Next Generation First – UK Budget 2016

Another complicated budget from Chancellor Osborne.  Lots of tinkering with the tax and spending systems in Conservative ways that may distract from the gloomier economic numbers and the further austerity to come.  That is not a criticism just an observation.

Let’s start with the macroeconomics.  A slowing global economy, fragile financial markets and low productivity growth everywhere sees the Office of Budget Responsibility cutting its growth and inflation forecasts and, crucially, its assessment of future productivity potential.  With employment still set to be the main engine of growth, UK real GDP is said to rise only 2% in 2016, down from 2.4% as forecast as recently as early December.  The OBR could still be optimistic for this year, especially if BREXIT uncertainty increases and cuts investment and consumption even more than currently expected.  Despairingly, only 2.1% growth is now seen as the underlying trend for this Parliament even if EU membership is retained.  Inflation only returns to target (2% per annum) in 2018:  a sorry tale, which monetary policy, with the threat of negative interest rates, is not helping.  (Alarmingly, the FPC has been told to be particularly vigilant over the state of the banking system from now on.)

The economic forecasts mess up the government finances, keeping borrowing up in the near term and worsening debt ratios over the forecast period (debt/GDP 82.6% in 2016/17 and only down to 74.7% in 2020/21).  The fiscal surplus target is delayed until 2019/20 – just in time for the next election when the Chancellor might be tilting for another job?  Against this background, government spending is set to fall from 40% to 36.9% of the economy by 2020, as the government departments seek to find another £3.5bn a year by 2019/20.

The state is seeking to get more funds by finding £12bn from further measures to cut tax avoidance and evasion.  Promise of a further cut in corporation tax to 17% and reductions to business rate thresholds, commercial stamp duties, and oil and gas taxes is offset by attacking loopholes, mainly exploited by large corporations.  The Chancellor is selling a theme of large companies pay more and small companies pay less.

Other goodies are offered in the great devolution dance, for the national administrations and the English regions.  From halving Severn tolls in 2018 to a combined authority for East Anglia, the Treasury offers a plethora of devolution measures that may yet turn out to be more mirage than substance, especially if you have not got an elected Mayor.  The aim of 100% of local authority resources being raised and spent locally by 2020 is a transformation that could turn out to be highly stimulative and yet highly divisive.  Yet another experiment in local development that may or may not be real before it becomes politically unacceptable.  It is interesting that the Treasury is cutting business rates just when they are going to devolve them to local authorities!

This Budget claims growth is driven by infrastructure, education and enterprise.

  • On infrastructure, the government will commission various road and rail schemes in the north (M62 widening/HS3 rail Man-Leeds/Man-Sheff tunnel), London (cross-rail 2 but nothing on a 3rd runway) and the South West (rail resilience).  Meanwhile the insurance premium tax goes up another 0.5% specifically to pay for flood defences.
  • On education, all schools are to be, at least, on the way to Academy status, independent of local authorities, by 2020.  There are plans to boost performance in northern schools and to devise a new funding formula for all schools.  On childhood obesity, the government is introducing a levy system on soft drinks in 2018 in order to promote more sport and other activities ‘out of’ normal school hours.
  • On enterprise, class 2 national insurance contributions will be abolished in 2018, (helping the 3mn or so self-employed), most indirect taxes remain frozen, and capital gains taxes are cut from next month (base 18% to 10% and higher 28% to 20%).

Finally, with regard to personal taxes and savings, everyone’s finances are helped.  For example, the personal income tax allowance will rise from £11,000 to £11,500 in April 2017 and the higher rate threshold will reach £45,000.  The Chancellor also announced measures to help the under 40s to save, recognising the bewildering position that exists at present with pensions and other investment opportunities in a world of zero interest rates.  The existing personal ISA limit increases from just over £15,000 to £20,000 in April 2017.  A new “Lifetime ISA” will be created for the under 40s and until you are 50.  As long as it is to be used for long-term savings (pensions or housing), savers can put £4,000 into this ISA and the government will add £1,000 per annum.  Te help to buy ISAs (only just started) can be rolled into this new Lifetime ISA.

The budget is being headlined as one that puts the “next generation first”.  Many parts of the Budget come later rather than sooner, however.  There is a lot of detail to be worked out and many consultations to conduct before those details are finalised.  Moreover, there are negative aspects in the detail yet to be analysed.  Overall, the real worry is still in the macroeconomy.  If realised, the wider risks could blow all these complicated fiscal measures and intentions out of the water.




In 2016/17, there will be a UK referendum on whether or not to stay in the EU.  Most of the arguments, particularly currently espoused about what PM Cameron might secure in terms of EU reform, are political.  What about the economics?

  1. In or out, it won’t come cheap.  Some EU-sceptics talk about repatriating funds from the EU worth £50mn a day.  Dream on – that’s gross and the costs of extracting UK from all the current arrangements will cost money.  If there is no Common Agriculture Policy or development funds for Cornwall, do you think the UK government will do nothing to soften the blow for those affected at home?  Just think how much money the lawyers are going to make from re-writing contracts and how many civil servant/ bureaucrats we’ll need to make the change…  It could easily take five years to extract the UK from current contracts and processes and replace them with new ones.
  2. Meanwhile, there will be an investment strike.  If you are a foreign-owned multinational based in the UK, faced with great uncertainty as to the vote and its eventual result, at the very least, you’ll 1) wait and see or 2) you may re-direct investment to facilities still likely to be in the EU or low-cost centres elsewhere and, at worst, 3) you’ll close UK operations and supply the UK market from continental Europe – with potentially disastrous consequences for UK exports  and productivity.
  3. UK borrowing costs and sterling volatility will rise and fiscal. management may be disrupted, at least in the near term.  This will also encourage overseas rather than domestic activity – investment, employment and trade.  Again, uncertainty and borders restrict exchange and wealth creation.
  4. Migration flows will shift – unpredictably.  The UK recovery has benefited from net migration over the last few years – this could reverse, again with a short term negative economic shock and, perhaps, wider politico-social (e.g. NHS) effects.
  5. In the long run, however, it is quite feasible for a good relationship to emerge between an outside UK and an ‘ever closer’ EU, as it does for Norway, Switzerland, et al.  In a decade or so, no economist, let alone politician, can tell you whether we’ll be better or worse off in or out of the EU especially if, as a result, Scotland becomes an unreliable, one-party, independent state.  All we can say is there will be winners and losers and it won’t be easy to spot who will be which, bar the usual suspects.

    The economic issue for me is the short term – by which I mean 3- 5 years after an ‘out’ vote.  BREXIT will cost the UK a lot of economic activity and potential that it might otherwise haveBREXIT still might be the right political and social choice for our island race.

    I only hope the forthcoming debate makes the real costs and benefits of the two options clear to us all in great detail before we get to the actual vote.

2015 revisited – 2016 considered

The latest numbers show UK real GDP growth slowing from 2.9% in 2014 to 2.2% in 2015.  The year ended with a 0.5% quarter-on-quarter rate of increase in the last three months of the year: services continued to thrive but manufacturing and construction were soft.  At the same time, there was no inflation (CPI average) last year whilst unemployment dropped towards 5%.

In simple terms, the UK economy is being driven by employment growth and, with little or no productivity growth and adverse external factors – (China, oil and stock markets, Middle East and immigration, Brexit etc), current economic momentum is not sustainable.  Further slowing of growth is expected in 2016.  We are not yet talking about a return to recession but, with our real growth forecast now expected to be 1.6%, it looks like being a sluggish year ahead.

New Year Blues – Waves of Uncertainty

In early 2016, the world economy appears to be floundering. The imbalances of financial, trade and other flows that were exposed by the “Great Recession” have never been properly resolved. Waves of new uncertainties are taking their toll, breeding fear into business and investor confidence at a time when stabilisation policy options are stretched and seemingly ineffective.

The first uncertainty concerns the Chinese Economy.  China is still growing faster than many others and there is no particular reason why the slowing of Chinese real GDP growth to what are still relatively fast rates (over 5% per annum) should affect the mood right now as opposed to in any other period – past or future.  A correction, however, is underway, as a) the Chinese currency falls, b) Chinese political risk rises – pushing its claims over various offshore islands, c) accusations are made about Chinese product dumping in US and EU markets, and d) financiers worry about China’s ability (and will) to continue propping up subsidised industries and banks carrying bad debts.

The second uncertainty reflects events across the Middle East and North Africa to do with Syrian and other civil and religious wars and terrorism, population disruption and exodus, and relations between Iran and Saudi Arabia.  Russia and the West are also at loggerheads and relations between the EU and its near neighbours are strained to east and south.  Some of these issues look irredeemable at the moment. The failure to constrain the effects of the conflict to a small geographical area could be serious.

The third (and partly related) uncertainty is the oil and other commodity markets. The drop in prices undermines fiscal stability, growth and earnings in a number of countries, led by Russia, Brazil and even Australia.  Oil prices have fallen below US$30 a barrel. It is not unusual for oil prices to have periods of high volatility and wide swings as the demand and supply balance adjusts. Although there are significant lags in the process of adjustment, what goes down will come up. Already, there is talk of the supply chain drowning in oil. This will lead to stoppages, closures and mothballing at the wellhead. Supply will fall again and, since world demand continues to grow, oil prices will get back to US$100 a barrel – not now, but eventually.   Meanwhile, low oil prices are good for most of the business economy, at least in the short term. Why are investors panicking about something that should be boosting non-oil profits now? Methinks, it is another case of too much contagion for the markets’ own good.

The fourth uncertainty is about equities themselves. Was the run up in share prices over the previous three years or more a ‘sugar high’ related to the enormous liquidity pumped into the system through various bouts of Quantitative Easing and related monetary largesse by the West’s central banks? Is there real value in the corporate world or is it all built on sand? Today, the markets seem to believe the latter. But, they may be wrong. First, a lot of the excess liquidity was never made active. Second, technological progress and innovation is gathering rather than losing pace. Despite some demographic ageing, the medium to long-term prospects for growth and development do not seem diminished. Yes, we need to get western productivity rates up to support living standards but that calls for more investment and net inward migration, not less. There is a positive story to tell about the underlying economy that should outweigh the short-term ‘bears’, eventually.

The fifth uncertainty surrounds politics in America and Europe. The possibility of a Clinton-Trump contest for the US presidency in next November’s election is alarming many. One is reminded of Churchill’s famous statement along the lines of “America will always do the right thing … after it has flirted with all the other options”.   There may be scope, therefore, for a political bounce in economic prospects, as we approach the election and a rational outcome seems more likely. Meanwhile, there is the matter of UK-EU negotiations for ‘real’ reform and the UK’s in-out referendum. The current betting is on some sort of ‘offer’ kicking off the full referendum debate in late February and being resolved by a vote in the summer. The polls are close and the reform proposed is unlikely to satisfy the sceptics. The question is whether the majority of middle-ground Brits will “do the right thing” in the end? No one knows. But, I worry about the investment delaying and diverting effects of the debate and the vote itself. In the short term, why would companies invest in UK industries until a resolution of ‘BREXIT’ emerges? In the long term, why would you expand UK operations if access to the single EU market is no longer guaranteed on competitive terms? To a regional development economist, borders and boundaries are always a constraint on economic potential and performance.

So, there are five reasons to be unsure about the external environment for UK economic prospects. How do domestic factors play into this mix?

First, 2015 was a year of slowdown. Real GDP growth was barely on trend (c 2.3%) and was weaker at the end of the year than at the start. There was no inflation overall, although this hid wide swings between segments, such as houses (+7.7% year to November) and energy (-7.3% year to December). Meanwhile, unemployment fell to 5.1% overall (September-November). The employment-led recovery is intact but, inherently, it is unable to spark a strong upturn without support from higher productivity, which remains in the doldrums – at a level only just above its previous peak. The demand chain is propped up by the effects of modest real earnings growth on private consumption but, unless and until it is supported by other demand factors (business investment and net trade), this is not going to last – especially if, as expected by the forecasters, the labour market is now leveling off.

Second, the economy is not rebalancing. The trade deficit remains huge and volatile, and the current account is being worsened by a collapse in returns from UK FDI abroad. At about 5% of GDP, the current account deficit remains unsustainable for the long term. Also, manufacturing continues to struggle against global headwinds, as typified by the headline loss of capacity in the steel industry. Manufacturing output is still some 6% below its previous peak (Q1 2008). Since the recession, there seems to have been a permanent loss of productive capacity and a worrying erosion of viable supply chains.

Third, the policy environment is tortured. The public deficit is responding very slowly to fiscal austerity. As yet, ‘crowding in’ of private activity as the public sector retreats is a myth. The monetary environment remains incredibly loose, with low interest rates continuing to dampen investment’ (saver and investor) spirits and, thereby, prospects for underpinning sustained growth. Lost in an austere liquidity trap, the stabilisation policy mix is not supporting growth.

Against this background, the forecast consensus is for a weaker economy in 2016. The January collection of independent forecasts issued by HM Treasury sees growth averaging 2.2% this year after 2.3% last. This represents a downward adjustment by the forecasters from late last year, but still seems modest. Given what’s happening in the financial markets, it would be astonishing if these forecasts were not revised below 2% for 2016 over the next few months. My own current estimate is 1.75% for growth in UK real GDP this year. Importantly, as highlighted above, the downside risks are significant and potentially bigger than the upside.

Other current consensus forecasts include:

  • Inflation is expected to rebound a bit: +1.3% for this year after zero in 2015, largely because of previous ‘bigger’ falls dropping out of the index.
  • Unemployment is predicted to average 5.1% – a rate it has already reached, suggesting no further progress in 2016.
  • The current account deficit is expected to improve barely at all – from £81.5bn in 2015 to £77.6bn in 2016. This is also a “no change” view.

The UK economy is losing momentum and, in several ways, 2016 already looks like a ‘lost year’. Given the waves of uncertainty crashing on the economic beach at the moment, the fear is that the outlook deteriorates from something fairly benign into something worse.

There are some more hopeful signs. It is entrepreneurs, workforce skills, innovation and competitiveness that drives the growth process, not the financiers and panicky markets. There is no evidence that these factors are diminished. Indeed, they are what have been keeping the recovery going despite the headwinds of poor policy and politics. Some of the new technologies will be disruptive for jobs – aspects of artificial intelligence and new consumer interfaces (clouds, hand-held information and communication outlets and driver-less cars). Nevertheless, let us pray that the value-creating songs of the inventors and the risk-takers are not drowned out by the New Year Blues now so prominent in our ears

Regional GVA in 2014

In December, the ONS releases the gross value added (GVA – income based) and GVA per head data for the UK regions, devolved administrations and lower geographies. This provides our basic comparative measure of local economic performance.  It is a corner stone of most UK applied economic analysis below the national level. The table below summarises the new, local data for 2014.

Southern England 2014

2014 GVA


GVA per head (£) GVA per head (UK = 100)
Bournemouth & Poole 7941 23254 94.5
Rest of Dorset 8248 19719 80.1
Somerset 10641 19648 79.8
Plymouth 5195 19864 80.7
Torbay 2066 15354 63.1
Rest of Devon 15418 20146 81.8
Swindon 6551 30357 123.3
Rest of Wiltshire 9841 20369 82.7
Southampton 5782 23572 95.8
South Hampshire 11048 24568 99.8
Central Hampshire 14164 26479 107.6
Portsmouth 5381 25735 104.5
Isle of Wight 3071 22074 89.7

Source ONS

The new data confirms many of the descriptive characteristics that we already know about local southern economies. The relative performance of the regional economy seldom changes significantly over time.

  • Last year, was one of relatively good GVA growth, with averages for the UK as a whole of 3.6%), for SW England of 3.1% and for SE England of 2.8%.  Given negligible inflation, these are virtually real rates of growth.
  • Within southern England, north and east tends to perform ‘better’ than south and west. Also, urban areas tend to perform better than more rural areas.  This is normal, reflecting the workplace basis of the data, sector spatial characteristics and a typical concentration of high value economic activity in the more urban parts of any area.
  • Relative to the UK as a whole, southern GVA per head tends to be below average, but this reflects the effect of the ‘black hole’ that is Greater London on that average rater than any underlying weakness or fragility.

As well as providing new data, the ONS revises its numbers for previous years. This can change history quite markedly, although this time the revisions have, generally, been reasonably modest. Summarising the latest long-term series for GVA per head indices,

  • Relative performance has been fairly flat over the last two decades. The comparative scores have tended to sag a fraction.  The SE index tends towards 110 (10% above) versus the UK average whereas the SW index tends to 80 (20% below).
  • Generally, the historical series are remarkably consistent. It seems to be difficult to shift these fundamental measures of relative local economic performance over time, despite cyclical ‘booms and busts’ and profound structural changes to industry, technology and demographics.

A third aspect of the new local information is the sector breakdown by major industries.  The sector data for 2014 confirms that:

  • In aggregate terms, SW manufacturing and construction were only 11.9% and 6.8% of GVA respectively.
  • Amongst services, 17.9% of total SW GVA were distribution, 34.2% were financial and business, and 20.6% were mainly in the public sector.

GVA is our base indicator of economic performance. The latest figures show southern areas holding their own (within the regional economic league tables) and maintaining their industrial structure.  2014 was a good economic year.  There has been some loss of momentum in 2015.  Nonetheless, it would be a surprise if the relative score has moved much in aggregate terms and in terms of industrial structure over the last twelve months

The development community may wish and is tasked to shift its relative economic score over time. This means a relative improvement in measures such as GVA per head. This may be a worthy aspiration but it needs to be tempered by a healthy dose of realism. Without radical change in the economic fundamentals (including major investment in infrastructure, innovation and skills, competitiveness, and the wider capital base), the best that might be achieved is running to stand still.

Radical change means an emphasis on private sector productivity, engagement with markets and technologies, and a focus on the quality of our environmental and human capital.  In the years ahead, that would be a sound, strategic vision for growth of, and development in, the southern economies.


Autumn Statement – fortune favours the brave

In headline terms, the Chancellor’s Autumn Statement/Comprehensive Spending Review surprised many commentators, from its withdrawal from cutting tax credits to its lower than expected percentage cuts in many departmental expenditure settlements.  Nevertheless, overall, it remained an austerity budget based on higher taxation and lower public spending.  It is a settlement that, if fully enacted, will, itself, tend to detract from economic growth over the next five years.  Some of the measures, however, will re-direct activity to the private sector and, in theory, might ‘crowd in’ more private activity.

These ideas should be evident in the macroeconomic forecasts published by the Office of Budget Responsibility at the same time as the statement.  In fact, the forecasts offered are remarkably flat.  If the OBR is right, we are in for a period of rather boring overall macro trends with subdued growth in output and investment, in inflation, and in employment and productivity, leading to a gradual improvement in the public finances (see table).

OBR Forecasts November 2016 2015 2016 2017 2018 2019 2020
Real GDP (%ch pa) 2.4 2.4 2.5 2.4 2.3 2.3
Inflation (%ch pa) 0.1 1.0 1.8 1.9 2.0 2.0
Employment (%ch pa) 1.3 1.3 0.6 0.6 0.3 0.6
Productivity (%ch pa) 1.1 1.1 1.9 1.8 2.0 1.7
Investment (%ch pa) 6.1 7.4 7.1 7.0 6.6 4.5
Unemployment rate (%) 5.5 5.2 5.2 5.3 5.4 5.4
2015-16 2016-17 2017-18 2018-19 2019-20 2020-21
Deficit borrowing/GDP (%) 3.9 2.5 1.2 0.2 -0.5 -0.6
Debt/GDP (%) 82.5 81.7 79.9 77.3 74.3 71.3
Source: OBR

The more interesting facets of the announcements are micro in nature.  The local impacts of the devolution measures on governance and business rates, conformation of local development ‘growth deal’ funding, the creation of more enterprise zones, the infrastructure and house building proposals, and the buy-to-let stamp duty, apprenticeship levy and other taxes may have a profound effect on the way local economy’s develop over the next five years.  Although the central view is that this will not affect very much the underlying potential growth rate of the economy as a whole, there is plenty of cope for unforeseen consequences and distributional effects to be significant.

In SW England, we will be particularly intrigued to see how plans for devolution, (particularly the prospect of local government rationalisation in Dorset), and the new/extended enterprise zones at Dorset Green (Wareham), Bristol and Bath/Somer Valley, and Heart of the SW (Exeter and Bridgwater) will develop.  History suggests our expectations should be cautious … but, perhaps, fortune favours the brave.


ASHE 2015

Each year in November, the ONS releases local data on earnings for employees (not including the self-employed) across the country (ASHE – Annual Survey of Hours and Earnings).  This provides important benchmark data for studying our sub-national economies.

Overall, there was a small (nominal and real) increase in pay in 2015, with the UK averages reaching £426 median and £508 mean a week, respectively 1.9% and 1.3% higher than in 2014.  (The averages in this briefing report are a summary mixture of both full-time and part-time pay.)

The table below highlights the data just released for April 2015 across the Local Enterprise Partnership (LEP) areas of SW England and compares them with the English totals.  The first six columns relate to gross average weekly pay by residence and the rest the equivalent by workplace.  The first column in each section shows the jobs in the area covered by this survey in thousands.  The second and fourth columns show median and mean gross Average Weekly Earnings (AWE) respectively.  The third and fifth columns show the figures as indices relative to the SW total = 100.

In nearly every case, SW pay is less than the English average (which is pulled up by pay rates in London and the South East) and the gap between median and mean earnings (where the latter is pulled up by the comparatively few very high earners) is often less severe than elsewhere.  Unsurprisingly, workplace averages are higher than residence averages, reflecting both commuting patterns and business sector concentrations.

Overall, the latest figures suggest that the traditional differentials across SW England remain intact, with pay higher in the North and East than in the South and West.  The highest LEP averages (West of England) are about 8% above the regional average and the lowest (Cornwall) are about 15% below.  Even the LEP total, however, can be misleading.  There are significant differences within LEP areas too.  Generally, urban areas have higher pay than rural ones, both between and within the LEP areas – though there are exceptions (e.g. Torbay in Devon).  The highest pay averages are in Bristol and Swindon and the lowest in Devon (e.g. Torridge and North Devon).

Residence Jobs AWE median index AWE mean index Workplace Jobs AWE median index AWE mean index
West of England 489 435 108.7 502 107.2 West of England 532 422 108.1 492 108.3
Gloucestershire 260 426 106.4 509 108.6 Gloucestershire 255 417 106.7 477 104.9
Swindon & Wiltshire 282 424 106.1 504 107.6 Swindon & Wiltshire 255 412 105.3 485 106.8
Dorset 306 399 99.7 469 100.1 Dorset 303 386 98.8 447 98.3
Heart of the South West 667 376 94.0 432 92.1 Heart of the South West 633 375 96.0 424 93.4
Cornwall & Isles of Scilly 186 345 86.3 399 85.2 Cornwall & Isles of Scilly 164 332 84.9 377 83.0
South West England 2,188 400 100.0 469 100.0 South West England 2,142 391 100.0 455 100.0
England 21,112 430 107.6 516 110.1 England 21,406 430 110.0 516 113.4

Growth & Interest Rates

The SW purchasing managers’ indices (PMI) for October (just released) rebounded a bit from September’s lowish levels.  The UK recovery appears to be intact but it has slowed from the pace set earlier in the year.  Indeed, the PMI series peaked in January 2014 and they have tended to drop since then.  The latest output and employment balances were 54.1 and 52.6 respectively: the former was the eighth highest and the latter tenth highest (of 12), showing that the recovery is softer locally than in most UK regions and devolved administrations.  The slowdown is most evident in the weakness of new orders and business outstanding.

According to the Bank of England’s latest Inflation Report (November 2015), the softening of growth reflects international factors, especially slower growth in China, emerging markets and the EU.  These dampening effects come directly through physical trade but, more importantly, indirectly through financial exposures and markets: commodities, bonds and equity prices have all fallen in recent months.  Comparatively, the domestic economy is more robust, lead by some emergence of real incomes growth (+3%) and, at last, some positive change in productivity in Q2 2015 – although, so far, most of the recovery has been driven by an increase in hours.

Inflation remains about zero, largely reflecting the decrease in world import prices.  Core UK inflation is said to be more like 1% with wage increases starting to build price expectations.  The Bank says that interest rates will rise over time but, right now, it is signalling a further delay in the needed upward adjustment in base rates.  A return to ‘normal’ base interest rates of 4-5% is considered unlikely for many years.  An increase to a range of 2-3% would be welcome for normal economic working/incentives but is also probably more than two years away.

Inflation will start to rise as last year’s major drop in oil and other global prices fall out of the annual calculation.  This should mean an end to nearly 7 years of 0.5% base rates is imminent.  Central Bankers remain cautious, however, and there is a risk that policy increases come later and then have to be larger than might otherwise be necessary.  A slow rise to 1-1.5% over the next 12-18 months seems advisable but the resistance to action remains strong.  The danger is that tool little too late means more volatile adjustments … even renewed recession … in due course.

The recovery is less strong than it was.  The winter will probably see only modest growth.  SW businesses face a more difficult economy in 2016.


SER October 2015

At the top of the list to the right, you will see a link to our latest Strategic Economics Report covering business economic conditions in 2015 to date and the prospects for the rest of the year and 2016.

Although forecasters see the recovery continuing, recent evidence suggests a weakening of official statistics and survey balances across many aspects of sector and geographical economic detail.

Our main finding is that the recovery is slowing and the imbalances in the economy remain unresolved.  With policy stuck in fiscal austerity and monetary accommodation mode, if the recovery is to be sustained, growth needs to be driven more by productivity and international trade rather than just employment and the domestic consumer.

The Living Wage

The government surprised many UK economy watchers with its announcement in the July Budget that it would implement a “living wage” policy.  From April 2016, Chancellor George Osborne said there will be a new, compulsory living wage that will be paid to workers aged 25 and above.

Initially, it will be set at £7.20 an hour, with a target of it reaching more than £9 an hour by 2020.  Part-time and full-time workers will get it. Workers under 25 will still get the minimum wage, currently to be increased to £6.70 an hour from next month (October 2015).  The Low Pay Commission will review and recommend what the living wage will be for April each year thereafter.

The Living Wage will give a significant pay rise (7.5% in percentage terms and 50p an hour) to six million workers.  Those who keep their jobs and hours will see a welcome rise in incomes and spending power.

But, the Office of Budget Responsibility estimates that it will forfeit 60,000 jobs and reduce hours worked by four million a week.  A lot of business comment has concluded that the Living Wage policy is a “gamble” that will cut employment opportunities for low-paid people because it will undermine profitability for many vulnerable SME businesses.

What is the economics here?  Well, in simple terms, yes, an increase in labour costs tends to reduce employment, increase prices and reduce overall economic activity.  It is not, however, quite that simple.  It depends where you are starting from and heading to.

First, timing is everything.  If wage rates are increased when the economy is strong, (i.e. good growth in orders, outputs and incomes generally), then the change can be absorbed by many firms with relatively little disruption to investment and product or service plans and activity levels.

Second, sector is everything.  Lots of firms and business groups are complaining and worried about the Living Wage’s effects on profit margins in a non-inflationary environment when cost increases can not be passed on to customers along the supply chain.  It is true that it is harder to absorb in some industries than others.  Of relevance here, is the impact on, low-paid jobs and services in, among others, the leisure industry (catering and tourism etc) and on health and social care.

Perhaps, however, a shift in value shares from profits to wages is warranted right now.  Since the Great Recession of 2008+, wages have gone up very slowly if at all for many workers.  It could be argued that some rebalancing of income shares from profits to wages is overdue and merely starts to restore a fairer and more economically positive situation. Since living wage recipients will tend to spend rather than save, it might even stimulate more consumption and, thereby, help economic growth. In the end, then, business may well get back the Living Wage pay increase through higher sales!

Third, scale is everything.  Economies adjust to new realities in time. In the short term, there may be an adverse shock but, eventually, the effects of the new Living wage will depend on how it is going to be raised thereafter – presumably in line with trends in other real earnings to attain and maintain the desired 60% of median earnings target.

To an extent, the Living Wage will replace internal, annual wage bargaining for many companies once it is part of the annual fabric.  However, the worry is that taking the market out of the basis of labour costs creates a rigidity that will not always be appropriate.  In due course, it could mean a higher ‘natural rate of unemployment’, as observed in some of our peer countries.  Whether that is a price worth paying is as much a political as an economic question.

Fourth, productivity is everything.  The real questions are will low-wage workers respond to being paid more by working harder and better?  Will firms seek other ways to manage costs – fewer jobs in the short term but a boost to capital investment and productivity in the long term?  Given the UK’s parlous productivity record, any incentive to invest in more productive working practices from the higher costs of the Living Wage, might yield positive net benefits over time.

Generally, market economists do not like imposed as opposed to market-determined prices. Moreover, the history of state imposed wages is mixed – there are examples of rapid absorption and of unwelcome disruption.

The problem with this particular policy is it looks like it might impose a big wage increase for firms in a year when growth may already be slowing.  In 2016/17, that is, it may have a dampening effect on jobs and growth compared with what otherwise might have happened.  In time, however, I would expect the economy to adjust well, with the higher wages boosting productivity and sales.

As is so often the case, it is a bit of ‘on the one hand this’ and ‘on the other hand that’.  It will be interesting to see how the policy adapts to changing economic circumstances in the year ahead.