Chasing the wrong deficit

Nice economy, shame about the politics. This seems a fair summary of the conventional wisdom on the state of Britain as it heads towards the general election. But is the economic outlook really that much better than the political mess which almost everyone expects to be disgorged by the ballot boxes on 7th May?

The widespread impression that Britain’s economy has recently enjoyed some kind of renaissance and has done significantly better than the rest of Europe since the global financial crisis, is simply not true. The problem is not just that strong job growth has been secured at the cost of the biggest decline in wages since the 19th century, or that public services have been sacrificed for budgetary rigour, or that exports have suffered from endless euro crises. All this is true, but Britain’s economic malaise is deeper and implies a major new risk after the election: a vicious circle of economic underperformance interacting with political instability, especially if a Labour-led government emerges in May. The risk of triggering a vicious circle between politics and financial markets may explain why Labour has failed to point out that the five years of coalition austerity has not just been socially painful but economically counter-productive.

The structural flaws that even Ed Miliband prefers not to mention can be summed up in two numbers. The first is the current account deficit, the difference between Britain’s international income and spending. The current account is the truest measure of dependence on foreign capital and the extent to which the country is “living beyond its means.” The second critical statistic is Gross Domestic Product per head, the best gauge of material living standards and productivity across the whole economy.

Britain’s 2014 current account deficit is estimated by the International Monetary Fund as being $120bn, or 4.2 per cent of GDP. This was easily the biggest deficit outside the United States in dollar terms and the biggest relative to GDP among all the economies of the Organisation for Economic Cooperation and Development group of countries. It was three times larger than the next biggest deficit in Europe, the $41bn or 1.4 per cent of GDP recorded by France. A related statistic, the inflow of short-term foreign capital unconnected with direct or portfolio investment in British companies or property, was an even more extraordinary $210bn, equivalent to 8 per cent of GDP. This was the largest inflow of “hot money” on record. These unprecedented figures imply that Britain is now more dependent than ever on speculative inflows of foreign capital. Such hot money, notoriously fickle about politics, taxes and regulation, could easily reverse if May’s election changes Britain from a haven of government stability into one of the most politically unpredictable countries in Europe, possibly edging towards an European Union exit.

Why should political unpredictability disturb international investors who have reacted with equanimity to gridlock in Washington and even in Italy or France? Because neither the US nor any major European economy has been as dependent on foreign capital inflows as Britain is today. For a country with the world’s highest current account to GDP ratio, political paralysis is a dangerous experiment.

Note that in warning of a vicious circle between politics and economics, I have not even mentioned government deficits or debts. While public finances have deteriorated dramatically under the coalition and this issue has dominated Britain’s political debate, the fact is that government borrowing is a fairly unimportant number, giving no real indication of financial vulnerability or national profligacy. Investors are queuing up to lend at rock-bottom interest not only to the British Treasury, but also to the US and Japanese governments, despite huge increases in all their debt burdens. This confirms the fundamental Keynesian precept that budget deficits are not dangerous and can actually be healthy in an economy where labour and capital are under-employed and the government has controls of its own central bank. Under such conditions, large-scale government borrowing can be tolerated and even welcomed. Government deficit reduction should be viewed as a by-product of economic growth, not as an independent target. As evidenced by the disappearance of “trillion-dollar deficits” not only from US statistics and also from Washington’s political discourse, fiscal outcomes depend less on decisions about government austerity or extravagance than on economic growth.

Which brings us to the second set of statistics that really should worry British voters. In terms of GDP growth per head, Britain has dropped from the top to the bottom of the international league. From 1992 to 2007 Britain enjoyed the best growth of GDP per head among the G7 countries, easily outpacing the US, Germany and France. So good, in fact, was Britain’s performance in this 15-year period that it more than made up for the relative weakness of the previous decades, allowing Britain’s growth to overtake the US, France or Germany, when averaged over the 50-year period from 1965 to 2014. But this world-beating record has been marred by drastic deterioration since the global financial crisis.

Despite the brief boom generated in 2013-14 by George Osborne’s Help to Buy mortgage subsidies, Britain has still not fully recovered from the crisis and has lagged behind all other major economies, including even France and Japan, since 2007. Britain’s GDP per head is still 0.5 per cent below its 2007 peak at the latest reading, whereas the US, Germany, France and Japan have exceeded their pre-crisis peaks by 4.1, 1.3, 1.1 and 0.1 per cent respectively.

The fact that Britain has experienced the weakest growth among the major economies to have run up the biggest international deficits so far suggests a structural competitiveness problem. It also explains the Treasury’s failure to hit budget targets that needlessly dominate public debate. In the 20 years to 2007, Britain’s international competitiveness, its world-beating GDP growth and its strong fiscal record were due mainly to the dynamism of finance and related business services such as law, accounting and consultancy, plus the trickle-down effect from these sectors to the rest of the economy via consumer services, mortgage lending and public sector benefits and wages. Since 2007, however, our most internationally competitive industries have been crippled: first by the financial crisis, then by banker-bashing and over-zealous regulation and now also by the threat of an EU exit, while the trickle-down effect has been reversed by public spending cuts and restrictions on mortgage borrowing and lending. If this self-harm continues, Britain will condemn itself to endless fiscal austerity, devaluation and stagnation. If, on the other hand, the next government stops worrying about deficits and instead does everything possible to restore Britain’s dominance of global finance, including committing firmly to EU membership, then fiscal problems will disappear of their own accord, the current account will improve and the heady growth of the pre- crisis period will resume. In short, Britain can restore economic prosperity by rediscovering its love of bankers. Is there a politician unorthodox enough to say this to the voters?