Examination of Witnesses (Questions 20-39)
MR ROBERT
CHOTE, PROFESSOR
DAVID MILES,
MS BRIDGET
ROSEWELL AND
DR MARTIN
WEALE
17 MARCH 2008
Q20 Chairman: Could one of you answer
that and then we have got to move on, John.
Professor Miles: I think that
it is a question of time horizons. I have no doubt that we need
a lower exchange rate in the UK. It is the natural market reaction
to a current account deficit that is probably unsustainable. You
may need ultimately a rather large depreciation of sterling. If
it all happened in the space of two or three months it would be
very unpleasant because it would generate a lot of inflation six
or 12 months down the road. Ideally what one would want is a rather
prolonged but steady and gradual decline in sterling. The problem
is that it is impossible to try and manufacture such a thing.
Q21 Peter Viggers: Returning to the
key issue of stability and resilience, the Institute for Fiscal
Studies, Professor Miles, said that the economy was less able
to weather an economic shock than it was a few years ago. Of course
the Treasury has produced a paper on resilience and the Chancellor
of the Exchequer made a key point of resilience. Are you persuaded
by his arguments?
Professor Miles: I think on some
measures the UK is not very well-placed to suffer a sharp downturn.
Clearly there is not much margin of error left if the Government
is to meet its fiscal rules and in that sense you would not want
to start from here. If there had been more of a buffer or more
of a margin, then it would have been easier to offset some weakness
with a relaxation in fiscal policy. That is much more difficult
given that you start from here so in that sense the Chancellor's
claim does not quite add up. I guess there is another sense in
which there is something to it though, which is that what we have
achieved over the course of the last ten years with Bank of England
independence is a pretty credible anti-inflation regime. And even
though we have seen oil prices rise very, very sharply, food prices
go up, and inflation a little bit above the Bank of England's
target (and it will probably move a bit further) nonetheless,
expectations about where inflation will go remain pretty well
controlled. Certainly if you look in the government bond market
the yields on government bonds have stayed at an exceptionally
low level which suggests to me that most people believe inflation
will stay very low in the UK. We have avoided what would have
been arguably a catastrophic situation. Had we been going into
a very difficult period for the economy and at the same time people
had lost faith that inflation would stay low, then I think we
would have seen a toxic combination of much higher nominal interest
rates as the shocks hit the financial system. I think that would
have been a truly terrible situation to be in. So there is something
to be said for what the Chancellor was talking about, but it does
not quite read across very well in terms of where you start from
with fiscal policy.
Q22 Peter Viggers: Dr Weale, you
referred to the Asian crisis and our resilience as we came through
that. Do you think that the unusually fast growth of public expenditure
was a determining factor in carrying us through that?
Dr Weale: I do not think so at
that point. As Bridget Rosewell mentioned, that was a factor in
the resilience after the dot-com boom but I think it was simply
that the Asian crisis was resolved more quickly than people feared
or was less damaging than people had feared.
Ms Rosewell: In some senses there
are some parallels between the Asian crisis and what we have been
experiencing recently, but it was much more corralled in the sense
that there were serious financial consequences, not in Western
economies but for the Asian economies, and there were some knock-ons
into things like the Russian debt and long term capital management
and so on and there were some bailouts but they were more corralled
and they are less pushed over into lots of different financial
institutions, so there was not that kind of fear as to where the
difficulties were. Everybody was reasonably clear where those
difficulties were and if there was a bailout it was in a more
restricted area than the things we have been experiencing more
recently.
Q23 Peter Viggers: The Treasury document
on resilience seeks to show with a diagram that the estimated
root mean squared error of shocks is lower in the United Kingdom
than most other countries, but of course we have been buoyed up
recently by our relationship with the United States, by the relevance
and importance of our financial services industry and by the housing
boom. Are you more concerned about the latter which look forward
rather than the statistics which look backwards?
Dr Weale: I am concerned about
the way in which the growth has been sustained because essentially
it has been sustained by, you have described it as a housing boom,
a land price boom, and we are now in a situation where in the
short term to alleviate our problems we want prices to stay up,
we want people to go further into debt or the government to go
further into debt on their behalf, but in the longer term that
is actually what really got us into the difficulties that we face,
so I think there can be a real concern that the stability that
we have enjoyed has in some sense been an illusion and based on
a fool's paradise of essentially wealth appearing in people's
balance sheets through rising house prices.
Q24 Peter Viggers: The Treasury seems
confident that there will be a rebalancing of the economy during
the remainder of 2008 with consumption and business investment
slowing and external demand receiving a boost from the depreciating
pound. Does that correspond with your own thinking?
Dr Weale: Again it corresponds
with my view of the circumstances that give rise to the Treasury
forecast. I mentioned earlier that it was very similar to our
January forecast and that had the same sort of rebalancing with
exports benefiting from the fall of the exchange rate, so once
again if the credit crunch persists and intensifies then we may
find that exports are also weaker than we would like, but it is
a coherent view of the world.
Q25 Ms Keeble: I want to ask some
questions about unemployment. Does the increased flexibility of
the UK labour market mean that employment will be more resilient
to an economic slowdown than previously?
Dr Weale: I think it probably
does. It is unclear because the slowdown may be of a nature that
we have not had for a while and it may be that things like the
minimum wage do significantly reduce the flexibility. On the other
hand, when you have had significant numbers of migrant workers
coming into the country, and possibly in this case not bringing
their families with them, then the experience of other countries
is that in downturns they may tend to leave, so what we may see
is a reduction in the number of people employed without a sharp
increase in unemployment.
Q26 Ms Keeble: There are two particular
points following on from there. Is there any study done of the
impact of slowdowns on, for example, overtime rates and such like
which potentially by impacting on household incomes can have a
very substantial impact on housing repossessions, child poverty,
and the like, whereas those figures do not necessarily appear
in an unemployment claimant count. Do you take my point?
Dr Weale: Yes I do and I am afraid
my answer is I do not know.
Q27 Ms Keeble: Does anyone else know?
Ms Rosewell: I do not know of
any study. We certainly know that when there is a slowdown that
things like overtime rates and so on are hit first. Of course
there are large numbers of people for whom there are no such things
as overtime rates so not all of those would come through in that
kind of way. The point on flexibility is also one of the things
you notice, if there is a severe downturn at any rate, then you
get rising self-employment, you get people going into part-time
work and so on and so forth, and it requires the ability to be
able to do that. With part-time and temporary workers increasingly
being treated as if they are permanent workers, people may be
less willing to offer that kind of employment flexibility in the
future. I think we have yet to see that because a lot of the regulation
in that area has changed quite a lot in the last few years, so
I do not think we quite know how that would perform in a downturn
compared to previously.
Q28 Ms Keeble: I also wanted to ask
about the impact on migrant labour because, Martin, you set out
if there is a slowdown then migrant labour is probably displaced
first. Would you want to expand on that? You are talking about
them leaving but are they not more likely to be made unemployed
or is there a possibility that perhaps because they are prepared
to undercut that it is the non-migrant who might be disproportionately
affected?
Dr Weale: That is obviously possible.
I think the experience in Continental countries going back 30
years and so on has been that there is flexibility and some migrants
have tended to return home, particularly when they are migrants
from not too far away, but what you suggest is also a possibility,
that they will be available for working though possibly illegally
at below the minimum wage or something like that and it may lead
to undercutting; we do not know.
Ms Rosewell: Also there is a big
difference between different kinds of migrant groups. We are already
beginning to get anecdotal evidence, not to be statistically relied
on, that some of the big groups are now seeing that there are
more opportunities back in their own economies, Eastern European
countries, in particular Poland, than maybe they are now thinking
the UK can offer. It is a pull factor, "I can now do better
at home", rather than there is a pull factor to stay or a
push factor to come here. Refugee groups is obviously a very different
proposition and the way that they behave and the way that wage
rates operate are also quite different. It is really hard to give
a blanket answer to this kind of question.
Dr Weale: Except that the number
of refugees is rather small compared with the number of people
who have come from Central and Eastern Europe.
Q29 Ms Keeble: Has anyone else got
a view on the impact on labour market flexibility and migration?
No. Going on to issues about the housing market, do any of you
think that the downside risks for the UK housing market are greater
than the Treasury have suggested?
Professor Miles: I am not quite
sure how they quantified how big the risks were. I think in some
sense the risks are great but in a deeper sense there is an opportunity
as well, which sounds a strange thing to say so let me briefly
describe what I mean. It seems to me not at all implausible that
we will go through a possibly prolonged period where house prices
move lower. Maybe they drift lower and month on month prices are
down on average 1% or so for a long period, or maybe we see something
that will be a little sharper than that. It seems to me that the
probability of this happening is quite substantial. That sounds
a pessimistic and gloomy view. But I think that would not be such
a bad thing. Firstly, for the obvious reason that we have a real
problem of affordability for first-time buyers getting into the
market and the quickest and easiest and most effective way of
that problem being alleviated is if house prices are lower. Secondly,
I am not convinced that there is a such a very strong direct link
between movement in house prices and people's general spending.
I think it is possible to have a situation where we see house
prices move lower over the next year to 18 months, maybe ultimately
by quite a significant amount, but that in itself is not a big
driver of much weaker consumer spending. If that were to happen,
I think that would be quite a good thing.
Q30 Ms Keeble: Could I turn it round
the other way. House prices are linked presumably to wages but
they are also linked to supply. Is there any evidence that people
who have been holding land are going to not build because of a
perception that the prices might be going down? There is then
a risk that prices do not go down and there is real pressure on
lower income house families in trying to afford housing.
Professor Miles: If you have got
land with planning permission, then given the cost of building
a house and the cost of selling a house with the land, then even
if house prices were to be rather significantly lower, I would
imagine for the great majority of people who have got planning
permission on land it still remains commercially viable, to actually
build the house. The difference between the value of a plot of
land when you can build a house on it and building a house and
selling it, and the value just left as non-residential land is
so enormous that I think there is a lot of scope for incentives
to build even if prices were to move lower.
Ms Rosewell: There is an issue
however for some of the companies concerned who might otherwise
be building houses in that at the moment they have not got any
cash. It depends on the mix of things that they might be building
so there is a number of banks and building societies who are restricting
further loans on apartments and flats for example, new builds
of all kinds, at this moment in time, so they may not be able
to afford to.
Q31 Ms Keeble: There has been an
assumed read-across from the problems in the US housing market
to the UK market. Do you actually think there are similarities
and do you see our housing market vulnerable to the same kind
of problems that afflict the US?
Professor Miles: There are similarities
in the sense that we are one of the few mortgage markets outside
the US that has something recognisable as a sub-prime mortgage
market. It has been possible for people in the UK with impaired
credit histories and county court judgments against them to borrow.
That is not true in the majority of other countries in Europe.
Clearly it is true in the US, so in that sense the UK mortgage
market looks more like the US than almost any other mortgage market
in Europe, which in itself sounds quite a worrying proposition.
I think the good news here though is that the kind of toxic mortgage
product that really has caused a lot of the problems in the US,
where people were given mortgage debt with very little prospect
they could repay it even at the current rate, but then with a
built-in feature that the interest rate would re-set a year or
two years down the road dramatically higher, that kind of product
really does not have a UK counterpart. So I am a little bit more
optimistic than some that we can avoid the worst aspects of what
is playing out in the US.
Q32 Andrew Love: In the IFS Green
Budget, Mr Miles, you forecast that there was a one-in-three prospect
of there being a recession. I cannot remember whether that was
a technical recession or not. If you were writing that report
today would you change your mind?
Professor Miles: One in three
was what we thought a couple of months ago. I guess the world
looks a marginally more risky place this morning than it did back
then at the end of January. I might put that probability a little
bit higher. Of course that is the probability of what we call
a technical recession, that is two quarters in which GDP does
not rise; it might fall by a small amount. I remain of the view
that the most likely outcome is that we will miss even that. That
remains the more likely outcome; even if we do go into a technical
recession there are technical recessions that are so mild that
if you look back at them in years to come they hardly show up
as much of a blip. So although one in three (and maybe the chances
are a little higher than that) sounds very worrying, it is perfectly
possible to have a short, shallow, temporary recession and therefore
the risks of something really bad happening to the UK are in a
sense exaggerated by looking at a one-in-three chance or something
like that.
Q33 Andrew Love: Dr Weale, there
has been quite a lot of comment that the Government are being
for too optimistic in terms of the credit crunch disappearing.
In the light of recent events in the United States, would that
be a reasonable assumption to make? Are we fully taking into account
the likely longevity of the credit difficulties we are facing?
Dr Weale: The credit difficulties
do seem to me worse and therefore I think probably also more likely
to be sustained for at least the major part of this year than
I would have said.
Q34 Andrew Love: Do you think it
will go into next year, 2009?
Dr Weale: I really do not know.
I would be very surprised if we see a return next year to the
situation we had before the beginning of these problems in the
summer of last year. In that sense, I think we have seen a permanent
change, but I think one way or another, and it may involve more
in the United States than here, the taxpayer will be taking over
liabilities that they were hoping not to pick up. I suspect that
American taxpayers are going to have to dip fairly deeply into
their pockets to pay for the past success of their financial system.
The question will be how long it takes the authorities to come
to grips with that, and of course the fact that there is an election
in the United States this year and the President does not take
office until January of next year may mean that it is harder to
come to a political solution than would have been the case in
three or four years.
Ms Rosewell: I think you have
got to distinguish between two different things going on here.
One is the semi-permanent change, since all things go in circles
of some length or another, which is the end to cheap money. It
came to a head in 2005-06 really when interest rates were extremely
low and people could borrow for almost anything because there
was also a huge amount of lending that was possible—Japanese
carry trade, borrow cheap and move it over to another jurisdiction.
I think the events we have had now mean that at least for the
next five or six years interest rates will for all sorts of purposes—corporate
purposes, personal purposes, you name it—be higher and the
cost of doing that kind of business will be higher. If you like,
the credit crunch is therefore permanent in that sense. That is
not the same as talking about the credit crunch crisis and the
sorts of things that we have been seeing over the weekend with
banks getting into severe difficulty and having to be bailed out.
That is the bit that we should hope will come to an end in the
next few months because if it does not come to an end in the next
few months we really are for the high jump.
Q35 Andrew Love: I do not want to
get onto the issue about whether boosting liquidity is going to
address the real fundamental problem that we face, but since you
talked about higher interest rates and the impact on the corporate
sector, the Government is suggesting that there will be a decline
in business investment, are they being too optimistic? You were
all mentioning earlier this important word "uncertainty".
How large a part is uncertainty going to play in business decisions
about investment?
Ms Rosewell: I think it is partly
an investment question but it is also a working capital question
not just investment. One of the things that I am observing around
the place is that banks are coming along to corporate clients
and shortening credit lines, raising the price, just on ordinary
working capital, and that is one of the things that increases
uncertainty and makes businesses more cautious about any kind
of activity, even if it is going out into the market for investment
funds, which is the big investment that people tend to think about.
A lot of investment is quite small scale, for example taking on
a couple of people, and we know that investment in intangibles—and
the Treasury has done some interesting stuff around that—is
much more important than it used to be, so a lot of investment
may not be measured. Nonetheless, I think that general tightening,
maybe a screw not very much tightened but just making it that
much more difficult to do business, will in general increase people's
caution. I do think they may be being too optimistic about investment,
although that is the measured investment bit which I do not think
is the whole story.
Q36 Andrew Love: Dr Weale, one final
question, we have just been talking about the constraints on business
investment; will it be the availability or the price of credit
that will be the more important constraint?
Dr Weale: The business sector
as a whole is fairly flush with funds at the moment, so it is
difficult to say. For some businesses—
Q37 Mr Love: The Bank of England
characterised it in their recent report as there are successful
companies where profitability is good, they have got money in
the bank, if I can say that, and they do not have a problem, but
then there is another part of the business sector that is in a
much worse position and I think the concern is about that other
part of the business sector which maybe has more difficulty and
real problems in both availability but also price. Which is going
to be more important or are both going to play a factor in business
investment decisions?
Dr Weale: I think both are going
to play a factor. If you have not got the cash and cannot borrow
it all you obviously will not be rushing to invest particularly
as the equity market is weak and, therefore, rights issues are
not terribly attractive. Equally, I think businesses will be having
to pay more for credit. Sorry, to reiterate the point: if that
premium persists for a substantial period, as indeed it did in
Germany in the first half of this decade, then investment undoubtedly
will be rather weak.
Chairman: I think we will have to move
on.
Q38 Mr Brady: How much scope was
there in the Budget to use fiscal policy to support monetary policy?
Ms Rosewell: Not a lot.
Dr Weale: It depends what you
mean. If you take the view that is what you should be doing with
fiscal policy when the country is in difficulties then there was
quite a lot of scope because, after all, the limits that the Government
set on its borrowing are just arbitrary. On the other hand, if
the Government wanted to maintain, I suppose, the letter as they
define it of the fiscal rules, because I think they have given
up on the spirit of them, the letter as spelt out by the Treasury
then, as Bridget has said, I do not think there was room to support
monetary policy.
Q39 Mr Brady: Is it just the fiscal
rules that limit that?
Dr Weale: Yes, I think it is.
Ms Rosewell: Clearly the Government
could go out and borrow; there is nothing to stop it going out
into the market, although it might have to pay a bit more. If
you ask for more money you might have to pay a bit more, but it
is a triple-A rated institution and it can go out and raise funds.
Indeed, there are increases in borrowing put into this. The self-imposed
constraints are clearly very serious indeed. In fact, the only
reason this current Budget works at all in terms of its forward
planning is by effectively saying the cycle has ended and will
not start again, so we are at the zero point and it is going to
stay there, which seems quite an unlikely outcome to emerge. Certainly
in itself it is an imposed constraint. I suppose the next question
is would it be better if a more relaxed attitude had been taken
to fiscal policy. Given the background to where we are I think
it would be quite difficult for a government to take the sort
of view that has been taken in the US simply because of the scale
of the deficit which exists in what has been a high growth period.
It is quite hard then to say, "We are just going to have
to push it further" as a deliberate thing rather than as
would happen if the economy slowed down where borrowing would
increase because spending would increase on unemployment benefit,
et cetera.
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