How are we really doing?

This post looks at the current state of the economy.  Although the data may seem to be a few months out of date, it is the latest available and indicates a difficulty for economic bodies such as the Bank of England who try to control the economy. Their task is made even more difficult because, for example, not only are the Labour Force Survey figures out of date, they also do not respond quickly to changes in the economy since employers often wait a few months before hiring or firing workers to see if changes they experience are permanent or temporary.

GDP growth slowed at the end of 2018 from 0.4% to 0.3% in the three months to the end of October. This was largely due to a 0.8% fall in the manufacturing sector, particularly the manufacture of vehicles and pharmaceuticals. Our productivity continues to disappoint having been almost flat for 10 years, and about 20% below what it would be if it had grown at the trend rate for the last ten years. Investment has fallen for the last nine months, unlike our G7 partners who have experienced double digit growth.

However, the labour market continued to do well between August and October with the number of people in work increasing to 32.48 million, 396,000 more than a year earlier. The employment rate (the proportion of people aged from 16 to 64 years in work) was 75.7%, higher than a year earlier (75.1%) and the joint-highest estimate since comparable estimates began in 1971 while the unemployment rate (unemployed people as a proportion of all employed and unemployed people) was 4.1% or 1.38 million people. As a result, the proportion of people inactive was approximately 21%, again the joint lowest since 1971.

Inflation, measured by the CPI, dropped to 2.1% in December, the lowest since January 2017 when it was 1.8%, caused by falling air fares and oil prices (causing falling petrol and diesel prices among other things). Employee average weekly earnings increased by 3.3% over the year, giving a real increase of 1.2%, a welcome change from recent years when the rate of inflation has exceeded the increase in earnings. However, over the year, poverty increased, with 14 million people (22% of the population) in relative poverty (defined as 60% of the median income after housing costs). This includes more than 4 million children, with more than half of the children in single parent families in poverty. Food bank use has increased by 13% in the last year.

The balance of payments current account deficit increased to £26.5 billion between July to September, 2018, which equated to 5% of GDP, the largest deficit recorded for two years in both value and percentage of GDP terms. Contributing to this was an increase in the deficit on trade in goods and services, as the service sector surplus fell, and an increase in the primary income deficit caused by an increased net outflow of profits from FDI in the UK. (Primary income is the net flow of profits, interest and dividends from investments in other countries and net remittance flows from migrant workers). The majority of the deficit was financed by foreigners purchasing UK shares and UK investors selling part of their overseas portfolios.

Finally – an apology to younger readers. The latest government figures have shown that the share of UK wealth held by those over 65 has grown to 36% of the total, averaging £1.1 million.  The proportion of over 65s who are millionaires increased from 7% in 2006 to 20% in 2016. This wealth is in the form of property, their pension funds, holdings of shares and other savings. The biggest losers were those in the 35 – 44 age group whose share has dropped from 15% to 10% (although the value of their wealth rose from £180,000 to £190,000. This is a major change over the last 20 years when 21% of pensioners were in poverty.

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How was Christmas for consumers and retailers?

UK consumers did not have a good Christmas and, since consumption is the main component of aggregate demand, this is a serious problem for the UK economy and for retailers in particular who rely on high spending at Christmas. Furthermore, not only was consumption lower than hoped for by retailers, it has also been financed by significant increases in household borrowing (see Mr Dean’s recent post). According to the British Retail Consortium, the retail sector experienced their worst Christmas since the financial crisis in 2008 with sales which were basically the same as last year. They reported that, although spending on groceries was higher than last year, spending on other categories such as clothing, were lower. Barclaycard confirmed this when they reported a real terms fall in consumption in December of 0.5%

There are a number of possible causes for low consumption. In the past, we would have looked at what has happened to consumers’ real income. However after many years of falling real incomes, last year incomes started to increase at a faster rate than inflation so this is no longer a factor. More likely is a fall in consumer confidence as doubts about the future of the UK economy increase as progress towards Brexit falters. There have also been declining car sales with new car registrations falling 6% in 2018 compared to 2017 caused by Brexit uncertainty and a fall in the attractiveness of diesel cars. There has also been a fall in spending on recreation and travel. Not only have foreign holidays become more expensive as sterling has dropped in value, consumers have cut back on meals out, recreational activities and travel.

But possibly not all is not doom and gloom. Part of the reason for the fall in December spending was people buying more in November to take advantage of ‘Black Friday’ offers. However this was not good news for retailers in the high street since many of the ‘Black Friday’ purchases were on line. This might mean that there will be more stores following Maplin, Toys R Us, Carpetright, HMV, Poundworld and House of Fraser.

20 Years of the Euro

The origins of the euro were set out in 1992 in the Maastricht Treaty, which set out the pathway to economic and monetary union (EMU). This involved increased co-ordination of monetary policy, more converged economies and then the establishment of the European Central Bank and a single currency. In 1999, the euro came into existence as an accounting tool and, three years later, it became a physical currency, the official currency of the Eurozone.

In order to be successful, a single currency requires that member countries are both in similar stages of the economic cycle and are converged in terms of key economic variables. This means they will respond similarly to external shocks such as rising oil prices or a major demand-side shock in the world economy and changes in interest rates will have a broadly similar effect on businesses and households in each country.

The countries joining the eurozone had to meet convergence criteria to join. These were:

  • an inflation rate no more than 1.5% greater than the average of the 3 lowest countries
  • long term interest rates no more than 2% greater than the average of the 3 lowest countries
  • a stable exchange rate within the exchange rate mechanism (an agreement to limit the flexibility of exchange rates) for 2 years
  • a budget deficit less than 3% of GDP and a national debt less than 60% of GDP or falling towards it.

The advantages of belonging to a single currency revolve round greater economic stability because there are no exchange rate fluctuations, leading to increased investment, including foreign direct investment, economies of scale and greater international trade, in line with comparative advantage. There are also lower costs since commissions paid when changing currencies no longer apply to members of the single currency (but still apply when trading with counties outside the single currency area). There is also greater price transparency which increases competition since it is easier to compare prices in different countries

The UK did not join because it believed that the disadvantages would outweigh the benefits. The key one was the loss of economic sovereignty. Not only did member countries lose control of their interest rates, there now being a single one set by the European Central Bank which might have different priorities to the UK government, there was also no possibility of adjusting the exchange rate to boost exports and cure a balance of payments deficit. This meant that adjustment to economic problems would have to be internal, via cuts to real wages, probably accompanied by higher unemployment, in order for a country to improve its competitiveness. Furthermore  the UK government did not want  to limit its scope for fiscal adjustment because of government borrowing restrictions. There was also the fear that the UK economy, because of its higher level of home ownership (and therefore more homeowners with mortgages), closer links with the USA and its role as an oil producer, was not sufficiently converged with the members of the eurozone. There was also the issue of losing the pound which weighed heavily with politicians.

So how has the eurozone done since it began? It survived the financial crisis and the debt crises faced by the PIGS, the weakest eurozone countries, (Portugal, Ireland, Greece and Spain), setting up a fund to provide support to members in difficulty. The currency has also been accompanied by a growth in foreign trade, with eurozone trade doubling between 1999 and 2008, (but we do not know what would have happened without it). Furthermore, it has grown from the original 11 members and now has 19 members -Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. As the FT pointed out, “the euro has become the second most important currency in the world. It accounts for 36% of global payments and 20% of central banks’ foreign reserves, second only to the dollar. The euro is used by 340m people in 19 countries. Another 175m people outside the eurozone either use it or peg their currency to it”.

However there is a more pessimistic view. Joseph Stiglitz, a Nobel prize-winning economist, argued last year that the euro has not been that successful, when one compares its growth with that of the USA. He also argues that there could be a new euro crisis in the offing with high Italian government borrowing, continued inequality in incomes between richer and poorer members of the eurozone with the latter suffering from low growth and poor competitiveness. The Economist (5th Jan 2018) talked of the ECB being too restrictive in terms of its interest rate policy, low rates of growth and high unemployment among some eurozone members. How the eurozone will cope if interest rates increase in 2019 or if there is another debt crisis remains to be seen.

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.

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.

Is the next financial crisis round the corner?

It is now 10 years since the financial crisis and concern is beginning to be expressed that we could be heading for another in the near future. If it does occur, how well-placed is the UK to withstand it?

The IMF recently examined the finances of 32 countries, comparing what governments owe, e.g. pension liabilities and national debt, with what they own, e.g. land, buildings and natural resources, and concluded that, by this measure, the UK has a net liability of more than £2 trillion – over 100% of GDP. This is not the usual way of looking at a government’s indebtedness, which compares government debt to GDP, but, for example, it does highlight the difference between Norway and the UK in terms of making use of the revenues received from North Sea oil. Norway used them to build up a large stock of financial assets, currently worth over $1 trillion, or almost $200,000 per person which has generated income, while the UK used its North Sea oil revenue for current consumption and tax cuts.

Just as the IMF was undertaking its analysis, the Financial Policy Committee of the Bank of England warned of excessive world-wide lending by banks to businesses and the danger that banks are relaxing their lending standards, particularly in the US, and compared the current situation to the approach to the 2008 crisis. However, a big difference between now and 10 years ago is that commercial banks’ capital reserve rations have increased, and they are now more closely monitored with regular stress tests which examine the way different scenarios, such as rising inflation or unemployment, will affect banks’ ability to withstand shocks. The results of UK stress tests will be published in December.

Worryingly, it is not only business borrowing which is an issue. UK household debt has also increased dramatically. The ONS suggests, not surprisingly, that it is the poorest families who are most in debt. Their analysis showed that, in the 2016/17 financial year, the lowest 10% of households spent two and a half times their disposable income   while the richest 10% spent less than half of their disposable income.

A National Audit Office report in September suggested that average UK household debt (including mortgages) was £58,540 in June, and, overall, people owed nearly £1.6 trillion at the end of June 2018, up from £1.55 trillion a year ago. British households are now among the most indebted in major western countries, with credit card debt and payday loans climbing to record highs. Another source of debt which is potentially worrying is car finance where PCPs (personal credit plans), which allow one to buy a new car with a very small deposit but pay for it over three to four years, are becoming popular.

A key question which worries the Bank of England is what will happen to debt if interest rates continue to rise. Will zombie businesses and poorer households be able to afford higher interest payments or will they, like the sub-prime mortgage borrowers of the last decade, end up defaulting on their loans? On the positive side, wages are growing at their fastest rate since the financial crisis, up 3.2% in the three months to September, but faster wage growth, indicating that the labour market is finally tightening  in response to record low levels of unemployment, might encourage the Bank of England to raise interest rates sooner than they otherwise would have done, possibly hastening a crisis.

Trade Wars

In an attempt to escape from the latest Brexit news, this week’s blog examines the trade war between the USA and China. Until recently, economics textbooks glossed over tariffs, quotas and protectionism; they were mentioned as possible approaches to improving a country’s balance of payments but it was accepted that although there were customs unions in existence, such as the EU, with a common external tariff (i.e. all products entering the union paid the same tariff, irrespective of where the goods entered the customs union, tariffs were not changed frequently as an economic weapon. This was because the accepted view among economists and (most) politicians was that world free trade was beneficial, allowing goods and services to be made  in the countries most suited to their production (lowest opportunity cost in economic terms) and then traded for products made overseas, thereby allowing consumers to benefit from lower prices and an increased standard of living.

However all of that has changed with the imposition of tariffs by the USA on Chinese goods and retaliation by China, followed by retaliation for the retaliation by the USA! The crisis began in July, after months of negotiations, when the USA imposed 25% tariffs on an initial $34 billion of Chinese goods, including machinery, electronics, cars and computer components such as hard drives.  China then retaliated and the following month the USA placed 25% tariffs on a further $16bn of Chinese goods which were matched by reciprocal Chinese tariffs on American goods such as cars. Then in September, President Trump imposed further 10% tariffs on $200 billion of Chinese goods and has threatened to increase this to 25% next year. China has retaliated with tariffs on $60 billion of US goods. The rationale for the American tariffs was two-fold – firstly that, according to President Trump, China had an “unfair” trade surplus in goods of $376 billion with the USA, thereby hitting American jobs, and secondly that China engaged in unfair trading practices, frequently involving foreign firms being forced to share their technology with Chinese ones.

The effects of the tariffs will depend on many factors. It is possible that businesses might find a way round the tariffs. For example, US soya producers have complained about the tariffs on their products but there is already evidence that they have been able to increase their exports to Brazil and Brazilian firms have exported to China. However many US businesses have expressed concern over the rise in costs of components imported from China and the effect they will have on consumer prices in the US. On the other hand, President Trump has argued that the tariffs will persuade US firms to produce more in the US to avoid the tariffs but others suggest that US firms will still produce overseas, where manufacturing costs are cheaper, but in countries other than China. A key factor will be the price elasticity of demand for the goods affected. This will determine whether producers can pass on the tariff,  whether they will have to absorb some or all of it and whether they will need to cut output with subsequent effects on output and employment.