Bill Robinson

The London Business School econometric model of the UK

Abstract This paper describes the London Business School econometric model — the first fully computerized model of the UK — which has been used for regular public forecasting since 1966. The model, estimated on quarterly data, is organized around the income expenditure accounts with a fully integrated flow of funds sector which ensures consistency between portfolio decisions and income, savings and investment decisions. Aggregate demand is built up from its individual components so that demand influences are important for the short- and medium-term behaviour of the model. But there are important supply-side effects which work through the real exchange rate and real wages. Monetary conditions have a powerfull effect on the model through the exchange rate, personal sector wealth and interest rates. Wages and employment are determined in a labour market in which employment decisions depend on the level of demand and real wages while real wages depend on the level of unemployment, real benefits and direct and indirect taxes as well as underlying trends in productivity. Asset prices move in any period to clear both the spot and the future market in assets so that current asset prices in the equity, gilt-edged and foreign exchange markets reflect all current information about the expected state of the economy. In contrast, goods prices adjust sluggishly. The combination of continuously clearing asset markets and sluggish wages and prices gives the model many of the theoretical characteristics associated with the open-economy models of Dornbusch and Buiter and Miller.

THE REAL WAGE GAP

Over the past year a gap has opened up between the growth of manufacturing productivity and that of real wages. This gap cannot persist indefinitely, but it can be closed in many different ways. The best that can happen is that wage settlements fall while output and productivity accelerate. The worst outcome would be continued stagnation of real output and no deceleration of wages, in which case the required productivity improvement would have to come about through renewed labour shedding. There are worrying signs that this has started to happen. An intermediate solution might involve a fall in the exchange rate, with some improvement in competitiveness boosting real output (so that UK producers get a larger share of buoyant consumer spending) and some rise in prices holding back real wages. We continue to believe that the most likely outcome is a rise in output and a fall in the rate of wage settlements. In our June forecast this occurs despite a fall in the real exchange rate. In these circumstances we expect the growth of unit labour costs to fall back from its current high level so that the current 3 per cent inflation rate becomes a true “core” rate. But a moderate fall in the real exchange rate may prove hard to achieve, especially if the oil price continues to weaken. We therefore explore what would happen if the required depreciation happens more rapidly, so that interest rates have to remain high to prevent it getting out of control. In this case we would expect lower growth and higher inflation than we forecast in June.

Economic Viewpoint: The Dangers of “Reaganomics”

After four years of steady output growth, and with the prospect of even faster growth this year, capacity constraints are emerging and inflation has doubled from the low point of May 1983. But unemployment has not fallen and some commentators are still calling for fiscal expansion. The ranks of the expansionists have been swollen by the signs of economic slowdown in the US, which have prompted the OECD to call for “an international configuration of policy-settings conducive to a performance that is both sustainable and adequate”. The noted US-based economist Rudiger Dornbusch has also called for a fiscal expansion worth about £5bn as part of a general plan to expand borrowing in Europe while the US cuts its deficit. The obvious objection to such a policy prescription is that it would be inflationary. However proponents of reflation are now careful to couch their expansionary fiscal policies in an anti-inflation framework of tight monetary discipline. In this Economic Viewpoint we take issue with this prescription. We show that there are good theoretical reasons why the combination of tight monetary policy and fiscal expansion will always produce high interest rates and an uncompetitive exchange rate, and we show how this happened to Japan in the mid-1970s as well as to the UK in 1980 and to the US at the present time. Our examination of these earlier episodes suggests that, although this policy mix is generally successful in boosting consumption and containing inflation, its longer-term effects on investment and net trade are adverse. Even in a large, relatively-closed economy these adverse consequences mean that the policies have sooner or later to be reversed. In a small open economy this reversal will happen sooner rather than later.

The Recession of 1980 and its Causes

During 1980 total output fell by 5% per cent and manufacturing output by 16 per cent. By May 1981 manufacturing output was 20 per cent below its 1979 peak level. in this Briefing Paper we use the London Business School model to explain the current recession. We conclude that the main identifiable came was the rise in the price of oil. but output was also affected by the increase in VAT and the reductions in public investment. Those cawes directly explain a reduction in output of about 3 per cent in 1980 compared with what might otherwise have happened. We suggest that additional links (not fully incorporated into the model) increased the impact of those shocks and led to the severe fall below potential output. The first part of the paper describes briefly the events of I979 and 1980. in the second part we ask how far the economic developments were predictable and in the third part we set out our explanations.