UK economy must perform a rebalancing act

By Martin Wolf

How ill is the UK economy? What are the challenges for economic policy? These questions seem to me to be far more urgent than before any general election since 1979, when Margaret Thatcher came to power.

The one point on which everybody agrees is over the depth of the fiscal hole: the government is borrowing a pound for every four it spends. But nobody wants to discuss what might need to be done. This is not surprising: today’s fiscal deficits exceed those of any previous period in peacetime. Yet even if one accepts that these deficits must be tackled, huge questions remain over the timing and content of such action.

In the UK at least, the fiscal deficits are mirror images of private sector surpluses. Moreover, the direction of causality is from the latter to the former. The necessary conditions for a return to fiscal (and economic) health are a recovery in private spending, a huge increase in net exports or, ideally, both. The big question is whether the essential recovery in private spending and net exports will occur before, or after, it becomes difficult for the government to borrow on reasonable terms. If it comes before, a smooth fiscal exit is feasible. If it comes after, a crisis would intervene. I am optimistic on this, but am not blind to the risks.

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Between 2007 and 2009, net lending – the gap between income and expenditure – of the UK private sector jumped by a massive 9.8 per cent of gross domestic product (see chart). Since the net inflow of capital from abroad fell little, the principal offset to this shift towards frugality was the government’s towards profligacy. Net government borrowing jumped by 8.6 per cent of GDP between 2007 and last year.

Now look at the private sector components. Between 2007 and 2009, the shift of households towards surplus was 6 per cent of GDP. The shift of non-financial corporations was 3.2 per cent. The impact of the crisis on private spending has overwhelmed the monetary policy offsets from the Bank of England, at least in the short term.

Now consider the policy challenge: it is not to cut the fiscal deficit, regardless; it is to cut the fiscal deficit, while sustaining recovery and growth. It is stabilisation with growth, not stabilisation at the expense of growth. Economic misery is not desirable but detestable.

If the actual fiscal deficit is to be cut by, let us say, 10 per cent of GDP, then the sum of the financial surpluses of the domestic private and foreign sectors must fall by the same amount. If this is to occur with growth, there needs to be a strong surge in spending in these sectors. Andrew Smithers of London-based Smithers & Co offers a compelling analysis of what this might mean.* In particular, he points out that this is impossible without a massive improvement in the external balance.

Alas, the UK’s net household savings are exceptionally low. This is consistent with the sector’s huge shift into deficit between 1992 and 2007. Household savings need to rise, not fall. While an offsetting jump in residential investment would be most desirable, it is unlikely to occur.

As Mr Smithers notes, UK fixed investment has been extremely low for years. It has, most recently, been running at a mere 14 per cent of GDP (see chart). A big rise would be desirable, to generate current demand and future growth. It would be optimistic, however, to expect its share of GDP to rise even by as much as 5 percentage points. Moreover, it is unclear that this would drive the non-financial corporate sector all the way to balance, because higher profits (and so retained earnings) would probably be a condition for the higher investment. The overall balance, then, could remain positive.

The conclusion is that the foreign balance – and so net exports – need to shift by at least 5 per cent of GDP. Unfortunately, a disturbing new paper by Ken Coutts and Robert Rowthorn, for the think-tank, Civitas, argues that trends in the UK’s external position are in the opposite direction. Weak sterling, far from being the problem, is a big part of the solution. But it will not be enough. Attention must also be paid to nurturing a more dynamic manufacturing sector. With the decline in energy production under way, this is now surely inescapable.

The Panglossian view is that if the fiscal deficit were reduced, domestic private spending and the external balance would adjust automatically. But, with real interest rates on index-linked gilts at just 0.6 per cent, short-term interest rates at 0.5 per cent, yields on conventional 10-year gilts at about 4 per cent and weak growth of credit and broad money, this is a fairy story. The situation is entirely different from that in 1981, when the Tories tightened fiscal policy successfully in a recession.

Yet even if fiscal tightening is far more likely to follow recovery than cause it, it does not follow that current fiscal deficits will be easy to finance for long enough to permit the needed economic adjustments to occur. While the UK’s private sector surpluses are nearly big enough to finance the fiscal deficit, this may well not be how it decides to invest its money, at least at present prices. It might buy foreign assets instead.

The question is whether, or when, a further fall in sterling could turn into a rout. Such a loss of confidence might then undermine inflationary expectations and raise long-term interest rates. The result could be both a renewed recession and an explosive path for public debt. At the same time, a further fall in sterling seems desirable, if not inevitable, not least given the poor recent performance of productivity (the flip side of the welcome employment performance). Weak demand in the eurozone, the UK’s biggest trading partner, only makes such a fall even more necessary.

The decisive fact about the UK economy, then, is that it has to manage a huge, multi-year economic rebalancing. Policymakers must bear four points in mind: first, they must promote the essential strengthening of investment and net exports; second, they must realise that this big economic adjustment is a necessary condition for a durable fiscal improvement; third, they must also prevent the fiscal deficit from crowding out the needed rebalancing; and, finally, they cannot assume that today’s huge fiscal deficits can be comfortably financed indefinitely, should the rebalancing of the economy itself fail to occur.

This is going to be a very tricky policy performance. How to carry it off will be my subject this Friday.

* UK: Either a Large Trade Surplus or Grim Prospects for Profits and the Fiscal Deficit, March