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 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.

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.

 

Good news for the Chancellor?

Friday’s papers contained news which might make life easier for the Chancellor when he prepares for his budget on 22nd November. Government borrowing in August fell faster than expected, meaning that the Chancellor will have approximately £10bn more to spend on helping reduce student debt, boosting public sector salaries, spending on the NHS, improving our infrastructure, etc. At £5.7bn, the Government’s August deficit has fallen to its lowest level for a decade. The reason for the fall is twofold. VAT receipts have soared because of  high consumer spending while current government spending, particularly local authority spending, has fallen.

However all is not rosy. Firstly, when interest rates rise, which is likely to happen sooner rather than later, government debt interest payments will increase, as will interest paid on index-linked borrowing because of higher inflation rates (borrowing where the rate of interest is linked to the rate of inflation). Furthermore, there are certain commitments which have already been made, particularly with regard to public sector pay, which will necessitate higher government spending. If these factors are not to increase government borrowing then either taxes will  increase, other areas of government spending fall or the UK economy must grow sufficiently strongly to generate enough extra tax revenue.

Secondly Moody’s, one of the major ratings agencies, last week downgraded the UK’s credit rating from Aa1 (the top rating, sometimes referred to as triple A) to Aa2 on the grounds that leaving the European Union was creating economic uncertainty at a time when the UK’s debt reduction plans were in danger because of the decision to raise spending in certain areas. This follows a downgrading in 2016 by the other major agencies, Fitch and S&P. The downgrade might affect how much it will cost the government to borrow money, particularly on foreign financial markets. The Labour Party has called the downgrade a “hammer blow” to the economic credibility of the Conservatives.

Thirdly the stronger than expected level of consumer spending which boosted VAT receipts is unlikely to be sustainable as real incomes fall because of the low levels of wage increases combined with the higher levels of inflation. The forecast for the growth in retail sales compared to a year ago was 1.1% whereas the actual number was 2.4%, with last month showing particularly strong growth. There are many possible reasons for this. Possibly the weak pound caused more people stayed at home instead of going overseas for a holiday, possibly the falling unemployment had an effect and possibly the figures will reverse next month since they are extremely volatile.

Finally it is worth noting that the OECD (the Organisation for Economic Co-operation and Development, an organisation comprising the world’s major economies) forecasts that we will fall from being the second fastest growing  G7 economy to the second slowest as the other main economies improve and we do not.

If the UK economy is to flourish, an increase in the rate of growth, an improvement in productivity and a satisfactory agreement with the EU are all crucial.

Unemployment, inflation and the Phillips Curve

Recent data published last week on inflation and unemployment in the UK is causing excitement among economists – something rare among the practitioners of what Victorians called the “dismal science” after the gloomy predictions of Thomas Malthus.

Employment reached a record high of 75.3% and unemployment fell to 4.3%, a 42 year low, and almost half its 2011 peak of 8.5%. However, inflation rose, reaching 2.9% in August, up from 2.6% the previous month. Since wages rose only 2.1% in the quarter ending in July, real wages fell because the rate of inflation exceeded the rate of wage increases. This is unexpected since falling unemployment normally coincides with rising real wages as workers use the tightening labour market to obtain pay increases. Compared to the other 34 members of the OECD, only Greece, Mexico and Portugal have experienced weaker recoveries in wages than the UK.

There are two theoretical questions resulting from these figures. The first is whether we have yet reached the “natural rate” of unemployment (the rate at which inflation is stable) or whether there is scope in the economy for unemployment to fall even further without causing a significant rise in inflation. The Bank of England previously estimated the natural rate to be  5% and now estimates 4.5%. Yet wages are still not increasing as fast as before the financial crisis. Is 4% rate a better estimate?

The second, linked question is what has happened to the Phillips Curve. This was an important idea for economists and politicians since an article written by William Phillips, a Keynesian, in 1958. He suggested there was an inverse relationship between the rates of wage inflation and unemployment via the level of demand. Subsequent economists substituted price inflation for wage inflation and the idea of politicians facing a trade-off between inflation and unemployment was born. This lasted until the stagflation (stagnation and inflation) of the early 1970s when many developed economies simultaneously started to experience rising inflation and rising unemployment, something not possible with the original Phillips curve. As a result, economists such as Milton Friedman, argued that although the trade-off indicated by the Phillips Curve was valid in the short run, there was no long run trade off. He suggested that there are a number of short run Phillips Curves and a vertical long run Phillips Curve, which exists at the natural rate of unemployment – the rate of unemployment at which inflation is stable. Although one would experience lower unemployment and higher inflation in the short run if the government were to stimulate the economy, in the long run, as inflation eroded the effects of the stimulus and workers and businesses adapted to the higher rate of inflation, the economy would move back to the natural rate of unemployment but with a higher rate of inflation.

What we have today is a curve which seems flat. Unemployment has been falling but, although inflation has risen, it is still low (and largely explained away by the fall in the value of sterling following the referendum) and real wages are falling. Has the labour market changed significantly to finally kill off the Phillips Curve or is it that fear of the consequences of Brexit and economic uncertainty are allowing employers to recruit more staff without significantly raising wages?

Mini cheers for BMW

At the end of July there was positive news about the UK car industry. Production was 1.7 million vehicles, the highest since 1999, and  newspapers reported favourably on the decision by BMW to assemble the new electric mini at its Cowley plant, near Oxford, rather than in Germany or the Netherlands, when it goes into production in 2019.

Greg Clark, the Business Secretary, called this a “landmark decision” showing confidence in the Government’s intention to make Britain a key player in the production of the next generation of motor vehicles.

However it is worth examining this decision in more detail to see what it suggests about the UK economy. A key concept in the discussion of the gains from international trade is “comparative advantage” which relates to those goods and services in which a country has the greatest relative advantage in production over other countries. (In economic terms we are looking at focussing on the production of goods and services where a country has a lower opportunity cost than its trading partners).

Ideally, the UK would like to be involved in the high value-added aspects of the production process since this is where the most income is likely to be earned and hence workers’ pay, profits and living standards will increase. In car production this is in the development and production of such things as batteries and motors rather than the assembly of component parts into the finished product. The most important parts of the new Mini, the electric motor and battery, containing new technology, will be manufactured and assembled in Germany and then shipped to Oxford to be put in to the vehicles. While the assembly of the vehicles will ensure that jobs will remain in Britain, the greatest value-added is likely to occur in Germany since that is where the highly-skilled parts of the production process will occur.

Fifteen years ago James Dyson moved the manufacture of his vacuum cleaners to Malaysia because of the significantly lower labour costs while emphasising that the high value areas, such as research and development will remain in Britain. Similarly, Apple designs its products in the USA but the manufacture is outsourced to plants in China, Korea, Mongolia and Taiwan.

Is the BMW decision a sign that this is the way the UK economy is going?  Are we going to become a low-skilled assembly hub, trying to keep costs low in order to offset tariffs imposed on us by the EU? (With no deal with the EU, we could be facing tariffs of 10% on vehicles and 4.5% on parts). Alternatively do we look to the success of prestige British manufacturers such as Rolls Royce, Bentley and Jaguar which, although now foreign-owned, successfully manufacture high quality products in the UK?