Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

MR MERVYN KING, SIR JOHN GIEVE, MR CHARLIE BEAN, PROFESSOR TIM BESLEY AND PROFESSOR DAVID BLANCHFLOWER

30 NOVEMBER 2006

  Q20  Mr Breed: IVAs are going to double this year, it looks like. To what extent is that the result of pretty heavy marketing of IVAs and whether they are an appropriate form of action for everyone that perhaps enters into them?

  Mr King: I think that is more a question for you to discuss with those who provide and offer them. It is not really in our territory at all. You made them available as a legislature and you should ask the people who are engaging in it how it is working.

  Chairman: A fine answer!

  Q21  Kerry McCarthy: The outlook for each of the components in the GDP forecast is pretty robust. Does this mean the economy is beginning to rebalance?

  Mr King: It is going to rebalance. As I said, the central view we have is that it will continue to rebalance, but we have had false starts before. There is still a long way to go, there is still a significant trade deficit, but during the course of the past year what has been encouraging has been that the business investment, which before that had looked surprisingly weak, has now has now started to pick up. Admittedly it has done so more in services than in manufacturing. Exports also seem to be more buoyant, at least as far as the surveys are concerned. So, I think we are beginning to see some rebalancing and I would expect that to continue. None of us have a central view that consumer spending will grow at the rates that it did in the late 1990s and early 2000s. We expect consumer spending to grow at a rate really no more than the growth rate of the economy as a whole, and we expect to see some further recovery of business investment, some falling back in the growth rate of public spending and some strengthening in exports. That is only a central view and all kinds of things could change that outlook. But that is what we would expect to see, and I think that rebalancing would be desirable.

  Q22  Kerry McCarthy: How important is the slowing up of public sector spending as a factor?

  Mr King: No one factor is important and another unimportant; they are all key numbers that feed into the total outlook for growth. As I have said before, what matters is that public finances are well balanced, the fiscal rules are met, but, within that, what that means for the overall levels of spending and taxation is matter for you and others in Parliament to debate and vote on. We will see a new PBR next week. The numbers in the budget are now relatively dated in terms of the outlook for the economy, and I think we all look forward to seeing the PBR next week.

  Q23  Kerry McCarthy: Can I ask the others quickly what they see as the greatest risks, the greatest elements of uncertainty within the forecast?

  Mr Bean: As far as I am concerned, I think I would put the most significant risks as being from the external side. Our central view is for the slowdown in the US to be relatively short-lived and for growth there to pick up back to a round trend through next year. But there is the possibility that that slow down, which so far has been concentrated in the housing market and residential investment, spreads to the wider economy and that the rate of growth there continues to be depressed for a while and that that also has bigger spill-overs to the rest of the world than we have factored in. That, of course, would hit our export performance. Personally, I would regard that as the most significant risk, but there are clearly risks to both consumption and investment. On the consumption side, it is quite possible that the build-up of household debt in the past may act as a drag on consumer spending. On the other hand, we have been surprised, on the upside, by the strength of the housing market, and that may continue to add support to consumer spending going forward and lead to consumer spending outstripping our expectations. Similarly, as far as the investment goes, we have a central view which sees a reasonably firm recovery in investment, but it is easy to see the outturns being either stronger or weaker than that. Investment is very volatile and very hard to predict.

  Sir John Gieve: On the down side, I agree with Charlie, it is the US and whether the world economy will slow down faster than we are predicting. I think consumption is on the upside, and we are expecting it to perhaps slow down a little bit at the end of the year a bit below where it has been for several years and I think we have yet to see that happen. So, on the upside, the British consumer could prove as resilient as in the past.

  Professor Besley: Also, I think a component of the rebalancing we have seen comes from the renewed strength in euro zone growth; so that is something, if it is sustained, which could be to the upside but it is something that is obviously a further risk factor. Then just down the line, what we discussed earlier in the context of asset prices obviously has implications potentially for consumption in both directions.

  Professor Blanchflower: I think, following on more from Charlie's point, my concerns for quite a while have been about the US economy, especially the housing market, and I think I have been rather more concerned than others, particularly given where I live. The housing market latest numbers last Friday were that house prices in new England had fallen by about 5% in the last 12 months and nationally, for the first time, there has been an overall house price fall, so there is a serious set of questions and debate in the US about the extent of that fall. It is an open question, but the recent data are rather softer than they were in the last few months. So I have rather more concerns, and I have expressed them several times, about the decline in the US. It is still an open question, but the recent data are not strong.

  Q24  Mr Love: In your statement read out earlier on you indicated that business investment was continuing to recover and that the recovery was stronger than the committee had anticipated, but, if I heard correctly, Charlie Bean just said that you are expecting a firm recovery in investment. Is it that optimistic or over optimistic?

  Mr King: No. Investment growth is very volatile and when it recovers it tends to grow at growth rates above that in the rest of the economy. What we are factoring in is not something that looks at all strong in comparison with recoveries in the past. We have been concerned that investment growth had not picked up as we might have expected when the economy did start to recover earlier this year. The same puzzle, interestingly, was seen in the euro area and the US. It went away in those two parts of the world economy, as investment did recover there, and, finally, we have now seen a recovery here too. Business investment has picked up, it is likely, I think, to continue to recover. Of course, there are significant risks but, given the weakness in the past, there is some ground to make up and I think that the central projection we have of a recovery in business investment is a reasonable one.

  Q25  Mr Love: Manufacturing seems to have been one of the areas that are disappointed, yet manufacturers continue to say that they are optimistic about an increase. How do we square that? What is the problem in manufacturing?

  Mr King: Of course, over a very long period the share of manufacturing outputs in total GDP has fallen. In the past year manufacturing has had its strongest year for a long while, the growth in manufacturing has been not far short of 3% over the past year, but it is true that investment has not been strong and that, partly, I think, reflects a change within manufacturing. It is not the case that all manufacturing companies have grown by 3% over the last year—there are big changes within manufacturing. But I suspect that if this recovery is sustained then you would start to see investment pick up too. Despite the falls in manufacturing investment, it has not actually been as bad as the average of the past decade or so, which has been an even more depressed outlook for manufacturing investment. We are going through big structural changes in our economy and, based on the regional visits I have made, there are some very successful manufacturing companies out there. It is not a question of being high-tech, it is a question of having a niche for your own product, knowing your customers and producing something that people want. That has certainly been possible. We have had a lot of stability in the economy as a whole. Manufacturers have seen, some of them, very significant increases in their costs, energy costs and raw materials, which have been very difficult for some of them. But wage costs, which have been typically a concern in the past, have not been a problem. Exchange rates have moved in a way that has made it easier than it was for companies competing with the euro area but harder for companies competing with the dollar area. There are always changes going on in the fortunes of companies within manufacturing, but, overall, the past year has been a good one.

  Q26  Mr Love: Let me press you on that. As I understand it, quite a lot of the comment from manufacturers has been the need to export more. You mentioned about the different areas, but exchange rates are now almost at their highest level overall (I think it is 195 to the dollar) and we have had two modest increases in interest rates. Is that the climate which we are likely to get, both the modest increase in the balance of trade that you are talking about to rebalance economy and the increase of business investment?

  Mr King: You have talked about the fall in the dollar against sterling, and this morning the rate was, indeed, 1.95, which is high relative to the past decade. But our effective exchange rate against an average of all other currencies has not risen in anywhere near the way that we have risen against the dollar. In fact, for a number of years now, our effective exchange rate has oscillated in a small range. There is a chart on page 11 which shows that our effective exchange rate, which is only an average against other currencies, has moved within a pretty narrow range compared with much of our past experience. That is on page 11 of the Inflation Report, bottom right-hand corner. I think that if you take that view, that does suggest that the stability we have had in the economy as a whole has carried over to stability in the exchange rate. Of course, no individual manufacturing firm is the average, and those who are particularly concerned about exporting to the dollar area have found life much more difficult in the last six to 12 months. In the late 1990s, the pressure was the other way round: those companies had no concerns about exporting to the dollar area; it was companies that tried to export to the euro area or were competing with euro area companies in third markets that were suffering then. There are swings and roundabouts. All we can do is to try to think about stability on average. There is a lot of change going on within manufacturing, even though, in terms of the effective exchange rate and, indeed, overall manufacturing growth, things look pretty stable at present.

  Q27  Mr Love: The Inflation Report commented on disappointing public sector investment. Is this a criticism of the Chancellor?

  Mr King: No. I think our job in the Inflation Report is simply to take the numbers. We base our judgments on the stated spending plans of government, but as long as those plans are financed—

  Q28  Mr Love: But it is disappointing?

  Mr King: It is a question of what has happened in the data relative to the previously stated plans, but there are always swings in investment from one quarter to another. The Government must determine the level of public spending. It is not for the Bank of England to comment on. The Bank of England will comment only if the spending gets completely out of line with the tax revenue, and that puts up the pressure on borrowing and perhaps, eventually, in turn on inflation. No, it is for you to have the debate on the appropriate level of public investment.

  Q29  Mr Love: We will.

  Mr King: No doubt next week you will have an interesting debate.

  Q30  Mr Love: Can I turn to Sir John Gieve. You have commented on business investment in a recent speech. Would I be correct in characterising that you may be a little more pessimistic about the possibilities of a significant increase in business investment looking forward? You seem to be puzzled in your speech.

  Sir John Gieve: No, actually somewhat the reverse. The puzzle in the speech was why has investment been so low in the UK for so long. For many years we had a ready-made explanation, which was that macro-economic volatility would put people off making long-term decisions. We have now had a long period of stability but we have not yet seen the increased investment that we might have expected. My speech was saying that the ground seems set for a stronger investment performance. I would not be surprised to see quite a strong investment performance, but I do not know whether the increase we have seen this year is the start of that.

  Q31  Mr Love: Let me just press you. We have been waiting for this adjustment process to take place in the economy in overall demand. The Governor has recognised that consumer expenditure will not continue to rise at its previous level, yet we do not seem to be seeing either the increase in the net exports or the business investment. Why should we be confident that that rebalancing is going to take place?

  Sir John Gieve: We are seeing, in this last year, an increase in investment. Whether that will prove part of a sustained increase over a period of years, we do not know, of course, and, on the evidence I am getting—less from the figures (which are pretty cloudy) than from talking to manufacturers and so on—I think exports also are doing quite well at the moment. Again, the question is will that be sustained in the long-term. My speech was saying that, looked at objectively, you would expect investment in Britain to catch up with the average elsewhere and, therefore, there is no reason to think this will not be part of a sustained increase, but you have to check what is happening each time. We have been disappointed before.

  Mr Love: Maybe global free trade is not as free as we think it is.

  Q32  Chairman: Why are you puzzled if you think things will move on?

  Sir John Gieve: My puzzle was: why has investment been so low in the UK, despite the long period of economic stability, pretty good profitability and very easily available funding? I could not come up with a convincing answer to that, so I said I would not be surprised to see it recover; I would expect it. In other words, the puzzle is that it has not recovered so far. Maybe we are now seeing it do so.

  Q33  Chairman: So you are really puzzled, but you have a great amount faith.

  Sir John Gieve: I do not think I am particularly—. You asked earlier where I saw the balance of risks, and I think I see them as slightly on the upside both for output and inflation, partly because I think there are good reasons to expect investment to be strong and exports to be strong and I do not see much evidence yet that the consumer is reining back.

  Q34  Chairman: You are puzzled that we are walking hand in hand to a better future?

  Sir John Gieve: I obviously should not have chosen an interesting title for my speech.

  Q35  Peter Viggers: The American economy, of course, is the elephant in the room, representing, as it does, appreciably more than 50% of the world's market capitalisation in Stock Exchange terms and a huge economy, and one of the members of the Monetary Policy Committee expressed concerns about the US economy as being his reason for expressing a view. Can you give a further weather forecast on the US economy, please?

  Mr King: No. I do not attempt to forecast the US economy, I am quite happy to leave that to the Fed. We made judgments about the risks, and I think, very much as the Fed and others would think, that the risk of a sharp slowdown in the US economy, which is always possible, looks a little less than it did. We are starting to see the other parts of the economy in the US, outside residential investments, still maintaining some buoyancy, but we will see. I think you should not exaggerate the significance of the US economy to our judgments about the UK economy. In terms of the effective Exchange Rate Index, the euro area is three times more important than the US economy in affecting our trade in goods and services. One of the features that has been clearly concerning us in recent years has been that, despite the great strength of the US economy, we have not been seeing strength in the euro area economy and that had, as Mr Love pointed out, affected our trade. As Tim Besley said a few minutes ago, one of the reasons for the recovery in the export outlook is the fact that the euro area economy, although not growing at anywhere near the sorts of rates that the US did five years ago, has now started to recover. No one can be certain about whether it will continue but it is not as much in the doldrums as it was. That is good news for exports in total because the euro area is much more important in terms of trade to the UK than the US. Of course, there is a broader world economic picture, but I think we are starting to realise that when you think about the world economy you have to give enormous significance now to Asia, not just Japan but China and other economies there. We are in a world economy which is not just the US, it is not just the euro area, it is the whole of the world economy that matters. We have been through the strongest three-year period for the world economy for a generation and that has helped us to sustain the growth. After a period like that there are always bound to be downside risks, and we have tried to factor those in. Overall, I think we would want to look at the world economy in total and not just focus too much on the US.

  Q36  Peter Viggers: The property market is a greater proportion of GDP in the United States than in the United Kingdom. The property sector has been a little weak, but this has not been reflected in consumer spending.

  Mr King: Yes.

  Q37  Peter Viggers: Can you explain that? Do you sense some stresses here that will come through in due course?

  Mr King: People may take different views on it. I have always maintained that the link between house prices and consumer spending was a lot more complicated than many people would have you believe. If the value of your house goes up a great deal, what are you supposed to do? Unless you actually sell the house and move to a smaller one, you cannot use the proceeds to spend. It may make it easier to borrow against the greater equity in house prices, and that is, I think, the main link that we see between house prices and consumer spending, but you require a motive for wanting to borrow in the first place to trigger a pass through from house price increases to consumer spending, and so we are not particularly surprised. Sometimes house prices seem to be correlated with consumer spending growth and other times not. The real difference between the US and the UK is, interestingly, in the investment aspect. The movements in house prices in the US do trigger either increases or reductions in investment in housing, and in the UK residential investment does not respond anywhere near as quickly as it does in the US. So the US economy is more sensitive to its own housing market than we are to our housing market, because our investment in housing seems to be remarkably immune (at least in the short run) to changes in house prices and, obviously, the whole gamut of issues concerning planning and the supply side of housing is responsible for that.

  Q38  Peter Viggers: Can I ask Professor Blanchflower to comment on the last question.

  Professor Blanchflower: Certainly the evidence now in the US is that residential investment has been falling quite strongly. Residential investment there really means new construction and refurbishments, and we have seen shares of companies that are doing that kind of activity have strongly fallen recently, so that is where the major declines have come. As I think I said a little earlier, for the first time now, recently we have seen falls in actual prices and we have yet to see whether that will feed through to consumption, but I agree with the Governor that up to this point it has not done that. For the first time, these house price falls may start to feed through, but up to this point we have not really seen it, it has really been in residential investment, as the Governor has said, rather than in prices and hence in consumption, but, if those declines continue, that might occur. It does look to be fairly regional in nature, in the sense that the declines really are in New England and the mid west, but it has not fed through to consumption there yet.

  Q39  Peter Viggers: Governor, your comments about the euro economy just now were really very positive. There has been recent comment that the weakness of the dollar might cause difficulties to some manufacturers within the euro zone because of the effect on prices of the euro. Can you comment on that?

  Mr King: Yes, of course. The fact that the growth in the euro area economy has picked up this year does not mean to say that it will carry on doing that, there is always uncertainty, and the rise in their effective exchange rate may be something that will dampen the growth of export demand, which has been a key factor in the growth of total demand in the euro area economy. I think we should put the recent changes into perspective. We have not seen a really big change in the effective exchange rate of the euro or, indeed, the dollar over the last few weeks or months. There has been a big fall in the effective exchange rate of the dollar in the last four years. It has fallen by around a quarter, and that is a big change, but it has been gradual and cumulative. I think that factor is one of the reasons why there is some optimism that maybe big changes to imbalances can be brought about in a way that does not inevitably lead to sharp and disturbing changes in the pattern of demand around the world, but that is really still to be seen in the future.


 
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