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27 April 2015

How sound is Britain’s recovery?

Unbalanced, uneven, and fragile. The recovery isn't all it's cracked up to be.

By Peter Kenway

“The single biggest issue affecting the country at the moment”, Ken Clarke told the New Statesman the other day, is that “we still have not created a rebalanced, modern, competitive economy, which can start producing sustainable rises in living standards”.

How can that be? On the face of it the economy looks to be into a good recovery phase – growth at its highest since 2006, record employment levels and the public sector deficit under half what it was at its peak in 2010. When Ken Clarke says this isn’t “balanced”, isn’t he just being awkward?

A new, and mercifully short, report – authored by myself, Dan Corry and Steve Barwick and published today by NPI – coincidentally provides an answer. On the surface, the report confirms the economy is indeed doing well. But look ‘beneath the bonnet’, it goes on, and you find not an economy set fair for sustained growth, but an unbalanced economy whose growth is reliant on households spending to the hilt and a balance of payments deficit with the rest of the world which has ballooned.

So what would a balanced economy look like? As history would have it, there was once another year when the public sector deficit also stood where it does today, at 4.5%, coming down steadily in the years following a deep recession. That year, 1995/96, was the third in a run of eight golden years of economic growth, which started under a Conservative government and continued under a Labour one. 

The point the report uses to compare now with then is that by definition, the public sector deficit equals the sum of the financial surplus of the household sector plus the financial surplus of the corporate sector plus the balance of payments deficit. The chart shows these other balances for the two years in question, along with the 20 year average.

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The state of the economy is better judged by looking at all the balances not just one. In 1995/96, the 4.5% public sector deficit was matched by a household sector still saving like mad (+7.0%), a corporate sector borrowing to invest (-3.4%) and a small balance of payments deficit (+0.9%). So this was economy where investment was driving growth, where there was plenty of room for the balance to deteriorate a bit and where the main policy challenge was to encourage households to spend more.

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2014/15 looks quite different. Now, the household sector needs to save more not less. The balance of payments deficit (+5.3%) is already well above its long term average (+1.8%). The corporate sector deficit (the first since 2002) is a relatively bright spot but (at -1.5%) is pulling the economy a lot less strongly than it was in 1995/96.

In short, the last time the public sector deficit was where it is today, the other parts of the economy were quite differently and much better aligned, leaving the economy balanced and poised for growth in a way that it is not now. And the last time the public sector was where it is today, the Chancellor was Ken Clarke.

Things could still work out in 2015: an export boom, shrinking the balance of payments deficit and encouraging firms to invest more in pursuit of export markets, would work wonders. But encouraging foreigners and companies to spend more is not what conventional management of the economy is about at all.

Unconventional monetary policy, in the shape of quantitative easing, came to the rescue after the global banking crisis. Other ‘unconventional’ economic policies are now urgently needed. Deficit reduction is desirable; but it is nowhere near enough. The next government may be in for a much bumpier economic ride than any of the political parties like to imagine.

Beneath the Bonnet: How sound is Britain’s recovery? can be read here.