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Britain’s Productivity Problem

Paddy Hirsch wrote . . . . . . . . .

On Thursday, British Prime Minister Liz Truss resigned after just 44 days. To some she was an economic naif, brought down by delusions of resurgent Thatcherism; to others she was a conservative clown, who had turned the United Kingdom into a laughing stock. The turmoil in the UK economy caused by her budget prompted European newspapers to mock Britain for leaving the European Union. American media outlets wondered if she could last until the end of the month. Britain’s own newspapers compared the Prime Minister to a rotting head of lettuce — and then noted the lettuce outlived her. Italy’s leading daily, Corriere Della Sera, ran with the headline “Panic in London: ‘We have become the new Italy’.”

This last jab was particularly galling for Truss, and not just because it nodded at how politically unstable the UK has become (Italy went through six prime ministers in the ten years between 2006 and 2016: when Truss’ successor is named, that will be four in four years for the UK). The comparison also points to the UK’s economic malaise: its low growth, its bloated public services — and its sluggish productivity, a long-lived feature of the UK economy that Truss vowed to reverse.

Mind The Productivity Gap

Truss and her ill-fated finance minister, Kwasi Kwarteng, were two of the five co-authors of Britannia Unchained, a booklet published in 2012 warning that the UK was mired in a slough of low productivity, lack of ambition and an inability to compete with fast-growing Asian economies.

“The British are among the worst idlers in the world,” they wrote. “We work among the lowest hours, we retire early and our productivity is poor. Whereas Indian children aspire to be doctors or businessmen, the British are more interested in football and pop music.”

Truss telegraphed her intent to tackle Britain’s culture of unproductive laziness during the race to replace Boris Johnson, so it was no surprise to anyone who was listening when she burst out of the gate, guns leveled at Britain’s low productivity and growth. Her mini-budget, released on September 23, promised the biggest tax cuts the UK had seen since 1972, as well as an energy price freeze, all to be paid for with a massive borrowing spree.

It all went as her opponent for the leadership, Rishi Sunak, had predicted: markets freaked out, the pound fell to an historic low, bond yields flew higher and the Bank of England had to step in with an emergency bailout package to protect funds managing the assets of British retirees. Within a month, both Truss and Kwarteng were gone.

The Productivity Problem

Productivity is important to an economy: it’s how you make more with less, and it’s vital to improving a nation’s living standards. Britain was a highly productive country in the 1800s — if not the most productive — thanks to the Industrial Revolution and colonialism. When the 20th century rolled around, however, Britain lost its place to the US, and — thanks in part to two World Wars — never won it back.

Productivity languished for years. Margaret Thatcher made improving it one of her missions, urging people to “Travel abroad, and see how much better our neighbors are doing,” while she was in opposition. Once in power, in 1979, she ushered in a series of reforms that cut taxes, empowered employers over unions, dismantled public ownership of assets and deregulated much of the economy.

And productivity did improve, relative to other European nations. The downside was that the hollowing out of unions and manufacturing depressed wages, stifled innovation, and left the UK overly dependent on the financial and services sector. That kept a lid on productivity and growth right through the millennium. Still, by the early 2000s, productivity was growing at a rate second only to the US. When the financial crisis hit in 2008, however, productivity hit a wall. Diane Coyle, a professor of public policy at the University of Cambridge, says it has never really recovered.

“We’ve had flat lining productivity since the mid-2000s,” she says. “And while compared to other countries, they’ve had slowdowns, we’ve just had a much worse slowdown than anybody.”

Between 2009 and 2019, Britain’s productivity growth rate was the second slowest in the G7, just ahead of Italy. Coyle says there are plenty of factors to blame for Britain’s weak productivity growth; there are so many in fact that she likens the search for a culprit to the conclusion of an Agatha Christie mystery: Everybody turns out to have done it.

“It’s a system problem,” Coyle says. “And I can give you a list of things that have gone wrong: low investment, very centralized government decision making, really inadequate skills, training, constant chopping, and changing of policies; an economy that’s much too weighted towards financial services and professional services at the expense of manufacturing.”

Blaming Brexit

One suspect that a lot of people are pointing the finger at: Brexit. Soumaya Keynes, an editor for The Economist, says Britain’s departure from the EU undoubtedly had an effect on productivity.

“That created all sorts of uncertainty and stability, and that made it harder for businesses to plan in the kinds of productive investments that would be good for the economy,” Keynes says.

That uncertainty may have depressed business investment by as much as 11 percent in 2019. A study from the Bank of England estimated that the Brexit process has cut the productivity of British companies by between 2% and 5%since the 2016 vote to leave. Output per hour worked in Britain is around 15% below that in the United States, Germany and France.

Brexit’s effects on the UK economy, however, may only be short term. That’s because much of the productivity drain came from executives spending time on planning and preparation, and the uncertainty over Brexit should fade over time.

Other potential causes of a lack of productivity in the UK are more entrenched. Soumaya Keynes says the lack of investment in business and industry by both the government and the private sector is one of the most affecting. And not just the kind of investment that acquires new equipment that helps people do their work better.

“There’s intangible investment that you can’t touch so easily, like building brands or intellectual property or designing better processes; that other kind of investment that’s much harder to measure, but is very important in a services-based economy like Britain.”

Keynes says the amount of money the UK government spends on investment in businesses is relatively small, compared to the private sector, but the government has the vital role of creating the conditions that encourage spending by private sector companies.

“A necessary condition for healthy investment is certainty and stability, and an expectation from businesses that there’s going to be a strong economy and healthy demand,” Keynes says. “It’s really those necessary conditions that haven’t really been satisfied over the past few years.”

That lack of investment has put the UK on the back foot, compared to its peers. A report from the London School of Economics and the Resolution Foundation think tank found that business capital investment in Britain was 10% of gross domestic product in 2019, compared with 13% on average in the United States, Germany and France. And the UK government spends a lot less on research and development, too.

Low investment, along with an education shortfall, a skills gap and deep regional inequality is further complicated by a byzantine planning system that is so devolved and bureaucratic that it makes it really, really difficult to build anything in Britain. Altogether these barriers represent a severe, long-term and systemic obstacle for improvements in the UK’s productivity. And to be fair to Liz Truss, she did want to address these issues in her mini-budget. The problem, Keynes says, was that she tried to combine reforms directed at this barrier with a package of big tax cuts all at the same time.

“I think her sequencing was wrong,” Keynes says. “If you step back, her primary objective was going for growth, and that is admirable. Well done, Liz Truss, identifying this huge problem and really trying to fix it.”

But Truss was naive, Keynes says. “There are huge vested interests that want to see the current planning system kept as it is. And with her announcement of lots of unfunded tax cuts, investors took fright. We’ve got a hostile global economic environment: It was a very risky environment in which to try to do that.”

Stuck in an unproductive rut

The UK is caught in a bind over its low productivity and growth, which have been exacerbated by external issues in the global economy — particularly the war in Ukraine. If the UK wants to increase productivity, it needs to boost investment. But within the current economic context of high inflation and budget woes — and a bond market that won’t permit much more borrowing — that means cutting domestic spending, which will squeeze households at a particularly difficult time and cause pain for years to come. The LSE-Resolution study estimated that increasing business investment funded by domestic resources could generate an extra 8 percentage points in GDP growth over 20 years, but it could take 15 years before household consumption recovered from an initial fall.

Another path to take is to attract foreign investment, but a big part of that will involve lowering taxes. The demise of Liz Truss shows how tough it is to get that kind of policy passed when inflation is high, and citizens are bracing for a hard winter.

Poor Liz. She was dealt a bad hand from the get go. Her successor isn’t likely to do much better in the shuffle.

Source : NPR

Bank of England Makes Biggest Interest Rate Hike in 30 Years

Danica Kirka wrote . . . . . . . . .

The Bank of England rolled out its biggest interest rate increase in three decades Thursday, saying the move was needed to beat back stubbornly high inflation that is eroding living standards and is likely to trigger a “prolonged” recession.

The central bank boosted its key rate by three-quarters of a percentage point, to 3%, as Russia’s invasion of Ukraine has driven up food and energy costs, pushing consumer price inflation to 40-year highs. The aggressive step was expected after a more cautious half-point increase six weeks ago and matches the recent moves by the U.S. Federal Reserve and the European Central Bank.

While higher interest rates will boost the cost of mortgages and credit card debt for already-stretched consumers, the move was necessary to control inflation that has left people with less money to spend and is slowing economic activity, Bank of England Gov. Andrew Bailey said.

“If we do not act forcefully now, it will be worse later on,” Bailey told reporters, hinting he’d be prepared for more increases ahead.

The bank, whose task got tougher after former Prime Minister Liz Truss’ economic plans roiled financial markets, forecast that the British economy is likely to contract for two years through June 2024. That would be the longest recession since at least 1955, according to the Office for National Statistics.

The rate increase is the Bank of England’s eighth in a row and the biggest since a short-lived 1992 hike. It comes a day after the U.S. Federal Reserve announced a fourth consecutive three-quarter point jump.

Central banks worldwide have struggled to contain inflation after initially believing price increases were fueled by international factors beyond their control. Their response has intensified in recent months as it became clear that inflation was becoming embedded in the economy, feeding through into higher borrowing costs and demands for higher wages.

Thursday’s rate decision was the first since Truss’ government announced 45 billion pounds ($52 billion) of unfunded tax cuts, which sent the pound plunging to record lows against the U.S. dollar, pushed up mortgage costs and forced Truss from office after just six weeks.

While most of Truss’ program has been canceled, the fallout remains: Borrowing costs are higher for the government, companies and homeowners because of concerns about economic and political stability in Britain, the bank said.

Truss’ successor, Rishi Sunak, has warned of spending cuts and tax increases as he seeks to undo the damage and show that Britain is committed to paying its bills. Sunak and Treasury chief Jeremy Hunt plan to reveal their economic plan on Nov. 17.

“The most important thing the British government can do right now is to restore stability, sort out our public finances, and get debt falling so that interest rate rises are kept as low as possible,” Hunt said.

The Bank of England expects inflation to peak at around 11% in the last three months of the year, up from 10.1% in September. Inflation should begin to slow next year, dropping below the 2% target within two years, the bank said.

The squeeze on people’s incomes likely contributed to a 0.5% decline in gross domestic product in the three months through September, which may be followed by a 0.3% drop in the fourth quarter, according to the bank’s forecast.

The projections are based on financial market data suggesting the key interest rate will rise to 5.25% by the third quarter of next year. The bank’s survey of financial professionals forecasts a lower peak of 4.5%, which would shorten the recession.

Bailey said there is uncertainty about how far and how fast the bank will boost interest rates because of volatility in natural gas prices and the country’s tight labor market.

The war in Ukraine boosted food and energy prices worldwide as shipments of natural gas, grain and cooking oil were disrupted. That added to inflation that began to accelerate when the global economy began to recover from the COVID-19 pandemic.

Europe has been particularly hard hit by a jump in natural gas prices as Russia responded to Western sanctions and support for Ukraine by curtailing shipments of the fuel used to heat homes, generate electricity and power industry and European nations competed for alternative supplies on global markets.

Wholesale gas prices in the U.K. increased fivefold in the 12 months through August. While prices have dropped more than 50% since the August peak, they are likely to rise again during the winter heating season.

The British government sought to shield consumers by capping energy prices that are fueling inflation. After the turmoil from Truss’ economic policies, Hunt limited the price cap to six months instead of two years, saying the program would be focused on only the neediest households beginning in April.

That injected another degree of uncertainty into the bank’s inflation forecasts.

But the economy will recover, Bailey said.

“We cannot pretend to know what will happen to gas prices. That depends on the war in Ukraine,” Bailey said. “But from where we stand now, we think inflation will begin to fall back from the middle of next year, probably quite sharply. To make sure that happens, bank rate may have to go up further over the coming months.″

Source : AP

Charts: U.K. Economy in Turmoil

Source : Chartr

How the Bank of England Should Respond to U.K. Fiscal Policy Crashing the Pound

Adam S. Posen wrote . . . . . . . . .

Given the irresponsible fiscal policy announcement of the UK government last Friday, and the rout of the pound that followed, the Bank of England had few good options on Monday. Clearly, there is a fundamental macroeconomic conflict between the Truss government’s so-called growth program of large-scale spending and the Bank’s need to reduce trend inflation. While there cannot be a currency crisis in the UK, which has a flexible exchange rate and issues public debt in its own currency, a collapsing currency is still a major problem for its inflation and financial stability. The Bank had to make a choice.

So the Bank’s governor, Andrew Bailey, issued a statement that the central bank’s Monetary Policy Committee (MPC) would make a “full assessment” at its next scheduled meeting in November and that “The MPC will not hesitate to change interest rates by as much as needed….” The pound then continued to fall, and market expectations priced in more future interest rate increases, up to 6 percent in 2023.

It is right and necessary for an independent central bank to wait silently (in public) for the elected government to move forward with its fiscal plans, whatever they are. When the Bank of England leadership made clear a preference on fiscal policy for one party’s platform in the run-up to the 2010 UK election, it was a grievous mistake. But it is also right and necessary for an independent central bank to speak frankly about the economic impact of the sitting government’s fiscal plans once made and state that it will alter policy in response. Part of the inflation problem in the US at present is because the Federal Reserve failed to respond publicly to the massive short-term fiscal stimulus of the American Rescue Plan once passed in March 2021. There is a point in the sequence where the central bank should not stay neutral or encouraging (just as elected officials are free to criticize monetary policy ex post).

I believe that the Bank of England should be making it clear that the government’s reckless budgetary statement is having consequences that will surely require higher interest rates. The Bank can do so by making clear the program’s implications for the UK economy and thus for what the Bank will do with interest rates. When a government’s discretionary expansionary fiscal policy leads to a falling rather than a rising currency, despite rising rates, it is a clear signal that markets doubt the credibility of the government’s economic competence or goals, in this case for good reason.

One option would have been for the Bank to remain silent, letting the currency fall further. This would have been a clear statement that depreciation of the pound was only to be expected, given the fiscal policy, and the onus was on the government to reverse that policy. That would be a risky choice, and if a newly installed Prime Minister and Chancellor had privately made clear they would not reverse until calamity hit, it would be irresponsible for the Bank to let the pound go into free fall.

Once the Bank decided to speak, however, it should have put more emphasis on a promise of higher interest rates, rather than sounding neutral about the proposed fiscal policy and even positive about parts of it. For example, I would not have acknowledged that the initial effect of the energy price caps would be to reduce headline inflation since that benefit is likely to be offset, perhaps fully, by the inflationary effects of tax cuts and depreciation of the pound. Certainly, I would not have included in the statement the seemingly complimentary comment, “I welcome the Government’s commitment to sustainable economic growth,” when the option was available to make no normative comment at all.

So, the statement I would have issued would read as follows:

“It is a simple economic reality that sustained large movements in exchange rates will affect the UK inflation forecast, and therefore the amount and duration of moves in the Bank’s policy rate in response. It is also a simple reality that the Bank takes the Government’s programs as given when making our forecasts, so large movements in HM Government’s fiscal stance will be responded to by monetary policy in so far as they alter the inflation outlook on net.

Our path of interest rate hikes in the period ahead therefore will likely have to steepen and lengthen from what it was before the Chancellor’s announcement last Friday and the subsequent movements in the trade-weighted pound exchange rate (if those changes persist). If in the Monetary Policy Committee’s assessment the inflation outlook will be higher, policy will be set accordingly. While it remains for the Committee to make a more precise update of the economic outlook ahead of our November meeting, there is no question that outlook must be for significantly higher inflation now than it was when we last met.

The exchange rate is not a target of the Bank’s monetary policy. The pound is not in a fixed exchange rate arrangement, and therefore there is no market-traded level of the pound that threatens the Bank’s mandated goals in and of itself. The impact of movements in the exchange rate, however, can be material for the inflation outlook, and accelerating movements can be destabilizing in extreme situations for inflation expectations and financial markets.

As was the case in 2008-09, the MPC is ready to make rapid adjustments in the stance of monetary policy between scheduled meetings as part of our mandate should financial conditions warrant. These adjustments could be in the policy rate, in balance sheet operations, or both, as needed. If we see acute indications of rising financial stress or jumps in inflation expectations, we will not wait for a planned MPC meeting to respond.”

The irony is that the founding triumph of the Bank of England’s inflation targeting regime was the anchoring of inflation when the pound left the European Exchange Rate Mechanism in 1992, 30 years ago this month. For the three decades since then, including during the Global Financial Crisis, the Bank was able to largely ignore the exchange rate when setting monetary policy. This was because it was confident that the pass-through from moves in the sterling exchange rate to domestic inflation would be temporary and one-off.

As I warned starting in 2017, Brexit would undermine this anchor because it would make less credible the commitment of UK governments to stability. A smaller, more closed economy, with less access to markets and more friction with its largest economic partners, would be less buffered from economic shocks. Large inflation shocks would then be more persistent contributing to trend inflation, not simply one-off as before.

That meant the UK macro regime was going partway back to the 1970s, irrespective of the Bank of England’s commitment to its inflation target. The MPC would have to again start to keep one eye on the exchange rate when setting policy, not solely focusing on the domestic outlook.

Now, the Truss-Kwarteng fiscal policy package has taken the UK policy regime right back to 1974, bringing pound weakness front and center. The years that followed were the nadir of British postwar economic performance and awful for the British people.

One key difference now is that the Bank of England is independent. That independence should be exercised to put up rates quickly all the while explaining to the public that interest rates will have to go even higher for longer than they otherwise would have, given the government’s fiscal stance and its impact on the pound.

As with Brexit, UK elected officials have the right to disregard predictable and predicted economic costs. And as with Brexit, the Bank was right to stay publicly silent on those costs until the political decision was made. Now, however, the Bank of England should not hesitate to respond to those sad realities and to matter of factly attribute them to the government’s choices.

Source : The Peterson Institute for International Economics

Chart: U.K. Is Progressing Toward Emerging-market Status

Source : Bloomberg

Chart: India Overtakes UK to Become Fifth Biggest Economy

Source : Statista

Chart: Low Confidence in Truss on All Key Issues

Source : Statista

Boris Johnson Is Handing His Successor an Economic ‘Catastrophe’

Julia Horowitz wrote . . . . . . . . .

Across the United Kingdom, businesses and households are warning that they won’t make it through the winter without help from the government. That sets up enormous challenges for Liz Truss, the incoming prime minister.

For months, the United Kingdom has endured a leadership vacuum while the country has skidded toward a recession and a humanitarian crisis triggered by soaring energy bills.

Since Boris Johnson announced he would leave office in July, the outlook for growth has weakened. Annual inflation is running above 10% as food and fuel prices leap. Frustration over the rising cost of living has compelled hundreds of thousands of workers who staff ports, trains and mailrooms to go on strike. The British pound just logged its worst month since the aftermath of the 2016 Brexit referendum, hitting its lowest level against the US dollar in more than two years.

“It’s just one blow after the other,” said Martin McTague, who heads up the UK’s Federation of Small Businesses. “I’m afraid I can’t find any good news.”

The situation could get much worse before it gets better. The Bank of England anticipates that inflation will jump to 13% as the energy crisis intensifies. Citigroup estimates inflation in the United Kingdom could peak at 18% in early 2023, while Goldman Sachs warns it could reach 22% if natural gas prices “remain elevated at current levels.”

A man with a trade union flag awaits the start of the sold-out campaign event "Enough Is Enough." Faith leaders and unions came together to raise support to tackle the cost of living crisis by demanding real pay rises, slashing energy bills and taxing the rich.

A man with a trade union flag awaits the start of the sold-out campaign event “Enough Is Enough.” Faith leaders and unions came together to raise support to tackle the cost of living crisis by demanding real pay rises, slashing energy bills and taxing the rich.

Truss, who had been serving as foreign secretary, now faces calls to announce a swift intervention as she becomes the fourth Conservative leader of the country in a decade.

The most urgent problem she must address is the skyrocketing cost of energy, which could unleash a wave of business closures and force millions of people to choose between putting food on the table and heating their homes this winter. Experts have warned that people will become destitute and cold-weather deaths will rise unless something is done fast.
Truss told the BBC on Sunday that she would make an announcement on the “serious issue of energy” within one week. A broader economic package would follow within a month, she added.

“Everybody is assuming that there will be a swift and decisive announcement that puts this issue to bed, or at least provides people with reassurance,” said Jonathan Neame, who runs Shepherd Neame, Britain’s oldest brewer. “If there’s not, that person will come under very considerable pressure.”

An energy ‘catastrophe’

Energy bills for households will rise 80% to an average of £3,549 ($4,106) a year from October. Analysts say the household price cap could rise to more than £5,000 ($5,785) in January and jump above £6,000 in April ($6,942).

As people are forced to reevaluate their budgets, the boom in consumption that followed the Covid-19 lockdowns is dissipating fast. The Bank of England has warned the UK economy will fall into a recession in the coming months.
“The key challenge that the energy price surge poses is that households that use lots of energy — and in particular poorer households — are going to really struggle to make ends meet,” said Ben Zaranko, senior research economist at the Institute for Fiscal Studies. “It’s going to mean really big cutbacks in other areas of spending.”

Meanwhile, Neame, whose portfolio includes about 300 pubs across southern England, said business owners are panicking. They’re getting quoted insane numbers for year-ahead utility bills, if they can find suppliers at all. Nick Mackenzie, the head of the Greene King pub chain, said that one location it works with reported its energy costs had jumped by £33,000 ($38,167) a year.

“It’s really daunting for a lot of businesses, especially the ones who came through Covid in a weakened state,” McTague said. “They’re now struggling to deal with another once-in-a-lifetime catastrophe.”

The crumbling British pound could exacerbate problems, making it more expensive to import energy and other goods, pushing inflation even higher.

Overlapping crises

It’s not the only reason business owners and investors are increasingly anxious. While job vacancies fell between May and July, they remain 60% above their pre-pandemic level. Finding workers to fill open roles has been a particular challenge in the United Kingdom since the country voted to leave the European Union. About 317,000 fewer EU nationals were living in the United Kingdom in 2021 than in 2019, according to the Office for National Statistics.

Brexit is also scrambling trade, particularly with the European Union, the UK’s largest trading partner. Exports and imports will be about 15% lower in the long run than they would have been if the United Kingdom stayed in the EU, the Office for Budget Responsibility has projected.

Dean Turner, UK economist at UBS, said it’s up to the new prime minister to try to make the most of the country’s position without creating further disruption. Yet hardline British lawmakers are still pushing to cast aside a key part of the Brexit agreement Johnson signed with the European Union, which could ultimately trigger a trade war with the UK’s biggest export market.

“Brexit’s happened. It is what it is, we’ve all got our own opinions on it,” Turner said. “But we’ve got to work with it to make it better for us, and I just struggle to see if there’s any momentum to do that.”
No easy solutions

Truss, who starts on the job this week, has vowed to jumpstart the economy by slashing taxes. But many economists fear this approach could fan inflation and hurt fragile public finances, while failing to put money in the pockets of those who need it most.

“The benefits of cutting [taxes] would largely flow to the people who pay more tax, which are generally people with more money,” said Jonathan Marshall, senior economist at the Resolution Foundation.

There’s no way for the state to avoid paying huge sums to deal with the energy situation this winter, but targeted measures will be necessary to avoid waste. Freezing gas and electricity prices over the next two winters could cost the government over £100 billion ($116 billion), according to researchers at the Institute for Government.

“Energy is expensive, gas is expensive,” Marshall said. “To avoid people freezing in their houses, that needs to be paid for. But the state doesn’t need to pay for it for people who can afford it.”

There are also questions about how the Truss government will afford a large-scale economic intervention, especially if slashing taxes — and therefore government revenue — remains the priority.

The UK government borrowed heavily to provide support during coronavirus lockdowns. The country’s debts are now almost 100% of its gross domestic product. When interest rates were at rock bottom, and access to cash was cheap, this wasn’t a major issue.

But that’s no longer the case. The Bank of England has been aggressively hiking rates as it tries to put a lid on inflation. That will make it increasingly expensive for the government to service its debt. The United Kingdom also has issued a large number of inflation-linked bonds, adding to its vulnerability.

“It’s almost a perfect cocktail of challenges that make public finances look at risk in a way they haven’t in recent times,” Zaranko of the IFS said.

Kwasi Kwarteng, who is expected to become finance minister, wrote in the Financial Times on Sunday that the Truss government would act in a “fiscally responsible way.”

Source : CNN

Chart: Only 12% Of Brits Have Trust in Truss

Source : Statista

Chart: The U.K. Has Europe’s Biggest Unicorn Stables

Source : Statista