This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.
The forecast of UK economic growth for 2012 has been reduced from 1.2% in the previous report to 0.8%. But the rate of inflation is forecast to remain above the 2% target well into next year. However, at the two-year horizon, inflation is now forecast to be 1.6% – below the target, thus giving the MPC scope for further quantitative easing.
In the introduction to the report, the Governor, Mervyn King, writes:
Over the past year or so, two factors have hampered the recovery and rebalancing by more than expected. First, higher-than-expected world commodity and energy prices have squeezed real take-home pay, dampening consumption growth. Second, credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs as the challenges of tackling the indebtedness and lack of competitiveness in those countries have intensified.
And at the news conference launching the report, he said:
We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country’s history, the biggest fiscal deficit in our peace time history and our biggest trading partner – the euro area – is tearing itself apart without any obvious solution.
The idea that we could reasonably hope to sail serenely through this with growth close to the long run average and inflation at 2% strikes me as wholly unrealistic. We’re bound to be buffeted by this and affected by it.
The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states:
Business surveys suggest only a small proportion of firms are operating below capacity. That finding looks odd given the economy’s output is still 4% below its level at the start of 2008, and is much farther below the level it would have reached if GDP growth had continued at its long-term rate. The picture painted by surveys could be right if a chunk of the economy’s potential has been written off for good. But Sir Mervyn King, the bank’s governor, doubts this. There is “no obvious reason” why the economy could not rejoin its pre-crisis path, though it might take a decade or two to get there, he said on May 16th.
We look in more detail at the question of lost capacity in Part 2.
Articles
Bank of England cuts growth forecasts: Sir Mervyn King’s speech in full The Telegraph (16/5/12)
Bank of England sees inflation up and growth falling Independent, Ben Chu (17/5/12)
Hard going The Economist (19/5/12)
Bank of England optimism dented again Financial Times, Chris Giles (16/5/12)
Eurozone is ‘tearing itself apart’, says Mervyn King. True, but the UK’s problems are as intractable as ever The Telegraph, Philip Aldrick (16/5/12)
Inflation Report
Inflation Report: portal page Bank of England
Inflation Report: May 2012 Bank of England (16/5/12)
Additional Data
Statistical annex to European Economy. Spring 2012 European Commission, Economic and Financial AffairsAnnual macro-economic database European Commission, Economic and Financial Affairs (11/5/12) (see particularly section 6.5)
Forecasts for the UK economy HM Treasury
Questions
- What explanations are given for the rate of CPI inflation remaining persistently above the 2% target?
- Why have the prospects for economic growth worsened since the publication of the February Inflation Report?
- How might it be possible to have a narrowing (negative) output gap and yet a stagnant economy?
- Why may capacity have been lost since the financial crisis of 2008?
- Why has M4 declined despite the programme of quantitative easing? (See M4 in record fall despite QE.)
- What scope is there for monetary policy in achieving faster economic growth without pushing inflation above the 2% target?
Just how large is the UK economy and how rapidly is it growing? These were questions we asked, back at the turn of the year, in Getting real with GDP when reviewing economic data for the third quarter of 2010. We update this blog in light of the latest Quarterly National Accounts release from the Office for National Statistics.
The latest Quarterly National Accounts release estimates the value of our economy’s output during Q1 of 2011 at £375.3 million. When measured across the latest four quarters, i.e. from the start of Q2 2010 to the end of Q1 2011, the total value of our economy’s output was £1.472 trillion. Across calendar year 2010 the UK’s GDP is estimated to have been £1.455 trillion.
When analysed in terms of the total expenditure on the goods and services produced in the latest four quarters, household final consumption contributed £931 billion of Gross Domestic Product. In other words, household expenditure over these four quarters was equivalent to 63% of GDP, almost exactly in line with its average since 1948. This demonstrates the importance of spending by households for short-term economic growth. Households help to shape the business cycle.
Another important expenditure-component of GDP is gross capital formation. This is capital expenditure by the private and public sector and is estimated to have been £219.6 billion over the latest four quarters, equivalent to 15% of GDP. As well as affecting current levels of GDP, gross capital formation also affects our economy’s potential output. In other words, changes in capital expenditure can impact both on the demand-side and the supply-side of the economy. Interestingly, the long-term average share for gross capital formation in GDP is around 18% and so about 3 percentage points higher than is currently the case.
So far we have looked at the level of economic activity measured at current prices. But, what about the rate at which the economy is growing? When analysing the rate of economic growth economists look at GDP at constant prices. By doing this economists can infer whether the volume of output has increased. This is important because in the presence of price rises, an increase in the value of output could occur even if the volume of output remained unchanged or actually fell. For instance, in 1974 the volume of output or real GDP fell by 1.3%, but because the average price of our domestic output – the GDP deflator – rose by 14.9%, GDP measured at current prices rose by nearly 13.4%.
The latest ONS figures show that in the first quarter of 2011 real GDP grew by 0.5% (nominal GDP grew by 1.7%). This follows a 0.5% fall in real GDP the final quarter of 2010 (nominal GDP grew by 1.2%). Compared with Q1 2010, the volume of output of the UK economy in Q1 2011 is estimated to have grown by 1.6%.
Exports were the fastest growing component of aggregate demand in Q1, rising in real terms by 2.4%, while import volumes decreased by 2.4%. Export volumes in Q1 were 9.3% higher than a year earlier. In contrast, capital expenditures contracted sharply in the first quarter, falling by 4.2%. This follows on the back of a 0.6% fall in the final quarter of last year. This has reversed much of the strong capital expenditure growth seen during the earlier part of 2010.
We finish by looking at the growth in household spending. In the first quarter of the year real household spending fell by 0.6%. This follows a 0.2 fall in Q4 2010 and zero growth in Q3 2010. This helps to explain some of the difficulties that particular retailers have faced of late. Some context to these disappointing consumption numbers is provided by patterns in household sector disposable income. The sector’s disposable income fell by 0.8% in Q1 2011 which follows on from a 0.9% fall in the last quarter of last year. The result of this is that the household sector’s real disposable income in Q1 2011 was 2.7% lower than in Q1 2010. This was the fastest annual rate of decline since the third quarter of 1977.
Articles
Household incomes sees biggest fall since 1977 BBC News (29/6/11)
UK service sector sees biggest fall for 15 months BBC News (28/6/11)
UK economic growth revised down BBC News (29/6/11)
Service sector output slumps Guardian, Phillip Inman (29/6/11)
Household raid savings as income squeezed Independent, Sean O’Grady (29/6/11)
Poor GDP numbers add pressure on Osborne Guardian, Phillip Inman (28/6/11)
UK economy suffers blow as tepid growth confirmed Telegraph (28/6/11)
Service sector slumps deals heavy blow to economic recovery hopes Scotsman, Natalie Thomas (30/6/11)
Data
Latest on GDP growth Office for National Statistics (28/6/11)
Quarterly National Accounts, 1st Quarter 2011 Office for National Statistics (28/6/11))
ONS Time Series Data Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission
Questions
- What do you understand by the terms nominal GDP and real GDP?
- Can you think of any other contexts in which we might wish to distinguish between nominal and real changes?
- The following are the estimates of GDP at constant 2006 prices:
Q1 2011= £330.724bn, Q4 2010= £329.189bn, Q1 2010= £325.360bn Calculate both the quarterly rate of change and the annual rate of change for Q1 2011.
- What would happen to our estimates of the level of constant–price GDP in (3) if the base year for prices was 1996 rather than 2006? What if the base year was 2011? What would happen to the quarterly and annual growth rates you calculated in each case? Explain your answer.
- Explain how gross capital formation could have both demand-side and supply-side effects on the economy. How significant do you think such supply-side effects can be?
- How important for short-term economic growth do you think household spending is? What factors do you think will be important in affecting household spending in the months ahead?
- What factors do you think help to explain the 2.7% annual rate of decline reported in Q1 2011 in the household sector’s real disposable income?
- The real annual rate of decline in household spending reported in Q1 2011 was 0.5%. Would you have expected this percentage decline to have been the same as for real disposable income? Explain your answer.
“There are ‘incredible economies of scale in cloud computing’ that make it a compelling alternative to traditional enterprise data centers.” According to the first article below, cloud computing represents a step change in the way businesses are likely to handle data or use software. Rather than having their own servers with their own programs, they use a centralised service or ‘public cloud’, provided by a company such as Microsoft, Google or Amazon Web Services. The cloud is accessed via the Internet or a dedicated network. It can thus be accessed not only from company premises but by mobile workers using tablets or other devices and thus makes telecommuting more cost effective.
There are considerable economies of scale in providing these computing services, with the minimum efficient scale considerably above the output of individual users. By accessing the cloud, individual users can benefit from the low average costs achieved by the cloud provider without having to invest in, and frequently update, the hardware and software themselves.
In the case of large companies, rather than using a public cloud, they can use a ‘private cloud’. This is hosted by the IT department in the company and achieves economies of scale at this level by removing the need for individual departments to purchase their own software and servers. Of course, the costs of providing the cloud is borne by the company itself and thus the benefits of lower up-front IT capital costs are reduced. This is clearly a less radical development and is really only an extension of the policy of many companies over the years of having centralised servers holding data and various software packages.
In autumn 2010, EMC Computer Systems commissioned economists at the Centre for Economics and Business Research (cebr) to quantify the full impact that cloud computing will have over the years ahead. According to the report, The Cloud Dividend:
The Cebr’s research calculates that €177.3 billion per year will be generated by 2015, if companies across Europe’s five largest economies continue to adopt cloud technology as expected.
The Cebr found that the annual economic benefit of cloud computing, by 2015, will be:
• France – €37.4 billion
• Germany – €49.6 billion
• Italy – €35.1 billion
• Spain – €25.2 billion
• UK – €30.0 billion
Will the ability of cloud computing to drive down the costs of IT mean that a new revolution is underway? Just how significant are the economies of scale and are they likely to grow as cloud providers themselves grow in size and experience? The following articles look at some of the issues.
Articles
Reports and information
Questions
- What specific economies of scale are achieved through cloud computing?
- Why might the minimum efficient scale of cloud computing services be above the level of output of many companies?
- What are the downsides to cloud computing?
- How would you set about assessing the statement that we are on the brink of a fundamental revolution in business computing?
- Why are customer-heavy sectors, such as financial services, utilities, governments, leisure and retail, expected to buy into the concept fastest?
- How can product life cycle analysis help to understand the stages in the adoption of cloud computing?
The issue of the state of the public finances has dominated much economic-thinking in 2010. This is not just a UK issue, it is a global issue; deteriorating public finances have led to governments around the world making some often very difficult fiscal policy choices. For instance, here in the UK we are continuing to debate the issues arising from the Comprehensive Spending Review which presents the government’s spending plans for the next few financial years. Over in Ireland concerns have resurfaced about the ability of the Irish to finance its burgeoning stock of public debt (see articles below). The fragility of the Irish banking system has meant that interventions by government have been needed to support financial institutions which, some estimate, will see net borrowing by the Irish government this year rise to the equivalent of over 30% of Ireland’s Gross Domestic Product.
The International Monetary Fund’s World Economic Outlook Database is a rich source of information for anybody looking to make international comparisons of public finances. Being able to extract key messages from data and to make economic sense of them is a crucial skill for an economist. But, in doing so it is important that we have an understanding of some of the terms being used by those presenting the data. In this case, to help you undertake your own study of the size of government expenditures, revenues, deficits and debt for countries around the world, we provide a short overview of some of the terms relevant to understanding public finances and illustrate them with reference to a sample of countries.
The IMF’s public finance figures relate not to the whole of the public sector but to general government and thereby exclude public corporations. The general government’s budget balance is presented in both national currency and relative to its Gross Domestic Product. The latter is very useful when making comparisons across countries. A negative figure indicates net borrowing, i.e. expenditures exceed receipts, while a positive figure means that government is a net lender, i.e. receipts exceed expenditures. Forecasts are available for 2010, but, naturally, can be rather unreliable, given that the fluidity of economic events means that they are subject to sizeable revision – Ireland being a case in point.
If we look at the period from 1995–2009 as a whole, the UK was a net borrower with a deficit equivalent to around 2¾ of GDP. Ireland, in contrast, averaged close to a balanced budget with some sizeable surpluses, such as in 2006 when it ran a budget surplus equivalent to 5.2% of GDP. Some countries, such as Australia (0.5% of GDP), averaged budget surpluses over this period. But, the UK’s deficit was not especially large by international standards. From 1995–1999, the USA ran a deficit equivalent to 4.5% of GDP, Greece 5.7% of GDP and in Japan, where several fiscal stimuli have been attempted to reinvigorate the economy, 5.9% of GDP. Nonetheless, the UK’s predicted deficit for 2010 of in excess of 10% of GDP does place it towards the higher end of the deficit-scale, though by no means at the very top!
Another budget balance measure is the structural balance. This attempts to model government expenditures and receipts so as to be able to predict what the budget balance would be if the economy was at its potential output, i.e. that output level when the economy’s resources are being used at normal levels of capacity utilisation. At the moment, for instance, many countries are experiencing a negative output gap, with output below its potential. This puts upward pressure on expenditures, largely welfare expenditures, but also depresses receipts, such as those from taxes on income or spending. The UK is estimated to have run a structural budget deficit equivalent to 2.6% of potential GDP from 1995–2009. With the fiscal measures to support the economy this is forecast to be as high as 7.9% in 2010. Japan is estimated to have run a structural deficit over the period from 1995–2009 equivalent to 5.4% of potential GDP, while in Greece it is estimated at 6.1%.
Another commonly referred to budget balance measure is the primary balance. The primary balance excludes any interest received on financial assets held by government, and, more significantly, interest payments made by the government on its stock of debt. This measure gives us a sense of whether governments are able to afford today’s spending programmes. The UK ran a primary deficit between 1995 and 2009 equivalent to 1% of GDP, while in America and Japan respectively the primary deficit averaged 2.6% and 4.8% of GDP. Interestingly, because of the size of debt stocks in many countries the exclusion of interest makes a notable difference to this fiscal indicator. For instance, Greece typically ran a primary surplus equivalent to 0.9% of GDP.
Budget balances are flows, whereas debt is a stock concept. In other words, budget deficits and surpluses can add to or reduce the stock of debt. Figures are available both on gross debt and net debt. The latter is net of financial assets, including gold and currency reserves. The UK’s average stock of gross debt to GDP between 1995 and 2009 was 45.2% of GDP, but this has risen to over 75% in 2010. In fact, by international standards our public-debt to GDP ratio remains favourable. In Greece, gross public-debt to GDP is predicted to be around 130% of GDP this year, but as high as 225% in Japan.
Finally, consider an interesting case: Sweden. By international standards its public expenditure to GDP share is high, averaging 54% between 1995 and 2009. But, it ‘balances the books’ with a small average budget surplus of 0.2% of GDP and a primary surplus of 0.8% of GDP. Its stock of debt has been falling even in recent times and stands at only a little over 40% of GDP. In 2010, despite the prediction of a small overall budget deficit of 2.2% of GDP, it will continue to run a structural surplus of 0.4% of potential GDP. Hence, Sweden demonstrates nicely the danger of assuming that, in some way, public expenditure necessarily translates into government deficits and, in turn, stocks of public debt.
IMF World Economic Outlook Database
World Economic Outlook Database International Monetary Fund
Articles
Ireland warns jump in borrowing costs very serious Telegraph (12/11/10)
Ireland’s cost of borrowing soars after dramatic sell-off Telegraph, James Hall, (11/11/10)
Imperative Budget is passed – Lenihan RTE News (12/11/10)
Lenihan welcomes EU move to calm markets RTE News (12/11/10)
Irish crisis demands new EU response Financial Times , Mohamed El-Erian (12/11/10)
Britain backs EU rescue missions for debt-ridden Ireland Guardian , Phillip Inman and Patrick Wintour (12/11/10)
Questions
- The IMF’s figures relate to general government. What do you understand by the term general government and how does this differ from the public sector?
- What does net borrowing indicate about the government’s budget balance? What if it was described as a net lender?
- What do you understand by the term structural budget balance? How is this concept related to the business cycle?
- What is measured by the primary balance? Would you expect this to be higher or lower than its budget balance? Explain your answer.
- How does gross debt differ from net debt?
- What factors do you think affect investor confidence in buying government debt?
- Japan’s stock of gross debt is about 225% of GDP while that in Greece is 130%. Does this mean that Japan should have greater problems in financing its debt? Explain your answer.
The growth in money supply is slowing. This is not surprising, given that the programme of quantitative easing, whereby the Bank of England injected an extra £200bn of (narrow) money into the banking system between March 2009 and February 2010, has come to an end.
Should we be worried about this? Has sufficient money been injected into the economy to sustain the recovery, especially as fiscal policy is about to be radically tightened (see the BBC’s Spending Review section of its website)? One person who thinks that the Bank of England should do more is Adam Posen, an external member of the Bank of England’s Monetary Policy Committee. In a speech on 28 September 2010, he argued that the UK was in danger of slipping into Japanese-style sluggish growth that could last many years. The reason is that capacity would be lost unless aggregate demand is increased sufficiently to bring the UK back up towards the potential level of output. Firms are unlikely to want to retain unused plant and equipment and underutilised skilled labour for very long. If they do start ‘disinvesting’ in this way, potential output will fall.
What, according to Adam Posen is the answer? With fiscal policy being tightened and with Bank rate as low as it can go, the only option is to increase money supply. But with CPI inflation at 3.1%, considerably above the target 2%, is there a danger that increasing the money supply will cause inflation to rise further? Not according to Posen, who sees inflation falling over the medium term.
Not surprisingly other economists and commentators disagree – including some of his colleagues on the MPC. The following articles look at the arguments on both sides. You will also find below a link to the speech and to money supply data. There is also a link to the latest Bank of England inflation and GDP forecasts.
Articles
Posen calls for QE to be resumed Financial Times, Chris Giles (28/9/10)
Weak lending data fuel debate on QE Financial Times, Norma Cohen (29/9/10)
Bank of England’s Adam Posen calls for more quantitative easing Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Posen pleads for new stimulus to save economy and democracy Independent, Sean O’Grady (29/9/10)
Bring back the usury laws Independent, Hamish McRae (29/9/10)
Rocking the boat on the MPC BBC News blogs, Stephanomics, Stephanie Flanders (28/9/10)
A Response to Adam Posen The Source, Alen Mattich (28/9/10)
Adam Posen is posing the Bank of England a tricky question Guardian, Nils Pratley (28/9/10)
UK economy: optimists vs. pessimists FT blogs, Chris Giles (29/9/10)
What should the Bank of England do next? BBC Today Programme, Stephanie Flanders and John Redwood (1/10/10)
Interest rates will rise, predicts former Bank of England deputy governor Guardian, Dan Milmo (4/10/10)
UK interest rates on hold at record low of 0.5% BBC News (7/10/10)
Speech
The Case for Doing More Speech to the Hull and Humber Chamber of Commerce, Industry and Shipping, Adam Posen (28/9/10)
Data
Money supply data
Money and Lending (Statistical Interactive Database) Bank of England
Bank of England Inflation and GDP forecasts
Inflation and GDP forecasts (Inflation Report) Bank of England
Questions
- Summarise Adam Posen’s arguments for a further round of quantitative easing.
- How may changes in aggregate demand affect a country’s potential (as well as actual) output?
- What are the similarities and differences between the UK now and Japan over the past two decades?
- Describe what has been happening to the various components of money supply over the past few months.
- What might suggest that the Bank of England was wrong in believing that the trend rate of growth was about 2.75%?
- What are the moral arguments about personal and state borrowing? Should we begin the ‘long retreat from the never-never society’?
- Analyse the arguments against a further round of quantitative easing.
This has been a week of gloomy prognostications. On Wednesday 16 May, the Bank of England published its quarterly Inflation Report – and it makes worrying reading.
The following articles look at the Bank of England’s predictions and at the challenges facing the UK economy as the crisis in the eurozone deepens and as inflation in the UK remains stubbornly above target. They also look at the issue of the extent to which capacity has been lost as a result of the continuing weakness of the UK economy. As The Economist article states: