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UK CPI inflation rose to 3.1% in November. This has forced Mark Carney to write a letter of explanation to the Chancellor – something he is required to do if inflation is more than 1 percentage point above (or below) the target of 2%.

The rise in inflation over the past few months has been caused largely by the depreciation of sterling following the Brexit vote. But there have been other factors at play too. The dollar price of oil has risen by 32% over the past 12 months and there have been large international rises in the price of metals and, more recently, in various foodstuffs. For example, butter prices have risen by over 20% in the past year (although they have declined somewhat recently). Other items that have seen large price rises include books, computer games, clothing and public transport.

The rate of CPI inflation is the percentage increase in the consumer prices index over the previous 12 months. When there is a one-off rise in prices, such as a rise in oil prices, its effect on inflation will only last 12 months. After that, assuming the price does not rise again, there will be no more effect on inflation. The CPI will be higher, but inflation will fall back. The effect may not be immediate, however, as input price changes take a time to work through supply chains.

Given that the main driver of inflation has been the depreciation in sterling, once the effect has worked through in terms of higher prices, inflation will fall back. Only if sterling continued depreciating would an inflation effect continue. So, many commentators are expecting that the rate on inflation will soon begin to fall.

But what will have been the effect on real incomes? In the past 12 months, nominal average earnings have risen by around 2.5% (the precise figures will not be available for a month). This means that real average earnings have fallen by around 0.6%. (Click here for a PowerPoint of the chart.)

For many low-income families the effect has been more severe. Many have seen little or no increase in their pay and they also consume a larger proportion of items whose prices have risen by more than the average. Those on working-age benefits will be particularly badly hit as benefits have not risen since 2015.

If inflation does fall and if real incomes no longer fall, people will still be worse off unless real incomes rise back to the levels they were before they started falling. That could be some time off.

Articles

UK inflation rate at near six-year high BBC News (12/12/17)
Inflation up as food costs jump – and gas crisis threatens worse to come The Telegraph, Tim Wallace (12/12/17)
UK worst for pay growth as rich world soars ahead in 2018 The Telegraph, Tim Wallace (12/12/17)
Inflation rises to 3.1%, adding to UK cost of living squeeze The Guardian, Larry Elliott (12/12/17)
UK inflation breaches target as it climbs to 3.1% Financial Times, Gavin Jackson (12/12/17)
Inflation surges to 3.1% in November, a near six-year high Belfast Telegraph (12/12/17)

Data

CPI annual rate of increase (all items) ONS: series D7G7
Average weekly earnings, annual (3-month average) ONS: series KAC3
UK consumer price inflation: November 2017 ONS Statistical Bulletin (12/12/17)
Commodity prices Index Mundi

Questions

  1. Apart from CPI inflation, what other measures of inflation are there? Explain their meaning.
  2. Why is inflation of 2%, rather than 0%, seen as the optimal rate by most central banks?
  3. Apart from the depreciation of sterling, what other effects is Brexit likely to have on living standards in the UK?
  4. What are the arguments for and against the government raising benefits by the rate of CPI inflation?
  5. If Europe and the USA continue to grow faster than the UK, what effect is this likely to have on the euro/pound and dollar/pound exchange rates? What determines the magnitude of this effect?
  6. Unemployment is at its lowest level since 1975. Why, then, are real wages falling?
  7. Why, in the light of inflation being above target, has the Bank of England not raised Bank Rate again in December (having raised it from 0.25% to 0.5% in November)?

In delivering his Budget on 22 November, Philip Hammond reported that the independent Office for Budget Responsibility had revised down its forecasts of growth in productivity and real GDP, and hence of earnings growth.

Today, median earnings are £23,000 per annum. This is £1500 less than the £24,500 that the median worker earned in 2008 in today’s prices. The OBR forecasts a growth in real household disposable income of just 0.35% per annum for the next four years.

With lower growth in earnings would come a lower growth in tax revenues. With his desire to cut the budget deficit and start eventually reducing government debt, this would give the government less scope for spending on infrastructure, training and other public-sector investment; less scope to support public services, such as health and education; less scope for increasing benefits and public-sector wages.

The normal measure of productivity, and the one used by the OBR, is the value of output produced per hour worked. This has hardly increased at all since the financial crisis of 2008. It now takes an average worker in the UK approximately five days to produce the same amount as it takes an average worker in Germany four days. Although other countries’ productivity growth has also slowed since the financial crisis, it has slowed more in the UK and from a lower base – and is now forecast to rebound less quickly.

For the past few years the OBR has been forecasting that productivity growth would return to the trend rate of just over 2% that the UK achieved prior to 2008. For example, the forecasts it made in June 2010 are shown by the grey line in the chart, which were based on the pre-crash trend rate of growth in productivity (click on chart to enlarge). And the forecasts it made in November 2016 are shown by the pale green line. Yet each year productivity has hardly changed at all. Today output per hour is less than 1% above its level in 2008.

Now the OBR believes that poorer productivity growth will persist. It is still forecasting an increase (the blue line in the chart) – but by 0.7 of a percentage point less than it was forecasting a year ago (the pale green line): click here for a PowerPoint of the chart.

We have assumed that productivity growth will pick up a little, but remain significantly lower than its pre-crisis trend rate throughout the next five years. On average, we have revised trend productivity growth down by 0.7 percentage points a year. It now rises from 0.9 per cent this year to 1.2 per cent in 2022. This reduces potential output in 2021-22 by 3.0 per cent. The ONS estimates that output per hour is currently 21 per cent below an extrapolation of its pre-crisis trend. By the beginning of 2023 we expect this to have risen to 27 per cent.

Why has there been such weak productivity growth?
Weak productivity growth has been caused by a mixture of factors.

Perhaps the most important is that investment as a percentage of GDP has been lower than before the financial crisis and lower than in other countries. Partly this has been caused by a lack of funding for investment as banks have sought to rebuild their capital and have cut down on riskier loans. Partly it has been caused by a lack of demand for investment, given sluggish rates of economic growth and the belief that austerity will continue.

And it is not just private investment. Public-sector investment in transport infrastructure, housing and education and training has been lower than in other countries. Indeed, the poor training record and low skill levels in the UK are main contributors to low productivity.

The fall in the pound since the Brexit vote has raised business costs and further dampened demand as incomes have been squeezed.

Another reason for low productivity growth has been that employers have responded to weak demand, not by laying off workers and thereby raising unemployment, but by retaining low-productivity workers on low wages. Another has been the survival of ‘zombie’ firms, which, by paying low wages and facing ultra-low interest rates, are able to survive competition from firms that do invest.

Why is weak productivity growth forecast to continue?
Looking forward, the nature of the Brexit deal will impact on confidence, investment, wages and growth. If the deal is bad for the UK, the OBR’s forecasts are likely to be too optimistic. As it is, uncertainty over the nature of the post-Brexit world is weighing heavily on investment as some businesses choose to wait before committing to new investment.

On the other hand, exports may rise faster as firms respond to the depreciation of the pound and this may stimulate investment, thereby boosting productivity.

Another factor is the effect of continuing tight Budgets. There was some easing of austerity in this Budget, as the Chancellor accepted a slower reduction in the deficit, but government spending will remain tight and this is likely to weigh on growth and investment and hence productivity.

But this may all be too gloomy. It is very difficult to forecast productivity growth, especially as it is hard to measure output in much of the service sector. It may be that the productivity growth forecasts will be revised up before too long. For example, the benefits from new technologies, such as AI, may flow through more quickly than anticipated. But they may flow through more slowly and the productivity forecasts may have to be revised down even further!

Articles

The OBR’s productivity “forecast” Financial Times, Kadhim Shubber
U.K. Faces Longest Fall in Living Standards on Record Bloomberg, Simon Kennedy and Thomas Penny (23/11/17)
Britain’s Productivity Pain Costs Hammond $120 Billion Bloomberg, Fergal O’Brien (22/11/17)
OBR slashes Britain’s growth forecast on sluggish productivity and miserly pay The Telegraph, Tim Wallace (22/11/17)
Budget 2017: Stagnant earnings forecast ‘astonishing’ BBC News (23/11/17)
Economists warn Budget measures to lift productivity fall short Financial Times, Gavin Jackson and Gill Plimmer (22/11/17)
Why the economic forecasts for Britain are so apocalyptic – and how much Brexit is to blame Independent, Ben Chu (24/11/17)
Growth holds steady as economists doubt OBR’s gloom The Telegraph, Tim Wallace (23/11/17)
Britain’s debt will not fall to 2008 levels until 2060s, IFS says in startling warning Independent, Lizzy Buchan (23/11/17)
Philip Hammond’s budget spots Britain’s problems but fails to fix them The Economist (22/11/17)
Debunking the UK’s productivity problem The Conversation, Paul Lewis (24/11/17)
Budget 2017: experts respond The Conversation (22/11/17)
Autumn Budget 2017 Forecasts Mean ‘Longest Ever Fall In Living Standards’, Says Resolution Foundation Huffington Post, Jack Sommers (23/11/17)
It May Just Sound Like A Statistic, But Productivity Growth Matters For All Of Us Huffington Post, Thomas Pope (24/11/17) (see also)
UK prospects for growth far weaker than first predicted, says OBR The Guardian, Angela Monaghan (22/11/17)
UK faces two decades of no earnings growth and more austerity, says IFS The Guardian, Phillip Inman (23/11/17)
Age of austerity isn’t over yet, says IFS budget analysis The Guardian, Larry Elliott (23/11/17)

Summary of Budget measures

Budget 2017: FT experts look at what it means for you Financial Times (24/11/17)

Official Documents

Autumn Budget 2017 HM Treasury (22/11/17)
Economic and fiscal outlook – November 2017 Office for Budget Responsibility (22/11/17)

IFS analysis

Autumn Budget 2017 Institute for Fiscal Studies (23/11/17)

Questions

  1. What measures of productivity are there other than output per hour? Why is output per hour normally the preferred measure of productivity?
  2. What factors determine output per hour?
  3. Why have forecasts of productivity growth rates been revised downwards?
  4. What are the implications of lower productivity growth for government finances?
  5. What could cause an increase in output per hour? Would there be any negative effects from these causes?
  6. What policies could the government pursue to increase productivity? How feasible are these policies? Explain.
  7. Would it matter if the government increased borrowing substantially to fund a large programme of public investment?

Thirty years ago, on Monday 19 October 1987, stock markets around the world tumbled. The day has been dubbed ‘Black Monday’. Wall Street fell by 22% – its biggest ever one-day fall. The FTSE 100 fell by 10.8% and by a further 12.2% the next day.

The crash caught most people totally by surprise and has never been fully explained. The most likely cause was an excessive rise in the previous three years, when share prices more than doubled. This was combined with the lack of ‘circuit breakers’, which today would prevent excessive selling, and a ‘herd’ effect as people rushed to get out of shares before they fell any further, creating a massive wave of destabilising speculation.

Within a few weeks, share prices started rising again and within three years shares were once again trading at levels before Black Monday.

Looking back to the events of 30 years ago, the question many fund managers and others are asking is whether global stock markets are in for another dramatic downward correction. But there is no consensus of opinion about the answer.

Those predicting a downward correction – possibly dramatic – point to the fact that stock markets, apart from a dip in mid-2016, have experienced several years of growth, with yields now similar to those in 1987. Price/earnings ratios, at around 18, are high relative to historical averages.

What is more, the huge increases in money supply from quantitative easing, which helped to inflate share prices, are coming to an end. The USA ceased its programme three years ago and the ECB is considering winding down its programme.

Also, once a downward correction starts, destabilising speculation is likely to kick in, with people selling shares before they go any lower. This could be significantly aggravated by the rise of electronic markets with computerised high-frequency trading.

However, people predicting that there will be little or no downward correction, and even a continuing bull market, point to differences between now and 1987. First, the alternatives to shares look much less attractive than then. Bond yields and interest rates in banks (at close to zero), unlike in 1987, are much lower than the dividend yields on shares (at around 4%). Second, there are circuit breakers in stock markets that suspend dealing in cases of large falls.

But even if there is a downward correction, it will probably be relatively short-lived, with the upward trend in share prices continuing over the long term. If you look at the chart above, you can see this trend, but you can also see periods of falling share prices in the late 1990s/early 2000s and in the financial crisis of 2008–9. Looking back to 1987, it seems like a mere blip from the perspective of 30 years – but it certainly didn’t at the time.

Articles

Three decades since Black Monday – are markets on the verge of another tumble? The Telegraph, Lucy Burton (19/10/17)
Black Monday: 30 years on from the 1987 crash Citywire, Michelle McGagh (19/10/17)
30 Years Ago: Lessons From the 1987 Market Crash U.S.News, Debbie Carlson (12/10/17)
Black Monday: Can a 1987-style stock market crash happen again? USA Today, Adam Shell (19/10/17)
Black Monday anniversary: How the 2017 stock market compares with 1987 MarketWatch, William Watts (19/10/17)
30 years after Black Monday, could stock market crash again? MarketWatch, William Watts (19/10/17)
The Crash of ’87, From the Wall Street Players Who Lived It Bloomberg, Richard Dewey (19/10/17)

Questions

  1. Explain what are meant by ‘bull markets’ and ‘bear markets’.
  2. Share prices are determined by demand and supply. Identify the various demand- and supply-side factors that have led to the current long bull-market run.
  3. What caused the Black Monday crash in 1987?
  4. For what reasons may global stock markets soon (a) experience, (b) not experience a downward correction?
  5. Distinguish between stabilising speculation and destabilising speculation on stock markets.
  6. What determines when a downward correction on stock markets bottoms out?
  7. Explain how stock market circuit breakers work. Can they prevent a fundamental correction?
  8. Does the rise in computerised trading make a stock market crash more or less likely?

The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.

While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.

The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth

The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.

An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.

The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.

The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.

In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.

But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!

Videos

Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)

Articles

Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)

IMF Fiscal Monitor

IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)

Questions

  1. Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
  2. What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
  3. Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
  4. Why may governments reject the IMF’s policy recommendations to tackle inequality?
  5. In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
  6. Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
  7. What does the IMF report suggest about the shape of the Laffer curve?
  8. Explain what is meant by tax elasticity and how it relates to the Laffer curve?

In various blogs, we’ve looked at the UK’s low productivity growth, both relative to other countries and relative to the pre-1998 financial crisis (see, for example, The UK productivity puzzle and Productivity should we be optimistic?). Productivity is what drives long-term economic growth as it determines potential GDP. If long-term growth is seen as desirable, then a fall in productivity represents a serious economic problem.

Recent data suggest that the problem, if anything, is worse than previously thought and does not seem to be getting better. Productivity is now some 21% below what it would have been had productivity growth continued at the rate experienced in the years before the financial crisis (see second chart below).

In its latest productivity statistics, the ONS reports that labour productivity (in terms of output per hour worked) fell by 0.1% in the second quarter of 2017. This follows a fall of 0.5% in quarter 1. Over the whole year to 2017 Q2, productivity fell by 0.3%.

Most other major developed countries have much higher productivity than the UK. In 2016, Italy’s productivity was 9.9% higher than the UK’s; the USA’s was 27.9%, France’s was 28.7% and Germany’s was 34.5% higher. What is more, their productivity has grown faster (see chart).

But what of the future? The Office for Budget responsibility publishes forecasts for productivity growth, but has consistently overestimated it. After predicting several times in the past that UK productivity growth would rise towards its pre-financial crisis trend of around 2% per year, in its October 2017 Forecast evaluation Report it recognises that this was too optimisitic and revises downwards its forecasts for productivity growth for 2017 and beyond.

As the period of historically weak productivity growth lengthens, it seems less plausible to assume that potential and actual productivity growth will recover over the medium term to the extent assumed in our most recent forecasts. Over the past five years, growth in output per hour has averaged 0.2 per cent. This looks set to be a better guide to productivity growth in 2017 than our March forecast of 1.6 per cent.

Looking further ahead, it no longer seems central to assume that productivity growth will recover to the 1.8 per cent we assumed in March 2017 within five years.

But why has productivity growth not returned to pre-crisis levels? There are five possible explanations.

The first is that there has been labour hoarding. But with companies hiring more workers, this is unlikely still to be true for most employers.

The second is that very low interest rates have allowed some low-productivity companies to survive, which might otherwise have been driven out of business.

The third is a reluctance of banks to lend for investment. After the financial crisis this was driven by the need for them to repair their balance sheets. Today, it may simply be greater risk aversion than before the financial crisis, especially with the uncertainties surrounding Brexit.

The fourth is a fall in firms’ desire to invest. Although investment has recovered somewhat from the years directly following the financial crisis, it is still lower than might be expected in an economy that is no longer is recession. Indeed, there has been a much slower investment recovery than occurred after previous recessions.

The fifth is greater flexibility in the labour market, which has subdued wages and has allowed firms to respond to higher demand by taking on more relatively low-productivity workers rather than having to invest in human capital or technology.

Whatever the explanation, the solution is for more investment in both technology and in physical and human capital, whether by the private or the public sector. The question is how to stimulate such investment.

Articles

UK productivity lagging well behind G7 peers – ONS Financial Times, Katie Martin (6/10/17)
UK productivity sees further fall BBC News (6/10/17)
UK resigned to endless productivity gloom The Telegraph, Tim Wallace (10/10/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (10/10/17)
UK productivity growth to remain sluggish, says OBR BBC News (10/10/17)
Official Treasury forecaster slashes UK productivity growth forecast, signalling hole in public finances for November Budget Independent, Ben Chu (10/10/17)
The Guardian view on Britain’s productive forces: they are not working The Guardian, Editorial (10/10/17)
Mind the productivity gap: the story behind sluggish earnings The Telegraph, Anna Isaac (26/10/17)

Data and statistical analysis

Labour productivity: April to June 2017 ONS Statistical Bulletin (6/10/17)
International comparisons of productivity ONS Dataset (6/10/17)
Forecast evaluation report OBR (October 2017)

Questions

  1. Explain the relationship between labour productivity and potential GDP.
  2. What is the relationship between actual growth in GDP and labour productivity?
  3. Why does the UK lag France and Germany more in output per hour than in output per worker, but the USA more in output per worker than in output per hour?
  4. Is there anything about the UK system of financing investment that results in lower investment than in other developed countries?
  5. Why are firms reluctant to invest?
  6. In what ways could public investment increase productivity?
  7. What measures would you recommend to encourage greater investment and why?
  8. How do expectations affect the growth in labour productivity?