Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
Originally posted at: http://allaboutalpha.com/blog/2012/09/24/the-future-of-the-uk-economy
The United Kingdom is a tiny island, with an astonishing economy. This is the nation credited with building the largest empire history has ever known, and which played a pivotal role in many of the greatest global economic advances (from industrialisation to globalisation). This rock-star status has allowed the country to grow to become (as at today) the 7th largest economy in the world- with a GDP of US$2.43 trillion and tremendous political, military and social influence.
The pace and ferocity of the global economic crisis has left the UK, along with the majority of developed economies, wounded. Businesses and consumers are suffering, and the government- even with ever more existentially large pools of liquidity- are seemingly unable to revive the economy into growth. The country is heavily burden with debt. The Guardian in January 2012 reported that, “…total public sector net debt (excluding the impact of the 2008 banking bailouts) rose to £1.004tn in December, the highest since records began in 1993 and equivalent to 64.2% of GDP (up from 59.4% a year ago)…..” The ECB also notes that the UK’s gross external debts are now well over 400% of GDP (over US$9 trillion).
To learn more about the state and future of the UK economy, we speak to David Blanchflower (Bruce V. Rauner Professor of Economics at Dartmouth College) and John Cridland CBE (Director General of the CBI).
David ‘Danny’ Blanchflower is a leading labour economist and currently a professor of economics at Dartmouth College in the US. Until 2009 he was also one of the Bank of England’s senior policy makers. As a member of the Bank of England’s Monetary Policy Committee (MPC) for 3 years, he was one of the few economists to correctly call the depths of the recession gripping the economy and has spoken out about the caution of his fellow MPC members.
John Cridland is Director General of CBI– the UK’s premier business lobbying organisation, representing more than 240,000 companies of every size, including many in the FTSE 100 and FTSE 350, mid-caps, SMEs, micro businesses, private and family owned businesses, start ups, and trade associations… Cridland joined the CBI as a policy adviser in 1982 and has been Director of Environmental Affairs and of Human Resources Policy. John was Deputy Director-General from 2000 to 2010. He is a board member of Business in the Community and a UK Commissioner for Employment and Skills. He is also a member of the Council of Cranfield University. He was Vice Chair of the National Learning and Skills Council between 2007-2010. He spent 10 years on the Low Pay Commission and the ACAS Council, and was also a member of the Commission on Environmental Markets and Economic Performance.
Q: What is the current state of the UK economy?
[Prof. David Blanchflower]At best you could say there is no growth in the economy. There are puzzling issues and data about the labour market- output has been negative for five of the last seven quarters. It looks like no growth or likelihood of growth within it- and the temporary stimulus from the Olympics will wear off pretty quickly.
The economy is in the doldrums and likely to worsen. The UK economy has performed worse than most Euro Zone countries, and the calls for a change of course are becoming pretty loud. The economists who backed Osborne (UK Chancellor of the Exchequer) in 2010 have basically withdrawn their support, the IMF lowered its growth forecast and so on. The government’s economic strategy is clearly in disarray.
[John Cridland] My view is that it’s pretty much flat. Clearly there are parts of the business community who are doing better than that- principally those who are well positioned to take advantage of growth in emerging and new economies. There are also those who are worse than flat, particularly where they are exposed to the doldrums on the British high street, property and construction markets. If you balance it out- my instinct says ‘flat‘.
That’s a more significant statement than it sounds because the Office for National Statics believes that we are in negative territory. I’m giving you an instinctive, qualitative view based on talking every day to a batch of Chief Executive’s with real-time intelligence. My view is that the GDP figure is a bit too negative, and the real position as we speak- moving forward- is flat.
We could see a recovery as we move into the winter, gradually gaining speed- and a stronger economic position in 2013. We could even see growth of over 1% in that year. Trade is picking up, and consumer confidence will hopefully pick up as inflation falls
Q: What are the key risks and challenges to the UK economy?
[Prof. David Blanchflower] There are three key risks.
Firstly, I agree with the MPC (Monetary Policy Committee), the key risk is the downside to the Euro Zone crisis- although they feel unable to numerate it. The obvious story is that slowing output in the Euro Zone countries (which are the UK’s major export market) is a major downside risk- as is the rest of the world slowing! We see evidence of this in Latin America and elsewhere… the world is slowing. The risks are all pointing to the downside- and then you have the MPC complacently saying that the risks are approximately ‘marginally balanced‘. The risks to the downside are- in fact- substantial.
Secondly, the vast majority of spending cuts are yet to come.
Thirdly, the construction sector is in a state of close-to-collapse because of the Government’s crazy decision to cut infrastructure spending. Construction is an industry that could be helped immediately by- for example- a large boost in infrastructure spending.
[John Cridland] Whilst almost a statement of the blindingly obvious, it’s no less true for saying it- it’s about confidence… that’s what’s lacking. Confidence is preventing businesses investing significant amounts of their balance sheet strength, they simply do not feel they will get returns on that investment, and so they’re holding cash. Consumers are not in such a good place- most do not have spare cash, and a large number feel chastened. The biggest challenge is the lack of confidence.
I still believe the biggest risk is the Euro Zone. Each time we get a bit of momentum in the economy, each time our exporters make up for the fact that domestic demand is flat…. we get knocked back by the Euro Zone. Those same companies who are doing increasingly well in exporting to emerging economies simply do not have the volume to make up for the weakness in traditional Western European demand.
Q: What needs to be done to ‘fix‘ the UK economy?
[Prof. David Blanchflower] There are a series of short, medium and long term things that we need to do.
I would essentially- start by abandoning everything Osborne set out to do. I would be cutting taxes, not raising them. I would immediately reverse the VAT raise that he had. I would immediately remove national insurance on the young, and give firms very big tax incentives to hire and invest. I would impose those within an hour of taking office. I would also give a 2 year holiday to any firm hiring anybody. The technical details can be worked out by the CBI, Institute of Directors and others, but those are the fundamentals.
I would immediately restart the school building programme, and think about how to spend the GBP 100 billion funded by the Bank of England, earmarked to get money flowing to small firms.
I would also immediately freeze the spending cuts that are due to come.
[John Cridland] My policy prescription for what we can do in the UK, given global and European uncertainty- is to invest in infrastructure. That provides short term boosts on the supply side with job creation- particularly for lower skilled unemployed people- but also strengthens the medium term economy. That infrastructure investment must now come primarily from the private sector and not taxpayer funding. A lot of that will be international money. The UK is a very open economy, and has been particularly successful at inviting sovereign wealth investment into infrastructure- together with pension fund investment from places like Canada and Australia. It’s vital that the shop-window of the UK as a place to invest is a good shop-window, and that the signals we send out are positive. Without being flippant, I think the Olympics and Paralympics are good confidence builders- they show Britain’s ability to do things well, on-time and on budget.
Q: What are your views on interest rates and inflation for the UK?
[Prof. David Blanchflower] The outlook is as grim as I said it was two years ago. I said that interest rates were going to have to stay approximately where they are, perhaps even with the cut that’s been priced into the market for the next five years. I don’t think there’s any likelihood that the Bank of England can raise rates due to the disastrous fiscal policies this Government has operated under. Rates will remain flat for a very long time, the Bank of England will have to do more unconventional QE.
On inflation, there are outside shocks occurring that have nothing to do with the Bank of England. The Bank of England should not be responding to the fact that there is a drought in the Mid Western United States that is likely to put up food prices. That’s just a temporary shock the market has to deal with.
Once you take out shocks, the deflationary environment is there. The Bank of England’s forecast right now says that inflation will be below target, and maybe they should have done more. The reality is that inflation is falling- although we can be hit by temporary shocks such as oil and exchange rates.
The long run trend however, looks to be deflationary.
Q: What do you feel are the strongest sectors and segments in the UK economy?
[Prof. David Blanchflower] I don’t see any.
The only growth areas you have seen are in self employment. People are giving up good employee jobs to take worse paid self employed jobs.
Construction is flat, manufacturing is flat… there’s some temporary jumps in London and the South West due to the Olympics, but I don’t see anything like a “march of the makers” coming because the Government has caused consumer and business confidence to collapse. Why would anybody at all invest in an economy where the three leaders said the country was bankrupt?! That’s what’s killed off confidence and investment in the economy.
To talk of “a march of the makers“…. I was just looking at a collapse in the numbers of process, plant and machine operatives…. We’ve seen a decline in the numbers of these groups and in skilled trade. In the last two years- process, plant and machine operatives are down 63,000 with skilled trade being down another 60,000. The march of the makers has actually been a march of the unemployed-makers! Even if you look at the numbers self employed, the story hasn’t changed dramatically.
If you want rebalancing, you have to understand that you must rebalance from construction and finance into something else. But what? It’s very hard to see where any sustainable growth can come from.
Big firms can get credit and are not using it while small firms cannot get credit at all. Project Merlin and all these other lending programmes have not worked. I am very depressed about the state of the UK economy. Recession deniers can fiddle around all they want, but I do not see how this government will generate any growth at all.
The upside- I suppose- is that inflation is starting to fall, but wages are falling faster so we have negative real wage growth.
[John Cridland] Let me draw the analogy of Germany’s success as an exporting nation over the past decade. Germany has been a successful exporter based on capital goods. I think the next decade could be Britain’s! Those emerging and developing economies are particularly keen on branded consumer goods and services- a UK strength.
People in parts of the world are increasingly interested in Jaguar cars, Burberry fashions, British music and films…. they rather like having their airports designed by British architects…. Across a range of engineering, professional services and creative industries, I think Britain has quite a lot to sell
Q: Do you see the UK’s role in the global economy as being sustainable?
[Prof. David Blanchflower] The government killed it off the moment they came in and said the country was comparable to Greece and was bankrupt! That moment destroyed business and consumer confidence- and also investment.
[John Cridland] In a rebalanced economy, we need positive net trade. This will come from backing sectors in which we stand a chance of having above-critical-mass. Those sectors can be in the manufacturing economy or service sector. Five years ago, our automotive sector was struggling with recession. Look at it today! 80% of cars produced in the UK go for export. That is a mature sector using British innovation, design and engineering- often with international ownership and money.
There are other sectors too. I think the climate change debate provides real opportunities for a manufacturing renaissance in the UK. I don’t want to over-gild the Lily but if you go somewhere like The Tyne in North-East England, you will see a renaissance within the old shipyards of marine engineering and renewable energy. These are quite exciting sectors. Different parts of manufacturing will certainly therefore see growth.
80% of the UK economy is in services. We have a domestic and international economy here which are mutually supportive. When I talk to some CBI members in the retail sector, they are innovating as rapidly as they can with product and service delivery. We’re Europe’s leader in online trade and retailing. Those same companies you thought of as domestic businesses are increasingly finding that British retail has a market around the world and are moving with the globalisation journey.
Britain needs to identify the half-dozen sectors that people want to trade with us in, nurturing and encouraging them.
Q: What are your views on the UK as a venue for investment?
[John Cridland] I think potentially the UK is a great place for investment. The very fact that we have international money market confidence in our ability to manage our fiscal affairs and hence low borrowing rates shows a positive story. The fact that we are an important gateway to Europe but are not constrained by the problems of the Euro Zone, makes the UK potentially quite an attractive place.
Q: How do you perceive attitudes to the UK economy from within and externally?
[Prof. David Blanchflower] Consumer confidence has really collapsed- that’s clear. People are fearful of losing their jobs. The recession has generated an extra thousand suicides! There’s been an Olympic boost, but how long lasting is that….. There’s very little support for the Government in the polls either.
From outside, it’s difficult to say. I live in the US and we heard Mitt Romney talk of how jobs growth of 160,000 was a terrible blow to middle class families. Well, in the UK- chance would be a fine thing! People perceive that the UK is a country that is not growing, and one where austerity hasn’t worked. People perceive there being no growth plan, and understand the UK economy will not grow without a change of course.
Q: What do you see as being the shape of the UK economy over the next 10-25 years?
[Prof. David Blanchflower] There will be an inevitable u-turn of some kind.
Economics gets to change when politics change- there are elections and governments get thrown out!
People talk of a Japanese style lost-decade, but the UK’s performance would be improved if it only had output growth of zero. Output growth is dropping, so zero would be better than we have now!
It’s criminal that the Government have deployed austerity without corresponding growth plans. You have to cut spending on consumption, and lower taxes to give people incentives to hire and invest.
How can raising taxes boost the economy? it’s hard to understand that.
[John Cridland] We are in the early days of quite a complex rebalancing. Away from an overdependence on leverage and debt, and too much dependence on financial services growth. I don’t want to lose that but I want to see other pillars growing as well. Business investment and net trade will take years to change.
There are also some important structural changes. In 10, 15-20 years- success will be if the UK Economy has a longer tail and an impressive head. Quite often our very best companies are very visible in international markets, but you rarely see the equivalent of the German ‘Mittelstand‘. If you look at what sort of business will create jobs and which ones will grow quickly and in-scale? it’s not the very smallest (even though they are very important in aggregate), and it’s not the very largest. Medium-sized businesses are the Cinderella’s of the British economy, and traditionally we have not had enough of them. As well as a rebalanced economy, I would like to see a value chain with more in the middle- a stronger middle.
If I look at the next decade, we have to get used to a new normal. That means lower levels of growth than we got used to in the decade to 2007. I would settle for modest year on year growth from a rebalanced economy.
What does this mean for investors and risk managers?
The world economy is a very different place now to the theatre on which most investment and risk scenarios were planned. People still have a tendency to treat countries and regions as islands apart from themselves… fleeing to the “…safety of Switzerland…” or escaping “…the risks of the Euro Zone…” The fact is that our economy is global, interconnected and fast. Whilst one can perhaps make some psychological gain by shifting money around, the risks are no less reduced. A market event which would (for example) trigger a catastrophic Greek collapse, would almost certainly threaten the entire European economy (and those tied to it). In truth, there is no effective hiding place.
The United Kingdom has a number of risks, but also has the foresight and will to eventually mitigate them through policy. It has done before, and it will do again. The country carries a tremendous amount of goodwill internationally (politically, socially and economically) and has a uniquely advantageous trade position which it has not even begun to exploit.
There is no doubt that the next few years will be tough, but the fundamentals suggest that with the right policy decisions- this could be the UK’s time to shine.