The eurozone and UK economies slowing markedly

In this week’s bulletin:

  • Ahead of the Chancellor’s Autumn Statement tomorrow, we have included the first in a series of articles written for us by Dr Andrew Sentance, Senior Economic Adviser at PricewaterhouseCoopers and former member of the Bank of England Monetary Policy Committee. Dr Sentence discusses some of the possible steps policymakers might take to put Britain’s economy back on the road to growth.
  • Financial markets were once more embroiled in the eurozone debt crisis which took a new turn following a disappointing bond auction in Germany, which until now has been seen as one of the last refuges of safety by investors.
  • Yields on Italian and Spanish bonds resumed their upward trend back towards the key 7% level at which some form of bail-out has usually followed. Against this backdrop, equity markets fell back across the board as investors once more waited for policymakers to take decisive action.
  • With the eurozone and UK economies slowing markedly, all eyes will be on Chancellor George Osborne tomorrow when he uses his Autumn Statement to announce new growth initiatives for the UK economy.

Market Eye

Last week the markets continued to be dogged by the two central concerns dominating investors’ minds this year: the eurozone crisis and how it will be resolved plus slowing growth in the developed economies, including the UK. On the former, the crisis took another turn for the worse as a disappointing auction of German Bunds rattled investors midweek. Up until now, the eurozone’s strongest economy has had no problems selling government debt – yields on German bonds hit historic lows only two weeks ago, reflecting confidence in the country’s financial position. But with the markets in an unforgiving mood it was no real surprise that concerns over Italy, Spain – and also Belgium – caused bond yields there to test the crucial 7% level: the tipping point for the likes of Portugal and Greece to need bailing out. Despite this intense pressure from the financial markets and German Bund yields jumping sharply, Angela Merkel stood firm: refusing once again to allow the European Central Bank to become the buyer of last resort and dismissing the idea that the region should go down the cross-subsidy route by issuing ‘eurobonds’ which would lower borrowing costs for peripheral economies.

Against this backdrop, global equity prices fell back, reflecting concerns over the outlook for eurozone financial stability and also, more fundamentally, the prospects for future economic growth. The situation was not helped by weaker-than-expected economic data from China which surprised on the downside. Here in the UK, corporate news was mixed: holiday giant Thomas Cook was forced to seek further help from its banks to the tune of £200m and at the cost of 1,000 jobs; but more positively, Toyota and Nestlé unveiled plans to create 2,000 new jobs. Official figures confirmed UK GDP growth of 0.5% in the third quarter and the release of minutes from the Monetary Policy Committee’s last meeting revealed no opposition to more quantitative easing, implying the possibility of more when the current programme expires next February.

The weakening outlook for economic growth is forcing policymakers to focus on how best to stimulate much-needed activity in the months ahead and no more so than for George Osborne. Tomorrow the Chancellor will use his Autumn Statement to set out the government’s plan for boosting the UK economy, creating jobs and getting people back into work. Details of some schemes, such as the youth work programme, have already been released but expectations are high that Mr Osborne will announce some major government growth initiatives.

 

An alternative view

Today’s Bulletin includes the first in a series of articles written for us by Dr Andrew Sentance, Senior Economic Adviser, at PricewaterhouseCoopers and former member, Bank of England Monetary Policy Committee. Ahead of the Autumn Statement, Dr Sentance discusses some of the possible steps policymakers might take to put Britain’s economy back on the road to growth.

The past year has seen disappointing economic growth in many western economies. In the US and the euro area, GDP growth has been around 1.5% over the past year. And in the UK, it has fallen short of 1%, even if the dampening impact of weak North Sea oil and gas production is excluded.

Concerns about disappointing growth have led to a renewed focus on trying to stimulate demand through monetary policy, with the Bank of England embarking on a new round of ‘quantitative easing’. And they have fuelled concerns about the ability of economies encumbered by high levels of public and private debt to meet their financial obligations.

The question “Where will economic growth come from?” has been posed before at this stage of the economic cycle. In his memoirs, former Chancellor of the Exchequer Nigel Lawson recalls a similar discussion in the early 1980s – against a background of plant closures, rising unemployment and a massive restructuring of UK manufacturing industry. I recall a similar debate in 1992 and 1993, when the economy was struggling to recover from the early-90s recession. In that case, official statistics now tell us that the growth picture in the early stages of the recovery was stronger than it appeared at the time – something we should bear in mind when looking at the weak provisional estimates of economic growth in this recovery.

So where does economic growth come from? What are likely to be the main sources of growth in the current situation? And how can it be best encouraged by economic policy?

In the short term, the most significant influence on the rate of economic growth is the pattern of spending – from households (consumer spending), firms (investment), and government and overseas (exports). We see this most dramatically in a recession, when falls in spending cause a build-up of stocks of unsold goods, cutbacks in production and job losses. As confidence returns and spending picks up again, the economy moves into a recovery phase and growth resumes. But it can take many years to take up the slack created in the recession. In the UK in the 1990s, unemployment only returned to its pre-recession level in 1997, five years into the economic recovery. And after the early 1980s recession, it took over two decades for unemployment to return to the late-1970s rate of around 5% of the workforce.

When it comes to analysing growth over these longer periods of time, an assessment based on the amount of spending in the economy is a largely circular exercise. Consumer spending depends on household incomes, which in turn are driven by the rate of growth of the economy. Similarly, business investment will be heavily influenced by the health of company finances and business profitability – which are also very sensitive to the level of economic activity. Government spending can be sustained by deficits for a while. But even here, sustainable public spending growth is dependent on tax receipts which are underpinned by economic growth.

The key drivers of spending in the domestic economy therefore depend, themselves, on the rate of growth. We therefore need a different framework for thinking about economic growth over the longer term, taking into account the more fundamental drivers of wealth creation.

That means thinking about the factors which enable businesses to add value through their activities, which underpin economic growth over the longer term. It means looking at the economy from the supply side rather than the demand side; and considering how economic policies can best support the supply-side processes which enable businesses to create wealth and add value.

From this supply-side perspective, there are three key factors which are important influences on economic growth. The first is the contribution of labour: the growth of the workforce, more flexible labour markets and the creation of skills through education and training. In the past few decades, fast-growing populations and flexible labour markets have supported growth in the United States and Asia. European economies with generous benefits and employment protection have struggled to achieve the same degree of labour flexibility – though investment in labour skills is a vital ingredient for economies like the UK which need to remain competitive in high value-added manufacturing and to stay ahead in innovative service industries.

The second key supply-side factor is the availability of capital and the way in which capital markets operate. Here, it is quite likely that the financial crisis – and the preceding credit boom – are having a dampening impact on growth which will persist for a number of years. In the credit boom, capital was freely available; but it flowed into many activities where it was not very productively employed. The investments of banks in the US sub-prime mortgage market and other speculative investments have yielded disappointing returns or have had to be written off. More recently, this problem has been aggravated by the difficulties faced by many small and medium-sized companies in accessing bank finance, which has hampered their growth potential.

The third key factor underpinning economic growth is the entrepreneurial and innovative capacity of businesses in the economy and our ability to develop dynamic new enterprises. This helps to underpin productivity growth as these businesses are more likely to use labour and capital efficiently and productively. Also, countries which provide an attractive climate for inward investment from major global enterprises should benefit from their ability to attract highly competitive international businesses with a high value-added potential.

This contribution to growth is also at risk in the current environment. Developing new business ideas and opportunities involves taking risks; and the current climate of risk and uncertainty is likely to act as a dampener on entrepreneurial and innovative activity.

At present, the economic debate “Where will economic growth come from?” is focussed on the contribution of demand: consumer spending, capital investment, public expenditure and overseas sales. But measures which pump up one or more of these categories of demand will not necessarily create a stronger sustainable growth trend. As we have seen over the past year in a number of economies, when growth is not underpinned by strong supply-side fundamentals, it is quickly eroded by inflation or a renewed bout of financial volatility.

A policy for sustaining growth over a number of years, therefore, needs to focus on the supply-side drivers. First, we need to ensure that that labour markets are functioning well and supporting the development of the skills needed to underpin the growth of high value-added businesses. Second, we should be prepared to take specific initiatives to help ease borrowing constraints for small and medium-sized enterprises with high growth potential, while recognising the dampening impact that the recovery from the financial crisis will inevitably have on capital markets. Third, we need a climate which is highly supportive of innovation and enterprise in business, and which makes the UK attractive as a business location for inward investment from overseas.

There is great potential for government policies to support the process of wealth creation in the UK economy and elsewhere by focussing on these fundamental drivers of growth. In the UK, the Autumn Statement provides an opportunity for the coalition government to start to lay out a new agenda for growth, based on these business fundamentals.

It may not be as superficially alluring as the Bank of England pumping more and more money into the economy to support spending. But policy measures aimed at improving supply-side fundamentals should be much more successful in terms of sustaining growth over the longer term. They should leave our economy much less exposed to the risk that sustained growth is undermined by inflation, or a renewed bout of financial volatility.

We will be issuing a bulletin later in the week detailing the Chancellor’s statement, it’s implications for the UK economy and any practical steps investors should take.

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