Why bother with GDP?

Modern GDP statistics (“the value of goods and services produced in a given period”) have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data in order to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

A major criticism of GDP is that it takes no account of what is produced, merely its value. As a result,  disasters can be good for GDP if they involve countries reconstructing roads or buildings damaged in the disaster. War is also a good way of boosting GDP since it will involve producing more tanks, weapons and aircraft! Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread butter. GDP and GDP per capita also take no account of how the income is shared among the population. A rich oil producing country might have a high GDP per head but, if the income is concentrated in the hands of a few, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who identified activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new DVD recorder is easier to use and records more than a previous model but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they are legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK are part of the shadow economy but in the US they are legal, widespread and contribute to GDP.

GDP data is particularly suspect in developing countries where a significant percentage of production takes place in the hidden economy; for example, in Zimbabwe only 6% of the labour force is formally employed. Similarly, my purchase of bottled water from Sainsbury’s is counted in the UK’s GDP, but the effort of an African villager who spends hours walking to and from a stream to collect “free” water has no value according to GDP statistics. There are also basic measurement difficulties in LDCs, such as obtaining accurate population figures, accurately measuring inflation and valuing the hidden economy, e.g. only half the maize produced in Nigeria is sold in a shop or market.

There is now a consensus that we are trying to measure too many things in our single GDP number and, although we can improve it by using GDP per head or median GDP or NNP, it is still deficient.

Economists have therefore started both to consider other possible methods of estimating economic activity and to develop alternative measures which go beyond simply the output of goods and services. One way of tackling the former is to look at light intensity to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated. It also provides a fascinating snapshot of the difference between the North and South Korean economies.

However a major concern is how we measure the damage which our focus on output is doing to the environment. China’s focus on growth has resulted in 40% of its river water being undrinkable and one cannot always see the stars at night because of pollution. GDP does not take into account depreciation of natural resources lost to build houses and factories and damage to the environment but this is not easy to do. How does one put a monetary value on a rainforest, beautiful view or footpath by a river? One way is to make an estimate based on how much people pay to see them and, for things which benefit the environment, how much it would cost to replicate them. The UK government in 2012 formed the “Natural Capital Committee” to advise the government on things such as ‘forests, rivers, minerals and oceans’ and by 2020 the ONS must include a measure of natural capital in the UK’s national accounts. The aim is to move towards sustainable growth. Along the same lines, a US think tank has invented Earth Overshoot Day – the date when the earth used up its regenerative capacity for the year. In 2018 this occurred on 1st August.

Other measures include the Genuine Progress Index – a measure of economic welfare which is currently in use in Maryland. GDP is the base but invisible “goods” e.g. leisure time, volunteering, & housework are added while “regrettables” e.g. crime prevention spending such as burglar alarms, pollution and commuting time are subtracted. The Happy Planet Index tries to measure what matters – namely sustainable wellbeing for all and tells us how well nations are doing at achieving long, happy, sustainable lives.  Some countries have followed Bhutan which developed a Gross National Happiness index which sets out priorities such as psychological well-being, health, education, living standards, good governance and ecological resilience. Before adoption, all new projects must undergo a GNH impact review. We carry out an annual happiness survey as does the OECD and many of its members. These focus on six key variables which determine happiness – GDP/head, healthy years of life expectancy, having people to turn to, trust in others, freedom to make decisions and donations to charity.

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Bicycle Wars

The trade war between America and China rumbles on, confused somewhat by the recent actions which the US has taken over the involvement of Huawei in technologically-sensitive areas of the economy. The use of tariffs to protect industries involved in areas of national security can be justified by WTO rules. President Trump has been free in his use of this justification He has used it to justify tariffs on steel since it is an important product for the defence industries. His use of the argument that he has to protect strategic industries suffers when he simultaneously talks of the need to reduce the “BAD” US balance of payments deficit, which, according to him is the fault of foreign countries and not due to a lack of competitiveness among US industries.

Another more long-term example was highlighted by The Economist in a recent article about bicycle exports from China to America. (The same article also provides an insight into of the workings of global supply chains.)

In the 1970s, the vast majority of bicycles sold in the USA were made in the USA – around 15 million. By the late 1980s, US producers were suffering from Chinese-made bicycles entering the American market very cheaply and then, suffering even more when the Chinese producers further cut their already-low prices to drive out domestic US production – an example of dumping. Remaining US producers sought anti-dumping tariffs but the US government was more interested in good relations with China and did not act.

Some bicycles are still made by a US firm – BCA, the Bicycle Corporation of America, which was launched when Walmart decided to operate a Buy-American campaign. However BCA is now a subsidiary of a Chinese firm, Kent, (previously a US family firm which was half bought by a Chinese firm) and, furthermore, BCA only assembles in the USA, it buys its parts from a Kent factory in China.

Last September bicycle prices were raised by 10% tariffs and a further 15% tariff was imposed in May, hitting US consumers.

What right did President Trump have to do this? He used a US government power – section 301 – which allows the US government to protect intellectual property. How does this apply to Chinese bicycles?

The UK’s Foreign Exchange Reserves and the value of Sterling

Last week was the worst for the pound for a year as holders of sterling sold it following the collapse of the talks between the Conservatives and Labour on how to proceed with Brexit.  On the foreign exchange markets, the price of a currency is determined by supply and demand and, if holders of sterling wish to sell it to buy euros or dollars, then the supply of sterling increases and the price falls. Simultaneously, given the state of political uncertainty, demand for sterling on the foreign exchange market fell, further weakening the value of the pound against other currencies. As a result, sterling dropped to $1.27, losing 1.85% of its value during the week.

Most forex transactions are made using the U.S. dollar, euro, pound and Japanese yen; although one might think that currency is mainly traded on the FOREX market to buy foreign goods and services, this is not the case. On average $5.5 trillion is traded each day but less than 5% of this is to buy goods and services. The majority is to purchase financial assets (e.g. foreign shares and government bonds and to place money into an overseas bank account) or to speculate about the likely movements of currencies to make a profit. Therefore, confidence in an economy is crucial in determining its value.

The UK’s reserves of foreign currency, currently standing at $137bn, are used by the Bank of England to protect the value of the pound on the foreign exchange market. The reserves, at their highest level for at least 21 years, are held mainly in US dollars and can be used to buy pounds on the foreign exchange market, thus increasing the demand for pounds and hence increasing the price, or rate of exchange of the pound against other countries.

According to the IMF, they grew 19% in the last quarter of 2018 because the government wanted to have them available in case they were needed after the originally-planned Brexit date. However if one compares the value of our reserves against the £420 billion of sterling traded daily by UK financial institutions one can see that, while the UK authorities might be able to nudge the value of sterling and slow down its fall, we do not have the resources to withstand a major fall in its value unless the government decides to borrow heavily overseas from foreign governments, banks and the IMF.

A look at the world economy.

Recently there has been considerable attention given to the current, positive economic indicators for the UK economy. The three months to February showed the number of people in work reaching a new high of 32.71 million, or 76.1%, the highest for 48 years, the unemployment rate falling to 3.9%, the lowest since 1975 and average weekly earnings increasing by 3.5% in the year to February. With March CPI inflation unchanged at 1.9% (and core inflation also unchanged at 1.8%), real incomes are increasing although there is  concern that inflationary pressure will increase as earnings continue to rise while productivity remains weak.

However for the UK, which is a very open economy, what happens elsewhere has a significant impact on our performance. Three areas are significant – Europe, China and the USA.

Europe is struggling. Its strongest economy, Germany, has cut its growth forecast for 2019 for the second time in three months, now predicting growth of only 0.5%. The reasons cited for the slowdown are the continuing trade dispute between the USA and China, a general world slowdown, Brexit uncertainty and falling car sales. Italy is also a cause for concern. Not only is it predicting growth of only 0.2%, its financial situation is worsening and there is concern that it will breach the targets agreed with the European Commission for government borrowing and its national debt. While the Eurozone was able to deal with a financial crisis in Greece, if Italy, a key member of the Eurozone, continues to run excessive deficits, the implications for financial stability would be more serious.

The Chinese economy appears to be doing well. Over the first three months of the year, GDP grew at an annual rate of 6.4%. However there is concern over the impact of the continuing trade dispute with the USA, worry about the increases in China’s debt, which is financing the growth, and, possibly most importantly, fears over the sustainability of its growth because of its reliance on infrastructure spending. In most countries, high infrastructure spending would be a positive feature but there is concern in China about an infrastructure “bubble” with reports of new cities being constructed which have few people, cars or shops.  One way of appreciating the scale of the spending is to consider a Washington Post report that China used more cement between 2011 and 2013 than the USA used during the entire 20th century. These concerns coincide with China’s diminishing balance of payments surplus as the Chinese buy more foreign goods and travel overseas more and its exports are falling. In 2007, the surplus was 10% of GDP, it is now only 0.4%. While this is good for the UK if Chinese consumers buy more UK exports and decide to visit UK tourist destinations, if it heralds a slowing of China’s growth, the positive impact might be short-lived.

The third pillar of the global economic triangle is the USA and US economic growth slowed to an annual rate of 2.6% in the last three months of 2018. The high growth in 2018 was partially caused by a large tax cut and an increase in government spending and it is expected that once the effects of the stimulus wears off, growth this year will fall towards its long-term level which the Federal Reserve suggest is between 1.7% a year and 2.2%, some way below President Trump’s target of 4%. USA prospects are likely to be influenced by the impact of trade negotiations with China and the EU which are unknown at present but if we are unable to strike a trade deal with the US and UK businesses find tariffs placed on their exports, the impact on the UK could be severe.

A Confusing Tale of Two Economies (with apologies to Charles Dickens).

What is going on in the UK economy is currently hard to understand. Are we doing well or badly? There are many conflicting pieces of evidence and, in some ways, it is like an abstract painting – different people can look at it and see different pictures.

Consider the labour market – in the last three months of 2018, employment rate reached 76.1%, or 32.71 million, the highest since 1971, rising by 220,000 workers, of which 144,000 were female. Over the same period, unemployment fell to 1.34 million or 3.9%, the first time it has dropped below 4% since 1975. While some people see this as a positive sign of economic progress, others present three reasons why the data actually shows an economic problem for the UK.

Firstly, there is a view that the rise in employment is because of an increase in zero hours contracts, with workers working far less than they would like, suggesting that we have rising under-employment instead of unemployment. Secondly some suggest, similarly, that self-employment has been responsible for some of the fall in unemployment, with many of the newly-self-employed working less than they would like. Finally, others argue that the reason for falling unemployment is that employers have cut back on investment, preferring to meet additional demand by hiring more workers, knowing that they can get rid of them if the economy stagnates after Brexit. This last explanation dovetails well with the UK’s poor productivity record, with productivity actually falling by 0.2% in the last quarter of 2018.

Turning now to earnings and inflation; with unemployment so low, we would expect both earnings and inflation to be rising rapidly. In fact, last month, average earnings growth fell from 3.5% to 3.4% and the CPI only increased from 1.8% to 1.9%, due to prices for some food and alcoholic drink items increasing more in price this year than they did a year ago, and core inflation (which ignores the price of food and energy because they are highly volatile) fell by 0.1% to 1.8% in February. Nevertheless, some economists regard this as only a temporary respite, suggesting inflation will rise to 2.5% in the next few months because of higher oil prices and rising wages, with a further jump possible if tariffs rise after Brexit (whenever that is!).

Turning now to GDP, it grew by 0.2% in the three months to January 2019 with the service sector expanding while manufacturing and construction contracted. This meant that growth for 2018, was only 1.4%, the slowest rate for 10 years. Also suggesting that the outlook is poor was a survey of consumer confidence showing that it had fallen over the last year and data showing that we currently have the lowest annual house price growth in the UK for six years. However, government borrowing is at a 17 year low because of rising tax receipts – £200m in February 2019 compared to £1.2bn in February, 2018, meaning that the government is on course to meet its target for structural borrowing to be below 2% of GDP in the financial year 2020/21. Further confusing evidence of our economic situation is provided by the latest UN Annual Happiness Report, which shows the UK has risen from 19th  to 15th out of 156 countries surveyed, with Finland, once again at the top of the table, followed by Denmark, Norway, Iceland and the Netherlands.

It is not surprising that economists find it hard to assess how the economy is doing since some of the indicators discussed above reflect what has happened in the past, rather than what is currently happening. (Imagine steering a car by only looking in the rear-view mirror). Unemployment, for example, shows the state of the economy six months to a year ago since firms do not immediately hire or fire workers when their orders change. Other indicators, such as GDP are subject to frequent revisions as more accurate data becomes available. Therefore some economists prefer more informal guides to the economy. David Smith, Economics Editor of The Sunday Times, uses the number of skips in his road, since more skips suggest more building and home improvements and therefore greater economic activity.  In an attempt to improve our awareness of the current state of the economy, the ONS is introducing new economic indicators such as the volume of road traffic and businesses’ value-added tax returns which will, hopefully, provide a more up-to-date picture of the economy.

An Economic Update

Rising employment                   Falling unemployment       Low inflation                Rising pay

Forecast inflation increases    Falling productivity              Forecast job losses

Falling confidence                      Increasing balance of trade deficit    Rising household debt

Over the last two weeks there has been much economic data published, together with forecasts of what might be in store for the economy over the next few years. While some of what has been announced for the future is easy to assess, such as Honda’s announcement of the closure of its Swindon factory in 2022, some of the data is contradictory, so it is not easy to see exactly how we are doing. Furthermore, the picture is clouded by difficulty in distinguishing between temporary features due to Brexit uncertainty, such as businesses delaying investment decisions with the Head of Make UK, a body representing engineering companies, talking of a no deal as being “catastrophic”. There are also factors such as increasing household debt which might have a significant long-term impact on the economy.

On the optimistic side, the latest labour market figures are positive. Employment has risen in the last three months of 2018 and, compared to a year earlier, has increased by almost half a million, with most of the increase being accounted for by an increase in female employment. Unemployment remains at 4.0%, or 1.36 million people, the lowest rate for approximately 40 years; the employment rate (the percentage of 16 – 64 year olds in work) was at 75.8%, another record, and therefore the activity rate – those who cannot or do not wish to work such as students or those medically unable to work – has fallen to a record low. In addition, the number of vacancies has risen to 870,000, the highest ever recorded, with the increases being mainly in the service sector such as retailing.

The ONS has also announced the January inflation figures which show prices are now rising at 1.8%, down from 2.1% in December. This is partly due to the energy price cap and falling fuel prices, but economists are predicting that the fall below the government’s 2% target will only be short-term as increasing oil prices and planned energy price rises feed through into the CPI.

Because of the tightening labour market, it is not surprising that wages are increasing with the latest data showing an annual increase of 3.4%. Comparing this figure with the latest inflation data shows that real incomes are now increasing by 1.6%, the fastest rate since summer, 2016. However, in real terms, average pay is still £10 per week lower than it was ten years ago and, despite rising real incomes, consumer confidence is falling, as measured by the Household Finance Index. This is a measure which tries to predict changing consumer behaviour. It is based on monthly responses from over 2,000 households, chosen to accurately reflect the country’s income, regional and age distribution. Among items examined are changes in household income, spending and savings, job security, household debt and borrowing, inflationary expectations, house prices and confidence in the government.

A key negative figure for the economy is the low GDP growth, which was only 0.2% in the last three months of 2018 and 1.4% for 2018, the lowest increase since 2009. While household and government consumption were positive, a poor balance of payments and falling investment reduced growth. The combination of high employment, low investment and low growth in GDP explain the poor productivity data for the UK with output per person falling 0.1% last year.

However, one positive figure is the latest data on government borrowing which, for January 2019, was a surplus of £14.9bn. While January is always a good month, because of self-assessed income taxes, capital gains tax, corporation tax and VAT falling due in January, the actual taxes received were higher than previously predicted, and government spending increased less than anticipated, meaning the actual budget surplus was almost 50% larger than the forecast surplus for the month of £10bn. The improved figures mean that government borrowing for 2018/19 is now likely to be £22bn rather than the previous forecast of £25.5bn, the lowest figure since 2001, and the National Debt, at £1.8 trillion is forecast to be 82.6% of GDP, compared to 85.6% last year. Most importantly, the deficit is likely to be only 1% of GDP giving the Chancellor scope to cut taxes and increase spending to boost the economy yet still remain within the 2% figure he suggested as a ceiling.

 

 

 

 

 

 

 

Brexit, the WTO and the Irish Border

The World Trade Organisation was established in January,1995 to promote free trade since it believes that it provides benefits in the form of greater choice and lower prices, stimulates economic growth, raises incomes and promotes world peace. It also acts as a forum for negotiations to reduce tariff barriers,  provide technical assistance for developing countries and  resolve trade disputes between its 164 members. For example, in August 2018, Turkey complained to the WTO about US sanctions on Turkish exports of aluminium and steel. If, after investigation and consultation, the WTO believes a country has broken its rules, it can authorise retaliatory tariffs.  Until the Brexit referendum, the WTO had not featured  in UK newspapers. However since the vote and the lack of progress in  talks with the EU, there has been increased interest in its role in regulating world trade  since, if no agreement is reached, the UK will fall back on WTO rules following its departure from the EU on 29th March.

Anyone wishing to join the WTO must agree to accept all its rules, particularly the  ‘Most Favoured Nation’ agreement whereby countries  must apply the same tariff to similar goods, irrespective of the exporting country, unless there is a free trade agreement between the importing and exporting countries. Thus if we leave the EU without an agreement, the EU will apply the same 10% tariff on UK car exports into the EU as it does to those coming in from other non-EU countries. Similarly, if the UK government were to announce a unilateral move to zero tariffs on agricultural products from the EU, without a trade deal, we could not levy tariffs on agricultural goods from elsewhere.

A significant concern is that WTO rules do not reduce regulatory barriers. At present, because of the Single Market, a UK car manufacturer can sell products as easily in Rome as Romford. This will cease if there is no agreement with the EU and therefore we would expect UK goods to be inspected when entering the EU, in the same way that British goods entering  Japan are currently examined to ensure that they meet EU standards. This might not seem a major problem but exporters fear that administrative burdens of completing customs forms and the delays to drivers at borders will be significant, therefore increasing costs.  This will be particularly important for those trading in perishable goods, some medical products which need to be refrigerated, and companies currently operating with minimal stocks in order to reduce costs.

A third concern is that WTO rules do not currently provide as much freedom for trade in services as they do for trade in goods. At present, for example, UK banks provide services for individuals, businesses and other banks across the EU without needing to duplicate all of their physical locations overseas. Leaving the EU will make trade in services, which make up 80% of the UK’s GDP, far more difficult and explains why UK financial consultants, bankers, accountants, etc are moving staff and  have established physical locations overseas.

Some in favour of leaving the EU argue that these arguments will not be significant since much non-EU trade is done under WTO rules. However the Economist pointed out (4th August 2018) that the UK would be the only large country trading solely on WTO rules and many other countries have arrangements in place to reduce the administrative customs burdens which hinder trade.

The problem with the border between the Republic of Ireland and Northern Ireland is also causing difficulties in our negotiations with the EU since two almost incompatible ideas need to be reconciled. On the one hand, the EU is insisting that, unless there is a new  form of customs union between the UK and the EU (which some pro-Brexiteers resist since it will reduce our ability to sign other deals), there must be a border between the UK and the EU to allow for customs checks to ensure that goods pay the appropriate tariffs and meet regulatory standards. For England, Scotland and Wales, this will be a sea border. However between Northern Ireland and the Republic, it will be a land one. Not only will this be  hard to enforce since there are many possible routes between the two, there are also very major political difficulties in re-establishing a hard border which relate to historical issues between the two countries. The idea of a “back-stop” which would allow free trade between the two countries would involve a different regulatory regime for Northern Ireland compared to the rest of the UK, something which is equally politically difficult to accept.

It is difficult to predict what the effects on our trade will be until the Brexit agreement is reached. As part of the EU, we currently benefit from free trade treaties between the EU and other countries and we do not know whether we will be able to negotiate to keep these agreements. A recent example of this is the recently-signed EU-Japan trade deal which we hope to replicate. However the Japanese have made it clear that it will not be ready to be signed by 29th March and, given the importance of Japan-UK trade, this is potentially a serious issue. Indeed, Dr Fox’s claim in 2017 that  the UK would be able to replicate up to 40 EU free trade deals, immediately we leave the EU is not going to happen. So far we have signed  agreements with Australia, Chile, the Faroe Islands, some African nations, Israel,  Palestine and Switzerland. The failure to sign agreements is already impacting on British businesses trading with Asia since goods now being shipped will not arrive until after 29th March and exporters do not know whether they will be liable to tariffs or potentially might even be sent back to the UK. If there is no deal by 29th March, then 18th April becomes the next key date since, by then, the UK must confirm whether it will make contributions to the EU’s 2019 budget which are due by the end of April. A decision to make these payments will  require a vote in Parliament. If we do not make these payments, then our relations with the EU will deteriorate further and the chances of a trade deal will diminish even further.