Examination of Witnesses (Questions 20-39)
MR ROGER
BOOTLE, PROFESSOR
ANTON MUSCATELLI,
PROFESSOR DANNY
QUAH AND
MR JOHN
BUTLER
7 MARCH 2006
Q20 Mr Fallon: Why do you think they
are forecasting continued steady growth in household consumption?
Do they have it wrong?
Mr Butler: My view would be that
is where the disappointment is going to come this year. I would
say basing a forecast on a wealth link, at a time when the outlook
for disposable income growth I think is deteriorating, is going
to suggest a consumer recovery does not come through. So I would
be at odds with the Bank of England's latest central projection.
Q21 Mr Fallon: It is not in the January
figures, is it?
Mr Butler: In terms of retail
sales?
Q22 Mr Fallon: No.
Mr Butler: My guess is that it
will not be in the February or March figures either.
Q23 Mr Fallon: Do you think it would
be helpful if the Bank split its forecast for GDP growth into
the component elements, so that we could see more clearly the
weight it attached to each?
Mr Butler: Yes.
Mr Bootle: Undoubtedly.
Professor Muscatelli: I think
it would be helpful for us interpreting what they are doing. On
the other hand it is incredibly much more difficult to do so,
especially on some of the components of expenditure. Forecasting
some things, such as investment expenditure or net trade, which
can be hugely volatile, is extremely difficult.
Professor Quah: I do not know
that the Bank does not already do that in constructing the GDP
growth forecasts.
Q24 Mr Fallon: But it does not publish
it.
Professor Quah: That is right.
Those are two different things. Internally the Bank might well
have some understanding of what is happening with consumption
and investment going forwards that does not manifest in just their
forecasts of just GDP growth.
Mr Butler: In terms of the spirit
of what the Bank of England tries to do, they would argue it is
very difficult because they would have to provide fan charts for
all the different components. I think they can flesh out how they
have made a change, in that you look at this forecast in February
versus November and you think there is absolutely no change in
the Bank of England's optimism, yet the story behind that had
fundamentally changed in three months, and I think that is something
that could have been brought out much more than it was.
Q25 Mr Fallon: Your explanation is
that the optimism appears to be based on the perception of higher
asset prices and the perception of easy access to cheap finance.
Mr Butler: Yes. I think this is
a key part of the story, in that, if wealth is rising, what channel
is that feeding through into the consumer? It is either boosting
consumer confidence—well, we are not seeing that—or
it is working in terms of you liquidating those gains, say from
mortgage equity withdrawal, and spending it. That is a link which
has already been to some part exhausted over the last couple of
years and I think that opens the obvious question: Are you comfortable
about housing valuations and is this making you less comfortable,
going forward, if people are tapping into that wealth more to
support spending?
Q26 Mr Fallon: You just think the
Bank is wrong to rely on a consumer recovery to the extent it
is.
Mr Butler: My forecast is very
different. My forecast is one in which the consumer rally you
saw at the end of last year will not persist and you will revert
back to the similar story you saw from most of last year with
the consumers weak. So, yes.
Q27 Mr Fallon: It was 1.8% last year,
the Bank is saying 3%, and you are saying . . .?
Mr Butler: Their 3% is at the
end of the year, but I am 1.8% again for 2006 as a whole.
Mr Fallon: Thank you.
Q28 Susan Kramer: I have been very
concerned about the whole business investment issue. I am grappling
around to try to understand why the numbers have been coming out
as they are, particularly with borrowing so cheap, at the long
end, and companies cash-rich. Could you help me with this. Am
I right in the perception that a lot of companies are now simply
using their cash to buy back stock, rather than investing either
in expansion or productivity? Is there anything abnormal about
the pattern that we are seeing at the moment?
Mr Butler: I think there is. As
you say, a lot of the conditions for investment have been fairly
supportive. The oddity is that companies are not feeling confident
enough to come out and start investing. I have two explanations
for why that might be. I think part of it is that companies do
not like to invest in an environment which is becoming more uncertain,
and most of the business surveys suggest that they are more pessimistic
about the profit outlook than at any time since 2003—which
may seem odd, given the equity markets, but I think that is a
broader economy element and may be related to the retail sector.
The other issue is that I think companies at the moment have other
priorities. You have highlighted the buy-backs, the cash-outs,
almost rewarding shareholders for some associated risk, but I
think there is another issue, which is pensions. There is no way
of proving it, but it seems more than a coincidence that companies
have added an extra £20 billion a year into their occupational
pension schemes where business investment has risen by £1
billion. I think it is showing you that there are other priorities
which are using up the cash rather than just investment, and if
you are realising a future liability at the expense of investing
for future growth, then that could have long-term detrimental
effects for the UK economy.
Q29 Susan Kramer: Do you think that
the Bank should be working more closely with the Pension Regulator
to try to ensure that contributions towards pension deficits or
to offset pension deficits do not harm the growth forecast?
Mr Butler: I am not sure that
is the Bank of England's role.
Q30 Jim Cousins: Whose role is it?
Mr Butler: I think it is an issue
about regulation, and putting pressure on companies to do something
about your pension deficits is much more a government role.
Professor Muscatelli: I am very
concerned about what is happening in business investment. I am
not sure exactly what the causal effects are—because, of
course, to some extent investment does tend to follow the economic
cycle with a lag, so we might still be observing the lag from
the recent slow-down—however, I am concerned about what
the implications are for that in the upswing, and I have highlighted
that in my note. I think it is of concern that productivity has
fallen, possibly for cyclical reasons, but now we are observing,
on the back of that, a low growth in business investment that
might constrain the Bank's actions during 2007.
Mr Bootle: I agree with what has
been said, particularly John Butler's point about pensions, but
I think we ought to take account of the international aspect of
all this. It is striking that business investment has been pretty
low in relation to GDP in most parts of the world. China is obviously
a different case, but it has been pretty low almost everywhere,
so I think you have to ask yourself what global forces could be
behind all that? There are two which particularly attract me as
possible explanations, though it is very difficult to measure
them. One is that business is suffering from the after effects
of the collapse of the dot.com boom: business managements feel
enfeebled in relation to all that; they feel extremely cautious.
The second explanation is to do with the workings of globalisation.
Although the economy overall, certainly in this country and a
number of others, has been pretty stable at a macro level, at
a micro level it has been exactly the opposite. People are all
at sea with regard to where business is going to go over the next
10, 15, 20 years: they do not know what the comparative advantage
of their country is going to be, never mind a particular sector.
It is very difficult against that backdrop to muster the confidence
to invest for the future, when you think that the activity might
be leeching away to some other place. You just do not know where
the land is going to lie. That might go some way to explaining
why investment is pretty low in most countries.
Professor Quah: There is a certain
dissonance in the way that all of us are trying to think about
the risk environment, what is going on internationally. We give
all the reasons we can think of: a lowering in risk premia; people
coming up with new financial products; we understand financial
markets better; central banks are doing a great job globally,
so there is a decline in risk premia worldwide and so long-term
interest rates are low, and that is the story we tell. On the
other hand, when we turn round and try to think about what is
going on with business investment, we have to tell the opposite
story: the situation is uncertain; nobody really understands what
is going on; everybody is just holding cash; nobody wants to make
a first step. There is a dissonance there that I think we need
to think through. We cannot leave the story as it is with just
the two different parts inconsistent with each other. Initially,
I thought that the weak business/weak UK investment had to do
with factors specific to the UK—the worrying about the particular
state of pension funds in this country, the Turner Report and
all the things that are going on there—but, as Roger points
out, this is worldwide. It is a global phenomenon, and we do not
understand why this is going on. We have risk on the one hand
declining; risk on the other hand increasing, Everybody is waiting.
The dot.com boom ended March 2000, yet by some measures dot.com
boom Mark II has already taken off and there is a lot of optimism
in that sector now. So I think the signals are very contradictory
and inconsistent and we really do need to understand what is happening
with investment much better. But I do think that, whatever the
reason for our consumption-led recovery, it cannot be sustained.
No economy for any long stretch of time has ever had just the
consumer continuing to propel it to ever greater success. We have
to bring investors on board.
Q31 Susan Kramer: From what I am
hearing, you do not think this is just a measurement issue, because
sometimes we do hear from the Chancellor or others: "It is
just a measurement issue. It will all come right when we get the
figures a few months down the line."
Mr Bootle: It is very difficult
to be confident that it is not a measurement issue, but, again,
I think the international evidence is quite intriguing in this
regard. If we were looking at a circumstance where only British
investment were low and everywhere else it were pretty much normal,
then I think the argument that there is something wrong with the
way we measure it has a certain amount of force. If, however,
you are looking at weak investment around the world, where it
is measured in all sorts of different ways in different places,
I think it has really rather less force.
Mr Butler: Quite an important
element in the Bank of England's forecast is this increased uncertainty
about the data and expecting revisions to come through this year.
Three months ago, the confidence about that was (1) about historical
revisions and (2) that employment was still rising, inflation
was picking up, so surely growth was stronger because there must
be less spare capacity in the economy. Three months on, employment
is now falling and inflation has been coming down. I think the
evidence such is that there are always uncertainties about data
but I do not think those uncertainties are any greater today than
they have been in the past.
Q32 Peter Viggers: I want to follow
the point about pension shortfall and its effect on investment—and
I declare an interest as chairman of a pension fund (which is
fortunately well invested). The asset and liability management
has forced pension fund managers to be more cautious and put more
money into bonds. Of course the lower interest rates have caused
greater difficulties. Those who say that there is no particular
problem arising from pension shortfall, talk about the global
amount available where there is £24 billion available to
industry to invest, but of course what they fail to identify is
the fact that it is an individual, localised problem. There is
a significant number of companies, some of them quite large, which
have major problems with their pension shortfalls, so it is not
good enough to say there is no global problem. It is an individual,
localised problem, as Mr Butler has pointed out. There will need
to be significant reconstruction of a number of companies and
no doubt equity sacrifice. Do you agree that there is a major
problem here? How do you see it working its way through?
Professor Muscatelli: I agree
with your analysis: there is a difficulty here. I am hoping that
the resolution will be that they will take a slightly more sanguine
view about what yields you might get from pension funds over the
longer term. It seems to me that we have gone from a situation
in which we had a very asymmetric system of valuing assets and
liabilities, to one where we are putting a huge amount of strain
on companies. Although I cannot claim to be a pension expert,
it seems to me as if we have moved too much in that direction.
We are forcing everybody to deal here and now with problems that
have to do with asset liabilities away in the future and there
needs to be some way of valuing these liabilities that do not
call on companies to take drastic action in the very short term.
But, as I say, I am not a pension expert, so that is just my first
view of that.
Professor Quah: My only response
to that is we do have this demographic problem generally, globally.
The ageing population is a worldwide problem. I think there is
a danger that we are all going to rush in and try to solve the
problem too quickly. Businesses are not best placed to be the
ones to solve pension fund shortfall problems. Businesses should
be making things or providing services or doing things for the
rest of the economy. Somebody else should be solving these pension
funds problems—financial markets or some other institution.
We should not be devolving responsibility onto individual businesses.
Q33 Chairman: Roger, you mentioned
globalisation. We are undertaking an inquiry into globalisation.
Are there any particular issues in the macro field we should be
looking at?
Mr Bootle: This is a huge subject.
What I have mentioned earlier on would bear some inspection. I
have not seen any detailed work on it. It would be interesting
to see the extent to which businesses at the micro level felt
fearful and uncertain about their own situation and the extent
to which that affected their policies with regard to investment
and employment. It is a very, very difficult thing to test because
you are really trying to get at a state of mind, a sort of attitude.
I am not sure you would clearly find it demonstrated in the data,
but if you could come up with a convincing answer on that question
alone it would be extremely valuable. There are others I could
mention, particularly with regard to inflation. Again, the extent
to which the fear of market pressures, competition from not only
Asia but also Eastern Europe is constraining behaviour now with
regard to wages and prices. I think that is also a fascinating
question.
Mr Butler: I think it challenges
a lot of the framework in which we think about economies. We tend
to start from the building block of: Is there spare capacity in
the economy? What does that mean for inflation? But maybe much
more emphasis should be on global output gaps rather than domestic
output gaps, given the disinflationary effect we have had from
import prices for some time. The point Roger made, which I think
has been absolutely critical for the UK, is the supply of labour.
How do you judge whether a labour market is tight or not, when
you can tap into labour markets from around the world?
Professor Quah: One large factor
is that the entrance of China and India into the global marketplace
has doubled the world's labour force. That is a massive increase
in the number of people out there who can work, willingly work,
for relatively low wages. When you ask the question of what you
should be studying, looking at something like that makes me think
of a whole range of questions. That impacts on inflation; price
behaviour; income inequality; labour markets; wages; international
trade; outsourcing—a huge range of issues. Maybe your focus
is more on monetary developments and inflation, but I think that
even with that alone we can try to understand what happens with
labour markets, the flow factors, investment and price behaviour.
Professor Muscatelli: I think
the analysis has to be very much divided between short-run impacts
and long-run impacts. In the long run, clearly effects of the
type Danny has described are bound to be beneficial for the world
economy: a huge amount of untapped labour coming onto the market,
a more efficient allocation of resources across the globe. The
problem in the short run is the adjustment towards this: what
it does to balances, how the US whole imbalance situation is going
to unwind. It is the fact that it has come on stream very, very
quickly, I think, which poses the risks for the world economy.
People often make the comparison with Japan. Japan joined the
world economy very rapidly during the 50s and 60s, but in terms
of size it is nothing like the Chinese and Indian shock. It is
a much bigger shock. I think understanding how the inevitable
imbalances will unwind is a key area to study in the short run.
Mr Butler: It is a very difficult
question for policy makers, in that, if inflation is low because
of big supply changes, with China coming on stream it is not necessarily
obvious that you respond to that in the same way that you would
respond to, say, weaker domestic demand. I think that has been
critical for MPC over the last couple of years, responding perhaps
to supply changes as if they were evidence of deficient demand.
Chairman: We have already visited China,
and we are visiting India in June, but I will get the staff to
remind you of the terms of reference of our globalisation inquiry,
and if you have any further comments we would be pleased to receive
a note from you on that.
Q34 Ms Keeble: I would like to ask
a bit more about growth, and it follows on very much from what
Michael was asking as well. The first question is for John Butler
and Roger Bootle. What are the main reasons for the Bank's optimism
on GDP growth for 2006/2007 and indeed 2008 compared with the
forecasts from your own organisations?
Mr Butler: I think the Bank of
England have a story, as I highlighted before, which has changed
over the last few months but it is one where the imbalances in
growth persist for longer than they had previously expected, so
consumer a bit stronger, investment picks up a little later than
they expected, but eventually you get a rebalancing in the economy
and a pretty good growth rate. Where I see the risk is that I
think the constraints on corporates may mean the investment recovery
is more muted and is more lagged than they are currently expecting.
On the export side, we are probably more concerned about the sustainability
of the global growth picture. A lot of the issues that are highlighted
as risks in the Bank of England's forecasts we would probably
incorporate more as a central projection, such as that the US
consumer starts to slow, and, with it, UK exports soften.
Q35 Ms Keeble: They soften further?
Mr Butler: You do not get the
strong recovery in exports that the Bank of England is eventually
forecasting. On the consumer side, I think we will come back in
three/six months time with the same issues. I think the squeeze
on people's disposable income at a time when I think the labour
market will be starting to deteriorate will reduce households'
willingness to spend.
Q36 Ms Keeble: You do not think that
the slow down of consumer demand which you are predicting would
then have an impact on imports, which would obviously help.
Mr Butler: Yes. My forecast would
be one in which net trade does not boost GDP.
Mr Bootle: I have a very similar
view to John. To some extent we covered this earlier on. Of course,
quite why the Bank takes the view that it does is shrouded in
a certain amount of uncertainty, given that it does not publish
the breakdown, so we are fighting in the dark. I would, as John
has said, think that the risks are a good deal more serious on
the downside than the Bank is allowing for. Our central forecast
for consumer spending growth would be 2%—not a disaster,
but a good deal weaker than you would think would be consistent
with the sort of growth rate for the GDP overall that the Bank
has. To be fair to the Bank, there is obviously a very plausible
case behind the idea that consumer spending could bounce back
this year. In particular, I think a lot depends on how you view
what happened last year. The Bank at one point tried to pin responsibility
for what happened to consumer spending on a series of one-off
rises in energy prices, household bills and so on and so forth.
If you believed that that pressure was going to abate, I suppose
you could believe that consumer spending was going to bounce back.
My argument against that is partly that not all those pressures
are in fact going to abate—some of them are still very much
there—but also the weakness of the labour market is potentially
a very big factor. When you look at last year and you see how
weak productivity growth was in this country, I think you have
to ask yourself some pretty serious questions. Admittedly, again
the numbers may be wrong, but, if they are right, why were businesses
behaving in such a way as to allow productivity growth to slump
as seriously as that? I think a substantial part of the answer
must be that they did not believe in the slowdown, they did not
believe it was going to be sustained, and, accordingly, they hung
on to labour hoping that the economy would turn up. If that is
the case and the economy does not turn up, then they release more
labour—and the latest figures, of course, were extremely
weak—and as we see the labour market deteriorating, you
have to imagine then that, although that was not the original
source of consumer weakness last year, it becomes the source of
consumer weakness this year.
Q37 Ms Keeble: Your colleague Jonathan
Loynes has been much more critical than that. He is quoted in
the Guardian as having said, "It would have been better
to have left the growth forecast unchanged, but that would have
lowered the inflation forecast to below its target" and "They
are having to work hard not to cut interest rates." [3]That,
given the sort of critical statements that you are making about
their growth projection, comes perilously close to saying they
are starting to make the facts fit the decisions and not the other
way around. What do you think of what your colleague Jonathan
Loynes said? Do you agree with him in his criticisms, which pretty
trenchant of the decision?
Mr Bootle: I would hesitate before
disagreeing publicly with what Jonathan said. What he was particularly
referring to, as I understand the remark, is something akin to
what Stephen Nickell has been arguing; that is to say, this is
not only about what the current growth rate is and what that might
do to inflation; it is also about your perception of the output
gap and where growth has been. The fact of the matter is we had
a year, last year, when nearly all forecasters were surprised
by how weak the economy was—it was pretty weak—and
you therefore expect that ought to have opened up some spare capacity.
Given all that, even if you had a growth rate as strong as the
Bank is forecasting for this year, I think you might still argue
that inflation would be on the downside.
Q38 Ms Keeble: Do you think there
is also an issue about not wanting to cut interest rates because
that would start a trend?—which is one of the issues that
has been raised as well.
Mr Bootle: I do not think that
would be a good argument for not cutting interest rates; that
is to say, that if you cut them the markets would perceive this
as the beginning of a trend. I do not recall, for instance, that
being an argument in the opposite direction. I do not recall Mervyn
King ever saying that we should not increase interest rates once,
because if we did that the markets would say: "This is the
beginning of a substantial trend." No, surely you have to
view each case on its merits. If the situation demands low interest
rates, you should cut interest rates.
Q39 Ms Keeble: Professor, do you
think the Bank is being overly bullish in its forecast?
Professor Muscatelli: I do not
think they are being overly bullish but I think it is very delicately
poised. As I said in November, I certainly was amongst those who
felt at that stage it merited a cut. We have to take these projections
at face value. There is a complex timing issue, but if consumption
does hold up and if business investment does grow moderately as
they are expecting—and I am quoting from page 32 here—then
I can see their forecast coming true. [4]There
are downside risks. There are downside risks, as we have already
discussed, in investment, and there is also a downside risk in
trade—in which case I can see a scenario in which they would
have to cut interest rates, but I can see the logic of adopting
a wait-and-see attitude. I am not saying that we will never cut
interest rates. I am saying that at the moment the evidence is,
as far as consumer demand is concerned, and looking at what is
happening to asset prices, that they are being cautious about
cutting interest rates because they want to see how that works
out over the next couple of months and look at the next inflation
forecast.
Ms Keeble: Thank you.
3 The Guardian, 16 February. Back
4
Inflation Report February 2006, Bank of England. Back
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