(Written by our Chair Linda Yueh based on her new book)
The uneven gains from globalisation have contributed to a backlash against the existing global trading system. Can it be reformed to serve the many and not just a few? Is it possible to rebuild faith in globalisation? In a time of crisis and vast change, it’s helpful to turn to history – to return to the founders of economics and draw on their wisdom for what we should do. The Greats are the economists like Adam Smith and David Ricardo. The Great Economists worked on general models while later ones tended to focus more narrowly. They crafted the models that help explain how an economy works and when it doesn’t work. For instance, Adam Smith’s ‘invisible hand’ showed us how demand and supply works to create markets back in the 18th century. In the early 19th century, David Ricardo explained why countries trade and what determines what they trade. Their ideas transformed the world, underpinning the Industrial Revolution that improved all of our lives. Allow me illustrate by asking what the Great Economists would say about why globalisation doesn’t work for everyone. We need to start with the premise of free trade. It is based on utilitarian principles. Utility is maximised for a society when the greatest happiness for the greatest number is achieved, so distributional consequences, i.e., who in particular in an economy benefitted mattered less. This sort of abstract thinking led the father of international trade, David Ricardo to be viewed as a theorist – which was not intended as a compliment in his day. There’s even a term “Ricardian Vice” – to capture David Ricardo’s tendency to make ‘heroic assumptions’ about the world in a simplified manner that just did not reflect reality. The modern day version is the classic joke about economists. An economist would ask: “It works in practice, but does it work in theory?” Today, some of the losers from globalisation are manufacturing workers. But, in Ricardo’s day, the losers were the landowners who lost the protection of the Corn Laws in 1846 that shielded British agriculture from competition after trade was opened up and such protectionist measures were repealed. Ricardo had the least charitable view of wealthy landowners, describing their ‘situation is never so prosperous, as when food is scarce and dear; whereas, all other persons are greatly benefited from procuring food cheaply.’ He went on to say: ‘I shall greatly regret that considerations for any particular class, are allowed to check the progress of the wealth and population of the country.’ Thus, there have always been winners and losers from international trade. Ricardo, and the classical economists, focused on the gains to the whole society which accrued as the economy grew more prosperous with trade. But, these uneven gains from globalisation have led to discontentment that needs to be addressed. So, it fell to the great economist Paul Samuelson, who wrote in the middle of the 20th century and was the first American winner of the top prize in economics – the Nobel Prize, to further the work of David Ricardo. He examined the impact of globalisation on the income dynamics within countries that traded. His theory of factor price equalisation explains why wages in richer countries converge towards those of poorer ones in the sectors in which they trade. That is indeed what the evidence shows. US manufacturing wages have stagnated while those in China have risen towards American levels. Median real wages, which account for inflation, have stagnated for four decades in the US and two decades in countries such as Japan and Germany. In Britain and other advanced economies, low-end manufacturing has shrunk as a share of national output. In these rich economies, mid-skilled, manufacturing workers have “lost out” while skilled workers have done better. But, globalisation is only one factor and not the most important one. Technology, specifically automation/robotics, is a much more important reason for stagnant wages. Robots and artificial intelligence play a much larger role in reducing demand for workers than trade. And technology is spreading beyond the factory floor to other parts of the economy. So, while wages are rising in places like China and thus placing less pressure on the West, automation’s influence is growing. Technology is transforming our workplaces, ranging from AI answering call centre phones to restaurants that are increasingly automated. The last McDonald’s I went to on the A303 had an entirely automated ordering and payment system. It is likely only a matter of time before robots grab your burger from the dispenser and place it on the counter. What this means is that helping the losers from globalisation involves much more than reforming trade policy. If the world of work is changing, then people’s skills and education (their human capital) need to be geared at being flexible and prepared for an economy that will be disrupted by technology in unimaginable ways. The current policies that aim to “redistribute” incomes to help losers haven’t been enough, so new policies that “pre-distribute” and invest in people are likely needed. Right now, redistribution policies such as unemployment benefits support those who have lost their jobs. Pre-distribution could mean state-supported investment in roads or rail that could create new jobs in construction that is also mid-skilled and similar to the ones lost in manufacturing. And the infrastructure in a number of economies could use some investment that would also likely support economic growth. In other words, instead of redistributing monies after the fact to help those who have lost their jobs, focus on acting before there is a need to redistribute – such as by educating workers to prepare for a different economic future. It’s not easy of course. Workers have found it difficult to upgrade their skills from working with industrial machinery to learning computing. But, this digital age holds promise. I was speaking at the Bristol Festival of Economics when a couple of audience members in their 50s said they were learning to code! So, the Great Economists would likely seek to remedy the downsides of international trade through domestic policies geared at better preparing individuals for a rapidly changing future. But none would advocate turning a country inward. At the heart of addressing the backlash against globalisation is to assess how each individual fares in society. The economy is simply the sum of the output of every person so it is evident that each individual matters and policymakers have an obligation to help those who are left behind by globalisation. The challenge is to prompt policymakers to take action to do both: fashion appropriate policies to help the losers whilst also boosting trade that helps economic growth. In the words of Paul Samuelson, who was an advisor to US Presidents, “I have yet to meet a President who was over-burdened with a knowledge of economics.” Although challenging, the attempt to craft more inclusive policies to ensure that globalisation benefits more people would be supported by the Great Economists who lived through the prosperous times that greater opening to the world economy have brought. Paul Samuelson is considered the “last great general economist,” as described by The Economist magazine at the time of his death in 2009. Samuelson also worked on a range of other big economic questions, including how to fashion optimal economic policies. His argument was for policymakers to take the stance of an ethical observer. For instance, if you wanted to judge whether a policy such as building a new road was worthwhile, you might view it through an ethical lens. It’s a version of the 20th century American philosopher John Rawls’ “veil of ignorance.” If you stood behind a veil of ignorance, then you would not know if you would benefit from building that road or whether you were rich or poor, etc. So, you would judge that policy based on its merits, divorced from your personal interests. In this way, the best policies would be supported. Of course, that is easier said than done, which explains why too many good policies fail to be adopted. Ever since Britain’s rejection of protectionism during the 19thcentury, its economy has flourished. The first industrialised country continues to punch above its weight in the world due to its international orientation. But to make globalisation work for everyone, it must work for the many. That would be the insight gleaned from the Great Economists who have guided us through the Industrial Revolution to the golden age of economic growth after the Second World War to this current digital age. I have no doubt that their wisdom can help us find solutions to a better economic future – and help restore our faith in the global market system. The tit-for-tat exchange of tariffs between the United States and China gives the impression the world’s two biggest economies are headed down the road towards a trade war, which would have hugely damaging economic consequences. But this could be averted if they continue quiet backroom discussions to open up their markets, particularly China’s.
The US imposition of tariffs on a range of Chinese imports – which amounts to a tax on imported goods – is the first step in a series of measures announced by the Trump administration. So far, China has responded by announcing tariffs on US imports. The next stage would be for the US to restrict Chinese investment into America. Presumably, if this happens, then China would respond in kind. In other words, the tensions between the US and China could go beyond taxes and directly disrupt global supply chains as investment is targeted. Any disruption to supply and distribution chains, which are a key part of world trade, could have a lasting impact. In the worst-case scenario, companies may have to relocate factories or distribution centres. Investment decisions affect employment and taxes raised, and are in some ways more disruptive than tariffs, which can be reversed more easily. This escalation would be damaging for the US and Chinese economies since global companies, such as Apple, invest in both countries. This would affect not only US businesses but also American consumers. Retailers such as Walmart import goods from China, so prices would go up and living standards would be squeezed. And since US goods are sold worldwide, if they are reliant on parts from China, consumers here in the UK and in the rest of the world would also be affected. The same applies to Chinese consumers and producers, particularly since about half of Chinese exports are made by enterprises with foreign investors. The US is targeting hi-tech manufacturers to disrupt President Xi’s flagship industrial strategy, the Made in China 2025 plan, which seeks to make Chinese manufacturing globally competitive by introducing more artificial intelligence and automation. The ability of emerging economies such as China to “catch up” with rich economies depends on their being able to access and adapt the best technology in the world. This lies at the heart of the problem. The US has launched these trade measures in retaliation for China’s poor record on intellectual property rights protection, which includes requiring foreign companies to transfer their technology as a condition of investing in China. So, there is a lot at stake for both countries. But a trade war wouldn’t result in better protection of US technology or give American firms better access to Chinese markets. Nor would it help China invest in America. A perennial Chinese complaint is that its companies are blocked, particularly in the technology sector, which is crucial for its economic growth. After an initial round of tariffs on steel and aluminium was unveiled, US and Chinese officials met to discuss ways to open markets wider and create a more level playing field. Opening up China would improve the US trade position. After all, its huge trade deficit could be reduced either by cutting back on imports – or, a much better option, expanding exports. China may be reluctant to open up its relatively closed markets to foreign competition. It firmly believes its industries need protection against the dominance of multinational companies. But it has some of the biggest companies in the world, such as Alibaba, Huawei, and Tencent. And more competition may well improve China’s growth prospects by increasing productivity, especially in sectors where there are less efficient state-owned enterprises. But far from the US and China coming to the table and forging an agreement to open up trade, more rounds of trade barriers could be announced with growing economic damage and no resolution in sight. President Trump may even show his dissatisfaction with the body that oversees international trade, the World Trade Organisation, which he has described as a “disaster”, and pull America out. That would potentially overturn the whole worldwide trading system with dire consequences. So it’s critical that a US-China trade war is avoided at all costs. At the annual meeting of China’s parliament last week, it was announced that the country would maintain its growth target at about 6.5 per cent in 2018 while targeting “high-quality growth” and containing financial risks. It seems that worries about slowing growth have receded. Chinese growth is hovering between 6.5 per cent and 7 per cent, but economists see it decelerating to closer to 6 per cent in the coming years. Will China’s growth slow so much that it never becomes a wealthy nation?
The answer to the question of whether one-fifth of humanity will become prosperous will transform not only the livelihoods of people in China, but also the world economy. But is it possible for a communist country to become rich? Although China has veered far from its Marxist roots, there are communal principles derived from Karl Marx, such as elements of communal property and state ownership, that still permeate the economy. China would be the first mixed economy to become affluent. China is unusual in that strong growth has taken place while it remains a communist state governed by the Communist Party. It is therefore unsurprising that the rule of law and other market-supporting institutions, such as private property protection, are weak, as there is no independent judiciary. This gives rise to the “China paradox”, because the country has grown well despite not having a well-developed set of institutions. China’s economic growth is, therefore, in many respects both impressive and puzzling. Indeed, one of the most complex areas of Chinese growth is the role of legal institutions. The predominant view is that market-supporting institutions, such as those which protect property rights and provide contracting security, are important for growth. China as an outlier requires a closer examination. Specifically, the reliance on relational contracting – transacting with those you trust – can help reduce reliance on the judicial system which is being gradually improved as more Chinese firms clamour for better protection of their inventions, for instance. The role of informal institutions such as social capital, also cannot be overlooked. Entrepreneurs in China have relied on social networks, known as guanxi, to overcome the lack of well-developed legal and financial systems. The cultural proclivity towards interpersonal relationships meant that social capital played a key part in the development of self-employment and the impressive emergence of the private sector. That China would allow entrepreneurs to emerge within a communist system is, perhaps, not something Marx would have anticipated. After reaching “middle-income status” in the early 2000s, China found that it needed to rebalance its economy to grow in a more sustainable manner. Its ability to overcome the “middle-income country trap”, whereby countries start to slow after reaching upper-middle-income levels and never become rich, depends on it. Poor countries tend to grow through exports and cheap manufacturing. Growth in a middle-income country is driven more by consumption by its own middle class, leading to a diversified economy that is not heavily reliant on exports to consumers in other countries. China has also shifted towards services so that the “factory of the world” now has a bigger services sector than manufacturing. The country is still upgrading manufacturing, expanding overseas investment and opening up its financial sector more. It is also promoting the internationalisation or global use of its currency, the renminbi. To achieve these aims will require examining the institutional framework of the economy, including the role of state-owned enterprises and the legal system. The retention of large state-owned firms and the problematic lack of a level playing field for both foreign and domestic private firms vis-à-vis state-controlled companies raises doubts as to the efficiency of China’s markets and thus its ability to grow. There’s also the issue of financial stability. All major economies experience a crisis eventually. We know from past experience that an economic crisis, depending on the causes, could trigger a long-lasting downturn. Marx would view this as inevitable in a capitalist economy. In China, a financial crisis linked to too much debt or some other issue in its banking system would not be surprising. Estimates of total Chinese debt by the Bank for International Settlements and others place it around 260 per cent of gross domestic product, similar to Europe and the US. But a key difference is the large amount of corporate debt in China, which is more worrying than government debt if there is a risk of large-scale bankruptcies that could bring down the banking system. And part of that debt is owed to the shadow banking system, where lending is done outside the formal banks. Shadow banking debt isn’t measured accurately, so the overall level of Chinese debt is a concern. The growth of shadow banking is linked to the Chinese government not introducing sufficient competition into the state-owned banking system. A rapidly growing economy, powered increasingly by private entrepreneurs, requires credit. As private firms sought funds that the formal banking system, which predominantly lent to state-owned firms, was reluctant to provide, unlicensed lending grew. Progress in reforming the state-owned banks that dominate China’s financial system is slow, owing to the powerful vested interests that benefit from running state-owned banks. Here, the communal property system hampers the growth of the marketised economy, and yet reform is difficult in a communist regime. So, can China grow rich? It will require addressing some key challenges related to its communist political system and the partial retention of state ownership. China’s transformation into a largely market-based economy, still ruled politically by a communist party, would not have been foreseen by Marx, for whom communism and capitalism could not coexist. Marx might have been intrigued by the continuation of the communist political system governing an economy that shares challenges such as inequality with the most capitalistic of economies, the US. If China overcomes its challenges and becomes rich under capitalism, then perhaps Marxists might have to reconsider the role that his principles played in guiding communist China – because in Marx’s theory, after capitalism takes hold, there is always scope for a worker rebellion and revolution in the future. President Donald Trump certainly thinks it does. Since his campaign, he has tweeted frequently about his unhappiness with America’s trade deficit. Trump’s latest response is to impose tariffs on imported steel of 25% and 10% on aluminium. He once observed the problem was that there were a lot of Mercedes-Benz in New York and not many Chevrolets in European cities. But is that due to unfair trade barriers which can be addressed through imposing tariffs or to what consumers in America and Europe demand?
Economists since the days of Adam Smith and David Ricardo have pointed to the latter. Of course there are trade barriers and aspects of the international trading system that are not a level playing field. But, on balance, a country’s trade position is a reflection of its economic strengths and weaknesses. Trump’s planned 10% tariffs on all aluminium imports has led the very industry that it is supposed to help to ask the President to think again. The Aluminium Association that represents 114 aluminium producers has warned the tariff will likely do more harm than good. A tax will raise the cost of traded aluminium that will hurt their industry and their supply chain partners in Europe and elsewhere. Their suggestion is to focus on China as the source of over-capacity. More broadly, that can be said for a lot of trade barriers. If there are trade barriers that distort markets, then adding new tariffs or other barriers is likely to increase the distortions that can harm the industry that it intends to protect. Instead, something more targeted could potentially work better if the grievance can be established as falling within the rules of the World Trade Organisation, e.g., national security or anti-dumping. But, the more important factors that determine a country’s trade position are not tariffs; what a country produces leads to its trade position. This was understood in David Ricardo’s day when Britain repealed the Corn Laws in the mid-19th century which raised the cost of imported grain and was favoured as a protectionist measure by landowners. Ricardo is known as the father of international trade and his model pointed out that a country’s comparative advantage determined what it produced and thus traded. If a country was producing goods that were highly demanded by consumers everywhere, then it would sell that good abroad. So, to improve the trade balance, a country should focus on how to increase productivity and production of highly demanded goods and services. Because of specialisation, a country would produce less of other products and import those while focusing on what it was good at. Looking at America today, its long-standing trade deficit is due to a number of factors. Given that the U.S. economy is largely based on services, the lack of liberalisation of the global market for services in contrast to manufacturing has hindered its exports. America is still the largest exporter of services in the world and tends to run a surplus in this sector. For instance, the U.S. trade deficit rose to 2.9% of GDP due to an increase in its goods deficit and a decrease in its surplus in services exports. To remedy this would entail promoting the opening up of the services sector in markets around the world, which was a part of the abandoned US-EU free trade agreement (TTIP). Once investment flows are taken into account in the broadest measure of the external deficit, America still runs a current account deficit, but it is because foreign companies and investors invest in the U.S. Since the dollar is the global reserve currency, there is a lot of demand for US investments, debt and assets. So, there are “imports” of investment funds, due to the attractiveness of the U.S. economy. America’s deficit with the rest of the world thus reflects a range of economic considerations that explains why it has a long-standing current account deficit, of which tariffs are but a small part. Therefore, trade deficits only matter if they reflect an underlying weakness of an economy. For the U.S., that’s not likely to be the case. Borrowing to invest and counting it separately from day-to-day government spending was an idea proposed by John Maynard Keynes after the last systemic banking crash. He proposed that governments should separate out investment or capital spending from the current spending on welfare, etc. by the government. This way investment that can generate future economic returns to growth can be separated out and the greater transparency offered by counting it separately can help assuage fears of investors. The concerns over the budget deficit since the banking crash have centred on this concern about investor perceptions about the UK as an attractive country to lend to, which determines borrowing costs.
In the Spring Statement, the Chancellor of the Exchequer has done just this. Philip Hammond said that the UK will run a current budget surplus in 2018-19, so it will be borrowing only to invest. The Office for Budget Responsibility (OBR) estimates the budget deficit in that year will be 1.8% of GDP, then falling to 1.6%, 1.3%, 1.1%, and to 0.9% in 2022-23. Public debt is now expected to peak in 85.6% in this tax year and fall thereafter, even figuring in borrowing to invest in capital spending. Keynes was supportive of governments borrowing to invest since he believed the economy usually operated below its potential and public investment should therefore supplement private investment. He believed that since state investment would boost economic growth, it would not mean that government debt would increase as share of GDP. Fast forward to now, that is also the conclusion of the OECD who estimated that raising investment by 0.5% of GDP would increase the size of the economy by at least that amount. Keynes was the first to point out that there is no ‘crowding out’ of private investment when the economy is operating below its potential. ‘Crowding out’ refers to how governments borrowing to invest would make it harder for private firms to do so because their demand for loans would push up the interest rate and make it more expensive for others to borrow. However, since the British economy lost over 6 per cent of its output during the 2008 recession, and interest rates for loans are low, ‘crowding out’ would be unlikely, because the economy has lost so much output that there is a lot of scope for the public and private sectors to invest before their demand for funds pushed up borrowing costs. Moreover, increasing public investment can help economic growth, as it can have a ‘crowding in’ effect. In other words, government investment can make private investment more efficient, for example a good telecoms infrastructure increases the returns to a pound invested by a private company by giving them the fibre network to deliver faster services. The Spring Statement shows that the UK is not aiming to eliminate the overall budget deficit and is instead focused on borrowing to increase spending in roads and housing as well as digital infrastructure. As bond investors’ concerns have shifted from deficits more towards slow economic growth, Britain’s growing emphasis on improving growth through investment, even if it means borrowing, is unlikely to shake markets. And indeed today’s announcement hasn’t. There is a historic shift occurring in terms of where the new middle class consumers will be located in the coming decade. The emerging middle-income countries, notably in China and also elsewhere in Asia, will also have an opportunity to re-shape the energy mix that underpins these increasingly prosperous economies.
For the first time in 150 years, more of the global middle class will be in Asia rather than the West in the coming years. By 2030, there are projected to be 4.9 billion people in the middle class out of an estimated 8.6 billion in the world. Of this, three billion will be in Asia. This is largely due to China leading the East Asian region in lifting billions of people out of extreme poverty – those living on less than $1.90 per day adjusted for purchasing power parity or what a dollar buys in their country. The World Bank estimates that East Asia is on the brink of eradicating abject poverty. As poverty falls, the middle class grows in the fastest growing region of the world. As more people become middle class, they expect a better quality of economic growth. This is seen prominently in China. In 2014, President Xi Jinping pledged that greenhouse gas emissions would peak in 2030 and committed China to the Paris climate change accord. As China accounts for half of the world’s use of coal, this was an important step towards combating global climate change as well as signalling an even bigger push for China to reorient its energy mix towards renewables. China plans to rely on renewables for one-fifth of its energy use by 2030, up from around one-tenth at present. Relying on less polluting and more sustainable sources for energy caters better to the needs of its people who desire a better quality environment to match their middle-income lifestyle. Consumer preference matters a great deal since the pollution split between consumption and production is 80 per cent to 20 per cent for developed economies versus 20 per cent to 80 per cent in developing countries. So, as China and Asia grow richer, the energy choices of their consumers will increasingly matter. And China has invested in a range of renewables. It has surpassed the United States, Europe, and other major economies in terms of investment over the past few years. This push began before the 2014 pledge by president Xi. China’s focus on green energy in particular was fuelled by its interest in technological upgrading - a key component of its economic plan to become a prosperous nation. Investing in technologies such as solar panels furthers China’s ambitions to have high-tech industries, which are part of the foundation of a stronger economy. As such, China has become the world’s largest user and producer of renewable energy technologies. It is also leading in smart-grid technologies, which can foster a new model for energy consumption. As part of the Belt and Road Initiative China is investing in high-speed rail and other infrastructure, both at home and overseas, as well as planning to create high-tech, AI-focussed manufacturing by 2025. With such focus on investment and production, fossil fuels are still an important part of China’s energy mix. Its Belt and Road Initiative sees China investing up to $800 billion in some 65 countries over the next five years with another $100-200 billion in its Silk Road Fund that could be deployed to support this outward investment push. Part of its rationale for such massive overseas investments in rail, ports and roads, including in the Middle East, is to increase energy security. Although criticised by the European Union in terms of the environmental impact of its investments, China’s shift in terms of its energy focus will increasingly come into play. For instance, with its focus on technology and growing emphasis on green energy, China’s investments will influence those countries in which it is present. China is aiming to invest in green jobs and environmental improvements along its New Silk Road and back solar and other renewable projects. For countries such as the UAE, China’s shift in focus would offer opportunities to work with its second largest trading partner on a wider range of projects. The UAE and other OPEC nations supply around half of China’s imported oil needs, so the region is important as China will still rely on traditional sources of energy for some time to come. This partnership has and can evolve to benefit both countries and regions. Specifically, with China and the UAE’s focus on sustainability around a range of issues related to energy, water and the transition to a more sustainable energy mix, this is a crucial moment. Not just for these nations but also for the rest of the world. As Beijing’s influence in the global economy grows and Washington seemingly pulls back under its “America First” policy, tensions similar to that between China and Australia may be expected.
Even before President Donald Trump’s presidency, China was making strides as a world power. The “Belt and Road Initiative”, in which Beijing plans to invest US$1 trillion in the next five years in a New Silk Road that will involve the building of infrastructure across some 65 countries, revealed its ambition to become a bigger force in the global economy. Its growing influence comes as the Trump administration is losing its focus on the multilateral trading and economic order. Unlike the previous Obama administration, which promoted an “Asian pivot”, the United States today is questioning its role in international organisations such as the World Trade Organisation, creating a gap in global economic leadership. China’s influence has already caused political upheaval in Australia, where it has invested a great deal and has been accused of meddling through political donations. But this is not the only place where its long-standing policy of non-interference has been chipped away because of its necessary engagement with policymakers in countries where it wishes to invest. Building railways and investing in the energy sector involve negotiating licences and agreements, which naturally means that China will want to impose its own terms for such investment while the recipient country wishes to maximise its own benefits. For instance, in Kenya, where China is building a major railroad extension, China’s agreement is to hire 70 per cent locals, the rest, Chinese. The Chinese point to a dearth of skilled workers as one reason for this. China is training Kenyans to develop some of those skills as a result. But, other African countries point to China’s greater bargaining power as the main reason they cannot negotiate deals as favourable as those China had with foreign investors during a comparable stage of economic development. Yet, China is providing much needed investment, so even if the formal aspects may not be as favourable, its infrastructure and development projects are expected to aid growth. In that respect, China’s clout is likely to mean favourable terms of investment along the New Silk Road. This also points to a gap in global governance since there are no international rules of investment, unlike the rules for trade of merchandise under the WTO. Those trade rules were largely led by the US. Could China be forging a new de facto global investment system through the belt and road plan? If a China-EU investment treaty is agreed, that would be another building block in such a system. China’s growing influence is also seen elsewhere, such as its establishment of newly created international organisations that offer a counterweight against the Bretton Woods institutions. For instance, the Asian Infrastructure Investment Bank (AIIB) is Chinese-led, unlike the Western-led World Bank and the International Monetary Fund. Thus, China is already leading the setting of rules for development and investment in the projects that the AIIB funds, which has input from nations such as Britain and France. Setting rules doesn’t just refer to the formal aspects. Institutions are also informal. So, when China leads, it will increasingly shape norms and customs. This is where the “soft power” aspect comes in. America’s influence extends beyond setting the “rules of the game”. American culture, such as rock n’ roll and films, can be found around the world. China has already begun to promote its culture, as Chinese film studios have pumped money into Hollywood films, which have begun to feature China in action sequences. The bigger question of China’s global influence regards its approach to the multilateral system. Will it be like the United States, which has at times led in a unilateral fashion? Or, will China be inclined to lead in a bilateral manner, perhaps in partnership with the European Union? Or, could China become a leader in liberalising the multilateral framework? For instance, could China take a leading role in further opening up global markets in the area of services as well as investment? As the saying goes, power abhors a vacuum. And China is increasingly stepping into the gap in the world economic order. That global system is likely to look rather different than the world today. The most startling part of the UK Budget and the economic forecasts it is premised on is the significant downgrade to growth and people’s incomes. Britons will be no better off in 2022 than they were in 2008; in fact, they’ll be worse off since real (after taking into account inflation) average pay will be £800 lower. The Office for Budget Responsibility (OBR) forecasts that real cumulative per capita GDP growth will be the slowest in the UK among G7 countries. It means that even by 2022, a decade and a half after the banking crash, people will still, on average, be worse off than they were before the crisis. That’s the stark consequence of slow economic growth due to a slump in productivity.
The OBR had been expecting productivity to pick up, but decided to forecast along the lines of what the Bank of England has done, which is to downgrade the potential growth rate of the economy due to slow productivity growth. Output per worker has been flat since the crash and the OBR had expected it to return to the previous growth rate of 2% per annum. As it hasn’t picked up nearly a decade later, the OBR has now downgraded the GDP growth rate of the British economy to around 1.5% (dipping as low at 1.3% for a couple of years before picking up to 1.6%) for the next five years. The UK used to grow at between 2-2.5%. To work out what that means for the size of the economy and national income, a rule of thumb is to divide the number 70 by the growth rate. So, at 2%, the UK economy would double in 35 years. But at closer to 1% would mean that our average income would double in 70 years. That’s why the growth downgrade is so troubling for standards of living. This worrying downgrade of what the economy is capable of growing at is why the Chancellor decided to “loosen” fiscal policy to try and raise productivity to change this “new normal” growth rate. Of the additional spending of £25 billion announced in the Budget, £10 billion is earmarked for quick expenditure to try and improve these forecasts. Even though it is a global issue in that productivity growth has slowed across major economies, Britain’s challenge is worsened by a dramatic cut in investment since the crash and having had low rates of investment before. The Chancellor is aiming to raise public investment as a share of GDP to a sustained 2.4%. That’s still lower than most of the G7 who have averaged 3.5% of GDP for two decades. Private investment has also been the lowest in the G7 since 1997, according to the OECD. Therefore, the fiscal stimulus in this Budget is divided between productivity-enhancing investment, including in housing and electric vehicles, and other spending needed to address urgent issues such as the NHS and preparing for Brexit. Focussing on the productivity-related measures, the government is increasing the size of the National Productivity Investment Fund to £31 billion and has extended its life to 2022. About two-thirds is geared at housing and transport infrastructure which leaves about a third on digital infrastructure and R&D. For instance, in 2017-18, the Fund will allocate £25 million to digital communication and £425 million R&D funding out of a total spend of £1.5 billion. There are also other measures such as increasing the R&D tax credit by 1 percentage point to 12% and £406 million allocated to improve STEM education to help produce skilled workers/researchers. Of course, better hard (transport) and digital or soft infrastructure would also raise productivity. But, focussing on the crucial component of R&D, these measures go toward realising the government’s aim to raise the UK’s investment in research & development to 2.4% of GDP in a decade in 2027. That is an improvement, but it would still be lower than other major economies. Still, the technology-focus in the Budget is a welcome shift. The challenge will be whether these measures are sufficient to turn around a decade-low productivity slump. It takes time for investment to generate returns and for R&D to produce technological innovations that raise the productivity of the economy. It would also be hard to differentiate between whether a lack of productivity improvement is due to the length of time it takes to innovate or upgrade capital or due instead to insufficient investment by the government and private sector. In other words, although the Budget is mildly stimulative, the spending measures are modest because the Chancellor still aims to hit the government’s fiscal target of bringing the structural (non-cyclical) deficit down to 2% of GDP by 2020-21. He is able to do so in this Budget partly because of what the OBR calls “fiscal illusions.” In other words, by selling shares in the largely state-owned bank RBS and re-classifying housing associations as private, the balance sheet looks a bit better. But, the OBR warns it’s illusory and can mask risks in the underlying health of the economy. Even with these “fiscal illusions,” the OBR judges the government has missed one of its fiscal targets which is to bring the budget into balance by the mid-2020s. Instead, it looks like the Budget won’t be in balance until 2030, which would mean three decades since the UK’s budget had last been balanced. Given that the deficit target was hit due to the above measures and the fiscal objective of a balanced budget was missed, it’s arguable that the government’s fiscal rules are not as reassuring as intended. In which case, perhaps the government might consider a more straightforward change to its fiscal rules to allow for greater investment to try and turn around the productivity trend. By separating capital from current spending, so investment is not considered similarly to the day-to-day running of government, there would be greater scope to invest. By accounting for these categories separately, it would be transparent to financial markets to consider whether the government is acting prudently since the fiscal rules are intended to reassure investors and creditors of Britain. That may be something to consider if productivity doesn’t pick up and slow growth worsens the budget deficit. After all, even after considering these new government policies, the OBR has forecasted that by 2022, the end of this Parliament, the productivity trend won’t have significantly improved and thus average incomes for Brits will not have surpassed 2008 levels. By doing more, there might be a greater chance of changing the current path of the British economy. Not by a huge amount, but the 2017 Budget shifts course to promote economic growth. As declared by the British PM and the Chancellor, this was a “balanced” budget to meet the government’s fiscal target of reducing the structural deficit to 2% of GDP by 2021 while at the same time spending a bit more on productivity-enhancing measures such as supporting technological innovation as well as helping the national health service (NHS), preparing for Brexit ,and increasing house-building. In other words, it was a departure from previous years when the Chancellor would announce “fiscally neutral” Budgets that meant that any additional spending would be funded by a tax rise/spending cut elsewhere so that the UK could reduce its fiscal deficit that was 10% of GDP in 2009-10 to the Maastricht Treaty level of 3%. The European Commission today declared the UK met that target as the deficit was 2.3% this fiscal year, so it comes off of the Excessive Deficits list (two EU nations remain on it).
Irrespective of the EU-wide target, the government has been aiming to hit its own structural (underlying) budget deficit target that is not due to the business cycle. On current projections, it looks like it will do so as the structural deficit will fall to 1.3% in 2021. But the government has decided against hitting it sooner because it has chosen to spend the minimal fiscal room it has on boosting economic growth. In other words, the government had been expected to run a £10 billion surplus in 2019-20 but that will now be a deficit of £35 billion instead. In 2022-23, there will still be a deficit of some £26 billion. Running a budget surplus has been abandoned and the reason was apparent from the start of the Chancellor’s speech. It’s due to a worrying growth picture. The UK’s economic growth forecasts were severely downgraded due to slow productivity growth. Instead of growing at 2% per year as it was before the crisis, productivity growth has been flat. This has led the Office for Budget Responsibility to cut GDP growth to around 1.5% for the next 5 years of this Parliament. Growth is expected to be 1.5% this year and then slow to 1.3% in 2019 and 2020 before picking up a bit to 1.6% in 2022. This is in line with the recent assessment of the Bank of England that the potential rate of growth for Britain is now just 1.5% instead of around 2%. So, the Chancellor has chosen to try and raise economic growth by spending what fiscal space is available to address the productivity challenge that has led to slow growth. Increasing support for R&D and investment in a range of technological sectors, including electrical vehicles, was part of the refrain heard during the Chancellor’s speech that stressed a post-Brexit, tech-oriented future. As faster economic growth usually means more tax revenues, this slight fiscal loosening to raise growth may help the government’s fiscal position in the coming years. This somewhat looser fiscal position is more necessary because the Bank of England has begun to tighten monetary policy by raising interest rates and higher rates make borrowing and investment more costly. Given the scale of Britain’s productivity challenge, if the measures announced today do not raise economic growth as expected or the government faces a worsening fiscal deficit because slower growth becomes a bigger drag on tax revenues, then there may be those who wonder whether more should have been done. Many economists expect the Bank of England to raise interest rates for the first time in a decade on Thursday. With low unemployment and stable economic growth - and after being nearly zero for nearly 10 years, rates are due to rise. But, there are a number of reasons why the Bank may wait for a few more months at least.
First, although inflation is considerably above the Bank’s 2% target and expected to rise further to above 3%, that isn’t enough on its own. It’s because the Bank discounts inflation caused by weak Sterling. The Pound had fallen considerably after the EU referendum last June. When the Pound is weak, imports are more expensive so that raises the price level of the economy. Since the currency fluctuates – and Sterling has already regained some of its value, the Bank doesn’t act on its movements. They tend to “look through” such inflation. Instead, the Bank focuses on wages. If firms pay more in wages, then their higher costs lead them to raise prices. Prices are essentially wages and costs plus a margin. At present, real wage growth – wages after taking into account inflation – is hardly budging. So, weak wage growth may lead the Bank to hold off raising rates. One wrinkle is that unit labour costs are over 2% amidst weak productivity growth, so that suggests that there are underlying cost pressures which could lead firms to raise prices. That suggests a rate rise is more likely, which is why Governor Mark Carney and others have pointed to a rate hike cycle as looming on the horizon. Another factor has to do with consumer debt. The Bank has issued a number of warnings about the £200 billion consumers owe on their credit cards and other forms of debt. That figure has grown by nearly 10% over the past year. They warn that as much as £30 billion may never be repaid. If interest rates were to rise, that could lead to more defaults. Of course, waiting a few more months wouldn’t lead to a significant difference in the consumer debt load. But, giving plenty of warning about the impact of higher repayment costs may forestall further accumulation of debt and allow those who are indebted to plan accordingly. Then there’s Brexit. The Bank has been worried for some time about the uncertainty around what will happen after the UK leaves the European Union. They have asked commercial banks to come up with contingency plans to ensure that the financial system won’t be disrupted should there be no deal with the EU in place in March 2019. But, it takes a year for banks to implement contingency plans, so the Chairman of RBS has said that absent a transition deal by March of next year, banks will have to start moving jobs out of London. Given the size of the City and the number of jobs linked to the financial sector, there will likely be an economic impact. That could lead the Bank to wait for a few more months until next spring before raising rates. It’s also because central banks prefer to not have to reverse themselves – once they raise rates, they want markets to expect and plan for more rate rises and not wonder if rates will be cut again. Some central bankers disagree with this approach. They argue that should rates need to be cut again because the economy needs help, then it’s not problematic to reverse the direction of the rate cycle. But, the Bank of England has tended to move consistently in one direction. So, we may be surprised on Thursday when the Bank of England doesn’t move on rates. They may wait a little while longer. Governor Carney has been hinting that a rate rise is imminent - but that’s why markets have dubbed him an unreliable boyfriend. |