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.

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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.

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.

The impact of technology – The Fourth Industrial Revolution?

Amazon has opened a shop in Seattle with no checkouts and customers who do not pay on leaving. Instead, with the appropriate app to link the shopping to an Amazon account, all that is needed is to go round the store, put items in a bag and scanners and sensors do the rest. After leaving the store, payment is debited from your account. There are no queues and no cashiers.  So successful has it proved that more have been opened. It already has three in Seattle and one in Chicago and plans ten by the end of 2018, 50 by the end of 2019 and, according to some press reports, 3,000 such shops within three years.

Electric cars have also been in the news over the summer, with a focus on how they will reduce the environmental damage from driving. What has been less well-publicised is their possible impact on the demand for workers in the factories of the future. Electric cars are easier to manufacture than current ones because their mechanism has fewer moving parts than the internal combustion engine. This means both that fewer workers will be needed and those on the manufacturing process will be less skilled, making it easier to outsource manufacture to other countries. However new technology in the motor industry could, potentially, have an even greater impact with the arrival of driverless vehicles. Uber is already looking into driverless taxis and black cab and white van drivers could become a distant memory in the same way that stokers on railways are no longer with us and blacksmiths are a rarity.

A robot is being developed, based on technology used in the NASA Rover to explore Mars, which will drive itself round battery chicken sheds, measuring the chickens by sight and checking their temperatures. This machine is likely to be popular if farmers face a shortage of labour after Brexit since they will replace human workers.

There is considerable dispute over the numbers and what the future will look like. Some suggest traditional, full-time jobs will decline and there will be an increase in remote working but overall, there will  be little impact on the number of jobs. Others argue that the impact will be positive, with new technology creating more jobs than are lost. They suggest there will be a much greater need for workers to develop, build and maintain the new technology and there will be some areas such as the care industry (growing because of an ageing population) where more human workers are likely to be needed to care for patients. McKinsey, a worldwide consultancy form,  recently predicted that robots will have the same impact on the global economy as the development of the steam engine, adding 1.2%pa to global growth by 2030.

A report by the World Economic Forum (The Future of Jobs, 2018), one of the more optimistic forecasters, has suggested that 42% of the world’s jobs will be done by machines by 2022, up from 29% today. It also estimates that although 75 million jobs will be lost by 2022, 133 million new jobs will be generated, resulting in an additional 58 million jobs. They see losses in administration, clerical, manufacturing, construction, legal, and maintenance sectors but increased demand for those in data analysis, management, computing, architecture, engineering, sales, education and training. Different numbers come from PWC, a worldwide firm of accountants, who predicted in July that about 7 million jobs will be lost by 2020 because of technology but 7.2 million will be created. They see losses in manufacturing, transport and public administration while the increases will occur in healthcare, science and technology and education.

Others are less optimistic. During the summer, Andy Haldane, the Bank of England’s chief economist, made the news by predicting that the impact of artificial intelligence could be more disruptive than previous industrial revolutions and would lead to widespread job losses. He argued that previously machines had replaced labour doing manual tasks whereas increasingly machines, because of developments in AI, are undertaking tasks previously thought to be beyond them. Mr Carney, the Governor of the Bank of England, suggested that the latest industrial revolution would threaten 10% of jobs in the UK and, while some workers would benefit from being more productive and earning higher wages, others, losing their jobs,  would not easily be able to find employment providing a reasonable standard of living and would need to be able to access education and re-training throughout their lives.

However the big issue will be that the people filling the new jobs are unlikely to be those losing the old ones. How society copes with this will be a major issue for the future.

Productivity and the Economy

By definition, productivity is the measure of output per unit input. Inputs include labour and capital while output is typically measured in revenue. Between July and December data shows that output per hour rose by 1.7% – the fastest rise since 2005. However, part of the rise was due to the fact that the number of hours worked has fallen. Labour productivity grew by 0.7% in Quarter 4 2017 and it was the second quarterly increase in a row leaving productivity at 1.8% above its peak in Quarter 4 2007 (before the financial crisis). However, the output per worker and output per job only grew by 0.1% showing that there has been a fall in the average hours worked. The fall in average hours worked also suggests that workers incomes are stagnating and so due to inflation, their real incomes may be falling.

Productivity plays an important role in the economy as there are many benefits that come with higher productivity. If a firm is more productive, it will have lower costs of production as they are able to produce more goods and services in a set amount of time. This means that the firm can become more competitive, assuming ceteris paribus, the lower costs of production means that a firm can decrease their prices. This decrease in prices can lead to an increase in demand and mean that UK goods and services could become more competitive in global markets. This can also lead to an increase in revenue for the firms and so these can be reinvested back into the firm to make it even more productive. These benefits can also lead to economic growth as output increases due to higher productivity, which in turn brings benefits to the country. If workers are receiving higher wages – as they work the same hours to produce more output meaning that a firm’s costs of production lowers and so firms are able to afford wage increases – this can also cause a further shift outwards of AD due to the multiplier effect. If a worker receives a pay rise, he will then spend some of his extra income on goods and services and so this in turn increases AD.

So the big question that occurs is why is the productivity in the UK so low? It has been a question that is very hard to answer. New machines and technology can make workers more productive, however companies’ capital spending is only 5% above its pre-crisis peak, compared with a 60% increase over the decade after the 1980s recession. This could explain a reason as to why productivity in the UK has remained so low as workers haven’t got the capital they need to become more productive. Another reason that could have caused low productivity is that firms have been retaining relatively (unproductive) workers rather than investing in machines. Helen Miller from the Institute for Fiscal Studies commented that “changes to state pensions and benefits are likely to have contributed” showing that people have been more willing to work in this financial crisis compared to other recessions. Therefore, firms have avoided large costs by investing in machinery and have instead increased the number of workers in order to meet demand. This is supported by the fact that the UK now has the highest employment rate since 1971 at 75.3%. With real pay (after accounting for inflation) down 0.2% in 2017 compared to the same time in 2016 – it shows that it is easier for firms to increase workers due to a low wage demand as inflation is not at a high rate relative to wages. This means output becomes more labour intensive which often have a lower productivity.

The blog also mentions that the government imposed an apprenticeship levy, with the idea to increase skills and training workers receive and this can in turn increase their productivity – the workers can develop the skills needed to produce more goods/services in a set period of time. The scheme was introduced in 2015 and aims to create 3 million new apprenticeships by 2020. However, in January 2018 there were 25,400 apprentices in training compared to 36,700 a year earlier showing that the scheme may not be as effective. However, this is focusing on human capital rather than physical capital such as machines. In some industries, such as construction, it is easy to run an apprenticeship scheme and train labour but in the services industry it has proven much more difficult to provide apprenticeship training. This supports the idea that it is easier to increase and improve labour than capital as the government have focused on encouraging firms to increase apprenticeship programmes. In the long term it is more important to focus on increasing capital than it is labour. This is because as technology advances, capital becomes more advance and so it can aid workers to produce more goods/services in a set amount of time. It is also more important than an increase in skilled labour as if you increase capital – the worker can become more productive too and so produce more goods and services. However, an increase in skills doesn’t affect how productive the capital is and so there may be a limit to how productive a worker can be without an increase in the capital available to them. An increase or improvement of capital means that LRAS will shift outwards and the sustainable output of the economy will increase.

The UK productivity is only above one other G7 country. All of the other G7 countries have a higher GDP per hour worked than the UK. This is shown in the graph below. Here you can see that the UK is the second lowest country despite all being at the same rate in 2007. There has been a slow down in labour productivity in the G7 countries, however there seems to be a higher slowdown in the UK. The UK’s nominal productivity gap in output per worker terms narrowed from 16.9% in 2015 to 16.6% in 2016, compared with the average for the rest of the G7. Compared with the rest of the G7, the UK had below average real productivity growth in both output per hour and output per worker terms in 2016. The UK has the largest gap between pre-downturn productivity trend and post-downturn productivity performance was 15.6% in 2016 which is double the average of 8.7% across the rest of the G7. This shows that the UK has suffered a larger productivity problem compared to the other G7 countries.

 

Lower productivity levels are detrimental to the UK. If the economy remains unproductive, it will not be able to benefit from lower average costs (unless wages remain low) as firms won’t be able to produce as much as more productive firms in the same time period. This means that UK goods will be less competitive on a global market – due to that prices of UK goods will be higher as costs of production remain higher due to lower productivity. This could worsen the balance of payments as exports remain low, and result in lower Aggregate Demand as the balance of payments is one of the components. The higher priced goods are also bad for UK consumers as demand for goods and services will fall due to the high prices. This means that there will be little, if any, increase in output and employment as demand levels remain the same. Higher prices, and lower demand, will mean that businesses retain lower profit from sales. This means that they don’t have as much money to reinvest into the firm which could be spent on training or capital in order to become more productive. The government will also not receive an increase in tax receipts if productivity remains low, as firms will not be selling as many goods and services and so the amount of Value Added Tax and Corporation tax that they receive won’t change.

Low productivity also means that workers wages will not rise as much as the firms cannot increase wages due to a lower demand and profit. This also means that the government will receive less tax receipts from VAT and income tax. Economic growth is also impacted by low productivity. This is because without an increase in productivity the Long Run Aggregate Supply curve will not shift outwards and so the sustainable output for the economy will not increase.

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”.