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Wednesday, June 11, 2003

UK: Right Decision Wrong Time?

Morgan Stanley's Joachim Fels with some interesting reflections on the UK economy:

it is impossible to disagree with the Chancellor's assessment that the UK economy has been better off staying outside the euro for the past five years. With the benefit of hindsight, euro entry in 1999 would have implied markedly lower interest rates given that euro area interest rates have been below UK rates at all times. This would have fuelled an even bigger housing price boom, stronger consumer spending, and higher inflation, with the latter being reinforced by the fact that the currency would have been weaker, which would have stimulated exports and pushed up import prices. In short, within EMU, the UK economy would probably have overheated in the last several years and might have seen what the Treasury calls another cycle of stop-go economics, or a boom-bust cycle, as we prefer to call it...........arguably, the last five years were an exceptional period for the UK economy, which is unlikely to last much longer. In retrospect, the strength in consumer spending owed much to the new stability-oriented monetary and fiscal policy regime introduced in 1997. Giving the Bank of England operational independence created a credible commitment for low inflation, which quickly anchored inflation expectations at around 2.5% and led to sharp decline in interest rates. This in turn helped fuel house prices, which created the well-known mortgage-equity-withdrawal bonanza for private households, very much akin to the mortgage refinancing cycle in the US. The consumer spending was reinforced by sterling's appreciation against the euro, which made imports cheaper and helped the Bank in securing low inflation with relatively low interest rates.

Alas, the days of the consumer boom with low inflation are numbered, in our view, and the UK economy is facing a tough challenge. House price increases, after the fireworks of last year, have slowed and are likely to peter out soon. Thus, a major support for consumer spending is fading. Sterling has weakened, which has helped push inflation higher to 3%, curtailing the growth rate of real disposable income. Taxes and National Insurance Contributions have been raised to finance the government's push to raise public investment. Taken together, the consumer should no longer be the driver for the UK economy -- the recent GDP data for Q1 already showed a significant slowdown in household spending.

So far, so good. But his next point leaves me really bemused. If UK interest rates are where they are now, then this is because of all the concern about a housing boom-bust cycle. When this 'bubble' bursts, UK rates will fall, most probably faster that ECB rates, possibly arriving close to zero (Mervyn King is an astute follower of the US 'deflation' debate, and the 'lessons' of the Ahern paper will not go unlearnt in Threadneedle Street). Prolonging the 'boom', even were this possible would be extremely unwise (I am with Joaquim's boss Stephen all the way here), and the UK will now have to face up to some pretty harsh post-bubble realities. On the currency lock-in argument, this is just the point, what the Uk does not want to do is lock-in its currency, at this or any other rate. If the shock following the fall-back in house prices is severe, then (as all adepts of the 'foolproof path' well know), letting the currency value decline is one way of easing the deflationary pressure, but this is only an option the UK will have outside the euro. On FDI, I think we need to look a bit closer at the dynamics of the knowledge based economy, and at the advantages in having English as a first language, but this will have to await another post.

By joining the euro now, the UK could have killed two or even three birds with one stone. First, with the level of euro area interest rates now fully 175 basis points lower than UK rates, the house price boom could have been prolonged and consumer spending would have been supported further. Second, by locking in a competitive exchange rate at around current levels, the UK could have secured a major expansion of trade with the euro area. One of the Treasury's many thorough background studies published yesterday concludes that the potential increase in UK trade with the euro area resulting from UK membership of EMU is between 5 and 50 percent in the long run, which under certain assumptions could raise the level of UK per-capita GDP by up to 9.25% in the long run. While such estimates have to be taken with a large grain of salt, there is no denying the fact that joining a currency area has a significantly positive impact on trade with other members of the area.

Third, but not least, by joining the euro now, the UK could have ensured higher foreign direct investment in the UK from both inside and outside the euro area. This could have helped to both minimize the crowding out of domestic investment by public investment and raise the tax base to pay for higher government spending. The costs of staying out of the euro in the form of reduced inward investment have already been felt by the UK in the last several years, when it has attracted a smaller share of inward investment in the European union than before the start of EMU.
Source: Morgan Stanley Global Economic Forum

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