Dora Iakova

Robust economic growth, low inflation, and falling unemployment have marked the economic performance of the United Kingdom over the past decade. Recent IMF staff research has focused on key policy challenges during that period—implementation of the fiscal policy rules, addressing the causes of a wide productivity gap, assessing the case for joining the European Economic and Monetary Union (EMU), and monitoring financial sector risks. Staff papers have also examined the rapid rise in asset prices, the causes of low inflation, the effect of rising oil prices, and the impact of outsourcing on employment growth.

The United Kingdom’s fiscal policy framework—based on a golden rule (current balance or better over the cycle) and a debt ceiling (40 percent of GDP)—is one of the strongest among industrial countries. IMF staff research has focused on both theoretical and practical issues in the implementation of the framework. Koeva (2005) points out that the asymmetry of the golden rule (which does not allow the cumulative current balance to be negative over the cycle) implies that there is a positive probability of breaching it, even if a significant safety margin is maintained. Her simulation, based on the historical distributions of output and asset price shocks, suggests that the average current surplus needed to meet the golden rule with 75 percent probability is about one-half of 1 percent of GDP, but rises to 2¼ percent of GDP if the rule is to be virtually always met. She concludes that guarding against all shocks can be too costly and that the uncertainties should be explicitly acknowledged.

The recent widening of the fiscal deficit has raised concerns about breaching the debt-ceiling rule over the medium term. Using the IMF’s Global Fiscal Model, Botman and Honjo (2006) examine the output effects of different timing and composition of fiscal consolidation. They find that early fiscal adjustment, focused on containing the growth of spending, would have the most favorable impact on output. Long-term fiscal challenges strengthen the case for fiscal consolidation. Honjo (2006) estimates that health spending is likely to rise by nearly 6 percent of GDP by 2050. The projected increase in pension liabilities is relatively modest, since the current government strategy emphasizes reliance on voluntary private saving. Koeva (2004) warns, however, that there may be significant contingent liabilities if the strategy is not successful and people do not save enough for retirement. In recognition of this problem, the government is now considering ways to reform the pension system.

The robust growth performance over the last decade has been accompanied by a low and steady inflation rate. That has been attributed, in part, to the credibility of the monetary policy framework. Staff research based on an open-economy Phillips curve finds that changes in import prices (especially oil prices), external competitive pressures, and changes in employment have also contributed to the favorable inflation performance (Batini, Jackson, and Nickell (2005) and Honjo (2005)). Honjo (2004) examines the effectiveness of monetary policy more generally. Her analysis suggests that the interest sensitivity of output in the United Kingdom, the United States, and the euro area are similar, but the main channels through which interest rate changes affect output differ. In the United Kingdom and the United States, consumption is highly sensitive to changes in interest rates, while investment is more responsive to interest rate movements in the euro area.

The recent increase in oil prices posed a dilemma for monetary policy as it entailed a growth slowdown and an acceleration of inflation. Using the IMF’s Global Economic Model, Hunt (2006) shows that a permanent increase in energy prices leads to a spike in inflation and a reduction in the economy’s supply capacity. The inflation effects are not expected to persist if the negative supply-side implications are incorporated into the policy-setting process and workers accept a decline in their real consumption wage.

House prices in the United Kingdom have risen three-fold over the last decade—faster than in almost any other industrial country. Vladkova Hollar (2003) assesses the extent to which house price increases can be explained by fundamentals. Her analysis, focused on demand-side factors, suggests that prices are currently above their estimated long-run equilibrium. Schule (2005) uses regional data to look at the effect of property taxes on house price inflation. Iakova (2006) finds a strong link between changes in housing wealth and private consumption growth. Hunt (2005) discusses the range of appropriate policy responses in the event of a slowdown in economic growth induced by a negative asset price shock. Using the IMF’s Multimod model, he finds that monetary policy can effectively mitigate the impact of the shock without having the negative effects on the stock of debt that a fiscal policy response would entail.

Although both GDP growth and productivity growth over the last decade have been higher in the United Kingdom than in most other advanced economies, a large gap in labor productivity remains. Improving the productivity performance has been the focus of active debate and numerous policy initiatives. Using growth-accounting decomposition, Escolano (2003) finds that the U.K. productivity gap can be attributed mainly to low total factor productivity (TFP). He discusses various policies that can increase TFP, including stimulating research and development, enhancing competition, and increasing human capital. The paper also argues that increasing productivity would not necessarily require a higher capital-output ratio, although the U.K. ratio appears to be lower than those of most European countries. A cross-country study of investment flows (Koeva, 2003) establishes that U.K. equipment investment—the part of aggregate investment most closely related to productivity—is comparable to those of other Organization for Economic Cooperation and Development (OECD) economies.

The U.K. economic performance has benefited from a highly developed financial sector. Recent staff research has focused on specific areas of potential risks. Rapid financial innovation has allowed banks to transfer credit risk outside the banking sector. Chan-Lau and Ong (2006) find that credit derivatives and structured credit markets do not pose a substantial threat to financial sector stability at this point, given the diversity of holdings across major financial institutions. More broadly, Ong and Andersson (2006) provide an update on developments in key areas identified in the 2002 Financial Sector Assessment Program and assess current risks facing the U.K. financial sector.

A common concern in industrial countries in recent years is that the rise in outsourcing could lead to a loss of domestic jobs. In a case study of the effects of outsourcing in the United Kingdom, Amiti and Wei (2005) find no evidence that sectors with high growth of outsourcing have lower rates of job growth.

The U.K. government policy on EMU membership includes a commitment to the principle of joining the EMU when the economic case for euro adoption is “clear and unambiguous.” Cottarelli and Escolano (2004) take a critical look at the detailed assessment of the case for euro entry published by the authorities in 2003. They suggest areas that deserve to be explored further in future assessments and point out that in several areas relevant to the entry decision, the margin of uncertainty will remain significant, regardless of any reasonable attempts made to reduce it.