Rebalancing in the Dark Rebalancing in the Dark Bill Martin Centre for Business Research, University of Cambridge HM Treasury seminar, 27 th July 2010 y , y Disclaimer: views expressed are the author’s and are not necessarily those of the CBR
Outline Outline 1 1. Rumsfeld uncertainty Rumsfeld uncertainty 2 2. Medium-term scenarios di i 3. Robust rebalancing strategy
How much uncertainty? 1. Recession forecasting errors 2. Credit crunch impact? 3. Lessons from past business cycles
Recession forecast errors Overprediction of 2009 GDP level, % of outturn HM Treasury Consensus 12.0 10.0 8.0 8.0 % 6.0 4.0 2.0 0.0 Two years ahead One year ahead
Bean’s wealth calculation 1. Fall in consumption in advanced countries due to wealth shock (banks’ write-offs) 2. But loss of advanced country GDP relative to potential “more than 10 times bigger” than (1) “ So we cannot come near to explaining the “Great Contraction” purely in terms of wealth effects.”
Credit crunch? Bank lending to non-financial business & households, % of GDP 20.0 16.0 12 0 12.0 % 8.0 4.0 0.0 -4.0 1Q 1980 1Q 1985 1Q 1990 1Q 1995 1Q 2000 1Q 2005 1Q 2010
Recession puzzle of 2009 Percentage points unless stated 2008 2009 Output gap, % (new data) -2.2 -9.3 Output gap, % (old data) -1.8 -8.9 Identified factors: -2.0 -5.2 Export shortfall -0.4 -3.1 Wealth & confidence shocks Wealth & confidence shocks -1.6 1 6 -3.1 3 1 Stabilising fiscal policy 0.0 1.1 Unexplained residual 0.2 -3.7
Banking crisis “lessons” – two camps • Camp 1 – permanent loss Camp 1 permanent loss (Reinhart & Rogoff & many others) • Camp 2 – strong recovery (C (Cecchetti, Mussa, Ormerod) h i M O d)
Rumsfeld uncertainty • Deeply uncertain outlook - not fan chartable • Credit crunch – large impact? large impact? • Policy makers have to consider a range of sharply • Policy makers have to consider a range of sharply contrasting future economic conditions of seemingly equal prior plausibility
Two medium-term scenarios • Fast & slow recovery scenarios - updated for June Budget • Fast recovery scenario - strong export revival, strong competitiveness response, credit crunch fades di h f d • Slow recovery scenario - more limited export revival & competitiveness li it d t i l & titi response, credit crunch persists
Scenario analysis – three steps 1. Baseline – align with OBR forecast but query - productivity assumption - import penetration assumption import penetration assumption 2 2. Impose alternative assumptions Impose alternative assumptions - external trade & competitiveness impact - asset prices & credit crunch impact 3. Model “fast” and “slow” recovery profiles
OBR productivity projection Productivity index (GDP per worker; 2007=100; OBR projection after 2009) mechanical projection: 2.0 % growth p.a. after 2007 140 120 100 80 60 40 20 0 1949 1959 1969 1979 1989 1999 2009
Import “elasticity” I Annual import "elasticity" - import growth divided by private TFE growth 40.0 y 1949-2010 35.0 30.0 25.0 25 0 ency, %, yearly 20.0 15.0 10.0 Freque 5.0 0.0 below 0.5 0.5 to 1 1 to 1.5 1.5 to 2 2 to 2.5 above 2.5
Import “elasticity” II Import "elasticity" - overlapping 5-year intervals 50.0 0 arly, 1949-2010 45.0 40.0 35.0 30.0 quency, %, 5-yea 25.0 20.0 15.0 10.0 5 0 5.0 Freq 0.0 below 0.5 0.5 to 1 1 to 1.5 1.5 to 2 2 to 2.5 above 2.5
HMT & OBR forecasts for 2010 Forecast for 2010 Volume growth, % Import “elasticity” y GDP GDP I Imports t PBR Dec 2009* 1.3 0.7 0.6 Budget Mar 2010* 1.2 2.3 1.4 Budget June 2010 1.2 5.5 2.3 *Mid-point forecasts. Imports ex. MTIC fraud. Elasticity – p p y import growth divided by private TFE growth (inferred )
Rebalancing assumed The forecast is conditioned on the assumption that: “ the shape of the recovery in the UK economy embodies an orderly adjustment in the sectoral financial balances and a rebalancing of domestic financial balances and a rebalancing of domestic and external demand supported by sterling’s depreciation. ” December 2009 PBR, A.42, page 146 See also March 2010 Budget B 42 page 157 See also March 2010 Budget B.42, page 157
Scenario analysis – three steps 1. Baseline – align with OBR forecast but query - productivity assumption - import penetration assumption import penetration assumption 2 2. Impose alternative assumptions Impose alternative assumptions - external trade & competitiveness impact - asset prices & credit crunch impact 3. Model “fast” and “slow” recovery profiles
Scenarios – GDP growth GDP growth projections Fast Slow Consensus OBR Projection from 2009 4 2 0 % -2 -4 -6 2007 2008 2009 2010 2011 2012 2013 2014 2015
Scenarios - unemployment Unemployment rate, end-year, % Fast recovery F t Sl Slow recovery P Projection from 2009 j ti f 2009 12 10 8 % 6 4 2 0 2007 2008 2009 2010 2011 2012 2013 2014 2015
Scenarios – private financial surplus Private sector financial surplus, % of GDP Fast recovery Slow recovery Projection from 2009 14 12 10 8 8 % 6 4 2 0 2007 2008 2009 2010 2011 2012 2013 2014 2015
Private surplus – slow recovery Private sector financial surplus, % of GDP Slow recovery Projection from 2009 14.0 9.0 % 4.0 -1.0 -6.0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Scenarios – budget deficit Budget deficit, % of GDP Fast recovery Slow recovery Projection from 2009 14 12 10 8 % 6 4 2 2 0 2007 2008 2009 2010 2011 2012 2013 2014 2015
Scenarios – government debt Government debt, end-year, % of GDP Fast recovery Slow recovery Projection from 2009 100 80 60 60 % 40 20 0 2007 2008 2009 2010 2011 2012 2013 2014 2015
Private financial wealth & public debt Private financial wealth & government debt, % of GDP Private financial wealth Government debt Slow recovery projection from 2009 100 80 80 60 % 40 20 0 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015
Scenarios – balance of payments Current account of balance of payments deficit, % of GDP Fast recovery Slow recovery Projection from 2009 4 2 2 % 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 -2 2 -4
“Full-employment” financial balances "Full employment" financial balances, % of GDP in 2015 strong trade performance g p moderate trade performance p 10.0 9.0 8.0 7.0 7 0 6.0 % 5.0 4.0 3.0 2.0 1.0 0.0 Unemployment Budget surplus Private deficit BoP deficit
Scenario lessons • Optimistic OBR • Fast recovery with latent balance of payments problem payments problem • Slow recovery trap
Policy challenges • Keeping the recovery going - is monetary policy enough? y p y g • Encouraging a balanced recovery - supporting resource reallocation supporting resource reallocation - raising future competitiveness - resisting currency appreciation resisting currency appreciation
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