This article explores Mervyn King’s “paradox of policy” which describes policymaker’s need to balance short-term economic stimuli, with a long-term desire to transition to a truly healthy economy. It also assesses how far Britain has progressed in this transition.
Yesterday evening the Governor of the Bank of England, Mervyn King, gave a speech to the South Wales Chamber of Commerce in Cardiff. At the heart of his speech was the concept he has dubbed the “paradox of policy”, in which he recognizes that in the long run we need to rebalance Britain’s economy “away from domestic spending and towards exports, to reduce our trade deficit, to repay our debts, and to raise the rate of national saving and investment.” However Mr King also believes that we must “try to slow the pace of the adjustment in order to limit the immediate damage to output and employment.”
What this means is that “policy measures that are desirable in the short term appear diametrically opposite to those needed in the long term.” Mr King explained that the Bank of England’s (BoE) monetary policy plays a vital role in aiding this adjustment process.
In combating the economic downturn the BoE has cut the Bank Rate “to its lowest level ever” and has “purchased £375 billion of assets in order to inject money into the economy.” Mr King went on to say that, “although this unprecedented degree of monetary loosening has prevented a depression, it has caused pain to those dependent on interest income. And we have not been able to avoid a sharp rise in youth unemployment.”
Mr King also made it clear that “loose monetary policy today will eventually give way to a tighter stance of policy as the economy recovers.”
Essentially what this “paradox of policy” amounts to, is this: The government and Bank of England are trying to gradually wean the UK economy off cheap money and credit, and return it to economic growth that is actually based on savings and investment, rather than borrowing and spending. The problem is, it’s now more than five years since the global credit bubble burst and we have made little (if any) discernible progress.
Where are we in the adjustment process?
In August Britain’s trade deficit was the second biggest ever recorded at £4.2 billion. The latest deficit, which is the difference in the amount of goods and services we import and export, came from a £9.8 billion deficit in goods, partially offset by a £5.7 billion surplus in services.
Commenting on the latest figures Osman Ismail, an economist from the Centre for Economics and Business Research (CEBR), said “The prospect of export-led growth seems as remote as ever… For the three months to August, even services exports remain 2.8% lower than the equivalent figure from a year ago.”
Meanwhile, Melanie Bowler at Moody’s Analytics predicted that “The UK goods trade balance will remain firmly in deficit into 2013 – slowing exports will be the key drag.”
The UK is the world’s fifth-largest trading nation and as such it is highly dependent on foreign trade. It exports manufactured items like telecommunications equipment, automobiles, automatic data processing equipment, medicinal and pharmaceutical products. However, it must import almost all its copper, ferrous metals, lead, zinc, rubber, and raw cotton and about one-third of its food.
As far as debt repayment is concerned we are still moving in the wrong direction. As we reported back in March, since 2008 Britain’s total debt, that is all the loans and fixed-income securities of households, corporations, financial institutions, and government, has actually increased by around 20% of GDP.
Just focusing on public sector debt, the official figure for the end of September 2012 was £1,065.4 billion, equivalent to 67.9% of GDP, and thanks to the government’s budget deficit, it is increasing at around £120 billion a year. In 2012 the interest on the national debt alone will cost taxpayers £44.8 billion.
The Office for Budget Responsibility (OBR) currently forecasts that Britain’s debt will continue to rise until 2016-17 when it will exceed £1,500 billion.
Over on the savings side, the proportion of income saved by households (known as the saving ratio), declined rapidly during the ‘noughties’, fuelled by rising levels of consumer spending and borrowing. Lower interest rates and greater economic stability prior to the middle of 2007 also reduced the perceived need for households to hold precautionary savings.
According to a report by the Halifax, “the saving ratio fell to a low of 1.5% in 2008 – equal to the ratio recorded back in 1959. On a quarterly basis, the saving ratio dropped into negative territory (-0.7%) in 2008 Q1, the first – and only – negative reading since 1958 Q4 (-0.9%).”
The saving ratio rose sharply during the recession as households sought to shore up their balance sheets by paying down debt and increasing their savings. As the chart below shows the saving ratio reached a peak of 8.2% in the second quarter of 2009.
UK household saving ratio Q1 1997 to Q2 2012
Source: Office for National Statistics (ONS)
Although households are now saving more than they were in the years leading up to the crisis, it remains extremely difficult for savers to achieve a “risk free” positive rate of return. Something we addressed recently in the article The perfect portfolio for risk-averse investors & retirees.
In order to make the transition back to a healthy economy in which thrift is rewarded and investment encouraged, interest rates must return to their historical 4-6% range.
The latest data on UK business investment shows a slight pickup in the second quarter of 2012 and there is a definite uptrend.
UK Business investment Q2 2009 to Q2 2012
Source: Quarterly Survey of Capital Expenditure – Office for National Statistics (ONS)
The OBR forecasts that Business investment, which is a measure of capital expenditure by manufacturing and non-manufacturing businesses on physical assets such as buildings and machinery, will rise by 1% between now and 2016-17. This improvement is due to the cut in corporation tax announced in this year’s Budget from 25% in 2012 to 22% by 2014.
The bottom line
There is no doubt that we cannot avoid the much needed process of economic adjustment indefinitely. It also seems quite clear that after five years Britain has barely begun that process.
The question is, given enough time, will the policies being pursued by the government and BoE successfully bring about the adjustment process? And, if so, how much longer will it take?
Personally I believe it’s far more likely that these policies will lead to another financial crisis that is even more severe than the one we experienced in 2008. What we need are far more radical policies such as those outlined here: How To Solve The Global Financial Crisis: A 20 Point Plan.
But assuming the current policies do eventually work, and taking into account our current rate of progress, it’s likely that we face 7 to 15 more years of economic gloom.
Time to face facts
There is one other point I would like to make regarding Mr King’s speech. Addressing the state of Britain’s economy, he said, “Despite the probable rise in output in the third quarter, the big picture is that GDP is barely higher than two years ago, and remains some 15% below where steady growth since 2007 would have taken us.”
I don’t want to imply that Britain’s economy isn’t in dire straits, it is, but to use our 2007 growth rate as a yard stick by which to measure today’s performance is hugely misleading. What Mr King refers to as “steady growth” was in fact the absolute height of a multi-decade debt fuelled boom in which excessive liquidity (provided by the BoE) allowed businesses, households and the financial sector to take on massive amounts of new debt. Between 1987 and 2007, for example, total household debt in the UK increased by more than 300%.
It’s time to face facts: Our impressive 2007 annual growth of 3.5% (figure from the World Bank) was made possible only by borrowing from the future, it was therefore completely unsustainable.