These are challenging times for business. Economic growth has weakened markedly over the past 18 months with output currently growing at an annual rate of around 1.5 per cent, a percentage point below the long-term average. Spending power continues to be squeezed, with the annual rate of inflation in October reported to be running at 3.1 per cent compared to annual earnings growth of 2.5 per cent (see the squeeze continues). Moreover, consumer confidence remains fragile with households continuing to express particular concerns about the general economy and unemployment.
Here, we update our blog of July 2016 which, following the UK vote to leave the European Union, noted the fears for UK growth as confidence fell sharply. Consumer confidence is frequently identified by macro-economists as an important source of economic volatility. Indeed many macro models use a change in consumer confidence as a means of illustrating how economic shocks affect a range of macro variables, including growth, employment and inflation. Many economists agree that, in the short term at least, falling levels of confidence adversely affect activity because aggregate demand falls as households spend less.
The European Commission’s confidence measure is collated from questions in a monthly survey. In the UK around 2000 individuals are surveyed. Across the EU as a whole over 41 000 people are surveyed. In the survey individuals are asked a series of 12 questions which are designed to provide information on spending and saving intentions. These questions include perceptions of financial well-being, the general economic situation, consumer prices, unemployment, saving and the undertaking of major purchases.
The responses elicit either negative or positive responses. For example, respondents may feel that over the next 12 months the financial situation of their household will improve a little or a lot, stay the same or deteriorate a little or a lot. A weighted balance of positive over negative replies can be calculated. The balance can vary from -100, when all respondents choose the most negative option, to +100, when all respondents choose the most positive option.
The European Commission’s principal consumer confidence indicator is the average of the balances of four of the twelve questions posed: the financial situation of households, the general economic situation, unemployment expectations (with inverted sign) and savings, all over the next 12 months. These forward-looking balances are seasonally adjusted. The aggregate confidence indicator is thought to track developments in households’ spending intentions and, in turn, likely movements in the rate of growth of household consumption.
Chart 1 shows the consumer confidence indicator for the UK. The long-term average of –8.6 shows that negative responses across the four questions typically outweigh positive responses. In November 2017 the confidence balance stood at -5.2 roughly on par with its value in the previous two months, though marginally up on values of close to -7 over the summer. However, as recently as the beginning of 2016 the aggregate confidence score was running at around +4. In this context, current levels do constitute a significant change in consumer sentiment, changes which do ordinarily mark similar turning points in economic activity.(Click here to download a PowerPoint of the chart.)
Chart 2 allows to look behind the European Commission’s headline confidence indicator for the UK by looking at its four component balances. From it, we can see a deterioration in all four components. However, by far the most significant change in the individual confidence balances has been the sharp deterioration in expectations for the general economy. In November the forward-looking general economic situation stood at -25.5, compared to its long-run average of -11.6. (Click here to download a PowerPoint of the chart.)
The fall in UK consumer confidence is even more stark when compared to developments in consumer confidence across the whole of the European Union and in the 19 countries that make up the Euro area. Chart 3 shows how UK consumer confidence recovered relatively more strongly following the financial crisis of the late 2000s. The headline confidence indicator rose strongly from the middle of 2013 and was consistently in positive territory during 2014, 2015 and into 2016. The fall in consumer confidence in the UK has seen the headline confidence measure fall below that for the EU and the euro area. (Click here to download a PowerPoint of the chart.)
Consumer (and business) confidence is closely linked to uncertainty. The circumstances following the UK vote to leave the EU have undoubtedly created the conditions for acute uncertainty. Uncertainty breeds caution. Economists sometimes talk about spending being affected by two conflicting motives: prudence and impatience. While impatience creates a desire for spending now, prudence pushes us towards saving and insuring ourselves against uncertainty and unforeseen events. The worry is that the twin forces of fragile confidence and squeezed real earning are weighting heavily in favour of prudence and patience (a reduction in impatience). Going forward, this could create the conditions for a sustained period of subdued growth which, if it were to impact heavily on firms’ investment plans, could adversely impact on the economy’s productive potential. The hope is that the Brexit negotiations can move apace to reduce uncertainty and limit uncertainty’s adverse impact on economic activity.
Articles
UK consumer confidence slips in December – Thomson Reuters/Ipsos Reuters (14/12/17)
UK consumer confidence drops to lowest level since Brexit result Independent, Ben Chu (30/11/17)
2017 set to be worst year for UK consumer spending since 2012, Visa says Independent, Josie Cox, (11/12/17)
Carpetright boss warns of ‘fragile’ consumer confidence after profits plunge Telegraph, Jack Torrance (12/12/17)
UK consumers face sharpest price rise in services for nearly a decade Guardian, Richard Partington (5/12/17)
UK average wage growth undershoots inflation again squeezing real incomes Independent, Josie Cox (13/12/17)
Bank sees boost from Brexit progress BBC News (14/12/17)
Data
Business and Consumer Surveys European Commission
Questions
- Draw up a series of factors that you think might affect consumer confidence.
- Explain what you understand by a positive and a negative demand-side shock. How might changes in consumer confidence generate demand shocks?
- Analyse the ways in which consumer confidence might affect economic activity.
- Which of the following statements is likely to be more accurate: (a) Consumer confidence drives economic activity or (b) Economic activity drives consumer confidence?
- What macroeconomic indicators would those compiling the consumer confidence indicator expect the indicator to predict?
- Analyse the possible short-term and longer-term economic implications of a fall in consumer confidence.
- How might uncertainty affect consumer confidence?
- What do the concepts of impatience and prudence mean in the context of consumer spending? When consumer confidence falls which of these might become more significant for consumer spending?
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
- Apart from CPI inflation, what other measures of inflation are there? Explain their meaning.
- Why is inflation of 2%, rather than 0%, seen as the optimal rate by most central banks?
- Apart from the depreciation of sterling, what other effects is Brexit likely to have on living standards in the UK?
- What are the arguments for and against the government raising benefits by the rate of CPI inflation?
- 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?
- Unemployment is at its lowest level since 1975. Why, then, are real wages falling?
- 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
- What measures of productivity are there other than output per hour? Why is output per hour normally the preferred measure of productivity?
- What factors determine output per hour?
- Why have forecasts of productivity growth rates been revised downwards?
- What are the implications of lower productivity growth for government finances?
- What could cause an increase in output per hour? Would there be any negative effects from these causes?
- What policies could the government pursue to increase productivity? How feasible are these policies? Explain.
- 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
- Explain what are meant by ‘bull markets’ and ‘bear markets’.
- 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.
- What caused the Black Monday crash in 1987?
- For what reasons may global stock markets soon (a) experience, (b) not experience a downward correction?
- Distinguish between stabilising speculation and destabilising speculation on stock markets.
- What determines when a downward correction on stock markets bottoms out?
- Explain how stock market circuit breakers work. Can they prevent a fundamental correction?
- 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
- 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?
- 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?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- 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?
- 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?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?
