A lack of credibility is a disaster for policy-makers. Credibility is so important because most economic decisions, such as household spending or firm investments, involve making plans about the future. This also applies to decisions about price setting, such as wages demanded and paid, and prices charged by firms.

Macroeconomic policy can help with this planning if it promotes a stable economic and financial environment and convinces people that the economy will evolve in predictable ways. In that sense, macroeconomic policy is concerned with managing the expectations of different groups of people or organisations in the economy.

Fiscal credibility

When a government like the UK’s is making decisions about fiscal policy – measures related to public spending and taxation – it can finance itself more easily and more cheaply when it is credible. This is because the UK, like most countries, maintains a large stock of government debt and regularly runs deficits by spending more than it collects in tax revenue.

There is nothing wrong or unusual about this. But it does mean that the government needs to borrow money regularly. And like any borrower, prospective lenders want to be sure that they will get repaid.

Governments are not like households or firms – there is a greater expectation that the country will still be around to pay back any borrowing. They also have the power to tax to be able to make their repayments.

But governments do sometimes default on their debts and the greater the chance of this happening, the less enthusiastically lenders will make funds available. Of course, they can offer to pay back higher interest rates, and this will make it worthwhile for lenders to take the risk.

But higher interest rates mean that a greater share of government spending goes on interest payments rather than providing useful public goods and services, or reducing taxes.

The role of credibility has been particularly important in macroeconomics for around 50 years. And a key part of maintaining credibility is how institutions are set up.

For example, these days, the central bank – the Bank of England in the case of the UK – is typically independent from politicians. This allows it to make tough decisions, even at uncomfortable times, to ensure it gets as close as possible to achieving its objectives of low and stable inflation (and financial stability).

More recently, governments have subjected their fiscal plans to scrutiny by independent experts – the Office for Budget Responsibility (OBR) in the UK – while still, rightly, leaving the specific policy choices to elected officials.

This is why budgets can be costly if they are not set against a clear and credible plan to finance any new spending (or tax cuts). Even if that financing will take place over many years or even decades, the presence of a clear plan can reassure potential lenders that the policies are well thought out and sound. Transparency of plans and endorsement by an independent fiscal council provide reassurance to the markets and the public.

This is part of what made the UK’s recent ‘mini budget’ such a disaster. By declaring it as a 'non-budget', the new Chancellor rendered it outside the remit of the OBR, which would usually provide independent macroeconomic forecasts for any budget, as well as properly costing proposed policies. Immediately, lenders became suspicious and nervous.

Combined with other events, such as the recent removal from office of the most senior Treasury civil servant and repeated talk that the government was thinking about reviewing the mandate of the Bank of England, alarm bells started to ring. Loans to the UK government, because they now appeared riskier, would need to pay a higher interest rate.

Monetary policy credibility

It is not just governments that need to be concerned about credibility. Central banks equally must worry about their reputation. Academic economists don’t necessarily always agree with one other; and neither do academics and policy-makers on all issues. But one thing on which there is reasonably strong agreement is the need for monetary policy to be credible.

Central banks can more easily hit their inflation target if everyone believes that inflation will turn out to be at the target level. This is because when they make financial and economic decisions, they do so with the expectation that prices will increase by something close to the target.

So, when firms decide how much to charge for their goods or services, when workers determine what wage to ask for, or when banks choose what interest rate to charge on a loan, they base it on expecting the target rate. In doing so, they then contribute to everyone facing prices consistent with the target. It is self-reinforcing.

Alan Blinder, an American economist and former central banker at the US Federal Reserve, once wrote that ‘A central bank is credible if people believe it will do what it says’ (Blinder, 2000). But credibility is not a given: it is earned.

Indeed, the Federal Reserve’s policy-making body (called the Federal Open Market Committee, FOMC) – arguably the most powerful and credible central bank in the world – worries consistently about its inflation-fighting credentials (Cieslak et al, 2022).

Of course, there are times when it makes sense to throw caution to the wind – this is the use of credibility to provide insurance against the worst possible outcomes. But there are other moments when the potential loss of anchored inflation expectations must be taken seriously. Sometimes, the risks of the latter follow from a period when the central bank provided the insurance and prevented a potentially much-worse downturn.

The case for higher interest rates

In recent months, some commentators have argued that the Bank of England raising interest rates is counterproductive. Why, the argument goes, should the central bank raise interest rates and compound the misery of high inflation for people by increasing their mortgage repayments and the costs of debt repayment for firms? There are two answers.

The first concerns the exchange rate. When central banks raise rates, this tends to strengthen the exchange rate. A stronger (more appreciated) exchange rate means that goods priced in foreign currency become relatively cheaper: for example, oil and gas, paid for in dollars, become cheaper in terms of sterling. The opposite happens when rates are lowered.

Importantly, it is the relative movement of interest rates versus other central banks that can cause this. Even if the Bank of England raises interest rates by 50 basis points (bps or hundredths of 1%), this can seem too little when other central banks are raising by 75 bps, as the Fed has done several times recently. The ensuing depreciation of sterling introduces even greater inflationary pressure into the economy.

The second answer is credibility. This is not always intuitive. It relies on realising that the official central bank policy interest rates are only one driver of the rates that households, firms and the government itself are facing.

Like any investor, a lender worries about the return – the annual income they will receive from the borrower for use of the loaned amount. While most lending contracts are expressed in money terms (the nominal value), what really matters is the return after adjusting for inflation (the real value) because this determines the purchasing power of the return.

Lenders wanting to receive a 2% real return will have to add the inflation that they expect over the life of the loan. Lenders also worry that the future may turn out differently to how they expect. When they worry that inflation might be more volatile in the future, they increase the required return to compensate for this, in the same way that they increase the required interest rate when a borrower looks less likely to be able to repay in the future.

The central bank has two linked influences on these beliefs. The first is their framework, which, in the UK, sets the objective of the Monetary Policy Committee (MPC): to achieve a specific low and stable value of inflation (the inflation target).

The second is that the central bank takes policy actions that influence, not directly set, the real return that lenders require and hence the rates at which lenders in the economy provide loans. And the lenders must think of the amount that they will need to get over the life of the loan. This can, in the case of mortgages, be 25 years or more. Lenders need to think about what actions the central bank will take in the future.

The central bank must take policy actions to ensure that it maximises the chances that it will hit the inflation target. Sometimes these decisions are difficult ones. A former long-serving Chair of the Federal Reserve, William Martin Chesney Junior, described the central bank as ‘the chaperone who has ordered the punch bowl removed just when the party was really warming up’.

In some circumstances, such as those we face today, it is much tougher than that. It feels like central banks are taking away the water and paracetamol when everyone has a hangover. And the hangover wasn’t even because of their own over-indulgence – it feels like their water was spiked with vodka!

In a world where lenders understand that the central bank’s actions will ensure that inflation will be around target in the future, and not too volatile, the lending rate rises just because of the central bank’s action. This is where the central bank has maintained its credibility.

If, on the other hand, the central bank appears to ignore its inflation target and instead to cut rates to try to ease the burden on households, then its credibility is likely to be lost. In this case, lenders might not expect policy rates to go up, but lending rates rise anyway because the weakened commitment to the inflation target means that the lenders charge more for expected higher and more volatile inflation.

In both cases, interest rates faced by households and businesses rise. So, is there a difference between these two scenarios?

In the short run, maybe not – both are painful for households and businesses. But in a world where credibility is maintained, the central bank will at least have retained anchored inflation expectations. This gives it some chance of bringing mortgage rates down when inflation is reduced.

In the world where credibility is lost, the central bank will have to work harder, with higher interest rates for longer, to show that it really is committed to low and stable inflation again.

Central banks want to take decisions that do the least amount of damage. Building up credibility is hard, so working not to lose it can be the best option. This can even be the case if it involves short-run pain (for a discussion of the US experience in the 1970s and 1980s, see Reis, 2021).

But since tough monetary policy risks adverse effects on the economy and the financial sector, the central bank needs to strike a balance between toughness, but not counterproductive destruction. This is why it is much easier to not lose hard-earned credibility.

In those difficult circumstances, fiscal policy – changing taxation or public spending – can be used to safeguard the most vulnerable. What is not helpful is talk of weakening the commitment to low inflation (because interest rates rise).

Similarly, uncosted and unchecked fiscal plans – which cause markets to worry that the government will inflate away the debt (because interest rates rise) – can be damaging.

Further, any policies that raise interest rates increase the risks to financial stability, which make the Bank of England’s job of re-anchoring inflation expectations much harder. The monetary-fiscal mix, even in a world of independent institutions, remains important for macroeconomic outcomes.

Where can I find out more?

• Central-bank credibility: why do we care? How do we build it? Article by Alan Blinder in the American Economic Review.
• Policymakers' uncertainty: Anna Cieslak, Stephen Hansen, Michael McMahon and Song Xiao.
• The Fed pivots: goodbye soft landing – hello disinflation: by Carl Walsh.
• Losing the inflation anchor: Ricardo Reis, Brookings Papers on Economic Activity, 2021

Who are experts on this question?

• Jagjit Chadha
• Richard Davies
• Michael McMahon
• Ricardo Reis
• Silvana Tenreyo

Author: Michael McMahon

Picture by pcruciatti on iStock

The post What can happen when economic policy-makers lose credibility? appeared first on Economics Observatory.

Voters are likely to be presented with the same question on the ballot paper as in 2014, when 55% of them selected ‘no’ in answer to: ‘Should Scotland be an independent country?’

Economic issues were important to how voters chose between independence and remaining part of the UK back in 2014. If asked to choose again in a second referendum, the major economic events in the intervening years – from Brexit to the fluctuating value of North Sea oil – mean that the economic arguments in a second referendum campaign are likely to look a little different.

Amid all the uncertainty around Scotland’s future, economic research can help voters and policy-makers to understand the big decisions that an independent Scotland would face and whether its choices would be in the best interests of its economy and its people.

Should an independent Scotland re-join the European Union?

In the 2016 Brexit referendum, 62% of the Scottish electorate voted in favour of the UK remaining in the European Union (EU). The UK’s departure from the EU has fuelled the Scottish government’s demand for a second independence referendum. Indeed, polling data suggest that Brexit is a factor in attitudes to independence.

Would EU membership be in Scotland’s best interests?

There may be many reasons for wanting to be part of the EU again, but on the critical subject of international trade, research suggests that an independent Scotland may be better off outside the EU.

It is true that re-joining could expand trading opportunities with EU member states for Scotland by reducing border costs. These are the costs that stem from import tariffs, customs checks and differences in regulations between countries, among many factors.

An analysis of international trade in goods finds that border costs between EU countries are 13% lower than those between countries where at least one of the partners is not in the EU. This is why most economists expected Brexit to make the UK worse off (Sampson, 2017).

But the costs of trade between EU countries are still higher than trade costs within the same country. Border costs within the EU are 23% more than trade costs between US states, for example (Comerford and Rodriguez Mora, 2019).

Four out of Scotland's top five international export markets are in the EU: the Netherlands, Germany, France and the Republic of Ireland.

But Scotland’s biggest export market overall is the rest of the UK, comprising 60% of Scotland’s total exports, including North Sea oil, whisky and seafood.

The magnitude of the change in border costs between Scotland and the rest of the UK if Scotland were to become independent is highly uncertain, and would depend on the outcome of negotiations between the governments of Scotland and the rest of the UK.

Some estimates suggest that they could increase by 15-30% if Scotland were to remain in a common market with the rest of the UK (Comerford and Rodriguez Mora, 2019; Huang et al, 2021). This is similar to the expected effects of Brexit on trade costs between the UK and the EU (Scottish Government, 2018; Bevington et al, 2019).

On balance, research suggests that for as long as the rest of the UK remains Scotland’s most important trading partner, Scotland would be better off prioritising integration with the rest of the UK. This means not re-joining the EU. That said, there are countries that have found new markets for exports in the EU following independence, including the Republic of Ireland, the Czech Republic and Slovakia. While these changes in trade patterns are possible, they also happen over decades, if not longer.

Could an independent Scotland rely on North Sea oil and gas revenues?

The fortunes of North Sea oil and gas have been on a tumultuous journey in the past decade. They have bolstered pro-independence arguments when profits have been plentiful, but played a smaller role in independence debates at times of severe decline.

Research suggests that the sector’s recent rise in revenues – thanks to rocketing oil and gas prices – could offer a short-term boost to Scotland’s economy but cannot be relied on over the long term.

While offshore revenues played an important role in the 2014 referendum debate, between 2014 and 2020/21, the industry faced a sharp fall in the price of oil. This had knock-on effects on Scotland’s economy and North Sea tax revenues, which dropped from £7 billion a year to just £500 million.

This has had a significant impact on the onshore economy, and it is a big reason why Scotland’s economy has grown more slowly than that of the UK as a whole over the past few years.

Russia’s invasion of Ukraine has precipitated a spike in global energy prices, with oil prices rising from $18.38 per barrel in April 2021 to $117.25 in March 2022. Over the same period, gas prices rose from £0.55 per therm to £3.14. As a result, North Sea revenues soared to £3.2 billion in 2021/22 and are now forecast to reach levels not seen in over a decade.

The effect has been a slightly larger reduction in Scotland’s net fiscal balance compared with the UK’s, although it remains roughly twice the size. Scotland’s net fiscal balance fell by just over 10 percentage points: from 22.7% of GDP in 2020/21 to 12.3% of GDP in 2021/22. In comparison, the UK’s fell by just over 8 percentage points, from 14.5% of GDP in 2020/21 to 6.1% of GDP the following year.

But this revenue stream is clearly volatile, and the long-term trend for oil and gas revenues is for a phased decline. Production peaked in 1999, and remaining reserves are now in more challenging and costly areas of the North Sea. At the same time, governments – including the Scottish government – are committed to reaching net-zero carbon emissions, which means moving away from fossil fuels.

Relying on high oil and gas revenues would not be a safe long-term option for securing a sustainable source of tax income for an independent nation. Tough choices on tax and spending, and efforts to improve economic growth beyond what North Sea reserves can offer, would be needed.

Which currency should an independent Scotland use?

The question of currency continues to be controversial. Independence would offer Scotland a choice of currency and choosing one of its own would give the country control over its monetary and fiscal policy. But research suggests that sticking with sterling would have benefits for Scotland’s economy.

In the 2014 referendum, the Scottish government’s official policy was to remain part of the UK’s formal monetary union. This was despite George Osborne, then Chancellor of the Exchequer, ruling out this option. Uncertainty over currency is seen as a big reason why more people voted ‘no’ than ‘yes’ to independence in 2014.

The Scottish National Party (SNP) now says it favours the continued use of sterling even without a formal agreement. Many in the pro-independence movement favour a transition to a new separate currency in the future.

The use of sterling in an informal relationship has never been tried in a country of Scotland’s size or level of economic development. There would be no typical ‘lender-of-last-resort’ and the health of Scotland’s economy, including its public finances, would be closely tied to its balance of payments position. Scotland is currently estimated to run a deficit on both its public finances and its balance of payments.

Continuing with sterling would have the benefit of preventing an increase in the costs of trade with Scotland’s main trading partner, the rest of the UK. There are the conversion costs, but also the uncertainties that come from fluctuating exchange rates that, with them, affect the value of goods and services. The sterling option also avoids the costs of setting up a new currency – not just for government, but also for households and businesses.

It is also possible that a newly minted currency would be more volatile, at least during the early stages. In 2014, such costs were argued to be between 0.5% and 1% of GDP for Scotland – between £500 million and up to £2.5 billion (see MacDonald, 2014).

Scotland could also look to the Republic of Ireland for historical lessons on currency. Over the past century, since independence, Ireland has had five currency regimes, including sterling, its own currency and the euro. In the immediate post-independence era, sterling was Ireland’s default currency, followed in 1927 by a one-for-one peg with sterling against the Irish punt – that is, the value of the punt was tied to sterling.

Sterling was the obvious peg of choice as the UK was Ireland’s main trading partner – as would be the case for Scotland today, Irish banks had sizeable sterling assets in London, and sterling was seen as a stable currency. 

At first, this relationship cushioned the punt from the effects of global volatility – a world of economic depression and hyperinflation. But in the longer term, maintaining the sterling peg constrained fiscal policy considerably, effectively keeping the Irish economy tied to the turbulent fate of the UK’s.

Scotland’s choice of currency has major implications for its fiscal institutions too. At independence, Scotland would be likely to want to set up its own central bank and debt management office, and to expand the powers of its fiscal watchdog. Its currency would shape what these institutions could do.

For example, a new Scottish currency would not only give Scotland more power over fiscal and monetary policy, it could also allow its central bank to become involved in political issues.

Central bankers around the world may debate how far they should be involved with issues like inequality or climate change, forming policies that redistribute wealth, for example, or which manage financial risks brought by rising temperatures. But Scotland’s central bank would be limited in its ability to influence these issues without its own currency.

What would be the effects of independence on Scotland’s public finances?

Should Scotland become independent, it would need to make big decisions to ensure a better balance of public finances. As things stand, it is likely to have a large budget deficit – the gap between public spending and tax revenues – which may mean its government would have to make spending cuts or increase taxes.

One major consequence of independence would be that Scotland would have the power to oversee the collection of broad-based taxes, such as income tax and VAT. Even though the Scottish government can vary tax bands and rates on income tax, administration is still undertaken by HM Revenue and Customs (HMRC).

Total public expenditure – which comprises spending by the UK government for and on behalf of the people of Scotland, as well as Scottish government spending in devolved areas – is currently higher than tax revenues raised in Scotland (hence the negative net fiscal balance mentioned earlier).

For example, during the period between 2014/15 and 2019/20 spending per person in Scotland was £1,550 (or 12.3%) higher than the UK average, while tax revenues were £325 (or 2.8%) lower per person. 

In the short term, independence might weaken Scotland’s economy and reduce rather than increase tax revenues. A harder border between Scotland and the rest of the UK, for example, would suppress trade.

To avoid higher taxes or lower spending continuing in the longer term, stronger growth would be needed post-independence to make up for the loss of money from the rest of the UK. This longer-term picture would depend on how Scottish policy-makers choose to respond to the challenges and opportunities presented by independence.

Independence would give the Scottish government additional powers – currently held by the UK government – potentially to strengthen the economy. Faster growth is easier to promise than deliver, and many of the key elements of a successful economic strategy would take time to have an impact.

There are a number of policy areas where a different path might be taken. For example, independence would give Scotland an opportunity to develop a different immigration policy to the UK’s. This might help to attract skilled migrants into Scotland and ease the pressure of the country’s ageing population and skill shortages.

Similarly, there may be opportunities to use trade policy to shift trade away from the UK and towards other countries, as Ireland did in the late 20^th and early 21^st century. But these changes take time, with changes in trade patterns likely to take decades rather than years.

What can Scotland learn from other countries?

There is no precedent for establishing a new economically advanced country, which adds to the uncertainties when debating Scotland’s future. But in making its choices around whether to be independent, and what to do with independence if achieved, Scotland could turn to other newly independent and/or small countries for economic inspiration.

Other countries may offer hope that things could work out well for an independent Scotland in the long term, despite initial economic difficulties.

The experiences of Ireland and the Czech Republic/Slovakia offer some clues to life post-independence. Disruption and short-term costs followed the split of Czechoslovakia in 1992, for example, and unemployment in Slovakia rose sharply. But the longer-term picture has been one of rising prosperity.

Both the Czech Republic and Slovakia joined the EU in 2004 and are also members of the OECD. In terms of GDP per capita, both are making progress at closing the gap with the EU average. But a big part of their success lies in the strong economic ties that they have maintained with one another. This would suggest that an independent Scotland would have much to gain from keeping its strong links with the UK.

Pro-independence campaigners often point to the successes of small independent countries elsewhere in the world, especially Nordic ones – claiming that these show that a country can be both small and prosperous.

Smallness has the benefit of strengthening public sector accountability because citizens can monitor bureaucrats’ behaviour more easily. Communication and coordination are also easier. But evidence suggests that it is medium-sized countries that tend to have the most effective bureaucracies, all else being equal (Jugl, 2019).

A medium-sized population of between 15 and 94 million gives a country economies of scale for efficient public sector spending. Any smaller, and a country runs the risk of an over-stretched government that lacks specialist skills and knowledge.

With a population of just 5.5 million, Scotland’s size falls below this ‘golden mean’. But an effective bureaucracy at this scale is clearly not impossible. The lesson here is that an independent Scotland would have to take steps to improve its administrative effectiveness and reduce inefficiency.

This would need strong communication and coordination between agencies and departments, with a greater focus on common goals and ‘big picture’ questions. Research shows that some smaller European countries – such as Estonia, Iceland, Latvia and Luxembourg – have mastered this challenge (Sarapuu and Randma-Liiv, 2020; Jugl, 2020). 

But being small also comes with challenges: from the risk of greater economic volatility and less scope to manage fluctuations in the economy. Smaller countries typically have to run tighter fiscal policies as they have less influence over international capital markets.

Some smaller countries also have lower economic diversity and often depend on larger economies for much of their exports. It is also possible that smaller countries can lack influence over major economic decisions, for example, at the International Monetary Fund or the World Trade Organization, and in the setting of international standards in areas such as financial services.

Ultimately, Scotland’s success or otherwise as a small independent state would depend less on its size than on its leaders’ ability to exploit the benefits and overcome the disadvantages of small population size.

Yes or no?

If there is one conclusion that can be drawn from the research, it is this: in the run-up to a possible second referendum, any bold claims – made by either side of the debate – stating exactly what will happen to the Scottish economy after independence need to be taken with a pinch of salt. 

Post-independence, it is likely that there would be a number of significant economic challenges in the short term. But over the longer term, the path would depend heavily on Scottish leaders’ choices and abilities.

Polls show that recent voting intentions among Scottish people are close: 47% say ‘yes’ to independence, and 53% ‘no’, as of September 2022. But the polls also show that the balance towards either answer regularly flips.

Research shows that some voters will say ‘yes’ to independence if they can’t see that the economy would be any better off by sticking with the UK. This was true of some pro-Leave voters in the UK’s EU referendum in 2016 (Curtice, 2017).

This means that in the event of a second referendum, unionists would need to demonstrate clear economic benefits of staying with the UK to win the argument. For nationalists, on the other hand, a draw might well be enough.

Where can I find out more?

• This article draws on the Economics Observatory’s series of articles on Scottish independence: a collection of the articles is available as a pdf here.
• Scottish independence: The Institute for Government.
• Scottish Government Economic Statistics.
• Government Expenditure and Revenue Scotland.
• What Scotland Thinks?

Who are experts on this question?

• Anton Muscatelli
• Nicola McEwen
• Graeme Roy
• Stuart McIntyre
• Ronald MacDonald
• John Curtice

Author: Michelle Kilfoyle

Editors' note: This article is part of our series on Scottish independence - read more about the economic issues and the aims of this series here.

Photo by barmalini on iStock

The post An independent Scotland: what would be the options for economic success? appeared first on Economics Observatory.

Kwasi Kwarteng also promised further deregulatory reforms in the months to come. In addition, the proposal to reduce the top rate of income tax to 40% – which has now been reversed – may have been partly driven by the hope of attracting talent into the UK’s financial services sector.

What do we mean by the City?

The City is shorthand for the UK’s financial services sector. Economists use the expression because, as Figure 1 shows, over 53% of financial services output in the UK is in London. Most of that is concentrated in the square mile that is the City of London. Indeed, 19% of London’s total economic output comes from the City (Hutton, 2022).

Figure 1: Regional financial services output by country and region, 2020

Source: Hutton, 2022

The financial services sector includes a gamut of institutions including banks, insurers and investment fund managers. A broader definition of the sector includes related professional services such as accounting, legal services and management consultancy.

What does the City contribute to the UK economy?

London has been a global financial capital since the 17^th century (Neal and Quinn, 2001). In the 19^th century, US railroads and emerging economies issued their securities on the London stock exchange and London’s banking system was at the heart of the global monetary system.

London financed and facilitated global trade, and insurance companies based there insured lives, property and shipping around the world. Despite the vicissitudes of world wars and bouts of deglobalisation, London remains one of the world’s leading financial centres.

In terms of economic output, the UK financial services sector contributed £174 billion or 8.3% of total UK gross value added in 2021. If we add in the related professional services that support the industry, the totals rise to £261 billion and 12.5% (TheCityUK, 2022). The financial services sector is therefore an important part of the economy in terms of output.

Figure 2: Share of economic output from financial services industry, 1990-2021

Source: Hutton, 2022

Over the past three decades, the City has become much more important to the UK economy in terms of its contribution to economic output. As Figure 2 shows, the majority of this growth happened in the run-up to the global financial crisis of 2007-09.

The financial services sector is a major source of employment. In 2021, 1.1 million people were employed in the industry, which constitutes 3.3% of all UK jobs. These figures rise to 2.2 million and 7.4% when related professional services are included (TheCityUK, 2022).

Although the financial services sector has grown over recent decades, it employs the same number of people and a smaller proportion of the UK workforce than it did 30 years ago (Hutton, 2022).

The industry has been a big adopter of new technology, with the result that it can produce more output with less labour. This means that financial services have one of the highest levels of labour productivity of any sector in the UK. The output per hour in the sector in 2020 was £83.30 compared with £39 for the whole economy (TheCityUK, 2022).

The financial services sector is also a major contributor to the nation’s tax income. In 2019/20, the UK financial sectors contributed about £75 billion of tax or just over 10% of the government’s total tax receipts for the year (see Figure 3).

Figure 3: Tax contribution of UK financial services

Source: The Corporation of London and PwC, 2022

How is Brexit affecting the City?

The UK has historically been a major exporter of financial services. This is still the case today, with the trade surplus generated by the financial services industry being £45 billion in 2021 (see Figure 4). If we add related professional services, this trade surplus doubles in size.

To put this in perspective, the financial services trade surplus is equal to the combined surpluses of the next two leading economies – the United States and Singapore. It is also greater than the trade surplus of all other UK industries that produce one (TheCityUK, 2022).

The worrying feature in Figure 4 from a trade surplus perspective is that exports of financial services have been falling since 2019. How much of this decline has been due to Brexit?

As part of the European Union’s (EU) single market, UK financial services firms had market access to the rest of the EU through ‘passporting’. In other words, a firm’s UK licence to operate as a financial institution allowed it to operate in EU member states without the need for further authorisation. From the end of 2020, UK institutions lost their passporting rights and had to apply for a licence to operate in each and every EU country (Shalchi, 2021).

In 2019, 40% of UK financial services exports went to the EU. By 2021, this figure had fallen to 33% (Hutton, 2022). Comparing the first quarter of 2020 with the same period in 2022, financial services exports to the EU had fallen by 17%. Brexit appears to have hurt the UK’s largest producer of a trade surplus.

Figure 4: UK trade in financial services

Source: Office for National Statistics, 2022

This context goes some way to explaining the Chancellor’s desire to stimulate growth of the City. Another reason may be to boost the City’s competitiveness.

Each year, the Global Financial Centre Index measures the competitiveness of leading financial centres. Since the Brexit referendum, London has fallen from first to second place and it has suffered a large drop in its rating (see Table 1). At the same time, Amsterdam, Frankfurt and Paris have made major strides and are moving up the rankings.

Table 1: Global Financial Centres Index, 2016 and 2022

Source: Z/Yen, 2022

Can the City hurt the economy?

A long-standing argument going back many decades says that the City has failed to finance UK industry adequately because it is preoccupied with directing funds overseas rather than towards UK entrepreneurs (Edelstein, 1976; Kennedy, 1987). Increasingly, studies have been finding that there is less and less evidence to support these claims (Capie and Collins, 1992; Campbell et al, 2021).

The City can also stoke speculation and provide the finance that fuels asset bubbles (Quinn and Turner, 2020). The bursting of these bubbles can cause major economic problems, as witnessed during the banking crisis of 2007-09.

Finally, there is a debate as to whether a country can have too much finance in that its financial development reaches a point where it causes a fall rather than a rise in economic growth (Law and Singh, 2014; Arcand et al, 2015; Cho and Eberhardt, 2022). The negative effects on growth can come from financial crises or the recessions that follow credit-induced booms. They may also come from the fact that the financial sector diverts talent away from more productive sectors of the economy (Tobin, 1984).

The UK’s financial services sector as a percentage of the overall economy is 8% (Hutton, 2022). Only three OECD countries have a higher ratio than the UK – the United States, Switzerland and Luxembourg.

The City is important to the UK economy. It provides many well-paying jobs, it contributes handsomely to the country’s economic output, it is a major export earner and it contributes nearly 10% to government tax revenue.

The Chancellor’s attempts to boost the City may well boost the UK’s economic growth. But a question remains as to whether the relationship between the UK’s financial system and its growth will continue to be positive.

Where can I find out more?

• The Global Financial Centres Index: The Financial Centres Futures report for 2022.

• Key facts about UK-based financial services: 2022 report by TheCityUK on the state of UK financial services.

• Financial services: Contribution to the UK Economy: House of Commons Library research briefing on UK financial services.

• Too much finance?: A VoxEU article examining whether finance can be bad for growth.

• Little evidence for ‘too much finance’: A VoxEU article arguing that there is little evidence to support the too-much-finance hypothesis.

• Bankers’ bonus cap: Recent survey of top European economists about the potential effects of removing the cap on bankers’ bonuses on economic growth, financial stability and the global competitiveness of the City.

Who are experts on this question?

• Jagjit Chadha
• Michael Moran
• John Wilson
• Barbara Casu

Author: John D. Turner, Queen’s University Belfast

Picture by anthurren on iStock

The post How important is the City to the UK economy? appeared first on Economics Observatory.

• Forgiveness of $10,000 of federal student debt for those earning less than $125,000 in 2021.

• Increased forgiveness of $20,000 for recipients of federal means-tested Pell grants. These are non-repayable contributions from the federal government towards the cost of going to college (tuition, books, rent and so on) for low-income students up to $6,495 (in 2021/22).

• Simplification of and increased subsidies to the mechanisms of federal student debt repayment.

Could a similar policy package be effective in the UK? As we explain in this article, there are key differences in the student loan landscape between the two countries, which suggest that a scheme of this kind would be less well targeted in the UK:

• First, loans in the United States are more likely to be taken up by low-income students, while almost all students in the UK take up loans.

• Second, dropout rates are much higher in the United States than in the UK. This means that many American students leave university with debt for the years that they studied, but without being able to reap the financial rewards from a degree.

• Third, private sector refinancing of loans is a feature of the US system but not the UK’s.

• And finally, the UK has a well-functioning and progressive income-contingent loan repayment system.

How does student debt work in the United States?

In the United States, 43 million people have federal student loan debt. This totals $1.7 trillion, up from $0.5 trillion in 2006.

On average, students owe $31,100 at graduation now, compared with $26,900 in 2006 and $6,760 in 1990. As a result, students who graduate now owe around 55% of their starting salary in debt, compared with 25% in 1990.

The repayments do not affect everyone equally. Someone on an average salary, making payments of 10% of their monthly income, could pay off their debt in just over six years. In contrast, a low-end earner would need to pay 15% of their monthly income to repay their debt within the typical ten-year repayment window.

It is perhaps not surprising then that while 55% of Americans support the cancellation of up to $10,000 in federal student loans, support is very much divided by income group. Over half (56%) of those who strongly support the package earn less than $50,000 annually (median earnings in the United States are around $41,000). By contrast, only 14.3% of those who strongly support the package earn more than $100,000.

The policy is also contested among economists. Some in the United States see the package as a step in the right direction towards undoing some of the damage done by a ‘dysfunctional’ funding system. Opponents argue that it will be regressive, redistributing tax dollars from lower-income families who didn’t attend college to higher-income graduates.

Would a similar package work in the UK?

Our analysis suggests that if a similar reform were to be implemented in the UK, it would be less well targeted at lower-income students. This may be a disappointing conclusion to many younger graduates with large outstanding student debts, who would be relieved to see a reduction in their loan balance, especially in the middle of the biggest cost of living crisis in a generation.

But the student funding landscape and the demographic profile of those in educational debt is very different in the UK compared with the United States. This means that a similar policy would be a very different social and economic proposition. Here, we highlight four key differences.

It is much more common for US parents to pay for their child’s university education

Nearly all (95%) new students in the UK take up government loans. In contrast, 30% of US undergraduates do not use federal loans, with 85% of families using parent income or savings to pay for some proportion of college costs.

In the United States, students from more affluent backgrounds are more likely to leave with no debt. So, in the United States, helping those with debt is a progressive policy, at least within the university-attending population.

In contrast, helping debtors in the UK would mean offering support to all undergraduates equally, rich and poor alike. Consequently, it would not be a progressive policy within the university-attending population.

It would also be poorly targeted considering the population as a whole, since undergraduates tend to be from more affluent backgrounds than those who do not go to university.

The dropout rate is very low in the UK

In 2019/20,5.3% of UK undergraduates taking their first degree were no longer in higher education a year later, and 11% ultimately did not obtain a qualification.

In comparison, 24.1% of first-time undergraduate freshers in the United States drop out within the first 12 months of their studies, and 32.9% do not complete their degree programme. In other words, individuals in the United States are far more likely to be repaying student debt for a degree that they did not obtain.

Indeed, it has been estimated that 16.6 million people in the United States have debt but no degree six years after first entering college. This means that the link between student debt, degree-level qualifications and a graduate earning job is much stronger in the UK.

Figure 1 compares the proportion of the US and UK adult populations with degrees over time, which is similar despite lower initial participation in higher education in the UK. This reflects the higher rates of dropout in the United States.

Figure 1: Proportion of US and UK adults with degrees over time

Source: Office for National Statistics (ONS) and US Census Bureau

Notes: UK – percentage of those aged 21-64 in the population with higher education; US: percentage of over 25s with a college degree

In the United States, there are private sector options for refinancing student loans

Many well-informed higher-income graduates in the United States have refinanced their loans at lower rates using private companies such as SoFi. Private companies can afford to offer rates lower than the federal government as they are selective in whose debt they take on.

The US policy of limiting the cancellation to the federal debt therefore targets those debtors at most risk of default.

In the UK, all student loans are held by the Student Loans Company, meaning that, once again, debt forgiveness would not be progressive within the university-attending population.

The UK has a well-functioning income-contingent student loan system

Undergraduates in the UK take on twice the amount of debt of American students. The relatively low uptake of loans in the United States means that the average student debt of an undergraduate in the United States is £23,640 ($27,000) at public colleges, £29,500 ($33,700) at private non-profit colleges, and £34,930 ($39,900) at for-profit private colleges. This compares with £43,650 in the UK, where all but five universities are public.

The major reason why there is a ‘debt crisis’ in the United States but not in the UK is that in the latter, students are automatically enrolled in an income-contingent loan scheme. Under this system, they only pay a proportion of their income over a threshold on student debt repayments (Murphy et al, 2019). So, if graduates fall on hard times, their debt repayments are reduced or can even stop.

In contrast, the majority of students in the United States are on a fixed period (ten years, for example) repayment plan, and will have to pay the same amount every month come rain or shine.

This means that both graduates and those who have dropped out can face a very large repayment burden straight after leaving university, sometimes representing half of their income (Barr et al, 2019).

That the UK system already has a progressive forgiveness system built into it means that any general debt forgiveness would be relatively less progressive. This is certainly the case compared with the United States, where debt forgiveness will have a much greater direct impact on the day-to-day financial situation of graduates.

The only effect it would have on UK graduates is to reduce the number of years over which they repay. It would have no effect on their monthly repayments.

Ironically, the parts of the US reform designed to simplify contingent loan programmes (which cap monthly payments on some loans to a percentage of a borrower’s discretionary income) have received less attention. But these measures (such as reducing the cap on undergraduate federal loans to 5% of a borrower’s discretionary income, down from the typical 10%) have the potential to reduce the repayment burden for more graduates for many years to come, by moving the risk of low graduate earnings from the individual to the state.

Where can I find out more?

• Why I changed my mind on student debt forgiveness: New York Times article by Susan Dynarski.

• Lessons from the end of free college in England: Brookings report by Richard Murphy, Judith Scott-Clayton and Gill Wyness.

• The end of free college in England: Implications for enrolments, equity, and quality: Article in the Economics of Education Review.
• Expert views on student debt forgiveness in the United States (2020).

Who are experts on this question?

• Richard Murphy
• Gill Wyness
• Susan Dynarski
• Judith Scott-Clayton

Authors: Richard Murphy, Stuart Campbell, Gill Wyness and Lindsey Macmillan

Picture by f11photo

The post US student debt forgiveness: should the UK follow suit? appeared first on Economics Observatory.

Proponents of independence have argued that North Sea revenues strengthen Scotland’s fiscal position and control from Edinburgh would lead to better decision-making. This could include saving for future generations (like in Norway) and support for the transition to renewable energy sources.

Those against argue that an independent Scotland would inherit a weaker budget position than the UK as a whole and that oil revenues are likely to be insufficient to close that deficit.

How have North Sea revenues changed over the years?

Receipts from taxes and royalties on North Sea oil and gas production have fluctuated significantly over the last 50 years. These have followed peaks and troughs in world oil prices, trends in investment, levels of production and changes in the tax regime.

Currently, companies operating in the North Sea pay three different taxes on oil and gas production: including a ring-fenced corporation tax, supplementary charge and petroleum revenue tax (PRT).

Figure 1: North Sea revenues (£ million)

Source: Statistics of government revenues from UK oil and gas production, 2022

Oil and gas revenues peaked in the early 2000s, hitting an all-time high (in cash terms) in 2008/09. But adjusting for inflation, revenues were much higher in the early 1980s, amassing – in today’s prices – nearly £35 billion in 1984/85. To put that in context, total health spending in Scotland last year was around half that, at just over £18 billion.

In recent years, receipts have fallen sharply, driven by falling production and a relatively low oil price. At the same time, changes to the fiscal regime – which determines how revenues are shared between the government and energy firms – have reduced the government’s take on each barrel of oil produced.

These changes were designed to prolong investment in the North Sea as the basin enters its twilight years. Companies can also offset some of their tax liability for decommissioning.

Until recently, revenues from the North Sea were projected to raise less than £1 billion per annum for the foreseeable future (Office for Budget Responsibility, OBR, March 2021 forecast).

But Russia’s war in Ukraine and the spike in global energy prices have sparked a dramatic turnaround. Oil prices increased from $18.38 per barrel in April 2021 to $117.25 in March 2022. Over the same period, gas prices rose from £0.55 per therm to £3.14. 

As a result, North See revenues jumped from just £500 million in 2020/21 to £3.2 billion in 2021/22.

In their March 2022 forecast, the OBR projected that North Sea revenues could rise further to £7.8 billion in 2022/23. This is well over ten times higher than pre-pandemic receipts and would be the highest fiscal return from the North Sea since 2010/11.

Others point out that the outturn figure for this year could be even higher (Phillips, 2022). Why? So far, oil and gas prices have exceeded the OBR’s March forecast.

At the same time, the UK government has increased the tax rate on profits from oil and gas production by 25 percentage points (through the energy profits levy or ‘windfall tax’). It is estimated that this alone could raise £5 billion in 2022/23.

How much North Sea activity takes place in Scottish waters?

Under the UK fiscal and regulatory regime, responsibility for North Sea revenues is ‘reserved’ to the UK government, and pooled for the benefit of the UK as a whole.

It is still possible to provide an estimate of ‘Scotland’s share’ of these revenues by measuring how much production, investment and profit are generated in waters that could be described as being ‘Scottish’.

In most statistical publications, the Scottish government uses the definition set out in the Scottish Adjacent Waters Boundary Order (1999), which paved the way for the devolution of marine policy. This is shown in Figure 2.

Figure 2: UK continental shelf and Scottish boundary

Source: Marine Scotland

Over the decades, the majority of North Sea production has taken place in Scottish waters. In 2019, 82% of total production (and 95% of oil production) is estimated to have taken place in the dark blue sector denoted as Scottish waters.

How important are North Sea revenues for Scotland's fiscal position?

Under the current constitutional settlement, there is no one government responsible for all public sector activity in Scotland. Nor is there a set of income and expenditure accounts that track all revenues collected from people in Scotland and money spent.

But each year, the Scottish government publishes a consolidated set of fiscal accounts for Scotland – the Government Expenditure and Revenue Scotland (GERS) report.

It includes both Scottish government and local government spending and tax revenues, but also UK government spending and taxes spent for and raised on behalf of the people of Scotland.

For context, Figures 3 and 4 illustrate the balance of devolved (i.e. Scottish government) versus reserved (i.e. UK government) expenditures and revenues in Scotland.

Figure 3: Devolved and reserved revenues, 2020-21

Figure 3 shows that over 64% of revenues in Scotland are set and collected by the UK government even after significant fiscal devolution through the Scotland Acts of 2012 and 2016.

In contrast, Figure 4 shows the share of expenditure in Scotland that is controlled by the Scottish government. Here we see the opposite picture, with the majority (55%) of public expenditure in Scotland now devolved.

Figure 4: Devolved and reserved expenditure, 2020-21

Each year, the GERS report attracts considerable attention given its relevance for the Scottish independence debate. It is regularly used to argue the case for or against Scottish independence.

It is important to note that they are based upon the current constitutional settlement. But there is widespread recognition that while any such estimates are subject to margins of error and most importantly different choices (depending on the decisions an independent Scotland may take on spending and taxes or the outcome of negotiations with the UK government on any transition and division of assets and liabilities), they remain the best place to start for analysis of what an independent Scotland’s public finances might initially look like.

Figure 5 shows the estimated difference between revenue and expenditure – the net fiscal balance – for Scotland since 1998.

Figure 5: Net fiscal balance: Scotland and UK, 1998/99 to 2021/22

Source: GERS, 2022

As Figure 5 shows, North Sea revenues have important implications for any assessment of Scotland’s notional ‘fiscal deficit’.

First, until the fall in revenues from 2010 onwards (see Figure 1 above), including a geographical share of North Sea revenues significantly improved Scotland’s estimated fiscal position.

Second, in most years, Scotland is estimated to have a weaker position than the UK as a whole – largely driven by higher spending per head – but this relative gap is closed (and even eliminated on occasion) when oil revenues are included.

What might the recent spike in oil revenues mean for the independence debate?

The Scottish government has announced plans to hold a referendum on Scottish independence in 2023 (although this is currently subject to a referral to the UK Supreme Court). As we set out in our series of articles earlier this year, debates over the economics of independence are likely to feature heavily in any prospectus, as they did in the 2014 referendum.

The most recent figures show that Scotland’s estimated budget deficit fell from 22.7% of GDP in 2020/21 to 12.3% of GDP in 2021/22. This is a reduction, relative to GDP, of just over 10 percentage points. The UK’s deficit fell from 14.5% of GDP in 2020/21 to 6.1% of GDP the following year – a reduction of just over 8 percentage points. The key reason for this relatively ‘better’ performance in Scotland was the increase in the value of North Sea oil and gas output and revenues.

Remember that revenues for 2022/23 are expected to be higher still. So, will this be universally good news for Scotland?

Whether Scotland’s fiscal position improves in 2022/23 won’t just depend on what happens to energy prices. Broader economic developments will also play an important role.

For example, in recent months, the UK government has announced a package of financial support for households to help them with rising energy bills, with more measures currently being announced. This will increase spending across the UK, including in Scotland. At the same time, if the economy enters a recession, this will weaken growth in tax revenues more broadly, while higher inflation will feed through to higher debt interest.

The net effects of all of this on the deficit are complex and, at this stage, uncertain. Nevertheless, it is very likely that the different factors affecting the public finances at the current time will be – in relative terms – ‘better’ for Scotland than the UK as a whole.

In short, the key beneficial public finance effects – oil and gas revenues – will be concentrated in Scotland, whereas the costs – such as higher spending or the effects of a recession – are spread across the UK as a whole.

The Institute for Fiscal Studies (IFS) estimates that oil and gas revenues would need to total around £14.5 billion this year for the Scottish implicit deficit to match that of the UK as a whole. They conclude that ‘such a figure is plausible, and may be exceeded’.

This may well change the context of debate around Scottish independence and be more favourable to the ‘Yes’ campaign.

But it is important to note that the long-term trend for oil and gas revenues is for a phased decline. Oil and gas production peaked in 1999 and remaining reserves are now in more challenging and costly areas of the North Sea.

At the same time, governments – including the Scottish government, in which the Green Party holds two ministerial positions – are committed to the transition from fossil fuels to renewable forms of energy, with the objective of reaching net-zero carbon emissions.

Conclusion

North Sea revenues are on track this year to jump to levels not seen in over a decade. Higher oil prices are likely to strengthen Scotland’s relative fiscal position vis-à-vis the UK as a whole, although it is likely that the overall public finances will weaken. Relying upon high oil and gas revenues is unlikely to be a long-term strategy for an independent Scotland’s public finances. Tough choices on tax and spending, and efforts to improve economic growth, will still be needed.

Irrespective of this outlook, Scotland – like many other countries – faces important long-term fiscal challenges associated with an ageing population and rising healthcare spending. Whether constitutional change will make these challenges easier or harder to solve is likely to be a key fault-line in any future debate on Scottish independence.

Where can I find out more?

• Government Expenditure and Revenue Scotland, 2021-22: Scottish government publication on revenue, spending and the overall position of the public finances in Scotland.
• Government Expenditure and Revenue Scotland (GERS): A look beyond nearly 30 years of controversy at what it does and doesn't tell us about Scotland: by Graeme Roy and Mairi Spowage.
• Approach to fiscal sustainability consultation paper and Trends in Scotland’s population and effects on the economy and income tax, Scottish Fiscal Commission, August 2022.
• Country and regional public sector finances: financial year ending 2021: Office for National Statistics publication on revenues, spending and public finances by UK nation and region.
• Scotland – the new case for optimism: The report of the Scottish National Party’s Sustainable Growth Commission.
• The Scottish National Party’s economic prospectus for independence: Out with the old? Article in Political Quarterly.

Who are experts on this question?

• David Bell, University of Stirling / University of Glasgow
• Stuart McIntyre, University of Strathclyde
• James Mitchell, University of Edinburgh
• Gemma Tetlow, Institute for Government
• David Phillips, Institute for Fiscal Studies
• Graeme Roy, University of Glasgow

Authors: Stuart McIntyre and Graeme Roy

Picture by nielubieklonu on iStock

The post Higher North Sea revenues: what impact on Scotland’s independence debate? appeared first on Economics Observatory.

On Monday, the Conservative Party leadership contest finally came to an end. Liz Truss emerged victorious, gaining 81,326 votes (57.4%) from party members, with former chancellor, Rishi Sunak, backed by 60,399 (42.6%) voters.

But there is to be no honeymoon period for the new prime minister, not least with the passing of Queen Elizabeth, just two days after inviting Truss to form a government. Soaring energy and food prices, the war in Ukraine and issues around the Northern Ireland protocol make for an in-tray few would envy. Truss’s reaction to these challenges – among many others – will quickly define opinions among her own MPs, international leaders and the public.

She has already announced her new government’s response to the energy crisis. The UK energy price cap will be fixed at £2,500 a year for a typical home for the next two years. According to the prime minister, the policy will save the average household £1,000 a year and comes in addition to the £400 energy bill discount announced earlier this year.

Businesses are also to be offered some government protection. They will see their energy costs capped at the same price per unit as households for six months (from October). This will then be reviewed, with possible additional protection to be offered to businesses in more vulnerable sectors.

Crucially, this intervention will not be funded via a windfall tax on energy companies’ excess profits, despite renewed calls to do so from the Labour Party. Instead, the scheme – which could cost in the region of £150 billion over the two years – will be financed via government borrowing. This will have significant and long-lasting effects on the UK’s public finances and future fiscal strategy.

Trust in me

For the prime minister to gain buy-in for this and other policies from the public, rebuilding trust in government will be essential. The importance of trust for effective policy-making is discussed by Chris Dann (London School of Economics) in a recent Economics Observatory piece.

If the government is perceived to be trustworthy, people will be more likely to comply with public policies via consent, such as paying taxes and following the rule of law. As Chris highlights, if we think of state capacity broadly as ’the government’s ability to accomplish its intended policy goals’, then compliance – and therefore trust – is critical.

But the latest data paint a dire picture. In the UK, only 35% of the people trust the government (according to these data from the Office for National Statistics, ONS). This is well below the OECD average of 41%.

Opinions on Westminster seem to be particularly negative compared with local administrations. Around 42% of people trust their local government; and trust is even higher in the civil service, at 55%. Political parties are the institutions in which the public places the lowest level of trust, at only 20% (see Figure 1).

Figure 1: Trust in political institutions

Source: ONS

Clearly, Liz Truss faces a large challenge in rebuilding trust among the public in the UK. This will be vital for the success of her premiership, but also for developing a better long-term relationship between the state and the people. As the country faces significant challenges, such as the current cost of living crisis, it is important for people to believe that those governing have their best interests at heart.

As Chris points out, developing a greater commitment to procedural fairness and amplifying people’s voices in the political process are key. This will help to ensure that policy decisions are seen as being legitimate, strengthening trust.

Pale shelter

The announcement of the energy bill plan will have come as a relief to many who face much increased costs. But as highlighted by two new Observatory articles this week, not all households are affected by the cost of living crisis equally. Two groups that are likely to be disproportionately hurt are disabled people and those already living close to or below the poverty line.

As outlined by Jennifer Remnant (University of Strathclyde), people with disabilities are more likely to face higher household bills already – whether because of extra transport costs or the need for specialist equipment or additional heating. What’s more, they are often excluded from full economic participation, particularly employment.

Benefits, designed to offer support, are of limited assistance as they are falling behind the cost of living. This also affects poorer households, as emphasised by Helen Barnard (Joseph Rowntree Foundation). Individuals with fewer resources are more likely to take on debt to cover essential bills and goods, and this extends the effects of the cost of living crisis and increases the likelihood of falling into poverty.

Hard bargain

With the prices of essentials such as food and other basic household items going up at an alarming rate, some politicians have suggested that ‘looking for bargains’ is the answer. But is this even possible? In another new article, our director Richard Davies explores whether inflation is avoidable and if, by shopping carefully, savvy customers can keep their food bills down.

Drilling into the micro data, Richard finds that many of the prices of bargain options are going up faster than those of higher-cost equivalents. Those who buy goods in the cheapest three baskets of goods (the 10th, 20th and 30th percentiles) are seeing higher rates of inflation than those at the top (the 70th, 80th and 90th percentiles). In short, prices have gone up more for families who already shop for bargain products (see Figure 2).

Figure 2: Average inflation rates, consumer price baskets

Sources: ONS and Davies, 2022

The key issue is that eventually, there are no cheaper options. At some point, the bargain-hunters will end up with much of their shopping taken from the cheapest possible value ranges. And while historically prices in this range have risen more slowly, with the UK’s latest bout of inflation, this is no longer the case.

Winter is coming

For now, at least, some of the pressure caused by rising energy bills may have been eased. But for families and businesses across the country, the months ahead will still be difficult. Prime minister Truss and her new cabinet will need to find a way to mitigate the worst effects of inflation, which Bank of England forecasts suggest could reach 13% by the end of the year.

There are also concerns that tightening monetary policy could plunge the country into a recession, which is likely to bring with it rising unemployment, lower investment and diminished tax revenue to fund public services.

Finding the balance between managing the cost of living crisis and protecting the economy presents a daunting task for UK policy-makers. Failing to rise to the challenge will have serious implications not only for Truss and the Conservative Party, but the country as a whole.

Observatory news

The Festival of Economics will be returning to Bristol on Monday 14 to Thursday 17 November. We’re delighted to announce a packed programme of talks and events, details of which can be found here.

And finally, as the nation enters a period of mourning, here’s a reminder of what’s changed and what hasn’t in the UK economy during the 70 years of the second Elizabethan age. John Turner (Queen’s University Belfast), one of our lead editors, wrote this piece to mark Queen Elizabeth’s Platinum Jubilee back in the summer.

Author: Charlie Meyrick

Image by pesian1801 for iStock

The post A matter of trust appeared first on Economics Observatory.

On Tuesday, the temperature reached 40.3°C in Coningsby, Lincolnshire. This made it the hottest day ever recorded in England, and the latest peak in an alarming upward trend. According to the Met Office, nine of the ten warmest days ever recorded in the UK have been since 1990.

Even as the sun set, it barely cooled down. Provisional data suggest that from Monday into Tuesday the country experienced its hottest night on record, with parts of the East of England remaining above 25°C from dusk until dawn.

Such extreme heat poses serious dangers, not only to people but to animals, plants and infrastructure. This week zoos were closed, trees burst into flames and several train services were cancelled for fear that the metal in the tracks would warp and buckle under the blistering sun.

As fires erupted across the UK and continental Europe, emergency services were put under substantial pressure. On Tuesday the London Fire Brigade were called out to over 2,600 incidents, making it their busiest day since the Second World War. In Gironde, in south-west France, tens of thousands of people have been evacuated from their homes as nearby forests burn.

Further afield, temperatures also rose above 40°C in North America, the Middle East and Asia. Looking at the global data, Steve Pawson, Chief of the Global Modelling and Assimilation Office at NASA, concluded that the recent record-breaking heat is ‘another clear indicator… that human activity is causing weather extremes that impact our living conditions’. The latest global heatwave is a dangerous backward step for mankind.

Extreme weather costs

These extreme weather events also have significant economic costs, as highlighted in an Economics Observatory article by Ilan Noy (Te Herenga Waka - Victoria University of Wellington). The piece – first posted as part of our COP26 collection – explores how economists calculate the costs of extreme weather. He argues that the true economic impact of these disasters, and their effects on equality, are being underestimated. This means economists and policy-makers may also be misjudging the urgency required to implement cost-effective mitigation policies.

A particularly alarming chart from the article plots the first full-flowering day of cherry blossom in Kyoto over time (see Figure 1). Using data running back over a millennium, the graphic highlights how the trees are coming into flower earlier and earlier each year, particularly since 1900. In 2021, the trees blossomed on 26 March. This is the earliest they have done so in more than 1,200 years.

Figure 1: First full-flowering day of the cherry blossom in Kyoto, Japan

Source: NOAA, based on Aono, Kazui, 2008; Aono, Saito, 2010; and Aono, 2012

People face different levels of risk from extreme weather events. For Ilan, climate change ‘is not an equal opportunity menace’. In fact, its impact on minority and low-income families is potentially much higher. It is the poorest in society that are most vulnerable to floods, fires and freak events. This makes combatting climate change a social justice issue as well as an environmental one. Stopping its effects is the only way to ensure equal economic opportunities, as well as basic security, for millions of people around the world.

The numbers behind the crisis

The increasing cost of living is another crisis from which there is little respite. Prices are continuing to rise, as shown by new data from the Office for National Statistics (ONS) released this week.

Inflation rates in the UK have reached levels not seen for decades, with the consumer prices index (CPI) up 9.4% over the past year (see Figure 2). Wages are failing to keep up – as data released on Tuesday show – meaning that British workers are witnessing the value of their real-term pay shrink drastically.

Figure 2: CPI (1988-2022)

Source: ONS

But what is actually causing the crisis? Economics Observatory Director, Richard Davies, has dug deeper into the data, exploring which products are causing the biggest surge in people’s day-to-day living costs.

To understand what’s going on, it’s important to consider how measures like CPI are calculated – something discussed in detail in a recent Observatory article by Jason Lennard (LSE) and Ryland Thomas (Bank of England).

In his article this week, Richard highlights how the numbers that underpin the ONS’s findings – known as the ‘micro data’ – are the individual prices collected in shops and businesses up and down the country. This dataset is huge, with over 40 million prices recorded since 1988, which allows economists and policy-makers to take a closer look at how, and why, inflation is surging.

In normal times, there is substantial flux in the data. This means that even when headline inflation is rising, there are some shops or businesses that are cutting their prices. In short, prices tend to ebb and flow, overall.

But Richard shows that recently the shares of prices rising and falling have diverged (see Figure 3). This means there are fewer price cuts taking place, demonstrating just how widespread the current inflation facing the country has become.

Figure 3: Month-on-month price changes

Source: ONS; Davies, 2022

Worse still, it is food items that dominate the list of prices that are rising. According to the micro-data, milk, spaghetti, baked beans, salmon fillets, bacon, lettuce, cucumbers and eggs are all increasing in cost. Normally these are exactly the type of items that see a great deal of flux. But with price cuts very rare at present, these price jumps look likely to become ‘locked in’.

The competition heats up

Whoever takes over from Boris Johnson as prime minister in September will face tough policy challenges. Climate change and extreme weather events will continue to pose significant risks to people’s economic and physical wellbeing. The cost of living crisis looks set to deepen, with the Bank of England predicting that inflation could reach 11% before the end of the year. And a struggling NHS, the war in Ukraine and a battered education system will also each require urgent and sustained attention.

High inflation is not just squeezing ordinary people at checkouts and petrol pumps. New data released on Thursday show that the country’s public finances are under substantial strain, with interest payments paid by the government hitting £19.4 billion in June. This level of debt burden is largely a result of higher inflation, as the rate paid on government bonds is linked to the retail prices index, which hit 11.8% in June.

The two remaining leadership hopefuls, Rishi Sunak and Liz Truss, have each made claims that they are the most well-equipped to manage to country’s economic policies. At the centre of both their campaigns are promises to fight inflation while promoting growth. Although they differ on the nature and timings of tax cuts, both candidates are trying to convince Conservative party members that they are ready to make the difficult calls and restore the party’s tarnished reputation.

Addressing the manifold and connected economic challenges seems likely to make or break the UK’s next leader. Controlling inflation and servicing the country’s swelling debt, all while appeasing calls to cut taxes, will be extremely difficult. Getting the balance right will be critical.

Observatory news

This will be our last newsletter for a couple of weeks. We will be back on Friday 19 August. In the meantime, keep an eye out for some exciting announcements for the autumn.

Author: Charlie Meyrick

Picture by ???? ?????? on iStock

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The United Nations (UN) process to tackle climate change recognises finance as one of its three pillars and includes the only agreed international treaty on providing finance to developing countries. The legally binding Paris Agreement of 2015 reinforced this commitment. So, are rich countries doing enough; and what would ‘enough’ be?

Developed countries are expecting to meet a collective goal of mobilising $100 billion per year in climate finance in 2023, three years after they made this commitment.

While that amount is substantial, the design of the target means that much of the money has been rebadged or diverted from other development objectives such as economic development and poverty reduction. Policy officials at the UN and within individual countries are beginning work, mandated by the Paris Agreement, to agree a post-2025 climate finance goal from a floor of $100 billion per year.

While economic analysis of the externalities of climate change – effects not experienced by the company or country causing them – could justify a much larger figure, if the design of the target doesn’t improve, that money may not make a difference to those dealing with the worst effects.

Despite the importance of combating climate change, high quality economic research on it is still lacking. In 2019, a study assessed nine of the top economic journals and identified just 57 papers on climate change out of a total of around 77,000 (Oswald and Stern, 2019).

The authors suggest that this may reflect a bias towards ‘conventional’ topics among editors and authors. It may also reflect the absence of reliable data – but the result is relatively thin research on arguably the most important issue of our time.

What are the costs of climate change and adaptation?

It is well understood that emissions of greenhouse gases such as carbon dioxide are trapping the sun’s heat, raising temperatures and affecting weather patterns. Each tonne of carbon dioxide, wherever it is emitted, is damaging to the environment and has associated costs.

Various reports have estimated these costs, although doing so relies on taking a view on how badly the planet and the economy will be damaged if and when emissions peak.

If climate change ultimately destroys much of the planet, the cost of each tonne of carbon will be extremely high, relative to one where the goals of the Paris Agreement – which commits to limiting temperature increases well below 2°C – are achieved. One authoritative summary, led by the US government puts the cost at $40 per tonne in 2020.

We have used that figure to look at historical emissions and their cost. Even if we discount the externality cost historically, and don’t count emissions at all before 1979 – when awareness grew and the first world climate conference was held – the costs are very significant.

They are estimated at $34 trillion globally, or $15 trillion for OECD countries – around 28% of their national income (Robinson et al, 2021). Paying off just the OECD’s historical liability would cost $190 billion per year to 2100.

The costs of climate change could also be estimated by aggregating government or business costs of mitigating emissions and adapting to the effects of climate change. The true costs would be those relative to a scenario or ‘counterfactual’ without climate change.

But this is a difficult calculation. Even for, say, flood defences, it requires attributing some share of the cost to changed climate; and there is no automatic reason for governments or businesses to do so.

But under the Paris Agreement, every country must produce a nationally determined contribution (NDC), which estimates emissions pathways and includes financing costs in many cases. As these develop over time, they may give a fuller picture of national costs.

These estimates of costs are different from the climate finance target. The latter is a negotiated outcome as part of an agreement to reduce emissions, not an attempt to set finance to match the costs of climate. But clearly any ‘liability’ for climate damage is relevant to that negotiation.

The COP process has a separate track on ‘loss and damage’ (article 8 of the Paris Agreement), which is where discussions of compensation take place. But these have made little progress as industrialised countries have been unwilling to agree to liability – although Scotland made the first financial contribution of £2 million under this article at COP26 in Glasgow in late 2021.

The $100 billion climate finance and other development finance targets

In practice, the $100 billion per year target, originally agreed in 2009 at the 15^th COP and reaffirmed by the Paris Agreement, is currently the only active mechanism for redistribution.

The other well-known international agreement on development finance is the 60-year-old UN agreement to provide 0.7% of gross national income (GNI) in official development assistance.

This long-standing target is accepted in principle by many high-income countries (but not by the United States or Switzerland), although in practice few have met it consistently. Across the 29 rich countries that comprise the OECD’s Development Assistance Committee, development assistance has typically amounted to 0.32% of GNI or $161.2 billion in 2020.

These efforts overlap with the COP climate finance target – nearly a quarter of official development assistance is now badged as climate finance (and counts towards the $100 billion target).

Climate finance was originally intended to be additional to existing development finance efforts. The first UN meeting of the conference on climate change (UNFCCC) in 1992 called for ‘new and additional’ resources. This language has appeared consistently in COP agreements, including the 2009 Copenhagen Accord, which set the $100 billion per year goal, and the Paris Agreement that reaffirmed it.

In practice, rich countries have shifted resources from aid programmes or rebadged activities to make progress on the climate goal. By 2019, the OECD suggests that climate finance grew to $78.9 billion but that was within an increase of all development finance of just $43.6 billion.

This suggests that only around half of climate finance was additional in absolute terms. Relative to national income, the picture is even worse: high-income countries’ contributions have remained unchanged as a share.

This failure to commit additional funds is particularly obvious in the case of the UK. The country is the current COP president and aims to double its climate finance to total £2 billion annually until 2026.

Despite this commitment, the UK has reduced its wider aid budget by £4.5 billion per year. During 2021, nearly all of the UK’s aid partners saw their support fall by a third or more, while the UK claimed to be increasing its support for climate.

The climate finance target was not defined clearly – it lacked a measure, baseline or any attempt to assess additionality. It also counts loans as equivalent to grants.

This has led to major disagreements in the past. Ahead of the Paris negotiations, India’s government famously suggested that credibly new and additional climate finance actually disbursed (rather than just ‘committed’) was more like $2.2 billion in 2014, far below the OECD’s claim of $62 billion for the same year.

Not only has this meant fewer resources to tackle climate change, but the lack of definition and progress has also undermined trust in the Paris Agreement. Without trust, countries do not have the incentives to make major adjustments to their policies or emissions.

Where next on climate finance?

At COP26 in Glasgow, developed countries set out a ‘delivery plan’ that would ensure the $100 billion target will be met three years late, from 2023 onwards. Although this is no guarantee of additional resources, for which there are acute needs in low-income countries to deal with the health and economic fallout from Covid-19, a food price crisis exacerbated by Russia’s invasion of Ukraine and record levels of humanitarian demand mainly due to the conflicts in Syria, Ukraine and Yemen.

The Paris Agreement commits to a new climate finance target from a floor of $100 billion per year from 2025 ‘taking into account the needs and priorities of developing countries’. Officials are starting work on the design of that target now.

This work will be crucial both in financing development, but also ensuring trust between nations as they look to transform their economies in the coming decades. Industrialised nations will need to recognise their responsibility for the damage caused by emissions and be prepared to provide financial support to those most vulnerable to deal with their effects on the climate.

Where can I find out more?

• The UN Framework Convention on Climate Change gives an introduction to climate finance and describes the agreements on its provision.
• An analysis of which high-income countries are providing climate finance by the World Resources Institute.
• Ministers from Canada and Germany published a Delivery Plan in autumn 2021, demonstrating how and when developed countries will meet the $100 billion goal by 2023.

Who are experts on this question?

• Joe Thwaites, World Resources Institute
• Clare Shakya, International Institute for Environment and Development
• J. Timmons Roberts, Ittleson Professor of Environmental Studies and Sociology at Brown University
• Nicholas Stern, London School of Economics

Author: Ian Mitchell

Photo by Kongdigital from iStock

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The new system applies to all those moving to the UK for work, study or family reasons, with the exception of Irish citizens. Migrants from the rest of the world also face new rules post-Brexit, but these are considerably more liberal than those applied to workers and students from the EU.

EU (and EEA/Swiss) nationals already resident in the UK are able to apply to remain indefinitely under the ‘settled status’ scheme, and most have already done so. As of 31 March 2022, 6.5 million applications had been received by the UK government (Home Office, 2022).

What are the new rules?

The key provisions of the new system are that:

• A skilled work visa is available for migrants coming to work in a job paying more than £25,600 or the lower quartile of the average salary, whichever is higher, and in an occupation requiring skills equivalent to at least A-levels (Regulated Qualifications Framework, RQF3).

• There is a lower initial salary threshold for new entrants and for those in occupations where there is a shortage of workers. This means that for some occupations, the salary threshold may be as low as about £20,000. There is also a lower threshold for those with PhDs, especially in science, technology, engineering and mathematics (STEM) subjects.

• The health and care visa provides a streamlined and cheaper process for those coming to work in the NHS and (from earlier this year) social care. For the latter, the skill threshold will no longer apply, and the minimum salary is about £20,500.

• The new graduate visa allows international students graduating from UK visas to remain in the UK for two years after graduation, and to work in any job.

The new system represents a significant tightening of controls on EU migration compared with free movement. Migrants from EU countries coming to work in lower-skilled and lower-paid occupations will, in principle, no longer be able to gain entry. EU-origin migrants coming to the UK to study or for family reasons will have to qualify under the same rules as those from outside the EU.

Those who do qualify will still need their prospective employers to apply on their behalf. They will also have to pay significant fees and will, as is the case for non-EU migrants at present, have significantly fewer rights – for example, in terms of access to the benefit system.

For non-EU migrants coming to the UK to work, the new proposals represent a considerable liberalisation compared with the current system. There are now lower salary and skill thresholds and no overall cap on numbers.

Approximately 68% of UK employees work in occupations requiring RQF3 level skills or above. Given the requirement for new migrants to be paid at or above the lower quartile of earnings for occupations at that level, this implies at least half of all full-time jobs would, in principle, qualify an applicant for a visa (Portes, 2022).

This represents a substantial increase – perhaps a doubling compared with the previous system for non-EU nationals. In contrast, for most of the period between 2012 and 2019, migrants from outside the EU were subject to an overall quota and a resident labour market test.

These changes also mean that the new system is considerably more liberal with respect to non-European migrants than the rules in most EU member states or other advanced economies, which typically apply much more restrictive skill or salary thresholds, and often enforce a resident labour market test.

What will the new system mean for migration numbers?

Migration from the EU fell sharply between the Brexit referendum in June 2016 and the first emergence of Covid-19 in early 2020, while non-EU migration rose (Office for National Statistics, ONS, 2020). The pandemic further accelerated these trends. While it reduced both immigration and emigration overall, a significant number of EU citizens returned to their countries of origin, while non-EU migration was less affected (ONS, 2022).

Figure 1: Net migration, 2012 to 2021

Source: ONS, 2021 and ONS, 2022, and author’s calculations: statistics provisional, experimental and not fully comparable between years.

The new system, for the reasons set out above, was expected to accelerate these trends further. Estimates made before the pandemic suggested it would reduce EU migration by perhaps 60,000 a year, partly offset by a smaller increase in non-EU migration (Home Office, 2020).

While both effects have indeed materialised, the actual increase in non-EU migration may be larger than anticipated, which means that the overall impact on numbers may be relatively small. The latest data show that the number of work visas has risen significantly relative to pre-pandemic levels, even after taking account of the new requirements for EU nationals to obtain visas. Over the same period, student visas have risen even faster (Home Office, 2022).

The changes have also shifted the sectoral, skills mix and countries of origin of new migrants to the UK (Migration Observatory, 2021). The number of non-UK born people working in the accommodation and hospitality sector has fallen substantially, as EU-born migrants have left the sector and not been replaced by new arrivals.

By contrast, the health and information and communications technology sectors account for by far the largest proportion of skilled work visas issued under the new system. Reflecting this, there have been sharp rises in the numbers of migrants from India, Nigeria and the Philippines.

Although we have few data so far, the new system is also likely to affect the parts of the country to which migrants go. Those coming to work in the health sector are widely dispersed; those coming for private sector jobs are very concentrated in London, where higher average salaries mean that it is much easier to exceed the required salary.

Table 1: Work-related visas granted, by visa type

Source: GOV.UK
Note: The ‘Other work visas and exemptions’ category includes frontier worker permits and older routes such as European Community Association Agreement (ECAA) businessperson, domestic workers in private households, UK ancestry visas and pre-points based system routes that are now closed.

What are the economic effects?

The evidence on the economic impact of migration to the UK suggests that migration boosts growth, by increasing the labour force. Yet it is less clear whether it boosts GDP per capita. This will depend on the impact on productivity, where there is some evidence for a positive effect, especially for more skilled migration (Migration Advisory Committee, 2018).

Some argue that immigration may reduce businesses’ incentives to invest in productivity-enhancing technology or training, although the evidence does not support this (Campo et al,  2018).

Overall, the effects on the labour market are relatively small, with little or no direct impact on unemployment or average wages. But research indicates that migration may have some relatively small effect of decreasing wages for lower-paid workers (Portes, 2018).

Migration also appears to bring overall fiscal benefits: migrants pay somewhat more in taxes – directly and indirectly – than they ‘cost’ in public services and benefits, at least relative to natives. This appears to apply both in the short and long term, although the fiscal impacts of individual migrants, like those of individual natives, vary hugely (Oxford Economics, 2018).

Overall, then, the impact of migration is broadly positive, but there are likely to be distributional implications – in other words, the effects will be felt differently by those on higher or lower incomes. In addition, the longer-term effects on growth and productivity are harder to assess.

Macroeconomic and fiscal impacts

Pre-pandemic analysis of the new system suggested that if it led to a substantial reduction in migration, this would, in turn, reduce growth and worsen the fiscal position – the balance between public spending and tax revenue raised. This would be partially offset by an improved skill mix among new migrants.

Most studies suggested that the direct impact on per capita GDP would be close to zero (Portes, 2022). Since the overall numbers appear to be only modestly affected, the impact may be more positive, with a smaller – or no – negative impact on growth and a greater positive one on GDP per capita.

Overall, a relatively liberal system for work-related migration, based on a salary threshold, is expected to be positive for growth. But this is conditional on the government committing to this broad approach and not micromanaging the system in response to short-term changes in demand for workers.

Counterbalancing this, the end of free movement – and the imposition of bureaucratic costs and barriers on migrants from nearby countries – is likely to reduce the flexibility of the UK labour market and economy, and hence impose some economic costs.

Effects on wages

The distributional impacts are also of interest. In particular, there has long been concern that migration, especially migration to work in lower-skilled and lower-paid jobs under free movement, depressed the wages of resident UK workers.

As a result, one of the stated policy goals of the new system was to reverse this. The existing evidence, suggesting that migration had depressed wages in lower-skilled jobs in the service sector (by perhaps 1-1.5% over a decade) appears to support that argument, while at the same time implying that any impact would be relatively marginal (Nickell and Salaheen, 2017).

As set out above, the new system appears to be achieving its objective of shifting the balance towards higher-paid migrants, working in higher-skill occupations. Partly as a result, vacancies are high in some relatively low-paid sectors and occupations, including accommodation and hospitality.

As yet, this does not appear to be having a substantial impact on relative wages. Indeed, compared with the period immediately before the pandemic and the introduction of the new immigration system, wages appear to have risen most in finance, information and communications technology and professional services, rather than in low-paid sectors with high migrant penetration. Concurrently, wages have risen most for the top 1% of the earning distribution (Xu, 2022).

Effects on different sectors

The end of free movement has led to substantial sectoral shifts in migration flows, with particularly sharp falls in the number of migrants coming to the UK to work in the accommodation and hospitality sector, and possibly in less-skilled and lower-paid administrative jobs.

This has led to sharp rises in vacancies in these sectors, although there are also high vacancy rates in other sectors, for example, health and social care.

Over time, employers will have to adjust to the new system. This could be through any or all of the following mechanisms (Sumption, 2022 forthcoming):

• By increasing wages, or improving working conditions in other ways, so as to attract more resident workers.
• By improving productivity, for example, through automation, ‘upskilling’ the existing workforce or switching to less labour-intensive goods and services.
• By reducing output.

As noted above, there is little evidence of the first mechanism at work so far. It is also important to note that if employers’ response is simply to increase nominal wages without increasing productivity, this is unlikely to lead to increased (real) wages across the whole economy. Since prices will also have to rise, this will mean changes in relative wages, with workers in sectors where migrant competition has lessened gaining and those in other sectors losing (Portes, 2021).

The social care sector is of particular interest as there have been long-running staff shortages resulting from lack of government funding, exacerbated by the decline in EU migration since the Brexit referendum. Although lower-paid jobs in the care sector were originally not eligible for the health and care visa, the government extended eligibility in early 2022. This suggests that in this sector at least, it does not regard any of the mechanisms above as feasible or affordable.

Effects on universities

The new system is also likely to have major impacts on the university sector. The graduate visa has made the UK considerably more attractive to international students, especially from India, Nigeria and Pakistan.

At the same time, the requirement to pay international rather than domestic fees makes the UK less attractive to EU students. But this does make those students more lucrative for universities.

Combined with the sharp squeeze in real terms on domestic tuition fees, government policy provides a very strong incentive to increase the number of international students, while limiting growth in domestic student numbers (Public Accounts Committee, 2022). While this may have some short-term economic benefits – international student fees contribute to UK service exports – it may also have some longer-term negative consequences if the result is a reduced supply of UK-origin graduates.

Where can I find out more?

• Much of the discussion in this article is based on Immigration and the UK economy after Brexit, by Jonathan Portes, published in the Oxford Review of Economic Policy.
• The Migration Observatory provides accessible briefings on migration issues and overviews of research, data and statistics on migration to the UK.
• UK in a Changing Europe provides objective analysis and research on issues related to Brexit, including migration.
• The Centre for Research and Analysis of Migration (CReAM) carries out high quality, cutting edge and non-partisan research on migration.

Who are experts on this question?

• Madeleine Sumption, Migration Observatory, University of Oxford
• Alan Manning, London School of Economics
• Christian Dustmann, University College London
• Uta Schoenberg, University College London
• Jonathan Portes, Kings College London
• Giovanni Peri, UC Davis

Author: Jonathan Portes

Photo of UK Border control from Wikimedia Commons

The post How is the post-Brexit immigration system affecting the UK economy? appeared first on Economics Observatory.

The strictness of lockdown measures varied by country and over time. For example, the UK is currently the country with the least stringent restrictions in the G7 (as measured by the University of Oxford stringency index), but it had the tightest reported restrictions at the start of 2021.

New data from the Office for National Statistics (ONS) outline the level of spending and provide comparisons between the G7 countries’ labour markets. Figure 1 outlines the level of spending by each country on fiscal measures to offset the negative impact of lockdown on household incomes. The chart plots the level of spending on non-health measures and forgone revenues in response to the pandemic as a share of 2020 GDP.

Figure 1: Spending on non-health measures as a percentage of 2020 GDP – by G7 country

Source: ONS, IMF

The United States spent the most (at around 22% of 2020 GDP), with the rest of the G7 spending between 7% and 15% of 2020 GDP. These ratios are huge relative to the response to previous economic shocks. For example, the European Commission recommended a stimulus plan of 1.2% of GDP for member countries during the global financial crisis of 2007-09.

But these numbers do not include the impact of automatic stabilisers – the (non-discretionary) increases in transfers and falls in tax revenues caused by a negative economic shock. This means that the percentages shown in Figure 1 may underestimate the extent of government spending across the G7.

What did governments spend money on during the pandemic?

Beyond healthcare, fiscal spending during Covid-19 was targeted primarily at two areas: job retention schemes and wage support; and direct support to households through extended benefit payments and tax deferrals. European countries seemed to have favoured spending more on the former area compared with Northern American countries, which made greater use of the latter.

Job retention schemes, such as furlough in the UK, were part of the response of all G7 countries. The Organisation for Economic Co-operation and Development (OECD) estimates that job retention schemes were supporting 50 million jobs across its member countries by May 2020. These schemes not only aimed to help households maintain their stream of income but were also used ease the bumps as economies were re-opened as the pandemic started to subside and vaccines were rolled out.

What was the impact on G7 labour markets?

During the period from the last quarter of 2019 to the last quarter of 2021, employment levels across all G7 countries apart from France and Canada remained below pre-pandemic levels – with UK employment 1.4% below its 2019 Q4 level.

Within employment statistics, people of working age (15 to 64 years) can be labelled in three different ways: employed, unemployed or economically inactive (not working but not seeking to start or cannot start work). This means that flows out of employment do not necessarily mean flows into unemployment. They can also be made up of flows into inactivity. Flows into inactivity have been particularly large in Italy, the United States and Canada. This is perhaps a result of lockdown measures discouraging people from searching for jobs.

Another possible explanation for the increase in the number of inactive workers may be that the closure of schools has led to childcare pressures on women in the working age population. The extra burden of home schooling, which fell disproportionately on women in the UK, may also have caused more women of working age to withdraw from the workforce, and become inactive.

But increases in inactivity levels have now been reversed across the G7, with the exception of the UK. Analysis from the Office for National Statistics (ONS) finds that this is partly a reflection of older workers leaving the labour market since the start of the pandemic – now that so many near-retirement people have left the workforce, a smaller proportion of those left over fall into this category.

Figure 2: Changes in real household disposable income, annual hours worked per worker, and the employed population

Source: ONS, OECD

Figure 2 reflects different fiscal policies adopted by each country. According to the data, across the G7, employment levels fell most compared with 2019 levels in the United States (-6.2%), followed by Canada (-5.2%) and then Spain (-2.9%).

Turning to the change in hours worked, this fell most in the UK (-11.1%), followed by Italy (-9%) and then France (-7.2%).

Finally, in terms of the change in real disposable income, this actually increased in the Unites States (+6.2%), Canada (+6.8%), Germany (+0.3%) and Japan (+3.8%), but fell in the UK (-0.7%), Spain (-5.4%) and Italy (-2%). Real disposable incomes remain unchanged from 2019 levels in France.

Changes in disposable income are large in countries that focused their fiscal strategy on direct support. For example, the United States and Canada used cash handouts to help households during the pandemic. European countries, which focused on wage support, do not see this strength in disposable income, because wage support schemes will not fully replace workers’ income (the UK’s furlough scheme only paid up to 80% of a worker’s wage).

Notably, the largest falls in employment and in the hours worked per worker come from the United States and Canada, again highlighting the differing outcomes from fiscal strategy.

Conclusion

Protecting both lives and livelihoods was at the heart of public policy across the G7 during Covid-19. Different countries adopted different strategies to protect their labour markets, which placed greater emphasis on either direct transfers or income support. As a result, the impact of the pandemic on various labour market outcomes varied across countries.

In North America, employment fell further but real household incomes were protected. In Europe, the opposite was true, with jobs being protected at the expense of real income levels. Across the board, the share of fiscal spending as a share of GDP was high, with the United States spending the most proportionally.

Where can I find out more?

• The ONS data are available here.
• Previous releases can be found here.
• The Covid-19 Government Response Tracker – or University of Oxford stringency index – is available here.

Who are experts on this question?

• Jonathan Cribb
• Mike Brewer
• Abi Admas-Prassl
• Richard Disney
• Jonathan Wadsworth
• Andrew Aitken
• Stephen Machin

Author: Elias Wilson, Charlie Meyrick

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