The Next Budget

Possibly, the Chancellor of the Exchequer, Sajid Javid, spent New Year’s Day in No 11 Downing Street, working on the budget which Boris wants ready for February when the UK has left the EU. If so, he will be aware that preparing the budget will be tricky because no one knows what the terms of the UK’s future trading relationship with the EU will be. Although Boris talked of a deal being signed in a year, business leaders and civil servants in the UK and many in the EU feel that this was unrealistic, given how long trade deals take to negotiate and the UK’s failure to reach the target for the number of trade deals promised during the referendum campaign. One can argue that, given the increase in protectionism in recent years, a close deal is vital, especially since the potential new markets are relatively small, compared to our trade with the EU.

Philosophically, the government has a potential  problem with the right of the Conservative Party favouring a free market approach with tax cuts and reduced regulations, while many new MPs elected in former Labour seats are looking for measures to help their constituencies which contained new Conservative voters, won over by the promise of Brexit, but whose jobs are at risk from increased competition from manufacturing companies in Asia, the loss of exports to the EU and a possible UK slowdown after Brexit. Many of these areas, with significant aerospace, chemicals and food production industries, rely heavily on exports to the EU and have to meet EU rules and regulations. If the future trade deal did not allow such exports to continue and instead allowed the EU to impose tariffs and implement customs checks, the consequences for some areas would be significant. The Flintshire and Wrexham area has an Airbus factory and a thriving pharmaceuticals industry and 87% of all goods made are currently exported to Europe. Elsewhere, in Derby North, where there is a Rolls-Royce factory, over 25% of the economy is linked to sales to the EU.

There is general agreement that the UK has spent too little on both business and infrastructure investment and encouragement for businesses to do the former and a determination by the government to do the latter will help improve UK productivity – a major UK issue. Incentives to help people, particularly first-time buyers, buy housing are important but, just as important as increasing demand, is the need to increase supply, possibly by encouraging more building on brown field sites. Another major area of need is the level of skills in the workforce and the need to bring UK vocational training up to the standards of other countries.

Fortunately, there is scope to boost the economy since the new government has adopted looser fiscal rules than its predecessor. In 2016, then Chancellor George Osborne’s fiscal rule was to eliminate the deficit by 2019/20 which was relaxed by Philip Hammond, who moved the target to 2025. What the current government has promised was to ensure that they raised enough in tax revenue to cover day-to-day spending but would borrow to invest. However infrastructure, such as building new roads, schools and hospitals takes time and very few projects are ‘shovel-ready’. This is worrying since growth started to stagnate and the labour market weakened before the election but possibly, following the clear election result, businesses and consumers might become more confident and increase their spending. Something to wish for at Xmas!

What sort of economy will the new Prime Minister inherit?

In elections, the economy is usually a key focus  on the campaign trail with opposition parties taking every opportunity to criticise the government while the latter explains how they have improved the economy after the disastrous state they found it in when they took office.

In this election, with its focus on Brexit and many lavish future spending plans, the current state of the economy has not yet featured heavily but were one asked to comment on its current state, it would be difficult since there is so much contradictory evidence at present.

Consider the following data and one sees why it is so hard to see how we are doing.

  • Although GDP grew by 0.3% in the third quarter of the year, the yearly growth of 1% is the lowest since 2010. Will this increase or fall after the election?
  • Unemployment is now 3.8% which, in historic terms, is low. However this is slightly up on the last month so does this, pessimistically, suggest we are on the cusp of an increasing period of unemployment, especially since unemployment is a lagged indicator – firms do not immediately reduce labour when demand for their products fall. Alternatively, one can look at the figures and note that the falling number of people in work is because part-time employment has fallen by more than the rise in full time jobs so, positively, more people are in “real” employment or have the part-time workers who have failed to find full time jobs simply stopped looking and left the labour force?
  • Productivity has only increased by 2.4% since June 2007. Before then the UK had averaged 2% per year, so we are producing over 20% less than we would have been had the trend continued. Possibly this is due to the long tail we have in the UK in terms of productivity with too many firms a long way below the best in their industry. How can this be improved?
  • Inflation fell to 1.5% last month because of lower gas and electricity prices but retail sales fell last month as consumers possibly lost confidence in the economic outlook for the next few months. Earnings are increasing at 3.6% so real incomes are rising at 2.1% but if productivity is static, then inflation will increase as firms’ costs rise.
  • UK exports have dropped, possibly because of Brexit uncertainty and the slower world GDP growth following the US-China trade war.
  • The public finances have deteriorated. Borrowing has risen by a fifth during the first half of the financial year, and in September was £9.4bn compared to £8.8bn last year and the national debt was £1.8tn at the end of the financial year ending March 2019, equivalent to 84.2% GDP. Therefore how will the political parties finance their announced increases in spending without considerable increases in tax or borrowing?
  • UK consumer debt is rising, standing at £59,441 per household in August 2019. What will happen when interest rates increase as they are likely to do if government spending increases significantly or if the economy enters a downturn when Brexit occurs? Are we heading for another financial crisis?

How is the UK doing?

In the run-up to a big boxing or tennis match, the media is fond of making comparisons between the two competitors, comparing key measures such as height, weight and reach. As we approach Brexit on 31st October or later,  it is worth doing the same exercise for the UK and world economies to see what state the UK is in.

Optimists, looking at data published in August, highlight the increase in average earnings of 3.6% in the year to June, the highest increase since June 2008, the rise in employment to 32.8 million (largely due to increased females working), giving the joint highest participation rate ever.

However pessimists focus on the fall in GDP of 0.2% from April to June, the sharpest fall in high street sales since December, 2008 (although these are survey figures, so might not be representative) combined with a fall in internet shopping, the increase in inflation to 2.1%, the small increase in unemployment to 3.9%, the lower than expected government budget surplus and the balance of payments current account deficit amounting to 5.6% of GDP. They also worry about the quality of some of the new jobs being created, possibly on zero hours contracts, and ask whether the rise in employment is because firms are reluctant to commit themselves to expensive investment projects because of low confidence in the economic outlook.

The current state of the world economy is also a concern for the UK. Germany suffered a fall in GDP in the last quarter and is expected to move into recession (two consecutive quarters of negative growth), the trade war between the US and China is dragging on and growth in the latter is slowing, and the International Monetary Fund has cut its forecast for world growth to 3.2%, the lowest for ten years. The world economic situation has been a key factor in last month’s fall in UK manufacturing output – the fastest rate of fall for seven years. However, worryingly, another explanation provided was that some foreign firms are cutting the UK out of their global supply chains in anticipation of Brexit (but bear in mind that manufacturing is now only 10% of UK GDP).

However what was a feature in the news last month was the technical concept of an inverted yield curve. The yield on a financial asset, such as a government bond, is the rate of return based on its purchase price and, normally, it is higher for long term assets than short term ones. If the government borrows money for three months, the rate of interest would normally be lower than if it borrowed for ten years. This is because lenders are rewarded for committing their money for a longer, and therefore riskier, period. When this is reversed, i.e. governments can borrow at a lower rate of interest for ten years than one or two, it signals that the markets expect that the future will be poor and the government will cut short-term interest rates in the future, therefore savers will wish to lock into the current long-term rates of interest. An inverted yield curve also shows that savers wish to lock into safe assets, such as US, German and UK government bonds, and are prepared to pay a higher price for them. The higher price reduces the yield from the bonds. An additional concern is that current interest rates are already at very low levels so the scope for reducing them is limited so, despite concerns about high government borrowing, fiscal policy might be the only weapon left.

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

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

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

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

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

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

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

So how is the economy doing?

This week has seen the publication of considerable economic data and much of it is contradictory, making it hard to tell exactly how well the UK economy is (or is not) doing.

In the year to March 2017, household spending in real terms returned to levels not seen since before the financial crisis, reaching £554 per week. The UK budget deficit has fallen and was £2.6bn in December, compared with £5.1bn in December 2016, and almost half economists’ expectations. This was partly due to higher than expected tax revenues from income tax receipts because of higher employment, higher VAT receipts and a refund on contributions to the EU. The positive news on the budget deficit means that government borrowing is likely to be at its lowest level since the financial crisis. Before celebrating too much, be aware, firstly, that the higher VAT receipts were due to higher inflation as well as to the growth in consumption and, secondly,  the refund from the EU was because the UK share of the EU budget has been revised downwards as a result of slower growth in the UK than the rest of the EU.

Another boost for the UK economy  was news that the employment rate had risen to a record high of 75.3% or 32.2 million, confounding forecasters who had predicted that the employment boom was over, based on the fall in October 2017 which is now being treated as a temporary fluctuation. At the same time as the employment level rose, the unemployment rate remained at 4.3% or 1.4 million, a 42-year record low. Equally encouraging was the shift from part-time work to full-time work which occurred over the period.

Further positive news  was that the economy grew at 0.5% in the last three months of 2017, faster than expected, largely because of the resilient service sector which makes up about 80% of the economy. As a result, growth last year was 1.8%, significantly higher than the 0.5% prediction by some disappointed economists following the Brexit vote. However, it is worth noting that the UK has dropped from being a growth leader to a laggard among the G7 countries, its growth rate is now at its lowest rate for the last five years and, given more rapidly rising incomes among our main trading partners, a slowdown in UK growth is disappointing.

On the downside, wage growth continues to be slow, meaning that real incomes are falling, the number of people starting apprenticeships fell by a quarter in the three months between August and October compared to last year, and sterling rose to its highest level since the Brexit vote. While this is good for importing businesses and holiday makers, it is less good news for exporters who have enjoyed the benefits of a low pound. It has also hit the share prices of companies with significant dollar earnings which are now worth less when converted into sterling.

Finally a word of caution; some of the figures, such as consumption spending, relate to the previous financial year while others, such as the growth in GDP, are subject to significant revision over time. Most recently, the figures for UK productivity have been questioned because the ONS might have significantly over-estimated inflation in the telecommunications industry and therefore underestimated the increases in its output. As a former Governor of the Bank of England pointed out, “trying to control the economy is like steering a car by looking in the rear view mirror”.

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.

Productivity and the election

Many of my recent posts have focused on productivity and the UK’s poor record when compared to other countries. As mentioned before, in general terms, UK workers produce in five days what workers in the USA, France, Germany and Italy produce in four. Although GDP growth has been good until recently (only 03% in the last quarter) and employment data in the UK is extremely positive with the employment rate standing at 74.6%, the highest since data was first collected in 1971, it has been accompanied by poor productivity growth with the increase in UK productivity since 2008 (the period immediately before the recession) being only 1.1%. This means that pay, and therefore living standards, will be lower in the UK than in more productive countries. The Bank of England’s latest Inflation Report suggests that incomes will rise 2% this year and inflation will rise to 2.8%, therefore implying a fall in real incomes.
There are many explanations for this. One explanation, which neatly sidesteps the problem, is that the main issue is not that the UK has low productivity, but is that we are simply poor at measuring it in the service sector, a key area in the UK economy. In manufacturing, it is relatively simple. One can count the number of goods produced; however, in services it is trickier particularly as the digital economy grows. 10 years ago, if I wanted directions, I would buy a map and eight years ago I bought a satnav and put it in the car (both are easy to measure). Today I  use my smartphone and these additional services are not easy to measure.
Nevertheless, most economists accept that there is a  productivity issue in the UK. Andy Haldane, chief economist at the Bank of England, suggests that poor management is a key factor, particularly in sectors where competition is low, allowing x-inefficiency to flourish. Lord Browne, former Chief Executive of BP, suggests three key factors. Firstly our service economy is not sufficiently professional compared with the USA; secondly there is a shortage of finance available in the UK for entrepreneurs wishing to start new businesses and, finally, he cites the anti-science culture in the UK where it is acceptable to profess an ignorance of mathematics and science. However almost all economists would agree that the UK’s low level of investment is a contributory factor and the uncertainty around Brexit and the election itself could cause businesses to delay their investment plans until the future is more certain. There is already anecdotal evidence of many financial institutions looking to open offices overseas.
There has been little focus specifically on the issue in the election. Labour plans to increase Corporation Tax to 26%. (It is currently 19% but due to fall to 17% over the next two years) which might impact on investment in the future but some of their spending plans might, in the long term, improve productivity. They also intend to renationalise the railways, water, the national grid and Royal Mail and borrow £250 billion to create a fund for infrastructure projects. The Conservative’s statement that “no (Brexit) deal is better than a bad deal” and a reluctance to remain in the Single Market has also caused anxiety among businesses, while a focus on grammar schools is not the best way to tackle Lord Brown’s concern over the UK educational system. However they do present themselves as a more pro-business, low tax government and hope that such sentiments will encourage investment. They are also committed to spend 2.4% of GDP on R & D by 2027 and to create a national productivity investment fund of £23 billion.
The IFS, an independent think tank focus on Labour’s additional infrastructure spending which would boost GDP in the near-term and would increase the productive capacity of the UK economy in the long term, although their increased labour market regulations such as a higher minimum wage would have the opposite effect as would four additional bank holidays and their higher rate of corporation tax. The Conservatives’ commitment to reduce net immigration would also weaken growth, although no specific timescale has been announced. Most disappointingly, the IFS suggest that there will be NO overall impact on productivity from either party. It is difficult to take into account the impact of Labour’s plans to take significant parts of the economy back into public ownership, not least because of the time which such measures would need to come into effect.

Roll on Thursday!