Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 100-119)


28 MARCH 2006

  Q100  Kerry McCarthy: In the past there has been an admission that the contribution of software investment has been seriously under-estimated. Do you think the new methodology that has now been adopted by the ONS is appropriate?

  Mr King: Yes, I think we feel it is appropriate. It has been quite a long time in the making. Our staff have talked to the ONS staff. It does not really affect our view of the economy. Essentially what is happening is that a certain amount of activity that used to be deemed as intermediate activity and not final demand has been redefined as final demand. So the level of total demand will be revised up over quite a long period, but it is not going to make a very noticeable change to the growth rates over time. In terms of our conjectural assessment of the economy—where the economy is and what is likely to happen—this is not going to have an impact even though it does have a noticeable effect on the total level of estimated final demand.

  Q101  Mr Gauke: I was going to raise the question of pension fund deficits because certainly one explanation that has been suggested to this Committee is that it is one of the leading factors in reducing business investment. I would just be grateful if you could elaborate on that point and say what consideration the MPC has given as a whole to the idea of pension fund deficits being a factor in this area.

  Mr King: It may well be and I think we certainly could not rule it out. I will ask Charlie to talk in a moment about an empirical study which some members of the Bank carried out on this issue which did not come up with very much supportive evidence for it. It is very difficult to expect to find it because if you ask individual businesses about decisions, from their point of view, quite rightly, it is the strategy of their business, what is happening to their product, which is going to drive their decisions. From the point of view of the economy as a whole, when you are aggregating across all these different businesses, you would expect to find the more impersonal factors, such as relative costs of labour, changes in productivity growth and the cost of capital to be having an impact in explaining the total level of investment. For any individual business, by far and away the most important issue is their particular market, the strategy that they are following. They will be looking at very different factors for driving their investment decision as we might look at in trying to explain the total level of business investment as a whole. Since pension deficits must be a major factor facing a large number of firms, where the size of the deficit will look big relative to their likely cash flow or in some cases even the net assets of the firm. Some companies look more like little operations attached to a pension fund and for them, the pension fund must be a major issue. It does not follow from that that you can easily track annual movements of investment as being particularly closely linked to changes in pension deficits, which themselves can move around a lot. Actuaries change their views about the appropriate way to measure these things as the numbers on longevity and real rates of interest in the economy also alter. We did do a study on it and perhaps Charlie can say a bit about it.

  Mr Bean: There were two strands to it. One is looking at the behaviour of aggregate investment relating to the normal sorts of determinants that people believe might affect investment, demand, profitability, things like that and seeing whether there is any additional explanatory power for including a measure of pension fund deficits in that relationship. That has failed to turn up any effect. However, it should be said that most empirical models of investment are singularly poor. Steve, Mervyn and I all started our professional careers as academics trying to estimate investment equations, but we all realised that it would be sensible to move on to something more practical! We think the fact that the aggregate study did not turn up any very significant effect is not particularly revealing or particularly surprising. We have also tried to look at the behaviour of different sorts of firms, comparing the investment behaviour of firms with large pension deficits and those with smaller pension deficits relative to their sales. Again, there is not any strong indication there that those with larger pension deficits relative to their sales have acted as a drag on investment. But again, the empirical results are not very clear and strong. Rachel has already reported our agents' survey, which, again, seems to suggest it was not very important but, on the other hand, when we go round and talk to business people on our agency visits, I can guarantee that it comes up around the table as a restraining factor for some businesses. So I think we are very much in a position where it is unclear exactly how significant an effect it is having.

  Ms Lomax: The incidence between different firms varies widely. For some old-established firms that have had good pensions schemes, this could be a very big issue indeed, but within the same industry, you get relatively new firms for whom it is not an issue at all. So even at the anecdotal level there is a lot of unevenness. On the question of whether you would ever expect to pick it up econometrically, this is an issue which has raised itself in importance and salience dramatically in the last few years, so I think some of these longer run studies would not really pick it up—the last two years really, so I think it is a bit soon to hope to get it out through conventional techniques.

  Q102  Mr Gauke: To what extent do you think the problem with pension fund deficits is caused by the fact that we have relatively low interest rates at the moment? If interest rates rose, rather counter-intuitively, you might see an increase in investment. Is that a fair point?

  Mr King: We are the Monetary Policy Committee, not the Monetary Pensions Committee. I am sure one could spend hours debating issues of policy on pensions, and that is probably not for today. We do not see ourselves as experts on that. What we are trying to do is to ask ourselves how these issues will affect spending in the economy. Broadly speaking, our view would be that, as far as households are concerned, it is certainly quite possible that the outlook for pensions in the economy will affect their desired savings rate. This is likely to be a slow-burn, medium-term issue, not something that will drive quarter-to-quarter movements in consumer spending. It is a longer-term thing that we look at when trying to form a judgment about where the saving ratio will go.

  Q103  Mr Gauke: Looking at the economy as a whole, do you have a concern that there could be this misallocation to low-risk investments rather than looking for new business investment because of a concern about pension fund deficits? Is that something that is high on your agenda or not?

  Mr King: I do not think that is the issue here on pensions, unless you think the overall level of physical investment is going to be affected. Where the physical investment in the economy goes depends on which opportunities are profitable. The question about pension funds is who bears the risk in the economy. In the past we have had companies with pension funds attached to them which were mechanisms by which they were engaging in very substantial cross-company share purchases, buying shares in each other to put forward a sort of moneybox to fund pensions. That is a risky thing to do where the pension promise is not contingent on the performance of the fund. So I think the whole debate about the private sector pension scheme is a debate about who bears the risk, and that is rather different from a question about what assets are the economy as a whole investing in.

  Q104  Jim Cousins: I wonder if I could ask the Deputy Governor, who made a very interesting speech at Chatham House earlier this year, with lots of interesting issues which I would like to explore but really cannot use this occasion to do that. You did say—this is just one sentence—"Policy makers need to ensure that their policies are robust to the possibility that market expectations may not be consistent with economic fundamentals." That does seem to imply a course of interest rate setting that would be perhaps slightly higher than you might expect to contain these potentially incorrect market expectations.

  Ms Lomax: I am not sure it has quite that implication. What I had in mind was that it is very consistent with the way we think about risks, and that you need to be alive to the possibility that there could be an unwinding of very low interest rates, for example, and think through what impact that might have on your forecasts, in considering how your fan chart looked. It is that sort of thought that was in my mind. It does not necessarily mechanically link through to a super-cautious approach to setting interest rates.

  Q105  Jim Cousins: So reining in market expectations plays no part, as you see it, in the Bank's setting of interest rates?

  Ms Lomax: No. When we set interest rates we are hoping to influence market expectations. That is part of the transmission mechanism. If we simply set interest rates at the very short end and they had no other consequence at all, banks would not change mortgage rates and the other interest rates which affect people's behaviour would not change. So we are always attempting to influence longer-term interest rates by what we do and by what we say. We are trying to persuade people by the clarity of our thought.

  Q106  Jim Cousins: Just following on that stream of thought, in the Quarterly Bulletin there is some fascinating material on the staggering scale of leveraged buy outs. The description of this plays a very large part in the description of market operations in the Quarterly Bulletin. In your own speech in Ashford you referred to risk premia, that they may have become unusually compressed and investors may be taking on more risk. You said, "It is questionable whether such behaviour can persist." Do you have real concerns about the scale of leverage buy-outs, private equity activity, hedge fund activity which are referred to in the Quarterly Bulletin?

  Mr King: I do not have concerns about the flows of funds through those mechanisms, no, but to go back to the question you put to Rachel just now, I think we are trying to influence market expectations of inflation. In terms of expectations of asset prices, or equivalently, risk premia, I do not think we are trying to say to markets this is where they should go, but sometimes we do pose a question. That is why I said in a speech it is questionable. I do not think we have the answer to it but I do think from time to time that we simply say to markets "Ask yourselves the question, is this risk premium or price level sustainable?" That is not the same thing as trying to give a coded signal that it should move in a particular direction or by a certain amount, because we certainly do not know that. There is no way that we can do it. But I do think from time to time it may be that we want to say to people that if you look at past behaviour, this is clearly very unusual relative to the past. There may be good reasons why that can continue. It may well be at present that there are good reasons why risk premia can be exceptionally low, and we have pointed out that a whole range of risk premia in credit spreads are, historically, extremely low. As long as people ask themselves the question "Am I willing to buy and sell assets at this low level of risk premia?" and they have thought about it and answered yes, then that is fine But from time to time a central bank may feel the need simply to pose the question. It is no more than that. There is no way that we can possibly have the knowledge to tell markets or imply to markets that something is mis-priced. We are not in a position to know that, but we are in a position sometimes just to pose a question.

  Q107  Mr Newmark: I think Mr Cousins actually asked an important question there. There is far more private equity funding flowing into the economy, so that up to 20% now is actually in the UK economy. I think the danger is on the debt cash flow that is being borrowed at the moment, so that whereas debt/equity ratios were far lower historically, at the moment private equity firms are borrowing far more against cash flow, and if there is a disruption at all in the debt markets, this could have a big impact on the economy if interest rates suddenly moved.

  Mr King: I think if there were to be large and dramatic moves in interest rates, it would not just be private equity firms that would find themselves in some difficulty; a large range of institutions, including many households, would find themselves in difficulties. The whole point of our framework is that we hope to avoid very large and disruptive movements in interest rates. The deeper aspect of this question, which goes to the point that Rachel made and the question that Mr Cousins asked, is what do central banks know and what should they be suggesting to the wider public? To repeat what I said, we do not know enough to say to someone that a price level is inappropriate. We do sometimes say, "Let's look at the historical experience. Here are the facts. This looks clearly very much out of line with the past." There may be good reasons for that. The future does not have to look like the past, but just think it through, and if you have a good reason, that is fine, but our job sometimes is to pose a question. I put it no more strongly than that.

  Q108  Jim Cousins: I wonder if I could turn to Professor Nickell, being led by the Governor's thoughts that I have been talking about the top end of the range risk, but there was a very interesting article in the Quarterly Bulletin which throws some important light on the bottom end of the range risk. In an article about the distribution of assets, for example, your research teams tell us that one in eight of British households have negative net worth. Are you concerned about this? You have suggested that there was a potential for serious problems for distressed households on low incomes because of their exposure to debt, both secured and unsecured.

  Professor Nickell: Yes. There are two aspects of household debt which are important in this context. One aspect is how it affects the macro-economy, how it affects monetary policy and so on, and the other aspect is how this issue affects the division in social welfare. My instinct is that the position of households at the moment in terms of risks and dangers is more geared to the latter than the former, that is to say that I think that social welfare issues are perhaps more important than the macroeconomic issues. By and large, if you look at household debt as a totality, 95% of all household debt, including unsecured debt, is owed by households who are owners of property or mortgage holders. There is only 5% of all debt which is owed by people who do not have properties. However, if you do surveys and say which households are most in trouble with debt, the majority of people who are most in trouble with debt are poor people, and that is hardly surprising, because poor people often have relative to their incomes quite a lot of debt, and of course, they do not typically have access to the low levels of interest rates that wealthier people have. In fact, the interest rates they face are often extremely high indeed. So there are these two aspects of debt, and I think while the social welfare aspects of debt are fantastically important, of course, for monetary policy they are not very significant because they are just not very big in the economy as a whole. So are there issues with regard to monetary policy in the macroeconomy? One important factor is, of course, that the sheer volume of debt is vastly greater than it was 30 or 40 years ago, in the main because the sheer volume of owner occupation is vastly greater, and house prices are higher anyway relative to incomes. So there is naturally going to be more debate about, and in those circumstances, does it make a difference to monetary policy? The answer is yes, it probably makes household behaviour somewhat more sensitive to interest rates, because if you have vastly more debt around, then changes in interest rates mean more to more households. This comes through basically because the households who owe money, their expenditure tends to be more responsive to interest rate changes and income changes than households who lend money.

  Q109  Jim Cousins: Governor, in the Chancellor's Budget speech last week he, rightly, took credit for a long period of economic stability, and I think he did also say that you and your team have played some part in that. Do you think that an element of moral hazard has crept in here, that we are all taking you and your team for granted, and your successes for granted, and that perhaps both at the top end of the range and the bottom end of the range, people are taking on more risk than ultimately they will be able to bear?

  Mr King: It is a very interesting question. It is not easy to know the answer. Let me give arguments on either side. I think the Chancellor is right to take credit because, in my view, the success of the MPC is the success of the institutional framework. One thing which we are all very conscious of—and I think all past, present and future members of the MPC would be very conscious of—is that any of us could fall under a bus tomorrow and it would not make any difference. The success of the MPC is due to the institutional framework, not to the individual members of it. In that sense, people would be justified, I think, in thinking that the framework is likely to continue. There is no reason why this could not go on indefinitely. On the other hand, where I am slightly worried is if people draw the conclusion that the extent of the stability that we have seen to growth and inflation can continue at the same level. I think the Chancellor and everyone else is perfectly right to claim that, with this sort of framework, we should be able to avoid the big monetary policy mistakes of the past. I do not think it follows from that that you can expect always to see positive growth in every single quarter for ever. There will come a point when there will be a shock to the world economy, whether it is from Europe, from the Far East, from the United States, or indeed whether it is due to some change in sentiment at home, that means that we may well have—for a short period—a period of negative growth. The key thing is not that we have that, because that in itself is not particularly damaging; the key thing is that the Committee would respond to it and would change interest rates in such a way as to bring growth back to its sustainable rate and inflation back to the target. That is what should give people comfort. So my slight concern would be that if people believe that this extraordinary degree of stability can always be maintained in the same quantitative sense, they may be having a slightly optimistic view. But I do not want to encourage people to go to the opposite extreme and suggest that the big swings that we have seen in the past should be characteristic of the future. There is no reason why we cannot have a kind of stability which other major successful Western economies have had over a very long period.

  Q110  Chairman: Governor, the FSA came out with a report this morning on the establishment of a baseline, and they took a number of data snapshots of the population. I have a couple of the conclusions here: 70% of people have made no personal provision to cover an unexpected drop in income, and of the 1.5 million who say they are falling behind with bills and credit commitments, one-third say they have real financial problems and 2 million households say it is a constant struggle to keep up with commitments. Whilst that would not affect the macroeconomic framework, are there any comments you have on the behavioural characteristics of the UK population at the moment?

  Mr King: I think that is going beyond our basic remit. I share Steve's view. There are concerns, and I said this before, that a minority of households have got themselves into quite serious difficulty. I have said for a number of years now on several occasions, both in connection with the housing market and mortgage borrowing, but also more generally, that it is very important for people to think before they borrow. Once people have got into difficulties, of course, that may be rather too late for them to think but it is something that everyone should take on board. There will be a period now in which a number of families will have to work through some quite serious financial problems which have resulted from the expansion, particularly of unsecured, borrowing in recent years. As Steve says, that is not primarily a macroeconomic issue; it is more a question of concern to your Committee and to FSA if they feel that the way in which loans have been made or encouraged has gone too far. That is really, I think, a matter for you and FSA and those people concerned with what Steve described as the social welfare implications. Our job—and I think the only reason the Committee will continue to be successful is if we focus on our one remit—is inflation and stability of the macroeconomy. From that perspective, as Steve says, although there may be some small change in the sensitivity of the economy to interest rates, overall we do not see the build-up of unsecured debt as posing a particularly major issue for macroeconomic policy.

  Q111  Chairman: Steve, given that you are retiring, give us a fulsome answer. Can you add to what the Governor said?

  Professor Nickell: I did have some thoughts on this subject. I think the key issue is employment security and income security. It is true that people do not have fantastically long memories. It is less than 15 years ago that there was a very rapid rise in unemployment and a lot of people were made redundant, and that has had quite strong implications for what was happening in the economy as a whole and the housing market and so on and so forth. It is always possible that there will be a shock which is big enough to make that happen again, and which we could not eliminate by monetary policy. In some sense, when people take out mortgages, when they borrow substantial sums of money, they generally think in terms of life carrying on as it is today. Touch wood, they are right to do so, but there is always this risk, which even the greatest monetary policy in the world could not eliminate. There is always that kind of danger around, and the economy is a more dangerous place than a lot of people now think.

  Ms Lomax: Can I just make an observation? I think people's personal circumstances are also highly uncertain. Even if the economy were enormously certain, people's personal circumstances are subject to all sorts of risks. It does seem to me that a lot of this is down to something which is right outside our remit but it is still important, which is that people's understanding of financial matters simply has not kept pace with the opportunities on offer. People do not have the grasp of financial issues that is necessary to cope with the financial products that are available to them. Financial education has just got to be a large part of that. That is not something that we are deeply into, though we do produce materials, resources, for schools which are helpful in citizenship classes, giving people some general awareness about issues to do with inflation and monetary policy in a very broad sense. I hope we may be making some contribution to basically improving the level of education about these things, but I think that is the fundamental issue.

  Chairman: Just to reinforce that point, the FSA's report this morning said that 40% of people who own an equity ISA are not aware that its value fluctuates with stock market performance, and 15% people who own a cash ISA think its value does. Given that those are the more high-value end of the market, there are possible big problems for us.

  Q112  Mr Gauke: Can I turn to spare capacity. Professor Nickell, you mentioned earlier that you believed there was a fair amount of spare capacity in the economy at the moment.

  Professor Nickell: It depends what you mean by "a fair amount."

  Q113  Mr Gauke: Can I ask all of you what your view is on the amount of spare capacity in the economy at the moment?

  Professor Nickell: I said that I had heard that unemployment had gone up by about 0.5% of the labour force, so there is 0.5% in some sense, plus what firms can do without employing any more people. As far as the surveys are concerned, it seems they have a certain amount of capacity, which is, of course, the other side of the coin from the fact that the productivity growth has been very low, partly, we think, because of labour hoarding, which suggests that a bit more output could be produced without hiring anybody. The total amount of the spare capacity is not large. If one adds the 0.5% plus a bit, so between 0.5-1%, it is hard to describe that as a substantial amount, but nevertheless, between 0.5-1% means that if it is to be eliminated, you do need some above-trend growth. So there is some spare capacity.

  Mr Bean: Small but highly uncertain.

  Ms Barker: My own reading of the capacity surveys is that in fact, if you look back into the peak of the economy in 2004, it looked as though capacity was actually pretty tight. Firms' capacity surveys have fallen back since then, but by historical standards, they are not particularly low. So I guess I think there is a little bit less spare capacity than Steve does, but I also agree with Charlie; it is pretty uncertain.

  Q114  Mr Gauke: The Chancellor seemed to take the view in his Budget last week that actually, there was a fair amount of spare capacity in the economy. He talks of a reasonably substantial output gap. Can I ask your views as to what extent you disagree with that assessment and why?

  Ms Barker: I must admit that I have not had the opportunity since the Budget to read the Budget documents carefully so I do not actually know what the Treasury said on the output gap. I have explained why I think the output gap is not particularly large at the moment. I agree with Steve's comments on the labour market, and I have made the points about capacity, and we do of course approach it in a slightly different way, but it is very uncertain how big the degree of spare capacity is. This Committee has also made the point over the past year or so that this whole concept of spare capacity in the UK has become much more uncertain with the increasing use of migrant labour. So it is actually pretty difficult to be definitive about what spare capacity is at any point in time.

  Mr Bean: The one thing I think that is worth stressing is that spare capacity is not something that we directly observe, the output gap or anything like that. Whereas we can, roughly speaking, observe GDP and we have the ONS to measure it for us, there is no direct measurement of potential output, and you can only talk about that in the context of a particular model and develop ways for trying to measure it indirectly. The Treasury adopt a very different approach to measuring the amount of spare capacity in the economy from the way we do. We tend to build it up by looking at the margin of unused resources in both the labour market and the product market, looking at business surveys and so forth. They have a more top-down approach, and that may well be more suitable for their slightly longer-term perspective. I think it is fair to say we take a view that has a smaller margin of spare capacity than the Treasury envisages at the moment. But, as I said before, it is highly uncertain, so their estimate comes well within my confidence interval.

  Q115  Mr Gauke: Professor Nickell, do you have anything to add?

  Professor Nickell: No, not really. I do not think the Treasury's estimate of spare capacity is that big actually. It would not be fantastically different from where I see it, and Charlie is a bit below me, but we are talking rather tiny numbers here.

  Q116  Mr Gauke: I have the Red Book in front of me. For your information, because it is a chart that is not necessarily clear to see, that the output gap for 2006 it is between 1-1.5% seems to be what they are suggesting. The question I have, I suppose, is that Professor Nickell, you tend to be closer to where the Treasury is on this.

  Professor Nickell: I said between 0.5% and 1% and they say 1-1.5%.

  Q117  Mr Gauke: Yes, but you are perhaps closer than your colleagues. Your view, if I understand it correctly, is that interest rates should be coming down. I would like to ask those who hold a stricter line on this whether, if you believed the Treasury forecast, you would be more inclined to lower interest rates, because it seems to me that that is the implication of the Treasury assessment, that interest rates should be reduced.

  Mr King: Can I go back to Charlie's point about the output gap being something that only economists ever talk about. The most embarrassing cartoon of me that was ever published followed the appearance of the film "Notting Hill", in which the Daily Telegraph, I think, took off the head off Hugh Grant and replaced it with mine, having dinner with Julia Roberts, with the caption: "Mervyn King, seen here explaining the output gap to Julia Roberts." I think the point of this is to illustrate that the output gap does not actually exist in the real world. It is an abstract concept that economists find useful but it does not correspond to anything you could go and measure. Maybe, given the Red Book, it should be a cartoon of Gordon Brown explaining the output gap to Julia Roberts, and maybe he would have more success, but I am not at all convinced that this concept is one that you can easily quantify precisely. Let me give you several reasons why. One is that the figures of output growth in the recent past that were used to construct these numbers are themselves subject to a great deal of revision. What the output gap seems to be in five years' time, when the ONS have had a mature look at the past and revised the data—probably quite significantly—will look quite different from how this so-called output gap seems now. Secondly, all the estimates of it are based on the view that the growth rate of productivity follows a completely exogenous path which is fixed and constant from quarter to quarter. I do not believe there is any good reason to believe that is necessarily the case. As we discussed before, productivity growth may well change from quarter to quarter, and you simply cannot tell the difference between changes in underlying productivity growth and changes in capacity utilisation. They are observationally equivalent. There is no way you can observe an output gap without forming some completely a priori view about the underlying path of productivity. Thirdly, we know, and David Walton has talked a bit about this, that it is quite possible, as we saw in the past, that higher energy prices may have slowed the growth rates of supply capacity. So for all those three reasons—and if you would like a fourth, I would throw in labour migration as something that makes even the concept somewhat dubious—I think it is very difficult to put precise estimates on it. It is a useful shorthand phrase but I am not sure if it amounts to much more than that.

  Q118  Mr Gauke: Accepting that, would you agree that there does seem to be some sort of divergence between the approach of the Bank of England on monetary policy and the Treasury?

  Mr King: Since the methods used to construct estimates of the output gap are different between the Treasury and many other people estimating it, including some of the Bank estimates, then the numbers cannot be compared directly. That is why I think I would be very cautious about just taking numbers and saying this is the output gap.

  Ms Lomax: There is nothing new about it either. We have often found that what they (the Treasury) say and what we might have said are not the same.

  Q119  Mr Todd: Two of you have touched on migrant labour as being a significant uncertainty in this. When we questioned you before, Governor, about the role of migrant labour, you said that it was providing a safety valve for pressure on the economy which would automatically unwind if the economy were to weaken, which implies an extraordinarily smooth process of migrants arriving in this country to take up opportunities and then departing when those opportunities cease to exist. I think on reflection you probably would not see it quite as neatly as that anyway. Presumably, some of this migrant labour will actually stay here and replace the indigenous labour force who may not be able to offer the same skills at the competitive rates that they offer. That is presumably your view.

  Mr King: They may or may not. One thing that is very clear from the views that we hear from businesses around the country is that they recruit directly in Eastern Europe, and if the labour market is not as tight and they do not feel the need for more labour, they will not be out there recruiting as much. So there is bound to be some offset there. I am not saying it is one for one, but nevertheless, they are not the same as people who are born in the UK and feel they have no easy alternative place to live but here. The numbers moving in in response to a tight labour market will not move in at quite the same speed or in the same number when the labour market is looser. That is all I meant by that. There is certainly some degree of flexibility.

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