What UK numbers have I missed?  The ONS confirmed weak growth in Q1 largely driven by inventories.  Moreover, services output increased by just 0.1% in March and fell 2.3% year-on-year.  The trade deficits remain huge.  Inflation is falling – CPI down to 2.4% and PPI to 1.1% in April.  The financial markets have remained positively volatile.

In conclusion, a quick ‘catch up’ suggests the economy is moving forward very slowly but still has large headwinds in terms of debt and trade.  Against this background, ‘value’ is paramount to overcome the problems of subdued current demand and constrained supply productivity.  Providing ‘value’ is the source of debt reduction and trade balancing.

The alternative argument is that monetary stimulus from the central bank authorities is falsely fuelling the equity upturn.  Quantitative easing (QE) and its hybrids have pumped $-trillions into the world financial system and this money has not all gone into the real economy (through increased bank loans and higher business investment) but has gone into assets (stocks an bonds).  Hence, when the money ‘tap’ is turned off, the markets will drop again.  The current market reflects a false dawn.

But, if it was just a ‘money-rush’, we’d be seeing higher inflation and higher growth already.  Actually, whilst the monetary base has exploded, M2 monetary growth has not.  Perhaps, the banks should be applauded (what!) for not indulging the authorities’ QE nonsense of potential over-stimulation.  (QE needs to be scaled back and interest rates raised.)

The market is anticipating a lower share of government in the economy and new technologies that will boost growth in the long run.  Therefore, it is seeing an undervalued corporate population whose future returns could be quite strong.  On balance, I think the rebound in share values is real and can continue.  Of course, values can easily be blown away again by further shocks from sovereign debt debacles and policy mistakes.  Negative risks are still high.  But, if these risks are not realised, the stock market recovery should be heralding a wider moderate but sustained economic recovery for the medium term – not now in 2013 but perhaps in 2014+.  For the first time in quite a while, I find myself on the positive side of the consensus.

This does not mean I am totally optimistic.  There are some big clouds out there, coming from the euro-zone, falling real incomes and inflation expectations.  Growth is still likely to track below trend for the foreseeable future.  But, I think I am feeling some winds of change.  I’ll be right if those businesses with cash, with good products and services, and with aspiration start to plan for higher investment and hirings this summer.

The debate rests on views about some key economic relationships:  whether high sovereign debt, levels and ratios, lead to higher risks of default; higher inflation and interest rates; and low and volatile economic growth.  There is a link between debt and default but the other theoretical links are not proven by the evidence.  Historically, high debt has been associated with both high (1970s) and low (2010s) inflation and interest rates.  (Inflation is linked to money expansion and fiscal deficits, not debt as such.)  Historically, the UK sovereign debt has been higher than it is now, notably 1800s-1850s and 1920s-1960s, with a default on 1917 War Loan debt occurring in 1932.

Also, it is unclear whether high debt causes low growth or low growth causes high debt or, indeed, whether they are both caused by something else (the ‘bust’ banks).  In fact, the answer is all three are at work.  UK sovereign debt was rising before the 2007/8 crisis but it surged when the state then rescued the banks.  Thereafter, the policy to reduce debt has hindered growth and low growth has raised the debt.  The need to pay off debt can reduce growth and low growth can raise debt.

The question is which needs most current attention and when.  1)  Raising debt to offset recession can be good – if it leads to better growth and lower debt later.  2)  Using growth to build productive capacity based on debt can be good because investment in new capacity can help future living standards.  3)  Causing recession to pay down debt can be bad – indeed, self-defeating.  4) Fuelling excess growth by excess debt is really bad – bubbles always burst and houses built on sand always sink.  

For the long run, UK debt levels are too high at present but the path to getting them down to sustainable levels may actually require a movement to even higher debt levels first.  Debt to fuel productive and competitive investment in infrastructure, innovation and skills can bring a return later.  It is all uncertain, a priori and you would prefer not to start from here.  But, basically, dear Treasury, the economic theory to move sovereign debt counter-cyclically, lowering it to sustainable levels over several cycles, remains robust.

In the short run, throwing more labour at a problem can increase growth but, in the long run, high employment levels/rates are only sustainable if workers increase their productivity through skills acquisition (training and experience) and innovation (in technology, product and process).  Relative and absolute improvements in productivity are the holy grail of long-term economic performance and higher living standards.  What is valued may change but efficiency and effectiveness of delivery of that value remains the essential economic(s) question.

This week, the ONS has released its latest productivity statistics for the parts of SW England in terms of Gross Value Added (GVA) per hour in 2011.  Compared with the UK average, set as an index of 100.0, most areas of the region remained below average.  At NUTs 2 level, Gloucestershire. Wiltshire, Bristol and Bath were at 101.0, Dorset and Somerset at 88.0, Devon at 86.7, and Cornwall and the Isles of Scilly at 72.6.  The far edge of the peninsula is 28.4% less productive than the northern part of the region.  This is a big, persistent gap.

It is normal for more rural areas to perform less well than urban areas on these productivity measures, for the obvious reason that (high value) economic activity and jobs tend to be concentrated in towns and cities.  It is also normal for most SW areas to be below average because the UK average is pulled upwards by the economic domination of London and the South East.

Accordingly, it is more useful to compare urban and rural parts of SW England with similar areas and to look at their progress over time.

Looking by place, the table below shows productivity in SW England’s main areas.  It reveals that the rural South West is relatively homogeneous.  The central County Council areas of Devon, Dorset and Somerset are very similar and exhibit room for improvement compared with the “similars” in Wiltshire, Gloucestershire and Hampshire. In urban areas, Bournemouth and Poole is similar to Southampton but below Swindon and Bristol: again indicating some potential for future growth.  ”Rest of WoE” is ‘middling’ whist Plymouth is a relative laggard and Torbay grossly so.

GVA per hour 2011

Over recent times, SW urban areas have seen their relative productivity increase whereas SW rural areas have lost ground.  In other words, during the downturn (Q2 2008 to date), the productivity gaps between rural and urban areas has increased.  Bristol, Swindon and Bournemouth and Poole all had higher relative GVA per hour indexes in 2011 than before the 2008 recession.  In contrast, Gloucestershire, Dorset, Devon, Somerset and Cornwall all had lower comparative statistics.  The performance of Wiltshire, Plymouth, Torbay and Bath etc was relatively flat or mixed.  If prolonged, this implies a widening of living standards across the region over time.  It is clear to me that the ending of the RDA pipeline of programmes and projects and the slow start of the LEPs has exacerbated this macro trend.

The macro trend probably reflects the fact that the main areas of prolonged weakness in our economy have been in domestic consumption by households and the public sector.  In share terms, these elements of spending are more important to rural areas.  It also reflects the comparative weakness of business investment and net exports.  In essence, the productivity gap between town and country has widened from the mid-2000s to 2011, undoing the previous closure of the gap.

There are several implications of this.  To consider just three: first, economic activity is getting more concentrated over time; second, future growth will probably be lead by the conurbations; and third, the urban-rural split will encourage further local commuting.  Importantly, rural areas may be relatively unproductive (workplace) but that does not mean they are relatively poor (residence), although the income ranges do tend to be wider and rural deprivation can be more hidden.  Travel-to-work areas may continue to expand unless offset by stagnant real incomes, fuel inflation and greater cognisance of environmental disbenefits.

These productivity numbers are important and interesting figures.  The question is whether anything can, or should, be done about them in terms of development intervention.  At one level, such urban-rural differences in economic performance are natural and support the non-economic characteristics of SW England that we would wish to protect.   At another level, development agents, such as the Local Enterprise Partnerships, need to consider whether it is their aim to close such productivity differentials over time by supporting “the worst”, even at the cost of some overall growth, or whether they are happy to widen the productivity gap further by supporting “the best” in a search for maximum growth.

Professor Nigel Jump, 12th April 2013

There are three interrelated aspects to any UK budget. In no particular order, there are:

• The political context: the need to make policy that follows a particular political-economic philosophy, previous statements and mandates, and satisfies the Chancellor’s and the Premier’s party.  We know the rhetoric: ‘there is no alternative’.  It would be surprising if there was any significant deviation from “Plan A”.
• The macro context: the balance of effect on the economy as a whole from government spending and taxation.  In its simplest terms, the Treasury is trying to judge the balance of three effects.   First, if government spending exceeds taxation (as it does), the state provides a net positive injection to the economy in the current period …  but, if the net injection is shrinking, it negatively affects the rate of real GDP growth, year-on-year.   Second, if the scale and scope of government net injections are out of kilter with those of the private economy (as they are), it may be a negative influence on the development of the economy in the long run.  This is known as ‘crowding out’ where the government displaces more efficient and effective resource allocation by the private sector.  Third, if state spending exceeds the tax take (as it does), the Treasury has to borrow the difference.  This affects a range of financial rates and levels in the short run and the freedom to act of governments and citizens in the long term.  Broadly, today’s borrowing is tomorrow’s taxation.
• The micro context: specific measures in the budget, such as decisions on excise duties for alcohol and fuels through to decisions to spend on major transport infrastructure, affects the incentives for businesses to invest and households to spend or save.  In any budget, there are measures that help and others that hinder overall growth prospects, corporate decision making and individual living standards.  The question is whether, in net terms, the Budget supports the incentives of businesses and households to invest for their future and boost immediate activity.

Looking ahead to Wednesday, please remember that , whatever the headline debate about ‘spending within means’, ‘paying down debt’, and arguments about boosting growth and creating jobs, the government is, and will still be, a big influence on UK business conditions.  How and where it spends our money matters: not least in terms of local procurement and jobs.  The balance between capital and current spending is important, whether it is on infrastructure and other productive facilities for the long run or on current items, such as benefits, wages, immediate goods and services, that boost current activity.  The ultimate test is will we get more ‘value’ for the money we send to Westminster after this Budget?

Also, consider how any tax measures will affect your personal spending and prospects.  Changes to VAT, basic tax allowances, benefit systems can affect personal incentives dramatically.  For what it’s worth, my own view is that the parlous state of UK demand and productivity, (driving the lack of business confidence to invest and hire), means that I would favour an increase in the VAT payment threshold for small businesses to £100,000 and a reduction in the  rate to 15%.  Over time, this would probably raise UK growth rates sufficiently to pay for itself compared with staying stuck in today’s economic doldrums.  But, don’t hold your breath.

Part of me says, “Please, do nothing at all”.  Treasury fiddles with things so much without ever seeming to assess whether previous policies were, in fact, good or bad for the economy.  Another part of me says, “Please, do no harm.”  We need action to stimulate confidence and growth but keep it simple and focused on incentives that everyone can understand.  Anyway, it’s that time again – enjoy the debate, be sceptical.  We will assess what it might mean for UK prospects  shortly after the Chancellor’s statement.  See our March 2013 Strategic Economic Report (link alongside this blog) for our view of the background the Budget is trying to change.

This gives our view of the global, national and local economy now and for the year or so ahead.  Importantly, whilst many business conditions remain strained, at best, this is the first time Strategic Economics ends up with a more positive assessment than our previous SER Report.  In a year’s time, we hope to be looking back and recording that now (spring 2013) is the time that the outlook started to improve.

We do think, however, that government and others need to help to underpin any forward momentum.  As well as long term investment expenditure and incentives to create the structural competitiveness the UK needs, we think an increase in the VAT threshold to £100,000 and a cut in the rate, ideally to 15% would encourage many businesses to invest and hire in the short term.  We hope something is in the Budget to engage the Laffer curve.

In addition, we want to see the Bank of England moving away from the liquidity trap and increasing interest rates to restore a yield curve that encourages risk and return decisions. Stop worrying about zombies and support the growers.

• In 2012, UK real GDP growth was just 0.2%, made up of contributions of 0.6% from both household and government consumption, 0.0% from investment and -0.8% from net trade.
• In sector terms, agriculture contributed 0.0%, total production -0.4% (including -0.2% manufacturing), construction -0.6% and services +0.7% (including +0.4% government and +0.3% in business and financial services).

The longstanding downturn at home and abroad has made it hard to address fiscal deficits, current account deficits and other imbalances.  Moreover, despite an incredibly loose monetary policy, the UK’s ‘liquidity trap’ endures.  It is easy to be worried.

According to Reuters, Moody’s said Britain’s growth was likely to be sluggish due to a mix of weaker global economic activity and a drag “from the ongoing domestic public and private-sector de-leveraging process.  This period of sluggish growth poses challenges to the government’s fiscal consolidation program, which we now assume will extend well into the next parliament”.  Oh, really – didn’t see that coming!  Talk about closing the stable door after the horse has bolted.

I would like to make two points:

1.  What took you so long?

The credit agencies should have cut the UK’s rating (and many others) in 2006/2007.  Any credit scoring system should be based on current trends and how they might move forward, i.e. based on an objective, proactive assessment of risks.  Instead, the credit rating agencies have become backward looking, reactive bodies.  Maybe, now is the rightr time to re-assess UK prospects and downgrade but, because no action was taken as things deteriorated before the 2008 credit crunch and nothing has been done in the 4+ years of downturn since, this move is well behind the curve.  Having done this sort of risk analysis for a major international bank in the past, I would judge that the UK’s rating should already be lower than it is now and we should be anticipating that the next move, though some way off, may be upwards rather than still wondering whether it’s going to come down again.

2.  What does it mean?

The main effect will be that the UK will have to pay more for it’s borrowing and this will encourage the sterling depreciation that is already underway (at least, against the dollar).  Gilt yields should rise and their prices should fall.  Some investors won’t like that, but gilts are already very over-priced and, like the rest of us, holders need to take some pain if a viable recovery is ever to get underway.  Yields are still only just above 2% (10-year) and with inflation staying above that for the foreseeable future are effectively losing money in real terms.  A recovery to a ‘normal’ yield curve would see such rates closer to 5.5%.  It may still be years before we get back to those rates but, for a sustainable, well-functioning recovery, the current situation is untenable and, again, behind the curve.  If the Moody’s downgrade starts a process of adjustment towards a better assessment of risk and return, we can all cheer that things are starting to adjust back to a better economic balance.

Finally, at the latest MPC meeting, the soon-to-leave Governor of the Bank of England voted for more gilt purchases and the soon-to-arrive Governor has indicated a willingness for further monetary stimulus.  I wonder if they are facing the wrong way.  Some of the recent business surveys suggest a bit more confidence is evident.  Without further monetary shocks, the real economy may start to move forward over the next year or so.  The monetary authorities, the markets and the credit raters should be planning for a return of growth rather than a maintenance the doldrums.  I think some indication that the next move at the short end of the yield curve will be upwards might actually help business and investor sentiment about the future.  The horse needs to get some real growth exercise outside the monetary stable.

Money is similar but not exactly the same.  It appears to have economic mass and generate gravity: like matter, money attracts money and appears capable of destruction (through inflation) or expansion (through real growth).  It also appears to have economic energy, fuelling a range of supply and demand chains that suggest “what goes around comes around”.  Money can be sucked into a black hole (the event horizon of a debt-deflation induced liquidity trap) or it can be ejected out to grow new business stars with planets where new species (living standards) can evolve.  Creative destruction is a force of physics and economics.

Does monetary economics have the equivalent of the physics laws of thermodynamics concerning the conservation of energy and the process of entropy?  Yes, in the sense that the monetary system is always in balance – for every credit there is a debit, for every export there is an import,  - and yet it does seem to degrade over time (discounting the future).  Work and order are finite in the economy as well as the physical universe.  In both, some chemistry of creation and destruction seems all too natural

Bankers, whether central, investment or high street, have found ways to innovate with money over the years to influence the development of these laws of “flationarydynamics”.   Sometimes they goes too far – causing imbalances in stocks and flows that upset normal market functions and cause eruptions – supernovae that eliminate existing structures and trends.  Yet, in the death of one monetary star, the seeds of creation are soon.  New, more complex elements emerge to enrich the next cycle of growth.  Sometimes financial innovation, including in response to crises, can add real value, reallocating resources in a way that makes markets more efficient through new businesses, products, processes and markets.  New stars with complex elements that fuel recovery and development.

Right now the question is has the destructive phase of the 2008 financial supernova run its course or has it further to go before some new money-stars are born.  An optimist looks to new technologies, inventions and organisations, as well as the skills and creativity of the young, for our salvation.  The pessimist sees only the debt hangover, fiscal austerity, the low velocity of money and structural logjams.

The cycle turns but, in this period of “monetary physics”, we know not when.  As yet, it’s still long run opportunity and short term threat.  Just perhaps, however, we are getting nearer to the turn in confidence we need.