The Rt Hon Sir Edward George: The economic prospect
Speech by The Rt Hon Sir Edward George, Governor of the Bank of England, at the JiJi Press London
Top Seminar, London, 30 May 2001.
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Mr Chairman, I am delighted to join you today for this Jiji Top Seminar and to have this opportunity to
meet with so many senior representatives of the Japanese business - and financial-community here
in the UK.
I have chosen to speak in my opening remarks on "The Economic Prospect", which today more than
ever means the international economic prospect. But before I come to the immediate situation, let me
say just a few words about what it is that we are all trying to achieve through our overall approach to
economic management, which can perhaps best be summed up as "macro-economic stability and
supply-side flexibility" - though that characterisation needs elaboration.
On the macro-economic side we have learned - and it has taken some countries longer than
others - that you cannot achieve what we are all trying to achieve - sustained growth, high levels of
employment and rising living standards - simply by pumping up demand in our economies through
expansionary monetary and fiscal policies without proper regard to the underlying supply-side capacity
of our economies to meet that demand. Short-term demand management through monetary policy too
often led instead to accelerating inflation, and increasing external deficits, which had then eventually to
be brought under control through recession - an absolute recipe for short-termism in both financial
and business behaviour. Equally, excessive public expenditure - which had ultimately to be financed
through higher taxation - imposed burdens on the private sector which weakened its capacity to
generate employment and income and wealth.
So the emphasis now, throughout the industrial world but increasingly too in the developing, emerging
and transition economies, is on effective price stability as the immediate objective of macro-economic
policy - not simply as an end in itself but as a measure of the balance between aggregate demand
and underlying supply in the economy as a whole. In effect the aim of monetary policy in particular is
to moderate, rather than aggravate, the economic cycle, and so to provide the basis for sustainable
growth at around the underlying rate of growth of productive, supply-side, potential. And the emphasis
now in relation to fiscal policy is to limit public sector borrowing, and the outstanding level of public
sector debt, to levels that can be sustained into the medium and longer term without the need for
increasing tax burdens or the imposition of rising real interest rates on the private sector.
Of course on occasion the flesh proves to be weaker than the spirit - and achieving these
macro-economic objectives is not easy in practice even as a technical matter. But the intention - the
international commitment to macro-economic stability - is clear.
Acceptance of the aim of macro-economic stability served to bring into sharper focus the structural,
supply side, of the economy - that is the whole raft of influences that can affect the underlying growth
rate of capacity and thus the growth rate of aggregate demand that can be sustained.
And here, too, there has been a strengthening international presumption in favour of open markets
and free competition - both domestically and internationally - with a continuing strong presumption
against predatory trade or exchange rate manipulation. The justification is that undistorted competition
contributes to potential global economic growth through increased efficiency and the more effective
allocation of productive resources. Faster growth in turn provides a more favourable context for
addressing social concerns, including the issue of poverty.
The international presumption in favour of free markets in itself is somewhat remarkable, given that, at
the micro-economic level, increased competition invariably constitutes a threat to established
producers - and their employees - who might well be tempted to urge protection in one form or
another on their national governments. Consumers, who benefit from such competition, tend to be less
vocal or well organised. The threat of protectionism is never, therefore, far away. But in fact the
presumption in favour of competition has proved encouragingly robust. And that is not just in relation
to international trade. There is a parallel presumption in favour of freedom of capital movements, and
much greater openness around the world to foreign investment.
Among other things on the supply-side, there is a shared emphasis on the need to direct public
spending to developing human resources through education and training, to effective health care, and
affordable social safety nets. There has been a global trend to privatisation through which
governments have increasingly returned essentially commercial activities, in which they have no
necessary comparative advantage, to market disciplines. And there is a common recognition of the
need for reforms in labour and product markets designed to remove unnecessary regulation, and to
reduce distortions, which impede the efficient allocation of resources.
But broad agreement on the principles, does not make them any easier to apply in practice. This is
evident from the imbalances which have built up within and between the major industrial countries in
recent years. It is uncertainty as to how those imbalances are likely to be corrected that underlies
much of the current concern about the prospects for the global economy.
The major uncertainty relates to the situation in the United States which has experienced a period of
exceptionally strong economic growth with relatively low inflation until quite recently. Briefly - and no
doubt oversimply - this very strong performance is widely seen as driven largely by exceptional
productivity gains, as the application of new information and communications technologies spread
through the economy. This development promised a higher sustainable rate of growth in the US
economy and higher corporate earnings growth. That expectation contributed to a rapid rise in equity
prices, especially in the "high tech" sectors, which in turn helped stimulate both business investment in
the US and consumer demand causing the private sector to move into financial deficit. It also attracted
massive direct and portfolio investment inflows from abroad which over-financed an increasing current
account deficit in the US and caused the dollar to strengthen against other currencies. By the first half
of last year the US economy was expanding at a rate of over 5%, which even on the most optimistic
view of underlying productivity growth was clearly unsustainable. The pace of demand growth in the
US needed to slowdown - as of course it has.
The big questions now are about the extent of the slowdown and how long it will last. And the reality is
that no one can be confident that they know the answers.
What we do know is that the US data on the whole have not so far been as weak as many
commentators predicted. Consumer spending in particular has held up reasonably well, though there
has been a fall-off in investment growth, as well as a sharp downwards stocks adjustment and an
associated decline in US imports. On an optimistic view, if consumption continues to hold up, and
assuming that the recent underlying productivity gains can be maintained, investment spending will
recover as the spread of ICT through the economy resumes, and the downward stock adjustment will
come to an end.
On this view we can look forward to a pick up in US activity as we move, say, into next year. But the
pessimist is inclined to point to the weakness of private sector saving, which could induce more
cautious consumer behaviour especially if unemployment continues to rise; he points to a possible
overhang of past investment excesses; and he points to the US external deficit which will at some
point need to be corrected. These adjustments might take place gradually over time, in which case the
US might face a more protracted period of relatively slow growth; or, if you are really pessimistic, the
adjustments might be more abrupt implying a possible period of negative growth and global financial
instability. The recent somewhat erratic recovery of US stock markets from their earlier gloom
suggests that they are beginning to side with the optimists; some of the survey evidence of consumer
and business confidence on the other hand still supports a rather more pessimistic view. For what it is
worth, and given the strong policy response in the US, I am modestly optimistic, but I recognise the
downside risks. The outcome is obviously the major uncertainty surrounding the global economic
prospect, and policymakers elsewhere can only monitor, continuously and very closely, the emerging
evidence and react to that in the light of its likely impact on their own situation.
The US slowdown comes at a particularly bad time for Japan which is already suffering from a
combination of weak domestic demand - particularly consumer demand - and supply-side constraints
reflecting pressures on the banking system, heavily burdened with non-performing loans, and an
acknowledged need for restructuring parts of the non-financial sector. Japan has pretty well exhausted
the scope for macro-economic stimulus. Successive fiscal packages focussed on public works, and a
sustained period of attempted monetary expansion, at near-zero interest rates in the face of deflation,
have failed to overcome a high rate of precautionary saving by an ageing population facing an
uncertain economic future. The policy emphasis of the new Japanese administration appears to be
shifting towards firmer action to bring about supply-side reform in the belief that this will help to
engender greater confidence. The danger is that, to the extent that more aggressive restructuring
results in bank ruptcies and higher unemployment in the short term, that in itself might tend to weaken
consumer demand for a time before the benefits of the restructuring come through. I make no
judgement about the prospects in Japan. You certainly are better placed to do that than I am!
Closer to home in this country, the Euro area economy is a good deal better placed to withstand the
US slowdown, although we are all bound to be affected to some degree. For most of last year the
Euro area economy performed relatively strongly, with overall output growth well above trend, and
unemployment in the area as a whole continuing to fall from its earlier chronically high level.
A problem, of course, was the persistent weakness of the Euro in foreign exchange markets, despite
strong "fundamentals" in terms of conventional analysis. This was largely the result of an outflow of
capital, much of it drawn into the US by the magnetic attraction of prospective corporate earnings
growth - and apparently continuing despite the US slowdown.
The euro's weakness gave rise to widespread - but in my view unjustified - criticism of the ECB. The
task of a central bank operating an independent monetary policy is necessarily a limited task, not least
because it effectively has only one instrument - its control over short-term interest rates. Its role - as I
said earlier - is essentially, to use that instrument to influence aggregate demand in the economy, with
the aim of keeping demand broadly in line with the supply-side capacity of the economy. The measure
of its success is consistently low inflation. Against that criterion the ECB has been relatively
successful. The Euro area economy has grown, above trend, with core inflation nevertheless
remaining within the tolerance range of 0-2%, even though on the headline measure, influenced by
rising oil prices and the weaker exchange rate, inflation has for the time being moved above the top of
that range. The ECB would have put that internal stability of the Euro area as a who le at risk if it had
attempted at the same time to use monetary policy to target the euro's exchange rate, which is what
implicitly many of its critics were effectively suggesting that it should do.
The more recent criticism has been that the ECB has been slow to respond to the weakening of the
US economy. Implicit in that criticism is no doubt a judgement about the extent and duration of the US
slowdown and its likely impact on the euro area. As I have said there is a great deal of uncertainty
about that.
But the ECB has to take account, too, of domestic demand pressures in the euro area, and of the fact
that even on the core measure Euro area inflation has been moving up gradually towards the top of
the ECB's 0-2% range. Frankly I don't see how anyone can be confident whether the ECB has it
precisely right or wrong - it is perfectly normal for even the best-informed people to disagree on these
judgements, as anyone who reads our own Monetary Policy Committee meeting minutes will tell you.
But, as it showed just recently in making a modest reduction in interest rates, the ECB is sensitive to
changes in the balance of risks around those judgements.
So, too, are we in the United Kingdom. In our case we have been fortunate, since being driven out of
the ERM in 1992 and moving to a symmetrical inflation target, in enjoying a sustained period of
relatively stable economic growth. In fact we've experienced the longest period of continuous quarter
by quarter growth since quarterly records began, with average annual growth at around 3% over the
whole period compared with our long term trend rate of 21⁄4-21⁄2%. Employment has steadily increased,
and unemployment has fallen to its lowest level for 25 years. Meanwhile the rate of inflation has been
consistently relatively close either side of the Government's 21⁄2% target - the lowest and most stable
rate of inflation that most of us in this country can remember. Domestic demand growth in the UK has
remained relatively robust into this year, but we too are affected by the US slowdown and by the
associated weakening of equity prices. And we have had a new problem of our own in the form of Foot
and Mouth Disease, the effects of which have gone a good deal wider than just the agricultural sector.
These new developments were likely to have a dampening effect on overall demand pressure within
the economy, both through their direct impact and through possible damaging effects on confidence.
Given the fact that we started from a position in which inflation was below target (and expected to
remain so for some period ahead); and given only modest upward pressure - at least so far - on
wages and earnings growth, despite the continuing tightness in the labour market; we have judged, on
the information so far available to us, that we needed to reduce interest rates by 3⁄4% in order to
cushion the impact of the global slowdown and meet the inflation target further ahead.
Of course I am well aware that a stable overall macro-economy does not - and cannot - mean equally
stable economic conditions for every individual sector or individual business. A particular complication
over the past few years has been the surprisingly persistent strength of sterling's exchange rate
against the euro, itself a reflection of the puzzling more general weakness of the European currency.
This has contributed to an uncomfortable imbalance within the UK economy primarily between the
euro-exposed sectors, which have been under consistent pressure, and the domestically-oriented
sectors, which have by and large been doing relatively well. Understandably the suffering sectors and
businesses - and I know that they include some Japanese companies operating in this country - tend
to complain that monetary policy takes too little account of their position, often pointing out that
inflation has for the past two years fallen somewhat below the target. The implication is that monetary
policy has been tighter - interest rates have been higher - than was necessary, which, they say, in
turn at least helps to explain the behaviour of the exchange rate.
I have genuine sympathy with their concerns, and I very much admire the huge efforts that many of
the adversely affected businesses have made to overcome the disadvantage coming from the strong
exchange rate. If it's any comfort, I can assure you, that the resulting imbalance within the economy
has been a persistent pre-occupation also for us on the MPC.
We necessarily, of course, take account of the exchange rate in trying to predict the future course of
the economy. Its strength against the euro has been a factor which has dampened both external
demand and the rate of inflation, so that interest rates have certainly been lower than they would have
been if the exchange rate had been weaker. It is nevertheless true that, in common with most other
analysts, we have not fully anticipated the persistence of euro weakness.
We don't of course have a crystal ball - but even if we had, it is important to recognise that the link
between relative interest rates and exchange rates is much more complicated - and indeed more
unpredictable - than is often suggested. Our own exchange rate against the euro today, for example,
is stronger than it was before our reductions in interest rates this year; and the dollar, too, is
substantially stronger against the euro than it was before the much larger cuts in US interest rates. So,
in setting interest rates, we can - and do - make allowance in our projections for what has happened,
and, on a best guess, for what is likely to happen, to the exchange rate, and that may cause the
exchange rate to soften or it may cause domestic demand growth to strengthen, thereby offsetting the
exchange rate's dampening effect on the economy. But what we cannot do - any more than the
ECB - is to target the exchange rate, without putting the stability of the economy as a whole at risk of
re-emerging inflation. That would not be in the interests even of the internationally-exposed sectors of
the economy except possibly in the short term. They operate in the same labour market as more
domestically-oriented businesses; and what matters to them is the real, rather than the nominal
exchange rate, and it is not at all clear how that would be affected.
Mr Chairman, given the uncertainties, I am reluctant to speculate as to how, precisely, the present
imbalances within and between the major industrial economies will work themselves out, as they
necessarily will over time. But, notwithstanding the current difficulties, I am convinced that the best
prospect for a relatively happy ending is for all of us to persist in our attempts to achieve the
macroeconomic stability and supply-side flexibility which I identified as our common goal at the outset of my
remarks.
I am very happy now to take your questions.