Economic Report #3 - October 2010

Issue date
19 Oct 2010


Economic Report

Number 3 October 2010

Part One: Economic data overview

Key economic indicators are outlined below:

Recent economic developments

At the end of September the International Monetary Fund published its annual 'Article IV' report on the UK, which cut forecast growth for 2011 from 2.1 to 2 per cent and encouraged the Bank of England to maintain a loose policy, being prepared to resume quantitative easing if necessary. More attention was paid, however, to the report's complimentary remarks about the government's austerity package.

This position was contradicted the following month when the new edition of the Fund's World Economic Outlook implicitly criticized aggressive fiscal consolidations. The IMF periodical included an historical survey, showing that (contrary to the assertion s of some economists) cuts are associated with losses of output and increases in unemployment. When, as at present, many countries plan adjustments at the same time, 'fiscal contraction is likely to be more painful.'

The Bank of England also found itself apparently facing in two directions at the same time. The Governor's speech to the TUC Congress, arguing that the cuts are a necessity, was widely reported. But later in September, in an interview on Channel 4, his Deputy, Charles Bean, said that interest rates had had to be held down to encourage people to spend more and boost demand - implicitly accepting that the cuts will have the opposite effect. Within a day, MPC member Adam Posen argued in a speech that the Bank should resume quantitative easing if the UK was to avoid deflation on the scale of Japan's 'lost decade'. (Mr. Posen is recognized as the English-language authority on Japan's economic problems.)

A series of economic results underlined the risk that, when government spending was cut, there would not be sufficient alternative sources of demand.

The Quarterly National Accounts from the Office for National Statistics confirmed the initial estimate that GDP grew by 1.2 per cent in the second quarter of the year. Within that overall total, the estimate for government expenditure was revised upwards from 0.3 per cent to 1.0 per cent, demonstrating that (particularly when public spending in the construction sector is considered) Government spending made a considerable contribution to overall growth. In August, the Government hailed the GDP estimates as proof that the economy could grow without a contribution from public spending; they were silent on the subject in September.

At the end of September, the GfK/NOP Consumer Confidence Index fell slightly, and the Nationwide House Price Index was stagnant. The Consumer Confidence Index fell to minus 20; this was down from minus 18 in August and minus 16 in September 2009. The House Price Index three-monthly rate of change fell from 0.0 per cent in August to -0.9 per cent in September. These figures suggest that household consumption is unlikely to make up for the effect of government cuts.

The following day, the Manufacturing Purchasing Managers' Index fell to its lowest level for ten months. For the first time since July 2009 there was a decline in export orders. The Government believes that large cuts in public sector spending will 'crowd in' private sector investment and that exports will help deliver jobs growth, so these figures are challenging to that assumption.

The August Index of Production figures, published in October, were more positive. The Index of Production stood at 89.4, up 4.2 from August 2009. The separate Index of Manufacturing stood at 91.2, up 6.0 on a year previously. This was the largest year-on-year rise for 15 years, and there were increases of 16 per cent in the index for machinery and 7.7 per cent in that for food, drink and tobacco. These annual improvements, however, reflected very strong performance in the first three months of the year, the increase from the previous month was a much more modest 0.3 per cent.

Office for Budget Responsibility

On 12 October, the Chancellor announced new terms of reference for the Office for Budget Responsibility. It will now be located outside the Treasury and the Treasury Select Committee will have a veto on appointments. These reforms were widely trailed as having been necessitated by the perception that the OBR's independence had been compromised.

The labour market

Early in October, a survey by Abbey Legal Protection found that a third of workers were worried about losing their jobs. At the same time, the monthly Report on Jobs from the Recruitment and Employment Confederation (the trade body for employment agencies) revealed that permanent appointments at their lowest level for a year and temporary appointments at their lowest for eleven months. The REC described the trend as 'starting to flatline'.

The October labour market statistics revealed that cuts were beginning to make a difference to working people's employment prospects.

The 'headline' employment figure - comparing the most recent three month period with the previous three mo nth period - showed a rise of 178,000. But the figures for June and July, showed the employment level doing no more than holding steady.

The proportion of people in involuntary part-time employment (those only working part-time because they could not find full-time work) was the highest on since this figure was first recorded (in 1992). 1,137,000 part-time workers - more than one in seven - were in this position. What is more, while the number of full-time jobs rose on the quarter (35,000) it fell significantly on the month (31,000).

Unemployment by the International Labour Organization (ILO) measure fell, both on the month (19,000) and on the quarter (20,000). This was mainly accounted for by an improvement in unemployment levels among 16-17 year olds.

The 'claimant count' measure of unemployment, which provides a more recent picture (with data available up until September) rose again, and was 5,300 higher than in August.

The claimant data also showed a rise in new claims, with the number of people who had been claiming Jobseeker's Allowance for less than 6 months rising by 16,000 between August and September.

The increase in short-term unemployment is particularly worrying for young people, where it is now showing in the ILO measure. The number of 18-24 year olds unemployed for up to six months rose by 45,000 on the quarter (and 2,000 on the month) and long-term unemployment for this group jumped 16,000 on the quarter (as well as on the month).

Women's short-term unemployment has also risen, by 17,000 on the quarter. The equivalent result for men was a 19,000 fall. On the year, women's unemployment is up 77,000, compared to a fall of 100,000 for men. The gap between male and female unemployment is still significant (there are 423,000 more unemployed men than women, and more men have lost their jobs during the recession than women) but the gap between the two levels is now the smallest since January 2009.

Pay

Average Weekly Earnings (total pay, including bonuses) continued to rise, by an average of 1.5 per cent (three month average on the year), with pay excluding bonuses rising at the slightly faster rate of 1.8 per cent. Pay growth (including bonuses) was stronger in manufacturing (3.3 per cent) and finance and business services (2.7 per cent). It was lower in the public sector (excluding financial services) where it was 1.4 per cent, and in construction (0.4 per cent).

According to Incomes Data Services, (the IDS pay database for the 12 months to 4th October) the whole economy median for pay settlements is 2 per cent, with the lower quartile now being 1 per cent (a positive move, given that the lower quartile has seen pay freezes for much of the previous year) and the upper quartile starting at 2.5 per cent. In the public sector settlements are lower - the median over the same period was 1 per cent, with the lower quartile being pay freezes and the upper quartile was 2 per cent.

Part Two: Policy Briefing

The Deficit

On 20 October, the government will publish its Comprehensive Spending Review, setting out how it plans to cut spending on public services. The government says these cuts have to be made to cut the public sector deficit and pay off the public sector debt.

Ministers often argue that the UK has a large deficit because public spending rose to unaffordable levels. But the evidence that the cause is in fact the loss of government revenues following the global recession if extremely strong. The global recession was not caused by public spending, but by the instability of international finance. This article looks at:

  • what we mean by the deficit and the debt,
  • how it grew to become a problem,
  • why the deficit does have to be addressed,
  • dealing with the deficit by spending cuts, revenue increases and economic growth,
  • the likely impact of a 25 per cent reduction in public spending.

The deficit and the debt

All governments spend money on benefits and services and raise money (mainly by taxes) to pay for them. When the money that is less than expenditure, the amount by which it falls short is the deficit. The debt is the total of previous years' deficits.

It is normal for debt and the deficit to rise in a recession and fall during the recovery. During a recession businesses and individuals have lower incomes and spend less, so tax revenues go down; at the same time, more people need to claim benefits and demand for social services tends to be higher, pushing spending up. During a boom, these processes go into reverse. If we look at spending in the last 13 years, we can see quite clearly the impact of the recession on public spending:

Chart 1: Total Managed Expenditure as a Percentage of GDP

graph


Most governments aim to run a surplus in the up phase, which balances with the necessary deficit in down phase. This was reflected in one of the last government's 'fiscal rules', the so-called 'golden rule': that 'on average over the economic cycle, the Government will borrow only to invest and not to fund current spending.'

The other half of the last government's fiscal strategy was the 'sustainable investment rule': that 'net public debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level'[3] which was often interpreted as meaning 40 per cent of GDP.

Despite some criticisms from political opponents, this was an entirely respectable policy. In an open letter to Robert Chote, the new head of the Office for Budget Responsibility, John Kay (former Director of the Institute for Fiscal Studies) said it was a 'sensible' framework.[4] There was no particular need to set the limit for public debt at 40 per cent of GDP, but this figure reflected the consensus view of policy makers. These rules were appropriate at a time when the government believed that that there would be 'no return to boom and bust' but they did not survive the turmoil of 2008 and were not used for the last eighteen months of the Labour government's time in office.

The importance of the economic cycle for the balance of public spending leads many economists to talk about the structural deficit. Also known as 'cyclically-adjusted public sector net borrowing', it is the notional size of the deficit if it weren't for cyclical factors.

Government spokespeople often point to the size of the structural deficit as evidence of the profligacy that must now be corrected. The Treasury currently estimates the structural deficit at 8.7 per cent of GDP:[5]

graphChart 2: Structural Deficit as a Percentage of GDP

As can be seen here, there is a coincidence between the onset of the recession and the rise of the structural deficit - it has a remarkably cyclical look. Howard Reed and Chris Dillow have both pointed out[6] that the way in which the structural deficit is calculated is very important. The recession will have permanently destroyed some proportion of the economy's potential - this means that any given level of deficit will be a larger proportion of GDP now than it would have been before the recession. The amount of potential output that has been destroyed therefore has a major impact on the size of the structural deficit, but calculating that number is an art, not a science; no matter how authoritative an estimate of this loss may seem it is always uncertain. As Howard Reed puts it, 'though most of the deficit is classified as structural rather than cyclical, a large proportion of the structural deficit is the consequence of the financial crisis and subsequent recession.'[7]

Spending, debt and the deficit in context

Several commentators have pointed out that the current level of government spending is not unprecedented - as a proportion of GDP, it is quite low, compared with the levels just after the Second World War. But it is not necessary to go that far back:[8]

Chart 3: Total Managed Expenditure as a Percentage of GDP

graph


The trough in the 1990s is also the period when many people felt that under-funding was causing a crisis in public services; it is likely that continued funding at that low level was just not sustainable. The tick up on the right hand side shows the effect of the recession.

We are often told that the levels of debt and the deficit are unprecedented, but it is important to distinguish the two. Current levels of debt are high, but not out of line with levels during the last three major recessions:

Chart 4: Public Sector Net Debt as a Percentage of GDP

graph


The deficit, on the other hand, is very high by historical standards:

Chart 5: Public Sector Net Borrowing as a Percentage of GDP

graph

None of these charts shows a glut of public spending, but they do show the impact of the recession. Most importantly, spending grew at about the same rate as revenues until the recession began. In the next chart, the red dotted line shows total current public expenditure and the blue unbroken line shows public current receipts:

Chart 6: Government Expenditure and Receipts (£ billion)

graph

(12 month moving averages)

Spending did grow under the last government, but as noted above, it could be argued that this was overdue and the reduction in GDP we have seen in the recession has magnified this effect. Martin Wolf has noted that:

'Between 1999 - 2000 and 2007 - 08, the ratio of total managed spending to GDP did rise from 36.3 per cent to 41.1 per cent. But the latter was still modest, by the standards of the previous four decades. The jump to a ratio of 48.1 per cent, forecast for this year in the 2010 Budget, is due to the recession. Nominal spending is currently forecast at 3.5 per cent higher in 2010-11 than forecast in the 2008 Budget. But nominal GDP will be 10.3 per cent lower and tax revenues 16.4 per cent lower. Critics of his fiscal policies were right, but the error was far larger than anybody imagined.'

The next chart shows the evolution of total managed expenditure over the past 13 years, both as a percentage of GDP and in real terms (2009-10 values):

Chart 7: Total managed expenditure

graph

In this chart we can see how Labour's acceptance of strict limits to public spending in their first two years of office only allowed a very small increase in cash terms, and, as the economy grew, spending as a proportion of GDP fell. Thereafter, spending grew till 2006, when it was held at around 41 per cent of GDP. After 2008, as the size of the economy shrank, so the proportion of GDP accounted for by spending rose dramatically.

It is certainly possible to argue that the last government made a serious error in relying on revenues from a financial sector that was to be hit hard by the economic crisis and not thinking how to maintain public spending if that source dried up. But they were hardly alone in these errors. Until 2008, the opposition promised to match the government's planned spending levels, and was not noticeably demanding a shift from reliance on finance.

Why the deficit must be addressed

The deficit has to be paid for by borrowing, either from British people or from abroad, and government spending includes the interest on public debt. If the government's revenues grow faster than the deficit this will be manageable but if that does not happen it will grow. In principle, if this goes on for long enough a government can reach a point where it can no longer pay its debts. More usually, lenders start worrying about default before it is likely to happen and insist on higher interest rates to compensate them for their loans being riskier. They are very influenced by credit rating agencies, which is why rumours that these agencies are going to downgrade UK sovereign debt could cause problems. As the risk premium goes up, so it becomes more difficult to meet the payments, forcing premiums up further and governments find their existing policies can no longer be maintained.

That is why few argue that the deficit should just be ignored over the long-term. However, those who oppose the government's approach argue that the key to dealing with deficits and to paying off debt is to maximise economic growth. Higher growth increases government revenues and reduces the need for many benefits and public services.

It is argued that when growth is low or fragile the effect of these measures on demand can be such that the net effect can be to reduce the ability to address the deficit. At times like this, allowing the deficit to grow - even allowing it to grow at a faster rate than the long-term rate of economic growth - can be a sensible strategy.

Public spending on services

The debate about the deficit must also take into account the impact of cuts on public services and the people who rely on them. Unfortunately, the impact of 25 per cent cuts, as proposed by the government, is not widely understood.

The chart below illustrates estimated Government expenditure for 2009-10 broken down into ten broad functional categories. It demonstrates that the greatest proportion of public spending is on 'social protection', followed by 'health', then 'education'.

Chart 8: Public sector expenditure on services by function 2009-10 (real terms, £ billions)

pie chart


This data also allows an illustrative analysis of what a real terms cut of 25 in expenditure would mean by each functional group. While the Deputy Prime Minister has recently argued that the cuts that the Coalition are proposing will, as a percentage of GDP, 'only' take spending back to the levels of 2006, this analysis does not apply when the real terms expenditure on service budgets is considered individually. The following table shows what would happen to spending levels if cuts of 25 per cent of expenditure were applied across public services from next year. Cuts of this scale for defence and employment policies would mean that spending levels fell below those of the late 1980s (when the data series begins), while in areas including public order and safety, transport and education spending would be cut to the real terms value of ten years ago. Cuts of this scale would therefore have significant service impacts - particularly when the additional pressures that population growth and technological developments over the last decade will have placed on these budgets are considered.

Table 1: Impact of a 25 per cent real terms reduction in public sector expenditure on services by function (£ billions)

The Treasury data also allows analysis of how public spending has changed in real terms over time. The following chart shows that real terms spending on defence and economic affairs fell during the 1980s and 1990s, and then increased throughout most of the next decade. In contrast, spending on environmental protection, housing and recreation, while showing some variation, has remained relatively stable in real terms and spending on health, social protection and education has shown strong real terms growth throughout the last decade.

Chart 9: Public sector expenditure on services (general public services, defence, public order and safety, economic affairs and environmental protection) by function (real terms, £ billions), 1987-88 - 2009-10

graph


Chart 10: Public sector expenditure on services by function (housing and community, recreation culture and religion, education and health (LHS) and social protection (RHS)), 1987-88 - 2009-10 real terms, £ billions)

graph


In their most recent edition of Social Trends, ONS describe social protection as follows 'the assistance provided to those in need or at risk of hardship, through the provision of financial assistance and services....it provides a safety net to protect the vulnerable in society who are unable to make provision for themselves for a minimum decent standard of living, such as those with caring requirements, low income and age-related problems...assistance is provided through direct cash payments such as social security benefits or pensions, payments in kind such as free prescriptions, and the provision of services such as local authority home care help.'

While politicians have recently been keen to discuss the supposed problem of social protection spending, it is worth bearing in mind that social expenditure in the UK is below the OECD average, with many other economically successful countries spending far more.

Chart 11: Gross public social expenditure by OECD country as a proportion of net national income (NNI) 2005

graph


The Government is right to say that over recent years there have been significant increases in both overall social protection spending, and specifically in the social security budget, but the reality is that spending in the UK remains relatively modest compared to many other countries and that spending rises have been driven by the pressures of a rapidly ageing population. This can be seen in the following ONS analysis, which shows that over the period 1990-91to 2007/08 spending on older and disabled people increased by £66 billion in real terms, whereas spending on unemployment fell by £9.3 billion. Even at its height in the early 1990s spending on unemployment was by far the smallest part of the social protection benefits budget: in 1993/94 spending on unemployment was 7 per cent of the social protection budget, which had fallen to 2 per cent by 2007/08. This fall is a result both of falling numbers of unemployed people and the falling value of their benefits: analysis recently published by the Joseph Rowntree Foundation has shown that the real terms value of Jobseekers's Allowance is the same now as it was in 1997 (and that its current rate is just 41 per cent of the JRF's Minimum Income Standard for a single working-age adult).

Chart 12: Expenditure on social protection benefits in real terms by function (old age and survivors[20] and sickness, healthcare and disability (LHS) and unemployment (RHS)) 1990-91 to 2007-08

graph


Despite these trends, public attitudes suggest strong support for greater reductions benefits for those who are unemployed. Furthermore, the British Social Attitudes Survey shows that between 1998 and 2008 public attitudes towards unemployed people hardened, with rising proportions of the public believing that people who are out of work should receive less or much less (over 50 per cent of the public now support this position), a 20 per cent increase from 1998. There was also a 12 per cent drop in the number of people who believe that disabled people who cannot work should receive more support.

Table 2: Attitudes to government spending on social security benefits

There have however been some small improvements in public attitudes towards some groups of people in receipt of social security benefits. Slightly fewer people now believe that single parents should receive less support and support for increasing the entitlements of low income working parents has remained relatively high.

But although it is not reflected in public debate around 60 per cent of total benefit expenditure (£152 billion in 2008/09) in Great Britain is paid to people of state pension age, 2 per cent to children (Tax Credits and child benefit are not included in these statistics), 13 per cent to people with disabilities not related to age and the remaining 25 per cent were paid to people of working age.

Separate analysis of Tax Credit data shows that these payments also make a significant difference to working families. In April 2010 close to 1.5million out of work families received Tax Credits, as did 4.8 million working families (benefiting, in total, 10.2 million children). In addition, close to half a million working families receive support with childcare through the Tax Credit system, receiving an average of £69.89 a week in support. While there has been much Government discussion about the anomaly of households with incomes of over £50,000 receiving Tax Credits, there are in fact only 156,000 families nationally in this position (2.5 per cent of all Tax Credit recipients). In contrast, 63 per cent of recipients (4 million) are out of work or earning less than £20,000.

Social protection spending in the UK is vital to our social and economic health. It provides millions of people with much needed income assistance and support. The majority of state spending in this area is targeted at people of state pension age, while real terms spending on unemployed people has fallen. In recent decades, support for families has also increased, concentrated on supporting those on the lowest or on middle incomes. This reality is far removed from the political rhetoric - and means that if the welfare bill sees further large scale cuts the costs to individuals and communities will be extremely high.

Notes


Other reports and briefings have also looked at this issue. Two that are particularly useful are Rethinking Deficit Reduction by Howard Reed for the Progressive Economics Panel, June 2010, available at and Countering the Cuts Myths, by Dr Alex Nunn, published by Red Pepper and The Other Taxpayers Alliance, August 2010, available at http://www.redpepper.org.uk/IMG/pdf_cuts-web.pdf

Chart derived from table B2 of the Treasury's Public Sector Finances Databank for 30 September 2010, available at http://www.hm-treasury.gov.uk/d/public_finances_databank.xls

Departmental Report of the Chancellor of the Exchequer's Departments, HMT, 1999, para. 1.2.6, available at http://webarchive.nationalarchives.gov.uk/+/http://www.hm-treasury.gov.uk/d/107.pdf

'A fiscal watchdog should not need a crystal ball', John Kay, Financial Times, 22 Sept 2010, available at http://www.johnkay.com/2010/09/22/a-fiscal-watchdog-should-not-need-a-crystal-ball/ He did, however, have serious criticisms of the last government's 'extensive and expensive attempts to circumvent its self-imposed rules.'

Chart derived from table A1 of Treasury's Public Sector Finances Databank

Rethinking Deficit Reduction, Howard Reed, p 2, available at ; 'The myth of the structural deficit', Investors Chronicle website, Chris Dillow, 15 February 2010, available at http://www.investorschronicle.co.uk/Columnists/ChrisDillow/article/20100215/1b8f8020-1a1e-11df-b0bd-0015171400aa/The-myth-of-the-structural-deficit.jsp

Rethinking Deficit Reduction, Howard Reed, p 4, available at (emphasis in original.)

Chart derived from table B2 of Treasury's Public Sector Finances Databank

Chart derived from table A6 of Treasury's Public Sector Finances Databank

Chart derived from Public Sector Finances, ONS, 21 September 2010, table PSF9, available at http://www.statistics.gov.uk/pdfdir/psf0910.pdf and historical data from ONS Statbase, available at http://www.statistics.gov.uk/statbase/tsdtables1.asp?vlnk=pusf

Chart derived from table A8 of Treasury's Public Sector Finances Databank.

'The economic legacy of Mr Brown ', Martin Wolf, Financial Times, 13 May 2010, available at http://www.cfr.org/publication/22123/economic_legacy_of_mr_brown.html

Data from HMT PESA 2010, Table 4.3

For example, see http://www.guardian.co.uk/commentisfree/2010/sep/20/clegg-talks-pure-cameronomics

Ibid.

Social Trends 2010 is as a downloadable publication at: http://www.statistics.gov.uk/downloads/theme_social/Social-Trends40/ST40_2010_FINAL.pdf

Data downloaded from OECD statistics portal. The most recent comparable data are for 2005

Data are taken from Social Trends 2010 (Ibid). The data are not provided beyond 2007/08, but it's likely that if they were a small increase would be seen in expenditure on unemployment as a result of the recession. This would not however impact significantly upon the broader trend, as the falling costs of unemployment have been driven both by falling numbers of unemployed people (prior to the recession) and falls in the real terms value of their benefits.

Fothergill S, Horgan G, Kenway P and MacInnes T (2010) Working age welfare. Who gets it and what does it cost? York: JRF Available to download from: http://www.jrf.org.uk/sites/files/jrf/working-age-welfare-summary.pdf

Survivors are defined by ONS as those whose entitlement derives from their relationship to a deceased person (for example, widows, widowers and orphans).

Data are taken from Social Trends 2010 (Ibid). Respondents aged 18 and over were asked 'Some people think that there should be more government spending on social security, while other people disagree. For each of the groups I read out please say whether you would like to see more or less government spending on them than now. Bear in mind that if you want more spending, this would probably mean that you would have to pay more taxes. If you want less spending, this would probably mean paying less taxes.' Excludes those who responded 'don't know' or did not answer.

ONS Social Trends 2010 (Ibid).

HMRC Tax Credit statistics, available to download from: http://www.hmrc.gov.uk/stats/tax_receipts/table1-3b.pdf