After a period of relatively good performance, UK economic growth appears to be easing up, and data from the global economy also shows a deterioration. In particular, the Chinese economy is slowing, while the news from the Eurozone is dismal, with the once apparently mighty German economy flirting with recession, and the rest of the area performing poorly, and struggling to recover. All this shows that the effects of the Great Recession and its causes remain with us. In this context, how is the UK to achieve a sustained recovery?
The UK recovery of the last 18 months or so has been driven by growth in consumer spending, some investment and contrary to stated government policy, an easing of austerity and a still large budget deficit. Real wages have been falling, which exerts a drag on consumption, unless savings fall or employment grows. Indeed, this is what has been happening, with the boost to consumption from healthy employment growth and falling savings offset to an extent by falling real wages. It is also possible that recent rapid house price growth has contributed to rising consumption through wealth effects as homeowners feel more wealthy and confident enough to increase their spending. Unfortunately, the effects of rising house prices and falling savings can only be temporary, and will eventually have to reverse, so a sustained rise in household consumption can only be driven by rising real wages and employment. Rising real wages can in turn only be sustained by rising productivity and here the UK’s performance has been dreadful since the recession. Indeed, falling productivity would appear to be the driver of falling real wages. So a continued economic recovery rests on a turnaround in the UK’s productivity growth so that the latter rises. But what drives productivity growth?
Arguably, the main driver of productivity growth is investment, both public and private. There have been some signs that business investment has begun to rise in the UK, but overall it remains insufficient to power a sustained recovery. Government investment was initially slashed by the coalition as an ‘easy’ way to pursue austerity, but in the medium to long run this can only be a false economy. Public sector investment in well-chosen infrastructure projects can boost demand and employment in the short run, while adding to capacity and hopefully ‘crowding-in’ or stimulating private sector investment as the business environment is improved. Especially with interest rates so low, a significant boost to public sector investment would seem to be a no-brainer right now, funded by borrowing. The Labour party’s plan to reduce the current budget deficit (that is, borrowing for government consumption), while allowing borrowing for investment if it wins the next election, appears sensible. In addition, policies that create a house-building boom would also boost economic growth and employment, while putting downward pressure on house-prices in the longer term as the housing shortage is eased.
So investment is key to a sustained recovery. Investment should boost productivity, which allows real wages to rise, providing the foundation for rising consumption, which can stimulate business profits and encourage further rounds of investment, leading to a potentially virtuous circle of rising and more balanced prosperity. But apart from public sector investment boosting that in the private sector, what would lead business to significantly raise investment? The answer is rising profitability, both current and prospective.
Business profits can rise in a number of ways. Firms can reduce costs by cutting the workforce and capacity. They could also invest in new and improved technological capacity which can raise productivity and mean that the same size workforce is working with more efficient equipment, which ultimately costs less to use. In practice, some combination of these is often carried out, which can be seen as a re-organisation or restructuring. Sometimes firms may need to borrow for such restructuring, and at other times, profits may already be high enough to fund it. In the UK, firms have raised profits by holding down wages, but productivity has failed to rise, so unless they start to significantly raise investment, for the business sector as a whole, these rising profits are unsustainable since growing productivity, real wages and consumption are the key to long-term growth.
We have discussed the sources of rising current profits, but rising expected profits are partly caused by rising consumption. So rising profits to fund investment, and rising consumption which can sustain those profits, are vital to increased prosperity in the long run.
As I discussed in an earlier post, a sustained boost to the UK’s net exports would be an ideal way for the economy to rebalance away from its reliance on private and public debt, potentially reducing both as the economy grows. A stimulus from foreign sources of demand, which could raise the UK’s exports, would after a time stimulate investment in new business capacity as the profits of exporting firms rise, raising capacity and employment. This could in turn raise tax revenue for the government, reducing the deficit over time. Growth in net exports could boost growth across the economy as investment and productivity rise, real wages follow, and the newly-employed and better-paid workers spend some of their higher wage packet as consumption, eventually boosting growth across the whole economy. And as the growth in consumption should be driven by higher real wages, there should be less need for borrowing to fund consumption, and private sector debt as a proportion of GDP will fall as the latter rises while the debt itself does not.
So in this way, the UK economic recovery could become sustained over a number of years, based on a rebalancing of activity. However, the dreadful performance of the Eurozone, our largest export market, is a major drag on UK exports and this provides a significant constraint on growth which, in the absence of devaluation and a Eurozone recovery, is unlikely to be reversed. All that UK firms can do is try to tap into demand from more vibrant export markets, but as the world economy begins to slow once more this prospect becomes harder. It seems a shame to end on a downer, but for the moment, this is the reality that we face. For the moment, the UK economy will rely on growth in domestic demand which, if the current account deficit continues to grow, will become ever more difficult to sustain as private debt accumulates. The solution to current difficulties lies partly in the international arena, and since the flurry of activity at the height of the 2008-2009 financial crisis, decisive action has been increasingly lacking. At the same time, the resolution of global economic imbalances between nations is part of the cause of weakening global growth. I will post on this another time.