House of Commons - Budget 2014

Budget 2014 - Treasury Contents

2 Macroeconomy

Prospects for growth

11. Figures from the Office for National Statistics (ONS) show that the UK's economic recovery maintained momentum through to the end of 2013. Compared with the previous year, Gross Domestic Product (GDP) is estimated to have grown by 1.7 per cent,[9] 0.3 percentage points (pp) higher than the Office for Budget Responsibility (OBR) had forecast in December 2013.[10]Chart 1: OBR's real GDP growth forecasts (per cent)

Note: Per cent, quarter-on-quarter; ONS estimates Q1-2010 to Q4-2014 (black) and OBR forecasts Q1-2014 to Q1-2019 (grey)

Sources: ONS, Quarterly National Accounts, Q4 2014, dataset series ABMI; Office for Budget Responsibility, Economic and Fiscal Outlook - March 2014, supplementary economy table 1.1

12. In its March 2014 Economic and Fiscal Outlook, the OBR revised up its forecasts for GDP growth in 2014 and 2015 by 0.3pp and 0.1pp respectively.[11] These changes were driven primarily by upward revisions to its forecasts for business investment. But the OBR lowered its forecast for growth in 2018 by 0.3pp. It explained this revision as follows:

Table 1: OBR's real GDP growth forecasts (percent)

	December 2013 Economic and Fiscal Outlook	March 2014 Economic and Fiscal Outlook	Change (percentage points)*
2013	1.4	1.8	0.3
2014	2.4	2.7	0.3
2015	2.2	2.3	0.1
2016	2.6	2.6	0.0
2017	2.7	2.6	0.0
2018	2.7	2.5	-0.3

* change may not equal difference between December 2013 and March 2014 columns due to rounding

Source: Office for Budget Responsibility, Economic and Fiscal Outlook (December 2013 and March 2014 editions), Table 1.1

13. The OBR's projections for growth in the short term sit just below the median of those made by major independent forecasters in March 2014. Forecasts for growth in 2014 range from 2.5 per cent to 3.3 per cent. For 2015, forecasts range from 2.0 per cent to 3.2 per cent.[13] In its World Economic Outlook, published on 10 April 2014, the IMF forecast growth in the UK of 2.9 per cent in 2014 and 2.5 per cent in 2015.[14]

14. The pick-up in growth through 2013 took many economists by surprise. In explaining the origins of the recovery, the OBR acknowledged that "the ongoing weakness of productivity, real incomes and UK export markets over this period make it difficult to explain why activity has picked up as strongly as it has."[15] However, in evidence to the Committee, Robert Chote, Chairman of the OBR, said that "a combination of factors" explained why the recovery took hold when it did, including:

15. Other economists agreed that heightened consumer and business confidence, a more benign global economic environment, and some reduction in the pace of fiscal consolidation have all played a role in the recovery. Measured by the change in real-terms public sector net borrowing, there was a fiscal consolidation of £39.2bn between 2011-12 and 2012-13, but a forecast fiscal loosening of £13.3bn between 2012-13 and 2013-14.[17] Paul Mortimer-Lee, head of market economics at BNP Paribas, said:

Michael Saunders, Head of West European Economics at Citi said that "the shift from very heavy fiscal restraint to almost no fiscal restraint in 2012, 2013 and 2014" had "lifted a headwind".[19]

16. The OBR identified a number of risks to the recovery, which are examined in more detail in the rest of this chapter. When asked about the sustainability of the recovery, Mr Chote said:

Business investment

17. The OBR expects a strong revival in business investment, with real terms growth averaging 8.3 per cent per year during 2014-18.[21] Over this forecast period, business investment is expected to account for a quarter of growth—even though it currently represents just 8 per cent of GDP.[22]

18. The forecast is grounded in the strong pick-up in investment activity during the second half of 2013, together with business survey data which indicated both reduced uncertainty about future demand, and stronger investment intentions.[23] The strength of corporate finances, and the fact that business investment is more than 20 per cent below its pre-crisis peak, are, according to the IFS Green Budget, further reasons to believe that there is significant scope for growth.[24]

19. By the end of the forecast period, the OBR expects businessinvestment to reach 10.9 per cent GDP, a level only achieved briefly on one occasion in the past 40 years.[25] When asked whether this was plausible, Mr Chote noted that a business investment to GDP ratio of 10.9 per cent was unexceptional by international standards:

20. Despite its positive forecast for business investment, the OBR noted that "it remains to be seen whether the recent pick-up in business investment indicates a turning point in investment spending".[27] Mr Chote added that the OBR had "predicted pick-ups in business investment before that have not materialised", adding that "the data is hard to interpret. There is tentative evidence."[28]

21. Other economists expressed differing views about the likelihood and strength of the recovery in business investment. Mr Saunders wrote that "we are reasonably confident about the prospects for such an investment pick-up"[29] and in oral evidence pointed to the fact that "corporate balance sheets and aggregates are in terrific shape with very strong liquidity" as grounds for such optimism.[30] Mr Mortimer-Lee thought that investment would grow strongly in the short term thanks to the 'catch up' necessitated by postponed investment plans, but questioned how long this could be sustained:

22. Even as confidence and optimism recover, there may remain structural factors that continue to inhibit business investment. Although the funding picture for larger firms has improved, access to finance may remain a problem for SMEs which want to invest. Robert Wood, Chief UK Economist at Berenberg Bank, said that "very poor availability of finance over the past few years has almost certainly prevented some rapidly growing firms from expanding".[32] The CBI wrote that "SME underinvestment is a structural rather than a cyclical problem" and recommended broadening the range of financing sources available to smaller firms as a means of tackling this.[33] Among larger companies, the Kay Review of equity markets has described how short-termism among shareholders can manifest itself in under-investment.[34]

23. Investment is important for the recovery in the short term, but it is also needed to drive the productivity growth necessary for sustainable growth in the longer term. As Ian McCafferty, external member of the Monetary Policy Committee, put it in a recent speech:

Trade and global headwinds

24. The OBR and the Chancellor both agreed that the UK's export performance since the financial crisis had been disappointing.[36] Their assessment chimes with that of the IFS Green Budget, which described export growth since 2008 as "disappointing, especially when considering the sharp depreciation of sterling during 2008-09",[37] and the IMF, which described the UK's recovery to date as "unbalanced, with business investment and exports still disappointing".[38]

25. In explaining the UK's export performance, economists we heard from agreed with the OBR that weak global demand, particularly in the Eurozone and US, which together account for 55 per cent of UK exports,[39] had played a significant role. However, the IFS Green Budget suggested that "structural failings within the domestic economy" were also to blame.[40] It went on to cite a recent report from the Ernst and Young ITEM Club, which found:

The Chancellor also believed that a failure to gain a foothold in emerging markets had held back UK exports:

26. By the first quarter of 2019, the OBR expects exports to reach £672 billion on an annualised basis, well short of the Chancellor's target of £1 trillion by 2020.[43] Imports are expected to grow at a similar rate, leaving net trade (exports minus imports) making no contribution to growth over the coming five years.[44] The IFS Green Budget forecast "modest positive contributions" to growth from net trade, with export growth underpinned by a shift towards emerging markets.[45] By contrast, Mr Mortimer-Lee believed the OBR's assessment to be unduly optimistic. He told us that ongoing weakness in the Eurozone meant the export growth implied by their forecasts was "too rapid".[46]

Chart 2: UK exports and target trajectory to reach £1 trillion by 2020

Sources: ONS Balance of Payments Q4 2013, dataset series IKBH; OBR, Economic and Fiscal Outlook - March 2014, supplementary economy tables, Table 1.2; HM Treasury, Budget 2012, p.43

27. The OBR, however, identified to a number of global risks that could affect the outlook for trade and the wider economy. These include the effects of capital flight on emerging markets of a tightening of monetary policy in advanced economies, particularly the US; the failure of "euro area economies and banking systems […] to complete the adjustment toward sustainable demand and competitiveness", particularly in an environment of very low inflation; and an escalation of political instability in Ukraine.[47]

Spending, saving and debt

28. The OBR wrote that "consumer spending, supported by a falling saving ratio, has been the biggest driver of recent growth".[48] In the face of weak real income growth, this spending has been financed by a reduction in savings: between 2012 and 2013, the savings ratio fell by 2.2pp from 7.3 per cent to 5.1 per cent, its sharpest year-on-year fall since at least 1988.[49]

29. The IFS Green Budget summarised the factors it believed provided the impetus for this shift from saving to spending during 2013:

Mr Wood added that an easing of credit conditions had buoyed consumer sentiment and encouraged a reduction in saving:

30. The OBR, and other economists from whom we heard, agreed, however, that rising consumption could not be financed by falling savings indefinitely, and that spending growth would soon have to fall back into line with real income growth. Mr Chote said:

The IFS Green Budget also forecast that the path of consumer spending would soon begin to follow that of real incomes: "As the household savings ratio levels out, consumer spending is expected to realign and more closely follow the evolution of income growth over the next two years."[53]

31. Even with real household incomes growing throughout the forecast period, the OBR expects that consumption will continue to be financed in part by falling savings. The savings ratio is expected to carry on falling, albeit at a slower rate, throughout the forecast period. By 2018, it is forecast to reach 3.2 per cent,[54] well below its average of 6.1 per cent over the period 1987-2013.[55] When asked whether this was a cause for concern, the Chancellor said:

Chart 3: Savings ratio

Note: Percentage of disposable income saved; annual; ONS figures 1977-2013 (under two different methods)and OBR forecasts 2014-18
Sources: ONS, Quarterly National Accounts, Q4 2014, dataset series NRJS; OBR, Economic and Fiscal Outlook - March 2014, p.87

32. Professor Steve Nickell of the Budget Responsibility Committee avoided expressing a view on whether there was a desirable level for the savings ratio, but noted that "before the crash, it had probably got to a level that was too low", adding that "what one does not wish to see is long trends, particularly downwards, in the savings rate".[57]

33. In his speech to the House, the Chancellor indicated that the reforms to pensions proposed in the Budget would address low levels of saving and high levels of borrowing:

34. In its forecast, the OBR acknowledged that there was considerable uncertainty about the effects of the pensions and savings measures on saving and spending, but on balance assessed their effect to be neutral:

Mr Chote reiterated this in evidence to the Committee, saying:

35. The economists we heard from differed in their view as to the effect of the measures, but agreed that there was significant uncertainty. Mr Wood said "frankly, I don't know how big the number would be but I think directionally it would be positive for consumption".[61] Mr Mortimer-Lee said "I agree that there will be a short-term boost to demand and to tax revenues. Longer term, people may actually save more".[62]

36. When asked about the OBR's view that the pensions and savings measures would not affect the savings ratio, the Chancellor suggested that their assessment was coloured by the fact that the measures had not yet been put into law:

37. The OBR also forecasts a rising household debt-to-income ratio, from 141.9 per cent at the end of 2013 to 165.7 per cent by the beginning of 2019, close to its pre-crisis peak of 169.9 per cent.[64] Mr Chote said that this growth was driven predominantly by the housing market and "a pick-up in house prices and a pick-up in the size and the number of mortgages".[65] He drew a distinction between the falling savings ratio, which had driven the recent growth in spending, and rising household debt, which was a "balance sheet story […] You can have an increase in the household debt-to-income ratio that is not a particularly important part of the consumption story. It is just because houses are more expensive".[66]

38. The economists we heard from were divided about whether the rising debt-to-income ratio forecast by the OBR was worrying. Mr Saunders questioned the forecast itself, saying:

Mr Wood believed that rising debt could increase vulnerablity in the event of a downturn:

Mr Mortimer-Lee was more concerned. He said:

39. The sensitivity of household finances to changes in monetary policy was examined by the OBR. Its central forecast assumes that the Bank of England rate rises in line with market expectations to reach 3 per cent by the start of 2019, but that mortgage rates rise only 0.8 percentage points in response. In this scenario, it estimates that 5.5 per cent of households would have to adjust their behaviour by spending less, working longer hours, or changing their mortgage terms.[70] However, the results are substantially altered if it is assumed that changes in the Bank rate feed through one-for-one to mortgage interest rates:

The housing market

40. Housing market activity has continued to pick up, supported by Government policy, low interest rates and greater mortgage availability. The OBR summarised recent developments thus:

41. This activity has been reflected in rising house prices. According to the Nationwide index, prices grew by 9.2 per cent across the UK in the 12 months to March 2014. In London, prices increased by 18.2 per cent over the same period, their fastest rate of growth since 2003.[73] The Land Registry and Halifax house price indices show similar trends. Adjusting for consumer price inflation, however, house prices remain 22 per cent below their peak across the UK and 6 per cent below peak in London.[74] Market activity, measured by mortgage lending or housing transactions, is also below its pre-crisis peak.[75]

42. Nonetheless, concerns have been expressed that the housing market is entering a bubble, defined by Professor Nickell as "when demand is being driven by people wanting to get in because of expectation of price growth rather than as somewhere to live"[76] and in the IFS Green Budget as when "asset prices are driven by expectations of future price increases rather than by the intrinsic value of the asset involved."[77] If this were the case, house prices would be more vulnerable to a sharp decline in the future.

43. Mr Chote believed that recent developments in the housing market could be adequately explained without reference to such speculative behaviour:

44. The IFS Green Budget examined recent housing market trends in detail. It found that:

However, it highlighted the market in London as a "particular focus of concern":

45. Mr Chote agreed that there were "some bubbly components to what is going on in the housing market in particular parts of the country perhaps rather more than generally".[81] The OBR, which makes a long-run assumption that house price inflation follows the rate of household income growth,[82] forecasts that house price inflation peaked at a rate of 9.2 per cent at the end of 2013, and will fall back to rate of 3.7 per cent by the start of 2017.[83] Prof Nickell has previously appeared to question this empirical link between house price growth and income growth, telling us that "[…] the ratio of house prices to disposable income […] is a number that has been rising by nearly 1 per cent a year for the last 40 years".[84] However, he recently told us that:

46. In identifying emerging signs of a bubble, the IFS Green Budget discussed two approaches: firstly, determining the 'appropriate' trajectory of house prices and testing whether the actual prices deviate from this; or alternatively, investigating whether house purchasers are reporting that they are buying primarily for capital gain.[86] When asked what principal indicators of a housing bubble were, the Chancellor had a different view:

47. Even in the absence of a bubble, house prices may continue to increase if rising demand is not met with a strong response in supply. Mr Chote said that housing supply was "very unresponsive" to demand.[88] Although residential construction has increased, with housing starts 23 per cent higher in 2013 than 2012, the IFS Green Budget noted that the near-term prospects for supply remain weaker than they were before 2008:

48. The Chancellor announced in his Budget speech that he had "asked the [Financial Policy] committee to be particularly vigilant against the emergence of potential risks in the housing market".[90] The remit and recommendations for the FPC, published on the same day as the Budget, do not appear to require any additional vigilance, compared to what was being exercised before; rather, they endorse existing levels of vigilance:

When asked about house price inflation, the Chancellor said:

49. The FPC's statutory responsibility is the "identification of, monitoring of, and taking of action to remove or reduce, systemic risks with a view to protecting and enhancing the resilience of the UK financial system".[93] Mr Wood pointed out that house prices were a concern to the FPC only to the extent that they affected financial stability:

In a written briefing, he added that the FPC's primary means of mitigating financial stability risks from the housing market was to require banks to hold more capital, "rather than attempting the impossible task of stopping house prices rising".[95]

50. By some estimates, the gap between house prices in London and the rest of the country has reached a record level.[96] The Chancellor said that it was important to draw a distinction between developments in other parts of the country and "some of the phenomena you see in central London, which are caused by international money and the like coming into central London property."[97] Mr Chote said that price growth at the "top end" in London "is not mortgage driven. It is overseas buyers and so on."[98] The IFS Green Budget also noted the role of foreign cash buyers in "prime London areas", but added that the data in this area was "relatively poor".[99] The latest Bank of England Financial Stability Report also pointed out the prevalence of foreign buyers in "prime central London", but added that taking the London market as a whole "they appear to have accounted for only a small share of the London market—around 3 per cent of all transactions, according to some estimates."[100]

51. Regional housing market developments have only a limited bearing on the FPC's remit and competence. In evidence to the Committee, Dr Mark Carney, the Governor of the Bank of England, said that developments confined to a particular region were unlikely to have implications for the UK's financial stability:

Stewart Hosie:

Dr Carney:

101

52. When asked about the balance of accountability for stopping house price bubbles, the Chancellor said that "Government and Parliament are accountable for housing supply […] the FPC have the tools given to it by Parliament to deal with issues like mortgage standards".[102]

53. The 2004 Barker Review of Housing Supply places some responsibility for housing costs in the hands of Government; its first recommendation states that "Government should establish a market affordability goal […] to reflect housing as a national priority".[103] It argues that the UK's history of booms and busts "has contributed to macroeconomic volatility, creating a more difficult environment for businesses and for economic policy makers".[104] As well as making further recommendations relating to housing supply, the Review noted that "tackling issues of macroeconomic stability may also require measures to address the demand for housing. Demand side measures, such as the reform of property taxation could help to mitigate house price cycles".[105]

54. House price and commercial real estate bubbles are easy to spot in retrospect. The problem for the Financial Policy Committee is to spot them in advance of their bursting and take whatever action is required to mitigate their negative effects on financial stability.

55. Wider economic concerns are the responsibility of the Government and the Monetary Policy Committee. The Government is also responsible for fiscal and policy tools which directly influence the housing market. It should therefore state what indicators it believes are most important in detecting any wider economic risks arising from the housing market. It should also set out how it plans to address these risks, should they arise.

56. The Chancellor has asked the FPC to be "particularly vigilant against the emergence of potential risks in the housing market". It is not clear precisely what this means in practice, since the new remit document endorses the existing levels of vigilance. The Chancellor should provide a more detailed explanation of his comment, and whether he expects the FPC to interpret its remit in a way that might prompt it to take further action as a consequence.

Productivity and the output gap

57. Productivity—the output produced for a given quantity of inputs—has failed to recover in line with output. In particular, labour productivity, measured by output per hour worked, was 4.3 per cent below its pre-crisis peak in the final quarter of 2013,[106] while GDP was just 1.4 per cent below peak.[107] The weakness in productivity has been manifested in a stagnation of real wages.

58. Other things being equal, productivity growth serves to offset additional demand for new workers as the economy recovers. The weakness in productivity has consequently contributed to a very strong labour market picture, with employment growing by two million over the past two years, and the unemployment rate falling from 8.3 per cent to 7.2 per cent.[108]

59. The OBR's forecast is underpinned by a gradual revival in productivity. Labour productivity in particular is expected to grow by 1.3 per cent in 2014, and by more than 2 per cent in subsequent years.[109] This drives the rising real incomes that in turn provide the basis for sustained household spending growth. Mr Chote said that a pick-up in productivity was crucial for the sustainability of the recovery:

110

60. The OBR acknowledges that "productivity has been exceptionally weak in the recent past"[111] and Mr Chote said that economists were little closer to understanding the causes of this.[112] He also said that the OBR had "been waiting for this pick-up in productivity growth to come for some time", adding that "if you are asking for one single question mark over sustainability, that is probably the score."[113]

61. The failure of productivity to grow in line with output during the recovery has meant that, in the OBR's judgement, "the unexpected strength of GDP growth over the past year [has] been largely cyclical";[114] in effect, that recent growth has not been associated with an increase in the economy's supply capacity. The corollary of this judgement is that the OBR's estimate of the output gap in 2013—the difference between actual and potential output—was revised down from 3.8 per cent to 1.7 per cent between its March 2013 and March 2014 forecasts.[115]

62. Estimates of the output gap vary considerably between independent forecasters. At the time of the Budget, the range of independent forecasts for the output gap in 2014 varied by 6.6 percentage points: the most optimistic estimated that the economy was operating at 5 per cent below potential; the most pessimistic estimated it was operating at 1.6 per cent above potential.[116]

63. Despite the uncertainty about its size, or even whether it is positive or negative, the output gap has crucial implications for judging performance against the fiscal mandate, since it determines how muchborrowing is a result of temporary, rather than structural, factors. However, the OBR and the Bank measure the output gap on a different basis. Mr Chote clarified the distinction and the reasons for it:

117

64. The OBR judges that the potential rate of GDP and productivity growth will eventually return to a rate consistent with historical trends, but that this will not happen before the end of its forecast period.[118] Mr Chote said that this was "simply by virtue of the fact that we have no better basis upon which to make a long-term judgement", adding that "there is no reason to think that the financial crisis should have affected the long-term growth rate of potential GDP or long-term underlying productivity performance".[119] Professor Nickell added that "aside from the world wars, this [trend rate] has been going on for 100 years and it is very hard to argue that we are in a new regime".[120] However, the OBR acknowledges that there are alternative views and significant uncertainty surrounding this judgement:

Some believe the financial crisis of 2008 coincided with a permanent slowdown in productivity growth, perhaps reflecting the exhaustion of 'low-hanging fruit' efficiency gains in the IT sector. Others are more optimistic, assuming efficiency gains have continued apace but that weak demand is masking the process.

121

65. The evidence we took concurred with the view of the OBR that the recovery to date has been driven by an increase in demand without a corresponding rise in supply potential. The output gap is being reduced in size and, so far, there is insufficient evidence to support the view that productivity growth is returning.

9 ONS, Quarterly National Accounts, Q4 2014, dataset series IHYP Back

10 OBR, Economic and Fiscal Outlook - December 2013, Table 1.1 Back

11 OBR, Economic and Fiscal Outlook - March 2014, Table 1.1 Back

12 OBR, Economic and Fiscal Outlook - March 2014, p.9 Back

13 HM Treasury, Forecasts for the UK economy: a comparison of independent forecasts, March 2014, Table 4 and
Table 7 Back

14 IMF, World Economic Outlook database April 2014 Back

15 OBR, Economic and Fiscal Outlook - March 2014, p.54 Back

16 Q112 Back

17 OBR, Public finances databank, 26 Mar 2014 Back

18 Q9 Back

19 Q25 Back

20 Q114 Back