Select Committee on Treasury Minutes of Evidence


Memorandum submitted by Mr Martin Weale, National Institute of Economic and Social Research

MACROECONOMIC PROSPECTS

  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 forecast.

Table 1

CONTRIBUTIONS TO GROWTH OF GDP

  
2001
2002
2003
Household Consumption
2.8%
1.9%
1.7%
Government Consumption
0.6%
0.9%
0.4%
Investment
-0.2%
0.4%
1.2%
Exports
0.2%
0.2%
2.4%
Less Imports
-1.0%
-1.2%
-2.6%
Residual
0.0%
0.1%
0.0%
Total-GDP Growth
2.3%
2.3%
2.9%


  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 position.

  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

  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.[3] 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.

Table 2

TOTAL MANAGER EXPENDITURE
£bn2000-01 2001-022002-03 2003-04
FSBR 2001368.3 393.7417.8442.6
PBR 2001363.5393.7 418.2444.3
Growth Rate(% pa)8.3% 6.2%6.2%


  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 surplus.

  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.

Table 3

PUBLIC SECTOR FINANCES: CURRENT RECEIPTS AND PAYMENTS

£bn
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
Receipts (PBR)
382.2
391.2
406
430
452
474
Receipts (Cautious)
382.2
391.2
406
425
446
467
Payment (PBR)
357.2
380.8
403
426
445
466
Payments (Continuing
fast growth)
357.2
380.8
403
426
451
477
Growth Rates Receipts (PBR)
2.4%
3.8%
5.9%
5.1%
4.8%
Receipts (Cautious)
2.4%
3.8%
4.8%
4.8%
4.8%
Payments (PBR)
6.6%
5.8%
5.7%
4.5%
4.7%
Payments
(Continuing fast growth)
6.6%
5.8%
5.7%
5.8%
5.8%
Current Surplus (PBR)
  
25
10
3
4
7
8
Current Surplus (Cautious revenue and continuing expenditure growth)
  
25
10
3
-1
-5
-10


  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 out.

MONETARY POLICY ISSUES

  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


3   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


 
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