Examination of Witnesses (Questions 1-19)
MR ROBERT
CHOTE, PROFESSOR
DAVID MILES,
MS BRIDGET
ROSEWELL AND
DR MARTIN
WEALE
17 MARCH 2008
Q1 Chairman: Welcome to our first session
on the 2008 Budget. Could you introduce yourselves for the shorthand
writer, please?
Ms Rosewell: Bridget Rosewell,
Volterra Consulting.
Mr Chote: Robert Chote, Institute
for Fiscal Studies.
Dr Weale: Martin Weale, National
Institute for Economic and Social Research.
Q2 Chairman: I will introduce David
Miles, in his absence, from Morgan Stanley; he will come along
shortly. Treasury growth forecasts appear optimistic compared
to the range of independent forecasts detailed in the Budget.
Why do you think the Treasury have been over-optimistic?
Ms Rosewell: I think that if they
had been less optimistic then the strains in the public finances
would have shown up rather more obviously than is the case here.
I think that it is quite odd that the forecasts should be as optimistic
as they are, particularly as the consensus itself is continuing
to fall, and indeed is likely to fall still further in the light
of most recent events. Of course if there is weaker growth then
there are weaker tax revenues and that makes it even more difficult
to sustain the public finances, which are already running £6
billion ahead of where they were estimated to be even six months
ago.
Q3 Chairman: Martin, you usually
have something to say.
Dr Weale: The Budget forecast
seems remarkably like the forecast that we produced in January
and that was slightly more optimistic than the consensus, but
justifiably, so on that basis the Treasury is optimistic but not
over-optimistic. I think what has been happening since then is
that the financial crisis seems to be intensifying. Obviously
the latest sign of that has come after the forecast was prepared
and indeed after the Budget, but I think that what the document
could have made much more of, or could have made something of,
was of the significant downside risk that a prolonged financial
squeeze will create and the implications of that. Once again it
is a document that says very little about how things might go
wrong.
Q4 Chairman: Robert, to what extent
is the Treasury's overall view dependent on its outlook about
the duration of the credit crunch? A number of economic commentators
have said there is a benign approach by the Treasury on this in
that they see the credit crunch having a bit of an effect just
now but we will sail into 2009 and onwards and forget all about
it.
Mr Chote: As you say, the revision
downward to growth is relatively modest in both of the next two
years and given what you say about that relative to the independent
consensus we would certainly have some concerns there. As regards
the impact on the public finances, it is also worth noting that
at the same time that they have revised down real GDP growth they
have also revised up whole economy inflation, the GDP deflator.
So in fact the profile for money GDP through the five years of
the forecast period is very little changed from the pre-Budget
Report and that, in a sense, masks what you would otherwise see
as a bigger temporary deterioration in the public finances.
Ms Rosewell: The particular form
of optimism that I find most disturbing was not that overall headline
number, where even the bottom end of the range is above the current
consensus, which seems odd, but also the discussion about the
UK's resilience to economic shocks and how this is expected to
have increased. It was the complacency surrounding that which
I found particularly disturbing. We know for example in the dot-com
collapse in early 2001 that we had quite a sharp fall in output
and it was only stopped from being sharper by the fact of increases
in spending going through at that particular time which buttressed
that. Indeed London, which is more exposed to private sector developments,
did go briefly into recession in 2001. I think the fact you have
been resilient over the last couple of occasions, it needs to
be shown why that means you are going to be more resilient in
the future. Given the scale of things that are going on at the
moment, indeed were going on before Alistair Darling stood up,
I found that particularly worrying.
Dr Weale: Could I add to that
I do not understand the argument about the resilience of the UK
economy. The UK economy is considerably more geared than some
of its neighbours, perhaps most notably Germany where over the
last ten years debt income ratios have been falling rather than
showing the sharp rise that we have had. We are not as exposed
by that measure as Spain and the Irish Republic, we are slightly
more exposed than the United States, and of course we have had
a house price bubble even more pronounced than that of the United
States, so the fact that things have not gone too badly wrong
in the past one would hope could be reassuring, but it certainly
would not be something that you would grasp at without thinking
of all the sorts of risks that the economy does face.
Q5 Chairman: The Treasury argues
that inflation will fall back to 2.5% by the end of 2008 and return
to target in 2009 and thereafter. Again there has been quite a
bit of comment from commentators that that is a bit optimistic.
Who agrees with the Treasury's forecast?
Dr Weale: I do largely agree with
it to the extent that a few percentage points do not matter too
much. I think that, yes, we do have the prospect, as the Governor
of the Bank of England has said, of a further rise in the inflation
rate at the moment, but I think there is a reasonable basis for
expecting that to fall back towards target. Of course that is
on the assumption that the Bank of England does maintain a relatively
tight monetary stance and also that we do not see a large collapse
in demand. If we do see a marked collapse in demand then inflation
may fall below target eventually next year.
Ms Rosewell: I think I would agree
with that. The Treasury has simply taken the view that the Bank
of England will meet its target and will be committed to meeting
its target, and all the evidence suggests that that is indeed
what they are committed to doing, and they will move interest
rates to enable that to happen, so that seems a perfectly plausible
view for the Treasury to take.
Chairman: Fine. George?
Mr Mudie: The Treasury is assuming that
credit conditions will start to ease during the second half of
this year and normalise by mid-1990, this seems optimistic. Do
you think it is optimistic?
Chairman: We asked them that George!.
Mr Mudie: I asked it better than you
though and probably we were not satisfied with the answers! Can
I just ask something on that then because my follow-up was going
to be—which the Chairman did not ask—there is a disagreement
in terms of some people view the ability to lower interest rates
as being a useful tool in achieving that and other people think
because of inflation that will not allow the interest rate to
be used in that way. How much do you think the Chancellor has
factored into his growth projections interest rate cuts? You did
not ask that, did you?
Q6 Chairman: No.
Ms Rosewell: Given that he essentially
seems to have factored in the view being taken by the Bank that
they will hit their inflation target, that would suggest, on the
basis of what we are seeing currently coming out of the Bank,
that there is probably limited scope for rate cuts, and indeed
that would be more or less consistent with what the market is
expecting, which is another two cuts this year. In fact, I think
things are contingent on a number of additional factors which
are going to be quite hard to balance out. On the one hand, we
still have considerable pressure on some of the underlying cost
increases coming through from, for example, oil and other commodity
prices. Supply difficulties in a number of those areas suggest
that there is going to be continued if not increased upward pressure
at least nudging at those. Oil prices are still rising, over $110
in some markets, so that is going to limit the ability to do that.
However, against that, there is the fact that the market interest
rates that people are actually having to borrow at have moved
away from base rate, and indeed that has happened again in the
last couple of days, so cutting interest rates does not necessarily
cut the borrowing rates that people are actually faced with and
so how that interest rate is working through into the market place
is quite a hard call for the Bank currently to make. They may
feel that they need to cut rates even though that will not necessarily
make much difference to the cost of borrowing, it may stop it
increasing too much, so there is a conundrum there. The third
thing is that if we are right, as most of us seem to be thinking
that the Treasury is optimistic about growth, then as growth declines
that may actually mean that the Bank is more willing to see it
break its inflation target in order to try and maintain some pace
of growth if things look particularly bad, and we have yet to
see that.
Q7 Mr Mudie: In the States we have
seen the sub-prime stuff move across to the mainstream with very,
very worrying consequences. If an intensification of the credit
squeeze happened here, what do you see the effect on the UK economy?
Professor Miles: I think it has
the potential to be serious. The UK economy is like the US economy
in the sense that the household sector has borrowed a great deal
of money, we have a very low savings rate, and there is a lot
of debt out there. And if we were to see the cost of debt to households
and to some extent to companies rise—and we have not seen
much of a rise yet but there is obviously the potential for it
to play out that way—that has quite an impact on the disposable
income of many households. It would affect the growth forecast.
So far the thing that has not happened in the UK (but it clearly
has happened and will continue to happen in the US) is that there
really is no firm and strong evidence of sharp rises in defaults
on mortgages. As yet in the UK although people are very worried
about that, we really have not seen a very significant deterioration
and we are still in a position where bad debts and arrears on
mortgages and repossessions of property are still running historically
at a really rather low level. So it is a risk as opposed to the
situation in the US something that really is already playing out
in front of our eyes.
Q8 Mr Mudie: Going off the housing
side, that has repercussions for the rest of the financial economy
and that would be more likely to hit us first rather than what
you say in the mortgage field. Could you see that happening here?
Are you worried about the developments in the last week in the
States? Martin, you were going to answer the question before I
suppose!
Dr Weale: Yes, I am afraid I was.
Obviously the effect of a credit crunch depends how tight the
crunch is but, for what it is worth, our estimates are that if
rates to borrowers were pushed up by four percentage points for
one year that would take 1.3 percentage points off GDP, so that
would turn us into a state where there was very little year-on-year
growth. It would effectively mean, depending what definition people
adopt, a recession, so a tight credit squeeze does very much have
the power to deliver that, and it could do it here as well as
in the United States.
Q9 Mr Mudie: Back to Mr Miles, David,
if you wanted a massive injection of liquidity by the Bank of
England or the creation of an emergency state mortgage lending
agency, you would be overwhelmed to see that the Government has
set up a working group to examine market-led initiatives. Could
you give us your view on how you think they will work?
Professor Miles: I think a couple
of things have happened. Firstly, and not related to the Budget,
the Bank of England did announce last week, I think it was, that
they would continue the practice of lending for relatively long
horizons—three months—against a broader range of collateral
than in their normal operations. They will have an auction, I
believe it is tomorrow, of £10 billion: that follows two
unusual auctions that they did in December of last year and January
of this year and they have announced they are going to do that
again in this month, March, and again in April. So there has been
some action by the Bank of England and, who knows, we may see
more announcements by the Bank of England in due course. In terms
of the working group that was set up, and that was announced in
the Budget, its aim is to make the mortgage-backed securities
market work a bit better. To be honest, I think it was probably
the most sensible thing because there were some rumours that perhaps
the Government was going to announce a rather prescriptive regime—a
so-called kite mark regime or gold standard for mortgages such
that mortgages that had certain characteristics would be given
some kind of official seal of approval. That was mooted, at least
in public, as being maybe the way the Government was going. Relative
to that, which was a rather dangerous strategy, I was rather pleased
they have gone down the road of looking for a market-based solution
and getting the input from practitioners in the market. I would
say that I think the actions of the Bank of England have gone
in the direction that I thought was helpful and necessary at the
time I wrote a short piece in the Financial Times a month
or so back.
Ms Rosewell: I would support that
because I very much agree with David that producing some sort
of kite mark for the mortgages that everybody knew were all right
was not actually going to make any difference one way or the other.
What is much more at issue here is the mechanisms by which banks
finance themselves and each other and the inability to get longer
term finance when in fact nothing much had changed in the market-place,
even for institutions which were largely only issuing these kinds
of debt, and that was because the money being wiped off other
banks' balance sheets was reverberating through the system so
that people normally doing business were just not doing that business
because they were finding it hard themselves to get finance. That
is the circular nature of banking after all. That is why this
move by the Bank of England to continue a slightly—three
months is not long, I have to say, in term but it is certainly
better than overnight—longer term auction enabling people
to pick up some at least medium-term funds in a more normal basis
than they have been able to do recently is quite important while
this disruption is going on. The disruption, I think it is important
to understand, is not particularly because there is much toxic
debt in the UK housing system (there may be overextension in a
number of places but I do not think it is anything like it was
in the States) it is because of the way that individual banks
in other institutions who have been exposed to that have had to
write money off and therefore have much less ability to generate
further normal "business as usual" finance, so there
is some exposure but a lot of it is just as much about the ability
to do business as usual.
Dr Weale: I think the difficulty
we have is that in the short term we probably—more than
probably—want to see more mortgages becoming more readily
available. The restriction in mortgages we have seen is likely
to be a problem for the economy but in the longer term we do want
to move to a situation where mortgage finance is less readily
available than it was in, say, July of last year and excessive
availability of mortgage finance has been fundamentally the cause
of these difficulties.
Q10 Mr Mudie: That is a controversial
statement, Martin, but there we are. Back to David, what about
the Government's preoccupation with long-term fixed rate mortgages;
how successful do you think the Budget will be in moving on that
debate?
Professor Miles: Well, first of
all I think there is a good reason for the Government to continue
to be concerned about this area. Part of the problem we may see
playing out in the UK economy over the next few years is that
people may be faced with mortgages that are more expensive than
they thought when they borrowed money two or three years ago.
And that would not be because the Bank of England has increased
interest rates very sharply. It is another risk, which is that
mortgage lenders may feel they need to charge more even though
the Bank of England may be cutting base rate. That just emphasises
there are many risks that people take on with variable rate mortgages.
It is not just about what is the rate of inflation and what the
Bank of England will do; it is about the whole operation of the
financial market, and I think that is one reason why the Government
quite rightly remains concerned in this area. In some sense I
think the Government's focus in what they announced at the Budget
always was going to be somewhat narrow because it was very much
on the wholesale funding of mortgages; it was not so much, in
fact it was not at all about the way in which mortgages are sold—the
information people are given, their understanding of risks. That
set of concerns is very much in the area of the Financial Services
Authority in its regulation of mortgage sales. That regulation
is an on-going process. The FSA is reviewing its current way of
regulating mortgages, seeing how well it works. I think the Government
focus in this Budget and the announcements they have made and
the consideration they will give when they come back at the Pre-Budget
Report to the issues, are very much on the funding side, where
to my mind the issues are probably to some extent less significant
than where I think the real issues in the mortgage market are.
That is about consumer understanding, about information, about
people's ability to understand risks and the incentives of lenders
and intermediaries. That set of issues really is not part of the
process that the Government is looking at right now.
Q11 Mr Mudie: With the problem in
mortgage markets and the threat of falling house prices, is it
a sensible time to be pushing? It seems to be a preoccupation.
Professor Miles: I think it is
a preoccupation for a good reason, which is that we have a mortgage
market in which because house prices are very high in the UK people
are borrowing a great deal relative to their incomes. It remains
the case that the cost of variable rate mortgages is very difficult
to predict. I have got very little confidence where mortgage rates
will be six or nine months from now. It depends on a whole range
of factors, many of which are nothing to do with what goes on
in the UK economy. Thinking about the type of debt people take
on and their understanding of risk and their ability to handle
unexpected movements in the cost of debt, one can see why the
Government remains of the view that this is very important and
I think they are right.
Ms Rosewell: But long-term mortgages
are not cheap.
Q12 John Thurso: I would like to
follow up on the question that George Mudie asked about the effect
of America. Can I quickly get a handle; how many of you think
that America will go into recession in 2008 and what level of
severity might you be anticipating?
Ms Rosewell: I think it probably
is in recession.
Q13 John Thurso: Is that a fairly
consensus view?
Dr Weale: Whether it is in recession
or not depends on how you measure recession. I think it depends
on whether the financial crisis does persist or whether things
do start to ease up fairly quickly. If things do start to ease
up fairly quickly I think we could have year-on-year growth of
1% or more than 1% this year compared with last year in America,
and that may still mean two quarters of falling output, which
some people use to define a recession.
Q14 John Thurso: So your view would
be that it is not going to be severe, it is not going to be a
repeat of the early 1990s for example?
Ms Rosewell: I do not think we
are really in a position yet to know quite the answer to that.
It is not about 2008; it is about 2009. It is clearly getting
worse at the moment. As Martin says, if the economy recovers and
business as usual returns in the back end of this year, then the
American economy is very flexible and it could bounce back in
2009, and you would have a picture much like the end of the dot-com
boom, for example, a sharp decline and then a bounce back. If
the sorts of things we have been hearing in the last couple of
days go on then 2009 we will not be in that kind of position.
I think it is quite finely balanced at the moment.
Q15 John Thurso: Two questions wrapped
up as one really, people always used to say that when the States
sneezes everybody else catches a cold. What is that going to mean
for the UK? How do you see that impacting on the UK? There has
been of course tremendous development in the Asian economies which
are no longer as linked as they used to be, so how do you see
that impacting on us?
Ms Rosewell: I do not really believe
we have decoupled from the United States as much as some people
have suggested. It is still the largest single economy in the
world and although China may be growing very fast, certainly from
the UK perspective we do not do that much business with China
and certainly in terms of exports we do not do that much business
with China. If you look at what is happening to the European economies,
they are trundling along but again they look slightly vulnerable
to what is going on. German banks in particular have been struggling
with the consequences of the American sub-prime debacle. Japan
has also moved down quite sharply. It is quite hard to see that
the ramifications of this current global financial business do
not go right across the whole world.
Dr Weale: I think the point is
that although the UK has other export markets and the United States
is an appreciably smaller share of the world economy than it was,
the sort of financial crunch that we are seeing is inevitably
international and it is hard to imagine that it could not be,
so if the United States simply sneezes because people decide to
save more, then the rest of the world could probably cope with
that, but if the cause of the disease is a credit crunch, then
I think the rest of the world will be affected and if it does
persist into next year in the United States then the United Kingdom
will be affected in the sort of way that I indicated.
Q16 John Thurso: The Treasury expects
euro area GDP growth to slow to below trend rates in 2008 but
returning to trend in 2009. Does anybody not share that view?
Dr Weale: I think again that view
is contingent upon how you expect the credit crisis to play itself
out. It is entirely coherent with the view in the Budget document
and the fault is not that they have that view, it is they do not
give enough attention to alternatives, or any attention to alternatives.
Ms Rosewell: Hear hear.
Q17 John Thurso: I have a huge sense
of de«ja" vu from having run a business through
the 1993 period where everybody went on talking about how there
might be a soft landing and it was all going to be all right on
the night and then before you knew it we were into negative equity
and businesses were struggling to survive. The de«ja"
vu feeling that I have is everybody is trying to talk themselves
into a reasonable outcome and every day we get worse news.
Dr Weale: That is fair enough
but one can also remember occasions when everyone was trying to
talk themselves into recessions that did not happen, for example
1998 and the Asian crisis when you could have made exactly the
same comments as have been made now about the Treasury forecast
being optimistic but actually the projection was lower than things
turned out. What that does is demonstrate the uncertainty.
Ms Rosewell: The Governor of the
Bank of England is always coming in front of you to talk about
uncertainty and the role that it plays, but that is precisely
why I agree with Martin, that the failure to discuss some of the
risks which are in this Budget Report at this particular time
seems to be so complacent.
Q18 John Thurso: Let me turn to one
of those risks; how many of you are concerned that the UK's current
account deficit is now at its highest level since records began
in 1955?
Dr Weale: It is important to remember
that the current account deficit measures the difference between
saving and investment. Compared with three or four years ago we
have had two things going on and contributing in roughly equal
proportions. One is that we have had an increase in investment
as a proportion of GDP, and that may be explained by the surge
in immigration that we have had because if you suddenly have a
lot of workers that you were not expecting then it is sensible
to import the means of finance of the capital that they use to
work with, and that increase in borrowing does not worry me enormously
and that has accounted for roughly two percentage points of GDP.
However, we have also had a two percentage point decline in the
savings rate and that is simply people spending money that they
have not got. To be quite frank, I am surprised that the Government
has in its Budget documents over the last two or three years paid
absolutely no attention to that.
Q19 John Thurso: Do you think that
the drop in savings is a critical problem?
Dr Weale: I think the United Kingdom
has a long-term problem of undersaving. For what it is worth,
work that I have done suggests that if each cohort paid its own
way consumption would be about 8% lower than it is. In other words,
we are relying on being supported by someone else at some point
and either our descendents will have to pay or be disappointed,
one of the two. I think the United Kingdom does have a particular
problem in that respect and it is something that the Government
has approached piecemeal but it has no overall strategy about
what it thinks we ought to be saving and why and how to achieve
it.
John Thurso: Are any of you particularly
concerned by the possible inflationary impact of continuing falls
in sterling?
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