HC 1691 Treasury - Minutes of EvidenceHC 1691

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Oral Evidence

Taken before the Treasury Committee

on Monday 5 December 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

Mr Pat McFadden

Jesse Norman

Teresa Pearce

Mr David Ruffley

John Thurso

________________

Examination of Witnesses

Witnesses: Roger Bootle, Managing Director, Capital Economics, Paul Johnson, Director, Institute for Fiscal Studies, Andrew Lilico, Director and Principal, Europe Economics, and Jonathan Portes, Director, National Institute of Economic and Social Research.

Q1 Chair: Thank you all for coming.

Jonathan Portes, in your evidence, you say that "it remains our view that in the short term fiscal policy is too tight, and a modest loosening would improve prospects for output and employment with little or no negative effect on fiscal credibility." That presumably means fiscal credibility in the markets. What evidence do you have for that?

Jonathan Portes: What we can clearly see is that the assertions that were made about the need for accelerated fiscal consolidation to establish fiscal credibility 18 months ago were simply wrong. For example-and this is a typical example of things that Treasury Ministers and others said literally dozens of times-one Treasury Minister wrote: "Britain’s AAA credit rating was under threat…George Osborne had no choice but to come up with a comprehensive deficit reduction plan-not to merely to halve the deficit over four years, but to eliminate it." The reason was that if we didn’t do that, clearly our fiscal credibility would have been shot. Well, we now know that you can publish a Government document, an autumn statement and an OBR forecast that say that we will halve the deficit over four years, but that we will be borrowing more in 2014-15 than we would have done before the fiscal consolidation was announced, and yet there is clearly absolutely no threat to the Government’s fiscal credibility-bond yields hardly moved at all when this plan was announced last week.

So we can see clearly that the reasoning that was advanced in the spring and summer of 2010-that we had to accelerate fiscal consolidation because a plan to borrow £70 billion in 2014-15 would have been totally incredible, would have led to us losing our credit rating and would have led to turmoil in the markets-was wrong. We need to ask ourselves, "Why was that reasoning wrong? Why did the Treasury come up with an explanation that, ex post, was clearly inaccurate?" The answer, quite simply, is that, as Martin Wolf has put better than me, the numbers have to add up-the private sector financial surplus balances the public sector deficit in the current account and, simply as a matter of arithmetic, what we are seeing on the fiscal deficit side is primarily a counterpart of a very large private sector surplus.

Q2 Chair: So the fact that, with a weaker economy, the fiscal position has been looser than it would otherwise have been-in other words, there has been less deficit reduction-is in your view evidence that, going forward too, we can take further risks.

Jonathan Portes: Well, I am not sure what you mean by "further risks", Andrew. If you were worried about fiscal-

Q3 Chair: I am only reading what you said here. What you said here is your view that fiscal policy is too tight and that it can be loosened with little or no negative impact on fiscal credibility.

Jonathan Portes: Yes, that is my view. Clearly, again, if you took the view that our fiscal credibility would be jeopardised by a short-term loosening of fiscal policy, then the position would be even worse now than it was 18 months ago because, as you say, the economy is weaker. Projections, at least in the OBR’s forecast -[broadcast lost for 60 seconds]

Roger Bootle: - as indeed has happened, than would be the case if the fiscal numbers turned out to be higher because there was a deliberate policy on the part of the authorities to expand domestic demand by increasing the fiscal deficit. Having said that, as I started off by saying, I do not think that this means necessarily that you must be doing nothing at all. Saying that something is risky does not mean to say that you should not in some cases take on some of the risk. You have to be careful, but it does not mean to say that you should do nothing at all.

Andrew Lilico: In my view, you can build credibility by early action, which then means that if things subsequently get worse people are likely to think that you may be willing to do more if necessary later. That might mean that, actually, after you have done the early action, you do not then need to do a second round of action, even if that returns you to where you are because, as much as anything, markets are not simply interpreting the progression of events on unchanged policy, they are trying to interpret what you might do if things go ugly.

Another thing to bear in mind is that we are now further down the risk tree, as it were-the set of possibilities-and matters have moved on from where they were in the past. Some of the most dramatic bad scenarios have not yet occurred-who knows whether they might?-but there was obviously the possibility, 18 months ago, that the kind of things that people have talked about as disaster scenarios, with the total collapse of the euro, might already have occurred by this point. So I do not think that one should neglect the fact that one has progressed along the risk tree.

Q4 Michael Fallon: Mr Bootle, in your paragraph 5, you are pretty critical of the OBR’s forecasting of growth and the output gap. You point out that, for the level of GDP in 2015, the OBR is now forecasting £65 billion lower than it forecast six months ago, and that the output gap, instead of being 3.9%, will be 2.8%. How much certainty can we attach to any of the figures, given the scale of that forecasting error?

Roger Bootle: No certainty at all. After the figures that you quote from my piece, I admit that our own forecast record of capital economics isn’t wonderful either, although we have been about one of the gloomiest of all forecasters. As it turns out, we weren’t anywhere near gloomy enough. Forecasting is an extremely difficult business at the best of times, and we are probably at a particularly difficult juncture at the moment. It’s not so much the idea that the OBR hasn’t got things right that I think is worth noting; rather, it’s the question that you referred to-namely, to what extent should one base a policy on what the OBR, or indeed anyone else, is forecasting, in something that is, by its very nature, almost completely unforecastable? The notion of the output gap has acquired a sort of scientific patina, but, as I say in my note, coming to a reasonable judgment about the size of the output gap is exactly that. It is more art than science.

Q5 Michael Fallon: You are implying that it isn’t really appropriate that the output gap should underpin the fiscal mandate.

Roger Bootle: I think one must have some notion of how much spare capacity there is in the economy, but I’m not sure that there is, as it were, a great deal to be said for hammering the various techniques used by the OBR to get a precise number, and on the back of that, calibrating the whole fiscal policy.

Q6 Michael Fallon: What do you think the consequences are, if it has to revise it again next year?

Roger Bootle: That depends partly on what direction it revises it. If it revises the output gap lower again, with the result that yet more of the deficit is thought to be structural rather than cyclical, I think the Chancellor is going to be in a very difficult position. I would imagine that by that stage the OBR’s forecasting credibility will have been damaged, or it will be open to the Chancellor to then decide whether he wants to continue down this route or not. I think it would certainly be quite damaging to then say, on the back of these forecasts, "We’ve got to tighten fiscal policy yet again." It would not just be damaging, but be really rather incredible, frankly.

Q7 Michael Fallon: So this is really a measure that is bearing too much weight in terms of policy and consequences. Is that right?

Roger Bootle: I would argue that it probably is bearing too much weight.

Q8 Jesse Norman: This is a question for you, Mr Bootle. What impact do you think a euro area default or a complete breakdown might have on bank lending activity in the UK?

Roger Bootle: I can’t give you a precisely quantified answer to that, but I imagine that the effect, initially, would be pretty seriously negative. We are given to understand that UK banks’ exposure to continental sovereigns is low compared to other countries in the eurozone, and that UK banks have been cutting down their exposure to banks in the eurozone. I think that there are reasonable grounds for believing that the impact here would not be as great as it would be on the continent, but nevertheless, there has got to be a substantial hit to the capital of UK banks. Accordingly, I would imagine that UK bank lending would similarly be hit. It is very difficult to put figures on it, but I think there will be a substantial impact.

Q9 Jesse Norman: This question is for you and any other member of the panel. Do you share my view that we don’t need the crisis to escalate even further for the money markets and bank borrowing to become sufficiently illiquid to create a serious problem in and of itself, if you see what has happened, for example, over the past three months? Increasingly, many are directly funded by the ECB. Short-term rates have narrowed from 90 to 35 days, and credit swap rates are way over the top.

Roger Bootle: Other members may have a different view. My suspicion is that we are very nearly in the worst of all possible worlds at the moment, and that the markets see a possible crisis, which could end up in the break-up of the euro, large-scale defaults, or both. There are a number of different ways in which this crisis can develop. The uncertainty is causing banks not to want to lend to each other, and hence there is a big increase in the funding rates facing banks. As so many people have said before, it is coming up to crunch time.

There are many different ways in which this crisis could pan out, but I suspect the best thing for British banks would be if at least it happens and there is a solution, rather than continued uncertainty.

Q10 Jesse Norman: Does anyone else want to come in on that? The question was about whether we could run into a funding crisis irrespective of what happens with the eurozone.

Andrew Lilico: I would distinguish between the shorter term and the longer term. If the eurozone crisis is resolved in a way that does not result in a disorderedly default, you might expect in the short term to see some recovery in inter-bank lending. A fundamental underlying issue in the UK economy, however, is that if we do not have sufficiently rapid growth over the medium term, we will find that we get a UK-specific problem of households being dragged into default and being unable to service their mortgages, and that in due course will drag down UK banks. That is more of a four or five-year issue than an immediate one.

Q11 Jesse Norman: I think I am right in saying that the OECD forecast last week was premised on an expansion in quantitative easing on the monetary policy side. Do you regard that as inevitable, and have you made any estimates about what UK growth would look like without that additional QE?

Jonathan Portes: I would say that given the projected path of output and inflation in our forecast, the OBR forecast and the Bank forecast, it is reasonable to conclude that some further expansion of the QE programme is likely. It is difficult to say what the counterfactual position would be. We have got only one set of point estimates on the impact of QE from the first time the Bank did it, and on that basis, they have come up with what I am sure they would admit is the fairly arbitrary number of £75 billion more. I think some new estimates will be constructed, based on the short-term impact of that, for whatever happens going forward.

Q12 Mark Garnier: Roger Bootle, may I turn to business investment? Given that there seems to be slightly less capacity in businesses than we originally thought back in March, how much do you think that has affected the perception of pent-up demand for business investment?

Roger Bootle: That is clearly an issue, but the more relevant point is the way that businesses see the state of aggregate demand. How much spare capacity you have is one thing, but if you do not see aggregate demand performing to your advantage over the next year or two, it does not do much to encourage you to invest. Over the past few weeks, the overall climate with regard to the prospects for domestic demand has deteriorated enormously. The autumn statement was very pessimistic, the crisis in the eurozone is continuing to brew, and the Governor of the Bank of England has warned that this is the worst thing since I don’t know when. In that environment, if you are a business man, you do not exactly draw a lot of encouragement for investment.

Q13 Mark Garnier: There is another side to this question that I would like to ask you about. Presumably you are saying that existing businesses are now less likely to invest or expand into their potential capacity. Also, there are a lot of other businesses that were created prior to 2007 on a sort of false prospectus. There was too much liquidity around, and banks were lending too much money. Do you think that is a fair criticism of where we were then, and that a lot of the businesses that were created and have now closed and have boarded-up shop fronts will never come back again?

Roger Bootle: I do not know; I am fairly sceptical about this. Capital of this sort is a very difficult concept. It may well be that particular businesses never come back again, but I would be sceptical of the notion that large amounts of investment have taken place and in some sense been wasted. I am very sceptical about that indeed. That would be one way of trying to explain the sort of numbers that the OBR comes up with, but I do not find it very convincing.

Q14 Mark Garnier: So looking forward, where do you think the risk lies for the future of our economy? Do you think that things are more likely to get worse than they are to get better?

Roger Bootle: For the economy as a whole?

Mark Garnier: For intelligent business investment.

Roger Bootle: Well, I am not sure that I have a great deal that is original to say on this. On the whole, large British companies are in a pretty good financial position. Their balance sheets are strong, they have a lot of cash and they are not as dependent on banks for finance as other parts of the corporate sector are, or as individuals are. Many of them can raise finance on the bond markets if they need it, but they have internally generated funds anyway.

One can disagree about the extent to which there is excess capacity, but to go back to what I said before, the key thing is, why should they spend their money on investment when they think that the immediate environment for the next few years involves virtually no growth in aggregate demand at all? You do not invest then. That is the fundamental issue. This is one of the ways in which the fiscal stimulus that we debated earlier is so important. If you could convince these companies that there was some prospect of aggregate demand growth, for whatever reason, they might well decide to invest more, in which case there will, of course, be more aggregate demand.

Q15 Mark Garnier: I will try to summarise what you are saying. It sounds as if you are suggesting that there is a huge amount of pessimism built into prospects, and that any change is likely to be on the up side. Is that fair?

Roger Bootle: I am not sure it is likely to be on the up side. It could easily be on the down side, believe it or not. What does follow is that there is the potential for a considerable up side revision with regard to businesses’ view of the future. If that were to happen, they would invest more, and to a large extent, that would prove to be self-justifying.

Q16 Mark Garnier: Does anybody have anything to add?

Jonathan Portes: I agree entirely with Roger. There is a danger of self-fulfilling pessimism here. We collectively talk the economy down, businesses sit on their hands and don’t invest, demand continues to stagnate, hysteresis effects take over, the structural rate of unemployment goes up and good businesses go to the wall. All that becomes, as I said, self-fulfilling pessimism. On the other hand, if through luck or judgment one succeeds in convincing consumers and businesses that aggregate demand is likely to rise and that they are justified in spending and investing, then conceivably, things could surprise on the up side.

One reason why I advocate a temporary-let me emphasise "temporary"-fiscal stimulus is that it is one thing that is within the power of Government to effect. It is not the only thing that could get us into a benign rather than a destructive equilibrium, but at least it is something that the Government could constructively do. Obviously, other things, like a spontaneous increase in confidence or a successful resolution to the eurozone crisis, would also help potentially surprise on the up side.

Q17 Mark Garnier: Can you define temporary fiscal stimulus?

Jonathan Portes: Very simply, the proposal that I suggested as a starting point would be a very substantial cut in national insurance contributions for both workers and employers, targeted on the low-paid and young people. This would be explicitly time-limited for two years, or, arguably, you could say that it would remain as long as the rate of unemployment was above, say, 7%. Since the OBR estimates that the rate of structural unemployment is 5.25%, by definition, this is a non-structural measure. Such a measure, whether time-limited or tied to the unemployment rate, is by definition temporary and non-structural and does not affect the fiscal mandate in any way, so it is entirely consistent with the Government’s strategy.

Andrew Lilico: I have considerable sympathy for the thought that there is scope for an increase in investment, but I don’t think it’s right to think that confidence is really the key issue. I do not buy a faith-healing concept of macro-economic policy where if you just believe in it hard enough, then the economy will grow faster, in any sustainable way. I think that it is more a matter of uncertainty. If there is great uncertainty about what is going to happen, businesses are unlikely to be as willing to invest in an environment of great uncertainty. There is uncertainty about the macro-economic outlook in terms of growth, but also in terms of inflation possibilities and liquidity provision and availability. If you are worried that in the near future, your bank might go belly up, you are going to want to sit on more cash than if you think you might have access to credit if you really need it. While I agree with the underlying thesis, my diagnosis of what is going on would be different. Hence, my diagnosis of the appropriate policy response is different to some extent.

Q18 Andrea Leadsom: I’d like to go back to the impact of the eurozone crisis briefly. The European Central Bank, at the moment, is not really a lender of last resort. We have been talking a bit about market psychology and I wonder whether any of you would like to put forward a thesis for how the euro crisis can be sorted. We have been talking a bit about market psychology and I wonder whether any of you would like to put forward a thesis for how the euro crisis can be sorted. We have a situation in which European Government bonds are trading at enormous yields. How and by what process are they going to get back to under 5%? That is the question. Is this going to get sorted?

Andrew Lilico: I have a well-know view on this, which is that I think it can be resolved with fewer eurozone members, with a system involving centralised fiscal control-the things that we might think of as a stability union element-combined with a system of fiscal transfers, which I would see as an extension of the structural funds arrangement. I think that the crisis will be resolved when we move away from debt pooling-that is, once people stop telling the Germans that they should pay everyone else’s debts-and instead have an arrangement whereby, on a longer term basis, things run via the European Union and you have systems of transfers that go via it and systems of scrutiny that go via a central European-

Q19 Andrea Leadsom: So you are advocating, basically, that the eurozone collapses, because it will be smaller-an orderly collapse of the eurozone.

Andrew Lilico: No-fewer members, but not a collapse.

Andrea Leadsom: An orderly, political unwinding.

Andrew Lilico: No, I mean fewer. It might be only the Greeks and the Cypriots who you need to lose. I don’t think you would have a euro without the Italians.

Q20 Andrea Leadsom: Roger Bootle, what do you think?

Roger Bootle: I think there is a way of keeping the euro going and bringing these yields down. It would involve large-scale purchases by the ECB, and in the end they may not even need to be that mega to bring the yields down. Just the mere prospect that the ECB would be prepared to buy eurozone bonds ad nauseam would, I think, change the market dynamics considerably. First of all, I do not think that is very likely, given current circumstances, but also I do not think it is really a fully independent solution, in the sense that, to go back to what was wrong with the design of the eurozone-it is now commonplace to acknowledge this-to have a fully functioning monetary union in the long run you have to have a fiscal union, and to have a fiscal union that makes any sense you have to have some sort of political union. To have the ECB buying bonds willy-nilly before you have a fiscal union would be really rather odd, because the moral hazard risks of this would be absolutely enormous.

It seems to me that you could only credibly imagine the ECB coming in and buying large amounts of bonds once you have sorted out who is paying for this, what restraints there are on overspending and all that sort of stuff. I think, in that regard, that the German position, as it were, is logically right, although it involves the very uncomfortable position, in the short term, of the thing being faced with a financial crisis. If you wanted to solve the short-term financial crisis, you would just have the ECB buy bonds willy-nilly, but that would, before very long I think, bring you face to face with the essential underlying issues. I am quite sure that we will have at least one more dollop of euro-fudge and I think it’s coming within the next several days-an attempt to shore the thing up that does not address the fundamental problem.

What I find disturbing about this is the way in which the British Government seem to have decided, on the basis of I don’t know quite what, that British self-interests are best served by the continuation of the euro, and, even more than that, by the formation of a fiscal union in the eurozone. I am not convinced of that at all. I suspect that Britain’s interests are best served by a break-up of the euro-the euro is part of the problem, not the solution.

It is not by any means accidental, I think, that you have the same combination within the eurozone as you have on the world scale, which is a problem between China and the emerging markets on the one hand and America and other countries like it on the other, and of essentially a fixed exchange rate system enabling the continuation of underspending by the dynamic, competitive country and the inability of the weaker country-in this case the United States-to get out of this problem. Within the eurozone it is exactly the same. What I find very odd is that on the international scene, not least among the American authorities, they are well up on the first case and they want to end it. That is to say that they want to break the fixed exchange rate regime and persuade the Chinese to raise the renminbi and to boost domestic spending, but when it comes to the European version of exactly the same thing, suddenly the clouds and the mists come over and they cannot see it clearly at all and think that our interests lie in preserving this system.

If it broke, there would be several advantages for Britain. First of all, the vulnerable, peripheral countries of the south would regain competitiveness and could therefore enjoy the prospect of better economic growth, which would then enhance the quality of their assets. Secondly, the northern countries, led by Germany, whose exchange rate would presumably rise, would be under enormous pressure to boost domestic demand, and the result would therefore be a stronger market for our products there.

Q21 Andrea Leadsom: Can I just come back at you? In the short term, that would, however, be a disaster for the banking system, wouldn’t it? You accept that?

Roger Bootle: It would be a problem, yes. This is a short-term, long-term issue. If you preserve the eurozone-apparently, that is what politicians on the continent are desperately trying to do-you forestall some of the short-term difficulties. I do not think you can forestall all of them, because Greece is going to default in some sense or other anyway, and so, probably, is Italy, and you are going to get consequences from that. But if you do not address the fundamental problems, which include the loss of competitiveness by the southern members, what sort of prospect does that hold out for economic growth in those countries, which amount to around a third of the eurozone? They are actually, collectively, bigger than Germany. You are sealing all this in; you are sealing up the idea of very, very weak growth, or depression, for a huge part of the continent, which is one of our most important markets.

Q22 Andrea Leadsom: What is the panel’s view on the fact that the eurozone is refusing the concept of quantitative easing for fear of hyperinflation, yet the UK is embracing it? That is an apparent contradiction of views, which nobody seems to address.

Jonathan Portes: We are right, and they are wrong.

Andrea Leadsom: We are right, and they are wrong. Excellent.

Chair: That is very helpful and succinct.

Q23 Andrea Leadsom: Does anyone want to expand on that?

Chair: Don’t feel the need to expand for a long time.

Andrew Lilico: In the eurozone collectively, one of the jobs of the European Central Bank is maintaining price stability, and it has actually done it rather well. I do not think that, collectively, the eurozone faces the same deflation risk or threat that we do in the UK or the US over the medium term, so I do not think it needed to do quantitative easing in the same way that we did. There are separate arguments about lending to sovereigns, but in terms of quantitative easing, I do not think it had the same needs that we did.

Roger Bootle: I agree with Jonathan: we are right, and they are wrong. But to go briefly deeper, why do they take the stance that they take? Again, this goes to the fundamental failings in the way this thing was constructed. They take the stance that they take because they do not want the ECB involved in bailing out Governments. What do you buy when you do quantitative easing? Most of what you buy is going to be Government debt in some way or other, so you cannot separate that from the issue we were talking about earlier. If you try to, the ECB is buying corporate debt, much of which is very dodgy, and you get into all sorts of awkward situations. The other reason why they are dead against this is because of the ghost standing behind them all the time-the Bundesbank and the need to be, apparently, just as monetarily austere as the Bundesbank was. Those are the two reasons why they cannot or will not do QE. In essence, I agree with Jonathan: they should be doing it, if those two things were dealt with.

Chair: So, in a nutshell, the whole panel thinks that the monetary accommodation that is taking place is right, but the panel is divided on whether we should be accompanying it at this stage with further fiscal shots from the locker. Is that correct? Yes? I thought it was.

Q24 Teresa Pearce: Good afternoon. The levels of youth unemployment are of deep concern to everybody. We have had the announcement of the youth contract. The CIPD has said it thinks the youth contract is unlikely to have any real effect on youth unemployment levels. Jonathan, do you agree?

Jonathan Portes: I think that is somewhat unfair. The youth contract is actually a good start and a sensible move in the right direction. Going back to what I said, the fundamental problem at the moment that is making things worse is clearly a lack of labour demand, and that, in turn, comes from a lack of aggregate demand in the economy. To solve that, you need to solve the macro-economic problems we were talking about before. In that sense, clearly, the youth contract will not, and is not designed to, do something about the fundamental problem of a lack of demand. However, that said, I still think the youth contract contains a number of very sensible components-in particular, the proposal for a significant wage subsidy that is roughly comparable to what was in the new deal for young people when that was first introduced. The evaluation that NIESR and others did of the new deal shows that that wage subsidy was the most effective part of the new deal. I do not see any reason why that should not have a positive impact. It will be important that it is delivered and implemented effectively. We know we have had problems with schemes like this before-that take-up has been insufficient-but if the DWP put some effort into ensuring that employers take up this quite significant wage subsidy, I do think it will have a meaningful, positive effect.

Similarly, the fund for disadvantaged 16 to 17-year-old NEETs-effectively those who have dropped out-relates to a serious problem. It has been a structural problem for a long time. It would probably be a problem even if we did not have the aggregate demand problems. So, I think it is entirely the right thing to do and to some extent goes some way, at least, towards cleaning up the serious policy mistake the Government made when they abolished the education maintenance allowance in the teeth of the evidence, constructed by Paul’s colleagues at the IFS and others, that it was actually making a positive difference. It will not solve the problem, but it is a meaningful, positive step.

Q25 Teresa Pearce: So what you are saying is that the subsidy is the thing that will make the difference. Do you think then that the young people who become employed will be employed at the expense of somebody else?

Jonathan Portes: Some of them will become employed at the expense of someone else. All active labour market policies have a significant deadweight impact, but some of the people who will employ those people will offer genuinely additional new jobs that would not have been there, and that is very much worth doing.

Q26 Teresa Pearce: On a related point, these young people will be assisted early on in their unemployment before they go on to the Work programme. Will that have an effect on the Work programme? It tries to place people who are on the Work programme into work; the jobs will have already gone to those young people who have been helped by Jobcentre Plus. Do you think that that might be a problem?

Jonathan Portes: There will be some effects, but these subsidies will also be available to young people on the Work programme as well. That will give the Work programme providers, and if the Work programme works the way that it is intended to work, with these private sector providers being more dynamic and coming up with better connections, for example, from employers, then you would expect them to say, "Well, here is some free money, effectively, that I can use to help me achieve my targets." That should be a powerful marketing tool and also a powerful incentive for them to take advantage of that. So I would not be too worried about the- I am much less worried about the displacement and deadweight effects of active labour market policies in current circumstances than I would be in normal times, when the Treasury and DWP are, quite rightly, very worried about just getting jobs that would have happened anyway. I am much less worried about that in current circumstances.

Q27 Teresa Pearce: Do any of the panel have a view on that.

Paul Johnson: I think that is broadly right. The evidence on these things is positive, but certainly not overwhelming. I mean, this is not going to fundamentally change the labour market. One of the issues that Government and others will need to keep an eye on is how this relates to those who are just outside of the scope of the policy. If I was a 25-year-old who had been out of work for nine months, I would be really quite worried at the moment, or even more worried. It must also increase the probability that the 18 to 24-year-olds will not get jobs at six or seven months, and they will be kept on till nine months. But you have to draw these boundaries somewhere, if you are going to limit what you are doing. That age group and that length of unemployment is probably as good a limit as you could put on it. As with all of these things, there are trade-offs.

Q28 Mr Love: I would like to come back to QE, and particularly to the two on the top table here who are in favour of a mild fiscal stimulus. The Governor of the Bank of England, when he came to us a couple of weeks ago, said the classic economic response to the current situation was tight fiscal policy and a loose monetary policy. Clearly, he is only prepared to go a certain amount of the way because inflation is still at 5%, but assuming-this is, of course, the forecast that he is making-that inflation will come down very rapidly in the new year, that will open up a space for him to boost the economy by significantly greater quantities of QE. What is wrong with that as a strategy? Why do we need a mild fiscal stimulus to help that process? Mr Portes, you are in favour of a mild fiscal stimulus.

Jonathan Portes: I think that in what one might generally call broadly normal times, one would try to manage aggregate demand in the short term, primarily through the use of monetary policy. These are clearly not normal times. The monetary transmission mechanism has been badly impaired; we have zero interest rates; and we are using a tool-quantitative easing-that is worth using and worth trying, but it is clearly very much untested and uncalibrated, and there are certainly credible arguments out there that it has not had as large or as positive an impact as it might have had and that, in addition, one might expect at some point diminishing returns from QE.

In particular, my view is that the first time round QE clearly had a significant positive confidence impact, because it convinced commentators, business and so on that, whatever else would happen, we-the collective economic policy making establishment-were not just going to let the bottom drop out of the economy entirely and that we were ready to take unorthodox measures to stop things collapsing. But you only get that kind of confidence boost once. So it is far less clear to me that QE will necessarily have as large and as positive an impact this time round as it did the first time round.

Q29 Mr Love: Can I ask Mr Bootle a question? Of course, the Governor quoted from the Bank’s report in relation to what level of growth was achieved by the last round of QE and what level of inflation. Everybody seems to be assuming that there will be a lot more inflation this time, but where is the evidence for that?

Roger Bootle: I am very sceptical about what the Bank said about the power of QE on that first occasion. As Jonathan said earlier on, we have not got an awful lot of evidence to base that on and I am not convinced by the various channels through which QE is supposed to work, other than the confidence effect, which Jonathan correctly emphasised. I think that it is rather a question of what do you do when you are faced with a ghastly situation, which I think is probably just about completely unprecedented and which could yet get even more ghastly. I think that the common-sense thing to do is to try a bit of whatever you can do with a reasonable chance that it might actually work. That includes more QE and I happen to think that it probably also includes a bit of fiscal stimulus.

With regard to the fiscal stimulus, of course there are different sorts of things you can do. In my own mind, I see this as being closely tied in with the objective of trying to get the private sector to spend more money, in particular on infrastructure. If you want to get really big infrastructure projects going-let us think, for instance, about "Boris island", or call it what you will-there is the potential for a lot of private sector spending in a project like that, but there has got to be some public sector spending as well. I am not necessarily endorsing that particular project, but I think that it is an example of a general phenomenon and that I would want to be able to spend a bit more public sector money if I thought that that was the key to unlocking the private sector expenditure.

Q30 Mr Love: I suspect that Boris Johnson is a rather happy individual this week, because he has had a number of endorsements for an idea that a year ago was considered somewhat beyond the pale. We will be interested to see how that idea shapes up.

You mentioned earlier, on the prompting of Mr Fallon, that you did not think that the OBR’s record of forecasting was very good, but accepted that there were extenuating circumstances. Its explanation for why it got so badly wrong was the squeeze on incomes, caused by the shock of international inflation. Is that an adequate explanation as to why the OBR was so badly out in its forecast?

Roger Bootle: It has got a lot to do with it, but not all. I think that largely explains the effects on consumption, but over and above that you have got to explain why investment has been weaker and why net exports have been weaker. There are indirect linkages there. I think that it probably goes a fair way, but not all the way.

Q31 Mr Love: Mr Lilico, you were shaking your head. You are yet to be convinced?

Andrew Lilico: I think it’s a mechanism, not an explanation; actually, you are just describing the process rather than saying why you made the mistake. I think that, fundamentally, the OBR have been overestimating how fast the economy could grow-the growth in potential output-because they, along with many other policy makers, have been overestimating the sustainable growth rates of the economy for many years. That means that they tend to both overestimate how fast it will grow in any period and underestimate how much inflation there is associated with that.

Q32 Mr Love: Arising from their explanation that it was due to a squeeze on incomes, the TUC in their paper to this Committee suggest that in the future, over the next few years, the OBR expects household spending to rise, despite falling real incomes over that period. How can that be the explanation for the problem that they’ve got, and yet they are reversing that? They’re saying that it was because of falling incomes that consumer expenditure didn’t match what they expected; but now they are expecting it to match, even though incomes are falling. Is that a problem?

Jonathan Portes: It is a problem. I think their explanation would be that, although real incomes may be falling, there will not be the sharp squeeze on real incomes that has happened as a result of the rise in oil prices, for example, over the course of this year, so the headwinds for consumer expenditure next year will not be quite as bad. But I agree that this is still a potential risk, and I think we are slightly less optimistic than them on this score.

Q33 Mr Love: Mr Lilico, assuming the likely continuation of the euro difficulties as a backdrop to consumer confidence in this country, do you think that the OBR is wise to suggest that consumer expenditure is likely to increase in future years?

Andrew Lilico: The eurozone crisis will have to be resolved one way or another fairly soon. I don’t think it can continue for another five years in anything remotely like the way it has for the past couple of years, so I do not quite buy that. On the other hand, I think it is a little odd to assume that, in any economy as heavily indebted as we are, households will be running up additional debts, so I think that is problematic. Households need to be running down their debts.

Q34 Chair: Five more years of the euro crisis really would be something. Jonathan Portes, you have said you want a fiscal and a monetary stimulus. QE is quite large as a proportion of GDP in percentage terms. What size of fiscal stimulus do you want to see as a proportion of GDP?

Jonathan Portes: Following up on what I said before, I think it would be reasonable to cut national insurance-

Q35 Chair: I am just asking for a number as a proportion of GDP.

Jonathan Portes: Approximately 2% of GDP for the next year or two.

Q36 Chair: What size is QE as a proportion of GDP?

Jonathan Portes: Well, QE as a proportion of GDP-you want me to do mental arithmetic now. £275 billion divided by £1,500 is about 15%.

Q37 Chair: So we are talking about something very small in relation to GDP.

Jonathan Portes: To be fair, I do not think the Bank would regard that comparison as being valid at all. It is very different to cut your taxes as opposed to buying Government bonds and increasing bank reserves.

Q38 Mr Ruffley: Roger Bootle, you have been very consistent and I have a lot of sympathy for your view-consistent this year compared with March when you gave evidence about tax reductions being perhaps worth trying. When the IMF also made that observation in their last big report, they talked about tax relief to further investment and tax relief to further job creation. Could you flesh out a bit more what tax relief you would favour, in terms of the fiscal stimulus that you thought might be worth trying?

Roger Bootle: First, there is a distinction to be drawn here between, on the one hand, some sort of tax reduction when it is acknowledged from the start that it will increase the deficit, which is a straightforward Keynesian expansion, and, on the other, a tax reduction that stems from further cuts in Government spending, which is a different thing altogether. On the first idea of tax reduction in straightforward Keynesian fashion, I think that could be tried, but I am much more nervous than Jonathan would be about market reactions. I would be keen for it to be clearly time-limited, and I’m not sure that it’s necessarily better than increasing Government investment spend, particularly if the money is in some way tied into an overall attempt to get private sector investment spending going, which is where I would put my firepower.

An option that seems not to have been examined enough is the one I referred to as a second option: to cut Government spending faster with a view not to bringing the deficit down, but to bringing taxes down, and in the process thereby stimulating economic growth. You would then have a debate on which taxes to reduce, and I would probably put high emphasis on taxes on employment: national insurance contributions.

Q39 Mr Ruffley: In that second scenario, it is deficit neutral, and you would just reduce spending by the amount you cut taxes.

Roger Bootle: That is what I would-

Q40 Mr Ruffley: To quantify that, analogous to the question the Chairman asked Mr Portes, if you wanted to deliver a fiscal stimulus, and you wanted to do that fully funded by further public sector reductions, what’s the order of magnitude of the fiscal reduction you say would be needed to have an appreciable effect on GDP? Are we mucking around with £5 billion or £10 billion? What sort of percentage of GDP are we talking about?

Roger Bootle: It’s as long as a piece of string.

Q41 Mr Ruffley: What is likely to have a negligible impact, and what is likely to have more than a negligible impact?

Roger Bootle: I think £5 billion is negligible. Looking at the scale of the revisions from the OBR, we’re talking about increases in debt in a few years of £111 billion, versus what it forecast a few months ago. I think the odd £5 billion thrown into the pot won’t make a great deal of difference.

Q42 Mr Ruffley: But in percentage terms, what would be the tax reduction? Let’s assume it is targeted in the way you are suggesting, and it’s matched by public spending so there’s no net deterioration in the deficit; what order of magnitude are we talking about as a percentage share of GDP to have a favourable impact on GDP?

Roger Bootle: Jonathan was talking a moment ago about 2%-the 15% was QE-with regard to fiscal stimulus. That’s approximately £30 billion, so we are talking serious figures. Perhaps I could put a quick wrinkle on this. I have argued for some time that what could be done in these straitened circumstances is to lay out a forward tax plan. We have a forward plan for expenditure-we’ve always had that-we have a forward plan for borrowing, or at least a projection for it, and we have some sort of forward plan for corporate tax, but we haven’t got a more general forward plan. It seems to me that that would offer an awful lot in connection with what we talked about earlier on the confidence of businesses.

If you had the courage and political will to lay out a full programme for cutting public spending-offset by big reductions in, let’s say, national insurance contributions-and that could be believed, that might make a major contribution to bolstering the business sector’s confidence, which could then have an aggregate demand.

Q43 Mr Ruffley: Hear, hear. Perhaps I may quickly address the next question to both Mr Johnson and Mr Portes. I am trying to get a handle on the magnitude of the real-terms cuts in general Government expenditure over the CSR period announced last year, and then taking into account the first two years of the next Parliament, on which there were additional announcements in the autumn statement last week. Mr Johnson, could you give me an indication of how historic the real-terms cuts are that the Chancellor confirmed in his statement last week?

Paul Johnson: Well, they are pretty historic. The additional cuts pencilled in for the first two years of the next Parliament come to, in real terms, £15 billion in 2016-17 against GDP-which is the normal baseline-of £30 billion in that year, so there’ll be £30 billion less relative to GDP than if spending had gone up in line with GDP. Over the whole period, that is a cut at least as big as the average cut we are seeing over the four years of the spending review going forward. That means that over that six-year period there is a whole series of firsts. One is the total amount of cut over that period, and second is the number of years. To put that in perspective, it is worth saying that we also had an historic period of increases under the previous regime.

Mr Ruffley: Exactly.

Paul Johnson: Put those two together and it looks slightly less remarkable.

Q44 Mr Ruffley: That is what I am after. Have you done any work; can you provide context for this? It is frequently said that this year we are spending, in cash terms, about £670 billion, and cash at the end of the CSR is going to be £730 billion plus. We all understand that a large component of that increase is higher debt interest and automatic stabiliser payments-I get all that-and therefore the cuts in programmes are really quite savage. But set against what was spent from 1997 till, say, 2005, aren’t we just getting back, net, to where we were in 2000 in respect of real-terms general Government expenditure?

Paul Johnson: Public service spending as a proportion of national income is, I think, basically going back to where it was in 2000. You have a big spike up and a big down spike, and you end up-

Q45 Mr Ruffley: So what is the big deal? Why is the Chancellor seen to be the hard man, Mr Austerity? Why do you keep on talking that way when the context-

Paul Johnson: There was a very big increase and there is a very big decrease. Whatever the appropriate level is, that is not a very happy way of getting there. But you are absolutely right: in terms of public service spending as a proportion of national income, the spending review gets us back to where we were in about 2000.

Q46 Mr Ruffley: So people like me say, "Big deal", but that’s not the message I get from your organisation when I read your commentaries.

Paul Johnson: The historic thing is a big increase and then a big decrease. This is the first time, certainly since the war, when you have had six years of cuts in a row and when you have had cuts of that scale in a row. That is historic and that is-

Q47 Mr Ruffley: From a ridiculous base, which hasn’t ever been as high before. I take your point; that’s very helpful. Mr Portes, would you like to make some comments?

Jonathan Portes: Paul is the expert on the profile and the numbers, but I will make a couple of comments-two very quick points. One point to note is that you can look at this one way, which is to say, "Well, public spending has been about 40% for a long time. It’s gone up and now it’s come down, so what’s the big deal?" The other way is to say, "Actually, there has been quite a shift in what that money is spent on. A lot more of it is being spent on health and education." The other argument is to say that this is the standard Baumol effect. You would expect countries as they get richer over time to choose to spend more money on health and education. We choose in this country to provide that funding primarily through the public sector. Therefore you have to say, "Either you let public spending rise as a proportion of GDP over time or you transfer some of that spending to the private sector." But the idea that you can continue to spend more on health and education, spend it all via the public sector and keep it to 40% of GDP implies a very, very tight squeeze-an unprecedented squeeze-on other bits of the public sector, so there are some choices that need to be made.

Mr Ruffley: That is very helpful. Thank you.

Q48 Stewart Hosie: The Governor of the Bank of England told us that the stock of SME lending was down by £5 billion last year. That is a significant amount of money for the smallest businesses, so the Chancellor has embarked on the national loan guarantee scheme to see whether that can do the trick and unlock business finance for the smallest businesses. To what extent do you think that is an admission that Project Merlin failed?

Paul Johnson: I do not know whether it is an admission that Project Merlin failed or not. Clearly, there is an issue about availability of finance for small business, and as Jonathan and Roger have been saying, it is worth trying things at the moment to see whether they work. This feels like an effort to do exactly that. We know that there is a problem. Here is an interesting, rather novel way of trying to get money into the economy and into an area where we know it is needed. It feels like it is worth a shot. I don’t think we have any very clear idea of how effective it is likely to be.

Q49 Stewart Hosie: That is interesting because in your opening remarks you were generous to the Government and you said, "We could at least say that they were trying a fair range of options." You also said that credit easing might boost the availability of cheaper loans, but again both the details and the effects will need to be seen. The Government are doing this through the banks, but Adam Posen from the MPC has suggested the creation of new institutions to put these guarantees out and make sure the money gets lent. Do you think the Government are right to use the banks, or do you think Adam Posen was right that we should have done it more directly, through new institutions?

Paul Johnson: New institutions take a while to set up, so he may be right in the medium run, but I would be surprised if he was right in terms of getting things through quickly, because if you want to get things through quickly, you need to use existing institutions, and institutions set up by the Treasury will probably not be in place in the next year.

Q50 Stewart Hosie: Do any of you have any sense that the national loan guarantee scheme will actually work to boost lending? Do any of you have a sense of how that might work or if it will work?

Paul Johnson: The idea is that it would work, in large part, by reducing the interest rates that banks are able to charge and by increasing the guarantees that they got. The mechanism through which it might work is reasonably clear. The banks would have the guarantee against which to loan and that would allow them to loan at a lower rate. What we do not know is the level of behavioural change that that would imply.

Q51 Stewart Hosie: I suppose it will answer the question about aggregate demand. Roger Bootle, if it does not work, if SME lending does not increase and if it confirms that aggregate demand is incredibly sluggish, flat or shrinking, does that increase the case for direct fiscal stimulus, rather than this sort of mechanism?

Roger Bootle: Well, if you have a series of possibilities that you are going to try, and if you can rule one or two of them out, I suppose it puts more of a burden on the others that have not yet been disproved. Let us put it that way. I can be no more encouraging than that.

But of course, in relation to this, the point that I would make about the scheme is that it is not obvious-at least not to me-whether it will lead to more lending. It may reduce the cost of lending, which of course would be of some help to businesses, but that is not quite the same thing as boosting aggregate demand through actually making more lending available. We do not yet know the answer to that.

The other point that I would make about this is that it is going to be very difficult even after the event to decide how effective it was, because these effects could easily get swallowed up in other things that are going on-notably the deterioration in conditions in the wholesale money markets for banks-which is going to make it very difficult to see quite what measure had what effect.

Q52 Stewart Hosie: I have a question on aggregate demand. If aggregate demand is proved to be really flat, Paul, and there is no increase in SME lending take-up, does that increase the case for direct fiscal stimulus?

Paul Johnson: That question on direct fiscal stimulus and its effect on the macro-economy is really one for my colleagues here.

Jonathan Portes: Yes is the short answer and for the reasons that you have just given. Just because I think that aggregate demand is a major part of the problem does not mean that I do not agree very much with what Paul and Roger said, which is that it is worth trying this sort of scheme. It may or may not work and, at least in the margin, we may or may not be able to tell whether it works.

Q53 Mr McFadden: I would like to ask you, Paul, about the slides that the IFS produced last week on living standards and the distributional impact of the Chancellor’s measures. On living standards first of all, you say in your slides that if the OBR is correct, there is a 4.7% fall in per capita real household disposable income between 2009 and 2012 and then, a little bit later on, you are forecasting a 7.4% fall in real median net household income between 2009-10 and 2012-13. Can you first of all tell us the difference between the 4.7% and the 7.4%?

Paul Johnson: The numbers that the OBR were using are from a national accounts aggregate, which essentially just takes all of the income in the economy, sticks it together and provides an average, so there are several things that are different between that and what we are doing. The first is that is a mean rather than a median, so it is impacted by what is happening towards the top and that takes account of a whole of series of things about capital incomes and so on, which are not captured by the median.

Secondly, what we have done is, as it were, build this from the bottom up, so we have looked at changes in benefits and earnings and tax rates across the distribution. We then looked at the household in the middle. The household in the middle in general tends to do rather less well than the mean, mostly because of what is happening on the distributions of earnings and so on, but that is also, in this case, possibly to do with some of the tax and benefits changes.

So they are different sorts of measures, and they are not directly comparable. There is a general story to take away, which is that, essentially because of what is happening to earnings, households are getting worse off.

Q54 Mr McFadden: That is what I will come on to. You are quite clear in your slides that this is in historic terms a very big squeeze on people’s income. We had the Governor of the Bank of England last week who said in response to the Chairman’s question that he thought the bulk of downward revisions had followed growth projections which was down to the eurozone. Here in your slides you have exposed a real squeeze on household incomes over the period 2009-10 to 2012-13. Are we looking too much at the eurozone and not enough at the squeeze on people’s family incomes?

Paul Johnson: In a sense the interesting thing about what is happening to family incomes is this. Over recent years there have been three periods. There was a period from 2001 to 2008 when median incomes grew pretty slowly. So you got a slow growth. Then you have the period after 2010 when there was a sharp drop. We are in the middle of that sharp drop. Then you have a period from about 2013 when there is a slow growth again. You have actually got a much longer period than the period of the eurozone crisis over which there has been a significant squeeze. That squeeze started before 2008. It has taken a big shot and we are in the middle of that big shot. Then there is a very gradual recovery. Now, the thing that the eurozone crisis is really going to impact on, I guess, and a lot of what we have just been talking about in terms of the macro-economy, is the speed of that recovery. One of the reasons that we are going to end up in 2014 with incomes which are relatively low is because the speed of the recovery is now much lower than we expected.

Q55 Mr McFadden: But it is not surprising that the retail sector is in trouble and people are a bit nervous about Christmas and the economy over the next year if we are in the midst of one of the sharpest contractions in household income since the war.

Paul Johnson: Indeed. The OBR got criticised back in March for having spending projections in the household sector which looked too optimistic. There is some sense that that may still be the case. If you look historically their projections back in March were still the least optimistic of any time over at least 50 years. So they were criticised for being too optimistic and it has turned out that they were too optimistic. But again, that partly reflects the historically unusual times that we are in. The level of consumption is still a long way below where it was before the crisis and is likely to stay there for some time.

Q56 Mr McFadden: I want to ask about distributional impact but does anyone else want to come in on the squeeze on household incomes and its impact on growth?

Paul, your slides on the distributional impact taking effect over the current years were pretty graphic. The Government claims that the top decile in terms of household income sees the largest reduction in income, but your analysis appears to show that it is the poorest decile groups who take the biggest losses. Why is there a difference between your verdict and theirs?

Paul Johnson: Because we are comparing different periods, essentially. The chart you held up is just the effect of changes coming in next year in 2012-13. So that includes what was in the autumn statement plus what was previously announced. That is a combination of the tax credit cuts, some other changes to the benefit system, an effective real reduction in fuel duties and so on. That is what is in there. What is in the Government’s document is essentially everything that has come in from 2010 or since the Government took office. That includes national insurance increases, freezing of the higher rate tax threshold and things. So if you look back at the chart we put out after the Budget, which looks at the same period but just does not have the couple of relatively small things that were announced in the autumn statement, our chart looks reasonably similar to what the Government are doing. Now, it is different in two ways. First, we include the effect of employer national insurance contributions, which we assume feed in to individuals, so that has a bigger impact on people all the way across the distribution. Secondly, we model some changes to the local housing allowance and to tax credits, which the Treasury are modelling. Broadly, our picture for that period looks pretty similar to the Treasury’s picture for that period. It is just that what we put out last week was just looking at what is coming in next year.

Q57 John Thurso: Paul, can I come to you first? In your opening statement, you made a nice little comment, which was that Osborne’s second autumn statement had more in common with Mr Brown’s Budgets than either of them would particularly like. Was that just a nice soundbite or were you actually driving at a point?

Paul Johnson: There is a point there.

John Thurso: Would you like to make it for me?

Paul Johnson: There is a combination of things that take me back, as it were. One, of course, is that the fiscal forecasts have got worse. That was a common feature of the last several years. Another factor is that there are a whole range of little policies in there. Again, that was a feature of a number of things from previous Administrations. The continual putting off of the indexation of fuel duties is something we have seen on a number of occasions. To some extent, it was just a nice soundbite, but it was not without some grounding in reality.

Q58 John Thurso: Were there any winners or anyone who was not worse off as a result of the announcements made?

Paul Johnson: Those people who drive a lot and who are not dependent on tax credits will be somewhat better off as a direct result of the announcements. Most pensioners certainly were not made worse off by the announcement. Those dependent on state pensions have been protected fully against inflation and have not been hit by anything else. If you are looking at the longer period of changes in the tax and benefit system, inevitably nearly everyone is losing because there are significant tax increases and benefit cuts-although, again, the distribution is quite uneven. Some people in areas with high housing costs and who are dependent on tax credits and so on will lose significantly. There will still be groups of pensioners who have not been hit at all by any of the changes.

Q59 John Thurso: Last question. May I come to Roger Bootle? You put your finger on the dilemma within Europe, which is: you have got one big creditor country basically doing the producing and a lot of lesser countries doing the consuming. You pointed out that that was also broadly the position between China and the west. Everybody is in favour of some kind of fiscal stimulus. If that fiscal stimulus simply increases demand, do we not exacerbate that problem? Is the challenge not to find a fiscal stimulus that does not put us right back where we started a few years ago with the imbalances across the whole world? That is where the real genesis of this process lies.

Roger Bootle: The first best solution-if, indeed, there is a solution-is of the sort you describe. It involves doing something about the imbalances at a world level, of which the eurozone is just a part. Indeed, the Governor of the Bank of England has said that several times recently. But, I am not sure we have a great deal of influence over all that. To some extent, we have to accept as given what China’s policy is with regards to domestic spending, the renminbi and so on. We have to think to ourselves: what, in those circumstances, can we do about it?

But, with regard to the point you were making, if there was scope for some fiscal stimulus, I would like to see it directed more towards public investment than towards boosting private consumption. As I said before, public investment has the chance of tying in or encouraging extra amounts of private investment expenditure as well. That would not directly help the sort of rebalancing that involves more dependence on exports rather than consumption, but it would help rebalancing in a broader sense if it was more about investment.

Q60 John Thurso: The critical point is that any money that goes in has to be for investment rather than immediate consumption, if it is not simply going to exacerbate the underlying structural problems.

Roger Bootle: My feeling is that the quintessential problem is so much to do with a shortage of aggregate demand that if it were a choice between something that was going to boost consumption expenditure and not having any boost to aggregate demand at all, I would accept the boost to consumption expenditure, even though it would worsen the imbalances.

Q61 Chair: Andrew Lilico, you have been sitting there very quietly and patiently for some time. Before we close, is there any particular point you want to throw in that you have not had the opportunity to express?

Andrew Lilico: The fundamental problem with the economy is that its medium-term sustainable growth rate may not be high enough for households to service their debts. It is a mistake to think that what is desired here is some sort of stimulus that might provide you with an additional quarter or two quarters slightly faster growth, even if you could work out how to deliver that. What we need is more rapid growth over the medium term. If we do not get sufficiently rapid growth over the medium term, households will default on their mortgages and our banking sector will be dragged down, and the sovereign will be dragged down with it, through its entanglement with the banking sector.

If you think of various sorts of stimulus options or other kinds of tinkering, you should beware of doing anything that-even if you could make it work-might provide you with a short-term injection, if the consequence would be an undermining of that medium-term growth rate. That is the thing that George Osborne should wake up every morning trying to dream up new ways of improving, and go to sleep every night fearing that he has failed to do so.

Chair: That is a very helpful, if slightly pessimistic, note on which to end the first session. Thank you very much for giving evidence this afternoon. We appreciate it. We’ll adjourn for five minutes and then resume with the second panel.

Sitting suspended.

On resuming-

Examination of Witnesses

Witnesses: Nancy Kelley, Deputy Director, Policy and Research, Joseph Rowntree Foundation, Ed Cox, Director, Institute for Public Policy Research North, Lee Hopley, Chief Economist, EEF, The Manufacturers’ Organisation and Andrew Cave, Head of External Affairs, Federation of Small Businesses.

Q62 Chair: Thank you very much for coming before us this afternoon; I am sorry that you had to wait a little longer than you might have hoped. I shall begin with a question first to Lee Hopley: do you think that SMEs really are having these difficulties accessing finance or is it just the price of that finance? Or are they really making a great fuss when, in fact, they do not have very good projects to lend to?

Lee Hopley: First, it is both. EEF has been tracking credit conditions across manufacturing since the end of 2007. We ask both about the availability of credit and also about the cost of finance, and on both measures there were clearly a lot of problems going through 2008-09 and even into 2010. At the beginning of this year, we had seen the squeeze on availability start to ease, even for SMEs, so we saw a small balance of small and medium-sized companies saying, "Finally", as after several years, the supply of finance had improved slightly.

We had not seen any movement on the cost front. That had remained elevated, not just the interest rate on borrowing, but increasingly, and supported by a lot of anecdotal evidence from across our membership, it is around ancillary costs and other costs wrapped around new borrowing. Terms and conditions also seem to have changed significantly since the financial crisis. Clearly, there may be some good reasons for that, but I think that part of the issue is also just a lack of transparency about the new rules in terms of how the costs and terms and conditions were being applied. Yes, I think that there are problems on the supply side.

Q63 Chair: So SMEs do have good projects and the banks are not being helpful, or are not capable of being helpful.

Lee Hopley: Clearly, there will always be a group of small businesses, particularly at the micro end of the spectrum, that is not in a position to put forward good business plans that have cash flow projections and the kind of information that the bank needs. The question that we need to ask is what changed through the financial crisis. Are we seeing more small companies that are not able to put forward these business plans, or has there been a change in the behaviour on the supply side? We believe it is the latter.

Chair: Andrew Cave, do you want to add something?

Andrew Cave: I would concur. The difference between now and 2008 is that in 2008, there certainly were many instances where businesses were seeking lending, but they just did not have the right business plan in place. They were being unrealistic. That period has passed and sadly, a lot of those businesses are no longer with us.

Our polling work and the anecdotal comments that we get from members is that for those businesses that are seeking finance and are being turned away, that is having a dramatic effect on their businesses. Some 31% believe that they have missed their growth opportunity, while 21% have been forced to delay investment plans, and 18% believe they are now operating at a competitive disadvantage, primarily because they were not able to access those funds. It is impossible for us to speak to every single one of those businesses, but they are not the kind of profile of businesses that are on the cusp of bankruptcy. They are looking to grow and most recently, a survey we undertook suggested that over 60% of our members intend to grow at some point.

Q64 Chair: What you are describing is very much the anecdotal evidence picked up by MPs right across the country, and certainly in my constituency. Why is it that so many small businesses are reluctant to talk publicly about it?

Andrew Cave: I think that those businesses that are going to banks and seeking finance do not want to talk publicly about it because there is a lot wrapped up in that relationship.

Q65 Chair: They are afraid of the banks.

Andrew Cave: They are partly afraid of the banks, but there is also a lack of information given to them. Of the businesses that were turned away, 16% say they do not know why they were turned away from the bank when they sought to access finance, so they are still not equipped with the information from the bank about what they need to do to go away, reconsider and resubmit applications.

Q66 Mark Garnier: Looking at household consumption-this question is mainly to Ed Cox and Nancy Kelley to start off with-we have seen a significant reduction in household borrowing. In fact, we have seen negative household equity withdrawal rates of £9.1 billion in the second quarter of 2011. To what extent do you think that is a symptom of low household consumption, or is actually responsible for low household consumption?

Ed Cox: I am not sure that I know the direct answer to that question, but I would suggest that it is more likely to be a symptom than it is-forgive me, I am not sure I know the answer.

Q67 Mark Garnier: Sure. In that case, to what extent is it a cause of a fall in household consumption? How much is it affected by the fact that people are choosing to pay off their mortgages, rather than actually spend money in the high street? What do you think is driving that? Is it a lack of confidence? Do you think it is that people have suddenly woken up to the fact that we have the highest personal debt levels in the world, practically? What is behind it?

Ed Cox: I do not have direct evidence that could answer that question, but my feeling is that yes, people are affected by a sense of there being a deficit throughout British culture, so to speak, and for that reason, people are very concerned to keep their own personal borrowing down. However, I do not have any evidence to prove that case.

Q68 Mark Garnier: Nancy Kelley, do you want to add anything?

Nancy Kelley: Not much more helpful than Ed, except to say that for people at the lower end of the income distribution, they are already juggling so many instances of needing to borrow from Peter to pay Paul, that I think it is unsurprising, at a time when incomes are so squeezed, that they are focusing on servicing their core requirements, such as mortgages, for instance-although it is also important to note that there is a very serious problem in the mortgage lending market, and with people’s capacity to repay that in reality.

Q69 Mark Garnier: But this is paying off mortgages. There is not a slow-down in growth of mortgages; there is money coming out of the economy paying back these mortgages. Where do you think that money is coming from?

Nancy Kelley: We do not have any evidence that would speak to that, I’m afraid.

Q70 Mark Garnier: Should we be concerned that the rise of buy-to-let mortgages that are coming out is going to create a new housing bubble?

Nancy Kelley: One of the things that we can say, based on evidence looking at the last big surge in buy-to-let, is that a lot of the concerns were not borne out and that the PRS is actually a reasonably effective market. There is a slight lag between demand and supply, but basically what we saw with what was termed the last buy-to-let PRS bubble was an upswing in supply of rented accommodation to meet an upswing in demand. On the basis of that, I would say there isn’t any particular reason for concern that there will be a driving up of a bubble in that market.

Q71 Mark Garnier: Do you think we are still in a housing bubble?

Nancy Kelley: Housing economists would be better placed to answer that than me. Certainly, the medium-range forecasts for the housing market are not good-they are stagnant at best-and I think that most estimates say we are still overvalued in terms of property values, and that is part of the reason why we have such problems in terms of affordability. How that plays out in the different housing markets in the UK is, I think, a different question. We have an increasingly disaggregated housing market-there’s a very big difference between London and the south-east and the rest of the UK-but I think that there is certainly room to shrink, as it were.

Q72 Mark Garnier: My next question has more to do with business investment, so it is relevant to Lee Hopley and Andrew Cave. We learned last week that the unused capacity in businesses that we thought we had last March probably isn’t there to the same extent that we thought. What effect do you think that is going to have on pent-up demand? Do you think it will lead to a dramatic reduction in pent-up demand from businesses to invest in the future?

Andrew Cave: There is clearly a problem in that area and I think it probably will lead to exactly that scenario.

Lee Hopley: I would agree from a manufacturing perspective-my comments will generally be from a manufacturing perspective. We saw capacity constraints within manufacturing through the recovery. The rebound, particularly through 2010 and the beginning of this year, was a lot stronger than I think a lot of companies, particularly those further down the supply chain, had expected, and we saw a number of private sector surveys-our own and the PMI, for example-indicate an inability of companies further down the supply chain to gear up and respond as a potential constraint on production.

Following that, we have also seen a very sharp rebound in investment intentions. Our own business trend survey, for example, almost paints a V-shape recovery in investment intentions, so companies clearly had a will to invest, much more so than we have seen coming out of previous recessions. What we have not seen, particularly, again, at the small and medium-sized end of the markets, is that not being translated into actual commitments to new capital expenditure. Our concerns are that if this uncertainty about the eurozone, for example, and how that spills over into other parts of the global economy continues, what will happen to that pent-up demand for investment? Our concern is that it will simply disappear over the course of a year to 18 months.

Q73 Mark Garnier: Roger Bootle talked mainly about larger businesses and said that he felt that it was the uncertainty out there that was actually resulting in businesses that had plenty of cash not investing into any sort of expansion at all. Looking more to the small and medium-sized side of it, obviously we hear a great deal about the fact that SMEs are finding it difficult to get access to capital, but there are some that certainly have either access to capital available to them or capital sitting on their balance sheets, yet they don’t seem to be investing for the future. Do you think that what Roger Bootle was saying about larger businesses is exactly the same for smaller businesses and that there is just not the confidence there to invest or to see a future worth investing into?

Lee Hopley: I would agree. I think those factors are consistent across firm sizes and sectors. Lack of certainty about demand is always one of the biggest drags on investment decisions. Access to finance is a particular problem at the smaller end of the market, so that is not helping.

Andrew Cave: I would agree. We have seen a quarter-on-quarter fall in levels of confidence to the point that every region of the UK now is in negative territory in terms of business confidence. For the likes of our members, as the smallest businesses that are much further down the supply chain, it feeds very much from the lack of confidence in larger businesses. I think there are some positives to take out of the autumn statement last week, in that what we need is the Government to give a clear sense of direction in certain areas that will give confidence to business, which will hopefully feed through to the likes of our members as well.

Lee Hopley: For mobile companies of all sizes-I think this is also true small of small and medium-sized companies-there needs to be confidence that the UK is a competitive location to invest in for the long term. They are looking at how we stack up against other economies, given that the strength of demand in the medium to longer term is not going to be there in Europe-our main market-but beyond EU markets. Is the UK the right place to serve those markets from?

Ed Cox: If there is a problem with a lack of confidence in the UK as a whole, the additional problems in terms of confidence in the north of England are that much greater. Particularly when businesses are looking around themselves and looking at the public sector environment-this assumes over-dependency on the public sector-that becomes even more problematic in terms of confidence in the north.

Q74 Teresa Pearce: Rising youth unemployment is a concern to everybody. In response to that, the Government have announced a youth contract. The CIPD has said that it thinks the youth contract is unlikely to have any real effect on net unemployment levels. Nancy, do you agree with that?

Nancy Kelley: The evidence base for intermediate labour market approaches around young people, in particular, is mixed, but there is some evidence, as I think the previous panel indicated, that this kind of approach has some merit. The problem, essentially, is that it is swimming against the tide of a much more difficult long-run story about youth unemployment, which has been rising steadily and steeply since 2004. You have a much larger number-a population bump, if you like, if not a population boom-of young people and a far more competitive working environment. The 25-plus age group has a far higher level of skills and qualifications than it did 10 years ago, so young people are entering a very competitive market, and that is why you are seeing those sorts of problems around youth unemployment. In that context, something like the youth contract is a good thing to try. It is not going to reverse that long-run trend in terms of youth unemployment. Whether it creates new work, as opposed to displacing older workers, is a moot question, and I would guess a mix of both things.

Q75 Teresa Pearce: Ed, do you agree? Do you think this will stimulate new jobs for young people, or will it just result in a displacement in terms of the people who are unemployed?

Ed Cox: I do agree. There are dangers of displacement, but what is particularly beneficial is that this measure is very much targeted on young people. One of the concerns IPPR has had before now is that the apprenticeship scheme has been open to everybody. That creates a much greater possibility and opportunity for displacement, where employers are actually looking to subsidise training for existing workers, for example. But this contract, being focused on young people, is a much more effective and targeted thing. I am concerned, though, that there may not be sufficient demand for these kinds of placements, and that is why IPPR has suggested that we still need to look at things like job guarantee schemes, as well, which can, albeit very often in the public sector, provide opportunities, and be sure of providing opportunities, linked, for example, to the green deal. After a certain period of time, young people will have a much greater obligation to seize those opportunities and, therefore, not risk the so-called scarring that they often face as a result of not being able to take up any work opportunity at all.

Q76 Teresa Pearce: Andrew and Lee, from the employers’ side, do you think that the youth contract, with the funding incentive it has, is sufficient to create new jobs, or are there other barriers that prevent your members from taking on young people?

Andrew Cave: The most significant barrier is the one that has already been discussed-the lack of demand. Talk to a small business, and unless it has enough work to undertake, it will not want to take somebody on. That is for good reasons, actually, because it does not want the prospect of having to let them go further on.

The scheme that has come forward is certainly welcome, but we have some concerns that it does not start until next April; you have that six-month period before it kicks in. It follows a trend of a number of schemes, which are right in their instincts, but which are too little and, quite often, too late. We have seen this with work trials, for example, which are fantastic. It should be available sooner and it should be available more widely. Incidentally, work trials have a 50% conversion rate in creating full-time jobs for people who are on them.

We would say the same about the NICs holiday. It has been seen to fail, but it has not been implemented in a way that would have allowed it to succeed. So there is certainly potential here and it will serve as an incentive for those businesses that are looking to take people on, but there is a range of other factors-not least the lack of demand-that we have to tackle first.

Q77 Teresa Pearce: So are you saying that somebody who possibly takes on somebody in this way would have taken somebody on anyway? Are you saying that, or are you saying that this will actually convince them to create a vacancy where there may not have been one?

Andrew Cave: I think it will convince people to create a vacancy that is not there. I talk to a lot of businesses that have had to make people redundant during the course of the recession. When you are employing a small number of people that is a highly emotionally charged thing that you have to do, so you are reluctant to take more people on.

It is partly due to that, but there are also the risk factors. When the regulatory environment keeps changing, combined with the costs associated with taking somebody on, all of that bundled together makes the risk too great to take somebody on. If we are chipping away at that risk-and this measure does that, as one of the factors-it is likely to push people into the zone where they would take people on when they might not otherwise have done so.

Q78 Teresa Pearce: So you think it is helpful, but not hugely?

Andrew Cave: It is certainly helpful, but it is not a panacea-it will not solve the problem.

Lee Hopley: I do not want to add too much to Andrew’s comments. For manufacturers, there is a skills mismatch. There has been an interest for some period for manufacturers to really get ahead of the succession planning challenge that they will face with an ageing work force, and there has been much more of an interest in recent years in taking on apprenticeships at all ages. But they are really struggling to find people who are interested in doing an apprenticeship or working in a manufacturing company, or who have the basic skills and qualifications to do so.

Q79 Teresa Pearce: So you think it is one of the barriers to people taking on younger workers?

Lee Hopley: In manufacturing, yes, because it is increasingly a highly skilled business and there is a need for some level of basic qualifications in maths and science if you want to be able to progress and have a successful career in the industry.

Q80 Teresa Pearce: So do you think that perhaps that link with business should start earlier-maybe in schools?

Lee Hopley: Yes, there is a lot that needs to be done, in terms of building the 14-to-19 pipeline.

Q81 Mr McFadden: Lee and Andrew, I want to take you back to this well-worn ground of credit-the price, the availability and so on. The last Government and this Government have grappled with the same problem, which is how to make sick, weak banks lend, while at the same time repairing their balance sheets. Our constituents cannot understand how the Government can own large stakes in banks, and in one big case a majority stake in a bank, but they cannot make them lend to businesses. Do you think that Project Merlin has worked?

Lee Hopley: Project Merlin only ever targeted part of the problem, which was making finance available and so getting a commitment from the banks to intend to lend. It didn’t focus on the cost side of the equation at all. So I think that the credit easing package-it was a package of measures, with the national loan guarantee scheme and extension of the enterprise financial guarantee scheme, etc-was really a recognition that a lot more needed to be done beyond Project Merlin. Actually, it was very positive in respect of recognising that there are challenges on the supply side, and one of those is cost.

Q82 Mr McFadden: Andrew, do you think that this new credit easing scheme that was announced in the autumn statement is the Government admitting that Project Merlin has not done what it should have?

Andrew Cave: Project Merlin was what it was, and it has quite clearly failed micro-businesses; the numbers stack up to demonstrate that. We were never in favour of it from the outset, because there is a certain moral hazard involved, in that you are trying to force banks to lend and, despite what we say about the banks, we don’t think that they should be forced into that position. With credit easing coming forward, that is quite clearly an admission that Project Merlin has not solved the problem, if it was ever meant to solve the problem completely.

Going back to where you started, though, the issue is that there is no easy solution and we have got the same possible pitfalls with credit easing as we had with the enterprise finance guarantee scheme, in that there is a certain hazard associated with giving guarantees to the existing banks, because you are further entrenching the existing players and running in the opposite direction to competition, which is not what we want.

The second thing is that it would be very difficult to communicate on the ground. If you think back to the way EFG was delivered, and the confused messaging around that when businesses came into contact with branches, I fear that you may have the same problems emerging this time. As a consequence, you will see another wave of small businesses complaining that this Government scheme is not working and that banks are not playing ball. That is obviously not true in its entirety, because I do not think that it is ever going to extend the amount of money out there.

Q83 Mr McFadden: What the enterprise finance guarantee and this scheme have in common is that the Government are still trying to encourage the banks to lend, rather than stepping over that and lending themselves. Again, to ask both of you, Adam Posen, for example, has said that there should be a new institution. Would you prefer the Government, rather than dangling these carrots in front of banks, to step over this and set up some kind of new institution-national investment bank; call it what you will-to lend directly from Government to businesses?

Andrew Cave: There are very strong arguments for a national investment bank in this country, but it is not going to be a short-term solution. It should certainly be considered over the medium term. If you try to bring something like that in too quickly, you could have all kinds of negative unforeseen consequences. What we would prefer to see the Government do at the moment is look at, as much as possible, opening up alternative routes to finance. There are certainly many out there.

There is a huge growth at the moment in the area of peer-to-peer lending, yet that is not regulated and there are no tax incentives to promote it. We think that there are things the Government could do, without committing funds, to actually give more certainty to that area and promote it further, so that you are actually connecting people out there, many of whom are sitting on piles of money and not getting a decent return through the banks at the moment, with those businesses that can genuinely grow and offer a good investment opportunity. So there is a lot of ground to be covered there before you consider a new investment bank.

Lee Hopley: At the moment, a market-driven solution is the right one, given that the liabilities would obviously sit in the Government’s balance sheet and I am not sure how that would work in practice. I think speed is of the essence now, as well. We are potentially looking at a period where the situation is going to get more difficult, rather than easier, for small and medium-sized companies, looking at what is happening in our biggest market and the risk of that spilling over into the financial sector and having an impact on SME lending.

Building a new institution is probably not going to deliver results in the time scale in which we really need this to happen. But I think Andrew is absolutely right-there is no silver bullet for this problem. It is one we have been living with for several years. Credit easing is a package of measures. Andrew is absolutely right. We need to look at alternatives to bank finance for SMEs, whether that is equity or other kinds of debt products. There are not a lot of options in the market at the moment. Also, coming back to the competition point, we need to see this credit easing announcement followed up really quickly with some kind of positive commitment to drive forward competition, enhancing reforms as the ICB recommended.

Ed Cox: I think I agree with my colleagues that this is not a short-term solution, but we are exploring the idea of a regional investment bank, or regional investment banks, as another way around the particular problems we have. There are German models that suggest that this is something that could be explored. Okay, the German context is different, but I think there are still possibilities there.

There are a number of ways in which it might work, particularly in relation, for example, to local government pension funds. It could work in relation to EU funding, with post-2013 negotiations about to start. This is something that we should look at alongside the notion of a national investment bank.

Q84 Mr McFadden: The Chairman wants me to finish, so just quickly, one other thing that obviously has been tried a lot is QE. Now, the Chancellor-this Chancellor and, I believe, the previous one-has allowed the Bank of England to do more with QE than it has done. It has chosen to buy gilts with the funds available. Are you frustrated that it has not done more in terms of buying corporate bonds and, again, directly lending to business?

Lee Hopley: I understand the reasons why it has chosen not to-the expertise involved in getting into that market within the Bank. QE is what it is; it has not really fed through and had much of an impact on SME lending, and further rounds will probably not make much of a difference either. We have got to look beyond QE solutions.

Q85 Mr McFadden: So your members do not see any benefit from QE.

Lee Hopley: I am quoting the Bank of England’s own study on this, which said that it made a negligible difference to SME lending.

Andrew Cave: If there are any out there, they are not consciously aware of it. Going back to your point about Adam Posen’s suggestion, that very much stems from the frustration that QE is not getting to the micro-businesses that need it the most. I am not aware that it is getting through.

Q86 Mr McFadden: Is it not extraordinary that you have £275 billion of an initiative and neither the manufacturers nor the small business are seeing any benefit from it?

Andrew Cave: It is extraordinary.

Q87 Mr Love: Can I turn to the raft of housing-related policy issues that were announced partly before but also as part of the autumn statement? First, will the mortgage indemnity scheme do anything to address housing affordability?

Nancy Kelley: I have a quick, one-word answer: no. It has the potential to stimulate some building and to lend to a different set of people, although I do not think it will necessarily increase the overall amount of mortgage finance available, but there are also lots of concerns about the indemnity scheme. From our perspective, we are concerned about the risk associated with marginal home ownership, the very high volume of home owners who are struggling to meet their mortgage repayments already, and the much greater number who are subject to forbearance and so are not showing up in the figures yet-the Bank of England has been concerned enough about them to ask for an FSA report on forbearance.

Given that context, our sense is that the Government would have been better placed to focus on protections for existing home owners, perhaps through a partnership insurance model involving lenders, Government and home owners, rather than indemnifying a very particular kind of purchase for a new set of people.

Q88 Mr Love: Mr Cox, the Government’s stated objective, of course, is to build new houses. Is that not an attractive feature, particularly for regional economies, because resuscitating the building industry may be one of the easiest and quickest ways to get the economy moving again?

Ed Cox: Yes, I think it is, and we are encouraged by any effort to build new homes. We have been talking a lot this afternoon about short versus medium versus long-term measures, and it is fair to say that house building has, I think, the highest multiplier effect within the local economy, so it is very important that we encourage it. Whether the mortgage indemnity scheme is the best way to go about it is a different matter, in so far as it does not necessarily benefit those who want to buy houses; it is more likely to benefit house builders, in our analysis.

Q89 Mr Love: Mr Cave, lots of small businesses are in the building industry. How are your members looking at the scheme?

Andrew Cave: I have to say that the construction sector is not the worst hit in all the sectors that we cover in our survey work. However, its strategic importance is such that the scheme is very much welcome. We are certainly not experts on the mortgage indemnity scheme, but from what we see, it looks as if it might be something that will stimulate building, which is obviously a very positive outcome.

Q90 Mr Love: I want to press you in relation to moving back to 95% mortgages. That, of course, opens up the possibility that if house prices continue to deteriorate, people might end up in negative equity again, and you talked about marginal owners. How serious a problem might that be with this scheme?

Nancy Kelley: It is difficult to say, because it depends how many of the people who take up the opportunities in the scheme are existing home owners who are sizing up, if you like, versus how many are first-time buyers who are struggling with incomes. But there has been an historical issue, particularly around new build, of overvaluation. I recognise that that has been addressed substantially, but there is a reason why lenders are still somewhat wary about lending on new build. In a context where the housing market is relatively flat and has the potential to sink, 95% loan to value on new build is a risk. There is a particular risk that a substantial number of first-time buyers are people who will then be marginal home owners-i.e. people who are struggling to meet the commitments on their mortgages. We already have a really large number of those people.

I absolutely agree with what colleagues have said about stimulating employment and growth. Particularly in weaker local and regional economies, of course house building is a good thing, and of course we have a serious, long-run supply issue, but the Government would do well to think about how they might best protect the very large number of vulnerable home owners we already have.

Q91 Mr Love: Moving on, another part of the housing market on which the Government have made recent announcements is, of course, the social sector. They are revitalising the right to buy. Again, the argument is that through the way in which that will be funded, they can build a further social housing unit for every unit sold, which is something that never happened in the past with the right to buy. Is that an attractive proposition for building new homes and solving some of the housing problems that we have in this country?

Nancy Kelley: The arcana of local government finance being somewhat beyond me, I am not sure whether all the complexity around what you can do with the receipts from sales adds up. Having said that, I think that of course it is a good thing to get more supply. The people who will take advantage of the new right to buy initiative will be buying at a substantial discount, so unless they are on extremely low incomes, there is a greater prospect that they will be able to meet their debt repayment needs in terms of their mortgage. There is less of a concern that they will be vulnerable to repossession and long-term debt.

There is an issue about what the social sector is for, what it has been for in the past and what we want it to be for. It has become a tenure of last resort and a residualised tenure, and lots of effects have flowed from that. Part of the move away from council housing in the social sector is about a concern that tenure in itself has an impact on life chances. It is very clear from all our evidence that there is no tenure effect and that social housing provides a good, secure home for people over the long term. Maintaining or even expanding the social rented sector should not, in itself, be a bad thing.

Q92 Mr Love: I have one further question for Mr Cox and Ms Kelley. Getting away from the discussion of whether the affordable rent policy will fund all these additional units of accommodation, the reality is that there is a mismatch in timing, because you sell a property first, and then you make arrangements to build. There will be quite a mismatch. Do you think that will make any sort of contribution to solving homelessness and the housing need that exists in different parts of the country? Perhaps we can take Mr Cox as an example of a regional economy and then get a national picture.

Ed Cox: I am not sure I know the answer to that question, but if the notion of right to buy is in order to encourage labour market mobility, as I understand it to be, there are some significant questions about whether or not it will enable people, particularly poorer families, to move on in the way in which I think Government intend. It is not necessarily logical that just because you can move to a house somewhere else, you will want to break all your social networks and so on, which are fundamentally what support you into employment in the first place. I am not sure that some of the schemes being suggested will necessarily encourage the labour market mobility that they hope to achieve.

Q93 Mr Love: Would you agree with that, Ms Kelley?

Nancy Kelley: On the labour market mobility point, I absolutely agree. There’s a very basic starting point about the link between tenure and how long people stay in the same place: 50% of home owners have been in their house for 10 years. So, if you are in a lower-income family and the costs associated with moving are very high from your perspective, the likelihood of your moving for work, however good the work prospect, is quite limited. At a very basic level, the tenure that is most suited to labour market mobility is the private rented sector. Both the social rented sector and home ownership have very long average stays. That is a really interesting and fruitful area to think through in terms of the role of the private rented sector in encouraging and promoting economic growth.

Q94 Mr Love: So they should have done more for the private rented sector?

Nancy Kelley: Absolutely.

Q95 Mr Ruffley: May I ask Mr Cave a question in relation to the autumn statement’s proposal to exempt businesses with fewer than 10 employees from certain labour regulations-the idea of no-fault dismissal? We have had some evidence from the Chartered Institute of Personnel and Development, which said of the proposal, "There is a danger of creating a two-tier labour market, causing confusion for employers and employees alike, and introducing a perverse disincentive for micro-businesses to recruit more staff and grow." It goes on to say, "Pitching employment deregulation as a major contribution to driving economic growth is at best a distraction and at its worst could undermine efforts to boost competitiveness and productivity." What is the attitude of your average member to those criticisms?

Andrew Cave: That is a very interesting question.

Q96 Mr Ruffley: Because it is counter-intuitive. Most of us would have thought, when Mr Osborne announced it, that it was whackingly good news for micro-businesses, that it would boost productivity and so on and so forth. This organisation seems to be saying that is not true.

Andrew Cave: We welcome the consultation that is going to flow from this. It will be very interesting to see how it will work in practice, because it is far from clear at the moment how it would operate. You are right to highlight the concerns around the possibility of creating almost a glass ceiling that would stop businesses growing beyond that, and opening up the possibility of a two-tier labour market, depending on how it is handled.

There is no conclusive view among our members as to their position on this. Speak to some and they would agree with the analysis that you have just outlined. Others would see it as a brilliant opportunity. You also need to look at it not in the context of what is happening in Westminster at the moment but how it is actually for a business on the ground. This year the employment law landscape that they are confronted with has changed dramatically. While we are keen to consult on the issue of no-fault dismissal, you have also seen this year the removal of what was seen before as a brilliant no-fault dismissal scheme through the default retirement age.

That is what businesses on the ground are confronting today. Any consultation into what you are talking about now would take some time. We would sooner see a complete stop to any change to employment law, and for what is already on the books to be simplified and clarity brought to it for businesses to understand; so that we could tell them that for the next two years or so there isn’t going to be any change. That would give them more confidence than throwing ideas out there to change. As much as we welcome the opportunity to consult on it, I am concerned that it will lead perhaps to greater confusion.

Q97 Mr Ruffley: Anyone else quickly on this, because I want to move on to another area. Any comments on what the CIPD has said? Is there anything in its argument?

Ed Cox: It’s not so much what the CIPD has said. BIS itself carried out a survey. I think only 6% of SMEs thought that further deregulation was necessary. BIS itself is quite clear about that.

Nancy Kelley: I want to add to what Andrew said about the diversity of views among his members. As part of a programme of research that we did into low-pay, no-pay cycling-people moving in and out of work-we did a research project focused on employers, their views and approaches.

One of the interesting things that came out of that research was that it was very clear that you could have sets of employers operating effectively the same business model: one set would be absolutely convinced that highly flexible labour was essential to that business model, that they needed to be able to hire and fire quickly to scale up and scale down; while the other set would be absolutely convinced that the best way to deliver their business model was stability, investing in staff and so on. There would be not a great deal of difference in productivity or outcomes. There is an interesting thread to be untangled there about what businesses believe about the kind of labour market they need to operate effectively and where that might be right and where there might be scope for more employee protection.

Q98 Mr Ruffley: Was there any difference between sectors? You talk about comparing two businesses-one with a sort of pro-employee model and one much more deregulatory. Does it depend on the sector? Is it sector sensitive or not?

Nancy Kelley: It was a relatively small research project. It looked at a very small number of businesses, so I would not want to hazard a guess. The thing that sprang from that for us was a programme of work on the labour market to try to understand better where there are instances where the flexicurity model is core to delivering business growth and where flexicurity is not needed.

Q99 Mr Ruffley: Could I change tack and question Miss Hopley? The autumn statement talks about getting UK pension funds involved in supporting UK infrastructure investment, and there has been discussion of a memorandum of understanding. Given what you have seen of this, do you think that pension funds currently have the expertise in the next few months to be able to make this work effectively?

Lee Hopley: I have to say that I do not have the expertise on pension funds to be able to answer that question.

Q100 Mr Ruffley: But your manufacturing businesses, presumably, will be looking to benefit from better infrastructure. If you have no readout on that, would anyone else like to comment?

Ed Cox: I do not know whether pension funds have the expertise or not, but they are going to need it. We have been doing analysis on the current national infrastructure plan, with the update that we had in the autumn statement-

Q101 Mr Ruffley: Just so I get some intelligent replies to this, forget whether the pension funds have the best expertise and just tell me, from what you have read, does this look like a runner and can you point out, for the benefit of the Committee, what areas need serious work to flesh things out make this a reality and to make it successful?

Ed Cox: I think that it has to be a runner, if we are to stick with the current deficit reduction plans that the Government have. If we look at the national infrastructure plan spending proposals as they sit now, in transport infrastructure spending, 80% of the major transport projects will be investment in Greater London and the South-East, with only 7.6% of funding going to the North of England. In our analysis, the only way in which we are going to generate significant infrastructure investment in the North of England is through a much more creative approach in the North of England itself.

Q102 Mr Ruffley: I think we all agree on the desirability of it, but my question was really for you-any of you-to advise the Committee on what, given the relative paucity of detail, we should look at to query and stress test the proposals. It is all very well HMG saying, "We want to lever in money from pension funds. Isn’t that a good thing?" That is apple pie and motherhood. From you, I am trying to get where you think the glitches will be and what the Government need to tell us about now, up front, on how this will work. Mr Cave, any thoughts?

Andrew Cave: Again, that is not an area where our organisation has expertise. I can only tell you what a good announcement it was and how many members have been in touch to say how pleased they are that these infrastructure projects are moving forward. We represent people who care about the A14, because they use it every day. That is how they look at these issues. We do not have the expertise to comment on the details of how it will work.

Q103 Mr Ruffley: Miss Kelley, any thoughts?

Nancy Kelley: No, not my area of expertise I am afraid.

Q104 Mr Ruffley: So at the moment, from your point of view, it is all a good thing, but you are not entirely clear what the timeline is or how it will be delivered?

Ed Cox: If it is any consolation, we had a meeting with a firm this morning to talk precisely about how we can move things forward, particularly in relation to local government pension schemes, but it is a long way off.

Q105 Mr Ruffley: Final point: you represent significant sectors of British economic life, so I am puzzled that none of you can speak with confidence about what the intentions of her Majesty’s Treasury are in respect of this very significant proposal. You are telling me that you have not had any calls or discussions with HMT officials-nothing. Nix. Is that what you are telling us? I find that rather disappointing and really rather surprising.

Ed Cox: We would be very keen to have those discussions, but I think that, to date, no, we have not.

Q106 Mr Ruffley: It sounds as if HMG had better get its skates on with your organisations. Is that a fair representation of the position?

Lee Hopley: In terms of the autumn statement, infrastructure has been badly needed by our economy for a significant period. Was this our priority for the Government to commit that level of spending to boost short-term growth? No.

Q107 John Thurso: May I ask you, Ed Cox, what you have noticed in respect of the regional variations in the economy? The Government in the autumn statement had one paragraph basically saying, "We want to see a more even spread in the economy," and it has been a policy of rebalancing since the start of the Government. Are you seeing any evidence either of rebalancing or of differential problems between different areas?

Ed Cox: Yes, we are seeing differential problems between different regions. Clearly, looking for an example, we put out a briefing last week which suggested that in the north of England employment figures will not reach 2008 levels until 2018 in the north-west, 2019 in Yorkshire and Humber and possibly not at all in the north-east, compared with London and the south-east where employment levels will go back to their 2008 level by 2014. So it is very clear to us that there are some very significant problems and disparities occurring between north and south. I think that is evident in a number of other factors as well. The primary cause of this has been the public sector spending cuts and at the same time coming without a significant plan for growth, particularly-

Q108 John Thurso: Is that because the areas that are worst affected are more heavily dependent on the public sector?

Ed Cox: That is part of it. Let us not forget that the north of England was doing rather well until 2008. The recession has hit very hard and, as colleagues will tell you, manufacturing, surprisingly, has been most badly affected even though the crisis started in financial services.

Q109 John Thurso: You are saying that manufacturing has been badly hit in the north?

Ed Cox: Through the recession, yes. But you have to add that to the fact that public sector spending cuts have not only hit public sector workers in the north of England disproportionately to the rest of the country, but there are then spin-off effects for the wider economy. PWC suggests that the 400,000 jobs that were going to be lost in the public sector would spin out to a million jobs across the whole country when you add in private sector employment alongside that. Let us remember that the Office for Budget Responsibility has said that-

Q110John Thurso: What is the net effect-

Ed Cox: That has now increased to 710,000 so we can probably expect 1.5 million if not more than that.

Q111 John Thurso: The theory is that on the other side of the equation private sector jobs are being created. Do the PWC figures net that off in any way?

Ed Cox: I do not know specifically whether they net that off, but I think it is fair to say that the Government’s assumption that there was crowding out going on and that as you cut back the public sector the private sector would therefore grow to fill that gap clearly has not taken place, certainly not in the north of England.

Q112 John Thurso: But the key point you are making is that for a variety of reasons there is a considerable regional differential?

Ed Cox: Absolutely.

Q113 John Thurso: Can I follow up that manufacturing point? One of the things that I have always done, as it interests me, is to talk to all the companies in my part of the world. We are about two and a bit times the national average for engineering companies, all of whom have just had a stonkingly good year and it is the second stonkingly good year in succession. Most of them are exporting to Europe and to BRIC countries. Is that a picture you recognise or is the north of Scotland just incredibly lucky?

Lee Hopley: No. That is a picture that we definitely recognise. Our own survey suggests that we have had eight solid quarters of growth. Things have slowed a bit in the past three months. A lot of that has been underpinned by export growth. Europe isn’t universally bad at the moment but it does seem that it is emerging markets not EU markets that are holding up considerably better.

Q114 John Thurso: You have started to answer my follow-on question. In the last four weeks I have started to pick up from people a definite sogginess in forward order books going into next year and the alarm bells are beginning to ring. Do you recognise that?

Lee Hopley: Yes. The survey we published this morning said that the past three months were not too bad. The balance of companies still say that output is growing and orders are up. Forward looking, confidence has just sapped and drained away. We are expecting a marginal balance of companies to say that output and orders will contract in the first quarter. We feel that a lot of that is sentiment driven, looking at what is happening in external markets, but it is very patchy in terms of sector divergence, for example, and the different markets that manufacturers are exposed to. Clearly, looking ahead, at least in the very short-term, there is not a lot of confidence in predicting any kind of growth.

Q115 John Thurso: Right at the beginning of this session you talked about the skills mismatch. I remember a year or 18 months ago talking to EngineeringUK, which pointed out that we would be, I think, 600,000 engineers short over a five-year period; engineers I talk to today tell me exactly the same thing. To what extent should the Government ignore the immediate future and look to the medium-term and long-term and invest in engineers and others required in the manufacturing industry?

Lee Hopley: We have seen elements of both over the last year or so. There has clearly been a reprioritisation of funding within the Department for Business with a much greater emphasis on apprenticeships, particularly higher-level apprenticeships, which are things that manufacturers are looking for. Clearly some interventions are needed where people do not have any qualifications in the labour market. So the direction of travel there appears to be the right one. Where the challenge has been over several decades is the increasing complexity within the skills system. How do you find the money and the provision, and does it suit their needs?

Q116 John Thurso: "Keep it simple and get the job done." Is that what you would say to the Government?

Lee Hopley: Yes, and a bit of stability, please, in the skills landscape would be good.

John Thurso: Simplicity and stability. That has a nice ring to it.

Nancy Kelley: May I add a little to knit together the two conversations on skills and regional differences. There is a piece of research by the LSE, which has not yet been published, that looks at the performance of young people, 18 to 24-year-olds, in local labour markets. A range of things come up from that study, including a very high level of competition, but one of the things that is really clear is that there is not sufficient matching locally. The skills needs of labour markets are highly localised, and both young people and their intermediaries, the people who are supposed to help them get the jobs, have very poor understanding of the skills that are required by local employers. From one perspective I can see an argument for keeping it simple, but there is this layer of complexity. Labour markets are not national; from a human being’s perspective labour markets are within 10 miles of where you live. So we need to get better at matching up the skills development of local young people, their aspirations and their idea of what a working career might look like with the opportunities that are available in their immediate or proximal labour markets.

John Thurso: That is most helpful, thank you.

Chair: Thank you very much indeed for coming. I am sorry that it has been a slightly longer session than perhaps you had envisaged when you agreed to come, but the evidence you have given is extremely helpful to us as we prepare our report on the autumn statement.

Prepared 29th February 2012