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.

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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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India and, especially, China are transforming the shape of the global economy. In 1980, they accounted for just 3% each of global output, whereas the EU25 accounted for 26% and the US for 20%. By 2006 China’s share had increased to 15% and India’s to 6%, whereas the EU25’s share had slipped to just over 20%. The US’s share had remained fairly steady.

Looking ahead to the middle of this century, the UN expects some quite staggering demographic changes, which will inevitably have major implications for the growth prospects of individual countries. China’s working population is expected to fall after 2015/2020, whilst India’s is projected to continue expanding rapidly. The working populations in Japan and Europe, especially Eastern Europe, are expected to decline whereas the US’s should continue to expand.

In this latest Economic Perspective Ruth Lea, Economic Adviser to Arbuthnot Banking Group, analyses the productivity performance of the public sector. Drawing on published research by the Office of National Statistics she draws two broad conclusions. The first is that productivity has almost certainly fallen for the public sector as a whole over the past decade and the second is that, on the whole, the situation deteriorated as public spending accelerated in the early years of this decade.

Data are available for education, healthcare, social security administration and adult social care. Productivity in all these sectors fell for much of the last decade at a time when there was reasonable growth in whole economy productivity. The performance in health, where spending has nearly doubled in real terms since 1999/2000, was notably poor.

Two of the major planks of Alistair Darling’s first budget will be the economic forecasts and the prospects for the public finances. The economic forecasts will almost certainly require downward revision compared with the 2007 Pre-Budget Report.¹ The Chancellor’s October projections for the public finances also look too sanguine. The third major plank will relate to taxation and is expected to include further statements on the announcements made by Darling in his 2007 Pre-Budget Report. Gordon Brown, in his 2007 Budget, also made a number of statements on tax policy that will significantly affect taxation in financial year 2008/09.

In the run-up to the UK Budget on 12 March 2008, much will undoubtedly be made of the expanding sea of red ink in the public sector finances. This is perfectly sensible. There is little doubt that the rapid increase in public spending has not been matched by higher revenue since FY2001 (2001/02) and the result will inevitably be higher deficits and more borrowing.¹ But it is nevertheless also sensible to consider, not just the short-term pressures in the public finances, but also the longer-term impact of the increasing share of GDP taken by the state and the long-term prospects for GDP growth.

Since the beginning of the current decade, two of the major drivers of GDP growth have been household consumption and government spending. But both of these are set to decelerate. Indeed government consumption spending growth has already sharply declined. Moreover, given the poor state of the public finances, the government is constrained in what it could do to stimulate the economy if it turned down sharply.     

Consumers have also been on a spending binge, which has boosted GDP growth. Over the past decade the saving ratio has fallen from nearly 10% to 3%, the lowest on record. This is unrepeatable and unsustainable. The next few years will inevitably see some belt-tightening. 

 The labour market is set to deteriorate in 2008 

The last set of official labour market statistics suggested that the labour market was still buoyant. Unemployment, as measured by the claimant count, fell to 807,700 (2.5%) in December, whilst the more comprehensive measure from the Labour Force Survey dropped 13,000 in the three months to November to 1.65 million (5.3%). Employment was up by 175,000 in the same three month period – a healthy, if erratic, rise by any standards.

Britain’s trade figures have deteriorated alarmingly and, with the country living beyond its means, the position is simply unsustainable. The current account deficit in 2007 was probably around 5% of GDP, compared with 4% of GDP for the previous year and a negligible deficit recorded just 10 years earlier.

Sterling has already fallen sharply, especially against the euro, and is likely to weaken further. The weaker currency could exacerbate inflationary pressures but a lower currency is surely necessary to help correct the trade imbalances.

The British economy is slowing

There is little doubt that the economy is entering a period of slowdown – not least of all because of the Bank of England’s tightening of policy which began in August 2006. Sometimes this rather prosaic part-explanation for the economy’s deceleration gets lost in current economic debates, which tend to emphasise the, doubtless significant, impact of the credit squeeze on consumers and businesses. The ¼ % cut in December does not alter this assessment.

Introduction: disappointing public sector data

The recent public sector finances press release for the months up to and including October 2007 made for sober reading.¹ In spite of rapid economic growth, the public finances are deteriorating significantly. As table 1 shows the current deficit in the first seven months of FY2007 was £11.5bn – over £4bn worse than the equivalent period a year earlier. The deterioration in net borrowing was worse. In the first seven months of FY2007 borrowing was over £24bn. It was £17.5bn in the equivalent period of FY2006.

According to the IFS² the current deficit for the whole year could be £7bn and net borrowing could be as high as £42bn (over 3% of GDP), if current trends continue.