Memorandum submitted by Mr Martin Weale,
National Institute of Economic and Social Research
The macroeconomic analysis in the Pre-budget
Report is on the optimistic side of average. However, on this
occasion it is easier to side with the Chancellor of the Exchequer
than with average opinion. The forecast for overall economic growth
is eminently attainable provided that consumer spending remains
reasonably buoyant and that the government comes close to meeting
its spending plans. The weakness in the world economy reduces
the risk of excessive growth but is unlikely, in itself, to lead
to recession. Given the substantial bias in the early estimates
of GDP growth, a value of 2¼ per cent per annum, the middle
of the Chancellor's range, might be expected to rise to almost
2¾ per cent per annum when the data settle down.
The following table shows the contribution to
overall growth made by each component of demand in the Government
CONTRIBUTIONS TO GROWTH OF GDP
Note: Rounding errors mean that the total is not always the
sum of the components
Source: Pre Budget Report p 161.
Thus the contribution of consumer spending to overall growth
is expected to decline over the next two years, with the gap being
filled next year by higher government consumption and a recovery
in investment and in 2003 by investment and an improved net trade
Looking at these components, there is first of all, the question
whether consumption growth will slow further than the table shows.
Lower levels of wealth associated with more normal stock market
valuations should depress consumption growth. On the other hand,
by comparison with five or six years ago wealth levels are high
relative to consumption and housing wealth remains a buoyant force.
Equally those consumers who are cash-flow constrained find borrowing
very cheap at the moment; we have probably not seen the full effects
of interest rate cuts on consumer borrowing and it would be no
great surprise if consumer spending made contributions next year
larger than that shown in the table, at least if the short-term
interest rate remains at 4 per cent per annum.
As is so often the case, the short-term indicators give a
confused picture. Retail sales fell in October, but consumer credit
continues to rise. It is quite possible that the fall in October
sales is a reaction to warm weather rather than a first straw
of slowing consumer spending growth.
The question of investment is harder to analyse. Housebuilding
has been very depressed this year, despite a buoyant market and
part of the overall improvement in investment growth is caused
by housebuilding simply stabilising. Business investment has been
flat as excessively optimistic expectations of future prospects
have become more realistic. Prospects next year will obviously
be supported by very cheap money, but damped by stock market weakness.
A reasonable analysis is that investment is currently being held
up by economic uncertainty, raising the costs of carrying out
investment relative to waiting. If the uncertainty is resolved
as the Chancellor expects, without recession, then there is likely
to be a back-log of investment to be made up. The Pre-Budget
Report suggests that the government is fairly confident of
delivering rapid growth to government investment this year, after
under-spending last year. The rise in public investment spending
itself adds about 0.4 per cent to GDP in both 2001 and 2002, in
addition to the figures shown for public consumption.
The trade position is consistent with a situation where the
British economy grows faster than the other large countries next
year, but where world activity is generally higher in 2003.
The main downside risks to the forecast lie in the possibility
that consumption might slow rapidly or that the world situation
might worsen further. If the savings ratio rose from its current
level of 5 per cent to the average figure for the 1900s of 9 per
cent, than output would be very depressed. Such a change is unlikely
when interest rates are so low. In the world as a whole, it is
likely that an economic recovery will start early next year. We
expect the United States to have fairly rapid growth through the
year (from 2002Q1 to 2003Q1) even though its growth rate comparing
the average for 2002 with the average for 2001 is going to be
meagre. Focus on annual averages can give a misleading impression.
The overall picture is much more optimistic than that given
by typical industrial surveys. The reason for this may lie in
the composition of demand, with surveys often giving coverage
biased towards manufacturing businesses and therefore disproportionately
involved in the production of exports and investment goods. but
it should be noted that many of these are showing the worst figures
for three years. In 1999 output grew by just over 2 per cent.
The fiscal position is best judged against the Chancellor's
own rules and in particular the requirement that, averaged over
the cycle, the current budget should remain in surplus. The figure
for the trend rate of growth used in the calculation of cyclical
deviations has been audited by the National Audit Office. But
the equally important question of where the trend line lies or
whether there is a clear trend does not seem to have been.
Implications of this are discussed below.
Total managed expenditure is shown as rising more rapidly
in the current year than was projected in March, but only as a
correction to the underspending in FY 2000-01. It is noteworthy
that the figures so far show underspending; the Pre-Budget
Report implies very rapid growth in public spending in the
second half of the current fiscal year.
TOTAL MANAGER EXPENDITURE
|Growth Rate||(% pa)||8.3%
Thus there is the question, faced also in all previous years
whether the government will actually deliver its expenditure plans.
In future years planned spending has risen slightly.
Last summer a general impression gained ground that taxes
would have to rise beyond 2003-04 if the rate of growth of public
spending of the next two to three years were to be maintained.
At the time the basis for this view was not clear, since at the
end of 2003-04 the current account was set to remain in substantial
However, as the table below shows, the government is making
the assumption that revenue will be buoyant in 2003-04. A more
prudent assumption would be that, unless tax increases are planned,
the low growth of tax revenues predicted for 2001-02 and 2002-03
is permanent. Beyond this revenues should be assumed to grow only
in line with the long-term growth of nominal GDP (4.8 per cent
pa) at least if the principle of caution is to be taken seriously.
This is shown as the cautious assumption in table 3. In this case
tax increases will be needed if spending growth is to continue
at the rate of next year from 2004-05 onwards rather than, as
the government assumed, slowing down.
PUBLIC SECTOR FINANCES: CURRENT RECEIPTS AND PAYMENTS
|Growth Rates Receipts (PBR)||2.4%
(Continuing fast growth)
|Current Surplus (PBR)|
|Current Surplus (Cautious revenue and continuing expenditure growth)
Of course these calculations take no explicit account of
plans for substantial increases in health spending. Wanless reported
that in 1998 health spending in the UK amounted to 6.8 per cent
of GDP while the income-weighted average is average for the EU
was 8.4 per cent. since the UK comprises 15 per cent of the EU
bringing UK spending into line with the EU average will itself
raise the EU average to 8.7 per cent of GDP even if spending in
the other countries remains a constant share of income.
In 1998-99 health spending as shown in FSBR 2000 amounted
to 4.4 per cent of GDP. In 2003-04 this is projected to rise to
5.4 per cent of GDP under current spending plans. Thus of the
1.9 per cent point increase needed to achieve EU parity, 1 per
cent point should have been achieved then and a further £10
billion is needed to meet the EU average. However, the component
of health spending not covered by the Department budget may also
have risen since 1998-89, reducing the increment needed. Furthermore,
a part of the incremental spending will presumably be capital
spending outside the current budget; the increment to current
spending needed is therefore probably similar to the budget surplus
projected in the PBR for 2003-06 and is a bit lower than the incremental
spending path shown in the table if the rate of growth of 2003-04
is continued for another two years.
Thus, if the future turns out as the Government projects
it, tax increases will not be needed to bring UK health spending
in line with the 1998 EU average. If the more cautious estimates
of revenue growth shown in table three turn out to be correct,
then either tax increases or cuts to other spending will be needed.
If rapid growth of spending in other areas continues, for example
to pay for the child tax credit, then the need for tax increases
become more obvious. Of course, in the most optimistic view, then
the whole of the revenue short-fall in 2001-02 and 2002-03 would
be made up, providing more than enough money needed to fund the
extra spending plans. This favourable scenario cannot be ruled
The Treasury plainly expects interest rates to rise sharply
in 2003-04. The evidence for this is given in table B3, where
the retail price index (all items including mortgage payments)
rises much more sharply than the retail price index excluding
housing costs. There is, however, a more substantial range of
questions about the interest rate path set by the Monetary Policy
Committee. First of all, from the account of the transmission
mechanism given by the Monetary Policy Committee (The Transmission
Mechanism of Monetary Policy, Monetary Policy Committee, 1999),
it is difficult to see why it is necessary to change interest
rates between regular meetings or, even as frequently a monthly.
Secondly, the Bank of England has not offered any view of
what it believes has been achieved by the MPC's interest rate
changes. The suggestion that they had been too active (National
Institute Economic Review October 1999) met with considerable
criticism, but has not been superseded by any official analysis.
At the present time one can again be concerned that the Bank of
England is paying too much attention to surveys and the unpublished
reports of its agents. Certainly, the Pre-Budget Report
forecast is consistent with a view in which the most recent interest
rate reduction is unnecessary and only temporary. The pattern
of the differential between the two measures of retail price inflation
shown in consistent with interest rate increase next year. Once
again, averaging means that, in year on year data, the effect
shows up in the inflation rate for 2003-04.
This does not mean that the interest reductions we have seen
in the autumn will necessarily prove to have been mistaken. But
the credibility of policy-making will be enhanced if the Monetary
Policy Committee presents a coherent ex post analysis of
what it thinks has been achieved relative to a more measured course
for interest rates.
1 December 2001
The Government is assuming that there is clear reference level
for real GDP at which the output gap is zero, so that periods
of slow growth and weak revenues are followed by fast growth.
A more cautious assumption is that a period of weak growth results
in a medium term loss of output, so that "cyclical"
losses are not necessarily made up promptly. Back