The UK’s current account deficit recently made the economic headlines, hitting 6% of GDP in the third quarter of 2014. Indeed, the BBC’s economics editor Robert Peston has been worrying about it for some time and commented on this statistic in his last blog before Christmas. As he says, the UK chancellor of the exchequer George Osborne and the Prime Minister David Cameron, publicly obsess about the public sector deficit, claiming that it is the UK economy’s major problem, but choose not to mention the current account deficit, which has been over 5% of GDP for 15 months. They also choose not to mention the UK’s appalling productivity record in recent years, which is behind the sluggish behaviour of real wages, popularly known as the ‘cost of living crisis’, and drawn attention to by the opposition Labour party in their criticism of the government’s record.
With a public sector deficit, the government is spending more than it is receiving in taxes, and at its current level, the stock of public debt is rising year on year. With the large current account deficit, the amount the UK owes abroad is also accumulating. These trends are unsustainable in the long term, and need eventually to be reversed as the UK must ultimately pay off these debts. It can be shown that the only way for the UK public sector to run a budget surplus as the chancellor has claimed he wants to do by the end of the next parliament, and for this not to lead to a dangerous and also unsustainable rise in private sector debt, is for the UK economy to run a current account surplus for a number of years. Using the simple algebra from my previous blog post, representing public and private sector expenditure flows for a national economy:
(S – I) = (G – T) + CA
where on the left hand side of the equation, (S – I) is private sector savings minus investment or net private sector saving, and on the right hand side, (G – T) is government spending minus taxation or the public sector deficit, and CA is the current account surplus of the balance of payments. This is actually an identity and is true by definition, whatever happens to the economy in question. From this we can see that if our economy always has a balanced budget, or G = T, then (G – T) = 0, and net private saving equals the current account surplus. If net private saving becomes negative, or (S – I) < 0, then CA < 0, or the current account must be in deficit. In the current UK case, CA = – 6% (a negative figure represents a deficit) of GDP and (G – T), the public sector deficit, equals roughly 6% of GDP. The left hand side, private sector net saving, is therefore around zero, since -6 + 6 = 0. George Osborne is aiming to run a public sector surplus by 2020, let’s say of 2%, represented by (G – T) = -2% (a surplus is the same as a negative deficit). If we assume that the current account stays at -6% of GDP through to 2020, the private sector would need to shift from balance to net dissaving of 8% of GDP, or – 8 = – 2 – 6 for our equation above. This would mean that although the stock of public debt would be by this stage falling fairly rapidly, private sector debt would be rising even more rapidly if (S – I) stays negative. As mentioned in my previous post, this would probably only be possible if there were another housing or stock market boom which drives the increase in private sector debt. This would probably lead to another bust, in which asset prices fall, and private saving increases once again, sending the economy into another recession. Osborne’s ‘long term economic plan’, in these terms, is unsustainable and dangerous economically and financially.
In an ideal world, how could Osborne’s plan for the deficit work? As mentioned above, the only way for the UK government to run a budget surplus over a number of years and pay off substantial amounts of the stock of public sector debt, without the risk of serious economic and financial instability domestically, is for the UK economy to run a current account surplus. Using our equation above, if the UK current account were to swing into a surplus of 2% of GDP (which seems implausible on current trends, but bare with me) by 2020, then CA = 2. The UK government could then run a budget surplus of 2% of GDP, or (G – T) = – 2%, with private sector net saving equal to zero, or in balance as (S – I) = 0 in our equation, since 0 = – 2 + 2. In this situation, the UK economy would be running down its stock of public debt, and paying off debt owed abroad through its current account surplus. At the same time, with private sector net saving equal to zero, the risk of an unsustainable rise in private sector debt, from already high levels, would not be being taken.
Sadly, the rosy scenario outlined above is unlikely to materialise in the medium term. With the UK’s main trading partner, the Eurozone, stagnating economically, the prospect of net exports and other income from abroad rising substantially appears to be poor for the next few years. The world economy is not performing well enough to stimulate a rapidly improving UK current account through a strong increase in foreign aggregate demand. There is not a great deal that the UK can do about this. Even a weakening sterling exchange rate may not do it, at least until global demand recovers sufficiently to improve the prospects of UK exporters.
To sum up, if the chancellor’s ‘long term economic plan’ for the deficit is achieved by 2020, then it is likely that serious risks will have been taken with UK economic and financial stability and we run the risk of another serious balance sheet recession. In the current global economic climate, a sustainable alternative, as outlined above, would appear to be very difficult to achieve.