House of Commons - Pre-Budget Report 2008

Pre-Budget Report 2008 - Treasury Contents

2 The Economy

2. At the time of Budget 2008, the Treasury forecast that GDP growth would be 1¾% to 2¼% in 2008, 2¼% to 2¾% in 2009 and 2½% to 3% in 2010.[2] At that time, and after taking evidence from several witnesses, we noted in our report on the Budget that the lower boundaries of the Treasury's forecasts were "above the average of independent forecasters". We concluded that the Treasury might have:

given insufficient weight to the risks of continued financial market turbulence and that some of the UK economy's characteristics that have proven beneficial in past crises (rapidly rising residential property prices, close links with the US and an increasing reliance on the financial services industry, for example) might prove to be conduits through which the current problems in global financial markets are transmitted to the UK real economy.[3]

The forecast as presented in the Pre-Budget Report 2008 was significantly weaker, with the Treasury forecasting only ¾% GDP growth in 2008, a range of -1¼% to -¾% GDP growth in 2009 and 1½ % to 2% in 2010, with growth reaching 2¾% to 3¼% in 2011.[4] The Treasury explained its forecast as follows:

Having slowed progressively over the past year, GDP is forecast to fall by a ¼ per cent on a year earlier in the second half of 2008, leaving output in 2008 as a whole up ¾ per cent on a year earlier. The recession is forecast to continue into the first half of 2009, before GDP growth begins to recover in the second half of the year as credit conditions start to ease and the boost to real incomes from lower commodity prices, the stimulus from monetary and fiscal policy, and the effects of sterling's deprecation, take hold.

3. Colin Talbot, Professor of Public Policy and Management at the Manchester Business School, was not convinced that the economy would rebound as quickly as the Treasury had forecast. In his written submission, he noted that under the Treasury's forecast while the UK would go into a deeper recession in 2009 than the G7, it would then recover to GDP growth levels higher than in the G7 in both 2010 and 2011.[5] He told us that he was "not convinced" by this forecast recovery and that he had "not seen anything in the PBR which explains why that is likely to be the case".[6] The Treasury however, explained that there were four factors underpinning its forecast:

the sharp fall in commodity prices which would boost households' purchasing power;
the very sharp fall in interest rates (including a fall of 300 basis points in one nine-week period;
the fiscal stimulus and other discretionary measures which amounted to 1% of GDP; and
the significant depreciation in the value of sterling which would stimulate activity away from imports.[7]

4. When asked to explain why the UK would achieve higher rates of growth during the recovery phase than the G7, Dave Ramsden, Managing Director, Macroeconomics and Fiscal Policy, HM Treasury, explained that, compared to the euro area, interest rates had fallen faster in the United Kingdom.[8] He also noted that "The experience of the UK is that we do have relatively flexible markets and that means it is reasonable to assume that they will adjust relatively quickly following a recession with growth picking up".[9] Prompted to provide details of other forecasters providing a similar forecast to the Treasury, Mr Ramsden cited Morgan Stanley for 2010, and the Bank of England.[10] The Governor of the Bank of England ('the Governor') supported that Treasury's stance, accepting that in "broad terms our forecast, allowing for all the probabilities, is close to that of the Treasury".[11] Mr Ramsden however, did accept that not all external forecasters were in step with the Treasury's forecast, noting that "There are forecasters such as Citigroup, HSBC, who have a much weaker recovery".[12] He also stated that "but I do not think that our forecast of growth in 2010 of 1½% to 2% in 2010, while I am happy to acknowledge it is at the top end of the range of outside forecasters and is close to the Bank of England's, is anything other than achievable".[13] The Chancellor supported the forecast as presented in the Pre-Budget Report 2008, but noted that uncertainties remained, telling us that:

I think, based upon the information that we have, based on the low interest rates, the advantages that will come from lower inflation, the fiscal stimulus that I put into the economy in the Pre-Budget Report, and also there are other factors — our economy is pretty flexible—I believe that the economy will start to grow in the second part of next year. It is broadly in line with what the Bank of England, quite independently of us, has also been saying. But there is a lot of uncertainty out there.[14]

The Treasury's forecast in the Pre-Budget Report is for a swift recovery in economic growth for 2010, after a significant decline in output in 2009. The outlook for economic growth remains highly uncertain, but the balance of risks to the Treasury's forecast is on the downside, as illustrated by the two packages which have since been introduced.

LOST OUTPUT

5. As part of its assessment of the economic outlook, the Treasury forecast a reduction in the trend output of the economy, giving the following explanation for doing so:

For the 2008 Pre-Budget Report, to take account of the likely negative effect of the credit shock on trend output, a phased reduction to the trend level of productivity (and therefore the trend level of output) of about 4 per cent has been assumed over the two years from mid-2007, a period consistent with the credit conditions assumption that underpins the economic forecast more generally. This adjustment is within the range of external estimates of the impact of the shocks to credit and energy markets on medium-term potential output, though it is a key forecasting judgement around which there is very considerable uncertainty.[15]

Robert Chote, Director of the Institute for Fiscal Studies, highlighted why this forecast loss of output was important:

[The Treasury] have basically taken the view that the long-term output of the economy is going to be about 4% lower than it would have been expected to be prior to the announcement of the PBR, so in effect they are saying that for two years the trend growth rate of the economy will be 0.5% a year, not 2.5% a year. That knocks a £60 billion hole in the economy and means that you effectively have a permanent loss of about £40 billion in tax revenues and higher social security expenditure.[16]

6. There was disagreement as to whether the Treasury's forecast of the reduction in the trend growth rate of the economy was realistic. Mr Chote stated that "Judging whether 4% is the right number in the middle of the two-year period in which you expect that adjustment to be taking place is a very difficult thing to do, but I have to say seeing the magnitude of that number in cold print it did not look to me as though they were being egregiously optimistic, it seemed to be a reasonable stab at that analysis at this stage".[17] Roger Bootle, Managing Director of Capital Economics, though held a less sanguine view:

the uncertainties are enormous but my reaction to the 4% was to think how large the figure was particularly given the uncertainties. If you read the section of the PBR where they try to explain and justify this, it really is the worst sort of 'Noddy' economics. It is all about the difficulty of co-ordinating inputs of labour and capital and there are no examples and no quantification. It really is a complete stab in the dark. No-one has a clue.[18]

He suggested that the Treasury's forecast was "much too high", stating that there would be "counter-vailing factors" from the recession that would increase the supply potential.[19] He provided the following examples of how such changes could come about:

Things get cleared out and moreover if the shape of our economy changes along the lines that we have been speaking about, that is to say a shift away from consumption and, relatively speaking, from government spending towards export, we may well find a period in which those parts of the economy whose natural productivity growth is faster are the ones that are growing fastest.[20]

Mr Ramsden, for the Treasury, was staunch however in his defence of both his Department's forecast of the reduction in the potential output of the economy, and its presentation of that forecast.[21] He maintained that the Treasury, like the Bank of England had "not only taken account of the demand side impacts of these shocks but also the supply side impacts of these shocks".[22]

Fiscal stimulus

7. The significant worsening of the economic outlook since the 2008 Budget led the Government to announce at the time of the Pre-Budget Report 2008 a fiscal stimulus. This comprised a "temporary reduction in the VAT rate to 15 per cent with effect from 1 December 2008 to 31 December 2009", as well as bringing forward £3 billion of capital spending from 2010-11 to 2008-09 and 2009-10.[23] According to the Pre-Budget Report 2008, this discretionary action, which would cost £16 billion, would deliver an overall fiscal stimulus of around 1 per cent of GDP in total in 2009-10.[24]

8. Giving evidence on the November 2008 Inflation Report, the Governor was broadly supportive of the fiscal stimulus, as set out in the Pre-Budget Report. He told us:

I thought in these extraordinary circumstances a modest fiscal stimulus was perfectly reasonable and appropriate, provided it met two conditions: the first condition was that it was temporary and the second condition was that it set out a very clear map and path back to fiscal sustainability. I think the announcements made yesterday meet those two conditions. Of course, the proof of the pudding, in terms of ensuring that we do get back to fiscal sustainability, will be in the eating, and there is a long, hard path back to fiscal sustainability.[25]

Sir John Gieve, Deputy Governor of the Bank (Financial Stability), agreed that "the case for a fiscal stimulus was a strong one".[26] On the question of whether the estimate of the impact of the fiscal stimulus was correct, Mr Chote told us that it seemed to be in line with the sorts of multipliers that the Treasury, had laid out when it was looking at the use of fiscal activism in its studies for the euro.[27] One concern he had lay in the extent to which the impact of the stimulus would be modified by the extent to which other countries adopted similar measures "and therefore the benefits of the stimulus are not, in a sense, them leaking away or the benefits of other people's stimuli leaking to us to the same degree that ours is leaking to them".[28] Simon Kirby, Research Fellow at the National Institute of Economic and Social Research (NIESR), suggested that NIESR was expecting a "slightly smaller" effect from the fiscal stimulus than the one forecast by the Treasury.[29] For the Chancellor, the fiscal stimulus was "absolutely necessary".[30] When the argument that the automatic stabilisers alone might have been sufficient to support the economy, rather than a fiscal stimulus, was put to the Chancellor, he argued that "If you allow a recession to become deeper and longer than it might otherwise be there is a cost to it".[31] The Chancellor also did not rule out further fiscal stimuli in the future.[32]

9. We discussed with several witnesses the design of the fiscal stimulus, especially the Government's decision to reduce the rate of VAT, rather than other options such as reducing income tax, or providing rebates. One of the concerns about a temporary tax cut, is that consumers will save the additional money, rather than spending it. Charlie Bean, Deputy Governor of the Bank of England (Monetary Policy), explained that a temporary cut in income tax might be saved by individuals, rather than spent.[33] He argued that:

a cut in Value Added Tax at least gives households an incentive to bring forward some spending from the future to the present in some sort of switching over time. In that sense … it is a measure that works because it is temporary.[34]

The Governor went on to explain "that during the second half of next year there will be a lot of advertisements saying: "Buy now before VAT goes up in January 2010"".[35] This would lead to expenditure-switching, where expenditure by households would be moved from one period to another. The Governor did however point out that if demand were weak in the period after the stimulus ran out, and VAT rates had been reset, the switching would have been between the wrong time periods, and so of limited effect.[36] When asked whether the stimulus would lead to expenditure being concentrated towards the end of the lower-VAT period, the Governor explained that:

It is more likely to but, of course, people who have been thinking of spending may decide that some point in the next year is a good time to spend, why not do it now rather than the second half of next year? Decisions will vary from one individual or household to another.[37]

Mr Kirby, however, thought that the credit crunch might impact on the ability of households to take advantage of the lower VAT rates. He outlined the problem as follows:

The more important fact behind this is that one of the main points of the stimulus is a VAT cut. In normal times work would suggest that that is the sensible route to go. However, the problem is that we are currently in a banking crisis and we have households and firms that are credit constrained. It is trying to stimulate spending without addressing the problem of credit constraints which may mean that the actual VAT cut has less of an impact than we or even the Treasury at first think. Fundamentally, if you are going to do a VAT cut you also need to address the problems of credit constraints as well and, unfortunately, that is not happening.[38]

10. Professor Talbot was in favour of the model adopted in the United States of America of a "direct and obvious cash benefit to individuals".[39] He then noted that should some of that direct payment have been saved, this would have helped in the recapitalisation of the banks.[40] Mr Chote told us that he had expected a larger proportion of the stimulus to come in the form of "a permanent increase in the generosity of benefits and tax credits for relatively less well-off families on the grounds that they are relatively likely to spend a higher proportion of it and you would take it away from other richer households in the future".[41]

11. Mr Ramsden explained the rationale of the design of the fiscal stimulus as set out in the Pre-Budget Report 2008:

it should be temporary so that you get the maximum effect over the period, something that the Governor of the Bank of England has raised, that it should be timely, which was why we went for the VAT reduction of 2½% that could be introduced immediately as well as bringing forward existing investment projects rather than starting new ones. We wanted it to be targeted, so we saw that VAT could actually impact not only across all sectors of society who pay VAT but also would be of help to ensuring that volumes continued in the retailing industry and help the retailing industry through a difficult period in that sense, so we looked at the quantum of thinking that 1% was about appropriate.[42]

Mr Ramsden also pointed out that the automatic stabilisers, such as unemployment benefit and a decrease in the tax take, were also active in stabilising the economy at this time.[43] This had therefore determined the size of the fiscal stimulus. Mr Ramsden assured us that the Treasury had not felt "constrained" by the state of the public finances.[44] When asked whether this measure would lead to a bunching of consumption to the end of the VAT reduction period, with consumers cashing in on both the VAT reduction and falling prices, Mr Ramsden argued that the VAT reduction was a valid strategy. Real purchasing power for consumers would rise straight away, for a 13 month period (other measures could not have been introduced until later in the year) since most retailers appeared to be passing the reduction on in savings to consumers; the other advantage was that the reduction achieved a "relative price effect", making consumption cheaper now relative to a future date:

we have assumed that that relative price effect will be particularly strong actually at the beginning of the recovery, i.e. in the second half of next year, and that was the experience in Germany. Before their VAT went up at the beginning of 2007 there was a bunching of consumption because the relative price effect was stronger then but the income effect, the first effect, will apply throughout, so you get these two effects.[45]

He then went on to confirm that the multiplier effect was the one that had led the Treasury to decide upon a cut in an indirect tax.[46]

12. The overall effect of the fiscal stimulus remains uncertain. The cost of the reduction in VAT is considerable and, in the view of the majority of commentators, the Treasury's analysis of its impact is an optimistic one. We will continue to monitor its effect as part of our ongoing work, and will return to this issue at the time of the Budget 2009.

Bank lending

13. The continued dislocation within the financial markets, and subsequent reduction in bank lending, remains a key risk to economic growth, affecting both companies and households' access to credit. As such, the Pre-Budget Report 2008 notes one of the risks to the consumer spending forecast is the "the speed at which credit conditions normalise", and that the "risks around the depth and duration of the adjustment in the UK housing market are linked to the ability of banks to resume profitable lending, further rebuilding their capital positions and increasing the availability of mortgage finance".[47] Companies face similar problems, with the Pre-Budget Report 2008 noting that "There are risks to the business investment forecast from developments in credit availability".[48] The Governor of the Bank of England also highlighted this risk, telling us that the "single most pressing challenge to domestic economic policy is to get the banking system to resume lending in any normal sense".[49] Mr Bootle agreed, that "getting the banks lending again is absolutely critical".[50] Mr Ramsden suggested that the Government acknowledged this point:

the return of credit conditions, both in terms of the price of credit and the quantity of credit, to what might be considered a more normal position is absolutely critical to achieving the forecasts that we set out. Indeed, it is the key assumption on which the forecasts were based.[51]

14. The Government has provided significant support to the banking system. On 8 October 2008, the Government announced a bank recapitalisation programme of up to £50 billion, a Government guarantee of new short and medium term debt issuance of up to £250 billion (known as the Credit Guarantee Scheme), and the provision of at least £200 billion to be made available to the banks under the Special Liquidity Regime.[52] The Chancellor told us at our meeting on 10 December 2008 that £100 billion had already been subscribed for by the banks under the Credit Guarantee Scheme.[53] Despite this support, the banks were not yet lending. The Governor offered an interesting analysis of how bank lending appeared not to be in the interest of individual banks at present, even if it were in their collective interest:

What is happening, at present, is that what the banks are saying to themselves is: "Even if we see some apparently profitable lending opportunities, we had better forgo them because we are under enormous pressure to reduce the scale of our leverage" (to use that awful word) "of borrowing and we have to reduce the scale of our balance sheet." So they are giving up profitable lending opportunities in order to behave defensively and reduce the size of their balance sheet. Individually, it makes sense for a bank to behave in that way; collectively, it makes no sense at all, because if all the banks behave in that way not only will the economy go into a steep recession but the banks themselves will start to see even bigger losses on their pre-existing loans. … [we have] to find a way in which their individual incentives do not lead to a collective outcome that is clearly adverse.[54]

15. Several solutions to encourage the resumption of bank lending were suggested to us. The Governor outlined four steps that he thought needed to be taken. First, better monitoring of the lending that was actually being undertaken. Secondly, ensuring that financial markets understood the aim of the bank recapitalisation. The Governor explained that it was of "the utmost importance that the tripartite authorities make crystal clear that regulatory minimum requirements have not been raised and, if anything, in these circumstances, might be lowered because banks will need to see their capital used to absorb losses in order to maintain lending". Thirdly, further recapitalisation of the banks might be required. Fourth, the Government might have to intervene directly to ensure lending by the banks.[55] One further solution which we put to the Governor was the creation of a "memorandum of understanding or a concordat" under which the principles of the levels of lending expected of the banks would be set out.[56] The Governor, while not wishing to commit himself, did not want "want to rule anything out".[57] Mr Kirby told us that further recapitalisation of the banks was one way forward. In his view, although the recapitalisation had to date cost very substantial sums of public money it should represent only the first tranche:

The average cost of a banking crisis is around 10% of GDP. Currently we have put in around 2.5% of GDP into a number of banks, so the Government perhaps wants to think about moving more towards putting some more money into banks, changing slightly how they do it, perhaps less onerous but taking more control over the banks themselves. Another 2.5% of GDP might move us towards the point where we can actually get the banks lending because at the end of the day that is what we need to do to get the economy moving.[58]

Mr Bootle felt that further action, above and beyond recapitalisation, might be required:

I do not think this is only a matter of the money. You could be putting in lots of money and having no control and getting not much result. Equally, you could put in not that much money and take control and get a big result. I do not think it is necessary to own all the banks in order to direct their lending. I would point out to the Committee that in the years immediately after the Second World War it was normal in this country and other so-called capitalist economies for a weapon of monetary policy to be direction of bank lending. It was quite normal and it seems to me that we cannot go on for very much longer just encouraging banks.[59]

Clive Maxwell, Director Financial Services at the Treasury, suggested that the Government had taken two steps to counter the problem. First, those banks which had used the recapitalisation scheme underwritten by the Government had made commitments to maintain lending in certain key respects, and these would be monitored by UKFI.[60] Secondly, a Lending Panel, comprising the main lending institutions had been created. Mr Maxwell explained its role:

[it] is intended to bring together different groups to, firstly, monitor levels of lending and then look at the policy issues and other issues that arise in relation to that. It is a forum to bring people together, and it gives an opportunity to look at the situation and understand exactly what is happening and decide if things need to be done.[61]

Mr Maxwell also indicated that one of its key priorities would be to make sure it had "sufficient information to actually understand what is happening".[62] The Chancellor provided further detail on the Lending Panel, telling us that he would meet with:

the chief executives of banks along with Lord Mandelson on a monthly basis ... In addition to that there are three groups at a working level, one looking at the small business side of things, and that has been meeting for a couple of weeks now, one looking at mortgage finance ... and another one looking particularly at the credit card problems which are slightly separate but are part of the whole.[63]

The Chancellor also confirmed that he was prepared to look at other initiatives in this area.[64] When asked whether he would be prepared to direct the banks to lend, the Chancellor suggested that there were practical limitations on the nature of government involvement:

Where I think it will be more difficult is for any government, frankly, to be standing in the place of bank managers up and down the country and saying to you, ... when you come in, "Yes, I will lend you so much at such-and-such a rate and these are my terms and conditions". You could do it with a few large customers, I suspect, or you could do it in sectors but for the state to get into millions and millions of individual decisions would be difficult. I would rather use the banking system, … to make sure that it delivers for us.[65]

Overall though, he acknowledged the need for the banks to lend given the public money that had been provided to them:

The banks have to understand that we have put very substantial sums of public money in to support them. They, in turn, have to play their part ... There are a number of areas where I believe they need to go much further.[66]

16. On 19 January 2009, the Treasury announced a new set of measures to support the banking system and encourage additional lending. These comprised:

Extending the drawdown window for new debt under the Government's Credit Guarantee Scheme;
Establishing a new facility for asset backed securities;
Extending the maturity date for the Bank of England's Discount Window Facility;
Establishing a new Bank of England facility for purchasing high quality assets;
Offering capital and asset protection schemes for banks, with proposals for this to be coordinated internationally; and
Clarifying the regulatory approach to capital requirements, through an announcement by the Financial Services Authority.[67]
- We have taken no evidence on these measures.

17. The lack of bank lending remains the single most critical problem for the economy in the near term. The Government must ensure that the availability of credit, both to households and businesses, increases quickly. Without that increase in availability, the recovery of the economy will be placed in jeopardy. We recommend that the Lending Panel, or a suitable agency of the Treasury, provide regular updates on the actual lending by the banks to the real economy. We were very struck by the Governor of the Bank of England's analysis that lending at the present time might not appear to be in individual banks' interests even if it were in their collective interest. We note the Government's proposals announced on 19 January 2009. We will monitor their implementation and effectiveness, both at the time of our inquiry into Budget 2009, and as part of our ongoing inquiry into the Banking Crisis. This is a matter we will discuss with the Chancellor in due course.

18. Some concern was also expressed that the terms of the bank recapitalisation scheme might be hampering the ability of the banks to lend. Mr Kirby explained that the bank recapitalisations were on "rather onerous terms with 12% preference shares".[68] He suggested that "making the terms less onerous is a more prudent approach because then banks might actually come forward to want to take the recapitalisation rather than going to foreign countries and trying to raise capital that way".[69] The Chancellor explained that the remuneration on the preference shares was "to stop us putting money into a bank simply to see it go out the other side straight to the shareholders without actually doing what we are wanting".[70] He noted that "The Government has made facilities available. Banks, of course, can go elsewhere if they want but some of them have found it is more expensive than coming to us."[71] In this context it is worth noting that Barclays, which did not accept the Government's facilities, recapitalised via private capital at a rate of 14%.[72] However, the Chancellor also promised to look again at this matter as part of his general review of how the Credit Guarantee Scheme was working.[73] The Chancellor also noted that:

I remember there were a lot of questions in the House of Commons at the time with people saying, "Well, the tax-payer was doing this but are you getting a return for it?" The actual amount we charge, there is no magic number to that, the important thing is to get it right, although interestingly, as I say, £100 billion has already been subscribed, which does tend to suggest there is a demand for it at the price that we are offering but, as I say, it is one of a range of things we are looking at.[74]

19. On 19 January 2009, the Treasury announced that, in consultation with UKFI, the Government had agreed to convert the preference shares the Treasury held in RBS into ordinary shares, thus releasing RBS from paying the 12% coupon on those preference shares.[75] We have taken no evidence on this measure.

20. We are concerned that the terms of the original recapitalisation programme of the banks may be hampering their ability to lend. We note the conversion of preference shares held by the Treasury in RBS into ordinary shares. We recommend that the Treasury continue to monitor the effectiveness of the recapitalisation scheme, and whether further renegotiation of the original contracts will be required so that the banks concerned can maintain and increase their lending.

CROSBY REPORT

21. On 9 April 2008, the Chancellor announced the formation of the Mortgage Finance Working Group, led by Sir James Crosby. The Working Group's remit was to "consider options for improving the mortgage-backed securities market, including measures aimed at broadening the investor base for mortgage-backed securities and improving the robustness of the market".[76] The Chancellor said at the time that the "work will be an important contribution to stabilising the cost and supply of UK mortgages".[77] Sir James produced an interim report on 29 July 2008 entitled Mortgage finance: interim analysis.[78] His final report, Mortgage finance: final report and recommendations, was released with the Pre-Budget Report 2008.[79] The Chancellor in his Pre-Budget Report statement welcomed the publication of the report, noting that its principal recommendation was that the Government should support the mortgage market by providing for a temporary period of guarantees for securities backed by new mortgages. Whilst the Chancellor shared Sir James's concerns about the availability of mortgages he noted one major obstacle:

To implement Sir James's recommendation, the Government would need to obtain State Aid approval from the European Commission and resolve some technical and practical considerations. But we will proceed to work up a detailed scheme based on his recommendations and seek State Aid approval to proceed. I will also take into consideration the interaction between this proposal and the Credit Guarantee Scheme.[80]

22. However, in the period between the publication of the interim and final Crosby Reports, the Government announced the implementation of the Credit Guarantee Scheme. The Governor told us that "Since [the publication of the Interim Crosby Report] we have put in place the credit guarantee scheme which is designed for a time limited period to give incentives to the banking system to make it possible for the banks to borrow money irrespective of which kind of lending they want to use that borrowing to fund".[81] The Governor therefore appeared cautious towards the recommendations in the final Crosby Report. He suggested that the Report could not be looked at in isolation, but that the Credit Guarantee Scheme had to be taken into account as well:

It does not make sense to have two completely separate packages, so it would make sense to think how the credit guarantee scheme, which offers guarantees for unsecured borrowing, would fit with the Crosby proposals which offer guarantees for secured borrowing. They are different types of borrowing. The Crosby scheme is restricted to only one kind of lending. It is not obvious to me why you would want to discriminate in favour of mortgage lending as opposed to lending to small businesses, for example. It would be a big mistake to regenerate lots of lending for the housing market at the expense of crowding out lending to small businesses. What is most important now is to sit back and ask how these Crosby proposals would fit with the proposal for the credit guarantee scheme which I see as a broader based scheme which does not discriminate among different kinds of lending.[82]

Mr Bootle also noted the potential for the Crosby Report recommendations to favour one type of lending. He remarked that "I am ... conscious of the danger of, as it were, shifting bank lending from one particular channel into another where what we should be wanting to do is increase or maintain overall bank lending".[83] He warned of the danger of a "piecemeal approach", where "we guarantee a bit of this, we subsidise a bit of that, we encourage a bit of something or other else, all adding up to not all that much and, in the process, distorting the market."[84] Mr Maxwell also noted the need to ensure an integrated approach between the Crosby recommendations and the Credit Guarantee Scheme. He indicated that there would be a report on their progress at the time of the Budget.[85]

23. The Governor also raised a more specific concern about trying to reinvigorate the mortgage-backed securities market. He told us that "I am all in favour of finding ways of encouraging a sustainable rate of mortgage lending but I am not entirely confident that the best way to do this is to resurrect an instrument which, for rather good reasons, has fallen out of favour".[86] As evidence of this, he noted that "It is quite striking that in the last two or three days some of the American rating agencies have made clear that they would not be very enthusiastic about giving high ratings to mortgage-backed securities unless a lot more information were provided about who the borrowers were behind those pieces of paper, and one can understand that".[87] Mr Bootle shared the Governor's concern over whether it would be desirable to reinvigorate the market for mortgage-backed securities, stating that "I think we have got to be quite careful about trying to resuscitate an aspect of the financial system which does not seem to have been particularly effective and was actually very dangerous".[88]

24. We have already noted the announcement by the Treasury on 19 January 2009 of the guarantee scheme for asset backed securities. This scheme, according to the Treasury, drew on the recommendations of Sir James Crosby.[89] This scheme will include, but is not limited to, triple-A rated mortgage-backed securities.

25. We note the creation of the guarantee scheme for asset backed securities. We will examine this proposal as part of our inquiry into the Banking Crisis

Monetary policy

THE RECENT PATH OF INTEREST RATES

26. The worsening of the economic outlook has also seen the Monetary Policy Committee (MPC) cut interest rates. Before our hearings on the Pre-Budget Report 2008, the MPC had cut interest rates on 6 November 2008 by 1.5 percentage points,[90] and again on 4 December 2008 by 1.0 percentage points.[91] After our hearings had concluded, the MPC again cut interest rates by 0.5 percentage points on 8 January 2009, leaving the official Bank Rate paid on commercial bank reserves at 1.5%.[92] In our hearing into the November Inflation Report, the Governor highlighted three reasons why the outlook for inflation had changed so considerably, allowing the reduction in interest rates:

First, following the failure of Lehman Brothers, the turmoil that has affected financial markets over the past year intensified into the most serious financial crisis since the outbreak of the Great War. The flow of lending to households and businesses has been severely disrupted. Confidence has been badly affected. All this will hold back demand growth looking into next year. Second, the short-run indicators for activity have turned down sharply both at home and abroad. Surveys, reports from the Bank's Agents and indeed my own discussions with businesses suggest that there was a significant fall off in demand coming into the fourth quarter. As I remarked last month, the UK economy probably entered a recession in the second half of 2008. That is reflected in the labour market—unemployment has been rising at its fastest rate for 17 years. Third, although CPI inflation did rise above 5% in September, as we had expected, it has now started to fall sharply: to 4.5% in October. Oil prices have collapsed by around two-thirds since the summer, and the price of metals on world markets has halved. Measures of short-run inflation expectations have retreated. And the cut in VAT announced yesterday will also lower inflation in the short run. Given these three factors, the outlook for inflation has shifted down significantly. Over the next few months inflation will be markedly lower than we anticipated in August. It is likely that inflation will return to target at some point early next year, although the precise speed at which inflation falls back will depend on how quickly the recent depreciation of sterling feeds into consumer prices. As a result, the upside risk to inflation in the medium term, emanating from elevated inflation expectations that had been important for much of this year, has receded. And the downside risk, reflecting the possibility that weak demand might pull inflation below the 2% target in the medium term, has increased significantly.[93]

THE RISK OF DEFLATION

27. The focus of the MPC has changed from one of a concern about the impact of rising commodity prices, to anxiety about the implications of the economic slowdown on inflation and the economy in general. One of the potential risks we discussed as part of our inquiry was deflation. The Governor stressed that it was only a particular type of deflation that was of concern:

I think it is probably worth distinguishing between two different definitions of deflation in this context. One is simply a point of time when the inflation measure actually turns negative. That is very likely to happen to RPI [Retail Prices Index] inflation next year—in fact almost certain to happen now with the cut in VAT—and it may happen to CPI [consumer price index] inflation, though it is not our central view. The other definition of deflation is the one that economists worry about, which is a period of continuing, self-reinforcing falls in prices which then make it very difficult for real interest rates to fall to sufficiently low levels to get out of a downturn in spending. I do not think we feel that is the position that we are in or likely to be in, because the likely duration of the period when the measured inflation rate will be negative is likely to be pretty short.[94]

Mr Bootle however felt that there existed a very real danger of just this type of deflation:

I think the really awful risk in all this is that deflation gets into the mind and with the fact that we seem to be entering a period when the authorities are perceived to be weak (and I think are actually fairly weak in what weapons they have to deploy against a deflationary danger) the risk is that you enter into a depressive mood which affects consumption and investment expenditure. If people think that prices are going to be falling significantly for a prolonged period they put off consumption and they also put off investment projects.[95]

For the Treasury, Mr Ramsden maintained that the fall in prices would be temporary. He told us that the cut in VAT, and the reduction in interest rates, which would then feed into the RPI measure of inflation, were both temporary, and therefore were not the start of a deflationary cycle.[96] He explained that both the reductions in interest rates and in VAT were designed to stimulate demand rather than the reverse, which was the implication of deflation.[97] The Chancellor was also keen to suggest the temporary nature of the potential falls in prices. He pointed out that "If we look ahead, although now, for example, with oil at about $40 a barrel, it seems a long time ago, but in the summer they were way up approaching 150 but, as the economy starts to grow and the world comes through this, some of the inflationary pressures that we saw in the summer, I am afraid, have not gone away in relation to commodity prices".[98] While he acknowledged the risk of deflation, he told us that "the greater risk to our economy and the greater risk to the world economies is the need to maintain growth and the need to maintain bank lending".[99]

28. One potential impact of deflation would be that in an effort to combat the deflationary spiral, the monetary authorities might lower nominal interest rates to close to zero. However, because prices are falling, real interest rates (interest rates adjusted for inflation) would remain positive. Nominal interest rates have already fallen close to zero in both the United States of America and Japan.[100] Mr Bootle highlighted the problems a near-zero interest rate would cause:

This is the danger, that you get to zero [level of interest rates], people know that rates cannot come down any further, deflation begins and perhaps even gets faster, so people see that the real rate of interest and the real cost of borrowing is actually rising and therefore that is a major deterrent to spending.[101]

However, Mr Bootle did suggest that "quantitative easing" might be used, should interest rates fall to close zero to combat a deflationary spiral.[102] Quantitative easing refers to ways of boosting economic growth after traditional monetary policy tools, such as interest rate targets, have been exhausted. Central banks increase the money supply to the banking system by more than is needed to keep official interest rates at zero or a low rate, to shore up the financial system and promote lending, usually by buying up large quantities of assets from banks.[103] The Governor of the Bank of England accepted that "close co-ordination between government and the central bank" would be needed if interest rates fell to zero.[104] He explained that "it is very much a question of how the different types of instruments that the Government uses to finance itself are determined - whether they start to issue very short-term instruments in order to make more liquid the portfolios of the private sector".[105] The Chancellor explained that interest rates were still at 2%, so the risk of interest rates was not immediate, but that "the situation is full of uncertainties".[106] Dismissing newspaper reports that the Government was considering quantitative easing, the Chancellor said that this was "just something that we are not looking at at the moment".[107]

29. The cut in VAT, instituted as part of the fiscal stimulus, discussed above, will also have the effect of reducing prices while in operation. Professor Talbot highlighted the problem this might cause with an example:

the VAT cut is deflationary and it is largely non-transparent to the public and in this situation where even on the Government's projections we are bordering on deflation, the RPI is actually forecast to be going negative and the CPI only just remains positive. There is a real danger that the VAT cut could have the completely opposite effect of what is intended and that is to discourage people from purchasing in the short term. Certainly if I were buying a new car at the moment I would wait [until] the end of the VAT cut period and buy it then, on the grounds that prices are likely to have fallen by that time.[108]

However, Treasury officials were keen to point out that the VAT cut was a temporary measure, and therefore not of concern. Mr Ramsden told us, "the VAT measure, by the very nature of being temporary, should give people reassurance that, whilst it will bear down on the price level in the short term, the price level will then go back up in the medium term, as highlighted in last week's MPC statement that accompanied their interest rate cut".[109]

30. We have already noted the announcement by the Treasury on 19 January 2009 of the Bank of England asset purchase facility. This scheme will allow the purchase by the Bank of England of a wide variety of high quality private sector assets to boost the availability of corporate credit.[110] We have taken no evidence on this measure.

The current forecast suggests that any future falls in prices will only be temporary. But the risk of a self-reinforcing deflationary cycle exists in the UK economy at present. The Treasury must be alert to this possibility. Nominal interest rates have already fallen significantly, and may soon reach a rate of zero percent or just above. We recommend that the Treasury prepare and publish the actions it may consider taking should a period of "quantitative easing" be needed. We note the creation of the Bank of England asset purchase facility, and would expect it to be included in such an analysis.

31. This paper must also contain the actions that will be expected of, or have been recommended by, the other relevant public bodies related to the Treasury, such as the Bank of England and the Debt Management Office. We will continue to examine the need for, and design and function of, the Bank of England asset purchase facility in our future inquiries into the Budget 2009, and the Bank of England's Inflation Reports.

IMPACT ON SAVERS

32. The reduction in interest rates, while beneficial to those who have borrowed money, reduces the income available to those who rely on the interest from their savings. One particular group of such savers are pensioners. Mr Ramsden told us that the recent fall in interest rates "is intended to ease the burden on borrowers".[111] When we asked Treasury officials whether they were considering measures to assist those who suffered from interest rate falls, Mr Williams first pointed out that many pensioners had little savings, but that for those that did some measures were in hand:

[many] continue to receive their bank or building society interest with tax deducted in circumstances where they could fill in a form and get the tax not deducted or make claims to get some of the tax back afterwards. We are about to run a new campaign to raise awareness of the ability to get the interest paid gross or to get back some of the tax in circumstances where savers at the 10p tax rate apply.[112]

The Chancellor pointed out that the desire of banks to maintain savings rates had to some extent limited the pass-through of reductions in interest rates to borrowers.[113] The Chancellor acknowledged the problem that savers faced:

There are a lot of people who have saved for their retirement. They have got money in the banks and building societies and stocks and shares and when interest rates come down there are two sides to that. It depends whether you are a borrower or a saver. … I recognise that, which is why a number of the building societies and some of the banks were saying "Interest rates came down last time but we have also got to remember we have got to attract savers", and that is particularly true in the building society sector.[114]

33. Interest rate reductions, while favourable to borrowers, once passed through by financial institutions lead to a decrease in income for savers. While the need for lower interest rates to maintain economic growth is crucial at the present time, the needs of savers must not be forgotten. We recommend the Treasury consider measures that will provide support to savers at this difficult time.

Net trade and the exchange rate

FORECAST FOR NET TRADE

34. The Pre-Budget Report 2008 contained a forecast that net trade would provide a positive contribution to GDP growth from 2009.[115] However, the Report also stated that net trade has not provided a positive contribution to GDP growth, on average, over the period 2000-2007:[116]

Despite sluggish export growth in 2008 and 2009, the slowdown in import growth in 2008 and decline in import volumes in 2009 mean that net exports are forecast to contribute positively to overall GDP growth. At around ¾ of a percentage point in 2009, the contribution of net exports to growth would be of a similar order of magnitude to that seen in the past three UK recessions.[117]

Mr Kirby thought that this was a positive development for the UK economy:

I can certainly give you one silver lining: in a sense, looking ahead, the decline in sterling is going to help rebalance the UK economy. We would expect to see competitive gains feed through to net trade having a more positive contribution to growth and that means basically that the rebalancing of the economy will be done partly through sterling rather than relatively weak income growth for households over the coming years. That possibly is the one silver lining you can get from that.[118]

The Chancellor was also positive about the outlook for net trade, stating that "In volume terms, our exports actually went up by just over 2% in the three months to October", and that "if you look at the performance of our manufacturers and the service industry in terms of its exports, we have done quite well over the last few years".[119]

THE FALL IN STERLING

35. The positive outlook for net trade stems in the main from the significant decline in sterling's value against other currencies. The recent cuts to interest rates, and concerns about the overall state of the economy, have seen a marked decrease in the value of sterling against other currencies, as since 1 January 2007 the sterling effective exchange rate index has fallen by around 28%.[120] As Professor Bean explained, these falls in the value of sterling against other currencies have both positive and negative effects. Falls in the value of sterling make UK exports cheaper in other countries' currencies, allowing the UK's exporting industries to compete more effectively in those countries. But, significant falls in sterling could pose a risk to the UK economy, as Professor Bean explained:

An alternative scenario is one where external investors lose faith in the policy framework that the UK operates under and expect much faster rates of inflation in the future or something like that which results in downward pressure on sterling now, an old-fashioned sterling crisis, if you like. That, I have to say, I would be much more worried about, if there was a lack of support for sterling on the down side. I do not think that is the position we are in at the moment.[121]

One such disadvantage from a depreciation of sterling is that it would import inflation, as the goods imported into the United Kingdom from other countries become more expensive as the value of sterling falls. The imported inflation counteracts the positive impact of a weaker currency on the UK's exports.

36. A relatively recent major currency crisis faced by the United Kingdom was when sterling was withdrawn from the Exchange Rate Mechanism on 16 September 1992.[122] The position faced by the UK at the current time is different, as sterling currently floats freely, a point Mr Ramsden made to us while explaining that the Government had no target rate for sterling.[123] Mr Bootle told us that, at the present time, the floating exchange rate gave the UK "a massive competitive advantage against those currency areas and at the same time we are able to set our own interest rates".[124] Mr Bootle pointed out that sterling had, prior to the current devaluation, been "roughly stable at massively too high a level and much of what has gone wrong in our economy can be pinned on that".[125] Mr Ramdsen highlighted the advantages to the UK economy of its exit from the ERM, and how these might apply now:

At first we saw it in prices with exporters improving their margins and then it came through later on in volumes. What we have assumed in this forecast is that principally in the short-term the benefit effects will be from import substitution rather than from some big increase in export volumes, that UK consumers will switch more towards domestic production rather than imported production because the price of imported production will go up and then over time you will get the export volume effects.[126]

37. When questioned as to whether a further devaluation had been considered, Mr Ramsden replied that the Treasury examined "all kinds of scenarios for the economy to think about whether our forecast judgments are reasonable".[127] The Chancellor pointed to the recent volatility in exchange rates.[128] He was then asked whether there was a level of sterling that would be harmful to the economy, and in such a scenario, whether the Treasury would be prepared to support the currency. The Chancellor confirmed that he would "do everything that I can to support our economy".[129]

38. The recent fall in sterling is providing a stimulus to the exporting sections of the UK economy. However, the fall in sterling has its negative impacts, such as the risk of imported inflation, and we will continue to monitor the situation. We recommend that the Treasury include an update at the time of Budget 2009 about these negative impacts, and what mitigating measures, if any, it has taken.

RISKS TO THE NET TRADE FORECAST

39. One potential risk to the Treasury's forecast of a positive contribution from net trade to GDP growth is the impact of protectionism. The Pre-Budget Report 2008 outlined the risk as follows:

Protectionism is a major risk to global economic prospects and to lifting developing countries out of poverty. As global growth slows while global imbalances remain significant, there is a risk that countries retreat to protectionism or trade-distorting subsidies in a futile attempt to support their domestic economies. Further economic cooperation will help to boost trade and investment flows to the benefit of global growth. A successful conclusion of the Doha Round of world trade talks is a matter of urgency in terms of boosting global trade, and reassuring markets that policymakers will not repeat the mistakes of past global downturns.[130]

Mr Ramsden however told us that he was "encouraged by the G-20 meeting back in mid-November where there was concern expressed about any return to protectionism".[131] He said that he hoped that he could see "through the G-20 statements and through other statements from policymakers—that the lessons have been learned from previous downturns and that if you have a shift into protectionist action that actually prolongs the downturn rather than encourages the recovery".[132] He then stated that the UK's position as an open economy meant that the UK was "at the forefront, I think, of making a case for free trade, for wanting to see progress on Doha and for stressing the risks and costs to a return to protectionism".[133]

40. However, the impact of a fall in sterling in providing a stimulus to exports depends on the size of the capacity of the exporting sectors of the country's economy. Questioned as to whether the size of the UK's manufacturing export capacity had diminished, and whether this had been taken into account, Mr Ramsden said that "Obviously our forecasts are based on the size of the manufacturing sector as is and we have tried to factor in that effect".[134] The Chancellor acknowledged that "There may be less manufacturing around—if you remember, it really suffered a great deal in the recession of the early 1980s and took a long time to continue," but pointed out that " in engineering, pharmaceutical, the bio-tech industries, aviation, we have been able to compete pretty well".[135]

41. The rebalancing of the UK economy will require healthy UK exports, along with adequate access to foreign markets. We endorse the Treasury's anti-protectionist stance.

Business Support

42. The ongoing dislocation in financial markets, and the economic slowdown, has begun to affect companies outside the financial sector. In November, newspaper reports suggested that the Secretary of State for Business, Enterprise and Regulatory Reform, Lord Mandelson, was considering whether to provide direct government support to industry.[136] Mr Bootle was hesitant, but suggested such support could potentially be justified:

If you believe in markets, and admittedly the number of people who do seems to be falling by the month, you would think that sort of issue is best left to the markets. Governments do not have a very good record in making that sort of judgment. I would hope that we did not go down that particular route, but perhaps in thinking about the agenda that I mentioned before and those industries which had some key strategic reason to continue but which for some reason or another the market would not support, if we tried to think about market failure, why would an industry that we thought was particularly significant not receive the support of the market, and in those circumstances it might be justified to support them.[137]

When we asked the Treasury whether it had been involved with these discussions on supporting industry, Edward Troup, Director, Business and Indirect Tax, at the Treasury suggested that the Treasury and the Department for Business, Enterprise and Regulatory Reform were working together as follows:

If you have had a chance to look at the Strategic Challenges document which we published alongside the PBR, you will see in paragraph 4.2 it says: "The Government has an important role to play in recognising those business activities in which the UK has relative strengths. By working closely with industry sectors the Government could help identify barriers to growth." I think that is almost exactly what the Secretary of State for Business, Enterprise and Regulatory Reform said at the Hugo Young lecture last week when talking about the phrase "industrial activism" when he said: "It means recognising that by investing the right way in people and infrastructure and joining up the relevant decisions taken by government, we can dramatically improve our chances of coming out ahead. We need to focus on areas of policy like technology, skills, regulation, investment and export markets and how we set the relevant conditions for business success." I think those two statements are almost exactly the same and I think they reflect the way the Treasury and the Department for Business are working together on this.[138]

The Chancellor did not dismiss suggestions that support might be available. He told us that "for understandable reasons, unless the person who approaches us chooses to make it public, we do not intend to make public people's approach if they think they might need assistance in difficult conditions, because it could be quite unhelpful, but what I am saying is we would look at all these things on the merits".[139] He also pointed to examples of support given to industry by the Government in the past, such as that provided to Vauxhall.[140]

43. On 14 January 2009, the Government set out details of business support package announced in the Pre-Budget Report. The Committee noted that the package included the following measures:

A working capital scheme for companies with a turnover of up to £500 million a year by guaranteeing 50 per cent. of the risk on existing and new working capital portfolios worth up to £20 billion.[141]
A new enterprise finance guarantee to support up to £1.3 billion of bank loans to companies with a turnover of up to £25 million by allowing these firms to borrow up to £1 million, of which the Government will guarantee 75%.[142]
A new £75 million fund to provide equity finance to companies with viable business models that have exhausted traditional forms of finance. The capital for fund will provide £50 million of Government funding with £25 million from major banks. It will be run by professional fund managers.[143]

We have not taken any evidence on this package.

44. Support provided directly by Government to industry may be justified. Clearly, reasons of commercial confidentiality make it difficult for an open debate to take place over specific measures. However, we recommend that the Treasury, in consultation with BERR, should provide a consultation document setting out the criteria against which support packages would be considered.

2 Budget 2008, page 157, Table B3 Back

3 Treasury Committee, The 2008 Budget, Ninth Report of Session 2007-08, HC 430, page 3 Back

4 Pre-Budget Report 2008, page 166 , Table A3 Back

5 Ev 71 Back

6 Q 5 Back

7 Q 111 Back

8 Q 115 Back

9 Ibid. Back

10 Qq 111-113 Back

11 HC (2007-08) 1210, Q 69 Back

12 Q 114 Back

13 Q 115 Back