SURPLUSES AND DEFICITS

The US economy has twin deficits: internal (the budget deficit) and external (the current account). In sharp contrast, the UK combines a PSBR surplus with a rising current account deficit. Japan and West Germany both enjoy large current surpluses, though in Japan the public sector deficit is narrowing whereas in Germany it is rising. Remarkably, as Figure 1 shows, the present position on the public sector and overseas balances in each of the three major OECD economies and the UK is quite different. Japan is the mirror image of the US: the budget and overseas balances have been moving in the direction of surplus - private sector savings have been more stable. For the UK and West Germany (though again as images of one another) it is movements in private sector savings which have driven the current account. How has this come about?     

Forecast Summary

Led by private sector demand, the economy has grown very rapidly in the last 12 months, Output has risen nearly 6 per cent and unemployment has fallen by over ½ million but the current account deficit has widened dramatically and wage and price inflation is increasing. Monetary policy has been tightened sufficiently, we believe, to produce a gradual reduction in the current deficit over the medium term and to prevent inflation from breaking the 7 per cent level which a higher mortgage rate will ensure early next year. But, as demand is reined back, there is a cost to output which rises 3 per cent next year, 2–2½ per cent thereafter. Unemployment continues to fall, dropping below 2 million at the end of next year and reaching 1.8 million by 1992.     

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.     

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 UK'S PERSISTENT TRADE DEFICIT

The UK current account deficit reached a peak in excess of £20bn in 1989, equivalent to 4 per cent of GDP. In the next two years, as recession took its toll of domestic spending, it shrank quickly - on the latest data the deficit was only £4.4bn last year, 3/4 per cent of nominal GDP. Over the same period the trade gap narrowed front £25bn to £10bn, in each case taking the deficit back to the levels of 1987, before the late 1980s' boom really got under way. Since 1989, therefore, both 011 trade and the current account, there has been a significant reduction in the external deficit. Yet it remains the case that, despite the length of the recession - non-oil GDP has fallen for six successive quarters - the current account is still in deficit. Moreover, despite there being no concrete data to point to the beginnings of recovery, the shortfall is widening. The low point was the second quarter of last year, with a rare current surplus recorded in June, since when the trade deficit has steadily widened again as the consequence primarily of a 5.5per cent increase in the volume of imports over the last 12 months. Why is it that, in contrast with the experience in the 1980-81 downturn, this recession has not produced a trade or even a current account surplus? Does this mean that the recovery, when it does come, will inevitably widen the deficit with the possible consequence that ‘balance of payments problems’ will undermine the pound inside the ERM? We conclude that, while it is disappointing that UK producers have not managed to claw back more of the domestic market - in contrast with the experience of exporters in world markets - our forecast of a current account deficit of 0–2 per cent of GDP should be relatively easily financed and will riot therefore cause serious problem for economic policy. This conclusion would riot necessarily hold if the recovery occurs more rapidly than we expect arid sucks in a greater volume of imports. It may be the case that the UK will continue to run a current deficit with Japan in particular as the counterpart to ongoing Japanese direct investment in this country.     

Is the Economy Overheating?

In the last year total output has risen 4 per cent and manufacturing is up 6 per cent. Unemployment has fallen by 400,000. The current account, which was in surplus in the first half of the year, has moved back into deficit. Does this mean that the economy is “over- heating”? In the context of our forecast we examine this issue; we consider how rapidly supply can increase and how fast demand is increasing. We conclude that the growth of output in the last year was initially driven by supply and that, more recently, domestic demand has been growing very rapidly. The emergence of a current account deficit is evidence of excess domestic demand but from now on we expect demand to grow less rapidly. With non-oil supply expanding at a rate in excess of 3 per cent, we forecast steady output growth and little change in either inflation or the current account. In our judgement, the economy, though hot, is not overheating.     

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.     

Savings and the Budget

The fall in the personal sector savings ratio to a record low last year has been a major factor behind the rapid growth of domestic demand in the past two years and the associated deterioration in the current account. It is also a major uncertainty in the Chancellor's Budget judgement. Existing econometric relationships for the consumption function have failed to predict the fall in personal savings over the past few years. Possible explanations include statistical error, the effects of financial deregulation, the housing boom, expectations of higher growth in incomes, and demographic influences. In this Viewpoint, we report on a new consumption function that successfully explains the decline in savings. It provides evidence of a major demographic influence resulting from the decline in the proportion of the population in the 45–64 age cohort, the main savers in society. Subsidiary effects arise from the boom in house prices, and statistical mis-measurement. The equation predicts an appreciable revival of savings over the next few years as the 45–64 age cohort grows again. These shifts in demographic structure reflect the after-effects of the Second World War. This new evidence suggests that the Chancellor has done quite enough to ensure a slowdown in consumption, and that he would be ill-advised to heed calls for special measures to boost savings. By contrast, well conceived tax changes that remove microeconomic distortions in the tax system (perhaps moving in the direction of an expenditure tax) would improve the tax structure, and may well increase the scope for tax cuts in future budgets. Our new consumption function also lends weight to the Chancellor's argument that the current account deficit is not a source of concern, insofar as it arises from a shift in savings associated with demographic changes that will be reversed in due course.     

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.     

Forecast Summary

There is one overriding question which this issue of Economic Outlook seeks to address: to what extent will the tight monetary policy now in place produce a slowdown in consumer spending and take the savings ratio back up from last year's record lows? The answer, provided by the forecast, is that the savings ratio will rebound this year and our Macroeconomic Viewpoint argues that this will be sufficient, in combination with a rising budget surplus, to effect a reduction in inflation and the current account deficit over the medium term. But it does not achieve the government's target, set out in the MTFS, of a balanced budget - the public sector remains in chronic surplus. This objective requires national savings to be privatized and, in a special Microeconomic Viewpoint, we put the case for tax incentives to boost personal saving and enable the budget surplus to be reduced in a way which does not add to demand.     

The London Business School with Gower Publishing

With the benefit of hindsight, we can see that the course of the world economy in 1988 was a product not so much of the stock market crash of October 1987 but of the reaction to the crash. Monetary policy and to a lesser extent fiscal policy were eased and consumer spending responded to cuts in interest rates and rising real incomes. With the world recovery in its sixth year, capacity pressures began to emerge and investment also boomed, helped by a lower cost of capital. As a result of this strong private sector demand, OECD output increased 4 per cent in 1988 as a whole and industrial production and world trade rose even more rapidly. Against the background of buoyant demand and output, inflationary fears have resurfaced. Since the spring monetary authorities in most countries have been tightening policy, raising interest rates by early 1989 above the levels which helped bring about the stock market crash. Their aim is to effect a slowdown in demand before a significant upward movement in inflation and inflationary expectations takes hold. In our judgement the present policy stance will achieve its aim of a "soft landing" for the world economy. The pick-up in world inflation is contained below 5 per cent and by the second half of this year inflation eases, paving the way for a relaxation of monetary policy. Output growth slows from 4 per cent to 3 percent in 1989 and 2 per cent in 1990, picking up again as interest rates are lowered in 1991–2.     

Forecast Summary

The lower exchange rate offers UK industry a remarkable competitive advantage in world markets which, we believe, will be expanding rapidly over the next two years. As domestic demand is also likely to be strong in the run-up to the General Election, output is forecast to rise 3 per cent both next year and in 1988. But, even so, the short-term supply response is not expected to be sufficient to prevent the current account from recording a large deficit next year. Excess demand pressures also point to a higher rate of inflation from now on. We forecast a steady increase in inflation to 3¾ Aper cent by the end of next year and a peak of 4½ per cent in late 1988.     

The Changing Structure of the UK Economy: Implications for the Current Account

In common with other developed countries, the UK has seen the relative importance of the service sector grow, accounting for an ever greater share of employment and output — a trend that has accelerated over recent decades. At the same time, globalisation means that international trade is of increasing importance as a share of UK expenditure. With the traded goods sector dwindling in importance, what are the implications for the current account? This paper examines the changing structure of the UK economy and prospects for the current account. Although the current account is expected to remain in deficit for the foreseeable future, the size of the deficit is likely to remain manageable as growing surpluses from trade in services and investment income offset a widening goods deficit.     

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.     

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.     

Total Reward and pensions in the UK in the public and private sectors

Recent controversy has surrounded the relative value of public and private sector remuneration. We propose a comprehensive measure of Total Reward (TR) which includes not just pay, but pensions and other ‘benefits in kind’, evaluate it as the present value of the sum of all these payments over the lifetime and compare it for the highly educated in the UK public and private sectors. Our results suggest that TR is broadly equalised over the lifecycle for highly educated men while highly educated women have a clear TR advantage in the public sector by the end of their career. We suggest that the current controversy over public–private sector pension differentials and the perennial issues of public/private sector pay gaps requires a lifetime perspective and that the concept of TR is appropriate.     

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.     

Briefing Paper: Non-Manufacturing Investment and UK Aggregate Demand

The standard view of business fluctuations gives the leading role to investment, in both fixed capital and stocks, which raises aggregate demand in boom and reduces it in slump. The recent behaviour of the UK economy seems to have been a particularly marked departure from the standard model. Movements in personal consumption have played an unusually important role in both the rapid increase of demand from 1986 to 1989 and in the current recession. Stock investment, owing to improvements in the technology of stock control, is no longer a driving force. Manufacturing investment, while rising during the boom, contributed relatively little to increasing demand. The conventional wisdom now has it that recent UK experience is that of a consumption driven business cycle.
This Briefing Paper argues that this down-playing of the role of investment has been overdone. What has deceived the eye is the concentration on manufacturing. Investment did make a very large contribution to the recent boom, with the biggest increases in investment undertaken by non-manufacturing industry: a component of demand which attracts little regular scrutiny and less understanding. The textbook model still applies to the UK.     

Forecast Summary

The recovery that we forecast in February remains intact, though its composition is shifting between external and domestic demand. As we reported in International Economic Outlook earlier this month, the recession in Europe is intensifying so that, even with the devaluation-induced improvement in competitiveness, exports are being held back The weaker world outlook is the main factor behind a lower growth forecast next year. For 1993, however, we are continuing to forecast growth of 11/2 per cent, principally on the basis of more buoyant consumer spending. But the boost from consumption, while welcome in the first stage of recovery, is short-lived since the higher taxes already announced for next year hold back the growth of disposable incomes. Again this is desirable for the share of consumption, private and public, in GDP has been rising steadily and needs to be reversed in order to devote resources to reducing the two deficits: the PSBR and the trade gap. Over the forecast as a whole it is exports and investment which drive demand, not consumption. Underlying inflation has fallen below 3 per cent for the first time in twenty years, but it is now at its cyclical low point. We expect some increase in inflation from now on, though the Government's 1–4 per cent target is not likely to be breached this year. Next year and beyond, however, without more action on the budget deficit or a sharper increase in interest rates than we are assuming, inflation is forecast to settle in the 4–5 per cent range. Unemployment has fallen in recent months but the underlying trend remains upwards. We expect the three million level to be reached in the second half of the year.     

STERLING AND THE DOLLAR: SIMILARITIES AND DIFFERENCES

In the first two years of the Conservative government elected in May 1979 sterling rose 25 per cent on a trade weighted basis. It then fell back and is currently little changed from the level inherited by the Conservatives. In the first two years of the Reagan administration the dollar rose 30 per cent on the same basis. It too fell back thereafter, but only briefly - throughout 1983 the rise of the dollar has been resumed and it now stands at its highest level for at least twenty years. In this Forecast Release we examine the similarities and differences between these two currencies. We argue that a crucial element explaining the performance of the currency has been the size and expected development of the public sector deficit and that prospects for the dollar depend crucially on this. A sharp fall in the dollar could occur in the next year or two if rapid growth of output begins to produce a signijcant reduction in federal borrowing.