Rising energy prices and sharply decelerating house prices combined to create a challenging environment for U.K. policymakers in 2005. But the economy, which has recorded strong, steady growth in recent years, is proving resilient. In effect, the stresses of the past year have amounted to the toughest test yet for the country’s widely respected monetary and fiscal policy frameworks, say Susan Schadler, Deputy Director of the IMF’s European Department, and James Morsink, Division Chief for the United Kingdom. They discuss with the IMF Survey why these frameworks may also provide worthwhile examples for other countries facing similar challenges.
Schadler: Other countries can learn much from the United Kingdom’s strong, clear, and transparent policy frameworks, which have made important contributions to its robust and steady performance over the past decade. Particularly in the face of the increase in energy prices and deceleration in house prices in the past year, these frameworks have really proved their mettle.
Monetary policy is formulated in an inflation-targeting framework. The independent Monetary Policy Committee, comprising experts from outside and inside the Bank of England, makes decisions on interest rates with the objective of keeping inflation at the 2 percent target. This framework has produced decisions that seem well considered and consistently appropriate.
The fiscal framework has three pillars: clear fiscal rules—the golden rule over the cycle (requiring the current budget to be in balance or surplus, on average, over a business cycle) and a limit of 40 percent of GDP on net debt of the public sector—that guide decisions about budgets with a medium-term focus while allowing for policy to be countercyclical; transparency requirements; and a medium-term budgeting framework with multiyear spending allocations.
In recent years, this framework has been tested. Starting in FY2000/01, the government increased investment and current spending to meet concerns about the adequacy of public services. When revenues increased less rapidly than the government had projected, however, the deficit grew. Adjustment measures are now needed to bring the fiscal position back in line with the golden rule over the cycle.
To the credit of the fiscal rules, the need for this adjustment is quite transparent. Performance of fiscal policy can be judged against the rule, and there can be a clear discussion about the size of the required adjustment. The IMF staff has taken the position for several years now that an adjustment is needed. The government has been slower to come to this view, but it now has plans that entail immediate measures—such as increased taxation of North Sea energy production—and, starting in FY2008/09, restraint on the growth of current spending. Whenever there is such back-loaded adjustment focused on spending restraint, it is easy to ask whether and how it will be done. The government, however, has clearly committed itself to spending restraint, and the staff has commended this forward-looking commitment. We believe the fiscal framework will help ensure that the commitment becomes reality.
Morsink: There are two important lessons. First, a soft landing is possible. The growth rate of U.K. house prices slowed sharply between mid-2004 and mid-2005, but so far there has been no decline in house prices. This is in sharp contrast to the experience of the early 1990s, when a boom rapidly turned into a bust, with significant declines in nominal U.K. house prices. Second, even though house prices appear to have achieved a soft landing, the growth rate of private consumption slowed sharply. House prices can affect consumption through effects on the value of household wealth and of the associated collateral that may be used as a basis for borrowing. House prices and consumption may also be positively related because they may both be driven by the same variables, such as expectations of income growth. In an IMF Selected Issues Paper, Dora Iakova found that, in the United Kingdom, a 10 percent decline in housing wealth has, in the past, tended to reduce private consumption by about 0.7 percent. The slowdown in house prices in 2004-05 thus explains much of the decline in private consumption growth.
Schadler: Productivity growth in the United Kingdom over the past decade has been strong, exceeding the average in other Group of Seven countries. However, there is still a 5-10 percent gap in the level of output per hour. We support the government’s strategy of addressing the five main drivers of productivity growth (innovation, enterprise, competition, investment, and skills), including its current focus on regulatory reform.
Morsink: In most countries, fiscal sustainability is the key concern. In other words, there are now doubts about whether the promises once made can be kept. The U.K. solved this problem several decades ago by shifting the indexing of key elements of the state pension system from wages to retail prices, which rise more slowly. Because the generosity of its state pension system had already been reduced, fiscal sustainability is not now the key issue. However, a frugal state pension system works only if individuals save enough for their own retirement. Unfortunately, there is growing evidence that many people are not saving enough, and this may force future governments to increase the generosity of the state pension system.
To address this issue, the Pensions Commission recently recommended three things. First, it said that the United Kingdom should create a national defined-contribution pension scheme with automatic enrollment and low operating costs to address the difficulty many people face in making rational long-term saving decisions and the high cost of many privately run pension schemes. Second, it suggested improving incentives to save by reducing the projected spread of means testing in the state pension system. On current policies, means testing will cover about three-fourths of pensioners by 2050, and this is likely to have adverse effects on the incentives for saving. And, third, it urged that the pensionable age be raised to 67 from 65 by 2050 to take account of rising life expectancy. This is important to help pay for the increased generosity of the state pension system. These recommendations are a very good first step in developing a national consensus in the U.K. on how to raise private saving while ensuring fiscal sustainability. They are good ideas that other countries, with similar pension systems, should consider.
Schadler: As a highly open and quite flexible economy, the United Kingdom is at the cutting edge of economic policies and developments—whether in the refinement of policy frameworks or ways of dealing with globalization. Exploring and understanding how the United Kingdom copes with general trends and specific shocks influencing all advanced economies will therefore remain the most intriguing aspect of the IMF’s annual Article IV consultations with the country. Let me mention a few issues that will be challenges for the years to come and on which we hope to focus our work next year.
First, we want to look at what has been and could be the effect of immigration on potential output, inflation, and, more generally, monetary policy decision making. This year, we briefly examined the United Kingdom’s experience as one of three European Union members to fully open its borders to migration from the 10 new members. Our report underscores that additional inflows since May 2004 have been moderate—about ¼ of 1 percent of the working-age population—with few signs of significant displacement of local workers. In fact, inflows may have had the beneficial effect of relieving skill shortages.
How globalization affects the U.K. economy is another issue that we want to focus on. A first and obvious impact is on inflation, where we’ve seen goods prices—heavily influenced by import prices—increase very little or even fall over the past few years. The questions are, how much is globalization influencing inflation, and could this influence allow greater scope for easing monetary policy without inflationary consequences?
Finally, on the fiscal framework, we will continue to ask whether refinements—particularly of the golden rule over the cycle—are possible. The framework’s strengths are that it is concrete—once the cycle is defined, the rule is clearly testable—and that it explicitly allows fiscal policy to play a countercyclical role—the budget can be in surplus in good years but in deficit in weak years and the rule will still be met. But a weakness is its dependence on the definition of the cycle. Particularly toward the end of a cycle, there is much room for reasonable economists to disagree. We will ask whether, once current balance has been restored, a rule with a more forward-looking focus would be a clearer and more binding guide for fiscal policy in a country that, in fact, has very mild cycles.