Select Committee on Treasury Second Report

1  The economy

Economic performance and forecasts

3. After a period when the Government's forecasts for growth in the economy have been subject to downward revision over time, the 2006 Pre-Budget Report marks a change, stating that United Kingdom GDP growth "has been stronger than expected at the time of Budget 2006. GDP has expanded by 0.7% in each of the past four quarters."[7] In turn, the Government raised the forecast for GDP growth in 2006 to 2¾%,[8] up from the 2006 Budget forecast of 2 to 2½%.[9] The Treasury's forecast for economic growth in 2007 of 2¾% to 3¼% remained unchanged since the 2006 Budget.[10] This was somewhat above the average figure supplied by independent forecasters of 2.4%.[11]

4. In contrast to the upward revision of its forecast for economic growth in 2006, the Government has revised down the economic growth forecast for 2008.[12] This followed a revision by the Office for National Statistics of its estimates of economic growth in previous years which meant that, according to the 2006 Pre-Budget Report, "since Budget 2006, estimates of growth in non-oil GVA [Gross Value Added] have been revised up by around a ¼ percentage point in each of 2003, 2004 and 2005".[13] This revision implied that the degree of spare capacity in the economy was smaller than had been anticipated at the time of the 2006 Budget, which Treasury officials explained meant that,

with the output gap smaller, there is less room for future growth because our forecasting model, as set out in the Pre-Budget Report, assumes the economy comes back to trend over two or three years, so, if it is closer to trend now, it has less growth to make up to come back to trend and effectively growth is higher this year than in the past and it is 0.25% lower in 2008 as a result.[14]

Monetary policy and inflation

5. One change between the 2006 Budget and the 2006 Pre-Budget Report has been the forecast for Consumer Prices Index (CPI) inflation in 2006. At the time of the 2006 Budget, this was forecast to be 2% at the fourth quarter of 2006.[15] By the time of the 2006 Pre-Budget Report, this forecast had risen to 2½%.[16] The 2006 Pre-Budget Report stated that "the recent rise in CPI inflation has not been driven by domestic cyclical factors, but by energy and food prices".[17] In view of rising inflation, the Bank of England increased interest rates by 0.25 percentage points twice, once in August 2006, and once in November 2006.[18] The Chancellor of the Exchequer defended the Government's record on forecasting inflation, telling us that "our Budget inflation forecast was exactly similar to that of the Bank of England".[19]

6. On the future path of inflation, the 2006 Pre-Budget Report stated that "CPI inflation is expected to remain above target into the first half of 2007, before quickly returning to target, with monetary policy keeping inflation expectations firmly anchored".[20] This view was similar to that expressed to us by the Governor of the Bank of England in November 2006: "Inflation is expected to rise further above the target in the near term before falling back to the target as energy price inflation falls".[21] The Governor highlighted "particular uncertainty" around the supply side of the economy, given uncertainties around migration and the labour market.[22] On the risks around the Government's inflation forecast, Treasury officials explained that "the uncertainties we see are pretty much the same as the ones the Bank see" on the supply side.[23] The Chancellor of the Exchequer said that "I think that we are surmounting what has been an inflationary pressure on the economy better than other economies and you will see the inflation rate going down over the course of the next year".[24]

Business investment

7. In our Report on the 2006 Budget, we recommended that the Treasury "continue to monitor the performance of business investment".[25] This was after we had received evidence that, although there were favourable conditions for business investment at that time, there was little sign that this was flowing into the growth rate of business investment.[26] Sir John Gieve, Deputy Governor of the Bank of England, gave a speech in September 2006 which covered similar ground, noting that, "in 2005, business spending on investment in the United Kingdom was at its lowest relative to whole economy income since 1965, when official data were first collected".[27] At the time of the 2006 Budget, business investment was forecast to grow by 1 to 1½% in 2006.[28] The 2006 Pre-Budget Report estimated that business investment in the first three quarters of 2006 grew by 5¼% on a year earlier,[29] a substantial increase on the 3¼% growth in business investment reported for 2005.[30] The 2006 Pre-Budget Report went on to state that "though the Pre-Budget Report business investment forecast for 2006 has been revised up substantially compared with Budget 2006, there are still significant upside risks in 2007 and beyond".[31]

8. Dr Martin Weale of the National Institute for Economic and Social Research thought that "you would expect business investment to be rising … We are seeing a lagged response to an unexpected surge in the labour force."[32] He added that, "so far, we have not seen the sort of increase in the capital stock that you would expect, given the increase in the labour force that we have had, so the prospect does look fairly good".[33] He also noted that, "if you look at what people actually spend on business investment, although it has picked up, it is not terribly high and, given the profitability of business, I suppose I still find it disappointing".[34] Ms Bridget Rosewell, of Volterra Consulting, agreed, telling us that "I would still say that the level of investment is disappointing and likely to remain so".[35]

9. The 2006 Pre-Budget Report considered the issue of the under-reporting of certain types of investment, noting that, while the United Kingdom was developing into a knowledge-based economy, activities such as training and research and development were still classified as current expenditure rather than investment.[36] We raised this issue in our Report on the 2006 Budget,[37] and Ms Rosewell told us of her concerns during this inquiry:

You could argue that much of what really is investment does not count as investment in the books, as it were, because it is not investment in plant and machinery; it is investment in intellectual property, it is investment in software and various things which do not count as such, at least in the national accounts. To some extent that must be right, that we have moved the mix of investment towards such sorts of asset.[38]

Professor David Miles of Morgan Stanley thought that the risks to future business investment were not well understood, and that the sense of the uncertainty was shared by the Treasury.[39] Mr Jon Cunliffe, Managing Director, International Finance, HM Treasury, repeated the message of the 2006 Pre-Budget Report, stating that the Treasury saw an upside risk to its forecast for business investment because of strong profits and cheap corporate financing.[40] We welcome the recent rise in the growth rate of business investment, although we note that, given the supportive conditions at the time, the previous weakness in business investment remains unexplained. In these circumstances, although there may be an upside risk to the Treasury's forecast for business investment, it needs to be borne in mind that there is also a downside risk in that the previous weakness remains unexplained, and it is possible that this period of weaker than expected performance may be resumed.


10. Consumption is the most significant expenditure component of GDP.[41] In our Report on the 2006 Budget, we noted that, "while the forecasts of the Budget do not suggest that consumer spending growth will reach the previously high levels seen in the recent past, several outside observers note significant downside risks to these forecasts".[42] The 2006 Pre-Budget Report stated that real private consumption growth had been revised down in 2004 and 2005 by a ¼ percentage point since the 2006 Budget.[43] The Governor of the Bank of England told us in November 2006 that, over that period since the start of 2006, "official estimates of the growth of consumer spending have been volatile".[44] The 2006 Pre-Budget Report noted that "private consumption is forecast to grow at slightly slower rates than the overall economy, reflecting the lagged effect of higher than expected inflation on real incomes, the effect of recent interest rate increases and a higher propensity to save".[45] The 2006 Pre-Budget Report also set out the risks around the forecast for consumption:

Surveys of consumers' saving intentions suggest that the pick-up in the household saving ratio over the past year could continue and exceed the Pre-Budget Report forecast, and recent interest rate increases could constrain consumer spending more than expected given levels of household gearing. Offsetting that, developments in the housing market have been somewhat stronger than expected and could be associated with higher consumption growth.[46]

Ms Rosewell told us of her concerns about consumption in 2007:

We are seeing at the moment, for example, another Christmas which is looking a bit shaky as far as the retailers are concerned. That, of course, may change. They can be volatile people, these consumers. If you think back a year ago we were quite nervous about the consumer for 2006 and the 2005 Christmas was looking bad and then it all seemed to sort itself out during the year, but I think that nervousness of the consumer is still a particular issue and we could well see 2007 looking weak.[47]

Dr Weale expressed a more benign view for consumption in 2007. He thought that "the household sector has, more by luck or more by rising house prices than anything else, acquired quite a lot of wealth over the last ten years and it is showing a willingness to spend some of that wealth so I believe it has a cushion of wealth which, if you like, protects consumer demand from the sort of nervousness that you are talking about".[48] Treasury officials maintained that the Treasury forecast on consumption was balanced: "We have to look very closely at what is happening on the side of household finances, but whilst we factor it into our risk assessment, I think the consumption forecast that we have at the macro level is a measured one and there are upside and downside risks to it".[49]

11. One important risk to the consumption forecast stems from the outlook for house prices. In November 2006, a report by Professor Miles and Melanie Baker of Morgan Stanley suggested that "sharp falls in real house prices may not come for a year or so, but come they probably will".[50] In contrast, the 2006 Pre-Budget Report indicated that the risk to consumption forecasts from house prices might be on the upside because "developments in the housing market have been somewhat stronger than expected and could be associated with higher consumption growth".[51] Explaining the Treasury's analysis, Mr Cunliffe identified the following channels via which house prices influence consumption: a 'wealth channel', whereby people whose assets had grown felt more confident in spending; and a 'liquidity channel', where asset price rises increased the collateral against which households could borrow.[52] Mr Cunliffe thought that the link between house prices and consumption "is not as strong as it was and certainly, although house prices have come back, we have not seen consumption come back".[53] Mr Dave Ramsden, Director, Macroeconomic and Fiscal Policy, HM Treasury, also stressed that

even though house price [rises] are in double-digit rates, they are still moderated from where they were and we expect them to continue to come down to grow more in line with income, but we are not expecting the kind of real house price falls that some forecasters were projecting; we have not seen any evidence of that.[54]

12. Another concern about future consumption has been the recent rise in the level of personal insolvencies. The Governor of the Bank of England told us in November 2006 that

the real problems in indebtedness are not in the mortgage market, but in the unsecured debt market where a number of people have got themselves into desperately serious trouble, and for them and for their families that is a really serious problem".[55]

Mr Charlie Bean, Chief Economist for the Bank of England, told us then that about 8% of households in the Bank of England's sample regarded their debt as a heavy burden, but that those household corresponded to only around 5% of the income total, because they were poorer households. The fraction of households going into an Individual Voluntary Arrangement or bankruptcy was even smaller at 0.2% of households per year.[56] The Governor therefore considered that "there are not enough of them [those in serious debt] and they are not rich enough to mean that this is likely to have a significant impact on total household spending".[57] He did note that Individual Voluntary Arrangements were probably changing behaviour, and that their purpose was to ensure continued consumption while debts were restructured.[58] Treasury officials acknowledged that concerns had been raised over the marketing of Individual Voluntary Arrangements, which the Financial Services Authority was examining, but Treasury officials were muted in their concern as to the risk posed by the rising levels of insolvencies to the macro-economic outlook, telling us "we have to look very closely at what is happening on the side of household finances, but whilst we factor it into our risk assessment … the consumption forecast that we have at the macro level is a measured one".[59]

13. The 2006 Pre-Budget Report also stated that "the possibility of a larger increase [in the savings ratio] represents a downside risk to the consumption forecast".[60] The saving rate increased last year, but this was in part due to increased employer contributions to employees' pensions. These contributions, regarded as saving by households in the national accounts, may not have been taken into account by households themselves when they considered how much they were saving.[61] Treasury officials explained that this posed a risk to the consumption growth forecast if households decided to consume less to save more, a risk exemplified by a finding that, "in surveys, households seem to be saying that their saving intentions are greater than their actual saving is".[62]

14. We note there are several risks around the consumption growth forecast. These include the potential for house prices to fall, for an increase in the influence of insolvencies on consumer spending, and for an increase in the overall saving rate of households, which then dampens consumption. We note the rise in the numbers of households using official forms of insolvency, especially Individual Voluntary Arrangements. We may return to examine matters relating to the regulation of the marketing of Individual Voluntary Arrangements, as well as further considering the economic implications of the rise in personal insolvencies.

Net trade

15. In the 2006 Budget, the Government forecast that net trade would provide a zero input to GDP growth in 2006.[63] The Government's revised forecast in the 2006 Pre-Budget Report was for net trade to detract from GDP growth in 2006 by a quarter of a percentage point. However, the Government again forecast that net trade from 2007 would be a zero input to GDP growth.[64] The Pre-Budget Report acknowledged that the trade statistics were currently distorted by Missing Trader Intra-Community (MTIC) fraud, which meant that "estimates of MTIC-related activity are subject to inevitable measurement difficulties, which in practice may carry over to estimates of net trade".[65] We examine the revenue implications of this fraud later in this Report.[66]

16. The 2006 Pre-Budget Report outlined a downside risk to the Treasury's export forecast from a weaker than expected US economy, and an upside risk from the European Union.[67] This position was reiterated to us by Treasury officials, when the possibility of a downturn in the US housing market spreading to affect the US economy as a whole was discussed.[68] Evidence taken during our hearing with the Bank of England on the November 2006 Inflation Report confirmed that the US economy might be a risk to the GDP growth forecasts, with Monetary Policy Committee members Mr Charlie Bean and Professor David Blanchflower citing a greater than expected downturn in the US economy as a downside risk.[69] In evidence during the inquiry into the 2006 Pre-Budget Report, Ms Rosewell also highlighted the risk from the USA, telling us that "At the time of the Budget it looked like the US economy was slowing. I think that the potential for a much stronger downturn in that economy has probably increased since then, although we are still by no means certain about it."[70] Dr Weale, when discussing the sterling/dollar exchange rate, reiterated that "certainly trade with the United States will be harder but, as the Governor of the Bank of England said, that is only 15% of total United Kingdom trade".[71] Professor Miles, on the other hand, provided a more upbeat assessment of what would happen to the United Kingdom economy should the US economy falter:

The rest of Europe is something like three times more important to the United Kingdom just in terms of trade and all the rest of it, so it would not take much of an increase in growth in the rest of Europe to offset even quite a significant slowdown in the US. I am fairly optimistic on all that and I do not think one should believe that what happens in the US is the real driver of what happens in Europe in general and the United Kingdom in particular.[72]

Treasury officials highlighted the risks "around the US economy and whether the housing market downturn will broaden into a more widespread slowdown of the US economy" as a downside risk to the economic outlook for the United Kingdom economy, but were also keen to point out that "the export forecasts … are affected more by the forecasts for the eurozone".[73] Asked if they expected some rebalancing in exports between the US and the eurozone, Mr Cunliffe replied "Yes, and I am expecting the very sharp decline in exports to the euro area that we saw in the first three or four years of this century to correct somewhat".[74]

17. During our inquiry into the 2006 Budget we examined the potential of a disorderly unwinding of global economic imbalances to affect the United Kingdom's economy.[75] The 2006 Pre-Budget Report again highlighted a disorderly unwinding of global imbalances as a current risk to the economic forecast.[76] When asked whether the recent movements in the US dollar could be considered as part of the unwinding of these global imbalances, Mr Cunliffe replied:

The question on global imbalances is not so much whether they will unwind, because I think most economists think they will, but how and whether they unwind in an orderly way. Actually the dollar depreciation that we have seen over the past four years has been pretty orderly. The very recent one that we saw at the end of November was not as big as the dollar depreciation against the euro certainly in the spring, but it has been quite an orderly process.[77]

He went on to state that "[The dollar] has appreciated against the Renmimbi yuan [the Chinese currency] a little bit and it has appreciated against the yen, but clearly a more global rebalancing of the exchange rates must be part of the overall global rebalancing story".[78]

The labour market

18. At the time of the 2006 Budget, we recommended that the Treasury monitor the implications of what then appeared to be a slight weakening in the labour market.[79] A weakening labour market would pose a potential risk to both consumption growth and the Government's spending plans. While the 2006 Pre-Budget Report referred to "robust employment growth",[80] it also noted the "recent rise in unemployment".[81] Ms Rosewell thought that this combined rise in employment and unemployment might be explained by migration, and that "it would not be therefore any surprise that, if you have got much larger numbers of new people entering the labour force, you might simultaneously get rising employment and rising unemployment, depending on the particular locality that you are looking at".[82] Treasury officials thought that the rise in the labour force stemmed from migration, natural population growth and the fall in the inactivity rate.[83] However, Mr Cunliffe told us that the Treasury forecast was that "claimant unemployment has already flattened off … by at least 15/16,000 over the last six months and we expect that to continue and probably reverse and unemployment on the other side, the labour force survey model, we expect to turn around as the demand in the economy picks up".[84] On 13 December the Chancellor of the Exchequer told us that that day's set of labour market statistics showed that "unemployment is actually down 7,000 and the claimant count is down 5,700".[85]

19. One aspect of the labour market that continues to be shrouded in mystery is the impact of migration on that market. We recommended in April 2006 that the Government study the effects of migration on the overall economy more thoroughly.[86] In November 2006 the Governor of the Bank of England told us of his concerns about the net migration statistics. He questioned the validity of a system of counting migrants based on self-declaration, and concluded that "we do not have in the United Kingdom any particularly accurate method of measuring migration, either gross or net".[87] Ms Rosewell echoed this concern, stating that "one of the difficulties is that we do not really know how big the labour force is".[88] She went on to explain the consequences that arose from uncertainty about the level of migration, telling us that "understanding either what is happening to productivity, employment or unemployment is quite difficult".[89] Treasury officials admitted that the poor quality of migration statistics meant that there was a "risk that the effective labour force is larger than we think and, therefore, there is more slack in the economy and more room for growth".[90] However, they did assure us that the Office for National Statistics had a programme of work in place to try and ensure that the migration statistics improved.[91] The Chancellor of the Exchequer thought that the Office for National Statistics would report on this work soon.[92] The rise in the employment rate is welcome. However, the lack of robust statistics on migration means that it is difficult to assess the overall functioning of the labour market. We note that the Office for National Statistics is undertaking work on these statistics, and we recommend that the Government summarise the results of that work in the 2007 Budget.

The trend growth assumption

20. The trend growth assumption is an important part of the fiscal framework that operates in the United Kingdom. Essentially, the trend growth assumption is the estimated level of economic growth at which the economy can operate, without there being undue inflationary pressure. The trend growth rate assumption is thus an integral part of the measurement of the level of the output gap, and thus the timing of the economic cycle and the achievement of the fiscal rules which we consider later in this Report.[93] The 2006 Pre-Budget Report announced a change to the Treasury's trend growth assumption:

The Treasury has revised the neutral estimate of trend output growth for the post-2006 period in line with the ¼ percentage point upward revision to working-age population growth. Instead of falling to 2½% a year, for the 2006 Pre-Budget Report the trend output growth projection will continue at the same 2¾% rate as since 2001.[94]

This change was audited by the National Audit Office. The Comptroller and Auditor General stated that, "given the market sensitive nature of the assumption for the underlying growth rate, I was not able to consult as fully as would otherwise have been possible".[95] He nevertheless concluded that "the revised Treasury assumption is reasonable and cautious".[96] Ms Rosewell told us that, "if you look at the long-term performance of the economy, the 2.5% looks pretty solid; 2.75% over the forthcoming cycle looks to me to be optimism".[97] Treasury officials explained to us their reasoning for maintaining the trend growth assumption at 2.75%, stating that they had originally intended to reduce the trend growth assumption because of the effect of the retirement of post-baby boom female workers, but now thought that this effect would be "offset by the increase in the population of about 0.2%, and that comes mainly from an assessment of current migration trends".[98] The change to the trend growth rate assumption, post-2006, though audited by the National Audit Office, is mainly based on migration statistics of questionable quality. We note that any significant error in this assumption will have implications for the Government's assessment of its compliance with its fiscal rules.

7   Pre-Budget Report 2006, para A.42, p 195 Back

8   Ibid, Table A4, p 198 Back

9   HM Treasury, Budget 2006: A strong and strengthening economy: Investing in Britain's future, HC (2005-06) 968, March 2006 (hereafter Budget 2006), Table B3, p 232 Back

10   Pre-Budget Report 2006, Table A4, p 198; Budget 2006, Table B3, p 232 Back

11   Pre-Budget Report 2006, Table A9, p 212 Back

12   Ibid, Table A4, p 198; Budget 2006, Table B3, p 232 Back

13   Pre-Budget Report 2006, para A.47, p 197 Back

14   Q 171 Back

15   Budget 2006, Table B3, p 232 Back

16   Pre-Budget Report 2006, Table A4, p 198 Back

17   Pre-Budget Report 2006, para A.54, p 199 Back

18   Ibid, para A.46, p 196 Back

19   Q 329 Back

20   Pre-Budget Report 2006, para A.55, p 199 Back

21   HC (2006-07) 89-i, Q 2 Back

22   Ibid Back

23   Q 154 Back

24   Q 331 Back

25   Treasury Committee, Fourth Report of Session 2005-06, The 2006 Budget, HC 994-I, para 25 Back

26   HC (2005-06) 994-I, paras 21-24 Back

27   Speech by Sir John Gieve, Deputy Governor, Bank of England, entitled "The Puzzle of UK Business Investment", at the University of the West of England, Tuesday 26 September 2006 Back

28   Budget 2006, Table B6, p 240 Back

29   Pre-Budget Report 2006, para A.70, p 204 Back

30   Pre-Budget Report 2006, Table A7, p 206 Back

31   Ibid, para A.72, p 206 Back

32   Q 10 Back

33   Q 12 Back

34   Ibid Back

35   Q 13 Back

36   Pre-Budget Report 2006, Box A8, p 205 Back

37   HC (2005-06) 994-I, para 23 Back

38   Q 13 Back

39   Q 14 Back

40   Q 123 Back

41   Pre-Budget Report 2006, para A.57, p 201 Back

42   HC (2005-06) 994-I, para 13 Back

43   Pre-Budget Report 2006, para A.59, p 202 Back

44   HC (2006-07) 89-i, Q 2 Back

45   Pre-Budget Report 2006, para A.56, p 201 Back

46   Ibid, para A.105, p 213 Back

47   Q 16 Back

48   Q 34 Back

49   Q 141 Back

50   David Miles and Melanie Baker, 'UK Housing: How did we get here', Morgan Stanley, 22 November 2006, p 11 Back

51   Pre-Budget Report 2006, para A.105, p 213 Back

52   Q 137 Back

53   Q 138 Back

54   Q 141 Back

55   HC (2006-07) 89-i, Q 19 Back

56   Ibid Back

57   HC (2006-07) 89-i, Q 19 Back

58   Ibid Back

59   Qq 141-142 Back

60   Pre-Budget Report 2006, para A.62, p 202 Back

61   Qq 135-136 Back

62   Q 135 Back

63   Budget 2006, Table B4, p 235 Back

64   Pre-Budget Report 2006, Table A5, p 201 Back

65   Pre-Budget Report 2006, para A.75, p 208 Back

66   See paragraphs 84-88. Back

67   Pre-Budget Report 2006, para A.107, p 214 Back

68   Q 123 Back

69   HC (2006-07) 89-i, Q 23 Back

70   Q 3 Back

71   Q 15 Back

72   Q 17 Back

73   Qq 123,149 Back

74   Q 150 Back

75   HC (2005-06) 994-I, para 27 Back

76   Pre-Budget Report 2006, para A.101, p 213 Back

77   Q 151 Back

78   Q 152 Back

79   HC (2005-06) 994-I, para 16 Back

80   Pre-Budget Report 2006, para A.50, p 197 Back

81   Ibid, Box A5, p 195 Back

82   Q 6 Back

83   Q 127 Back

84   Q 128 Back

85   Q 345 Back

86   HC (2005-06) 994-I, para 16 Back

87   HC (2006-07) 89-i, Q 43 Back

88   Q 6 Back

89   Ibid Back

90   Q 123 Back

91   Q 124 Back

92   Q 479 Back

93   See paragraphs 27-39. Back

94   Pre-Budget Report 2006, para A.34, p 191 Back

95   Audit of Assumptions for the 2006 Pre-Budget Report, National Audit Office, December 2006, para 46, p 9  Back

96   Ibid, para 47, p 9  Back

97   Q 22 Back

98   Q 156 Back

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