With the Conservatives and Liberal Democrats now in power in the UK and with the Labour Party, having lost the election, being now in the midst of a leadership campaign, politicians from across the political spectrum are balming Gordon Brown for the ‘mess the country’s in’. The UK has a record budget deficit and debt, and is just emerging from a deep recession, when only a few years ago, Gordon Brown was claiming the end of boom and bust. But is the condition of the UK economy Mr Brown’s fault? Would it have been any better if others had been in charge, or if there had been even greater independence for the Bank of England of if there had been an Office of Budget Responsibility (see)?
The following podcast by Martin Wolf, chief economics commentator of the Financial Times, considers this question. He argues that:
Everybody would like to blame Gordon Brown for the financial crisis. But he was only acting in line with the national consensus on economic policy.
The economic legacy of Mr Brown FT podcasts, Martin Wolf (13/5/10)
The economic legacy of Mr Brown Financial Times, Martin Wolf (13/5/10)
Questions
- Explain what is meant by ‘the great moderation’.
- Should regulation of the banks be handed back to the Bank of England?
- Why may controlling inflation not necessarily result in stable economic growth? Is this a case of Goodhart’s Law?
- Why was the UK economy especially fragile during the banking crisis and its aftermath?
- What, according to Martin Wolf, was Mr Brown’s biggest mistake?
- Could a mistake be now being made by following the conventional wisdom that cutting the deficit is the solution to achieving sustained recovery?
Research from the Halifax estimates that the total wealth of UK households at the end of 2009 was £6.316 trillion. Putting this into context, it means that the average UK household has a stock of wealth of £236,998. In real terms, so stripping out the effects of consumer price inflation, the total wealth of households has grown five-fold since 1959 while the average wealth per household has grown three-fold while. The growth in wealth per household is a little less because of the increase in the number of households from 6.6 million to 26.6 million. For those that like their numbers, total household wealth in 1959 was estimated at £1.251 trillion (at 2009 prices) while the average amount per household was £72,719 (at 2009 prices).
But, do changes in household wealth matter? Well, yes, but not necessarily in a consistent and predictable manner. That’s why so many of us love economics! For now, consider the prices of two possible types of assets: share prices and house prices. The prices of both these assets are notoriously volatile and it is this volatility that has the potential to affect the growth of consumer spending.
It might be, for instance, that you are someone who keeps a keen eye on the FTSE-100 because you use shares as a vehicle for saving. A fall in share prices, by reducing the value of the stock of financial assets, may make some people less inclined to spend. Housing too can be used as a vehicle for saving. Changes in house prices will, of course, affect the capital that can be realised from selling property, but also affect the collateral that can be used to support additional borrowing and, more generally, affect how wealthy or secure we feel.
The Halifax estimates that the household sector’s stock of housing wealth was £3.755 trillion at the end of 2009 while its stock of financial assets (such as savings, pensions and shares) was £4.024 trillion. In real terms, housing wealth has grown on average by 5% per year since 1959 while financial assets have grown by 2.8% per year. Of course, while households can have financial and housing assets they are likely to have financial liabilities too! We would expect households’ exposure to these liabilities – and their perception of this exposure – to offer another mechanism by which household spending could be affected. For instance, changes in interest rates impact on variable rate mortgages rates, affecting the costs of servicing debt and, in turn, disposable incomes.
The Halifax reports that the stock of mortgage loans was £1.235 trillion at the end of 2009, which, when subtracted from residential housing wealth, means that the UK household sector had net housing equity of £2.519 trillion. It estimates that the stock of mortgage loans has increased on average by 6.5% per year in real terms since 1959 while net housing equity has grown by 4.5%. The stock of households’ unsecured debt, also known as consumer credit, was £227 billon at the end of 2009. In real terms it has grown by 5.3% per year since 1959.
The recent patterns in household wealth are particularly interesting. Between 2007 and 2008 downward trends in share prices and house prices contributed to a 15% real fall in household wealth. The Halifax note that some of this was ‘recouped’ in 2009 as a result of a rebound in both share prices and house prices. More precisely, household wealth increased by 9% in real terms in 2009, but, nonetheless, was still 8% below its 2007 peak.
Given the recent patterns in household wealth, including the volatility in the components that go to comprise this stock of wealth, we shouldn’t be overly surprised by the 3.2% real fall that occurred in household spending last year. Further, we must not forget that 2009 was also the year, amongst other things, that the economy shrunk by 4.9%, that unemployment rose from 1.8 million to 2.5 million and that growing concerns about the size of the government’s deficit highlighted the need for fiscal consolidation at some point in the future. All of these ingredients created a sense of uncertainty. This is an uncertainty that probably remains today and that is likely to continue to moderate consumer spending in 2010. So, it’s unlikely to be a time for care-free shopping, more a time for window shopping!
Halifax Press Release
UK household wealth increases five-fold in the past 50 years Halifax (part of the Lloyds Banking Group) (15/5/10)
Articles
Household wealth ‘up five-fold’ UK Press Association (15/5/10)
We’ve never had it so good: Families five times richer than in 1959 Daily Mail, Steve Doughty (15/5/10)
Household wealth grows five-fold in past 50 years BBC News (16/5/10)
Average household wealth jumps £150,000 Telegraph, Myra Butterworth (15/5/10)
Questions
- Draw up a list of the ways in which you think consumer spending may be affected by: (i) the stock of household wealth; and (ii) the composition of household wealth.
- What factors do you think lie behind the annual 5% real term increase in the value of residential properties since 1959?.
- How might the sensitivity of consumer spending to changes in interest rates be affected by the types of mortgage product available?
- Why do you think consumer spending fell by 3.2% in real terms in 2009 despite real disposable income increasing by 3.2%?
- What would you predict for consumption growth in 2010? Explain your answer.
The latest inflation release from the Office for National Statistics shows the annual rate of CPI inflation for April at 3.7%, up from 3.4% in March. In other words, the average price of a basket of consumer goods – the Consumer Price Index – was 3.7% higher in April than in the same month last year. In three of the last four months, the rate of inflation has been in letter-writing territory, i.e. more than 1 percentage point away from the government’s central inflation rate target of 2%. Of course, this time it was George Osborne, the new Chancellor of the Exchequer, who was the recipient of the obligatory explanatory letter from Mervyn King, the Governor of the Bank of England.
Over the past six months the average annual rate of rate of consumer price inflation in the UK has been 3.1%. It is, therefore, no surprise that there is considerable debate amongst commentators about the need for the Bank to raise interest rates. Part of the debate concerns the extent to which the Bank is right to argue that the current inflationary pressures are essentially short term and, according to May’s letter from the Governor to the Chancellor ‘are masking the downward pressure on inflation from the substantial margin of spare capacity in the economy’.
The Bank points to the impact on the inflation figures of what we might term ‘one-off effects’. These include, for instance, the restoration in January of the standard rate of VAT to 17½% and the raising in the Budget in March of certain excise duties (commodity taxes), such as those on alcoholic beverages and on petrol. The Bank also points to the effects from the weakening of Sterling, specifically on the prices of imports, and from the increase over the past year in the price of oil because of higher demand on the back of the global economic recovery. Again, the Bank continues to argue that these pressures should weaken over the next 12 months.
As you might expect of the economics profession, there are others who argue that the Bank is being somewhat complacent over the prospects for inflation. Of course, these are incredibly uncertain times. In effect, the Bank is having to assess, on the one hand, the significance of cost pressures, such as those emanating from oil and other commodity prices, and, on the other hand, the future strength of aggregate demand, particularly in response to the likely fiscal tightening, not only in the UK, but in many other parts of the world too.
While economists will always hold divergent views on the prospects for inflation and, more generally, the economy, we may see another debate reignited in the months ahead: the debate over the extent to which the government’s powers over both fiscal and monetary policy are constrained.
Since 1997, the Bank of England has had a clear mandate to target the rate of inflation. But, to what extent might this mandate cause tensions between fiscal and monetary policy in the months ahead given the government’s plans for fiscal consolidation? In particular, with a tightening of fiscal policy, so as to reduce the size of the government’s budget deficit, will the Bank of England be able to maintain low interest rates and thereby help to sustain aggregate demand? This will, of course, depend on the path of inflation and, importantly, the sources of inflation. Nonetheless, it will be interesting to see whether the clear, if limited, remit of the Bank of England places pressure on the UK’s macroeconomic policy framework in these difficult economic times.
Articles
UK inflation hits 17 month-high BBC News (18/5/10)
A tale of two zones BBC News blogs: Stephanomics, Stephanie Flanders (18/5/10)
Shock rise in inflation risks higher rates and unemployment Independent, Sean O’Grady (19/5/10)
Q&A: Unpleasant surprise for Threadneedle St Financial Times, Chris Giles (18/5/10)
Inflation rise see King rebuked Financial Times, Chris Giles (19/5/10)
UK inflation fears Financial Times (18/5/10)
Inflation: mercury rising Guardian (19/5/10)
The elephant in the room just got bigger Times Online, David Wighton (19/5/10)
Weak pound and tax rises lift inflation to a 17-month high (including video) Times Online, Grainne Gilmore (19/5/10)
Data
Latest on inflation Office for National Statistics (18/5/10)
Consumer Price Indices, Statistical Bulletin, April 2010 Office for National Statistics (18/5/10)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank
Questions
- What do you understand by cost-push and demand-pull inflation? To what extent are each of these significant in explaining the current rise in the rate of inflation?
- Outline the potential advantages and disadvantages of granting the Bank of England independence to set interest rates in meeting an inflation rate target.
- If the Bank of England’s remit were relaxed, say to include targeting output growth too, how might this affect its response to rising cost-push inflation? What about rising demand-pull inflation?
- Distinguish between a rise in the level of consumer prices and a rise in the rate of consumer price inflation.
- Describe the likely impact of an increase in the standard rate of VAT on the average consumer price level and on the annual rate of consumer price inflation both in the short term and in the longer term.
According to political business cycle theory, incoming governments tend to take harsh measures at first, when they can blame the cuts on the ‘mess they’ve inherited’ from their predecessors. And then two or three years later, as an election looms, they can start spending more and/or cutting taxes, hoping that the good will this creates will help them win the election.
So are we seeing the start of a new political business cycle with the start of the new Coalition government? The following two articles look at the issue.
Coalition will inflict cuts now and spend later to win a second term Guardian, Larry Elliott (17/5/10)
If you get all the bad news out at once, the only way left to go will be up. Or will it? Independent, Sean O’Grady (18/5/10)
Questions
- Explain what is meant by the ‘political business cycle’.
- Would the existence of a political dimension to the business cycle amplify or dampen the cycle, or could it do either depending on the circumstances? Explain.
- Does the existence of an independent central bank eliminate the political business cycle?
- Will the new Office for Budget Responsibility (see Nipping it in the Budd: Enhancing fiscal credibility?) help to eliminate the political business cycle? Explain your answer.
In our blog article IMF warns of the long-term need for fiscal consolidation we highlighted the concerns that the IMF had about the size of public debt-to-GDP ratios in those countries with weak fiscal credibility. Since 1997 the UK has undertaken a series of measures designed to enhance the credibility of fiscal policy and, in particular, to dispel the notion that fiscal policy is unduly sensitive to political needs. Firstly, we have seen the introduction of a Code for Fiscal Stability which outlines a series of principles which should underpin fiscal policy measures. Secondly, in response to the worsening state of the public finances, we have seen the introduction of a Fiscal Responsibility Act which requires governments to outline plans for delivering sound public finances and places a duty on them to deliver them.
The new UK coalition government is now introducing a new independent Office for Budget Responsibility (OBR) which will have responsibility for assessing the public finances and the economy, including the generation of forecasts, and for assessing the public-sector balance sheets (i.e. the sector’s assets and liabilities). The OBR will begin its work immediately in readiness for an ‘emergency Budget’ on the 22nd June. According to the HM Treasury press release on 17 May the OBR will be headed by Sir Alan Budd, an economist who was a founder member of the Monetary Policy Committee (MPC) of the Bank of England. Sir Alan will head a 3-member Budget Responsibility Committee (BRC) which will be supported by economists and public finance experts currently working in HM Treasury, but who in the longer-term will redeployed from the Treasury. Legislation will be drawn up in order to establish the OBR on a permanent statutory basis.
In arguing the case for the OBR, the government points out that all Budget forecasts since 2000 of public borrowing for more than ‘1 year ahead’ have underestimated borrowing. For instance, the average error for ‘2 year ahead’ forecasts since 2000 is £29.5 billion, i.e. borrowing for the financial year after next has, on average, turned out to be £29.5 billion higher than predicted. Of course, we would expect shorter-term forecasts to be more accurate. The evidence presented shows the average error for ‘1 year ahead’ forecasts since 2000 to be £6 billion, i.e. actual borrowing in the following financial year has, on average, been £6 billion higher than forecast. But, more than this, since 2000 four Budgets – those in 2000, 2006, 2007 and 2009 – have produced ‘1 year ahead’ forecasts that over-predicted levels of borrowing.
While it will certainly be fascinating in the years ahead to assess the accuracy of the OBR’s own crystal ball in forecasting, the creation of the OBR is undoubtedly an interesting development in the way in which fiscal policy is both designed and implemented in the UK.
HM Treasury Press Notice
Chancellor announces policies to enhance fiscal credibility HM Treasury (17/5/10)
Articles
Osborne braced for cuts Financial Times, Lionel Barber, George Parker and Chris Giles (17/5/10)
Chancellor launches audit of government spending Independent, Andrew Woodcock (17/5/10)
Osborne gives up power to forecast Financial Times, Chris Giles (17/5/10)
Why the Office for Budget Responsibility Matters BBC News blogs: Stephanomics, Stephanie Flanders (17/5/10)
Osborne confirms new U.K. budget watch dog MarketWatch, William L Watts (17/5/10)
Osborne warns of ‘disastrous consequences’ for economy BBC News, Ben Wright (17/5/10)
Chancellor announces new fiscal watchdog BBC News (17/5/10)
Robert Chote on new OBR BBC Daily Politics, Robert Chote (17/5/10)
George Osborne discovers the joys of kitchen-sinking Telegraph, Tracey Corrigan (17/5/10)
George Osborne tackles Labour’s toxic handover Guardian,
Larry Elliott (17/5/10)
Mixed reaction to Office for Budget Responsibility Public Finance, Jaimie Kaffash (17/5/10)
Questions
- What do you understand by the concept of fiscal credibility?
- How important do you think the new OBR will be in enhancing the UK’s fiscal credibility?
- In what other ways have UK governments attempted to enhance the UK’s fiscal credibility in recent years?
- What do you see as the potential economic benefits of enhancing fiscal credibility?
- One of the first things that the incoming Labour Chancellor, Gordon Brown, did in 1997 was to make the Bank of England independent and create a Monetary Policy Committee (MPC) to set interest rates. What parallels do you see between the MPC and the newly created Budget Responsibility Committee (BRC)?