9 September 2015
Cridland: UK economy is rebalancing, but artificial wage hikes are 'a gamble'
Full version of CBI chief John Cridland's major economics speech at King's College London.
Thank you Professor Byrne for that introduction.
I’d like to thank all of you for coming to today’s anniversary lecture and extend my thanks to King’s College London for kindly agreeing to host this event.
As a former Assistant Secretary of the Treasury - Edgar Fiedler - once said: “Ask five economists and you’ll get five different answers – six if one went to Harvard.”
Well – luckily for all of you - I’m not an economist, but a historian.
And I’d like to start with a number of real historical significance to both KCL and the CBI. The number 50.
It was in 1950 that a young 20-something named Peter Higgs graduated from this very university.
This was the start of a quest for the “holy grail” of physics – culminating in 2012 with the confirmation of the existence of the Higgs Boson. The missing link in the Standard Model of particle physics.
Yet whilst physics has found its “holy grail”, for business and economics the quest continues.
As you might have guessed - our story begins 50 years ago.
In 1965, the CBI was formed with the objective of “developing the contribution of British industry to the national economy.”
Our first 20 years were dominated by one Holy Grail quest which ended in disappointment – the corporatist era symbolised by the CBI president of the day sitting on the National Economic Development Council.
Then along came Mrs Thatcher with the biggest set of supply side reforms in our modern economic history and another grail quest began. Relatively unbridled capitalism. The CBI reinvented as a competitiveness ‘brains trust’. And it felt like we might just have found the economics Holy Grail.
Building on some of those changes, from 1993 to 2007 the economy grew for the longest uninterrupted stretch for more than 200 years. But this apparent stability masked massive underlying imbalances – growing trade deficits, underinvestment relative to our peers and rising household debt.
As a consequence - in the years following the Great Recession and throughout my time as Director-General – we’ve all been on the hunt for a “rebalanced” economy. An economy which moves away from unsustainable debt and towards trade and investment.
This matters. It matters because rebalancing isn’t just about more growth, it’s about better growth. A more balanced economy should not only grow faster over the medium-term, but should also produce more resilient growth.
So have we rebalanced our economy? What has held us back? And how can we rebalance our economy and drive sustainable growth in the future? These are the questions I’d like to address today.
Have we rebalanced?
Back in 2011 when the CBI published its “a vision for rebalancing the economy” report, UK growth was dominated by household and government consumption. Household debt to income was peaking at around 160%, the government borrowed £131 billion in the 2009-10 financial year and government debt had ballooned to 145% of GDP.
And today - open the papers and the ‘rebalancing story’ isn’t exactly positive. Earlier this year, the Economist said that “instead of rebalancing, Britain has returned to its old ways." And just last month The Independent spoke of “the abject failure of the Government’s pledge to rebalance the economy."
Yet I would argue that in the last five years we have made good progress.
Of course - we’ve seen a broad-based recovery and we recently revised up our growth forecasts for both this year and next.
At home, this recovery hasn’t been over-reliant on consumer spending and there has been some rebalancing of activity towards investment. We’ve seen rebalancing away from the public sector and towards the private sector. Away from unemployment and towards employment. And we’ve also seen some rebalancing within the services sector itself.
Yet in dealing with the rest of the world, net trade’s contribution to GDP and our current account balance are two areas where there’s room for improvement.
The UK’s trade deficit has actually shown some improvement in recent years – the deficit fell back to 1% of GDP in Q2 of 2015, which was the lowest in 17 years.
But the UK’s net earnings on its investments abroad have deteriorated significantly. This has fed a widening in the current account deficit which swelled to its largest on record in Q3 of 2014 - 7.1% of GDP.
Part of this rebalancing story is shown by these ‘before’ and ‘after’ graphs.
Before the crisis household consumption accounted for almost three-quarters of growth, while investment contributed one fifth.
But since the crisis - whilst there hasn’t been much change in net trade’s contribution - growth has been more balanced.
So services are a key part of the solution. Our strength in services should be a cause for celebration, not concern.
And a sustainable recovery will also have to be geographically balanced.
Strong demand for business services has benefited London in particular, meaning that little ‘regional rebalancing’ has taken place.
Between 2009 and 2013, London and the South East accounted for 42% and 21% of total UK growth respectively.
But while London is a special case, it’s not really about North versus South. Whether North or South, it’s all about local business environment. Fundamentally, this is an opportunity to support these local environments and drive centres of private sector growth across the UK.
So there are plenty of credits on the rebalancing balance sheet. In the years leading up to the crash, we thought we might have found the Holy Grail – but hadn’t.
Yet in the last seven years, the UK has done well in raising its exports to Greater China and the Middle East & North Africa.
We’ve been gaining market share in emerging markets in key sectors – such as automotive and pharmaceutical. UK exports of cars to China – for example - have increased by over 40% per year over the last decade. But it’s important to stress we’ve started from a low base.
And we’re still missing out on opportunities to other fast-growing regions – such as parts of South East Asia.
Overall - a comparison with other G7 countries indicates that we’ve lost export market share faster than our peers, suggesting our competitiveness has suffered.
On services, the UK is a world leader when it comes to exports and recent research from the IPPR shows we’ve become more competitive over time.
Yet – on manufacturing – whilst some sectors have stayed highly competitive, we have become more specialised in the last 5-10 years. The number of goods sectors displaying a comparative advantage is now relatively small, and at risk of falling further. We risk becoming too specialised.
This lack of diversity matters. Putting all of our eggs in just a few baskets leaves us exposed to sudden changes in global demand.
Ultimately, if we aren’t competitive in a more diverse range of sectors, we won’t get growth.
The way we approach our Industrial Strategy is central to maintaining this diversity. And the Strategy has already helped cutting-edge sectors like automotive stay ahead in a world of global competition. We need to see how we can learn from the best in business here.
Untangling the various influences on international competitiveness is difficult.
Recent research from the Bank of England shows that UK exports rebounded much more slowly than might have been expected following the financial crisis, taking into account traditional determinants of competitiveness, such as the exchange rate.
The limited response of exports to the depreciation of the pound following the crisis was – in some respects – surprising. Talking to CBI companies, it seems that many firms decided to hold prices steady to protect margins and compensate for lower demand. This – in turn – protected jobs.
Some have argued that this approach squandered the opportunity to reboot our export performance. I don’t agree. Like so much of the commentary on the recovery from the 2008 crash, such a view underestimates the scale of the task business in Britain is facing and therefore expects too much too soon.
We are rebuilding our traditional reputation as a world trader – in many markets from a low base. Against the backdrop of an overall deficit in our current account, we ran a surplus last year in non-EU trade of 1.5% and I will return to the UK’s export opportunity a little later.
The second challenge to the successful rebalancing of our economy is that of productivity. Indeed, in their July 2015 Command Paper ‘Fixing the foundations: creating a more prosperous nation’ George Osborne and Sajid Javid refer to productivity as “the challenge of our time”. They state that in every OECD member where average wages are above UK levels, productivity is also higher and that UK productivity – which grew in the decades before the financial crisis – has stalled sharply in the wake of the crisis.
While I will happily accept the productivity challenge, I don’t accept that it is a puzzle. Indeed, the only puzzle to me is that some economists still call it a puzzle.
We now have a good appreciation of what has held productivity back. But to rise to the productivity challenge, it is important to tailor policy carefully.
I have always favoured a targeted approach to supply side interventions – the Montgomery approach to winning the Second World War by advancing directly on Berlin – rather than a broad brush approach of tackling any policy issue which might make a difference – the Eisenhower approach of advancing on all fronts at all times.
In understanding why productivity growth stalled, I am indebted to my old colleague Ian McCafferty of the Bank of England’s Monetary Policy Committee for his sectoral perspective. Over the last five years, productivity growth has differed greatly across sectors.
Productivity vs output
There has been an important cyclical component in the UK’s weak productivity performance.
Sectors which have seen the strongest recovery in demand – like transport equipment – have also seen the strongest increase in productivity. Meanwhile, sectors like machinery and equipment – which have seen lower demand, have also seen lower productivity.
The same pattern can be seen in most service sectors – with administrative and support services at the top end and finance towards the bottom.
In services, employment growth has also been generally stronger than in manufacturing, weighing on productivity. In some respects, this is a good thing, to the extent that it reflects a “jobs-rich recovery.”
And intelligence from CBI companies points to a range of more persistent, sector-specific trends.
Two key sectors which have been critical to UK productivity growth but which have had particular constraints since 2008 are financial services and oil and gas in the North Sea.
Global trends have had an effect on both sectors, but also on the agricultural sector.
Regulation has clearly been a factor not only in financial services, but also in construction, transport and distribution, where new licence rules have led to a shortage of permanent, full-time HGV drivers.
Generally, raising productivity growth in transport and other key network sectors, such as electricity & gas, is especially important for tackling the productivity challenge, since they are widely used as inputs by all other sectors.
Similarly, supporting the growth of the tech sector can help boost the supply of these necessary skills and get new technology and innovations into the wider economy. Eileen Naughton, Google's Managing Director for UK & Ireland said: "It can be easy to think that technology is just for start-ups, but we know it can bring real growth to all businesses.”
CBI companies are clear that changing business models have influenced productivity in financial services and other sectors. But competitive pressure has not always led to productivity improvements in the way we would expect.
In the retail sector – for example – CBI companies have highlighted heavy price competition from “discounters”. To maintain a competitive edge, some retailers have been taking on more workers to provide a more personalised customer service. So while the quality of retail experience has arguably improved, measured productivity has got worse.
Yet further up the food and drink supply chain, these same pressures have had different effects. To compete on price, food and drink manufacturers have made investments which have driven up productivity.
And there are signs that – in a whole range of sectors – firms are starting to respond, with investment in new IT, software and machines which should lead to greater productivity growth in the years ahead.
As well as understanding – quite forensically – the causes of the productivity stall, we need to be sure we are confident in macro productivity measures before we jump to policy solutions. For many CBI companies – on a matched plant basis their productivity is as good as elsewhere in the world. For others – the measure of output per person hour doesn’t make sense.
In our data-driven, knowledge-based economy – where services play a key role - it’s less and less just about the quantity of widgets coming off production line and more and more about the quality of customer interaction.
We need productivity data which understands this - helping policy-makers reach the right conclusions and find the right solutions.
Of course we want to grow our productivity in order to grow our economy – and I will come back to that shortly.
The third ingredient of a rebalanced economy which has been missing until recently is that of rising living standards.
As I have toured the country during my time as CBI Director-General talking about our improving economy, I have often received a different reaction from the public to that from employers, especially outside of London and the South East.
Meeting people for whom GDP figures were irrelevant if they couldn’t touch, smell and feel economic recovery.
And even though we had a jobs-rich recovery it was long time before we saw a pick-up in wage growth, because that depended on the turn in demand, in business investment and in productivity.
The good news is that the missing pieces of our economic rebalancing are now coming into place and it’s to that more optimistic story which I will now turn.
How can we rebalance our economy?
Turning to the future, stronger growth in investment and productivity will remain crucial to the UK’s economic outlook.
We now need to do in more emerging markets what we are already doing in China – and double our exports.
Britain is well positioned to do this – better positioned than many of our competitors. The last decade of exports may have belonged to Germany, but the next decade can be ours. There’s a big prize to be won – if we act now.
Forecasts commissioned by the CBI from Delta Economics suggest that UK exports of goods and services could be worth an additional 350 billion pounds per year by 2025, an increase of around 70% over the next decade.
Despite all the recent turmoil, forecasts from Oxford economics show that emerging markets are likely to account for 58% of global GDP growth over the next 10 years.
While the big commodity exporters like Russia and Brazil will find life tougher over the next decade with low oil and commodity prices bringing their own rebalancing challenges, Asia’s prospects look bright, despite the plummet in China’s equity prices.
While the big commodity exporters like Russia and Brazil will find life tougher over the next decade with low oil and commodity prices bringing their own rebalancing challenges, Asia’s prospects look bright, despite the plummet in China’s equity prices.
World GDP growth
Population growth in India and South East Asia along with urbanisation empowered by new technology will drive enviable GDP growth, even if it’s slower than the sprinting pace of the last decade.
And the growing spending power of middle classes in these emerging markets is likely to play to Britain’s trading strengths.
Research by the National Institute of Economic and Social Research for BIS has looked at how import demand changes as GDP increases.
It shows that several sectors in which the UK has a revealed comparative advantage are particularly responsive to rising incomes, and are therefore likely to be strong sources of growth for UK exports in future years.
Opportunities in emerging markets
Commercial services will be a major opportunity. Overall demand for “business services” is forecast by Delta to grow at a steady 2.5% per year, with legal, consultancy and architectural services showing particularly strong growth above 5%.
The global market for UK pension and insurance services is predicted to grow by about 4% a year over the next decade. And whilst relatively small in absolute terms, the market for construction services could grow at a rate closer to 6%.
When it comes to goods, the UK could see strong export growth in pharmaceuticals, aerospace, vehicle manufacture, chemicals and mineral products.
Whilst Europe and the US will remain our biggest export markets, the Asian giants of China and India will continue to contribute to this emerging middle class.
CBI companies are following China’s rocky road to more open financial markets closely. And we’ve already revised down our exports forecast for 2016, largely due to lower growth in China bearing down on global prospects.
Yet – even if China grew by 5% this year, that’s the same as adding an economy the size of Belgium to the global economy. And – looking forward - we need to keep our eyes firmly focused on the long-term picture.
China is likely to remain the largest source of overseas demand for vehicle manufacturers, accounting for more than a third of growth over the next decade.
While UK pharmaceutical trade is still predominantly with developed countries, China is projected to account for 10% of export growth, as healthcare in China becomes more sophisticated.
Overall, exports to China should grow at more than 8% per year in the next decade, whilst exports to India are predicted to rise by 6%, with solid growth across all categories. And later this year, state visits to the UK by Indian Prime Minister Narendra Modi and Chinese President Xi Jinping will be a great opportunity to deepen these trading ties.
But when I talk to CBI companies, they’re not just looking to the “usual suspects” - the BRICs – like India and China. Forecasts show strong growth in demand for UK goods from smaller countries with growing middle-class populations – like Thailand, Malaysia and the United Arab Emirates.
Smaller emerging markets
In April, Rolls Royce landed a £6.1 billion deal to provide engines and long-term services for 50 of Emirates’ “A-Three-Eighty” superjumbos in their biggest-ever deal. One month later, the UAE-UK Business Council agreed a new bilateral trade target, aiming to double the value of trade to 25 billion pounds a year by 2020.
We’re also seeing promising signs in South East Asia - like Jaguar Land Rover’s authorised dealer – City Automobiles - presenting seven vehicles from its portfolio at an auto exhibition in Bangkok, Thailand last year.
And Vietnam – in particular – could be a real chance for British exporters.
Goods exports to Vietnam have grown by an average of 8% from 2005-14 – totalling $523m in 2014. The market is forecast to be worth more than $1 billion per year by 2025. Today, top goods exports include machinery and equipment and pharmaceuticals.
According to Boston Consulting Group – Vietnam’s middle and affluent class will double in size between 2014 and 2020 - growing from 12 to 33 million. And the recently signed EU-Vietnam Free Trade Agreement should help break down barriers to trade.
Ethiopia could be another opportunity. Whilst certain parts of the economy – including some service sectors – remain closed, goods exports to the country have grown by an annual average of 12% from 2005-14, and were worth $182m in 2014.
Top goods exports already include machinery and equipment and electrical goods. The market for goods exports is forecast to be worth $386m per year by 2025, meaning an additional $960m in export revenues over the next decade.
By 2025, Ethiopia’s population of 90 million is set to increase to 120 million. And with GDP per head at purchasing power parity set to triple by 2025, in ten years’ time Ethiopia will become a middle-income country.
So with these emerging markets and growing middle-classes, there’s a big prize up for grabs. But we’re not the only ones in the running.
The UK remains the world’s second largest exporter of services after the US. But over the last 10 years, Germany has narrowed the gap on services exports. Whereas the UK is strong in financial services, Germany is strong in the transportation sector.
In recent years Germany has overtaken the UK in exports of telecommunications, computer & information services, and revenues from intellectual property. And we’re facing a stiff challenge in other business services.
But this competitive challenge is one Britain can rise to. Middle Class consumers want branded goods and services, and the Union Jack flies high here.
Jaguar cars, Prudential Insurance, and where we really score – our creative industries.
Adele’s music, James Bond films. British architects designing the fan roofs of Asia’s airports.
In 2013 we exported over £1.8 billion of services from the UK’s creative industries to Asia. But we can do even better.
Consumer goods and services to the middle classes of the new world – this is the sweet spot for British exports.
And what of productivity and living standards?
Where next on that part of our rebalancing journey?
A dynamic economy?
Well, there is much I agree with in the Government’s ‘fixing the foundations’ plan for creating a more prosperous nation – the first actions from which were announced in July’s Budget.
Encouraging long-term investment in economic capital, including infrastructure, skills and knowledge.
And promoting a dynamic economy encourages innovation and helps resources flow to their most productive use.
All good stuff. With one caution, one revision and one omission.
The caution is about politicians mandating wage rises, rather than them rising with productivity growth.
The revision is about the gap in the education system.
More than 2 in 5 young people are being let down and not getting 5A*s-C including English and Maths.
And the omission is the need to focus on the dynamo of the economy – the British Mittelstand.
A word on each.
First – a note of caution.
Political targets risk undermining the ‘triangle’ of business investment, organic productivity growth and sustainable wage increases that have supported UK employment.
It’s business investment which drives productivity growth.
And it’s productivity on which wage growth depends.
All three are now rising.
National Living Wage
An improvement in productivity growth seems to be underway and forthcoming productivity data for Q2 this year are likely to show that UK productivity has finally just about risen above its pre-crisis peak in the first quarter of 2008 and its subsequent peak in the third quarter of 2011.
We have also started to see wage growth lifting. Last month we revised up our forecasts for average earnings growth this year and next. And the improvement in productivity should help to support that trend going forward.
But wages can only grow as businesses grow. A £7.20 National Living Wage in 2016 and a £9 National Living Wage by 2020 are laudable objectives, but they are a gamble.
They depend on organic productivity improvements, not on political whim.
And we should be careful what we wish for. Our jobs-rich recovery is a success which depends on entry level jobs and progression routes on our high streets and in our leisure sector.
I've talked to many CEOs who feel they may now have to make changes to their business models which could result in fewer job and progression opportunities.
The necessary revision? The gap in our education system.
We’re still struggling to achieve a balance between the academic and vocational needs of young people in the UK.
The Government want schools to offer a broad and rigorous academic curriculum, building knowledge, skills, character and resilience. Its answer is for all pupils to study the English Baccalaureate, more rigorous GCSEs and A-levels, alongside apprenticeships and high-quality technical education.
This will improve rigour, but I doubt it will help all young people become rounded and grounded.
The Ebac speaks to Grammar School kids like me, but the technical qualifications for those who don’t want the academic route and the focus on character and resilience for all are still pale and out of focus alongside the Ebac.
It’s time that all young people have learning routes relevant to them from 14-18, that GCSEs were retired and that a full range of A-levels recognise technical and personal achievement as well as academic.
And the notable omission?
The UK’s forgotten army of medium-sized businesses are the real engine of future growth, and they need our support.
The British Mittelstand – the 20,000 or so companies with a turnover of £10-100 million a year are the principal dynamo of growth in the British economy and have the most potential employment growth for innovation and exports.
To coin a phrase from the 1992 US Presidential election, “It’s the middle, stupid!”
So let’s start by abolishing the term ‘SMEs’ so that both start-up Britain and scale-up Britain can get the relentless focus they need. Growing medium-sized businesses need ambition for growth, a supporting Coalition of the willing and – most importantly – patient capital.
Now talking of patience, you have been very patient!
So let me draw to a conclusion.
At the beginning of today’s lecture I asked three questions.
First – have we rebalanced?
Well, the answer is more positive than many allow for.
Since the crisis, growth has been more healthily balanced – shifting towards investment and away from debt-driven consumption.
I then asked what held us back. Well, both export performance and productivity growth have been slow to build. But neither are a puzzle. The nature of the economic crisis determined the pace of the recovery.
And the future opportunities? I do believe that Britain now faces economic prosperity despite global downside risks. My job is to make this country the best place in the world from which to do business around the world.
And I think we stand a good chance of being just that. As the CBI celebrates its 50th anniversary, the search for the Holy Grail goes on. Like Galahad in the legend, we at the CBI are passionate about the mission.
I look forward to the next 50 years of the CBI with optimism.