Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20 - 39)



  Q20  Damian Green: Is there any way that the higher oil price could have had a greater effect on the British economy than on other G7 economies?

  Mr Broadbent: No, I think it is true that we do not consume any more oil relative to our output than any of the other G7 countries, so it is not clear why it should have had a bigger effect. I do not think the fact that we are a producer makes that much difference, but on the spending side I think we probably spend less per pound of GDP on oil than, say, the United States does and some of the European countries do as well, so I do not see why it should have had a bigger effect here.

  Professor Miles: If I can just offer a thought on that. I think there is one reason why you would expect the effect on the UK to be smaller than most other countries which is that we are more or less, at the moment anyway, self sufficient in oil and therefore you do not get the hit to national wealth or in terms of trade that other countries which have to import oil have. So there is a reason why it should be less of a story for the UK.

  Q21  Damian Green: What about the long-term effect? The Treasury seems pretty sanguine that the effect on long-term productivity potential is not very high. What do you think about that?

  Mr Broadbent: Martin addressed that earlier; it is extremely difficult.

  Q22  Damian Green: Do you agree?

  Mr Broadbent: Yes, I would not be precise about the numbers. The Bank of England had a page in the last Inflation Report without mentioning a single number. They have been quite wary of doing that. I know that they are working quite hard on trying to refine those estimates, or in fact to come up with one, but in most estimates, for example, relative to the Treasury's Budget forecast, the oil price is around $15 a barrel higher. That might mean on a standard estimate something like 0.5% off GDP and I think Martin's numbers had a permanent effect relative to two years ago of 1% on output. That certainly does not seem implausible to me.

  Q23  Damian Green: That suggests the Treasury is being a touch complacent?

  Mr Broadbent: Possibly. Certainly it is one of the reasons why I think collectively all of us have the opinion that the forecasts not necessarily for next year but for 2007-08 may be on the high side and have not allowed for any effect of higher energy prices on potential output.

  Q24  Kerry McCarthy: Turning now to exports, recently the Bank of England noted that given the expansion in world trade UK export performance has been somewhat disappointing. What factors would you say account for this disappointing performance? I am not quite sure who to direct it to? Maybe somebody from one of the banks

  Professor Miles: I think a factor here has been in play for quite a long time in the UK which is that since sterling appreciated very sharply in the back end of the 1990s on many estimates it has remained at a level which makes it very difficult for parts of UK industry to compete in world markets. I think it is one of the reasons why manufacturing output has been far weaker than other parts of the economy which are less open to international competition. I think it is one of the reasons why the current account deficit in the UK has gradually moved up and has been very persistent for several years. Our own estimates at Morgan Stanley would suggest that sterling remains pretty significantly overvalued on a fundamental long-term basis against a range of other currencies. Looking to the future, as interest rates likely move up, and have moved up in the US relative to the UK and may well be moving up in the euro zone relative to the UK, it is possible that that will bring sterling back down to a more sustainable competitive level, so I think there is some reason to be optimistic that the outlook for exports is somewhat more positive over the next few years than it has been over the last four or five years.

  Q25  Kerry McCarthy: Does that mean you think the Treasury's projections of export growth of 5% to 5.5% for 2006 are reasonable?

  Professor Miles: That seems a not unreasonable central forecast. I think there are other areas where the Treasury might be on the optimistic side. That to my mind is not one of them.

  Mr Broadbent: I agree with what David has said but it is also true of course that a lot of the growth in world trade has been between countries where we have a very small export presence. If two Asian countries start trading a lot more with each other—and trade between Japan and China has boomed in the last few years—that is not necessarily going to reduce our share of the total. We have also lost a bit of ground even when you look at our trade weighted export market growth, which I agree with David is probably due to an overvalued currency.

  Mr Weale: Could I just add to the point that while I am happy with the numbers, Britain is less well-placed than, say, Germany for exports to oil producing countries and that, for obvious reasons, is looking like an area where there is some growth potential at the moment.

  Q26  Kerry McCarthy: That was going to be my next question. How well-placed is the UK to benefit from increased demand from oil-producing countries?

  Mr Weale: I think better than the United States, and for that reason one could say that the United States is likely to be hit more than other countries by the high oil price but less well-placed than particularly Germany which has a very efficient export structure, has good links with the oil producing countries, and is likely to be helped very considerably, so partly good, partly bad. It is taken into account certainly our numbers which are similar to the Treasury numbers, but other people will do better there.

  Q27  Kerry McCarthy: On the question of the US trade deficit in the past people expressed concerns that it looked as though it was exceeding 5% and now it has gone past 6% and the dollar is still strengthening. Do you think that means an increased risk from global economic imbalances?

  Mr Weale: Could I say that I see the US trade deficit as being a sign rather than the fundamental cause of the imbalance, which is that the United States and also the United Kingdom are not saving nearly enough. The United States is going on investing but it is doing its financing from abroad. We are investing at a rather lower level but financing it from abroad. Whether that would ever lead to a major financial crisis I would not like to predict, but you can be quite sure that what it means is that in the end people will be disappointed that their incomes are lower than they would like.

  Q28  Kerry McCarthy: Do the others share that view?

  Professor Miles: I think there is a significant chance of these imbalances in the world economy playing out in a way that might cause abrupt adjustments, in particular I am thinking about the possibility that at some point in the near future those investors outside the US who have been willing to buy more and more US financial assets, particularly US government bonds, decide they have got enough, and if they stop buying them, at that point you need something to adjust very quickly, and the most likely thing is a combination of the US exchange rate falling sharply and maybe long-term interest rates in the US moving up very sharply. That will be very painful both for the US and countries in Europe as well. I would judge that as a real possibility.

  Q29  Susan Kramer: If I could talk to you just a little bit about the Sustainable Investment Rule. Professor Miles, I notice from your comments that you say the Sustainable Investment Rule is more likely to be a binding constraint than the Golden Rule. I think most of us think the Golden Rule is not much of a rule any more. Could you give us your rationale for that opinion and also do you think there is any case for targeting the rule at a broader set of liabilities, for example including public sector pension liabilities or a greater share of PFI liabilities?

  Professor Miles: I think my reason for thinking they might become more of a constraint on Government action and Government investment in particular was the following: if growth turned out to be below the above trend 3% projection for 2007-08, it would be a plausible response for the Government or for the Treasury to say precisely because of that although borrowing will be higher there was therefore more slack in the economy and that you push forward the date at which you assess the cycle will end, and that although you are borrowing more it would not necessarily follow that you were going to miss the first rule because you just push the cycle further forward, no doubt to a time when you thought that there would be some surpluses and therefore everything could still look okay. What you could not do is say you were deciding to change how you measure net debt which is, in a sense, a further, harder number and that that number if you did not see less than 3% growth in 2008-09 would not be the 38% odd in the forecast, it would be then be very close to 40% and you would be pretty much up against a binding constraint at that point on borrowing more. That was my reason for feeling that it was more of a constraint probably than the first rule. On the question of whether you should include a much broader range of liabilities, including future commitments to spending on pensions or health, one could do that. I think it depends on how firm you think the commitment is, and there is an argument that the Government should quite rightly remain flexible on its plans for the future partly because we do not know much about how demographics will play out, there is this huge uncertainty, so what is the point of putting in a firm number for future commitments when there is so much uncertainty? If you were to decide nonetheless that you wanted to widen out the range of liabilities then of course it would make sense to increase very substantially the acceptable level of those liabilities relative to GDP. It is not entirely obvious what the advantage of doing that is. I think the key thing is how much flexibility does the Government have on certain kinds of commitments down the road to spending? I would argue that on education and health and particularly on pensions there is or there should be a lot of flexibility and therefore it does not make sense to treat them in the same way as you treat the issue of an index-linked government bond where there is a very firm promise to pay certain amounts of money.

  Q30  Susan Kramer: Do we need an additional measure? Is there something that is missing because there is so much more happening off balance sheet and so much more longer-term commitment to the way that public sector programming is being developed, are we missing a new measure we might need to try and pick that up?

  Professor Miles: I think it really comes back to how much is there a very firm liability that lies with the Government to spend specific amounts of money, and once you focus on the issue of how firm is the commitment to spend certain amounts of money, then you are on a spectrum where at one end there is something which is a very firm commitment (you issue an index-linked bond which guarantees that you pay certain real amounts of money for the next 30 or 40 years) and at the other end there are areas of commitment that are much more flexible. I think it is difficult to decide where exactly you draw the line and include this stuff that is a firm liability and this stuff that is flexible.

  Q31  Susan Kramer: Mr Broadbent, you looked as though you had a comment?

  Mr Broadbent: No, Robert is probably much better placed to answer this than me. I agree with David. I think you mentioned specifically pensions for public sector employees which I would regard, excluding bonds, at the firmer end of commitment, and where probably one could conditional on some assumptions about the future make reasonable projections about what the future flow was and therefore what the present value of those commitments was. It would certainly be helpful. Whether or not it should be included in another rule or an existing rule I am not so sure.

  Mr Weale: If I could make the point that the Government does, of course, produce its long-term fiscal projections in an accompanying paper and the difficulty that they face is very much what Ben and David have described. The Treasury is able to produce projections which say if we pay this much on pensions, this much on health, then the finances look fine, even given demographic change, but of course the really interesting question is are the numbers in there credible? Is it credible to say the pension credit will be linked to prices and not to wages from 2008 into the indefinite future? So I think documents of that sort are valuable but they are valuable because of the scope for discussion they create rather than the hard and fast rules that they allow you to set. On the other hand, I do agree with the other witnesses that the issue of public sector pensions does seem to me rather important and that there are a number of other off balance sheet numbers associated with the PFI which seem to me much more like the issue of government debt than they do the question how much pension credit the Government is going to pay in 30 years' time.

  Q32  Mr Todd: I would like to turn to public sector investment. I think Mr Miles has commented on some of the issues potentially constraining that in the future. If we look particularly to the back end of the forecasts in the Pre-Budget Report, what conclusion do you draw from those which suggested a growth in public expenditure of only 1.9% between 2008 and 2011, if one bears in mind that needs to accommodate both public sector investment and some of the liabilities that have just been talked about?

  Professor Miles: I think the projections for overall spending are such that after about 2007 or so spending is predicted to grow less than GDP, which would represent pretty tight limits on spending in particular areas. I think my concern—and it really comes back to issues about the net debt rule of 40%—is that that rule may come to affect decisions on highly desirable elements of government investment and spending which might be curtailed in a way that is undesirable. In other words, projects that might have a high expected return might not get done because we were very close to the 40% rule. My own view on that is that there is an argument for that 40% number actually being higher and it runs like this: if you are close to 40% on the net debt—

  Q33  Mr Todd: —which we may well be during that period.

  Professor Miles: —which we are likely to be within a few years, if you are very close to that and you hit the first rule of balancing the budget on the current account then how much net investment you can do is limited to 40% of the increase in GDP. If you start out with a situation where due to under-investment in infrastructure in the past you may well want to do more than that in terms of investment to try and catch up from the past, you would be constrained by that 40% rule. It seemed much less likely when the 40% rule was put in place several years ago that that would become a binding constraint, but that is where we are right now and my worry is that could curtail investment in infrastructure.

  Q34  Mr Todd: Bearing in mind all of your views that the growth forecasts in that period are probably on the optimistic side, it suggests an even greater likelihood of a constraint on public sector investment during that period.

  Mr Chote: If I could just add, you made the point about the spending projections at the moment for the period of the next Spending Review. Within that period, the Treasury have assumed that net investment remains at 2.25% of GDP, so it is not squeezed as a share of national income in the way that the rest of public spending would be at that time.

  Q35  Mr Todd: Yes, but that also presents an issue that if one maintains that as a fixed element it suggests that other elements of public expenditure will be squeezed rather tighter, does it not?

  Mr Chote: It does. Current expenditure is now pencilled in to grow by about 1.9% a year in real terms over that period. If you take into account the fact that the Wanless Report is implying 4.4% real growth in the NHS, we have a commitment to raise overseas aid as a share of GDP, and it seems unlikely that you are going to want to shrink education as a share of national income, then obviously what is left ends up being squeezed that much harder.

  Q36  Mr Todd: The other element the ONS has certainly commented on is the realism of the delivery of public sector investment targets anyway and they are pretty consistently underspent each year simply because it seems to be harder to get the bricks into the ground than people have suggested.

  Mr Chote: That has been a conspicuous pattern which the Committee has pondered before. It is worth putting in context with David's point that maybe you want to raise the ceiling on what you can invest. Even getting to the point where you are investing as much as you want to within the existing ceiling would be a start. It has got better, but certainly for a long time the Government said, "We are very happy to be spending more on investment," but it just was not happening. It may be bad schemes were not being done in which case it is not a bad thing.

  Q37  Mr Todd: Yes, but the other thing that appears to be happening is consistent carry forward of expenditure into subsequent years, which in theory at least, if then drawn down in that year rather than simply knocked on into a subsequent year (which normally seems to happen) could potentially have quite a significant impact on the fiscal position. Is that something that you have any concern about or do you just think this under-performance will continue ad infinitum?

  Mr Weale: Could I say that the under-performance seems to be as regular a feature of the data as the upward revisions in the ONS growth estimate and of course neither of those is a forecast that it will continue ad infinitum. We always assume that the investment plans in the Budget statements are going to be delivered, but of course that does not happen. I really do not know.

  Q38  Mr Todd: But that failure to perform certainly this year has been met by an increased expenditure in current expenditure and has provided space for that growth which of course brings many of its own burdens into subsequent years as well.

  Mr Weale: I think in the past it has been said that investment spending was the easiest thing to cut and of course people have criticised various governments because of that. We may get to the point where if some sort of tighter fiscal position is needed the Government does take the view that current expenditure has increased quite a lot and may be that is where the brake should be applied, and in that sense to have the 40% rule doing that (if it does work like that) could be quite valuable.

  Chairman: Sally, you have a question about medium-term sustainability.

  Q39  Ms Keeble: Earlier you were all quite critical of the growth forecast and Mark has covered that as well. How likely do you think that either tax rises or spending cuts will be needed to ensure sustainable public finances in the medium term? Also if you are looking at the different areas of public spending and the implications then for different issues that arise, for example, productivity problems in the economy (which Martin you said you saw the biggest single factor as being education) are there particular areas that you would in effect want to see ring-fenced or protected, given that you have also got the problems of pressures for extra spending on pensions and also on the Health Service, which I think David just referred to?

  Mr Weale: I would be very hesitant to say that any particular areas of public spending ought to be protected in a general environment which is likely to be slower growth in spending rather than actual spending cuts. I think that each type of public spending needs to be looked at on its merits. What we have seen really over the last five years or so is a substantial amount of politically driven spending, for example a Government commitment to smaller classes in primary schools. Maybe that is what the voters want and therefore want to pay for. Whether it delivers better education seems to me a much more doubtful proposition. One can make the same point about reduced waiting lists for hospital treatment. That had been a hot political issue for quite a long time. There are some very extreme cases which do matter but a slight reduction in the average, one can reasonably question whether that is a good way of spending money where the fundamental purpose of the service is to cure people and treat things that are wrong with them. So I do think the Government has got into a position where some key items of public spending have been driven by the political environment rather than necessarily the value that they deliver and perhaps it would need to assess that rather carefully.

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