IN 1997 the Conservatives bequeathed to Tony Blair’s Labour government what they now call a “golden economic inheritance”. National output was bounding ahead and unemployment tumbling. The public finances were on the mend after a relapse in the recession of the early 1990s.
The legacy after the 2010 election could hardly differ more. The economy is only just starting to recover from the worst recession in modern times. Unemployment is still rising. The blowout in public borrowing is far graver than in the 1990s.
There is a way out of the mess, but the journey will be arduous and perilous. A sustained recovery must be combined with a harsh clampdown on government spending and increased taxation. That will curb domestic demand, which will in any case be held back by high private indebtedness. The hope is that Britain can trade its way out of trouble while keeping interest rates low enough to contain the pain of servicing excessive debts. But things could easily go wrong, not least if the Greek crisis infects other parts of the euro area and Britain suffers as a consequence.
A recovery has begun but it is nothing to write home about. After a year and a half of contraction, GDP grew by 0.4% in last three months of 2009. National output carried on rising in the first quarter of 2010 but by only 0.2%, according to the Office for National Statistics (ONS) in late April (see chart). That still leaves it 5.6% below its peak in early 2008.
This cheerless picture could brighten as more information becomes available (the first estimate draws on about 40% of the data that eventually go into calculating GDP). After all, the ONS first worked out that national output had grown by 0.1%, not 0.4%, in late 2009. But the statisticians deny that such revisions tend to be upward (at least since the mid-1990s), and there were solid reasons for growth to be dismal in early 2010. The main rate of VAT, a consumption tax, went up from the level to which it was dropped to fight recession. Factories and shops were hit by unusually cold weather at the start of the year.
More timely business surveys suggest that the recovery will pick up. An index of manufacturing conditions based on the views of purchasing managers rose in April to its highest since 1994, reported Markit, an economic-research firm, on May 4th. That chimes with an industrial-trends survey published in late April by the CBI, a business lobby, which recorded a sharp rise in business optimism.
Yet forecasts for growth this year remain low. The economy will expand by just 1.3% in 2010, according to the average of independent forecasts made in the first half of April and compiled by the Treasury. Much of that feeble growth will come from a turnaround in the inventory cycle as companies stop de-stocking at the scary rate that exacerbated the recession in 2009. Consumer spending will no more than sidle ahead, and fixed investment will continue to decline.
Such a meagre growth rate will not suffice to stop further job losses. Unemployment has reached 2.5m, or 8% of the workforce, its highest since 1996. It is likely to carry on rising, even if it falls short of the 3m that looked likely in early 2009 when output was plummeting.
The pallid recovery should strengthen next year as exporters, spurred by a weak pound, hit their stride. The value of sterling against a trade-weighted basket of currencies is now around 25% lower than in mid-2007, before the financial crisis began. That is a bigger depreciation than the one that occurred after the pound was kicked out of the European exchange-rate mechanism in September 1992 and fell by 18%.
The response of export volumes has been disappointing until now. Rather than trying to increase market share by lowering their foreign-currency prices, exporters have rebuilt their profit margins. But much the same occurred after Black Wednesday in 1992. Just as that earlier fall in sterling eventually fed through to higher exports, so this bigger depreciation should also lead to a big boost. “It’s after that rebuilding of margins that firms start to invest in expanding their overseas market share,” says Stephen Radley, head of policy at the EEF, a manufacturing-employers group.
Cheaper sterling should also help British producers win back market share at home from imports. If net trade—exports less imports—can make a decent contribution to GDP growth in 2011, that should encourage a recovery in business investment, which slumped by almost a fifth last year.
Companies are certainly in a position to invest. The non-financial corporate sector is running a big surplus (ie, it is saving more than it is investing). What is holding back firms from investing is now mainly uncertainty about demand rather than access to credit, says Mr Radley. Many big companies are in any case able to bypass banks and raise funds directly from the markets by issuing bonds or shares.
If all goes well, a sustained recovery can be driven by net trade and business investment. That will be essential because the fiscal retrenchment needed to sort out the public finances will act as a persistent drag on the economy. Public spending, which has boosted growth over the past decade, will instead be pulling it down. Meanwhile tax increases, almost certainly beyond anything indicated in the election campaign, will also curb demand.
But even this painful escape route out of the fiscal and economic mess will be beset by traps and ambushes. Much will depend upon whether the Bank of England can keep monetary policy as loose as possible, to offset the big fiscal tightening. Even if it does, the base rate will have to rise, sooner rather than later, from its current emergency low of 0.5%. That blast of reality will deliver quite a shock to Britain’s heavily indebted households.
Some worry that Britain could go the way of Greece. After all, both had similar budget deficits last year—11.5% of GDP in Britain, 13.6% in Greece. But the differences are more telling. Greece’s government-debt burden of 115% of GDP at the end of 2009 was much higher than Britain’s 68%. The average maturity of the Greek debt is nearly eight years, compared with 13.5 for Britain’s at the end of last year; this means that Greece has to refinance a bigger portion of its outstanding debt each year. Most important, Greece is locked into the euro, and thus cannot regain competitiveness by allowing its own currency to depreciate, as Britain has done.
Despite these differences the crisis in Greece could still dent Britain’s recovery. Although Greece makes up only about 2.5% of euro-area GDP, its woes are proving contagious. To the extent that this weakens European growth, Britain will suffer since the euro area is its biggest trading partner, buying nearly half of British exports. No economy is an island and one as open as Britain’s will be diminished by the bell tolling in Europe.
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