Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 40 - 59)



  Q40  Angela Eagle: Have you given any thought—I am sure you have, but perhaps you would like to explain to us what it is—to the prospect of the cold winter and some of the scaremongering which I think is going on at the moment about volatility of energy prices for business? Has that played a part in any of your deliberations up to now in the decisions you have made on interest rates?

  Mr King: I referred to it briefly earlier when I said that there might be some risk to economic activity over the next year if there were to be reductions in supply as a result of the inability of firms to have as much gas as they wanted. Here I feel tremendous affinity with the Met Office.

  Q41  Angela Eagle: You are doing a very similar thing in many ways.

  Mr King: They too employ extremely qualified and talented people, they too are very careful in their statements and they too find that many journalists and newspapers find the concept of probabilities extremely difficult to understand. The Met Office made it absolutely clear. They said that there is a two-in-three chance that there will be a colder winter than normal. That is a very reasonable and sensible statement based on their analysis of all the data, in particular the North Atlantic oscillation and the likely fact that that may become negative. There is a very good intuitive story behind it, which is that if that happens, then, given the change in the likely direction of the winds, we shall have more east and north-east winds in the winter than we would normally have. On average that would lead you to expect it to be colder.

  Susan Kramer: You really have spent time following this, have you not?

  Q42  Angela Eagle: I must say that I find it rather reassuring.

  Mr King: Let me make clear as a matter of record that I am an Associate Fellow of the Royal Meteorological Society. The important point here is that this is a matter of balance of risks and what the Met Office said was that, in their judgment, there is a two-in-three chance that it might be a colder winter than normal. That is the kind of statement that they are paid to make. If it turns out not to be a colder winter than average, that does not mean to say that they were wrong and the rest of the world was right and they were incompetent; it is merely the fact that you cannot judge this kind of forecast record except over a long period. It is just as true of the MPC and I refer you to an article in the August Quarterly Bulletin which pointed out that when we make judgments about the central projection, there will be many occasions when the outturn will be different from the central projection. Every now and then, the outturn will be a long way from the central projection. That does not mean to say that we are wrong or that other people were right. It is a question of balancing probabilities. So that is a rather long-winded way of answering your question. I go back to the point that one of the most important roles that you have to play in public life, you have to play as politicians leading public opinion, is to make sure that you understand probability yourselves first and do not jump on the band wagon of saying, ex post, when an outturn is different from the central projection, that these people do not know what they are doing. That is a completely silly reaction and I want to flag that in advance before some of the journalists decide to jump on the Met Office.

  Q43  Angela Eagle: Perhaps you could give that lecture to the editors as well, and then we might all be in a more predictable situation.

  Mr King: I am hoping that some of them are listening by default.

  Q44  Kerry McCarthy: In your Inflation Report, there is a comment that UK export performance has been somewhat disappointing in recent years given the expansion in world trade. How do you explain that disappointing performance?

  Mr King: What we have looked at is the share of exports in world trade and that has continued to fall. It fell faster after the sharp appreciation of sterling against the euro and it has continued to fall. The position during the course of 2005 looks more encouraging. The growth rate of exports in the first nine months of this year, exports of goods, has risen at its fastest rate for five years. So the signs are that there is beginning to be a rebalancing in the economy, but only the very flickering of an early sign. Over the next few years we need to see a continuing expansion of exports. World trade is growing solidly and there is no reason to be overly pessimistic on that front. It is also an area—and I think this makes our life extremely difficult—where the data are particularly problematic. If you look at the export data, you certainly cannot look at them monthly and draw any conclusion. In my view you cannot even look at them quarterly and draw a conclusion; you need to look at them in half years. There is often a straight zigzag pattern, quarter by quarter, which is a classic symptom of measurement error. So you have to look at the pattern of exports in half-yearly frames. Even there the picture in the last few years has been distorted by alleged fraud, whereby goods are both exported and then imported as a VAT avoidance device. This has inflated the figures for trade. The ONS try to make an adjustment for it to produce what you might then think of as "economic" imports and exports. But when the data themselves are subject to large measurement error on a quarterly basis and there is a very significant amount of fraud the data themselves produce a very cloudy picture here which complicates our attempt to tease out what is happening; it is not easy to see what is going on. There are some encouraging signs during this year and the underlying picture is one in which, given the exchange rate and the very solid growth of world trade, we should expect to see continuing growth in exports.

  Q45  Kerry McCarthy: To what extent do you think the UK's dependence on exports to the euro zone, as compared to the US and China which are doing better, is a factor?

  Mr King: Undoubtedly the fact that over 60% of our trade is with the euro area means that the weakness of domestic demand growth on their part is a depressing factor for our export growth. It continues to be the case, and we see it as we go round the country and listen to exporters—they are still awaiting a significant pickup of domestic demand in the euro area. Again, we are beginning to see now some more encouraging signs. We expect even in Germany, that over a period domestic demand would rise to match their quite sharp pickup in exports. There are some countries in the euro area, particularly in the southern part, which are experiencing more softness. We are beginning to see now in the euro area some signs that growth is likely to pick up towards trend, but in their case the major economic challenge is that the trend growth is relatively low.

  Q46  Kerry McCarthy: The report also notes that rising energy prices have resulted in large current account surpluses in oil producing countries, particularly the OPEC countries, Russia, Norway. What evidence is there that they are beginning to spend these surpluses?

  Mr King: There is evidence that they are beginning to spend them, particularly on purchasing manufactured imports, and particularly capital goods. There is no doubt that that is one reason why German exports have picked up so much. This was mentioned to us at international meetings by the Bundesbank six to nine months ago, as something that they were already seeing and now it has been visible in the data for Germany. We have also picked up from comments in the UK—perhaps not quite to the same extent—that people are now finding there are more opportunities to export to the oil-producing countries. There are clear signs of a pickup, but maybe Andrew or Rachel heard other comments on their visits around the country.

  Sir Andrew Large: No, I have heard the same thing. You ask how they are spending their money. You only have to look at the stock markets in the oil-producing countries to see some evidence of that. On spending externally on goods that would be exported from us and from other countries, certainly I have the impression that there is a reasonably robust amount of activity there.

  Ms Lomax: It is just going to take time. They cannot crank up their spending overnight and some of these domestic markets are booming, but even so, if you look at the current account positions, the impact of higher oil prices has been one reason why the divergence in current account positions across countries has widened this year.

  Q47  Kerry McCarthy: From what you say, it looks as though there is both investment in infrastructure going into manufacturing again, but also in financial assets as well, so it will have a knock-on effect on savings.

  Mr King: Certainly much of the surplus they now have on their current accounts through the export of much more valuable oil is being saved and therefore invested in overseas financial assets. Some of that, as Rachel said, is beginning to come through now to actual spending on imports. It would be crazy on their part suddenly to massively buy things they cannot implement; it will take time. The effect of that is already being seen, in the UK too, not just in Germany.

  Ms Lomax: Relative to the 1970s, it is a very different situation. Most people would say that the ability to spend is much greater than it was in the 1970s.

  Q48  Kerry McCarthy: Economists have said that when the US deficit is reaching the 5% point it is getting to the point where it has to correct and you recently pointed out that now it is topping 6% of GDP the dollar has tended to strengthen. What is the explanation for that?

  Ms Lomax: I should be a rich lady if I knew. Economists are not very good on timing. I think everybody agrees that this is not a sustainable position, but that it can go on for quite a long time. Why is the dollar tending to strengthen at the moment? Possibly David is better placed to answer this than I am since he understands the mind of a trader from previous experience. Relative interest rate differentials are probably one reason why the dollar looks a good buy at the moment and the US economy looks very strong and so on. I guess people may get bored: the dollar has not gone into freefall, and something that is not going to happen for a year may be not worth trading on. Many people may have decided that the relative interest rate story is enough to keep the situation stable for the next year and the longer term is not something which is worth factoring into their considerations at the moment. My American colleagues describe the situation at the moment as one of "stable disequilibrium" and I could not improve on that.

  Q49  Kerry McCarthy: Can you improve on that?

  Mr Walton: I am pleased to say that in my previous life I was never paid to forecast exchange rates, so no, I do not have anything to add to that.

  Q50  Mr Ruffley: I was interested by your comments at your press conference about the factors which caused the slowdown in consumer spending. You referred to two causes worth emphasising. "One is the quite sharp rise in the ratio of taxes to household disposable incomes, that ratio has gone up by almost two percentage points over the last couple of years and contributed to a sharp slowing in real disposable incomes in the second half of 2004. It is not surprising therefore that with that slowing households spent less". I know you have already given an explanation to my colleague, Mr Green, but could you just remind us whether that sharp rise in that ratio is more than you would expect from normal fiscal drag?

  Mr King: Yes, it is more than one would expect from normal fiscal drag because it reflects in part the rise in national insurance contributions which took place.

  Q51  Mr Ruffley: Which was a policy change.

  Mr King: Yes; absolutely.

  Q52  Mr Ruffley: Does that 2% rise include other taxes, taxes other than NICs and income tax? Does it include council tax? I am just asking you to unpack that rise.

  Mr King: It is income tax and national insurance contributions.

  Q53  Mr Ruffley: It is direct.

  Mr King: Yes.

  Q54  Mr Ruffley: What is interesting is that in reply to Mr Green you implied that the ratio going forward will not really have much impact on consumer spending, other than maybe keeping it at the level which is sustainable. It is historic average or just approaching historic average.

  Mr King: Clearly the Government planned for an increase in the ratio of taxes to disposable income and indeed, it was not just household taxes but also corporate taxes that were planned to increase. The increase in taxes was designed to meet the fiscal rules and to finance the higher public spending on health and education. So this increase of two percentage points is meant to apply, not just to household incomes, but to national income as a whole. It is too early to judge what is going to happen to corporate taxes but we have already seen a good part of that increase in household taxes come through to household incomes.

  Q55  Mr Ruffley: On page 31 of the Inflation Report, you say "It is also likely that real post-tax labour income growth will recover moderately in the first part of the forecast period, in part reflecting a gradual pickup in earnings growth. In addition, there have been signs of a gentle recovery in the housing market, providing support to the pickup in consumer spending growth". You conclude "Overall the Committee's central view is for consumer spending growth to edge up towards its historical average". In that you are making some assumptions. You are making an assumption about the effect of a gentle recovery in the housing market, are you not?

  Mr King: I think our view is that the housing market is probably continuing to be broadly stable in terms of prices. We have seen a recovery in activity through this year and loan approvals are actually slightly ahead of their historical average. The way I should want to describe the housing market is one of broad stability.

  Q56  Mr Ruffley: May I just pick you up there? I am just reading from page 31, ". . . there have been signs of a gentle recovery in the housing market, providing support to the pickup in consumer spending growth".

  Mr King: What we mean by gentle recovery in that sense is that house prices have risen a little—a little faster than we had expected in August in fact—so house price inflation is positive. I do not want to over-stress that. Surely broad stability is the right way of describing it but activity has recovered in the housing market and we feel that recovery of activity and house prices will add a little bit to support consumer spending; we do not think there is much of a wealth effect from house prices to consumer spending but there is a collateral effect. The fact that people have now seen that house prices have not fallen in the way that many people anticipated they would—and there were many scare stories in the latter part of 2004 that we would see very sharp falls in house prices, which did not materialise. Indeed, in the last few months there have been small signs of a gentle rise in house prices. That will give greater confidence to the view that we may be less likely to see those falls in house prices than people might have thought. You can never rule it out, anything can happen. Now the view is that there is this stability in the housing market which, if it persists, will remove some of the uncertainty. That itself will mean that consumer spending growth will not be quite as weak as it was at the turn of the year.

  Q57  Mr Ruffley: That is useful. You say on page 31 that ". . . real post-tax labour income growth will recover moderately in the first part of the forecast period". When Mr Green was asking you about the tax burden point you were giving us a strong impression that that was backward looking and going forward real post-tax labour income growth will recover in the forecast period. You have made assumptions in the part of page 31 I read out about the housing market. I rather wonder whether the Bank, in the interests of good policy making, have made any assumptions about future tax rises. Before you leap in and say of course you are not going to answer that, may I just say it seems to me that if you are making assumptions about the housing market, you made assumptions on the supply side about what oil prices might be and what migration might be, it would be sensible to have a view on some of the predictions that the IFS make that two years out from now, the Chancellor, to meet his golden rule, might have to raise taxes by up to £10 billion a year, a kind of fiscal tightening that I would have thought you might want to make assumptions about. Have you anything to say on that?

  Mr King: We do make assumptions about the path of taxes; you are right that we do need to do that and we do. The assumption we use—and it is one we have always made—is that we take the figures from the latest published government plans, both for nominal spending and for the ratio of taxes to income. We do not take the Government figures for tax payments at face value, because we may have a different view about the path of the economy, but we take their planned and stated intentions for the structure of the tax system, for effective tax rates, as given. What the IFS might be saying is that they think the Government will be forced to change their policy in two years' time. We do not make that kind of judgment, because there is nothing to force the Government. The Government have made their plans clear, they have stated what they will do with the ratio of taxes to incomes and we use that as a basis for our forecast until such time as they change that. What I have often said in the past, and at this Committee, is that many commentators are inclined to draw strong conclusions from the monthly path of revenues, spending and the borrowing requirement that there is no prospect of meeting the tough fiscal targets at the end of the year. The one thing we do know is that revenues tend to be bunched, particularly the unpredictable parts of revenues, at the end of the fiscal year. It is very, very difficult to judge what is actually likely to happen to those numbers and hence whether any further action will be required. So we take the position that, when the Government say that the ratio of taxes to incomes will rise by two percentage points, as it did, we take that as our central view. The Committee is always entitled to take the viewpoint that we think there are risks to that and it may move on either side. The Committee has not formed a view that there are risks to that at this stage, but it is open to the Committee to form that judgment, if it so wishes. So far, we have taken a central view from the published government documents, both at budget time and PBR time, as to what the ratio of taxes to incomes will be and that we factor in. Of course, our view as to what will happen to the tax base—incomes—is different from the Government's, because we form our own judgment about the pace of economic activity and inflation.

  Q58  Mr Ruffley: I just conclude by saying that it follows, does it not, from what you have said of what we know, that if there are policy changes of the kind the IFS indicate might be necessary, taxes go up, the consumer spending path will be hit and growth will be affected? But we know that, do we not, that if taxes go up it is going to hit consumer spending and growth?

  Mr King: What we do not know are the circumstances in which that policy change might be made. It is possible that policy change would be made in circumstances where public spending was stronger, in which case the weaker consumer spending might be offset by stronger public spending.

  Q59  Jim Cousins: May I ask a question of Rachel Lomax and David Walton, both of whom have made reference to the forthcoming wage round in the remarks they have made to the Committee? The Chancellor, in the last 24 hours, has made it clear that he would like public sector pay to be pitched at 2%. Do you think that was a helpful remark?

  Ms Lomax: I have no view on that. As I understand it and as I recall from the past, Chancellors and the Treasury frequently provide some input to the Review Body deliberations. I just assume that was what would have been happening this time. It is just part of the normal process.

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