Abstract
This 2001 Article IV Consultation highlights that in 2001, the economy of the United Kingdom grew faster than any other G-7 economy. Despite the slowdown in world demand, output grew by 2.4 percent reflecting strong domestic demand. Private consumption remained buoyant, fueled by several years of strong earnings and employment growth, low interest rates, and rising housing wealth, which largely offset the adverse impact of lower equity prices on consumer spending. Following several years of robust growth, private investment was hit by the downturn in the information and telecommunications sector.
Let me begin by expressing my authorities’ appreciation for the work of Carlo Cottarelli and his team. As always, staff have produced an extremely interesting report and my authorities will take careful note of their comments.
Economic fundamentals
The economic fundamentals in the UK remain sound: growth in 2001 of 2.4%, inflation at 2.6% (1.6% HICP), interest rates at 4%, and employment at a record rate of over 74%. Growth slowed during 2001 and is expected to remain below trend during the first quarter of 2002, reflecting the global slowdown. But with improving world conditions from the middle of 2002, and supportive UK monetary and fiscal policy, my authorities expect growth of 2 to 2½% in 2002 and 2¾ to 3¼% in 2003. Inflation is expected to remain close to target over the next two years.
Short-term prospects and the policy framework
My authorities agree with staff that the new policy framework and sound fundamentals mean that the UK is better placed than in the past to cope with turbulence in the world economy. However, as staff note, there are risks. A weaker global recovery poses a clear downside risk to the UK. Continued weakness in business investment or unexpected falls in asset prices would also have implications. Conversely, a stronger global recovery or unexpectedly strong domestic consumption could pose upside risks.
So my authorities will continue to set policy on the basis of the macroeconomic policy framework established in 1997, and based on the principles of transparency, responsibility and accountability:
Fiscal policy set according to two fiscal rules:
the Golden Rule - over the cycle, the Government will borrow only to invest;
the Sustainable Investment Rule - over the cycle, public sector net debt will be held at a stable and prudent level, defined as 40% or less;
Monetary policy set by the Bank of England’s Monetary Policy Committee (MPC), with responsibility for achieving a symmetric inflation target, set at 2½%. An ‘open letter’ system provides transparency should inflation move more than 1% from target either way.
The symmetric inflation target allows the MPC to act to support growth when inflationary pressures are weak: interest rates were cut seven times - by a total of 200 basis points - over the course of 2001. They will remain vigilant and forward-looking to ensure that inflation remains at or near target.
On fiscal policy my authorities will remain prudent and cautious, with policy guided by the fiscal rules. Public sector net debt has fallen from 44% in 1996/97 to around 31% in 2001/02, and is projected to remain at this level over the medium term. My authorities’ medium term fiscal projections are based on cautious and independently-audited assumptions. They show public sector net borrowing of around 1% over the medium term, reflecting the plans for public investment. Even on the most cautious assumptions, the UK is on track to meet the fiscal rules over the cycle.
My authorities have noted staffs proposal on the sustainable investment rule (paragraph 22). They agree with staff on the importance of clarity and predictability in fiscal policy. But they think that these objectives are best served by the existing framework. They also note that stability in the framework over time further enhances the credibility of fiscal policy.
The staff report discusses the contrast between the current conjuncture and the situation towards the end of the 1980s. My authorities agree with staff that any imbalances are likely to be resolved gradually, provided prudent policies are maintained. In particular, they note that output is close to trend, inflation is low and stable, consumption growth has been driven by strong underlying fundamentals, and households’ debt-servicing costs have remained stable and affordable over time, suggesting that debt levels are sustainable.
Medium and Long-term Issues
My authorities agree with staff that the main structural challenge is to raise productivity. This is the key to higher long-term growth and living standards. They have therefore set out a strategy, based on macroeconomic stability and microeconomic reform, to tackle the productivity gap. Specific reforms have already been introduced to strengthen competition, stimulate enterprise and innovation, support investment, increase participation in the labour market, improve skills and training, and raise public sector productivity. My authorities will continue to pursue this agenda over the coming years.
Staff rightly note the legacy of under-investment in public services. In 1996/97, public sector net investment stood at 0.6% of GDP, having fallen by 15% annually in real terms between 1991/92 and 1996/97 and leaving the UK with the lowest level of public investment of any large EU country. As staff note, the result was a deterioration in public services, which has been a major issue of recent debate. My authorities are determined to address this. They have therefore set out medium-term plans, consistent with the fiscal rules, for substantial increases in the funding of essential public services, including a rise in net public investment to 1.8% of GDP by 2006/07.
However, the key issue is not the level of spending but the quality of the public services delivered. My authorities agree with staff on the need to improve efficiency and effectiveness. To that end, they have introduced results-based Public Service Agreements (PSAs), with each department publishing clearly-designed output indicators. This output-oriented approach will guide the forthcoming spending review. Furthermore, through Public Private Partnerships (PPPs) my authorities continue to work actively with the private sector to improve the provision of public services. PPPs will enhance investment, encourage innovation and bring the expertise and efficiency of private sector practices into public service delivery.
My authorities’ policy on the single European currency remains unchanged. In principle they are in favour of UK membership; in practice, the economic conditions must be right. They will make an assessment of the five economic tests for UK membership within the first two years of this Parliament. This assessment will be rigorous and comprehensive, and will be published. On the basis of this assessment my authorities will decide whether to recommend membership to the UK Parliament, and then to the British people in a referendum. The assessment has not yet started but the necessary preliminary and technical work is underway. My authorities published further details of this work in November 2001.
My authorities agree with staff that the financial sector remains sound. They look forward to continued cooperation with staff on financial sector issues in the context of this year’s FSAP. As staff note, the UK meets the forty recommendations of the Financial Action Task Force (FATF). The UK also complies with the eight special recommendations agreed by FATF in October 2001 and has established a Financial Intelligence Unit. The Financial Services and Markets Act 2001 strengthened existing legislation against money laundering and gives the FSA enforcement powers against non-compliant institutions. Since completion of the staff report, legislation has been passed implementing the OECD anti-bribery convention (see paragraph 34).
Conclusion
The benefits of the new policy framework can be seen in sound fundamentals. My authorities are cautiously optimistic about the outlook. But there are risks and they remain vigilant to them. They are also committed to meeting the challenges of closing the productivity gap and improving public services.