The British Economy

Inflation. Inflation in Britain has been uncannily stable. This was true before 1997 when the Labour government made the Bank of England independent, and it has been very much true afterwards. During that period we’ve also had a very tight fiscal policy. Perhaps what was most notable before 1997 was the sharp drop in the pound’s value when Britain was forced to leave the Exchange Rate Mechanism of the European Monetary System. Many people, including me, thought that we would again have a spike in inflation. That was the dog that didn’t bark. It did not happen. Now we have stable inflation. The Bank of England’s target rate is 2.5 percent, and if the Governor of the Bank of England misses that rate—either too high or too low—he has to write an open letter to the Chancellor of the Exchequer apologizing for this. We all expected him at some stage to have to write a letter apologizing for having too high inflation. He is quite soon going to have to write a letter apologizing for having too low inflation.

Unemployment. Low unemployment is, of course, the indicator that brings the most joy to any politician. British unemployment has halved in the last nine years. At the same time, employment as a percentage of the working age population has risen to 75 percent, back up to the level of the 1970s. We’ve gotten rid of the resistant long-term unemployment problem that we still had during the 1990s. The unemployment rate, based on the International Labor Office measures, is roughly half the unemployment rate in our European neighbors.

GDP Growth. In the 1990s, Britain out-performed the current members of the European single currency. This performance led, I think, to a regrettable superiority complex in Britain. It was very often said that the British economy was now overtaking and out-performing our European partners. What happened in the end of the 1990s and still now, is that euro-area growth has overtaken growth in this country. But we have been tracking each other quite closely for the last two years. What’s notable for our North American friends is that those growth rates, even now, are about a percentage point below the growth rate that the United States itself has been seeing over the last few years.

Manufacturing and Productivity Growth. We’ve had a tale of two economies in Britain. We have had an economy in which services output and activity has been growing very fast over the last four years, whereas manufacturing output has been fairly flat. It has had its ups and downs over those years, but it has been fairly flat. This has an important effect on regional distribution within Britain because manufacturing on average takes place in northern Britain and services is more a southern phenomenon. That’s a caricature, but nevertheless it’s true. This has meant that the prosperity of the southern part of the United Kingdom has moved forward much more rapidly than in the north.

Manufacturing has done relatively less well, but I think there is a different significance that one should also draw from our performance in manufacturing, which is related to the level of the pound sterling. As we know, the pound sterling has been very strong in recent years, after having collapsed when Britain left the ERM in the early 1990s. In the late 1990s it climbed very high on a trade-weighted basis. From the beginning of 1997 it climbed to its peak—almost 15 percent. (It has since fallen; it is approaching again its level of 1990.) During that period manufacturing was put under a great deal of pressure. The manufacturing industry in particular complained about the high level of the pound, most vociferously about the value of the pound against the euro, which for manufacturers is the area of our major trading partners. The significant point is that manufacturing was actually fairly steady during this period. In the 1980s, certainly in the 1970s, if we had that sort of pressure from a strong pound sterling, manufacturing would have suffered much more. Manufacturing did feel a lot of pain and pressure from the high level of the pound, but more significant is how well it has resisted the high level of the pound. In recent months, manufacturing exports have in fact been one of the stronger parts of the economy.

Why has manufacturing resisted? Because Britain’s productivity performance has improved somewhat. A key question for Britain and for Europe was why the “new economy” productivity growth that we were seeing in the United States had not crossed the Atlantic. One popular and easy explanation for Europe was its inflexible labor markets. But Britain has a flexible labor market. We have seen some rise in productivity in Britain at the end of the 1990s, perhaps because of the implementation of more information technology. But this is still not new economy levels. Productivity growth helps explain why manufacturing has done reasonably well under a strong pound, but this is also the major area where there is a lot of room for improvement. Our productivity growth has not been strong. There are two possible and popular explanations. One is that the skill level of British workers, because of the legacy of the past, has remained poor. The other is what the traditional economists claim, which is that the figures themselves are wrong; the problems are in the statistics. The answer is probably a bit of both.

Will Britain Join the Euro?
Bob Worcester has told you that Britain will join the euro after 2005. Let’s look at the formal tests set up by Gordon Brown for whether Britain joins the euro (see Box). Tony Blair’s official position is that the Government will assess Britain’s performance against these tests during the first two years after this general election. So we can expect a report of some sort from the government on how we are doing against these tests. But the bottom four of these tests—that membership in the euro must not harm financial services in the city of London; that it must help investment (formally, the test says investment, but most people think it means foreign investment); that it must not cost jobs in Britain; and that Britain must be sufficiently flexible to be able to deal with economic shocks in the euro area—are not susceptible to statistical measurement. They are essentially discretionary. They are basically questions of judgment rather than knowledge.

The first test—whether there can be sustainable convergence between Britain and the economies of a single currency—is susceptible at least to some measurement. What are the facts? The first fact is that in goods trade we are heavily integrated with the European Union. More than 55 percent of our trade in goods is with the other fourteen members of the European Union. But this is not so true of services. In the British debate you hear different figures being quoted. The difference is between those who calculate trade in “goods,” and those who try to allocate trade in services by country and look at services together with trade in goods. Adding services trade means that integration with Europe is closer to 50 percent than 60 percent. Still very high.

What does convergence mean? Well, to some degree it means cyclical convergence. As I noted earlier, we have had convergence with Europe for two years in the expansionary cycle. The other form of convergence is interest rate convergence, which makes a difference, of course, for inflationary control. It also makes a difference to the flexibility question because so much of British housing loans are based on floating rates. This means that they are quite violently susceptible to rises or falls in interest rates. There has been close convergence between the Bank of England’s rate and the European Central Bank’s rate. But the big question is, What is meant by “sustainable”? How do you measure that? This is a question of judgment.

My view is that the government’s judgment is going to be essentially political. These economic tests mean almost nothing and play almost no role. They are just a way of postponing the issue. I do think that Labour will win the next election with a majority of more than 100. Indeed, I would even go a bit higher than Bob Worcester’s 120. My bet is that they will call a referendum at the end of the first two years of the Labour government and I think they’ll have an even chance of winning it.