Monday, 16 January 2012

My (belated) predictions for 2012 for the FT and New Statesman

At the end of last year, the FT asked me and many other UK economists to answer a set of questions about likely economic developments over the coming year.  They summarised the results here, but for obvious reasons didn't go into much detail (perhaps not surprisingly, the only direct quote from me was my joke in the first line of my response to question 1 - an old joke but a good one..).  In any case, in the interests of (future) personal accountability, my full responses are below (in order to be rigorous, I have not modified in any way since I sent them in late December, although not that much has really changed since).   I have also appended my responses to Mehdi Hasan  at the New Statesman, who asked a similar, but not identical, set of questions (his article is here); there is considerable, but not total, overlap/duplication.


Responses to questions from the FT


1) Recovery: To what extent will the UK economic outlook improve or deteriorate in 2012? How close will Britain be to a balanced economy?

One is tempted to say - to paraphrase an old Soviet joke - that 2011 was an average year for the British economy. Not as good as 2010, but better than 2012..

More seriously,  under our baseline scenario - that the eurozone muddles through - quite similar to this year, so not great, but not disastrous. Premature fiscal austerity will continue to weigh on the economy, leading to lower growth and unemployment than necessary - and high youth unemployment will do permanent social and economic damage. This will be compounded by eurozone weakness.  But as in the US, very aggressive monetary policy will limit the damage, and exports to the rest of the world will help. Moreover, with inflation falling, real incomes will stop shrinking so fast, so consumer confidence may pick up a bit. 

And, as in the US the underlying position of the UK economy is not as bad as it is sometimes painted; I think the OBR projections for medium to long term potential may be too pessimistic, although in one or two key areas the government is doing its best to reduce growth potential (eg, immigration policy). So with a bit of luck - and ideally, better policies - there is also potential on the upside.. We might even start thinking about what to do about the real long-term problems for the UK and the developed world - unacceptable levels of inequality, and how to make the financial sector serve the real economy rather than extract rents from it for the benefit of a very few.

2) International: How many currencies will exist in the area now called the eurozone by the end of 2012? How effectively can the UK insulate itself from the eurozone?

Ultimately the first question is a political question not an economic one. What I would say is that the draft Treaty/agreement that the Prime Minister vetoed is not only the wrong answer to the problems of the eurozone, it isn't even directed at the right question.  The eurozone crisis is not the result of fiscal imprudence - if so, the exceptionally fiscally responsible Spanish and Irish would not be part of it - it is the result of the internal imbalances within the eurozone, driven primarily by private sector behaviour. The draft agreement doesn't even pretend to address these issues; if the Prime Minister had declined to sign it on the grounds that it was economically illiterate and damaging, he would have been entirely justified.

So we are definitely not out of the woods. If eurozone leaders stick to their current approach, the risks of a disorderly breakup (as a consequence of the political unsustainability of self-defeating austerity in one or more country, and/or a catastrophic bank failure) are high. But the baseline remains predicated on the view that eurozone leaders ultimately understand/will have to understand this, and therefore that both monetary and fiscal policy will respond, either through ECB bond purchases/quantitative easing or large multilateral loans, combined with looser adjustment programmes for the peripheral countries. If so, it won't be pleasant, but the eurozone should muddle through.

The consequences for the UK of a disorderly breakup range from the damaging to the disastrous.  Clearly any breakup would have a negative impact on exports and hence on our economy, if only through exchange rate effects (the pound would presumably rise sharply) quite possibly pushing us into recession, but not necessarily a severe one. The wildcard is the financial system.  If a breakup was accompanied by systemic disruption to the global financial system, which is clearly a significant possibility, then all bets are off.

3) Productivity: What do you think has caused Britain's feeble productivity performance since 2007? What scope is there for a bounce in Britain's productivity growth in 2012?

I am not convinced that the productivity figures are much more than a statistical artefact at this stage. Clearly we have lost some output as a result of the crisis, but the magnitude of that loss is far from clear. What is clear is that there is plenty of spare capacity, particularly in the labour market, and with the right policies (and a benign, or at least not disastrous, international environment) considerable potential scope for growth. Over the medium term, although the UK economy has some structural weaknesses (excessive dependence on a rent-seeking financial sector, educational inequality) it has also has a number of strengths (a well-functioning labour market, openness, the higher education sector) and there is no reason, given sensible policies, we should not return to strong productivity growth in the medium term - as we have seen over the past 30 years.

4) Monetary policy: To what extent will the Bank of England have demonstrated its ability to control inflation by the end of 2012? Will it still be buying gilts?

One reasonably safe bet is that inflation will fall sharply over the next year, probably back towards the target.  Assuming the central scenario above - ie no severe further downturn - it will no longer be buying gilts by the end of 2012.

5) Fiscal Policy: To what extent has deficit reduction been going too far and too fast? Can the UK retain the bond market's faith over the next year?

It remains NIESR's view that in the short term fiscal policy is too tight, and a temporary loosening would improve prospects for output and employment with little or no negative effect on fiscal credibility.


It is worth noting - particularly given George Osborne's assertions that those of this view, which include Martin Wolf and Paul Krugman, are "on the outer fringes of the international debate" - that Olivier Blanchard, the Chief Economist of the IMF, agrees with us.  As he said just this week,  "To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast..Substantial fiscal consolidation is needed, and debt levels must decrease. But.. “slow and steady wins the race.”

As for "retain the bond market's faith" it is unclear what this means.  The UK will not default, no-one with a brain seriously thinks it will, and the opinion of the rating agencies is irrelevant.  We have nothing to worry about on that score. But our current historically very low level of interest rates is - just as in Japan - a sign of economic failure, not success. The government has got the rhetoric and the economic logic completely wrong on this. Gently rising long term rates, back towards levels consistent with decent economic growth, would be a good sign; sustained very low or even falling long term rates would be a very bad signal -perhaps the onset of a lost decade. 

6) Credit: Will credit easing be remembered as a transformative policy in a year's time? How should policy address the supply of credit if at all?

No - as currently proposed it will have a positive, but probably marginal, impact. Much more radical reform of the UK financial sector is required. 

7) Policy: What policy would be most effective in fostering Britain's supply potential? What is the best policy to stimulate demand?

On the supply side, we need to look at the short, medium and long term.

  • In the short term, fixing the broken financial sector so that savings can be channelled to productive investment. 
  • In the medium term, a host of policies - reversing the misguided and damaging immigration limits on skilled workers and students, which will have a negative impact on growth and innovation, facing down the lobbies on planning reform, and the localisation of public sector pay - could help. 
  • Over the long term, nothing matters more than people; the priority should be investing in programmes that will help disadvantaged children, both before and during their school years.  Unfortunately while the government means well on this score, and genuinely does understand the importance of reversing the entrenched educational inequalities of the UK system, far too much effort and resources is being devoted to changes to the school system which the international evidence suggests aren't likely to improve things much.  And, like its predecessor, it is fixated on targets which incentivise schools and teachers not to focus on those who need it most.

On the demand side, a temporary, but very large, cut in National Insurance Contributions for younger workers and/or the low paid, would stimulate both consumer demand (since those who would benefit typically have high propensities to consume) and labour demand.  Other possible measures include extra (not just speeded up) infrastructure spending, and restoring some of the excessive cuts to local authority expenditure on services like social care and Sure Start.  But the basic principle - that fiscal loosening should be focused on measures where it is likely to lead to direct increases in final demand - is obvious


Responses to questions from Mehdi Hasan (New Statesman)

1)       How bad a year for the global economy do you think 2012 will be? And why?

The baseline scenario is still that we muddle through, with a mild recession in the eurozone, but finally a reasonable recovery in the US and continued growth in the rest of the world, so not great but not disastrous overall.  The main drivers of this would be simply that the US has gone through a wrenching period of adjustment in the labour and housing markets, the Federal Reserve has provided unprecedented monetary support, and at some point things have to turn round, given that there's not that much wrong with the underlying US macroeconomy; meanwhile, relatively sensible policies in China and other emerging markets, and continued scope for catch-up, mean continued strong growth.

In the eurozone, there will be both too little policy coordination (on the institutional changes and structural reforms needed to boost growth) and too much (on self-defeating austerity) but ultimately it will not be allowed to come apart. This will lead to recession - nasty in places - but not depression, as ultimately the northern Europeans realise that austerity alone will not prevent disaster.  

2)       How bad will it be for the UK economy? Worse than 2011? Again, why?

Under this scenario, quite similar to this year, so not great, but not disastrous. Premature fiscal austerity will continue to weigh on the economy, leading to lower growth and unemployment than necessary - and high youth unemployment will do permanent social and economic damage. This will be compounded by eurozone weakness.  But as in the US, very aggressive monetary policy will limit the damage, and exports to the rest of the world will help. Moreover, with inflation falling, real incomes will stop shrinking so fast, so consumer confidence may pick up a bit.  And, as in the US the underlying position of the UK economy is not as bad as it is sometimes painted; I think the OBR projections for medium to long term potential may be too pessimistic, although in one or two key areas the government is doing its best to reduce growth potential (eg, immigration policy). So with a bit of luck - and ideally, better policies - there is also potential on the upsid.Preview


3)       Are we heading for a break-up of the Euro in 2012? And what would that mean for both Britain and the global economy?


See the preamble on prediction...

 Ultimately this is a political question not an economic one, so I'm reluctant to give a straight answer. What I would say is that the draft Treaty/agreement that the Prime Minister vetoed is not only the wrong answer to the problems of the eurozone, it isn't even directed at the right question.  The eurozone crisis is not the result of fiscal imprudence - if so, the exceptionally fiscally responsible Spanish and Irish would not be part of it - it is the result of the internal imbalances within the eurozone, driven primarily by private sector behaviour. The draft agreement doesn't even pretend to address these issues; if the Prime Minister had declined to sign it on the grounds that it was economically illiterate and damaging, he would have been entirely justified.

So we are definitely not out of the woods. If eurozone leaders stick to their current approach, the risks of a disorderly breakup (as a consequence of the political unsustainability of self-defeating austerity in one or more country, and/or a catastrophic bank failure) are high. But my baseline (for  questions 1 and 2 above) remains predicated on the view that eurozone leaders ultimately understand/will have to understand this, and therefore that both monetary and fiscal policy will respond, either through ECB bond purchases/quantitative easing or large multilateral loans, combined with looser adjustment programmes for the peripheral countries. If so, it won't be pleasant, but the eurozone should muddle through.

The consequences for the UK of a disorderly breakup range from the damaging to the disastrous.  Clearly any breakup would have a negative impact on exports and hence on our economy, if only through exchange rate effects (the pound would presumably rise sharply) quite possibly pushing us into recession, but not necessarily a severe one. The wildcard is the financial system.  If a breakup was accompanied by systemic disruption to the global financial system, which is clearly a significant possibility, then all bets are off. 

4)       What's the big "unknown unknown" we should be on the look out for next year? The potential political/economic crisis that no one's really paid much attention to?

I'm definitely not in the business of predicting political crises, like the Arab Spring. But in terms of major political events impacting the world economy, the obvious potential "risk" is China; I don't see how the current political/economic equilibrium is sustainable in the medium to long term, and the potential for a very disruptive transition - who knows to what? - is in my view high. But the probability of this happening next year is presumably low.

 5)       What will the world and/or Britain look like this time next year? Please paint me a brief picture..

In an optimistic scenario we'd be well over the worst of the economic downturn, and although it won't be plain sailing, beginning to see concrete signs of improvement.  With - see above - an economy that is in underlying reasonable health, we should be looking forward to reasonably strong growth, perhaps better than the current forecasts. With President Obama reelected on the back of a solid recovery in the US, and the eurozone with finally a coherent if not comfortable approach to its problems, there is a reasonable degree of economic policy coordination and a generally much better international atmosphere. We might even start thinking about what to do about the real long-term problems for the developed world - unacceptable levels of inequality, and how to make the financial sector serve the real economy rather than extract rents from it for the benefit of a very few. 

The pessimistic scenarios follow from 3 and 4 above and I have no desire to spell them out. 




2 comments:

  1. If you expect that inflation will remain above target, by what metric is fiscal policy "too tight"?

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  2. I think you're too optimistic when you say "And, as in the US the underlying position of the UK economy is not as bad as it is sometimes painted;".

    The UK is the most indebted country in the OECD. The 2011 Budget Report reckoned our private debt at 450% of GDP. Note that the 2012 Budget Report barely mentions private debt, and there are no policies to deal with it. Interest payments also have a depressing effect on the economy. Business bankruptcy levels are creeping back up again having come down from their peak in 2009 - the really weak went to the wall almost immediately. Now we're seeing the longer term attrition caused by poor demand, which in turn is affected by deleveraging and austerity.

    12 July 2012 Jamil Baz (FT: p.32) said "deleveraging has not even begun yet, the crisis of the world economy has not begun either... it will take a minimum of 15 years for the economy to reach escape velocity".

    Though of course the banks have used government hand-outs and lower lending levels to get back to pre-crisis leverage levels and pre-crisis profit levels in many cases.

    You obviously get this in your answer to question 2, so I'm not sure why it doesn't inform you answer to question 1. Japan 1990-2005 is the model a lot of people are citing. Europe is unlikely to hold. Any kind of optimism sees misplaced. Indeed those small number of economists who did predict the credit crunch and subsequent bursting of the debt bubble are all saying that we'll have another credit crunch sometime soon.

    Re 4 I agree that the inflation measure as stated will come down as you predict, but with real wages falling, and house prices falling aren't we looking at a period of real deflation?

    The policy area that no one is talking about is a means to deal with private debt. The government seems to have linked it's policy to business investing more, but the private sector taken as a whole is massively over-indebted and busy deleveraging or going bankrupt. We need some kind of QE for the people, to inject cash into the real economy rather than helping the banks who caused the problems and probably will again.

    Secondly in the short term a Robin Hood Tax would provide some funds for investment in the real economy, especially green technology.

    In the long run the banking system needs to move towards the model of Burnley Savings & Loans: small, local, personal, and lending savings to the real economy. Banks should not be allowed to create money, nor should they be allowed to loan money for gambling on asset prices and commodities. If people must gamble let them risk their own wealth.

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