Charles Dickens Revisited – A sad Christmas story for the Brexit Era.

The Chancellor of the Exchequer, George Philip Scrooge, or GP to his friends, distantly related to Ebenezer Scrooge, was at home in No 11 Downing Street, on Christmas Eve, 2019, writing a paper for the Prime Minister on what to do about the British economy, following the departure from the EU earlier in the year. Deep down he admitted to himself that the only reason he was doing this on Christmas Eve was because he was lonely. All his parliamentary friends (not that he had many of them these days) had left Westminster to go home to their families and even his neighbour, the Prime Minister, had gone to Washington to spend time with her friend Donald and his Russian acquaintances. GP also knew that he was very unlikely to get a visit from Santa this year. Not only were most presents held up at Calais because of the delays caused by border controls, Santa was having difficulty getting permission to bring his reindeer into the country because of new regulations affecting animals entering the UK and, if that wasn’t enough, his friends and relatives blamed him for the higher prices caused by import tariffs imposed on goods from the EU.

Gradually, despite his interest in the Treasury’s latest macroeconomic forecasts and the excitement of looking at all the negative numbers they contained, he started to feel sleepy, very sleepy. The next thing he knew, the room was full of people all keen to talk to him. The first, who looked well over 100 yet was wearing a very trendy hoody with a large letter K on the front,  started to talk to him about the need to raise aggregate demand, by cutting taxes and raising government spending in order to offset the fall in consumption and investment which had occurred early in 2019 as the UK economy crashed out of the EU after Parliament failed to ratify Teresa May’s plan and the subsequent “People’s Vote” resulted in an almost dead heat when 50.5% of the voters opted for a No Deal departure from the EU. One of K’s friends, a Canadian called MC, asked what he should be doing about interest rates since he had people telling him to cut them to boost the economy while others, due to go off skiing in the New Year, told him to increase them to boost the value of sterling, which had slumped after the decision to leave and was now at parity with the dollar. K was not too bothered about interest rates – he kept going on about being caught in something painful called the liquidity trap.

As soon as K and MC stopped talking, a new American voice piped up, with the letter L on his back, suggesting that what was really important was not to listen to K and his friends but to focus on the supply side of the economy and, in particular, on increasing incentives to work and raising productivity in the economy. L was illustrating his ideas on a napkin, suggesting that taxes should be cut, therefore encouraging people back into work and explaining that this would be self-financing, since government spending on benefits would fall and revenue would increase as the newly-employed paid taxes and spent more, increasing VAT and corporation tax receipts.

Suddenly GP awoke from his nightmare and his unwanted guests disappeared.  “I need a holiday” he thought said to himself and grabbed his laptop to start searching for a short break. He gave up on Europe pretty quickly because of the permit he would have to buy to go to the EU. Although it was only 7 euros, these days, following the fall in the value of sterling, 7 euros was a lot of money. He started to look at breaks in the UK. Driving was out because of the rising cost of fuel after recent oil price rises and the fall in the pound so it had to be a train journey, until he remembered that Crossrail had not been finished, HS2 had been scrapped because of rising cost estimates and the rest of the network were not running between Christmas and the New Year.  Back to the Treasury forecasts and looking forward to Xmas Day with the Queen’s Speech, while eating a Gregg’s turkey sandwich for lunch.

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Life After Brexit?

Although we are no clearer about how, when or even if the UK will be leaving the EU, it is worth considering areas the UK government must address in order to make the best not of the next few months, but of the next decade.

Two months ago, in the World Economic Forum’s annual report on countries’ competitiveness, the UK slipped down two places to eighth out of 140, with the top places held by the USA, Singapore, Germany, Switzerland, Singapore, the Netherlands and Hong Kong. The WEF, best known for its annual Davos conference, takes a wide-ranging view of competitiveness, considering such things as infrastructure, macroeconomic stability, health, skills of the labour force, the financial system and the quality of universities.  Although the UK did well in areas such as workforce diversity and the quality of our legal institutions, we dropped down the table because of poor health provision and a lack of investment in ICT-related infrastructure and human capital.

Although the UK currently has record low levels of unemployment, our productivity (output per hour) compared to our competitors is low and this correlates with the WEF comments about our low investment in human capital. In the 1980s our productivity growth averaged 2.4% pa, in the 1990s it was 2.3% pa, in the 2000s it had fallen to 1.4% pa, largely due to the financial crisis, and, since 2010 it has averaged 0.5% pa. If we had been able to maintain the productivity growth of the earlier decades before the financial crisis, UK GDP would be about 20% higher than at present. However, despite all the attention paid to productivity in recent years, the situation might not be as bad as predicted. A recent OECD reports suggests that the UK has over-estimated the number of hours worked by not fully accounting, among other factors, for the increase in part-time work. Nevertheless, it still remains that if UK workers are to get richer, then the country must produce more, either by working longer or becoming more productive.

One area which will need addressing to boost productivity is research and development (R&D). Our R&D spending has been a lower proportion of GDP than many competing countries with the UK spending only 2/3 as much as a percentage of GDP as Germany, Japan and the USA. However the government has committed to increase this to 2.4% of GDP by 2027, up from 1.4% today, and has created a Productivity Investment Fund worth £31bn to assist. It has already committed £7bn with 600 projects receiving funds but there is still scope to increase this.

Another is business investment which, for the last twenty years has been among the lowest of OECD members, not helped recently by the uncertainty in the economy. From 1997 to 2017, gross fixed capital formation in the UK (capital expenditure by the public and private sectors, e.g. spending on factories, plant and machinery, transport equipment, software, new dwellings, and improvements to existing buildings and roads) averaged 17% of GDP pa compared to 21% in Germany and the USA and 25% in Japan.  It is particularly weak in the low wage sectors of the economy and, ironically, it is possible that a decline in inward migration might encourage investment in these sectors if the supply of cheap labour dries up in the future. Low corporation tax and generous tax allowances and grants will be crucial in boosting our investment but, as well as generous financial assistance, businesses will be seeking a guarantee that the tax regime  will be stable to allow them to plan for the future.

A third area which needs addressing is infrastructure. Although the UK has delivered some successful infrastructure projects (e.g. London 2012), our record is not good. Crossrail is likely to be delayed even further and cost more than predicted, estimates for HS2 are increasing and London airport expansion seems stuck in an eternal holding pattern. Not only does such investment increase our productive potential, it also creates a very powerful stimulus to aggregate demand since so much of the cost remains in the UK economy in terms of labour and raw material costs, creating a powerful multiplier effect. Note that while we have been considering expanding Heathrow’s airport capacity by one airport, China is aiming to increase its number of airports from 207 in 2015 to 260 by 2020. There is also a feeling that too much infrastructure has been focused on the South East and a recent development which might help to address the imbalance is the appointment of regional mayors. The seven current mayors argue that transferring more power and resources to them will increase growth and improve productivity in their regions. They want more control over public services including skills, training and apprenticeship services, and the programmes designed to help people get back to work. They also want greater control over how tax revenue is spent, rather than relying on Government grants and control over any regional funds set up to replace EU funding.

A final key area to address is the level of skills of the workforce. A variety of solutions have been proposed such as boosting STEM subjects, improving management training and improving the status and quality of vocational training. Technical qualifications have traditionally been seen as inferior to the more academic A’levels and degrees and the introduction of the Apprenticeship Levy, intended to increase the number of apprenticeships, coincided with a decline in their number. However the most recent data suggests that this fall is being reversed as employers become more familiar with the new scheme. With a likely decline in the number of skilled migrants entering the UK from the EU, this area will be key if the UK economy is to prosper over the next decades.

The UK’s current problems

Attention in the UK is focused heavily on Brexit and what might or might not happen in the next few months – will Mrs May’s deal get through Parliament? If not, will there be a new deal negotiated or will we leave with no deal? Will there be a second referendum or even a general election or both or neither? However it is worth looking beyond the short term and  considering the problems we face, many of which might have influenced the Brexit vote.

On a global scale, there is talk that another recession might be approaching (although to be fair, there is often talk of another recession approaching!) A possible cause is the rise in interest rates which have already happened in the USA and the UK and is likely to happen in the Eurozone during next year. The US rise has already started to cause problems for some emerging economies because money which moved into their economies as interest rates fell and QE reduced bond yields in developed countries, has moved into dollars to buy US government bonds or to be placed in interest-bearing accounts. In addition, the strength of the dollar has caused some emerging economies further problems since many of their loans and interest payments are denominated in US dollars. A further potential cause of a world slowdown is the decline in China’s growth rate. A growth rate in China of 6% adds the equivalent of Russia’s entire GDP to Chinese GDP each year so even a small slowdown has an impact on the world economy. There is a fear that, as China grows, the opportunities for continued, fast growth diminish so it becomes more difficult for them to rapidly expand. Nearer home, there is also concern about Italy’s high level of public borrowing and the possible implications of this for the euro.

In the UK, there has been much discussion about possible economic factors which influenced the vote in 2016.  One issue was the regional imbalance between London and the South East compared to the North of England, with the latter feeling that they were ignored by governments which focused their activities on the South. Infrastructure is poor in the North with lower transport per head than in the South, incomes are higher in the South with average London incomes being 2 ½ times those in the North East and, since 2010, London incomes have grown 20% while those in the North East have only risen 6%. Many Northern companies have moved their headquarters down to London and there has also been a move in skilled labour in the same direction.

Another issue was the falling real incomes which many workers have experienced since the financial crisis. Following the recession in 2008, average wages fell almost consistently in real terms until mid-2014. Although there has been some recovery, there are still major problems with poverty in the UK. The Joseph Rowntree Foundation reported this month that almost 4 million working adults were below the poverty line because their wages were so low, about half a million more than five years ago. This was based on the idea of poverty being people or families receiving less than 60% of the median income by household type (e.g. married with two children), adjusted for the cost of housing. The implication of their report was that, although unemployment has fallen significantly in the UK, many of the new jobs are low paid ones. (It is worth noting that these figures are not accepted by the government since they focus on relative poverty and uses a definition of poverty now updated).

A further issue has been the effects of a decade of austerity on voters. Not only is there increasing concern over the quality of public services (think train delays and NHS waiting times) but a recent report from the OECD points out that the % of GDP taken by taxation has risen to 33.3%, a 49 year high, and above countries like France (46.2%), Italy (42.4%) and Germany (37.5%), but below Japan (30.6%) and the USA (27.1%). The prediction for this year is that the tax burden will rise further and if correct, since 2009 the share of GDP taken by tax will have risen by 2.2% while the share taken by government spending will have fallen by 5%, hence people feeling that they are paying more but receiving less from the government. There has also been a perception that EU migration has imposed further strains on the economy – using the NHS, filling up schools, taking scarce housing, claiming Job Seeking Allowance and other benefits and taking jobs from UK workers (although these last two are contradictory!). The positive benefits of migration in terms of providing skilled labour and contributing tax revenue have not received the same attention.

While there is very little, if anything, which the UK can do to prevent the global problems mentioned above, it can take steps to tackle the issues specific to the UK. Solving these will place the UK economy in a much stronger position to withstand global shocks and to make the best of whatever Brexit outcome occurs and will be the focus of the next post.

A Brexit Update

It is now 23 days to Xmas and 117 days to Brexit on 29th March 2019. While one of these events is certain, the other is less so and this post looks at the Brexit picture in the run-up to the vote in Parliament on 11th December.

What happens in the vote is crucial. One possibility is that Mrs May wins but this is looking increasingly unlikely since there are two key groups likely to vote against her. Firstly, there are those seeking a “Hard Brexit”, such as the members of the European Research Group, on the right wing of the Conservative Party who are not happy with the way the deal ties us to Europe. On the other side are those who would wish to remain in the EU or seek the softest possible Brexit deal and might oppose it, hoping it will open up the possibility of a second referendum. If the government does lose the vote much will depend on the scale of the loss. It is possible that after falls in the value of sterling and of UK shares as markets take fright and, maybe, some small adjustments in the terms of the UK’s departure arrangements, (said by the EU not to be on offer), that there is a second vote and the government’s deal is accepted.

Alternatively, it could be that there is no majority for the current deal and this leads to Parliament opting for either a “People’s vote”, the UK leaving with no deal, a general election or the current or a new prime minister seeking a new agreement during an extended transition period. A “People’s vote” has difficulties – it is likely to take at least five months to organise and there will be significant disagreement over the question or questions to be asked. Is the choice between the current offer and no deal or should we include the possibility of remaining? Finally, what might the effect of a second referendum voting to remain be on those who voted to leave previously who were told that the 2016 vote was a “once in a generation” decision.

A no deal Brexit, whether adopted deliberately or drifted into is another possibility. The view of the KPMG Head of Brexit is that the government is not prepared for this and, while some sectors, such financial services, pharmaceuticals and the motor industry are ready for this, many others, particularly those dominated by SMEs (small and medium-sized enterprises) are not. A key area which the government will have to address is the transport of goods into and out of the UK. At present 17% of UK trade and 1/3 of our trade with the EU in goods uses the port of Dover. It is the shortest crossing, making it the cheapest and fastest way to import and export to nearby countries, particularly important for perishable products and those companies adopting ‘just in time’ production methods. It has been estimated that a 2 minute delay at the Dover ferry and Eurostar terminals would cause a 20 mile tailback on the motorways into Dover.  This would arise because lorries which are currently able to enter and exit at Dover do not face checks because of our membership of the single market which, among other freedoms, allows the free movement of goods. The government has suggested that other ports might take part of the traffic but, not only would this result in longer and therefore more expensive crossings, pushing up prices, other ports lack the necessary infrastructure for customs checks and do not have the capacity, and possibly not even the space, to expand in the short term.

While we can be certain, or fairly certain, that the impact of a ‘no deal’ would be mitigated by the government for essential industries such as water and pharmaceuticals, those which are less essential will suffer. Newspapers are already reporting stories of firms building up stocks of components and finished products; for example, a major pharmaceuticals company is planning to build up 6 months stocks of products and raw materials on both sides of the Channel and even Fortnum & Mason, the luxury Piccadilly grocer, has built up an extra two months’ supply of champagne! However, such actions are costly for firms and impossible for some which might lack the space or cash to build up stocks. Another area of concern is our import of fresh food. At present the ratio of fresh: frozen food imports is 9:1 and a result of ‘no deal’ might be to increase the proportion of frozen food imports. Although this seems relatively straight-forward, it would require an increase in refrigeration capacity, not currently available.

No deal will mean that tariffs are placed on UK goods entering the EU so, for example, the 54% of UK car exports which go to the EU would face a 10% tariff, making them less attractive to EU consumers, and thereby reducing sales and employment in the car industry and possibly even encouraging firms, particularly foreign ones, to relocate from the UK to the EU to avoid the tariffs. At a recent FT conference on Brexit, the Senior Vice President of Honda Europe suggested that, as well as tariff barriers,  non-tariff barriers, such as the need for physical inspections of  vehicles being exported and components being imported at customs, would be equally important for the company, which operates a ½ day Just In Time production model with components being delivered straight to the production line. The Economist recently reported on the BMW Mini plant in Oxford where 200 lorries deliver 4 million parts to the factory EACH DAY. Therefore, border delays of even a few hours  might impact significantly on their ability to produce smoothly. Because of the threat of a hard border, some UK chemical and pharmaceutical firms are considering opening a second testing facility in the EU so that its products can be sold there without difficulty. Such adjustments are costly and will be passed on to consumers in due course.

Supporters of a no deal see our departure from the EU as a matter of moving from EU to WTO rules on trade, reinforced by our ability to sign free trade deals with many countries. (It is worth noting that we have not yet been able to negotiate independently all the deals that we, as members of the EU, had with 3rd countries). However the CBI point out that this would mean both taxes on our exports and us levying taxes on imports from the EU. Also important will be such things as checks on food products which will be introduced on our exports. Another concern is that the WTO focuses more on trade in goods than in services, which has explained why a number of financial institutions are establishing bases in the EU. Interestingly, the FT conference referred to above was partially sponsored by Paris and Luxembourg, both using the opportunity to promote themselves as attractive places to set up. We do not know the effect which ‘no deal’ would have on sterling, with some talking of it even dropping to parity with the dollar, as holders of short-term sterling assets sell them. Bearing in mind that a 10% fall in sterling causes an increase in inflation of 2%, the effect of such a steep fall would lead to significant falls in real incomes. We also do not know whether the Bank of England would increase interest rates in order to protect sterling or cut them to boost GDP if a recession loomed (and the scope for the latter is seriously limited by their current low levels).

Even the impact of Mrs May’s deal, which involves maintaining the single market in goods but not services, is not totally clear since although the documentation on the UK’s departure is extensive, it is not clear exactly what will happen for the UK when the transition period ends in December 2020, since there is still much to be decided, hence, for example, the need for a backstop to prevent a physical border between Northern Ireland and Eire if a trade deal is not signed.

In the last two weeks, a number of estimates have been published. The National Institute for Economic and Social Research, a well-established think tank, suggests that Mrs May’s deal will leave the UK’s GDP per head 3% smaller by 2030 than if we had remained in the UK. Another think tank, ‘The UK in a changing Europe’, published research from the Institute of Fiscal Studies, LSE and King’s College, suggesting GDP per head would be between 1.9% and 5.5% smaller by 2030, depending upon what happens to productivity. The Bank of England and the Treasury have also published forecasts. The latter looks at the impact on the UK economy in 2035, 15 years from the end of the transition period (a longer period than the previous two forecasts) and suggests that, under a no deal scenario, GDP might drop by 10.7% while under Mrs May’s deal, the fall would only be between 0.2% and 1.4%.

A different option which is being proposed by Nick Boles MP is called ‘Norway for Now’  or ‘Norway Plus’. This involves the UK negotiating to join the European Free Trade Association (where we have free trade with the member countries but, unlike a customs union, there is no common external tariff). We would also negotiate a customs deal with the EU. This would allow unrestricted access to the EU market but would allow the UK to escape the jurisdiction of the European Court of Justice, be outside the Common Agricultural and Fisheries Policies and pay less to the EU than at present. However EU immigration would not be restrictable unless there were significant problems and we would not be able to sign trade deals with other countries outside EFTA and the EU.

All that is clear at the moment is that nothing is clear! Hopefully, after 11th December, we might know a little more but even that is doubtful.