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It takes time

Created:

9 December 2008

Written by:

Chris Dillow

One useful rule of thumb in macroeconomics is that everything takes longer than you might think. Recent figures illustrate this.

Today's numbers show that the slump in the pound is doing nothing obvious to help manufacturers. Output has fallen for eight successive months, the worst run since 1980. And export volumes, excluding oil and erratics, are 2.7 per cent down on last year.

Meanwhile, several retailers think the VAT cut has not yet boosted sales. Yes, John Lewis says it has, but their figures might tell us more about the merits of co-operative ownership, and the rationality of consumers, than about macroeconomics.

Truth is, though, I wouldn't expect much quick effect at all from either the VAT cut or fall in sterling. Both take longer than people think to affect the economy, because they work in a different way than you might think.

The common view is that lower prices of VAT-rated goods and higher prices of imports cause people to substitute towards consumer durables and UK-made goods, thus boosting economic activity.

But this substitution effect is weak. There are other, slower but more powerful effects.

In the case of VAT, there's an income effect. If people don't respond immediately to the VAT cut at all, but merely carry on spending as usual, they will find that they have more cash left over than they thought, because the VAT-rated goods they bought cost less. Eventually, they might get round to spending this spare cash. There's no reason to suppose they will do so immediately, though.

In the case of sterling, there are two effects.

One is a real options channel. At the margin, a weak pound makes it profitable for a UK firm to enter an overseas market. Firms have, in effect, a call option on exporting. But you do not exercise options the moment they become in the money. You might instead wait for them to be even more in the money. And holders of export options have good reason to cling onto them, as uncertainty about overseas demand, and the future price of the pound, mean it's possible that exporting will become much more profitable later. So why incur the costs of investing in overseas sales networks now?

The second is a profitability channel. A weak pound - at the margin again - weakens the overseas competition faced by UK firms. Less competition, other things equal, means higher profits. And higher profits lead, eventually, to higher spending.

All these effects take time - many months.

Personally, I doubt that the VAT cut will in truth have much effect even in the longer run - I'm more confident about the eventual effect of the low pound - as it'll be offset by Ricardian equivalence effects. But I wouldn't dream of judging its effect yet.

So, let's remember - the economy moves, for good or ill, more slowly than we think.