Examination of Witnesses (Questions 40-59)
7 MARCH 2006
Q40 Mr Todd: Could I turn to labour
and productivity issues, which have been touched on a bit already.
The Governor, when he gave evidence here at the end of last year,
said, "I should expect flows of migrant labour to be responsive
to the state of the UK economy, that more people would come in
if the labour market were buoyant." He then went on to say,
"I think that is providing a safety valve for pressure on
the economy which will automatically unwind if the economy were
to weaken." Is it as neat as that?
Mr Bootle: There are other motives
for migration than that.
Mr Butler: The issue is I do not
think it has been tested. I think in the past a lot of the migration
the UK has seen has been through commonwealth countries where
they are here for lifethey stay. It is unclear whether
that would be the same with migration from some of these accession
countries. It could be tested fairly shortly, if the block on
flows from Eastern European countries ends into other western
economies and they have alternative economies where they can go
in Europe rather than just Sweden, Ireland and the UK. That could
be a test. I think part of it is cyclical and I think part of
it is structural. I think the Bank of England had a very neat
chart which showed the wage growth in certain sectors and the
sectors which have gained most from the migration flows, like
construction, and how wage growth has been very benign. I think
it has been an incredibly important change to the UK labour market,
but I do not think it is the only change. I think there are other
just as important changes to the flow of labour migration; that
is, the participation rates of people: for instance 50% of people
who got a job in the UK last year were aged over 64, so you are
tapping into a whole new source of employment, and those flows
have just been as important as migration.
Q41 Mr Todd: What do the rest of
you think about this?
Mr Bootle: Two things. First of
all, I doubt very much whether flows of labour respond quite so
smartly in the sort of carefully calibrated ways of economic incentives,
as was implied in the remark that you quoted, and I suspect that
there are profound cultural and sociological factors at work here.
The fact of the matter is that, on the whole, this country has
been pretty welcoming to flows of labour from Eastern Europe,
and, as news of that spreads, I think that has its own momentum,
irrespective of the economic conditions.
Q42 Mr Todd: Strength of the English
Mr Bootle: That is another very
major point. The second point I would make in regard to all that
is in relation to what might happen if the UK market were a lot
weaker; that is to say, would the immigrant groups, substantial
numbers of them, find themselves unemployed? We do not know the
answer to this, but, I must say, I have my doubts about it; that
is to say, in the markets where they are present, they are so
competitive and extremely, as it were, entrepreneurial at a personal
level at what they do, that I suspect they might be the ones who
are still disproportionately employed, and that the weakening
labour market demonstrates itself rather more in increased unemployment
for the indigenous workforce.
Q43 Mr Todd: You would expect some
churning and displacement to take place.
Mr Bootle: Yes. To the extent
that were the case, then you would not get the discouragement
of flows for straightforward economic reasons that was implicit
in the remark that you quoted.
Q44 Mr Todd: I think I share your
view on that. The remark that labour hoarding may have taken place
last year on the mistaken assumptions of growth, is that a view
shared by others on the panel? Roger has already said that, I
Professor Muscatelli: Yes. Labour
hoarding is a hugely important factorand we know that because
we observe it over every business cycle. You simply have to look
at the way in which productivity cycles over time to noticeand
chart 3.4 shows that very clearly.
You really have to abstract from that labour hoarding and capacity
utilisation effect. There are also utilisation effects obviously
in physical capital, so that is absolutely right. Could I add
a grace note on the migrant labour point: at the moment we are
observing this phenomenon in the UK, but of course the UK, alongside
a couple of other Western European countries, has been most welcoming
to the new accession countries, and, of course, as those barriers
begin to fall across Europe, that may also change the cyclical
pattern. Apart from that, I am fully in agreement with what John
Q45 Mr Todd: Do we not retain some competitive
advantage in having anyway a more liberal employment market than
many other European countries, full stop? You have raised a technical
barrier in relation to Eastern European migration, which exists,
but it remains true that this country is far more liberal in employment
practices than most other parts of Europe.
Professor Muscatelli: That is
true. We need to see how that will evolve over time, but there
are other European countries which are changing their employment
practices as well.
Professor Quah: Could I speak
to your first question. It is true that prices move a lot faster
than people do. You can have changes in inflation and in prices,
but people who have come to this country from Eastern Europe and
elsewhere have set a stake here and they will not flit about because
wages have changed by 0.3% this month rather than last. That degree
of competition is good for this economy. The way in which price
pressures and people movements unwind, that depends: it depends
on how this economy reacts to having this group of willing, eager
workers in place. If prices fall, there is no reason why unemployment
need rise if labour markets remain competitive and flexible.
Q46 Mr Todd: We have also briefly
touched on how reliable measures of productivity actually are.
There has been one quite significant data change in dealing with
software investment which appears to have gone through fairly
consensually as being broadly explicable in international measurement
terms. Is that a view you share?
Mr Butler: It is still an experimental
series and I do not think it gets introduced until 2007. It seems
to make sense in terms of taking business software investment
away from a business cost and classifying it as an investment.
I have some concerns maybe they have gone too far in the other
direction, but I think the key for productivity is that it will
raise the level of productivity in the UK. But I think a lot of
the issues that we have been highlighting and which Roger mentioned
earlier are more about the growth in productivity rather than
the level. So you may raise the level of productivity but you
cannot get away from the issue that productivity growth has slowed
towards zero over the last couple of years.
Q47 Mr Gauke: I would like to ask
about the output gap, which we have already discussed a couple
of times this morning. How significant do you see the output gap
in the UK economy at the moment? Therefore, how significant a
factor should the output gap be in determining our interest rates?
How important do you think the MPC is treating the output gap
in determining our interest rates?
Mr Butler: I think it is one of
the key inputs from the Bank of England's forecast. I think it
is an interesting issue at the moment, in that the Bank of England
put a lot of weight on uncertainties about GDP through last year
and I do not. I do not think the GDP data was significantly under-recorded,
so I would have a different perception about spare capacity in
the UK. I would say that over the last year the slowdown in the
economy has meant that spare capacity has increased. I think the
majority of members on the Bank of England in terms of their public
comments seem to suggest they believe there is a little spare
capacity in the UK. I think the one exception to that is probably
Stephen Nickell. That takes you back to their perception about
there being a little spare capacity could be holding them back
from cutting rates and, therefore, their concerns about the quality
of data are actually instrumental for policy making.
Professor Quah: I think the theory
and the idea behind using the output gap is a nice one. If it
actually worked in practice, it would be a successful theory.
The fact of the matter is we do not know what the output gap is.
Nobody really knows what the correct capacity of an economy is.
Studies in the US and elsewhere, in which they have tried to relate
different kinds of measures of the output gap to behaviour of
inflation and wages, have not been terribly successful. I think
it is much more useful to take note of the data that are measured
appropriatelyasset prices, wage dynamics, output itself.
I think the Bank of England have done exactly that; they have
done exactly the right thing.
Professor Muscatelli: As Danny
[Quah] says, it is very difficult to measure the output gap. If
we had an unambiguous measure, we would not really need a committee
to make these judgmentsyou basically could have a very
simple model which tells you what should happen to interest rates.
If you look at utilisation data, which is one way of measuring
itone way is statistical and just looking at the way output
moves relative to trend; another way is looking at current utilisation
data, either from the CPI in capacity utilisation or skilled labour
shortages. What we have seen in the last year is a situation very
close to the median over the last couple of decades, so I suspect
that is what is concerning the Bank and that is what is causing
them to be slightly cautious. There is evidence that there is
a sort of output gap but they feel the economy has enough momentum
to take it toward trend and it does not need more of an impetus
at this stage. I do not think there is anything staggering from
the CPI which says we have a huge output gap and we have got to
cut interest rates in order to get to trend.
Mr Bootle: I would like to agree
with what has been said. I think it is a very slippery concept.
It is not just a measurement issue. Conceptually it is quite difficult,
because, for it to give you the results you want, the output gap
should be measuring a gap between output that currently exists
and the output level that would need to exist to maintain inflation
stability. There is a great impression given in the words that
somehow this is almost an engineering-type concept, but it is
not, it is an economic concept. If behaviour changes; that is
to say, if economic agents become more or less inflation prone,
then frankly the measure of the output gap ought to change as
well. So this is extremely slippery. It gives you the impression
that it is enabling you to bypass all the difficult issues and,
in fact, it is not because all the difficult issues are embodied
in it right from the start. I think it is a useful way of proceeding,
in thinking what might happen about inflation, to ask yourself
what spare capacity might be, but I agree with what was said earlier
by Professor Quah that you then have to look at prices and behaviour
of real world agents and see whether it confirms or denies the
impression given by your measure of the output gap. I do not think
it is by any means a short-cut to a simple answer.
Q48 Mr Gauke: You also agreeand
I think it is a point that John made earlierthat the globalised
nature of the world now is such that you cannot just look at domestic
output gaps, you have to look at this issue internationally, and
that makes it even more difficult now in how you measure an output.
Mr Bootle: I think it is a very
good point, but if it is difficult to measure and even conceive
quite what the UK output gap is, what do you do on a global standpoint?
It is hopeless.
Mr Butler: The message that comes
across is that output gaps themselves are not going to solve anything,
what they do is provide a framework in which you discuss the main
issues because it is just demand versus supply.
Q49 Mr Gauke: One point that Professor
Sheila Dow has made is she thought it would be helpful if there
was an explicit indication of the MPC's estimates of the output
gap in the Inflation Report as it would improve market understanding
of monetary policy; is there any support for that view from our
Professor Muscatelli: I do not
think so, everything you have heard around this table tells you
that it is a very complex and slippery concept, and I think actually
it would distract the attention of commentators and of policy-makers
to just fix on a single figure as if it was, as Roger says, an
engineering concept where you just pull the lever at this point
or push the lever. It is very difficult and I do not think we
should see that sort of estimate, it can be very deceiving.
Mr Butler: It would make a pretty
Q50 Chairman: Roger, I am an avid
reader of your Sunday Telegraph and Daily Telegraph
Mr Bootle: You are the one.
Q51 Chairman: Yes. I looked at your
February one in the Daily Telegraph about oil prices and
you mentioned that: "In the US, no new refining capacity
has been built in the last 20 years. It seems bizarre in that
context that BP should be able to return $65 billion to investors
as though there is nothing that it can plausibly to do with the
money . . ." and you mentioned also that "BP has been
operating with an internal reference price for oil of $25 per
barrel . . . The more the likes of BP hold back from oil investments,
the more likely it is [obviously] that the oil price stays high."
Give us your views on this as being good or bad news for the economy
in the future? It seems quite alarming, some of the points you
Mr Bootle: It is alarming. To
be fair to the oil companies, again, one has got to take on board
the influence of the past, and what has happened in this market,
which is completely opposite from conventional opinion, is that
it has been extremely cyclical. There have been times when the
oil majors have invested an awful lot in response to high oil
prices, only to find that the oil price has fallen very substantially.
It is not that long ago, after all, that we were operating in
a period of very low oil prices, and what they fear is that the
same thing is going to happen all over again, so the way they
constrain that result is by setting a very low internal oil price.
However, I do wonder whether this is not another specific example
of a point we were discussing earlier on about the weakness of
business investment. Here we have homed in on one particular sector,
earlier on we were talking about all the macro factors which might
well explain low investment in general, and here we have come
across a particular micro circumstance. I suspect this is another
example of extreme corporate caution; dissonance was the word
that was used before. So often in economics we assume that there
is a straight line, dependable connection between financial investment
and real investment and what seems to me to have happened is that
there has been a breakdown in that link, something has gone badly
wrong in the linkage between financial investment and real investment.
Here are investors falling over themselves wanting decent returns,
to the point where they are actually pouring money into index-linked
gilts at less than ½% and there are the international oil
companies being so cautious that they want to hold down their
internal reference price and not invest money in oil exploration
and development. Having said that, the signs are as I understand
itand I am no oil expertthat actually a substantial
amount of oil will come on-stream in the next few years as a result
of previous investment in Canada and Alaska. My suspicion is that
we will be in for another cycle all over again; this is classic
stuff, it is extremely difficult to judge this, no one knows where
the oil price is going so I would not want to be overly critical
of the oil companies although it does strike me as being a bit
bizarre to operate at $25 a barrel.
Q52 Chairman: To what extent are
oil companies still using that internal benchmark of $25 per barrel
in appraising potential capital projects?
Mr Bootle: I am not up to date
on this, I do not know.
Mr Butler: I do not know.
Q53 Chairman: You say no one knows
what is going to happen to oil prices, so is the MPC reasonable
in assuming broadly flat oil prices over the forecast period?
Mr Bootle: That is a conventional
approach which it takes to a number of variables and it is probably
the only reasonable one to take, given the uncertainties. Given
that no one knows it would be very odd, I think, because it is
a very important price, to come out with a very opinionated view
and to base the forecast on that. You have a choice really; you
either assume conventionally that oil prices stay at the current
level, or you assume that they follow a path embodied in the current
futures and forward markets. Anything else is extremely dangerous.
Professor Muscatelli: If you look
at what is happening to consensus forecasts there is an absolutely
huge range between consensus forecasts over the next year, ranging
from around $40 to about $75. That is absolutely huge and just
addresses the sort of point which Roger made which is that this
is so linked to political risks, it is so linked to what will
happen to new investments coming on stream that it is actually
very, very difficult to judge where the oil price will be, even
12 months from now.
Professor Quah: I fully agree
that we have huge uncertainty over what is going to happen to
oil and gas prices more generally. The reason for optimism, if
you want to call it that, is I think that the sensitivity of the
macro economy and monetary developments to fluctuations in oil
prices is now a lot lower than popular impression suggests it
should be. Two pieces of evidence on that are what the experience
has been over the last six to nine months: oil prices went through
the roof and basically nothing happened to the world macro economy
and, secondly, more micro economic studies of patterns of consumer
expenditure: despite what the popular impression is of how we
are all driving gas-guzzling SUVs down the roads of Hampstead
and we are all going to be so much affected by the price of oil
now, the evidence is that the fraction of spending on oil, certainly
by consumers and perhaps more generally, is now a lot smaller
than it was 15 or 20 years ago.
Mr Butler: The source of the shock
is important in terms of what they are telling. If higher oil
prices has been driven by stronger global demand, it would be
odd to argue higher oil prices is a big negative for global demand,
it is important in how you interpret inflation. If that is the
case, should you just strip out oil from inflation and look at
core inflation like some people suggest? If you are doing that
then you should take out the other side of the equation which
is the cheap goods on the high street which are coming in as a
consequence of China coming on stream. I have no strong feeling
about what oil price they should use, there is so much uncertainty
out there, but the issue Danny [Quah] mentioned in terms of how
that feeds through into the economy is an important one.
Mr Fallon: Given the gap that is going
to be created on the MPC by the departure of Steve Nickell, how
important do you feel it is that we have his replacement as somebody
who can test and challenge the economic insider view at the Bank,
and who would you individually nominate?
Chairman: Apart from yourselves.
Q54 Susan Kramer: They can nominate
each other, can they not?
Professor Muscatelli: I have to
say that what you need is a broad range of skills. We must remember
that the external MPC members are supported by very expert staff
who are able to provide them with a lot of information. It is
important that what you have there is a mix of skills, people
who have the intellectual capacity to actually deal with the information
that is put before them, but I do not think you need a whole set
of economics professors on there, to give you an example. For
one thing, yes, they might have strong analytical strengths, they
may understand models well, they may be able to question the econometrics
that lie behind some of the estimates and some of the forecasts,
but they may actually not have the same knowledge of a range of
macroeconomic data that somebody who, say, comes from a City background
or different background would have. I really think that what you
should have there is a mix of skills, and the last thing you want
is actually for the process to become in any way politicised,
because I think the huge strength of the UK system over the last
few years is that it did not run into the sort of partisan politics
issues which, for example, governed US appointments before Alan
Greenspan or even the Bundesbank Council where there were alternate
appointments coming from different houses. What we have got here
is actually something which is good in the sense that it has not
really been affected by partisan politics and we have had a very
wide range of expertise on the MPC. I think that has been one
of the secrets of its success.
Q55 Mr Fallon: Who is your candidate?
Professor Muscatelli: Sorry, I
would need to think about that one.
Q56 Mr Fallon: Professor, have you
thought about it?
Professor Quah: I will take a
stab at this. It is absolutely essential that the MPC be full
of robust discussion and we need exactly that, it is a model for
the rest of the world to admire, I think, and rightly so. My one
name as nomination would be Larry Summers.
Q57 Mr Fallon: John Butler?
Mr Butler: The process in the
UK is one member, one vote, one conscience so it is incredibly
important that you get a good mix on the Committee of free thinkers,
independent thinkers, and from the outside looking in the process
is pointing to a quarterly process where they tend to move interest
rates at inflation report meetings. That suggests, again from
the outside looking in, that the forecast process has become incredibly
important, so someone who understands the forecast process, can
test the Bank of England's models and can raise key issues is
important, but that is a lot of noise without offering any names
and I must admit I have not got any candidates.
Q58 Mr Fallon: Roger Bootle?
Mr Bootle: I have not got a candidate
either, but what I would say is the importance of this depends
very much on how the MPC is run, and maybe it has changed a fair
bit over the last few years. You can imagine circumstancesand
maybe it was like this in its early yearswhen the workings
of the model, for instance, had less of a bearing on the ultimate
decision than they currently now do. There is a sense in which
discussion now on the MPC has become really pretty technical and
is clearly linked into a set of attitudes that I would describe
as essentially academicyou can take that whichever way
you like, it is a good thing and a bad thing. That being the case
it probably is important that there is someone on the Committee
who is able to challenge that thinking; it has not got to be everybodyI
would agree with the other remarks that one does want a wide variety
of skillsbut the way the MPC currently seems to be it is
important that at least one person is able to challenge the orthodoxy.
Mr Fallon: Thank you.
Q59 Chairman: Larry Summers would
certainly bring life to it and he is looking for a job at the
moment anyway, is he not?
Professor Quah: So I hear, yes.
Chairman: Are there any other questions
from my colleagues? If not, can I thank you very much, that was
very, very helpful to us this morning. Roger, I am looking forward
to next Sunday. Thank you very much.
5 Inflation Report February 2006, Bank of England,
p. 20. Back
Sunday Telegraph, 12 February 2006, City Section, p. 4. Back