Last week the UK government’s new Chancellor of the Exchequer, Phillip Hammond, known to some as ‘spreadsheet Phil’, gave his first Autumn Statement to parliament. This outlines the state of the UK economy and the government’s finances, and announces new policies on government tax and spending.
The forecasts of the Office for Budget Responsibility for the UK economy’s likely trajectory over the next few years were somewhat gloomy, and laid much of the blame for this at the door of the decision to leave the EU, or Brexit. Growth will be slower, investment weaker, and public borrowing and debt higher than otherwise.
I will avoid reiterating details regarding the Autumn Statement that were covered in last week’s press, and instead focus on the potential for debt reduction and overall economic performance over the next few years, which the government is trying to manage and improve upon: the Prime Minister wants an economy that ‘works for all’. Fine aspirations indeed.
If UK debt is to fall, then the economy will have to undergo a fundamental rebalancing. Now when governments talk about debt they usually refer to public debt. But private debt in the UK as a share of GDP is higher than public debt. At the moment the UK is still living ‘beyond its means’, and overall debt is accumulating faster than GDP growth, so that the share of debt is also rising. This is demonstrated by the current account deficit, currently around 6% of GDP according to The Economist magazine.
The current account deficit represents foreign lending to the UK. The latter is by accounting definition equal to total domestic borrowing, or the excess of total domestic investment over total domestic saving. Since the public sector deficit (annual government borrowing) is about 4% if GDP, the private sector deficit is roughly 2%, as these two figures are equal to the current account deficit (4+2=6). As already mentioned this is a matter of accounting rather than economic theory. These three financial balances must evolve together, so that if domestic borrowing is to fall, then foreign lending reflected in the current account must also fall. This says nothing about causation, but it is a useful framework for economic analysis and sets the constraints which govern the evolution of the economy as a whole.
If UK borrowing is once more to become sustainable, and economic growth is to be strong enough to maintain relatively low unemployment without continuously rising debt, this must be reflected in a much smaller current account deficit or, even better, a surplus. The latter would mean that domestic public and/or private debt could be repaid without the need for eventual default or inflating it away.
The current account must rebalance dramatically, and this would then mean that total domestic saving would rise by more than total domestic investment. Private and public investment in the UK are both far too low and this is reflected in sluggish growth in output and even more so in productivity and wages. If wages are to rise productivity needs to rise, and this requires higher productive investment. Domestic saving also needs rise by even more than the rise in investment. How can this be achieved? Part of the answer is devaluation.
The devaluation of the pound since the vote for Brexit in June should be welcomed, as it should boost net exports (exports minus imports), and raise the value of net investment income from abroad. These two components together make up the current account. For this to happen, the lower value of the pound needs to be sustained, if necessary through government policy.
It has been five months since the pound fell dramatically in the wake of the vote, and it is not entirely clear that the beneficial effects are coming through. We have been promised higher inflation due to higher import prices, but surprisingly little has been said about the potential boost to exports and investment income. Of course, if the higher inflation from higher import prices negates the impact of the weaker pound on exports, there may be little or no change in the trade balance. But the improvement in the value of net investment income should take place.
There is an important element missing from this account of the potential for the UK economy to rebalance and begin to pay down its debt while sustaining more satisfactory growth rates. The necessary rebalancing must also occur in the rest of the world economy, in an equal and opposite direction. This means that for the UK to move from current account deficit to surplus, the rest of the world must necessarily move from running a current account surplus with the UK to running a deficit. After all, the sum of all the current accounts in the world economy must be equal to zero. They must balance!
The largest current account surpluses are run by China, Germany and Japan. For the world as a whole, and for the UK in this instance, these three economies need to rebalance. According to Michael Pettis, in these economies consumption is too low and total domestic net saving (net of investment) too high. This is caused by policy and institutional constraints which repress the household share of national income, leading to repressed consumption and excessive saving. In the years leading up to the crisis of 2008, these countries exported their excess savings abroad, which fueled debt, consumption and asset price (stocks and housing) bubbles. When these burst and deleveraging (paying off debt) began, the world fell into recession.
The upshot of all this is that the rebalancing of the world economy is a reciprocal process. If Germany, China and Japan do not rebalance then the UK can only do so at the expense of rising imbalances elsewhere. It will therefore be interesting to observe the evolving picture for the UK if the new lower value of the pound is sustained. In my view the latter is essential for the UK to rebalance and to move its accumulation of debt onto a more sustainable footing.
There is nothing wrong with debt if it is used to finance the accumulation of productive assets, which prove more than able to fund the repayment of the debt when it matures. But if debt finances the purchase of unproductive assets and fuels financial bubbles which eventually burst, leading to deleveraging in order to repair the resulting damaged balance sheets, the result will be economic and financial crisis, perhaps followed by a lengthy period of stagnant growth.
The consequences of the 2008 crisis continue to evolve in critical fashion. Until substantial global rebalancing occurs, not least in the UK, we will not be free of them.