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  Assessment and Recommendations

  The UK economy has proved remarkably resilient during the recent downswing with output falling only a little below potential. At the same time, inflation has remained close to the target and the unemployment rate is among the lowest in the OECD. More recently the economy has been gaining considerable momentum, well ahead of the euro area. This strong performance is underpinned by wide-ranging structural reforms and sound macroeconomic policy frameworks. A pro-active monetary policy successfully stabilised activity and inflation, helped by a strong transmission channel operating through the housing market. The government budget balance was in substantial surplus at the peak of the cycle and this has enabled fiscal policy to be strongly supportive of growth during the downswing, although the government deficit has now become sizeable. In the context of this impressive macroeconomic performance the decision that was taken in June 2003 to wait further before holding a referendum on entry into the European monetary union is perhaps unsurprising. All in all, the United Kingdom seems well placed to take advantage of the global recovery and move towards a more broadly based growth that relies less on consumption and housing wealth...

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  Macroeconomic Developments, Prospects and Policy Challenges

  Since the mid-1990s, GDP growth, inflation and unemployment have been remarkably stable in the United Kingdom (Figure 1.1). Nowhere else in the OECD has economic activity remained so consistently close to trend over this period (Figure 1.2).1 The United Kingdom has also been among the most resilient economies during the recent downturn. Apart from Canada, it is the only G7 economy, for which output has not fallen by significantly more than one percentage point below potential. Moreover, it has been one of the few European countries (large or small) to display such a high degree of robustness during the downswing (Figure 1.2).2 At the same time the unemployment rate has remained continuously close to 5 per cent. In 2003, it will be the lowest among the major seven economies, while deviations of inflation from the target have been as small as could have been reasonably expected. This impressive macroeconomic performance is a testament to the strength of the current macroeconomic policy framework as well as more than two decades of structural reform.3 It has also been an important factor behind the decision to postpone a referendum on entry into the Economic and Monetary Union (EMU) (Box 1.1). In this generally favourable context, the United Kingdom seems well placed to take advantage of the ongoing world recovery and to move towards a more broadly based growth that relies less on consumption and housing wealth, but extends to so far lagging exports, investment and manufacturing activity...

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  Reducing the Risk of Instability from the Housing Market

  Over the last couple of years the housing market has been a major consideration in the setting of monetary policy as demonstrated by numerous references in the minutes of the Monetary Policy Committee (MPC). The high interest rate sensitivity of the housing market strengthens considerably the transmission channel of monetary policy, in marked contrast with most continental European countries. On the other hand, there are a number of episodes over the last three decades when developments in the housing market have either been a cause of, or exacerbated, macroeconomic instability. The challenge is therefore to retain the inherent strength of the current framework, i.e. a strong reactivity to interest rate changes, while reducing its drawbacks in terms of potential instability and possible misallocation of resources in the long run. The government is committed to a comprehensive programme to improve the functioning of the housing market, addressing both supply and demand issues. Such measures are seen as encouraging greater convergence with the euro area economies, but are also considered "beneficial in their own right to improve the stability and flexibility of the United Kingdom housing market and wider economy." The remainder of this chapter puts the UK housing market in international context, evaluates it as a source of macroeconomic instability, and finally considers what the appropriate policy response is, both in the current cycle and over the longer term...

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  The Fiscal Challenge

  The United Kingdom has endeavoured to increase the quality of public services in three strategic areas where it lags behind countries with a similar degree of economic development: public infrastructure, education and health. Raising quality of services involves more public spending. This ambitious spending plan will have to be executed without compromising a fiscal framework that has served the United Kingdom well so far and is mainly based on a "golden rule" that seeks to prevent a decline in public net wealth in the long-run while providing flexibility over the cycle. This framework allows the financing of new public infrastructure subject to a "sustainable investment rule" which sets a target for net public sector debt that is comfortably met at present. However, the increase in current expenditure will have to come either from increased taxation or slower growth of expenditure in the long run. The government has already increased taxes and has set very strict targets for spending outside health and education. The government also started from a strong budgetary position that could accommodate part of the spending increases on health and education. However, the surpluses achieved in 1999-2000 seem to have had an exceptional character, with buoyant tax receipts linked to the equity price bubble. Recent budgetary developments indeed suggest that the underlying position of public finances is weaker than originally expected in Budget 2003. Going forward, an important strategic variable is the speed of the build up in priority spending. It could be reduced on several grounds: firstly, cost-effectiveness needs to be ensured, to lock in improved performance, rather than higher costs; secondly, more time to pilot and implement promising innovations in health care would be available; and finally, potential strains on a fiscal framework that has been very successful so far would be diminished. This chapter will first assess how much the government deficit has departed from the original plans and evaluate the consequences for the government’s room for manoeuvre. It then considers how best to meet the challenge of adhering to the government’s fiscal rules and code while at the same time raising standards in health and education. An in-depth examination suggests that the existing room for budgetary manoeuvre is less than expected and that securing increases in the quality of services may call for a somewhat less rapid growth in spending in the future...

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  Policies to Enhance Potential Growth

  While macroeconomic policy has been very successful in ensuring that output remains close to potential, the evidence is less compelling that structural policy has succeeded in lifting potential output growth closer to best performance.66 Productivity gaps with the best OECD performers remain large, as discussed in Chapter 1, despite a wide range of policies addressing this weakness. While employment rates are relatively high, they fall well short of the highest in the OECD, and the proportion of the population that is not engaged in the labour market at all has remained flat over recent decades, so that the major source of increased labour input has come through a reduction in structural unemployment. The remainder of this Chapter assesses what areas are most promising in promoting potential growth, considering in turn, labour utilisation and productivity. A summary of progress on structural reforms, following-up and updating recommendations from the previous Survey, can be found in Annex A...

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  Product Market Competition and Economic Performance

  There is a well–identified empirical connection between the intensity of competition in product markets and better productivity performance (OECD, 2002a). In general, competitive pressures appear to be relatively strong in the United Kingdom but this does not mean that there is no room for improvement. The overhaul in competition legislation that occurred in recent years was long overdue and active enforcement along with the new market studies and market reference regimes of the competition enforcement agencies should help to ensure that markets are competitive. In service sectors the United Kingdom has experienced relatively strong labour productivity growth over the 1990s and a large part of this is due to the introduction of increased competition over this period. However, market power on the part of incumbent firms in some sectors remains a concern and current planning restrictions are inhibiting competition in the retail sector. While recent steps by the government overcome the most serious weaknesses of the privatised rail system, problems regarding incentives and clear lines of responsibility remain to be resolved...

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  Some Aspects of Sustainable Development

  There is a growing concern that long-run sustainable development may be compromised unless measures are taken to achieve balance between economic, environmental and social outcomes both domestically and on a global basis. This section looks at three specific issues of sustainable development that are of particular importance for the United Kingdom: climate change, improving living standards in developing countries and sustainable retirement income. In each case, indicators are presented to measure progress and the evolution of potential problems, and an assessment is made of government policies in that area. The section also considers whether institutional arrangements are in place to integrate policy-making across the different elements of sustainable development (Box 6.1)...

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  Annexes
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