UK GROWTH PERFORMANCE LAGS ADVANCED ECONOMY PEERS
The UK economy is currently experiencing its most protracted period of sluggish growth in two centuries. As with other G-7 countries, it emerged from recession in 2009, but real GDP is still 2.6% below its previous peak. Per capita real GDP is 6% below its 2007 peak whereas at this point in previous post-war recoveries it was typically 6-8% higher.
Among the G-20 countries, only Italy has had a lower growth rate than Britain during the past five years. UK real GDP fell by 6.3% during the recession compared to 9.2% for Japan, 8.1% for Italy, 6.8% for Germany, 4.7% for the US, and 4.3% for France. It was the worst downturn for the UK since 1830 while it was the worst post-war downturn for other countries. Since the downturn, the UK economy has grown by 3.9% compared to 8.7% for Germany, 8.3% for the US, and 8.7% for Japan. Italy and Spain have been in recession since mid-2011 while France has slid back into recession.
Real GDP Growth Performance by Country 2004-12
The UK economy lost 2.5% of its jobs during the downturn compared to 1.8% for Germany, 2.2% for France, and 6.2% for the US. The modest job losses caused UK output per hour to decline by 9.9% from its pre-crisis trend, or by more than in any previous post-war business cycle. Germany had a work sharing program to protect jobs during the recession while France has numerous legal restrictions on layoffs. It was surprising that the UK had such modest job losses because the UK labor market is more flexible than many other countries. The latest World Economic Forum Global Competitiveness Index ranks the UK fifth for labor market efficiency. The UK has the lowest degree of labor market protection in the OECD except for the US and Canada. The UK unemployment rate rose from 5.1% in early 2008 to 8.3% in late 2011 and has since declined to 7.7%. The unemployment rate in the US rose from 4.5% to 9.9% during the recession and has since declined to 7.5% while the unemployment rate in continental European countries other than Germany has been increasing since early 2011. It is now nearly 11% in both France and Italy and over 27% in Spain.
The poor performance of UK productivity did not have a major impact on the country’s competitive position because there was a large decline in the value of sterling after 2008. UK unit labor costs in US dollar terms fell by 16% between 2007 and 2011 while they increased by 18% in Germany and 15% in Italy. Spain held unit labor costs stable through pay cuts. The poor performance of UK productivity during the past four years suggests that British firms have been less ruthless than their American counterparts in trying to slash costs. Nonfinancial corporate profits in the US have increased 86% since 2009 while in the UK they have increased only 34%. The fact that UK firms did not engage in aggressive cost cutting four years ago will probably make them cautious about new hiring during 2013 and 2014.
US and UK Nonfinancial Corporate Profits 2001-2012
The European Commission’s monthly business and consumer survey of UK confidence fell to 96.2 in April from 98.2 in March. The latest figure is 1.5 standard deviations below its pre-crisis average and the lowest level since September. It confirms that the UK economy is weak despite the fact that real GDP grew by 0.3% during the first quarter.
UK ECONOMIC GROWTH REMAINS CONSTRAINED BY DELEVERAGING
The economy has been constrained by a variety of factors, but the most important has been deleveraging by the household sector. There was far more expansion of private debt during the years before the 2008-09 downturn than during previous business cycles. During the recovery of the mid-1990s, for example, the growth rate of private debt matched the growth rate of real GDP. During the period 1997-2007, by contrast, real GDP grew by 36% while real private debt rose by 122%. The ratio of private debt to GDP rose from 125% in 1997 to 206% in 2007. The growth of UK private debt was far greater than in the US and much more similar to Spain. The surge in Spanish debt resulted from the fact that it experienced a large decline in interest rates after joining the European Monetary Union. Spanish three month interest rates fell from 9.36% in 1995 to 2.10% in 2004. If the UK had joined the monetary union and enjoyed interest rate levels comparable to those in Spain, it might have tripled its private debt after 1997, not doubled it.
European Private Debt Levels by Country 1995-2011
The surge in private borrowing had many spillover effects. There was a large rise in house prices which made households feel wealthier, and thus encouraged yet more spending. The household sector became so confident that its savings rate plummeted from 8.13% in 1997 to 1.67% in 2007. The real estate activity boosted government tax revenues and made the Labour government more willing to increase public spending. As with all booms, the momentum from increased borrowing had self-reinforcing effects on both asset prices and spending.
UK Household Saving Ratio 1987-2012
The economy’s recent weakness reflects the leveraging process going into reverse. There has been little growth in consumer credit for nearly four years. The household savings rate has increased by 6.9%, or by more than during any recovery since 1970. In the business cycles of the 1970s and 1980s, the household savings rate declined while during the 1990s it increased by 3%. The recent uptick in the savings rate has been unprecedented.
Inflation has also helped to restrain consumption. Wage growth during recent years has been only 2% while the inflation rate has fluctuated in a 2.5-5.5% range. The Bank of England has not been able to restrain inflation because its major priority has been to encourage economic recovery. It has engaged in significant quantitative easing by purchasing £375 billion of government securities to compensate for the fact that interest rates are at record lows. In his latest budget speech, Chancellor George Osborne endorsed the bank having a flexible inflation target in order to promote economic recovery. The new governor from Canada, Mark Carney, is likely to expand the balance sheet further after he takes over in July.
IS AUSTERITY TO BLAME FOR THE UK’S WEAK GROWTH PERFORMANCE?
Many critics blame the government’s fiscal policy for the economy’s weakness. In its first budget after the 2010 election, the new government outlined a plan to eliminate the fiscal deficit over five years, but it has now abandoned those plans. It is now projecting a fiscal deficit of 7.4% of GDP this year, 6.8% next year, 5.9% in 2014-15, 5% in 2015-16, 3.4% in 2016-17, and 2.2% in 2017-18. The deficit was 11.2% of GDP in 2009-10, so it has been cut by one-third during the past three years. The public sector’s net debt will be 75.9% of GDP this year compared to 57.1% in 2009-10. The government projects that it will peak at 85.6% of GDP in 2015-16 and then decline to 84.8% in 2017-18.
The government’s problem is that a weak economy limits the growth of tax receipts while public spending is still increasing. The government offered a few proposals to boost growth in its latest budget. It will reduce the corporate tax rate to 20% in 2015, the lowest level among the G-7 countries. It will give every firm a £2,000 rebate on their national insurance contributions, a measure which will help small firms. It will boost government infrastructure investment by £3 billion in 2015 after reducing it this year for the first time since 1999.
The Office of Budget Responsibility is predicting that growth will be only 0.6% this year. It then expects a recovery to 1.8% output growth in 2014, 2.3% in 2015, 2.7% in 2016,and 2.8% in 2017. The OBR has been projecting such an upturn since 2010, so it has simply been changing the timing of its forecasts, not their trajectory. It believes the UK has a potential GDP growth rate close to 2.5% if financial conditions are normal.
The most novel feature of the recent budget was the chancellor’s proposal to help create a much larger subprime mortgage market in the UK. Banks currently require homebuyers to make a 25% down payment when they purchase a home. Many people cannot afford such a large down payment, so the number of housing transactions in England and Wales has fallen from over 1.2 million in 2006 to just over 600,000 recently. The chancellor has offered to help potential homebuyers who can only afford a 5% down payment by loaning them 20% of the home value in order to qualify for a loan. He is prepared to help create £130 billion of new mortgages with this proposal, or an amount equal to more than 10% of the value of existing mortgages. Before the collapse of the mortgage-backed bond market in 2007, banks routinely offered mortgages worth more than 90% of the value of a home. Such lending came to an end in 2008 and has never recovered because of banks wanting more protection from falling house prices. The chancellor’s proposal will promote a much faster recovery in housing demand. As the UK has many planning restrictions on hew homebuilding, the effect could be to produce larger house price increases than would normally occur. The chancellor’s plan will create a contingent liability for HM Treasury, but it will not threaten the deficit targets by increasing public spending. The plan can be criticized for duplicating what Fannie Mae did in the US mortgage market seven years ago and creating new moral hazard risk in bank lending, but it is clear that the chancellor is searching for a new growth locomotive when large fiscal deficits constrain his ability to increase public spending.
The Bank of England is also taking special measures to improve lending conditions for home buyers as well as small and medium-sized enterprises. It has created a Funding for Lending Scheme which will attempt to provide lending at 25 basis points above the bank’s core lending rate of 50 basis points. If banks expand their lending, the cost of this subsidy could decline. If they shrink their lending, the cost could increase. Mortgages account for 60% of the assets on British bank balance sheets. As the program makes loans available at a yield of only 3.5% compared to 6.0% one year ago, households are taking advantage of it. Loans to small and medium-sized enterprises account for 20% of the assets on bank balance sheets. As a result of the weak economy and bank attempts to restrain credit risk, loans to SMEs have fallen 3.5% during the past year. The yield on such loans is also about 3.75% compared to 1.67% during the lending boom of 2003-07. Private analysts estimate that about 15% of SMEs, or 600,000 small firms, are having difficulty obtaining new loans. Many of these credit starved firms are in the construction sector. The government is concerned about SME lending, so it has offered a new incentive to banks to increase such lending. The Bank of England will now offer banks ten pounds of FLS lending for every pound of new SME loans they accept. They can use this extra funding for any purpose they deem appropriate. Such a generous incentive should help to make monetary policy more effective in promoting economic recovery. The Bank of England has been able to drive interest rates to the lowest level in over three hundred years, but it cannot create a recovery unless banks are able and willing to lend.
EUROZONE WEAKNESS IS HAMPERING THE UK’S GROWTH PERFORMANCE
The other negative factor in the UK economy this year is the European recession. Europe takes about half of UK exports and the downturn reduced them by 4.7% during 2012. Exports to Germany were resilient, but they declined in France, Italy, and Ireland. UK manufacturers report that export orders fell for the fifteenth month during March as a result of weak demand in Europe and strong competition in third markets such as North America. The UK has had success boosting exports to emerging market countries such as China, India and Brazil during recent years. Exports to China have doubled since 2008 while exports to Brazil have increased 60%. These export gains are long overdue. In 2009, the UK exported more to Ireland than to China, India, Russia, and Brazil combined. As Europe could languish for some time, the UK will need to place a greater emphasis on exporting to the higher growth emerging market countries. The prime minister has been visiting China and India with large business delegations to promote this objective.
UK Exports by Region 1996-2012
The one risk with the government’s international economic policy is the plan to hold a referendum on EU membership after 2015. The uncertainty about this issue could cause some multinational firms to hold back on new FDI projects in the UK. American, Japanese, Korean, and other foreign firms regard Britain as an export base for the region, and thus want Britain to remain in the EU.
RISING OIL PRODUCTION IS SET TO BOOST UK GROWTH IN FUTURE
There is a revival occurring in one of the UK’s growth locomotives of the 1970s and 1980s, North Sea oil. Oil and Gas UK, a trade body says that investment in offshore oil and gas fields will reach £13 billion this year—a record for the industry. The group expects UK oil output to rise from 1.5 million barrels per day this year to 2.0 million barrels per day by 2017. This number is less than half the peak of 4.5 million barrels in 1999, but it is still an impressive gain for such a mature basin. The energy sector now accounts for just over 4% of GDP compared to a peak of 10.4% in 1982. Many of the large companies which drove growth in the sector thirty years ago have pulled out because of high costs and uncertainty about government tax policy. In 2011, George Osborne launched a £2 billion tax raid on North Sea oil. He raised the effective tax rate on North Sea oil and gas development to 62% and 81% for some mature fields. He later softened the blow with new tax incentives, but his action confirmed the perceptions of many oil industry executives that UK tax policy is unpredictable. The majors have been replaced by many independent companies as well as some state-owned oil groups. Abu Dhabi’s national oil company bought $1 billion of assets from BP last year.
UK Offshore Oil Production 1975-2012
China’s Sinopec bought $1.5 billion of North Sea oil fields from the Canadian group Talisman. Many of the fields now being developed were discovered many years ago, but only now is the technology available to bring them into production.
WHAT DOES THE FUTURE HOLD FOR FUTURE UK FISCAL POLICY?
There is now growing disagreement about British economic policy within the government as ministers offer different priorities for how to promote recovery. Some place a heavy emphasis on boosting small business lending while others favor more public investment. George Osborne embarked upon a restrictive fiscal policy three years ago to protect the country’s credit rating. Two major agencies have now downgraded the rating, but UK government bonds still yield close to 2%. The markets do not appear to care that deficit reduction will occur much more slowly than the government promised in 2010. The chancellor has therefore abandoned his initial fiscal targets and will accept a deficit equal to nearly 6% of GDP in the year of the next parliamentary election. Any attempt to hit the original targets with new tax increases or spending cuts would have been self-defeating by driving the economy back into recession. Mr. Osborne knows that he has no choice, but to accept larger deficits for longer. All he can offer is less fiscal restraint, not genuine fiscal stimulus.
The UK has long debated about whether it should join the European Monetary Union. As a result of the crisis now gripping the Eurozone, everyone is thankful to Gordon Brown for having avoided entry during the late 1990s. Britain could have had a crisis comparable to Ireland’s if it had joined. British three-month interest rates fell from 6.86% in 1997 to 3.69% in 2003, but they remained consistently 150-200 basis points above interest rates in Ireland and Spain. If Britain had joined the monetary union, there probably would have been a private lending surge and real estate boom comparable to Ireland’s. As in Ireland, there would then have been a large increase in non-performing loans which would have required the government to rescue all the clearing banks, not just the Royal Bank of Scotland. The cost of rescuing the banks would probably have pushed the government debt-to-GDP ratio to Irish levels, or over 120% of GDP. As a result of the crisis in the eurozone, the Bank of England now has the same level of interest rates as the European Central Bank, but this is the first time that interest rates for the two central banks have been the same.
Three Month Interbank Borrowing Rates by Country 1995-2013
Opinion polls show there is now a great deal of pessimism among the British people about the economic outlook. A survey by YouGov for the Resolution Foundation provides some perspective on the issue. Forty-six percent of people expect their living standards to be worse in 2015 while 28% expect there will be no change. Thirty-six percent believe the economy will not fully recover for another four to five years while 29% expect it to take another six to ten years. The pessimism is now so rampant that it’s doubtful any sudden change in economic policy would affect the mood. The British people instinctively grasp that large fiscal deficits are a potential threat to their standard of living. As Labour cannot reduce the deficits any more quickly than the coalition, it is unclear how they can benefit from the economy’s sluggish performance. They must also take responsibility for the fact that the government share of GDP rose from 39.3% to 49.0% during their period of government. Labour would have had to reduce public spending even if Gordon Brown had won the 2010 election. There will be protest votes in the 2015 election, but they could go to non-mainstream groups such as the UK Independence Party.
There is no simple solution to Britain’s economic problems, but there are some signs of recovery. In the latest purchasing agent survey, the service sector reported its largest gains in new business activity since last August. Service firms increased their payrolls during April for the fourth month in a row. As the service sector accounts for 75% of GDP, its uptick greatly lessens the risk of a double dip in the economy. The manufacturing and construction sectors also stabilized during April. The manufacturing sector benefited from an uptick of orders to the US and the Middle East. It could rebound further if the IMF is correct that global growth will rebound to 4% in 2014 from 3.3% this year. The construction sector is weak because of cuts in government infrastructure spending and the subdued housing market, but it should rebound next year as a result of increased government investment and the new scheme to stimulate the housing market. If all three sectors are able to improve during the next twelve month, the government may finally hit the OBR target of 1.8% output growth or better in 2014. It is not an exciting story for a government whose popularity is suffering from austerity fatigue, but it could mark the start of a sustained upturn which will last through the life of the next parliament. Whoever wins the 2015 election will therefore have a good chance of winning in 2020 as well.