(This is the translation of a previous entry).
Lately the British economy has been causing some stir in the United Kingdom, given the proximity of the next elections in May. George Osborne presented some weeks ago his proposals for the next term (in case of being re-elected), and since then there have been quite a few analysis on the evolution of the British economy over the short and medium term (here for a deep analysis). I think then it is worthwhile to make a few points on the evolution of the British economy up to now.
We think the best way to understand the British economy is through the sectoral financial balances approach. Such balances are simply the sectoral net lending/net borrowing positions in a given year (flow variables), and (needless to say) their sum have to add up to zero. The sectors are five: households, government, non-financial corporations, financial corporations and the rest of the world. However, in order to simplify, households and corporations are sometimes mixed into a single sector, the “private sector”. Such financial balances approach (and let me be a bit optimistic) has been gaining popularity in the UK in the last few years, being Martin Wolf (among others) one of its main proponents (here and here).
Our analysis will focus on the following graph, which shows the evolution of the quarterly sectoral balances as a share of GDP since 1987:
As you can see, the balances provide in a neat way a lot of useful information. For instance, until the beginning of 2000s the corporate sector was running deficits and the household sector was running surpluses, a state of facts considered to be conventional in economic analysis (firms invest and households provide financial resources), but since then the corporate sector has been running surpluses (even above 4%) and households have considerably gone into debt. Our readers will see that these corporate surpluses (similar to corporate profits, but not the same thing) have been helped by ‘generous’ government spending (around 6%), given that at the macroeconomic level expansionary fiscal policies boost corporate profits (see a previous entry for the US case). It is also worth pointing out the poor performance of the British current account, since it has been in deficit (with two short-lived exceptions in 1995 and 1998) through the whole series, reaching its peak in the third quarter of 2014, standing at a 6% of GDP (remember that the balance of the rest of the world is considered from the point of view of the rest of the world, so a positive balance means a deficit and vice versa). Although the British current account will be addressed in a future post, it must be remembered that, in virtue of the financial balances accounting identity, a deficit in the current account acts as an important restriction on the evolution of the rest of the sectors, as we will see in a while.
This may seem interesting in itself, but the readers may be wondering what the connection is between financial balances and, for instance, GDP. The next graph shows the same financial balances (but households and firms are now consolidated) and the evolution of GDP since 1987:
You can see that the private sector financial balance has been one of the main engines in the change in GDP – at least in the last 15 years. The private sector financial balance was positive in mid-1990s (around 4%), but then it was negative at the beginning of 2000s. This means that the private sector was selling assets (or accumulating debt) during this period, having thus a positive impact on GDP. The same mechanism, although to a lesser extent, was working after the dot-com crash (but in this case, as you can see in graph 1, households were calling the shots). Both crisis, 2000 and 2008, allowed private sector to fix its financial balance (through expansionary fiscal policies), although in both cases this effect was not long-lasting. The latest numbers for the British economy show that the private sector is in deficit again. The worst aspect is that in this case, and unlike the two previous decades, such change in the private sector financial position since 2009 (from a surplus of 8%) has barely contributed to the growth of the British economy in the last few years: although it can be argued that 2013 and 2104 have been relatively good years for the UK economy, the performance in the previous years was quite disappointing (see this Wren-Lewis’ post for a critique against those who are bullish on UK growth).
The “exorbitant burden” of living in Mayfair
In the 1960s, the French Minister of Economy and Finance, Valéry Giscard, coined the sentence “the exorbitant privilege”, in reference to the US economy. This sentence now belongs to the economists’ argot, and it is used to mean the US capacity to finance huge deficits in the current account in a recurrent manner, “thanks” to the fact that the dollar is considered the main reserve currency. According to many economists, this has been very beneficial to the US economy in economic terms (among others, cheaper funding). However, the economist Michael Pettis has recently argued (convincingly, from our point of view) why such privilege is actually a “exorbitant burden”, given that (in a nutshell) high capital inflows (as in the case of the US, given the “quality “of its currency and assets) lead to a surplus in the financial account, which means a deficit in the current account (reminder: the current account has to be equal to the financial account, but with opposite sign, since exports and imports of goods have to be financed somehow). In other words, Pettis argues that capital inflows will provoke sooner or later current account deficits, and so if you want to understand the evolution of the balance of payments is more enlightening to pay attention to capital flows (as causa prima) than to goods and services.
Some parallelism can be found between this “exorbitant burden” in the US and its counterpart in the UK. True, the sterling does not have the same status in international markets as the dollar does, but the British economy has been persistently running deficits in the current account; if we take the parallelism one step further, we could say that the main British asset considered to be “reserve” at the international level (provoking huge capital inflows) is the real estate: after several years of marked rises in the price of British houses, in 2014 prices rose 8.3%, whereas in London such increase was a mind-blowing 21%. Even the rough anecdotical evidence suggests that something is going on in London: in the first half of 2014 a flat was sold (nothing to write home about, just in case the reader is wondering) in Mayfair for 140 million pounds. Such record has made me think at the aggregate level of the implications of the real estate bubble and the “exorbitant burden” of having houses at these prices.
If we really think that the current account deficit is given by financial considerations and we think that it cannot go under 3%-4% of GDP in the following couple of years (a modest hypothesis given the historical experience and the recent real estate bubble), then the scenarios for the future British government are quite narrow. Even with lower oil prices and the Eurozone recovery during this year (but with a more unfavourable euro-pound exchange rate), if the government keeps pushing spending down, then the private sector will go further into deficit – even if we assume that the balance of payments absorbs some part of the spending cuts. Therefore, we think that the private sector has little margin to contribute to GDP growth in the short-medium term.
At any rate, it will be interesting to follow in the next few weeks how the media and the various political factions offer their analysis on the strengths and weaknesses of the British economy.