Examination of Witnesses (Questions 40-59)
25 NOVEMBER 2004
PROFESSOR CHRISTOPHER
PISSARIDES, PROFESSOR
DAVID MILES,
PROFESSOR ANDREW
SCOTT AND
MS BRIDGET
ROSEWELL
Q40 Mr Heathcoat-Amory:
On exchange rates, the big story is the depreciation of the dollar.
The MPC seems relatively unconcerned by this, although the Governor
has said that the main strain of adjustment will be felt by those
currencies that float against the dollar, noticeably the euro
zone. What dangers do you see for the euro zone, first, and the
British economy, second, particularly for not just inflation but
for other factors as well?
Ms Rosewell: The
euro zone was beginning to get up off its knees before the dollar
began to go down. My worry is that that recovery is not sufficiently
well established not to be knocked off course by what is happening
in the exchange markets. It is a big group of economies, the Euro
zone, so it can hold its own account, if you like, without necessarily
worrying too much about the external environment so long as it
has already got some dynamism and something happening there, but
given that exports are not trivial within the euro zone to the
USA, in particular, I would think also what is going alongside
what is happening to the dollar is, if you like, some sort of
geo-political issue. It is interesting, I think, that the Chinese
have stood up and said, "Oh, US, you have to do something
about this." This is very much flexing their muscles in a
new kind of way, which I had not expected to happen for another
couple of years. I think we may be into a period of quite a bit
of volatility as well in exchange rates, which would be bad for
the stability of trade and the stability of exports, not just
for the euro zone but also for us. So I am rather concerned that
it will slow the euro zone's recovery down, that they will not
begin to get going, and that there will be considerable instability
going forwards as well, both for the euro zone and, indeed, for
ourselves as well.
Q41 Mr Heathcoat-Amory:
As regards the sterling, is there a danger that as we are running
quite a considerable trade deficit as part of a quite big current
account deficit, do you think, we could catch the American phenomenon
of declining exchange rates which would create possible inflationary
problems here?
Ms Rosewell: But
it would also create export opportunities. There are always two
sides to that particular coin. Indeed, very many firms around
the country have been complaining for ages about the level of
sterling; so they ought to be jumping up and down and grabbing
those opportunities. That is, after all, why exchange rates fall
under these circumstances, that there is a deficit. One of the
things that happened before, you remember, when we had the previous
bout of high sterling and how this was all going to create inflation
and interest rates would have to go up, actually the competitive
pressure was such that it did not. I would be more relaxed about
sterling coming down on the inflation front than some people tend
to be. I think if sterling does continue to decline, we may be
sitting here in a couple of years saying the same things as we
were saying a moment ago about the labour market: why has it not
produced inflationary pressure? We are living in a time where
inflationary pressure is generally low. There is a lot of competition
out there, globalised industries, and so on, and that is generally
keeping prices down around the piece.
Q42 Mr Heathcoat-Amory:
You are saying it is just as well we are not hitched to the euro?
Ms Rosewell: Yes.
Q43 Mr Heathcoat-Amory:
Would that be generally felt, that we are well out of that one?
Is that a consensus view?
Professor Scott:
If the euro is going to rise against sterling on that particular
issue, then it would suggest that over the next few years we could
do without an appreciation of sterling. I am not sure that is
the same thing as saying we are better out of the euro. I think
we are just talking about the recent (next year's) change in the
exchange rate.
Ms Rosewell: I
am prepared to say we are better out of the euro.
Professor Miles:
I would say that if we are to adopt the euro it would be better
not to adopt it at the current exchange rate, which is a slightly
different statement again. I think this is a potential worry for
the inflationary outlook, because we are, as you point out, in
a situation with a rather substantial trade deficit, probably
an overvalued currency, substantially overvalued against the US
dollar, which itself looks like it is heading down—it certainly
has been, and might continue to do so. I think it would be helpful
for the UK economy—in terms of rebalancing, that sterling
did depreciate, but it might happen in a more rapid way than is
consistent with the inflation outlook that the Bank of England
has as its central part. I do think there are problems here in
the UK.
Ms Rosewell: But
given some overshooting, on the current inflation path, in any
case, you know, there is a bit of room for manoeuvre here.
Professor Miles:
It is a better place to start from than if inflation were above
target.
Q44 Mr Heathcoat-Amory:
Would you say that the recent events in the exchange markets have
hardened the traditional Treasury opposition to eschewing the
sterling to another trade block irrevocably? Have recent events
strengthened the case for sterling being a kind of middle pegging
currency between continental economies and the dollar, though
we can apparently get the best of both worlds?
Ms Rosewell: Sometimes
we get the worst of both worlds, it has to be said, under these
circumstances, but, generally speaking, I think that room for
manoeuvre is a useful thing for what is after all a large economy;
but what effect that has had on the views of the Treasury, I know
not.
Professor Pissarides:
Right now we are better off with sterling depreciating against
the euro and against the weighted basket, given what has been
happening to the economy—that is correct—but, as Bridget
has said, things could change and get worse. What I would mainly
like to point out, though, is one factor that was mentioned only
briefly, what I am more concerned about with respect to the depreciating
dollar is that it might cause too much volatility in world currencies,
especially in the Asian economies, which have big surpluses. They
are expanding their trade very fast and many of their currencies
are tied to the dollar and depreciating, now that the Dollar is
depreciating, for US domestic reasons. There has to be some resolution
to that. It cannot continue for ever. Especially if the American
fiscal and trade deficits continue and the dollar continues coming
down. Asian currencies cannot continue coming down, creating huge
surpluses for their economies and then their central banks going
and buying American bonds which are losing value to finance a
huge expansion in maybe US consumption. That situation cannot
go on for ever. If it were to implode it would have serious consequences
for UK trade.
Q45 Mr Heathcoat-Amory:
You are worried about the refusal of the Chinese to revalue?
Professor Pissarides:
Essentially, yes, but the question really is could they revalue
without causing a lot of uncertainty and volatility throughout
the area and by implication to European and UK trade? If they
could, then, of course, I want to see it immediately. They should
do it now. I also have to say that the longer they wait and the
longer it takes the Americans to take some action about their
fiscal deficits, the worse the situation is getting.
Ms Rosewell: That
is why the Chinese are so concerned and are challenging the US
to bring down their deficits: because it enables them to stabilise
their own situation without having to do anything themselves,
which, as has Chris said, might actually be quite hard for them
to do. At the moment we have got a fund cycle that runs from the
US out to the East and back again, financing the American consumption
on the way and financing the Chinese and Asian exports on the
other side of the coin, but it is building up bigger and bigger
financial imbalances, asset imbalances, as you go. The question
is how, if at all, we can unwind that without a lot of volatility
in the process. It is going to be very hard, if it is even possible.
Q46 Mr Heathcoat-Amory:
The world may be tired of buying American paper?
Ms Rosewell: Exactly.
Q47 Mr Heathcoat-Amory:
But you think that they will not tire of buying British paper
because our deficit is not so significant?
Ms Rosewell: It
is not so big.
Q48 Mr Heathcoat-Amory:
That is the difficulty?
Professor Pissarides:
They earn good money on British paper too, whereas on American
paper they are losing good money.
Q49 Mr Walter: Is there
not a danger here in the sort of scenario we are looking at that
those who are managing, let us say, the reserves of the Chinese
Central Bank decide to liquidate their dollar holdings ahead of
any revaluation, that that could actually engender even further
instability into the market?
Ms Rosewell: There
is indeed that risk, absolutely, and some Middle Eastern countries
have just decided to move their reserves into euros—I forget
which—and out of the dollar because of the way the dollar
is sliding. That, of course, exacerbates the situation. I am much
more worried at the moment about international risks than I am
about UK domestic economy risk and, in particular, these international
financial imbalances about which we have all been talking. Every
time we say, "There is a risk about international financial
imbalances", and yet the trade trundled on, the road runner
kept running; but you do get to the point where you have gone
over the edge of the cliff and you are still running but actually
there is nothing underneath you. While the Chinese were willing
to finance American consumption we went on running when there
was some ground underneath. If they are unwilling to do that,
then the ground begins to drop away underneath us and then we
are looking at the risk to financial instability, world credit
problems and all the things which bring world trade growth to
a nasty grinding bump.
Q50 Angela Eagle: In the
past when this kind of effect happened with sterling and the dollar
we have had to leave the gold standard and have the great depression,
and we had the Breton Woods institutions collapsing when we had
more fixed systems. We do not have that kind of system now. We
have a partially fixed system, with the Asian currencies tagging
themselves to the dollar and everyone else floating. Technically
can you see a way of adjustments being made which would ensure
stability in the would economy rather than the kind of crunch
that you are talking about which the world economy, albeit at
a different time in its history, has experienced twice in the
20th century because we have got the same institutions we had
then? We are in a different situation.
Ms Rosewell: I
think that is a political question. Are there institutions which
allow those adjustments to be made? We invented Breton Woods precisely
to have such institutions. This now involves the Asian economies
as well, and it is across those economies that you need to make
those adjustments. The short answer is that I do not know whether
we have got enough political institutions or political connections,
if you like, in the right places to enable those adjustments to
be made. I just do not know.
Q51 Angela Eagle: Otherwise
the Americans have to start getting their deficit into some kind
of control?
Ms Rosewell: It
would be helpful.
Professor Scott:
If Treasury bond prices fall, that would be a big incentive to
the Treasury to do something about fiscal policy. At the moment
the US is borrowing at 1%, and it has not got much of an incentive
to turn round fiscal policy. I am not sure we need international
institutions to bring about that change.
Q52 Angela Eagle: Do you
think markets will do it by themselves?
Professor Scott:
If the dollar falls, the Chinese switch to a basket of exchange
rates while achieving a slight revaluation and the US starts to
try and turn round fiscal policy because it finds it more expensive
to finance it. That, I think, is still the most likely outcome.
We are talking here about the risks of a big crash, but it is
where the system can deal with that; it just may not deal with
it as quickly as we would like it to; and there is always the
risk of something terrible happening, but the most likely outcome
will be what I have just outlined.
Q53 Mr Walter: While we
are talking about the risk of crashes, let us go on to the housing
market. Did the Governor intentionally, do you think, talk the
housing market down? You remember the headlines back in June,
The Times: "Bank of England Governor says it could
damage your wealth. Official warning: Do not buy a house. Bank
boss: It is a bad time to buy a house", I think was in The
Mirror. In the November inflation report, the MPCs central
projection implies that "House prices may fall modestly for
a period", although on page seven of the report it says,
"However, the extent of prospective slow down in house price
inflation remains uncertain", the report forecasting then
a modest fall in house prices for the first time, although, as
I said, Mervin King warned of the dangers back in the summer.
Do you think the MPC has been trying to deliberately talk the
market down, and, if so, do you think it is a good thing or a
bad thing?
Ms Rosewell: I
would say it was trying to talk the market stable, which is probably
a good thing, while minimising the risk of talking it down. Whether
they have succeeded is another matter altogether. Certainly transactions
now are well down off peaks, and, indeed, anything over the last
three or four years, transactions are down probably somewhere
between 20 and 50% across the piece and in some areas prices are
undoubtedly falling.
Q54 Mr Walter: Is there
a difficulty here? The inflation report on page 6 has this rather
nice demonstration of who measures what when.
Ms Rosewell: Yes.
Q55 Mr Walter: In terms
of the housing activity data and the house price data, one starts
to get data coming through from people like Right Move in the
first ten weeks of looking for a house, and then you end up, if
my maths is right, it looks like, about three months later with
data from the Land Registry. What is the right measure? Should
we be looking at the Halifax, Nationwide type data? Is that more
accurate than the Land Registry data or is it simply that there
is a time lag in it?
Professor Miles:
I would have thought the Land Registry data, in some sense, is
definitive, in that it is the price at which transactions actually
took place, whereas most of the other measures are, if you will,
indicative.
Ms Rosewell: But
it appears with a long lag, so we use the Halifax, the Nationwide,
the Right Move as indicators essentially of what the Land Registry
will be telling us when we get that data. It comes back to one
of the points I made earlier: you never know where you are; if
you are lucky you know where you have been. That is one of the
biggest difficulties in managing the economy.
Professor Scott:
Surely the issue here is because house prices is not a target
it does not really matter whether it is the correct measure of
house prices, it is which one is most useful in forming a guess
at what is going to happen to inflation, and so no doubt they
keep an eye on all of them. I think what is most interesting about
house price analysis in is this entire report is on page 12, where
you see the correlation between inflation and consumption growth,
and basically the Bank uses that recent sharp fall in that correlation
to argue that it does not matter what happens to house prices
for the inflation forecast. That is perhaps really what we should
be focusing on rather than what will actually happen to house
prices; because if that analysis is right, it does not matter
whether house price inflation is stable or is going to fall, it
is not going to have much of an impact on inflation.
Ms Rosewell: One
of the reasons for that, presumably, is that if you look the proportion
of people's incomes they are spending on housing, that has not
changed much either.
Professor Scott:
The logic to me was not compelling here. There seemed to be a
story that because over the last two years—It is very unusual
for a forecaster to say, "Gosh, there has been a big change
in the last couple of years. Let me factor that in as a permanent
state of affairs in the future." It is a very big assumption
to make for a forecaster. The logic seemed to be that the only
reason house price inflation fed through to inflation was that
it enabled one to borrow more but that, given the sharp increase
in house prices, people really were not credit constrained any
more and so there was no danger it was going to feed into inflation.
I think there is an important asymmetry between good times and
bad times if you want to borrow more in bad times. So you may
find the correlation picks up.
Professor Miles:
I have a lot of sympathy with what the Bank is saying on all of
this, because I think what they are arguing is that if you look
at correlations from the past they are just that, correlations,
they are not causations; but it is perfectly clear that if you
look at periods where house prices went up a lot, and inflation
went up, and consumer spending went up a lot—the late 1980s—the
idea that it was house prices that moved first and caused other
things to change is pretty weak as an explanation of the correlation.
What happened then was that real interest rates were relatively
low, people's expectations of income were very optimistic, employment
rose quickly, disposable income rose quickly; all of which would
mean that people would tend to want to spend more on consumer
goods and on houses; and that is what generates the correlation,
but it is not causation. I think the Bank, quite rightly, is pointing
out that we should not look at the average degree of correlation
between house prices and consumer spending, as such, in the past
and say it will be like that this time. I think it is really rather
telling what they show, which is that over the last four years
house prices in the UK have doubled, and if you believe that house
price increases always cause a boom in the economy and consumption
to rise, you cannot explain the last four years: because at the
period when house prices have doubled the savings rate in the
UK has been absolutely flat. In other words, consumer expenditure
has grown precisely by as much as you would expect if you simply
looked at disposable income and forgot about the housing market
completely. I think the Bank makes rather a telling point here,
which is that if we were to see a substantial fall in house prices,
it is absolutely not clear that that would have a big knock-on
effect on consumer spending.
Q56 Mr Walter: I think,
Professor Miles, you said in something you wrote on 27 October,
if I quote you, "A significant fall in house prices may not
have a strong effect on consumption and is unlikely to lead to
the kind of clogging up that we saw in the early 1990s."
Basically, you are suggesting that the MPC is right in being cynical
about a strong linkage between consumption and house prices in
this cycle because of the differences with 1990.
Professor Miles:
Yes.
Q57 Mr Walter: Could I
just look at something else? The property industry would say,
would they not, that their warning that the MPC has overdone things
in terms of their moves and rates and has forced the housing market
into something of a nose-dive? They are suggesting, rather on
the lines that Alan Greenspan when we met in the summer was suggesting
(and I quote from Greenspan), that, "We have concluded that
we could not address the bubble straight on"—that is
in terms of asset price bubbles—"but rather should
deal with the effects on the economy once the bubble had burst.
I suspect this is also true of the housing market." On that
basis, do you think that the expectations, some researchers have
warned, can play a particularly important role in determining
the trends in the housing market and can produce considerable
volatility, even if the fundamentals have not changed at all?
Ms Rosewell: Yes,
certainly. If we go through a period where all the headlines are,
"This is a bad time to buy a house", then people will
not buy houses and that will produce some volatility, certainly,
in that market place. On the other hand, whether that changes
the trend is another question altogether. If we are still in a
position where our ability to build houses is pretty constrained,
there is a lot of policy going on around us at the moment, in
any case, so some of that may be relaxed, but if it remains the
case that people want to have houses and it is quite hard to get
them, then prices will come back over the medium term, but there
may certainly be a position where there are still people trying
to sell houses, because they have to move or whatever, and people
saying, "I do not know about that", then prices may
move quite sharply over a short period and come back.
Q58 Mr Walter: The scale
and the timing of the slow down in the housing market seems to
have surprised the MPC a little, but there is also evidence to
suggest that the mortgage market has been disrupted by the change
in regulation which has taken place this autumn. Do you think
that has had an effect on house prices?
Ms Rosewell: Not
yet. It has only been in place for two weeks.
Q59 Mr Walter: But some
lenders were withdrawing from the market or were slow to—You
do not think it has had any effect at all?
Ms Rosewell: I
do not think so.
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