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  Although the data may seem to be a few months out of date, it is the latest available and indicates a difficulty for economic bodies such as the Bank of England who try to control the economy. Their task is made even more difficult because, for example, not only are the Labour Force Survey figures out of date, they also do not respond quickly to changes in the economy since employers often wait a few months before hiring or firing workers to see if changes they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


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.

UK household debt reaches peak

Article of the week – Harjot M.

High levels of household debt pose a risk to the economy because any increase in interest rates could lead to a sudden collapse in consumption. Higher borrowing costs mean households have less discretionary income resulting in a fall in consumer spending. Aware of this risk, firms may consider cutting investment in the expectation of a fall in future demand. Consequently, aggregate demand decreases causing a fall in inflationary pressures, a decrease in economic growth and, potentially, an increase in demand-deficient unemployment.

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.

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.

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.