UK GDP for 2011Q4, due this Wednesday, is expected to show a small fall (0.1%) despite the seemingly buoyant December retail sales figures, which rose by 0.6% in the month. If GDP does show this modest quarterly drop then economic growth in 2011 was about 0.9%, compared with
1.8% in 2010.

In this Perspective Ruth Lea, Economic Adviser to the Arbuthnot Banking Group, does some medium-term analysis, using the IMF’s forecasts to 2016, and long-term crystal ball gazing to 2050.

In this Perspective Ruth Lea, Economic Adviser to the Arbuthnot Banking Group, discusses the latest developments in the Eurozone after the recent Summit (8-9 December).

In this Perspective Ruth Lea, Economic Adviser to the Arbuthnot Banking Group, discusses the Autumn Statement (29 November).

In this Perspective Ruth Lea, Economic Adviser to the Arbuthnot Banking Group, discusses the upcoming Autumn Statement (29 November), Britain’s deteriorating growth prospects and measures for stimulating growth.

The Bank of England downgraded its GDP growth forecasts last week to about 1% both for this year and next. The OBR’s November forecast, which will accompany the Chancellor’s statement, will probably follow suit. The OBR will also revise their projections for the public finances. They may conclude that the Chancellor’s fiscal mandate, which relates to the elimination of the cyclically-adjusted current budget deficit, may not be met.

Last week’s UK GDP was figure for 2011Q3 was better than expected. GDP grew in the quarter by 0.5%, bouncing back from the depressed second quarter estimate, but it was still only 0.5% above a year earlier. The economy has almost flat-lined over the past year and there must now be a risk of a “double-dip” recession. Chart 1 shows the third quarter data. Positive contributions to growth were made by all sectors except construction. Over the year the transport sector and Government and other services (especially health and education) have been the strongest growing sectors.

Last week’s economic news was mixed, biased towards the negative. Starting with the good news, exports picked up in August, whilst imports fell back, resulting in a modest improvement in the trade balance. But, given the downturn in our major export markets, the much-desired export led growth projected by the OBR in March is far from guaranteed. Manufacturing slipped back in the month and unemployment jumped to 2.57 million (June to August) to a 17-year high.

Sir Mervyn King was in apocalyptic mood last Thursday, 6 October, as he described our circumstances as “…the most serious financial crisis we have seen, at least since the 1930s, if not ever.” Though voices were raised to denounce such “scaremongering”, there are significant risks that Sir Mervyn’s comments may prove to be only too right given the deepening Eurozone crisis. The deep malaise in western economies, which erupted in 2007 when the global money markets froze over, has not gone away. It has morphed with concern currently centring on the Eurozone’s banks. Franco-Belgian Dexia was bailed out last week amid Eurozone leaders’ discussions over recapitalising the banking sector, as well as further discussions over Greece’s economic plight.

Last weekend’s IMF and G20 meetings were of the utmost significance. Amidst crashing equity markets and IMF downgrades, the Eurozone’s leaders came under intense pressure and criticism from other participants to resolve the Eurozone crisis. By Saturday night another rescue plan for the Eurozone had been revealed which, at the very minimum, should give the currency union some breathing space and, at last, seemed to acknowledge the near certainty of a Greek default.

The recent economic indicators have been very disappointing. The production industries fell by 0.2% in July, within which manufacturing rose by only 0.1%. And NIESR’s monthly estimates of GDP suggested that output grew by 0.2% in the 3 months ending August, compared with 0.6% in the 3 months ending July. But even this poor rate of growth was flattered by the drop in output in April.¹

In spite of all the financial turmoil of the last three years, the City of London, and more generally the national financial services sector, still make a very major contribution to the economy.1 If the City fails to prosper, London’s economy and, by extension, the general British economy will be adversely affected. There is much discussion about a "desirable" switch from financial services to manufacturing industry in order to "rebalance the economy". There is, in itself, nothing wrong with this objective. But if it comes about through the neglect of the City’s international competitiveness, thus undermining one of Britain’s most successful and productive sectors, the whole economy would be damaged.  

It is has become almost hackneyed to talk about the shifting "tectonic plates" of the global economy.1 But shifting they are. As the Eurozone crisis rumbles on and the Standard and Poor’s rating agency downgrades US debt from AAA to AA+ (on 5 August) there is a very distinctive air of the inexorable relative decline, though not quite the eclipse, of the developed world as the emerging economies gain importance. The deep 2008-09 recession, which disproportionately affected the developed economies, and the more recent travails of the "west" have highlighted just how fundamentally the global economy is changing and how western hegemony is slipping away.

Introduction: the US and the UK
The markets were understandably concerned last week with the political stand-off in the USA over the raising of the debt ceiling from the current level of $14.3tn. A compromise deal does now seem to have been agreed, just ahead of the 2 August deadline. The political difficulties over the debt ceiling overshadowed the release last Friday of the latest US GDP figures, which were disappointing to say the least. Not merely did the first estimate for 2011Q2 fall below expectations, growth was 1.3% (annualised) compared with expectations of around 1¾%, but the first quarter growth was revised down to 0.4% (annualised) compared with the previous estimate of 1.9%. As we discussed in a recent Perspective, debt ceilings apart, America’s "soft patch" should worry us all.1

Since our last Perspective1, the Eurozone debt crisis has worsened significantly. Specifically there have been three major developments:

Moody’s downgraded the sovereign debt of Portugal and Ireland to junk status. Fitch downgraded Greece to CCC grade.

There has been delay and political disagreement over the terms of the second bailout package for Greece, not least over the nature of the private sector contribution, which hardly inspires confidence. Eurozone heads of state will convene on 21 July to discuss the bailout further and hopefully come to some agreement. 

There has been contagion to other Eurozone countries, especially to Italy.

As we have discussed in previous Perspectives, the Government is partly relying on "export led growth" to drive the British economy forward over the next few years.1 The US is our biggest trading partner, by a very considerable margin. In 2010 the UK exported £38.0bn of goods alone, the bilateral services data are not yet available, to the US compared with £27.8bn to Germany, our next biggest trading partner. But whilst Britain experienced a visible trade deficit with Germany of £17.7bn we chalked up a healthy surplus of £10.5bn with the US. In the three months to April, exports to the US increased by over 5%, whilst imports fell back by nearly 5%. The US’s economic health is, therefore, of a key factor in our own recovery. And the US’s economic "soft patch" should be of great concern.

Greece’s current financial needs
The Greek debt crisis, and the possibility of a Lehman-like shock to the global financial system if Greece defaults, is focusing minds in the capitals of the EU. The urgent matter is the quick resolution of Greece’s immediate funding needs. Greece requires an urgent instalment of €12bn from the €110bn emergency loan agreed in May last year1 to avoid defaulting on its debts due for repayment over the coming months. Even though the €12bn has yet to be signed off by the EU and the IMF, this tranche looks almost certain to be paid as both the EU and the IMF wish to avoid the almost certain financial turmoil following a Greek default.

Some recent indicators suggest that the economic recovery may be running out of steam. But, even if the economy continues to grow, there are several factors that make the current recession-recovery exceptionally challenging.

The crisis in the Eurozone is deepening. As Portugal awaits its bailout package, concern intensifies over Greece’s position, with speculation of restructuring, or a further bailout or even departure from the Eurozone (in extremis). And yet it was only 12 months ago that the rescue packages were agreed for, firstly, Greece and, secondly, for the other “weaker” members of the currency union. These rescue packages were intended to solve the problems of the Eurozone, at least until 2013. But, as we concluded at the time, they were merely a matter of buying time because they singularly failed to address the fundamental and underlying problems of the Eurozone, namely diverging economies in terms of growth and competitiveness.^1,2

Introduction: the economy is marking time
The preliminary estimate for GDP for 2011Q1 showed a modest 0.5% increase after 2010Q4’s fall of 0.5%, suggesting that the economy has not grown at all since the third quarter of last year. Even though services industries (76% of GDP) bounced back rising 0.9% in the quarter and manufacturing (13% of GDP) was up 1.1%, the construction industry (6% of GDP) fell back by 4.7%. Of course the data may be revised, but the overall picture suggests a weak recovery. GDP has still 4% below its recent peak in 2008Q1, as shown in chart 1.

Amidst all the talk of the Chancellor’s public spending “cuts” in order to correct the appalling public sector deficits, one of the implications of his actions barely gets a look in. And that is that the public sector as a share of GDP is projected to fall back quite significantly over the forecast period. As can be seen from chart 1 below, the total public spending ratio (spending as a % of GDP) fell from nearly 50% in the late 1970s to about 37-38% in FY1997 and FY1998. It then rose rapidly throughout the 2000’s, exacerbated by recession, and was nearly 48% in FY2009. The share of GDP accounted for by the public sector had risen by 10 percentage points in just over a decade. The public spending ratio was about 47% in FY2010 and is forecast to fall back to just under 40% by FY2015. These figures are not just dependent on the success of the spending reduction programme but also, of course, on the private sector delivering growth and driving GDP.

This week’s MPC: no change expected
This Thursday will see the announcement of the Monetary Policy Committee’s policy decision for April. It is widely expected that there will be a “no change”, with an unchanged Bank Rate and no extension (or withdrawal) of Quantitative Easing.

The themes of the Budget of 23 March have been well-trailed as the Budget for Growth and from "rescue to reform". The Budget is intended to be the "most pro-growth budget for a generation" as the Government aims to switch the economic policy debate from "cuts" to "growth".  

The Monetary Policy Committee’s next interest rate announcement will be on Thursday, 10 March 2011. It seems most unlikely that the Bank would move rates 2 weeks ahead of the Budget (23 March). But more to the point there is little evidence from the February MPC minutes that a majority of the members are ready to vote for a rise at this stage - even though attitudes are hardening and three of the 9-strong committee voted for a rise in February.1 The Governor himself takes the view that an early move would be a "self-defeating gesture."2 His stance are in sharp contrast to ECB President Trichet’s recent comments that suggest a rate rise in April - probably from 1% to 1.25%.3

In the last Perspective we discussed the need for a radical pro-growth strategy, given that the private sector will have to deliver all the growth in GDP over the next four years - and then some more in order to offset the impact on the economy of the planned real terms spending cuts.1 We also touched on the Government’s Growth Review, a rolling programme to last the whole of this Parliament with the objective of “restoring UK competitiveness”, which was launched last November. The Review “will be a fundamental assessment of what each part of Government is doing to provide the conditions for private sector success and address the barriers faced by industry”.2 The Review’s first report will be released by the Budget on 23 March 2011.

Speculation about the contents of the next Budget (23 March 2011) is already beginning. However a package of measures for stimulating growth in the private sector as fiscal retrenchment begins to bite looks a racing certainty. As we have discussed in previous Perspectives, if the OBR’s GDP forecasts are to be met, then the private sector will have to grow by around 5-6% per annum for the next 4 years.1-3 Such growth rates are not without precedent. Private sector growth in the mid-1990s, after the pound’s eviction from the ERM, was very buoyant. But circumstances were more favourable then. There was buoyant growth in Britain’s export markets, the banks were stronger and the economy was almost certainly more competitive than it is today.

There are no signs that the Eurozone’s sovereign debt crisis is being resolved. After the Irish bailout at the end of November 2010, speculation continues to mount that Portugal will be the next country in need of a bailout. And then there may be others. Even though outside the euro, the on-going crisis has major implications for the financial stability in the UK. But, before looking at these implications, it is helpful to look at the degree of exposure of Britain’s banks, and indeed of other major EU countries, to other key Eurozone countries, including exposure to their sovereign debt.

This Thursday will see the Monetary Policy Committee’s first policy announcement for 2011. It is widely expected to be a “no change”, with an unchanged Bank Rate and no extension (or withdrawal) of Quantitative Easing. We believe that, on balance, this would be the correct call despite the higher-than-expected inflation figures.

The Commonwealth as an economic bloc is rarely discussed in Britain. But, as the global economic and political focus shifts to partnerships with non-western economies in the wake of the global financial crisis, this is arguably an opportune moment to readdress and re-evaluate the economic potential of the Commonwealth.1 Added to which, as the forces of 21st century globalisation gather pace, the Commonwealth countries can expect to grow in relative importance as Continental Europe continues its relative decline.2 There are, moreover, sound business reasons to consider Commonwealth countries as trading partners.

The Office for Budget Responsibility (OBR) released its latest economic forecast on 29 November. It contained few surprises.1

An IMF-EU bailout for Ireland is imminent. Indeed it may have been announced by the time this Perspective is released. At the time of writing expectations are for a bailout of less than €100bn. Perhaps half of this will be for recapitalising the ailing bank sector and half for the wider economy. Doubtless there will be conditions placed on the Irish Government, including the requirement to increase the 12.5% corporation tax rate which has long been a bone of contention with the French and the Germans as contrary to the spirit of the harmonised Single Market and “unfair”. An increase in the tax rate will inevitably damage Ireland’s international competitiveness and attractiveness to inward investors. It would de facto be a partial end of tax sovereignty. There may also be plans for an early exit from the generous bank guarantees. The package will be agreed against the background of another Irish austerity budget, expected on 7 December. 

In the last Perspective we discussed the outcome of the Spending Review and the overall framework for the spending cuts in the UK.1 It was clear from that analysis that, despite all the media hype surrounding the overall degree of fiscal retrenchment, the cuts are manageable and they need to be kept in some perspective.

Introduction: little change to the spending totals 
Much as we expected in the last Perspective, the Chancellor basically stuck to his overall spending plans in the Spending Review. 1,2 In broad macroeconomic terms, therefore, there was little change in terms of the impact on the economy.

The Chancellor is due to reveal the details of the 2010 Spending Review for the four years from FY2010 to FY2014 on 20 October. The economic focus will be on the overall shape of the public spending plans rather than any detailed departmental breakdown and, more specifically, on whether the plans have been relaxed or tightened since the Emergency Budget of 22 June 2010.1

On 16 September 2010 “Black Wednesday” came of age. Black Wednesday, 16 September 1992, was of course the day when the speculators forced the pound out of the EU’s Exchange Rate Mechanism (ERM). It was a blessed relief for the British economy which had been struggling to keep up with Germany’s high interest rates (in the wake of the post-unification inflationary boom) which were unnecessarily prolonging Britain’s recession. German rates, right for the German economy, were clearly inappropriate for Britain. The “one size fits all” concept quite simply did not fit all. The economies were different and required different policy responses. Once out of the ERM, Britain was free to cut interest rates, which it did, the pound depreciated and the economy recovered well.

Introduction

We have already argued that the Coalition Government’s plans for fiscal retrenchment are fundamentally right. Public sector borrowing on the current scale is unsustainable.¹ We will not however know where the axe is set to fall in any detail until the Spending Review for the four years FY2011 to FY2014 is announced on 20 October. And therefore we do not know which regions will be especially hard hit by the fiscal tightening.

 Introduction: an erratic second quarter GDP figure

Revised GDP data for 2010Q2 showed a quarterly increase of 1.2%, revised up from the preliminary estimate of 1.1%, which in itself was higher than expected.¹ The increase in 2010Q1 had been just 0.3%. Inspection of the data suggests that the 2^nd quarter figure was an erratically, well-above trend increase. On the industry side, construction had recorded an 8.5% jump after falling by 1.5% in the adverse weather affected 1^st quarter.

Despite the severity of the 2008-09 recession in terms of lost output, the impact on the labour market was not as damaging as many feared. It was widely expected that unemployment would top the 3 million mark. But this did not happen – at least to date. Unemployment on the ILO measure peaked at just over 2½ million in 2010Q1, at a rate of 8.0%, and fell by nearly 50,000 in 2010Q2. But, as we discuss below, if there is a “double dip” or if the private sector fails to replace the expected job losses in the public sector over the next few years, unemployment could start rising again.

Weak bank lending is a hot topic, as is the widely-publicised implication that it is overwhelmingly due to supply constraints, with banks reluctant to lend, rather than deficient demand. This Perspective analyses recent developments in bank lending and concludes that, even though there are undoubtedly availability factors operating and credit availability remains tight, muted demand is also playing a significant role.

  Introduction: CEBS’s stress tests
On 23 July the Committee of European Banking Supervisors (CEBS) released its report of the EU’s 2010 stress test exercise for banks.1,2 The overall objective was “to provide policy information for assessing the resilience of the EU banking system to possible adverse economic developments and to assess the ability of banks in the exercise to absorb possible shocks on credit and market risk, including sovereign risk”.3   

  We discussed the feasibility of the Office for Budget Responsibility’s (OBR’s) pre-Budget economic forecast in a recent Perspective.1 We concluded that they looked optimistic – especially relating to investment and the “export-led” improvement in the trade balance.   

We recently speculated that June’s Emergency Budget would be a “game-changer”.¹ It was. It was a tough, hard Budget but, as we have argued on previous occasions, necessary after the years of profligacy. Its main objective was to close the public sector deficit and restore confidence in Britain’s public finances.² Provided the plans are delivered and the economy does not seriously falter, admittedly two very significant provisos, the public sector deficit should be closed by the middle of this decade. Fitch’s statement that the Budget, if delivered upon, will materially strengthen the UK’s “triple A” rating was the logical response to the Budget.

  Even though the March 1981 Budget was delivered in the depths of the early-1980s recession, it was tough and contained plans to cut public sector borrowing by some £3.3bn, mainly by increasing taxes. 364 university economists famously wrote to complain about the tightness of macroeconomic policy. In fact, though it was not clear at the time, the 1981 budget marked the beginning of Britain’s long economic upturn of the 1980s, which lasted until early-1990s. Far from deepening the depression, the Budget signalled the start of the recovery - though it should be noted that a 2% cut in interest rates and a weakening of the currency helped the recovery along. The 1981 Budget has gone down in history as a “game-changing” Budget.   

The Coalition Government’s first Budget will be announced on 22 June. It will be the most politically and economically significant Budget since the early 2000s, when Chancellor Gordon Brown turned on the spending taps and, in doing so, profoundly contributed to the dire state of the country’s public finances. The contents and tone of the Budget will shape much of what the new Government will be able to achieve for the rest of the Parliament. The Government has already made it quite clear that the need for deficit reduction, much discussed in previous Perspectives,^1,2,3 will be their first priority.

Introduction
In the first week of May the eurozone came extremely close to breakdown, totally eclipsing the markets’ interest in the British General Election. A reluctant German Chancellor, torn between a hostile domestic electorate and eurozone meltdown, finally agreed, firstly, to a €110bn bailout for Greece which effectively covers Greek credit needs for the next 3 years at rates of 5% or less and, secondly, a “shock and awe” stabilisation package amounting to €750bn for other weaker eurozone countries faced with funding problems. The €750bn consisted of a €440bn (up to) loan facility backed by the more creditworthy eurozone members operational for the next 3 years, €60bn of EU27 bonds and up to €250bn of support from the IMF.1

   At the time of writing Gordon Brown remains Prime Minister and discussions are in progress between the Conservatives and the LibDems with a view to forming a power-sharing government. If these discussions break down the Labour party has offered talks with the LibDems. The most likely options for a new government are, however, a Conservative-LibDem power-sharing arrangement or a Conservative minority government. A Lab-LibDem arrangement (possibly including other parties to reach an overall majority) looks less likely. These inter-party negotiations are, of course, necessary because the hung parliament outcome of the 6 May General Election.  

With less than a fortnight to go before the General Election on 6 May, the polls point to a hung parliament, where no one party has an overall majority. It is of course by no means certain and we are not suggesting a hung parliament is a foregone conclusion. Polls have been spectacularly wrong before, for example in 1970 and 1992, and the polls suggest that party support is especially volatile. This Perspective does not assume a hung parliament, we make no predictions, but merely seeks to discuss some of the issues if there is one.   

In something of a departure from the usual economic subject matter of our Perspectives, this Perspective discusses the statistical background to the forthcoming General Election on 6 May 2010.   

Introduction and the economic forecasts

Last week’s Budget, released on 24 March, was a “do little” Budget - more of a holding or “treading water” exercise before the General Election.¹ The projections for the public finances for both borrowing and indebtedness were marginally better than in December’s Pre-Budget Report.²  But the numbers remain shockingly bad. Very few policy initiatives of fiscal significance were announced and on the key issue of where the axe will fall on individual departments commentators are left to wait for the next Comprehensive Spending Review.   

     
Next week’s Budget will almost certainly be the last major political exercise before the calling of the general election, which is expected to be on 6 April, a month before the expected election date of 6 May. Economically it will surely be a holding exercise, with no major announcements by way of further higher taxes or spending constraints. There may be some pre-election lollipops for, say, pensioners or the lower paid – but little of fiscal significance. There will however, probably be much political rhetoric from the Chancellor about the alleged “clear blue water” between the current Government that will not cut spending until it is “safe to do so” in terms of the economic recovery (“protecting the recovery”) and suggestions that the opposition would, if they formed the next government, cut irrespective of economic circumstances. In effect the Budget will mark the beginning of the election campaign.

In the current debate about a possible German bail-out for Greece, one factor is increasingly clear. And that is the extreme electoral unpopularity in Germany of such a generous show of EU solidarity to ameliorate Greece’s problems. Part of the unpopularity relates to the unpalatable idea of bailing out the profligate and dishonest Greek government. But it is also about the disparity of Greek and German retirement pension rules. Even the prospect that Greece was planning to raise the legal retirement age from 61 to 63 as part of its austerity package seems to have been like a red rag to a bull in Germany, which recently raised its legal age from 65 to 67.1

There was, perhaps surprisingly, no confirmation of a specific Greek bailout at last week’s summit meeting of the Council pof the European Union. There was however an “Agreement to support Greece” which included the following:¹   

“EU heads of state and government have pledged to help Greece tackle its debt crisis, if needed. …They issued a statement stressing both responsibility by the Greek Government and EU solidarity. The Greek government is determined to improve the country’s public finances and aims to reduce the budgetary deficit by 4% in 2010. It has not requested any financial support. The (EU) leaders expressed a strong political commitment to take determined and coordinated action if necessary. ‘This agreement is the expression of a clear political will, and it is a political message that we wanted to send out today’ said Herman Van Rompuy.”

In the last Perspective we discussed how the eurozone economies were diverging. Specifically we discussed the divergence between the peripheral “Club Med” countries – Greece, Spain, Portugal, and possibly Ireland and Italy – and the core economies centring on Germany, France and the Benelux countries. We concluded that the peripheral countries were currently in a policy trap and the consequences would be painful however they tried to release themselves from this trap.

The current debate on Greece’s fiscal difficulties, possible bailout or default or, even, possible withdrawal from the eurozone is but one aspect of the seemingly intractable economic problems facing certain members of the eurozone. Back in the mid-1990s there was a hotly-contested debate about the potential eurozone as a possible optimal currency area in which all members could not just live with, but economically thrive, with the same currency and the same short-term interest rates as set by a European Central Bank. It clearly is not.

The Bank of England’s Monetary Policy Committee will meet this week and the usual announcement will be made on Thursday, 7 January, on their decisions. It is almost universally expected that the Bank Rate will remain at 0.5% and there will be no announcement concerning any further Quantitative Easing. The current plan is to achieve £200bn of QE by the end of January.^1,2  But the MPC could well discuss the merits and demerits of a further tranche of QE with the distinct possibility that, if there is to be one, this will be announced at the February meeting.

In last week’s Perspective we posed the question whether the Pre-Budget Report would primarily be a political exercise.¹ So it proved to be. And, as with the April Budget, the Chancellor procrastinated over the necessary medicine, the required repairs, for Britain’s damaged public sector finances.²

This week’s Pre-Budget Report (PBR) could have more political than fiscal or economic significance. Whilst there is room in the electoral timetable for a March (or even April) 2010 Budget, such an event would be before a rapidly approaching a general election (assuming this occurs in May or June 2010 and not before) which implies that the Government is likely to use the PBR for setting the economic battle-lines for the next election rather than wait until the Budget. 

Last week Eurostat, the Statistical Office of the European Communities, released the third quarter flash estimates for the EU27’s GDP. It showed a 0.2% increase in the quarter. For the euro area (EA16) in general, and for Germany in particular, they made more satisfactory reading. GDP for the EA16 rose 0.4% in the quarter, with Germany experiencing 0.7% growth.¹

There was much consternation when the third quarter GDP data for the UK were released recently.¹ They showed a quarterly fall of 0.4%. This was well short of City expectations of a rise of 0.1%, or even 0.2%, and the "end of recession". Within the total, the production industries and construction showed falls though services, especially distribution, were also weak and made a major contribution to the quarterly decrease.  

Several recent Perspectives have been devoted to the unfolding fiscal crisis.¹ But an issue we have been barely touched on is the implications for the public finances of the ageing population over the next 40-50 years.

The relative shift in economic power from the developed economies to the emerging economies is indisputable. The rise of China and India and the relative decline of European countries have been commented on many times.¹ It is difficult to see how these trends would reverse, especially given Europe’s ageing demographics, and it is reasonable to assume that they will not be reversed.

There is little doubt that one of the greatest economic problems facing the country, if not the greatest, is the state of the public finances. Last week the August figures for public sector borrowing were released and showed a shortfall of some £16bn, compared with borrowing of less than £10bn the year before.¹ Tax receipts have fallen, even after allowing for the reduction in the VAT take because of the cut in the standard rate from 17.5% to 15% last December. Income tax receipts have fallen and the corporation tax take has plummeted. Spending, not least of all social security payments, has increased as unemployment has picked up.

The coverage of last week’s G20 meeting of finance ministers in London was dominated by the debate on restricting bankers’ bonuses and the potential clash between France and Germany on one side and the US and possibly the UK on the other. (There seemed to be some ambiguity on the British part.) By the end of the meeting there was, however, some agreement on matters including disclosure and structuring bonuses to relate to the long-term fortunes of the business. The Financial Stability Board¹ was tasked with the job of devising detailed rules over bonus structures in time for the next G20 meeting of heads of state later this month (24-25 September) in Pittsburgh.

The MPC surprised the markets with their decisions at their last two meetings. At their July meeting they appeared to call a halt to further Quantitative Easing (QE), when the markets were expecting them to announce they would proceed with the further, permitted, £25bn of asset purchases through the Asset Purchase Facility (APF).¹ And at their August meeting they announced not just the extra £25bn - but an extra £25bn on top, making total planned asset purchases of £175bn.²

Britain’s four biggest banks will release their results for the first 6 months of 2009 this week and it is expected that some will declare profits.¹ But this news should not be interpreted as a “business as usual all-clear” for the banking sector and a return to pre-credit crunch “normality”. This clearly is not the situation as any inspection of the latest bank lending data and the, very significant, ongoing problems in the banking sector show.

A recent Perspective discussed the prospects for manufacturing industry. The paper concluded that "it may seem perverse to be discussing a brighter future for manufacturing when it is disproportionately suffering from the current recession. But, reflecting the need for the economy to be rebalanced and the continuing difficulties in the financial sector, manufacturing exports in particular and the sector more generally should play a bigger role in the economy in the future." ¹

Several Perspectives have dealt with the issue of public sector indebtedness and public sector spending in recent months. But as the political debate on the public finances intensifies, it is timely to return to the subject. 

Two months ago I wrote a Perspective on the “green shoots” of economic recovery and how they should be kept in “perspective”. Nevertheless I concluded on the basis of survey data of the services and manufacturing industries, better housing market data and modest improvements in credit availability that, at the very least, the rate of decline was decelerating after the much, much worse than expected falls in GDP in the final quarter of 2008 and the first quarter of 2009.¹

Even though the evidence of “green shoots” is patchy, on balance it does seem that the decline in British economic activity continues to ease.¹ But this should not deceive anyone into believing that Britain’s economic problems are behind us. They are not. As we have discussed before the public finances are truly horrendous, the Budget was a wasted opportunity to start tackling the public sector deficit and there is no sense of urgency in Government about what needs to be done.² Given the fact that a general election has to be called within a year, it is unlikely that any significant decisions will be taken until a new Government is in office.³

 It may seem perverse to speculate about a brighter future for manufacturing industry when the evidence shows that the sector is suffering disproportionately during this recession. In the first quarter of 2009, whilst GDP tumbled 1.9% in the quarter to be 4.1% lower than a year earlier, manufacturing output had fallen 5.5% to be 13.1% down on the previous year. Moreover, the economies that are especially sensitive to the growth in world trade manufactures are experiencing some of the worst declines during this recession.¹ Germany’s GDP fell a worse-than-expected 3.8% in the first quarter of 2009, to give a quite staggering 6.7% year-on-year drop.   

The latest Economic Perspective by Ruth Lea, Economic Adviser to Arbuthnot Banking Group, provides an analysis of last week’s Budget. The Chancellor painted a picture of the public finances for both borrowing and indebtedness that was breathtakingly, shockingly bad.

The economic background to the Budget remains dire, despite the tentative signs that the rate of decline of economic growth may actually now be easing.¹ And it is expected that the Chancellor will radically revise his GDP forecasts compared with those he made less than 6 months ago in his 2008 Pre-Budget Report (PBR). These were widely criticised at the time for being overly-sanguine. The table below compares the PBR forecasts with expectations for 2009 Budget. 

Last week saw some signs that, even though the economic outlook generally remains bleak, there were some tentative “green shoots” sprouting in the British economy. The apparently positive outcome of the G20 meeting probably contributed to the general mood of rising economic confidence – though the direct impact on the world economy, in general, and on the British economy, in particular, is likely to be very modest.¹

Last weekend’s meeting of G20¹ finance ministers and central bank governors, ahead of the G20 meeting of heads of state on 2 April, was widely reported as a conflict between the US, on the one hand, and Continental Europe, on the other, with Britain playing the role of honest broker. The US, goes this scenario, was pushing for Europe to do more by way of a fiscal boost, whereas Europe’s priority centred on reforms to the regulation of the financial system. Europe’s reaction to exhortations to more fiscal activism, especially from Germany and France, was to see how the fiscal stimuli already implemented would play out before considering further moves.  

As the economy deteriorates, there is increasing speculation that the British economy may be facing a Japanese-style period of falling prices or deflation.^1,2 Before taking the debate any further it is essential to be clear about the economic implications of different types of deflation.

During last Wednesday’s press conference on the Bank’s February Inflation Report, Governor Mervyn King hinted strongly that the Monetary Policy Committee would be discussing “unconventional” monetary policy instruments at its next meeting in March (4-5 March). Moreover, there was a good chance that the discussion would lead to their implementation.

The global economic outlook continues to deteriorate. The IMF recently downgraded its forecasts, yet again, and significantly. The sheer scale of the revisions indicates that in the current circumstances economic forecasters and their models, which tend to assume a normally functioning financial system, are flying blind. Despite the press headlines emphasising that the UK will have the worst growth performance of all the major economies this year, caution should be exercised in interpreting the figures.

There are several ways of defining recession. But taking the most usual definition of two consecutive quarters of falling GDP, then Friday, 23 January 2009, should be the day when the British economy is officially proclaimed as being in recession.

On Friday the 4^th quarter GDP preliminary estimate will be released by the Office of National Statistics. It is expected that it will show a substantial fall compared with the third quarter. The National Institute of Economic and Social Research (NIESR) has already published its estimate for the quarter, which shows a drop in GDP of 1.5%, after a revised estimate of a 1.1% fall for 3 months to November (compared with the previous three months). Since 1955 when quarterly figures were first produced there have been only 5 quarters in which output has fallen more sharply.¹

Credit conditions are still tightening

The credit statistics released last week made for difficult reading. Despite the aggressive cuts in official rates and the Government’s support for the banking sector, the Bank of England’s latest Credit Conditions Survey for the 2008Q4 showed a further deterioration in credit availability.¹ 

The year 2008 will go down in history. It is difficult to recall that in the first half of September there were actually some modest and tentative signs that the credit crunch may be easing. LIBOR rates were, for example, modestly ticking down. Such optimism was blown away on 15 September with the collapse of Lehman Brothers and the following financial crisis, which profoundly undermined consumer and business confidence.¹

shocking public finances

The public finance projections in the Pre-Budget Report (PBR) were as bad as expected – if not worse. Even allowing for the fiscal stimulus, which amounted to £9.3bn in FY2008 and £16.3bn for FY2009 (compared with the budget and including the announcements already made since the budget on, for example, the compensation for the losers of the abolition of the 10p tax band), the deterioration since the March Budget was dramatic.

Next Monday’s Pre-Budget Report will an unusually significant one – both politically and economically – reflecting the severity of Britain’s economic problems. The main economic ingredients of the Report will be the economic forecast, the public finances forecast and the “fiscal stimulus measures”.

The third quarter GDP data were dire
The economic news over the last fortnight has been dire. The fall in the third quarter GDP figure, of 0.5%, was significantly worse than the expected 0.2% decline.¹ Most sectors of the economy contracted – with the exception of agriculture (despite the wet summer) and “Government and other services”. The biggest fallers were “distribution, hotels and catering” (down 1.7%) and the production industries including manufacturing (down 1%).  But declines were also recorded in the construction industry, hard hit by the difficulties in the housing market, “transport and communication” and “business services and finances”. They all declined by around ½% in the quarter.

The current crisis in the financial markets, and the banking rescue, has understandably taken centre stage in the recent media coverage of finance and the economy. But as the Chancellor prepares for the Pre-Budget Report, expected next month, the real economy and the public finances will come to the fore. Central to the Pre-Budget Report are the revised forecasts for GDP, other key economic variables and the public finances. This note concentrates on the rapidly deteriorating public finances, which are, of course, partly dependent on our economic fortunes.

Although there are still some details yet to be fleshed out, the overall shape, and size, of the Treasury’s rescue plan is a very considerable step forward in addressing the current problems in the banking system. The collapse in confidence and the freezing-up of the credit markets call for radical policy responses. The current difficulties in the financial markets and the drying up of credit have major recessionary implications for the real economy, at a time when the economy is probably already tipping into recession. It is vital, therefore, that the British authorities, the Treasury and the Bank of England, act to unfreeze the credit market and normalise lending to businesses and households.

To date, the authorities’ policy to combat the worst aspects of the financial crisis had focused on nationalising failed banks, injecting liquidity of increasing magnitudes into the credit markets and raising the level of state guaranteed deposits from £35,000 to £50,000. But the large infusions of funds have clearly failed to stabilize the banking system. Concomitantly, it has become increasingly clear that the current liquidity crisis has had a more fundamental cause than mere shortages of liquidity and funding. And that has been the lending institutions’ fear of insolvency of their counter-parties. Re-capitalisation of the banking system is, therefore, a priority. The Treasury’s rescue plan has, rightly, grasped this issue square on.

The Treasury will make available at least £50bn of new capital in order to re-capitalise banks which have a substantial business in the UK and building societies. Such injections of capital are expected to be in the form of preference shares or Permanent Interest Bearing Shares (PIBS). £50bn is a very substantial sum and should be sufficient to keep the banking system functioning in these challenging times. £25bn is to be made available to the eight major banks that have confirmed their participation in this Government-supported re-capitalisation scheme¹ and at least another £25bn is to be made available for other eligible financial institutions.

There are two other, helpful, parts to the rescue plan. Firstly, the Bank of England will take all actions necessary to ensure the banking system has access to sufficient liquidity. This includes at least £200bn, a doubling, being made available under the Special Liquidity Scheme (which allows banks to swap their mortgage-backed securities and other illiquid assets for Treasury bills). And, secondly, the Government will guarantee new short and medium-term debt issuance to help eligible institutions refinance maturing, wholesale funding issues as they fall due. The Government expects the take-up of the guarantee to be of the order of £250bn.

But the authorities have clearly decided that they must also act to lower lending costs. Today’s announcement of the 0.5% cut, a day ahead of expectation, is another decision that should help confidence and the ailing economy. It is a most welcome move. 

The Government’s rescue plan, by providing much-needed capital as well as unlimited liquidity, should underpin confidence in the solvency of the banks. It is a very big, and comprehensive, step towards the normalisation of the banking system and the unfreezing of the credit markets.

Note

1.      Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland, Standard Chartered. 

The economic prospects and perceptions for Britain have deteriorated significantly over the past month as a new and vicious twist has developed in the credit crunch. It can be said, with little fear of exaggerating, that the current global financial situation is the most severe since the late 1920s and early 1930s

In my last Perspective, I wrote about the changing perceptions of the economic prospects for the US, on the one hand, and of  the Euro Area, on the other.¹ The broad conclusion was that the US, despite the ongoing problems with its financial sector and housing market, had, if anything, performed slightly better than expected a few months ago, whilst the Euro Area had performed worse. The IMF, for example, had recently downgraded its GDP forecasts for the EA15 for both 2008 and 2009 whilst barely altering its forecast for the US. The implication for the dollar (which arguably has been undervalued) and the euro (which arguably has been overvalued) is that the dollar should continue, financial crises apart, to strengthen against the euro.  

Over the last month there has been a marked change in the overall assessment of the Euro Area’s economic prospects and, related to this, the fortunes of the euro against the dollar. Until recently the “consensus view” was that the Euro Area would perform better this year than the US partly because it would be less vulnerable to fall-out from the “credit crunch” (perceived primarily as an Anglo-Saxon problem). It was, of course, accepted that growth prospects in the Euro Area would be damaged by slowdown in the key export markets of the US and the UK and this would be exacerbated by the strength of the euro against the dollar and the pound. But, nevertheless, the Euro Area countries could partly de-couple and perform reasonably well.

The current difficulties of the global financial industry, as it struggles with the “credit crunch”, are still frequently reported in the press. This is of great significance to the people closely involved with the financial sector, obviously, but it also has significance for the rest of the British economy – not least of all because of the knock-on effects on the real economy. But it is also worth noting just how much the City of London’s activities contribute to the economy.¹ If the City fails to prosper, London’s economy and by extension the British economy will be adversely affected.

The British economy: growth is stalling

The recently released second quarter GDP data confirmed a still weakening economy.¹ GDP rose by only 0.2% in the quarter, following the marginally stronger increase of just 0.3% in the first quarter. Construction output, reflecting the contracting house-building sector, fell by 0.7% whilst manufacturing was down 0.4%. “Business services and finance” rose by a paltry 0.1%, compared with a marginally stronger 0.2% in the first quarter. The ONS’s press release contained the explanation that “activities auxiliary to financial intermediation drove the deceleration, which was partly offset by increased growth in computer services and other business services”. In other words, the output of financial services almost certainly fell.

As the British economy slows and inflation rises, hit by the twin problems of the credit crunch and the rapid rise in oil prices, speculation increases that we will experience a nasty bout of “stagflation” or even fall into a true recession. Concerning “stagflation” comparisons are increasingly being made with the horrors of the 1970s. Turning to the possibility of a “recession”, comparisons are increasingly being made with the early 1990s or the 1980s.

Prices inflation is rising

There is no doubt that the economy is caught between the twin toxic affects of the credit crunch, on the one hand, and rapidly rising commodity prices which are feeding into higher consumer prices, on the other. Chart 1 shows just how significantly prices inflation has ticked up over the last 12 months. 

The huge expansion of state spending and the general mismanagement of the public finances have been discussed in previous Perspectives.^{1, 2}

But it is worth recapping the main developments over the past decade as background to this Perspective. The state spending taps were turned on in FY2000 (financial year 2000, 2000/2001) after a couple of years of politically-imposed restraint. Over the decade FY1997 to FY2007, state spending rose in total by over 80% - an annual average increase of over 6% in current prices. This was well above the rate of growth in the whole economy and, as a consequence, the share of total spending to GDP has risen from less than 39% in FY1997 to around 42% currently.³ Even allowing for inflation, the annual average increase over this period was 3½ to 4%, again well above the average growth rate of real GDP. ⁴

The recent increase in crude oil prices has been extraordinary. Between 1999 and 2006 oil prices, in nominal terms, rose from an unsustainable “low” of $10pb to $60pb. Since then they have more than doubled again and recently touched $135pb.

As the chart below shows, even if allowance is made for inflation, current prices are around the levels recorded in the late 1970s and the early 1980s, when supply was disrupted by the Iran/Iraq war. The current developments in the oil market can indeed be designated an “oil shock” – the “2008 oil shock”.

The housing market is now slowing significantly, partly reflecting the persistence of abnormally tight credit conditions. Forecasts for house prices worsen with each revision. And it is no longer unusual to speculate that nominal house prices could fall by as much as 10% over 2008 and a further 5% in 2009.1, 2 In other words, prices in December 2009 could be some 15% lower in nominal terms than in December 2007. This is a substantial drop by any standards. But should this be regarded as a “correction”, after the near tripling of house prices over the past 10 years, or should it be regarded as a “crash”? The terminology used is not unambiguous but the Oxford Shorter English Dictionary defines the terms as follows: • Correction: the action of putting right…errors. • Crash (figurative): a sudden ruin, failure or collapse, especially of a financial undertaking.

EMBARGOED UNTIL 0001 HOURS, MONDAY 5 MAY 2008 

In this latest Economic Perspective Ruth Lea, Economic Adviser to Arbuthnot Banking Group, discusses the feasibility of Britain’s targets for using renewable energy sources.

Britain currently has a diverse mix of energy sources for electricity generation. But the Department for Business, Enterprise and Regulatory Reform (BERR) expects this to change over the next 10-15 years as ageing nuclear power stations are decommissioned and a number of coal-fired power stations are retired in response to the EU’s 1988 Large Combustion Plant Directive (LCPD) that mandates the reduction in acid gas emissions, primarily SO₂ and NO_x, from large combustion units. The gap is expected to be filled by a combination of renewable energy sources and gas-fired generating capacity, with an increasing share of the required natural gas being imported with serious implications for energy security.

The UK is committed, through the EU’s “burden sharing” agreement, to a 15% target for renewable energy in final energy consumption (including transport) by 2020. In 2005 the share was a mere 1.3%. The electricity sector is expected to assume much of the burden of meeting the target because it presents an easy regulatory target. BERR has already estimated that at least 30%, and as high as 45%, of electricity should come from renewables, mainly wind-power, by 2020. The current share is 5%. Britain faces an insuperable task in hitting the 2020 target.

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In this latest Economic Perspective Ruth Lea, Economic Adviser to Arbuthnot Banking Group, discusses the impact of the current credit crunch, which is intensifying, on the UK housing market.  

There is little doubt that the housing market is weakening and prices are slipping but comparisons with the recent experience in the US are misleading, not least of all because there has been a glut of properties in the US, unlike the UK, and the lending practices in the US were even looser than in Britain. Similarly, comparison with the housing market in the early 1990s can be misleading. In the late 1980s and early 1990s, Britain experienced double digit interest rates, prolonged by membership of the ERM, which undermined both the housing market and the economy. The economy slipped into recession and the housing market crashed. This should not be the situation now.

Ruth Lea said “The impact of the credit crunch on the real economy, in general, and on the housing market, in particular, is intensifying. The housing market is looking very vulnerable. But there is a good chance that an early 1990s-style crash will be avoided. If need be, the Bank can continue to loosen monetary policy this time, inflationary-pressures permitting. In the early 1990s, when the UK was locked inside the ERM, interest rates could not be cut appropriately. Only when the pound was ejected from the ERM in September 1992 could rates be reduced as the economy required.”

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