Forecast Summary

Although hard evidence of recovery is still elusive, our forecast indicates that the trough of the recession occurred in the second quarter and that output fell 4 per cent peak-to-trough. We estimate that GDP rose 112 per cent in the third quarter - though only because of a rebound in North Sea oil production - and that for 1991 CIS a whole it will be 2 per cent down on 1990 levels. Next year GDP is forecast to rise 2 per cent but it is not until 1993 that the 1990 output peak is passed. Unemployment therefore still has a considerable way to rise - to a peak of 2.8 million in 1993. In the first year of full EMS membership, the economy has made an accelerated transition to European levels of inflation. Against a background of modest growth, it should be possible to consolidate this progress and we expect retail price inflation to average little more than 3 per cent over the next four years. Similar rapid progress has been achieved on the balance of payments where there is a trade surplus on manufactured goods for the first time since 1982. Here, however, we are less confident that the reduction in the trade gap can be sustained. In the recovery phase we expect imports to rise more rapidly than exports with the result that the current account deficit rises from £6bn this year to £8bn in 1992 and £10bn-£12bn in 1993-5.     

Forecast Summary

Nearly two years after the I990peak in output, the economy continues to 'bump along the bottom' of an L-shaped recession, which has turned into as severe a downturn as its predecessors in 1974-5 and 1980-1. The origins of the recession lie in the weakness of domestic demand, which has failed to respond to the 4.5per cent cut in interest rates that has taken place since we joined the ERM. It is now the turn of fiscalpolicy: public spending was raised in the Autumn Statement and, as the General Election approaches, the odds are on tax cuts in next month's Budget. This relaxation of monetary and fiscal policy should produce recovery and we see output moving ahead from the second quarter onwards. Nevertheless, the outlook for I992 is weaker than before: we forecast a rise in GDP of a little over I per cent, rather less for manufacturing industry. In 1993 and beyond n growth rate of around 2112per cent should be possible but it is the second half of next year before output passes its previous peak. This suggests that unemployment will rise for at least another year - to a peak in the summer of I993 of 2.8 million. The combination of a stable exchange rate inside the ERM and protracted recession has produced a rapid reduction in inflation and the current account deficit. As long as the pound maintains its present parity, inflation should moderate further, to the 3–4 per cent range by the end of the year and beyond. On the trade side, in contrast, imports have already bottomed out and exports are struggling in a weak world economy. This suggests that, as the recovery gets under way, the deficit on current account will widen from last year's £6bn to £8bn this year and £10bn by I995.     

Forecast Summary

Even if output recovers in the second quarter (as we expect), it looks as if there will be no increase in GDP this year in comparison with 1991. This reflects the weak start to the year, in which non-oil output registered its seventh successive quarterly decline. Through the year (fourth quarter to fourth quarter), however, we expect GDP to rise 1.5 per cent, laying the basis for a stronger recovery in 1993. Even so, it is not until late next year that output returns to its previous peak Paradoxically, we have raised our forecast of domestic demand from February (on a milder stock rundown) but imports are taking a disproportionate amount of the extra demand, holding back domestic output and aggravating the current account deficit. From nearly £9bn this year, we see the deficit rising to over £14bn by the middle of the decade, equivalent to 1³/4 per cent of GDP. While this is disappointing, it should be relatively easily financed even with lower interest rates providing the pound is held at its present DM 2.95 parity. we assume no ERM realignment which underpins a further drop in inflation to 4 per cent later this year and to 3-3 1/2 per cent by the mid 1990s. The weakness of output means that unemployment continues to rise for another 12 months, peaking in the middle of 1993 at three million, and that public sector finances will move still further into deficit - we project a PSBR this year of £30bn and a peak of £34bn in 1993-4, equivalent to 5 1/4 per cent of GDP.     

Focus: Supply-Side Improvements in UK Exporting of Manufactures

The present difficulties with the UK current account deficit have breathed new life into longstanding doubts in some quarters about the fundamental state of UK manufacturing, despite the supply side reforms of the last ten years and the large increases in labour productivity. The deterioration in trade in manufactured goods from a small surplus of £2bn in 1982 to a deficit of £21bn in 1988, is taken to be the most stark illustration of this deep structural malaise.     

Forecast Summary

In comparison with our February forecast, we are more optimistic on the prospects for output and unemployment both this year and into the medium term. But in consequence we have raised our forecast for the current account deficit. GDP growth, nearly 5 per cent last year, falls back to 3½ per cent this year and 2½ per cent in 1989; from 1990 onwards output is expected to increase at its underlying trend of 3 per cent. Inflation is currently rising but, as output decelerates, it peaks at 5 per cent and drifts gradually lower over the medium term. The current account deficit is projected at £5bn both this year and next; helped by a steadily depreciating exchange rate, which boosts exports, the deficit narrows from 1990 onwards.     

Forecast Summary

In themselves the drop in interest rates and the fall in the exchange rate following the ERM débâcle of "Black Wednesday" will have an expansionary effect on demand in the UK economy. But because of the way in which the policy shift was handled, any positive impact is likely to be offset by lower business and consumer confidence with the result in our forecast that recession continues well into next year. It is another six months before output stops falling and a rise of as little as 0.9per cent is in prospect for 1993 as a whole. Such a weak recovery will, however, limit the inflationary impact of a lower pound and, helped by lower mortgage interest rates, retail price inflation is forecast to be almost unchanged over the next 12 months. In 1994 and beyond, the inflationary effects of devaluation are more evident and we assume that the Government will tighten its monetary stance, raising interest rates back above 10 per cent to stabilise the pound, possibly re-entering the ERM at a new central parity of DM2.40. On this policy stance, output rises 3 per cent in 1994 but slows thereafter and the peak in inflation is held to 6 per cent late in 1994. The J-curve effects of devaluation enlarge the current account deficit to f20bn next year- The weakness of output over the next 12 months is the main factor behind a rise in unemployment to 3.2 million and a steady increase in the PSBR, which reaches a high of f43bn in 1995-6, equivalent to 6per cent of nominal GDP.     

The London Business School with Gower Publishing

In October we forecast 1 per cent output growth in 1993 accompanied by little change in retail price inflation, an increase in unemployment to 3.2 million by the end of the year and a £20bn deficit on the current account of the balance of payments. Since then we have revised our view of the international outlook and the Chancellor has made his Autumn Statement. There are also some hopeful signs in the latest data on retail sales, manufactured exports and the money supply that demand may be picking up both domestically and overseas. How do these developments affect our short-term forecast? The simple answer is very little: the outlook on output and inflation in 1993 is barely changed since October (Table I). We have lowered our forecasts for world inflation and for German interest rates which means that the pound can be held steady against the DM at lower UK interest rates and that the inflationary consequences of devaluation, though significant, are slightly less over the medium term than we made out in October. There is one revision of major significance, and that relates to the PSBR, which is now likely to reach f45bn in 1993-4, more than 7per cent of nominal GDP. The change is not on the spending side - the Autumn Statement confirmed existing expenditure plans - but on revenues, notably corporate taxes and tares 011 spending, which have fallen far more quickly than we envisaged. This, in combination with a projected near-2'per cent of GDP deficit on the balance of payments, poses a difficult medium-term policy dilemma. To escape from the twin deficits requires either deflation of demand, which conflicts with the Government's new-found commitment to growth, or a more buoyant economy to boost tax revenues and a competitive pound to underpin export-led growth. Of the two the latter is self-evidently more inflationary. This highlights the policy dilemma: at some stage the Government may have to choose between reducing the deficits and its 1–4 per cent inflation target or sacrifice its commitment to growth.     

The London Business School With Gower Publishing: FIGHTING YESTERDAY'S BATTLES

With still no firm evidence at home of a recovery in non-oil GDP, the government's main worries centre on the path of output ahead of the General Election. In a forecast, which relies heavily on exports to stimulate demand in 1992, the Treasury cannot regard the rising probability of renewed recession in the US or the very sharp slowdown currently taking place in Europe as the post-unification German boom runs out of steam with equanimity. The fear mist remain in Conservative politicians' minds that there will be no meaningful recovery within an electorally significant timescale. We sketch out this background, but our focus here is not on the prospects for recovery; rather we ask whether the recession has achieved its objectives. The recession was, it should be remembered, the direct product of government policy - interest rates were raised to 15per cent ahead of ERM membership - aimed at reversing the excesses of the late 198Os'boom and in particular at bringing inflation quickly down to acceptable European levels and reducing the deficit on the current account, which at its peak in 1989 amounted to 4 per cent of GDP. Our answer is that, over the last year of recession, considerable progress has been made: the rate of inflation is now in line with that in Germany and the current account deficit has fallen to under 1 per cent of GDP. But, on the government's own forecasts contained in the Autumn Statement, there will be some slippage on both counts in 1992. It is this worrying feature that we consider here. Our overall conclusion is that the recession has not completely delivered its objectives and that, even as the politicians turn their attention to recovery, we still have to fight yesterday's battles.     

Forecast Summary

Half way through 1991, there is still no firm evidence that a recovery is under way, though equally the recession does not appear to be worsening. This suggests that the economy is close to a turning point, bumping along the bottom, and that a recovery should begin in the second half. For the year as a whole we expect GDP to fall 2 percent followed by only a modest 1.5 per cent growth in 1992. Unemployment is likely to rise for at least another 12 months, reaching a peak of 2.8 million. The reduction in inflation and the trade deficit are continuing. By the end of the year retail price inflation is likely to be below 4 per cent and for 1991 as a whole the current account deficit should be around 1 per cent of GDP, well down from the 1989 peak of 4 per cent.     

Forecast Summary

Led by manufacturing industry, output has accelerated and GDP growth approaching 4 per cent is likely this year. But strains are emerging and we expect slower growth from now on. Over the medium term GDP is forecast to rise at a sustain- able 3 per cent rate, nearly 31/2 per cent for non-oil output. This should enable the reduction in un- employment to continue, though at a slower pace than in the last year. Against a background of rising activity, we expect inflation to remain at its present underlying rate of about 4 per cent and the current account deficit to settle at about £2bn p.a. We show in the Focus how this forecast might change if the stock market fails to recover from its mid-October crash     

West Germany

The government's argument that domestic demand is buoyant and that output is rising at a 3 per cent rate was vindicated by figures, for the second quarter. After a weak first quarter (partly due to another severe winter), GNP bounced back strongly and the annual growth rate reached 3.3 per cent, higher than the government's target of 3 per cent for 1986. This rebound, together with above-target monetary growth explains why the German authorities continue to resist pressure from the US to cut interest rates. Despite the rapid volume growth of imports as demand picks up, the fall in their DM price means that the trade surplus is continuing to grow. The current account surplus of DM40.5bn for the first seven months of the year is more than double that in the equivalent period last year.     

THE 1981 BUDGET

In this Forecast Release we examine the short-term prospects for the UK economy in the light of the Budget and other developments. Compared with our February forecast the Budget has raised taxes by about £2 bn but it has also increased public expenditure by a similar amount The net effect on the PSBR, compared with our February forecast, is therefore small, especially if the Treasury's estimates for nationalised industry profits and/or public sector wages prove over-optimistic. We therefore believe that the outturn for the PSBR in 1981-82 could be close to the figure of £12 bn presented in our last forecast.
We also believe that the prospects for output and inflation are little changed The Budget by itself will have raised prices by about 1 per cent compared with our previous forecast but because we had probably over-estimated indirect tax receipts, the net effect on prices is small For output, the likely reduction in consumers' expenditure is more or less offset by higher public spending. We continue to expect a fall in output between 1980 and 1981 of 1–11/2 per cent, inflation during the year at about 10 per cent, a current account surplus of £3 bn, monetary growth of 8 to 9 per cent and a PSBR of £12 bn.     

Forecast Summary

Backed by the lowest interest rates in fifteen years and a competitive exchange rate, we see the economy moving off the corrugated bottom of last year and recovery gathering pace as this year progresses. We expect output to rise 1.4 per cent this year, 0.5 per cent more than we forecast in October when we were expecting a far more cautious approach on interest rates, and 3 per cent in 1994. Here we have factored in another 1 per cent cut in base rates to coincide with the Budget on 16 March but this may prove to be the floor, especially if, as is rumoured, the Prime Minister has vetoed tax increases in the Budget for fear of derailing a fragile recovery. By the end of the year, however, we expect the trend in interest rates to be upwards to halt a sliding exchange rate and to cap the devaluation-induced price increases that will be feeding into domestic prices by then. On this basis we believe that inflation can be contained at 4 per cent underlying this year, 5 per cent in 1994 - outside the Chancellor's target range. While we are more sanguine than before on the outlook for output and inflation, major problems remain on the PSBR and the balance of payments. Beginning in the December Budget, the Government will have to raise taxes to avoid a debt spiral on the budget deficit and channel resources into net exports. Even on the basis of a £4bn tax hike in the first of the unified Budgets, we expect the PSBR to run along close to £50bn and the current account deficit in the £15bn-20bn range.     

The London Business School with Gower Publishing

Last year the Chancellor followed "the path of prudence and caution", cutting taxes by £4bn and budgeting for a public sector surplus of £3bn. This year - rather more compellingly - he is travelling the same route. Against the background of a record current account deficit and rising inflation, Mr. Lawson has tightened fiscal policy, cutting taxes in 1989–90 by nearly £2bn - less than is needed to offset real fiscal drag. His main priority, reaffirmed in the Budget speech, is to tackle inflation and, to this end, he chose not to revalorize excise duties. This was reinforced by a reduction in national insurance contributions, which not only benefits the low paid in relative terms, but also sharpens the incentive to supply labour at the bottom end of the wage spectrum. But this reform of national insurance is not cheap. Even though it is not practicable to implement the changes until October, the cost in 1989–90 is estimated at £1bn, rising to £2.8bn in 1990–1. This is equivalent, in PSDR terms, to a 2 per cent cut in the basic rate of income tax arid, in our post-Budget forecast, precludes further tax cuts in 1990. Unless there is an unexpectedly large rebound in personal savings, the Chancellor is likely to find himself in his present position in a year's time: presiding over a large budget surplus but unable to reduce it significantly for fear of rekindling inflation or aggravating the current account deficit. Simply writing declining numbers for the PSDR into the MTFS offers no genuine guidance on medium-term fiscal policy and may even be positively misleading to financial markets.     

Briefing Paper Import Penetration in the United Kingdom

There is widespread concern about the growth of imports in the United Kingdom. British industry is said to be ‘bleeding to death’ as a result of foreign competition and calls are heard for protective measures such as import controls to save the economy. There are three elements in the case for protection. The first is that trends in Britain's foreign trade in manufactured goods have been extremely adverse and that there are no good grounds for believing that they will change spontaneously. The second is that the growth of the economy is constrained by the balance of payments and that consequently a serious and growing depression will develop throughout the 1980s which could reach catastrophic proportions towards the end of the decade when North Sea oil production declines. The third is that import controls are an effective way of coping with the problem. It is recognised that the second two elements are controversial. As it happens we disagree with both of them. However, it is generally assumed that the first element - the view that increasing import penetration will destroy British industry - is common ground and that no-one disagrees with it. Our aim in this Briefing Paper is to challenge this view. There is no doubt that import penetration (which we measure as the share of imports in GDP) has growth rapidly, especially over the past two decades. In 1960 imports amounted to 25 per cent of GDP. By 1970 this proportion had risen to 28 per cent and in 1979 it had risen to 35 per cent. However, we shall argue that the economic processes that have been responsible for this development have on the whole been poorly understood. We reject the popular view that Britain is structurally unable to compete in world markets. Instead we propose an alternative interpretation of import penetration which explains UK trade performance in terms of the broader pattern of the world trade order. In the light of this theory we argue that import penetration in the UK is not an inexorable trend reflecting the relative weakness of the UK in international trade. On the contrary, UK import penetration has been adjusting to a new world trading environment and now that this process of adjustment is nearing completion the rate of increase of import penetration seems likely to abate. Moreover, the British people have benefited from this greater degree of free trade and any protective measures designed to inhibit the economic forces that we describe below would damage the economic welfare of the British public as a whole.     

Portfolio Selection and the Investment Performance of the UK Pension Funds*

Pension funds are the main institutional investors, accounting for 38 per cent of personal sector net financial wealth. As a result of their growing importance in mobilizing personal sector saving, they have emerged as the principal institutional investor, controlling over £200bn of funds at the end of 1987, their total net assets equalling 38 per cent of personal sector net financial wealth. Pension funds also dominate domestic asset markets, owning 27per cent of the stock of outstanding UK equity, 23 per cent of UK government securities and 17 per cent of total UK holdings of overseas equity. In this paper we present the conclusions from recent research, undertaken as part of an updating of the LBS Financial Model. Our results suggest that UK pension fund investment since 1980 is better than previous studies have suggested and, in particular, that funds outperformed the equity market in the 1980s, offering a higher return for any given level of risk. In addition fund behaviour is slow to change, with past behaviour exerting the strongest influence on current investment patterns. Fund managers also appear guilty of “short termism” in that they place little weight on events beyond the next three months. However, this has not made them inefficient. Finally, we find that actions to restrict the funds' surpluses should not affect their investment behaviour. Our results also suggest that the costs from exchange controls in the 1970s were substantial, amounting to some £4bn per year.     

THE CURRENT ACCOUNT

In the first half of this year the current account deficit widened sharply to £5.6bn, well above the Chancellor's full-year Budget forecast of £4bn and our own most recent forecast of £5bn. In this Forecast Release, we show that imports have continued to grow very rapidly but export growth has slowed down. This is in contrast to 1987 when exports were strong, very nearly keeping pace with imports. It can be said therefore that this year's balance of payments deterioration owes more to a failure of exports than to rising imports. As to why this has happened, we show that part of the explanation is a two-year decline in UK competitiveness but that the more important cause is the continuing strength of domestic demand which has not only sucked in imports but also diverted possible exports to the home market .     

Over the cliff edge and on to the rocks below

• ? If Brexit negotiations were to break down, the UK would face a significant increase in trade disruption from March 2019, even if it were able to put some basic trading arrangements in place. In a scenario where key sectors face extra friction, we find that the level of UK GDP would be 2.0% – or £16bn in cash terms – lower at the end of 2020 compared with our baseline. The impact on the remaining EU countries, including Ireland, would be much smaller .
• ? This article focuses on what a cliff‐edge Brexit means for trade costs and prices. This is only part of the equation – such a scenario would also influence supply chains and migration, while there is also potential for policymakers to mitigate some of the negative effects via looser policy.
• ? The notion that the UK could simply walk away from Brexit negotiations and rely on WTO rules to trade with the world is deeply flawed. The UK would need to re‐establish more than 750 very complex international arrangements just to maintain the status quo. We expect only the most critical issues – such as air travel – to be resolved by March 2019. Exporters also face a substantial increase in non‐tariff barriers.
• ? A breakdown in talks would also see both sides levying tariffs on imports from each other from March 2019, raising the cost of importing UK goods into the EU by 3.5% and by 3.1% for goods imported into the UK from the EU. For the UK, this will apply to roughly 60% of its goods exports and imports, but for all EU countries except Ireland the share would be less than 10%.
• ? The additional trade frictions would knock around 1pp a year off UK GDP growth in 2019 and 2020, resulting in a period of very weak growth. And the risks to this scenario are skewed to the downside – a slump in confidence or failure to establish the necessary customs infrastructure in time could easily generate a worse outcome

     

The London Business School with Gower Publishing

Last year saw the most coordinated cyclical upturn in the world economy since the early I970s, with OECD output rising 4per cent, industrial production and world trade even more rapidly. The boom in demand, which followed five years of continuous expansion, has outstripped supply and prices have begun to accelerate. To tackle inflation, the G7 monetary authorities have tightened policy over the last year, reversing the short-lived drop in interest rates necessitated by the stock market crash. This tightening may have to go further, especially in Germany and Japan where the effects of a rising oil price and higher indirect taxes are being exacerbated by currency depreciation. Although the rise in interest rates came too late to stop inflation rising, it has beet pursued with sufficient vigour to prevent inflation from seriously breaching the 5 per cent level. It is on these grounds that we forecast a relatively soft lending for the world economy on output, with growth continuing at 2.5–3per cent, accompanied by a limited reduction in inflation which stays in the 4–5per cent range. Progress on current account balances is also likely to be sluggish: in the absence of a serious attack on the budget deficit, the US deficit is likely to stay in the region of $140bn a year.     

The London Business School with Gower Publishing

The Autumn Statement updated the government's spending plans and its forecast from those announced in the Budget in March. On both counts there is very little difference between the Treasury view and our own forecast released in October. The Treasury supports our projection that output and demand will decelerate in 1989, that inflation will peak in the first half of the year at about 7 per cent and fall back to 5 per cent by the end of the year and that the deficit on the current account of the balance of payments will narrow only marginally over the next 12 months. On public spending in 1989–90, our October forecast was close to the unchanged official figures. It was clear to us - though not to most City commentators - that savings on unemployment benefit, debt interest and elsewhere would enable greater spending on programmes within an unchanged planning total. In later years the government has upped its expenditure plans from those announced a year ago, as we had assumed it would. As a result, the Autumn Statement projects significant increases in real public spending from now on. We show that, under a more appropriate inflation forecast, public spending rises nearly 2 per cent next year but falls back in 1990–92. Finally we argue that, unless the Chancellor decides to run an even larger PSDR (public sector debt repayment) than the £12bn built into our forecast - and the Autumn Statement forecast assumes a PSDR in 1989–90 similar to the expected outturn in 1988–9 of £10bn - the scope for tax cuts remains intact.