The UK economy is currently stagnating and may even fall into a triple-dip recession if growth proves to be negative in the first quarter of 2013. I have already written about the importance of fiscal policy in supporting recovery in a balance sheet recession, when nominal interest rates can hardly fall any further. However in the longer term, a sustainable recovery can only occur if the UK economy re-balances away from over-reliance on borrowing for consumption and financial bubbles and towards exports and private sector investment.
Recent UK trade performance has been poor, with a persistent deficit on the current account of the balance of payments, despite a substantial devaluation of the pound in trade-weighted terms since 2008. Sterling has depreciated by around 25% since then, with no discernible improvement in the current account.
If net exports (ie exports minus imports) were to grow rapidly, this would be exactly the kind of stimulus to demand that the UK economy needs. If sustained this demand from abroad for the output of UK-based companies would improve the current account and at some point stimulate investment in new capacity and employment as firms reach capacity constraints. Unemployment would fall more rapidly as GDP grows, and with falling jobless numbers and rising national output would come reduced welfare payments and increased tax revenues. The budget deficit would therefore fall from its current level even without extra cuts in public spending and increases in tax rates which are current policy in the UK. With increasing national income, household deleveraging could occur more rapidly, restraining consumption as individuals continue to save and pay off accumulated debts, while not leading to continued stagnation or even recession. All of this re-balancing would happen in an ideal economic world.
Sadly, we are not living in such a world, at least not yet. About a half of UK exports go to the EU, and much of that to the eurozone. The eurozone is currently in recession, partly due to the mindless pursuit of austerity across the continent (see graph at link). Recession among our European neighbours drags down their demand for UK exports. With the equally mindless pursuit of austerity in the UK, and the UK private sector in substantial financial surplus, where is demand to come from? The answer is: nowhere, unless private or public spending increase substantially. Despite having interest rates at record lows, UK business investment is languishing. Business as a whole is sitting on enormous cash surpluses, so the funds for investment are there, without the need to borrow. But it is quite possible that the lack of demand for their output is keeping investment plans on hold. If there is not prospect of increased sales, what would be the point in expanding capacity? A looser fiscal stance until recovery is established could help, especially if it took the form of public investment in goods and services with a low import content. Some leakage of an increase in demand to spending on imports is probably inevitable, reducing the multiplier as spending goes abroad, but suitably targeted public spending could minimize this effect.
The largest component of aggregate demand for the national income is consumption expenditure. Since the beginning of the recession households have chosen to save more, albeit relative to negligible rates of saving on the eve of the crisis, and they are paying down debt. This is to be welcomed as it helps to re-balance the economy and make it less dependent on unsustainable debt-fueled private spending for consumption. But it does act as a drag on growth. Throw in higher inflation generated by a weaker pound and therefore dearer imports, including commodity prices and the effect is compounded.
So when taking account of a drag from private consumption and languishing private investment, net exports, and the squeeze induced by the government’s austerity programme, there are no sources of demand left to generate a decent rate of growth and recovery for the UK. Despite the fact that the government is still running a substantial deficit, if the private sector is trying to run financial surpluses (ie with income greater than expenditure) greater than that of the public sector, then aggregate demand will fall and the economy will be dragged into recession.
But what if growth is not determined by demand but by supply in the long run? Well, Keynes did say that ‘in the long run we are all dead’, implying that policy-makers should act now to improve economic performance, rather than waiting for the long run to occur and hoping for the best (sounds a bit like the Cameron-Osborne strategy!), but in my opinion supply is just as important as demand, and the two elements interact in the growth process.
Those on the right of the UK Tory party are clamouring for steep tax cuts funded by steep public expenditure cuts, and deregulation, to ‘kick-start’ growth. This is all about the economics of incentives and stimulating entrepreneurial efforts, but ignores the importance of demand. Given that UK productivity has been falling recently, meaning that despite a stagnant economy, employment has actually been rising in the private sector, while real wages are falling, it might be thought that growth is not constrained by demand-side but by supply-side factors. The UK remains a ‘flexible’ economy with a ‘flexible’ labour market, as rated by the World Economic Forum on the issue, so if there are supply-side constraints, it is more likely that these are due to stagnant investment in capacity, which includes worker training, as well as relatively low levels of R&D and poor infrastructure. Since companies are unlikely to invest in new capacity and employment if they have low sales prospects, demand is important to stimulating investment. On the supply-side, if firms’ profits are taxed too heavily, or if wages take too large a share of earnings, they may once more come to the conclusion that it is not worth investing: these are supply-side constraints on growth. Neither of these sorts of constraints seem to be important at the moment. Wages are stagnant while firms are sitting on large cash surpluses, while the rate of corporation tax is not high by international standards. Demand seems a more likely constraint at the moment.
As long as firms have the capacity to increase production in response to a rise in demand, the expansion of net exports remains the most desirable route to recovery. But as discussed above, this is not presently forthcoming, especially while a turnaround on the continent looks remote in the short term. So the next-best source of growth must be domestically-led, in the form of a looser fiscal policy and incentives for UK-based firms to invest their cash surpluses in new capacity and employment. A boom in house-building would help as well! We are not powerless in the face of adversity.