Tag: UK

From The Economist.

For the past few months Theresa May and her ministers have allowed some ambiguities to swirl around Britain’s future relationship with the European Union. Yes, she confirmed in her conference speech in October, Brexit would take it beyond the jurisdiction of the European Court of Justice and the EU’s free movement regime. Some found this hard to square with reports that special arrangements would be sought for parts of the British economy (like the City of London and carmaking) or with Mrs May’s assurance to businesses that she would seek to avoid a “cliff edge” on Britain’s exit from the club. Many in other European capitals questioned whether Britain would leave at all.

To the extent that such uncertainties persisted despite her endless choruses of “Brexit means Brexit”, at a speech to EU ambassadors in London on January 17th Mrs May put them to the sword. Britain will leave the single market and the customs union, and will thus be able to negotiate its own trade deals with third-party economies. It will not pay “huge sums” to secure sectoral access (a phrase whose precise meaning now matters a lot). She wants this all wrapped up within the two years permitted by Article 50, the exit process she will launch by the end of March; ideally with a “phased process of implementation” afterwards covering things like immigration controls and financial regulation. In other words there will be no formal transitional period. There will, in fact, be a cliff edge of sorts.

This reflects two realities to which policymakers in Britain and on the continent must now get accustomed. First, Mrs May unequivocally interprets the vote for Brexit as a vote for lower immigration even at the cost of some prosperity. Never mind that the polling evidence supporting this assumption is limited: such is now the transaction at the heart of the new government’s political strategy. Second, even allowing for a certain amount of expectation-management, it seems Mrs May is not placing huge importance on the outcome of the talks. She wants a comprehensive free-trade agreement (FTA) based on the one recently signed between the EU and Canada; but where “CETA” took about seven years to negotiate, she has permitted herself two. She said that this might cover finance and cars, but also recognised the importance the EU places on the “four freedoms” (making freedom of movement a condition of market membership), suggesting a realism about the extent of any such FTA in the narrow time constraints available. Mrs May also wants some associate membership of the customs union but declared herself relaxed about the details. In short: she will do her best, but if the talks come to little or nothing, so be it.

Of course, they will be tough. The prime minister will want firstly to maximise the scope of the FTA, secondly to maximise the benefits of any associate relationship with the customs union and thirdly to minimise the precipitousness of the cliff off which British firms will fly in 2019. She hinted at how she intended to do so, characterising the country’s current defence and security co-operation with the continent as a possible negotiating chip and warning that her government could “change the basis of Britain’s economic model” (i.e. turn it into a tax haven) if the EU does not play nice. She also said that she would be willing to walk out on the talks: “no deal…is better than a bad deal.”

So Britain’s economy is in for a rough ride and, though the government will try to smooth it out, the priority is getting the country out of the EU in the most complete and rapid way possible. If the price of this priority is economic pain, then pay Britain must. All of which gives firms some of the certainty they have craved since June 23rd: those fundamentally reliant on continental supply chains or the EU “passport” for financial services, say, now have the green light to plan their total or partial relocation. It also means the Brexit talks will be simpler and perhaps even less fractious than they might have been had Britain tried to “have its cake and eat it”. The country will eat its cake and live with an empty plate afterwards. Brexit really does mean Brexit.

In a speech at Sheffield University, external MPC member Gertjan Vlieghe discusses the how the UK economic outlook has evolved recently and what this implies for the stance of monetary policy. He also examines several arguments that have been used to support the idea that low interest rates are counterproductive, either for the economy as a whole, or for a particular sector of the economy.

The UK economy in Q2 and Q3 has held up better than he expected: “Judging by headline GDP at least, the economy has continued in a “business as usual” manner”. However, financial markets seem to be expecting “some economic underperformance relative to pre-referendum expectations.” And investment and employment intentions by UK businesses “are generally below their pre-referendum levels”.

“Sentiment among UK households, on the other hand, appears rather buoyant”.

Jan argues that “the tension between the fairly pessimistic assessment by financial markets, the cautious assessment by businesses and the rather optimistic response by households so far, cannot last”. It might turn out that financial markets are too pessimistic and the economy continues to grow in a “business as usual” way, in which case I would expect the exchange rate to move higher over time. Or it might mean that households are too optimistic”.

Turning to the stance of monetary policy, the MPC has decided that the current policy rate of 0.25% remains appropriate. “Having an inflation projection that is ½ of a percentage point above the target at the end of the forecast period is uncomfortable for an inflation-targeting MPC. The reason we are willing to tolerate this particular inflation path, is that if we tried to bring inflation down faster, with tighter monetary policy, we would create more slack in the economy – lower real income growth, and higher unemployment”.

The reason why the current policy rate is so low relative to history in the UK as well as in many other advanced economies, is that monetary policy is responding to persistent global disinflationary forces. “It has been raining, so we have all opened our umbrellas”.

Not everyone agrees that this is the appropriate response for monetary policy. “Some argue that low rates themselves are the problem”. Jan argues that “is just a case of erroneously reversing the causality”. “Umbrellas together with rainfall are observed in many countries. Nobody actually believes that umbrellas cause rainfall”. “We have had several low interest rate, low inflation countries that have raised interest rates over the past decade. This was not followed by an escape from the alleged confidence trap”. “Higher interest rates, far from boosting demand and inflation, have caused growth to slow and inflation to fall”. “Some of these countries now have even lower short term and long term interest rates than the UK, as inflation expectations have drifted lower”.

Next he considers the argument that “low rates are a problem because they hurt savers”. This ignores the fact that savers hold significant amounts of non-deposit assets, which benefit from low interest rates and asset purchases. Moreover, many savers also work, and low interest rates “have helped lower the unemployment rate” and “have boosted wage inflation”. He presents evidence that the additional income to savers from the improvement in the economy due to lower interest rates is similar to the additional income earned by borrowers.

Jan considers the impact of low interest rates on defined benefit (DB) pension schemes: “the conclusion is not to deny that lower long term rates make life more difficult for pension funds. But, first to acknowledge low long term interest rates are not primarily caused by monetary policy, they are caused by other factors that monetary policy is reacting to. Second, that there is no evidence yet that large pension deficits are weighing on business investment. Third, that arguing for tighter monetary policy to help pension funds ignores the big offsetting effect accommodative policy has on corporate profitability through higher demand and lower cost of investment, and ultimately higher long-term interest rates.”

As well as considering the impact on DB pension schemes, Jan considers the plight of pensioners themselves. He shows that “Since the financial crisis, retired households have experienced faster income growth than non-retired households”.

After looking at these different groups within the economy, he concludes that “there is no evidence that monetary stimulus has hurt them, once the broader effects of monetary policy on employment, wages, profits and the prices of widely held assets are also taken into account”.

He asks whether “Even if, in further research, we were to find a specific group that had unambiguously suffered from very low interest rates, what would be the right policy prescription? Should monetary policy try to help them by tightening?”

He argues that “The suffering group would get a larger share of a shrinking pie. As monetary policy makers, we are trying to meet the inflation target by growing the pie in line with potential, and letting the government decide how to divide it up, using its fiscal and structural policy tools. Monetary policy cannot solve distributional issues, and should not be asked to try.”

From The Conversation.

Needing to perform a fiscal twist in a confined space, it looks like Philip Hammond has borrowed some dance steps from former shadow chancellor Ed Balls. Despite some mockery of his recent turns on TV show Strictly Come Dancing, Balls’ footprints are clearly visible on the spending boost the chancellor unveiled in his first Autumn Statement.

Balls regularly castigated the 2010-15 coalition government for being too hasty to cut public spending and raise VAT. He called, in particular, for a boost to infrastructure, skills and housing investment on the basis that without it, a stifled economic recovery would delay the return to budget balance.

Six years on, Hammond has taken much the same stance. Attempts to achieve a budget surplus have been pushed elusively forward to “the next parliament”. Meanwhile, the focus shifts to boosting growth, following a forecast downgrade by the Office for Budget Responsibility, with adverse implications for tax revenues.

To protect against another slowdown, additional spending on public infrastructure (especially housing, roads and telecoms) has been announced. Meanwhile, he is also slipping in some tax reductions – including a return to the 50p top rate and a reduction of taxes on in-work benefits – in case the Supreme Court’s Brexit verdict forces an early election.

Big infrastructure projects are a favoured way to kickstart stalling economies because they can quickly create jobs in areas that most need them. They also generate income that mostly gets spent, boosting other activity. Such projects can pay for themselves through extra tax revenues which then shrink the budget deficit in relation to GDP. Hammond’s quickstep addition is an annual £2 billion boost to research and development, aimed at making those already in work more productive.

Ed Balls. Nick Ansell PA Wire/PA Images

George Osborne did something similar. Following the failure of austerity and a dip back into recession in 2011-12, he quietly reinstated several of the initially-suspended infrastructure programmes. Hammond has signalled an intention to go much further with an extra £23 billion to be channelled in the first five years with his new investment fund. His hope is to reverse the impending slowdown and Brexit aftershocks.

Selective credibility

It’s not the first time that a party committed to cautious and balanced fiscal policy has veered towards plans it once mocked as ill-timed and irresponsible. A Keynesian-style stimulus – running a deficit to spur growth, and so raising national debt – has historically been easier for Conservative than Labour governments in the UK, and for Republican than Democratic presidencies in the US.

This is because conservatives normally push for lower taxes, based on the belief that tax reductions will actually close a budget deficit by boosting people’s ability and willingness to pay taxes. This wilts under economic analysis. And when reality bites, a switch is made from taxing less to spending more on structures that can constitute a public asset as “security” for the additional public debt.

Labour broke the deficit-boosting record in 2008-10 – but only after the unprecedented bailing-out of a collapsed financial sector. It had previously reduced the public debt, by moving the budget into surplus earlier in its term. Yet the Conservatives, with Hammond now as chancellor, have used the idea of Labour’s “fiscal irresponsibility” to justify huge public spending cuts.

Infrastructure spending. shutterstock.com

While the deficit has steadily narrowed since 2010, Osborne’s missed targets have meant the Conservative-led governments have added more to public debt than the Labour administration they replaced. Indeed, Labour governments – often elected after a boom has collapsed, and never trusted to borrow as much – have run consistently tighter budgets than those who accuse them of reckless spending.

Hammond’s new investment fund looks very much like the long-term investment bank that Labour has long dreamed of, and never succeeded in, launching.

The Conservatives argue that they can now afford some fiscal relaxation, having earned “credibility” through Osborne’s years of austerity. By drumming home the idea that they will shrink public spending to the smallest fraction of GDP since the 1930s and continuing to lambast Labour for leaving such a large deficit, they manage to deflect criticism. Yet the OBR has confirmed that weaker GDP growth and tax receipts left the 2015-16 deficit at £76 billion, four times its £18 billion forecast.

Is the timing right?

Chancellor Hammond can also argue that historically low interest rates on public debt make this the right time for governments to borrow more. In a world seemingly awash with capital and large corporations sitting on mountains of cash, tax cuts haven’t delivered the needed boost to enterprise, so the state must take a more direct hand.

But the six-year gap between Balls’ and Hammond’s plans may also present problems for the Treasury. With more inflation on the horizon and the UK’s credit rating heading downwards, the government’s phase of virtually costless long-term borrowing is coming to an end. Even yields on long-term bonds are rising, despite the Bank of England halving its base rate to 0.25% immediately after the June 23 referendum.

While big projects may cost more to finance under Hammond than if Osborne had launched them earlier, their growth-reviving benefits may also turn out to be smaller. The multiplier effect of deficit spending on national income is highest when labour markets and consumer spending are slackest, as they were in the UK in 2011-12.

Today, although the economy hasn’t grown enough to close the deficit, most of that slack has been taken up. Unemployment is at its lowest for a decade, employment at its highest since records began, and spare resources could soon be even scarcer if the UK adopts a hard Brexit, with tight immigration controls. In these conditions, firms building the extra houses, roads and railways could find themselves bidding for additional employees and raw materials, driving up costs and prices rather than output and employment.

Rising labour costs are, of course, economists’ code for the higher pay which voters – and the Chancellor’s party – expect to gain when Brexit uncertainty settles. If that promise secures the government’s re-election by 2020, Ed Balls could well claim to be the ghostwriter denied a royalty.

Author: Alan Shipman, Lecturer in Economics, The Open University