The Economic Issues facing the new UK government

This morning sees a new government facing the economic challenges for the UK economy. Firstly I would like to wish it well as we need substantial change in my view and around the world there is considerable economic turmoil. It will not be an easy task indeed as the Governor of the Bank of England has pointed out it will be a difficult one. Of course there will also be a considerable political dimension to the situation as the United Kingdom embarks on coalition government in a form not seen in many peoples lifetimes.I guess European observers will see this trepidation as somewhat curious as for much of Europe coalition government is considered normal but the UK it certainly is not.

Some hopeful signs

Recent economic figures have shown a hopeful trend. Yesterday saw figures for manufacturing and industrial production for March and these rose by 2.3% and 2% respectively. The National Institute for Economic and Social Research has just issued its updated estimate figures for growth in the first quarter of 2010 and feels it will be upgraded from 0.2%. Its own estimate of 0.5% growth covers the period from January to April so is not quite a like to like comparison. So the new government can briefly bathe in the reflected light of figures suggesting that there is some growth in the UK economy and that maybe 2010 might surprise a little on the upside.

The Problems

The main two problems for the UK economy are the fiscal or budget deficit which has an associated impact on the level of national debt and the level of inflation which in 2010 has been consistently higher than both official targets and official forecasts.

Inflation

Consumer Price Inflation (CPI) rose in March to 3.4% up from 3% in February and  this is 1.4% over its targeted level. Should it remain there this month then the Governor of the Bank of England will have to write a new explanatory letter to a new Chancellor of the Exchequer. Whilst this is bad enough the underlying situation is in fact worse because if you look at our previous measure Retail Price Index X inflation  which is the all items RPI excluding mortgage interest payments this was 4.8 per cent in March, up from 4.2 per cent in February. Perhaps the most revealing of all the numbers as this was our previous inflation target and was set at 2.5% so it is some 2.3% over its target. Many people are unaware that an element of a sleight of hand went on with our inflation targets back in 2002 and I discussed this issue in more depth on the 20th April in my Technical Point.

The latest figures for producer prices from last week were hidden a little by the news surrounding the economic turbulence in Europe but they were again troubling.  You see output price or what is called “factory gate” annual inflation for all manufactured products rose 5.7% in April.  Even worse than this input price annual inflation rose 13.1% in April compared to a rise of 10.3% in March. Month on month the output prices measure for all manufactured products rose 1.4% in April, mainly reflecting price rises in other manufactured products, petroleum products and tobacco and alcohol products. These are bad numbers and the trend is also deteriorating whilst as I have discussed before our inflation watchdog the Monetary Policy Committee has certainly one and maybe now both eyes closed.

The Fiscal Deficit

The election debate took place in something of a dream world on this subject and I hope that it does not turn into a nightmare. In essence all three main parties talked about it but never fully addressed the scale of the problem facing us. I wrote the following on the 15th April and it is still true.

However this is an area where all three main political parties have similar flaws in their plans. If you look at the three published manifestoes there is a hole in each of them of a similar size, £30 billion. So in truth none of them are being transparent and honest in their spending pledges. So the answer to the question what are they not telling us? Is in economic terms £30 billion. This is just over 2% of our Gross Domestic Product (GDP). Put another way it is around a quarter of the annual cost of the National Health Service.

So the new government has a serious issue and problem to face and it was one that our politicians were unwilling to address.

How did we arrive in this situation?

There is some new analysis from John Kay in the Financial Times which adds some extra insight on this subject.

“Total managed expenditure” is a record of the British government’s discretionary spending. Between 1995-96 and 2000-01 it increased by 17 per cent, slightly ahead of inflation. But from 2000-01 to 2005-06, a time of lower general inflation, total managed expenditure rose by a massive 44 per cent. At the same time, the standard rate of value added tax remained the same, and headline income tax rates were reduced – although there were roughly offsetting increases in the less visible payroll tax (national insurance).

So in a nutshell the previous Labour administration became fiscally spendthrift from around 2001. Now I do not wish to go into the politics of this as some will argue the money was mostly wasted and others will argue that we now have new hospitals and schools etc. This is an economics site and sticking to that subject one can say that this splurge did leave our public finances vulnerable  when the credit crunch hit us. At the time there was little real debate on this subject apart from more specialist economic bodies but it was significant. Then of course we got the credit crunch which made our deficit balloon to some £163 billion in the last fiscal year.

What will the new administration do?

There needs to be some combination of Conservative and Liberal Democrat economic policy but initially it looks as though this section of the Conservative manifesto has won. This had a committment to reduce the structural budget deficit which implied that they will cut faster than the previous Labour administration over the next five years and in essence achieve Labour’s objective a year earlier. They also say that they would split reductions in the deficit using a formula of 80% spending cuts and 20% tax rises.

Comment

Here we have mostly vacuity as to how that this will happen. If we look back into the past the Conservative administration when Ken Clarke was Chancellor had a successful retrenchment policy in the early 1990s but here the split between public spending cuts and taxation was 50/50 rather than 80/20. So we are asked to believe that an untried coalition government can do more in the area of cutting public expenditure than what an experienced single party one could do. If you have your doubts about this so do I. Much more work needs to be done in this area and there is not a lot of time.

Another problem: future economic growth

Forecasts for the UK fiscal deficit going forward do not look good. Unfortunately they were based upon unrealistic economic growth figures so in fact they are even worse than they appear. As I wrote above this year is showing signs of growth but 2011 and 2012 had official growth forecasts of 3% for each year compared with independent growth forecasts of more like 2% for each year and this is a little hand grenade in the figures that the previous administration left behind for the new Chancellor.

A Window of Opportunity

Like new Chief Executives of companies Chancellors of the Exchequer have a brief honeymoon period when they can blame their actions on their predecessors! This is a long tradition which is no respecter of political parties or individuals. So there is a window of opportunity for decisive remedial action to be taken and planned but I feel that the scale of it will come as a shock to many.

An interesting possibility

It appears that the Liberal Democrat suggestion of taking those on income of up to £10,000 our of paying income tax looks as though it has survived the merging of the two policies and here is what I thought of it on the 15th April.

Philosophically I have to confess I warmed initially to the idea of raising the personal allowance ( the income level at which income tax starts) to £10,000 as I am keen on measures to reduce the poverty trap of high marginal tax rates on our poorest citizens. However even with a cap at an income level of £100,000 per annum many other people who do not suffer from such high marginal tax rates will also benefit from this so the plan is very inefficient in this respect. Then when I looked at the taxes that were needed to pay for it there are simply too many particularly as in addition to them £4.6 billion is supposed to be raised by anti-avoidance and anti-evasion measures. So perhaps the best proposal ends up being funded by one of the worst examples of wishful thinking!

So in itself it travels in a direction that I approve of but of course it comes with a two big problems. Firstly this is more than 1% of UK economic output and is a tax cut leading to an even higher fiscal deficit and secondly as I wrote above there was an element of fantasy in the way that the Liberal Democrats were planning to finance it. If it does happen then at a minimum it will pose a severe challenge to our public finances.

Conclusion

The next few years will be a difficult balancing act for the UK economy at best. It is good that we appear to have some economic growth and we should hope for it to continue and to increase. But we should also realise that the official figures already allow for this and in fact probably overstate its likely impact. We also have an inflation problem which is persisting and as I type this I hear that unemployment is rising again so we also have an unfortunate combination there.

I hope that the incoming Chancellor does not face the position of the first Harold Wilson administration in the 1960s which came into power and discovered in their first briefing from the Treasury that the economic situation was much worse than the thought. You see that administration chose to pull the wool over its own (and everybody else’s) eyes to an extent for the first two years of its life. We can afford neither now.

It is a difficult time to make forecasts but I am sure of one thing as I wrote recently we can find what will happen next in the words of the Beatles.

If you drive a car ), I’ll tax the street,
(If you try to sit ), I’ll tax your seat,
(If you get too cold ), I’ll tax the heat,
(If you take a walk ), I’ll tax your feet.
Taxman…..

And you’re working for no-one but me,
(Taxman

Update 12.20pm

Gold is rallying again and is now US $1240 per ounce for the front month futures contract. It is an index of uncertainty and sometimes fear….

Advertisements

6 thoughts on “The Economic Issues facing the new UK government

  1. Shaun, thanks for once again pointing out the flaws in our inflation indices and the high underlying figures that are currently appearing. It would be nice to think that the new government would not indulge in ‘sleight of hand’ when dealing with the fundamentals of the economy; we’ll have to see.

  2. “Many people are unaware that an element of a sleight of hand went on with our inflation targets back in 2002”

    Some of us were aware and continue to be aware of continual manipulation of all of the inflation numbers produced by the ONS, since 1979 or thereabouts, to produce an illusion of inflation being significantly lower than it really is. This is to attempt to hide the additional effective tax revenue raised by governments using debauchment of the currency.

    As Andy observes, this is due to politics and mathematics not getting along!

  3. I completely agree that the major challenge facing the UK economy is how to garner sustainable economic growth, and how we can rebalance the economy away from consumer spending towards net exports and new industries. Sadly the attempts so far to actually come to grips with this issue have been conspicuously lacking.

    However, when it comes to the fiscal retrenchment needed to eliminate the structural deficit, surely the elephant in the room is just how variable the measure of ‘structural’ is? If the City and UK financial services are in fact less permanently weakened than first thought then the potential revenue from this sector could increase substantially.

    So I think constantly trying to measure the ‘black hole’ to the nearest billion is misguided. I don’t think we should go into this with a list to “reduce department A by x%, reduce department B by y%….” We should look at government as a whole and make a concerted effort to reduce the reliance on centrally-given funds.

    • Hi Edward and welcome

      Personally I am very cautious on measures of the structural deficit per se. Whilst conceptually it is reasonably clear I think that when you come to try and measure it things get much more difficult. In a way this is similar to the problems output gap theory has had as it for example has led to the Bank of England making policy mistakes as I have discussed today.

      You are right about the concept of spurious accuracy I think. What is important is that we start on the path before we come to the attention of world markets and that we cross our fingers for favourable economic growth as this is always the best solution. although official forecasts are already at the optimistic end with little room for upside surprises…

  4. What i feel that cause inflation in UK is that: the government should encourage their youth in going to school and also learning hw to to take some kind of little responsibility, am disputing the fact that they should not take care of their children but he should be ammended and that is why you see in UK, hardly will you see their adult youth working becuase they are satisfy with what the govt. is giving them. so govt. should stop unnecessary spending and charge them to work with some of their parent as well and by that you will the economy coming back to the normal shape. thank God bless you all.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s