FT/Wolf: UK economy must perform a rebalancing act
- From: Muggle <mugglefuggle@xxxxxxxxxxxxxx>
- Date: Wed, 14 Apr 2010 13:41:18 -0700 (PDT)
UK economy must perform a rebalancing act
By Martin Wolf
Financial Times
Published: April 13 2010 23:02
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.
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 2010, restricted
More columns at www.ft.com/martinwolf
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