ANNEX TO PRESS NOTICE 136 ("UK Economic Growth Remains Impressive"), 22 NOVEMBER 2000
United Kingdom – 2000 Article IV Consultation Concluding Statement of the Mission
1. The overall performance of the U.K. economy remains impressive. Output is growing at a brisk pace, the unemployment rate is at its lowest level in a quarter century, and concerns at the beginning of the year about a pick up in inflation have not been borne out despite the rise in world oil prices. These achievements reflect, in no small measure, sound macroeconomic policies underpinned by strong fiscal and monetary frameworks that emphasise transparency and accountability, as well as a decade and a half of fundamental structural reform that should, in many respects, be an example for many other European countries. That said, some aspects of the economic performance remain disappointing. In particular, the U.K.’s comparatively weak labour productivity performance in relation to other countries—due mainly to past underinvestment in physical and human capital—may be the Achilles’ heel of an otherwise strong economy.
2. Looking to 2001, the ongoing economic expansion appears set to continue with output growth in the range of 2½ to 3 percent. Private demand growth may slow down, but total domestic demand would still be buoyed by a sizable increase in government spending. Assuming that the real effective exchange rate of sterling stays at its present level, we would expect only a moderate drag on growth from the external current account. With output expanding on top of already high levels of resource utilisation, inflation could pick up somewhat, albeit from the quite low rates observed currently. There are, as always, a number of risks to this outlook, but the upside and downside risks would seem broadly balanced at this juncture. On the upside, private spending growth may not slow down as projected. On the downside, a possible slowdown in activity in the United States and continental Europe, turbulence in world financial markets, or a further increase in the price of oil could lead to a deterioration in the outlook.
3. Given these broadly favourable economic developments, our assessment does not call for any major changes in strategy. Rather it relates to the nuancing of policies that could, at the margin, contribute to better demand management and an upward shift in productivity. Our views are conditioned by the high degree of uncertainty as regards the scope for further noninflationary growth beyond 2001. The uncertainty stems from two sources: first, how much further the unemployment rate can fall before setting off wage pressure; and second, how fast productivity can grow on a sustained basis. On the first, the moderate behaviour of wages in 2000 is suggestive of a substantial fall in the economy’s structural rate of unemployment since the mid-1990s. However, this moderate behaviour could also reflect, at least in part, pressures from the appreciation of sterling in recent years as well as a lag in the response to the increase in headline inflation this year. On the second, productivity gains in recent quarters are tantalising, but cannot necessarily be extrapolated forward. Thus, we agree with the authorities that further efforts must be made to increase labour supply and the trend growth in productivity. However, such structural changes take time. Meanwhile, there is a need for caution in demand management to ensure that the short-run pace of demand growth does not outstrip the economy’s capacity for noninflationary expansion.
4. As regards demand management, we have some concerns about the fiscal policy announced in the March 2000 budget and the November Pre Budget Report. We recognise that the U.K. fiscal position is very healthy: the budget is in surplus and the ratio of net debt to GDP is declining rapidly. However, we are concerned that the fairly rapid adjustment of expenditures to the medium-term fiscal path, following a subdued level of spending last year, is imparting a sizable boost to total domestic demand at a time when resource utilisation is high. In view of the tentative signs that private spending is beginning to slow down, this expansion of public expenditure can, most likely, be accommodated without upward pressure on inflation or the exchange rate. However, if private spending growth does not slow down as projected or wage pressures re-emerge, it could complicate the conduct of monetary policy by tilting the balance of risks in favour of raising rates to protect the inflation target at a time when the real value of sterling is high. Therefore, a prudent course of action for the March 2001 budget would be to refrain from new expenditure commitments and to save some of the margins accumulated in the current fiscal year.
5. In this environment characterised by major uncertainties and a sizable increase in public spending, monetary policy will have to strive to avoid undue delays in taking action. The challenge is that increased uncertainty with regard to the structural rate of unemployment and the economy’s capacity for noninflationary growth makes it difficult to gauge the extent of inflation pressures further ahead. There are arguments in favour of “probing” the limits of noninflationary expansion, but policy should also be alert to early indicators of cost and price pressures. From this standpoint, the MPC’s decision to leave rates unchanged since February seems reasonable given the likelihood that the structural rate of unemployment has shifted down in recent years and the lack of convincing evidence so far that the inflation target would be compromised. In coming months, given the symmetry of the inflation target, policy makers will have to stand ready to move flexibly in either direction depending on how the risks develop. While prospects for sterling are a perennial source of uncertainty, a strengthening of the euro from its current low levels could bring about a weakening of sterling. A policy rate increase may be required in these circumstances, as it may be if private spending growth fails to slow down or wage settlements pick up excessively in early 2001. In contrast, opposite developments could justify a cut in the policy rate.
6. Turning to medium- and long-term issues, the authorities have set their policies with the broad purpose of enhancing the economy’s productive potential. The strategy is rightly multifaceted. Macroeconomic and financial sector stability underpinned by strong policy frameworks should continue to make an important contribution to raising both productivity and private investment. This is complemented by many targeted initiatives to enhance productivity as well as investment and private saving, encompassing medium-term fiscal plans to increase public investment in human and physical capital, policies to enhance prospects for the “New Economy”, labour market reform, pension reform, deregulation, and measures to promote competition—including in the provision of financial services. While we support the broad thrust of these initiatives, some adjustments in specific areas would be desirable.
7. Turning first to medium-term fiscal policy, we see two possible ways in which the public sector could make an additional contribution to raising private investment—namely, maintaining public saving at a level sufficient to cover all of the envisaged public investment and preparing the ground for tax cuts aimed at a further enhancement of the incentives for private saving and investment. These objectives could be achieved without reopening the three-year Departmental Expenditure Limits by ensuring that structural increases in revenues (above the cautious ones presently contained in the medium-term budget projections) are not channelled to a further expansion in public expenditure and that the spending margins that are likely to accumulate over the medium term are saved. Certainly, we recognise that, after several years of fiscal tightening, increases in public spending are needed in some areas, particularly infrastructure and health care. Nevertheless, there may be more scope for moderating the increase in current expenditures in other, less critical, areas. In addition, areas such as education—where there is a clear need to improve the U.K.’s relative performance—may benefit more from well-targeted, cost-effective reforms (e.g., to address low skill levels) than from greatly increased spending.
8. With regard to the tax burden, we welcome the fact that the levels of taxation and public spending in the United Kingdom are at the lower end of the respective ranges for industrialised countries in Europe and that the tax system is relatively broad based and neutral. Nevertheless, to the extent that some of the present revenue over performance is sustained over time, consideration could be given to a further broad based reduction in the corporate tax rates over the medium term aimed at improving the returns to private investment, particularly given the ongoing corporate tax reforms in continental Europe. A well-considered, preannounced strategy would be key in this regard since ad hoc, piecemeal tax breaks that are not aimed at correcting well-defined market failures are likely to distort incentives and vitiate the efficiency of the present system. We would sound a note of caution, in this connection, on the tendency in recent budgets towards tax expenditures aimed at particular groups which, experience has shown, can lead to tax avoidance.
9. In the same vein, consideration could be given to financing all public investment with savings on the current balance through the medium term, rather than partly through borrowing from the private sector as currently planned in the medium-term fiscal strategy. This would contribute to an increase in domestic saving—now at a low level in the United Kingdom—without which higher total investment would need to be financed from abroad. In view of the elevated real value of sterling at present and the U.K.’s past experiences with running excessive external deficits, a more prudent course would be to finance higher investment with higher domestic saving, to which the public sector is now well placed to contribute.
10. Turning to structural issues, we broadly agree with the priority areas identified by the authorities for fostering productivity growth: promoting innovation and research and development (R&D); strengthening competition; and encouraging enterprise. Reforms in these areas that are targeted at identified market failures should help improve market efficiency and the performance of less productive firms. While the guiding principles are clear, some of the specific measures—such as the R&D tax credit—have been tilted towards small- and medium-sized enterprises. A better approach would be to introduce well-designed broad based measures aimed at specific market failures—for instance, a less generous, but universal, tax deduction for R&D expenditures. In addition, it will be important for the Office of Fair Trading as well as various regulatory bodies to take an active role in identifying and penalising anti-competitive behaviour, especially among dominant market players, including in the telecommunications sector.
11. An important aspect of the productivity issue is the potential for accelerated gains from the production and use of ICT as illustrated by the “New Economy” experience of the United States. The productivity growth of some ICT-intensive sectors in the United Kingdom provides some early, circumstantial evidence that the New Economy may be taking hold following years of relatively high rates of ICT investment on par with those of the United States. However, we would caution against relying too heavily in the next few years on the effects of ICT investment to raise economy-wide productivity given the difficulty of determining the timing of potential productivity gains associated with the use of ICT equipment. Preliminary evidence suggests that the productivity gains realised to date in the United Kingdom come mainly from increases in the ratio of ICT capital per worker, underscoring the need to maintain high rates of growth in private investment accompanied by improving skill levels. The multifaceted approach envisaged by the authorities to enhance productivity growth in general will, of course, also enhance the development of ICT. However, there may be a need for more targeted measures, such as the recent decision to set up ICT learning centres. A good example would also be the removal of existing hindrances to low cost connections to the Internet. Looking ahead, given the recent sharp decline in equity prices in the high-tech sector, care should also be taken to ensure that avenues remain open for financing viable enterprises.
12. The labour market is an area where—particularly by comparison with most other European countries—U.K. policies continue to be exemplary. The targeted measures adopted over the past three years, including various New Deal initiatives and in-work benefits for low-income workers, appear to have created further incentives for and facilitated transitions from both unemployment and non-employment to work. In many respects, these measures have complemented and built upon the reforms initiated in the 1980s and early 1990s. Yet, some concerns remain. While employment and activity rates have continued rising for women, these measures have been declining for men, indicating the increasing marginalisation of men with low skills. Moreover, notwithstanding recent progress, the non-employment rates for some groups such as lone parents remain very high. Hence, more emphasis is needed on integrating various components of the welfare and unemployment benefits systems; programs directed towards raising participation rates of specific groups such as lone parents and those on disability benefits; and measures to increase the supply of workers with vocational and intermediate skills—an area where the United Kingdom remains deficient. Furthermore, unemployment benefits could be tapered in a manner that increases disincentives for rotating through the different options of the New Deal while remaining unemployed over long periods. An important concern going forward is that, although the National Minimum Wage (NMW) appears not to have affected employment or inflation thus far, significant increases in the NMW or changes that would bring the youth rate up to the standard NMW could have adverse implications for the prospects of integrating low-skill and younger workers into the workforce.
13. The pension system plays a key role in fostering private saving and channelling funds for investment. The ongoing pension reform, notably the planned introduction of stakeholder pensions, should catalyse the private provision of affordable pensions to a sizable segment of the population hitherto uncovered by existing schemes, raising their savings without burdening the public finances with future liabilities. The recent increases in allowances for poorer pensioners and the introduction of the pension credit adequately focus spending on fighting poverty while safeguarding the incentives of current workers to save. Nevertheless, the expanded income-related benefits will eventually place about half of the pensioner households on state benefits linked to average earnings, while recent increases in general pensioner benefits will also have a significant budgetary cost. We would stress the need for caution and far-sightedness in this area, since further increases in public pension-related commitments—even if they may appear affordable in the short term—could come at a high cost in terms of future public liabilities.
14. A competitive, sound, and well-supervised financial system is an important part of the strategy to foster high levels of private investment. In this respect, we welcome the steps taken by the Financial Services Agency (FSA) to implement some of the recommendations of the Cruickshank Report, particularly to enhance competition by ensuring adequate levels of disclosure and transparency. With regard to soundness, the banking sector is highly profitable and well capitalised, and we are reassured that the authorities remain alert to the implications of relatively high levels of household and corporate indebtedness, including banks’ growing concentration of exposures to the telecommunications sector. As for supervision, the FSA has made progress toward the full integration of supervisory services and it will be important to ensure that the adoption of the secondary legislation necessary to implement the Financial Services and Markets Act is not delayed.
15. The authorities’ intentions with regard to joining EMU remaining unchanged, we continue to view the five tests proposed as broadly appropriate for assessing the timing of potential entry, and we welcome the Government’s policy of preparing for entry beforehand should a decision to join be made early in the next Parliament.
16. In sum, while recent economic developments have been favourable, not least because of good policies, some key challenges remain. As regards demand management, the ongoing increase in public spending is sizable and there will be a need for caution in the March 2001 budget. Even then, the conduct of monetary policy will require great skill. As regards productivity growth, the authorities’ approach to this complex issue—combining a stable policy environment with key structural reforms—is certainly appropriate in terms of direction and emphasis. But it should be recognised that there is a need to balance the clear benefits from increasing some types of public spending against the advantages the United Kingdom enjoys from having a relatively limited public sector compared with major continental European countries. With this trade-off in mind, we encourage the authorities to continuously re-evaluate public spending policies in terms of their effectiveness and cost.