A New Industrial Strategy

 Although over-shadowed by the Budget and news of the forthcoming royal wedding, we saw an event last month which might potentially have a major impact on the UK. This was the launch of the Government’s Industrial Strategy which builds on the policy put in place by the coalition government from 2010.

Industrial Strategy is not new. The Labour Government introduced a National Plan in 1965 to boost the UK’s economic growth with a target of a 25% increase in GDP by 1970. To achieve this, there were key areas to be addressed such as reducing government spending at home and overseas, helping exporters, promoting regional equality and establishing an agreement between employers and trade unions on productivity, prices and incomes. The National Plan was abandoned when sterling was devalued in November 1967.

The next significant attempt at industrial strategy came with the Labour Government in 1975 which was facing the same long-standing problem of poor economic performance. The approach copied successful French and Japanese models and was based on ‘Indicative Planning’ – the idea that a government commitment to a long-term macroeconomic framework would give the private sector the confidence to invest and expand. The UK approach (An Approach to Industrial Strategy, November 1975) focussed on tripartite agreements between the Government, employers and trade unions to improve performance in individual sectors and firms, giving  priority to manufacturing industry over the growing service sector. By the time Mrs Thatcher’s Conservative Government took office in 1979, it had not met its targets and found no place in the economic armoury of the free market, anti-inflation of the new Government.

The latest approach, announced last week, aims to improve productivity while maintaining our high level of employment and focusses on four areas where the UK can become technological leaders. These are Artificial Intelligence and the Data Economy, Clean Growth, the Future of Mobility, making the UK a world leader in the way people, goods and services move and the Ageing Society, harnessing the power of innovation to help meet the needs of an ageing society.

The Government aims to raise R&D investment from 1.7% to 2.4% of GDP by 2027, via investment of £725m in a new Industrial Strategy Challenge Fund and  an increase in the rate of R&D tax credit to 12%. To improve skills, the White Paper talks of “establishing a technical education system that rivals the best in the world to stand alongside our world-class higher education system” and will invest an additional £406m in maths, digital and technical education, helping to address the STEM shortage. There will also be a retraining scheme to provide support for people to retrain in new industries including the forthcoming £64m investment for digital and construction training. The National Infrastructure Fund will be raised to £31bn for transport, housing and digital infrastructure; electric vehicles will be helped by a £400m investment in the charging infrastructure and an extra £100m to extend the plug-in car grant. The digital infrastructure will benefit from over £1bn of public investment for 5G providing fibre broadband for remote areas. There will be partnerships between government and industry to increase productivity, starting in the life sciences, construction, artificial intelligence and automotive sectors. A new £2.5bn Investment Fund will be established which it is hoped will increase private investment by over £20bn in innovative and high potential businesses. The Strategy also tries to address the problem of low productivity specifically among the weakest firms in many industries – the tail which is significantly longer than in many of our competitor countries. This is partly due to poor management which has been linked to the relatively large number of small, often family-run firms in the UK compared to our competitors.

Will the latest industrial strategy succeed where many of its predecessors  failed? Firstly although the numbers mentioned above seem large, they are not when compared to the UK’s GDP of approximately £2,000bn; the National Infrastructure Fund amounts to only 1.55% of GDP. Secondly the target of increasing R&D to 2.4% of GDP is very modest when both the USA (2.8%) and Germany (2.9%) already exceed it.

Thirdly businesses need certainty when planning investment decisions, and this is particularly important given the uncertainty which exists at present over the outcome of the Brexit negotiations. Therefore its chances of success would be significantly boosted if the Labour Party were to commit to keeping the measures in place were it to be elected.

 

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The Financial Crisis – 10 Years On

August 9th, 2007, is sometimes cited as the start of the financial crisis which has impacted on world economies for the last ten years. This was the day when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime mortgage investment funds, largely operating in the USA. This might not seem particularly significant, but what it suggested was that it was possible that money lent to a bank might not be repaid. Another key date for the UK was 14th September 2007 –  the date when Northern Rock suffered a “bank run” – the first in the UK for 150 years – and the news was full of pictures of people queueing outside Northern Rock branches to get their money out. For those in the USA, 15th September 2008 was significant since it was the date Lehman Brothers filed for bankruptcy protection, leading to the largest drop in the Dow Jones Index (similar to the UK FOOTSIE Index) since the September 11 attack in 2001.

Almost every bank in Europe and the USA relied on borrowing from other banks. The borrowing was via the inter-bank market (loans from one bank to another) and Northern Rock, like other banks, lent money to customers for long periods (e.g.  a 20 or 25 year mortgage) using both its customers’ deposits and money borrowed from other banks on a short-term basis in the money market. The BNP action made banks less willing to lend in the inter-bank market and as a result interest rates rose and the duration of loans fell despite central banks trying to inject liquidity into the market. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS in the UK,  found themselves in difficulties and confidence among banks fell further.

However, although the BNP Paribus action was significant, there were other factors which created the circumstances which made its action so important. Firstly, there had been an excessive expansion of the money supply, particularly in the USA, in the years leading up to the financial crisis caused by excessive lending and borrowing. This excessive money supply growth caused an increase in asset prices, especially housing.

Secondly, in the late 1990s there was a vast quantity of savings looking for a reasonable return, a large part of which came from Asian countries running large balance of payments surpluses seeking somewhere to invest their surpluses. This excess of savings resulted in low rates of interest and encouraged banks and other financial institutions to look for areas with a high rate of return. One of the most attractive areas was to take advantage of the property boom and lend to mortgage borrowers, particularly those classified as “sub-prime”, who were less financially reliable and paid a higher rate of interest than lenders could obtain elsewhere. In the climate of the early 2000s, this was a safe investment since housing markets were booming and if the borrower were to default, the lender would re-possess the property and sell it at a profit.

A third factor was the way in which financial organisations making these sub-prime loans combined them into packages to create a new financial asset consisting of a bundle of these individual loans, called CDOs, or collateralised debt obligations, which could then be sold on to other financial institutions. Further bundling then took place as financial institutions bundled CDOs together and sold off slices to other financial institutions. In theory, the CDO was safer than the individual loan since, the argument went, if one made one loan and it failed, one had lost all one’s money. However, if one invested in a CDO, where you might have a slice of 100 loans bundled together, one individual loan failing was relatively insignificant.

Unfortunately, as it transpired, when the sub-prime market as a whole collapsed, due to rising interest rates and falling house prices in parts of the USA, the CDOs were equally risky and quickly depreciated in value. They also suddenly became illiquid meaning that their holders were unable to sell them to realise even a part of their value.

A fourth factor to consider was the separation of responsibility for the regulation of the UK banking system from the operation of monetary policy, both of which were previously the responsibility of the Bank of England. However, in 1999, the Chancellor, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and the Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. Following the crisis, the FSA was replaced by the Financial Conduct Authority in 2013 which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition). The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.

In retrospect, a final factor must be the failure of the US authorities to arrange a bail-out for Lehman Brothers. It is difficult to speculate on what would have happened had Lehman Brothers not been allowed to collapse, but one can reasonably assume that there would not have been the same collapse in confidence which affected financial markets world-wide.

It is worth reflecting on the effects of the crisis by looking at what has happened to the UK economy in the decade since the crash. Since the third quarter of 2007 UK GDP has grown by approximately 11%. This was one third of the growth in the previous decade. As a result, economists talk of a  ”lost decade”.   The situation is even worse if we focus on the growth in GDP per head where we are only 3% up on where we were ten years ago. Focussing on real average weekly earnings shows an even worse picture. Although average weekly earnings are up 19% over the decade, the CPI has risen by  26%, showing that workers are 7% worse off in real terms. There has also been a shift in the distribution of income with the elderly gaining at the expense of workers through the triple lock (the commitment to link the increase in the value of pensions to inflation, the rise in average earnings or a minimum of 2.5% whichever is higher). As a result, the median income of retired households has gone up 13% compared to a fall of 1.2% for non-retired households.

Interest rates have fallen from 5.75% before the crisis to 0.25% today (31st October 2017).  Therefore homeowners with mortgages have gained significantly. For example, mortgage payments on a £150,000 fixed rate mortgage would have been £1355 per month in 2007 compared to £871 today, and an additional benefit has been that average   house prices have risen by 10%, although there have been significant regional variations. This is a further benefit to the elderly although since many of them might be savers, they have lost out from the low interest rates.

The National Debt has soared as a result of the measures taken by the government to reduce the effects of the crisis. In August 2007, the national debt was £534bn; it is now approximately three times as large at £1.6tr. The value of sterling has fallen from £1 = $2.11 to $1.3 today (but the implications of this deserve a separate article) and, on the positive side, UK unemployment is at a 42 year low.

The end of the era of low interest rates?

On Thursday 2nd November, the Bank of England increased interest rates. Although the increase was not large (from 0.25% to 0.5%), possibly it marks the end of an era. It was the first increase since 2007 and follows the cut in rates in 2009 from 4.5% to 0.5% after the collapse of Lehman Brothers. The rate was further cut in 2016 to 0.5% following the Brexit vote.

Traditionally the rate rise should benefit savers and make it more expensive for borrowers, particularly those with mortgages. However the UK economy has changed in the ten years since rates were last increased. Banks have been far slower to reward savers  than to punish borrowers when rates rise so savers should not get too excited by the rise in interest rates. More importantly, the number of homeowners with variable rate mortgages has fallen significantly, with The Times estimating that only 10% of households will be affected by the rate rise. This is partly because of the shift to fixed rate mortgages, which now account for 60% of mortgages, the increase in renting and the repayment of mortgages among older households.

Secondly, although in percentage terms the rise is large, in absolute terms it is relatively small and, for a family with a £250,000 variable rate mortgage, they will currently be paying approximately £1,125 per month and their payments will rise about 2.25% or £25 per month. This will reduce discretionary income and consequently consumption is likely to be slightly reduced. There are however two more significant effects. Those borrowing via  credit cards or taking out loans for large purchases such as cars or furniture, will see borrowing costs rise and this could deter future consumption. Another issue is that people currently with very high borrowing, particularly those on low incomes, might find it increasingly difficult to repay the interest on their existing borrowing, with an impact on bankruptcies. Most important is likely to be the psychological impact of the rate increase since a signal has been sent out that the era of ultra-low interest rates is coming to an end.

The rate increase is not unexpected, having been forecast in the press for some time. The recent rise in inflation to 3% made it more likely. However it is worth assessing the decision  in more detail. Normally interest rates increase as inflation rises in order to reduce inflationary pressures in the economy and keep inflation within the 1% – 3% band set for the Bank of England by the Government. According to the traditional Phillips Curve idea, rises in inflation are likely to occur simultaneously with falls in unemployment as increases in aggregate demand in an economy work simultaneously to increase prices and reduce unemployment as firms attempt to hire more workers to increase output, thereby putting an upward pressure on wages which then feeds into higher inflation. One could therefore easily argue that, at many times, an increase in interest rates is a sign of a strong economy experiencing rapid growth.

The current situation is slightly different. The increase in UK inflation can be partly explained by the fall in the value of sterling following the Brexit vote and this will drop out of the CPI index over the next few months. Secondly, although unemployment is at a record low at 4.3%, there has not been the rise in earnings which, in the past, we would have expected to accompany the strength of the labour market, thirdly there has been a slow-down in the UK’s rate of growth and finally there is still considerable uncertainty in the economy about the outcome of the Brexit negotiations which is affecting confidence among businesses. So why the rise in rates?

One explanation for the rise in interest rates comes from Ed Conway, the Economics Editor of Sky News who suggests that the UK’s ability to grow without inflation has fallen in recent years because of our poor productivity growth. Whereas in the past we might have been able to sustain growth of 2 – 2.5% without inflation, he thinks the maximum figure for non-inflationary growth might now be 1.5%. Therefore, without compensating action, inflation is likely to increase.

 

The WTO & Brexit

The World Trade Organisation has not featured  frequently in UK newspapers since its foundation in 1994. However since the Brexit vote, there has been increased interest in its role in regulating world trade  since, if no agreement is reached, the UK might be falling back on WTO trade rules following departure from the EU. Its aim, when it replaced its predecessor, the General Agreement on Tariffs and Trade (GATT), was to act as a forum for negotiations to reduce tariff barriers,  resolve trade disputes between members and provide technical assistance for developing countries.

GATT was established after the Second World War to ensure that there was no return to the protectionism which  took place in the 1930s as countries tried to protect their economies from the effects of the Great Depression. The WTO replaced GATT because of  developments in international trade since the Second World War, namely the rise of intra-firm trade where a company manufactures components in one country, assembles in a second and sells in a third, increased globalisation and the rise of trade blocs, such as the  EU, and NAFTA. It can authorise sanctions if a country breaks its rules. For example, in 2015 it ruled that the USA had acted illegally in insisting that all beef and pork sold in the USA should have the country of origin labelled. Canada, which sells much meat in the USA, applied to the WTO to impose retaliatory tariffs which will hit many different parts of the US economy in order to persuade the USA to reverse its requirement.

As well as regulating international trade, the WTO attempts to promote free trade since it believes that freer trade provides benefits in the form of greater choice and lower prices, stimulates economic growth, raises incomes and promotes world peace. It does this  via a series of meetings (or rounds) lasting many years, the latest being the Doha Round, which started in 2001, lapsed at the end of July, 2008 as trade fell due to recession, and has now been revived. But its success in reaching agreement is limited and has moved towards agreements covering specific products e.g. removing tariffs on high-end semi conductors rather than wide-ranging agreements which have been difficult to reach.

Anyone wishing to join 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 Malaysia.

Another 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 our lorries to be stopped when entering the EU and inspected, in the same way that British goods entering  Japan are currently examined. This has the potential to hinder  trade as lorries are inspected and goods checked to ensure that they meet EU standards. This might not seem a major problem but exporters fear that these delays will be significant, delaying drivers and lorries and therefore increasing 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 might require UK financial consultants, bankers, accountants, etc to  have more physical locations overseas and also to re-qualify in the countries they export to.

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. Equally, or possibly more importantly, we do not know what tariff and non-tariff arrangements will be in place between ourselves and the EU when we leave. Will UK consumers lose out because of  higher priced imports  from the EU or will these be outweighed by new trade deals negotiated by the UK with non-EU countries and will UK businesses see exports rise because of these new agreements or fall because of less trade with the EU?

 

 

 

Technology and unemployment

For many years people have worried about the rise of the robots and artificial intelligence. Science fiction writers have envisaged situations where robots gradually gain more intelligence and power until they are able to take over the world and whichever other planets feature in the story. Less exciting, but more immediately relevant, economists and politicians have also concerned themselves with the impact of the robots on society and particularly on the demand for labour. During eras of major technological change, it was predicted that the rise, firstly of steam, then electricity and more recently the computer, would lead to massive unemployment. Keynes, writing before the Second World War, predicted that new technology would drastically reduce the working week and we would have to tackle the problem of how to occupy our time with a 25-hour working week. In 1979 Fiat produced a now-famous advert for their new Strada (https://www.youtube.com/watch?v=-fXV6KzhBbM ) under the slogan “handbuilt by robots” which showed the construction of the car in a spotless factory without humans, with everything done by robots.

A recent report, “The Future of Skills: Employment in 2030” by NESTA, an innovation charity, paints a relatively attractive future. They suggest that while 20% of the labour force is currently working in occupations which are likely to shrink, about 10% are in occupations that are likely to grow as a percentage of the workforce. Re-training will be necessary for the former, either to cope with the way their existing job has changed or to allow them to join the latter group. These industries include those working in teaching and education, hospitality, leisure, health care, and other jobs which require workers to deal with people, such as care for the elderly. Another group which will do well are those working in occupations which require higher-order cognitive skills such as psychologists. Those possessing creativity and communication and problem-solving skills will do well while those in jobs which can be more easily adapted to robots and artificial intelligence, such as those involving routine calculations and basic manufacturing skills will be lost. If you are seeking advice as to how to invest your portfolio, it is already possible to put all the necessary information such as your attitude to risk, how much you have available to invest and for how long and a computer algorithm will devise your optimal portfolio.

The Return of the UK’s Productivity Problem

Last week the ONS reported a fall of 0.1% in UK productivity over the three months from April to June. This follows a fall of 0.5% for the three months from January to March and an overall fall and a fall of 0.3% compared to last year. While the numbers are small, they should be compared both to historical data for productivity growth and to other countries. Historically, some commentators have suggested that if productivity had grown since the financial crash at the rate it was growing before, we would be 20% more productive than we are today. When looking at other countries, German workers produce 36% more per hour while the French and the Americans are 30% more productive. Ed Conway, writing in The Times last week, noted that there are only three regions in the UK out of 168 which have higher productivity than the German average. A recent paper by Richard Davies, Anna Valero and Sandra Bernick for The Centre for Economic Performance (http://cep.lse.ac.uk/pubs/download/special/cepsp34.pdf)  note that productivity varies significantly by area with mid Wales at the bottom and, at the top,

“there are three high-productivity hubs: the oil industry around Aberdeen, the area around Greater Manchester and a band of productivity in the South. Contrary to popular belief the high productivity of London does not spread into the South East but rather spreads west along the M4 towards commuter towns like Reading and Slough which have their own high productivity companies.” (Page 3)

They also identify key sectors:

“The highest productivity sectors—real estate, mining and utilities—are small employers and so play little role in aggregate performance. Of the high employment sectors that drive national productivity the leading sectors are finance, information and communications, construction and manufacturing. Professional, scientific and technical services vary within and across regions–this sector houses some very high productivity firms together with much weaker ones. However, it is important to consider high employment sectors with weak productivity, such as retail and wholesale trade, administrative services and accommodation and food services. Raising average productivity in these sectors could have a large aggregate effect due to their high employment shares.” Pages 3 and 4

While not as exciting as Brexit or the Tory leadership, low productivity is a significant issue. If we have lower productivity then our workers are not producing as much as those in other countries and will consequently receive lower wages. Furthermore firms profits will be lower, hence meaning less funding available for investment, hence lower productivity growth and we find ourselves in a downward spiral relative to our competitors. Hopefully the Chancellor will address the problem in his budget next month but, if not, we face a slow decline in UK living standards and relative prosperity compared to our European neighbours.

 

What’s going on in the UK economy?

Trying to understand what is going on in an economy can be difficult. Running the economy has been described as similar to trying to drive a car while only being able to look in the rear-view mirror. You know where you have been but cannot see what is ahead. Economic forecasters today probably look back to the period before the financial crash when the UK was in the NICE decade (non-inflationary, continuous expansion) as a golden period. Today life is more complex and one cannot help but feel sorry for the Chancellor busy preparing his November budget and the Monetary Policy Committee of the Bank of England when they meet in November and have to decide whether to increase interest rates.

On the one hand, implying  a rate rise is not yet needed, the Office for National Statistics has just announced that GDP growth has fallen from 1.8% for the first quarter of 2017 to 1.5% for the period April to June which is below expectations and the weakest figure for four years. This is partly down to a fall in services of 0.2% which comprise 80% of GDP inflation. Furthermore discretionary income (what you have left to spend after tax and spending on essential items such as food, energy and transport, has fallen and 60% of households are worse off than they were a year ago as a result of wages rising at 2.1% while inflation is currently 2.9%. Another piece of evidence is that a survey published over the weekend by the Nationwide  reported that house prices dropped in London by 0.6% between July and September compared with the same period last year. This is the first such fall for eight years. 

However the high rate of inflation combined with the fall in unemployment  to 4.3% would suggest it is now time  to reduce the level of aggregate demand by raising interest rates.

Just to make the whole picture more confusing , there is the danger of depressing demand at a time when the economy is fragile because of uncertainty regarding Brexit and one does not want to do anything to discourage business investment which is supposed to be weak because of low confidence. Yet business investment actually rose by 0.5% in the second quarter of 2017! Furthermore, although the current account deficit rose to £23.2bn in the second quarter from £22.3bn in the first quarter, exports of goods and services actually rose by 1.7% while imports increased by 0.4%. Finally, just when you might think you have taken account of all the main variables – what about oil prices which have a significant impact on inflation and discretionary income. OPEC’s decision to curb production is intended to keep prices high and, although this looked to be failing earlier in the year, the combination of hurricanes damaging US oil refineries and the OPEC production curbs have started to have an effect on fuel prices.