Economic prospects for the UK

Andrew SmithChief Economic AdviserIndustry Forum

June 2015

andrew.smith.economist@gmail.com

Twitter: @AndrewSmithEcon

What are we talking about?

■ International economic background and economic policy

■ Issues in Europe

– Grexit

■ UK narrative

– Labour over-spent and over-borrowed

– This precipitated financial crisis and recession

– Conservatives had no option but to adopt austerity

– This is what has brought about recovery

■ Productivity puzzle

■ Brexit

■ Secular stagnation

Financial boom, bust and balance sheet repair

Balance sheet recession

– Over-borrowing by private sector precipitated financial crisis and left legacy of under-priced debt, over-priced assets, over-stretched borrowers and under-capitalised lenders (property)

– Private sector saving more/de-leveraging, depressing demand

– Desired saving > desired borrowing

– Liquidity trap – ZIRB

■ Government deficit reduction the wrong policy

– Sector surpluses/deficits must balance

– Household + corporate + government + overseas = 0

– Government deficit reduction depresses demand

■ Reliant on unconventional monetary policies

– QE, FG etc

UK Net Lending (+)/Borrowing (-) by sector

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014-170000

-140000

-110000

-80000

-50000

-20000

10000

40000

70000

100000

130000

Source: ONS

£m

Rest of the world

Corporations

Household

Government

“Recoveries” to date

Gre

ec

eC

roa

tia

Slo

ve

nia

La

tvia

Ita

lyC

yp

rus

Ire

lan

dS

pa

inP

ort

ug

al

Fin

lan

dD

en

ma

rkIc

ela

nd

Es

ton

iaN

eth

erl

an

ds

Bu

lga

ria

Ro

ma

nia

Eu

rozo

ne

Ja

pa

nF

ran

ce

Be

lgiu

mA

us

tria

UK

Ge

rma

ny

Slo

va

kia

Sw

itze

rla

nd

Sw

ed

en

US

Po

lan

d

-20

-16

-12

-8

-4

0

4

8

12

16

Source: Eurostat

GDP % away from peak

Unemployment rates (%)

Germany

US

UK

Netherlands

Ireland`

France

Poland

Eurozone

Italy

Portugal

Spain

Greece

0 5 10 15 20 25 30

Latest June 2015

2000 JAN 2001 DEC 2003 NOV 2005 OCT 2007 SEP 2009 AUG 2011 JUL 2013 JUN-3

-2

-1

0

1

2

3

4

5

6

7

Euro area Germany Ireland Greece

Source: Eurostat

Eurozone – in(de)flation

%

Collapsed bond yields

Background summary

■ Advanced countries experienced one of the deepest recessions ever and one of the slowest recoveries

■ Output remains below previous peak across much of Europe and dramatically below level if it had followed pre-recession trend

■ Persistent high unemployment in many countries

■ Positive output gaps ie unused productive potential

■ Business investment slow to pick up

■ Many countries flirting with deflation, led by oil and food prices – but core inflation rates sliding too

■ Government bond yields at unprecedented lows and negative in some countries

■ All suggestive of chronic shortage of demand

■ Risk/payoff ratio suggests policymakers should be doing more to boost demand

Annual growth forecasts

(%) 2010 2011 2012 2013 2014 (f) 2015 (f) 2016 (f)

US 2.5 1.6 2.3 2.2 2.4 3.1 3.1

Japan 4.7 -0.5 1.8 1.6 -0.1 1.0 1.2

Eurozone 2.0 1.6 -0.8 -0.5 0.9 1.5 1.6

Developing Asia 9.6 7.7 6.8 7.0 6.8 6.6 6.4

China 10.4 9.3 7.8 7.8 7.4 6.8 6.3

Latin America 6.1 4.9 3.1 2.9 1.3 0.9 2.0

Sub-Saharan Africa

6.7 5.0 4.2 5.2 5.0 4.5 5.1

Source: IMF April 2015

Eurozone no longer a crisis, it’s chronic

■ Monetary union brought German-style low interest rates to PIIGS, resulting in private over-borrowing, property booms, wage inflation, loss of competitiveness and trade deficits

■ Financial crisis and recession pushed up government deficits, particularly in “periphery”

■ ECB’s refusal to act as LoLR caused panic in financial markets in 2012 until volte face – “do whatever it takes” and OMT

■ Germany dictated continuing fiscal austerity across eurozone

■ Risk of new recession/deflation prompted ECB to adopt form of QE last year

■ Long-term, to stay together need to complete EMU:

– Banking union and strengthening of banks

– Fiscal union to validate fiscal transfers

– Political union to legitimise fiscal union

Greece “sui generis”

GREXIT?

In Greece, government over-borrowing/profligacy/lying/corruption etc WAS a cause of collapse

Mistake not to agree realistic debt restructuring/write-offs earlier

Bail-out was for German banks which had lent Greece the money – not Greece

Greece can’t run a primary deficit, nor a large primary surplus (troika demanded 5% of GDP), nor realistically pay back its borrowing (debt/GDP 180%)

Should be a new deal to run a small primary surplus, but IMF etc insisting on pension and labour market reforms as well

Consequences of GREXIT (default and new currency)

Economic and financial markets hiatus

Banks would need to be recapitalised

Contracts re-denominated (creditors lose)

Contagion risk – financial (markets call ECB bluff) and political

Could euro survive?

Geo-political implications

Initially more misery for Greece, but if a few years on devaluation worked…….

UK: GDP growth (% quarter-on-quarter)

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

-3

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

Source: ONS

UK recessions and recoveries

19881988 Q21988 Q31988 Q419891989 Q21989 Q31989 Q419901990 Q21990 Q31990 Q419911991 Q21991 Q31991 Q419921992 Q21992 Q31992 Q419931993 Q21993 Q31993 Q419941994 Q21994 Q31994 Q419951995 Q21995 Q31995 Q419961996 Q21996 Q31996 Q419971997 Q21997 Q31997 Q419981998 Q21998 Q31998 Q419991999 Q21999 Q31999 Q420002000 Q22000 Q32000 Q420012001 Q22001 Q32001 Q420022002 Q22002 Q32002 Q420032003 Q22003 Q32003 Q420042004 Q22004 Q32004 Q420052005 Q22005 Q32005 Q42006200720082009201020112012201320140

2

4

6

8

10

12

14

16

18

60

80

100

120

140

160

180

UK: household debt to income ratio and household savings ratio

Source: OBR/ ONS/ Datastream

%Debt to income (RHS)

Savings ratio (LHS)

%

UK: employment changes

0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102

108

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

1974 - 1979 1979 - 1987 1990 - 1999 2008 - %

Source: ONSMonths from peak

UK: consumer confidence

198030209

311821988

3313134104

199636053

370262004

389752012

-40

-35

-30

-25

-20

-15

-10

-5

0

5

10

Source: DataStream

Balance

UK: inflation and earnings

20012001 Feb2001 Mar2001 Apr2001 May2001 Jun2001 Jul2001 Aug2001 Sep2001 Oct2001 Nov2001 Dec20022002 Feb2002 Mar2002 Apr2002 May2002 Jun2002 Jul2002 Aug2002 Sep2002 Oct2002 Nov2002 Dec20032003 Feb2003 Mar2003 Apr2003 May2003 Jun2003 Jul2003 Aug2003 Sep2003 Oct2003 Nov2003 Dec20042004 Feb2004 Mar2004 Apr2004 May2004 Jun2004 Jul2004 Aug2004 Sep2004 Oct2004 Nov2004 Dec20052005 Feb2005 Mar2005 Apr2005 May2005 Jun2005 Jul2005 Aug2005 Sep2005 Oct2005 Nov2005 Dec20062006 Feb2006 Mar2006 Apr2006 May2006 Jun2006 Jul2006 Aug2006 Sep2006 Oct2006 Nov2006 Dec20072007 Feb2007 Mar2007 Apr2007 May2007 Jun2007 Jul2007 Aug2007 Sep2007 Oct2007 Nov2007 Dec20082008 Feb2008 Mar2009 2010 2011 2012 2013 2014 2015-1

0

1

2

3

4

5

6 CPI Average earnings (regular pay)

Source: ONS

%

Tax rises and spending cuts (£bn)

2012-13 2013-14 2014-15 2015-160

20

40

60

80

100

120

Tax rises Spending cutsSource: HM Treasury

Was it all Labour’s fault? Public spending and receipts (% GDP)

Did Osborne stick to Plan A? UK current budget deficit (%GDP)

Front-end loaded austerity?

UK summary

■ Osborne’s first-term policy was deficit reduction to produce growth, but didn’t get as much of either as he expected

■ “Expansionary fiscal contraction” doesn’t work when interest rates can’t be reduced further to offset the negative impact on demand – at best will subtract from private sector recovery, at worst overwhelm it

■ This year’s budget and election manifesto suggest new Government is about to repeat the experiment, with “other half” of deficit reduction to come from swingeing cuts, particularly to welfare (the more so if health, schools and overseas aid are “protected”)

■ What lesson has Osborne learnt from first-term? Tough at start, ease off later, win election?

■ Budget on July 8 and new Spending Plans later in year

■ What if another big shock or economic downturn for some other reason?

– Current contingency planning is to keep fingers crossed

– If expansionary fiscal policy ruled out and monetary policy has shot its bolts, left with “helicopter money” – BoE prints money to finance payments to households

UK productivity normally rebounds in and after recessions

UK productivity growth – GDP per hour worked, 1979Q1 to 2014Q3

Productivity puzzle

■ Measurement problems

■ Direct effect reduced availability of finance following crisis

– Reduced investment/slowdown in innovation

– Impaired resource reallocation

– Low no of insolvencies/failure to cleanse - firms survived which shouldn’t have?

■ Labour hoarding/new jobs are lower productivity jobs?

■ Substitution of cheaper labour for capital

■ Weakness of demand

■ Most of loss seems to be from within sector and within firm…..

■ ……and in TFP – management?

■ Cyclical or structural?

BREXIT?

What does Cameron want?

Opt-out from "ever closer union" European ambition (core principle)

Safeguards to ensure changes in the single market cannot be imposed on non-eurozone members by the eurozone

Protection for the City of London financial markets from EU legislation

Greater powers for national parliaments to block EU legislation

“Better“ regulation and flow-back of powers to Member States

Continued enlargement of the EU but with new mechanisms “to prevent vast migrations across the Continent“ (but free movement core principle)

Restrict access to in-work and out-of-work benefits to EU migrants

Referendum Q: Should the United Kingdom remain a member of the EU?

Referendum to be held by end 2017 – but aiming for 2016? Major Treaty change seems to be ruled out by time-table but scope to fudge, post-dated cheques, etc

If “NO” up to 2 years to negotiate exit terms – could we keep same market access?

Followed by SCOXIT?

Should we be worried about permanent weak growth?

■ “Secular stagnation” – structural demand issue?

– Will desired saving continue to exceed demand for finance for investment?

■ Ageing populations in West and lack of insurance in EMs raise precautionary savings and increase supply of funds globally?

■ Tech progress means less capital spending needed - more (cheap) computers, fewer (expensive) steel mills?

– “Natural” real rate of interest may be negative for extended period

■ Interest rates could remain low for very long time

– Case for expansionary fiscal policy and higher inflation target

■ Or supply-side weakness?

– Potential growth rate = change in labour force + productivity growth

– Ageing populations/declining workforces in West (and China!)

– IT hasn’t been a transforming technology like electricity, trains, planes?

– BUT earlier technology waves took time to boost productivity too

Budget March 2015

% change y-o-y 2012 2013 2014 2015 2016 2017 2018

GDP 0.3 1.7 2.6 2.5 2.3 2.3 2.3

Household consumption

1.5 1.7 2.0 2.6 2.7 2.5 2.3

Business investment

3.9 5.3 6.8 5.1 7.5 6.5 6.4

Govt consumption

1.6 -0.3 1.5 0.8 -0.7 -0.9 -0.2

Exports 1.1 1.5 0.4 3.9 4.0 4.5 4.4

Public borrowing £bn

114.8 107.8 90.2 75.3 39.4 12.8 -5.2

BofP C Account

%GDP

-4.0 -4.5 -5.4 -4.3 -3.2 -2.6 -2.4

Source: HM Treasury

Economic prospects for the UK

Andrew SmithChief Economic AdviserIndustry Forum

June 2015

andrew.smith.economist@gmail.com

Twitter: @AndrewSmithEcon