From The Economist print edition
The news goes from bad to ghastly. How awful are Britain’s economic prospects?
IN SWINDON, a town 80 miles to the west of London which thrived during the boom years now ended, the recession is biting hard. Regent Street is busy on a cold Friday afternoon, but the most favoured shops are those selling cheap goods, such as Poundland, where everything costs just £1 ($1.44). And if Poundland is busy, the government-run Jobcentre Plus in Princes Street is teeming with people looking for work after recent lay-offs.
The rest of the country has run into even greater economic turbulence. For a decade the British economy won plaudits for its good behaviour, not least from foreign investors whose confidence kept sterling strong and stable. Since the global financial crisis began in August 2007, that image has been thoroughly trashed: growth has turned to recession; unemployment is mounting; and the pound has suffered its biggest fall since the 1970s.
What appeared to be a model and well-run economy, expanding steadily for 16 years without inflationary strains, now looks a Heath Robinson affair. It was fuelled by debt—both public and private—and involved a star role for City bankers currently vilified for their excesses. Gordon Brown’s boast of ending boom and bust has returned to haunt the prime minister. Economic policymakers at the Treasury and the Bank of England, as well as banking regulators at the Financial Services Authority, are newly humbled.
How justified is Britain’s status these days as (some say) Europe’s new sick man? It is tempting to see in its fall from grace a simple morality tale: an economy with a swollen financial sector that borrowed a lot, ran a current-account deficit and had a huge housing boom has got its just deserts. But this caricature tells us little, for it is already apparent that supposedly virtuous countries such as Germany, which had current-account surpluses and avoided housing booms, are also in trouble. Among big economies, Britain is neck and neck with Germany and Japan in the race to the bottom, and there is plenty to worry about beyond the downturn. But its swing from paragon to pariah has gone too far.
A crisis that started 18 months ago in the City and other financial centres spread to provincial towns like Swindon through a collapse in mortgage finance. The first sector to keel over was residential construction, as demand for new homes dried up. The figures from Swindon are stark. Before the crisis began, roughly 2,000 homes a year were being built; in the year from April 2008 to March 2009 the council expects only 800 to be completed.
The demise of housing investment is most apparent at Wichelstowe, a development of 4,500 new homes to the south of Swindon. In a buoyant market the builders would be going full tilt, but so far only around 100 homes have gone up, most for publicly supported housing. The developer’s flags flutter gallantly in a keen wind by the four show houses of Bryant Homes, a subsidiary of Taylor Wimpey, but it is hard to put a brave face on the fact that it has built only 17 other private homes.
Official figures show that the decline in residential investment was the single most important thing pushing the economy into recession in the third quarter of 2008, when GDP fell by 0.6% from its level in the spring. But since then both the extent of the downturn and its reach have increased dramatically. Output fell by a further 1.5% in the final three months of 2008, the biggest quarterly decline since 1980. Manufacturing was particularly clobbered, dropping by 5.1%—its sharpest fall since 1974.
If Wichelstowe is Swindon’s unfortunate showcase for the retreat in housing, the nearby Honda factory at South Marston exemplifies the gravity of the manufacturing setback. On January 30th employees turned up for their final day’s work for four months. The factory, which had 4,500 workers when it was running at full capacity and producing 250,000 cars a year, will not reopen its assembly lines until June; and then it will be operating only one shift. Around a thousand workers are leaving voluntarily (helped on the way financially). The remaining employees will receive their basic pay for two months, and then 60% of it in April and May.
A similar story could be told in many countries. Britain was not alone in having a housing boom; Japan and Germany have suffered far more from the recent vicious downdraft in manufacturing, as global demand for the investment goods and vehicles in which their industries specialise has evaporated. Recent forecasts from the International Monetary Fund suggest that GDP will contract this year by 2.6% in Japan and by 2.5% in Germany.
Even so, the IMF tipped Britain for the biggest fall of all the G7 economies, forecasting that its GDP would tumble by 2.8% (see chart 1). This grim outlook was underscored on February 11th by the Bank of England. Its central forecast is that British GDP will shrink by almost 4% in the year to the second quarter of 2009, its steepest decline since the early 1980s.
The gloom reflects growing worries about underlying weaknesses that make Britain especially vulnerable to a recession spawned by the most serious financial crisis since the early 1930s. To start with, its housing boom was among the most extreme, measured by real price increases and resulting overvaluations. Property prices have fallen by around 20% since their peak in autumn 2007, pushing an increasing number of households into negative equity; some reckon prices have the same again to fall. Another bubble, in commercial property, has burst in even more spectacular fashion. Over the past 18 months office blocks and shops and the like have lost more than 30% of their value.
Both these booms were fuelled by debt, another reason why Britain looks particularly vulnerable now. Ten years ago, British households were the fourth most indebted among the G7 economies. By 2002 they had taken the lead, building up a burden equal to 185% of disposable income by the end of 2007. At the same time the public finances swung into the red. Associated with the boom in asset prices and rising indebtedness was a related and pernicious macroeconomic imbalance: a persistent current-account deficit.
A third reason why Britain looks worse off than other countries is the prominence of its financial sector. Although at its peak it accounted for only 8% of GDP, finance has been producing about a quarter of corporate-tax revenues. Once the glory of the economy, the City of London has been hit hard by the credit crunch and its sequel.
So Britain’s prospects do look bleak. Experience of past banking crises suggests that countries hit by them suffer deep and long recessions, and generally manage no more than a sluggish recovery. The aftermath of housing bubbles also tends to be unhappy. With Britain’s invidious combination of the two, it is easy to see why forecasters are vying to produce the grimmest predictions of economic performance.
The pessimism may be overdone. Britain has plunged rapidly into recession but it might pull out more steeply too. One reason to think so is that sterling has fallen sharply, its trade-weighted value down by a quarter since January 2007 (see chart 2). Though some see it as a national misfortune, sterling’s slide will help to cushion the economy this year and pave the way for eventual recovery. While global trade is in free fall, exports will drop too, despite the weaker pound. But profit margins on foreign sales will improve and, with imports dearer, domestic producers will grab a bigger share of the home market.
There are other reasons too why some forecasters are less glum. David Miles, an economist at Morgan Stanley, a bank, thinks the economy may shrink this year by just 1.3%—much less than the IMF’s forecast—though he concedes that the outcome could well be worse. A crucial issue is what happens to consumer spending, which comprises over 60% of GDP.
Mr Miles accepts that private consumption will fall, but thinks it will be more resilient than many fear. He makes three main points. After being squeezed last year by rising food and fuel prices, households will benefit from the sharp fall in inflation (which is likely to tip into deflation during part of this year). Spending will be boosted by the unprecedented cuts in interest rates since last autumn. And consumers will gain from the temporary reduction in value-added tax, worth about £12.5 billion over 13 months.
The pace of monetary easing also looks set to accelerate. Having cut the base rate to 1% this month (still higher than America’s near-zero rate but below the euro zone’s 2%), the Bank of England plans to drive down the spread between the yields on corporate and government debt by buying the former. Mervyn King, the bank’s governor, said this week that the monetary-policy committee may recommend increasing the money supply by “quantitative easing” in March, though the decision must be authorised by Alistair Darling, the chancellor of the exchequer.
Even with this help is Mr Miles a touch Panglossian? Swindon’s busy high street shows that people are still shopping. Yet even if shoppers are out in force, their purse strings are likely to be tightened by rising unemployment. In Swindon the number of people claiming jobless benefit jumped last month to 4,350, over double the claimant count of 1,795 in January 2008. That is a particularly severe outcome: though unemployment is climbing steeply in Britain (see chart 3) it is still lower than in many European countries. But fear of the dole may lead to an increase in precautionary saving.
Falling house prices are another force bearing down on consumption. At Henry George, an estate agency with an office in the heart of Swindon, Robert Skerten says turnover is down 60% on the year before. While they think prices will keep declining, potential purchasers—especially first-time buyers—will hold off, waiting for better deals, says Fionnuala Earley, an economist at Nationwide Building Society, also headquartered in Swindon. That will curb purchases of the big-ticket home goods that people buy when they move.
More controversial is the broader effect of falling property prices on consumer spending. The Bank of England argues that the link between real house prices and consumption reflects swings in income expectations by households. But others disagree. Declining house prices both reduce wealth and curtail access to credit, says Charles Collyns, deputy director of the IMF’s research department: it is one of the main reasons why the fund believes the British economy is especially vulnerable at the moment.
Some fret that things could get even worse. They portray Britain as Iceland writ large, horribly exposed because of its big banking sector and intimate involvement in the sort of global finance that has gone so spectacularly wrong.
This is overwrought stuff. Little Iceland had banking liabilities worth close to ten times its GDP, all piled up by its own banks and mostly in foreign currency. Britain’s banking liabilities are equal to some 4.5 times GDP. Over half of these are attributable to foreign-owned banks that have clustered in the City; they hold two-thirds of the British-based banking system’s liabilities and assets in foreign currencies. As a result, Britain is much less exposed to a run on its own banks by depositors holding foreign currencies than Iceland was.
And although Britain has exceptionally high external liabilities, thanks to the City’s status as the world’s biggest international financial centre, it also has very large foreign assets. The gap between the two peaked at the end of 2006, when Britain owed £370 billion—28% of GDP—more than it owned. Since then it has narrowed, helped by sterling’s fall (almost all of Britain’s external assets are in foreign currency but only around 60% of its liabilities). The gap is now some £150 billion, or 10.5% of GDP—hardly cause for alarm. The current-account deficit has fallen from an average 2.2% of GDP in the ten years to 2007 to 1.6% in the first nine months of 2008.
Yet Britain’s banks are ailing. Taxpayers have had to rescue two big ones—Royal Bank of Scotland and HBOS (now absorbed into Lloyds Banking Group)—with emergency recapitalisations, prompting apologies this week from those in charge. The state has also nationalised two mortgage lenders and is proposing to insure banks’ toxic assets against catastrophic losses. The questions bothering the markets—and prompting feverish talk in January about national bankruptcy—is how costly all this will prove, and whether the Treasury has the fiscal capacity to pay for it.
The answer to the first question depends in large part on how deep and protracted the recession turns out to be. Ben Broadbent, an economist at Goldman Sachs, a bank, has estimated that the Treasury’s insurance plan for bank assets could cost up to 8% of GDP. If other measures (recapitalisations, support for the two nationalised lenders and the rescue of British depositors with failed Icelandic banks) are included, the bail-out could take around 14% of GDP. That would be a lot more than the cost to Sweden of sorting out its banking crisis in the early 1990s (around 4% of GDP) but in line with Japan’s 14%.
If Britain’s bill turns out to be more like Japan’s than Sweden’s, the Treasury would gulp but could swallow it, for Britain’s official debt has been relatively smaller than that of other G7 countries. In 2007 Britain’s gross government debt was 47% of GDP; in France, for example, it was 70%.
That is no cause for complacency. Even excluding financial bail-outs, public debt as a share of GDP may rise by 20-30 percentage points by 2011, as recession pushes up public borrowing (see chart 4). If it does, Britain would end up somewhere in the middle of the pack. But the rapid rise in indebtedness is creating another vulnerability: markets need to feel sure that the government will make fiscal amends when recovery has set in, rather than seeking to inflate away the debt.
So far investors seem to be giving the Treasury the benefit of the doubt. Long-term borrowing costs remain low despite the mountain of new debt that will be issued over the next few years. That is vital; if gilt yields were to rise sharply it could lead to a vicious circle of rising debt-servicing costs and higher debt. Mr Darling laid out plans for higher taxes after the recession in his pre-budget report in November. In his spring budget he will need to reinforce his commitment to retrenchment.
Painful measures to restore health to the public finances will be all the more important because Britain’s longer-term prospects have dimmed too. The economy’s potential growth will be lower than before, and with it growth in the tax base. There are two main reasons, argues Martin Weale, director of the National Institute of Economic and Social Research (NIESR), a think-tank. The first is that the economy’s expansion for most of the past decade was boosted by the apparent success of the financial-services industry. As that model turns out to have been unsustainable, the resulting retrenchment in finance will curb overall growth. The second reason is that falling investment means companies will have less capital to enhance productivity. Recovery in investment is likely to be muted because firms will face higher long-term borrowing costs, as banks and investors charge more for the risk of lending to them.
Despite this setback, the NIESR forecasts growth of 2.2% in 2011 and 2.4% in 2012, not least thanks to the greater competitiveness a lower pound will bring. The City may take a back seat this time. But Britain remains a diversified economy, and it retains a flexible labour market that will allow companies to adapt to new conditions, notes Trevor Cullinan of Standard & Poor’s, a credit-rating agency that reaffirmed Britain’s AAA status as a sovereign borrower earlier this year.
Swindon had to cope with the collapse of the local railway industry in the 1980s, points out Bill Cotton, its director of economic development—one reason why he thinks the town can come through its latest trial. Tough times lie ahead, debt will have to be repaid and growth will be slower.
But just as there was too much optimism during the good times, so there can be too much pessimism in the bad times. RWE npower, an energy firm based in Swindon, for example, says it is going to boost its investment in Britain. Provided sound policies are pursued, above all credible plans to restore the public finances once a sustainable recovery has started, there is a way out of the mess. And, given the vigour with which monetary and fiscal policy has been eased, that recovery might just come sooner to Britain than to countries that look more resilient now.