Memorandum by Mr James Barty, Chief European
Equities Economist, Deutsche Bank
Table 2
CORRELATION BETWEEN UK, US AND EUROPEAN GROWTH
RATES
CORRELATION
COEFFICIENTS (GERMAN
FIGURES ARE
PAN-GERMANY)
|
| UK/US
| UK/GE | US/GE
| UK/FR | GE/FR
| US/FR |
|
| 1992-2000 | 0.40
| 0.13 | 0.39
| 0.13 | 0.69
| 0.54 |
| 1993-2000 | 0.27
| 0.47 | 0.55
| 0.12 | 0.74
| 0.64 |
| 1980-2000 | 0.55
| 0.09 | 0.17
| 0.37 | 0.44
| 0.15 |
| 1981-1992 | 0.46
| -0.04 | 0.15
| 0.47 | 0.23
| 0.05 |
| 1982-1993 | 0.50
| -0.22 | 0.13
| 0.30 | 0.38
| 0.05 |
|
CORRELATION COEFFICIENTS
PUBLISHED IN
1997 HMT DOCUMENT
|
| UK/US
| UK/GE | US/GE
| UK/FR | GE/FR
| US/FR |
|
| 1970-1996 | 0.66
| 0.31 | 0.40
| 0.46 | 0.65
| 0.30 |
| 1979-1996 | 0.56
| 0.01 | 0.17
| 0.38 | 0.49
| 0.10 |
| 1975-1981 | 0.86
| 0.82 | 0.78
| 0.82 | 0.97
| 0.86 |
| 1981-1992 | 0.47
| -0.14 | 0.10
| 0.48 | 0.19
| 0.05 |
| 1982-1993 | 0.52
| -0.30 | 0.11
| 0.35 | 0.42
| 0.06 |
|
Source: HM Treasury, Deutsche Bank estimates
There is an alternative view that while historical data shows
little sign of convergence, we may be on the brink of such convergence
in the near future. That seemed to be the conclusion of a report
published by the OECD on 8 June, which argued that in terms of
inflation, growth, and output gaps, the UK was narrowing the gap
with the Euro area. At face value there is some truth in that,
as can be seen from Figures 18 and 19. However, the major question
that needs to be answered is whether this convergence is superficial
or substantive. To my mind it is the former, as not only do you
need to judge whether economic variables are converging but why
they are converging. As I will outline below, I believe that any
convergence that there has been between the UK and the Euro area
is a function of completely different policy settings from the
central banks. If the economies had been subject to the same policy
settings that convergence would not have happened.
It is worth looking at the economic performance of the UK
and Euro area economies since 1997 to illustrate this point. Superficially
there would appear to have been some convergence between growth
rates in the UK and the Euro area over that period. Both economies
were relatively strong in late 1997 and early 1998 before weakening
markedly in the second half of 1998 and into 1999. Both economies
subsequently recovered through 1999 in response to easier monetary
policy. However behind this apparent correlation were markedly
different policy stances and components of growth. UK growth in
late 1997 and early 1998 was powered by consumer spending, which
rose over 4 per cent in the year to Q4 1997 and Q1 1998. In contrast
the manufacturing sector was struggling from the impact of the
appreciating pound with growth in the year to Q1 1998 falling
to just 0.1 per cent. The overall buoyancy of growth, combined
with higher wage inflation was keeping inflation above the Bank
of England's 2.5 per cent target. The Bank responded to this by
tightening monetary policy both via higher interest rates (base
rates reached a peak of 7.5 per cent in the summer of that year)
and by tolerating an appreciation of the exchange rate. This tighter
monetary policy as much as the impact of the emerging markets
crisis was responsible for the sharp slowdown of growth into 1999.
The Bank of England did, of course, respond to the slowdown by
cutting rates rapidly to a low of 5 per cent in Q2 1999. This
was also accompanied by some weakening of the currency at least
until early 1999.
In contrast, the continental European recovery into 1998
was driven by the industrial sector with industrial production
rising by over 6.5 per cent in the year to 1998 Q1. Domestic demand
in contrast was weak held back by the fiscal tightening implemented
by governments to meet the Maastricht criteria. Although EU-11
exchange rates were rising through 1998, interest rates were falling
as non-core countries cut their rates to the level of the core
countries. Calculations at Deutsche Bank show the weighted EU-11
interest rate falling from 4.4 per cent at the end of 1997 to
around 4 per cent by mid-1998 and to 3.3 per cent by the end of
1998. Monetary policy could not be described as tight through
that period.
Even from the middle of 1999 onwards, as both the Euro area
and UK economies recovered, policy stances could not be described
as similar. As we discussed above, policy remained expansionary
in the Euro area with only the latest rate hikes and recovery
in the currency starting to turn monetary policy tighter again.
In contrast, the Bank of England's policy stance has been tight
indeed, with interest rates moving back up to 6 per cent and the
currency surging to a 15-year high.
If the UK economy had faced the same monetary conditions
as the Euro area over the last 18 months, ie with an undervalued
rather than overvalued currency and significantly lower interest
rates, the situation undoubtedly would have been different. The
UK economy would, in my opinion, be growing much more strongly
and inflation would be significantly higher.
Why the UK economic cycle remains so far apart from the Euro
area cycle is difficult to pin down. To my mind it primarily reflects
the interest rate sensitivity of the UK economy, and in particular
the sensitivity to short term interest rates. The trade differences,
which are often referred to as a problem in that the UK exports
and imports less to the rest of Europe than other countries, are
not so great in my opinion as to generate such substantial differences.
On the latest numbers available it would appear that 58 per cent
of UK exports go to other EU countries against around 62 per cent
for France and 54 per cent for Germany. This seems unlikely to
be a major cause of divergence.
The problem on the debt side is crucially related to the
housing market. Although other countries in Europe have similar
proportions of debt to GDP or home ownership ratios, most of the
debt for house purchase is fixed rate. Indeed, in Germany mortgage
debt as a percentage of GDP was a little over 50 per cent at the
end of 1999 compared to around 55 per cent in the UK, but the
vast majority of that debt was fixed rate. In contrast it is still
the case in the UK (on Deutsche Bank calculations) that over 70
per cent of all mortgages are floating rate. While in recent years
more fixed rate mortgages have been taken out, the proportion
has been largely dependent on the shape of the yield curve. When
fixed rate mortgages offer lower rates than floating rate mortgages,
then the take up of the former increases. This can be seen from
the chart below where the proportion of new fixed rate mortgages
rose to over 60 per cent in 1998 (when base rates hit 7.5 per
cent and mortgage rates topped 9 per cent), subsequently falling
back to a little over 40 per cent in recent quarters.
This means that the UK consumer remains very sensitive to
changes in short term interest rates. Interestingly, the recent
abolition of Mortgage Interest Relief has exacerbated this fact,
as the tax subsidy used to provide at least something of a cushion
against interest rate movements. While on the subject of the housing
market, the last year has demonstrated that the UK market remains
rather volatile with house price inflation jumping above 15 per
cent in Q1 of this year. That inflation rate would have been considerably
higher if UK short rates had fallen as far as Euro short rates
last year.
Although data are harder to track down for the corporate
sector, there has traditionally been a floating rate bias in bank
lending for corporates, particularly small and medium sized enterprises.
While there are more sophisticated measures available to such
companies these days, such as swaps and caps, to hedge their interest
rate exposure, it is still likely that the corporate sector in
the UK is more exposed than its Euro area counterparts to short
term interest rates.
All of which strongly points towards the fact that the answer
to the Chancellor's first question of whether the UK can live
with Euro area short rates remains no at the current time. Moreover,
there is little evidence that the last few years have seen much
of an improvement. I would argue that if it had not been for the
strongly disinflationary effect of sterling in recent years, UK
interest rates would have had to rise much further to control
the domestic economy. Indeed, if sterling does extend its recent
fall and move back closer to its equilibrium rate, which is probably
at least 10-15 per cent lower than current levels, then UK interest
rates will have to rise further and remain significantly above
those prevailing in the Euro area.
(b) If problems emerge is there sufficient flexibility
to deal with them?
If the UK economy is likely to find it difficult to live
with Euro area interest rates the question is whether there is
flexibility elsewhere in the economy that can compensate. In its
1997 assessment, the Treasury focused on labour market flexibility
and to a lesser extent product market flexibility. It concluded
that "persistent long-term unemployment, lack of skills and
in some areas insufficient competition, indicate insufficient
flexibility to adapt to change". In this area I would argue
that there has been some improvement in the last couple of years.
Long term unemployment has dropped from a high of over one million
in 1993 to less than half a million now. Moreover, long-term unemployment
has been falling as a precentage of total unemployment from almosts
45 per cent in 1994 to less than 28 per cent now. Estimates by
my colleagues at Deutsche Bank also suggest that the NAIRU has
fallen significantly in recent years to around 5.5-6 per cent,
although the current unemployment rate on the claimant count (which
the work relates to) is actually under 4 per cent.
Skill problems are still evident in some areas of the economy,
notably in high tech areas, and when the economy has been running
at a high rate the surveys have shown problems in recruiting appropriate
staff. Nevertheless, in the UK, the fact that unemployment has
fallen sharply, indeed to a 20 year low, without triggering a
major pick up in wage inflation does suggest that the labour market
is more flexible.
In terms of the product markets the advent of the internet
and the IT revolution is opening up markets to ever more competition.
This can be seen clearly in areas such as car sales, banking,
utilities, insurance and retailing. Indeed it could be argued
that the UK is in the lead in many of these areas in Europe.
This flexibility in product and labour markets is not strong
in many Euro area countries. Labour market flexibility is markedly
less, as is evident in the much higher estimates for natural rates
of unemployment in the Euro area countries. Arguably that means
the UK would be in a better position to absorb adverse shocks
inside monetary union. However, in my opinion this flexibility
is not sufficient to compensate for the fact that Euro area interest
rates would be inappropriate for the UK. This is the case even
if we take into account the fact that the UK's very comfortable
fiscal position would give it room to adjust policy to offset
some of the effect of inappropriate monetary policy.
(c) Would joining EMU create better conditions for firms
making long term decisions to invest in Britain?
Given the conclusions to questions (a) and (b) that the UK
isn't ready for EMU from a macro perspective, the answer to this
question would appear to be "no" as well, at least for
now. There is, however, one major counter argument to this, namely
the effect on inward investment of the UK staying outside of EMU.
In my opinion, the longer the UK stays outside of EMU the less
attractive it becomes for foreign companies seeking a European
base. The major reason for this is the exchange rate instability
that remaining outside of EMU brings. To be sure the UK has many
other advantages, lower taxes, more flexibile labour markets etc,
but the currency volatility of the last few years is likely to
prove to be a major deterrent to inward investment going forward.
(d) What impact would entry into EMU have on the competitive
position of the UK's financial services industry, particularly
the City's wholesale markets?
Staying outside of EMU seems to have had little adverse effect
on the UK financial services thus far, with the major investment
banks continuing to focus on London as the key financial centre.
There are probably some areas where the City has lost its lead,
but whether this can be attributed to the single currency or other
developments is unclear. In my view, entry into EMU would help
the UK financial services industry, if only at the margin. Staying
outside would not be a major problem either.
(e) In summary, will joining EMU promote higher growth,
stability and a lasting increase in jobs?
Given the answers to the previous questions I would have
to conclude that joining EMU now would probably not promote higher
growth, stability and a lasting increase in jobs. Developments
since the Treasury assessment of 1997 have not really changed
enough for there to be a different conclusion at the moment.
CONCLUSION
If the government wants to ensure macro economic convergence
with the Euro area, it needs to be more proactive and cannot rely
merely on the attainment of economic stability to generate covergence.
Two areas in particular need to be addressed. The first is currency
stability. In my opinion, if the UK is to be sure of a successful
entry into EMU, it needs first to have a sustained period of currency
stability. That would involve either a change in the Bank of England's
mandate or even entry into ERM2. The second is the sensitivity
to short rates. My main concern if the UK joined EMU would be
that short term interest rates would be inappropriate; an obvious
way to offset that is to make the economy much less sensitive
to short term interest rates. That would require active incentives
for the lenders to provide longer-term finance both for mortgage
and other types of debt. Until these two issues are solved, the
UK economy on any objective assessment is likely to continue to
fail the Chancellor's tests.
9 June 2000
| 
