a 7.5% fall. In some regions, according to the TUC, the fall was close to or in some cases exceeded 10%: worst hit were the north-west, the wesd midland, the south-west and Scotland.

This is, of course, very unusual, “unprecedented” according to the IFS. The forces of supply and demand are conspiring to keep wages down. Though a record number of people are in work, nearly 30m, demand is barely keeping up with supply, so unemployment remains close to 2.5m.

That supply is partly the result of immigration but mainly a consequence of the fact that many older workers are no longer retiring gracefully (a record 1m over-65s workers are in employment). Also, partly as a result of government policy, many more single parents have stayed in the labour market.

It is also the case that declining union representation has made it easier for employers to freeze or reduce wages. Had the unions retained their power base and influence of, say, the 1960s, there would have been less of a fall in real wages for those who stayed in work, though almost certainly at the price of much higher unemployment. Fact 1, however, is that we have seen a big drop in real wages.

Fact 2 is that alongside that there has been a big fall in productivity. The latest official figures show that output per hour, across the whole economy, is still below its level in 2009, the recession’s low point. Output per worker and output per job are up, but only fractionally.

This, so far, is the recovery lacking productivity growth. Output per hour worked is more than 4% below its pre-crisis peak, a break with the past. As Paul Johnson, director of the IFS, noted: “The difference is remarkable. Output per hour worked started rising at a healthy pace very soon after the start of each of the last two recessions and within five years of the start of the recession had reached a level 15% above its starting point.”

All very gloomy. How can I possibly extract anything even remotely optimistic from all that? It is difficult but when it comes to pay - average earnings - it is clear that recently at least there have been some distorting factors at work.

Earnings growth has been particularly subdued for most of the past year but at least some of that, and I would not want to overstate it, has been the result of higher earners avoiding the 50% top rate of tax.

So private sector total earnings in March were down by 0.9% on a year earlier, while in April they were up 4.2%. That jump was driven by an explosion on bonus pay in April, up 47.5% in the private sector on a year earlier, and including sectors such as construction and manufacturing as well as financial services. Even the public sector joined in: its bonus payments in April were 32% up on a year earlier.

A bigger reason for hope is on productivity. Have we turned ionto a low-productivity economy in which low, or even falling real wages are fully justified? I do not think so.

The most interesting bit of IFS research, for me, was on this point. It showed that productivity and wages have held up relatively well in large firms but fallen among medium-sized businesses, those with 50-249 employees, and even more for small firms, with fewer than 50 workers.

Why have productivity and wages fallen among smaller firms? They have been credit-constrained, so have not been able to invest in productivity-enhancing equipment. They have been able to call on their workers to make pay sacrifices, without falling foul of the unions; most smaller firms are non-unionised and not subject to national pay agreements. And they have been keener to hold on to staff even in a time of subdued growth, because of the cost of recruiting and retraining.

But the IFS found that these firms are not instrinsically low-productivity businesses. Most had good rates of productivity before the crisis, suggesting that productivity can and will bounce back as the recovery gathers pace. We should not write it off yet.

That is my view and it is also the view of the CityUK’s independent economist group, chaired by the former monetary policy committee member Andrew Sentance. One of the biggest falls in productivity has been in financial services.

It thinks that this, along with the wider weakness of productivity, is more likely to be cyclical and thus temporary, rather than structural and therefore permanent. Solving the productivity puzzle will take time, But solved it will be and with a return to more normal rates of productivity growth. Let us hope so anyway.

Sunday, June 09, 2013
Still no money left, so the squeeze 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.

I once had a long and exasperating discussion with Gordon Brown. The former chancellor and prime minister could not be shifted from his view that the economy Labour inherited in 1997 was in a terrible state.

I and others present pointed out that an economy in its sixth year of robust recovery, with inflation low, unemployment falling, the budget deficit dropping and the current account of the balance of payments nearly in the black, was in remarkably good shape.

Most oppositions would not get anywhere near inheriting such an economy but the capacity of the Tories for self-destruction had presented Labour with a gift. But he would not budge.

Old habits die hard and Ed Balls clearly learned much at the feet of his old master. In setting out Labour’s plan to abolish the winter fuel allowance for better-off pensioners - saving a tiny £100m (0.05%) from a welfare budget of over £200bn - the shadow chancellor bemoaned the “bleak inheritance” Labour could expect in 2015.

Now it is clear that the economy in 2015 will not be in remotely as good a shape as it was in 1997. But it is also clear that it will be a lot better than in 2010, when the country was knee-deep in a banking crisis and teetering on the brink of a fiscal crisis.

The shadow chancellor has chutzpah, or you could say balls, but his comments may merely remind people of that 2010 inheritance. Taken together with his claim that Labour was not profligate on spending, you could sense a disappointment that the coalition has not done better in sorting out the public finances, thus opening the way for normal spending service to resume.

The Balls’ speech, together with Ed Miliband’s pledge that the next Labour government will introduce a three-year cap on do-called structural welfare spending - as well as not reversing coalition child benefit cuts - are political positioning.

Before the 1997 election Labour said it would stick to Tory spending plans for two years. This time Miliband and Balls say they will stick to the 2015-16 plans currently being hammered out, as well as making other pledges intended to persuade voters they can be trusted.

Behind the politics, however, there is also the economic reality. The coalition, having inherited a situation in which in the former Labour Treasury chief secretary Liam Byrne’s memorable phrase, there was no money left, intended to get to 2015 with the toughest period of austerity over.

Public spending, according to the Office for Budget Responsibility’s forecast in June 2010, would be down to the equivalent of 39.8% of gross domestic product - below the 40% deemed acceptable and sustainable - by 2015-16. Job done.

Or not. The OBR’s latest forecasts, in March, showed public spending in 2015-16 at 43.1% of GDP (against receipts of 38.1%) and spending not getting down to 40% over a forecast horizon that stretches to 2017-18.

The main reason for this is the weakness of growth. The lower the level of GDP, the denominator, the higher other measures, whether borrowing or spending, will be as a percentage of it.

Three years ago the OBR expected GDP in 2015-16 to be £1,902bn. Now it expects it to be £1,728bn. That is nearly a £200bn difference; a huge amount. Signs of stronger growth mean some forecasters are revising up their recovery predictions and there is more optimism around. But there is a lot of lost ground to make up and spending continues to be too high relative to GDP.

One puzzle, for many, is that spending continues to be so high, both in absolute terms and relative to GDP, at a time when many government departments, and providers of public services, are squealing so much about cuts.

Osborne and Danny Alexander, the current Treasury chief secretary, have done a reasonable job controlling overall spending. The OBR expects total managed expenditure in 2015-16 to be £745bn, lower that the £757bn it expected three years ago.

This is despite higher welfare spending than was expected - a combination of inflation-related benefit uprating and weak growth in wages - and the continued ringfencing of the National Health Service, overseas aid and the schools budget.

The squeeze on the non-ringfenced departments has, however, been intense. With overall departmental spending due to drop 10% in real terms this parliament, and a further 7.6% in the three years beyond 2015, those without the the ringfence have been hit very hard. Deep cuts much beyond the election may be hard to achieve, which is why the Institute for Fiscal Studies has warned of post-election tax hikes.

Unless there is a better way. All the headlines when the results of this spending round are published on June 26, covering 2015-16 only, will be about the £11.5bn of cuts hammered out in negotiations with departmental minitsers. There will, no doubt, have been blood on the carpet.

The bigger story, though, may be about what Osborne intends to do about spending which is outside these departmental negotiations, so-called annually managed expenditure, or as the chancellor put it in the budget, annually “unmanaged” expenditure.

While departments have been squeezed, this ‘AME’ spending, £352bn this year, has been growing, a cuckoo in the spending nest. Mostly it is is welfare but also some other items of spending. Osborne will set out ways in which this will be controlled, bringing some essential discipline.

Many would say this should have been done long ago. Why not in 2010, when the coalition had its first spending review? But these things often involve trial and error. We admire Canada’s successful spending regime, which cut spending by roughly a fifth in the 1990s and then held it down.

But, as an Institute for Government briefing on Friday pointed out, Canada did not get there straight away. Its attempts to control spending began in 1984 but only got into its stride more than a decade later.

The hope has to be that we can bring a permanent end to the public spending boom and bust much sooner than that. If he has time, maybe Mark Carney could tell ministers how it was eventually done successfully in Canada.

Sunday, May 26, 2013
No guarantee Carney will get the presses rolling
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.

Two weeks ago I pointed out that, while there were a few reasons for the stock market’s strength, quantitative easing(QE) by central banks was the most important.

Sure enough, a hint that America’s QE programme may not continue at its present $85bn (£56bn) pace , from Ben Bernanke, the Federal Reserve chairman, sent markets tumbling, led by a 7% sell-off in Japan. We may not have seen the end of the equity rally, but it relies on central banks playing the accommodative game.

One question is what this means for the Bank of England and its new governor, Mark Carney, who will take the helm in just over a month’s time.

A few days ago the International Monetary Fund concluded its annual health check on Britain’s economy, its Article IV assessment, with recommendations that had something for everybody. As a medical verdict, it was less radical surgery and more that the patient could do with taking a bit more exercise to speed up growth.

So George Osborne will continue with his fiscal strategy, although with a further nod towards boosting infrastructure spending where possible. Bringing forward £10bn such spending, to start now, as the IMF wants, may be easier said than done.

Where the chancellor has no quibble with the IMF is on monetary policy. Responding to its report, he described his approach as “monetary activism, a credible fiscal plan and structural reform”.

The Bank of England, in other words, has to do the heavy lifting on growth, while his fiscal consolition cuts the budget deficit. Structural reform, such as changes in education, welfare and tax, aims to raise growth over the medium and longer term.

What more monetary activism can the Bank do under Carney? Bank rate has been 0.5% for more than four years and there has been £375bn of quantitative easing through purchases of gilts (British government bonds), equivalent to roughly a quarter of Britain’s annual gross domestic product.

The new governor has not given too many clues recently. His valedictory speech, called Canada Works, lauded the performance of the Canadian economy and contrasted his country’s successful monetary union with the eurozone’s travails.

It would be nice if, in five years, Carney could reflect on the British economy with such a glowing assessment, though I suspect five years at the Bank will imbue him with a little more caution.

One thing we are unlikely to get is a cut in interest rates. Paul Fisher, the Bank’s executive director for markets and a dovish member of the monetary policy committee (MPC), warned on Friday that a rate cut from the current low level could have “perverse” effects and might not boost demand.

That does not mean the Bank has no ammunition. According to the IMF: “In addition to considering further purchases of gilts, the Bank of England could provide assurance to households and investors that policy rates will be kept low until the recovery reaches full momentum.”

Its second recommendation, so-called forward guidance, is likely to be adopted. Carney used it Canada at the height of the financial crisis. There is a question about how useful it would be now, when the markets already think Bank rate will not rise above the present 0.5% level until late 2016.

What it might do, however, is prevent the markets from responding to stronger economic data (if and when it comes) by pricing in an early rise in interest rates. The role of the MPC could be to point out that as long as the economy is so far below where it should be - real per capita GDP is 6% below pre-crisis levels - there will be no question of rates rising. Savers will hate it, but it could be a useful tool.

What about more QE? There has been an assumption that when Carney rides into town, the result will be an aggressive expansion of the Bank’s already aggressive programme of asset purchases.

For those of us who think this policy has already gone further than it should have done, this has been a disturbing prospect. There has to come a time when QE is put on ice. At some stage, of course, it will have to be put into reverse, and the gilts sold back, though not for a while.

Fortunately, it may not be as easy for the new governor to press the stimulus button as he, the chancellor and IMF might like.

The first obstacle is the rest of the MPC. The minutes of is meeting this month show that while three MPC members voted for £25bn more QE, including Fisher and Sir Mervyn King, six did not.

They warned that further asset purchases “could contribute to an unwarranted narrowing in risk premia and complicate the transition to a more normal monetary stance at some point in the future” The MPC majority wants to see whether the Funding for Lending scheme will work and, as the quote shows, is worried that the more QE it does the harder it will be to return to normal policy settings.

There is a view in the Bank that when Carney comes, the MPC will not want to see him in a minority. What was acceptable for King, an Aston Villa fan whose time as governor is nearly over, would not be acceptable for the star Edmonoton Oilers enthusiast from across the Atlantic.

That may not mean, however, that the rest of the MPC bends to his wishes. He may find that, if the prevailing mood is still against more QE when he takes over, it is best to keep his powder dry for another day.

The second obstacle could come from the data. Though details of the first quarter GDP numbers were disappointing - 0.3% growth came in spite of falling exports and investment - there is an expectation thatt growth will accelerate, to 0.5% or 0.6%, in the second. The service sector gained momentum during the first quarter.

Would more QE be warranted in August if second quarter GDP shows growth of 0.5% or 0.6%, alongside continued above-target inflation? Probably not.

The third obstacle could be what is happening elsewhere. There is no prospect of the Bank of Japan scaling back its QE but if Bernanke’s hints are taken at face value, late summer could be the time when the Fed is starting to wind down its programme. It could look odd if Britain were re-starting its QE at the same time.

Nothing is set in stone. Markets are split on what the new governor will do, and views shift with every data release. But the easy assumption that the arrival of Careny will bring a big and immediate increase in QE, is not nearly as easy as it was.

Sunday, May 19, 2013
The governor's eyebrows point to an upturn
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 CBI, the employers’ organisation, says Britain’s economy is “moving from flat to growth”. The Paris-based Organisation for Economic Co-operation and Development says its latest leading indicators point to growth in Britain at “close to trend rates”.

Most of all, Sir Mervyn King, presenting his final inflation report as governor, concluded his 82nd such press conference (he used to do them when he was chief economist and deputy governor), with the nearest thing to a hop, skip and a jump we have seen for a long time.

As he put it: “Today’s projections are for growth to be a little stronger and inflation a little weaker than we expected three months ago. This is the first time I have been able to say that since before the financial crisis.”

The Bank’s forecast is for “a modest and sustained recovery over the next three years”. Partly this is because some factors dragging growth down over the past 2-3 years - sharply falling North Sea and construction output - will cease to be a drag.

But mainly it is because it thinks more than four years of 0.5% Bank rate and £375bn of quantitative easing, together with better credit conditions as a result of the Funding for Lending scheme, and an improving global economic environment, will gradually strengthen the recovery. The upturn will remain weak by past standards, because of the hangover from the banking crisis. But an upturn it will be.

Specifically, the Bank expects the economy to build on the first quarter’s 0.3% growth with 0.5% in the second. Consumer spending will show sustained growth, though weaker than its 0.9% quarterly rise in 1998-2007. Business investment will grow, as will private sector employment, though more slowly than its astonishing 708,000 rise between December 2011 and December 2012.

It sounds almost too good to be true, or possibly a hospital pass from King to his successor. Wouldn’t it be terrible if Mark Carney’s first act as governor were to be to announce a forecast downgrade?

But King and his colleagues appear be genuine. Though this is not the first time since the crisis the Bank has predicted recovery - far from it - it means it about green shoots. Mention of green shoots takes me back to that very first inflation report of February 1993. I am pretty sure I was at that first press conference, albeit in short trousers, though details are grainy.

We have all changed a lot over 20 years and the Bank and its inflation report are no exception. In February 1993, blinking into the sunlight of greater transparency than in the previous three centuries of existence, the Bank stuck firmly to its brief.

There were no growth predictions (they did not come until 1997) and where the Bank touched on real economic variables, it was a touch pessimistic. So it expected rising unemployment to persist - in fact it peaked around the time that reported was published. It feared that big budget deficits would put upward pressure on inflation, though they soon began to fall.

Inflation was paramount. Coming off the high inflation of the late 1980s, there was a fascination about whether these new arrangements (with the Bank publicly advising the chancellor) could keep it under control. Growth, and forecasting it, was the Treasury’s job.

Some are nostalgic for those days, or at least a time when the Bank declared “inflation is a monetary phenomenon” and made it its mission, very successfully for the most part, to tame it.

Nowadays however most people are hungrier for what the Bank says about growth. When the governor is more optimistic about recovery, it makes the front pages (as it does when he is downbeat). The question is whether his cautious optimism now is justified.

On the day the latest inflation report was published official figures showed a 15,000 rise in unemployment to 2.52m over the January-March period and a 43,000 fall in employment to 29.71m. Is not that evidence of an economy getting weaker?

Probably not. The evidence is that the labour market strengthened during the quarter and I would expect a fall in unemployment, probably around 50,000, when the next figures are out in a month’s time. Employment is no longer growing as rapidly as it was, but has not gone into reverse.

The bigger worry, described here on April 21, is the weakness of pay, and falling real wages. Average earnings growth of 0.4% alongside inflation of 2.8% is a Micawberite recipe for misery.

It is also a puzzle. Consumer spending has risen for five quarters and. according to the Bank, probably rose in the first quarter. Private new car sales last month were 32% up on a year earlier. People are getting money somewhere, and only part of it is stronger growth in consumer credit.

I shall explore this further soon. But it is an odd sort of recovery in which real wages are falling and the Bank, to be fair, acknowledges consumer spending could be weaker than it expects, with households permanently shifting to a higher level of saving.

The other concern, of course, is Europe. Though France’s dip back into recession has attracted a lot of coverage - a 0.2% drop in GDP in the first quarter being the second in a row - its economy has essentially been flat over the past two years.

The problems are elsewhere. Italy’s 0.5% GDP drop was the seventh in a row and is starting to look like a proper and rather serious recession from which there is no obvious escape route.

Others, including Greece (GDP down 5.3% over 12 months), Cyprus (4.1%), Spain (2%) and Portugal (3.9%), remain in deep trouble. The European Central Bank has papered over the cracks but fundamental problems, and risks, remain.

The Bank has taken the view that policymakers will succeed in generating sustained recovery in the global economy, and even the eurozone will look better in the second half of the year. It acknowledges, however, that “disorderly adjustment” in the eurozone remains a risk. The hope is that it can be contained. Otherwise, the next governor’s eyebrows will be wearing an embarrassed frown.

Sunday, May 12, 2013
Central banks drive the stock market 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.

Spring has sprung with a vengeance for stock market investors. In recent days we have seen the Dow Jones industrial average close above 15,000 for the first time, Germany’s Dax hit record levels and the MSCI world equity index reaching its highest level since before the worst of the global financial crisis in 2008.

Even the FTSE 100 has been joining the party, trading comfortably above 6,500 and within sight, though not for the first time, of its all-time high of 6,930, reached as long ago as December 1999.

What lies behind this outbreak of stock market optimism and is it a harbinger of better economic news to come, or just a flash in the pan? Are markets, as some suggest, divorced from economic reality? A strong German stock market is, on the face of it, hard to square with an ongoing eurozone crisis and a European Commission forecast of continuing recession this year.

Stock market strength coincides with some evidence that, partly as a result of the eurozone’s woes, world growth is slowing. The April J.P.Morgan/Markit global purchasing managers’ index (PMI) dropped from 53 to 51.9 in April, signalling that while upturn was continuing, it was at its slowest rate sionce October last year.

Some economic news, it should be said, is consistent with market optimism. Investors were cheered by the 165,000 April rise in America’s non-farm payroll employment and a drop in the unemployment rate to 7.5%. Strong March German industrial production and manufacturing orders encouraged the view that its economy is riding out the eurozone recession.

Though the FTSE 100 is more usually moved by global developments, Britain’s economic data has improved. The 0.3% rise in first quarter gross domestic product was followed by stronger purchasing managers’ surveys for April and the announcement of a 1.1% bounce in manufacturing output in March.

The better news, together with the National Institute of Economic and Social Research’s estimate that GDP grew by 0.8% in the three months to April (helped by the recovery from a very weak January), has taken the sting out of the International Monetary Fund’s current visit to Britain.

Even Christine Lagarde, the IMF’s managing director and George Osborne ally, warned last month that Britain’s growth numbers were not good. They are still not great but they are looking better.

Ian Harwood, economist with Redburn Partners, says there is nothing in the global PMI to suggest that growth in the world economy is seriously faltering, and he sees some evidence that the upturn in global trade - which had stalled - is gaining momentum again.

But the stock market rally is not, to repeat, mainly a reflection of better economic news, though that does not make it irrelevant to the economy.
Equity markets are reflecting the fact that risks appear to have diminished.

Though the eurozone is still in trouble, the fear of imminent collapse has abated. Banks are not out of the woods but are inching towards something that resembles normality. Investors have moved from “risk-off” towards “risk-on” behaviour.

Stock markets are also benefiting, however, from what looks like a win-win situation, for the moment at least. Share prices gain when economic news is good, because that means companies should do better. But they can also gain when the news is not so good, because that increases the likelihood central banks will engage in further asset purchases - quantitative easing - thus boosting markets via that route.

Johannes Jooste of Merrill Lynch Wealth Management notes that even when economic data has disappointed, as some recent numbers from America and China have, “continued easy monetary policy supported global equity markets”.

The Bank of England’s monetary policy committee stayed its hand on Thursday but other central banks are engaging in plenty of unconventional activity in the form of asset purchases, including America’s Federal Reserve, $85bn (£55bn) a month, and the Bank of Japan with a monthly $79bn (£51bn).

The European Central Bank, which cut interest rates earlier this month, is contemplating purchases of asset-backed securities made up of loans to small firms. The Bank, with Mark Carney set to arrive within weeks, may not have done yet. This month has seen a slew of interest rate cuts, from central banks in India, Poland, Denmark, Korea, Vietnam and Australia, amongst others.

Central banks will see the rise of stock markets as a good thing. It is one way their policy gets transmitted to real economic activity. Booming markets boost wealth, increase business confidence and make it easier for firms - larger ones at least - to finance expansion.

Rising equity prices do not always signal there are better times on the way (or, for that matter, worse times when they are falling) but they are better than the alternative. In Japan, the rising Nikkei, up more than 60% since August last year, is regarded as a sign that the Abenomics of prime minister Shinzo Abe is working.

But you can have too much of a good thing. When does the rise in stock markets, given that much of it is driven by the actions of central banks, become dangerous? When does it become a bubble whose bursting would be very damaging?

The risks are there, and they are present in the fact that markets have moved well ahead of real economic activity. Markets that are mainly driven by monetary policy are, by their nature, unsustainable.

Any sign central banks were ready to start tightening policy, by raising rates or selling back some of the assets they have purchased, would send markets diving.

That may not be entirely logical: central banks would only start tightening if they believed the economy was well through the worst, but markets are not always logical. The danger is that central banks get trapped by the markets into keeping their foot on the monetary accelerator too long.

Sunday, May 05, 2013
Britain starts to pull away from Europe
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 Thursday the European Central Bank (ECB) cut its official interest rate from 0.75% to 0.5%, its president Mario Draghi citing the fifth successive quarterly decline in gross domestic product (the eurozone has only escaped a triple-dip because it is still in a double-dip) and very weak economic sentiment.

Economic weakness has spread from the periphery to “core” economies such as Germany, France and the Netherlands, which had been doing much better. While the ECB expects an improvement in the eurozone economy later in the year, it warns that the risks are on the downside.

The English Channel is not that wide but it seems some clear blue water is opening up between Britain and the eurozone. It has been there for some time when it comes to unemployment. Eurozone unemployment, at 12.1%, is more than half as much again as Britain’s 7.9% rate. Youth unemployment, which ranges as high as 59% in Greece and 56% in Spain, is also significantly higher on average.

Britain’s growth performance, while nothing to write home about, is also beginning to pull away from the eurozone. The latest forecast from the National Institute of Economic and Social Research is for another year of recession in the eurozone, with gross domestic product contracting by 0.4% after a 0.5% fall last year. It predicts that Britain will grow by 0.9% following last year’s 0.3% rise. Next year it expects 0.9% growth in the eurozone but 1.5% in Britain.

These differences do not, of course, alter the big picture of a weak recovery in Britain, or the fact that there is nothing to celebrate about Europe’s troubles, given the dependence of the UK economy on eurozone trade.

Even on that, however, there are signs of something stirring; a hint of the necessary rebalancing away from excessive reliance on Europe.

The latest Markit purchasing managers’ index for Britain’s manufacturing sector showed a rise from 48.6 in March to 49.8 in April, while its eurozone equivalent slipped from 46.8 to 46.7.

More importantly, Britain’s manufacturers reported the strongest rise in export orders since July 2011, driven by “increased sales to clients in North America, the Middle East, Latin America and Australia”. Eurozone export orders, by contrast, remained depressed.

This is part of an ongoing story. In 2008, Britain exports of goods to the rest of the EU totalled £142bn. They slumped to £125bn in 2009, recovered to £142bn in 2010 and grew well in 2011, rising to £159bn. But last year they dropped again to £151bn, helping to explain 2012’s weak GDP growth.

Exports to the rest of the world, in contrast, fell by less in the crisis - dropping from £110bn to £103bn from 2008 to 2009 - but have been rising since: £124bn in 2010, £140bn in 2011 and £149bn last year.

It has been nip and tuck in recent months whether exports to the rest of the world are marginally higher or lower than those to the EU. In the latest three months, non-EU exports were ahead, and this is likely to be the shape of things to come.

Comparing 2012, when there was a rough 50-50 split between EU and non-EU exports, with the position 10 years earlier, shows how things are changing. In 2002 nearly 62% of exports went to the EU. This is quite a shift.

Though Britain’s top five export destinations last year - America, Germany, the Netherlands, France and Ireland, in that order - were the same as three years earlier, plenty is happening further down the list.

China is now Britain’s seventh largest export destination (from ninth in 2009) and Russia is up from 22nd to 12th. The old chestnut about Britain exporting more to Ireland than Brazil, Russia, India and China put together, has not been true for a while. Last year 7.9% of exports went to the BRICs, 5.8% to Ireland. Not a big enough shift yet but a move in the right direction. A decade ago only 2% of exports went to these economies.

Britain’s biggest exports by category last year, incidentally, were mechanical machinery, electrical machinery, medicinal and pharmaceutical goods, and cars.

It seems reasonable to plan on the basis of European markets continuing to be weak, as the eurozone crisis plays out. The structural, fiscal and demographic challenges Europe faces argue for subdued growth, at best, in coming years.

The question is whether Britain’s exporters can do more than just substitute stronger markets elsewhere for eurozone weakness, but create a long-lasting upturn on the back of the faster-growing parts of the world.

When economists look for a rapid response from exporters they often underestimate the challenge firms face in establishing themselves in new markets, a challenge that is particularly acute for smaller firms. These things cannot be just turned on with the flick of a switch, they require planning and investment and help from official bodies such as UK Trade & Investment (UKTI).

But there are at least some reasons to be optimistic. Research by the EEF, the engineering employers’ federation, suggests firms are gearing up rapidly in emerging markets, with a clear majority of the businesses it surveyed planning to invest in the development of these markets.

The EEF notes that the fastest growth in Britain’s exports over the past six years has been to Qatar, China, Russia, Brazil, Thailand, India, Australia, Singapore, Norway and Malaysia.

The main problem, it found, was that firms encounter protectionism in countries like Brazil and Russia, and threats to their intellectual property in China.

The government’s aim is to increase Britain’s exports of goods and services to £1 trillion by 2020, from £488 billion last year. It is a huge challenge, requiring export values to grow more than 9% a year, with most of the heavy lifting in exports to the emerging world. But it is challenge exporters have to take up - they need it to succeed. So does the rest of the economy.

Sunday, April 28, 2013
A little growth takes a lot of pressure off 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.

0.3 is a very small number, but in recent days it has been hugely significant for George Osborne. It featured, most obviously, in the first quarter gross domestic product figures, the 0.3% rise breaking the hearts of the chancellor’s critics and allowing him to claim the economy is healing. That may be premature; the recent pattern means further quarterly GDP declines cannot be ruled out.

But as small mercies go, this was welcome and should lead to upward revisions of 2013 growth forecasts. The consensus was for 0.1% and the Office for National Statistics has a penchant for nasty surprises.

The other 0.3 relates to public borrowing: the deficit. Since December, when the Office for Budget Responsibility (OBR) endorsed the Treasury view that borrowing in 2012-13 would be down on 2011-12 (against the run of the numbers), the worry was that this would turn out wrong.

In last month’s budget, even after strenuous efforts by Treasury ministers and officials, the OBR concluded the margin would be wafer-thin, just £0.1bn. It was indeed wafer-thin, but £0.3bn - borrowing fell from £120.9bn to £120.6bn - and as the OBR pointed out, initial figures have tended to be revised lower in recent years.

Growth, of course, is still weak, and borrowing very high; about £30 billion higher in 2012-13 than officially predicted at the time of Osborne’s first budget in June 2010. Public sector net debt is rising and at the end of March was £1,186bn, 75.4% of GDP.

So what’s changed? Well, the heat has been taken out the International Monetary Fund’s visit to Britain next month. A GDP fall would have lent weight to the call by Olivier Blanchard, its chief economist, for Britain to relax austerity.

That was never going to happen. Osborne told the IMF he would continue with his medium-term deficit reduction plan. The IMF’s own research, showing so-called fiscal multipliers are very small in Britain - tax hikes and spending cuts do less harm than elsewhere - made its chief economist’s advice look odd.

If too much austerity is doing damage it is in the eurozone, where latest German surveys were weak and Spanish unemployment has hit 27.2%. But the IMF declared eurozone fiscal policy broadly appropriate.

IMF fireworks have been avoided, as probably have fireworks at the forthcoming monetary policy committee meeting on May 9. The MPC will probably refrain from further quantititative easing, particularly with the extension of the Funding for Lending scheme until 2015. This does not rule out action when the new governor, Mark Carney, arrives, though he is playing down expectations.

The great virtue of the GDP figure, however, was it should allow a sense of perspective to be restored. Anybody listening to the debate over the past week might conclude that the case for austerity had evaporated as a result of errors and omissions in research by two American economists, Carmen Reinhart and Ken Rogoff.

Reinhart and Rogoff, famous for their book This Time is Different, on financial crises, published research three years ago showing government debt above 90% of GDP is associated with slower growth.

That is still their finding, as they are at pains to point out. One always implausible result - debt levels above 90% are associated with negative growth of 0.1% - has been rightly removed from the record by the discovery by University of Massachusetts economists of the error. But the big picture, growth around a percentage point a year slower at high debt levels, remains.

There are two essential points on this. The first is that many studies have shown high debt is associated with slow growth. A 2011 Bank for International Settlements (BIS) paper by Stephen Cecchetti and others, concluded: “Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP.”

The IMF said in this month’s World Economic Outlook high debt overhangs lead to lower public and private investment and reduce room for manoeuvre. Other IMF studies found a 10% rise in the debt ratio associated with a growth reduction of 0.2%, while a 2011 study found significant negative growth effects with debt above 70%.

Of course there is nothing magical about 70%, 85% or 90%. Circumstances matter. When Britain ran debt of over 250% of GDP at the end of the Second World War it necessitated austerity but there was also a route out. The economy would return to peacetime spending, as war operations were run down. Debt to GDP halved in a decade.

It is different, however, when - as the Institute for Fiscal Studies pointed out in its green budget - without action to rein back the deficit - public sector debt would have been on a trajectory that would have taken it back up to 250% of GDP.

So we should step back from the often vicious debate among American economists. The case for austerity was never based on one paper, or mainly on the growth consequences of high debt.

It was about trying to stabilise an appalling deterioration in the public finances: a record peacetime budget deficit, a huge structural deficit and rocketing government debt and interest payments. It was about trying to avert a fiscal crisis.

That was why Labour proposed a Fiscal Responsibility Act with debt falling as a percentage of GDP by 2016, and why the coalition aimed, though will not achieve, an earlier fall. The sustainability of the public finances meant not letting debt rip.

What if the cure is worse than the disease? For austerity critics, the direction of causation is from growth to debt. In other words, if austerity had been less, growth would have been stronger.

That may be true in the short-term, though in Britain growth would have been weak even in the absence of austerity because of the credit crunch, falling real incomes and the eurozone crisis. Growth might have been slightly better at most but debt would have risen more.

In the long run, growth depends on the supply-side, not short-term fiscal or monetary activism. Look at high debt/slow growth economies like Italy and Japan. Japan’s current burst of expansionary policy will not change this. It is a slow-growth model Britain has to avoid.

Sunday, April 21, 2013
Low pay begins to do more harm than 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.

The old labour market rules have been turned on their head: there has been a revolution.

One of those rules is that when growth is weak, employment does not grow. That has not been true in the past 2-3 years. Even last week’s softer job numbers, which showed employment slipping by 2,000 to 29.7m in the latest three months, showed an increase of 488,000 on a year earlier.

And even in those numbers, full-time employment rose by 60,000 in the latest three months, while part-time employment fell by 62,000. Economic inactivity fell to its lowest rate since 1991.

The other rule, also apparently broken, is that pay (average earnings) rises more than inflation. I know this should be true, and not just in recent times. In the 1990s, the Bank of England marked its 300th anniversary (it was founded in 1694) by looking back on three centuries of inflation.

Its analysis showed that after a torrid time for workers in the Bank’s first 100 years or so, things then improved a lot. By the end of the 20th century real wages (i.e. adjusted for inflation), were six times their level in 1800.

Rising real wages were the norm, independently of the ebbs and flows of trade union power. In the 1980s inflation dropped as low as 2.4% but average earnings growth never fell below 7.5%. Now, of course, things are different.

The latest average earnings figures show growth of just 1% over the past 12 months. That is the lowest since the current data series began in 2001 but you would have to go back very many decades, probably to the 1930s, for anything lower. Excluding bonuses, earnings rose by only 0.8%.

Inflation, on the latest figures, is running at 2.8% (3.3% for retail price inflation). Real earnings are falling, as they have been for most of the past five years.

These two broken rules, employment rising in a subdued economy and prices outstripping prices, are part of the same story. Looked at positively, it reflects the great flexibility of Britain’s labour market: pay restraint making possible a higher level of employment.

Looked at negatively, as some do, it is employers exploiting economic fragility to hold down pay. Either way, it means that the wage bill is being shared among a larger number of people.

Flexibility has kept a greater number of people in jobs. Most of the recent net increase in employment, 88% of it in the past year, has been among British nationals. My attitude so far is that this is good news. Far better to have more people in work, even if their real pay is falling.

Now I am wondering if you can have too much of a good thing. Even if inflation gets back to the official 2% target, it will still be running ahead of current earnings growth. In fact, we may be entering a period in which both employment and wages are weak. That is not quite the worst of all worlds but it is heading that way.

So what should happen? Some say the minimum wage, which will rise from £6.19 to £6.31 in October, should rise much more. Others think that all employers should pay what has been defined as the living wage, the minimum needed to get by, defined as £7.45 an hour (£8.55 in London).

The living wage is an interesting idea, and has been taken up by some employers, but I do not think it would be good to impose either it or a much larger minimum wage on employers. That would not only hurt marginal workers but it could be the last straw for marginal firms.

I do think, however, the private sector as a whole would benefit from higher wages. They would feed directly into stronger domestic demand, sorely needed by business. Consumer spending remains well below pre-crisis levels and retail sales are struggling to gain any kind of momentum.

The weakness of private sector pay is striking. Total private sector pay in February was 0.5% down on a year earlier. Though this was dragged down by lower bonuses, the picture for regular pay, up just 0.6%, was barely better. Public sector pay, up 1.1%, was stronger.

Imagine the difference it would make to demand if private sector workers, 79% of the total, were given increases of 3% rather than next-to-nothing. The CBI would risk a a re-run of the “Red Adair” headlines it attracted when Lord Turner was its director-general and bemoaned the decline in the workers’ share of GDP, but should it not encourage its members to sign up to a 3% club, for employers happy to award pay rises that at least keep pace with inflation?

The potential advantages would not, of course, just come through in stronger demand. Thanks to the tax credits introduced by Labour and other in-work benefits, employers have been able to free-ride on government largesse. That gets more difficult now most working-age benefits are now capped at 1% (in line with earnings growth) but has meant many workers have been spared the full pain of the real squeeze on wages, because the state tops them up.

Stronger wage growth would benefit the public finances both directly and indirectly, restraining welfare spending and boosting tax revenues.

I know what you are thinking. If private sector firms paid their workers more, they would employ fewer of them. Wages going up would mean employment going down.

That is possible, though could be balanced by two factors. One is the employment-generating impact of the greater demand resulting from higher wages. The other is that firms, particularly large ones, have very healthy balance sheets. They may not feel confident enough to invest but for most a relaxation of wage restraint would be easily manageable.

The more telling argument is about productivity, which has barely risen in the past three years and on some measures has fallen. Isn’t weak pay the natural corollary of weak productivity growth?

Perhaps, but it may be possible to turn things around. It is not quite a question of paying peanuts and getting monkeys but declining real wages may not be a recipe for rising productivity. If workers are demoralised, stuck in a rut, it could take a decent pay rise to jolt them out of it, and into higher productivity. That 3% club could be worth joining.

Sunday, April 14, 2013
Supply-side reform: the winning formula of the 1980s
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.

Lady Thatcher's death has produced an avalanche of remininscence and interpretation of the 1980s' decade. I was around in the 1980s, and have the suits and Filofax to prove it, The first chancellor I interviewed was her first, Sir Geoffrey Howe. But fear not, this is not going to be another stroll down memory lane.

Rather, I wanted to draw out a more fundamental lesson. At the recent Royal Economic Society conference, LSE professors Tim Besley and John Van Reenen presented the findings and recommendations of its Growth Commission. One of the most striking was in what they called “the economic story of the UK”.

From 1870 to 1980, Britain suffered more than a century of relative economic decline. The British economy grew but France, Germany, America and other competitor economies grew faster.

Since 1980 that has not been true. On a range of measures, Britain’s relative performance improved. There was a turnaround. From 1980 to 2011 - including the 2008-9 recession and some of the subdued recovery - gross domestic product per capita outgrew America, Germany and France. So did GDP per working-age adult. The productivity gap narrowed and in some cases was reversed. Things got better. North Sea oil helped in the first haf of the 1980s but made little difference over the period as a whole.

Some people are determined not credit Thatcher for any of this, or say that it was more than outweighed by the huge negative of the crisis. I’ll return to that.

I regard the LSE’s Van Reenen as a fair witness. He was no fan of Thatcher when younger. Had he been at the LSE in 1981 he would no doubt have joined the 364 economists who signed a letter protesting at her policies. The rise in inequality and failure to invest enough in infrastructure were significant downsides of the Thatcher era, he says. But he also gives credit where it is due for the supply-side changes that led to the improvement in Britain’s performance.

Those changes: union and other labour market reforms, removing industrial subsidies, privatising and regulating state industries, strengthening competition policy, membership of the EU single market, opening the door to inward investment and expanding the higher education system all contributed to the improvement. As he puts it: “Most, but not all of these were initiated by Mrs Thatcher.”

Her supply-side changes mainly survived, Helped by changes in the structure of the economy, there was no return to destructive union power or, despite some huffing and puffing from Labour, no renationalisation of privatised industries.

Under Tony Blair and Gordon Brown from 1997 there was some re-regulation of the labour market but this was partly balanced by an improved competition regime, with the Office for Fair Trading and Competition Commission. Tax got much more complicated, though until the very end of new Labour the consensus held that low rates of direct taxation were best.

In the long run, it is the supply-side that matters and Thatcher enacted a series of supply-side reforms. Those changes laid the foundation for Britain’s improved perforamce over three decades.

We should remember that. Though we devote acres to whether George Osborne should relax austerity or whether the Bank of England should announce £25bn of quantitative easing, supply-side policies matter much more.

So cutting corporation tax to 20% and other changes to try to make Britain a magnet for inward investment; tax and welfare changes to improve work incentives;, education reforms and the cut in the top rate back to 45% matter a lot more than the fiscal picture set out in the next budget or autumn statement, or the next meeting of the monetary policy committee.

You can see that in the macroeconomic record of the Thatcher government. Though fiscal policy was prudent - average cyclically-adjusted net borrowing of less than 0.5% of GDP over the period 1981-9 was close to a balanced budget - it was too tight at the start and too loose at the end.

Monetary policy was a dog’s breakfast. Sir Alan Walters, her economic adviser, pointed out in the early 1980s that 17% Bank rate and a sky-high exchange rate inflicted unnecessary damage on industry.

When, after many twists and turns, her period in office ended with Britain in the European exchange rate mechanism, Walters told me it would undo 30% of the economic gains made. As it was, despite an average Bank rate of 12%, she left with inflation back in double figures.

The consensus is that inflation-targeting in 1992, followed by Bank independence in 1997, improved considerably on the turbulence of the 1980s. It certainly led to much greater stability, with low inflation and interest rates. But that, in turn, fostered excessive risk-taking. Once fear of sharp upward lurches in rates went, many of the normal constraints were removed.

The search for the Goldilocks macroeconomic policy middle-ground - which neither scares the hell out of people nor encourages them to throw caution to the wind - will go on. But through short-term macro trials and tribulations, we should remember the supply-side. Anything that can be done to improve it, even or perhaps especially in difficult times, will pay dividends in the long run.

What about the crisis? Wasn’t there a direct route from Big Bang in 1986 to the banking collapse in 2008? Wasn’t that the legacy? No. People forget Big Bang was all about ending the stock exchange’s restrictive practices. It was not just unions forced to change their ways: the City’s cosy cartel ripped off its customers.

Big Bang helped London regain its position as the world’s leading financial centre but did not give a green light for irresponsibility to investment banks, which occurred long after she left office. If you want to pin the crisis on anything, pin it on the rise of America’s shadow banking system and the relaxation and eventual abolition of the Glass-Steagall restrictions on its banks.

She would have taken a dim view of the irresponsibility. Given her unhappiness with the Bank in the early 1980s, I suspect she would have taken a dim view of independence too. That would have left the Bank in charge of banking supervision. Whether it would have done better than the Financial Services Authority we will never know.

Tuesday, April 09, 2013
Margaret Thatcher's four ages of monetary policy
Posted by David Smith at 04:00 PM
Category: David Smith's other articles

Monetary policy changed dramatically during Margaret Thatcher's period as prime minister, from hard-line or 'punk' monetarism to membership of the European exchange rate mechanism (ERM). This, from my book Free Lunch, explains how her period in office accounted for four of my seven ages of modern UK monetary policy. By comparison, the past 16 years have been remarkably stable.

There are seven ages of man and there are seven ages of modern UK monetary policy. It is a good way of looking at the trials and errors. Other countries have also groped for the ideal monetary policy, although few have done so as ineptly as Britain. If we go back a quarter of a century so, to the 1970s, this was a time of enormous turbulence for the world economy and near-disaster for Britain. It is also my first age of modern UK monetary policy, reluctant monetarism. In 1976 a near-bankrupt government had to call in the International Monetary Fund. This was the occasion for the burying of Keynesian fine-tuning. Peter Jay, sometime British ambassador to Washington, and economics editor of The Times and the BBC, drafted a speech for his father in law James Callaghan for the 1976 Labour party conference, which contained the immortal words ‘I tell you in all candour that you can’t spend your way out of recession’. The IMF’s prescription contained two main elements. It insisted on sharp cuts in public spending – the biggest by any government in the post-war period. And it forced the government to adopt monetary targets, to control the money supply or, more particularly, two measures of ‘money’, sterling M3 and for domestic credit expansion. There is no need to worry about the detail of what these were. The essential point was a simple one. To stabilise the economy, and to control inflation (which had risen above 26 per cent during 1975) it was necessary to control the money supply. There will be more on this when we meet Milton Friedman in the next chapter but the basis of this policy was quite simple – just as you cannot drive a car without petrol, you cannot have inflation without money. The faster that money is printed, and credit allowed to grow, the higher will be inflation. Targeting the money supply was by no means trouble-free. The Labour government found, as many governments have, that it was not possible to control the money supply and the exchange rate at the same time. By the time it lost the 1979 election inflationary pressures were starting to build up strongly. Even so, this ‘reluctant monetarism’ helped to save the economy.

In 1979, we had the second age, willing monetarism, under a Thatcher government philosophically committed to controlling the money supply as a means of limiting inflation.

Despite being acolytes of Friedman, the Conservatives chose a ‘broad’ monetary target, sterling M3, which he would not have recommended. They then proceeded to undertake other policy actions, notably the abolition of exchange controls – limits on the amount of currency and capital that could be taken in and out of the country - and of the Bank of England ‘corset’ (controls on the banks’ lending), which made it impossible to hit the targets for sterling M3. To this day many people think monetarism has something to do with public spending cuts. This was because the Thatcher government’s choice of money supply target was linked to the level of public borrowing, and therefore the amount of government spending. This phase of willing monetarism lasted two or three years, before giving way to third age, pragmatic monetarism.

By the early 1980s Charles Goodhart, then chief monetary adviser to the Bank of England, had come up with Goodhart’s Law, a kind of Murphy’s Law for economics. This did not say that if you drop a piece of toast it is bound to fall buttered side down but, rather, that any measure of the money supply you try to target will automatically become subject to distortions that make it hard to control. So the Conservative government adopted a more relaxed approach, making it clear that they still believed in controlling the money supply but also choosing to target a range of measures and not losing too much sleep if one or more of them missed the target. This approach worked pretty well. From 1982 until 1985 Britain had reasonable economic growth, albeit alongside high unemployment, and low inflation.

Unfortunately, sterling, the traditional Achilles heel of the UK economy, was still subject to periodic crises. In January 1985, not long after I had joined The Times as economics correspondent, the month began with interest rates at 9.5 per cent and ended the month at 14 per cent, sterling having come within a whisker of one-to-one parity with the dollar in the process. These days, we get excited when interest rates change by a quarter of a percentage point in a month and at time of writing they had not changed at all for well over two years. And so, in about 1985, Nigel Lawson, the then chancellor, became rather keen on taking sterling into the European exchange rate mechanism – the system of ‘fixed-but-adjustable’ exchange rates in Europe that had come into being in 1979 as a forerunner to the single currency. When Thatcher rebuffed him, he developed an alternative. Under the cloak of international efforts to stabilise currencies, the so-called G5 (Group of Five) and G7 (Group of Seven) Plaza and Louvre accords, that alternative was unofficial exchange rate targeting – shadowing the D-mark, my fourth age of monetary policy. How much was this responsible for the boom and bust of the late 1980s? Quite a lot, because interest rates were cut to try to hold the pound down. The earlier pragmatism was replaced by dogmatism, with dogma directed at preventing the pound from rising above three D-marks (Germany’s currency before the euro).

My fifth age is official targeting of the exchange rate – the ERM period. John Major was more successful than Lawson in persuading Thatcher of the virtues of joining the ERM, partly because he persuaded her that it was the route to lower interest rates. And so, when in October 1990 it was announced that the pound would be joining the ERM at an exchange rate of DM2.95, it was also announced that interest rates would be reduced at the same time. The problem with ERM membership was, however, the opposite of the one Major suggested, Far from being a route to lower interest rates, it blocked interest rate cuts at the very time they were needed. The combination of what was seen as a high exchange rate and the persistence of high interest rates meant that the period of ERM membership coincided with the 1990-92 recession. There was an additional complication. As a result of the pressures created by the unification of East and West Germany, German interest rates were higher than usual, and they set the pattern for the rest of Europe including, at the time, Britain. By the summer of 1992, the Conservative government, having narrowly won re-election in April 1992 (this time with Major as prime minister) was hanging on for dear life in the ERM. On September 16, 1992 the game was up. ‘Black’ Wednesday to the headline writers, ‘White’ or ‘Golden’ Wednesday to others, this was the day the Bank of England ran out of the reserves needed to prop up the pound within the system (it bought large quantities of sterling with its own foreign currency) but, thanks to George Soros and other speculators, it was to no avail.

The sixth age came after Black Wednesday and sterling’s departure from the ERM, and it can be called quasi Bank of England independence. In putting together a monetary policy framework out of the ruins of the ERM failure, and in doing it both quickly and in an environment where it seemed the government could fall at any moment, the Treasury and the then chancellor, Norman Lamont, performed a minor miracle. That framework, adopting an inflation target instead of money supply or exchange rate targets, requiring the Bank of England to produce a quarterly inflation report, and getting the Bank to advise openly and regularly on interest rate changes (this became the ‘Ken and Eddie show’ after Kenneth Clarke, Lamont’s successor and Eddie George, the Governor of the Bank) was enormously successful. It paved the way for the 1990s to be a period, after the disasters at the start, of non-inflationary growth, the holy grail of economic policy. From there it was a relatively short step to giving the Bank the job.

The seventh age is thus operational independence for the Bank in which the Bank sets rates to meet an inflation target, 2 per cent, set by the government Is this the final resting place for monetary policy? One is tempted to say yes. The possibility of Britain embracing Europe’s monetary union, the euro, under which the governor of the Bank would simply become a voting member of a large European Central Bank council, seems very remote. A question may arise over the Bank’s wider responsibilities, acquired in the wake of the crisis, for supervising the banks and the wider financial system. Errors made in this area could compound criticism of the Bank that emerged before, during and after the crisis. That criticism centred on the Bank’s failure, during a period its governor Mervyn King described as the ‘Nice’ decade (non-inflationary, consistently expansionary), to respond to sharply rising asset prices – mainly property – and rapid credit growth. This criticism, which was also directed at other central banks, and most notably the Federal Reserve, argued that an obsession with achieving low inflation meant that other dangerous developments were ignored. Had central banks adopted a more rounded approach, it was argued, they would have kept interest rates higher and used other methods to restrain credit growth, even if it meant measured inflation was below the official target. Such criticism persisted after the crisis, when soaring commodity prices and in Britain’s case a weak pound, pushed inflation up sharply. The ‘Nice’decade, more generally known as the ‘Great Moderation’, in which central banks seemed all-powerful, appeared to have benefited from considerable good fortune.

Sunday, April 07, 2013
Household debt no longer as big a burden
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What's changing in the economy? The promised rebalancing towards exports and investment has not occurred.

Nor, according to the Office for Budget Responsibility (OBR), should we hold our breath. Thnough it is optimistic on business investment from next year onwards, it does not see net trade contributing significantly to growth for the next five years.

Some things are changing, however. Last week I noted the financial sector’s shift from boosting growth to dragging on it. George Osborne wanted less reliance on financial services and has got it, though the effect on the measured recovery and the public finances suggests chancellors should be careful what they wish for.

There is another big change I want to focus on, and it concerns household debt. The rise and rise of debt has been one of the stories of our age. A nation of homeowners - nine-tenths of the debt is in mortgages - combined with easy credit availability to produce a striking increase in the amount owed by households.

From £239 billion at the beginning of 1987, household debt saw a more than fivefold rise to a peak of £1,550 billion at the end of 2008. Roughly £1 trillion occurred from the end of 1996. Though inflation played a part, debt rose from under 100% of annual household income to a high of 167.5%.

Times have changed. Household debt does not normally fall. In cash terms it carried on rising through the recession of the early 1990s, before regaining momentum as the recovery gathered strength.

This time, it has fallen. Not much, but it has fallen. At the end of 2011, household debt was £21bn lower than three years earlier. Though it has edged up a little since, it remains below its pre-crisis peak.

A more striking demonstration of this is when debt is measured against income. From that 2008 peak of 167.5%, it dropped to 141.4% in the final quarter of last year, according to the Office for National Statistics in its latest monthly economic review.

Nothing like this has happened before. Debt edged lower as a percentage of income in and after the recession of the early 1990s but not to any significant extent. This time the adjustment has been dramatic, and it many not yet have finished.

Why has it happened? If debt is to rise it needs to be available. Six years ago two-thirds of new mortgages came from so-called wholesale funding sources, rather than conventional bank and building society deposits. When the financial crisis hit, wholesale funding slowed to a dribble, turning mortgage feast into famine.

Even if mortgages had been available, households would still have been reluctant to take on debt. Debt appetite was replaced by an almost Pavlovian debt aversion.

If not, you might have expected individuals to compensate for the squeeze on their incomes by borrowing more. They did not do so, which is why consumer spending, despite a gentle rise since late 2011, is still 4% below pre-crisis levels.

People borrow when real incomes are rising and confidence high. It is not surprising falling real incomes and weak confidence results in a reluctance to borrow.

What happens now? The housing market is the key. Rising household debt is the natural consequence of a normally functioning housing market. Those who enter it, first-time buyers, do so with with debt, having taken on a mortgage to do so. Those who leave it, mainly older people, do so having paid off their mortgages years before. The net effect is a rise in debt.

Will the housing market ever function again in a normal way? The Funding for Lending scheme (FLS) has done a better job at boosting mortgage availability than it has in boosting small business lending, notwithstanding a small dip in mortgage approvals in the latest figures.

The Help to Buy scheme unveiled by George Osborne in the budget takes it further and has produced a curious reaction. The centrepiece of the scheme - £12bn of government guarantees to support £130bn of new mortgages over three years - seeks to address the mortgage famine that has so depressed housing activity.

Some of the criticism, suggesting it will create a sub-prime crisis in Britain, is preposterous. If we see mortgage lenders doling out loans to borrowers with no income, no jobs and no assets, America’s infamous Ninja borrowers, you might believe it. But that is not going to happen.

As for taking action at all, governments have always intervened in the housing market. In the 1970s local authorities were an important source of mortgage lending. For more than three decades homeowners received tax relief on their mortgage interest payments. A three-year time-limited scheme is modest in comparison.

Will the scheme pump up pver-inflated house prices? Prices have adjusted significantly, falling by by 26% in real terms since autumn 2007, according to the Nationwide building society. As Oxford Economics pointed out in the Institute for Fiscal Studies green budget, prices are now undervalued relative to their long-run trend.

The house price-earnings ratio is not a very useful measure of anything, but it has fallen by a quarter since before the crisis and, as Oxford Economics also pointed out, is in line with its average since the period of low interest rates began in the 1990s.

Will not government mortgage guarantees lead to the household debt burden rising? No. Even if Help to Buy results in £130bn of new mortgages over three years, which may be optimistic, the household debt ratio would not rise, based on what has happened to incomes in recent years. Nor is it likely to produce a new house-price boom: the scale is not there. Net mortgage lending was rising by well over £100bn annually before the crisis. £130bn over three years is small by comparison.

Should not people be encouraged to run down their debt further? There has already been unprecedented deleveraging and household balance sheets are healthy. Household assets are large in relation to income - 8.5 times according to the OBR - meaning that household net worth is 700% of household annual income.

That is not a bad position to be in. Some people took on too much debt in the run-up to the crisis and the overall level rose too quickly. But household debt, typically 25-year debt, of under 150% of annual income is sustainable. Encouraging it down much further will simply deprive the economy of the demand it needs.

Sunday, March 31, 2013
Britain's hidden growth explains the jobs 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.

This is not a great time to be in the garden centre or outdoor attraction business. If you are a retailer hoping to sell spring and summer clothing lines, this may be time for a quiet weep.

Anybody selling last minute holidays in the sun is probably feeling pretty smug, notwithstanding the fact that this will add to a balance of payments deficit that swelled to a worrying £58bn last year. Our current account is badly overdrawn.

The combination of the bad weather and an early Easter has put gross domestic product(GDP) in the first quarter on a knife edge. It does not take much to tip a fragile economy into negative territory, though both the Office for Budget Responsibility and the OECD expect Britain to avoid the dreaded triple-dip by a wafer-thin margin.

Revisions last week to past data mean the double-dip at the end of 2011 and the beginning of 2012 has now almost disappeared, as we knew it probably would, but that does not change the big picture. An economy that by now would normally be growing well is struggling to gain cruising altitude, for all the reasons we know about.

Today I want to present a slightly more nuanced picture. Some parts of the economy, we know, are growing. A 0.3% rise in service sector output in January, just announced, is the main reason for hoping there will be first quarter growth.

The service sector, which accounts for 77% of GDP, had a milder recession than the rest of the economy and has has a better recovery, growing by 1.1% in 2010, 1.2% in 2011 and 1.2% again in 2012. It is just, 0.3%, above its pre-crisis peak, while the overall economy is still nearly 3% below its peak.
Dig a little deeper into services and an even more interesting picture emerges. Financial services, including insurance, account for just over a tenth of GDP (10.4%) and just over an eighth of services.

They have had a torrid time. Turnover in this broad definition of financial services is 9% down since 2009 - when the economy began to recover - and 12% below pre-crisis levels. Though there is tentative evidence that the decline in financial services is levelling off, it will be a long time before it contributes significantly to growth, as it did in the heady days before the crisis struck.

What happens if you exclude weak financial services from the rest of the service sector? You are left with 66% of the economy and you are left with a picture in which growth has been reasonably healthy by today’s standards. This two-thirds of the economy grew by 6% from mid-2009 to the end of 2012 and is 2% above pre-crisis levels.

Not all of this two-thirds of the economy could properly be regarded as strong. Retail, for example, has been roughly flat in volume terms since the economy turned up in mid-2009. Air transport is down.

There are, however, areas of considerable strength. The motor trade is up 11.4% since 2009, wholesaling 5%, publishing, audiovisual and broadcasting up 15.8%.

What the Office for National Statistics calls accommodation is up 6%, telecommunications 6.3%, computer programming and consultancy 14.6%, arts, entertainment and recreation 6.7%, legal, accountancy and architecture 9.2%, other professional and scientific services 17.4%, and healthcare (including the ringfenced National Health Service) 10.4%.

The fact that these services are doing well may seem to be of small comfort if the rest of the economy is collapsing. Even there, though, the picture is more nuanced than often thought. Within manufacturing, output of capital equipment is up 21% since 2009, while transport equipment, notably cars, is up a stunning 46%.

If you add the parts of manufacturing where growth is good to the lion’s share of services doing fine, the result is that 70% to 75% of the economy is growing at a reasonable rate but is dragged down by the rest.

We know what the rest is, apart from financial services. It includes North Sea oil and gas, down 32% since 2009. It includes those bits of manufacturing, including chemicals, basic pharmaceuticals, wood and paper and textiles, where growth has disappointed. And it includes construction which, though marginally up on 2009, it is more than 10% down on this time in 2011.

What are the implications of all this? For British economy-watchers, the biggest current puzzle is why employment has been so strong when recovery is so weak. This, I think, goes a long way to explaining it.

The number of people in work is 3.3% higher than its 2009 recession low point and 0.7% above pre-crisis levels. Service sector employment is 722,000 up on the 2009 low and 490,000 higher than at the start of 2008, when recession struck. Those increases are 2.8% and 1.9% respectively.

The weaker bits of the economy, meanwhile, have not been shedding jobs as much as expected, either because they are hoping for something to turn up, or for safety reasons. So North Sea employment, while not huge, is up over the past three years and manufacturing employment only down by 30-40,000. Employment in financial services, overall, is barely down.

The main exception is construction, where more than 200,000 jobs have been shed since the recovery began. But the big picture is that the bulk of the service sector is generating jobs at a significant pace (while also raising its productivity). The jobs puzzle may have been solved.

The second big question is about those parts of the economy that are dragging down the rest. Some of them may be beyond saving. There are parts of low-value manufacturing which will struggle even with a competitive exchange rate.

The decline of two of the struggling sectors, the North Sea and financial services, is explicitly linked to the unbalanced economy and that huge current account deficit. We still need to sell financial services to the rest of the world. It is important the sector is better regulated but not over-regulated to the point of impotence.

North Sea oil and gas has come through a period in which taxation provided a major disincentive and is now looking up but will take time to turn around. Construction is highly cyclical. The government’s own test for the Help to Buy initiative George Osborne unveiled in the budget is whether it results in more housebuilding.

The broader message is that most of the economy has been able to grow at a reasonable rate in a very challenging period. Some of the growing parts are the high-skilled sectors we will need in the future. In fact we will need more of them.

Sunday, March 24, 2013
Don't bet on the Bank to pump up the 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.

What is left to say on the budget? By now, most people will have devoured the detail and it hasn't yet unravelled, though it is a bit battered around the edges.

Given George Osborne’s fourth budget was put together with considerably more care than his third, the chances of a big unravelling are not that high. Though this was a budget that disappointed on growth and borrowing, as foreshadowed last week, it was reasonably well-constructed.

On content, while it did not tick every box I set out last Sunday, it did quite a few of them, as well as a few I had not suggested. With little to play with, the chancellor found a lot to say.

This was never a budget with a large-scale assault on spending to pay for aggressive tax cuts. It was never going to be a “Plan B” spending budget.

Instead, there were positive, if modest, measures on jobs, including a new £2,000 employment allowance. Stamp duty is scrapped for “gazelles” (fast-growing firms) and there are funds for an industrial strategy aimed at replicating car industry success in 11 other sectors. The corporation tax cut to 20% in 2015 and a personal allowance in 2014 of £10,000 will top the list of coalition achievements.

Achieving the £10,000 target for the allowance may move it beyond the stealth tax cut described here last week. “Your first £10,000 free of tax” is not a bad slogan.

Some reaction to the Help to Buy scheme - equity loans and mortgage guarantees - was just silly. Anything that increases housebuilding and gets housing turnover up, as this scheme can if the details are got right, is welcome.

Housing turnover is half pre-crisis levels. Boosting it improves economic efficiency - allowing people to move for job reasons - and generates additional spending. When people move, they tend to improve.

There has even been some mildly encouraging post-budget news. The day after the budget official figures showed public borrowing in the first 11 months of the year nearly £3bn below last year’s levels, a significantly wider margin that the wafer-thin full-year £0.1bn deficit reduction predicted by the Office for Budget Responsibility.

The OBR had access to some but not all the figures, and March could be a bad month. But it is also quite possible some of the chancellor’s scramble to secure a face-saving deficit reduction this year will prove to have been unnecessary. There was also a welcome post-budget announcement of a 2.1% jump in retail sales last month.

One good retail sales figure does not, of course, turn muted growth into a strong recovery. It is how to generate that recovery, built on what Osborne described as combining “monetary activism with fiscal responsibility and supply side reform”, that I want to concentrate on.

What exactly might monetary activism mean? On budget day the Treasury published a 68-page review of monetary policy, the main conclusion of which was that the 2% inflation target, “which applies at all times”, should be kept.

So, sensibly, there was no adoption of a target range for inflation, or replacing the 2% target with one for the money value of gross domestic product. Though “at all times” means the Bank can choose when and how quickly it tries to hit the target, it was important to retain it.

The Bank has also been tasked with three things. When it is missing the inflation target it will have to set out clearly the trade-offs causing it do so so, for example if trying to get it down too quickly would push unemployment up too much. The Bank will be required to communicate.

It will be required to ensure that decisions by its new financial policy committee are co-ordinated with those of the monetary policy committee. To take a simple example, it would be odd if the FPC were reining back credit growth by recommending tougher capital controls on the banks while the MPC was trying to get more lending into the economy.

The Bank has also been set a specific task of investigating, in its August inflation report, whether it should issue what is known in the jargon as forward guidance based on intermediate thresholds.

That is a mouthful but in practice it means that the Bank would follow America’s Federal Reserve in, say, committing itelf to undertake further quantitative easing on a montholy or quarterly basis, until such time as unemployment drops below a certain level. The significance of the August inflation report is that it will be the first under Mark Carney, the new governor, who used such forward guidance in 2009 to signal to the markets that interest rates would stay low.

Is it a good idea? Sir Mervyn King has always insisted that the MPC takes one month at a time, not tying its hands for future meetings. Forward guidance would do that and could also run into the problem of leads and lags in monetary policy.

Suppose the MPC said it would do £25bn of QE each quarter until such time as unemployment is back to its pre-crisis level of 1.5m. Apart from the fact that the new norm for unemployment could be 2.5m rather than 1.5m, because of the damage the economy’s has suffered, the Bank could find itself overdosing on QE because it takes time for monetary policy decisions to be reflected in real economic data.

Would such guidance work? There is a lot of scepticism around. At a time when nobody expects a rise in Bank rate for the foreseeable future and most in the City expect more QE, why should forward guidance make any difference.

The circumstances when it might could be if growth picks up and the markets get it into their heads that interest rates will quickly rise in response. Guidance from the Bank that they won’t could prevent fear of higher rates nipping recovery in the bud.

Similarly, as it did last month, the Bank could make a habit of signalling to the markets that it will “look through” above-target inflation. The risk, of course, is that it looks through high inflation for so long getting back to 2% becomes unattainable.

The bottom line is that Osborne wants the Bank to become less opaque and mysterious, and more transparent. That, and the imaginative use of even more unconventional policies than the Bank has employed so far (an easy example of which is buying other assets than gilts) might help growth at the margin. But we should not expect it, on its own, to transform a slow-growing economy into something stronger. That will take time and patience.

Sunday, March 17, 2013
Five things that might just boost 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.

This week’s budget, it can be safely said, will be disappointing. George Osborne’s fourth risks being his most discordant yet.

It will be disappointing on growth. Weak fourth quarter gross domestic product and January’s awful manufacturing and construction numbers mean the Office for Budget Responsibility will revise down growth forecasts it made only three months ago.

It will be disappointing on borrowing. Unless Osborne has come up with another fiscal trick, his autumn statement triumph of announcing a drop in the budget deficit this year, badly wrongfooting Ed Balls, will have proved shortlived.

Both Osborne and the OBR will have egg on face if, as is likely, this year’s outturn is instead heading for an overshoot of several billion. It should be an open goal for Balls.

It will be disappointing in content. The more the chancellor is constrained by the deficit overshoot and the loss of the AAA rating, the more strident the demands have grown. To call some of those demands naive scarcely does them justice.

Perhaps a Tory government unencumbered by coalition could have slashed spending in its first three years, a Canadian-style short, sharp shock to cut the deficit faster and leaving room for the deep tax cuts beloved of the party’s right-wingers. It did not happen then and is not going to happen now.

Similarly, there are those who would have liked Osborne to emulate the Denis Healey of 1974-5, expanding spending when everybody else was showing restraint, and driving Britain into the arms of the International Monetary Fund.

It would also have been good then to seek an alternative to the big cuts in capital spending inherited from Labour. But that did not happen either. Osborne will announce a further shift from current into capital spending on Wednesday and the big cuts are in any case now behind us. More capital spending will be a theme of the June 26 spending review (surprisingly announced ahead of the budget).

I would be surprised, however, to see a big and explicit increase in borrowing to pay for more infrastructure. That would be too close to a Plan B to present it as a continuation of Plan A, particularly after last month’s ratings downgrade by Moody’s.

Any activism, it seems, will be on the monetary side, with speculation focusing on a looser inflation target for the Bank of England and the new governor, Mark Carney, being given carte blanche to do whatever it takes to boost the economy.

How disappointing will the numbers on Wednesday be? John Hawksworth of Price Waterhouse Coopers expects an £8bn borrowing overshoot this year - so not even close to the deficit reduction officially predicted in December - and for similar overshoots to carry forward to future years.

As for growth, Ross Walker of RBS expects the OBR to predict 1% growth this year, 1.8% next. These forecasts are down marginally on the autumn statement predictions but well down on a year ago, when they were 2% and 2.7% respectively.

What can Osborne do to make his budget less disappointing? He has to do a better job defending the government’s srategy than David Cameron did 10 days ago. To those who say austerity has been a failure, he could point as the Institute for Fiscal Studies did in its green budget to the alternative of Britain’s public sector debt being propelled on an unsustainable path, taking it first to 100% and then to more than 200% of gross domestic product.

The alternative might have been a full-blown fiscal crisis, an International Monetary Fund programme, many ratings downgrades and 10-year bond yields closer to Italy’s (BBB+ rated) near-5%, rather than below 2% as Britain’s are.

Though GDP continues to disappoint, it is not hard to think of an alternative in which employment growth would have been weak or non-existent and unemployment, instead of being under 8%, closer to the eurozone’s 12%, or even the higher rates among its weakest members.

So things could have been worse, but that is not much to build a budget around. What else should there be? I would like to see five things.

On tax, Osborne has spent many billions raising the personal allowance towards its £10,000 target, heading off increases in petrol duty and moving towards a target corporation tax rate of 20%.

All have merits but also shortcomings. Raising the personal allowance is a stealth tax cut. Most do not notice it, while they did notice the 2011 Vat hike. Postponing duty hikes, similarly, means petrol prices have merely risen somewhat less steeply. Business has not responded to lower coporation tax with an investment boom.

So, to the extent that there is any money at Osborne’s disposal, and there always is a little, it should be targeted at specific incentives to get firms to invest in new capacity and home-owners to invest in job-generating home improvements.

On infrastructure, I can’t understood why, when so much of the 2010 Tory mainfesto was torn up for coalition reasons, the commitment on no new airport capacity in the south-east remained sacrosanct.

That is unjustified and the most positive infrastructure signal Osborne could send now would be a commitment to build a third runway at Heathrow. A new London airport in the Thames Estuary is, like HS2, a project for later. We cannot wait that long.

On housing, a proven generator of jobs and growth, progress is being made, via the Funding for Lending scheme (FLS) and an array of other initiatives aimed at first-time and new home buyers.

These should be expanded and talk of redirecting Funding for Lending away from housing forgotten. Social housing has a big role too. Housing associations have been bypassing the banks, raising money directly for new developments through bond issues. We need much more of that.

As for small and medium-sized firms, the FLS is the latest in a series of damp squibs for the sector. While some banks have broken through the barrier of mutual suspicion, others have not, or do not want to. The case for direct lending, giving a government-backed business bank genuine financial welly, grows stronger by the day.

Finally, on the Bank of England, Osborne should be wary of changing its remit in a way that endorses a permanent inflation overshoot but he should encourage the Bank to think more imaginatively about ways of boosting growth.

I would get the Bank to take an active role in building markets for securitised (packaged) small business loans and infrastructure bonds. These and housing association bonds could be swapped for some of the £375bn of gilts the Bank has bought under quantitative easing. Whether this would succeed in generating growth we do not know. You never know until you try.

Sunday, March 10, 2013
The eurozone crisis could still blow Britain away
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 happens in Europe doesn’t stay in Europe, and right now the picture there is downbeat.

The dampening effect of the eurozone crisis will be one of the factors George Osborne cites in his March 20 budget (of which more next week), and was highlighted by David Cameron in his infamous economic speech a few days ago.

He meant to say that the eurozone, high oil prices and the prolonged banking crisis explained why growth has undershot the Office for Budget Responsibility’s forecasts of three years ago, not the tax increases and spending cuts it had alreday incorporated into its forecasts. But it came out differently, hence the rebuke from the OBR.

But the eurozone is the biggest risk to Britain’s recovery hopes this year, and it remains the central threat to the world economy, in spite of the calming effect of the European Central Bank’s pledge to buy the government bonds of troubled eurozone economies.

Figures last week confirmed that eurozone gross domestic product fell by 0.6% in the final quarter of last year, which included falls of 0.8% in Spain, 0.9% in Italy and 1.8% in Portugal. Even Germany succumbed, down 0.6%. A quarterly figure for Greece was not available, but its GDP was 6% down year-on-year; grim for a recession that began in 2008.

Eurozone unemployment, 19m, or 11.9% of the workforce, has risen by 1.9m in the past year. The European Central Bank, like the Bank of England, sat on its hands on Thrusday but confirmed a 2013 recession for the eurozone, predicting a drop of between 0.1% and 0.9% in GDP this year.

Some say Britain’s problems are unrelated to the eurozone’s woes but that is plainly not the case. Apart from the crisis’s effects on confidence and bank funding, it has impacted heavily on Britain’s hoped-for export-led recovery.

Between 2009 and 2012 exports did recover, by 11% in volume terms, though imports rose at a similar rate. Exports to non-EU countries have risen strongly, by 31% in volume terms, while EU exports have been much weaker.

Since 2009, Britain’s GDP has risen by 2.9%. Had exports to the EU risen as strongly as non-EU exports, GDP would have increased by 8.7%, close to 3% a year, and nobody would be talking about the economy’s failure to recover.

Even if a stronger eurozone economy had simply resulted in 21% rather than 11% overall export growth. the recovery would have averaged a respectable 2% a year.

But the eurozone crisis is the cross Britain’s exporters have to bear. When will it end or is Europe doomed, like Sisyphus, to keep trying to push the boulder up the hill, only to have it roll down again?

We are used to visions of eurozone disaster as set out by British economists. Roger Bootle of Capital Economics did it well recently at the Institute of Economic Affairs, arguing convincingly that the eurozone is not sustainable in its present form, that it will condemn Europe to prolonged economic misery and that partial break-up will be part of the solution, not the problem, for Europe.

What you do not expect is to get equally doom-laden assessments of the eurozone’s prospects from the heart of Europe. The Munich-based CESifo is one of Germany’s “five wise men” institutes, and is headed by Professor Hans-Werner Sinn, one of the country’s leading economists. It has just published its 2013 European economic advisory group (EEAG) report on Europe.

The report highlights, as I have taken to doing, the fact that there is not a single eurozone crisis but three inter-linked ones: the sovereign debt crisis, the banking crisis and what it describes as a balance of payments crisis.

As it puts it: “Large imbalances have emerged in the euro area since 2000 in the form of current account deficits and surpluses. The euro area periphery countries of Greece, Portugal, Spain and Ireland in particular experienced credit bubbles that led to current account deficits and corresponding capital imports.”

Credit bubbles were accompanied by a loss of competitiveness, with the troubled eurozone economies gradually moving further and further away from Germany, Europe’s benchmark economy, losing between 20% and 30% competitiveness since the euro came into being.

What that means, as well as sorting out banking problems and putting sovereign debt on a secure footing (which for countries like Greece will mean further write-offs), the problem economies have to claw back that lost competitiveness.

There are two ways of doing that. One is so-called internal devaluation; cutting their costs, in particular their wage costs. It is, as the EEAG report notes, likely to be painful, involving “prolonged recession and high unemployment”.

The other route, external devaluation - leaving the euro- is no easier, it says, boosting public sector debt, driving companies into mass bankruptcy, with even anticipation of a euro exit causing “destabilising capital flight and contagion effects”.

It is not all bad news. Ireland is held up as an example of a country that is meeting the challenge of clawing back competitiveness, not least because its crisis erupted about two years before the others.

For most of the others, however, progress is painfully slow or non-existent. Italy, having had chronically weak growth for years, is in a political crisis and was downgraded to BBB-plus by Fitch on Friday. France, which is having a torrid 2013 judging by the surveys, is not immune.

Does not the euro hold together as long as Germany will finance it? As Sinn put it wryly: “We love the French, they lover our money.” But German pockets are not bottomless. Germans are suffering a wage squeeze and face the challenge of an ageing and declining population.

Not everybody is so gloomy. Berenberg, a German bank, in a new report, says: “If the eurozone and its member countries stay the course, the euro crisis could be largely over by the end of the year.”

It thinks the weaker countries are making better progress in restructuring their economies than CESifo believes. Even here, however, there is a sting in the tail. France, it says, is not making progress and urgently needs economic reform. My take would be harsher; that France is goijng backwards under Francois Hollande.

We need to hope that the optimists are right and that the eurozone is closer to resolving its crises than appears. Britain needs growth, not fog, across the Channel. But Europe has disappointed before. The fear is that it will do so again.

Sunday, March 03, 2013
The Bank of England has lost its compass
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 the Bank of England was made independent in 1997, I thought it was an excellent move. What better way was there to protect the economy from flaky politicians? The days of interest rate cuts timed for party conferences or to secure a pre-election political advantage would surely be over. Low inflation would be safe in the Bank’s hands.

Now, the boot is on the other foot. George Osborne, responding to the Moody’s downgrade, has shown a lack of flakiness so far, saying it strengthens his determination to cut the deficit. The Bank is another story. It has taken me longer than some but I am no longer so sure monetary policy is safe in its hands.

As most will have seen from the headlines, a few days ago Paul Tucker, one of the deputy governors, took the Bank into new territory by floating the idea of negative interest rates. “I hope we will think about whether there are constraints to setting negative interest rates,” he said in evidence to MPs on the Treasury committee. “This is an idea that I have raised.”

He was talking about the possibility of a negative rate on some of the £280bn of reserves commercial banks hold at the Bank, with a view to encouraging them instead to lend into the economy. He probably did not expect it to be reported as a new assault on savers.

The confusion was, however, justified. Bank rate is what the banks receive on their reserves. To pay them a negative rate without penalising everybody would require an entirely different system, which is one reason why Charlie Bean, Tucker’s fellow deputy, distanced himself from it the following day. He would need some convincing that such a policy would work to justify the shake-up it would require.

The confusion did not end there. Markets, encouraged by speeches by Sir Mervyn King, and the monetary policy committee’s (MPC’s) own minutes, had got used to the idea that quantitative easing, £375bn so far, was being paused while the Bank gave the £80bn Funding for Lending scheme time to work.

Now, the Bank appears back in full QE mode. It emerged 12 days ago that three of its members, including King, voted for a further £25 billion of QE. Tucker told MPs that “nobody on this committee thinks that QE has reached the end of the road”.

Paul Fisher, his colleague, the Bank’s executive director for markets, said in a speech he favoured a “prolonged run” of gilt purchases. He also said, curiously, the Bank was wary of distorting markets. Surely purchases of gilts equivalent to 25% of gross domestic product are distorting?

This outbreak of hyperactivity from senior Bank people does not seem to have been driven by any deterioration in the economy. The bottom line is that the Bank is prepared to relax policy further - nobody will be surprised by another £25bn of QE this Thursday - even as its forecasts (which are usually optimistic) show inflation above target for at least the next two years.

This has not gone unnoticed in markets. BNP Paribas says there is “total confusion” over the Bank’s use of its policy tools. J.P. Morgan says the Bank’s policy framework is “creaking” and that there is a “shambles” over the issue of when it will seek to bring inflation back to target.

These are not the only worries. The Bank, by tradition, refrained from comments on the pound. I recall, at an IMF meeting in Prague in autumn 2000, trying to get Eddie George, the previous governor, to say something about sterling, which was strong (1.70) against a sickly euro.

I thought it was a subtle question but Eddie saw straight through it. He didn’t quite say: “I didn’t get where I am by talking down the pound”, but it was close. The last thing the Bank wanted was to be associated with a sterling slide.

Times have changed. Short of erecting a sign on the front of the Bank saying “Sell Sterling”, it could barely do more than signal its desire for a lower pound. King has been a champion of sterling depreciation, if that is not a contradiction in terms.

When he introduced the Bank’s November inflation report he said it was hard to see anything other than a “slow and protracted recovery” in the absence of a fall in the real exchange rate. The pound duly obeyed, vying wih the yen as the weakest major currency of 2013. In its latest minutes, the MPC noted the “expansionary impetus” from the pound’s fall.

Martin Weale, a fellow MPC member, in the most explicit endorsement of a lower pound, said in a speech on February 16 it was the “most natural” way of resolving Britain’s balance of payments problem.

The trouble with this is that we have already had one of the the biggest sterling falls in history, the 25% drop in its average value in 2007-8, the effect of which has been to push up inflation through higher import prices while doing little for exports. There is no reason to believe a further fall would be any different in its effects.

The pound, clearly overvalued against the euro in 2000 when it was 1.70, is undervalued now at 1.16. It should not be falling against a euro whose problems go beyond the tendency of Italians to vote for clowns. For the Bank to try to push it down is wrong.

What can be said in the Bank’s defence? Its senior officials seem determined to show, before the summer arrival of Mark Carney, that they are capable of imaginative thinking on monetary policy, even if those ideas come to nothing.

There is something in this, though it represents a late flowering for what has always come over as a conservative institution. There is also a proper way to convey new ideas, not in impromptu answers to Treasury committee questions.

The Bank can also argue that the inflation it influences is under control. Average earnings are rising by 1.4%, while the gross domestic product (GDP) deflator, which measures economy-wide inflation, rose just 1.1% in the past 12 months.

These are not, however, the things the Bank is supposed to target. It has rarely hit the 2% inflation target in the past eight years and, on its own forecasts will not do so in the next 2-3 years. A decade of above-target inflation is, for any central bank, flaky. The Bank has lost its compass.

Sunday, February 17, 2013
Close the productivity gap, or we get even poorer
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.

Why is Britain's productivity - the amount we produce per worker - in such a bad way? Why, relative to other countries, is it going backwards?

Official figures showed that in 2011, output per hour in Britain was 16 percentage points below the average for the rest of the G7 (America, Japan, Germany, France, Italy and Canada). The productivity gap, on this basis, has not been wider for two decades, since 1993.

Every hour worked in America produces 27% more output than in Britain; 26% more in France, 22% in Germany and even 3% more in Italy.

The gap when measured by output per worker was even larger, 21 percentage points. The rest of the G7, in other words, is roughly a fifth more productive than Britain. America, on this basis, is 39% more productive than Britain.

Should we be bothered? Yes. In another release, unusually, the Office for National Statistics(ONS) quoted Paul Krugman, the Nobel laureate turned New York Times columnist, and his observation that: “A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise output per worker.”

Krugman’s slightly snappier version is that “productivity isn’t everything, but in the long run it is almost everything”.

The weakness of productivity is directly linked to another phenomenon highlighted by the ONS: falling real wages. Adjusted for inflation, average earnings in Britain have been falling since 2009 and are now back at the levels of 2002-3. For the self-employed, the picture is even grimmer: real incomes are a fifth lower than they were a decade ago.

As far as the growth in real pay is concerned, it is almost as if the period between the Queen’s golden and diamond jubilees never happened. Worse, with inflation still running more than a percentage point above average earnings, the fall in real wages is not yet over.

I had always thought that the drop in real wages was a function of what we must now call the Bank of England’s “flexible” inflation targeting regime, as elaborated on by Sir Mervyn King in presenting his penultimate inflation report.

The Bank, in other words, is prepared to tolerate years of above-target inflation because it thinks the alternative would be worse. But that above-target inflation, as often noted here, stands in the way of meaningful consumer spending recovery.

The productivity numbers, however, suggest another explanation, which is that real wages are so weak because we are falling behind on productivity. It is not quite “pay peanuts and you get monkeys” but it does suggest employers have little choice but to hold down pay because productivity is so poor.

Britain, is seems, is turning into a low wage/low productivity economy or even a falling wage/falling productivity economy. It is particularly galling because only a couple of weeks ago I quoted figures showing that, starting in about 1980, Britain had reversed her long-term relative productivity decline. The good work, it seems, is being undone.

So how worried should we be? Are we condemned to falling living standards and never trading our way out trouble? If you have ever wondered why Britain’s exports are not doing better, a chart in the Bank’s inflation report provided an explanation.

Wages have been weak, but productivity even more so. Combining the two gives unit labour costs and Britain’s relative unit labour costs, what the Bank calls the real effective exchange rate, is up by between 15% and 20% over the past four years.

The question is how permanent is the poor productivity performance. Here, there are one or two grounds for optimism. Weak productivity since the financial crisis hit has been a European phenomenon, experienced by Germany, which we do not think of as busted flush, as well as Britain.

Countries that have done well in maintaining jobs, such as Germany and Britain, have done much worse on productivity. America, in contrast, had a much bigger drop in employment (and still suffers from higher unemployment than Britain) but has done better on on productivity. That is the way the arithmetic, always of course subject to statistical revision, works.

Second, most economists believe that Britain’s productivity weakness is temporary and will recover. History suggests it is is rare for economies to hit a brick wall.

Even the Bank’s monetary policy committee, which has been accused of productivity pessimism, is basing its new forecasts on what it describes as “a gradual revival in productivity growth” and allows for the the possibility that it could recover more rapidly than expected.

Finally, we should look at the particular causes of the productivity problem in recent years, over and above the need for more investment (the more capital per worker, the higher the labour productivity) and higher skills.

ONS research shows that plunging North Sea output, without a matching drop in the number of workers, has hit productivity hard in recent years. Without this, measured productivity would have grown by 1% a year more. Though North Sea output appears to have stopped slumping, we may have to wait for shale gas for a sustained productivity boost from energy.

The other important sector is financial services. Before the financial crisis iits productivity growth rate was more than 4% a year. Since it, productivity has been falling by nearly 3% a year.

That is not the only consequence of a smaller and neutered financial services sector. The Bank governor lamented the drop in Britain’s financial services exports, another reason why the current account deficit has remained stubbornly large.

The North Sea will never get back to its glory days and, whether glorious or not, the City will struggle to regain its former highs. That leaves the onus on the rest of the economy, particularly the wider service sector where productivity is below levels at the depths of the recession, to raise its game, partly by adopting better and more efficient ways of doing things. The alternative is declining living standards.

We do not have to be productivity pessimists. But we do need to work at generating higher productivity.

Sunday, February 10, 2013
Carney's no messiah but can he work miracles?
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 the past few days we have heard for the first time in Britain from the new Bank of England governor, we had a report on the economy from the Organisation for Economic Co-operation and Development (OECD) and we have had the Institute for Fiscal Studies’ always insightful Green Budget.

Any of these, in a normal week, would provide sufficient material for a column. Let me deftly, I hope, combine them.

Regular readers will not need reminding of the difference between fiscal and monetary policy, though the lines may have become a little blurred.

Fiscal policy, the preserve of the chancellor, is being tightened, through tax hikes and spending cuts. That leaves monetary policy, which from July 1 will be under the leadership of Mark Carney, to do the heavy-lifting or, as George Osborne put it: “Action by the Bank of England can and should continue to support the economy”.

The Bank, which on Thursday left interest rates unchanged at 0.5%, as it has for nearly four years, and maintained the amount of quantitative easing (QE) at £375 billion, would argue that this is precisely what it has done.

This loose money/tight fiscal demarcation - cut the deficit but keep the economy afloat with the lowest interest rates on record, topped up with QE - is the OECD’s favoured prescription. In its annual survey of Britain’s economy, it said that “monetary policy is the primary tool to stimulate the economy” and that “the fiscal stance remains appropriate”.

It backed Osborne’s decision in his December autumn statement to allow the so-called automatic stabilisers to operate - don’t raise taxes or cut spending further to offset a deterioration in the public finances due to weak growth - but does not think the solution to Britain’s growth problems lie with a “Plan B” or any other junking of the coalition’s fiscal strategy.

The question, however, is why loose money/tight fiscal, having generated strong recovery in the 1930s, late 1970s, 1980s (eventually) and 1990s, has struggled this time. Compared with the 1990s, sterling has fallen a lot more - 25% versus 14% - interest rates are plainly lower (real interest rates more so), and QE was not even a twinkle in the Bank’s eye then.

One explanation is that a damaged banking system means monetary policy is far less effective than usual, and there is plainly some truth in that. The other is that it could have been done a lot better.

Carney, in a marathon evidence session to the House of Commons Treasury committee, was urbane, polite about his new colleagues and mainly gave straight answers. He dismissed Lord (Adair) Turner’s idea of a “helicopter drop” of money (not literally) to boost the economy.

Advocates of a ripping-up of the Bank’s existing framework, and its replacement by a money GDP target with a more explicit commitment to growth, did not receive much encouragement. He praised what he described, and which Sir Mervyn King has taken to calling, Britain’s “flexible” inflation targeting regime. If that means the Bank doesn’t hit the target very often, it is a pretty good description.

But coming through the new governor’s testimony - accompanied by a 45-page written submission - were two messages. The first was that monetary policy has not yet reached the end of the road; I doubt if he would have taken the job merely to mop up what was done under King.

The second is that the Bank under Carney will be more open in the way it communicates its actions (there was a hint of that with the long statement that accompanied its no-change decision on rates). And it will be more imaginative in its use of “unconventional” policy - I cannot imagine him being content merely to carry on buying large quantities of gilts (UK government bonds). It will look for new ways of stimulating the economy.

The Bank’s slavish commitment to QE through gilt purchases, which has run into quite significant opposition for its effects on pensioners, is in some ways forgivable. Nothing quite like this, or at least on this scale, had been tried in Britain until 2009.

But if the definition of insanity is doing the same thing over and over again and expecting different results, there is an element of this in the Bank’s decision to persist with its existing model of QE. Quite what a new model might be is not clear but at the very least should widen the range of assets the Bank is prepared to buy.

If monetary policy could be improved, so very clearly could fiscal policy. The IFS’s Green Budget was clear that spending cuts and tax hikes were necessary, without them the budget deficit would still be around 11% of GDP and public sector debt would be on a trajectory that would take it to 250% of GDP in the coming decades.

But the IFS was also clear of the serious shortcomings in fiscal policy. Both Labour and the coalition thought the path to budgetary salvation lay with slashing public investment: the element of spending that has the biggest impact on growth.

Under current plans, meanwhile, welfare spending will rise from 28.5% of all government spending by 2010 to 32.5% by 2017-18. Some would say welfare feeds directly into the economy because those who receive it spend everything they get.

But the lion’s share of extra welfare is going to the elderly and, while those on low incomes do spend what they receive, that is not true for old people as a whole: they have relatively low propensity to spend.

If the “welfare up/investment down” split looks illogical, so does the fact that, in spite of headline government commitments to squeezing public sector pay, it has continued to go up, managers choosing instead to shed workers, which they will continue to do, to the tune of 1.2m in all.

There is also, as the IFS identified, a huge question about whether cuts to departmental spending can be delivered. These, real-terms reductions of a third in non-ringfenced departments by 2017-18, have barely begun. Only 21% have so far been delivered. Small wonder the IFS thinks tax hikes after the 2015 election will be used an alternative to some of them.

So there is a lot of work to be done to improve the effectiveness - and deliverability - of fiscal and monetary policy. Faster growth, the IFS notes, would help resolve some of the fiscal dilemmas.

As the excitement over Carney’s arrival has grown, I have taken to paraphrasing Monty Python and saying: He’s not the Messiah, he’s only a central banker. If he can deliver the growth that gets the government out of the fiscal mess, however, he really would be a miracle-worker. It promises to be an interesting year.

Sunday, February 03, 2013
Britain's not broken: but needs to shift up a 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.

A few days ago an unusual report was published on Britain’s economy. It set out some good ideas about how to generate growth over the medium and long-term through infrastructure, innovation, education and skills.

More striking, for me at least, the London School of Economics (LSE) Growth Commission stressed that Britain approaches the future with very conisderable advantages, and an economy that is far from broken.

I count myself an optimist but even I was surprised at some of the findings about our recent economic history. In the past 30 years or so, for example, gross domestic product per head has risen more rapidly than in advanced-country competitors.

As the Commission put it: “Despite the current gloom, the UK has many assets that can be mobilised to its advantage, including strong rule of law, generally competitive product markets, flexible labour markets, a world-class university system and strengths in key sectors, with cutting edge firms in manufacturing and services.

“These and other assets helped reverse the UK’s relative decline over the century before 1980. Over the following three decades, they supported faster growth per capita than in the UK’s main comparator countries – France, Germany and the US.”

Yes you are thinking but wasn’t this all the City? The financial services sector may not be broken but it is badly damaged and likely to remain so for some time.

Again, however, the report finds that the idea of a City-dependent Britain before the crisis is an urban economic myth. Between 1997 and 2007 market (private) sector productivity, output per hour, grew by 2.8% a year, of which only 0.4% came from financial services.

Business services contributed twice as much (0.8%) to productivity growth, industry (1.1%) almost three times. On other measures, as the report notes, growth before the crisis was no “finance-driven statistical mirage”.

The problem since the crisis has, of course, been lack of productivity; jobs are up while GDP has struggled. Again, however, Britain has been far from alone on this. The pos-crisis producivity record has been almost identical to Germany, and similar to Italy and France. Only America stands out among the big advanced economies, because the shakeout of jobs was much more brutal there.

The Commission’s co-chairs were tLSE economics professors Tim Besley and John Van Reenen and its members included Rachel Lomax (ex Bank of England deputy governor), Chris Pissarides (Nobel prize-winning LSE economist), Richard Lambert (ex CBI director-general), Lord Browne (former BP chief executive) and Lord Stern (economist and climate guru).

The LSE is on a roll. Last week it was granted a Regius professorship of economics by the Queen, an improvement in royal relations compared with autumn 2008, when she famously asked at the LSE why nobody had spotted the crisis coming and was not impressed with the answer.

The Growth Commission uses a German word, Schadenfreude, to describe what it sees as the attitude many Britons have to the economy and the way it is reported, “revelling in stories of national decline”.

This is not just the bonkers fringes of the City, media and internet with their constant talk of imminent national collapse. It has always been the case that doom-laden economic stories are more likely to find their way to the top of a news bulletin or the front page of a paper.

The economy is the ultimate political football. Nobody is happier than an opposition politician when economic news is dire. Ministers rarely acknowledge the contribution of an opposing party, When did you last see politicians of different parties working together in the national economic interest?

Yet the lesson of the past 30 years is the reversal of a century-long relative economic decline was not the product of one leader’s time in office. It may have started with the Thatcher reforms of the 1980s but it continued under John Major and Tony Blair.

There are some very good recommendations in the report. On infrastructure, it calls for a new strategy board, planning commission and bank, to get plans approved, financed and implemented, particularly in transport and energy.

On “human capital” it calls for a range of further improvements in schools and teacher quality, and to ensure Britain’s universities can continue to attract international talent, by exempting bona fide students from the cap on net immigration. It also has a range of proposals for tackling the traditional Achilles’ heel, intermediate workplace skills.

These and other proposals to boost investment and innovation, including a greater competition in retail banking, a business bank and new regulatory incentives to encourage long-termism in investment decisions, add up to a meaty package, which politicians should take seriously.

Perhaps the most serious message, however, is for politicians themselves. One reason for the success of the past 30 years was continuity. Eighteen years of Tory government folowed by 13 of Labour offered a degree of stability. Labour did not tear up much it inherited from the Tories.

That cannot be guaranteed. The LSE Commission suggests a National Growth Council whose role would be to challenge governments when growth-friendly policies were not being pursued, and to offer the continuity to pursue a long-term growth programme. As it says: “The absence of stable machinery at the centre of of government makes it more difficult to develop a long-term strategy for promoting economic growth.”

Politicians are not good at the long-term, though perhaps the commitment to HS2, the new high-speed train, is an example of a new approach. Typically, they think of the next budget or, as now, the next Bank governor.

But, while the Right sees the solution in tax cuts, and the Left in boosting spending, and while Mark Carney is seen by some as an economic messiah, the solution to Britain’s growth difficulties does not lie with short-term fiscal and monetary measures.

People have to believe that history did not end with the crisis, and the Growth Commission offers some encouragement. It does not believe, for example, that Britain’s growth rate has been permanently lowered, or that “the pre-2008 improvements in the UK’s economic position relative to the EU and the US are likely to unravel”.

For that optimism to be justified, the economy needs a sustained increase in investment in infrastructure, private sector capacity, education and skills. The gauntlet has been thrown down. The politicians should pick it up.

Sunday, January 27, 2013
Financial hangover is Britain's biggest growth headache
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.

Thanks to Friday’s figures, gross domestic product once again dominates the agenda. The GDP numbers, showing a 0.3% drop in the fourth quarter of 2012, completed a year in which Britain’s GDP was exactly flat, both comparing 2012 with 2011 and the fourth quarter of 2012 with the corresponding quarter of a year earlier.

Squaring that with another measure of how the economy is doing, the 552,000 rise in employment over the past 12 months, the biggest since the late 1980s’ boom, is hard to do. Squaring it with a 113,000 rise in full-time employment in the September-November period is as challenging.

The fact that GDP fell owes a lot to energy shutdowns, which reduced it by 0.2% over the quarter and a drop in "sporting activities" (you can't have the Olympics every quarter) which had a similar effect. Even so, when the economy is weak enough to be pushed off course by such factors, it is weak.

So GDP it is. Does its weakness mean, as Olivier Blanchard, chief economist at the International Monetary Fund has suggested, the government should re-think its austerity plans by the March budget?

No. The IMF is a strange body. Christine Lagarde, its managing director, has been something of an international cheerleader for the coalition’s fiscal strategy.

Last month the IMF published a working paper by three of its economists, Anja Baum, Marcos Poplawski-Ribeiro and Anke Weber, showing that the impact of tax increases and spending cuts on Britain’s economy, so-called fiscal multipliers, is very small.

Blanchard has a different view, which the Treasury is not taking too seriously because, though he is chief economist, his is not the IMF view. Whether or not the IMF does recommend a change of strategy we will not know until May, and its next detailed consultation, known in the jargon as an Article IV consultation.

It looks unlikely, not only because that work on the multipliers suggests austerity is not to blame, but also because the government has not tried to stick to deficit reduction willy-nilly. In the face of weaker growth it allowed borrowing to take some of the strain, allowing what economists call the automatic stabilisers to operate.

So why is GDP growth so weak? A paper by economists from Liverpool and Manchester universities, to be presented at the Royal Economic Society’s annual conference in April, argues strongly for a financial rather than a fiscal explanation for the slow recovery.

The most striking result from the research, which chimes in with the IMF’s detailed work, is how little difference the coalition’s austerity has made to growth. You cannot raise taxes and cut spending without some impact on growth. The point is that this impact has been small.

The economy has grown by roughly 0.5% a year since the coalition took office. In the absence of austerity, it would have grown only a little more strongly, perhaps 0.75%, the research suggests. The unemployment rate would have been a fractional 0.1 points lower annually.

Given the risks Britain faced if there had not been a programme to cut the deficit - the danger was of a full-blown fiscal crisis - this is a small price to pay.

The paper, The Impact of Stock Market Illiquidity on Real UK GDP Growth, by Chris Florackis, Gianluigi Giorgioni, Alexandros Kostakis and Costas Milas, focuses on the key role of liquidity - the availability of funds in the banking system and elsewhere - in Britain’s recent performance.

The drying up of liquidity in 2007, when the financial crisis hit, was a key factor in the severity of the recession. By the same token, it has been a significant constraint on recovery.

The Bank of England, responding to the crisis by providing liquidity to the financial system, and through quantitative easing, has tried to offset the liquidity drought and credit crunch. It has not, however, been able to eliminate the financial hangover.

Sir Mervyn King, in Tuesday’s final regional speech as Bank governor, in Belfast, barely mentioned fiscal policy as a factor in the slow recovery. Instead, as well as the high-inflation squeeze on real take-home pay and the eurozone, he focused on another financial factor.

The problem, he said, was “the extent to which the balance sheets of the major UK banks had grown before the crisis hit, and had been financed primarily by borrowing.

“So the subsequent reduction in bank lending – the deleveraging – was greater here than in many other countries. That deleveraging has as its counterpart a reduction in the amount of (broad) money in the economy and a reduced willingness on the part of banks to expand lending.”

These effects - the financial hangover - were predicted in one of the most important books of recent years, This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff.

It demonstrated that not only are banking and financial crises more common than we think but that they also lead to far deeper downturns and slower recoveries than normal cyclical recessions.

Rogoff is a former chief economist at the IMF who speaks sense. There is a debate among economists, particularly Americans such as Robert Gordon, about whether the West has reached the end of growth, because the technological progress that has driven living standards for 250 years has, no pun intended, run out of steam.

Rogoff does not believe that, though does think there is a risk the malaise we are suffering after the financial meltdown undermines long-run prospects. One danger is if new businesses that typically drive innovation and new products are strangled at birth by lack of credit.

When I asked him about the dilemma of economies such as Britain caught in a Reinhart-Rogoff slow recovery, he was clear that the solution does not lie on the fiscal side, or at least not with a fiscal stimulus.

The government, he said, could to shift resources to those areas of spending which boost long-term growth, such as infrastructure and education, and away from what he describes as entitlements. George Osborne has been trying to do a bit of this.

What the government also has to do is avoid getting to what he describes as the “rarefied air” of government debt rising above 90% of GDP. Britain has passed an important milestone, according to figures released last week, with public sector net debt rising from 69.3% of GDP in November to 70.7% in December, thus rising above 70% for the first time since the early 1970s.

Get above 90%, says Rogoff, and you get lower growth on a sustained basis that can last for decades. The financial hangover would be compounded by a fiscal millstone. That has to be avoided.

Sunday, January 20, 2013
Everybody gets hurt in a currency war
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 point that is not often made about the long period since the global financial crisis struck is that the world has behaved pretty well in these difficult times.

Beginning with the big G20 (Group of 20) meetings in 2008, countries decided co-operation was better than confrontation. The feared mass outbreak of protectionism, one of the great errors of the 1930s, never happened.

It is as well that it did not. World trade has slowed even without new trade barriers being erected. 2012 looks to have been one of those rare years when world trade grew more slowly than world GDP (gross domestic product). Normally trade grows roughly twice as fast.

Before we congratulate ourselves too much, however, we should keep an eye on what Simon Derrick, chief currency strategist at Bank of New York Mellon, describes as an outbreak of currency wars.

There is more than one way of skinning a cat in times when growth is hard to come by. Protectionism is one. Currency manipulation, often harder to detect, is another. And now we are seeing it.

Much of the focus so far has been on Japan, under its new Liberal Democratic Party prime minister Shinzo Abe, elected late last year. Earlier this month he unveiled a 10.3 trillion yen (£72bn) stimulus to boost the moribund Japanese economy.

But he also signalled what many saw as an explicit attempt to drive the yen lower, in order to boost exports, by urging the Bank of Japan to adopt a looser monetary policy and a higher inflation target.

Abe was pushing at an open door. The yen had already weakened significantly in the final few weeks of the outgoing government, also following a clear lead from the authorities that they favoured a lower exchange rate.

So what? Why should not Japan, which needs all the growth it can get - and some inflation to break out of its deflationary trap - not engage in a deliberate depreciation of its currency? Isn’t this its affair?

Well no, as Derrick points out. Deliberate currency depreciation is counter to the pledges that countries, including Japan, have made in the G20 not to do it. Not only that but one country’s competitive advantage is another’s loss.

South Korea, Japan’s big competitor in electronics, cars and other products, has seen its currency, the won, rise 22% against the yen since last summer. A Hyundai executive described the won’s rise and yen’s fall as “a double-torture situation”.

While describing it as “smoothing operations”, the governor of the Bank of Korea confirmed last week that it has been intervening to try to restrain the won’s rise.

A battle among two of Asia’s most formidable exports does not yet amount to a full-blown currency war but the danger is that it is heading that way.
There are only three big currencies in the world, the dollar, the euro and the yen, with sterling coming in fourth.

European officials appeared relaxed about the euro’s rise since the summer. A stronger euro could be seen as a vote of confidence in the single currency’s survival; market approval for the European Central Bank’s monetary “bazooka” - its outright monetary transactions - and Germany’s more conciliatory attitude towards Greece.

Lately, though, European leaders have been getting restive. The euro’s climb includes a 14% ascent against the weak yen, a fact not lost on German exporters who often have to compete head to head with their rivals from Japan.

Jean-Claude Juncker, head of the eurogroup of eurozone finance ministers, said on Wednesday that the single currency’s rise had taken it to “dangerously high” levels. With domestic demand depressed across the eurozone, exports have been seen as the escape route from its problems. But a sharp slowdown in the German economy to 0.7% growth last year, with a fall in GDP in the final quarter, suggests growth from that source is fading.

Everybody, it seems, wants a weak currency. America, despite its currency quarrels with China, has quietly been pursuing a weak dollar policy since the crisis began, the Federal Reserve under Ben Bernanke ensuring the dollar stayed low with repeated bouts of quantitative easing (QE).

The dollar’s average value is 12% lower than it was before the crisis. Its average value in 2012 was a huge 31% down on its level of a decade earlier.
America’s weak dollar policy has had repercussions. Brazil was one of the countries which protested, and took action, when the effect of Washington’s QE was to push its currency, the real, lower.

Switzerland, caught between the race to the bottom between euro and dollar, established a ceiling for its currency against the euro, and intervened to make it stick.

Britain is not immune from these skirmishes. On Thursday, the pound dropped below 1.20 euros for the first time in nearly 10 months, mainly as a result of the euro’s strength but also because of worries over the the potential loss of Britain’s Triple-A sovereign debt rating and the size of the current account deficit.

There were times when the pound’s fall would have been regarded as bad news. Indeed, there were times when it would have led to a rise in interest rates to defend it. These days it is different.

Sir Mervyn King said in November that sterling’s rise last year was “not a welcome development”. Introducing the latest inflation report, he said: “It may be unreasonable to expect anything other than a slow and protracted recovery absent a further fall in the real exchange rate.”

The Bank should be careful what it wishes for. Though Britain’s large current account deficit - more than £50bn last year - argues for a lower pound, and some of sterling’s safe-have appeal has been wearing off - a lower pound is no panacea.

Indeed, the response of Britain’s trade to sterling’s 25% fall over the course of 2007-8 can only be described as disappointing. Add in that a lower pound undoubtedly contributed to higher inflation, pushing up both industry’s costs and squeezing household incomes. Sterling’s fall was a big factor in the unprecedented weakness of consumer spending in this recovery.

Some countries, including Japan where the ongoing danger is deflation not inflation, are better placed to benefit from a lower exchange rate. But there is one clear and simple fact. All currencies are relative to each other. It is a logical impossibility for everybody to have a lower currency.

Competitive devaluations, as we have seen, cause tensions. The danger is that those tensions lead to a full-blown currency war. That has to be avoided.

Sunday, January 13, 2013
Glimmers amid the gloom as risks start to fade
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.

Stock market performance does not always reflect what is happening in the real economy. Many emerging economies have lousy stock markets. Though it has picked up recently, China’s Shanghai composite index is barely a third of the peak it reached a few years ago, in spite of the Chinese economy’s rise.

Conversely, this year’s strong opening for the FTSE-100, taking it to its highest levels since well before the collapse of Lehman Brothers in September 2008, does not seem to reflect any discernible improvement in Britain’s economic performance.

It does, however, reflect something that may impact on that performance, a perception among investors that the risks of another nasty downward lurch in the global economy have diminished.

So China, predicted by some pundits in recent months to be facing a definite hard landing, appears to have come through its mini-crisis rather gently and is gaining a strength which should mean growth of more than 8% this year.

America, judging from the data and surveys, was not too worried about the fiscal cliff shenanigans and has started 2013 with what looks like reasonable momentum.

Even the eurozone appears to be out of the emergency ward with Olli Rehn, the economic affairs commissioner, declaring that the dangers of a eurozone split are over, and Herman van Rompuy, the EU president, declaring that the “existential threat” to the euro was over and that growth should soon resume.

A pinch of salt is necessary. If we listened to the predictions of EU leaders there would never have been a eurozone crisis, let alone one that posed the biggest risk to the world economy and threatened the single currency’s very survival.

Stephen Lewis, veteran City economic commentator with Monument Securities, warns that America’s fiscal problems and the eurozone crisis will return to haunt markets, with Cyprus and Portugal as the next likely flashpoints.

Even so, the nature of the process of recovering from crises is that things do not go from dreadful to perfect overnight. Healing takes time. The more confidence there is that the healing process is under way, however, the better things will start to look, including in Britain.

What does the economy need this year? It needs the supply of credit to improve, so there is a big onus on the Treasury-Bank of England Funding for Lending scheme. It needs inflation to come down and stay down, restoring real incomes and boosting consumer spending. It needs some of the government’s initiatives on infrastructure spending to start showing through.

And it needs, as described above, the fear of new crises to be replaced by a sense that the world is coming through it. Apart from the direct effects on Britain of the eurozone crisis - with exports to the region down by 6% over the past year - it has been the biggest dampener on business confidence.

There are one or two glimmers of a change. The British Chambers of Commerce (BCC), in its latest quarterly survey, reported stronger readings for most of the measures of activity among its members it monitors. There is, it said, “resilience among UK businesses, coupled with rising confidence that the outlook will improve”.

The fourth quarter showed an improvement compared with the third, the BCC said, including a “marked increase in confidence which ... reinforces our view that the economy will recover slowly in 2013.” Though business still yearns for those untroubled pre-crisis days, export readings for the service sector were better than their pre-recession average in 2007.

The BCC, interestingly, sees a very different picture for what was happening last year than the Office for National Statistics. When the official figures were in double-dip territory in the first half of the year, it thinks there was growth, though is sceptical about whether there was any Olympic lift in the third quarter.

It is not the only hopeful sign. The Recruitment and Employment Confederation, with KPMG, takes the temperature of the job market each month. Its latest survey showed employment continuing to rise and job vacancies at their highest for 20 months.

So what will 2013 look like? Four years into a recovery 1% growth is not a lot to ask for. But, though it partly depends on the fourth quarter gross domestic product number in 12 days’ time, which will be depressed by Friday's weak manufacturing numbers. We can hope for more if the international clouds really do lift, but 1% may be as good as it gets.

The job market, having performed extremely well, will continue to generate new jobs. But employment may merely rise in line with the increase in the workforce, so the claimant count measure of unemployment will probably stay close to 1.6m and the wider Labour Force Survey measure remain within sight of 2.5m, barring a growth surprise.

As for the great rebalancing of the economy, we await final figures but the 2012 deficit is likely to have been well over £50 billion, from £20 billion in 2011. If the eurozone does hold up, a narrowing to £40 billion is likely this year; still very large.

I hope inflation will be closer to 2% than 3% or even 4% by the end of the year but anything lower than 2.5% looks optimistic.

There will be plenty to write about Mark Carney, the new Bank of England governor, before and after his arrival from Canada in the summer. He may signal that rates will remain low for a long time (as they have already) but I would not look for any change from 0.5%.

One day Bank rate will go up, reflecting a shift to more favourable economic conditions and a belief among the rate-setters that the economy is strong enough to take it. But, though I hope and believe things are slowly improving, we are not there yet I fear.

Sunday, January 06, 2013
Welfare: the elephant in every room
Posted by David Smith at 09:01 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.

Somehow, one senses, the word "triple" is going to feature quite a lot in discussions of the economy in the coming months: the triple-A rating ands the debate over a triple-dip recession..

Some City economists had thought it unlikely gross domestic product will have slipped back in the final quarter of 2012 (which would give the first leg of a triple-dip).

But weak purchasing managers' surveys for construction and services in December have put it back on the agenda - Markit, which prepares the data, expects a 0.2% quarterly GDP fall, and it is always unwise to second guess the Office for National Statistics, which will have its first stab on January 25. More before then.

This week let me look at that other triple, the triple-A rating. Britain’s AAA sovereign rating, having survived until now, is plainly under threat. All three of the main ratings agencies, Standard & Poor’s, Moody’s and Fitch, now have the country on negative watch or negative outlook.

I know what you are thinking. Why should we take any notice of ratings agencies, which have still not redeemed themselves for their performance ahead of the global financial crisis, when they scattered AAA ratings like confetti around securities that turned out to be junk.

The loss of the AAA rating, more likely than not from at least one of the agencies this year, matters less than it did. Had it happened three years ago, when America and France still enjoyed AAA status, it would have emphasised Britain’s particular vulnerability. But it would be a big political event, embarrassing for George Osborne, and reflect genuine concerns about Britain’s public finances.

There are many reasons why you might worry about Britain’s public finances. The loss of the revenue cash cows of the past, including corporation tax revenues from the City and the North Sea, is biting hard.

Weak growth, for reasons mainly not connected with fiscal tightening, is preventing the kind of virtuous circle Britain enjoyed in the 1990s, when a strong upturn under Norman Lamont and Kenneth Clarke resulted in a rapid deficit reduction.

One of the biggest problems, however, and it is not a new one, is welfare. Britain, as the Institute for Fiscal Studies’ excellent A Survey of the UK Benefit System points out, really is a welfare state.

Some 30m people, almost half the population, receive one or more benefit. The bill for all this is more than £200 billion a year, “£3,324 for every man, woman and child in the country”, and the equivalent of 13.5% of GDP and 29% of spending.

Seventy years from Sir William Beveridge’s hugely significant report, which called for the elimination of the “Five Giant Evils” of squalor, ignorance, want, idleness and disease, the welfare state has spread far beyond what he would have envisaged, without eliminating those evils.

Social security spending was just 4% of GDP at the dawn of the welfare state. In 40 years, from the early 1970s, it has risen more than 300% in real terms, double the increase in the size of the economy.

Welfare spending rises in good times and bad. It is hard to think of a period more conducive to control of welfare spending than the Blair years, 1997-2007.

But Labour ignored its welfare reform minister Frank Field’s good ideas. And, without pressures from rising unemployment, spending rose nearly 3% a year in real terms. The welfare state and entitlement culture expanded.

It goes on. So far this fiscal year (April-November) cash spending on net social benefits is up by 5.9% on a year ago, largely because of the 5.2% April uprating of most benefits. Welfare is easily the fastest-growing element of government spending.

Can it be turned around? The coming year is a big one for welfare. 2013-14, the fiscal year that begins in April, will on official forecasts be a rare year in which spending falls in cash terms.

The Office for Budget Responsibility predicts the cost of social security and tax credits will drop from £210.4bn this year to £207.7bn in 2013-14, under the impact of child benefit restrictions, restricting the employment support allowance and limiting to £500 a week total household benefits.

Then it resumes its rise, reaching a projected £230.7bn in 2017-18. That incorporates the 1% limit on annual rises in most working-age benefits for three years, on which parliament will vote on Tuesday.

The 1% limit announced in the autumn statement preserved the so-called automatic stabilisers (not taking money out of the economy when public finances have deteriorated for cyclical reasons) by recycling the cash saved - and more - in extra capital spending and raising the personal tax allowance.

It does not, in itself, represent the kind of far-reaching reform Britain’s welfare state needs. It is not yet clear the plans of Iain Duncan Smith, the work and pensions secretary, which revolve around the new universal credit, do so either.

As with other elements of government spending, we need to re-examine what the country can afford. This does not mean an attack on the poorest, nor should it. It does mean trying to steer the welfare state, for working-age people as well as pensioners, back towards its original purpose. A country in which half of people are on some kind of benefit can never be healthy, even if every attempt to rein it back results in squeals of protests from interest groups.

The 1% limit is a stop-gap. But this week’s vote is nevertheless important. Labour is opposing the change, as it has opposed other cuts, even some of those it set in train when in government.

If the coalition were to be defeated, which looks unlikely, the signal it would send out would be that Britain lacks the political will to tackle the welfare state and deal with the deficit.

Labour would no doubt celebrate the loss of the AAA rating, and the pressure it would put on the government. But something has to give. The fiscal arithmetic requires either further welfare cuts, as Osborne has indicated, or cuts in public services that may be impossible to deliver. This week’s political battle over welfare is the first of many.

Sunday, December 30, 2012
Jobs the bright spot in a downbeat year
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt. The table that accompanies this article in the newspaper is also available on www.thesundaytimes.co.uk

Even in a flat year the mood ebbs and flow, often quite dramatically.

This time last year the eurozone appeared to be teetering on the edge of the abyss, threatened by its own internal economic contradictions as well as by the politics. I know some very prominent people who thought it was only a matter of time before Europe dragged us back into extreme crisis.

Maybe it was only disaster postponed but it has to be said that this both underestimated the readiness of the European Central Bank, under Mario Draghi, to do “whatever it takes” to keep the euro show on the road, and the determination of European politicians not to let the single currency fall apart.

So the euro survived, and hedge funds and others made money out of betting that it would. There were some tricky moments, notably between the first and second Greek elections, but the eurozone, battered and weak though it is, struggles on.

There was a time when, as far as Britain was concerned, the dreaded double-dip looked like being avoided. In January and February surveys suggested some surprising spring in the economy’s step, despite the eurozone's woes.

One bit of the economy, however, had only concrete in its boots. The construction industry, down very sharply in the first quarter, weakened further in the second and third. Without teh fall in construction there would have been no drop in gross domestic product in the first quarter and a smaller fall in the jubilee-affected second.

As it is, we will have to wait for a few more data revisions to see whether the double-dip, and in particular the small 0.2% quarterly fall at the start of the year, survives long enough to make it into the economic history books.

Nobody expected much growth in 2012. We await fourth quarter GDP figures, which will be published on January 25, but for the moment there is no reason to doubt the assessment of the Office for Budget Responsibility, and the consensus, which is that the economy contracted by a modest 0.1% last year.

Unusually, there were some growth forecasts that were too gloomy. Standard Chartered’s bold prediction that the economy would contract by 1.3% proved to be a little too bold. On the other hand, the hope of some forecasters, that this would be when the economy finally got into its stride was also too optimistic.

Most forecasters, it should be said, did OK by aiming low on growth, but not too low. However, most were also taken by surprise by the continued strength of the labour market.

The lowest forecast for the unemployment claimant count at the start of the year was 1.6m and the average was a shade under 1.8m. The outturn was 1.58m. I will say it again: there is something odd about an economy that apparently does not grow but generates something like half a million net new jobs.

Long ago, economists used to swear by the Phillips curve, the inverse relationship between unemployment and (wage) inflation. The good news on employment and unemployment has indeed been balanced by disappointment on inflation, though not wage inflation, which has remained subdued at sub-2% rates of increase.

The Bank of England gets kicked for always predicting that inflation will return to the official 2% target. To be fair to the Bank’s beleaguered forecasters, however, that was the consensus view at the start of the year, with an average prediction of 2.1%.

Some thought weak growth would drag inflation below target but it was not to be, even if we came close to target in September. The latest inflation reading, for November, was 2.7%, closer to 3% than 2%.

The other disappointment has been on the twin deficits - the budget deficit and the current account. 2012 was the year when deficit reduction ran into serious headwinds after a couple of successful years.

This had less to do with the government’s austerity programme being self-defeating than two other factors: the sharp and unexpected weakness of corporate tax revenues, particularly North Sea revenues, and the fact thaat the low hanging fruit of deficit reduction has already been picked.

We are on the brink of the most important month of the year as far as the deficit is concerned. The Office for Budget Responsibility (OBR) is looking to healthy January self-assessment receipts to put the public finances on track. But it is touch and go whether the deficit falls this fiscal year and there will be egg on face for the chancellor and OBR if it does not. I imagine Ed Balls, the shadow chancellor, is looking forward to that one.

As for the current account deficit, official figures just before Christmas showed that it narrowed to £12.8bn in the third quarter, from £17.4bn in the second. But that still meant a deficit of 3.3% of GDP, and red ink for the first three quarters of the year of £42bn. I have not reason to doubt the consensus view the full-year deficit will be around £54bn.

Exporters have been hit by the eurozone’s weakness but this is still hugely disappointing. The current account deficit narrowed from £37.4bn in 2010 to £20.4bn in 2011, suggesting the economy was undergoing some kind of rebalancing. Now that process has gone backwards.

The economy could do better but which forecasters did best. The clear winner this time is the Economist Intelligence Unit, and congratulations to them. They have been pushing upwards in my forecasting league table for the past couple of years, from 11th in 2010 to 3rd last year. Now they are unchallenged for the top spot.

The EIU got most of the big numbers spot on, only slipping up slightly on unemployment. But nine out of 10 is a great performance in what remains an unpredictable era.

Congratulations too to Deutche Bank, oln its own in second place. Its forecast was closer on growth than the EIU but a little further away on the other variables. Along with most others, they expected the current acoount to do better than it did.

The OBR, like the Bank, gets a lot of flak for its forecasts but its 2012 effort was not bad, and was in the top half of the table. Some of those in the relegation zone at the bottom suffered, like Standard Chartered, from being too bold. Others appear in the Treasury’s monthly compilation of forecasts but handicap themselves by not predicting all the variables.

We will see whether things reverse themselves next year.

Sunday, December 23, 2012
Big bucks for Carney. But can he deliver?
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.

More than two decades ago Richard Giordano, an American, became the first boss of a British firm, the industrial gases group BOC, to be paid £1m a year.

Now another North American, Mark Carney, Canadian governor-designate of the Bank of England, is blazing the trail for salaries in the public sector. He will get no less than £874,000 a year, including a £250,000 housing allowance.

This is the equivalent of the pay of 42 newly-qualified nurses though perhaps a fairer comparison is within the Bank itself, where the new governor will get more than Sir Mervyn King (£305,368) and Paul Tucker and Charlie Bean, his two deputies (£258,809 each), combined.

External members of the monetary policy committee, on £131,771 - £30,000 of which is intended for them to put into their pensions - may suddenly feel impoverished. External members of the new financial policy committee, on £55,000, are Threadneedle Street’s poor relations.

There are caveats. Carney, like external MPC members, must make his own pension arrangements. The Bank’s non-executive directors say including him in the generous but now-closed pension fund for King and his deputies would have cost at least 100% of salary. The cost of employing him would have been at least double King’s £305,368 salary. That does not, however, explain the big housing allowance.

The Treasury insists you get what you pay for and, in an internationally competitive market, securing a man George Osborne describes as “the outstanding central banker of his generation” is worth a significant public investment.

Certainly if the new governor had steered Britain through the crisis relatively unscathed, as with Canada and her banks, nobody would begrudge adding a couple of zeros to that salary. We will never know. The two economies are very different and we cannot have an exact re-run.

Carney will earn his salary and more, however, if he helps deliver the economic holy grail of non-inflationary growth alongside a safe banking system that supports such growth.

On the latter, he will inherit a system already undergoing far-reaching changes. The challenge is to combine banking safety, including higher capital requirements, with a sufficient supply of credit into the real economy. We are some way away from that.

As for the quest for non-inflationary growth, the challenge is just as great. Last week saw disappointing inflation figures, with consumer price inflation remaining at 2.7% in November, still stubbornly above the 2% target, and set to go higher.

Some analysts think King will have one final letter to write to the chancellor in the coming months, explaining why inflation has risen above 3%. RBS, in a new medium-term projection, sees inflation staying above the 2% target until the end of 2014.

The MPC, in its latest minutes, warned that inflation was likely to be above target “for the next year or so”, blaming factors such as higher domestic gas and electricity bills and university tuition fees that it could not directly influence.

Higher inflation, it seems, is bedding in. The Bank used to blame international factors, such as oil and food prices, for overshooting inflation. But the latest figures show that stripping out energy, food, alcohol and tobacco, inflation, at 2.6%, is very close to the headline 2.7% rate.

The service sector is where the damage is being done, with inflation of 4.2%. Indeed, the norm for prices rises in services looks to be between 3% and 5%. Only when goods prices are falling can service-sector inflation on that scale be consistent with a 2% inflation target. Goods prices are rising modestly but they are not falling.

Some say it does not matter much if inflation is higher: a year ago the Bank’s prediction was for 1.7% now. After all, is not growth a bigger priority than pinpoint accuracy in hitting an inflation target? Who is to say 3% rather than 2% is not an appropriate inflation rate for Britain?

Carney himself has been musing about a switch to targeting the level of money gross domestic product (GDP). Others favour a money GDP growth target, a combination of growth and inflation, which would potentially offer the central bank more flexibility. We favour flexibility in most areas of policy, so why not in this one?

There are circumstances in which the argument for this kind of switch would be unaswerable. Imagine if the Bank, in its determination to hit its inflation target, had been imposing years of unnecessary pain on the economy. If the target meant tens of thousands of lost jobs, it definitely would not be a price worth paying.

That, however, is not the case. The MPC has been bending over backwards and performing somersaults over the past 3-4 years, in its efforts to support growth.

It believed a combination of ultra-low interest rates, £375bn of quantitative easing and a 25% sterling depreciation would deliver the goods. Importantly, it continued to stimulate the economy even as inflation continued above target. It is hard to argue that it was in any sense constrained by the 2% inflation target.

A 3% inflation rate, combined with 5% growth in pay, average earnings, would upset some purists but be far from the end of the world. That, unfortunately, is not where we are, nor likely to be. Inflation of nearly 3% runs alongside earnings growth of under 2%.

The squeeze on real wages continues and the prospect of a sustained consumer revival remains stalled. It is instructive that higher inflation in October and November was accompanied by weaker retail sales.

The struggle will go on. King is unfortunate that his golden age of non-inflationary growth came early, as chief economist, deputy governor and then for part of his first term as governor, he presided over the best of times. But people will probably only remember the last few difficult years.

Nobody knows what shape the economy will be in when Carney gets to the end of his five-year term in 2018. Nobody really knows who will be in government.

If, by then, the economy has broken out of the pattern of stubbornly high inflation and disappointingly weak growth, Carney will get be a hero. But it looks like a long haul. And a change of target is not a sensible way to try to make it happen.

Sunday, December 16, 2012
Oil's a drag on the economy: energy boost needed
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.

Once it was common to think of Britain's economy as being comprised of two distinct parts. There was the onshore, or non-oil economy, and often - I am talking about three decades ago here - its performance was underwhelming.

Then there was the oil economy, booming as a result of the opening up of the North Sea as one of the world’s most important sources of oil and gas from the 1970s. Combine the two and you got a healthy growth picture. Exclude oil and things were not nearly as strong.

Today, the picture is reversed. The non-oil economy is far from strong but it is growing. Output in the oil economy, by contrast, is falling fast.

A few days ago we had another instalment of the economic puzzle. There was a big, 82,000 fall in unemployment over the latest three months and, official figures showed, a net rise in employment of 499,000 over the past 12 months.

At a time when the economy has not grown at all, according to the gross domestic product figures, employment has risen by nearly half a million - to its highest ever number of 29.6m - and hours worked and vacancies have both increases sharply.

Some of this puzzle will be resolved in the fullness of time by data revisions. Some of it reflects the fact that pay has been, and continues to be, very subdued: it is currently rising by just 1.8% annually.

Part of the story, however, is to do with oil. Britain’s onshore economy is doing a lot better than its offshore economy. The decline in North Sea oil and gas output, a trend that began in the late 1990s, is striking.

Britain’s recovery began in the middle of 2009. For the North Sea, however, that was the start of an acclerated decline in output. In October, North Sea production stood at just 51% of its June 2009 level. The overall economy has grown, though not as much as anybody would have hoped, but North Sea output has halved.

In the old days, such a development would have been devastating, because North Sea oil had a bigger weight in the economy. These days the effects are smaller but still significant. So, instead of shrinking by 0.1% over the past year, as the overall GDP figures suggest, the non-oil economy has grown by 0.2%.

Compared with 2009, overall GDP has risen by 3.3%, its non-oil equivalent by 4.1%. Simon Ward, an economist with Henderson Global Investors, notes that this recovery is less of an outlier when adjusted in this way: the profile of non-oil GDP becomes more like the late 1970s and early 1980s.

This does not, I emphasise, solve all the puzzle. If you take the non-oil figures at face value, this is still a much weaker recovery than we would like. It points to an economy that has averaged only 1% to 1.5% growth in the recovery phase, and that growth has slowed the longer the recovery has gone on.

But it is part of the explanation and it has a couple of other interesting aspects. The first concerns Scotland. The debate about Scotland’s fiscal future under independence rests mainly on the proportion of North Sea revenues it would be allocated.

Fast-falling North Sea output suggests this is a shaky foundation on which to build an independent country. The Institute for Fiscal Studies recently concluded that if Scotland were assigned North Sea revenues on a so-called geographical basis - something that would have to be debated - its budget deficit would be proportionately smaller than the rest of Britain, thogh it warned about the volatility of such revenues.

For every swing, however, there is a roundabout. If Scotland were to get most of the oil revenues, its economy would also be more oil-dependent in general. The oil/non-oil distinction, important for Britain as a whole, would be hugely significant.

The IFS calculations suggest that North Sea oil and gas would account for 18% of the Scottish economy. What this means, by my calculations, is that Scotland would have had no recovery at all over the past three years.

It would, in fact, be rather worse than that. Assuming Scotland had the same 4.1% non-oil GDP rise as the rest of the country, this would be more than outweighed by the near-halving of output from a sector that makes nearly a fifth of its economy. Scotland’s GDP would be 4% to 5% below its mid-2009 levels and even further below pre-crisis levels.

The other interesting question is whether we can look to a future in which energy once more drives the economy rather than acts as a drag on it.

On Thursday the government gave its approval to Cuadrilla, an energy firm, for the resumption of “fracking” - hydraulic fracturing - for the exploitation of shale gas reserves. Shale gas is environmentally problematical and most of the evidence suggests that recoverable reserves do not approach those of the North Sea.

The British Geological Survey, however, which is the most reliable independent source, says “UK potential is as yet untested” and that there are “abundant shales at depth”. It has identified significant accumulations, including Widmerpool Gulf near Nottingham and the Elswick Gasfield, near Blackpool.

Caution is justified. Shale gas may never have the transformative effect on Britain it is having in America. But even an echo of those early North Sea days, when oil and gas helped mend Britain’s damaged public finances and helped the balance of payments, would be very welcome.

On both counts, we need all the help we can get.

Sunday, December 09, 2012
Osborne's austerity: not as tough 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.

We rarely compare Britain's budgets with those of other countries. Three years ago I had an opportunity to do so, being in Dublin on the evening Alistair Darling had unveiled his final pre-budget report and the Irish government had announced one of a series of austerity budgets.

Britain’s pre-budget report was a tinkering exercise, Darling’s achievement being to head off pressure from Gordon Brown in 10 Downing Street for a pre-election giveaway. Ireland, in contrast, announced a full-blooded austerity budget.

On Wednesday, history repeated itself. Despite the deterioration in the public finances, George Osborne’s autumn statement was broadly neutral in its impact over the next four years.

Ireland, in contrast, had another bloodcurdler, intended to take 2% out of the economy next year, through higher social insurance charges, fuel duty hikes, motor taxes, child benefit cuts, the taxation of maternity pay, a new local property tax.

The two economies are different. Ireland is constrained by euro membership and has had a ratings downgrade and a bailout. Britain is hanging on to her AAA status, for now, and has not had a bailout for 36 years.

I am not a headbanger on this. If you can avoid swingeing spending cuts or big tax increases it is generally better to do so. We have seen the effects of too rapid a cut in capital spending over the past two years.

The Irish comparison shows, however, that perception can differ from reality when it comes to austerity. Theirs is harsh, ours quite mild. A look at the numbers also shows how Osborne has been quietly doing what his critics have been demanding.

Some will recall Margaret Thatcher’s austerity budget of 1981, when the public finances needed fixing. Introduced by Sir Geoffrey (now Lord) Howe at a time of recession, its main measure was to freeze the personal tax allowance at a time of high inflation; it should have gone up by 14.8%.

Contrast that with what will happen in April. The personal allowance - the exempt amount before people start paying tax - will go up from £8,105 to £9,440, a combination of Liberal Democrat pressure and the Tories saying they wanted to do it anyway.

If the allowance were indexed, as was the norm, it would rise to £8,285. The bigger rise represents considerable largesse, and it costs. Had Osborne indexed it, he would have saved himself £4.9bn.

Had he “done a Thatcher” and frozen it, he would have saved £5.7bn. Raising the personal allowance means a £5-6bn tax cut that could have been used for deficit reduction. You could almost call it Keynesian.

A similar attitude prevails elsewhere. Take welfare. I have pointed out the relative generosity of welfare increases compared with wage rises and the statement highlighted it. In five years, out-of-work benefits have risen 20%, earnings 10%.

That is unsustainable but the response is quite mild. While Ireland has slashed welfare in its budgets, Osborne is limiting working-age benefits to 1% annual rises for three years. Tough but far from draconian.

As for the rest, it did not suggest a government under intense fiscal pressure. Cancelling next month’s fuel duty increase costs £890m this year, £1.64bn in 2013-14.

The very useful measures for business do not come without a price-tag either. The unexpected cut in the main rate of corporation tax 21% from 2014 has an eventual full-year cost of £875m, the two-year increase in the investment allowance to £250,000 a peak annual cost of £910m.

What does all this mean? I am not suggesting there is no austerity, but that it is more gradual and nuanced than you would think. Under the new plans, total government spending will rise from £674bn this year to £765bn in 2017-18. It will be higher as a percentage of GDP than this year for the next two years, and not drop below the magic 40% of GDP for five years.

The coalition is also, apart from tax gifts it can scarcely afford, adopting a textbook response to slow growth: allowing the automatic stabilisers to operate. Slower growth weakens tax revenues and pushes up government spending. Osborne, sensibly, has not tried to offset this now with tax hikes and additional cuts.

How bad a shape is the economy in? The surprise in the Office for Budget Responsibility’s (OBR) assessment was that the public finances were not worse, particularly this year.

Much excitement has been generated by the expected £3.5bn windfall from the auction of the 4G mobile phone spectrum in January. Though it is true to say without it borrowing would have been slightly higher than last year (partly because 2011-12 came in below the OBR’s March estimates), there is nothing unusual about governments counting asset sales in advance. The proceeds of this sale, of course, have to be set against future tax revenues from the mobile phone firms.

The more interesting story was that, stripping out all the distortions, the OBR is £5-10bn more optimistic than the independent consensus. Robert Chote, its chairman, thinks it has a better handle on what is happening to public spending than outside economists.

That is why, while most economists and a badly wrongfooted Ed Balls expected the deficit reduction strategy to turn into a deficit-increasing strategy this year, the OBR was able to come up with a tiny cut. If that call turns out to be wrong, Osborne and the OBR will feel the heat come March.

The bigger picture is that, despite disappointing growth, borrowing is still on its way down, if only gently. In that respect, I hope the OBR is right. Osborne was forced to abandon his target for reducing debt as a percentage of gross domestic product by the end of the parliament, shifting it into the next parliament. But he was spared the humiliation of a deficit increase.

What about the economy? As disappointing years go - the OBR estimates a 0.1% drop in GDP - this could have been worse. I have written a lot about the rise in employment but it is also the case, according to the OBR, that real household disposable incomes have risen by 2.1% this year, after falling on an annual basis since the second quarter of 2010.

What about next year and beyond? If the economy can grown by 1.2% in 2013 when the eurozone, according to the European Central Bank, shrinks 0.3%, that would not be a bad outcome, though industrial production figures on Friday showed that the fourth quarter started badly. But we will not see growth top 2.5% this side of the election, according to the new official forecast.

We know why. It grieves me to hear reputable economists blaming it all on austerity, which is a political not an economic verdict. Slow growth is the product of a range of factors, including the eurozone and a slower global economy, a damaged banking system which is not advancing enough credit and a corporate sector with cash to spend but caution holding it back.

Only when all this comes right can we expect good growth to return. In the meantime, we should not lazily lay all the blame on austerity. The lesson of the past week is that it is milder than you think.

Sunday, December 02, 2012
Can Osborne press the growth button?
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 coming week looks much tougher for George Osborne than the one just gone, assuming he does not have a Mark Carney rabbit to pull out of the hat in Wednesday's autumn statement.

One day the chancellor will stand up and tell the Commons he was too pessimistic last time and, accordingly, can revise his growth forecasts up and his borrowing numbers down. That day, sadly, will not be next Wednesday’s autumn statement.

In his March budget, growth was supposed to be 0.8% this year and 2% next. Lop a percentage point off those numbers and you have something like the new forecast.

Will he have to abandon one of his fiscal rules, for debt to be falling as a percentage of gross domestic product by 2015-16, the end of the parliament? The Treasury, I sense, has been braced for exactly this verdict from the Office for Budget Responsibility (OBR).

The Institute for Fiscal Studies, where OBR chairman Robert Chote resided before taking on his current job, said a few days ago that even on optimistic assumptions debt was likely to be rising as a percentage of GDP in 2015-16.

But it concedes the possibility emerging from City economists, that a combination of financial jiggery-pokery (the transfer of quantative easing interest proceeds to the Treasury from the Bank), asset sales and shifting around some spending, Osborne might yet convince the OBR he has a better than 50-50 chance of meeting his rule. That one is worth watching, though I think the Treasury agrees it would be daft to expend too much energy meeting a not very sensible rule.

The bigger question, of far more relevance to most people, is what he can do to boost growth. The 1% rise in GDP in the third quarter, confirmed in revised figures last week, has almost been forgotten in the autumn gloom, though November also brought strong retail sales according to the CBI, and a rare jump in consumer confidence, as measured by GfK-NOP.

The GDP figures, and a pocket calculator, also showed where the economy needs most help. Compared with where we were before the start of the 2008-9 recession, overall GDP is 3.1% down. Nearly five years on from that pre-recession peak in the first quarter of 2008, there is still work to be done just to get back to where we were.

There is, however, a big difference when it comes to the performance of different parts of the economy. The service sector is back above pre-recession levels, if only by a modest 0.4%. But manufacturing is down by 8% and construction a huge 18.3%.

Looked at by categories of spending, the biggest casualty is investment, down a massive 18.8% on pre-crisis levels, with business investment more than 10% down. Exports are modestly up, by 2.3%, while imports are 3.9% down. Consumer spending is nearly 5% down but may be starting to mend.

Government spending (excluding capital) is, continuing last week’s theme, up 6.7% on pre-crisis levels. All these figures are inflation-adjusted.

That tells me where the chancellor’s priorities should lie. The service sector is coming through the worst. It, and consumers, can look after themselves and they will get a bit of help from the expected postponement of the 3p a litre fuel duty hike on January 1.

That leaves manufacturing and construction as the sectors where the help is most needed, and it leaves investment - private and infrastructure - as the best way to deliver that help.

Talking the other day to John Cridland, CBI director-general, just back from a trade trip to Russia with medium-sized firms, I found him refreshingly optimistic about the outlook for Britain’s manufacturers.

He thinks they are shifting away from reliance on the European market, and this is supported by the data. But he also thinks there are things the chancellor can and should do to assist, while keeping its fiscal strategy on course.

In the last fiscal year, 2011-12, the government underspent by £1.6bn even its own scaled-back targets for capital spending. Next year it can expect £4bn from the sale of the 4G mobile phone spectrum. That only scratches the surface of the £700bn of assets, some of it unused land and buildings on prime sites, the Treasury could sell to fund an investment programme.

The CBI is not advocated a rushed “selling the family silver” type disposal, but it does think the chancellor has scope, to the tune of £1.5bn, to do something modest now building up to serious numbers later.

Some of that £1.5bn could be put to work on an accelerated programme of road repair and maintenance. Limiting next year’s rise in business rates to 2% would take some pressure off firms. Doubling the annual investment allowance from £25,000 to £50,000, could tip the balance in favour of investing now for hundreds of thousands of small and medium-sized firms, at a cost of just £330m.

The CBI is not the only body to have its eyes on an investment boost this week. The EEF, representing manufacturers, points out that Britain has the least generous system of capital allowances than any OECD country except Chile.

It wants time-limited 100% capital allowances, for two years, to jump-start investment, and points to the success of similar initiatives in America and Canada.

What about construction? The prize remains that of getting the big institutions, pension funds and sovereign wealth funds, investing in Britain’s infrastructure. Progress is being made on that but it is not fast enough. We should here more, however, on the government's infrastructure guarantees starting to have an impact.

In the meantime, the big frustration in the construction sector, and the wider business community, is that Osborne has cut capital spending much too hard, while the government’s current outlays have continued growing.

The chancellor may address that at the margin this week, as he has done before, though substantive action will have to await the next spending review, probably in a year’s time. With public finances tight, there is no room for big net giveaways.

That will leave Osborne open this week to the criticism that he is merely tinkering as the economy deteriorates. And if he does not give businesses some red meat to chew on, the danger for him is that they will join in with that criticism.

Sunday, November 25, 2012
Tackle welfare, or you'll never tackle the deficit
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

What should be George Osborne's priority for the public finances in his autumn statement on December 5? And how big is the risk to Britain's AAA sovereign debt rating?

Most monthly economic numbers do not deserve the headlines they generate, particularly those for government borrowing. October’s public borrowing, £8.6bn versus £5.9bn a year ago, was undoubtedly disappointing.

Some of it, however, was the impact of North Sea shutdowns on corporation tax revenues - down nearly 10% on a year ago - and the numbers are prone to revision.

In August, for example, official statisticians told us we had a rare July budget deficit (the figures are usually boosted by corporate taxes that month) and borrowing in April-July was running well above last year’s levels. Now, the red ink in that period has been revised down by over £5bn, and July is recorded as a surplus.

The big picture at present, which because of revisions can change dramatically, is that Britain is heading for a budget deficit of about £130bn this year, compared with an Office for Budget Responsibility forecast of just under £120bn.

That is disappointing. Though the latest official projections - in March - were for only a modest borrowing reduction this year, the latest estimate for 2011-12 being £121.4bn, a deficit reduction programme is meant to be just that. A deficit increase halfway hardly sends out the best signal.

It is not, in narrow terms, disastrous. The Treasury will see a small rise in the deficit as evidence the automatic stabilisers beloved of economists are being allowed to operate. When growth is slow, tax revenues suffer and cyclical elements of public spending rise.

Will the ratings agencies see it that way? Moody’s, which has Britain on negative outlook, downgraded France last week, to which the reaction ranged from “quelle horreur” to complete indifference.

The French think the Anglo-Saxons are ganging up on them, and that their public finances are healthier than Britain’s. But at least we do not have a government which has responded to the fiscal crisis by lowering the state retirement age and introducing a suicidal 75% top tax rate.

Moody’s says it will reassess Britain’s AAA rating early next year, when it has had time to assess fallout from the December 5 autumn statement. Though there is a case for a downgrade, at this stage it is hard to predict which way it will go.

There would be no case for a downgrade if the government had stuck to its deficit-reduction plans. By this I do not mean the ones set out in March - which will be revisited next month - but the original June 2010 plan, just after the coalition took office.

The first two years under that plan were not too bad, as I wrote a few weeks ago. This is the year, however, when it has started to go wrong. Public borrowing under that plan was supposed to be £89bn this year, 2012-13. If it is £130bn or more, that is getting on for a 50% overshoot.

Those June 2010 projections had borrowing down to £20bn in 2015-16. It is a long way off but it is now a pipedream.

What’s gone wrong? Labour pins all the blame on coalition tax rises and spending cuts, though the difference between what it would have done and what has actually happened under the coalition is small. The fact that few advanced economies have escaped post-crisis torpor strongly suggests there is more to it than that.

We know what the problems are, apart from fiscal consolidation: a damaged banking system unable or unwilling to extend credit; the eurozone crisis; risk-averse big businesses lacking the animal spirits to invest cash piles and the high-inflation squeeze on household real incomes.

There is, however, something else happening, and it goes to the heart of the government’s fiscal struggles. Seventy years on from the Beveridge report, we spend an enormous amount on welfare. In 2011-12 the combined figure for benefits (£175bn) and tax credits (£27bn) was £202bn, according to the OBR.

A few days ago, two things were neatly juxtaposed. One was a column in The Guardian by Polly Toynbee, under the headline ‘No amount of moralising will alleviate the hardship caused by Tory austerity’. The other came with the official figures for the public finances, showing spending last month on welfare, so-called net social benefits, up by 7.7% on a year earlier.

This Tory-led coalition is being so brutal, in other words, that benefit spending is up by nearly 8% in a year, or a shade under 15% over three years. October was no aberration, the 15% figure applies when the comparison is for the July-September quarter.

Why so much? It is not explained by unemployment, which at just under 2.5m is close to where it was three years ago. A lot has to do with the government deciding to maintain the real incomes of benefit claimants by uprating them in line with inflation, even as most people in work suffered from a huge real-income squeeze. Fraud certainly plays a part.

The tax credit system set up by Labour - with taxpayers topping up incomes of lower-paid workers - is a factor. Overall it is, however, a huge policy failure, a failure to grasp the nettle. Welfare spending has risen at almost double the rate envisaged when the coalition took office.

The government is getting blamed for welfare cuts it is not making. Under pressure from the Liberal Democrats the Tories have held back, letting things drift until Iain Duncan Smith’s welfare Big Bang, the universal credit, which will not be introduced until the autumn and winter of next year. Or there have been cackhanded reforms like removing child benefit from some higher tax-rate households.

It may be that things start to improve from next April, when the Department for Work and Pensions is targeting a real reduction in spending. It may be that talk of reining back inflation-linked benefit increases comes to something.

But at a time when the chancellor is said to be contemplating cutting pension tax relief, and after a period in which capital spending - infrastructure investment - by government has been slashed, with a devasting effect on the construction industry, it is clear where his priorities should lie. Unless you tackle welfare, you will never deal with the deficit. This government has failed to tackle welfare spending.

Sunday, November 18, 2012
Moving the goalposts rarely wins the game
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.

Moving the goalposts is a groundsman’s nightmare, but it appears to be all the rage. George Osborne is accused of it, with his £35bn or so grab of the Bank of England’s accumulated interest on the gilts (government bonds) it has bought under its quantitative easing (QE) programme.

Nine days after the Treasury and Bank announced what they said was a financial housekeeping exercise - officials said there was no point building up a pot of savings at the Bank while the country was running a huge overdraft - the debate is still raging.

It may rage for a while yet, at least until we get more clarity when the chancellor unveils his autumn statement on December 5 and the Office for Budget Responsibility delivers its verdict on the public finances.

Three points can, however, be made. If there was confusion about monetary policy before - QE is an untried, “unconventional” tool - there is even more now.

The transfer of the £35 billion from the Bank, where it was doing nothing, to the Treasury where it will be used to reduce public borrowing and debt represents a relaxation of monetary policy. This relaxation was, we can assume, at the Treasury’s behest, raising the question of how independent and how much in control of monetary policy the Bank genuinely is.

Second, the Bank always thought it needed the build-up of interest - so-called gilt coupons - to offset losses later when it has to sell them back into the market.

Now that money is being transferred to the Treasury, the Bank has lost this buffer. The result is likely to be that, while the move will improve the public finances in the short-term, it will leave the taxpayer with a significant bill in later years. It looks like the worst kind of short-termism; an attempt to polish up the public finances this side of the next election.

Third, because these transfers of interest from Bank to Treasury will be ongoing, the government can in effect fund part of the budget deficit for nothing. Whenever the Bank buys gilts under QE, the government’s cost of funding drops to zero. If the idea of a central bank buying its government’s own bonds was murky before, it is positively incestuous now.

Officials insist there is nothing wrong with this exercise — other governments whose central banks are engaged in QE do it — but as I noted last week, it is a bit too convenient when the public finances are under pressure. And, because it is a change of policy, it is a definite moving of the policy goalposts. When Gordon Brown was chancellor, such shifts presaged the collapse of Labour’s fiscal rules. The danger is that history is repeating itself.

PS: Not for the first time, I find myself disagreeing with Sir Mervyn King. In presenting the Bank’s inflation report, the governor made clear his discomfort with the pound’s rise over the past 12 months.

He also said he would like the pound to fall and that “it may be unreasonable to expect anything other than a slow and protracted recovery absent a further fall in the real exchange rate”.

Sterling’s big fall in 2007-8 did not produce the expected export boost but did push up inflation. King’s comments sent the pound down but when that raises inflation I can hear him blaming exogenous factors: not him, guv.

However, Britain’s poor inflation record has much to do with the Bank’s devaluationist tendency. Richard Ramsey, an economist with Ulster Bank, has updated his Britain-Ireland inflation comparison. Since August 2007, the start of the crisis, Britain’s CPI has soared 18.6%, compared with just 0.4% for Ireland. The difference is the huge squeeze on British households. Pushing the pound down more would add to it.

Inflation: Is the ONS right to want to shake up the RPI?
Posted by David Smith at 08:59 AM
Category: David Smith's other articles

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The ONS wants to change the way the retail prices index (RPI) is calculated, and is consulting on it. If it has its way, the longest-running and probably most trusted measure of inflation in Britain will look very different next year.

Any individual, business or investor which has its fortunes, revenues or outgoings linked to the RPI will see a change. Retirement funds paying RPI-linked pensions could see payments drop by 10% to 15% over the long-term, with a corresponding loss to pensioners.

Investors in index-linked gilts would see returns lowered and, subject to a judgement by the Bank of England, might have to be compensated. This could take Britain down a very rocky road, with international investors in particular suspecting trickery.

On the other hand, lower retail price inflation would mean smaller increases in rail fares and some utility bills (though these days they have a life of their own).

So why might it happen, and what would be the consequences? Inflation is always controversial. When, in 2003, Gordon Brown shifted the Bank’s inflation target from RPI (excluding mortgage interest payments) to CPI (the consumer prices index), Mervyn King, newly appointed as Bank governor but yet to be knighted, said: “When defending a free kick from David Beckham, you don’t expect somebody to move the goalposts.”

The change was blamed, wrongly in my view, for the Bank’s pre-crisis policy errors. It sparked suspicion the government was trying to foist a dodgy measure of inflation on an unsuspecting public. The ONS, in response, put a personal inflation calculator on its website, for people to work out their own rate. Apparently they still are.

What is the rate of inflation? Figures on Tuesday showed it is 2.7% for consumer price inflation, 3.2% measured by the RPI and 3.1% for RPIX, the old target.

One thing we know is that everybody has a different inflation experience. The average pensioner, living alone, had an inflation rate of 3.2% in the third quarter, but at the end of last year was being squeezed by a 7.3% rate.
Pensioners tend to suffer most when necessities are going up in price, so the latest round of energy and food price hikes will hurt.

People in general tend to notice prices when they are rising but not when they are stable or falling. We have an in-built upward inflation bias, even if when we shop, we try to avoid things rising too rapidly in price, switching to cheaper lines.

What is the ONS proposing? To answer we need to go back to three greats: Gian Rinaldo Carli (1720-95), Nicolas Dutot (1684-1741) and William Stanley Jevons (1835-1882). All three contributed ways of measuring inflation which are used today.

Dutot derived his index approach in 1738, as part of an exercise to compare the real wealth of Louis XII and Louis XV of France. Carli’s in 1764, was as a result of a study into what had happened to prices since the discovery of the Americas. The main contribution in this field by Jevons, in 1863, was the use of the geometric rather than arithmetic mean for calculating price changes.

The RPI is mainly a Carli and Dutot index, with nothing from Liverpool-born Jevons. The CPI is a Jevons index, with a little Dutot and no Carli.

None of the three measures is perfect but the Carli has the oddest characteristic of all, which is that if the price of a product rises but then falls back to its original level, a Carli index will still record it as a rise.

For some items where it is used in the RPI, this leads to huge differences. Clothing and footwear prices last month were down 0.1% on a year earlier in the CPI but up 6.4% in the RPI. At times the difference in clothing inflation between the two has been as 10 percentage points.

Most countries do not use Carli. The International Monetary Fund advises against it and the Consumers Prices Advisory Committee says it should be dropped.

The ONS is consulting, and the consultation period closes in 12 days’ time. By March, the national statistician will have recommended one of four options: no change, dropping the Carli in measuring clothing inflation, dropping it for all items in which it is used and aligning RPI formulae with those used in the CPI.

None of these changes would mean RPI inflation would exactly match CPI inflation. RPI excludes households on very low and high incomes, while the CPI does not.

However, the RPI has owner occupiers’ housing costs, including mortgage payments and a house price measure. The CPI does not, though a new series (CPIH), will next year include private rental costs.

For users of these inflation measures, however, what matters is the change. We have got used to CPI inflation being lower than RPI inflation, often significantly. ONS figures show, however, that if the so-called formula effect were eliminated RPI inflation would have been lower than CPI inflation since April last year. In October, RPI inflation would have been 2.3%, not 3.2%, so lower than the 2.7% CPI inflation rate.

These are surprisingly deep waters. Though any change would not be retrospective, if we have been overestimating inflation in the past it implies real incomes (and growth) were healthier than we thought.

But dropping Carli would mean the Bank would surely have to decide this was a “fundamental and detrimental” change affecting holders of index-linked gilts and National Savings. The ONS might produce a parallel RPI, using the existing method, for investors, though that cannot be a permanent solution. The longest index-linked gilts stretch half a century into the future.

What should happen? It is daft for the ONS to carry on using an RPI formula that comes up with obviously suspect results. From a statistical and economic perspective, the case for change is overwhelming.

The politics, however, are trickier. Unemployment figures have never regained the public confidence there was before the Tories introduced repeated changes to them in the 1980s. The Osborne £35 billion QE "grab" has had less public impact but has a whiff of something dodgy about it.

Anything like that has to be avoided for the RPI. If the public and the markets sense trickery, trust in the inflation numbers will disappear. Like the boy who cried wolf, once you get a reputation, it can be hard for people to believe you.

Sunday, November 11, 2012
Change at the top: Who'd be best at 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.

Barack Obama has been re-elected. There is change to a top in China and the Church of England. All that sets things up for the big one, the next governor of the Bank of England, to be announced by George Osborne before the end of the year, probably in his autumn statement on December 5, if not before.

I jest about the importance of this appointment, but not much. The new governor will take over on July 1 next year for an eight-year term. It will be surprising if that term in office does not stretch beyond Osborne and David Cameron.

A lot will happen between now and 2021. The successful candidate will have powers and responsibility denied any previous holder of the post. The new governor will do most of the heavy lifting in steering the economy, and the banking system, back to health. The prosperity of citizens, not to mention the City, will be in their hands.

The Bank paused in its £375 billion quantitative easing programme on Thursday and, one hopes, has put the policy to bed. Under the new leader’s term, the judgment will have to be made about when to raise interest rates - as go up they surely will - and sell back the gilts acquired under QE.

In the meantime, and rather too conveniently, the chancellor has raided the £35bn QE interest pot to improve the look of the public finances in the short term.

There are checks and balances. Sir Mervyn King often reminded us he had only one vote on the nine-member monetary policy committee (MPC). That will remain true, as on the recently-created 11-member financial policy committee.

But Alistair Darling, with his killer description of Sir Mervyn as “some kind of Sun King”, reminded us of the governor’s power within the Bank. It is unlikely to diminish much with a change at the top.

Who will it be? When I say nobody knows, I think it is true. There is a short-list of about six. The panel - Treasury officials Sir Nicholas Macpherson, Tom Scholar and John Kingman and Sir David Lees, who chairs the Bank’s court - is seeing candidates and will make a recommendation (or a choice of two) to the chancellor.

Who is on the short-list? Certainly Paul Tucker, Bank deputy governor for financial stability, the bookies’ favourite. Certainly too Lord Adair Turner, chairman of the Financial Services Authority.

Sir John Vickers, former chief economist at the Bank and head of the Osborne-appointed banking commission, must be there. The bookies think, in spite of his repeated denials, Mark Carney, Bank of Canada governor, is in the frame. Lord Terry Burns is a possibility for another career change, even at 68. Lord O’Donnell, another ex Treasury permanent secretary, has apparently ruled himself out.

There are potential women candidates, including DeAnne Julius and Kate Barker, former MPC members and Rachel Lomax, a former deputy governor. Sharon Bowles, the Liberal Democrat MEP , has applied.

Lord Green and John Varley are frequently mentioned ex bankers, though suffer from a toxic brand. There may be exotic names. The Economist has suggested Arminio Fraga, a former Brazilian central-bank governor, and Leslek Balcerowicz, former Policy central bank head.

I don’t rule out a dark horse possibility. The thing about them is that they surprise you by streaking ahead at the finish. In their absence, the front-runners are Tucker, Turner and Vickers.

Tucker, the favourite, having had his baptism of fire over Libor and his pally relationship with Bob Diamond, has the advantages and disadvantages of incumbency. He has been much more willing to admit to Bank errors and shortcomings than King.

There is little doubt he would have been more proactive when the crisis broke in 2007, and more responsive to the cries of anguish from banks when liquidity dried up. He recognises the importance of the City remaining a big global player, though one better regulated than in the past.

Tucker knows where the bodies are buried in the Bank, with an insider’s knowledge of how to improve things. But critics will say he is the continuity candidate, who should have been more aware of the financial iceberg looming before the crisis.

Turner joined the FSA late enough - in September 2008 - to be absolved of that criticism. In letting it be known he is keenly interested in the job, he has irritated some. A recent speech by King was seen by many as a public slapdown for Turner.

He does not suffer self-doubt. A joke doing the rounds in the City asks why the FSA chairman is covered in love bites, to which the answer is they are self-inflicted. His big aberration was aggressive advocacy of euro membership for Britain, and I remember him telling me I had got it entirely wrong on the euro. But he has recanted and he has upped his game.

Recent speeches show that he is putting in a lot of homework. In South Africa a few days ago, he cited the doyens of the Chicago School of Economics, as well as other ancient and modern economic texts. His attacks on the City’s “socially useless” activities and the failure of the banking system to support the real economy have struck a chord. He would be a good front man.

Turner would be the change candidate, but the fear is he would seek to shake things up too much. The City would see him as the WTM (worst than Mervyn) choice, while banks would be sent into a huddle of uncertainty. In his speech he debated whether fractional reserve banking - the basis of Western banking for centuries - should continue. That and the prospect of a mass exodus from the Bank if he got the job would make it risky.

Vickers, whose job application is his commission’s report, is ideal on paper. He knows about banking and he is a renowned economist, though not a macro-economist. He is known to the chancellor. He would be a safe pair of hands.

And yet he would suffer, like King, from being seen as too academic. He made no great waves when chief economist at the Bank and was not happy there. He was a low-key director-general of the Office of Fair Trading from 2000 to 2005. Chairing a commission on banking is not the same as dealoing day-to-day with the detail of complex and volatile markets and the new regulatory landscape, which has been Tucker’s role in the years since the crisis.

Because of this, the bookies are probably right to have Tucker as favourite. He remains the one to beat. But a credible dark horse, a genuine outsider, might be better.

Sunday, November 04, 2012
A strange kind of austerity for public sector 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.

George Osborne is knee deep in preparations for his autumn statement, on December 5, in between wondering what to do about the European Union budget.

He will have to decide how to respond to Lord Heseltine’s “No Stone Unturned” growth report. The former deputy prime minister, who brings a touch of showbiz to everything he does, has come up with a curate’s egg of a report.

Some of it looks like a bit of throwback to the patchy industrial interventionism and regional policy of the past, though menaingful devolution of economic power from London and the south-east would be welcome. His National Growth Council has echoes of “Neddy” (the National Economic Development Council), which was finally put out of its misery after three decades of existence in the early 1990s.

Other bits of the report: speedy decisions on airport capacity, and better planning, infrastructure and skills make a lot of sense. The question is whether a government that finds it difficult to pull any policy levers can manage to do so to implement some of these ideas.

The big issue for the autumn statement is, of course, the state of the public finances and whether Osborne can still meet his fiscal rules. There will be time for a more detailed look at that in three weeks’ time, following the November 21 release of the important October public borrowing figures.

In the meantime, let me whet your appetite. The chancellor will be under pressure on December 5 to boost government spending to accelerate growth, even after the welcome 1% bounce in gross domestic product in the third quarter.

Lying behind such calls are, I think, two pieces of conventional wisdom. The first is that public sector workers are being squeezed as never before, their pay frozen indefinitely even as inflation has stayed stubbornly above the official 2% target.

The second is that the economy’s struggle to grow has been made that much more difficult by cuts in government spending. The other components of output - manufacturing, energy, private services, construction - are having to work that much harder because government is getting smaller.

Today I can tell you that neither of those things are true. Let me start with public sector pay. I was alerted to this a few weeks ago by a report by Brian Reading for Lombard Street Research, described here. He suggested that public sector pay had risen by 9% over the past three years.

The response to this from readers, particularly those working in the public sector, was sceptical, so I checked the figures. Taking April 2009 as the starting point, when avarage weekly earnings in the public and private sectors were similar, I looked at the rise since then.

Sure enough, average weekly earnings in the public sector have gone up from £448 then to £491 now, a rise of 9.6%. In the private sector, in contrast, the increase has been from £446 to £469, 5.2%.

Public sector pay has risen nearly twice as fast as in the private sector in this supposed time of austerity. How can that be? One possibility is that the inclusion of RBS and Lloyds Bank employees in the public sector headcount, which happened in July 2009, bumped up the numbers. There is no evidence of that, however; no sudden jump in public sector earnings.

There are, instead, other explanations. The supposed squeeze on public sector pay provides a partial exemption for low-paid workers. In addition, public sector managers, including those in the civil service, appear to have been using other devices, including promotions withing salary bands, to deliver significant rises for their employees.

I would not pretend there has been no austerity affecting public sector workers. Public sector employment has dropped by 648,000 since the second quarter of 2009, or around 450,000 excluding the transfer of further education and sixth form colleges from the public to the private sector.

That in itself tells us something important. The strong growth in private sector employment in the past three years, more than 1m net new jobs, has a lot to do with wage flexibility. The suspicion must be that lack of pay flexibility in the public sector - and the big increase in the wage bill - has been a prime reason for the big public sector job losses.

That in turn raises the question of the role of the unions. In the public sector, 56.5% of workers belong to a union, compared with just 14.1% in the private sector. Have the unions looked after the pay of their public sector members, only to sacrifice hundreds of thousands of workers? They may well have done.

What about the second strong belief, about the effect of the cuts on growth? Those third quarter GDP figures were interesting in a number of respects but not least because they showed that 0.4 percentage points of the 1% rise in GDP was contributed by “government and other servicea”.

This component of GDP, all but a tiny bit of which is accounted for by public services, does not include benefit and pension payments, so its rise does not reflect the level of unemployment. It accounts for just over 23% of GDP. It is still rising.

Its third quarter jump was not an isolated event. Government has made a contribution to GDP growth for the past seven quarters. In the latest 12 months, while GDP has been flat, government output is up by 2.4%.

As noted here before, the “wrong kind of cuts” mean the government has been reducing capital spending. Those reductions have to be set agsinst the continued rise in government current spending. Even so, these figures show it is hard to claim that the economy is being dragged down by government.

The public spending enthusiasts will argue that you can never have enough. I would argue that we need to think a lot more about the mix of that spending and what we need, to return to Heseltine, to help medium and long-run growth. Osborne has been criticised for cutting spending too much. A more telling criticism is that he has not controlled it properly or sensibly.

PS Stranger things have happened than Andy Haldane, the Bank of England’s executive director for financial stability, turning up at a meeting of Occupy, telling it it was right, and crediting it with driving reform of the financial system. I can’t, however, think of many.

Banking reform was in train long before Occupy popped up. As for the 99% versus the 1%, it merely perpetuates the myth that if only the very rich could be brought to heel, the world’s problems would be solved and everybody would be happy.

The complexity of the issue was captured rather more successfully in the final report of the Commission on Living Standards, which met under the auspices of the Resolution Foundation. We have got used to the squeeze on living standards since the financial crisis.

The report pointed out that for those in the bottom half of the income distribution, that squeeze started well before the crisis; in the latter stages of the Blair-Brown upswing.

The reasons are many and varied. They include low education standards and workforce skills, a backfiring minimum wage - many employers regarding it as a norm, not a minimum - and an employment-unfriendly benefits and childcare system. Too many are trapped on low incomes.

Can anything be done? The Commission has a range of proposals in all these areas. Skills, benefit reform and a living wage all come into it. But the forces that are squeezing those on lower incomes have been building for decades. Turning them around could take as long.

Sunday, October 28, 2012
Good news starts to blow away the gloom
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 David Cameron’s too broad hint of good news on the way to Labour’s obvious disappointment at a better-than-expected figure, the GDP numbers have become a political football as well as the nearest thing the Office for National Statistics has to a sexy announcement.

It would be inconsistent of me not to say these preliminary figures are prone to revision. When they are unexpectedly weak, as in the second quarter, the expectation is that they will be revised up, as they were.

Given the 1% third quarter rise in GDP exceeded expectations, the risk this time is on the downside, though the ONS does not appear to have made unrealistic assumptions for what it does not know about the third quarter (most of September) and the story the figures tell is quite a logical one.

So, taking the second quarter’s 0.4% fall and the third quarter’s 1% rise together, you have a 0.6% GDP rise over six months. Part of that, 0.2%, was the ONS’s treatment of Olympic ticket sales. The remaining 0.4% splits into 0.2% underlying growth in each of the two quarters, which does not look to be stretching things too much.

In the fullness of time, of course, there will be many further revisions to the numbers. I would expect the double-dip from which we have just emerged to be exposed as phony, revised to become more consistent with far stronger job numbers. But we may have to wait years for that.

Even on the figures we have, the economy is not as weak as we thought. Since turning in mid-2009, overall GDP has risen by 3.3%, and is less than 3% below its pre-crisis level. Excluding the depressed North Sea sector, the economy is up 4.4% from its 2009 lows.

The big question, following on from last week, is whether the economy can maintain momentum after this 1% boost.

The problem for the economy so far is that it has been one damned thing after another. The coalition’s deficit-reduction strategy has coincided with a deepening of the eurozone crisis, an economy starved of credit in spite of the lowest interest rates in the Bank of England’s history and high, mainly commodity-driven, inflation.

Of these three brakes on recovery, the inflation news has been better. Even if a rise in food and energy prices pushes it a little higher over the winter, we should not get back to the 5%-plus levels of a year ago.

Oil prices have fallen from their highs, with US crude down 14%. Real incomes should pick up, maintaining the incipient recovery in consumer spending.

The eurozone crisis, in contrast, looks as though it will always be with us. Though the European Central Bank’s announcement of so-called outright monetary transactions - buying the bonds of troubled eurozone members - has removed the air of crisis, European economic numbers took a turn for the worst last week.

Following weak German surveys, the Ifo index and purchasing managers’ survey, it looks as if Germany, one of the strongest economies post-crisis, may go back into recession over the winter. Britain’s recovery is getting no help from Europe.

On the other side of the world, Japan may also be slipping into recession, partly because of a slump in exports to China due to tension between the two countries over the disputed Senkaku/Diaoyu islands.

We have to assume politicians in Washington are not stupid enough to allow the “fiscal cliff” of big emergency tax hikes and spending cuts to kick in, but the uncertainty is affecting US business sentiment.

It is not all bad news out there. China appears to be past its cyclical low. There is growth in the world economy, particularly the emerging world, the trouble being that not enough of it is close to these shores.

So can we build on the third quarter improvement? A positive sign that does not always get attention is highlighted by Simon Ward, an economist with Henderson Global Investors. Ward, who follows the monetary data closely, saw the third quarter GDP bounce as consistent with a rise in the real (inflation-adjusted) money supply. Encouragingly, he says: “With monetary trends improving further in recent months, this upswing should be sustained at least through next spring.”

Does that argue for more quantitative easing(QE) from the Bank to boost the money supply? The markets have concluded that the stronger GDP figure will mean the monetary policy committee will not do more QE next month.

I think that’s right. The veteran City economist Stephen Lewis of Monument Securities, in an elegantly written critique of his old classmate Sir Mervyn King’s speech in Cardiff last week, put it well.

“Sir Mervyn has no reason to believe the money the Bank creates through QE is as effective in stoking economic activity as the money that would have been generated through the extension of bank credit if the banks had been willing to lend,” he wrote. “Most likely it is less effective,”

After five years of inactivity, and over three years of QE, the Bank and Treasury are trying to get credit flowing through the £80 billion Funding for Lending Scheme, intended to get loans to small and medium-sized firms and mortgage borrowers by offering banks and building societies low cost funding linked to lending.

Two things, however, troubled me about the Bank governor’s speech. The first was its gloomy tone. Perhaps we have got used to a governor who talks about the “black cloud of uncertainty” coming our way from Europe, the “slow and unceratin” recovery, or that advanced economies will struggle “to get out of their current predicament”.

Maybe, like the character Mona Lott in the wartime radio comedy It’s That Man Again, it is being so cheerful that keeps him going. Perhaps he is being realistic. But when, to build on the third quarter you need consumers to spend and businesse invest, this is hardly going to do it.

The other was that Funding for Lending Scheme. It is early days – the scheme did not really get going until last month = and the Bank has high hopes for it. But my initial worries it would be another damp squib have not yet been assuaged. I keep coming back to comments by Bank officials when the scheme was floated in the summer, that in its absence there would have been a further lending fall. Maybe just stabilising it will be regarded as a victory.

King, in his speech, talking of Funding for Lending, said that “the window of opportunity which it provides must be used to restore the capital position of the UK banking system.” I thought the idea was to get credit into the economy not build up the banks’ capital buffers.

The authorities, judging by this, may more concerned about having an ultra-safe banking system than one lending enough to maintain the recovery. That is worrying.

Sunday, October 21, 2012
With a fair wind, lasting recovery starts here
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 gross domestic product figures for the third quarter are published at 9.30 on Thursday, the arguments are well-rehearsed.

Pessimists and the government’s critics will say any pick-up is a mere statistical blip, which does not change the picture of a flatlining economy prone to falls in gross domestic product (GDP). On this view, the double-dip will be followed by triple, quadruple and even more exotic dips.

The other is that the third quarter will mark the start of a sustained recovery. The upturn had a temporary setback, exaggerated by special factors and what the Office for National Statistics (ONS) concedes are more revision-prone data in recent years. But the economy’s firmer tone, reflected in strong employment growth, will persist.

You can, of course, never rule out new shocks. The eurozone crisis is still smouldering and America’s mad fiscal cliff of emergency tax hikes and spending cuts looms (though surely it will be avoided). But, on this view, this week should mark the beginning of better times.

Which will it be? There is a danger of counting chickens before they are hatched. Official forecasters were surprised when the ONS pronounced the double-dip in April, after the data in the early part of the year looked strong. There is always a risk the statisticians will bowl a googly again.

It would, however, be quite a surprise. Economists expect third quarter growth of between 0.4% and 0.8%, some of it merely reflecting a statistical bounce from the jubilee-depressed second quarter.

If it is near the top of the range, there will have been underlying growth since spring. A figure at the lower end, merely making up the second quarter fall, would maintain the picture of a flat economy.

What will happen after the third quarter? There is a great temptation, which the government’s critics fall for, of blaming every woe on George Osborne. I can understand it. He plays the role of pantomime villain well; not everybody could get booed at the Paralympics. He is no great communicator and, after an error-strewn budget, has work to do to inspire confidence. He gets into scrapes in first-class train carriages.

But it is nonsense to suggest that the economy has not grown because of his fiscal tightening, or that it cannot grow as long as austerity persists.

Two reports published in the past few days offered useful insights. One was from the Office for Budget Responsibility (OBR), the independent fiscal watchdog, which proved you can learn as much more from your mistakes as your successes.

After a brief interlude in which a crude exercise from the International Monetary Fund was leapt on as proof that the coalition’s fiscal tightening was solely responsible for disappointing growth, the OBR provided a more rounded picture.

It addressed the question of why, while the budget deficit in the coalition’s first two years came down in line with its June 2010 forecast, growth has fallen well short. Compared with a prediction that GDP would rise by 5.7% between mid-2010 and mid-2012, it only increased by 0.9%.

Where did the growth go? The biggest reason identified by the OBR is one frequently noted here. High inflation has eaten into real, or inflation-adjusted, consumer spending. Interestingly, consumers have been spending; the OBR’s forecast of a cash spending rise of 9.3% over two years was spot on. But it was eaten up by higher prices, leaving no room for “real” growth.

The other weak components of GDP were business investment, which the OBR attributes mainly to eurozone uncertainty and lack of credit, and exports, or net trade, similarly affected by eurozone woes.

Did it not allow enough for the impact of the fiscal tightening? Possibly, though any such effect is balanced by the fact that government spending so far has been significantly stronger than it expected.

The other useful report was from the ONS. To coincide with a seminar it held in Westminster on the great productivity conundrum - why has employment been so strong when GDP has been so weak? - it published a paper by Peter Patterson, its deputy chief economist.

Productivity is not the same as growth, though it is a key driver of it. It measures output per worker or output per hour. According to the latter, productivity was growing 2.4% a year in the decade or so before the crisis but has barely grown - a mere 0.2% a year - since mid-2009. An economy that does not generate productivity growth is in trouble.

Though most sectors of the economy are suffering from weaker productivity growth, two stand out. One is North Sea oil and gas, where output per hour has dropped more than 40% in five years.

The other is financial services, where productivity was growing by more than 4% a year, but in the past three years has been falling nearly 3% annually, as its output has plunged. Just these two sectors provide much of the explanation for the very weak productivity numbers.

So what do these reports tell us? In the case of the OBR’s assessment, it is possible the unhelpful factors that have depressed growth over the past two years will persist.

Some of them, however, are subsiding. The fall in inflation is easing the squeeze on real incomes and should support stronger consumer spending. The eurozone crisis has not been solved but has been contained. There is tentative evidence the global economy, after slowing, reached its low point in the third quarter. Any recovery will be good for exports.

As for the ONS exercise, there are signs that the plunge in output in the North Sea and in the financial services sector - which accounts for a tenth of GDP - is coming to an end. Even stable output would mean both being less of a drag on future growth.

Can we start to believe in a sustained recovery? With a fair wind, yes, and that is also the view of most economists. Consensus Economics, a consultancy, polls economists regularly. In its latest exercise, it asked for medium-term predictions.

For Britain, the forecast was for 1.2% growth next year, 1.9% in 2014 and 2.2% in 2015, election year, before settling at 2% over the medium-term. In the past that would have been regarded as so-so but it is not that much below America, which settles at 2.5%, the eurozone, which is seen as growing by 1.5% in the medium-term and Japan, which struggles to hit 1%. Britain is even seen as outpacing Germany, which grows in line with the eurozone average.

In the long-run, as Keynes noted, we’re dead. In the medium-term we can hope for better growth.

Sunday, October 14, 2012
Low inflation concealed dangers below
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 20 years since, in the aftermath of the ERM (exchange rate mechanism) Black Wednesday debacle, the then Tory chancellor, Norman Lamont, announced that the government was adopting an inflation target.

A young, or at least a younger, Mervyn King was, as the Bank of England’s chief economist, tasked with producing a quarterly inflation report. This enhanced role for the Bank paved the way for independence in 1997.

Had either the chancellor or the Bank’s chief economist said in 1992 inflation would average just 0.1 percentage points above the official target over the next two decades they would have been ridiculed.

But that, as an older Sir Mervyn King, now on his last lap as Bank governor, reminded us last week, was what happened. Consumer price inflation has averaged 2.1%, compared with a 2% target. Britain’s traditional Achilles heel - inflation averaged 12% in the 1970s and 6% in the 1980s - may not have been cured but for 20 years it has been strapped up.

Before getting on to whether this has been such a good thing, I should point out for the sake of purists that there was a different inflation target for more than half of the period in question. The original target, the retail prices index excluding mortgage interest payments (RPIX) was set at 2.5% and lasted well into the 2000s. The change does not, however, change the big picture of close-to-target inflation.

So should we doff our hats to Lamont and garland the Bank for its achievement? We should certainly give some credit where it is due but we should also not ignore the shortcomings. King, to be fair, took some of these on the chin in a 20th anniversary speech at the London School of Economics.

The first is that inflation has been too high over the past three years, indeed the past seven years, at the very time we needed it to be low to support consumer spending. The record for two-thirds of the 20 years was good, helped by favourable international factors, but the final third has been poor. In only 14 out of the past 84 months has inflation been at or below target.

King’s defence was that the low-inflation credibility built up earlier prevented recent inflation from being much higher. So, he said: “Since 2007 the UK has been able to absorb the largest depreciation of sterling since the Second World War, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3.2% over the past five years and without dislodging long-term inflation expectations.”

Fair enough, though the Bank was not merely an disinterested spectator in sterling’s fall. Quantitative easing, on the Bank’s own estimates, has boosted inflation and there has been a lot of it. The Bank was hit by unhelpful factors but also tolerated higher inflation, believing the alternative would have been much worse.

The bigger question is whether the inflation target breeds dangerous behaviour: one kind of stability promoting instability, volatility and excessive risk-taking elsewhere.

That may now be one for King’s successor, though it is also relevant to the incumbent’s record. Applications to succeed him closed last week and having Tu in your name (Paul Tucker or Adair Turner) looks to be an advantage.

King suggested there was nothing exceptionally frothy about Britain’s 2.9% growth rate in the run-up to the crisis - the International Monetary Fund (IMF) now disagrees - though admits it was unbalanced growth.

Monetary policy in Britain was not exceptionally loose in comparison with other economies. Interest rates were higher than elsewhere (and King reminds us he would have liked them even higher) and pre-crisis the pound was strong.

So what went wrong? Significantly higher interest rates - breaking Britain’s unbroken period of growth from the early 1990s to 2008 - could have changed behaviour. This is the argument that a couple of small recessions along the way could have prevented the big one.

Maybe, however, even if the Bank had deliberately aimed off the inflation target in that period and inflicted more pain on the economy, we would still have had the big one.

As King put it: “Leverage and the growth of credit may be relatively insensitive to interest rates, especially once a self-reinforcing cycle of optimism and credit expansion is underway. And this financial crisis was a global one: the UK alone could not have stopped it happening.”

So has inflation targeting done more harm than good? No, but given Britain’s high-inflation history, policymakers were guilty of giving too much prominence to it, and took their eyes off other dangers. It was a bit like the captain of the Titanic looking only at the calm waters on one side of the liner, missing the iceberg on the other.

That problem, we have to hope, has been corrected. If we ever get to a situation again where the banks are increasing their leverage too aggressively and credit is exploding, interest rates would rise whatever the inflation rate and “macroprudential” tools such as putting a cap on bank leverage would be employed. The Bank’s right hand - its monetary policy committee (MPC) - would co-ordinate things properly with its left-hand, the new financial policy committee.

Even that will not make Britain immune from the dangers. It was odd that in an era of globalisation it seemed for a time that nine members of the MPC had Britain’s economy under the tightest control; precision-guided policy.

It was an illusion then and it is an illusion now. The best monetary and macroprudential policy in the world wlll not prevent the economy being exposed to problems elsewhere, whether in the eurozone, America or other parts of the world.

Britain has been blown about and the gusts continue. The downside of inflation targeting was that it gave the impression that central banks had everything under control.

It will be a long time before we think that again, Tucker, Turner, or whoever else exceeds King, will not have gone into their job interviews preaching a doctrine of infallibility. All they can try to do is reduce the risks.

Sunday, October 07, 2012
Public spending is too important to be left to politicians
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 third speech tom the Tory conference as chancellor, this week, is probably his stickiest. In 2010, the coalition was in the first flush of optimism. The first of the four quarterly falls in gross domestic product on its watch was yet to come.

Last year was a little less comfortable but it came before the Office for National Statistics (ONS) gave us the double-dip recession.

This year’s is too early for the ONS to tell us whether there was growth in the third quarter - if not with favourable post-Jubilee and Olympic effects we might as well give up now - that will come on October 25.

But the backdrop remains a subdued one. Business surveys suggest some of the strength we have seen in the labour market may be subsiding. Purchasing managers’ surveys for manufacturing, construction and services averaged 51.1 in the third quarter, above the 50 dividing line between growth and recession but only just.

Some bits of the economy are doing well. New car registrations last month, the first for the new “62” plate, were 8.2% up on a year earlier, with sales to private buyers up 14.2%. Overall, though, this is an economy still in serious need of some oomph.

The most difficult area for Osborne is his fiscal strategy. No doubt we will hear a lot about “dealing with the debt” from ministers, when they should be saying “dealing with the deficit”.

But even dealing with the deficit is in trouble this year after a successful first two years, as discussed last week. Depending on how you measure it, borrowing is between a fifth and quarter up on last year. The fiscal strategy is in need of rebooting.

Some will say the coalition is suffering the inevitable economic consequences of trying to cut the deficit too quickly. Paul Krugman, the Nobel-winning American economist, will be over here to make that point again later this month.

I think the problem is rather a different one, and it goes back to the coalition’s early, over-confident days in the spring and summer of 2010. We had an inexperienced Treasury chief secretary - Danny Alexander only got the job when David Laws was forced to resign - and a spending review Osborne insisted was completed in time for its mid-October unveiling.

The result was an exercise intended to set the tone and the fiscal parameters for the parliament was a dog’s breakfast, hurriedly cobbled together. We have had, and continue to have, the wrong kind of cuts and the wrong kind of spending increases.

Handed a “there’s no money left” poisoned chalice by Labour and a sketch, no more, of a spending review in which the only thing slashed was capital spending - infrastructure - the coalition was silly enough to run with it.

Brian Reading, the economist, has deconstructed the errors made in a paper for Lombard Street Research, The Blunt Axe. I can do no better than sum up his main criticisms of that 2010 review.

As he writes: “Its claim to secure economic stability was made without any attempt to assess the growth consequences of spending cuts. It hid behind the fan of the OBR’s [Office for Budget Responsibility] rosy forecasts that had little regard for the uncertainty in the global economy.

“It slashed and burnt investment except on expensive prestige projects; It made no attempt realistically to identify where taxpayers’ money was to be saved.

“It made no to attempt to measure the real resources provided to its priorities, using bogus price deflators. It failed to protect front-line workers, identify them or determine what front line work they did. It made no plans for the inevitable cuts in government employment, delegating responsibility to public sector employers.”

The most egregious errors were on public investment and unemployment. Government investment has the highest “multiplier” of any fiscal action by government. Every pound spent results in at least a pound extra gross domestic product. Yet the government planned a 58% cut in public sector net investment by 2014-15.

Public sector employment, meanwhile, has fallen 300,000 more than the OBR said, mainly because the coalition’s aim, of holding down public sector pay, failed. Instead of rising just 3% since the election, average public sector pay has risen by 9%, Reading calculates. Jobs took the strain.

The problems persist. So far this fiscal year, benefit spending is 6.5% up on last, as a result of the decision to index most benefits by 5% in April. Where’s the axe there?

What should be done? Reading is clear and I agree with him. Politicians of all parties cannot be trusted to make the right decisions on spending and neither can Whitehall officials (his paper was written before the West Coast main line fiasco).

The most effective exercises in cutting public spending in the past, he points out, have been when governments got somebody in to do it. So the Liberals in the 1920s asked the businessman Sir Eric Geddes to advice on cuts, the Geddes axe.

In 1931 Sir George May, on his retirement as secretary of the Prudential, headed a committee to advise Labour, and then the coalition national government, on a programme of cuts. In 1976-7 the International Monetary Fund which oversaw cuts. We have learned a lot since those exercises. Public expenditure is still significantly too large in relation to the economy’s sustainable tax base, hence the deficit.

But we cannot afford another disaster like 2010’s spending review. Future cuts need to be planned in a way that has the minimum impact on growth and front-line services and enhances, not diminishes, Britain’s ability to grow in future.

So the next spending review, in 2013, needs to be overseen by an outside committee of experts, under a strong leader independent of politics. “A fresh start is urgently needed right now,” Reading writes. “A Geddes-style independent committee should be immediately established.” Indeed. Spending is too important to be left to politicians.

Sunday, September 30, 2012
Lending is the key to putting the fiscal strategy on track
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 party conference season, when the government's economic strategy comes under attack, and ministers run some eyecatching announcements up the political flagpole.

We have already had a foretaste of this from the Liberal Democrats. Most of it boiled down to ‘if you are Lord Sugar do not expect a free bus pass and expect to pay more tax on your mansion’, though not until after the elction.

For this week’s Labour conference, in Manchester, the coalition has at least been spared the indignity of an economy that has shrunk on their watch. Two months ago that was the case: the Office for National Statistics said then that gross domestic product in the second quarter was 0.3% lower than two years earlier, when the government took office.

Now, thanks to revised figures last week, it is 0.2% larger, and one of the five quarterly falls in GDP of the past three years - in the second quarter of last year - is now recorded as a rise. The initial 0.7% GDP drop in this year’s second quarter is now put at 0.4%. There will be many more such revisions to come.

This will not, for now, save the coalition from taunts about the double-dip recession. Nor will it prevent a political narrative that runs like this: the government’s fiscal strategy has not only flattened the economy but is failing on its own terms by not reducing the budget deficit according to plan.

There is a lot to say about this. The fiscal tightening is only one aspect of disappointing growth, the others being the high-inflation squeeze on real incomes (which the latest figures suggest has eased considerably), the absence of credit growth and the eurozone crisis. In the past year the eurozone’s woes have weighed down heavily on Britain’s economy.

A bit of a myth has grown up about the public finances, which we shall no doubt hear more of this week. The benchmark for the government’s austerity plan was laid down by the June 2010 forecast from the Office for Budget Responsibility (OBR), the official fiscal watchdog.

Its forecast then was for public borrowing, estimated at £155 billion in the 2009-10 fiscal year, the last year of the Labour government, to drop to £147 billion in 2010-11 and £116 billion in 2011-12.

Latest figures show borrowing running pretty close to those projections, with 2009-10 put at £159 billion, 2010-11 £142 billion and 2011-12 £119 billion. If you wanted to stretch it you might say that a reduction from £159 billion to £119 billion is slightly bigger than from £155 billion to £116 billion, but the central point is that as far as the tightening for the first two years is concerned it is a case of so far, so good.

It gets more difficult from now on. The OBR’s June 2010 forecast was for a drop in borrowing to £89 billion this year, leaving aside any accounting shenanigans from the transfer of the Royal Mail pension fund to the public sector.

So far in 2012-13, borrowing is running a fifth about last year’s level. That should change as we move into the second half of the fiscal year - there were similar worries about a big overshoot 12 months ago - but it would take a minor miracle to get back to where the OBR said in 2010 we would be, let alone achieve the deficit reductions to £60 billion, £37 billion and £20 billion for the following three years.

Future deficit reduction has become harder because of growth in current government spending, notably benefits, which in the April-August period were 6.5% up on a year earlier. This was mainly because of the decision to uprate most benefits by 5% in April and it is why talk is now turning to freezing such benefits.

Some tax receipts, particularly corporation tax, are also very weak, down nearly 10% on a year earlier. A rise in company profits in the second quarter should turn this around somewhat, but the loss of the revenue cash cow of the business and financial sector is genuine.

The big reason for the slowing of progress on deficit reduction is, of course, the disappointment on growth. When the coalition took over in May 2010, it adopted a tight fiscal/loose monetary strategy that had worked so well in the 1990s.

With hindsight (though it did not seem so at the time) Britain bounded out of the recession of the early 1990s, with growth rates soon hitting 3% or more. The loose monetary policy of the time; lower interest rates and a sizeable sterling devaluation, more than compensated for a fiscal tightening that saw hundreds of thousands of public sector jobs cut. A budget deficit of 8% of GDP turned to surplus in five years.

Why did it work then but is so much tougher now? The 1990s model required monetary policy to do the heavy lifting in kickstarting and maintaining the recovery. This time, monetary policy has struggled to keep the economy’s head above water.

Three and a half years of Bank rate at an unprecedented low of 0.5%, £375 billion of quantitative easing and a 25% drop in the level of sterling, most of which has stuck, have failed to do what a more modest monetary relaxation did two decades ago. Either the forces pushing the economy down are even more powerful than we thought, or monetary policy has lots its potency.

We may know soon enough. The Bank of England-Treasury £80 billion funding for lending scheme (FLS) is the latest attempt to reboot monetary policy. Last week the Bank announced the first 13 banks and building societies to have signed up, between them accounted for nearly three-quarters of the stock of lending to households and firms.

Under the scheme, lenders will be provided with cheap liquidity in the form of Treasury bills for up to four years, in return for commitments to maintain or increase lending between now and the end of 2013.

Paul Fisher, the Bank’s executive director for markets, is not suggesting that the scheme will transform a weak economy overnight. But, he said in a speech last week: “I am confident that the FLS will help the supply of credit. Before its introduction, it was more likely than not that the stock of credit would contract further over the next 18 months. Perhaps it still may. But any return to positive credit growth would be a better outcome than we could have previously hoped for.”

It needs to happen Monetary policy has to work to boost the economy, and to keep the fiscal strategy on track.

Sunday, September 23, 2012
Inflation still too high to beat the squeeze
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 week, another puzzle. The latest figures for retail sales, out on Thursday, showed a marginally disappointing 0.2% drop in volumes in August.

Store sales were generally fine but online spending dropped, because we watched the Olympics and Paralympics on television rather than clicked and shopped.

That may be a sad indictment of the way we live but even after the 0.2% slip, retail sales volumes were 2.7% up on a year earlier. Sales in August 2011 were a little depressed because of the riots but it was still the case that non-food sales last month were a hefty 5% up on a year earlier; more of a boom than a shoppers’ strike.

I promised a puzzle. Retail sales have grown, with volumes 1.4% up on their pre-recession peak in the first quarter of 2008.

Now let us look at consumer spending more generally, which is what matters for GDP (gross domestic product). In the latest quarter, April-June, spending in real terms fell 0.4% and was down by 0.8% on a year earlier. Not only has it failed to get back to its pre-recession levels but it is still a substantial 6.3% below it.

Retail sales, covering what people spend in stores as well as petrol and diesel purchases, are not the same as consumer spending. The latter includes gas and electricity and other household bills, bus and rail fares, and expenditure on housing, recreation, culture, hotels and restaurants.

Some of those, like nights out or tickets to sporting events, we like spending money on. Others, like household bills, insurance and train fares, we do not.

You could argue the current mix of rising retail sales and depressed consumer spending, is on balance better: people are spending less on things they would prefer not to spend on, and more on goods in the shops.

Even so, it is odd. Retail sales and overall consumer spending are usually closely correlated. It is unusual for them to be moving in opposite directions.

As far as the Bank of England is concerned, it is the wider picture for consumer spending that matters and, according to the latest minutes of its monetary policy committee (MPC), we are heading for another disappointment. Despite last week’s drop in consumer price inflation to 2.5%, the MPC fears - again - it will disappoint on the upside in the coming months.

“Any sustained recovery in output would probably need to be accompanied by a pickup in consumption...,” it said. “The prospective rises in prices for petrol, household energy and some foodstuffs would dampen real income growth in the second half of the year.”

It is not all one-way. Since the MPC met, oil prices have slipped, and this may feed through into lower petrol and diesel prices.

The read-across from above-target inflation to real income growth is not as direct as you might expect. People have other sources of income. In the 12 months to the first quarter of this year real incomes fell only 0.1%, even though inflation topped 5% during that period.

Even so, the most basic building block for a rise in spending is that earnings from employment go up more than prices. Normally it happens. In the eight years before the recession, earnings rose 39%, prices 15%. There was a real income bonanza.

But not now. The relationship has broken down. Pay, in the latest figures, is rising an annual 1.5%, well below inflation. Even adjusting for depressed bonuses, pay is rising less than 2%.

Nor is this just the result of the squeeze on public sector pay. It is rising by 1.2% but earnings in the private sector are only increasing by a slightly faster 1.8%.

There is now an official debate about how inflation is measured. Following a report from the Consumer Prices Advisory Committee, the national statsitician will consult on changing the methodology for calculating the retail prices index (RPI).

People will suspect a trick but certain aspects of the RPI, particularly clothing and footwear prices, have looked odd for a while. The so-called formula effect gap, which gives higher retail price inflation (currently 2.9%) than consumer price inflation (2.5%) may be removed.

That will not change the underlying reality, however, of prices rising more rapidly than pay. How can it be tackled? One way is for the Bank to aim, not merely for 2% inflation - its target - which it has struggled to hit, but to go for something lower. With wage growth so depressed, even 1% inflation is not too low for this economy.

The other is to look for a return to normal earnings growth. Before the crisis, allowing for what was then regarded as trend productivity growth of about 2% a year, 4% earnings growth was both consistent with the inflation target and good growth in consumer spending.

Can we return to such growth? One is tempted to say that if firms are worried about demand in the economy, as they say, part of the solution is in their own hands, in the form of more generous pay awards.

Looked at from a macro perspective, a new paper from the Resolution Foundation by Professors Paul Gregg and Stephen Machin, ‘What a drag: the chilling impact of unemployment on real wages’, does as its title suggests.

It finds that while unemployment has not risen as much as feared, at more than 8% of the workforce it has had a crushing impact on the growth in real wages.

Building on changes that were in place even before the recession - the economists think the greater sensitivity of wages to unemployment can be traced back to 2003 - Britain is a buyers’ market for employers.

The implication is that only a sharp fall in unemployment will change this. As they put it: “Real wage growth for low and middle earners will not return to significant positive territory until unemployment starts to fall significantly – probably below the levels (of between 4% and 6%) recorded in the period from 1999 to 2007.”

That is not going to happen for some time. The Bank can help by getting inflation down further. But the days when strong growth in real wages generated across-the-board rises in consumer spending are a fading memory.

Sunday, September 16, 2012
Better news - but we should still mind the trade 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.

We should celebrate and nurture good news. In the past few days there have been three sets. In Europe, the eurozone has moved further back from the brink, thanks to the German constitutional court decision to back, with strings, the rescue fund for its troubled members and the rejection by Dutch voters of eurosceptic parties. There is a long way to got but the sense of imminent euro collapse has gone.

Then, not for the first time, came excellent job numbers, with a rise of 236,000 in employment to 29.56m, within a whisker of its pre-recession peak four years ago.

The composition of employment has changed in that time, with a drop in full-time workers and a rise in part-timers. But these were very good numbers and, as before, hard to square with a stagnant economy, let alone a shrinking one.

It is gratifying to see some things going exactly according to plan. I expected private sector job creation to easily outstrip public sector job losses, as in the 1990s, and so it has. In the past three years, the private sector has added 1.36m jobs while the public sector has cut by 689,000.

There is a distortion to the figures from the reclassification of roughly 200,000 people who work in further education from public to private sectors. Adjusting for that still leaves 1.16m additional private sector jobs, against 489,000 public sector cuts.

It is the third bit of good news I want to concentrate on today. This was the sharp narrowing of Britain’s overall trade deficit in July to £1.5 billion, from £4.3 billion in June, with the deficit on goods dropping from £10.1 billion to £7.1 billion.

Exports rose by 9.3% in value in July, while imports dropped by 2.1%. Proof that the great rebalancing of the economy towards exports is under way?

Maybe not, or at least not yet. As was suspected a month ago, the June figures were heavily distorted by the Jubilee bank holidays, which hit exports harder than imports. It is always unwise to draw conclusions from one month’s data, particularly when the distortions are so obvious.

There is still something to celebrate in the figures. The three monthly picture, shows the overall trade deficit narrowed to £8 billion in the May-July period from £10.5 billion in the previous three months.Export volumes rose 0.9%, excluding oil and erratics, while imports fell 0.8%.

Exporters are being hit by the eurozone crisis, while doing better in non-EU trade. So in the latest three months goods export volumes to the rest of the EU edged up by 0.3% but were down by 4.4% on a year earlier. Non-EU exports, in contrast, rose by 4.5% and were 12.5% on a year earlier.

The weakness of Britain’s EU markets is one reason why it is too soon to celebrate the improvement in Britain’s trade position. The fact that, even after July’s improvement there was a £7.1 billion deficit in trade in goods is a rather bigger one.

Britain’s deficit in goods, the so-called visible trade deficit, has been on a deteriorating trend for decades; Britain’s last manufacturing trade surplus was in 1982.

In 1997 the deficit was £12.2 billion, rising to an alarming £94.1 billion in 2008. You might expect it to have fallen in the recession, and it did in 2009 to £82.8 billion. But then it rose again, hitting £100 billion for the first time in our history last year.

There are two worrying things about this. One is that the trade deficit is running at these record levels despite what should have been a huge boost from sterling’s 25% fall in 2007-8, most of which has stuck.

The second is that it has occurred despite the depressed level of consumer spending, still more than 6% down (in real terms) on pre-recession levels. If we have a £100 billion deficit with consumer spending subdued, heaven knows what will happen if it starts growing strongly.

Most of the time, the growing deficit on goods has been disguised by a rising surplus on services. Britain is second only to America as an exporter of services and the surplus on services has been almost a mirror image of the deficit on goods.

The services surplus, £18 billion in 1997, reached £76.4 billion last year. Services are keeping Britain afloat. The fear is that they may be less effective at doing so in future.

Michael Saunders, an economist with Citi, the bank, has used Eurostat data to show that while the volume of Britain’s total exports (of goods and services) is up a marginal 0.1% compared with the recession’s eve in early 2008, this is well below the growth achieved by America, 12%, Ireland, 9.7%, Germany, 9.5%, the Netherlands, 9.2%, and Spain, 7.4%. One reason is service sector exporters, particularly in financial and business services, are finding life tougher as a consequence of the crisis.

What do we need to do? People often ask me why the trade figures no longer seem to matter much anymore. The markets did not bat much of an eyelid either when the very poor June trade figures came out a month ago, nor when the much better July numbers came out last week. These days capital flows, rather than trade, drive the currency markets.

Trade does matter, however. The trade gap remains a useful barometer of this country’s economic health, and of the ability of companies based here to compete in global markets.

Vince Cable, the business secretary, has begun to sketch out an industrial strategy, focused on “sector strategies” for key parts of the economy. The fact that industrial strategy carries connotations of Labour in the 1970s and that targeting sectors sounds suspiciously like picking winners has had some on the right foaming at the mouth.

That is silly. The Thatcher government in the 1980s had an industrial strategy of attracting inward investment, mainly from Japan, to revive Britain’s car industry. I remember Lord Young, her business secretary (he preferred enterprise secretary) being mocked for predicting an eventual return to a trade surplus in cars.

But it has happened. Britain is this year heading for the first trade surplus on cars since 1976, with 80% of vehicles assembled in Britain intended for export If it can happen for cars, it can happen for a range of other products, and it is the ultimate test of the success of an industrial strategy. We really should mind the trade gap.

Sunday, September 09, 2012
Construction alone can't build the 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.

David Cameron has returned to work with a new ministerial team and, instead of freshly-sharpened pencils, some freshly-sharpened policies. In a week in which Britain’s growth was downgraded by the Organisation for Economic Co-operation and Development (OECD), the question is whether they will make a difference.

That downgrade, to a 0.7% drop in gross domestic product this year, is not all it seems. The OECD chose not to assume a statistical bounce this quarter from the Jubilee-affected second quarter, though that was the strong message from Friday's industrial production figures.

Even so, the economy is in serious need of some oomph. The question is whether it will get it. First we need to know what the government is doing.

There will be a new body to make funding and advice more accessible for small firms, probably modelled along the lines of America’s Small Business Administration; not so much a business bank as a one-stop agency.

Most of the flurry concentrated on the beleaguered construction sector, particularly housebuilding. So, on top of the £40 billion of infrastructure guarantees announced in July, there are £10 billion of housebuilding guarantees, to be used for homes for the private rented sector.

Why guarantees? The government believes it cannot reverse the capital spending cuts of the past two years without losing credibility. Though the worst of those cuts is over, it is relying on privately-funded, publicly-guaranteed spending for a boost in coming years.

There will be some tweaks to a planning system that was only recently put into place in March after what the Home Builders Federation describes as a two-year “policy hiatus”. But, while homeowners will now be able to build bigger structures in their gardens without planning permission than before, this is no planning free-for-all.

Housebuilders should get local authorities off their backs when its comes to onerous so-called Section 106 requirements to include a high proportion of affordable homes in new developments. They will be hoping the Community Infrastructure Levy, payable on new developments, is not used as a cash cow by local politicians.

Talk to housebuilders, however, and you get a simple message. Without mortgage availability, the industry will remain in the doldrums. Since the financial crisis fired an Exocet five years ago, cutting off two-thirds of new loans at a stroke, housebuilders and sellers of existing homes have been struggling under this handicap.

While builders welcome anything that makes planning less burdensome, mortgages matter most. The £280m extension of the government’s FirstBuy scheme for first-time buyers is welcome.

Most hopes lie with the £80 billion Treasury-Bank of England Funding for Lending Scheme. If it gets mortgages flowing, building will follow. If not it will remain very depressed. In the 12 months to end-June, new housing starts in England were just 98,670, 10% down on the previous year. Far from building its way to recovery, the industry has been digging into recession.

Three months ago I quoted a paper from the think tank CentreForum by the economic historian Nick Crafts. It stressed the role of housebuilding in Britain’s 1930s’ recovery, on the back of cheap money and an absence of planning controls.

Could history repeat itself? Crafts suggested perhaps an additional 3m new homes are needed, and rolling them out an extra 150,000 a year could generate 750,000 more jobs. I do not disagree with his numbers, though they would require the industry to more than double its output.

The question of whether construction can lead to stronger growth has to confront the fact that, important though it is, it is small relative to the economy as a whole.

Construction accounts for 6.8% of GDP, according to the Officed for National Statistics. New homes are only part of the eector, accounting for under a fifth of construction output last year, just over 1% of GDP.

This arithmetic means even a very substantial boost in construction has only a muted impact on overall economic activity. Let me demonstrate. Construction output in April-June was over 16% down on its pre-recession peak in early 2008.

Suppose, instead of sliding, construction had been flat. Would it transform the GDP picture? No, GDP would be a modest 1.3% higher than current figures suggest.

If all government initiatives doubled housebuilding next year (which is highly unlikely). It would be to boost GDP by a little over 1%. A similar result would be achieved with a 20% rise in output - again unlikely - for construction as a whole.

The point is not to knock initiatives to boost construction and housebuilding. I hope they work. But recoveries have to be rounded. They cannot rely on one sector.

If more housebuilding encourages consumers to spend more, over and above the multiplier effects of additional construction employment, then good. The 1930s, as well as a housebuilding boom, was the age of the consumer, with cars, electrical products, confectionary and cosmetics contributing to a sustained spending upturn.

If the promise of more airport capacity, however distant, persuades businesses that this is a time to invest, then good too.

And if. perhaps above all, the international environment improves, it is possible the government’s flurry of announcements will not fall on stony ground.

One discovery in recent years is that policymakers in Britain are powerless in the face of global events. We like to maintain the fiction that everything is the result of decisions by the chancellor or the Bank of England’s monetary policy committee.

As far as the short-term outlook for Britain’s economy is concerned, though, the big announcement was not from Cameron or George Osborne but Mario Draghi, president of the European Central Bank.

Many are concerned about his pledge of “unlimited” bond buying of eurozone countries’ debt under the new outright monetary transactions(OMT) programme. But if it boosts a shrinking eurozone economy and stabilises volatile markets, most will have reason to be grateful. The eurozone crisis has cast a long shadow. Anything that lets in a bit of sun will be welcomed.

Sunday, September 02, 2012
Quantitative easing has failed to pump up the economy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

The Bank of England’s monetary policy committee (MPC) meets this week, and quantitative easing will be on the agenda.

Though it is probably too soon for the Bank to add to the £375 billion it has already sanctioned - not all of which has yet been done - the City thinks there is more to come, probably in November.

If £375 billion of quantitative easing (QE) sounds a lot, equivalent to a quarter of Britain’s annual gross domestic product, some think it has not gone far enough.

Adam Posen, who left the MPC on Friday, said in an interview one of his biggest regrets was not persuading the rest of the committee to do more in 2010 and 2011.

So QE is a hot topic. Every time I give a talk, I get questions on it. People are engaged, and sometimes enraged.

What the Bank may have thought was a technical exercise has people interested, puzzled and worried. Many see it as an exercise in propping up undeserving banks, while others cannot understand why £375 billion, £6,000 a head, is not simply handed out to the public, or used for something worthwhile, like infrastructure or housing.

Others think QE is the kind of policy associated with dodgy dictatorships. When a central bank buys the debt of its own government, is it time to stock up on gold bars or move to Switzerland?

Most of these questions are quite easily answered. The Bank prefer to call QE asset purchases. It involves expanding the Bank’s balance sheet - electronically creating money - and using it to buy assets, overwhelmingly government bonds (gilts).

So far the Bank has bought just under £350 billion of gilts, nearly 39% of the total of so-called conventional stocks in issuance. It does not buy index-linked gilts.

The clue to why that money could not just have been handed out is in the name, asset purchases. The new money is used to buy gilts from pension funds, insurance companies and overseas institutions (the banks do not hold many). When QE has done its work, the assets will be sold back.

Unless households had assets to hand over, say a share of their property, there could be no equivalent policy for them. It would be a massive, unfunded tax cut.

The same applies, with a little qualification, to the arguments about infrastructure, housing or small businesses. It would have been possible for the Bank to buy infrastructure bonds, bundles of new mortgages or packaged small business loans, directing money to parts of the economy where it is needed. But the Bank is a conservative institution, and chose the least risky assets.

Buying gilts may be low risk, but is it dodgy? The figleaf of propriety is preserved by the fact that the Bank’s gilt purchases are not direct from government, or its Debt Management Office, but private holders.

It is, however, a figleaf. Many private holders of gilts are very short-term owners. There is no doubt funding a record budget deficit has been made infinitely easier by QE. A new buyer for gilts has come on to the scene when the government needed it.

Desperate times call for desperate measures, however, which is why I backed the first £200 billion of QE in 2009, though not the second round launched last autumn. The question is whether the policy has been as successful as the Bank claims.

In its most recent research, last month, the Bank looked at the effects of QE on different groups, largely to deflect criticism that it has hurt pensioners.

It identified four potential boosts to the economy. Gilt purchases give sellers money to move into other assets, including corporate bonds, equities and property.

They boost market liquidity, send a signal that interest rates are likely to remain low for longer (the Bank will not raise rates while doing more QE) and, it suggests, could boost consumer confidence.

Adding all this up, it concluded: “Without the Bank’s asset purchases, most people in the United Kingdom would have been worse off. Economic growth would have been lower. Unemployment would have been higher. More companies would have gone out of business.”

In earlier research, endorsed in its latest publication, it suggested that the first £200 billion of QE boosted the level of GDP by between 1.5 and 2 percentage points. The second round. launched last October, is not yet complete but, allowing for that, and the fact that the policy operates with a lag, suggests a total GDP effect so far, according to the Bank, of 2.5 to 3.5 percentage points.

Is this plausible? Latest official figures suggest the economy is only 2.1% above its recession low in mid-2009. The Bank’s numbers imply all that growth - and more - is due to QE. Without it, it seems, the economy would have shrunk. Tied to the fact that on current data it has shrunk in the past nine months, and the growth benefits look to be exaggerated.

In 2010, for example, Britain benefited from a strong rebound in the global economy, which grew by more than 5%, and by the turnaround in inventories - stocks - that always follows the worst phase of a recession. Every other economy began to recover in the middle of 2009, whether or not they adopted QE.

For me the simplest test is to look at what QE is supposed to do: boost the money supply. Since 2009, M4 money supply measure has risen around 5%, adjusting for financial sector deleveraging.

Though the relationship between money and other economic variables is never perfect, that does not cover the 10%-plus rise in prices in the past three years, leaving no room for a growth boost.

The Bank would say it is impossible to know what would have happened in the absence of QE. The same applies, however, to claims of its effects on other asset prices. Financial markets are international. Ascribing those rises to QE is pushing it.

If scepticism about the growth benefits of QE is in order, is it harmless? Not necessarily. At some stage the Bank will have to sell the gilts it has acquired, an exit strategy that might not be easy.

There is an inflation risk, though not a big one with the money supply so depressed. My argument has been that, though sterling is higher than when the policy first started, regular QE hints or announcements have kept it from rising more, contributing to higher imported inflation than necessary. Disappointingly, we may be seeing a re-run of that now.

The biggest problem is that markets are addicted to QE, in the way they used to be addicted to low interest rates before the crisis. If there is a bond market bubble, the Bank is helping to keep it inflated. We should be sceptical of the claimed benefits of QE. The sooner it ends, the better.

Sunday, August 26, 2012
The wrong kind of cuts leave Osborne struggling
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, amid the fall-out from the riots, turmoil in the eurozone and the stunning loss of America’s AAA debt rating, George Osborne looked to be in fiscal trouble.

Net borrowing in July 2011, initially reported at £20m, added to a picture of a deficit stubbornly refusing to come down . The deficit reduction programme, it seemed, was stuck.

Things changed. July’s small deficit was eventually revised to a surplus of £2.8 billion. Borrowing did come down significantly over the course of 2011-12, to £125 billion, from £148 billion in the previous year, 2010-11. The strategy survived.

Whether history is repeating itself remains to be seen. Public borrowing in the first four months of the current fiscal year is not just failing to come down, it is up.

Adjusting for two distortions - the transfer of the Royal Mail pension plan to the public finances and a payment to the government at the end of the Bank of England’s Special Liquidity Scheme - April-July borrowing was £47.2 billion, £11.6 billion higher than a year earlier.

Though the fiscal task this year is less onerous - on an underlying basis borrowing only has to drop by £5 billion to £120 billion - things are heading the wrong way.

There will be data revisions for all the usual reasons, and the fact the Treasury is running in a new computer system for monitoring spending. A North Sea shutdown artifically depressed tax receipts.

Nor was a July deficit quite as rare as it was painted when the figures were released. The government was £557m in the red in a month in which corporation tax payments are concentrated but this was better than two years ago, when the deficit was £3.4 billion, or three years ago, when it was £6 billion. Every year from 1993 to 1996, July was a deficit month.

Not only that but a glance at the details shows how complex working out what the government’s fiscal position is. It is a minefield, making the accounts of the messiest individual or business look like child’s play.

Perhaps because of this, both the Office for Budget Responsibility and the Institute for Fiscal Studies say it is too early to say this year’s fiscal target will be missed. There is time to make up lost ground.

Does this mean the chancellor’s garden is rosy? Not a bit of it. In fact, the more you look at it, the more of a mess it is.

Some readers will be too young to remember the Margaret Thatcher year. In her first term as prime minister, 1979-83, almost the entire nation believed Britain was reeling under the impact of “the cuts”.

Labour, the unions, most economists and the majority of voters believed it, and ministers did nothing to disabuse them of it. The reality was rather different.

Whie capital spending, on infrastructure, was indeed cut sharply, by more than half, the lion’s share, current spending, rose strongly, increasing by 13% in real terms over four years.

Some of this was the effect of recession, pushing up the bill for unemployment and other benefits. Much of it was public sector pay, after the government agreed to honour the recommendations of the Clegg commission (no relation).

Only in its second term did the government start to get to grips with spending.
It is happening again. Current spending is rising under the coalition, and is intended to carry on doing so until beyond the end of the parliament.

Capital spending, as then, is being slashed, from £48.5 billion in 2009-10 to £26.1 billion in 2011-12, Osborne having taken the plans he inherited from Alistair Darling and run with them. These are the “cuts”. As under Thatcher three decades ago, the coalition has failed to put a brake on the recurring items of spending.

So last month, current spending was up 5.1% on a year earlier. Welfare payments, (officially net social benefits), were up 6.2% year-on-year last month, and an even more worrying 7% in the April-July period.

This is not a temporary phenomenon. Cash cuts in current spending are not planned this year, next year nor the year after. By 2016-17, the government expects current spending to be £709 billion, £80 billion or 13% above the cash total for 2010-11.

In later years the hope is this spending bill will rise more slowly than inflation. The evidence so far is discouraging.

Why is it happening? Though some payouts such as child benefit and the working tax credit are being frozen, a government that has a reputation for slashing spending is being rather generous.

Most benefits rose by 5.2% in April, in line with last September’s inflation rate. It was a kick in the teeth for workers, who these days are lucky to get a 2% pay rise. It was not the action of a government determined to bear down hard on spending.

We may have to await Iain Duncan Smith’s reforms for better control of welfare spending, though they will not be fully effective until 2017. Osborne’s efforts, such as the cackhanded initial attempt to limit child benefit to basic rate taxpayers, have been unimpressive and ineffective.

In opposition, Tories talked about following Canada, which cut public spending by 20% over three years in the 1990s. In truth the gulf between British and Canadian policy is as wide as the Atlantic.

So far deficit reduction has come from two things: those deep cuts in capital spending and the hike in Vat to 20%. It is obvious why the Treasury wanted the Vat hike: it did not trust the politicians to cut spending. But higher taxes and cuts in infrastructure spending are bad for growth, short term and long-term.

Failing to tackle the current spending bill, by the same token, is bad for the economy: leaving us with a size of state that reflects the overblown Blair-Brown years rather than the current reality.

Some of the weakness in corporation tax revenues - down 19% in July compared with a year earlier - is temporary. But the OBR thinks some will persist. The days when the City was a giant cash cow for the Exchequer are over. The days when booming profits allowed ministers to play Lady Bountiful are gone for some time.

So, even though the latest numbers for the public finances are not quite the disaster portrayed last week, Osborne is in a deep bind. Strongly rising current spending and weak corporation tax leaves him little room for fiscal manoeuvre.

The boost to infrastructure spending business wants cannot realistically be achieved without cuts elsewhere. Getting such cuts past his coalition colleagues is likely to be impossible. He has made his choice. Like the early Thatcher, he has a reputation as a cutter that is undeserved. That may be where the comparison ends.

Sunday, August 19, 2012
Booming, slumping or flatlining? Take your choice
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.

Normally, even when economists fall down on forecasting they are pretty good at explaining things after the event. Now they are just left scratching their heads.

The latest very good job market figures has them scratching even more. How can economy that is supposed to be back in recession have generated 201,000 new jobs in the April-June quarter?

We will get the Office for National Statistics’ second take on that quarter this week, amid expectations that the initial 0.7% fall in gross domestic product will be revised. That alone will not solve the puzzle.

Nor will apparently simple explanations relating to the Olympics. Though there was a 99,000 rise in London employment in the second quarter, there was a proportionately bigger 69,000 increase in the smaller north-west region. Unemployment fell in most parts of the country.

The answer, I think, is in three parts. Gross domestic product is not as weak as current official figures suggest and will be significantly revised. There is no way GDP in the second quarter of this year was lower than two years ago.

The composition of GDP is also important. Even on unrevised data, service sector output has grown in the past two years, while manufacturing has been flat. The average has been dragged down by a 27% drop in “mining and quarrying” (mainly North Sea oil and gas), an 8% drop in construction and falling electricity output.

The 499,000 rise in employment over the past two years thus partly reflects those parts of the economy that are growing, including much of the service sector, combined with what seems to be an absence of job cuts in those that are shrinking.

Maybe the North Sea is a genuine example of fast-falling productivity, in that the oil and gas becomes progressively harder to get out but the numbers of people involved in doing it do not fall.

Second, as some labour economists point out, the job market may just be more efficient: better at getting people in to the available vacancies that is used to be. From the start of the crisis five years ago, the labour market has shown its flexibility. Employment, at just under 29.5m, is within 100,000 of its pre-crisis peak but its composition has changed in favour of part-timers and the self-employment.

Third, for employers, weak wages - and falling real wages - may have enabled them to keep people on when in a different environment they would have cut back. It has meant that they have recruited when at another time they might have held back. For firms, the wage bill is often as important as the headcount, if not more so.

The puzzle will not be fully resolved for some time but in the meantime there is another concern. The employment figures were not the only strong numbers last week. The weakness of demand has been the big obsession yet the latest retail sales figures suggested it is coming back.

Retail sales rose by 0.3% last month, which was better than expected. More interesting was that June’s apparent washout, initially reported as a 0.1% sales rise, was revised up to 0.8%.

Retail sales volumes in July were up by 2.8% on a year earlier, or 3.3% excluding petrol and diesel. Not only are they strong, but they are exactly following the script.

My argument has always been that the biggest reason for weak consumer demand was the unintended squeeze on households from high inflation.

That squeeze is easing fast - even a small upward blip in July did not prevent inflation, at 2.6%, being half its rate last September - and spending is picking up in consequence. Consumers have been late to the party but they now appear ready to join it.

Why the concern? Because the political debate is dominated by the very weak data, notably GDP. This is not entirely a bad thing. Some things being urged on the government because the economy is apparently not growing are sensible.

If it can find room within its broad fiscal plans to spend more on infrastructure and boost housebuilding that would be good. If funding for lending restores credit growth to small and medium-sized firms and home-buyers, that will be good too.

When they were asked recently to suggest ways of boosting growth, these were the suggestions of some of the signatories to a letter to The Sunday Times in February 2010, which supported deficit reduction.

But some of the things being urged on the chancellor from others, such as a fully-fledged Plan B of abandoning deficit cuts, would not be sensible at all and are a direct product of the apparent “no growth” economy.

The same is true of the Bank of England and quantitative easing. Would there be a case for greatly expanding the QE programme, as the Bank is doing with its near-doubling to £375 billion, in the context of a more rounded picture, taking in the strength of employment and retail sales, as well as the weakness of GDP, construction and parts of industry?

I think not. The Bank is aware of the problems with the GDP data - or should be - but is still rather too willing to use them as its guiding light.

Most of all, the risk is that the gloomy “double-dip” view undermines business and consumer confidence. That does not appear to be happening to firms as far as recruitment is concerned, but it may be constraining investment.

Consumer confidence has been weak in recent months even as retail spending has risen, so perhaps we can make too much of a gloomy mood. But it does not help.

One day, all this will be resolved. Norman Lamont, chancellor in the early 1990s, suffered when his “green shoots of recovery” of autumn 1991 were apparently snuffed out by a drop in GDP in early 1992. He was asked to step down in May 1993, with the economy seemingly struggling in vain to get up to cruising altitude.

The latest official figures show, however, there was no drop back in GDP in early 1992 and that the economy grew by a strong 3.1% in 1993. The numbers change, but usually too late.

Sunday, August 12, 2012
Five-year credit drought crunches the 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.

Let me start today with a simple statistical point. When the Bank of England came out with its new “zero” growth forecast for 2012 last Wednesday it was widely reported, particularly by broadcasters, that we can say goodbye to growth for the rest of this year.

But zero growth for 2012 in fact implies quite a lot of growth in the coming months. How so? The Office for National Statistics’ index of gross domestic product for 2011 was 102.6.

In the first half of this year it averaged 101.9, and in the Jubilee-affected second quarter only 101.5, pending revisions. We need an average of 103.3 in the second half just to achieve 2011’s average. By my calculations that requires 1% or so growth in both the third and fourth quarters.

It is, as they say, a tough ask and may not be achieved. But it is not a forecast of flatlining until 2013.

What does zero growth in 2012 mean in a wider sense? It means, however you slice it, and whatever data revisions come along, this is a disappointing recovery. Five years on from the “official” August 9 2007 start of the global financial crisis and credit crunch, the economy remains crunched.

Things have changed enormously in those five years, and it would be wrong to compare what people in authority were saying pre-crisis and now. But it is reasonable to look at how things have evolved since we knew the extent of the damage, at the economy’s low point in 2009.

Back then, in its August 2009 inflation report, the Bank predicted 3% growth for 2012. Its famous fan charts, which now tell us that in three years the economy could be growing by nearly 6% or shrinking by 1%, had a similar range back in 2009. As an aside, that range makes them next to useless for businesses and other users as a guide to what might happen.

To be fair to the Bank, when introducing that report, Sir Mervyn King warned that “recovery could be slow and protracted”.

The Treasury was even more upbeat with its numbers, predicting growth of between 3.25% and 3.75% for 2012 in the autumn of 2009, even as the economy appeared to be struggling to escape recession, and even when Alistair Darling, the then chancellor, was warning of the huge uncertainties that lay ahead.

When the coalition took over in May 2010, David Cameron and George Osborne lost no time talking of the huge challenges. But they also had a reassuring official forecast to draw on, the Office for Budget Responsibility predicting 2.8% growth for 2012. This was a forecast made after Osborne’s June 2010 budget, which announced the 2011 hike in Vat.

This is not to heap all the blame on the official forecasters, most non-official forecasts falling into the same trap. Maybe politicians, and the Bank, had to offer hope, for fear of making a bad situation worse.

Undoubtedly, however, the management of expectations could have been better. If people had been warned that things were so difficult we would be lucky to get any growth at all, the outturn would have been less disappointing.

By the same token, if back then the Treasury and Bank had believed the economy would be struggling to grow in 2012, maybe they would have put in a greater effort to prevent such an outcome.

By that I do not mean the necessary reduction of the deficit. We should not believe party propaganda on fiscal policy. Darling recognised Britain’s record budget deficit was unsustainable and began the task of cutting it. In 2010 he reversed the temporary Vat cut, increased the top rate of income tax and started drastically cutting public sector capital spending.

Osborne stuck with the capital spending cuts, raised Vat again but softened one planned Labour rise - employers’ National Insurance - and raised the personal income tax allowance. Growth may have been a touch stronger under Labour’s slower deficit reduction but not so you would notice.

Part of the reason for the growth disappointment has been that it has been one damned thing after another. Just as the uintended squeeze on households from high inflation begins to ease, so the impact of the eurozone crisis intensifies.

The latest trade figures show second-quarter exports to the rest of the EU were down 9.9% on a year earlier, even as non-EU exports showed an impressive 9.7% rise.

A credit crunch is, however, a credit crunch. Perhaps Osborne is too deferential towards King. Maybe the Treasury and Bank believed in a “creditless” recovery. Maybe they believed the forecasts.

The fact is, however, the response to the continued lack of credit in the economy, for small and medium-sized firms and households, has been piecemeal and mostly ineffective. We have had Project Merlin, credit easing, the NewBuy and other mortgage schemes, all attempting to get around the basic problem.

At no stage during this period have I had the impression that Osborne and King, sleeves rolled up, have been working together in a determined way to get credit flowing. The governor’s lack of enthusiasm has at times been palpable.

One thing the Bank has ploughed on with enthusiasm is quantitative easing (QE), launching a second round last autumn. I think we are entitled to more than a little scepticism about it.

Apart from the economic weakness that followed the latest round, QE is supposed to boost the money supply. Yet the Bank is honest enough to admit that in the nine months to June, £125 billion of QE only led to a £30 billion money supply boost.

Now all hopes lie with “funding for lending”, the £80 billion scheme launched last month to provide cheap funding for the banks as long as they maintain or increase lending.

Funding for lending is late, roughly by four years, and while I agree with it principle, the risk is of another damp squib. The Bank says its success will be hard to assess, and that it may only prevent lending from falling further over the next 12-18 months.

That would be yet another huge disappointment. Five years on, the economy is still in the grip of the credit crunch. We may be in its deadly embrace some time.

Sunday, August 05, 2012
Lessons from Sweden in assembling a 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.

Think today about two countries, both in Europe but not in the euro. They should, in theory, be facing very similar circumstances.

But one country, having performed strongly since the worst of the global financial crisis, surprised the markets a few days ago with a 1.4% jump in gross domestic product in the second quarter.

The other, having struggled since the crisis, shocked markets with a 0.7% second quarter GDP fall. In July, one country’s purchasing managers’ index for its manufacturing sector rose from 48.4 to 50.6, while the other’s slumped from 48.4 to 45.4, its lowest for more than three years.

To end the suspense, the first country is Sweden and the second, as you may have guessed, Britain. For Sweden, to quote Abba, it is a case of The Winner Takes It All.

Though Sweden’s latest GDP figures were a surprise, and have resulted in a hurried upward revision of 2012 growth forecasts, they were no flash in the pan.

After slumping 5% in 2009, Sweden’s economy surged 5.8% in 2010 and 4% last year. Britain shrunk a little less in 2009, 4%, but grew only 1.8% in 2010 and 0.8% last year. Leaving aside the vagaries of the data, the maths suggest any growth this year will be difficult. Sweden’s economy is well above pre-crisis levels of GDP, while Britain’s is more than 4% below it.

What is Sweden’s secret? It helps to have had a banking crisis in the past. The Swedish crisis of the early 1990s was used as a template in the wider crisis of 2008-9.

Bust banks were nationalised and assets sold off. Taxpayer funds were injected at considerable cost. The banks were later privatized and, on some measures, at no overall cost to government of the rescue.

The episode did not make Sweden immune to the crisis in 2008-9, as the GDP figures show. But, unlike in Britain, there has been no prolonged banking hangover.

Some Swedish lessons are water under the bridge. In Britain, the Bank of England and Treasury were happy to condone a sharp fall in sterling, around 25%, as the mechanism for rebalancing the economy in favour of exports and manufacturing.

Maybe the policy needs more time to work but you would have to say the evidence so far is discouraging. Britain’s manufacturers are struggling and export success has been balanced by rising imports.

In Sweden, in contrast, the currency has stayed strong but exporters have done well and conrtinue to do so. Ben May, who follows the Swedish economy for Capital Economics, notes that its exports of high-technology capital equipment, which is in demand all over the world, do not appear to need a devaluation boost. Britain has a current accountb deficit of 2%-3% of GDP, while Sweden has a 6%-7% surplus.

The fall in the exchange rate has, of course, had other negative effects on Britain’s economy, pushing up inflation via higher import prices. Officail figures last week showed that real incomes per head in the first quarter dropped to their lowest level since 2005, with high inflation the main culprit.

Some people think consumers are not spending in B ritain because of high levels of household debt. There is, however, no evidence of that. Sweden has similar levels of household debt as a percentage of GDP and income as Britain. It also had a similar pre-crisis rise in house prices.

Yet consumer spending has recovered much more strongly - up 3.6% in 2010 and 2.1% in 2011 - the absence of an inflation squeeze on real incomes being a big factor.

The final factor is fiscal policy. David Cameron used to talk about fixing the roof while the sun was shining. Sweden, having had awful public finances in the 1990s, went into the crisis with healthy ones, a budget surplus of 3.6% of GDP in 2007. Britain, in contrast, had deficits of similar size on comparable figures from the Organisation for Economic Co-operation and Development.

The result of what the OECD describes as “steadfast fiscal discipline in the past” is that Sweden has not needed the tax hikes and spending cuts Labour and the coalition were forced to introduce in Britain. With a budget close to balance, Sweden has room for a fiscal stimulus, if needed.

What can we learn from the Swedish experience? The most fundamental lesson is that, logical though it seemed, devaluation is no short cut to export success.

The route is a longer and more arduous one, having enough firms with the right products that other countries - particularly emerging economies - want. Britain has some - and is the world’s third biggest exporter of services - but not enough.

Second, inflation matters. Falling inflation is the main hope for a sustained recovery in consumer spending, as the growth in real incomes is restored. The Bank lost control of inflation - it would argue because of factors outside its control - and the ecnomy has suffered in consequence. At the very time low inflation was needed, it was not achieved. We have to hope things will be different from now on.

What about fiscal policy? Going into the crisis with a budget deficit was an error. Is trying to fix too quickly the bigger deficit that resulted from the crisis also an error?

The National Institute of Economic and Social Research examines this in its quarterly review. Nitika Bagaria, Dawn Holland and John Van Reenen, sensibly acknowledge that fiscal consolidation - deficit-cutting - “is essential for debt sustainability”.

Research in America by Bradford DeLong and Larry Summers suggests deficit-cutting when the economy is depressed - and monetary policy has little further room to respond by cutting interest rates - is more damaging. So the National Institute authors examine the case for delaying further deficit cuts until after 2014.

The effects, unsurprisingly, are that economy would grow more. What surprised me was that these effects are quite small. So next year the National Institute expects Britain to grow by 1.3% with deficit cuts but only 2% without them. In 2014, the numbers are 2.4% and 2.6% respectively, while in 2015 2.7% and 2.9%. After that, growth is weaker under the “delayed tightening” scenario than under existing plans.

So is it worth delaying? Even the International Monetary Fund has suggested next year’s fiscal tightening might have to be postponed, so it is a reasonable question.

More growth now is the economists’ equivalent of a bird in the hand worth two in the bush. Unemployment would be lower now - ameliorating some corrosive effects of long-term unemployment, particularly for the young - but higher later.

The big question is whether the government could get away with fiscal delay, in the markets and with ratings agencies. If the short-term growth benefits were more striking, ministers would no doubt be more willing to risk it. As it is, I suspect they will stretch “Plan A” as far as they can but stick with it. They must envy the Swedes.

Sunday, July 22, 2012
Gloomy growth numbers - but not so miserable now
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 Wednesday we will get figures for gross domestic product in the second quarter. Everybody is braced for a third successive decline and a fresh outbreak of gloom.

The National Institute of Economic and Social Research and RBS, both of which track the components that make up GDP, predict a 0.2% fall, following drops of 0.4% in the final quarter of last year and 0.3% in the first quarter of this year.

It is anybody’s guess what the Office for National Statistics (ONS) will come up with, though the recent pattern has been for it to come in well below independent predictions. If the number is down, expect some “triple-dip” headlines, though they should be reserved for a new recession, not a third successive quarterly decline.

I don’t want to repeat word for word what I said a month ago but the GDP figures still cannot be squared with the strength of the employment data.

Latest labour market statistics show in the most recent three months for which the ONS has data, March-May, employment rose 181,000 to 29.35m, its biggest rise since the three months to July 2010.

Unemployment fell by 65,000 to 2.58m, or 8.1% of the workforce. Though unemployment is higher than a year ago, and the figures may have been flattered by an extra day’s work in May (the late spring bank holiday was shifted to June), these figures were inconsistent with even a mild recession. They speak of a growing economy.

Isn’t the strength of employment just a London effect, an Olympic effect, which will disappear as soon as the five-ringed circus has moved on? Well, no, even apart from G4S’s recruitment woes.

While 62,000 of the 181,000 rise in employment in the March-May period was in London and the south-east, this is broadly in line with the region’s share of the national economy. It is hard to detect much of an Olympic effect in a 64,000 rise in employment in the north-west.

If not the Olympics, isn’t it all part-timers? Again, no. In the March-May period full-time employment rose by 133,000, part-timers by 48,000.

Let me make one thing clear. I am not suggesting we are enjoying a normal recovery. Last September, when the eurozone’s lurch into more serious crisis added to the headwinds, I said the best we could hope for was a flat economy until the middle of this year, after which consumers should get a boost from falling inflation.

It does not take much to tip a broadly flat GDP figure into a negative number, particularly on initial ONS data. For reasons frequently set out here - the inflation squeeze on real incomes, the government’s fiscal tightening, weak credit growth and the eurozone crisis - growth is much harder to come by than in a normal recovery.

The International Monetary Fund’s Article IV assessment of the UK economy, available on its website (www.imf.org) is a good summing up of constraints on growth. Its downward revision of growth this year to just 0.2% arose from the arithmetic of the GDP figures described above.

The labour market figures show us, however, that since the double-dip recession apparently began, in the early autumn of last year, the economy has added a quarter of a million jobs. Unemployment has come down by 100,000 (not as much as the rise in employment because the workforce continues to grow) and total hours worked in the economy have risen by 2%.

Let me put these numbers into perspective. The rise in employment, just since September, is more than in the entire growth years of 2002, 2003, 2006 and 2007, of which only the latter was affected by the crisis.

The rise in hours worked, again only since September, is more than occurred in any year during the economy’s long and undisturbed upturn from 1992 to 2008.

So what is happening? The labour market figures could be wrong, though they include data from different sources. Another measure, workforce jobs, rose by 471,000 between autumn and spring.

It could be employers are having to recruit because productivity - output per worker or output per hour - is so dire. While the University of Cambridge report on “productivity pessimism” by Bill Martin and Bob Rowthorn cited here recently argued that much of the growth in jobs has been in low-productivity sectors, a productivity collapse still looks implausible, not least because a shift from public to private sector jobs should boost productivity.

What can we take away from this? The GDP figures will eventually be revised higher, as always, after they have ceased to be of relevance. Even the battered Bank of England has fallen under their spell, launching another £50 billion of quantitative easing this month, despite its earlier scepticism about the official figures.

The Bank’s own regional agents report growth in the economy in all the sectors they monitor with the exception of construction. Growth appears to have moderated but this is not the same as recession.

What is really happening? Most people do not trouble themselves about the details of GDP figures, and subsequent revisions, though they may respond to the gloomy headlines when the figures are reported.

Headlines are not good at distinguishing between magnitudes. If this week’s figures show a 0.2% fall in the second quarter, GDP will have dropped by a little under 1%, pending revisions, over the course of nine months. That is less than half of the fall that was happening each quarter in the most intense phase of the 2008-9 recession.

People should also focus on the bigger picture. As well as the fall in the unemployment rate to 8.1%, we had an unexpectedly large drop in inflation to 2.4%. Unemployment and inflation are the two most important variables affecting households.

Unemployment, or the fear of it, keeps households from spending. Inflation, when it is too high, squeezes the income needed for that spending. Arthur Okun, the legendary American economist, famously combined the two - the unemployment and inflation rates added together - into his misery index.

Britain’s misery index hit a peak of 13.7 in September last year, made up of an 8.5% unemployment rate and a 5.2% inflation rate. Thanks to gently falling unemployment and rapidly falling inflation, it has now dropped to 10.5. It was last lower in November 2009 when, as we now know, the economy was pulling quite strongly out of its 2008-9 tailspin.

The mood may be gloomy but misery is easing, as far as most households are concerned. The test for the economy, and ultimately the recovery, will be whether this translates itself into spending in the second half of the year.

Sunday, July 15, 2012
'Guv'nor' needs to use his muscle to boost lending
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 Libor scandal has given us a new perspective on Sir Mervyn King. The governor has become The Guv’nor, the genteel grandee of the Square Mile as a bit of East End muscle.

In telling Marcus Agius, the Barclays chairman, Bob Diamond had to go, we saw not so much the governor’s eyebrows as the governor’s headbutt.

Maybe he had to be blunt because, judging from Agius’s circumlocutions in front of the Commons Treasury committee, he wanted to be sure it had sunk in.

This is not, of course, the first time the authorities have ordered the banks to do things they would have preferred not to. Fred Goodwin, the former RBS chief executive, memorably described being forced to take a huge chunk of taxpayer-provided capital as a “drive-by shooting”.

The banks are having the Vickers Commission proposals imposed upon them, which will ring-fence their commercial and investment banking operations.

The point is that the banks are being told to do a lot. There can be no greater official interference in the business of a private company than telling its chairman to sack his chief executive. This is not to say King was wrong, far from it, but it gave the lie to the idea of the banks being free agents.

This, for me, raises a bigger question. Why, if the authorities can order the banks to do so much, can the Bank and the Treasury not just tell them to lend? The Bank’s role is as much to ensure an adequate flow of credit into the economy as it is to prevent that flow from being excessive. Why is it failing in that task?

On Friday we had details of the latest official wheeze, “funding for lending”, unveiled at the Mansion House last month. Under it, the banks will be offered official funding at below market rates, probably at about 0.75%, in exchange for maintaining or increasing lending.

It is the latest in a long line of initiatives, including the Project Merlin deal with the banks on small business lending and the credit easing plan unveiled by George Osborne at last year’s Tory conference.

There is nothing wrong with funding for lending in principle, which has the potential to get £80 billion more into the economy. But the banks are required only to "maintain" their lending to get the cheap funding, and there is no guarantee they will pass the low funding costs on to customers. Business groups have welcomed it, but are sceptical about whether it will transform small firm or consumer lending. And I cannot help thinking that it and the other schemes are a roundabout way of proceeding.

If there is genuinely no appetite for borrowing, as the banks often say, even cheap funding will make little difference. If loans are only viable because they are made on the back of such subsidised funding, then maybe they should not be made at all.

But if, on the other hand, the banks are simply holding back, as I believe in large part they are, then a bit of the muscle directed at Agius over Bob Diamond ought to be enough to unleash more lending, rather than dancing around the problem with fancy and complex schemes.

The banks will say, when they are not blaming lack of demand for loans, that regulators are to blame for a credit famine that has seen small business lending fall almost continuously since early 2009.

Andy Haldane, the Bank’s executive director for financial stability, responded in The Times, saying it is not a bunch of “risk nutters” stifling the recovery. The Bank’s financial policy committee recently issued guidance that liquid assets can be used to support credit and growth, “not stuffed under banks’ mattresses”.

All well and good, but if the banks are under the impression that they are under regulatory pressure to de-risk themselves rather than lend, which they are, credit availability will continue to be a problem.

What does the Bank do when faced with a weak economy? It prints money. This month’s announcement of a further £50 billion of quantitative easing (QE) will take the total to £375 billion, analysts predicting an eventual £500 billion of asset purchases, mainly gilts (UK government bonds).

My position on QE is straightforward. I had no problem with the first round of £200 billion, launched in March 2009. The economy was falling off a cliff and the kitchen sink was needed. Stopping the slide was essential, and there was a genuine fear that prolonged deflation - falling prices - was a serious risk.

The second round, launched last October, was different. Growth had slowed but there was no collapse. Though inflation is now falling, deflation did not come into it. What should have been an emergency tool became an everyday instrument.

The Bank would say QE proved itself in 2009, boosting both growth and inflation. But we only have its assessment to rely on, and it is not an independent witness. I am not aware of a rigorous independent investigation of QE

I am not the only one concerned about the use of QE in these circumstances. Pensioners’ groups point out that, by depressing bond yields it has hit annuity rates, as well as widening pension fund deficits. There is something inherently uncomfortable about a central bank buying so much of its government’s own debt.

Such discomfort has reached the Bank for International Settlements, the central bankers’ bank. Ultra low interest rates and large-scale asset purchase programmes such as QE run serious risks, the BIS said in its annual report.

They could, paradoxically, damage the banking system, distort financial markets and put off necessary tough decisions, it warned. They have boosted commodity prices worldwide, pushing up inflation.

And, it added: “Failing to appreciate the limits of monetary policy can lead to central banks being overburdened, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally.”

We should listen to the BIS. It was prescient in warning of the strains that resulted in the global financial crisis. It is worried that central banks are getting hooked on the drug of printing money.

There is also the question of what QE is for. To be fair to King, from his first BBC interview on the policy in March 2009, he has insisted it was not a scheme to boost banking lending, but pump up money supply directly. That is fine, but over a prolonged period the money supply measure the Bank follows, M4, will not rise much if there is no increase in bank lending.

QE, like the other schemes, is a roundabout and potentially risky way of going about things. An economy starved of credit self-evidently needs more credit. The governor should use his newly-discovered muscle to get the banks to lend. And he should not take no for an answer.

Sunday, July 08, 2012
We were the best - now we're close to the worst
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, never very cheery, found much to be gloomy about in announcing a further £50 billion of quantitative easing (QE) on Thursday.

“Output has barely grown for a year and a half and is estimated to have fallen in both of the past two quarters ...,” it said. “Business indicators point to a continuation of that weakness in the near term.”

The lights have gone out at the Bank. As recently as April it was saying the weakness of some official data was “perplexing” and the growth of activity was “likely, if anything, to have picked up” since the second half of last year. Now it appears to accept even the perplexing figures.

There may be a crumb of comfort in the fact that, given its dodgy forecasting record, the Bank’s gloom now could be a harbinger of better times ahead. But it is not much of a reassurance.

As for QE, the analogy is with adding petrol to a damp bonfire. Eventually it will explode into life and take your eyebrows off. But whether it fires up into growth or inflation is an open question.

The Bank is not the only central bank trying to inject a bit of oomph. The European Central Bank, with its rate cut to an all-time low of 0.75%, and the People’s Bank of China, cutting to 6%, acted last week.

Gloom is also affecting the government. Nothing reflected more badly on George Osborne than his obvious glee that, amid economic woes and budget U-turns, he thought he could pin the Libor-fixing scandal on Ed Balls, his Labour shadow. His attempt to do so, clumsy and evidence-free as it was, did him no good at all.

Why are things so gloomy? We are, as Sir Mervyn King has told us, affected by the “large black cloud of uncertainty” emanating from the eurozone. But there is also a specific British disappointment, which will be explored by Price Waterhouse Coopers (PWC) in its UK Economic Outlook to be published this week.

John Hawksworth and Yong Jing Teow of PWC split the past 15 years into three periods, the growth years of the “great moderation”, 1997-2007, the great recession of 2008-9 and the post-crisis “recovery” since 2009. They compared Britain’s performance, on a range of measures, with other G7 economies (America, Japan, Germany, France, Italy and Canada).

Not to spoil the surprise too much, the headline verdict is that Britain was close to the best in the G7 from 1997 to 2007 but was close to the worst in the recession and subsequent recovery.

The period 1997 to 2007 - Gordon Brown’s chancellorship - may have been unsustainable, debt-fuelled and ultimately irresponsible, as Osborne and others frequently say. Looked at purely in terms of the numbers, however, it was also something of a purple patch for the economy.

So growth, which averaged 3.1% a year, was second only to Canada in the Group of Seven (G7), and thus faster than America and the rest. Britain’s growth rate was nearly double Germany and more than three times the rate in “lost decade” Japan.

Inflation, traditionally our Achilles’ heel, averaged 1.6%, the same as Germany and well below America. Only Japan, suffering deflation, was lower.

Britain did OK on unemployment but spectacularly well on labour productivity, which at 2.2% a year was the highest in the G7. The weakest bit of Britain’s performance over the 1997-2007 period, which is not a surprise, was on the fiscal side.

The cyclically-adjusted budget deficit widened by 2.6% of gross domestic product over the period, while Germany and Japan narrowed their deficits. America, however, pushed the boat out even more than Britain, widening its deficit by 3.1% of GDP.

Combining these measures, Britain comes very near the top of the G7 league over the 1997-2007 period, doing particularly well on growth, inflation and productivity, all of which makes the subsequent performance all the more disappointing.

In the 2008-9 recession, for example, Britain’s GDP felly by 6.3% and only Italy and Japan did worse. The 5.1% of GDP widening of the underlying budget deficit was exceeded only by America’s 5.8%.

It is the past three years, however, that Britain’s performance has taken on seven-stone weakling proportions. Only Italy, with 0.4% annual growth, has done worse than Britain’s 0.9% since mid-2009. Germany tops the G7 with 2.9%, followed by Canada, 2.8%, America, 2.4%, and even Japan, 2.1%.

The inflation story has been horrible, Britain’s average of 3.6% being more than a percentage point above anybody else. Labour productivity has gone from the G7’s best to the worst. Is there anything we have been good at? The budget deficit has dropped by 2.6% of GDP, the same as France and more than anybody else in the G7.

Why, overall, were we close to the best, and are now nearly the worst? It is not hard to think of reasons why growth has been weak, including the high-inflation squeeze on real incomes, the fiscal consolidation - tax hikes and spending cuts - and the credit famine.

PWC’s Hawksworth sees some of the recent underperformance as payback for the good years. From 1997 to 2007 Britain was, on the numbers, a 3%-plus growth economy. Maybe it was never genuinely more than a 2% economy. Feast to famine on public spending and credit are symptoms of the shift. Some growth over 1997-2007 was stolen from later years.

What of the future? Is Britain condemned to be the poor relation of the G7, or for the current poor performance to persist into a lost decade?

PWC says not, and I agree. Growth, it thinks, will settle at just over 2% in future, below America (2.8%) and Canada (2.3%) but above Japan (1.5%), France (1.4%), Germany (1.2%) and Italy (0.1%).

Inflation will remain relatively high, though not particularly troublesome. Britain’s projected rate to 2016, 2.1%, is the highest in G7. But with the exception of Japan, most other countries are quite close.

A 2% economy - 2% growth and 2% inflation - would once have been considered dull and disappointing. Given the all-pervading gloom around at present, it now looks like Nirvana. If we can get there.

Sunday, July 01, 2012
Infrastructure's doing OK, but we need more houses
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 government is on the back foot over its fiscal strategy again, partly because of its curious approach to policy.

George Osborne, having railed against the unfunded tax cuts proposed by Labour, managed to come up with one himself, postponing the 3p a litre fuel duty rise planned for August 1 until January.

The cost, £550m, will apparently be met through savings in spending by government departments, though the Treasury says it will take until the autumn statement to work out what they will be.

Osborne’s announcement, on the day poor public finance figures were revealed, may have merit in itself, as did the u-turns on the pasty tax, caravans, skips (yes) and tax relief on charitable donations.

They create an impression, however, of a chancellor who bends under relatively modest pressure. Is the cut in the 50p rate safe? What about the “granny tax”, another controversial element of the budget?

Would we be entirely shocked if, one say, Osborne was to stand up and say that in the light of events he had decided to suspend his deficit reduction programme? The Treasury insists these u-turns are minor adjustments and the big picture remains resolutely intact. But it makes you wonder.

The significance of the latest numbers for the public finances was not only the disappointing May figures. which showed borrowing of £17.9 billion, nearly £3 billion up on a year ago.

No, it was the trend over the past few years. The Office for National Statistics now thinks public sector net borrowing, the government’s preferred budget deficit measure, peaked at £158.6 billion in 2009-10, falling to £140.6 billion in 2010-11 and £127.6 billion for the fiscal year recently ended, 2011-12.

The 2011-12 figure was disappointing, representing an upward revision of more than £3 billion, but remained consistent with what looks like a successful deficit reduction strategy.

Except that the detail is rather less encouraging. The current budget deficit is important in this context. This represents the recurring elements of government spending - public sector pay, pensions and benefits, and so on - less current receipts, the majority of tax revenues.

The current budget deficit, adjusted for the economic cycle, is what the government aims to eliminate. Progress, however, is painfully slow.

From its peak of £110 billion in 2009-10, this deficit only fell to £99.5 billion a year in 2011-12. At a £5 billion a year pace of reduction you do not need a calculator to work out that it will take 20 years to eliminate it.

Why is the overall deficit down more than £30 billion since 2009-10, while the current deficit is a mere £10 billion lower? The answer is that the coalition persisted with the reductions in capital spending - on schools, hospitals, roads, and so on - it inherited from the Labour government.

So net investment by the public sector fell from £48.5 billion in 2009-10 to £28 billion in 2011-12. Take away that reduction and you barely have any drop in the overall budget deficit. Other things being equal, the deficit would be stuck at close to levels the coalition inherited two years ago, and the AAA rating would be long gone.

That is one reason why, despite ultra low gilt yields, the government resists calls to boost capital spending. Reductions in net investment have driven deficit reduction.

The task gets harder from now on because deficit reduction will have to be through reducing current spending and hoping for higher tax revenues. It would be greatly complicated if, at the same time, capital spending was being increased.

There is another reason. Listen to the debate on the British economy and you could be forgiven for thinking that, so sapped is business confidence if the government does not invest, nobody will.

That is not true in general. Business investment in the first quarter was up by 14.8%, in real terms, on a year earlier. Firms may be downbeat but they are spending.

It is also not true of infrastructure spending. The national infrastructure plan, updated at the end of last year, set the numbers out. Over the period 2005-10, £113 billion was spent on the infrastructure.

From 2011 to what it described as “2015 and beyond”, £250 billion of such spending is planned. There are a couple of caveats. There is many a slip between plans and delivery and “and beyond” offers a get-out.

To check, I contacted the Construction Products Association (CPA). In some of the key areas of infrastructure spending, there is indeed a boom, according to Nobel Francis, the CPA’s economics director. Spending on rail is on course for a 57% rise by 2014, and is exceeding spending on roads for the first time in many decades.

There is also high spending on water and sewerage and, in particular, energy, where electricity investment will treble by 2016. So it is plausible that, far from being starved of infrastructure investment, the economy is experiencing something like a doubling compared with 2005-10.

Could more be done? Spending on roads is falling. The £550m fuel duty postponement could have been used to fill potholes. It would have generated more jobs and, I suspect, kept motorists happier, though still have been unfunded.

There is, as discussed here many times, undoubted weakness in housebuilding. Most of the solution lies with the private sector, and restoring mortgage funding. It remains to be seen if the Treasury-Bank “funding for lending” scheme will do it.

There may also be a bigger role for the public sector. Whether you call it council housing or social housing, building now is less than 10% of its 1967 peak. We are not going to see a return to the building of the 1960s, but more could be done. The chancellor has pledged to use what he described as the strength of the government’s balance sheet to support infrastructure.

One way is to offer enhanced guarantees on bonds for building issued by housing associations, Another, suggested by the IPPR (Institute for Public Policy Research) in a new report, Together At Home, would be for the government to follow the practice of other countries, exempting local authority housing funding - which has a stream of rental income to offset its cost - from its deficit measures.

There is, as I say, a lot of infrastructure spending going on. The public finance numbers suggest the government could not afford a conventional boost in capital spending. But there is scope for the use of guarantees and other devices to bring forward more spending, on housing and on roads. We may hear more about this soon.

Sunday, June 24, 2012
Bright spots in a very peculiar 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.

We have become suspicious of good news. Analysts poke at any encouraging data, convinced either that it will not last or that it does not change the gloomier big picture.

Maybe that is the way it should be. There have been so many disappointments in the past few years perhaps downbeat should be our default position. You can see it in the stock market. Every time it gets a bit of wind in its sails, too often it is because another storm is approaching, usually these days from the eurozone’s direction.

There is also the old rule about not taking one month’s figures in isolation. Sometimes we should look a gift horse in the mouth; next month it will throw us.

Having said all that, the latest clutch of economic numbers were remarkably good. It started with a drop in consumer price inflation from 3% to 2.8%, and in retail price inflation from 3.5% to 3.1%.

Nor was this a one-month flash in the pan. Inflation came in below expectations (including those of the Bank of England) in both April and May.

It is hard to overstate the importance of this fall in inflation. High inflation, unusual in the aftermath of recession, has given us the unintended squeeze on real incomes that provides the biggest reason for the weakness of consumer spending. Spending has never been as depressed at this stage of a recovery as it is now.

The squeeze has not gone away. Regular pay is rising by an annual 1.8%, according to official figures, a percentage point below the annual rise in prices. But the gap is closing. In September inflation was 5.2% and regular pay was rising by 1.7%.

Back then, unless you were a FTSE 100 chief executive or in another favoured minority, your pay was almost certainly rising by less than prices. As the inflation hurdle falls, the bigger the proportion of people who can peer over it, in the happy position of having a rising real income.

Indeed, some of this may be showing through in another bit of upbeat news. Retail sales volumes jumped 1.4% in May compared with April. Some of that was due to the unwinding of the distortion due to panic buying of petrol and diesel a few weeks ago but, even adjusting for that, sales volumes rose by 0.9%.

In the latest three months, leaving aside petrol purchases (which is how the retail numbers used to be reported) there was a 0.9% rise compared with the previous three months and 1.9% compared with a year earlier. In May alone, sales volumes were 3% higher than in May 2011.

The dreadful June weather may give us a temporary setback but the evidence is of a bit of spending power creeping back in, and not before time.

There is other mildly encouraging news. The CBI said that manufacturers’ order books had improved, as had industry’s output expectations. The latest trade figures had raised fears of a collapse in exports but the CBI reported both a strengthening of export order books and that they are well above their long-run average.

There was also a pick-up in mortgage lending, with the Council of Mortgage Lenders reporting gross advances of £12.2 billion last month, 24% up on April and 11% higher than in May last year.

I have saved the best until last. Ever since Britain dived into recession more than four years ago, there has been a puzzling discrepancy between the statistics for the whole economy - gross domestic product - and for the labour market.

Employment fell by far less than expected in the 2008-9 recession, by 2.5% as GDP dropped by 7.1%, and it recovered as the economy returned to growth. Currently, while GDP is more than 4% below its pre-recession peak, employment is less than 1% below its pre-crisis peak.

The mystery has deepened with the latest figures. In the latest three months (February-April), employment rose by 166,000 to 29.28m, according to the Office for National Statistics, and this was the biggest three monthly rise since August 2010.

In the first quarter of the year, for which the ONS has a breakdown between public and private sector employment, there was a 205,000 rise in private sector jobs, only partly offset by a 39,000 drop in the number of people employed in the public sector.

The gap between private sector job creation and public sector cuts was dramatic in the first quarter but it was part of a longer-run trend. In the past two years there has been an 843,000 rise in private sector jobs, against a 424,000 private sector fall.

Those who scoffed at the idea that the private sector would compensate for public sector job losses were wrong. They have, by as near to two for one as you will get.

The first quarter, of course, was when - measured by GDP - Britain officially went back into recession, a 0.3% fall following a similar drop in the final three months of 2011. The economy has shrunk, on the GDP figures, by 0.1% over the past year and grown by a mere 1.4% over the past two.

I have been trying to resolve this discrepancy. Part of the weakness in the recent GDP figures has been due to energy: the gas and electricity we as households use (which fell as a result of the mild winter) and North Sea output. It is plausible such weakness does not have many employment implications.

A bigger reason for the apparent return to recession was falling construction output. Construction is a big employer, just over 2m people working in the industry. But the employment numbers do not speak of a sector in freefall. Employment in the first quarter, 2.04m, was fractionally down but it was higher than a year earlier.

In manufacturing , the EEF, which represents the sector, points out that manufacturing employment rose 38,000 or 1.5% in the first quarter, its biggest percentage rise since records began in 1978. Yet GDP figures suggest this is another struggling sector.

Of course it is possible to argue that productivity growth has slumped to the point where even in a non-growth environment employment grows. Is that remotely plausible? I can accept productivity growth is weak. I cannot believe it is negative, particularly when a shift from public to private sector employment should boost it.

The truth is that a 320,000 rise in private sector employment and a 1.9% increase in hours worked in the economy over the past 12 months is not consistent with a shrinking economy. A rise of 843,000 in private sector jobs over two years is inconsistent with economic growth of just 1.4% over that period.

In the past, governments have struggled to convince voters growth is happening when employment is weak. Now it is the other way round. I fear we are once more being led astray by the GDP figures and by the economy’s increasingly implausible slide into a double-dip recession. These numbers do not add up.

Sunday, June 17, 2012
No place to hide if Greece smashes the euro
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 the eurozone feels like a Horizon holiday brochure from the 1970s: last week Spain, this week Greece. Horizon went bust, and the question is whether one or more eurozone members will suffer a similar fate.

I shall come to Greece in a moment. First, let me offer my take on Thursday’s Mansion House announcements by George Osborne and Sir Mervyn King.

Having been banging on for longer than I can recall about the need to boost bank lending, including last Sunday, I welcome these initiatives. The £80 billion “funding for lending” scheme, the additional liquidity of at least £5 billion a month under the extended collateral term repo scheme and giving the Bank’s new financial policy committee an additional growth mandate add up to a reasonable package.

I do not believe this initiative will lead to a rush of risky lending. We can also dismiss the tired old “pushing on a piece of string” cliche: weak credit is holding back demand.

The dangers are on the other side, that the banks have locked them into a mindset in which they genuinely believe there are few creditworthy borrowers out there.

Many banks, indeed, appear to have adopted the approach of the old shop sign: “Please do not ask for credit, as refusal often offends. The ultimate sanction against them, if they refuse to play ball, is direct lending by the government, perhaps via state-owned Royal Bank of Scotland.

The truth is that Thursday’s scheme has been much too long in coming. The economy has been starved of credit for nearly five years.

The governor defended quantitative easing (QE) at the Mansion House, as he was obliged to, but something like the new scheme - or the purchase by the Bank of a wider range of private sector assets (rejected by King again) - should have been in place alongside QE when it was first launched in March 2009.

One thing is clear. This was not the response to fears of “Panicos”: renewed eurozone turmoil. It will take more than this to insulate Britain from what Europe could throw at us. If the eurozone goes badly wrong, other emergency banking and liquidity measures will be needed.

It is clear eurozone shocks are far from over, with bond markets unconvinced by the 100 billion euro Spanish banking bailout, its bond yield hitting 7%. Today’s second Greek election in as many months risks fresh turmoil.

Irrespective of party support, most Greeks want to stay in the euro, perhaps preferring the slow grind of years of austerity to the sudden and shocking collapse in living standards suffered by Argentina when it defaulted and devalued a decade ago. But is it in Greek hands?

Many Greek scenarios that have come my way. Aviva Investors sees a 40% chance of no exit/muddling through; 40% of a managed exit; and 20% of a disorderly departure, after which European equities drop a third. One of our biggest fund managers, in other words, sees only a 40% chance of Greece staying in the euro.

Berenberg, the German bank, has a set of scenarios linked to today’s election. If pro-bailout parties win, led by New Democracy's Antonis Samaras, the “troika” of EU, European Central Bank and IMF could agree a modest relaxation of austerity and there would be a 75% probability of Greece being in the euro by the end of the year.

If, instead, there is a victory for Alexis Tsipras's Syriza party and allies, he could renege on pledges and fall into line, or forced to negotiate an exit — Greece leaves chaotically. Under Syriza Berenberg sees only a 30% chance of Greece staying in.

Maybe we should expect, as on May 6, an inconclusive election, leaving the country and its euro membership in limbo, albeit with the EU keen for clarity before the June 28-29 summit of EU summit leaders.

The world can only wait so long for Greek voters. To paraphrase Lady Bracknell, one messy election is a misfortune, two looks like carelessness. Greece would begin to look ungovernable. Holger Schmieding, Berenberg’s chief economist, sees the probability of Greece staying in the euro in these circumstances as 50% or less.

You can see where this is going. There are circumstances in which Greece can stay in the euro but plenty in which it will not. The chancellor gave voice recently to a view expressed here, which is that a Greek exit may be the only way to break the log jam and persuade Germany to support remaining members of the eurozone.

The assumption is that a Greek exit is manageable, not just in the technical sense of replacing euros with a new drachma but also in ring-fencing other eurozone economies, halting the contagion that, left unchecked, would run from Athens to Lisbon, Dublin, Nicosia, Madrid, Rome and even Paris.

Given the EU’s record so far, however, and its apparent inability to organise a drink-up in a Belgian brewery, a managed “Grexit” may be hoping for too much.

How bad could the alternative be? On the Baseline Scenario website (baselinescenario.com), Peter Boone and former IMF chief economist Simon Johnson and Peter Boone sketched it out. Their piece, The End of the Euro: A Survivor’s Guide, makes for scary reading.

“Some form of new currency will soon flood the streets of Athens,” they write. “It is already nearly impossible to save Greek euro membership: depositors flee banks, taxpayers delay tax payments, and companies postpone paying suppliers — either because they can’t or because they expect soon to be able to pay in cheap drachma.”

Then, say Johnson and Boone, trouble really starts. “Europe’s electorate will be rudely awakened to the large financial risks foisted upon them in failed attempts to keep the single currency alive. If Greece quits the euro this year, its government will default on approximately 300 billion euros of external public debt ...

“More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (the ECB and the 17 national central banks in the eurozone).”

Capital flight from other peripheral euro members increases in intensity, the euro plunges, inflation soars, financial turmoil increases and the single currency is pulled apart by forces it cannot resist.

“A disorderly break-up of the euro area will be far more damaging to global financial markets than the crisis of 2008,” they write. “Europe’s rich capital markets and banking system, including the market for $185 trillion in euro-denominated derivative contracts, will be in turmoil.

“It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.”

Will it happen? One would hope not. Europe’s political establishment used to talk about the eurozone as a haven of stability. In the coming months they will have their work cut out to stop it becoming a source of massive instability.

Sunday, June 10, 2012
Britain needs a lot more monetary oomph
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 week can be a long time. A plunge in May manufacturing activity nine days ago, measured by the sector’s purchasing managers’ index, had prompted some City economists to predict dramatic action from the Bank of England on Thursday.

The Bank’s monetary policy committee (MPC), however, had other ideas. Despite a call from the International Monetary Fund for it to consider cutting interest rates, it left Bank rate unchanged at 0.5%, as it has since March 2009.

This was not too surprising. Anything is possible but the Bank thinks it has good reasons, partly to do with the operation of the money markets, for having 0.5% as a minimum official interest rate.

The debate over whether to add to the existing £325 billion of quantitative easing (QE) was no doubt closer, with some votes in favour. But the Bank, like the European Central Bank the day before, decided to keep its powder dry.

With so much uncertainty around, including next Sunday’s Greek elections and the on-off rescue of Spain and her banking system, discretion was seen as the wiser option. You may say that uncertainty adds to the need for central bank activism but there is an announcement effect as well as a practical impact as far as monetary policy is concerned.

The Bank, in other words, had it announced more QE on Thursday, would have been under pressure to announce even more in a month, should the aurozone be deteriorating further at the time.

As it was, better-than-expected data for services and construction, in their purchasing managers’ surveys, and for May retail spending, allowed the Bank to stay its hand. The economy is far from strong but it is not collapsing either.

That said, it is badly in need of some monetary “oomph”. I apologise for taking readers on a journey that to some will sound like an excursion along the motorway network, and to others will sound like an echo of the monetarism, as in monetary targeting, under Margaret Thatcher in the 1980s.

M4, the broadest measure of the money supply, is the one to think about in the context of efforts by the Bank to get the economy moving again by monetary means. On the face of it, those efforts are so far failing very badly.

In April, the M4 money supply measure was down nearly 4% on a year earlier, having been falling on an annual basis since autumn 2010, the time official figures say the economy stopped recovering.

To put this into perspective, M4 growth never turned negative in the early 1990s, while the problem for the Thatcher government in the early 1980s was too much, not too little, broad money growth.

The crude number may overstate how weak the money numbers are. The Bank prefers to adjust M4 for lending to so-called intermediate other financial corporations (OFCs). Think of it as banks’ lending to off balance sheet and other subsidiaries, which boomed in the years leading up to the crisis - the financial sector lent huge sums to itself - but has since gone into sharp reverse.

Adjusting for this has M4 up by 3.8% on a year ago, a significant acceleration on the spring of last year, when it was rising by just 1.5%. The latest bout of QE, it seems, has made a difference.

We should not, however, get carried away. The Bank’s rule of thumb was that you needed annual M4 growth of 9% for trend growth of 2.5% or so and inflation at the 2% official target. Even adjusted, M4 is growing less than half that rate.

Not only that but alongside adjusted M4 figures, the Bank produces statistics for adjusted M4 lending. These show, when you take out the financial sector distortion, lending into the economy is currently rising by 1.3% on an annual basis. That is better than a year ago, when it was not growing at all, but it is still pitifully weak. Both the money supply and bank lending are too weak to support recovery.

So what should the Bank do? One route is just to continue what it has done so far, implementing QE overhelmingly through the purchase of UK government bonds (gilts) but do so on an even greater scale.

David Miles, now the most aggressive proponent of QE on the Bank’s MPC, said in a recent speech that “exceptionally expansionary monetary policy” was the right course in current circumstances.

Michael Saunders of Citi, the bank, believes that there is much more to come - up to an eventual £500 billion - from the Bank in the form of conventional QE.

Or perhaps, I would argue, the Bank could do things differently. One thing that jumped out at me from the IMF’s recent assessment of the British economy was its recommendation that “options to further boost demand through credit easing measures that utilize the government’s balance sheet should be explored”.

It suggested purchasing private-sector bonds, on a significant scale, to support a greater volume of both mortgage lending and loans to business, particularly small and medium-sized firms. It also urged the Bank to provide longer-term bank funding facilities against a broader range of collateral, to ease funding pressures and get more lending into the economy.

This, to me, is what the Bank should be doing, suitably indemnified for any losses by the government. Adam Posen, soon to leave the MPC, suggested some months ago that the Bank should be buying securitized (bundled) small and medium-sized enterprise (SME) loans, a cry taken up by the British Chambers of Commerce.

We have just passed the fourth anniversary of my first suggestion that the Bank should buy new mortgage-backed securities - bundles of mortgages - to overcome the crisis’s abrupt loss of wholesale funding that continues to restrict housing activity to recessionary levels.

The government has just launched its £20 billion credit easing schemes for SMEs. It is a step in the right direction but does not go far enough. The global financial crisis saw many things go from feast to famine but nothing as dramatically as the availability of credit. And, to repeat a previous message, an economy starved of credit will always struggle to grow. Smarter monetary easing is needed.

Sunday, June 03, 2012
Government borrowing is cheap but risks 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.

After ‘Black Friday’, in which manufacturing in Britain and the eurozone slumped and America’s job market stalled, the search for growth is as urgent as ever.

Gilt yields are at record lows, along with US treasuries and German bunds. The 10-year gilt yield is under 1.5%. So why doesn’t the government do what Paul Krugman, the nearest thing to a rock-star economist, advocates?

Krugman, on a visit to Britain from America, put it in his usual colourful way, in a lecture at the London School of Economics and in numerous BBC interviews.

“If you want to worry about debt and deficits, fine, but this is the time, to quote St. Augustine, to say ‘Oh Lord, make me chaste and continent, but not yet,” he said at the LSE, adding: “The bond market is saying borrow, borrow.”

It is a view with many advocates here. Gilt yields are at record lows. Government borrowing is cheap. Why not follow the advice of a group I could call Keynesians but to avoid labels will call the borrowers?

Many people get confused in this debate, because there is a lot of confusion around. Jon Moulton, the venture capitalist, thinks the government should cut spending even harder. I shall leave that for another week.

The first confusion is over the causes of weak growth. Some borrowers imply it is all due to austerity, notably coalition austerity. But it is due to a range of factors, including austerity but also high commodity inflation (squeezing real incomes), the eurozone and the credit crunch.

I asked the Ernst & Young Item Club, which uses the Treasury model, to compare growth under coalition plans with Labour’s plan for slower deficit reduction.

The results are interesting. The economy grew 2.1% in 2010, 0.7% in 2011 and Item projects will grow 0.4% this year. Under Labour’s plans, assuming nothing else changed, growth would have been marginally higher in 2011, 0.8%, and in 2012, also 0.8%, but at the cost of around £24 billion additional government debt.

Item suggest, however, it is realistic to assume gilt yields would have been 0.5% higher under Labour’s plans. They fell this much between Labour’s March 2010 budget and George Osborne’s June 2010 budget.

Plugging this in to the model gives 2011 growth of 0.7% (as under the coalition), and 0.7% in 2012, only slightly faster than currently expected, though with an additional £37.5 billion of debt.

Yes, I hear you saying, but what if there was no austerity at all? Let me turn to the National Institute of Economic and Social Research, which is in the borrowers’ camp.

In May last year, it predicted 2% growth for 2012. Now it predicts zero. There has been no “news” on 2012 fiscal policy in the past year; the IMF suggests a modest loosening relative to previous plans. So other factors explain the shortfall.

The second confusion is over historical precedent. You might think cutting the deficit is some mad, ideological experiment. There is an excellent new Centreforum pamphlet, Delivering Growth While Reducing Deficits: Lessons from the 1930s, by the economic historian Nick Crafts .

Starting from much lower budget deficits than now — roughly 2% to 3% of gross domestic product - the then coalition acted to restore budget balance.

“Over fiscal years 1932/33 and 1933/34 the structural budget deficit was reduced by a total of nearly 2% of GDP as public expenditure was cut and taxes increased, the public debt to GDP ratio stopped going up while short term interest rates stabilized at 0.6%,” Crafts writes. “Yet from 1933 to 1937 there was strong growth such that real GDP increased nearly 20% over the period.”

As in the 1930s, so in the post-1976 period, the 1980s and 1990s. This is no laboratory experiment. It is what has worked every time before, combining fiscal consolidation - cutting the deficit - with loose monetary policy and a devaluation of the pound. If there was a UK economic policy textbook, this is page one, chapter one.

The borrowers, on the other hand, suggest something for which it is hard to find a British precedent. Public borrowing is close to peacetime records. Borrowing in 2011-12, 8.2% of GDP, would have been a record if not for even higher figures (11.2% and 9.3%) for the two previous years.

Labour had a time-limited fiscal stimulus worth about £25 billion in 2008-9, when the deficit was 6.9% of GDP. But I can find no example of a British government, faced with very high borrowing and having embarked on a fiscal consolidation, reversing it.

Things might be different if, as discussed last week, everybody agreed most of the deficit is cyclical not structural. They might be different if the eurozone produces a second collapse, though the deficit consequences do not bear thinking about.

None of this means the borrowers are necessarily wrong. The case for a stimulus does not rest on whether austerity caused the weakness. The lack of precedent may be because this time it really is different.

But what they are proposing is risky. A ratings downgrade is not the end of the world but Moody’s, in its January warning on the AAA rating, said a “discretionary fiscal loosening” would be a likely trigger.

Markets see Britain as a safe haven but that is not guaranteed. They can turn on a sixpence. Pimco, the bond firm, once had gilts “resting on a bed of nitroglycerine”.

The Office for Budget Responsibility, having pushed the government into a further fiscal tightening, would find it hard to condone a loosening, even one that focused on capital/infrastructure spending. The government has two fiscal rules, on the current deficit but also on debt.

I urged the Treasury last year to find room for more infrastructure, within existing plans - without borrowing more - and it did in the autumn statement. The IMF wants more of the same, by squeezing some current spending. I agree, though planning delays mean it is hard to get projects up and running quickly. “Shovel-ready” projects are not lined up in Whitehall waiting for the go-ahead.

What makes me most uneasy is government debt. Some borrowers say anything borrowed now would be strictly temporary. But clawing it back later would be hard, with the government already needing to find substantial extra welfare savings.

Public sector net debt is 65% of GDP, excluding direct support for the banking system, or 148% including it, says the Office for National Statistics. Eurostat, the EU statistical agency, puts the figure of 87%. Whichever measure you use, it is rising strongly and those banking liabilities may yet return to haunt us.

When does it become unsustainable? An influential paper by Carmen and Vincent Reinhart and Kenneth Rogoff, Debt Overhangs: Past and Present, argues that tempting though borrowing may be, governments should tread carefully, particularly those with sharply rising debt.

Once debt gets to more than 90% of GDP, the “overhang” consequences can become severe: annual economic growth more than a percentage point lower, sustained for an average of 23 years. As they say, “the cumulative effects can be quite dramatic”. This is something to avoid.

What should the government do instead of more borrowing? A lot more to ease the impact of the credit crunch on business lending and mortgage markets. Freeing up credit provides demand. The great housebuilding boom of the 1930s was built on easily-available credit and an absence of planning. I shall return to this.

Sunday, May 27, 2012
Britain has plenty of capacity 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.

Plenty of people have been giving advice on the British economy, including the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD) and others.

The IMF exercise was a bit odd. Pleasing though it is to have the elegant Christine Lagarde, its managing director, breezing through London, this kind of detailed dispensing of advice, in public, is normally reserved for countries in IMF programmes.

Yet Britain is giving the IMF money, not the other way around. I can’t remember Dominique Strauss-Kahn, her predecessor, doing this kind of thing. Maybe he had other things to think about.

Anyway, the IMF says the Bank of England should act now, and the government not too long afterwards. Not doing so could consign the economy to permanently weak growth. Grow slowly too long, and you get used to it. People who do not work for long periods may never do so.

Many of these ideas have been around for a long time. The Bank of England, which is urged to cut interest rates even further from the current ultra-low 0.5% level, considered and rejected this last October.

As for more quantitative easing, it is now plainly back on the agenda, but the monetary policy committee (MPC) voted 8-1 against it this month. Another idea, that the Bank should buy private sector assets rather than government gilts, has been debated for more than three years.

On fiscal policy, the IMF praised the government’s approach, Lagarde reacting with horror to what might have happened in the absence of the coalition plan.

But it also said that some things could be done better. The government could cut public pay and welfare harder, and raising more from unspecified property taxes, to pay for more infrastructure spending.

The other recommendation was a more explicit “Plan B”, including temporary VAT and national insurance cuts, though only if “downside risks materialize and the recovery fails to take off”. Not yet, in other words, but certainly in the event of a messy eurozone outcome hitting Britain hard.

Some will be delighted by this prospect, having argued for a Plan B even in the absence of a eurozone accident. Others will be horrified, pointing to the fact that Britain is already running a budget deficit of more than 8% of gross domestic product.

Last week saw a downward revision of public borrowing for 2011-12 but only to £124 billion. The deficit may be gradually coming down (from a peak of £156 billion in 2009-10) but debt, as conservative commentators keep pointing out, is rising strongly. Any minister wanting to cause mass apoplexy has only to confuse debt and deficit.

The big question, whether the government’s response is to cut the deficit more slowly or is forced to unveil explicit economy-supporting measures is how much deficit-cutting work that will leave to do later.

Debt and the deficit matter in cash terms. What matters most, however, is the structural deficit, that which is left if and when the economy recovers.

The Office for Budget Responsibility, the government’s fiscal watchdog, thinks some three-quarters of the budget deficit, about 6%, is structural. That is why it said last year the chancellor would need further measures, which he interpreted as spending cuts beyond the next election.

Any temporary fiscal stimulus, on this view, would have to be followed by even bigger cuts, or tax hikes, later.

But what if the underlying picture is better than the OBR, the Bank of England, Treasury, IMF and OECD believe? This is what Bill Martin and Robert Rowthorn of the University of Cambridge claim.

Martin, who had a long City career with UBS and Philips & Drew, published a paper in July last year, called Is the British Economy Supply Constrained? Now he has returned to the them, with Rowthorn, in a paper to be published this week: 'Is the British Economy Supply Constrained II? A renewed critique of productivity pessismism', available from Cambridge’s Centre for Business Research.

Since the first paper, productivity pessisism has become more ingrained in official circles. So they take on the pessimists.

The economy is 14% below where it would have been had growth continued at its pre-crisis pace, suggesting plenty of spare capacity. But policymakers are operating on the basis that it is only operating about 2.5% below capacity limits.

I have a great deal of sympathy with this. Spare capacity, the “output gap” is an elusive concept in a largely service-based economy. You do not need to build a new factory to expand output. The labour market has spare capacity, the 2.6m unemployed, as well as migrant workers.

Martin and Rowthorn take on the argument that growth in private sector employment over the past couple of years means employers have given up on productivity. Otherwise, why would they not squeeze more output out of existing workers?

The answer, they say, is that the higher-productivity sectors of the economy are behaving exactly as you would expect in a weak growth environment. They are not recruiting. The growth in jobs has been in low-productivity, low-wage sectors.

What about high inflation? Though the rate dropped to 3% last month, it is high for an economy with plenty of spare capacity. But inflation has mainly been due to import price shocks, they say, not an economy running into supply bottlenecks.

The most striking conclusion that emerges is that rather than a “structural” deficit of 6% of GDP, the true figure is nearer 2%. The authorities could safely expand knowing that most of the deficit will disappear as recovery persists.

It is a potentially game-changing verdict. Martin agrees with the IMF on more quantititative easing and, if possible, even lower interest rates than the current 0.5%.

On fiscal measures, he is less attracted to temporary tax cuts than measures that preserve the government’s fiscal credibility while increasing the flow of finance to the private sector - if necessary bypassing the banks - and investing in public investment projects with, as he describes it, “non-imaginary rates of return”.

The Martin-Rowthorn thesis is that policymakers have locked themselves into a gloomy mindset, in which the economy can only grow very slowly in what they call a narrow “corridor of stability”. If they are right, we could be liberated from at least some of the austerity of the coming years.

The productivity pessimists should respond. The hope has to be that they are indeed too pessimistic.

Saturday, May 12, 2012
Safe-haven pound need not kill off exports
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 European Union is turning into a very dysfunctional family. Greece, now combining deep economic pain with political instability, is the troubled teenager threatening to leave home for good. Spain, having a few years ago won praise for the way the authorities oversaw its banking system, is starting to look as if it might need the rest of the family to club together and help it out.

France, the flamboyant uncle whose disco days are over, is trying to relive the glory days when it could tilt the Franco-German axis towards growth.

Even Germany, the fatherland figure, is not immune from the mood change. Though Berlin looks resolute against any hint of a generalised fiscal relaxation, the Bundesbank is open to German inflation in future being above the eurozone average.

Though that is a logical requirement if other eurozone economies to regain their lost competitiveness, it would once have been sacrilege for the Bundesbank.

Where will it all end? Willem Buiter, chief economist at Citi, the bank, has raised his probability on a Greek exit from the euro, a “Grexit”, to 50%-75%. He thinks it most likely it would be combined with a massive EU/European Central Bank exercise to ring-fence other eurozone members from being forced out by the market backlash, though concedes that other more damaging scenarios are possible, including “uncontained” euro contagion.

As for France and its new president Francois Hollande, financial markets are relaxed about austerity being combined with more growth-friendly measures, including additional infrastructure spending. As noted last week, they see the new president working with rather than against the eurozone consensus.

That is unlikely to satisfy those who voted against austerity. The euro project was always as much political as economic. Politics will decide whether and in what form it can survive.

Where does that leave Britain, the black sheep of the family? Two things have happened since the Greek and French elections. One is that gilt yields have hit record lows, with the yield on 10-year government bonds, dropping below 1.9%.

This would be extraordinary at any time but for a country borrowing £126 billion with an inflation rate of 3.5% it is phenomenal. “Safe haven” is overused but gilts are clearly a port in the eurozone storm.

The other development has been that the pound, which has been looking perky for a while, received an extra fillip from euro woes. Sterling has been trading at close to 1.25 euros, a far cry from the days when the global financial crisis almost pushed it below one-for-one parity with the single currency. Even tourists have been getting more than 1.20 euros, welcome news for many ahead of the summer holidays.

Is it, however, very bad news for exporters, the great white hope for Britain’s recovery and rebalancing? Will it mean firms will lose their advantage in overseas markets just at the time the economy needs it most?

A few facts. At 1.25 sterling is a lot stronger than it was 2-3 years ago. It is still, however, considerably weaker than in the early months of 2007, the eve of the crisis, when it averaged nearly 1.50 euros. A 16%-17% depreciation is still worth having.

What is true against the euro is also true against other currencies. As recently as July 2008 the pound traded at more than $2; now it is in the low $1.60s. The sterling index, which measures its average value against currencies, is some 19% below pre-crisis levels. Britain’s exporters still have a big exchange rate advantage.

They have been using it, though it is customary to register disappointment about Britain’s export performance. Export volumes, excluding oil and so-called erratic items of trade, are up by around 23% from their recession low in the spring of 2009.

The trouble is that imports, on the same basis, are also up, by 20%. Because of the pound’s fall those imports have increased significantly in price, leaving Britain with a large trade gap.

Will the pound’s revival continue? Against the euro I have always had in mind a “fair value” level of 1.30 to 1.35 euros, so there is a little way to go to get there.

David Bloom, currency economist at HSBC, says that as well as benefiting from eurozone woes, the pound is gaining as a result of M & A (mergers and acquisitions) flows into Britain resulting from the takeover of British firms. The government, despite its political woes, is also hanging on to its reputation for fiscal discipline.

The level of the pound is important. Its long period of strength from autumn 1996 to autumn 2007 was instrumental in shrinking Britain’s manufacturing sector and the loss of 1m jobs in industry.

Some firms could not live with an overvalued exchange rate, while others shifted production overseas. In that period Britain lost a lot of suppliers of components, so-called semi-manufactures, a loss we are paying for in the trade figures now.

For sterling, how much is too much? I would argue that the pound moved from clear overvaluation before the crisis, buoyed by flows of international money into Britain’s banking system, and then went to an undervalued position when those flows stopped and it fell very sharply.

Its recovery now, bearing in mind how far it remains below those overvalued levels, need not do much harm. Indeed, some firms have been waiting for the bounce (which always happens) to assess what level of sterling they will be dealing with in the long term, and before planning their export strategy. They are naturally cautious about betting the firm on what might only be temporary weakness.

Some of the fall was temporary but much will stay, as is commensurate with the country’s changed economic position. That leaves plenty for exporters to go for.

In the end, of course, it is not just the exchange rate. Demand, strong in non-EU markets, weak in most of Europe, is the prime factor affecting export demand. Design, quality, reliability and service are other key determinants of export success. Get them right and a bit of perkiness for the pound should not be a problem.

Sunday, May 06, 2012
Euro anti-austerity votes pose dangers 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.

This weekend is a big one in the eurozone saga, with both the second round of the French presidential election and Greece’s parliamentary elections.

In both we are likely to see a vote against austerity and, by implication, eurozone bailout plans. It could be make or break.

And yet the markets have been eerily and surprisingly calm, with no repeat of the kind of panic we saw last autumn, either in eurozone sovereign debt markets or currencies. The European Central Bank, which decamped to Barcelona for its regular meeting last week, sat on its hands.

Markets reacted adversely to the first round of the French presidential elections but that passed. What about this time?

The key question, assuming the polls are right and Nicolas Sarkozy is replaced by Francois Hollande as French president is what kind of relationship he strikes up with Angela Merkel, the German chancellor. Will the end of “Merkozy” be followed by a Paris-Berlin stand-off?

I suspect not. Some of Hollande’s pre-election bark, even his tax plans, may be worse than his bite. When he talks about reorientating the eurozone towards growth, he is reviving a familiar argument.

The eurozone, you may remember, was originally governed by a stability and growth pact, though today there is not much of either. The Germans insisted on stability, fiscal discipline, while France pushed for growth as well, to avoid the eurozone turning into an austerity zone.

Despite apparent differences now, it is likely Merkel and Hollande will find a way of working together. It is also likely that there will be enough figleaves for the new French president in growth-friendly measures built around infrastructure measures and job-creation schemes. Hollande wants to rock the euro boat but not make it sink.

A potentially bigger risk comes from Greece. Holger Schmieding, chief economist at Berenberg Bank, sees a 40% chance of a Greek euro exit this year because of what he describes as “austerity fatigue in Greece or donor fatigue in Berlin”.

A Greek exit, should it occur, would eventually be good for Greece and remaining eurozone members, Getting there, however, without triggering a domino effect, and without a hugely damaging impact of the banking system, is the difficult part.

So, as it has been for two years, the eurozone remains the key global economic threat. It is back in proper recession and eurozone unemployment, at 10.9% (22.1% for young people), is at record levels.

My sense is that while we will see a strong vote against austerity this weekend, this is not yet the pivotal moment. Such are the eurozone’s problems, and so far are we from a permanent solution, that those who vote against austerity in the belief that their lives will be immediately transformed are bound to be disappointed.

How does this feed back to Britain? There are two routes. One is that today’s elections will usher in a period of renewed instability in the eurozone which will further undermine Britain’s recovery.

That could happen directly. Already the volume of exports to the rest of the European Union is down 3.3% in the latest three months compared with a year earlier, compared with 1.7% growth over the same period in exports to non-EU countries.

Or it could happen indirectly. The main effects of the eurozone crisis have been in the financial system, adversely affecting the cost and availability of funding.

This effect, pronounced in the second half of last year, was reversed by the European Central Bank’s 1 trillion euro long-term refinancing operation (LTRO), launched in December. There are signs this is wearing off. Many home-owners are receiving news of mortgage rate hikes, even with official interest rates un changed.

The other effect is on confidence, particularly among businesses that part of the weakness in business investment due to eurozone uncertainty.

That brings me on to the second route from the eurozone to Britain? Is anti-austerity catching, and could it force the coalition to releax or abandon its fiscal strategy?

The government is suffering serious mid-term blues, as shown by Thursday’s council elections and the opinion polls. Austerity is unpopular and Labour leads the polls.

Interestingly, however, if we take our own YouGov polling, voters are not yet ready to trust Labour again with the economy. David Cameron and George Osborne still enjoy a lead of several points over Ed Balls and Ed Miliband on this key question of trust in running the economy.

Only when Labour is decisively ahead on this, as after the Tories’ ERM (exchange rate mechanism) debacle in September 1992 should the coalition get really worried.

In the meantime, ministers need to do better explaining. Most people. I find, are ready to accept that the economy’s weak growth is entirely due to “the cuts”.

Official figures suggest otherwise. We do not yet have the detail for the first quarter, but gross domestic product numbers for the end of 2011 show government spending grew 0.5% in real terms compared with the final three months of 2010, following growth of 0.8% over the course of 2010.

The picture is a bit more complicated because the coalition inherited big cuts in public sector capital spending from its predecessor: it fell 5.1% during 2010 and 6.7% in 2011. Capital spending by government is, however, only a tenth of other spending, so the overall effect of government on the economy is still broadly neutral.

If not the cuts, then what? The big shift has been consumer spending, which grew in 2010 but fell in 2011. Some of that was Vat and national insurance hikes. Mostly it was unexpectedly high inflation.

Exports are contributing to growth, as is business investment, though modestly. One big reason why growth slowed in 2011 compared with 2010 had nothing to to with austerity, confidence or inflation. The economy was boosted initially by firms rebuilding stocks after the recession. This was always going to be temporary.

Even if they do not defend it very well, I think ministers will stick with the fiscal strategy, even if the politics gets more difficult. They will be hoping they are not trying to stick with it through a period of renewed eurozone chaos. Today’s elections will have some say in that.

Sunday, April 29, 2012
An economy starved of credit will struggle to grow
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 can I say about Britain being “officially back in recession”? Apart from the fact that no quantity of salt is big enough to be applied to these preliminary estimates, I am not going to spend too much time on them.

I have done it before, most notably three weeks ago, and so have plenty of others since the gross domestic product figures came out. The hope has to be that pinches of salt are being liberally applied by others.

After the figures, the CBI said manufacturers were at their most optimistic for two years, while Nationwide building society said consumer confidence was its strongest for nine months. Will this survive the headlines?

Even if it does, the economy is plainly weak. One way of looking at it is with reference to the GDP numbers. In 2009, the third quarter was initially reported as a 0.4% fall and the fourth quarter a 0.1% rise.

Now the data shows rises of 0.2% and 0.7% respectively, a big shift, partly because of technical changes to the calculations. It is not certain the latest GDP figures will undergo a similar revision.

Were they do so, however, the drop in GDP in the fourth quarter of 0.3% would become growth of 0.3%, while the latest quarter’s would go from minus 0.2% to plus 0.4%. The point is not whether the numbers will be revised precisely this way.

It is that even if they are, they will point to an economy growing only weakly. By this time in a normal recovery growth would be 3% or so. The underlying growth most economists think is happening now is much weaker, perhaps only 1%.

The government’s fiscal tightening is a factor. You cannot hike taxes and cut spending without impacting growth. But a deficit of 11% of GDP had to be tackled.

Labour’s so-called balanced plan for deficit reduction would not have survived the scrutiny of the ratings agencies and the markets, as was clear at the time of the May 2010 election. It cannot be regarded as a viable alternative.

To the extent it would have pushed sterling down further, inflation would have gone up more, further squeezing household real incomes and condemning the economy to even weaker demand.

Not everything George Osborne did on the fiscal side was right, as was clear long before the unforced errors of the March 21 budget. There was too much “it is going to be brutal” bravado when the coalition took office. The hike in Vat to 20% was an in your face, “we’re all in this together” tax hike at a time when some Gordon Brown stealth taxation might have been better.

The solution to weak growth does not, however, reside with fiscal policy. It does lie with a supply of credit that is woefully insufficient to support a decent recovery.

Last week the Bank of England produces its latest Trends in Lending report. It showed that bank lending to businesses was down 3% over the latest 12 months, continuing a fall that began in the early part of 2009. Lending to small businesses is down roughly 10% in the latest 12 months. Figures from the British Bankers’ Association show a similar picture.

It is not unusual for lending to firms to be weak in the aftermath of a recession. Banks become risk-averse. After the recession of the early 1990s, when they suffered large losses on their small firm loan books, business lending was also negative.

We have, however, now gone beyond the point at which business lending should be turning positive. In the 1990s it was two and a half years into the recovery. This recovery is now near its third anniversary and business lending continues to fall inexorably.

It is not just business lending. A good proxy for mortgage lending is the number of mortgage approvals for house purchase. Once it seemed this was one thing we did not have to worry about. From their low point in the final three months of 2008, approvals soared by 92% by the end of 2009.

Then, however, they dropped back and are now 8% below late 2009 levels and 58% below the pre-crisis peak. Some would say this is no bad thing. But an active housing market supports consumer spending and employment. Its absence is a significant drag on the economy.

Why is this happening? Some of it reflects the banks’ usual switch to risk-aversion after a recession. Some of it is due to the loss of some players, notably foreign (including Irish) banks. which were active in the small firm and mortgage markets.

Much of it, however, is due to the official response, from the government, the Financial Services Authority and the Bank of England. When the crisis hit, the authorities recognised credit was the lifeblood of a modern economy. Allowing banks to fail, and credit collapse, would have made the recession we had look like a tea party.

Unfortunately, the same logic was not applied to the recovery. Instead of ensuring an adequate supply of credit for a sustained upturn, the response has been to lock the stable door on the crisis after the horse has bolted. The authorities have been so busy acting to prevent the next crisis they ignored the need to shake off this one.

So we have had the Bank winding down its special liquidity scheme and the recommendations of the Vickers commission speedily reported and officially accepted. Last month the financial policy committee, the new “macro-prudential” regulator in the Bank, urged Britain’s banks “to raise external capital as early as feasible”.

We need a stable and safe banking system. But the authorities’ actions, together with evidence that Britain is going further than international counterparts, adds up to what banking analysts call “regulatory overkill”. It is an important reason for chronic lending weakness.

“Policy made without reference to the impact of its implementation is highly likely to deliver sub-optimal economic outcomes – in this case, costing the UK significant economic growth without any material uplift in financial stability in return,” says Alastair Ryan, banking analyst at UBS.

“The UK now has a well-capitalised, well-funded banking system that is raising prices and shrinking lending – and will need to keep doing more of both as the regulatory agenda expands.”

So we have a situation in which the Bank has undertaken £325 billion of quantitative easing, an exercise in monetary easing notable for its entire lack of impact on credit growth. The Treasury’s credit easing plan for small firms looks too small to make a difference.

Unless somebody in authority gets to grips with the conflicts between regulation and growth, and realises a credit-starved economy will always struggle, we can only expect more disappointing GDP figures.

Sunday, April 22, 2012
Bank takes a battering as it gets it wrong 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.

Once Sir Mervyn King, the Bank of England governor was master of all he surveyed, the King of Threadneedle Street, showered with new powers by the coalition government.

Now he has become the governor everybody loves to criticise. If there was a City TV show about him it would be called “Everybody Hates Mervyn”. The debate over his successor used to be couched in terms of who could possibly replace him. Now people are talking about the need for a new broom to sweep up after the mistakes of recent years.

You also have to feel a bit sorry for Adam Posen. The American member of the Bank’s monetary policy committee (MPC), and until now its most aggressive proponent of quantitative easing, was rash enough to say in an interview last year that if inflation did not drop to 1.5% or thereabouts this summer, he would not seek a second term.

I don’t know whether Posen was getting used to the London life and planning for a second term. But Paul Tucker, the Bank’s deputy governor, says inflation will not drop below 3% this summer. If that turns out to be the case Posen, in all conscience, cannot stay on. He now says the Bank has serious concerns about inflation. His term expires in August.

The Bank is getting it in the neck because some people have old scores to settle. Many of the criticisms of King, his downplaying of financial stability in the Bank before the crisis and the Bank’s initial slow and very unhelpful response to it, have been around for years. So has the fact that, unlike his predecessors, instead of rubbing shoulders with bankers, he has always rubbed them up the wrong way.

The renewed outbreak of criticism, however, has followed the latest inflation figures, together with the fact that a decision on the governor’s successor will have to be made in the next few months, even though his term does not expire until the middle of next year.

Consumer price inflation was 3.4% in February. Had the March figures, published last week, shown a fall to 3.3%, the reaction would have been that the pace of the fall was slow but nonetheless happening. An unchanged figure would have been disappointing but nobody would have got too excited.

The fact that inflation rose to 3.5%, however, and that the deputy governor described it as “bad news on the inflation front” and effectively tore up the Bank’s forecasts.

These were indeed bad figures. Two years ago the Bank predicted, not for the first time, that we would now be in a period of sub-2% inflation, which if true would have allowed Posen to stay on.

Even when that proved too optimistic, the Bank’s big story for this year was supposed to be a drop in inflation to 2.5% this summer, as a prelude to dropping below 2% before the end of the year. Anything is possible but most forecasters, and apparently now the Bank, think that is not going to happen. Whether King will see a rate of 2% or below before he steps down from the Bank in a year or so has become an interesting debate.

There are 12 broad components to the consumer prices index (CPI), ranging from food and non-alcoholic drinks through to clothing and footwear, transport and domestic bills. Only one of those 12, recereation and cuture, where prices are actually falling, has an inflation rate below 2%.

Since July 2005, when inflation rose above the 2% target, we have had 81 monthly readings. The overwhelming majority, 64, had inflation above target, with only 17 at or below it. Every monthly reading since December 2009 has been above target.

Since 2005, despite the worst recession in the post-war era, inflation has average one percentage point above target. There is a pattern here. What is it.
When King tackled the issue of the inflation overshoot in a speech in Newcastle in January last year, he set out a theme that has since become familiar.

Inflation was high because of factors outside the Bank’s control, including Vat hikes, the pass-through in import prices from sterling’s fall and global energy and commodity prices.

The first of these is no longer valid: inflation excluding the effects of indirect tax changes is 3.5%, the same as overall inflation. Give that sterling has been stronger in recent months, the second effect should have come to an end.

We are left with commodity and energy prices, and domestically-generated inflation. “Core” inflation, excluding food, energy, alcohol and tobacco is running at 2.5%.

This is all rather uncomfortable. The only time over the past few years when inflation fell decisively, if briefly, below target was when the global financial crisis hit commodity and energy prices hard. The Bank only hits its target, it would appear, when the world economy is in trouble.

Credit where it is due, and a lot of credit should go to Andrew Sentance, who left the MPC last year and is now with Price Waterhouse Coopers, for his perceptive analysis of this. Inflation would not come down to target but would be uncomfortably sticky, he said in an interview with me on leaving the Bank.

The Bank, he said repeatedly while on the MPC, gave too much weight to spare capacity at home - the output gap - and not enough to global inflationary pressures which, as we have seen, are no flash in the pan.

The majority on the MPC rejected Sentance’s call for a hike in Bank rate and, to be fair, raising rates against the backdrop of a weak economy may have been a step too far.

Not only did the MPC not raise rates, however, it then moved dramatically in the other direction, launching what turned out to be a further £125 billion of QE last autumn, against the backdrop of 5% inflation.

My argument against it at the time was that QE was a weapon to be used only in emergency conditions and when there was a real fear of deflation. MPC members countered by predicting that inflation was going to fall like a stone. So confident were they I thought surely this time they were right. Sadly not.

Some will say inflation a point or so above target is neither here nor there. But, at a time when total pay is increasing by 1.1% (1.6% even excluding bonuses), the fall in inflation was essential for the economy. Only by that means would the growth in real incomes needed to boost the 62% of GDP accounted for by consumer spending. We can only hope that inflation fall has been delayed, not cancelled.

As for the Bank, its reputation has taken another battering. There will be more letters from King to George Osborne explaining the inflation overshoot. And with each one, confidence in its ability to keep inflation on target will diminish.

Sunday, April 15, 2012
Consumers start to get back into their stride
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 could have been the horrendous traffic jams I encountered over the Easter weekend. Maybe it was a clutch of relatively upbeat data. Or was it one or two anecdotal reports of very strong spending in recent weeks?

The upshot is that I have wondering whether the British consumer, perhaps against the odds, is making a bit of a comeback. Consumer spending, as I have noted before, has never been as depressed at this stage of a recovery as now.

Both consumers and businesses need to spend to turn a weak upturn into something more meaningful. The question this week is whether the consumer side is starting to spring into life.

Those traffic jams, in the face of record petrol and diesel prices and the fear of a tanker drivers’ strike, were on the face of it surprising. The latest Department for Transport figures suggest car traffic is about 3% below its all-time high, achieved in the final three months of 2006.

Even so, we drive 243 billion car miles a year, and the figure is rising. Maybe it is boosted these days by forced staycationers. People drive for all sorts of reasons, of course. One of them is shopping.

The British Retail Consortium’s March retail sales monitor showed retail sales value up by 3.6% on a year earlier on a total basis or 1.3% “like-for-like”; adjusted for additions to floor space.

The increase was due to non-food sales and the BRC attributed part of the rise to the warm weather during the month, which boosted purchases of clothing, footwear and outdoor products. Online non-food sales were up by 13.9% on a year earlier.

The BRC remains cautious, particularly over the willingness of consumers to splash out on big-ticket items. For some such items, however, people are spending.

New car registrations in March, the month of the new ‘12’ plate, totalled 372,835, up by 1.8% on a year earlier. What was striking about the figures however, from the Society of Motor Manufacturers and Traders, was the strength of sales to private buyers, up by 7.4% on a year earlier in one of the two key sales months of the year. New car sales to private buyers in the first three months were 5.8% up on the equivalent period of 2011.

The biggest ticket item of all, for most people, is the house. No sector has provided more mixed messages over the past two 2-3 years, around a generally stagnant overall picture, than housing.

Even here, though, there are more signs of life than one might expect. Tomorrow Rightmove, the property website, will report a big monthly increase in asking prices for properties, taking them to record levels.

Most other price measures are not as buoyant. But the latest LSL-Acadametrics house price index, derived from Land Registry data, was prices up by 0.2% last month, the fourth rise in a row and the seventh in the past nine months.

Last month was also, according to the LSL index, the first March since 2008 when housing transactions in England and Wales exceeded 60,000, There is a stamp duty effect in there: the end of the sub-£250,000 holiday for first-time buyers.

There may also be something else happening, however, if the latest survey from RICS (The Royal Institution of Chartered Surveyors) is to be believed. It has seen a pick up in sales and its members are more optimistic than for a long time about the outlook for house prices.

“There is growing evidence in the RICS survey of a more fundamentally driven market improvement,” it says. “It is possible that surveyors are now beginning to factor in less economic downside risk going forward.”

What does all this add up to? Consumer spending recorded a rare rise in the final three months of 2011, given its recent history. The evidence we have points to a second successive rise in the first quarter of 2012.

It is too soon to talk of the return of the rampant British consumer, still less the pre-2007 housing market, neither of which would be welcome anyway. The pain at Mothercare, as well as some other retailers, speaks of the battle for scarce shoppers’ pounds.

Perhaps the latest Ernst & Young Item Club report, out tomorrow, has it right. Professor Peter Spencer, its economic adviser, says: “For the first time in years, the gap between wage growth and inflation should start to close. This will feed through to the tills on the high street and will be given an additional boost by the Olympics.”

But the Item Club forecast is for a rise of just 0.8% in consumer spending this year and, as Spencer adds: “Make no mistake; consumers can’t lead this recovery.”

The contribution of consumers to the recovery depends on two things, both of which we will learn more about this week when official figures are released.

The first is employment. The Report on Jobs from KPMG and the Recruitment and Employment Confederation suggests job vacancies hit an eight-month high last month, with permanent job placements similar to February’s strong level.

The official unemployment figures may show an easing of the pace of increase but it is too early - and growth is too weak - for a significant drop in the jobless total yet.

The other key factor is inflation. As Alan Clarke of Scotiabank points out, whether it is petrol or stamp prices (a 30% increase in the price of a first-class stamp), most of the recent news has been inflationary.

It may mean that the March figures show no improvement on February’s 3.4% consumer price inflation, while retail price inflation could be only marginally lower than the 3.7% recorded then.

This needs watching. Falling inflation, to restore the growth in real incomes, is an essential part of the consumer story. If inflation does not fall much from here, that story will be very considerably weakened, if not snuffed out entirely.

The spring signs of a consumer revival are, like certain bedding plants, still very delicate. It would not take much of a frost to kill them off.

Sunday, April 08, 2012
Growth figures become a national lottery
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, and not just to get another reference to Charles “bicentenary” Dickens into the column, I feel Britain resembles a tale of two economies.

I am not talking here about north versus south, or the City versus manufacturing. Rather, it is the very different picture presented by the official data, from the Office for National Statistics, and private surveys of economic activity.

The difference is not always one way. Retailers have often been left scratching their heads by the buoyancy of the official data for high street sales.

Mostly, however, gloomy official numbers have been at odds with much more buoyant surveys. Why is this, and what is really happening to the economy?

Let me take you back 10 days to the latest update from when the Paris-based Organisation for Economic Co-operation and Development (OECD). The headline-grabber was a prediction of a 0.1% drop in Britain’s gross domestic product (GDP) in the first quarter, following a 0.3% drop in the final three months of 2011.

It is probably the most arbitrary definition in economics, and one we should not really take too seriously, but every schoolboy knows that two consecutive quarters of decline equals a recession.

No matter that it was a forecast from the OECD, which does not have a great forecasting record, it spawned many “Britain back in recession” headlines. Then, however, something surprising happened.

The OECD’s pronouncement, rather than sparking deep gloom, was followed by a series of upbeat surveys on the economy. They included the monthly purchasing managers’ surveys, produced by Markit, for manufacturing, construction and services.

After the last of these was published, showing the service sector expanding strongly, Chris Williamson, Markit’s chief economist, declared that “UK economic growth picked up in March to round off the strongest quarter for a year”.

The three Markit surveys, indeed, were consistent with 0.5% growth in the first quarter. It may not sound much but it is a far cry, economially and politically, from the OECD’s 0.1% drop. The fact that in all three cases the March surveys showed growth strengthening through the quarter boded well for activity in the second quarter (which has just started) too.

It was not just the purchasing managers’ surveys. On the back of the British Chambers of Commerce’s latest quarterly survey, David Kern, its chief economist, prodicted 0.3% first quarter growth.

The BCC, which surveyed manufacturing and services in a sample of 8,000 firms, found both sectors were more upbeat and reporting stronger output, orders and employment. Manufacturing was stronger, suggesting Britain’s factories are shrugging off eurozone gloom and weak demand at home to take advantage of export opportunities further afield.

The surveys may not exactly have been a champagne moment but they were a welcome antidote to the gloom. Andrew Sentance, the former Bank of England monetary policy committee member, now with Price Waterhouse Coopers, kept a running score which reached OECD 0 Surveys 6.

Then, as is its wont, the Office for National Statistics, threw an almighty spanner into the works on Maundy Thursday. From its Newport lair, it published figures showing industry back in the doldrums. Its numbers are less timely than the surveys, so covered February, slap bang in the middle of the first quarter.

In that month, it said, manufacturing output fell by 1%, dropping below any month in 2011, and was 2.3% down on February 2011. Overall industrial production rose 0.4% thanks to a cold-weather boost to energy output. But it was 2.3% lower than a year earlier. Recovery, what recovery?

There was nothing in the surveys to suggest the weakest manufacturing numbers in over a year. Kern of the BCC said the numbers raised “serious questions” about the official data. I tend to agree.

The purchasing managers’ survey for construction has been growing since January last year and in March reported its fastest rate of expansion for 21 months.

Now consider the horror story unfolding in official construction numbers. They suggest output fell off a cliff in December and January (23% combined), so even a sprightly recovery in February and March may not stop the sector reducing GDP in the first quarter. Given industrial production is also likely to be negative, all the weight is on the shoulders of the service sector. After conceding a hatful of goals, the OECD could yet turn out to be right.

I can tell you at this point the official figures will be wrong. This is despite the ONS telling me all its statistics are produced using internationally recognised methods.

I know they will be wrong because a former national statistician, Len Cook, explained why in a paper a few years ago. Revisions to official data are “expected and inevitable”, he said. The ONS gets its figures out as soon as it can, knowing further information will change the picture.

Even “final” estimates of economic data can never be regarded as the truth because there will always be an element of statistical uncertainty in them. I know, from conversations with him, he was keen to attach reliability “star” ratings to official statistics, though it never happened.

Why do the surveys often appear to present a more realistic picture than official data? The ONS, despite the resources at its disposal, produces numbers that may be statistically pure - on the basis of the information available - but often jar.

The surveys, in contrast, build up a broader, internally consistent picture of business activity by asking a series of questions, covering orders, employment, investment intentions and the rest. Of course we need both official data and surveys. But we should acknowledge the limitations of the former and the usefulness of the latter.

The big picture looking at data and surveys in the round, is an economy growing at a modest rate which has been doing so for nearly three years. An economy that was “flatlining” as Labour keeps saying, would not have added nearly 700,000 private sector jobs in the past two years.

That picture of modest growth is true now, and will still be true whatever surprises the ONS has for us when it publishes its initial estimate of first quarter GDP on April 25. The challenge, as discussed last week, is to achieve stronger growth.

Sunday, April 01, 2012
The British tortoise and the American hare
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 natural instinct when confronted with unexpectedly weak growth figures is to question them.

Nobody doubts that this is a subdued recovery but the downward revision of gross domestic product in the fourth quarter of 2011 to show a fall of 0.3%, coupled with small, mainly negative changes for earlier quarters, had me asking questions again.

The GDP figures are out of line with surveys they usually track closely, notably the monthly purchasing managers’ index. Not only that but long experience has taught me it takes years to get the full picture.

The recession of 1990-92 was barely more than half as bad as first reported. I was wrongfooted in late 1998 and early 1999 when the statistics showed Britain flirting with technical recession, compared with the strong growth the numbers now show .

More recently, the economy’s apparent failure to recover in the second half of 2009, while Britain’s competitors were doing so, became a big issue for the last Labour government. Now we know the economy was recovering, thanks to data revisions.

The figures, however, are the figures, and they set the tone. It is on the basis of them that the OECD suggests Britain is in a mild double-dip recession. When they are revised, as they will be, few will notice.

Even so, as noted above, even data revisions will not turn this into a strong recovery. Britain’s emergence from the crisis and recession is hesitant and bleary-eyed. It is not as weak as the official statistics suggest but it is far from strong.

Britain, according to the OECD, is performing similarly to a weighted average of the three largest euroland economies; Germany, France and Italy (though Germany, in almost every respect, looks healthier).

Where there is much clearer divergence is in respect of America. While Britain will struggle to show any net growth in the first half of this year, the US economy will grow at an annual rate of nearly 3%.

This will maintain the post-crisis pattern. A US recovery that is disappointing by historic standards is much stronger than Britain’s. From its recession low-point in mid-2009, the trough, Britain has grown by 3.2%, an average growth rate of little more than 1%. America, in contrast, is more than 6% above its recession lows.

The US economy has surpassed its pre-crisis level while Britain is more than 4% smaller than before the crisis hit. Since the crisis originated in America, while exposing vulnerabilities elsewhere, some might consider that rough justice.

Why is this? I have dealt before with the crude “Keynesian stimulus versus coalition austerity” argument. The great experiment some wished for, of Obama pumping in spending and cutting taxes while Osborne was sucking the lifeblood out of Britain’s economy, was never there.

There were, however, important differences, and some of them relate to fiscal policy. By coincidence, even before the latest ONS numbers and the OECD, they had been addressed by Adam Posen, a member of the Bank of England’s monetary policy committee.

Posen, in a speech ‘Why is their recovery better than ours?’ (though confusingly he is American), listed several reasons why America has shown Britain a clean pair of heels. The two striking weaknesses in Britain are in business investment, which fell by 3.3% in the final quarter of 2011, and consumer spending.

Business investment rebounded much more in America, he said, because firms had a wider range of financing options. They were much less dependent on banks. If credit rationing has been a factor in Britain, and many small and medium-sized firms would say it has, this goes some way to explaining investment weakness.

The lending caution of British banks, meanwhile, has become entrenched because they are more exposed to eurozone risks than their US counterparts.

What about the weakness of consumer spending? The astonishing thing about this recovery is that the consumer has been a bystander. Though consumer spending perked up in the final quarter of 2011, rising by 0.4%, it was 1% down on a year earlier.

Consumer spending is less than 1% above its recessionary trough and 5% down on pre-crisis levels. Never before have we had a recovery in which spending has stayed so weak.

Posen, and this is where fiscal policy does come in, said part of the explanation is that there has been a bigger tightening in Britain than America, which is true.

Some of it is due to the nature of that tightening. George Osborne’s first big announcement, in June 2010, was a hike in Vat to 20% the following January. It was a conscious break with the stealth taxes of the Brown years, a big up-front tax hikes which showed that we were all in together.

But Vat, as the chancellor is discovering with pasties, is a bit too visible. People notice it. Retailers make sure they notice it, so price rises get blamed on the government. Three months after Vat went up, so did employees’ national insurance, a tax hike bequeathed by Labour. There was barely a squeak.

The biggest reason for weak consumer spending, and the fact that real incomes fell more last year than in any since 1977 (the year when the 1976 International Monetary Fund rescue hit home), was the unintended squeeze from high inflation.

Posen says the main reason British consumers fared worse than their US counterparts was that the rise in energy costs was amplified by the weakness of sterling; its 25% depreciation. An open economy blown around by international developments can be unhelpful.

There are other reasons why consumer spending is so weak. In 2007, when the crisis hit, the houssehold saving ratio was less than 3%. Now it is nearly 8%. Borrowing constraints and caution about employment have changed behaviour.

Will this change? Posen thinks the differences between America and Britain will subside. On consumer spending, the best hope remains a fall in inflation and a restoration of real income growth, with oil the biggest threat to that scenario.

As for business investment, a report from RBS notes the £754 billion corporate cash mountain but also warns that it could be next year before we see a decisive rise in investment. Jefferies, the investment bank, also cites the corporate sector as “the best hope for a stronger UK recovery”. Either way, whether corporates or consumers, there is some catching up with America to do.

Sunday, March 25, 2012
In time, the budget will fuel 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.

A chancellor who cuts the 50p top tax rate, reduces corporation tax to 22% (with an ambition of getting to 20%), and takes 840,000 people out of tax by raising the personal allowance, might expect to be garlanded.

Instead, George Osborne finds himself lambasted by the Tory press, criticised by the think tanks and scared of going out at night for fear of being pelted with Werther's Originals by irate pensioners.

Many people have asked how the Treasury could have found itself in this pickle. Why leak all the eye-catching announcements in the budget, while leaving the £3 billion “raid” on pensioners by taking away age-related allowances to grab all the headlines on the day itself? When even Labour accuses you of stealth taxes, you know something’s up.

I think, without giving away any trade secrets, there were two reasons. One was that the pre-budget leaks were not part of some carefully-planned Treasury strategy.

Treasury people are naturally secretive: left to them the most that would have come out in advance would have been localised public sector pay bargaining, relaxing Sunday trading for the Olympics and a 100-year gilt (government bond).

But budgets these days are collegiate affairs. Gone are the days when Gordon Brown kept it secret from Tony Blair until the day before. And the more people that know, from the prime minister through his chatty Liberal Democrat colleagues, the more likely things are to get out.

I also think the Treasury, and in particular Osborne’s key adviser Rupert Harrison, did not see the pension changes as very controversial. As an alumnus of the Institute for Fiscal Studies, he probably agreed with its verdict of “a relative modest tax increase on a group hitherto well sheltered from tax and benefit changes”.

So was it a good or a bad budget and what did it tell us about the government’s fiscal strategy and the economy?

Let me get two things off my chest. Unless things improve suddenly, I owe the Office for Budget Responsibility an apology. Since November, when it revised up its projection for public borrowing this year from £122 billion to £127 billion, I have been calling that decision into question.

The monthly numbers, which were pointing to a significant undershoot - the talk was of £120 billion or below - backed my judgment. Then, as it is wont to do, the official statisticians bowled a googly on the morning of the budget.

Thanks to a splurge of spending by government departments, borrowing hit a record £15.2 billion in February, more than £6 billion up on a year earlier and double City expectations.

A nice chart in the Treasury’s budget document shows the 12-month rolling total for borrowing neatly trending down to £120 billion from a peak of nearly £160 billion at the time of the election.

Unfortunately it did not include the February numbers, which have that rolling total jumping back up to £128 billion. Some of that may be unwound in the March data. But as it stands there is no undershoot of any significance: a token downward revision by the OBR of £1 billion to £126 billion.

There is a big drop in borrowing on the way, with a predicted £92 billion for the coming year, 2012-13. It would, however, be £28 billion higher if not for the transfer of Royal Mail pension fund assets to the public sector. Borrowing for 2013-14 goes back up to £98 billion. Borrowing over this parliament is officially put at £528 billion. It is moving in the right direction but averages more than £100 billion a year.

Borrowing is proving more intractable than the last time Britain was faced with budget deficits on anything like this scale; in the early 1990s. The virtuous circle then, of rapid recovery leading to a quicker fall in borrowing, is not happening yet.

I still do not see that the answer to uncomfortably high borrowing is more of it. The government’s critics offer two versions of the fiscal stimulus story. One is the temporary tax cut through Vat or National Insurance. The other is infrastructure spending, perhaps funded by issuing special bonds.

Neither stacks up. A temporary tax cut adds more to borrowing than it would add to gross domestic product and, because it was temporary, would reduce growth in future when reversed. Issuing infrastructure bonds to fund capital projects is a nice idea but it would still represent more government borrowing. Growth will come but there is no easy way of forcing it.

That brings me to the second thing to unburden myself of. A lot of commentary on the budget was that none of the tax cuts, whether for corporation tax, the 50p rate or raising the personal allowance, can amount to much because the official forecast is barely changed from November.

Apart from the fact it is a minor triumph to have had no forecast change since the autumn, this is not how forecasting works. The budget was broadly fiscally neutral, a £1.9 billion giveaway in 2012-13 and just under £1 billion the following year, clawed back in later years. A neutral budget, if plugged into an economic model, unsurprisingly does not affect growth much.

It is disappointing business investment is so weak. The OBR forecast of just 0.7% growth this year because of eurozone uncertainty compares with nearly 8% at the time of the budget. But it is ridiculous to say this reflects a failure of the corporation tax cut, which is singled out as factor likely to raise investment over the medium term. The OBR still expects a 40% rise in business investment over the next 4-5 years.

What are we left with? Even the chancellor’s best friends would not describe what we had as a bold, tax-reforming budget. Coalition budgets, as well as being leaky, will always be messy compromises.

But the signals it sent out were nevertheless important ones. Anti-business sentiment has threatened to take over in recent months. Osborne’s third budget was a corrective to that, in words and in some deeds. As a means of levering the economy into stronger growth in the short term, it made little difference. As a budget to provide a platform for stronger, business-led growth in the medium and long-term it might yet prove its worth.

Sunday, March 18, 2012
The budget matters but the Bank matters more
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

Wednesday’s budget provides an opportunity for the chancellor to set out a course for the economy and to send some important signals on tax, including the future of the 50p rate - if it has a future - and the level of corporation tax.

For George Osborne, it is an opportunity to clear up the tax confusion. In the absence of a clear lead from the chancellor, talk of mansion taxes and tycoon taxes has been free to take wing. If he revived William III’s window tax people might be surprised but not necessarily astonished.

I wrote on March 4 about how hard it has been to work out Osborne’s tax strategy. Paul Johnson, director of the Institute for Fiscal Studies, puts it better than I did. “Annual speculation in a vacuum is damaging and costly,” he wrote.

To paraphrase Oscar Wilde, for the IFS not to get your tax strategy smacks of carelessness. We need to know where the chancellor stands. This week is his opportunity.

Budgets are great theatre. They are important in setting the direction of taxation and the economy. This week should see the chancellor with the luxury (for him) of not having to revise down growth and revise up the borrowing numbers.

Though you can never say never with the Office for National Statistics, risks of a double-dip have eased. Osborne is on a firmer footing than a few months ago.

But businesses want a reason to be confident. Good budgets provide such reasons, for both firms and individuals. The EEF, the manufacturers’ organisation, says the clear targets set out in the government’s fiscal strategy should be matched by a growth plan with equally clear objectives.

Firms, it says, are fed up with talk of new taxes and the coalition debate over 50p. Osborne should be leading a growth drive with targets this parliament of increasing the number of firms bringing new products and services to market; attracting more globally-focused companies; lowering business costs and making the workforce more flexible and productive.

We shall see. It is fairly clear the budget will not have a big fiscal giveaway. With a deficit of roughly £120 billion, the ratings agencies hovering and the chancellor trying to get investors interested in 100-year gilts, this is a non-starter.

Indeed, much of the pre-budget debate has been stuck in a time warp. For many years leading up to the crisis it was understood that monetary policy, by which was meant merely changing interest rates, was the economic policy lever of choice.

Fiscal activism, cutting taxes or boosting spending to give the economy a short-term stimulus, had fallen into disuse. It had a brief revival in 2009, when the world was falling off a cliff. Since then governments, including America’s, have been implementing deficit cuts.

Pretty well all the stimulus action has been via monetary policy, with near-zero official interest rates, quantitative easing in Britain and America or the European Central Bank’s successful long-term refinancing operation (LTRO). Fiscal activism came and went very quickly though, as I say, nobody seems to have told those pushing for it to be used again this week.

A big fiscal giveaway would be £20 billion, roughly Alistair Darling’s 2009 stimulus package. But the Bank is in the middle of a monetary boost six times that, £125 billion, through quantitative easing (QE), on top of £200 billlion it did three years ago.

The two types of stimulus are not directly comparable. A fiscal giveway is for keeps, or at least until the governent reverses it, while the QE boost is intentionally temporary: at some stage all those gilts the Bank has purchased will be sold back.

How has the Bank been doing stimulating growth? The Times has run a series on Sir Mervyn King, including an interview in which the governor’s main defence was that history will be kind to him.

As far as monetary policy is concerned, the Bank was slow to cut when the crisis hit but acted quickly when the storm raged in 2008-9 and, for a conservative institution, embraced “unconventional” QE.

Some would say King is too gloomy - I know people who await his downbeat pronouncements with dread - but his supporters would say if ever there was a time you needed a dovish governor this was it.

What the Bank does matters a lot. Its senior officials are aware it has not yet responded adequately to criticism from pensioners and savers groups of the current round of QE.

Paul Tucker, King’s deputy and a strong candidate to succeed him, knows the Bank has to get supervision and regulation right, through its financial policy committee and prudential regulation authority. London’s role as a global financial centre means the Bank has to set an example to the world.

Perhaps the biggest economic challenge for the Bank, though, is how to return to normality for interest rates. Many see the Bank as so constrained by a weak economy and the fiscal tightening it will have no option buit to leave Bank rate at 0.5% and periodically pump in more QE, for years.

Some in the Bank are starting to think, however, of the exit strategy. Ben Broadbent, a member of the monetary policy committee, makes the sensible point that the financial crisis in Britain had little to do with the build up of household and corporate debt. It was mainly the banks, and in particular their overseas balance sheets.

Britain’s households, while they increased debt substantially, added to their ownership of financial assets at least as much. Household assets are several times liabilities (debt).

This means, he argues, the Bank will not have to tiptoe too much for fear of driving households and businesses over the edge. Most are strong enough to take higher rates, particularly if market conditions mean a lowering of margins between Bank rate and the rates people and firms actually pay, in contrast to the recent pattern.

Higher rates are usually reported as bad news. But when they do go up, even if not under the current governor (he has until mid-2013), it should be a sign that the long nightmare of the crisis is coming to an end.

The chancellor has a tough task this week combining good politics, good economics and some confidence-building but cheap measures. Most budgets, however, are soon forgotten. The Bank’s task in the coming months and years is arguably much harder and more important. Enjoy the budget, but remember the Bank.

Sunday, March 11, 2012
Britain's jobs machine is still working
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 the unemployment figures come out on Wednesday, expect to hear about it. They will be anticipated, discussed in phone-ins and be the subject of questions in the House of Commons. The Westminster and media villages will go into overtime, as they always do.

Even when the figures are not bad, as last month, they will be reported as gloomy. They are programmed that way. The Office for National Statistics’ February release showed the broader measure of unemployment as 2.67m, fractionally lower than in its January announcement.

Because the figures are announced by the ONS as a rolling three-month total, however, that small fall was reported as a 48,000 rise over the latest three months.

The beauty of the statistics is that there is always some bad news for those looking for it, whether high youth unemployment, the proportion of long-term jobless or the numbers forced to work part-time because not enough full-time jobs are available.

Maybe this is at it should be. We can never have zero unemployment but we should not be satisfied with higher than necessary unemployment. The lowest the Labour Force Survey measure of unemployment got to during the long recovery from the recession of the early 1990s was just under 1.4m in September 2004, after which it rose by 300,000 in the following two years in the absence of recession.

Unemployment is a million or so higher than its recent minimum. Behind that bald statistic is a waste of effort and talent and stories of personal disappointment.

Even when there is good news on jobs, such as 20,000 additional posts at Tesco and 2,000 jobs to be generated by the new Nissan Invitation in Sunderland, there is usually something to balance it.

In the north-east it was at least 300 jobs lost from the closure of the Lynemouth aluminium smelter. Nationally, it was the threat to 1,700 jobs for people with disabilities from shutting Remploy factories.

So we should not be complacent. What we should not do either, however, is overdo the gloom, in a way that does nobody any good. As I have noted before, there was a welcome disconnect in the recession between the drop in gross domestic product and the fall in employment.

GDP fell by more than 7%, employment by 2%, in sharp contrast to previous recessions, where the fall in employment was equal to or greater than the drop in GDP. GDP is still 4% lower than its pre-recession peak, while employment is 1.5% down.

One of the enduring narratives of recent months has been that the private sector is not generating the jobs to offset cuts in the public sector. Fortunately it is not true. Since December 2009 public sector employment has fallen by 365,000 while jobs in the private sector have risen by 630,000.

Though employment weakened at the end of last year, recent evidence, notably from the Recruitment and Employment Confederation survey, carried out with KPMG, is that it is strengthening again.

Two new contributions support my belief there is too much gloom around about the labour market. Goldman Sachs examines claims that headline figures conceal a large rise in “hidden” unemployment, such as the TUC’s recent estimate that true unemployment is 6m.

Statistics for hours worked and labour force participation (whether workers are “discouraged”) do not support the argument that a relatively small rise in recorded unemployment disguised a big increase in hidden unemployment, Kevin Daly and colleagues find. There are always people operating on the fringes of the job market but there is no evidence relationships between their numbers and those for recorded unemployment have changed.

The Goldman report draws comfort from a surprising source: low wage increases. The time to get worried about unemployment is when it is “structural”; it stays high even as the economy recovers. Low wage rises suggest a significant slice of unemployment is “cyclical”: it bears down on wages because people are available and have the skills to start work immediately.

The other contribution was John Philpott, chief economist at the Chartered Institute for Personnel and Development. Philpott, dubbed Dr Doom by The Sun, might not be the obvious person for reassurance.

In a recent speech, however, he provided it. Though the number of people unemployed for a year or more has increased from a quarter to a third of the total, this compares favourablly with the last time unemployment was close to current levels in the 1990s, when the proportion of long-term unemployed was 44%.

Talk of a “lost generation” of young people is misplaced, he said, because “core” (difficult to tackle) youth unemployment is 10%, not the 22% headlined in the official figures. The proportion of unemployed who are young people, just under 40%, is lower than it was, and the percentage of the young who are long-term unemployed, 25%, is in line with past experience.

The common theme is that there is nothing permanent about the higher unemployment we have now. As growth recovers, so employment will strengthen. Unemployment will come down.

Does that not argue for a big, employment-generating public spending boost in the March 21 budget? No. There are things the chancellor could do on infrastructure spending, which he is attempting. There is more that could be done to boost housebuilding, as Vince Cable said in his now notorious leaked letter last week.

But a short-term boost to public spending to generate jobs, in the knowledge that spending has to come down over the medium-term, would be a feeble, make-work plan, however, and ultimately a cruel deception on the unemployed.

It has to be the private sector. If the budget tries anything, it should be to encourage private employers to recruit and expand. There may be tax incentives to assist with that. Not increasing the national minimum wage for young people will help. In the end it has to be about giving firms confidence in the outlook.

Nobody pretends it is easy. Even 600,000 additional private sector jobs over the past couple of years has not been enough to offset the combined impact of public sector job losses and a growing workforce, which includes a rising number of migrant workers. But it can be done. Britain’s private sector job machine is working. It just needs to run a bit faster.

Sunday, March 04, 2012
Osborne can only disappoint on tax
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 should be a good time for George Osborne. In the run-up to his March 21 budget fears of a double-dip have eased and consumer confidence has picked up.

The government borrowing numbers have come good for the budget, which should enable him to declare a deficit undershoot for this year. It is too early to say but the hope among the chancellor’s advisers, that the Office for Budget Responsibility (OBR), the independent watchdog, may have overdone the gloom for later years is not just wishful thinking.

Economic forecasters, against the pattern of the past two years, have begun to eye the possibility of revising up their growth forecasts for this year and one or two have done so.

The OBR may not go that far but there is no reason why it should change its forecasts of 0.7% growth this year, 2.1% in 2013.

And yet, Osborne finds himself assailed from all sides, particularly on tax, to the point where the budget can only be a disappointment. Unless he can simultaneously abolish the 50p top rate of income tax, cut Vat and raise the personal tax allowance to £10,000 some of his critics will claim he has under-delivered.

He is being pushed to cut tax despite the fact, as he made clear in interviews attending the G20 finance ministers’ meeting in Mexico, the scope is not there.

“Any tax cut would have to be paid for,” he said. A government that “has run out of money”, as he put it, is in no position to splash the cash, despite the prospect of a borrowing undershoot. The word from the Treasury is that with the budget deficit still well above £100 billion, this is no time to declare victory and hand taxpayers some of their money back.

So why the pressure on him to do so? Some of it is deliberately mischievous: Labour’s call for a temporary Vat cut is more about forcing a humiliating U-turn than helping the economy.

Much of it, however, reflects a genuine uncertainty about what Osborne stands for. What is his tax philosophy? Does he think that if he keeps saying he is an instinctive tax-cutter, while at the same time hiking taxes, people will not notice the rises? Gordon Brown tried something similar but it did not work.

Consider the record. Osborne’s coup de grace was in the autumn of 2007. An audacious plan to raise the inheritance tax threshold to £1m - a big cut in capital taxation - was so well received that Alistair Darling was forced to announce his own inheritance tax cut and Brown scrapped his plans for a snap election.

We have not heard much about inheritance tax since the May 2010 election. The only notable change in capital taxation was a rise in capital gains tax from 18% to 28%. Was Osborne ever committed to lowering capital taxes, or was it just a piece of political opportunism?

What about direct and indirect taxation? The Tories have been habitual hikers of Vat, beginning in 1979 with Sir Geoffrey Howe’s increase to 15% (from rates of 8% and 12.5%) and continuing with Norman Lamont’s hike to 17.5% in 1991. In each case, however, it was a hike with a purpose. Howe did it to cut income tax, Lamont to reduce local taxation. Osborne, when he raised Vat to 20%, just did it.

Not only are indirect taxes going up but so are direct ones. A chancellor who was philosophically opposed to higher direct taxes would have blocked the hike in National Insurance he inherited from Labour, rather than just easing its impact on employers.

Most chancellors stamp their authority on the tax debate. The noises off we are getting now would be ignored because people would know what was possible and what was pie in the sky. The strategy would be clear. MPs putting their two pence worth into calls for lower taxes would be given short shrift; junior ministers doing so - let alone deputy prime ministers - would be given a carpeting.

Instead, Danny Alexander, the Treasury chief secretary and Nick Clegg, the deputy prime minister, openly call for a big increase in the personal tax allowance in the budget, with Alexander saying it should be funded by abolishing pension relief for higher rate taxpayers.

I would be astonished if this relief was abolished - indeed there are no easy tax-raising hits to fund cuts elsewhere. I would be equally astonished if the 50p rate were to bite the dust this year. The “scrap the tax” campaign risks using all its ammunition up early.

But the fact is that any increase in the personal allowance beyond the planned rise to £8,105 in April will be seen as a Liberal Democrat measure, despite a long Tory history of taking people out of tax this way.

Osborne does not engage very well in the debate. On tax he is seen a blank page. The political opportunism tag sticks because he spends a significant amount of his time as the Tories’ chief election strategist. The risk with stretching yourself between two jobs is that you do neither well.

His allies would say that is unfair. He began with clear ideas about making Britain a lower tax economy. When he and David Cameron talked about “sharing the proceeds of growth”, they meant that any room for fiscal manoeuvre should be split between higher public spending and lower taxes.
The deficit changed all that, as did the compromises of coalition. As for a tax philosophy, he set one out in his last budget.

“Our taxes should be efficient and support growth,” he said. “They should be certain and predictable ... simple to understand and easy to comply with. And our tax system should be fair, reward work, support aspiration and ask the most from those who can most afford it.”

That philosophy is set out clearly in what he has done on corporation tax, his supporters say, with a cut to 23% over the next three years and a well-received clarification of the rules on controlled foreign companies. The general anti avoidance rule (Gaar) to be unveiled in the budget is intended to make sure that by making everybody pay their fair share, tax rates can be lowered for all.

One day, maybe, that will happen and our tax-raising chancellor turn himself into a tax cutter. So far, however, he gets good marks for cutting the deficit, low ones for most other aspects of the job. It remains to be seen whether that verdict is any different after March 21.

Sunday, February 26, 2012
Osborne's borrowing headache starts to ease
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 the 21 months since the coalition government has been in office, a narrative has been developing.

It is that George Osborne’s fiscal strategy is not only crippling the economy but failing in its own right by missing its targets for cutting the deficit.

Every time the chancellor stood up to announce an increase in the official borrowing projections, it seemed like a nail in the coffin for the strategy.

For Labour, a cumulative upward revision of £158 billion in borrowing over the parliament by the Office for Budget Responsibility, provided a stick to beat Osborne.

Well, unless January turns out to have been an aberration, the tide looks to be turning. Last month’s £7.8 billion budget surplus put the government on course for an undershoot of the OBR’s £127 billion projection for borrowing this year, 2011-12.

You may say that is no big deal. After all, did not the OBR revise up that forecast as recently as November? Yes it did, from £122 billion. It will be disappointing, however, if borrowing is not below that figure too.

Indeed, if the optimistic forecasters are right, the deficit could undershoot by £10 billion. “A simple extrapolation of the data over the last ten months suggests that borrowing is on course to come in at around £116 billion,” says the IFS.

There is many a slip twixt cup and lip. The OBR is not yet ready to throw in the towel on its forecast and there are two months' figures to go. But this is rather interesting. Just over three years ago the Treasury under Alistair Darling predicted a budget deficit of £176 billion for 2010-11 and £140 billion for 2011-12.

In June 2010, when Osborne presented his emergency budget, the interim OBR predicted deficits of £149 billion and £116 billion respectively.

The £149 billion was far too gloomy (as was the earlier £176 billion), the outturn for 2010-11 being just under £136 billion. But that £116 billion for 2011-12 appeared to fall foul of weak growth in the economy.

Until now that is. If it turns out that borrowing is close to those initial June 2010 projections, in spite of a weaker recovery, some of the OBR’s gloom about future years may have to be revised. The fiscal strategy looks to be much more on track than it was given credit for. The deficit is still with us but is coming down faster than feared.

As an aside, the latest numbers makes the decision to put Britain’s AAA sovereign debt rating on negative watch look even more curious. It would have made a lot more sense to wait for the data from the key tax-raising month of the year.

Myths abound about fiscal policy and its impact on the economy. One is that the American economy is doing better because it has had a fiscal stimulus while Britain is doing exactly the opposite, inflicting unnecessary pain on a sickly economy.

Not true. The International Monetary Fund’s fiscal monitor shows fiscal policy in America was tightened by 0.8% of gross domestic product last year.

This was not as much as Britain’s tightening, 1.5%, but Britain’s was smaller than Germany, 2.3%. Germany, in spite of this, grew by a robust 3%. The relationship bewteen growth and fiscal policy is not simple.

Another myth worth exploding is that we have barely scratched the surface of the fiscal tightening, so that all the pain lies ahead. While it is true that the squeeze on spending will last for years, Treasury numbers, updated by Goldman Sachs, suggest the biggest single-year hit is behind us.

That was in 2010-11, a combination of the measures the coalition inherited from Labour, its own “in-year” cuts and the Vat hike in January last year. Policy, measured by the cyclically-adjusted primary balance, was tightened by a substantial 2.6% of GDP. This year’s tightening, by contrast, is 0.9% of GDP, roughly what it will average in future years.

Where does this leave Osborne as he plans his March 21 budget? He will be spared the embarrassment of having to present upwardly-revised borrowing forecasts and downwardly-revised growth.

He is being pressed by the Tory right to announce aggressive tax and spending cuts. The Liberal Democrats want the rich to be soaked more, by scrapping higher rate pension tax relief or introducing a mansion tax. I have an image of Ed Balls, the shadow chancellor, wandering up and down Oxford Street with a “Cut Vat now” placard around his neck.

I may have misread it but I would be surprised if he were to do any of this. The usefulness of the Tory right to the chancellor is that they make his plans look moderate. Neither the abolition of higher-rate pension tax relief nor a mansion tax are likely to see the light of day, for now at least. An emergency cut in Vat is about as likely as Elvis turning up at the Commons on budget day. Osborne will make a virtue of “steady as she goes”, banking the undershoot rather than spending it.

What about the 50p tax rate? Though self assessment receipts were disappointing in January, suggesting the absence of any revenue bonanza from the tax, the question of whether the 50p rate raises any net revenue is not yet cut and dried.

We await the verdict of Her Majesty’s Revenue and Customs (HMRC), which will be published with the March 21 budget. The politics of early abolition of the tax are awful. Even if it is a revenue loser, many people would want to keep it.

Osborne can, however, give a pointer to future abolition. He can also, and I feel bound to mention it given how many readers got in touch, tackle an absurd anomaly in the income tax system.

This is the 62% (combined tax and National Insurance) rate that kicks in when incomes hit £100,000 and continues to £114,950, after which it drops to 42%, until the 50p rate takes effect at £150,000. It happens because of the withdrawal of the personal tax allowance above £100,000.

The numbers caught in this anomaly are hard to come by but must be at least a couple of hundred thousand. As importantly, it introduces a powerful distortion and disincentive into the system. It needs to be changed.

Sunday, February 12, 2012
The 50p rate: a bad tax that's hard to scrap
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 February 21, the Office for National Statistics will publish figures for public finances in January.

These figures, which the chancellor of the exchequer will get a day early, are important in their own right. January is one of the big months for tax receipts, so they will tell us whether the government’s deficit reduction programme is on track, overshooting or undershooting.

The January numbers will also give us the first solid indication of the impact of the 50p top rate on incomes above £150,000. If they are strong, in what is the key self-assessment month, it will at least suggest that the tax is in some decent revenue. If they are weak, it will add to the sense of anticipation over the second piece of information heading Osborne’s way.

This is the exercise he commissioned from Her Majesty’s Revenue & Customs (HMRC) in order to provide a definitive answer to the question of whether the 50p rate is a net revenue raiser. Officials are currently going through the self-assessment forms and other evidence.

They will present a report to the Treasury in time for the March 21 budget, when the intention is to publish it. It will inform Osborne’s decision on whether to stick with the top rate he inherited from Labour.

I shall come on to the tricky politics of that in a moment. What do we know about the numbers? So far this fiscal year tax revenues have been rising reasonably strongly: from April to December last year central government receipts were 5% higher than in the corresponding period a year earlier.

When it comes to income tax and capital gains tax, however, a breakdown by the Office for Budget Responsibility suggests these were lagging well behind other receipts, up by only a cumulative 1.7%, though December on its own, up 4.6%, was a little better.

How much does the Treasury expect to raise from the 50p rate? Projections done by officials at the time Alistair Darling introduced the new top rate two years ago were for the net addition to revenue to settle at around £3 billion a year. This is not a sum to be sneezed at though it is only 0.5% of this year’s expected government receipts and under 2% of income tax revenues.

Even that sum is called into question by some independent experts. The Institute for Fiscal Studies, in its recent green budget, looked at the effects of the new rate on indirect taxes (such as Vat and excise duties) as well as direct taxes such as income tax and National Insurance.

It concluded that if spending by the high-paid is cut as a result of the tax, then the government may be robbing Peter to pay Paul. The fall in indirect tax revenues almost offsets the rise in direct taxes.

In this case, the IFS found, the net revenue raised by the tax reduces to less than £1 billion a year. Under other assumptions about the way incomes and spending have responded to the new tax, so-called elasticities, the net tax take turns negative. In other words the government’s coffers would be poorer as a result of the 50p rate.

There are things even the IFS cannot model but the Treasury is keenly aware of. If the 50p rate has resulted in enough high earners moving to Switzerland and elsewhere, then all the taxes paid by these people are lost to the economy.

The behavioural changes assumed by the Treasury in estimating the direct revenue gains mainly assumed people would engage in tax avoidance, not that they would choose to become tax exiles.

The fact that many high-earners can do so means that one way of preserving any revenues from the tax - clamping down even harder on tax avoidance schemes - could easily be counter-productive. The effect might be to put people on the next plane to Switzerland.

So what will happen? The chancellor will, as I say, publish the HMRC report in the budget and will respond to it. Given that officials are looking at direct taxes only, it will be surprising if it does not conclude that the 50p rate is bringing in at least some additional revenue, though probably not as much as the Treasury’s original £3 billion long-run estimate.

What will be Osborne’s response? When he was in Davos last month, the chancellor was clear. “I have always said this is a temporary tax,” he said. “The long-term damage of this tax is potentially quite considerable, and that's why it is temporary.” He urged British business leaders attending the speech to furnish him with the evidence on that damage to help him get rid of it.

Since he was in Davos, quite a few things have happened. We have had the affairs of both Stephen Hester’s on-off bonus and the now de-knighted Fred Goodwin.

The Liberal Democrats have increased the pressure for accelerating the move towards a £10,000 personal tax allowance, paid for by increasing taxes on the wealthy. At one time the proposed mansion tax was seen as the price the Tories might have to pay for getting rid of the 50p rate. Now it is being pushed as the way to pay for tax cuts for low earners. Danny Alexander, the Liberal Democrat Treasury chief secretary, wants to scrap higher rate pension tax relief in order to lift the personal allowance to £12,500.

There was a lot of emphasis on unfairness, fat cats and bonuses even before recent events. There is even more now. I may be reading too much into it but I did not see a mention of the 50p rate in Osborne’s speech last week to the Federation of Small Businesses. Some say it could be a deal-breaker for the coalition.

The danger, however, is that the 50p rate takes on an air of permanence. Margaret Thatcher cut the high top rate of income tax she inherited from Labour at the first opportunity in 1979. Nearly two years into the parliament, the “temporary” top 50p rate is intact and, given the politics, unlikely to go any time soon.

So Osborne is a bind. Does he keep a tax that raises little or any revenue and may be doing “considerable” damage to the economy, or does he abolish it and risk upsetting his coalition partners and being seen as the friend of fat cats and bankers.

A compromise might be a firm pledge to abolish it by the end of the parliament. At one time this was the minimum business expected from the government. Now it would be seen as a sign of boldness.

Sunday, February 05, 2012
To QE or not to QE? That is the question
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 ducks, it seems, are all lined up in a row. Gross domestic product fell in the final quarter of last year, inflation is falling and the money supply is weak.

Sir Mervyn King gave a broad hint in his first big speech of the year that he and colleagues on the Bank of England’s monetary policy committee (MPC) stand ready. It will be s surprise if there is not an announcement on Thursday at noon.

I am talking about the Bank deciding to increase its asset purchases, to add to the £275 billion of quantitative easing (electronically creating or “printing” more money) to boost the economy.

Since October, when the MPC announced an additional £75 billion of quantitative easing (QE), in response to “increased downside risks” for both growth and inflation, the markets have been waiting for this moment.

In 2009, the worst post-war year for the world and British economies, the Bank reached into its filing cabinet marked unconventional monetary policy and unleashed £200 billion of QE, overwhelmingly by buying gilts; government bonds.

Bank rate had been cut as much as was thought desirable - 0.5% represents easily the lowest in the Bank’s 318-year history - and more monetary oomph was needed. Hence the £200 billion of QE in these exceptional 2009 circumstances which, on the Bank’s estimates, added between 1.5% and 2% to the level of gross domestic product and 0.75% to 1.5% to inflation.

For the Bank’s view on how it did so, a paper “The UK’’s quantitative easing policy: design, operation and impact”, is on its website. It has also published some recent working papers which offer supportive evidence on the impact of the policy.

2009 was special because it was so very weak. To announce another £75 billion of QE in October reflected the Bank’s deep concern over the impact of the eurozone crisis, and its fear the economy was going into reverse. It said as much about the economy as any indicator.

The significance of this week’s MPC meeting is that the £75 billion announced in October has been done. In meetings since then committee members have said they would decide on wtether to do more when that point was reached.

The moment has arrived and the fact this is a month in which the Bank publishes a new quarterly inflation report means trhe markets will be surprised if there is not more this week.

A “cautious” MPC will announce a further £50 billion, according to Philip Shaw of Investec and Nick Stamenkovic of Ria Capital. Shaw cites evidence of operational constraints on the Bank - its appetite for gilt purchases may be grater than the markets’ willingness to sell - while Stamenkovic points to the Bank’s January minutes as signalling that some members are uneasy about repeating the October dose.

But both Michael Saunders of Citi and Geoff Dicks of Novus Capital, think it will be another £75 billion. Saunders thinks the Bank can carry on buying until QE reaches £600 billion, nearly 40% of GDP. That would leave £800 billion of gilts still in circulation, enough for institutional investors such as pension funds.

The shadow MPC, under the auspices of the Institute of Economic Affairs, is more restrained. Only three of its members favour an immediate extension of QE.

Could the Bank do anything else as an alternative to QE? Vicky Redwood of Capital Economics floats the idea of the Bank cutting the interest rate paid on commercial bank reserves to zero or even a negative 0.25% rate, as in Sweden. In theory, a penalty rate would encourage banks to boost lending rather than sit on these reserves.

The Bank, however, ran through alternatives last September. They included a cut in Bank rate below 0.5% and setting out guidance on the future path of interest rates, as the Federal Reserve has done. It seems unlikely to revisit those options now.

So it looks like more QE. Having opposed it in the autumn, am I still against it now? On the face of it, the Bank has been vindicated, particularly in its concerns over the weakness of the economy in the final few months of last year.

Some of that weakness, reflected in the 0.2% fourth quarter drop in gross domestic product, was not conducive to a money injection by the Bank. The Old Lady of Threadneedle Street does not have the power to vary the weather and boost energy consumption, or prevent North Sea oil output from falling.

Most surveys suggest, in contrast to the very sharp fall in activity the economy was enduring in 2009, when it did its first £200 billion of QE, a gentle pick-up is under way. Manufacturing appears to have shrugged off some of last year’s weakness. The service sector grew strongly in December and even more strongly in January.

This should be a prelude to stronger growth in the second half of the year, as falling inflation boosts real incomes. Were I at the Bank I would want to make doubly sure of this fall in inflation, particularly after the overshoots of recent years. Worrying about an undershoot of the 2% target in a couple of years’ time, given the forecasting record, seems self-indulgent.

Not only that but the route from QE through to stronger growth in the economy is much less obvious than it was in 2009. Gilt yields are already very low at about 2% and, while this partly reflects the expectation of more QE, it reduces the impact of further purchases.

There is also the question of the eventual unwinding of the policy. That is a long way off but at some stage the Bank will have to sell these gilts back, possibly into a very weak market because interest rates will also be rising. The more the Bank adds to that £275 billion, the more it will have on its books to unload when the time comes. That makes me uncomfortable.

But the Bank, which is not always very good at managing expectations, has given the impression it will do more. To avoid a destabilising policy lurch it probably has to do so. That to me means £50 billion this week and a “final” £25 billion in May. Let us see what happens.

Sunday, January 29, 2012
Small dip in GDP equals a big drop in confidence
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 all likelihood, the 0.2% fall in GDP announced by the Office for National Statistics (ONS) last week will be revised away in time. There were, as there always are, some special factors.

The second mildest autumn in more than 350 years produced a drop of over 4% in gas and electricity output, as well as making it hard for retailers to sell winter woollies and overcoats. A one-day strike by public sector workers on November 30 probably hit GDP, though the official statisticians do not know by how much.

I am not pretending that these were anything but disappointing figures, though there was some relief in the Treasury that they were not even worse. One official recalled what happened a year ago, when everybody was expecting a 0.5% GDP rise for the final quarter of 2010, only for the ONS to report a 0.5% fall. The recovery has been struggling ever since.

The 0.2% fall in fourth-quarter GDP did not change the overall numbers for 2011, which showed 0.9% growth, in line with the late-November projection by the government’s Office for Budget Responsibility. Non-oil GDP, resorting to a distinction that used to be made in the days of booming North Sea output, rose by a slightly stronger 1.4%. The economy has flattened, not dived.

But it was the 0.2% fall that did the damage and, unlike a year ago, there is no automatic reason to expect a bounce in the current quarter. Things are likely to remain flat for a while.

In the headlines and in broadcasts, there is no distinction between a small fall in a flat economy and, say, a 2% drop that would imply a deep recession. People read or hear about the fall, assume the economy is slumping, and their confidence takes another hit.

Another official number last week, showing government debt has topped £1 trillion for the first time, probably has a similar, confidence-sapping effect.

£1 trillion is a big number, equivalent to nearly two-thirds of Britain’s annual GDP, but the milestone did not really mean very much. It was a straightforward consequence of the large budget deficits of recent years.

Underlying it were monthly deficit statistics that are improving at a slightly faster rate than expected.

What about the gloom from the International Monetary Fund, slashing its forecasts for Britain and the world? The IMF has a French managing director, Christine Lagarde, and a French chief economist, Olivier Blanchard.

Though they are right to warn of the dangers of insufficient action by eurozone leaders, there is a danger in seeing everything through a European prism. The IMF looks a little too downbeat on America, predicting growth of just 1.8% this year, and may not have fully picked up on the improved feel recently in other economies.

The global economy did amazingly well in 2010, growing by 5.2%, and not badly in 2011, 3.8%. Even this year, the IMF expects 3.3% growth. It is a slowdown but certainly not a collapse.

It comes to something when you have to look to Sir Mervyn King for reassurance. The Bank of England governor, often criticised for his gloomy tone, reminded us that all crises come to an end.

King’s view on the economy, broadly flat until the middle of the year, before falling inflation eases the squeeze on real incomes and lifts consumer spending off the floor in the second half is one I share.

In the meantime, he said, adjustments are under way in bank, corporate and household balance sheets that will put the economy on “a more sustainable footing than at any point in the past fifteen years”.

Perhaps that is the way we should look at the current situation. Had growth come back quickly and strongly after the worst of the financial crisis, and been sustained, there would have been no need to change.

As it is, the government has belatedly started to introduce supply-side reforms that will bring dividends in the future. They include easing credit constraints on small and medium-sized firms and finding new ways of funding infrastructure.

Though it has been slow off the mark, these reforms, together with the proposed introduction of local or regional pay in the public sector, will have positive effects over the medium or long-term.

But there is much more to be done. The London School of Economics has launched its growth commission, inviting along former US treasury secretary Larry Summers and former monetary policy committee (and current fiscal responsibility committee) member Steve Nickell to do so.

Summers said Britain could not afford to ignore sectors in which it had comparative advantage, notably financial services. Nickell observed that governments had been good at commissioning reports to identify the problems, but less good at acting on them.

Gordon Brown, for example, commissioned McKinsey to report on Britain’s relatively poor productivity performance early in his chancellorship in 1998 but mainly failed to act on the recommendations.

The things identified then, regulatory barriers, low skills, poor management, becoming better at commercialising scientific innovations, remain relevant now. The LSE commission will come up with detailed recommendations

There can never be a magic bullet, or an instant remedy. Looked at with the benefit of hindsight, the despair of the early 1980s turned into a powerful, enterprise-led revival remarkably quickly. At the time it seemed agonisingly slow.

Even so, the questions are being asked now in a way they would not have been. As King suggests, growth disappointment now and the “arduous” recovery may be the process we have to go through to end up healthier in the long run. People and businesses, however, need the confidence to believe in that. At the moment most of them do not.

Sunday, January 22, 2012
Britain is not following the Japanese script
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 has a budget deficit that compares unfavourably with most of the economies downgraded by the ratings agency Standard & Poor’s a few days ago.

Britain’s overall debt, still rising mainly as a result of that budget deficit, vies only with Japan as the largest among leading economies, according to new figures from McKinsey, the management consultancy.

Yet Britain one of the few countries to retain a AAA sovereign debt rating with Standard & Poor’s - others in the club are Australia, Canada, Denmark, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, the Netherlands, Norway and Singapore, Sweden and Switzerland - and pays ultra-low interest rates on that debt.

It is quite an achievement, endorsing George Osborne’s claim to have made Britain a safe haven in the storm, though Treasury officials remain alive to the danger that one Friday evening it will be Britain’s AAA rating that gets downgraded.

There is, however, no evidence of that, or warning to that effect. And, given the verdict of the markets is more important than ratings agencies, low gilt yields, currently around 2% for the benchmark 10-year bond, are testimony to market confidence.

Or are they? Jonathan Portes, director of the National Institute of Economic and Social Research (Niesr), begs to differ. Portes, a former cabinet office economist who has taken Niesr back to its Keynesian roots, has a blog Not the Treasury View.

“Our current historically very low level of interest rates is - just as in Japan - a sign of economic failure, not success,” he writes. “The government has got the rhetoric and the economic logic completely wrong on this.”

I find this puzzling. Though this week’s gross domestic product figures for the final quarter of 2011 will underline the struggle Britain is in to get the recovery beyond stall speed, there are other economies with worse growth prospects and much higher bond yields, mainly in the eurozone.

The Japanese comparison also looks odd in other respects. The key to Japan’s lost decades (counting the 20 years since the early 1990s as a failure) was deflation; falling prices. Though inflation in Britain is falling, at 4.2% it remains high. So keen are markets to hold gilts they accept a negative real interest rate for doing so.

The fact the Bank of England is purchasing gilts under its quantitative easing programme is important but does not change the broad picture. It is easy to envisage a situation in which the Bank was buying gilts hand over fist while everybody else was dumping them.

Nobody expects years of deflation in Britain. Niesr is among the inflation optimists but its most recent forecast sees inflation over the next five years tucked just below the 2% target, not negative.

As an aside, and though it has a new forecast out shortly, it does not expect Japanese-style stagnation either. While downbeat for this year, it expects growth to average 2.5% over the 2013-16 period.

So we should knock the Japan comparison on the head. Somehow, though its critics will not have it, the government has fiscal credibility. If anything it is enhanced by the fact public borrowing is dropping even in a slow-growth environment. The fall under Alistair Darling’s plans, remember, was in the context of implausibly upbeat Treasury growth forecasts.

We should celebrate the fact that borrowing costs are so low. Not only will this lay the groundwork for a stronger recovery in future years but it will also mean a smaller proportion of spending will go on paying interest on the debt, with a higher proportion on public services.

Even the critics would surely applaud that. Debt interest used to be described by Gordon Brown as a “cost of failure”. Cutting that cost is to be welcomed.

While I am at it let me deal with another Japanese comparison, as drawn by McKinsey. As noted above, it estimates Britain’s total debt, 507% of gross domestic product, is close to Japan, with 512%.

Ireland is in a class of her own, with 663%, but others are lower. America has debt of 279% of GDP, Germany 278%, Italy 314%, Spain 363% and Portugal 356%.

McKinsey’s contention is that Britain has not begun to come down from these high levels of debt, to “deleverage” and needs to do so. The process of deleveraging, running down debt, is one that could undermine growth in coming years.

There is some truth in McKinsey’s view but not as much as you might think. There is a huge difference between Britain and Japan in government debt. Britain’s is 81% of GDP, Japan’s a huge 226%.

Corporate debt, 99% of GDP in Japan, 109% in Britain, is similar. Corporate debt in Britain is similar to South Korea’s 107% of GDP but lower than France, 111%.

What about Britain’s famously indebted consumers? I am not sure the household sector carries too much debt. Yes, at 98% of GDP it sounds high, and is well above Italy. 45%, France, 48% and Germany, 60%.

But debt is a stock while GDP is a flow and to compare them, while convenient, is apples and pears. Most household debt in Britain is in the form of mortgages. Countries with high levels of owner-occupation tend to have high levels of household debt.

US household debt is 87% of GDP, Canada 91% and Australia 105%. Britain’s household debt should ideally not rise much in coming years - and certainly not as much as it did in the pre-crisis decade. But nobody should expect or want a fall.

Where Britain does have a disproportionate amount of debt, 219% of GDP, is in the financial sector. This is nearly double Japan, more than five times America and roughly three times most other countries.

A significant proportion of that, however, reflects London’s role as a global financial centre and the preponderance of foreign banks in Britain. Take that out, as is appropriate, and total debt comes down to closer to 400% of GDP than 500%.

That is still too high. Not many people are aware that by far the biggest increase in debt in the pre-crisis period was not that acquired by households, companies or government but by the financial sector. The financial sector ballooned too much and, painful though it is in terms of credit availability, it is right it is now deleveraging.

What would be wrong, however, is to add to government debt. Even under the coalition’s deficit-cutting programme, debt will rise inexorably. Adding to that increase would guarantee Britain’s place at the top of the international debt league. It would also be the surest way of turning Britain, in terms of economic stagnation, into Japan. Clearly, it should be avoided.

Sunday, January 15, 2012
We need productivity, but first we need 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.

Maybe I spoke too soon. The appropriate response to the eurozone downgrades announced on Friday by Standard & Poor's is to ignore them. But that is not happening, so the eurozone is back in crisis.

This time last week I was celebrating the stronger than expected data we had seen since the start of the year. Then, three days ago, the Office for National Statistics came out with a gloomy set of industrial figures and we appear to be back to square one.

There is a difference. The surveys I was reporting on last Sunday applied to December, while the industrial numbers were for November, when we knew things were weak.

Even so, there is now a mountain to climb if Britain’s gross domestic product is to avoid a fall in the final quarter of 2011 when the statsitics are out on January 25. The arithmetic is straightforward. Industrial production taking October and November together was 1.2% lower than the third quarter.

That is enough, barring a December recovery, to shrink GDP by 0.2% in the fourth quarter. The service sector accounts for the lion’s share of the economy and could compensate but it too had a bad start to the quarter.

The National Institute of Economic and Social Research predicts 0.1% quarterly growth but it is in a minority. The City expects a small fall. Some of that will be down to temporary factors like the mild autumn which has reduced gas supply by 23.6% year-on-year (the weather is never right these days).

Some of it is explained by longer-run changes, including a 14.6% annual drop in “mining and quarrying”, which includes a sharp drop in North Sea oil production, Scottish Nationalists please note.

There is no doubt, however, that there was genuine economic weakness, which one hopes reached its peak in the autumn when fears of a eurozone catastrophe were at their height.

We also had figures for German GDP, “Bruttoinlandsprodukt” as they say in Wiesbaden. There was much to envy in these numbers, which showed 3% growth in 2011 after 3.7% in 2010. German GDP rose above pre-crisis levels during 2011, while Britain is still 4% below where we were. Even the German economy stalled at the end of 2011, however.

If growth in Britain has stalled, or worse - this week’s Ernst & Young Item Club report will talk of “ state of paralysis” for the economy - it will be regrettable, and not just for the obvious reasons.

The two fundamental questions for the economy in the next few years are first, whether growth in productivity - output per worker - can resume its earlier trend and secondly, whether the damage to the economy from the crisis and recession is as bad and as permanent as feared.

It is a big issue. Paul Krugman’s dictum, “productivity isn’t everything but in the long-run is almost everything” neatly captures the fact that without productivity there can be no sustained prosperity.

On the face of it, Britain has been living in a productivity vacuum for the past four years. Employment did not fall as much as feared in the recession but only because productivity did.

In a Policy Exchange pamphlet published at the end of last year, I pointed out that output per worker was some 14% to 15% below where it would be if the pre-recession trend had continued.

I offered some reasons for optimism. There has been no meaningful growth in public sector productivity since the mid-1990s. Rebalancing the eceonomy away from the public sector to the more productive private sector should automatically boost productivity. I also offered some policy advice around the coalition government’s five “drivers” of productivity: investment, innovation, skills, enterprise and competition.

Then, right at the end of last year, we had some modest grounds for optimism of productivity. Official figures showed output per worker rose 1.2% in the third quarter and was up on a year earlier.

The picture for manufacturing was particularly encouraging with productivity at record levels, up by 3.2% over 12 months on an output per job basis and 4.7% measured by output per worker.

Partly spurred by these numbers, Kevin Daly and Adrian Paul, economists at Goldman Sachs, published a rejoinder to the gloom on productivity and the permanent damage to Britain’s economy.

On the latter point, they noted that the economy has shown remarkably steady long-term growth, since about 1920, despite many shocks to the system along the way. As they put it: “Traumatic as the financial crisis has been, it is difficult to argue that it will have a more lasting effect on potential output than either the Great Depression or the Second World War.”

At the very least, it is too early to say that the economy has gone ex-growth, or entered a lost decade.

The Goldman Sachs economists were also optimistic on productivity. One commonly cited reason for productivity pessimism, that some of the highest growth in output per worker was in financial services and that will play a diminishing role in future, is balanced by the fact that so will the low-productivity public sector.

Not only that but Germany and Sweden, they noted, suffered bigger declines in productivity than Britain during the crisis and recession, but both have seen big improvements as their economies have recovered. A similar phenomenon is likely in Britain.

But this brings us back to those disappointing production figures and the prospect of a downbeat number for GDP. Economics can never be a laboratory experiment or merely a run on a computer model.

The test for productivity - and ultimately prosperity - will only come when the recovery is stronger. That will also provide a test of how much GDP was permanently lost and how much spare capacity remains.

A stop-start recovery does not provide the answers to these questions. It leaves us in limbo about where we will be as an economy in three, five or 10 years time.

We need productivity but first we need production. It is hard to have one without the other.

Sunday, January 08, 2012
Nice surprises so far - can they possibly last?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

This is not a time when you want to be dragged down further by deepening economic gloom.

Fortunately, despite the best efforts of some new year pundits, it is not happening. Pretty well every bit of economic data we have had so far has surprised on the upside.

As regular readers will know, the earliest readings on the economy are provided by surveys, and in particular purchasing managers’ surveys produced by Markit, a data provider. Official figures come a little later.

Before the publication last week of the December UK surveys, analysts were downbeat. Each one, however, was a pleasant surprise. The manufacturing purchasing managers’ index rose from 47.7 to 49.6, construction from 52.3 to 53.2 and the service sector from 52.1 to 54.

Levels above 50 indicate expansion and the weighted average of all three, up from 51.2 to 53.2, was the strongest since July. Were this just a phenomenon restricted to Britain, one might be suspicious. There are, however, plenty of signs of life elsewhere.

Gavyn Davies, formerly of Goldman Sachs and the BBC, now Fulcrum Asset Management, points out that leading indicators for the global economy bottomed out in July last year and are now showing a decent recovery.

China, which is more locked into the global economy than most countries, may be coming through its softer patch, to judge from the latest readings from its manufacturing sector. South Korean exports showed a significant jump. The global purchasing managers’ index, produced for J.P. Morgan rose to an expansionary 50.8 in December, its strongest since June.

In some cases the stronger numbers are a continuation of what ws happening last year. Back in August, without drifting too far into Irwin Stelzer’s territory, Standard & Poor’s downgrade of America’s sovereign debt rating coincided with deep gloom about the economy. A double-dip, it seemed, was certain.

Instead, America has had an “I’ll have what she’s having” tranformation. With few exceptions, the data has come in stronger than expected. Talk of a dive back into recession has faded.

Even in Europe, German unemployment has continued to fall and Spain’s jobless rate did not increase as much as feared. Survey data from the eurozone still points to mild recession but “mild”, rather than falling off a cliff, is the operative word.

Eight days into the new year is, of course, far too early to be cracking open the champagne, even if there were any left. This may be the economic equivalent of a dead cat bounce. Chris Williamson, Markit’s its chief economist, thinks the UK purchasing managers’ surveys are merely consistent with a flat figure for Britain’s gross domestic product in the fourth quarter.

Though that sounds a little too downbeat, it will take a decent bounce in official data for services and manufacturing to produce any GDP growth in the fourth quarter, fugures for which will be out on January 25. Perhaps for a while we will have to get used to the idea of flat being the new growth.

It can, however, be instructive looking back. As promised I am today publishing my annual league table of economic forecasts for 2011. What turned out to be a fascinating, event-filled year was also a pretty awful one for forecasters.

Let me concentrate on the big picture. Though we will not know for sure for another couple of weeks (and not for certain for many years), current evidence suggests the economy grew by 0.9% in 2011.

Every month, the Treasury publishes a compilation of around 40 independent economic forecasts. In January last year none of these - not one - had a growth forecast as low as 0.9%. The Centre for Economics and Business Research (CEBR) came closest, with 1.1%, and there were a few others starting with a “1” but the consensus was for 2% growth - twice what was achieved - and one optimistic group (Liverpool Macro Research) predicted more than 3%.

While forecasters were much too high on growth, they were far too low on inflation. I estimate that consumer price inflation will have averaged 4.7% in the final quarter of last year. A year ago the consensus was that it would be 3%. The closest was Michael Saunders with 4.1%. Many, however, had forecasts that suggested inflation would come in at barely more than half the outturn.

I have a lot of sympathy with the forecasters. Those who predicted weak growth thought, like the Bank of England, it would bear down more heavily on inflation. Those who thought inflation would be higher believed it would, at least in part, be a product of strong growth. The combination of weak growth and high inflation - and the lack of a response from the Bank of England in higher interest rates - was hard to forecast.

So nobody had a vintage year, which in the past has involved nine or 10 out of 10 in by scoring system. Congratulations, however, to Daiwa Capital Markets and Capital Economics for creditable sixes, with Daiwa just edging it.

Running close behind on five were the Economist Intelligence Unit and the CEBR and following them on four, BNP Paribas and Standard Chartered. I know in at least two cases - Daiwa and BNP Paribas - economists who were instrumental in producing the forecasts have moved on.

Most other forecasters, I suspect, will regard 2011 as a year best forgotten. My own score, a generous four or a more realistic three, was nothing to write home about.

Those who ignore the lessons of history are condemned to repeat them. The headline on the equivalent piece to this a year ago was “Forecasters failed to spot inflation surge”. Then they did it all over again.

What about now? Economists are subdued on 2012 growth prospects (consensus just 0.6%) but do expect inflation to come down to 2.1% by year-end. If they are wrong for a third year on inflation that would be unforgivable.

If they are right, they may be underestimating the positive impact on growth of lower inflation from the return of growth in real incomes and hence stronger consumer spending. This is something I have been talking about for a while. It offers the best hope for a year in which, in 12 months time, we may be able to say the forecasters, instead of being too optimistic, overdid the gloom.

Sunday, January 01, 2012
Chugging along: if we avoid the nightmare eurozone scenario
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.

Harry S. Truman, or one of his speechwriters, came up with the famous “give me a one-handed economist” line, so exasperated was he with economists saying “on the one hand this, on the other hand the other”.

Hedging your bets rarely convinces anybody. As with those red and green forecasting fan charts produced by the Bank of England and others, which encompass a very wide range of possibilities, nobody applauds a fence-sitter.

So, with all that said, let me get 2012 off to a good start by offering a two-handed view, or at least two distinct scenarios. There are good reasons for doing so, as I shall explain, before saying at the end which I think is most likely.

It will not have escaped anybody’s attention that the eurozone crisis has not been resolved. The Brussels summit at which David Cameron made his stand was as noteworthy for the failure of EU leaders to deliver the deal they were aiming for.

True, the markets showed a spirit of goodwill over the festive period and the European Central Bank bunged nearly ¤500 billion of cheap funding into the coffers of European banks but the underlying uncertainty persists.

Will it be resolved in a disorderly manner, with the eurozone disintegrating, or will EU leaders, the European Central Bank and the International Monetary Fund find some way of muddling through? Or could the euro could survive but with not all its members staying the course? This is something I have long thought likely, if not now then at some stage.

Any of these things are possible but tucked in there somewhere is a very nasty outcome for the eurozone and Britain, what I shall call scenario one, which would see banking crisis and recession return with all the intensity of the autumn of 2008. It should not happen - it should not be allowed to happen - but that is no guarantee it will not.

It is also impossible to ignore. You can split the outlook for this year into one based on fundamentals, which I shall set out below, or you can think about what might happen if we get a re-run of the blind panic of three years ago. As happened then, that would sweep any fundamentals aside.

Before we get too depressed, however, is anybody actually predicting scenario one? They may be doing so in private but publicly available forecasts for the economy say not. According to the Treasury’s compilation of independent forecasts released just before Christmas, the gloomiest, from Standard Chartered, is for the economy to shrink by 1.3% in 2012.

That would be bad news, guaranteeing a substantial rise in unemployment, a worse outlook for the budget deficit and a huge political headache for the coalition.

It would, however, be a far cry from the recession of 2008-9, when gross domestic product (GDP) fell by a cumulative 7.1%. A new recession on the Standard Chartered scale would be more of an aftershock than a dangerous and damaging slide. And remember, they are currently the gloomiest.

Forecasters may be wrong, of course. But most are assuming that the eurozone will be more of a running sore, admittedly a very troublesome one, than a couple of broken legs.

That leaves us with scenario two. We will not know how the economy did in the final quarter of 2011 until January 25 but the assumption is not very much. Either GDP will be flat, or it will have dropped by a little bit, or it will have risen slightly.

And, it seems, we are due for a few more months of this, until roughly the middle of the year. There is nothing to suggest, barring euro armageddon, that the economy is about to fall off a cliff. There is nothing to suggest either that it is about to burst into life.

In scenario two, exports remain adversely affected by the eurozone crisis, even if it does not descend into outright chaos. Businesses are cautious about investing and government spending is being cut.

The economy in these circumstances needs the consumer - how can it not need the two-thirds of GDP contributed by consumer spending? Such spending has been unusually depressed; more so at this stage of the recovery than ever before.

The mechanism for lifting it, and the spirits of consumers, is the restoration of growth in real incomes. That will come, as I have noted before, only when inflation falls far enough. If the Bank of England is right that will come in the second half of the year. Standard Chartered, for all its short-term gloom, expects inflation to be down to 1.7% by the fourth quarter.

Falling inflation, and hence rising real incomes, will be the trigger for stronger growth in domestic demand. With luck, the same starting-gun that gets Usain Bolt away in the 2012 Olympics will fire consumers up too.

Growth is unlikely to be spectacular. The 2012 consensus lurched downwards between November and December, no doubt partly as a result of the Office for Budget Responsibility’s 0.7% forecast. Nobody likes to be above the official forecaster so the new consensus is 0.6%.

I would expect something a little stronger, but closer to 1% (as in 2011) than 2010’s 2.1% expansion. More importantly. however, if this view is right, the tone will be different.

So, while 2011 was a year that started with growth hopes high and then saw them fade, 2012 should be a mirror image. With luck we would be looking forward with optimism to the sunnier climes of 2013 and beyond.

So which scenario will it be? Both are possible but if I had a spare ten shillings I would put it on the second. I would give scenario two a 75% to 80% probability and euro armageddon 20% or 25%. That is too high for comfort, and puts the onus on eurozone leaders to maintain the pressure for a solution to the crisis that lasts beyond the next summit. But it may be as good as we are going to get.

Sunday, December 25, 2011
A year of struggle for growth against high 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.

The eurozone crisis has provided a scary backdrop to every column I have written here over the past 12 months, as has the ongoing and rather sterile debate about whether the government should stick to its “Plan A” or opt for a “Plan B”.

The answer to that, of course, is that in a ideal world the government would not only have a Plan B, but Plans C, D, E and F as well. But this is not an ideal world. Far from it.

To add some more letters to the alphabet soup, Britain’s AAA rating is hanging by a thread and, as we saw in the autumn statement, George Osborne is struggling to meet his self-imposed fiscal rules. I can predict with confidence and some trepidation that the Plan A/Plan B debate will go on in 2012. The question of whether Britain clings on to that AAA rating will be a live one.

But the big theme of 2011 was one of disappointment. An economic recovery that started very well slowed markedly. As I always say, we should treat the Office for National Statistics’ (ONS) first guesses about gross domestic product with some caution. The figures will be revised.

The picture we have now, however, taking the ONS’s latest numbers, is of an economy that grew by 3% in its first 12 months of recovery - from the third quarter of 2009 to the third quarter of 2010 - but slowed to just 0.5% in the latest 12 months, up to the third quarter of 2011.

A better way of looking at it, perhaps, is by reference to calendar years. In 2010, Britain grew by a respectable 2.1%, the ONS now says. A year ago my expectation, and that of most independent forecasters, was that we would see something similar, that is growth of about 2%, in 2011.

This time last year the Treasury’s monthly compilation of independent forecasts showed an average expectation for 2011 growth of 1.9%, with the newest forecasts slightly more upbeat at 2%. One or two forecasters were positively glowing with optimism, predicting that the year’s growth rate would be 3% or more.

The disappointment is reflected in the latest assessment by independent forecasters, taken from the Treasury’s latest compilation published a few days ago. Now the assessment is that the economy grew by just 0.9% in 2011, less than half the 2010 rate, and half what was predicted by the consensus a year ago.

How worried should we be by this? It is not hard to think of reasons why we should be concerned. The eurozone crisis, of which more next week as I look forward, has hit confidence, particularly among businesses, as well as exports, and is far from resolved.

The issue of weak bank lending - the practical impact of the hangover from the banking crisis - remains with us. Despite the chancellor’s imaginative plan to launch credit easing, lending to small and medium-sized firms has been falling on an annual basis since early 2009 and continues to do so.

Some of the one-offs of 2011, such as the Japanese earthquake and tsunami and its impact on manufacturing supply chains worldwide, will one hopes not be repeated. But there will be other shocks, and there will be other repeat factors like additional bank holidays to celebrate royal milestones.

When an economy is strong enough it tends to shrug off such special factors. The fact that there was a response this time - latest figures show the economy did not grow at all in the second quarter - shows an underlying fragility.

The government’s fiscal tightening - its Plan A - clearly had an impact on growth during 2011. The Treasury would point out that there was also such a tightening during 2010 and so this alone does not account for the growth disappointment.

It is a fair point, though perhaps the nature of 2011’s changes, the Vat hike at the start of the year to a new high of 20% and April’s increases in national insurance contributions, brought home to people the fact that we are all in this together when it comes to cutting the deficit.

The big explanation for 2011’s growth disappointment, however, was the squeeze on real incomes - and to a certain extent business margins - from high inflation. Some of that was due to the Vat hike. Most was not.

A year ago, when we knew about the Vat hike, the consensus among forecasters was that consumer price inflation in the fourth quarter of 2011 would average 2.8%. In the event it has been roughly two percentage points higher.

That makes the difference between a mild squeeze on real household incomes and a savage one. The Office for Budget Responsibility says 2011’s drop in real incomes was the biggest in the post-war era. It made the single biggest difference to economic growth, turning the prospect of a dull but respectable recovery year into a disappointing one.

Without high inflation, growth of 2% would easily have been in reach in 2011. As it is, consumer spending has never been so depressed at this stage of a recovery.

Could anything have been done about it? I started the year thinking the Bank of England would have been wrong to accede to pressure for higher interest rates, given that the die for 2011 was already cast.

But Andrew Sentance, before he left the monetary policy committee (MPC), made a persuasive case that some of the factors that appeared to be beyond the Bank’s control could be influenced. In particular, to the extent we were suffering from high imported inflation, the Bank’s actions - by bearing down on the pound - exacerbated the problem.

So for a time we appeared to be moving towards a rate hike. Three MPC members voted for it and others seemed ready to join them. By the end we had gone full circle, with the Bank opting to resume quantitative easing.

Though I was rather uneasy about that, the proof of the pudding will be whether it is seen to be supportive of growth during the next few months and whether, as the MPC believes, inflation will fall very sharply in the coming months. That, as I shall discuss next week, has to be the hope.

Sunday, December 18, 2011
Inflation fall should start to ease the misery
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.

Many will be familiar with the Phillips curve, the economic relationship defined in the 1950s by Bill Phillips, a New Zealander who came to the London School of Economics after a dreadful time in a Japanese prisoner of war camp.

His relationship - when unemployment is rising, wage rises (and therefore inflation) will fall- was both logical and simple. It was subject to subsequent revision, most notably by Milton Friedman, but it remains central to policy thinking.

The reason the Bank of England expects inflation to fall is because of spare capacity in the economy. Unemployment, of course, is the human side of spare capacity.

For some time, however, the relationship between unemployment and inflation has seemed to go awry. Inflation has risen for most of this year alongside an increase in unemployment. Much more of that and people would seriously talk of stagflation.

Now, however, normal service is being resumed. Unemployment is rising, the rate for the August-October period was 8.3%. Inflation is falling, and on the consumer prices index measure has dropped from 5.2% to 4.8% in the past couple of months.

That should be the prelude for a much bigger fall in the coming months, notably as January's Vat hike drops out of the annual comparison. Spencer Dale, the Bank's chief economist, said last week that inflation should be in the "low threes" by March. Weaker growth in China, India and other emerging economies is putting downward pressure on commodity prices.

It is important inflation does fall, both to ease the squeeze on real incomes and for the Bank's credibility. It will also be significant in other ways. Inflation affects everybody while unemployment, or the fear of it, affects only a minority.

Even so, it is appropriate to think of the misery index: the unemployment rate plus the inflation rate. The index has risen this year to its highest since the early 1990s - higher than the recession proper - making us all feel thoroughly miserable.

Now, even if unemployment continues to rise, as is likely, it should be more than offset by falling inflation. We will not be happy in the coming months but we should be a little less miserable.

What of unemployment? A month ago we had some genuinely bad unemployment figures. The wider Labour Force Survey measure, having been stuck at 2.5m for two years, rose to 2.622m. Employment fell sharply over the summer.

The latest numbers were not nearly as bad. The new total, 2.638m, was up by a modest 16,000. The monthly claimant count rose by a tiny 3,000. Yet the way they were reported, you might have thought both sets of figures were equally awful.

Some newspapers laid the gloom on with a trowel while the BBC talked of “another leap” in unemployment. No self-respecting salmon would describe it as a leap. Unemployment will rise further but we should not overdo the gloom.

Indeed, something interesting is happening in the data. A month ago, so bad were the figures I thought we would see a sharp fall in both public and private sector employment in the third quarter.

Sure enough public sector employment fell, by 67,000, but private sector employers added 5,000 to payrolls. In the past 12 months public and private have roughly balanced out, a fall of 276,000 in the public sector and a private sector rise of 262,000.

Something else has been happening and on the face of it is rather surprising. In the latest three months the number of self-employed people rose by 166,000 to 4.14m, the highest since records began in 1992.

I wrote last month that we are entitled to be a little suspicious of strongly rising self-employment at a time of weak growth, the suspicion being that it is involuntary rather than a spontaneous outbreak of entrepreneurial spirit.

The statisticians have investigated this and found the new self-employed include the young, the old, some who have left employment but also some who were economically inactive but have set themselves up as self-employed. So it is widely-based.

I wonder, too, whether something else is happening. The public sector is more than meeting expectations for cutting headcount. There is a well-known phenomenon in central and local government, which is that people are made redundant and then re-hired as a self-employed contractors.

It is possible we are seeing some of that in these numbers, so the drop in the public sector headcount exaggerates the squeeze. It would help explain both some of the rise in self-employment and why public sector job cuts have been so much bigger than the Office for Budget Responsibility expected.

Finally, an aside. Given Britain’s financial services sector has been in the news, how important is it? The City UK, which represents the industry, claims financial and professional services together account for 14% of gross domestic product and employ nearly 2m. That, however, includes many in professional services who have nothing to do with finance.

More often it is claimed, including by letter writers to The Times, that financial services are 10% of GDP. That, however, is too high. According to the ONS, the 2008 weight of financial services and insurance in gross value-added was 8.9%. Since then the sector has suffered a bigger decline than the economy as a whole, so its contribution in 2010 was nearer to 8%.

Financial services and insurance employ 1.1m people, according to the ONS. The insurance industry has nearly 300,000 employees, the Association of British Insurers says, leaving roughly 800,000 in financial services alone. If we assume a similar split in terms of contribution to GDP, that suggests financial services are closer to 6% of GDP, perhaps 7% at the outside. That fits the more detailed ONS data.

Financial services are important, and Britain does well exporting them. But they are no more than half the size of manufacturing. Perhaps David Cameron's next veto should be to protect British industry.

Sunday, December 11, 2011
Eurozone rescue rests on shaky 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.

I am not going to add much to the thousands of words on David Cameron’s tactics in Brussels. But, if John Major could claim “game, set and match for Britain” (not necessarily accurately) 20 years ago at the Maastricht negotations, this was more: “It’s my ball and I’m taking it home.”

It is not obvious the prime minister’s veto will be of benefit to the City of London, whose interests he was keen to protect. A grouping of 10 euro “outs” with Britain as its leader might have been viable. One lonely objector out of 27 is different.

It points towards a looser relationship between Britain and the rest of the EU, a free trade relationship, though achieving it will be easier said than done.

Establishing the regulatory paraphernalia that goes with the single market is easier than dismantling it. Can Britain stay in the EU? Yes, but as the equivalent of a social member at sports clubs, not allowed to participate in most events.

Many in Europe, of course, see Britain as part of an Anglo-Saxon conspiracy seeking to derail their project. So the occasionally harsh judgments of the City on euro rescue efforts are of a piece with last week’s threatened downgrade of most EU economies by Standard & Poor’s, the ratings agency.

The fact some of us have a pretty low opinion of S&P, which seems to think its pronouncements are great publicity coups, is neither here nor there.

What of the deal struck by EU leaders in Brussels on bolstering the euro? It was probably as much as could have been expected. Angela Merkel has acceded to the idea of fiscal union, though she means enhanced discipline over euro members rather than a genuine pooling of debts and deficits.

The deal, limiting “structural” budget deficits of eurozone members to 0.5% of gross domestic product, imposing fines on those whose deficits exceed 3%, accelerating the permanent European Stability Mechanism and making available an extra 200 billion euros in firepower, makes sense as a resting place for the eurozone.

We have to get from here - big budget deficits and tough austerity programmes - to there. Comments by Mario Draghi, the president of the European Central Bank, left open the question of how much the ECB will be smoothing that journey.

We will see what happens in the coming weeks. My sense is that markets are suffering from crisis fatigue and will give the deal the benefit of the doubt for now. But nobody can pretend the crisis ends here.

What is the underlying problem? In introducing the Bank of England’s financial stability report a few days ago Sir Mervyn King rehearsed a familiar line.

The eurozone crisis, he said, was all about imbalances. Some members have big payments surpluses, others have deficits.

As he put it: “Governments will have to confront the underlying causes. A loss of external competitiveness in some euro-area countries has led to current account imbalances and large build-ups of private and public debt, much of it external. The problems in the euro area are part of the wider imbalances in the world economy.”

Hearing that I thought it was a brilliant summation of the problem. Then I thought there must be more to it. Imbalances are like the hunchback of Notre Dame’s “the bells”. They ring so loud they can make you deaf to everything else.

Emphasising global imbalances, whether for China, America or Europe, sounds like a counsel of despair. They have been around for decades. In an ideal world, they would not exist. In the real world they do. No system can deliver perfect balance.

I am not attacking King for being unduly gloomy. It would be alarming if he were suddenly cheerful. It is known in the Bank there are three distinct views: the optimistic, the gloomy and the governor in the corner with a dark cloud over his head.

The point is that the imbalances story does not fit the eurozone that well. True, countries like Germany, the Netherlands and Austria have big surpluses, while Spain, Portugal and Greece have deficits.

True, some countries went into the crisis with a lethal combination of big budget and current account deficits. That applied particularly to Spain, Portugal and Greece. Things, however, have moved on.

Ireland is already back in current account surplus, which did not prevent another tough austerity package last week. Every other eurozone country is correcting its external balance, says the OECD.

Greece, having had a 15% current account deficit in 2008, will be down to just over 5% in 2013. Portugal goes from 13% of GDP to less than 2% and Spain from 10% to 2%. France has a small current account deficit of just over 2% of GDP. Italy’s is 3.6% this year but falling to less than 2% in 2013.

As an aside, my long-time forecast of Britain returning to current account surplus is backed by the OECD, which sees surpluses for 2012 and 2013. Trade figures on Friday showed a sharp improvement.

The issue for the euro is not imbalances but what lies behind them. Nobody would claim Britain’s return to surplus, should it occur, is the sign of a healthy economy. It is happening because of depressed activity.

What is true for Britain is also true for the eurozone. Imbalances are narrowing because of extremely depressed conditions. Weak demand as the eurozone slides into recession is shrinking the imbalances.

The big long-term question, and this takes us back closer to King’s point, is whether eurozone members can claw back the huge loss of competitiveness they have endured since the euro came into being.

Since 2000, German unit labour costs have risen less than 5%. France’s, in contrast, are up 25%, Spain’s more than 30% and Italy almost 40%. Greece and Ireland have clawed back some lost competitiveness (but with a huge gap to close). Most countries will not begin to close the gap in the next two years, according to the OECD.

That, beyond the short-term rescue, is the long-term issue. Is there a mechanism for countries to grow their way out of trouble — and prevent debt from rising inexorably — while remaining in the euro?

I am not sure there is, or that it is in the gift of politicians to bring it about. The agenda in Brussels was about keeping the euro together, with or without Britain’s help. Call me Anglo-Saxon, but there will surely be future summits where talk turns to how to manage the exit of some eurozone members.

Sunday, December 04, 2011
Gloom takes Osborne closer to the edge
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 the past few days we have had lost decades aplenty, apocalyptic warnings from the Bank of England governor, collective action by central banks to stave off a global liquidity crisis and a general sense of impending gloom.

People want to know, understandably, what it all means. For me it means we are looking at growth which is at best negligible over the next few months, followed by the beginnings of somewhat stronger growth in the second half of 2012.

But that path takes us past a dangerous hazard labelled “eurozone elephant trap”, the one we fall into if Sir Mervyn King’s warnings about inaction come about. And if we fall into it, no amount of contingency planning would save us from a nasty recession, possibly worse than 2008-9.

As if George Osborne did not have enough on his plate, he had to cope with people comparing him with Gordon Brown, because his Autumn Statement contained so many “tinkering” measures. I don’t suppose the former prime minister was too happy either.

I think it was a bit unfair, though some people remain keen to turn Osborne into Denis Healey, the Labour chancellor who tried to spend Britain out of recession in the 1970s, only to be forced to turn to the International Monetary Fund for a rescue.

As it was, had Osborne merely presented gloomy economic and borrowing forecasts without some compensating growth ideas, he would rightly have endured a political pummelling. Credit easing (getting more money flowing to small and medium-sized firms) and additional infrastructure spending are not “game changers” as the Treasury would have us believe but they are useful steps in the right direction.

Where the Osborne-Brown similarity works is that both of them have had to repeatedly admit that they were too optimistic on growth and borrowing. Brown’s optimism left an uncomfortable legacy for Alistair Darling and for the coalition.

Osborne’s retreat from earlier optimism could have more serious consequences for him. He cannot afford a further deterioriation.

This time he only met his fiscal rules by the flimsiest of whiskers, and only as a result of telling the independent Office for Budget Responsibility (OBR) that he would cut public spending in real terms for the first two years of the next parliament.

If the outlook for borrowing were to get worse, the chancellor would either be forced to pile austerity on austerity, by announcing further measures, or lose Britain’s AAA credit rating. This, already under closer scrutiny since the autumn statement, could easily go. If it went, Osborne would be honour-bound to go too.

Let me offer a couple of correctives to the gloom, not forgetting the elephant trap. The Institute for Fiscal Studies is marvellous and you criticise it at your peril. I think, however, it laid it on a bit thick with its “lost decade” (and more) for real household incomes. Paul Johnson, its director, said real median household incomes would be no higher in 2015-16 than in 2002-3, to which one can only say “Ouch!”

That is true on one measure. If we look at real household incomes in aggregate, however, the picture is less gloomy. It takes until 2014 to get back to the 2010 level of real incomes and the biggest fall - this year’s 2.3% drop - is behind us.

On a per head basis (the mean rather than the median), allowing for population growth, it takes longer: until 2016 to get back to 2009 levels, but short of a decade. Retailers who felt suicidal should come in from the ledge.

There were other elements of the OBR forecast that were less downbeat than
the headline-grabbers. The headlines were grabbed by the new forecast of 710,000 public sector job losses by 2017 (compared with a March forecast of 400,000 by 2016).

But the forecast is for these job losses to be more than offset by 1.7m of new private sector jobs. It also eventually expects growth to perk up quite well, hitting 3% before the next election.

The bigger question for the OBR, and the chancellor, is whether the watchdog has got a key technical call right. Back in April I wrote a piece on the importance of the output gap, spare capacity in the economy. It did not set many pulses racing.

It came to the fore, however, last week. Had the OBR come up with a different verdict on the output gap, Osborne’s strategy - eliminating the structural budget deficit by the next election - could have still been on course. There would have been no need for spending cuts beyond the next election.

So a technical judgment by the OBR, that there is just 2.5% spare capacity, has huge implications for politics, and for the hundreds of thousands more public sector workers whose jobs are now under threat.

The OBR, to its credit, runs an alternative scenario in which the economy has not been permanently damaged by the crisis and the output gap is 11% of the economy. Under those circumstances the deficit disappears as the economy grows.

That looks implausible. But 2.5% looks aggressively low. Every 1% reduction in the size of the gap increases the size of the structural deficit - which has to be tackled by spending cuts or tax hikes - by 0.7% of GDP, just over £10 billion.

The OBR points out that many forecasters have smaller estimates of spare capacity (though the OECD, National Institute and European commission are higher). It also notes that its estimates of spare capacity during the recession and its aftermath are historically high (though the latest recession was also much deeper).

This is hugely uncertain territory. The output gap is an economic concept that is almost impossible to measure. I share with Geoff Dicks, formerly of the OBR, the view that spare capacity is rather flexible, particularly in a service-based economy. It is easy to get people in to expand capacity in an estate agency or call centre and, as we know from the unemployment numbers, there are many people to get in.

I apologise for drifting into nerdy territory but this matters. The OBR’s judgment has consequences for people’s livelihoods. A watchdog would not be a watchdog unless its bites were occasionally painful. My worry is that, amid so much uncertainty, the OBR is inflicting additional and unnecessary pain on us.

Sunday, November 27, 2011
Osborne faces struggle to stay on the road
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 will be surprises in Tuesday's autumn statement; there always are. The full picture will only become clear on the day.

Nevertheless, some things can usefully be said. Gratifyingly, some of the things I have been banging on about here in recent weeks and months will see the light of day.

So, proposals to launch a “credit easing” plan for small and medium-sized firms, are a direct response to the recovery-destroying fall in lending to this vital sector of the economy, which has been happening for the past three years.

The plan will draw upon the success of Germany’s KfW (Kreditanstalt für Wiederaufbau) and an existing European Investment Bank model, the government using its credit rating to access funds at low rates, which will be channelled through the banks to smaller firms. The scheme will not provide a full solution to the lending famine but is a step in the right direction.

The other is that, having denied it would do so, the Treasury has relented on capital spending. A feature of the spending plans the coalition inherited from Labour, to the extent they were detailed, was the savage cut in publicly-funded capital projects.

My suggestion was that the government should use the savings on debt interest (from low gilt yields) and by trimming some current spending to boost capital spending. That will happen, a £600m building programme for new free schools being one element of it.

The bigger long-term prize, tapping into the vast billions in pension and insurance company funds to privately finance much higher levels of infrastructure spending is also creaking into action and memorandums of understanding are being signed.

As well as these, we had the housing strategy, of which more below. Vince Cable, business secretary, unveiled what his department describes as the most radical employment law reform in decades, including an overhaul of employment tribunals and easing unfair dismissal rules. Nick Clegg, the deputy prime minister, gave us a £1 billion employment and training subsidy for young people.

Why the flurry of pre-announcements and well informed leaks? One possibility is that the chancellor has something so big to announce on tax on Tuesday that the decks had to be cleared. Some accountants have been warning of a tax shake-up, though the Treasury has been guiding against it.

The other is that the government expects this week to be so dominated by the Office for Budget Responsibility’s (OBR) downgrade of growth, and its expected warning that the fiscal rules are at greater risk of being broken, it might as well get some coverage for these other announcements while it can.

In March the OBR predicted 1.7% growth this year, followed by 2.5% in 2012. Both numbers now look too high; the consensus in new independent forecasts is 1% in each of the two years.

Though there are unlikely to be any surprises in the OBR’s forecasts, they will attract plenty of critical headlines. A gloomy forecast tomorrow from the Organisation for Economic Co-operation and Development will set the scene.

Though it has not happened yet, independent economists expect slower growth to impact on the public finances with the average forecast for public borrowing next year, 2012-13, £112 billion, against the OBR’s March prediction of £101 billion.

Carl Emmerson, deputy director of the Institute for Fiscal Studies, expects the OBR to say there is a better-than-even chance of balancing the current budget deficit (adjusted for the cycle) in 2016-17, the new target year, and for debt to be falling as a percentage of GDP by the end of the parliament.

John Hawksworth and his colleagues at Price Waterhouse Coopers sketch out three scenarios. In PWC’s main scenario, with a couple of years of 1% growth, followed by a pick-up, Osborne meets his rules; and does so comfortably in its optimistic scenario.

Only in PWC’s pessimistic scenario, in which the economy goes back into recession next year - a flavour of which we may get from the OECD - are the targets missed badly. Though the deficit goal is cyclically adjusted, a recession would knock it off track. Debt would be rising as a percentage of GDP by the parliament’s end.

The economics of this sound dry but the politics of such an outcome would be explosive. Even viewed in the light of PWC’s main scenario, Britain’s public finances remain in a poor state, though we should not ignore the fact that progress has been made.

It seems longer, but it was only two years ago we were waiting for Alistair Darling’s final pre-budget report. The budget deficit was going from unbelievably awful to completely disastrous. Darling said it would be £178 billion in 2009-10, falling only slightly to £176 billion in 2010-11, before dropping to £140 billion this year, 2011-12.

Though growth has been weaker than the Treasury expected, the deficit has been lower: £156 billion in 2009-10, £137 billion in 2010-11 and it appears to be on course for £122 billion (the OBR forecast) this year.

Over three years borrowing is expected to be nearly £80 billion less than predicted two years ago. Partly that is coalition policies. Mainly it is due to the tendency of economists to underestimate the scope for the public finances to improve in a growing economy.

There, of course, is the rub. For all the flurry of activity, there is not much the government can do about growth in the short-term, and I can predict with confidence two things that will happen on Tuesday.

The Plan B brigade will urge a fiscal stimulus, despite the OBR’s view that there is zero room for manoeuvre. After years when the consensus was that fiscal fine-tuning did not work, it is suddenly regarded by its proponents as the greatest thing since sliced bread. It never was.

The other predictable response will be from Britain’s equivalent of America’s Tea Party, young men of the right, who will criticise Osborne for presiding over a rise in debt. In March, to their horror, the OBR predicted a rise in public sector net debt from £909 billion in 2010-11 to £1,359 billion in 2015-16. This week’s figure will be higher.

This, however, is the way it has to be. You cannot go from a deficit of £156 billion, 11% of GDP, to zero overnight and it is economic illiteracy — of the kind that caused America’s debt deadlock in August — to suggest you can. Borrowing is being reduced; the most you can do on debt is slow its rise.

Sunday, November 13, 2011
Breaking up the eurozone is hard 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.

The eurozone is like a patient with a long-term illness. It has good and bad days. The last couple of days have been quite good, with a new prime minister in Greece and the end of Silvio Berlusconi in Italy. But the bad days will return.

One of the questions I get asked most often is why, if the eurozone is in such a terrible state, the euro is still so strong, particularly against the pound?

Sterling has perked up to the giddy heights of 1.17 in the light of Italy’s deep woes. But if I tell you it was briefly above 1.70 not long after the single currency’s birth 12 years ago, and just short of 1.50 when the global financial crisis broke in summer 2007, the fall from grace is clear.

Sterling is at least 10% below what any measure of fair value would suggest. The euro is also stronger than it should be against other currencies.

Why is this? When it comes to the pound, there is a good argument that it has been a victim of deliberate neglect. Every time it has threatened to recover to any degree, the Bank of England usually does something dovish to knock it back down.

That cannot, however, explain it all. It seems the currency markets regard the euro as greater Germany, while the bond markets see it as a Greek-Italian venture.

What do the currency markets know? They appear to be assuming, despite the brinkmanship among eurozone leaders over first Greece and then Italy, that an implosion - to the extent we have not already had one - will be avoided.

What that means is providing a eurozone bazooka big enough to persuade the markets they should lay off betting against the government bonds of Greece, Italy, Portugal, Spain and the others.

Since the proposed bazooka, expanding the 440 billion euro European Financial Stability Facility to an effective 1 trillion, is in considerable difficulty, the European Central Bank would seem to hold the solution in its hands. It, like all central banks, has the ability to expand its balance scheet, creating money, buying every troubled-economy bond under the sun, and also to swamp the system with liquidity.

To be able to use it, however, first requires a lot of swallowing of German pride and principles. Germany does not want the ECB to do this and neither do most people at the central bank. The assumption, however, is that if the alternative is armageddon, it will happen.

Such a solution cannot solve the euro’s fundamental problem. Instead of being a finely-honed grouping of similar and converged economies, it is a ragtag collection of dissimilar and divergent countries.

“It is clear that the eurozone will remain an unstable, crisis-prone arrangement unless critical steps are taken to place it on a more sustainable institutional footing,” write Simon Tilford and Philp Whyte in a hard-hitting essay for the pro-EU Centre for European Reform.

They argue the eurozone has to go part of the way towards fiscal union by means of debt mutualisation, or eurobonds, all members issuing bonds jointly guaranteed by the others. They are also sceptical about whether it will ever happen.

Which brings us to break-up. Reports last week that France and Germany have been quietly exploring the possibility of a smaller, “core” eurozone pricked up the ears of currency traders last week. In the short-term they expect muddling through, in the long-term they expect a stronger, narrower euro to emerge, which is why they have not been dumping the currency.

I have a lot of sympathy with this, having long argued that the euro would survive but with fewer members. Those who can live with Germany will do so, while others will be forced to go elsewhere. Before anybody worried about Greece, I had thought Italy was the weakest link.

The question is how you get there, or at least how you get there without huge fiscal and financial consequences.

UBS, in a research note, said a country exiting the euro would face “corporate default, collapse of the banking system and collapse of international trade”, a hit of 40% to 50% of gross domestic product in the first year. Not only that, “almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war”.

HSBC, in other research, warned: “Keeping the eurozone together will involve huge financial resources and considerable ingenuity. The alternative would be worse. A break-up of the euro would be a disaster and in a worst-case scenario could trigger another Great Depression.”

In the Financial Times Robert Jenkins, external member of the Bank of England’s interim financial policy committee, set out in gory detail the consequences of just a Greek exit, one being that “bank lending across the European Union ceases”.

So it seems to be a catch-22. We can’t live with the euro as it is, it seems, but we can’t live without it either. Or at least we can’t easily get to the point where the euro has fewer members and is sustainable.

People are right to be concerned. The eurozone is experiencing an aftershock of the global crisis so powerful it threatens to exceed that of the crisis itself. It comes when structures are already weakened.

There is no doubt that the short-term consequences for countries leaving are serious. Money would flood out of the country, the banks would take a huge hit, the new drachma, or lira, in people’s pockets would not be worth as much as the euro it replaced. For a while, countries that left would become bond market pariahs and need help from the International Monetary Fund, which would need every penny of the additional resources it can get.

I cannot believe it is impossible, however, particularly if the alternative involves struggling along with a flawed system. There is more to leaving the euro than devaluation in a fixed-currency system of the kind Britain undertook in 1949 and 1967. The challenges, though, are of a similar nature.

The parallels are not exact but some have recalled John Major’s words six days before Britain was forced out of the European exchange rate mechanism (ERM) in September 1992. “The devaluer’s option” would not be allowed to happen, he said; it would be “a betrayal of our future”.

It was not. And nor would it be a betrayal of the future of Greece, or for that matter Italy, to decide it was better to have a relationship with the euro - with their own currency - rather than be in it. These things are difficult. They are rarely impossible.

Sunday, November 06, 2011
Slowing China won't rescue the eurozone
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 was in China for much of last week, watching the eurozone crisis unfolding from a safe distance. There have been many contenders but this was the eurozone’s worst week. Greece’s on-off referendum may have all been about domestic politics but it also called the bluff of Angela Merkel and Nicolas Sarkozy.

They, for the first time, accepted that the departure of a member country was possible, indeed could be brought about by a democratic vote. Their tactic may have been intended to stoke up the pressure on the Greek people but it let the cat out of the bag. There is no such thing as a permanent, irrevocable monetary union.

All those learned pieces saying euro break-up was not possible because there was no mechanism for it were as daft as they always seemed. In desperate circumstances, governments do desperate things, whether treaties allow them to or not.

As for the G20 in Cannes, tasked six weeks ago by George Osborne with saving the world, it was the dampest of summit squibs. The one decision, to increase the resources of the international Monetary Fund, has been signalled so often that you believe it when you see it.

The “grand plan” agreed in Brussels 10 days ago is no clearer on the detail of how the rescue fund, the 440 billion euro European Financial Stability Facility, will be boosted to 1 trillion. The Greek shenanigans have taken us further from that.
What the past week has given us is a glimpe of the kind of disorderly break-up the euro could face when democracies are stretched to breaking point by protest and even big debt writedowns solve nothing.

I am all for an orderly reduction in euro membership, having argued a Greek exit, properly handled, is the best outcome. The key is “if properly handled”. That means successfully ringfencing other vulnerable economies and gaining market confidence. It is hard to have any confidence in the ability of eurozone leaders to achieve this.

So the eurozone, which the new president of the European Central Bank (ECB) Mario Draghi conceded is heading into “mild recession” (which could be a highly optimistic forecast), remains the big threat to the world and to Britain. The ECB cut its key interest rate from 1.5% to 1.25%.

The crisis will run and run. As things stand, it is no nearer resolution than it was in May 2010, the first Greek rescue.

I mentioned I was in China. One issue I was exploring was whether the country would be the eurozone’s sugar daddy. Even before the question of Chinese assistance through bond purchases was kicked into the long grass by Greece, it was clear hopes were being unrealistically raised.

Seen from China, any decision to purchase eurozone assets will be done - as everything is done - in the national interest. If there is a case in terms of diversification of reserves or because the return is attractive, China may act. There is no question of a modern version of Marshall Aid. China may be the world’s second largest economy but its 1.3 billion people remain poor, on average, by Western standards.

Not only that, China has her own problems, the other thing I was keen to explore. There is no shortage of pessimism about China, inside and outside the country. Analysts point to a property bubble bursting and an inflation problem disguised by official figures. Some hedge funds have done well betting against China.

China is attracting some colourful analysis. Albert Edwards, Societe Generale’s super bear, says China’s economic situation is “precarious”, “a credit bubble waiting to burst”. A soft landing is, he says, “surely yet another pyramid of piffle”.

Charles Dumas and Diane Choyleva of Lombard Street Research, in a new book The American Phoenix (which is upbeat about America), say China’s “red-hot” economy will slump in the remainder of 2011 and 2012. Its model of export-led growth, they say, has broken down.

How seriously should we take this? When you visit China, the story is familiar. The pace of development is blistering, cities expanding upwards and outwards. The anecdotes about money badly spent on shopping malls, roads, railways and other infrastructure projects are legion.

So is the fact that, while a growing Chinese middle class has never had it so good, life for the majority is tough, sharply rising prices making things uncomfortable.

China is still a fast-growing economy, however. Growth in the third quarter was 9.1% and so far this year 9.4%;. four times the rate, at least, of advanced economies.

Bearishness about China is not new. Analysts have been calling an end to the China growth story for most of the 33 years since it embarked on its reform-based revival, a period that has seen growth close to 10% a year. So far they have been wrong.

China is different. Even before the global crisis, there were worries about non-performing loans in China’s banks, a property bubble and debt hidden in local government and state-owned firms. The fears are back but need to be put in perspective.

China still has an underdeveloped financial system. Mortgages are only about 14% of GDP. There is not the leverage to cause advanced-economy type problems.

China also has the firepower most of the rest of the world can only dream of. It showed it three years ago by unveiling a $586 billlion fiscal stimulus and cutting interest rates and bank reserve requirements, instantly boosting credit.

More recently it has been raising rates and tightening reserve requirements, slowing the economy. But those moves could be reversed. HSBC says China is the least vulnerable of emerging economies.

So, piffle or not, it looks like a soft landing. Growth will slow, but to about 8% next year. The growth target under the current (2011-15) Chinese five-year plan is 7%.

Does Chinese growth matter for Britain? British exports of goods to China are growing, up an annual 15.9% in the latest three months, while imports from China fell 7.5%. But there was still a £5.49 billion goods deficit in the latest three months.

Britain sells other things to China. On my visit I gave a lecture at Nottingham University’s Ningbo campus. Education is an important and growing export to China, as are financial services, business services, civil engineering and so on.

We have an interest in China’s growth. We have a bigger interest in the eurozone avoiding disaster. You can be more confident about the first than the second.

Sunday, October 30, 2011
Eurozone deal won't stop growth taking a hit
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 1993, and Kenneth Clarke, the justice secretary, was chancellor. In the year after Britain’s humiliating exit from the European exchange rate mechanism (ERM), the system was on the point of collapse.

But Clarke, at a meeting of EU finance ministers, told them to pull themselves together and press ahead with monetary integration. The rest is history, though some would say Europe would be a lot better off if he had kept quiet.

Times have changed. These days EU leaders would never take advice from a British chancellor or prime minister.

That is partly because of their inexperience, partly the Tory attitudes towards Europe revealed in Monday’s Commons vote. But also because any goodwill towards Britain was lost in the years when Gordon Brown lectured them on how to run their economies.

So George Osborne and David Cameron were left wringing their hands and calling for something to be done. They are also left bemoaning the eurozone’s corrosive effect on Britain’s recovery. Are they right to do so, or are they covering for Britain’s home-grown problems? Has Europe done enough?

As it turned out, eurozone leaders came up with a version of the “grand plan” that has been circulating for some weeks and the markets, initially at least, liked it.

Whether intended or not, this was a good example of expectations management. Ahead of the meeting there were fears of no deal at all (though there always is).

The result, a beefing up of the European Financial Stability Facility (EFSF) to ¤1 trillion (£880 billion), a ¤106 billion (£93 billion) recapitalisation of European (but not British) banks and voluntary 50% haircuts on Greek debt, did enough to reassure.

Plenty of doubts remain, particularly over Greece and Italy, and over the details. The markets were perhaps a little too euphoric. The eurozone has been the biggest threat to the recovery, globally and in Britain. If there was an easy way out, the Next chairman Lord Wolfson would quickly be relieved of his £250,000 prize.

Time, however, is a valuable commodity. And the EU has bought it. Has it removed the threat to the rest of us?

Much of the sharp drop in business and financial market sentiment in the past few weeks can be laid at the door of Europe’s difficulties.

The CBI’s very gloomy industrial trends survey, published a few days ago, recorded the sharpest drop in business confidence since 2009, when the economy was in recession, and showed manufacturers expect a drop in output this quarter.

According to Ian McCafferty, the CBI’s chief economic adviser, confidence is “being sapped by uncertainty over developments in the eurozone, leading to broader concerns over global growth.”

If CBI members’ expectations of a drop in output in the current quarter turns into a generalised fall in economic activity, the drop in GDP that the monetary policy committee’s Martin Weale and Paul Fisher fear, the eurozone will be the proximate cause.

Despite the eurozone agreement reached in the early hours of Thursday morning. the downturn in the fourth quarter, certainly in the eurozone, possibly in Britain, is already baked in.

Both of the expected drivers of recovery, exports and business investment, have been affected by the eurozone’s problems. Investment has been undermined by fears of what the crisis might bring, while the sharp slowing in Britain’s biggest export market is taking its toll on trade.

Purchasing managers’ surveys for the euro area are this month below the key 50 level for the second month in succession, pointing to its economy being back in recession in the final quarter, which links directly to the pessimism among Britain’s manufacturers.

It is not all bad news on the trade front. Though export growth is slowing, the trade gap is also narrowing. In August it was £1.9 billion, just over half its level a year earlier. And, while not wanting to jinx it having some time ago predicted a return to current account surplus, the latest figures were also encouraging.

The Office for National Statistics is in one of its dramatic revision phases. As I have said before, this makes much of its data useless for short-term economic management. So we thought we had a current account deficit of £9.4 billion in the first quarter but that has now been revised down to £4.1 billion.

The second quarter deficit, £2 billion, was just 0.5% of gross domestic product. One difference between Britain and the problem hit countries of the eurozone is the absence of a serious current account problem. Greece had a deficit of more than 10% of GDP last year, while Portugal’s was just under 10%. Italy is on course for a deficit of more than 4% of GDP this year.

It would be wrong, however, to blame all Britain’s woes on the eurozone. Though consumer confidence has been pummelled, it would be unusual if British households were responding directly to events even as close as the other side of the Channel by reining back spending.

Thanks to the ONS’s revised numbers, we now have some rather different information on Britain’s households. This year was supposed to be the second in a row real household disposable incomes had fallen. But the new figures show, rather than falling by 0.8% last year, real incomes edged up by 0.1%.

The numbers do not change the broad picture of households not increasing spending in real terms. This, of course, has less to do with eurozone woes than high inflation, rising taxes and fear of unemployment, partly because of spending cuts.

But the ONS’s new numbers do show the previous picture - of consumers not spending but not saving either - was incorrect. The saving ratio in 2009 was revised up from 6% to 7.8%, while the ratio for 2010 is now put at 7.5%, up from 5.3%. In the latest quarter, the saving ratio was 7.4%.

What this tells me is that there is potential for a recovery in consumer spending, which after all is weaker at this stage of the cycle than in any previous episode. Consumers have quietly been putting their finances back into shape. When conditions are right they will spend more. Whether they will do so in time to make up for the shortfall in exports and business investment is the big question.

Sunday, October 23, 2011
An Irish alternative to high 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.

Unemployment is at its highest rate for 15 years and its highest level for 17. Inflation has matched its record high on the consumer prices index and is at its highest for 20 years on the retail prices index.

For followers of the misery index (the unemployment rate plus the inflation rate) this means only one thing; we have not been this miserable for 19 years. Some young people have never been.

So the Nationwide building society reported on Friday its consumer confidence index fell three points to 45 and is lower than when gross domestic product was falling. It is just above its all-time low in February, after the Vat hike to 20%.

The rise in consumer price inflation to 5.2%, and to 5.6% on the retail prices index, came less than a fortnight after the Bank of England had announced a further £75 billion of quantitative easing (QE).

The best way to think about QE is as the Bank does, the equivalent of cutting interest rates when there is no room to do so in the normal way. It calculated in its latest quarterly bulletin that the £200 billion of easing undertaken in 2009 was the equivalent of cutting Bank rate by between 1.5 and 3 percentage points.

The extra £75 billion, on this basis, is equivalent to a further 0.5 to 1 points off Bank rate. That the monetary policy committee did this unanimously ahead of figures showing inflation so far above the 2% target was either brave or very foolhardy.

Applying this relationship mechanically suggests monetary policy is operating with the equivalent of a Bank rate between minus 1.5% and minus 3.5%. It is a long time since monetary policy has been so accommodative or real interest rates (rates adjusted for inflation) so negative.

Sir Mervyn King gives four big speeches on the economy each year, together with the occasional television interview. I’ll come back to another aspect of his latest speech in Liverpool a little later, but on inflation, the content was familiar.

So, inflation is close to a peak and should soon fall significantly and, in any case, it is outside the Bank’s control. As he put it: “Domestically generated inflation remains subdued – and on some measures barely above zero. Increases in energy prices, import prices and Vat account for the current high level of inflation.”

And, while not spelling it out in this speech, his line is that to have kept inflation close to target would be by inflicting further pain on the economy. There was no realistic alternative, in other words. There would have been at least as much misery, though distributed differently between unemployment and inflation.

I would take issue with some of this. You cannot divorce import prices from the performance of the pound. Sterling’s fall, and the fact it has stayed down, has been a key element in Britain’s high inflation. The Bank has blessed a weaker exchange rate and by its actions ensured it is maintained.

High inflation is also a key factor in the disappointing recovery. Retail sales figures showed people spent an astonishing 5.4% more last month than a year earlier. If inflation were 2%, that would be consistent with a strong, consumer-led recovery.

Alas, high inflation meant all but 0.6% of the rise in spending was eaten up by rising prices. Stagnant real consumer spending is a consequence of inflation.

Was there an alternative? Interestingly, as Richard Ramsey, an economist with Ulster Bank points out, you do not have to go too far to find a country with a very different inflation experience in recent years.

Since August 2007, and the start of the global financial crisis, consumer prices in Britain have risen 15.5%. Average earnings have risen by only 8.8%, hence the squeeze.

In Ireland, in sharp contrast, consumer prices have risen less than 1% over those four years; 0.7% to be precise. This is a huge contrast. Even more surprising, as Ramsey points out, is some of the detail.

Some of those ‘impossible to avoid’ price rises in Britain have, in fact, been avoided in Ireland. Food and drink prices have risen by 28% and have been a major factor in sustained above-target UK inflation. In Ireland, however, food and drink prices are 0.7% lower than they were in 2007.

To paraphrase Dickens, this is a tale of two countries. Ireland had a much more serious recession, with a peak to trough fall in GDP of 12.6% versus 7.1% in Britain, as well as ratings downgrades and a rescue. Unemployment, at 14.3%, is much higher than the new 8.1% UK level. Because Ireland is part of the euro, there could be no independent devaluation of the currency.

Ultra low inflation is partly a consequence of Ireland’s economic weakness. Some of the country’s indicators are now moving in the right direction. GDP rose a strong 1.6% in the second quarter, after 1.9% in the first. Industrial production in August was over 11% up on a year earlier.

Ireland’s consumers are not making hay on the back of low inflation. Retail sales volumes are 3.6% lower year-on-year, partly because of high unemployment, zero (at best) earnings growth and higher taxes.

I do think, however, low inflation in Ireland stands the economy in good stead for the future. It is wresting back competitiveness in difficult circumstances and, while that adjustment has further to go, it provides an an example for the eurozone that default and exit are not the only options for troubled peripheral economies.

The Bank chose a different path. The latest MPC minutes spoke of a weaker growth outlook increasing the “margin of slack” in the economy, putting downward pressure on inflation and making it more likely it will undershoot the 2% target in the medium-term. Hence more QE.

I think this is a figleaf. There has been plenty of slack in the economy over the past four years but inflation has been high. There are mathematical reasons why it should fall next year but its path over the medium term will depend more on those factors the governor listed in his speech.

The Bank, with the government’s backing, has tolerated high inflation to prevent greater short-term damage to growth. That is fine, but it should be open and honest about that, rather than dress up all its decisions in terms of spare capacity and medium-term inflation. And whether this strategy is the right one for the economy in the longer-term I very much doubt.

Sunday, October 16, 2011
Building a jobs recovery from bricks and mortar
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 job market has performed remarkably well in recent years. Employment fell far less than expected in the recession, then recovered more strongly than feared when the economy turned up.

Unemployment appeared to be stuck at 2.5m, where it had been for the past two years. True, a drop would have been welcome, but at least it was not rising.

It did, however, rise last week, which was worrying. There was a 114,000 increase in unemployment, the biggest in two years, pushing the rate up from 7.7% in the March-May period to 8.1% in June-August. This was undoubtedly a weak set of figures, suggesting the private sector is not compensating for public sector job cuts.

Worse than the overall rise in unemplo