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CORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 750
HOUSE OF COMMONS
TAKEN BEFORE THE
NATIONAL INSTITUTE OF ECONOMIC AND SOCIAL RESEARCH
QUARTERLY REVIEW, OCTOBER 2012
Tuesday 13 NOVEMBER 2012
JONATHAN PORTES, DR ANGUS ARMSTRONG and SIMON KIRBY
Evidence heard in Public Questions 1 – 69
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Taken before the Treasury Committee
on Tuesday 13 November 2012
Mr Andrew Tyrie (Chair)
Mr Pat McFadden
Mr Brooks Newmark
Mr David Ruffley
Examination of Witnesses
Witnesses: Jonathan Portes, Director, National Institute of Economic and Social Research, Dr Angus Armstrong, Director of Macro-economic Research, NIESR, and Simon Kirby, Lead UK Economist, NIESR, gave evidence.
Q1 Chair: Thank you very much for coming in to give evidence this morning. Can I begin by asking you, Mr Portes, whether you think that the existing fiscal framework has carried any credibility gains in the markets?
Jonathan Portes: To be fair, it was reasonable, when the Coalition Government took office, to say that we needed a new fiscal framework, we needed one fairly quickly and we needed to set out what we were going to do. It was reasonable, therefore, for the Treasury to produce something that, while not perfect, would at least set out reasonably clearly what the objectives were. Initially the framework probably had some value-certainly compared with having no framework at all-and gave us some credibility gains. Whatever gains there were, however, are long past. As we said in our evidence to you last year, which I think I have here, the fiscal mandate, as it is currently phrased, "to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period", does not ensure long-run sustainability, because it is always five years ahead. I said that to you last year, and that penny has sort of dropped. People realise that, in itself, the five-year rolling target does not ensure credibility. The Treasury initially backstopped that with the 2015-16 debt mandate, but that is now being called into question. The current framework certainly does not have much credibility any more, and it is time to look for a replacement.
Q2 Chair: Do you think, when you talk about a replacement, that the proposal made by NIESR would carry more credibility in the markets?
Jonathan Portes: We do not have a proposal at the moment. We have not made a specific proposal.
Q3 Chair: You personally have a proposal out there at least, do you not, which is a 2% loosening of fiscal policy?
Jonathan Portes: No, that is completely different. That is my view on what a sensible, short-term path for fiscal and macro-economic policy ought to be. That is not the same as saying what the long-run fiscal framework or fiscal mandate that the Government is committed to is. As you know, a 2% boost in investment spending this year or next year would have absolutely no effect on either of the Government’s targets, because investment spending does not count against the structural deficit, and a boost this year or next year will not change the trajectory in 2015-16.
This is part of my problem with the fiscal mandate. You could have as much money as you like on investment spending this year, and it has absolutely no effect on whether or not we hit the fiscal mandate. It is important to draw a distinction between what the medium-to-long-run fiscal framework is that the Government sets itself so as to convince the markets that it is serious about the long-run sustainability of the public finances, on the one hand, and, within whatever that framework is, what the sensible course is for short-term macro-economic policy and, in particular, whether it is sensible to try to boost demand now through the sort of spending and borrowing increases that I have suggested.
Q4 Chair: We are coming back to the same question each time, from different routes. You are agreeing that there needs to be a long-term strategy to tighten policy.
Jonathan Portes: Yes.
Chair: By one means or another-in order to address the deficit.
Jonathan Portes: Yes.
Chair: That is not in dispute.
Jonathan Portes: No.
Chair: Therefore, the only question is, what risks or opportunities might be attached in the short run to pointing policy in the opposite direction and loosening policy further? Correct?
Jonathan Portes: I certainly agree that, in the short run, we should be pointing this policy in the opposite direction and loosening it further.
Q5 Chair: But it is pointed in the opposite direction already, is it not? We have automatic stabilisers kicking in. What is your estimate of their value?
Jonathan Portes: I am not sure. Do we have a quantitative estimate of that?
Simon Kirby: We do not have a quantitative estimate to hand. We can certainly provide that to you.
Q6 Chair: Clearly, this is the sort of thing that would require a range-and on the basis of assumptions about the output gap-but that is an issue that one needs to start with, almost, if we are trying to make improvements. What about the effects of the short-term strategy on debt service costs? What do you think the effect would be on those?
Jonathan Portes: At current real interest rates, you could fund a £30 billion investment programme for, as I said then, the amount of money that the Chancellor was expecting to raise through the pasty tax.
Q7 Chair: So you would want to roll this all over in Treasury bills at the short end of the market?
Jonathan Portes: No. I was referring to the real interest rate on very long-term index-linked gilts, which is very close to zero.
Chair: Yes, but that is indexed.
Jonathan Portes: Yes.
Q8 Chair: So it carries a potential longer-term price. If you look at the unindexed main gilt market, that is running at about 2%. There is a cost, is there not?
Jonathan Portes: The right rate to look at when you are talking about investment spending is clearly the real rate, Andrew. I had a fairly public dispute on this with David Smith, which he eventually conceded. As you know, the Treasury appraises whether a capital project makes sense by reference to the real rate. If you are borrowing to finance a one-off capital spending project, the right rate at which to discount that is the real return on-
Chair: I am sorry-we understand the arguments. The arguments are well rehearsed.
Jonathan Portes: Yes, they are indeed.
Q9 Chair: They are very well rehearsed and very well known to economists, but they are still controversial. Let us try something slightly less controversial. You would agree, would you not, that we have picked up some enduring credibility, notwithstanding your initial remarks, as a consequence of the introduction of a fiscal plan a little over two years ago, and that this is reflected in the differential between long-run debt service costs in the UK and in other countries?
Jonathan Portes: The second part of that is far from clear, frankly. You can see, for example, the analysis of the IMF, which suggests that that is not the case. Long-run debt service costs are low in countries that have independent monetary policies and borrow in their own currency-full stop. Turning to your-
Q10 Chair: Sorry-just before you move off that, that is a very important statement. You are saying that 100% of the differential between, for example, our long bond rate and Italy’s is attributable to the fact that they are in the eurozone and we have a floating currency. 100%? Just to give you the figures, which I have in front of me-I looked them up before coming in this morning-the differential between our 10-year rate and Italy’s in March 2010 was 20 basis points. The differential now is 307 basis points. Are you saying that the whole of that gap-300 basis points of differential-is attributable to the fact that Italy is in the eurozone and we have a floating exchange rate?
Jonathan Portes: I think that is essentially correct, yes. You might be able to attribute some part of the downward pressure on UK long-term interest rates to quantitative easing, which no doubt we will get on to, and that is quite controversial and difficult to unpick, but, fundamentally, yes, the basic explanation of the gap is quite clearly that we are not in the eurozone.
Q11 Chair: And none, just to be clear, to the credibility that might attach to the fiscal deficit reduction plan.
Jonathan Portes: I would answer that-this is the first part of your question-I would concede part of it. I think-
Q12 Chair: Sorry-I just want to be clear what you are conceding.
Jonathan Portes: In order to maintain credibility, the Government needed to come up with a fiscal framework that made some sense and a deficit reduction plan that put us on some sort of path towards long-run fiscal sustainability. That was necessary. It could have been a plan that differed in two ways from the existing plan. It could either have been stretched out over a longer period or it could have been state contingent, in the sense that it would have said, "Well, if things turn out significantly worse-"
Q13 Chair: Okay-we will not get into that, but what I do want to get into is, what proportion of this basis point differential, reasonably, as an assumption, it might be plausible to suggest you came from on the introduction of that plan.
Jonathan Portes: I am not sure that is quite the right question. If the Government-whichever Government-had come into office and said, "Right, fiscal credibility-who needs it? We are going to print money and spend it like drunken sailors", maybe our interest rates would be like Italy’s. If the Government had come in and said, "Right, we are going to reduce the structural deficit to zero over eight years rather than four", or if they had come in and said, "We are going to reduce it to zero over six years but, if the following things happen, then we will have an emergency investment programme for infrastructure", our interest rates would now, essentially, be the same. In other words, I would attribute none of the difference and none of the reduction in long-term interest rates to this plan, as opposed to another plan that would have been more macro-economically sensible, but also credible.
Q14 Chair: You are introducing all the time, in response to my questions, aspects of hypothetical outcomes that are not on the table. We have done this fiscal deficit reduction plan, and there is, in the real world, a basis point differential. You may say that it is not the best question that could be asked, but I am asking you the very straight question: is any of that differential attributable to the fact that the deficit reduction plan was introduced; any, a little or a lot?
Jonathan Portes: No, I am sorry, Andrew; you cannot ask that question. You have to say, what is the counterfactual? In order to establish whether it is 10 basis points, zero basis points or 100 basis points, you have to give me an alternative hypothetical. You have to give me a counterfactual. It could be no deficit reduction plan and, "We are just going to keep on spending". I will give you an answer to that. Or, it could be-
Q15 Chair: What is your answer to that?
Jonathan Portes: If the incoming Government, of whatever colour, had said, "We are not going to have any deficit reduction plan at all-"
Chair: If we carried on with the policies that were inherited, rather than there having been a change of course.
Jonathan Portes: If we carried on with the policies that had been inherited, no doubt those policies would have changed significantly in the light of circumstances.
Q16 Chair: But I am not asking you that. You have asked me for a hypothetical. Now I have given you a hypothetical. I would like to hear the answer to the hypothetical.
Jonathan Portes: I would say that, by now, gilt yields would be basically where they are now.
Q17 Chair: You are saying that, if that had been done, that is, if there had been no change in policy, the differential between our gilts and Italy’s gilts would be the same as it is now.
Jonathan Portes: I would say that is a pretty good starting point, based on the IMF-you are shaking your head.
Mr Newmark: Yes, I am shaking my head.
Q18 Chair: Hang on a minute. Let us carry on. I just want to be clear. You think that there would be a 20 basis point differential between us and Italy if we had carried on with pre-existing tax-and-spend policies. Are you really saying that, Jonathan? This is one opportunity to change your mind.
Jonathan Portes: We have, for example, the IMF analysis-
Chair: I have read the IMF analysis.
Jonathan Portes: No, not the multiplier analysis.
Chair: It is your view that I want, Jonathan.
Jonathan Portes: My view is based on the same sort of reasoning as the IMF, which is to say that we do not observe any observable correlation between changes in deficits for countries like us, which have floating exchange rates and an independent monetary policy, and gilt yields. I would add that, if you look at the statements of people who disagree with me on this point, they were saying back in March 2010 that, if we were on a deficit reduction plan that only led to us having reduced the deficit by a quarter by now, if we were on a deficit reduction plan that meant that we did not balance the structural deficit until 2017–18, which was, remember, the path we thought we were on then-those people, including Treasury Ministers, who have said that, in that event, gilt yields would have spiked, the bond market would have collapsed and we would have lost our AAA rating-all these disastrous things that people like Mr Newmark say would have happened would have happened. What has happened? Gilt yields have fallen, have they not? In other words, we took the path that we were told would lead to disaster, the path of only reducing the deficit by a quarter by now. We took the path whereby we get the deficit down to zero only by 2017-18. That was the path we were told would lead to disaster and would lead to our bond yields looking like those of Italy. Has it happened? Has it?
Mr Newmark: Because all the-
Q19 Chair: Hang on a minute. I just want to be clear on one more point. You not only think that this differential would be exactly the same had we continued with pre-existing policies. I just want to be clear. You are trying to draw this short-run/long-run distinction, which markets may not be so happy with-but anyway, between different parts of fiscal policy. Nonetheless, you are also saying that, if we acted on your proposal in the short run to loosen fiscal policy by 2% of GDP, there would also be no change to the differential in the bond market.
Jonathan Portes: If you look at-when I-
Chair: No, sorry-we do not need to go on for too long on this. I think you have said-
Jonathan Portes: Yes-no, I think-
Chair: You agree with that view, too.
Jonathan Portes: That is absolutely clear. I said it a year ago. Since then, as we know, borrowing estimates have spiralled upwards and gilt yields have not.
Chair: You are repeating that. I just want to be clear that I heard the point correctly first time round and second time round.
Jonathan Portes: Yes.
Q20 Jesse Norman: Mr Portes, could you tell me about how decision making takes place within NIESR on economic judgments? Do you get together and say, "This is what the house view is"? Does the council say, "We think you should be heading in this direction"? Do you, as director, say, "This is my view," and, "This is where we are heading"? How does that work?
Jonathan Portes: I would draw a distinction between the macro-economic forecast and a whole bunch of other things we do. For example, we do an evaluation of labour market policy. I take it you mean primarily on macro-economic issues like the ones we have just been discussing.
Jesse Norman: Sure.
Jonathan Portes: What happens in the context of the forecast is that about a month or so before we publish the forecast and this document, we sit around-it is usually my colleagues here, Angus and Simon, as well as Dawn Holland, who is our lead international forecaster and who is also responsible, essentially, for the production and upkeep of NIESR’s macro model-and talk about what the forecast is looking like, and we talk about what the key judgments are and how we should present them. As you can imagine, for the last year or so, every time we have done this we have said, "On what basis are we going to model what happens in the euro area? Are we going to assume that they suddenly get their act together? Are we going to assume it all falls apart? Is there a central scenario-"
Q21 Jesse Norman: You come together and have a kind of collective view, and that eventually finds itself in print.
Jonathan Portes: Yes.
Q22 Jesse Norman: When you do that, do you distinguish sharply between what you might call the descriptive economics and the normative economics, that is to say, what you think the economy is actually doing and is going to do, based on a set of descriptive judgments, or do you think more normatively, about what would constitute the success or failure of policy?
Jonathan Portes: I think we do both. For example, on the subject that we were just discussing, fiscal policy, we will talk about what the impact of current policies are and what the impact of alternative policies are, and then we will come to a house view, broadly, on what we think a sensible policy option is. We certainly do not say, "Okay, we are going to agree just on the positive", and then, on normative, we can say exactly what we like, and everybody can have completely different views. That does not mean, of course, that, in practice, we do not have somewhat different views on what policy ought to be but, on the broad things, we come to a consensus and-
Q23 Jesse Norman: Thank you. How would you describe your own politics?
Jonathan Portes: My own politics? I am not going to talk about my own personal politics. As director of NIESR, I can say that NIESR has no party affiliation, never has and will not.
Q24 Jesse Norman: You are often regarded as a man of the left. That is a mistake, is it?
Jonathan Portes: I find that a bit odd. I met your Chairman 25 years ago now, when I was working for Mr Nigel Lawson. Subsequently, we both worked in the office of Mr Norman Lamont. My personal history, as you know, is that for 23 years I was a civil servant, and I am accustomed, as a civil servant, to checking my politics in at the door. It is slightly different in NIESR, obviously, because in NIESR there is no question that some of my personal views on issues of policy come through in a way they probably did not when I was a civil servant, but I still check my political views in at the door, and I am very careful when I am writing on NIESR issues. I will criticise policy-
Q25 Jesse Norman: When you write newspaper articles or your blog, you do not check that with any people at NIESR, as to whether or not it is consistent with the house view or the institutional integrity of NIESR itself.
Jonathan Portes: If I thought I was writing something where there was an issue with our house view, particularly on macro issues, I would probably ask my colleagues here whether they agreed.
Jesse Norman: Have you in fact done that, before you have published things?
Jonathan Portes: Yes.
Q26 Jesse Norman: Just picking something at random, there was a recent piece of yours in The Spectator, "‘Plan A’ has failed." That seems to me to be a pretty political judgment.
Jonathan Portes: That was, in the economic sense, a positive judgment, was it not?
Q27 Jesse Norman: It is just that I could not imagine either some of your predecessors or those in parallel institutions, which are politically independent, saying things like "‘Plan A’ has failed".
Jonathan Portes: I think you will find that my predecessor’s most famous quote was that he could "smell the fudge" from the Treasury kitchens.
Q28 Jesse Norman: That is not a political quote at all. That is a quote about the bureaucracy.
Jonathan Portes: No, it was not a quote about the bureaucracy at all, Jesse; that is absolutely wrong. He was talking about a particular decision, which he rightly criticised, of a previous Chancellor-I think it was Gordon Brown, but I am not absolutely sure, although it does not really matter. He was talking about a particular decision by a Chancellor to make a particular change to the operation of what was then the fiscal framework. It was a perfectly proper thing for him to say. He said it because he-
Q29 Jesse Norman: I do not want to debate what he said. Let us just be perfectly clear that, whatever he said, there is a line here. The question is, are you transgressing it? If you are transgressing it, are you transgressing it with the institutional support of NIESR, or are you operating as a kind of rogue economist? I am very struck by the fact that you are not prepared to give the Government any credit at all on a 300 basis point difference between UK policy now versus Italy, and two years ago. That seems extraordinary to me. It seems to be not only a remarkable reading of the economic facts, but also to be influenced by things that go beyond economic judgment. I am surprised that you do not know the answer to this question. There is no knowledge to be had here. What we have is a balance of probabilities. You seem to be extraordinarily unwilling to give any credit or credibility. When the question of credibility is raised, your answer is to say, "Look at what actually happened". Of course, credibility does not concern just what actually happened-it concerns whether the market believed that the Government’s direction of travel was right, given the circumstances at the time.
Jonathan Portes: I think it is fair I should respond to that. First, in terms of giving the Government credit, I am quite happy to give the Government credit when credit is due, and I have done so. I wrote, to pick one example at random on a completely unrelated area, when we did some work on the impact of work experience-a subject that is quite controversial-about the employment prospects of young people who had taken up work experience opportunities. I wrote a blog based on the research that we had done with the Department for Work and Pensions. It was called "Work experience works", setting out the positive impacts that work experience had on the employment prospects of young people. That was not political. Some people object to work experience for political reasons. That is not my particular concern. What we said was that, in terms of the outcomes and objectives that the Government had set, this appeared to be a relatively successful programme. I said that publicly and I offered to write articles about it. It is on my blog-you can go and read it. I would entirely reject the insinuation that I have some political motives for making economic statements.
Jesse Norman: We can continue this, but-
Jonathan Portes: You are entirely entitled, of course, to disagree with me about the economics, but I would not say what I have said about the impact of deficit spending on gilt yields if I did not believe it. In the last IMF article IV report on the UK, there is a significant section devoted to a discussion of precisely this issue. It says quite clearly what the views of the International Monetary Fund are.
Chair: You have made that point.
Jonathan Portes: I just find it a little odd that Mr Norman is saying that, because I am saying the things that I am saying, I must therefore be in some way politically-
Chair: Okay. We have had that debate.
Q30 Jesse Norman: I have a final question, if I may. Just to be clear, you do not think that there is anything strange about not attributing any aspect of the UK’s long-term debt yield performance to Government credibility, and you do not think that there is anything strange about the lack of caveating in using a phase like "‘Plan A’ has failed" when the whole of economics relies on a series of judgments of probability.
Jonathan Portes: As I said-I made this very clear in my response to the Chairman-to make a quantitative assessment of the impact of Government’s fiscal policies on gilt yields, you need to specify the counterfactual. If the counterfactual is simply saying, "We do not care about fiscal responsibility. We will spend what we like. It really doesn’t matter", then there was clearly an impact. That, I think, is reasonably obvious. I said that, compared with an alternative but more macro-economically sensible policy that was clearly set out and that clearly set us on a path towards long-run fiscal sustainability, I did not think that the differential between two paths, one of which had a significantly higher deficit in the short run, but which eventually converged to long-run sustainability-indeed, basic finance theory tells you it shouldn’t-should lead to any significant impact at all on gilt yields. That is just a statement of the basic theory of interest rate determinations. I do not think that there is anything particularly ideological about that. You do not have to be a Keynesian or a monetarist.
Chair: Just for the record, I found you, Mr Portes, a loyal and thoughtful colleague when I was a special advisor to Nigel Lawson and John Major in the Treasury.
Q31 Mr Newmark: I am not going to dwell for too long on what the Chairman said or on what Jesse said, although I find it pretty odd that you feel that the rating agencies and the market do not reward direction of travel. We saw what happened to those countries that did not change their behaviour, and I am surprised that you do not think that the markets rewarded UK plc, certainly for the Chancellor’s initial emergency budget, when he put a very strong marker on the ground, saying that we needed to tighten things up. If we had carried on with the direction of travel from the previous regime- I am not going to get into a debate with you, but I believe that the markets rewarded us, and we ended up in a different place. You are absolutely right. Unfortunately, however, so did the eurozone and other countries. Everything is relative. Having continued with plan A, as you would say, to say that, if we flipped to a plan B, which, at least in the short run, listening to you, sounds like borrowing more money, running higher deficits and printing more money, somehow the rating agencies and the markets would reward us with a similar cost of capital strikes me as a little odd. Anyway, I do not want to dwell on that.
I want to talk about two other issues that I think are important to the public. One is to do with investment, and the other one is to do with the productivity puzzle. I think Pat McFadden will join me on the productivity puzzle; it is a conundrum to me as well. On the investment side, what do you think about the extent to which business investment has been weakened by a lack of confidence, rather than simply by a lack of bank lending? It is a big argument, with MPs getting up in Parliament and saying, "Hey, banks, you are not lending enough. You are not doing enough out there". When you talk to a lot of businesses and even banks-on both sides-it is really a lack of confidence about the future, it seems.
Jonathan Portes: I will pass that to my colleagues.
Simon Kirby: That is certainly what you get from the survey data. The lack of confidence and certainty about future demand, both domestic and, in particular, in our major export market, the euro area, is inhibiting business investment significantly. You hear a lot about firms being relatively cash-rich, and that clearly seems to be the case from national accounts. We also need to bear it in mind that, when we are talking about the business investment forecast that people present, that is largely a story of large firms. These large firms are relatively cash-rich. They have access to the corporate and equity markets to raise finance. In fact, they are doing that to reduce the scale of bank borrowing they have. The story is one of uncertainty about future demand and, therefore, of lack of confidence.
Q32 Mr Newmark: You are absolutely right; there are huge cash surpluses on a lot of the big companies. SMEs are the ones that are cash poor, and a lot of us here represent small- and medium-sized enterprises. It seems that they are the ones that are seen to be most frustrated with the lack of access to capital, and they are also fearful for the future.
Simon Kirby: I think that is entirely correct. For the SMEs, it is a completely different picture. Unfortunately, that is where data are most limited as to exactly what is going on with these firms. Some surveys suggest that this is a significant inhibitor to them for investment, but there are also surveys out there that do not suggest that SMEs are having more than a normal inability to raise finance from banks. There is a mixed element to the story. Overall, you are right. Finance from banks is a particular problem for SMEs at present.
Q33 Mr Newmark: Slightly related to that-I know this is going in a different direction, Mr Chairman-do you think that QE has effectively kept alive a lot of companies that normally would be dead? I cannot remember which private equity person it was, but he talked about zombie companies.
Jonathan Portes: That was Jon Moulton.
Q34 Mr Newmark: That was it; it was Jon Moulton, on the radio. He talked about zombie companies. Do you think there really are a lot of those? Are there more zombie companies today than would otherwise have existed?
Simon Kirby: There is a strong possibility that that is the case. Again, it goes back to data. It is interesting that the FSA and the Bank have been highlighting forbearance, in particular in the mortgage market and the commercial real estate market, but nothing wider. They should have the data to hand, and more announcements on that would provide us with a better picture. It is highly likely-it is not just QE, but it is just loose monetary policy generally. We know that, since 2009, the Bank rate dropped to record levels. Those that had access to funding would have seen rates drop accordingly. There is a real risk that these firms are being kept alive through relatively loose policy.
Q35 Mr Newmark: On a more positive note, you forecast that business investment would expand by almost 5% next year, rising to around 6.5% in 2014, but that, in the near term, business investment decisions would remain muted. Why are you so confident that there will be an increase in business investment next year and beyond?
Simon Kirby: A large part of the story is the reductions in uncertainty. This is resolution of the euro area crisis, which is a key assumption in our forecast. Easing of that situation-
Q36 Mr Newmark: What gives you confidence that there will be resolution in the eurozone in the next 12 months?
Jonathan Portes: It is an assumption, not a forecast. It is because we have to assume something to construct a forecast.
Mr Newmark: It has to be a reasonable assumption.
Jonathan Portes: We thought it was a reasonable assumption.
Q37 Mr Newmark: If you were looking at the tea leaves today, would you say that? Would you stick by that statement?
Simon Kirby: The ECB’s actions are one of the early steps. It fits with the early steps required for resolution of the crisis. I am not saying that it certainly will happen. There is a forecast wide degree of uncertainty about the outlook.
Q38 Mr Newmark: Just to press you a little bit, knowing what you know now, sitting before us, and with everything that is going on, would you change that?
Simon Kirby: I would not change the forecast at present. What you need to bear in mind is that, first, we are not talking about investment-to-GDP ratios getting back to anywhere near what they were pre-crisis, even on this forecast, over the forecast horizon-that is to 2017. We need to see some pick-up in business investment growth, simply to replace consumed capital.
Q39 Mr Newmark: Who is going to take on the productivity puzzle?
Dr Armstrong: Well, can I-
Mr Newmark: Let me ask the question. There have been several explanations for the productivity puzzle. You seem to subscribe to the view that it is employers hoarding their staff that explains it. Do you think this is the only factor?
Dr Armstrong: No.
Mr Newmark: Okay.
Dr Armstrong: It comes back to the issue you raised about zombie firms. The notion of zombie firms goes back to the Japanese recession back in the 1990s, and some very famous papers that were written on the back of that. The most important thing is that not only are these firms kept alive but they prevent new firms coming into the market. It is effectively a subsidy to existing firms. You have not only a static effect but also the ongoing ramifications. As Simon said, we have no evidence about the forbearance of banks towards firms. They would be quite able to give that, so the FSA and the Bank of England, through their connections, would presumably be able to find out the extent to which there is forbearance, which would start allowing you to get a sort of handle on these issues. However, the difficult bit with this zombie idea is that, first, lending rates are not exactly low for SMEs. If the lending rates were low, it would be an easy story to tell. Secondly, firms are hiring. If they were not hiring, it would be an easy story to tell as well.
Q40 Mr Newmark: Sorry-firms are hiring?
Dr Armstrong: Hiring labour.
Mr Newmark: Right.
Dr Armstrong: If businesses did not want to enter markets because the incumbents were being subsidised through this zombie policy, why would firms be starting to hire? The idea is that zombies are the living dead; that they would affect the new firms. It is hard to see that the story explains all of it.
What is interesting about the productivity puzzle is that these effects of banks-the secondary effects through what they mean for existing firms and so on-are very hard to measure, but most people who look at the finance area argue that they are very important effects. This gives you part of an explanation why TFP would be very weak-sorry, why productivity would be very weak-which growth theory would not do, because you do not have this element in growth theory, with just capital and labour and making an assumption about productivity. This idea of the reallocation of capital between firms and the role the banking system plays in that, particularly when it appears to be fairly impaired, would give you one of the explanations why productivity is much lower than before. Is it all overhoarding? No. I think it is part of this issue of the banks. Exactly how does this work? We have a lot more evidence to get, and I would suggest that the FSA and the Bank, on forbearance with firms, is a good place to start.
Q41 Mr Newmark: I guess there are two parts to this. I travelled around this summer. I went to 14 different cities or areas around the country. The feeling that I get-I can only go by the feeling from the businesses I spoke to, which are mainly SMEs-is that things are not too bad out there. I am out there trying to encourage them to hire more people and take on apprentices and stuff. There has been this sort of increase in numbers of people employed, both full-time and part-time, but I guess the part of the circle I am finding it difficult to square is this growth aspect. It seems to be that growth has been much more sluggish in the statistics that I read. When I am out there, it does not seem as bad. What has struck me is the revision. In 34 out of 82 quarters, there has been an upward revision in growth, which has been a huge positive change. Is part of the problem that the way growth is being measured is much more conservative in the way statisticians look at it than the reality on the ground, which is why these upward revisions keep happening nowadays much more than historically?
Dr Armstrong: I will pass to Simon on this-on the revisions-but I point out that, even if there are revisions, you have a lot of explaining to do. Sure, you might get a percentage point or two, but that still leaves a large part unexplained. It is not as though the UK is the only country which has seen this very poor productivity performance coming out of the declines in output. It is not just the UK. Interestingly, on a crude, cursory look, it tends to be countries with very big banks that have this slow productivity. In the US, where they have 8,000 or 9,000 small banks, the productivity has not been quite as bad. That is very circumstantial.
In terms of when you visit cities and people say, "Well, we are getting by", or, "It’s not too bad", the productivity and capital reallocation point is that some of the firms that are not particularly efficient are staying alive, so you get this effect. If you said to somebody, "Wow, you survived and you’re still in business", they might say, "Yes, things are not so bad", but, in terms of productivity, would they have survived? What, again, is the counterfactual? Then, they probably would not have done, which would have meant that you would have had higher productivity and the capital could have been redeployed in more productive areas. You could still tell that story but, getting back to the second question, is it the data? Even if the data were revised somewhat, you still have a big explanation to do.
Q42 Mr Newmark: If you fast-forward 24 months-Simon can answer this as well-would you expect to see UK plc GDP growth being a little bit better than it is today and employment figures maintaining their current strength, or would you expect that to begin to slow down?
Simon Kirby: That supposes that there is some evidence of bias in the official statistics and the GDP numbers at present. My understanding of the evidence is that, at the moment, there is not. The comparison is often made to the 1990s recession and the upward revisions then. There clearly was upward revisions bias in the data then. All of the introduction of the new methodologies into the 1998 Blue Book was designed to try to remove this bias. Various pieces of analysis done since have found no evidence of bias. That might change-it is not to say that there isn’t-and there may well be some modest upward revisions. As Angus has said, that will not revise away the productivity puzzle.
The one thing that we do know, from the labour market side, is that the ONS has done some analysis for England and Wales only for 2011, using census data, and they found that they undercounted the population by just under 500,000. That suggests that there is a higher level. These will feed through into the weighting of the labour market numbers. This suggests that there is a higher level of employment out there than we currently think there is, given the current estimates. There is some evidence that, in actual fact, the productivity puzzle is going in the other direction, potentially, due to revisions to data.
Jonathan Portes: I agree with Simon on the revisions. As far as I can tell, the one really hard piece of data that we have, as the Treasury is fond of saying, is data on tax receipts. As far as I can tell, although there is a lot of noise and uncertainty, those data are consistent both with the weak GDP story being broadly true but also with the strong employment story being broadly true. In other words, it is difficult, looking at the tax receipts data to think that the ONS has made a huge mistake, either on employment or on GDP. No doubt there will be revisions but, on the basis of that-that is real money coming into the Treasury-it does not look as if the numbers are obviously wrong by an awful lot.
Mr Newmark: Okay. I could press you more, but I appreciate that there are other people here. Thank you for that.
Q43 Mr McFadden: I want to continue with this point before going on to something else. Brooks Newmark talked about going forward, and I would like us to try to look forward. Let us assume, for the sake of this discussion, that, for the growth figures-yes, they might be revised a shade up or down here or there-the picture is broadly as has been published and that the labour market figures are broadly true. What can we expect going forward? There is a view about these zombie companies-or the argument about forbearance, if you like-that people who are surviving at the moment because of very loose monetary policy and low interest rates will, ironically, if the economy begins to strengthen and interest rates start to rise, suddenly run into trouble. Company insolvencies are at a very low level at the moment compared with the last few years. Is it a reasonable assumption to expect a wave of insolvencies and unemployment as the economy begins to strengthen because, suddenly, the real costs of survival become greater for companies that are just nursing themselves along, paying interest only and no principal at the moment? Simon, is that a question for you?
Simon Kirby: There is a real risk that, as the recovery takes hold and the Bank of England begins to raise interest rates, we will see a rise in corporate insolvencies and, potentially on the household side as well, a rise in arrears or in repossessions by banks. Part of that story will also need to be that the banks are in a sound and strong enough position to begin to foreclose. In some sense, this forbearance is a sign of the banking sector’s weakness. They cannot afford to take on board those losses, given the weakness of their balance sheets. If that persists, that could mitigate what you might expect to see, given the recovery. The risks are mixed out there.
Dr Armstrong: On this issue and on many of these issues, there is a way out of all of these arguments, which is that the output gap determines inflation full stop, pretty much. Therefore, as the economy recovers, demand will pick up for these people, so their employment prospects and the sales of their firms improve at the same time as interest rates are improving. Therefore, we have this wonderful path. However, is the output gap the only determinant of inflation? The answer to that is probably no, because it has not done a very good job of forecasting inflation in the past. Most people say that, over the last 15 to 20 years, the Phillips curve has been relatively flat. In other words, the level of unemployment has not had much impact on earnings.
The question becomes, what happens when interest rates go up, and what is the outlook for particular households and firms, if I can widen it to households? There is much more evidence of problems with forbearance in households, because the FSA made it clear. The real issue is what happens either when inflation goes up or when interest rates go up for those firms and households where the prospects have not improved. There it becomes problematic. Whether that is a big enough aggregate effect to mean that it becomes quite circular, and you get a pick-up in the first place, is really an issue of how broad a problem this existing problem is. In my view, in the household sector, for some of the firms there is quite a broad-based problem, and it is going to be quite difficult.
Q44 Mr McFadden: Jonathan, I take you back to the earlier discussion. You have seen the reaction of my Conservative colleagues on the Committee to this discussion around interest rates, plan A and so on. Do you think the public discussion about plan A and plan B is a little bit artificial in a way, given that borrowing is higher than it was projected to be, and that what would have been dismissed as wild irresponsibility, had it been advocated for infrastructure spending a year ago, has been accepted as being all within the plan when it is for automatic stabilisers?
Jonathan Portes: That is a slightly leading question, to which the answer is obviously yes. As I said, if you had taken what Treasury Ministers and some outside commentators had said about the disastrous consequences of the sort of borrowing track that we are on now literally, clearly the country would be bankrupt and we would not be able to borrow anything. That, clearly, has not happened.
I would re-emphasise that my view on this has always been driven by the basic economic theory and the evidence. The economic theory says that, when you are at or close to the zero lower bound, the impact of extra borrowing-when excess went private, and demand for private saving exceeds the demand for private investment-then, essentially, you can continue to borrow until you soak all that up. That is precisely what we have seen, of course.
I would also point to the empirical evidence. I pointed this out last time. This goes to Mr Newmark’s quite reasonable point, "What about the credibility of UK plc?" We have quite a neat empirical test on this. We can look at the day-to-day movements of gilt yields, and we can look at what their correlations are with. I have done quite a lot of this. Are they correlated, for example, with announcements that the Government makes about fiscal policy or political developments? Not really. You can hardly see it. Even at the time of the election, the change in our spreads with US Treasuries typically went the wrong way. There is a nice little analysis that somebody has done of this.
More specifically, on the work that I have done, in this case particularly on the point about the credibility of UK plc, what happens to the relationship between gilt yields and equity prices? If you thought that falling gilt yields or falling spreads reflected increased confidence in UK plc, increased confidence in the economy and all the rest of it, then you would have to believe that, when gilt yields fell, the stock market would do well. That is pretty simple. Is that what we observed? It is absolutely not what we observed. If you look at day-to-day movements, especially around the time when we were going through this supposed crisis during 2010, the correlation between gilt yields and equity prices goes exactly the wrong way. In other words, when gilt yields went up, equity prices went up as well. In other words, when people were feeling more optimistic, gilt yields went up. When people were feeling less optimistic, yields fell. It is not about credibility, it is about what you think is going to happen to the economy. Economic weakness leads to low long-term interest rates. This is really very basic macro-economics. Mr Norman, in particular, may think that I am making some sort of political point in continually pointing out that, when the Government says that low interest rates reflect economic confidence, all I am doing is pointing out that the Government is saying-
Jesse Norman: I would point out that-
Chair: Hang on.
Jonathan Portes: All I am pointing out is, "Look, this is what basic economic theory says ought to happen. This is what the empirical evidence says should happen". They coincide. It does not correspond with what the Government is saying. You can draw your own conclusions about how seriously to take people who say that.
On plan A versus plan B, you are right that drawing a strong distinction at this point is slightly odd. I suspect that when Jesse Norman read the particular quote he did, he may have been referring to the headline that the editor put, rather than what was in the text of the article. I am not absolutely sure. It is true that what we have seen is very sharp cuts in capital investment, low or lower-than-forecast tax revenues as a consequence of a weak economy, higher-than-expected spending on automatic stabilisers as a consequence of a weak economy, and some cuts, but not huge cuts, to current expenditure. All that has added up to a borrowing trajectory that is not too different from that which was forecast in March 2010, but the composition is quite different.
Q45 Mr McFadden: Could you quantify this? How far off are we in terms of borrowing billions today, compared with the Government’s initial targets set out after the election?
Jonathan Portes: I do not have the numbers to hand. I know that we are more or less on the same track as the OBR forecast on the basis of the pre-fiscal consolidation plan. In other words, regarding the OBR’s forecast in June 2010 on the basis of the announced policies of the previous Government, we are sort of pretty much on that track in terms of public sector net borrowing. How far off are we? We know that the Government’s initial target was to balance the budget in cyclically adjusted terms by 2014-15. That has now been pushed back to 2016-17. Our forecast would have them hitting that in 2017-18, which of course will be the new target if they stick to the current fiscal framework in the Autumn Statement. If you want the precise numbers, we would have to give them to you on paper.
Q46 Mr McFadden: So your argument-without the precise number-is that we are roughly on the track of the Alistair Darling plan, if you want to put it that way, in terms of where we are today, compared to where the Government said we would be after the election. I want to explore how much further this goes. If you based this on a credibility argument, I suppose you would argue, "Well, we might have got away with that, but we certainly cannot get away with any more", which is a view expressed around the table, but your argument is that the UK Government should consider using its low borrowing rates to support infrastructure spending more directly. The Government has a £250 billion infrastructure plan. Again, I ask you for some numbers. To what extent do you think cheaper borrowing rates would be available if the Government borrowed to fund that plan, rather than to fund the things that you listed in your previous answer, which are shorter-than-expected tax receipts, automatic stabilisers and so on?
Jonathan Portes: Clearly, the Government’s £250 billion infrastructure plan is not infrastructure that either should or could be built in, say, the current financial year, nor would it necessarily be sensible for the Government to fund all of that investment. In general terms, the Government should decide what infrastructure it funds and what is funded by the private sector under a sensible regulatory framework on the basis of what is a sensible allocation of risk between the public and private sectors. It is quite sensible that, for example, the private sector should build power stations, rather than the Government, within a framework of regulation for the energy sector that allows them to build them economically. I will not say that we should suddenly nationalise the entire infrastructure plan and build it today. Could the Government, without having any significant negative impact on borrowing costs, and with some beneficial macro-economic impacts, spend considerably more in the short term on building those things that it is generally sensible for the Government to build pretty much directly, for example roads or social housing, which it does by providing cheap capital to housing associations? Could it and should it do that without having any negative effects on borrowing costs? Yes.
Q47 Mr McFadden: Do you think there is a danger that some Conservative commentators could get caught behind the curve, because the Chancellor announces precisely that in his Autumn Statement, while they have been railing against the irresponsibility of it?
Jonathan Portes: I do not think that is a question for us.
Q48 Mr Ruffley: Mr Portes, there has been a bit of a comeback for Keynesian fiscal multipliers. The example of this is the IMF October report on high debt and sluggish growth. There has been some criticism of that piece of work, as you probably know, one example being the piece of work by the FT’s Chris Giles. He reports you as saying that you are worried that cross-country studies with small samples never prove anything, even though you believe that multipliers are higher than has conventionally been believed, up until the fiscal consolidation anyway. Could you explain what problems you have with the IMF’s piece of work? I am aware that your analysis differs from theirs.
Jonathan Portes: It is not so much a problem with the IMF’s piece of work itself, although I think that some of Chris’s criticisms are probably justified. This goes back to some of what I was saying before. If you just looked at the IMF piece in isolation and said, "Right, this proves that fiscal multipliers are very high," that would be a crazy thing to do, as I said to Chris. One starts with, "What does the underlying economic theory tell you about this?" Then you look at a range of empirical evidence. Cross-country evidence might be one. Empirical evidence from individual countries might be another. I would emphasise that NIESR has not changed its view that, in normal times-in quotes-when interest rates are flexible and so on, multipliers are fairly low in a small open economy like the UK. That still remains our view. However, we start from the view that theory tells you that, when you are at zero lower bound, when interest rates and monetary policy are not, at the moment, fully or even-
Q49 Mr Ruffley: So the multipliers are high.
Jonathan Portes: Theory tells you that and empirical observation of what is going on in the UK tells you that-and our economic model, once you suggest that, empirically, multipliers are likely to be significantly higher. The IMF evidence is just another brick, and not, by any means, the most important brick in that wall of evidence. That is why I am saying that you would be crazy to take that as proving anything on its own. It is an interesting and useful piece of work for them to have done, but-
Q50 Mr Ruffley: Okay, but you would, and you have given your health warnings clearly, but would you agree that it is highly dependent on Greece and Germany?
Jonathan Portes: What the IMF says? Yes, and that is one reason why, on its own, you would not take it as proving anything.
Q51 Mr Ruffley: How have the deficiencies that you have identified been corrected in your piece of work?
Jonathan Portes: If you are referring to our paper and our review-
Mr Ruffley: Yes, I am.
Jonathan Portes: This is a completely different approach. This takes NIGEM, our global macro-econometric model, which-I will not describe it, but it is not too different from the sort of macro-economic models that the Bank of England, the OBR, the IMF and other people use. Indeed, NIGEM is purchased and used by quite a lot of central banks and international organisations. It is a fairly standard modelling tool in the trade.
What we have done is to say that, in normal times, when monetary policy is responsive and consumers can adjust their spending and borrowing decisions to take account of future events, this gives you a particular set of projections for the impact of fiscal policy. What happens if you assume that interest rates are largely ineffective when monetary policy is at lower bound, and when you assume that a higher number of consumers and firms than normal are subject to credit constraints, that is, they find it either impossible or more expensive to borrow to smooth consumption than they normally would? Under those circumstances, what would the impact of fiscal policy and the multipliers be? We put those assumptions in the model and run through the observed fiscal policies of European Union Governments, including ours but also eurozone Governments, and we look at the impacts of fiscal policy on growth in that framework. We find that, given that, the model shows that multipliers are indeed significantly higher, hence the negative impact of fiscal contraction on growth is also significantly higher. It is a completely different approach. It does not disprove or prove the IMF approach, but it is a completely different approach to estimating the impact of fiscal policy.
Q52 Mr Ruffley: Just so I am clear, did the model work on those assumptions before you took over at the National Institute?
Jonathan Portes: No, but we were not in this position before I-
Mr Ruffley: Mr Kirby wants to come in.
Simon Kirby: Since the end of 2008 we have undertaken a variety of studies-multipliers. Previously, it was within the context of stimulus, both in the UK and abroad, and the assumptions about credit constraints and whether interest rates would react were looked at in these various studies. Some of them were published in the review, and some of them were published externally, in other sources.
Q53 Mr Ruffley: Mr Portes, on these basic assumptions about the multiplier being a lot higher than was the case in recent history, that has consequences for your judgment about the fiscal consolidation. Why, in your paper that we have in front of us today, do you exclude Ireland from your general thesis and your general claim that fiscal retrenchment harms economic growth?
Jonathan Portes: No, we do not do that. That is not what we say at all in the paper.
Q54 Mr Ruffley: No-there is a reference to excluding Ireland.
Jonathan Portes: No. Fiscal consolidation has a negative effect on growth in every country, as it would do even in normal times. It is bigger in abnormal times, and it has a bigger abnormal effect in Ireland than in other countries. Given what the model says about the Irish economy, we find that, unlike in other countries, fiscal consolidation does not make things worse in terms of the debt-to-GDP ratio there. You cannot conclude from that that we think Irish fiscal policy is great, and that fiscal policy everywhere else in the European Union is completely mad. We are simply saying that this is what the model tells you about the impact of the fiscal consolidation programmes on one particular variable, which is the debt-to-GDP ratio, which you would think of if you are worried about debt sustainability.
Q55 Mr Ruffley: Fine. Why is Ireland different?
Jonathan Portes: Effectively, what we are saying is that Ireland has somewhat lower multipliers.
Q56 Mr Ruffley: Why is that?
Jonathan Portes: It is a small, very open economy, in short. Even in this framework, as you would expect, multipliers are smaller in small, very open economies, whereas they are larger in larger, closed economies. One of the reasons why the impact on Greece is so negative here in our projections is that Greece, it turns out, is a much less open economy than you would expect for such a small country. The ratio of exports and imports to GDP in Ireland is much higher than it is in Greece.
Q57 Mr Ruffley: It is interesting. I quote from your report: "The main conclusion is that, while in ‘normal times’, fiscal consolidation would lead to a fall in debt-to-GDP ratios, in current circumstances, fiscal consolidation is indeed likely to be ‘self-defeating’ for the EU collectively. As a result of the fiscal consolidation plans currently in train, debt ratios will be higher in 2013 in the EU as a whole rather than lower. This will also be true in almost all individual members states (including the UK, but with the exception of Ireland)". I just wondered whether you had any particular explanation.
Jonathan Portes: Just the nature of Ireland. Ireland is a particular economy, and the model says what the model says.
Q58 Mr Ruffley: So there is no more explanation than that.
As Mr Norman has touched on your description of plan A having failed and as there is a view, current in some quarters, that maybe you-how can I put it-have a coloured view of the fiscal consolidation, could you tell me which other economic forecasters at major City institutions would share your view about the fiscal multiplier being so high? How many would agree with you, approximately?
Jonathan Portes: I am not in the habit of polling City forecasters, but-
Q59 Mr Ruffley: No, but you must have a general idea of whether or not your methodology, which you have gone to the trouble to explain to us in outline just now, is broadly accepted or not. Perhaps if you cannot answer, Dr Armstrong could answer for me, or maybe Mr Kirby.
Jonathan Portes: I will ask Angus.
Q60 Mr Ruffley: Have a stab. Go on.
Jonathan Portes: The last two times I was here, Roger Bootle and I-he is probably the City forecaster I would have a considerable amount of respect for, and I guess you have, since you continually invite him-disagreed, politely and moderately, on the appropriate counts of fiscal policy. I do not want to speak for Roger, but I would be surprised if Roger took a very significantly different-
Q61 Mr Ruffley: I did not ask that. You are picking one forecaster. I am going to ask somebody who might answer the question. What percentage of City forecasters would buy into your methodology and use of the fiscal multiplier? Mr Kirby-just a rapid percentage of the top three-dozen forecasters. Approximately. Is it half? Is it a tenth? Is it 90%?
Simon Kirby: I would expect that, if you were to present the report, approximately half would find the work reasonable and would agree with it. They would not necessarily agree with the exact conclusions, but I think they would be perfectly happy with the methodology.
Dr Armstrong: Very few City forecasters would have a global econometric model by which they work it out in this manner, taking into consideration all of the countries. On the international aspect, I would be surprised if they used the same technical, rigorous framework. On the qualitative assessment of what happens when you have an impaired banking system, do we think that multipliers are more likely to be higher, rather than lower? I think they would probably agree that they are more likely to be higher.
Mr Ruffley: I think there is a general consensus that they are higher than before the recession hit.
Q62 John Thurso: Can I come first to you, Jonathan? Reading your section that you wrote, it seems to me that the core point that you are trying to make regarding fiscal consolidation is that it is the simultaneous fiscal consolidation across almost every advanced economy at once that is giving us the particular problem. It is the classic case of where a policy for one country in one set of times might be extremely good, but the policy pursued by every country simultaneously turns out to be not very good news. Is that a correct reading, broadly?
Jonathan Portes: Yes.
Q63 John Thurso: Can I ask you, then, in particular about the effects of other economies on ours? First, there seems to be a policy response pretty widely around the US, ourselves and Europe, which is an extremely loose monetary policy. Have we reached the point where this is the classic pushing string?
Jonathan Portes: There is certainly an argument that the marginal impact of further quantitative easing, the current monetary policy lever, is diminishing. It may or may not be zero, but it is quite clear that it is less than it was when QE began. In that sense, yes, I am less convinced that there is not more room for monetary policy to function in the eurozone, where I am not sure we have reached the limits of monetary policy. One could of course pursue other unconventional means or even more unconventional means than QE in this country, which we have not tried yet.
Dr Armstrong: The second part, as well as the fallacy of composition that you were alluding to, about all countries doing the same thing at once, which is problematic, is about the state of the financial system and the question, "Why is zero lower bound not stimulative?" Zero or half a percent is quite a low interest rate. That, presumably, has something to do with the difference between the rate at which banks can at least fund short term and the rate at which they provide loans, which is quite substantial. This comes to the second part of the story, which is that the banking system is one of the reasons why the zero lower bound is not particularly stimulative, because that, of course, is not what households and firms borrow at.
On the answer to the question, "Does that mean that monetary policy is pushing against a string?" traditional monetary policy clearly has very little capacity to go any lower in terms of interest rates. Is that providing the normal stimulative effect? The zero lower bound would imply that it is not, because real rates are going up.
Q64 John Thurso: When we had the Governor before us about a year ago or so, I asked him whether it was an intelligent thing to do to move bank rates to 2.5% straight away. I knew it was not, but I thought it would be fun to see what his face was like. To take a perfectly logical point, every business I talked to-an SME or whatever-is paying something between 4.5% and 10% for its money. Whether or not the Bank rate is 0.5%, 0.75%, 1% or 2% is fairly irrelevant, because the real economy is operating on a wholly different set of interest rates, yet because interest rates are so low and returns on gilt yields are so poor, that means that a lot of people who depend on that income are on very depressed incomes. It seems to be a quandary that we are stuck in, where we have the negative effects of low interest without any of the positive effect. Is that an analysis that has any merit?
Dr Armstrong: It is an analysis that has merit.
John Thurso: Thank you.
Dr Armstrong: If you look at the rates that firms and households borrow at, despite a very radical reduction in the Bank rate-I think we can call it radical now-there has been very little change. Clearly, the idea was that you would change the borrowing rates for the real economy, and it has not happened. This really gets to the issue of why we are still sitting here today waiting for the economy to recover, wondering about TFP and many other things such that, even by the Governor and the latest financial stability report, there are still many issues to be resolved.
Q65 John Thurso: One of the points that is made in the opening part of the review-it is very much the thrust of the piece that you wrote-is, "The vulnerability of the global financial system is reflected in the vast accumulation of cross-border gross exposures in assets classes which are opaque and poorly understood." That begs the question, to what extent have policy makers not taken on board what is happening in the financial world, which is having an impact in the real economy? Have I got that right, and could you expand on it?
Dr Armstrong: Yes. My view is that that is correct. The initial problem was very much to do with the development of part of the financial system that was very poorly understood, in particular that the non-bank methods of intermediation, commonly called the shadow banking system, is almost excluded from any analysis, either that of the Vickers Commission or almost any other form of analysis. Yet, this is a very substantial part of intermediation today, because of technology. It has allowed us to do securitisation, which was not possible 30 years ago apart from by using a government agency. Batch processing allows you to do these forms of intermediation.
However, what you would like is to have a financial infrastructure that understands the assets that go into products and that understands how the markets work. Are the prices traded prices or indicative prices? It also understands the accounting practices in these specialised securities. We had this huge increase in cross-border gross flows. You did not have to run deficits to do this, because they are gross flows. The liability problems that they have left with banks are yet to be fully resolved through. If we look at the composition of typical assets in the UK banking system, roughly half of them are not even loans; they are securities. Securities are not just things that are traded on the stock market. They are lots of complex things, many of which are difficult to understand, and on which the Bank of England, in its financial stability report, does a very good analysis, showing the different types of assets and how difficult they are to understand. That is really about not looking at the infrastructure of financial markets that have developed beyond the structures that we had already set up. I do not think we have really got to task with that to a full extent yet, except perhaps for the Financial Stability Board, which is looking at these issues now.
Q66 John Thurso: There has been a lot of debate this morning about plan A, A+ or whatever. It seems to me that we have a perfectly respectable plan A and a huge change in circumstances, and everybody is stuck on the particular ground they were standing on, whether it is one side with plan A and another side with plan B or whatever, all of which is mildly irrelevant, because what has happened is that the world economy has set out a set of circumstances in the financial markets and we have none of the plans that we need. What we really need to do is to tackle this international paradigm, because it is a precursor to individual national economies being able to recover.
Dr Armstrong: May I make one adjustment to the way you describe that?
John Thurso: Please do. I am a complete amateur at this.
Dr Armstrong: No, you do very well.
It is not that this is an exogenous international shock that has hit us and otherwise we were absolutely perfectly fine. We already owned RBS and half of Lloyds, and so on. The situation that we found ourselves with was that our banks had clearly become too big and had assets that were not well understood, as the Bank of England makes very clear. It is very difficult for outsiders to understand the quality of the assets that are on bank balance sheets. That is why they trade at half the price-book ratio. That was not just an accident of what happened in the external environment. That was our own creation over the last two decades or so, and it was about the way we approached finance. I would not like to portray it as something that is just unlucky. It is something that you have to deal with, and we are doing so, very slowly. For me, the fiscal multiplier issue and many of the other issues stem from this very problem.
Q67 John Thurso: We have a particular interest in this on the Banking Commission at the moment; we are going into a really deep dive into some of this, as opposed to a surface skim. Just seeing how much complexity there is-if I have understood what you are saying and what I have read here, it is really that-we want to get a grip on our domestic economy, and have a far greater understanding of those financial systems and balance sheets, and the international complexities of those, if we are to have any hope of promoting strong growth in the real economy.
Dr Armstrong: To have strong growth that is a robust recovery that would lead to proper rebalancing, is a matter of proper firms that should be funded being funded and people who should not be funded not being funded, and an efficient allocation of resource. I completely agree with that.
Q68 Jesse Norman: Just to rebut something that Mr Portes said, on this piece that I mentioned in The Spectator, the headline is "Why George Osborne’s ‘Plan A’ has failed – and what to do next". That is a paraphrase of the article, which says, "His Plan A … was based on two key premises". It goes on, "The past two years have tested both assumptions, and found them failing". It is not an inaccurate paraphrase of the article. The article ends crediting Mr Portes as director of the National Institute of Economic and Social Research. As you will understand, Mr Portes, my question is not about the economics in this respect. It is about whether or not it is appropriate for you, in that position, to be making those kinds of grand statements, which inevitably have a political impact and implication. My suggestion is that such things may not do the long-term well-being of the NIESR much good.
Jonathan Portes: What you have read out accurately reflects my views. Plan A, or the Government’s plan-whatever you want to call it-relied on two assumptions. You can read out, if you like, what those assumptions were, but it is reasonably clear to me, from an economic perspective, that those assumptions have proved to be wrong.
Q69 Jesse Norman: Just to be clear, you have responded to my concern, which is not about the economics-that is a further issue-but is about your potentially using your position to advance a political agenda, or to say something that has political impact heedless of its impact, or not to check with your institution whether the things you are saying genuinely reflect an institutional view. Your responding to say what the merits of the economics are, in your view, is irrelevant to the point that I am raising.
Jonathan Portes: I will simply make the point that they do reflect the institutional view. As I said before, we discuss these issues, we come to a consensus and, when I talk publicly on these issues or write articles, I write them in my capacity as the director of the institution.
Do they have some political significance or import? That is not for me to say, but I would not be surprised. An economic research institute that is really the only major economic research institute in this country that talks predominantly about macro-economic policy -although it was not so much the case five years ago, maybe-is now, rightly, a subject of public and political debate. If we say what we think the economics says, that may have political implications, but that is not why we say it. We say it because it is our job, as an economic research institute that does macro-economic policy, to say what we think about macro-economic policy. I would not imagine that anybody of any political persuasion here would expect us to say, "Macro-economics? It is a bit too political; we are not going to say anything about that".
Chair: On the basis of some experience, I would say that the views of an institute with which everybody agreed would almost certainly be wrong, and you have certainly stimulated quite a bit of debate prior to this hearing and during it. We are very grateful to you for giving evidence.