Fortnightly insight into the current state of the economy and how it relates to Dorset by Nigel F Jump, Chief Economist of Strategic Economics Ltd (a Dorset Company) and Visiting Professor in Economics at the Universities of Bath and Plymouth.
See: www.strategiceconomics.co.uk
The latest figures show that the UK economy spluttered along in the first three months of 2013. Real GDP grew by just 0.3% on the previous quarter and 0.6% on a year ago. Significantly, growth largely reflected a 0.8% increase in services. Net exports, manufacturing and construction were all negative. Indeed, manufacturing and construction were still 10% and 18% below respectively the peak levels achieved before the downturn.
This macro pattern can be seen here in Dorset. Whilst, in all sectors, there are firms doing well with full order books, supplying valued products and services to growing markets, there are others suffering low activity levels, supplying faltering markets, facing squeezed profit margins and difficulty in gaining access to finance. Meanwhile, many businesses are essentially ‘flat lining’, with uncertainty over future demand restricting plans to invest, innovate and hire. Recently, one local supplier of equipment to major construction sites summed it up by saying to me, “We have the product. We have the staff. We even have the cash. The only thing that is missing is the confidence of our customers to make decisions. We need more demand.”
Demand is weak because spending is constrained. For households, at home and overseas (especially in Europe), this reflects the drop in real incomes, job insecurity and downward pressure on asset values. For businesses, it reflects high risks to investment returns and, for some SMEs, poor access to finance. For government, it reflects the austerity measures to reduce debt. Let’s look at the relationship between debt and growth a bit more.
In the fiscal year 2012/13, the UK’s debt/GDP ratio was up to 75.4%. Is this a good or a bad figure? Well, it’s higher than we’d like but, as anyone with a significant mortgage will know, having debt equal to 75.4% of your annual income may not be disastrous. The question is whether, over time, you have the earning capacity to pay off the debt and stop it rising as a share of your outgoings. We all borrow on the basis of paying back out of future income. Countries do the same – their future income is called future taxes and requires a buoyant and growing economy with business and households who can afford to pay, and do not avoid paying, tax.
Although it’s looking dodgy after recent increases, Italy lived with debt ratios higher than ours for most of the post-war era. For the UK ‘family’, then, the question is can we earn enough (through growth) to pay the taxes that will allow us to pay down the debt over time and, sooner rather than late.
Around such high figures and arguments, the ‘austerity’ versus ‘growth’ debate rages, especially as the Office of Budget Responsibility (OBR) predicts that the UK’s debt ratio will increase further over the next four years. One side says, “The debt is unsustainable and the economy cannot progress until it is reduced”. The other says, “Debt needs to be reduced but it cannot be lowered while the economy is so weak”.
This debate rests on views about some key economic relationships: whether high sovereign debt, (levels and ratios), lead to higher risks of default; higher inflation and interest rates; and low and volatile economic growth. There is a link between debt and default but the link is inconsistent in the evidence without some other trigger. Historically, high debt has been associated with both high (UK 1970s) and low (UK 2010s) inflation and interest rates. (Inflation is linked to money expansion and fiscal deficits, not debt as such.) Also, the UK sovereign debt has been higher as a ratio of GDP than it is now, notably in the 1800s-1850s (after the Napoleonic wars) and 1920s-1960s (after two world wars), with a default occurring on 1917 War Loan debt in 1932. In both cases, eventually, and not without a struggle, sustained growth got us out of the hole.
Without hindsight, it may not be clear whether high debt causes low growth or low growth causes high debt or, indeed, whether they are both caused by something else (the ‘bust’ banks). In fact, the answer is all three possible links are at work. UK sovereign debt was rising before the 2007/8 crises (high growth encouraged high debt) but it surged when the state rescued the banks (high debt bolstered low growth). Thereafter, the Coalition budget policy to reduce debt has hindered growth and, in feedback, low growth has raised the debt further. At this point, the need to pay off debt reduces growth and low growth raises debt.
The problem is what to do next:
1) Raising debt to kick-start growth can be good. If it is invested in future growth potential, the proceeds can be used to lower debt later. Using growth to build productive capacity based on debt can be good because investment in new capacity can secure higher future living standards.
2) Squashing growth to pay down debt can be bad – indeed, self-defeating. It’s really just an alternative to default. The only difference is who gets hurt – now and later. Politically, it might be easier to burden future generations than current bond holders and voters but, economically, this is seldom optimal.
3) Fuelling excess growth by taking on excess debt is really bad – bubbles always burst and houses built on sand always fall.
So, we come back to the basic truth. Debt is good if it encourages entrepreneurship, innovation and skills, allowing the country to pay back and become a creditor later. Debt is bad if it sustains current consumption beyond earning capacity or potential. Countries can always “borrow against the future” to an extent but only when the risk-return balance is right.
For the long run, UK debt levels are too high at present but the path to getting them down to sustainable levels may actually require a movement to even higher debt levels first as long as it is for investment rather than consumption. Of course, we would prefer not to start from here (high debt and low growth). But, basically, the economic theory that says sovereign debt should move counter-cyclically is robust. To get to high growth and low debt, we probably have to go through a period of high debt and high growth first
Professor Nigel Jump
