Select Committee on Treasury Minutes of Evidence

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 life—they 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 language is—

  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 think.

  Professor Muscatelli: Yes. Labour hoarding is a hugely important factor—and 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 notice—and chart 3.4 shows that very clearly.[5] 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 has said.

  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 appropriately—asset 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 judgments—you 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 it—one 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 agree—and I think it is a point that John made earlier—that 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 panel?

  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 fan chart.

  Q50  Chairman: Roger, I am an avid reader of your Sunday Telegraph and Daily Telegraph columns.

  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."[6] 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 made there.

  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 it—and I am no oil expert—that 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 circumstances—and maybe it was like this in its early years—when 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 academic—you 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 everybody—I would agree with the other remarks that one does want a wide variety of skills—but 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

6   Sunday Telegraph, 12 February 2006, City Section, p. 4. Back

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