Free Lunch (25 page)

Real life, of course, is more complicated than that. While manufacturing in Britain is only about a third of the size of the private services sector and a fifth of the economy, it punches above its weight. Manufacturers, for example, contribute more than their fair share of export earnings – manufactured goods account for some 62 percent of UK exports of goods and services. The economy could not manage without these. Britain has also been successful in attracting inward investment from outside the European Union, particularly Japan and America, much of it into manufacturing. This is hardly the mark of a country that has lost its comparative advantage in making things. Not only that, say advocates of manufacturing, other European countries with larger manufacturing sectors than Britain tend also to have higher living standards, higher per capita GDP. The UK would do better, in other words, with an expanded manufacturing sector. It is also the case, in Britain and elsewhere, that manufacturing firms tend to be more innovative, introducing more technologically driven products and processes than their service-sector counterparts. Innovation, as we have seen, is one of the drivers of economic growth. It may even be that the bald figures understate the importance of manufacturing. The Engineering Employers’ Federation and others have pointed out the substantial linkages between industry and other parts of the economy, notably service industries. Without manufacturing as a driver of demand, other parts of the economy would soon suffer. The broad picture is that while it is possible to discuss in the abstract the idea of Britain without a manufacturing sector, the economy will need one for the foreseeable future. That leads on to a further debate: if we need a vibrant and successful manufacturing sector, even a larger one than exists at present, how do we go about creating one? Pretty well every government gets around at some stage to launching a manufacturing strategy. None has yet been notable for its success. A stable economic environment is one essential ingredient, as are a ready supply of skilled workers and a change in the attitudes that have put industry at the bottom of the pecking order when it comes to, for example, graduate career choices. A full answer, however, would require another book.

It is time to go. We have been here for hours and the waiters are showing their impatience. There are many more arguments we could have about economics and I hope you will have been stimulated to have some. This has been a fairly rich diet of economics and I hope it has not caused any indigestion. I hope too that it has given the lie to the perception that economics is impenetrable and scary. In economics, as in so many things, there is usually nothing to fear except fear itself. Having read this book, nobody need have any fear of economics.

Bite-size glossary

Aggregate demand:
Total spending in the economy, or another way of describing gross domestic product. In a closed economy, aggregate demand would consist of spending by consumers and government and on investment (by business and government), as well as any change in stock levels. In an open economy aggregate demand also includes exports, but not imports.

Aggregate supply:
The direct counterpart to aggregate demand, being the total of all goods and services produced in an economy over a given period.

Asymmetric shocks:
Economic events that affect different countries, or different parts of countries, in distinct ways. It was long thought that Britain would be unable to participate in European economic and monetary union because of sterling’s greater sensitivity to oil price changes as a result of North Sea production.

Automatic stabilizers:
If governments allow public spending to rise and tax revenues to fall in a recession without doing anything about it, they are allowing the economy’s automatic stabilizers to operate. In a boom, tax revenues could be expected to be strong, public spending weaker.

Average cost:
The cost to a firm of producing a product, measured simply by taking the number produced in a given period and dividing it by the total cost. It is distinct from the marginal cost – that of producing an extra unit of output – just as the average rate of income tax, which in Britain is likely to be around 30 percent even for quite highly paid people, is distinct from the marginal rate of tax, which for top-rate taxpayers is 40 percent.

Balance of payments:
The sum of all a country’s transactions with the rest of the world. It builds up from trade in goods, exports and imports, and the trade gap beloved of headline writers, through to the current account. This measures trade in goods and services, as well as the so-called invisible items of trade, such as interest, profit and dividends paid to and received from abroad. The current account is the best overall measure of an economy’s external position and whether it is ‘paying its way’ in the world. The capital account of the balance of payments is made up of long-term investment flows, such as the building of a factory by a foreign firm, portfolio flows, such as investment in stocks and shares in the country, and short-term speculative or ‘hot’ flows, perhaps attracted by the current interest rate. There are also official flows. A country that has a current account deficit and insufficient capital inflows to match it will probably suffer from a falling exchange rate, it may also have to borrow or run down its foreign exchange reserves. The balance of payments, as its name suggests, has to balance.

Base rate:
The interest rate on which the banks base the rates they pay to depositors and charge borrowers. When the Bank of England changes interest rates it is common to refer to a base rate change, although the Bank alters a money-market rate, the so-called ‘repo’ rate. The base rate is not to be confused with the basic rate, which is the standard rate of income tax.

Bretton Woods:
The conference in 1944 that gave birth to the post-war international monetary system, including the International Monetary Fund, the World Bank and the ‘gold exchange standard’, a system of fixed-but-adjustable exchange rates that lasted until the early 1970s.

Bubble:
From the time of the South Sea Bubble of the 1720s, bubble has been used as a term to describe an unsustainable rise in asset prices. Thus, the technology bubble burst in March 2000, while some commentators refer to a house price bubble. The Japanese economy of the late 1980s was subsequently known as the bubble economy.

Budget:
The main annual fiscal policy statement, which in Britain is held in March or April and is mainly concerned with tax changes. A Pre-Budget Report, in the autumn, sets out some of the measures beforehand, for consultation. Under current arrangements a Comprehensive Spending Review takes place every two years to agree public spending totals for the following three years.

Budget deficit:
What arises when the government’s planned spending exceeds the amount it raises in taxation. A budget surplus occurs in the opposite situation, while a balanced budget matches government spending and tax revenues. Governments have adopted various rules over the years to limit their budget deficits. In Britain the Thatcher government ended up with the aim of balancing the budget over the economic cycle, while the Blair Labour government follows the ‘golden rule’ of borrowing only to fund public investment. Countries inside the euro are required to meet the conditions of the Stability and Growth Pact, limiting their budget deficits to 3 percent of gross domestic product and in normal circumstances aiming for a balanced budget or small surplus. There are many ways of measuring the budget deficit. For many years the public sector borrowing requirement was the key measure in Britain. Now it has been renamed the public sector net cash requirement, and other measures such as public sector net borrowing have come to prominence.

Business cycle:
The tendency to show a regular pattern of faster and slower growth, usually over a four to five year period. The cycle has four phases – recovery, peak, slowdown and trough. When the recovery is particularly strong it becomes a boom, when the slowdown is sharp it may turn into a ‘bust’ or recession. Governments and central banks often try to dampen the effects of the cycle by using fiscal and monetary policy. Real business cycle theorists such as Robert Lucas advise against this. There are plenty of other types of business cycle. A Juglar cycle, after the French economist Clement Juglar, lasts nine to ten years. A Kondratiev cycle, after the Russian economist Nikolai Kondratiev, lasts around fifty years. There is considerable debate about the continued existence of all these cycles. In the 1980s the UK Chancellor Nigel Lawson claimed to have abolished the business cycle.

Capital expenditure:
Investment by companies or governments in plant, machinery, vehicles, buildings, or, in the case of governments, the infrastructure.

Central bank:
The institution responsible for monetary policy and in some countries (not Britain) financial and banking regulation. The Bank of England, the European Central Bank, the Federal Reserve Board and the Bank of Japan are the world’s major central banks.

Comparative advantage:
The theory, developed by David Ricardo, in which countries can benefit from trade even if one has an absolute advantage in the production of all goods and services.

Competition policy:
Measures taken by governments to break down monopolies or other dominant positions within markets by firms, thus encouraging competition. In Britain since 1997 the Office of Fair Trading has been given an enhanced role in investigating and recommending action against anti-competitive behaviour, while the Competition Commission, which polices monopolies, has effectively been given independence from government. It used to be thought that there were ‘public interest’ monopolies – companies that were dominant in the home market but could use this as a springboard in the world market. Such thinking, that a monopoly position for national champions should be permitted, is no longer fashionable.

Competitiveness:
Essentially the ability of a country or its exports to compete internationally. Some economists argue that it is appropriate to measure competitiveness only among companies, not countries. Even so, a country that is uncompetitive will probably run a current account deficit, and may need a lower exchange rate, as well as more fundamental corrective measures.

Crowding out:
The situation in which an increase in government activity results in a fall in private sector activity, either because the public sector lays claim on resources (particularly workers) that could have been used by private firms, or because increased government borrowing pushes up interest rates.

Current expenditure:
Expenditure on non-capital items. Spending by governments on the wages and salaries of public sector workers, or on schoolbooks and medicines, all comes under the heading of current expenditure.

Deflation:
A fall in the general price level, the opposite of inflation. The last global deflationary episode was in the 1930s, although Japan also experienced deflation in the 1990s. Reference is sometimes made to deflationary policies. These are not aimed at bringing about deflation but, rather, slowing a strongly growing economy. A central bank raising interest rates or a government increasing taxes or cutting public spending could be said to be introducing deflationary policies.

Depreciation:
Two distinct meanings, the first being the declining value of a capital asset due to wear and tear and obsolescence. The second is the right expression for a fall in the value of a currency during an era of floating rates. If the pound falls from $1.60 to $1.40 against the dollar, it has depreciated.

Depression:
A prolonged economic downturn or period of stagnation, as distinct from a shorter recession. The last worldwide depression was in the 1930s.

Devaluation:
The correct expression for a fall in the value of a currency during a fixed rate era, such as the Bretton Woods system that lasted from just after the Second World War until 1973. In November 1967 the pound was devalued from $2.80 to $2.40 against the dollar, remaining at the new lower level.

Diminishing returns:
The situation in which a firm applies additional factors of production, for example extra workers, to increasing output but achieves a smaller increase in output for every additional worker employed. Diminishing marginal utility refers to the declining satisfaction each additional unit of consumption brings – one whisky might be enjoyable, the tenth much less so.

Direct taxation:
Taxes on income, for example income tax or National Insurance contributions, or in the case of companies, corporation tax.

Disinflation:
A reduction in the rate of inflation, not to be confused with deflation, a fall in prices.

Disposable income:
Income after (direct) tax.

Econometrics:
The application of mathematical and statistical techniques to economic theories and relationships. The equations that make up models of the economy are estimated using econometric techniques.

Economic growth:
The rise in gross domestic product, or per capita GDP, from one year to the next. Growth is the ultimate aim of economic policy. The trend rate of economic growth in Britain, its average over time, is currently estimated by the Treasury to be 2.75 percent.

Efficient market hypothesis:
The theory that the level of the stock market, or any other financial market, reflects the efficient use by market participants of all the information available to them.

Elasticity of demand:
The responsiveness of demand for a product to a change in its price, or to a change in the incomes of consumers.

Euroland:
Popular name for the area covered by European economic and monetary union, the euro area. Euroland came into being on 1 January 1999 with eleven members (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain). Greece joined later.

Exchange rate:
The value of one currency, expressed in terms of another, for example the pound’s exchange rate against the dollar is $1.50.

Externalities:
Costs, or benefits, generated by firms or individuals but affecting others. Pollution is a common negative externality, which is why firms are subject to anti-pollution controls and penalties. An attractive garden might generate positive externalities – benefiting not only its owner but also passers-by.

Fiscal policy:
Strictly speaking, matters pertaining to tax. The fiscal year is the tax year. In practice, fiscal policy refers to the tax and spending decisions by governments, usually taken annually in Budgets. The role of fiscal policy has changed over the years. In the 1950s and 1960s it was used for ‘fine-tuning’ purposes – managing demand in the economy. Now fiscal policy is usually framed in a medium-term context, with tax changes seen as impacting on economic performance and public spending also usually planned for some years in advance. Fiscal drag is a technical term describing the fact that in the absence of changes, the tax government takes from individuals will normally rise as a result of inflation as rising incomes move people into higher tax brackets. This is why income tax allowances, for example, are conventionally raised in line with inflation.