Economic Review - Second Quarter 2005 - The post-election landscape

Foreword

Arguably, the new Labour administration won its historic third term in office on the back of a period of unbroken economic growth, low inflation and low unemployment. This record was achieved against a background of pretty volatile international conditions which in previous periods may have caused the UK economy to fall into recession. The era of stable economic conditions has been good for business. The key question is will this continue?

There are many challenges ahead that will need to be addressed with some urgency by the new government. In particular, Roger argues that there will be pressures from the housing market, and the external deficit and public sector finances will present difficulties for the Chancellor if he is to retain his economic record for prudence, keep taxation under control and keep borrowing within the limits required to meet his Golden Rule. More than this, Roger argues that the disappointing productivity performance has the potential to undermine the long term competitive performance of the economy and this has to be of concern to any business leader.

The road ahead is one which is likely to see some significant challenges for Labour to retain its record of unbroken economic growth. It is a balancing act that we will all be watching intently.

Once again, I do hope that this Review helps you in both your immediate and long-term business thinking.

• In the recent election campaign, voters were bombarded with a baffling array of claims, counter-claims and statistics relating to the economy’s past performance and prospects. Now the election is over it is time to ask how well has the economy really performed in recent years?

• What’s without doubt is that the economy has registered an impressively long period of uninterrupted expansion in pretty d i fficult global conditions. But the average growth rate has not been particularly strong compared to that seen in previous decades, even the supposedly disastrous 1970s.

• Meanwhile, although the economy has performed well in comparison to many other countries, it is easy to overstate its relative strength. The UK has outpaced most members of the euro-zone and Japan, but lagged behind much of Australia, Canada and the US.

• A key factor behind the economy’s recent performance has been the stability and low level of inflation. This has owed much to the establishment of the Bank of England’s Monetary Policy Committee, but this was a further step in an existing low-inflation policy rather than an abrupt break from the past.

• In any case, the move to lower inflation has been a global trend. Similarly, while UK interest rates are very low by historical standards, they are just about the highest in the developed world.

• What’s more, behind the strong growth numbers lurk a number of imbalances which could have adverse consequences on the economy’s future performance. Most obviously, the over-valuation of the housing market threatens an abrupt downward correction, with knock-on effects on household spending and overall activity.

• Second, the trade position has steadily worsened as UK imports have grown rapidly and exports have been depressed by an overvalued currency. There is a danger of a sharp fall in the pound, which could threaten the stability of growth.

• Third, the public finances have deteriorated dramatically and are set to act as a drag on the economy in the next few years, as the g o v e rnment takes action to bring borrowing under control.

• Finally, a more fundamental black mark against the economy’s performance is the apparent lack of any acceleration in productivity growth. This could reflect mis-measurement, but it is too soon to conclude that any meaningful improvement is underway.

• Overall, our assessment is that the economy’s recent track record has been good. But with the election now out of the way, there are major challenges still to be faced.

Assessing the post-election landscape

During the general election campaign, claims and counter-claims relating both to the economy’s past performance and its future prospects were flying between the Government and the opposition parties in a baffling exchange of facts and figures. Pity the poor voters attempting to make sense of it all!

Now that the election is out of the way, the purpose of this piece is to cut through the statistics and the party politics and, as impartially as we can, take an objective look at the true performance of the UK economy in recent years. Has the economy really undergone an economic transformation? What are the major economic challenges ahead?

Let’s start with the relatively uncontentious, which is that the economy has recorded a long period of uninterrupted growth in recent years. Indeed, the official figures show that real (i.e. after inflation) GDP has expanded continuously since the third quarter of 1992, that is, for a full 50 quarters. The Government has boasted that this has been the longest period of continuous economic expansion since modern records began at the beginning of the industrial revolution.

This is strictly true and the lack of even a single quarter of falling output is certainly testament to the impressive stability of the economy in recent years against global economic conditions, which have been far from stable.

However, this observation on its own arguably overstates the comparative strength of the economy in recent years. Throughout the 1950s and 1960s, the economy grew strongly and yet there were rather frequent quarterly falls in output of minor extent and short duration. The result is that if you focus on the quarterly data, two decades of great economic success are disqualified as a period of continuous growth. But if you look, instead, at the annual data, then the economy is shown to have expanded continuously from 1947 to 1973, and this period, not the years since 1992, counts as the longest period of continuous economic expansion.

Likewise, a look at average growth rates over different periods also paints the recent run of uninterrupted growth in a rather less favourable light. The average growth rate since 1997, for example, has been 2.8%. Over the long period since 1831, the average was 2%. But growth averaged 2.7% in the 1950s, 3.3% in the 1960s, and even 2.4% in the supposedly disastrous 1970s.

Admittedly, the performance since 1997 compares well with the average growth rate of 2.1% seen under the Conservatives from 1979 to 1997. The reason for this comparatively low figure can be used both to indict them and to excuse them. Their governments w e re marred by two very serious recessions, in 1980-81 and 1991-92. The indictment derives from the fact that policy probably contributed to these recessions. The excuse is that, at least in the case of 1980-81, the government was grappling with fundamental problems of the economy which had lain untouched for a long time, namely high inflation, excessive union power and bloated state enterprise.

And after the exit from the ERM, the Conservative record on macroeconomic policy dramatically improved. Until their defeat in 1997, the average growth rate was 2.9%, marginally higher than the rate achieved by Labour since.

So despite the greater stability of growth in recent years, the average growth rate has been little different from many previous periods. In any case, assessing economic performance is bedevilled by long time lags. The comparatively good economic performance under Labour has been partly the fruit of the Conservative reforms.

While the economy has performed fairly strongly by our own historical standards, it is now a widespread belief in the UK that we have also performed better than many other countries.

This is largely true, but it is easy to overstate the case. It is true that British growth has been high compared to most members of the euro- zone and Japan. But what a low standard to set yourself! Since 1997, the UK economy has grown more slowly than Australia, Canada, and the US.

However, this partly reflects the fact that the UK workforce has been expanding rather less quickly than those in some of these other areas. Not only has UK GDP growth been the most stable of all members of the G7, but real GDP growth per head has been higher than in the rest of the G7 except Canada.

Overall, then, while a closer look suggests that the economy has not performed quite as strongly as some have claimed, it has been more stable than many other countries and more stable than at many other points in our history. What’s more, this has occurred against a background of pretty difficult global economic conditions which may have caused the UK economy to fall into recession in some previous periods.

What has caused this improvement? One major contributor is a favourite Gordon Brown boast – inflation is "the lowest for a generation". So often in the past, inflation has got out of hand and the attempt to bring it down again has led to a recession. Inflation has been remarkably low and stable in recent years.

Again, however, the major change occurred not over the last few years but rather in the early 1990s. By May 1997, RPIX inflation was already at 2.5%, roughly the same as it is now.

The one unambiguous achievement of the last few years in combating inflation is the granting of operational independence to the Bank of England and the establishment of the Monetary Policy Committee (MPC) in 1997. This radical move has been credited with ensuring that inflation expectations have remained firmly anchored around the inflation target of 2% on the consumer price index (CPI) measure of inflation (2.5% on RPIX before December 2003). 

This in turn has helped to keep wage claims under control and ensure that, even when inflation has moved away from its target, it has returned to it pretty quickly, instead of triggering a wage/price spiral as it may have done in previous periods.

Of course, the system has yet to face a very rigorous test, given the relatively stable general economic conditions since its establishment. But the doubling of oil prices in the last 18 months has presented quite a challenge and, although it’s still early days, the initial signs have been encouraging. Although headline inflation has crept higher in response to higher petrol prices and associated items such as airfares and gas and electricity bills, core inflation has remained subdued.

Yet even the establishment of the MPC was less of an abrupt break from the past than a development of existing policy. The road to the MPC began with the institution of inflation targets and the publication of the Inflation Report after the exit from the Exchange Rate Mechanism in 1992, along with the introduction of monthly interest rate meetings between the Chancellor and the Governor of the Bank of England, which became known as the "the Ken and Eddie show". Handing over full control of monetary policy to the Bank of England (albeit with the inflation target still set by the Government) was arguably just the next logical step along the road.

In any case, low inflation is not a uniquely British phenomenon. The "death of inflation" has occurred globally in response not just to a new commitment to low inflation on the part of global policymakers, but to a series of major changes in the behaviour of the global economy. The dismantling of trade barriers, the rapid growth of low labour costs countries like China and India and the explosion of the internet are just some of the changes that have contributed to a reduction in price pressures right across the developed world. Note, though that the UK has enjoyed the greatest combined stability in both activity and inflation.

Similarly, although UK interest rates are low by historical standards, so are they more or less everywhere. Indeed, our interest rates are just about the highest in the developed world.

So while the recent performance of the UK economy has without doubt been impressive, a closer examination reveals that at least some of the favourable developments apparent in recent years were either a legacy of changes put in place some time ago or have been part of a global trend.

What’s more, any assessment of the past performance of the economy has to include at least some reference to its possible future performance. In this respect, there are areas in which the legacy of the economy’s recent strength could have adverse consequences on its future behaviour.

The first of these involves the most talked-about aspect of the economy, the housing market. While Mr Brown has spoken proudly of banishing "the bad old days of boom and bust" forever, one part of the economy has certainly been enjoying a good old-fashioned boom – housing. House prices have risen by a total of 150% since 1997.

Of course, the strength of the housing market has helped to contribute to the growth of the overall economy in recent years. With the corporate and external sectors weighed down by the weakness of global economic conditions, the Monetary Policy Committee has deliberately shored up the domestic economy with very low interest rates. The housing market has been a key part of the transmission mechanism through which low interest rates have propped up the economy.

But most commentators, including the policymakers themselves, appear now to recognise the danger that the housing market could act as a negative force on the economy in the coming years. We do not intend to say too much about the housing market here, but suffice it to say that most indicators suggest that housing has become fundamentally over-valued both against other assets and against earnings and is therefore vulnerable to a downward correction. The ratio of house prices to average earnings, for example, is not only well above its long run average but also well above the levels reached during the previous three housing market booms since 1970

Admittedly, the Monetary Policy Committee has played down this danger by observing that the link between the housing market and household spending has loosened significantly in recent years, the implication being that house prices could fall with very little negative effect on spending. But the Committee itself has recognised that the risks to this view are on the downside and the slowdown in the growth of retail sales seen in recent months suggests that households may already be tightening their belts.

Indeed, this is one area in which the inflation targeting policy regime may eventually be found wanting. If a narrow concentration on the targeted measure of inflation allows "bubbles" in asset markets such as housing to inflate (and remember that house prices are not even included in the targeted measure of inflation, the CPI) then this could ultimately increase the volatility of both inflation and output as these bubbles burst.

The second area of concern involves the external sector. As we have already mentioned, the recent strength of the domestic economy has helped to offset a deteriorating trend in the UK’s trade position. The current account deficit has recently been running at around 2% of GDP. Admittedly, this is still modest by the standards of the US current account deficit, which stands at over 6% of GDP. Note, however, that the UK’s deficit has been held down by the strength of investment income. The trade in goods deficit has steadily widened to around 5% of GDP.

Part of this deterioration in the UK’s trade position no doubt reflects the general weakness of global demand in recent years and the dampening effects on exports. Meanwhile, the strength of domestic demand has prompted strong growth in imports. If household spending growth were to slow in line with the housing market, import growth would slow and this may prompt some improvement in the trade position.

But an additional factor has been the strength of the exchange rate, which appreciated strongly in the mid to late 1990s and has remained at high levels ever since. This is sometimes seen as a reflection of the UK economy’s strength, but it has undoubtedly made life very hard for UK exporters in recent years. Again, this problem could ease somewhat if a slowing housing market leads to falling interest rates and a falling pound over the next year. But much will depend on the speed and the extent of any drop in sterling. Previous falls in the pound have often come in sharp drops, forcing the policymakers to raise interest rates to head off inflation, with adverse results for growth.

The third area of vulnerability is the public sector. The public borrowing numbers have been allowed to shift from a surplus of some £15 billion a few years ago to a deficit in 2004-05 of £34.5bn, a turnaround of about 5% of GDP. Like the strength of the housing market and household spending, this has recently been a major contributor to economic growth, helping to offset the weakness of the external sector.

The path of public spending has been anything but stable. It has been a roller-coaster, and the ride is not yet over. Current plans involve the growth of spending slowing considerably and the taxtake rising in order to reduce the deficit. This will slow the economy. But it is perfectly possible that the deficit will remain obstinately high. In that case, taxes will have to go up and/or expenditure plans scaled back at just the time that the economy might be under pressure from a weakening housing market. Add in the growing concerns over the Government’s balloon ing offbalance sheet debts in the form of PFI-related guarantees and unfunded pension liabilities and it becomes clear that the fiscal situation will be extremely challenging.

These factors – the over-valued housing market, the poor trade position, and the budget deficit – all suggest that the underlying health of the economy is rather poorer than the latest published GDP numbers might suggest and could act as a constraint on the economy’s performance in the next few years.

But there is a more important issue for the UK economy which could have long term implications; namely, the weakness of productivity. The Government has paid much lip-service to the need for the UK to close the "productivity gap" with its key competitors but the evidence of such a development is patchy at best. Productivity has spent much of the last decade growing rather less quickly than its long-run average growth rate of 2.1% per annum.

Admittedly, productivity growth has accelerated somewhat over the last year, averaging 2.3% in 2004 compared to 1.3% in 2003 and a feeble 0.7% in 2002. But this may simply reflect the stronger performance of the economy over the last year. Firms appear to have hoarded labour during the period of weak demand in 2002 and 2003, with the result that employment has expanded relatively modestly as the economy has strengthened over recent quarters.

There are reasons to be hopeful that a more fundamental improvement may be in store, or even already underway. After all, business investment has been expanding rapidly in recent years and investment in ICT in particular has been growing almost as quickly as in the United States.

What’s more, it’s worth remembering that the celebrated "productivity miracle" which has occurred in the US since the late 1990s was not evident from the published data in its early stages, but has become visible only as the data has been revised. The sustained combination of strong growth and low inflation in the UK in recent years might suggest that a similar under-recording of the economy’s true productivity performance may be taking place here. For now, though, the behaviour of productivity is one area of any end-of-term report on the economy which is likely to draw an assessment of "could do better" or "must try harder".

We have not attempted to discuss and assess every single aspect of the UK economy’s performance in this short piece. Our focus, for example, has rested primarily on the economy’s behaviour at the macro level, while ignoring developments in the micro-economy.

Likewise, we have not sought to widen the discussion of the economy’s performance out from an examination of the published economic statistics, despite growing concerns that such statistics tell us little about the true quality of life. This may be one reason why, despite the apparent strength of the economy, there appears to be little of the "feel-good factor" at the moment.

Recognising these limitations, however, our assessment is that the economy’s recent track record has been extremely good – albeit less impressive than the bare numbers suggest. There are some aspects of its behaviour which are a vast improvement on that seen in many previous periods, the relative stability of economic activity and, in particular, inflation, being the most obvious.

But there are also areas of concern in the form of the over-valuation of the housing market, the external deficit, the state of the public finances and the disappointing performance of productivity. While none of these factors point to the imminent return of the bad old days of high inflation, unstable growth and dependence on the IMF, now that the election is over there are major challenges still to be faced.