How to make Western Economies more Competitive

24 January 2013

How to make Western Economies
More Competitive

Professor Douglas McWilliams

Thank you very much for joining us this evening.

Tonight’s lecture is about the key economic policy issues on which we should be focussing if we are not to end up in a dangerous cycle of the kind that has engulfed some of the weaker European economies already.

It builds on the three previous lectures and starts to look at the policy prescriptions to make Western economies more successful.

And I will use the UK – with which we are all more familiar –as my main reference point although the messages have equal relevance for other European economies and also, though to a lesser extent, to the United States.

The earlier lectures
Let me first repeat some of the points that I made in my earlier lectures because some of you will not have attended them and also with a 2 month mid-winter break some of us may need just to be reminded what was said a little time ago.

My first lecture described what is currently taking place – the industrialisation of the emerging economies and the shift from the West to the East - as the world’s greatest ever economic event. The lecture attempted to prove this by comparing with various other events in economic history. The conclusion was that compared with the most important previous economic event – the industrial revolution – what we are seeing today is 9 times more widespread and is happening 3 times as fast. This explains why some of the policy challenges that it is presenting for us are unprecendented. The ‘supercompetitiveness’ of the emerging economies also generates an unusual pressure on the trading performance of the traditional economies.

The second lecture looked at the supply of primary products. The argument that I presented was that for industrialisation to become pervasive rather than the monopoly of only a few nations would place severe pressure on the availability of primary resources. With the help of technical experts I looked at the outlook for energy, minerals, food and water. The conclusion was that there would be sufficient supplies of all of these but that except possibly for energy, there would have to be higher real prices to justify the investment that would be necessary. In particular, it looked likely that there would have to be much higher prices for minerals.

The third lecture was more academic – though in retrospect I think I fell a bit between two stools in making it a bit too technical for the generalists and insufficiently so for the academics. I presented a new theory of economic growth which showed that the two major constraints on growth in Western economies were trade competitiveness and inflation. It is using this new theory as a forecasting tool which has enabled my company Cebr to top the league table for forecasting UK GDP in recent years. It their dependence on traditional theories – now out of date – which assume mean reversal (a sort of inverse law of economic gravity where what goes down must go up) which has caused bodies like the Bank of England and the Office for Budget Responsibility to get their own forecasts so badly wrong.

In the case of the Bank of England, I argued that this had not mattered, mainly because the Governor, Sir Mervyn King, had largely ignored his staff forecasts.

In the case of the Office for Budget Responsibility, however, its bad forecasting track record has had serious consequences. Because we have a coalition government, the professional advisers assume enhanced status and the OBR’s forecasting errors have weakened the Coalition Government’s focus on the need to achieve economic growth in its first two years.

The new growth theory
The point about the new growth theory is that in the modern world, with international trade pervasive, balance of payments performance is critical in determining rates of growth. For small countries which – because they are bound to produce only a small proportion of the goods and services available to consumers – this means exporting performance.

Now in theory you can just devalue as long as (and this is critical) you don’t lose the cost benefits from the devaluation through domestically generated inflation.

So this makes inflation performance as well as exports critical to achieving economic growth.

Achieving low cost inflation is beneficial not only  because it makes goods and services more attractive to potential buyers and hence boosts competitiveness and so exports (or allows higher profits which boost investment in product design and innovation, quality and marketing to achieve the same result) but also it permits a weaker exchange rate which has a similar effect without breaching the inflation target. So it has a very high powered effect.

The three critical elements of policy
Given the focus that I have put on international trade performance and inflation, it is not surprising that the critical economic policies that I will highlight today are mainly export related or inflation related.

They are:
exchange rate policy, 
competitiveness policy, and
inflation policy.
Let me deal with them in turn.

Exchange rate policy

Given its role in affecting trade competitiveness and its impact on inflation, I will deal with exchange rate policy first.
The economics are pretty simple. If you devalue by 10% and there is no knockon effect on domestic costs, you are able to sell your products roughly 10% cheaper in export markets, though less if there is an import content. Alternatively, you can decide not to give all the cost reduction in currency terms to your customers and instead share it with your profit margins. Given that a typical profit margin is about 10% of selling price, a 50-50 split will boost the profitability of your exports by 50%. That is a real incentive towards exporting and will almost certainly incentivise marketing spend at least and probably some product innovation as well.

The academic work supports the conclusion that exports are sensitive to currency values and indeed, economic policy thoughout the emerging economies has shown that they believe it as well. This is why Germany and Japan when they were recovering post-war tried to keep their currency as low as possible (indeed it is a plausible explanation of the German attachment to the euro that it preserves an undervalued currency for them) while China has made huge efforts to keep its currency as low as possible.

The downside from devaluation is inflation. The law of one price says that prices adjust until the full impact from devaluation has been eroded. Experience says that this is a theoretical construct that rarely works in real life – at least in the short or medium term - but there are occasions where a devaluation triggers a wage price inflationary spiral where it can even have a negative effect. So any government needs to be extremely careful about a policy of deliberate devaluation.

The minimum inflationary effect of devaluation is the upward impact on import prices. Primary commodities such as oil are priced in world markets at world prices and a10% devaluation raises their prices in sterling terms by 10% pretty well automatically. Other importers have some scope between taking part of the hit on their profit margins and passing it on in full. The impact will depend on the market conditions. For example, those selling cheap cars normally squeeze their profit margins when the pound falls; those selling luxury cars normally pass on the impact in full.

But in addition to the direct impact on import prices, there is also an impact on those parts of domestic prices which are internationally based. Energy is an obvious example where the prices of the base products are essentially set by international price levels.

So devaluation is by no means a cost free option.

Constructing a policy to keep sterling low is also difficult. A little devaluation is something like a little pregnancy – it has a tendency to get bigger. This is because if the currency markets think that you are trying to weaken your currency the traders will shun your currency and pretty soon you can have a full scale currency crisis on your hands. I think that the best way to have a ‘weak currency’ policy is not to aim for it directly but to be opportunistic and work mainly on hitting an inflation target through monetary policy and where appropriate through fiscal policy.

Many commentators have forecast that sterling could weaken this year[1]. I suspect they are right, though the precise timing of exchange rate movements is always difficult to predict. Certainly in the long term we should expect sterling to be a weaker rather than a stronger currency, though of course once one makes such an assertion one also needs to look and the underlying position of rival currencies. I do assume that at some point the euro will break up and that sterling will hold closer to the Southern European currencies than whatever currency the Germans end up using.

Competitiveness
My next range of policy options is those that, without devaluation, improve international competitiveness.
One of the developments in my 40 years of working as an economist is that the major transmission mechanism through which competitiveness affects trade performance has changed.

In the 1960s and 1970s when I first started observing the UK economy the impact of competitiveness was mainly on the sales abroad (and also in the domestic market for import substitutes) of domestic firms, nowadays the main impact is through its impact on international investment in the UK.

This among other things means that the timing of the gap between changes in competitiveness and the knockon impact on actual exports is subject to a much longer delay than was the case when the effect was through the sales effort of domestic firms. It takes time for international investment trends to change – perhaps 4 or 5 years with the full impact only after a decade or so. So the effects of improved competitiveness often take a long time to be seen.

Probably the best economy in the EU at making itself competitive even in a fixed exchange rate context is Ireland. There is a lot that we can learn from the Irish.

The corporate tax rate is the first lever for maximising international investment.

One of the current government’s less heralded policies which will have a long term beneficial effect is that of bringing down the corporate tax rate. The UK rate is scheduled to be 21% next year, which will be the lowest rate in a major economy, though still noticeably higher than Ireland’s 12½%. For those academics who claim that corporate tax rates do not affect investment, I can only say that when I explained the impact of Nigel Lawson’s 1984 Corporation Tax reforms to IBM’s corporate head office in Armonk in the mid-1980s, they said ‘Wow, we really need to revisit our investment strategy towards the UK’. And I think it is telling that Ireland, with all the fiscal pressure on it as it tried to sort out the problems caused by its property collapse, sweated blood to resist pressure from the Germans to raise its corporate tax level.

It is important to note that the corporation tax is a very small part of total tax receipts. For most countries in the world it is only around 2% of GDP compared with total tax receipts of 40% of GDP or more. Any reasonable variation in corporate tax is only going to change the tax take by perhaps ½% of GDP, even without allowing for the knockon effects which are likely to limit or even more likely fully offset the impact of such changes. It is therefore largely irrelevant to fiscal deficits in the UK, Southern Europe and the US which require Budget cuts of 8-10% of GDP.

The second point is that Corporation Tax is only part of any tax payment by the corporate sector. Last year UK Corporation Tax payments were £43.8 billion. The main essentially corporate tax is VAT which last year raised £98.3 billion. The other large corporate taxes are employers’ national insurance contributions which raised £55.5 billion in 2010/11 and probably a couple of billions more last year and business rates (forecast at £26 billion in 2012/13). A total of about £8 billion in various so-called levies is also imposed on businesses, largely to promote environmental policies.

On top of that are the taxes paid by companies’ employees and their customers. It is a bit invidious to split these into the amounts directly due to the company and those directly due to the employee or customer. But there is certainly a corporate contribution.

It is for this reason that the 20-20 Tax Commission, of which I was a member, proposed a flat tax, with no tax paid by companies directly and taxes only paid by those receiving incomes from companies through dividends or salaries. We showed how our preferred tax approach could eventually boost GDP by about 10% - which is quite a lot for a change in the system of taxation.

This is why I believe that the pressure on corporates to pay more corporation tax by such campaigning bodies as UK Uncut is so damaging. It certainly is not the case that higher corporate tax payments would avoid the need to cut overspending by governments. It seems more likely that an attempt to get corporates to pay more tax would backfire and end up with lower GDP and lower tax receipts and hence an even greater need to cut public spending.

I think that in this area, careless talk may not cost lives, but it does cost livelihoods.

Quite apart from taxation, the climate towards inward investment is a critical part of export competitiveness.

The City of London – a major contributor to the balance of payments
The City of London is one of the UK’s biggest international trading assets, generating a balance of payments surplus of just under £50 billion a year before asset revaluations. I have criticised some aspects of the City consistently during the period when there were excesses, at the time when they were taking place. As a result, I think that I have rather more credibility to comment on the City than those who ignored excesses when they occurred but are now taking advantage of the unpopularity of bankers to attack the sector.

The current climate of banker bashing is unhelpful to the economy, as is the climate of enhanced capital requirements. When the problem is insufficient  bank lending, introducing policies to make lending more difficult is an extreme case of bolting the stable door when the horse has long headed for the hills. I can see why politicians wish to show that they are ‘doing something’ (one of the curses of our age). But what they are doing is damaging.

What is wrong with the City is mainly that some of the markets are insufficiently competitive, as a result of which profits have been excessive, resulting in excessive remuneration. This needs to be dealt directly by increasing competition, not in a way that throws the baby out with the bathwater. Regulation and increased capital requirements normally reduce competition and lead to even more excessive profits.

We have mismanaged our economy so badly over the past 100 years that we have relatively few national economic assets. We therefore need to cherish those that we have like the City of London – curb their excesses of course – but understand the scale of the contribution to the balance of payments and hence to economic growth.

Other areas for improving competitiveness
The other areas where there is scope for policy to boost trade competitiveness are regulatory policy, labour market policy, personal tax policy and innovation policy. These are all areas where government policy can either create a business climate that is receptive to inward investment or encourage existing firms to export more.

There is, at a different level, trade policy as well. But trade policy, in the sense of governments supporting exporters, is normally something where governments struggle to make much difference. Perhaps in encouraging diplomats to be more trade oriented they can do a bit. And by being careful about not implementing international agreements on things like bribery and arms sales any more aggressively than other governments they can avoid placing businesses based in the UK at a competitive disadvantage. And there are circumstances when because of the buying power of governments elsewhere or their requirement for linking trade with politics, it is necessary for the government to get involved in supporting exporting. But in general, it would be a mistake to exaggerate the importance of this. Most trade happens without government involvement.

In general I deplore the use of import restrictions  to improve trade performance. Although companies can use the shelter provided by such restrictions to improve their performance, they are more likely to use it to support inefficiency and to pay excessive wages and dividends.

Where there is a case for using import policy is in using the threat of tariffs or other restrictions to ensure that export markets are opened up. If and quite possibly when the UK leaves the EU, there will have to be some pretty tough negotiating to get reasonable trading arrangements and it would be foolish to deny the negotiators a negotiating tool.

So this summarises the obvious things that can be done to make an economy more competitive.

Let me now turn to inflation.

It is here that I see the potential for policy ideas that are completely novel which could generate a huge difference to economic performance.

Counter inflation policies
The IEA last month published a fascinating study about the use of price reduction policies as part of the process of improving the living standards of the poor directly rather than through paying benefits[2]. This not only reduces the cost of poverty to the rest of the economy but also improves the working of the labour market by removing some of the disincentive effects of benefits.

But I believe that the study underplayed the critical importance of getting prices down.

This isn’t a matter just of reducing the cost of living of the poor and those on benefits.

There are also macroeconomic benefits from reducing the cost of living for households as a whole. There is indeed the prospect of achieving  a disinflationary wage cost spiral. But in addition, the lower the rate of domestically generated inflation, the lower the real exchange rate that can be tolerated without prejudicing the inflation target. So a lower cost of living has a high powered effect.

Table 1Comparative cost of living in different economies IMF data 2011

Afghanistan 47.9 India 40.8 China 64.3 Russia 61.6 Greece 98.1 Korea 74.1 Spain 99.4 Italy 109.7 Japan 133.9 France 121.1 UK 109.4 Germany 111.4 Australia 153.8 Canada 124.5 Ireland 116.6 US 100.0 Singapore 75.7 Norway 158.5

The extent of this is demonstrated by some simulations I have carried out on Cebr’s macro model which incorporates the balance of payments and inflation constraints. What this shows is that a counter inflation policy that reduced the price level by 1 percentage point would boost GDP by roughly 2 percentage points. These quantifications are very rough and ready but give some idea of the scale of potential benefits.

How expensive is the UK by international standards?

International cost comparisons have some weaknesses but they give a rough idea. The latest set of IMF calculations gives the figures shown in Table 1[3]above.

It shows that the cost of living in the UK is 9.4% higher than in the US, lower than in France or Japan and similar to Italy or Germany.  But interestingly compared with India, costs are 2.7  times as high, compared with China about 1.7 times as high. Even compared with Singapore which has about the highest GDP per capita in the world, the UK cost of living is about 1.4 times higher.

The other data on this is from the OECD[4]. This data, using a more detailed methodology shows the cost of living in the UK is 11% higher than the OECD average and 18% higher than in the US.

Now let’s look at where prices are high and where there is scope for action. The OECD study on purchasing power parity gives a good indication of the areas where prices in the UK are particularly out of line.

The slide shows the price comparisons between the UK and the OECD average. The UK cost of consumers’ expenditure was 11% higher than for the OECD average. The areas where the gap is greatest are: housing and utilities (18%); transport (31%); recreation and culture (14%), restaurants and hotels (12%) and miscellaneous goods and services (15%).

Transport, which is the highest priced element, reflects a range of factors. Fuel duty has been historically high and other motoring costs in the UK have been kept up by a range of taxes and charges designed to disincentivise motoring. I will deal with ways of reducing transport costs in London in my 1 May Gresham lecture. For now let’s just identify the factors.

First, car usage is heavily taxed in the UK.

Second, public transport in the UK is amongst the most expensive in the world. Both train and bus fares are very high – and they are also heavily subsidised as well. Part of the problem is the high wages paid to the unionised employees. The extremes are in London - London tube drivers earn on average £50,000 a year, bus drivers above £30,000. Just to put this into context, the base salary of an Easyjet pilot is £43,000; that of a Ryanair pilot £53,500. As the great nephew of one of the founder members of ASLEF, I see a case for trade unions but they should not be exploiting the public in the way that the UK public sector transport unions currently do.

Part of the problem is that politicians have taken responsibility for the provision of public transport services. And they have been ruthlessly exploited by an unholy alliance of the transport providers and the trade unions both to exploit the taxpayer through high subsidies – particularly for London buses - and to exploit the consumer through high prices as is the case for trains.

Most of the other areas of excess cost in the UK reflect the high cost of property. This boosts the costs of most service sector activities. The McKinsey study on UK Competitiveness[5]in the late 1990s showed that there was a potential of a 20% price reduction through increased availability of property though planning policies that were more pro growth.

The coalition government has amended planning policies to take account of economic need. I have been an expert witness in a successful planning appeal under the new policies and there does seem to have been an impact from the policy change. Whether this is enough will take time to show.

But housing is the area where there is a real potential gain from improving planning policy.

Table 2Regional population density, the Netherlands, Switzerland, Germany, Belguim and the UK[6]

The reason UK accommodation is so expensive is the imbalance between supply and demand. It used to be argued that it was the widespread availability of mortgage finance which boosted UK housing costs, not the lack of supply. But the relative mortgage famine over the past 5 years has shown that this is not the case – it has simply shifted the high cost from capital value to rents and hence has proved that it is the physical shortage of housing that has been more responsible for pushing up the cost of housing, not excess demand.

It is often argued that UK house prices need to be high to cope with an unusual population density in the South East of England. This is simply untrue.

Table 2 shows the comparative table from the IEA report Redefining the poverty debate showing the population density in some of Europe’s more densely populated regions. The South East of England is some distance down the list, especially compared with much of the Netherlands.

The Barker Report (carried out by one of my successors as CBI Chief Economic Adviser) showed in 2004[7] that UK housing costs were excessive and needed to be reduced by increased supply. In fact the financial crisis and the associated reduction in lending has slowed the pace of housing development even further and as a result the shortage of housing has been exacerbated.

The OECD in an international survey of the impact of housing on economic growth[8]argued that the UK had a particularly low price responsiveness of supply in the housing sector arguing:‘the long-run price responsiveness of new housing supply tends to be relatively strong in NorthAmerica and some Nordic countries, while it is weaker in continental European countries and the United Kingdom’ . This low elasticity of supply is one of the factors blamed for the UK housing shortage.

Sir John Banham (my former boss at the CBI) recently released a report[9] last November for the Future Homes Commission also drawing attention to the economic damage resulting from high housing costs and the shortage of housing. His imaginative proposals included encouraging more pension fund investment in rental housing which surely makes good sense.

The final area where we in the UK have prices which are much higher than elsewhere is for energy. The Department for the Environment and Climate Change estimates that by 2015, Green policies will have boosted the price of domestic electricity by 26% and that of domestic gas by 10%. Even more dramatically, in those US states which have not accepted EU style Green obligations, electricity prices are now about half those in the UK[10].

More generally, securing a low cost level could be buttressed by giving the Office for Fair Trading the task of looking over all price levels in the economy that have a significant effect on the household cost of living or business costs and compare them with what one might expect given past history or looking at other countries. Where significant cost differentials exist, companies would be forced to explain them. This much more aggressive anti high price approach would I believe encourage the development of a cost effective mentality rather than a more pervasive approach of ‘how much can we screw them for‘ approach which seems to be more widespread at present.

Putting it all together
The impact of achieving OECD average prices for housing, commercial property, energy and transport for the UK would be an 8% reduction in the cost of consumer spending, worth just over £2,000 a year per household.

Of course these cost savings could not be made overnight. But supposing that they were phased in over 10 years, a rough and ready simulation suggests that they would be associated with a rise in GDP of around 15% compared with what would otherwise would have happened.

Such a boost would offset much of the growth weakness which I currently expect to take place for the UK over the coming years and would bring the rate of economic growth over this period to around the historic average of 2½%.

Conclusion
So let me recap. I do not think we are powerless in the face of competition from the emerging economies from the East. They have weaknesses as well as strengths. And we have strengths as well as weaknesses.

And we can be competitive.

But to achieve this we have to be focussed.

Focussed on two targets – making our economy internationally competitive and stripping out unnecessary elements in the cost of living.

We have to accept that in a more competitive world, economic performance has to have a higher priority than it has had for most of the past 20 years.

The good news is that we have enough fat to cut out to be successful and that if we cut that fat out, the probability is that we will be successful.

We can return to growth. But only if we really want to.

© Professor Douglas McWilliams 2013

[1]Eg Stephanie Flanders on the BBC  http://www.bbc.co.uk/news/business-21059213
[2]http://www.iea.org.uk/publications/research/redefining-the-poverty-debate-why-a-war-on-markets-is-no-substitute-for-a-war-   Report written by Kristian Niemietz, foreword by Gisella Stuart MP.
[3]http://www.econstats.com/weo/V013.htm
[4]http://stats.oecd.org/Index.aspx?DataSetCode=PPPGDP
[5]http://www.mckinsey.com/insights/mgi/research/productivity_competitiveness_and_growth/driving_productivity_and_growth_in_the_uk_economy
[6]Table 14 Page 81,  http://www.iea.org.uk/publications/research/redefining-the-poverty-debate-why-a-war-on-markets-is-no-substitute-for-a-war-   Report written by Kristian Niemietz
[7]http://www.barkerreview.org.uk/
[8]http://www.oecd.org/economy/productivityandlongtermgrowth/46941804.pdf
[9]http://www.architecture.com/Files/RIBATrust/FutureHomesCommissionLowRes.pdf
[10]The statistics in these two sentences come from http://www.iea.org.uk/blog/energy-bill-will-impose-immense-costs-on-households-and-businesses