Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20 - 39)



  20. With the benefit of hindsight, do you think policy has been set optimally given what we know about these provisions?
  (Mr Walton) The proof of the pudding is in inflation. At the end of the day the MPC is obliged to try to hit the inflation target. They have made a pretty good job of that over the past few years. I would find it very difficult to be critical of the MPC given the mandate they have been set, given the actual performance of inflation—particularly if you look at inflation historically compared with the last several years. There certainly does seem to have been some step change.

  21. Could I ask Roger what his thoughts are on David Miles's capital stock point? Do you think it is an interesting point to probe or less important?
  (Mr Bootle) Yes, I think I do. I very much agree with what he said. The implication ought to be that there is more spare capacity in the economy than was previously thought. In a sense, that goes some way towards an explanation as to why inflationary pressures have turned out to be lower than some members of the Committee imagined they would be, given the secondary-market rates that I have indicated. To a great extent, it may have indications for the immediate prospects for productivity growth and the sustainable growth part of the economy going forward.
  (Mr Walton) There is one simple thing which is that capacity can sometimes be too much of a good thing. One reason why the US is slowing so sharply is that they over-invested in the 1990s, the capital stock was growing too rapidly. A lot of that was done on the expectation of unrealistic expectations of the return that could be generated, and now we are seeing some results of that. I do not think the revisions are significant enough to mean that that is going to happen in the UK, but it is always a small risk.
  (Mr Walton) Perhaps it is worth asking the Committee how they see the comparison with the UK's position with regard to capital stock and what is happening in America.

  22. Could I finally ask for your views on what has been happening to productivity in the UK in the last four years, what the MPC's view on productivity has been and what assumptions they are making in the future? This really goes to the heart of the `new economy' debate. I have been puzzled by what we have heard from Treasury officials on this. I wonder what your assessment is of what is happening to productivity, what is likely to happen, what has happened in the last four years, and how this has affected the attitude to monetary policy?
  (Mr Walton) The productivity performance has not been great in the past four years. I think we would have hoped it would have been somewhat better, given these `new economy' type considerations. I think it is going to turn out in the US as well actually that the productivity performance, when we look at the entire cycle, is not going to be as good as some people were saying a year or so ago. I think the interesting test is going to come from now on, in a sense, because at least in the case of the UK I think productivity growth was depressed while unemployment was falling so sharply. If you remember, there has been a very substantial fall in unemployment rates during the last five to ten years in the UK. We are now arguably getting to levels where unemployment cannot fall anything like as significantly, so we are going to get a much clearer picture, hopefully, over the next few years, as to what the underlying productivity trend is and whether it really has improved. The problem always, of course, is that the cyclical fluctuations in productivity tend to be so big that it is actually quite difficult to know what the underlying trend is until quite some time after the event, and to the extent you get these upward revisions to output which, by implication, would imply higher productivity as well, again it makes the picture very difficult to read. So I think my conclusion would be that there would be a hope that some of these `new economy' factors rub off and lead to some increase in the underlying growth of productivity, but I would be a bit sceptical as to just how significant that trend could be. You could be talking of the order of ¼ per cent on growth rather than 1 per cent really, but it is actually going to take quite a bit of time before you can really tell what the true picture is.
  (Professor Pissarides) Perhaps I can say something about interest rates. The key issue here is whether the gains of productivity that we had over the last four years—and not only in this country, but in the United States—were cyclical, because the cycle happened to be so much better than previous cycles that we had, or whether they are `new economy' gains that will persist. I am sure the truth will come out somewhere in between. Given this inevitable slowdown now, the current one, if anything we have been shifting the direction that it was more a cyclical gain, and the `new economy' gains are not as big as we had suspected before, especially in services, I should add, in the so-called office revolution productivity is not really something that has increased from what it was previously as conventionally measured. The quality of office work may have increased because computers give you a much better output, but you do not need fewer hands or less time. So in terms of productivity gains that we are seeing in statistics, the answer is probably that there will not be as many gains that will remain in the economy; it is more a big cyclical expansion that was giving us the productivity gains that we had, rather than a permanent rise in the underlying productivity trend.
  (Professor Miles) I am sure that is right. If it is true, it is worrying. There is a picture on page 31, chart 3.14, which is a measure of productivity growth over the last five-and-a-bit years, which has been the upswing of a cycle for the UK. That productivity growth seems to me to average about 1½ per cent. It fluctuates a bit, and it increased a bit in 2000, but the average over this long period was about 1.5 per cent. If part of this performance is a reflection of a cyclical impact because we have been going through a quite steady growth phase, and actually underlying productivity is not growing at this rate, then it is a very depressing picture—it is less than 1.5 per cent.
  (Mr Bootle) Do you not think we ought to be pretty sceptical about these numbers, like all others?

Mr Tyrie

  23. Particularly in respect of productivity.
  (Mr Bootle) Yes. Of course, there is the doubt about output, and we have already discussed that. More importantly, there is the debate about the number of people employed. I must say, that is an extraordinary thing for economists to be debating, but I think the problem does really reside around what do you do with part-time workers, how you properly account for them? So I suspect that there has to be a real chance that productivity growth has done a great deal better than that.
  (Professor Miles) I hope you are right.


  24. I was going to ask how reliable are the productivity figures? I was at a seminar last week where it was said that the labour productivity gap between the UK and the USA is 41 per cent, between the UK and France it is 11 per cent, and between the UK and Germany it is 7 per cent. These figures just trip off the lips, but how reliable are these figures?
  (Professor Pissarides) The actual figures are not reliable because they use different measures. For example, if you take hourly productivity, how much output is produced per hour, we are better off in Europe than in the US because they work so many more hours a year than we do in Europe, especially in continental Europe, France, Germany and so on. If you look at productivity per person, it is higher in the US than what it is in Europe. So it is not surprising. It is not that statisticians do not necessarily know how to measure this. There are many different ways of measuring productivity, and of course when we talk about it we do not qualify it and talk about productivity per hour, productivity in such-and-such an industry. What is reliable is the rate of change of productivity, because we use the same definitions year in year out in computing the statistics. So to show, for example, in this figure that was mentioned before, in chart 3.14, that productivity had its ups and downs in previous cycles and then suddenly in the last four years it jumped up, and is it `new economy' or is it a permanent underlying rise, is a fair question to ask. This is a reliable figure. What is unreliable perhaps is how high it stands in this chart, but the ups and downs that we see, the cyclical fluctuations and the underlying trends, I would think are reliable.
  (Mr Walton) The other thing is do not particularly believe the official statistics published by statistical authorities, because those data are pretty unreliable and they do get revised, but there are quite a number of economists working in this field who do quite detailed cross-country studies comparing industries in different countries, and the broad qualitative result comes through that Britain's productivity level is lagging behind, particularly behind the US and some European countries. So whether the numbers are precisely right, who knows, but, as I say, if you take some of the more detailed micro-investigations where you look at the productivity of, say, one industry in the UK versus other countries, that gives you a pretty good handle on productivity performance qualitatively.

  Chairman: Going on to the international economy and the exchange rate, do any of my colleagues wish to mention that? If not, I shall put the first question.

Mr Plaskitt

  25. I want to come back to the overall picture. The consensus emerging amongst the four of you is that the MPC was a bit too upbeat about things. That is what we are hearing from you. Let me play devil's advocate on their behalf for a minute and test some of the things you have said. If you look, for example, at the US economy, at the moment there are negative real interest rates, a fiscal stimulus coming out of considerable proportions. If you take the UK economy, there is very strong consumption performance, a fair bit of fiscal stimulus as well, higher real interest rates, but historically quite low nominal rates. None of you has made very much about falling oil prices, but they have fallen a lot, and there are some predictions that they will fall a lot more than is normally the case, which is a bit of a counter consideration for the oil producers, but for the larger consumers that is a significant stimulus. Those are pretty big pluses out there, and they may be in the minds of the MPC when they talk about the prospect of the early, speedy recovery from this. Let us throw into the pot something David said earlier on which was quite interesting, about psychology. The very sudden, sharp drop-off in confidence in the US came after the terrorist attacks. Would it be right to say that the day the newspapers say, "Bin Laden Captured" or "Bin Laden Shot", then the Americans will say, "Right, that's that problem sorted out, now let's get down to business"? Are these not factors which could mean that quite logically it could quite quickly bounce back? Are these not factors which would suggest that we are not necessarily on the edge of some long slump in activity, but that in fact some of the signs of the stimulus that we have to look to be there are already there. On the UK economy, we have evidence in the Inflation Report, pages 8 and 9, about levels of borrowing. It says that total lending to individuals is growing at 10.1 per cent, the highest rate since 1991, total unsecured consumer credits increasing at 12.9 per cent. On the housing market, elsewhere—Roger, in your paper I think you talk about a sharply slowing housing market—there is no sign of that in what the MPC are telling us in the Inflation Report; it talks about some cooling, some easing back, which is significantly different language from "sharp slowdown". Perhaps I can finally make this point and add it to the pot—and I do not mean to be flippant—that the most recent evidence is from me last weekend, when I first of all visited a retail park in Bicester and it was literally bursting at the seams. The car park was full, the overflow car park was full, they were opening up fields in adjacent farming areas to take additional traffic.

  Mr Cousins: Where is this unfortunate place? I must avoid it!

  Mr Ruffley: It is full of Ralph Lauren shops.

  They were telling me it was their busiest and fullest weekend since they opened some years ago. Let me give you my final piece of anecdotal evidence. Earlier in the day I went to an art exhibition of moderately good art work. Buying pictures is arguably the most discretionary bit of spending anyone does, a totally unnecessary piece of consumption. The pictures were flying off the wall. The artists could not believe what was happening. Let me throw all that at you. Are you sure that your collective pessimism is rightly founded?
  (Mr Walton) Let me say, I do not have a view on the arts bit of it, but I do not disagree with much of what you said, that there are things happening which will generate recovery as we go forward. All of those things are likely to lead to some recovery in activity. Our forecasters in Goldman Sachs, for instance, have the world economy essentially in recession through to spring 2002 and then we have a recovery taking place thereafter, but you still end up with the US economy declining in 2002, you still end up with the UK only growing by about 1½ per cent, which in all cases is below trend growth, creating a slackening in American inflationary pressure. Central banks have responded to that. I think it is also important to bear in mind that if we end up with the US essentially just being flat between 2001 and 2002 on average, that will rate as one of the mildest downturns in the post-war period of the United States economy. So we should not forget that recessions do happen. As Chris said, we may not understand why they happen, but they do happen. What we are still seeing at the moment is just one of the mildest downturns on record in the post-war period. So I think it is important. Maybe we have sounded a bit too pessimistic, and I think that essentially the near-term outlook is still pretty gloomy, but there are factors in place that should generate recovery, and the behaviour of monetary policy is a key ingredient of that. If we did not think there was going to be any recovery as we go through the course of next year, then interest rates should not be stopping at around 4 per cent, and indeed the MPC should not be publishing forecasts which show the economy growing anywhere close to trend. If we were genuinely in a situation where the economy was not going to grow at all, then inflation would come in at a lot lower than we have seen to date. So I think it is important to distinguish between those two things. As you say, a lot of things have happened which should help to generate recovery as we go through the course of 2002.
  (Mr Bootle) I think it is largely a question of balance. I very much agree with what James Plaskitt had to say. That is the sense in which, it seems to me, the judgement of the MPC is right that the UK is unlikely to suffer an outright recession. I keep meeting people, businessmen, who are so gloomy they think a recession in this country is inevitable—they are coming at the issue from the other side of the question. I think the key to the balance is perceiving the different position of consumers on the one hand and manufacturers, if you like, on the other, but there are others and other parts of the economy that are hard hit. Look at the manufacturing situation. It does look really very serious indeed. The surveys are dreadful. Recent output performance has been pretty poor. As far as exports in particular are concerned, surely there is going to be a very significant hit to manufacturing. So all that is going to have a pretty big knock-on effect. Then, of course, there is something which we have not talked about at all so far, which is the position of London as a whole and the big financial sector employers in particular. There is no doubt that the London economy is suffering quite significantly from the world slowdown, and the financial markets are suffering both for that reason and other factors. So I do not think it ought to be difficult to point to places, whether it is art sales, the car parks or whatever, that are doing well in this particular set of circumstances, but that does not mean to say everything is going to be fine.
  (Professor Miles) I think it is a question of probability. I think the Inflation Report is quite right to echo many of the things that you have just said. There are possible scenarios where growth picks up very strongly, and GDP grows quite strongly in the next few years. What I think is slightly strange about the Inflation Report are these probabilities being asymmetric. Let me point out one thing in the report. Going ahead a couple of years to the end of 2003, they have probabilities of what growth in 2003 will be. This is page 56, table 6.8 at the bottom of that page. There is perceived to be a 39 per cent probability that growth will be more than 3 per cent in 2003—39 per cent—and a 7 per cent probability that growth will be less than 1 per cent. My own view is that it is not daft to think that there is a good chance that growth will be more than 3 per cent, but it is daft to say that there is six times as much probability that will be true as that it is less than 1 per cent.
  (Mr Bootle) I agree with that.

  26. Why do you think they have that view? If you think it is so daft, why do you think these reasonably intelligent people have come to this conclusion?
  (Professor Miles) Perhaps "daft" is a bit strong. I think it is surprising. I do not know why they attach such small weight to weak growth. That is not even negative growth, this is just less than 1 per cent, which would be considered to be a very mild slowdown, and yet the probability here is perceived to be extremely small. I think that is a good question to ask.

Mr Tyrie

  27. About 15 years ago or more the Treasury used to add an element of aspiration into the forecasts because of their effect on expectations. I would be interested to know whether anybody thinks there is still an element of aspiration in what the MPC put out?
  (Professor Pissarides) I do not think I would be too optimistic about the MPC's own actions and their own ability to control the economy and stop it going into recession, because what they are saying now is that you should look at consumer liquidity, ignore consumer confidence because it is volatile, consumer liquidity is high, retail spending is not suffering very much, as we saw, and the world is doing something about the recession, the United States is taking aggressive action and Europe is showing that it will take action. So they are saying that if they themselves take action and reduce interest rates, then there is no reason why the economy should go into recession. I think that is essentially what it is. It is not wishful thinking, it is more confidence in their own ability to control the economy, I think. That is something you might want to ask them; also, the fact that the alternative is, should there be a recession? There just is not any reason why there should be a recession two years from now. This is one of the things where I agree entirely with David. There is an asymmetry there. I am not surprised that is there. What surprises me is maybe the extent of the asymmetry. I can see why they would want to attach only 1 per cent probability to an outright recession two years from now. I would be extremely surprised if there is a recession two years from now. I would expect a slowdown in 2002, yes, but in 2003 I would expect the economy to pick up.

  28. Do you think that if they agreed with you that the downturn could be quite severe, they would put that into a report in those stark terms?
  (Professor Pissarides) No, because that would be like a criticism of their own ability to do something about it.

  29. So there is an element of aspiration about it, is there not?
  (Mr Walton) I think the question-mark is more about the next couple of quarters. There is nothing practically that the MPC can do about those quarters, so it might as well be reasonably honest about it. It is just making a judgement, I think, that the policy easing that we have seen has been quite aggressive and things are perhaps not as bad in the near term as most of us here are suggesting. I have no problem with them thinking that the economy will recover quite strongly on a two-year review, because it is consistent, in a sense, with their mandate. They have to believe that inflation is going to be broadly close to target in two years' time, or else that would imply that they should be doing something about it now on interest rates. If they believe that inflation can be broadly on target in two years' time, that ought to mean that the economy is somewhere close to trend. If in the very near term they think the economy is going to be growing a little bit below trend, then they ought to have an expectation that by their policy actions the economy at some point is going to have to grow a little bit faster than trend in order to get to that level.

  30. In which case there is a depressing circularity about the way they arrive at policy.
  (Mr Walton) Indeed, but that is going to be their thought process, and that is how it gets reflected in their forecasts at the end of the day. If they genuinely thought the economy was going to be a lot weaker, then arguably they should be taking more aggressive action on interest rates now in order to ensure it does not turn out to be so.
  (Mr Bootle) On the point about the Bank believing in its own abilities to prevent a recession, that may well be right psychologically, but I do not think formally it can stand up, because the table is put together on the assumption of constant nominal interest rates; in other words, they were assuming that they do not reduce interest rates any more, and they still come up with the figure, as David pointed out, of a 7 per cent chance of being less than 1. I agree with his judgement. Without saying it is daft, I think it is pretty striking.

  31. That will be a very interesting theme for our inquiry. Perhaps I can raise one other point. Most of this report is predicated on the view that things will not be too bad in Britain, because the exchange rate is going to go up a bit and there will be a big jump in global activity driven by measures taken to boost the US. Could I ask you about the US position, picking up what Mr Plaskitt said about zero interest rates? Without thinking of exceptional measures, it strikes me that the US could be quite close to having fired the shots in its locker, all the reasonable ones—tax cuts, cuts in interest rates, there is some increase in defence spending taking place as well at the moment. How much more leeway does the Fed have to cut rates further? What action is available to the authorities? What risk is there of deflationary traps?
  (Mr Walton) I would say on that the US has started from a position where it is running a budget surplus, interest rates are around 2 per cent, so there is still some scope for rates to go lower—they may not be so effective, but bear in mind they have already cut rates by 450 basis points this year—but keep in mind that recessions do happen, and that sometimes, particularly after you have had the longest period of expansion in the post-war period, it would not be surprising to see a year or two in which the US economy performs quite poorly. In particular, the worrying balances that were built up in the private sector. We have talked about the-over-investment already, but arguably there has been some over-consumption by households as they saw the big increase in financial wealth during the 1990s, borrowed against it and spent, and have not necessarily fully adjusted to the fall in wealth that has taken place over the past couple of years. Some of these judgements have to run their course. It is quite typically the case that during downturns US companies in particular end up having to finance all their activities out of their own resources, whereas at the moment they are still borrowing at about 3 per cent of GDP each year in order to finance their activities, so that almost certainly means, I think, that many companies will need to cut back further on investment and, indeed, almost certainly on jobs. As they do the latter, that is almost certainly going to lead to some retrenchment by households. The Federal Reserve has done the best it can to try to make sure this is as smooth and as modest an adjustment as possible, but once you set these adjustment forces in train, then quite often they just have to run their course and quite often, as we know from the UK in the early 1990s, these balance sheet adjustments can go on for longer and be more severe than you ever expect. So I think it is important to distinguish between the normal business cycle of behaviour, and it would be wrong to say that policy-makers had failed just because they have not been able to deal with extraordinary phenomena. Where they will have failed is if the US gets stuck in the low inflationary growth trap which Japan has been stuck in for the last decade, but it would be wrong to conclude that, I think, at this stage, and it would be wrong to conclude it even if the US turns out to have an even worse growth performance next year than most people think.

  32. Perhaps I could follow up on that point. You would argue—and I think the evidence is overwhelming—that the asset price imbalance in the United States is far less than in Japan. It is far less to unravel, and the banking sector is much stronger.
  (Mr Walton) The banking sector is much stronger, yes. You did not have the same wobble in land prices that you had in Japan. I would fully expect US policy-makers to learn from the experience of others and actually try to make sure that they do not get stuck into this deflationary type of trap.

  33. What extra measures can they take? This is the nub of my question. Let us take a bad-case scenario. Suppose things are worse than we think and they go right to the bottom? What are the actions, what are the policy measures that are available?
  (Mr Walton) On the fiscal side, we are still in a position where the US is running a budget surplus. It is proposing a fiscal easing of somewhere between 1½ to 2 per cent of GDP next year. That will still leave the US's finances in reasonably good shape. On the monetary side, interest rates can certainly fall further in the US. If it turns out that the US economy does start to suffer deflation, then some of the more aggressive means of expanding the monetary base would have to come under consideration. Those are things which I think can be kept in reserve for the moment. There is still quite a bit of probability in all of that.
  (Mr Bootle) On that score, US rates are currently 2 per cent, so they have got 200 basis points to go before they get to zero, so I think there is a fair amount of room left. It is worth noting that zero rates are not just a Japanese phenomenon; the US had zero interest rates in 1939, so you will actually only be returning to a situation which they experienced before, although in rather different circumstances. It seems to me that the speed of interest rate reduction is critical. This is what is so dangerous about the deflationary process as we have seen in Japan. If they delay, then the disinflation picks up speed, so the inflation rate falls very rapidly, but if the inflation rate is falling faster than they are cutting it, then real interest rates are rising. One thing that is quite clear from the US Fed's behaviour this year is that they are not backwards in coming forwards; they are pretty proactive and rapid, they do not mess about and are unlikely, I think, to be overtaken by events in the way the Japanese authorities were. I therefore agree with what David said about the scope for further US expansion. I do not think they have shot their bolt, and I think it is perfectly possible to imagine further fiscal stimulus. On the point about inflation, though, it seems to me that there is a serious risk, which policy-makers in the West must take seriously. For a long time it was impossible to use the "d" word without people thinking you were in some sense mad, because in all the textbooks deflation is incredibly easy to cure. So indeed is everything else: inflation, lack of growth, productivity, it was all dead simple. In practice, deflation is actually quite difficult to get out of, because, like high rates of inflation, it is deeply rooted in psychology and institutional structures. The whole Japanese experience makes it perfectly clear that it can be extremely difficult, so I think that is an important reason as to why the Americans should act boldly and soon, as I think they will. One last comment on that is that whilst it is not directly under their control, one way they could, and I suspect they will, ultimately ameliorate their situation is by allowing, perhaps even encouraging, a depreciation of the dollar exchange rate. People have been saying for ages that the dollar is over-valued and forecasting a fall, and of course it has not happened. It seems to me that the dollar is indeed over-valued, and equilibrium requires a much weaker dollar. Quite how it will come about I cannot say. One can imagine that the things we have talked about already in terms of cuts in interest rates, the Fed acting very boldly, might well bring on a sharp downward move of the dollar. That would put upward pressure on the US price level and it would also increase demand for US output. But this is a zero sum game. To the extent that causes America to avoid deflation and a weakening of their performance, of course, it is exporting its problems to other parts of the world. The prime candidate in this context, I guess, must be the European Union.
  (Professor Pissarides) On the US options, I think the only realistic option is a fiscal package if there is further evidence of deflation. On this and how it is going to affect the rest of the world and the British economy in particular, I think we should be optimistic, because again drawing on the Japan lesson, if you recall, five or six years ago Japan had problems, and Larry Summers was shuttling between Tokyo and Washington trying to persuade the Japanese to go for fiscal expansion. I realise he is no longer in the State Department, but unless there has been a sea change in the US fiscal policy, or unless the US officials have not learned any lessons from what Larry Summers was prepared to do, then I think there is a risk that if there is deflation there will be a fiscal expansion package that will help the world economy. On the dollar, I hope for Europe's sake that we do not go the dollar route, because if the dollar is to depreciate, it is going to depreciate against what? The yen obviously cannot afford it. The euro already they are saying will appreciate on its own accord because it has gone too far, so the only depreciation of the dollar will be against sterling and the euro, and that certainly will not help Britain and the rest of Europe.

Mr Cousins

  34. Do you think there is any reason to be concerned about the Argentina syndrome—not that Argentina in itself is of probably great importance, except of course to the people unfortunate enough to live there—but the income stream of Russia and a lot of the OPEC countries clearly taking a knock, private-sector capital flows to emerging markets clearly taking a downturn? Is there a source of any anxiety for you there?
  (Mr Bootle) Yes, I think is the answer. We heard earlier on about how lower oil prices are good news for the British economy, and that is undoubtedly right in all sorts of ways, but there are a few Doonside, and the impact on Russia is one of them. Let us not forget—it is amazing how short memories markets have—in 1998 they were worried about something that arguably originated in Russia bringing down the whole financial system. That was largely because of the weak level of world oil prices and the consequent weak state of Russian public finances. Why Russia has suddenly disappeared off the radar screen in the last couple of years is, funnily enough, because oil prices have been high. If oil prices were to end up very low, then I think we would again find that this led to problems in Russia. Argentina is probably completely different, but I think it would be very rash to assume—and Turkey would be another country which would be extremely vulnerable—that our financial system is sufficiently strong to take knocks from defaults or whatever other major financial shocks you care to name from those countries. These are things which are usually readily absorbable in normal times, but we do not appear to be in normal times. I should have thought that the particular vulnerability of those key countries is a major thing which could yet again unsettle financial markets at a very vulnerable moment.

  35. Several of you have said that you think there are members of the MPC who are very concerned about the possibility of a sudden, rapid depreciation in the value of sterling and the inflationary consequences of that, and that thinking may underpin some of the contradictions which we have been addressing. If one were to be one such person, which would worry you more: a continued increase in public spending in, let us say, health and education, or the introduction of new tax-credit-type fiscal policy measures which, of course, can always be dressed up as expenditure reductions?
  (Mr Walton) If you were concerned about a fall in the exchange rate, it would be because growth in the economy was too strong in the first instance, and you would then have a situation where a weaker exchange rate gives a further boost to demand and you get inflationary pressure. If you are in an environment, as I think we are going to be in the next two or three quarters, where the economy is growing at below trend, I suspect that policy makers will end up welcoming the fact that, perhaps more by luck than judgment, we have a fiscal expansion hitting the economy at the moment which is every bit as large as anything the US economy is facing and ultimately the exchange rate turns out to be a bit weaker, and this is part of the easing in policy conditions that you would want in an environment where the economy is growing below trend. If it turns out that the economy rebounds too strongly, then the Monetary Policy Committee would be obliged to react to that by raising interest rates; that is their job.
  (Professor Pissarides) The problem if there is a depreciation of sterling and then tax credits at the same time is that most spending will be consumer spending on imported goods and that gives balance of payments problems, whereas more public spending in the domestic economy is likely to be more effective because it is money actually spent whereas you do not know if the tax credits will have the desired effect or whether it will be an indirect effect. So if you look at the overall picture, what we are concerned about is what is happening in foreign exchanges and depreciation, and I think public spending would be more effective in stimulating the domestic economy than tax credits, if that was your question.
  (Professor Miles) I was going to make a brief point about the contrast between big increases in public expenditure and significant depreciation of currency in terms of their effect on inflation. The exchange rate decline would do two things which are to some extent inflationary. One is it would tend to increase demand pressures in the UK and the other one, probably more important, increase costs of imported materials. I think it is much less obvious what the longer-term net impact on inflation is of public spending because if large amounts of public spending are going on public services, health and schools, that is investment spending. It is increasing productive capacity, with a lag, of course, but nonetheless it is increasing both the demand and supply side of the economy.
  (Mr Bootle) I do not think I have got anything to add on the public spending side but on the depreciation aspect of your question there is something worth saying, which is to the extent that the Monetary Policy Committee is worried about a generalised fall in the level of sterling for UK-specific reasons I wonder if it is not exaggerating the risks. If you said to business people, "Is sterling terribly strong?" they would surely ask the question, "Against what?" The truth of the matter is it is not incredibly strong against the dollar. It is incredibly strong against the euro because of the relationship between the dollar and the euro. There is some chance of independent weakness—so the pound could fall by 20 per cent, let's say, against all currencies—but in my judgment it is unlikely. The major currency adjustment which the MPC fears is likely to be something that occurs in the course of a downward movement of the dollar and an upward movement of the euro, with the pound piggy-in-the middle. If you ask yourself how the inflationary impact is likely to pan out in those circumstances, it seems to me it may be quite different from circumstances in the past when the pound has fallen by a very large amount against the dollar, for a couple of reasons. First of all, although we do clearly import large amounts of manufactured goods which are denominated in euros and effectively economically determined in euros, it is still the case that the influence of the dollar is greater on our import costs, so there could be some favourable cost impact of sterling going up against the dollar, but the second thing, it seems to me, is that if the pound goes down a lot against the euro in this context you would of course be making those parts of British industry which are directly in competition with European-based producers much more competitive. These are the very parts of the economy which are in a serious position at the moment. These are the ones who are shedding labour, under massive pressure, output contracting, or with very slow growth. My own judgment is that in those circumstances they would have the capacity to respond to increased demand, made possible by the lower exchange rate, and so the inflationary impact of a lower exchange rate in these circumstances is likely to be a good deal lower than it might have been in the past.

Mr Laws

  36. I want to follow up that point on the exchange rate. We have already discussed the assessment in the Inflation Report that says: "At some point, the growth in external debt could prompt a re-assessment of the value of sterling. In consequence the Committee continues to judge that the balance of risks is for a sharper depreciation than in the central case," and that there would then tend to be an additional boost to domestic prices. Would all of you agree or disagree with the proposition that against the euro in particular the pound is "over-valued". If you do, can you see the constellation of circumstances that will cause that to be corrected in the near future?
  (Professor Pissarides) I would agree that the sterling/euro exchange rate is not what I would consider to be on an equilibrium. Sterling is over-valued but only because the euro is under-valued. The euro is still suffering from problems that it had when it was first launched. This summer there was a report by the IMF of those problems as being more European issues that would tend to reduce the value of euro. With many currencies coming together, a lot of funds realised they had too big a proportion of their investment in euros and they tried to move out. All those factors are more like the teething problems of introducing a new currency and now they are on their way out, so I think the euro will appreciate for those structural and financial reasons rather than anything else happening to the European versus UK economy and we will get back to balance, but I would agree that the sterling exchange rate is still too high compared to the euro because of the euro's problems.

  37. Do you think that this correction will be led entirely by the timing of a recovery in the euro rather than the UK's domestic circumstances, in particular the balance of payments going into significant deficit, prompting a revaluation of the pound?
  (Professor Pissarides) That is a lot more difficult to answer but on balance I think it would be led by the recovery in the euro and financial structural factors affecting the euro rather than be led by UK policy.

  38. Would you care to speculate on how much the trade weighted value of the pound might therefore need to fall in order to correct the over-valuation against the euro?
  (Professor Pissarides) I think market watchers would be better speculating on that.
  (Mr Walton) You have to think about this in the context of what is happening in the economy as a whole, which is the UK economy, until very recently, has performed well in comparison with other major economies in overall GDP growth, and part of the reason is you have a very strong financial services sector. Financial services have grown by five per cent a year in real terms on average for the last five years or so. The economy's capacity overall is probably somewhere in the region of 2.5 to 3 per cent range. So, necessarily, if you have got one bit of the economy that is growing much more strongly, then something else has to be squeezed and it is the manufacturing sector that has been squeezed and part of the way it has been squeezed is through depreciation of the real exchange rate. But the economy overall during this period has continued to grow close to trend rate. When you are thinking about the exchange going forward a lot is going to depend on the context. If the economy overall is very weak then a lower exchange rate could occur and indeed would positively be desired by the monetary policy makers in order to keep inflation close to target. If, on the other hand, business in the financial sector was still growing fast and you were positively willing the exchange rate to come down, all that is likely to happen is that inflation will rise and the real exchange rate will remain much the same as it was. It is very difficult to know clearly what is going to happen to the exchange rate. The Monetary Policy Committee have had assumptions about the exchange rate in each Inflation Report and typically they have tended to be wrong rather than right. What they have to do as policy makers is deal with the exchange rate when they see what happens. If it remains stronger than they expect that is almost certainly going to lead to some further cuts in rates. If the exchange rate falls sharply but it is in the context of the United Kingdom economy being even weaker than they expected I would have thought they would just accept that. And if it happened in the context of the economy growing quite strongly again because the world economy is picking up then those are the circumstances in which they would be looking to raise interest rates and correct some of the imbalances that have built up. We can all speculate what we think is the most likely but my feeling is that we do not, frankly, have the ability we would like to have to tell where the exchange rate is going to go.

  39. The outlook for growth seems still to be, as far as one can establish, that the prospects for British growth out-performing the other main developed world trading blocs seem to continue to be good, and does that therefore mean that the pound may continue to remain over-valued against the euro in spite of this general perception that the pound is over-valued against the euro? Does anyone see a particular set of circumstances in which the pound might fall in the very near future?
  (Mr Walton) My most likely scenario is one in which the US economy turns out to be quite a bit weaker than anyone expects, the US dollar then depreciates and, as the pound is reasonably closely linked to the dollar, the pound would probably weaken pretty much in tandem. The reason I think the pound would weaken in those circumstances is the weakened US economy is more likely to give rise to renewed weakness in asset prices and I think the United Kingdom economy is quite vulnerable to that because of the size of the financial services sector to the UK. You are already seeing an adjustment in the financial services sector and it could get quite a bit bigger if it looked as though the prospects of the financial markets were much poorer and activity in the financial markets was much weaker over a sustained period of time.

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