December 1, 2013 by johnmillsjml
Exchange Rate Reform Group
BULLETIN – December 2013
What are the prospects for the UK economy in 2015?
The next general election will be held in May 2015. No-one can foretell the voting outcome. It is, however, much easier to anticipate the economic prospects to be faced by whichever party or combination of parties wins power.
Even if the current momentum is sustained, living standards as measured by average GDP per head are likely still to be well below those prevailing in 2007. The foreign payments deficit is trending towards being considerably worse than the £60bn plus expected in 2013, further increasing the indebtedness of the country as whole. With a gap as large as this on foreign payments, it is very unlikely that the government’s deficit will be significantly lower than it is at the moment, and it may even be higher. Total government debt will then be approaching 100% of GDP. While this ratio has been much higher in the past, especially after major wars, on these other occasions there was a growing economy – probably lacking in 2015 – to absorb the debt. The widening balance of payments and government deficits may sap the optimism generated by rising house prices, dampening both consumer and business confidence. This means that the growth which we are currently experiencing may not be sustained. If the consequence is further government action to stimulate the economy in the run up to the election, to produce a “feel good” factor, the twin national and government deficits are all too likely to be correspondingly larger once the election is over.
In addition, the incoming government in 2015 will have other familiar problems to face. The gap in incomes, wealth and every other measure of welfare between both the regions of the country and between socio-economic groups may well be widening still further. Manufacturing – and with it our main capacity for paying our way in the world – is likely to have shrunk even more as a proportion of GDP to no more than 10% – down from 25% as late as 1980. Gross investment as a percentage of GDP – 14.2% in 2012, compared with a world average of 23.8% and 46.1% in China – is unlikely to have improved much, if at all. Productivity per worker, up 8% in America since the crash, is down by 5% at the moment in the UK and is unlikely to have picked up much by 2015. While the total number of people in employment, at close to 30m, is at a record level, about 8m of those with jobs are only working part time and there are over 5m people of working age who are not working at all. At the same time, the number of people of retirement age will be rising inexorably, precipitating the risk of widespread pensioner poverty as public expenditure becomes more and more stretched.
We are therefore facing a dauntingly unpromising future. Unless the economy can be made to grow, we have in prospect years of stagnation while all the adverse trends described above continue to move in the wrong directions. Is there anything which can be done to avoid these outcomes, or are they inevitable and unavoidable?
There is a way out of the stagnation which is otherwise going to be our lot, but it involves a very radical change in policy. Moreover, it is not a silver bullet which will solve our problems without creating some hazards along the way. It would, however, leave the economy in a far stronger position by the time of the next general election in 2020. Here is what needs to be done:
1.A The first requirement is to recognise that the fundamental problem which the UK economy has is that it is grossly uncompetitive in world trading terms. This is why our share of world trade has fallen from 10.7% in 1950 to no more than 2.6% now and why we have not had a surplus on our trade in goods since 1982 or an overall surplus since 1983 – 30 years ago.
1.B With such a weak balance of payments position it has been impossible for decades to run the economy at full throttle. This is one of the main reasons why we have such slow growth and such high unemployment.
1.C To make the economy more competitive we have to get the exchange rate down. How much lower it needs to be depends both on how sensitive world demand is to our export prices and on how much the exchange rate has to come down to generate import substitution on a large enough scale to reduce the size of the annual foreign payments gap to a sustainable level. All the available evidence indicates, however, that the elasticities of demand for exports and imports are in the right area.
1.D Having a competitive pound is also needed to play a crucial role in getting the economy rebalanced. To achieve a reasonably substantial but also sustainable rate of growth, we need to switch a significant proportion of our GDP towards manufacturing by making this far more profitable than it is at the moment – raising its percentage of GDP to about 15%. To do this, however, at the same time we will need very significantly to increase the proportion of our GDP going into investment. It will need to rise from barely 14% to 20% or more to cater both for the level of corporate investment which will be needed as well as to finance a substantial government programme of improvements to our infrastructure.
1.E One of the important reasons for increasing the proportion of GDP going to manufacturing is that productivity increases are much easier to secure in this sector of the economy than in services and this is one of the main keys to getting the economy to grow more quickly.
1.F To secure the rebalancing which is needed towards manufacturing, exports and investment, there will have to be a big increase in effective and sustainable demand, so that everyone can see that there has been a long term change in strategy. To ensure that this extra demand is on a sufficient scale to make a big enough difference, the reduction in the exchange rate will have to be large enough to make sure that this happens.
1.G If the population of the UK was static, an increase in GDP of 3% to 4% per annum would probably be sufficient but if the number of people living in the UK is increasing at anything up to nearly 1% per annum on average, as seems likely to be the case in future, the total growth rate needed to achieve the changes required may be as high as 5% per annum.
1.H A major revival of manufacturing, exports and physical investment would have a disproportionately positive effect on the regions of the UK outside the South-East, thus making financial services less dominant in the economy as a whole and thereby making a significant contribution to making the UK economy less unbalanced.
1.I Rapidly increasing demand will then require large scale supply side changes to the economy. There will need to be a major focus on educating and training the labour force for many new opportunities and challenges. There will be big pressures on the infrastructure, requiring substantial increases in investment in everything from road and rail to housing and schools and from high speed internet to airport capacity.
1.J A very significant increase in demand would also have a major impact on unemployment. Historically, productivity improvements among the employed labour force have averaged about 2% per annum. If this trend reappears and GDP per head rises at 4% or more per annum, this should increase the number of people employed by about 2% of 30m – or around 600,000 – per annum, making a very important contribution to the growth rate.
1.K Much stronger demand for labour, increasing its scarcity, should also shift the proportion of GDP going to labour instead of profits, rent and interest and should also raise the minimum acceptable wage, thus giving employers strong incentives to increase productivity by training and re-skilling.
1.L It would be crucially important to avoid rapidly increasing demand causing prices to rise too rapidly. Stimulating the economy to grow much faster should therefore as much as possible be achieved by methods which lower the Consumer Price Index, such as by bringing down the rate of VAT and National Insurance. If inflation nevertheless did rise to 3% or 4%, this would be a price worth paying to get the growth rate up to 5%. International experience, however, shows that economies with strong export and manufacturing sectors – such as Germany – tend in the medium to long term to have lower inflation rates than those with weaker economies.
While all these trends are positive, unfortunately the policies set out above are not without major real resource difficulties. There are at least two related problems which they will bring in train and these are:
2.A If, to get the economy to grow much faster, there has to be a significant increase in gross investment from about 14% to 20% or more, this is going to have to be found by reducing the proportion of GDP going to consumption – which means consumer and government expenditure – by about 6%. The same effect would be felt if the foreign payments gap fell from its current 4% of GDP to zero.
2.B There is thus a danger that the effect of the policies described above would be to reduce both consumers’ and government expenditure which have already been severely squeezed. This is clearly potentially a major political problem.
There are, however, solutions to these problems and these are:
3.A We do not need to regard a foreign payment deficit as such a major problem if the economy is growing fast and sustainably enough to make it clear that, even if debts are currently increasing, we will be able before long to pay them off. We could then afford to run a large foreign payments deficit for a few more years before it started coming down. This means that only the call on resources for more investment would, in the short term, have to be accommodated. Closing the foreign payments gap could wait.
3.B If the economy could be made to grow fast enough, a reduction in the proportion of GDP going to consumption could be offset by the GDP being much larger total than it was before. Consumer expenditure could then increase rather that decrease throughout the transition period to faster growth.
The prize would then be that, within five years, the economy would be in infinitely better shape. As the transition was completed, there would be rapidly rising living standards, much lower unemployment, less inequality, and a much better balanced economy. Before long the balance of payments gap would close and with it much of the need for any government deficit. The UK’s stock in the world would unquestionably be much stronger.
Why don’t we do it? There is nothing to stop us except that we are wedded to policies which don’t work and which very badly need to change.
Published by the Exchange Rate Reform Group
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