Economic Outlook - ideas taken from a presentation by James Sproule of the IoD

Overview

The Institute of Directors represents senior executives of businesses of all sizes in all sectors throughout the UK. James Sproule was recently appointed Chief Economist and Director of Policy at the Institute. The week he came to Leeds to share his thoughts on the economy with Institute members. Here is what I learnt.

In the UK the tax take is about 35% of GDP. It is a feature of developed economies that proportion remains very stable over time. The figure is lower in the US and much higher in Denmark (48%), but varies by little more than one percentage point up or down over time.

Financial Crisis

The financial crisis was not just down to the banks, although they lent more than they should. Consumers borrowed too much, businesses borrowed too much and governments borrowed too much and let the money supply got out of control. An inflation-led crash can be resolved relatively quickly. A debt-based crash, like the one we have just had, takes longer because the money has to be paid back. UK consumers are already well on the way to paying down debt to 2008 levels. Business has benefited from a weaker pound and has chosen to take greater margins rather than seek greater market share through price cutting. Greater margins have allowed business to pay down debt.

The Budget

The Institute’s members represent a significant proportion of the UK’s GDP and it is able to represent their views at the highest level of government. In advance of the budget, members indicated that they wanted business rate reform, a higher income tax threshold, a higher starting point for the 40p tax rate, pension reform and a review of airline passenger duty. Several of these suggestions were reflected in the budget and pension reforms went much further than expected.

HS2

The Institute has made it clear that it does not consider that HS2 will be a solution to the North/South divide - a view endorsed by “Failure to Transform: High-Speed Rail and the Regeneration Myth,” a report issued this week by the Institute of Economic Affairs. Apparently this view was not popular in Whitehall and the IoD was called to account but protested that as independent organisation it had every right to reflect its members’ views. The government is running regional roadshows to promote its case.

Threats to the Economy

The euro zone continues to have problems. In southern Europe the banks are unable to lend to prime the pump for recovery. This is partly because their safe asset ratio has been raised from 2% to 12%. More importantly, many depositors in the south have transferred their savings to banks in the north. The logic is that if any of the southern countries drop out of the euro then the new local currency is likely to devalue by as much as 30% or even 50%. Savings tucked away in euro in the north are safe, but not available to fund investment in the south.

Inflation is a likely future threat to the UK economy. Although there has been a rise in the money supply, inflation remains low because the velocity of circulation remains low. Governments always promise to keep inflation under control, but historically governments have always used inflation to reduce government debt, so who’s to say this government won’t be tempted?

Wealth Distribution

The Gini coefficient is a measure of wealth distribution where 1 means that all the wealth of a nation is in the hands of one person and 0 means that it is equally shared. Currently Saudi Arabia is rated at 0.6 and Russia at 0.2. In 1979 the UK was rated at 0.24, in 1980 at 3.4 and is currently at 0.4, slightly above the rest of Europe. In 1979 the average salary was £4,000 and the majority of earnings levels were clustered in a very small range. The reasons for this were lack of incentive with an 83% top tax rate, an industrial structure with very large employers and trades-union-led national pay bargaining. By 2013 average earnings were £25,000 and the range was very much wider. There was merit-based pay, no national pay bargaining and a more diffuse economy with small businesses and start-ups. It would be impossible to narrow earnings differentials by moving back to the 1979 situation.

One percent of the UK population are super-rich. This group is not affected by the same drivers that influence the rest of the economy; their position is the result of globalisation and opportunities where winner takes all. It would be possible to drive out the super-rich through taxation, but it is not clear whether that would be desirable. Taxation would put their wealth into the public purse and boost GDP in the short term. At the same time it would remove these funds from investments in the long term. Is the government the best spender of money? Should the US tax Bill Gates to the extent that he can no longer afford to fund the eradication of malaria in Africa?

Challenges for the Next Government

There is still work to be done on the deficit. Cuts will continue and their full effect has yet to be felt. Only a government with a substantial majority will be able to keep its nerve on this. Growth is good at the moment, trending at 2.5%. However, we are approaching a demographic inflection where the working population is shrinking. Unless we can improve productivity this could pull growth below 1%, which will feel like recession to many people.

Questions from the floor

What would be the effect if the living wage became the minimum wage? Wage rises have outpaced productivity. If wages rise even further it will make businesses less competitive. The benefit system overcomes this to an extent, but there is no doubt that the tax credit and benefits systems need reform.

Can we look forward to a stable GBP/USD exchange rate? Nobody can predict exchange rates. Continuing uncertainty in the euro zone may reduce the value of the euro against the dollar. The influence of the euro zone might cause the pound to weaken.

If HS2 is not the answer, what, if anything will correct the north/south divide? Logically, as overheads and wage rates rise it makes sense for organisations to move their back offices out into regional centres. The pressures are there, but for the moment they seem to be resisted. Within 20 years it is likely that more wealth will flow from the south-east to other parts of the country, but there will never be equality. In an aside, there is every possibility of a housing crash if interest rates rise. Traditionally borrowers mortgaged for three times annual income but in this time of unusually low interest rates they are borrowing four times or more. If interest rates go back to more normal levels many borrowers will be over-stretched, and not just in the south-east.