Just ten years ago, the British economist Wynne Godley, distinguished scholar at the Levy Institute at the time, published a short policy note entitled “Some Unpleasant American Arithmetic”, which addressed the problems the American economy was going to face in the near future (for a more in-depth discussion, see this report he co-authored the same year with some Levy scholars). It is worth quoting one of the paragraphs in full:
The private sector balance was negative 2.2 percent in the first quarter of 2005 – some 4 percent below its long-term average – mainly because there has been a furious housing boom financed by exceptionally high borrowing. It is noteworthy that between 1952 and 1997, there was not a single whole year during which the private sector balance was negative. If, during the next four years, the private sector balance were to recover halfway to normal (i.e., to zero), implying a large fall in private expenditure relative to income, and if the deficit in the current account remains at 6 percent, the general government deficit must rise to equal the current account deficit, that is, it must rise to 6 percent. This number follows arithmetically because, as already pointed out, the budget deficit is equal, by definition, to the current account deficit plus the private sector balance. If the private sector balance were to return to its long-term average (plus 1.8 percent), as might easily happen if the housing boom were to collapse, the government deficit would have to rise to nearly 8 percent of GDP.
For readers not accustomed to financial balances language, remember that by definition the balances of the three main sectors of the economy (private, government and foreign) have to add up to zero. What Godley was saying then is that with a 2.2% deficit (as a percentage of GDP) in the private sector and a 6.0% deficit in the current account, then the government was at the time running a deficit of around 3.8%. Nothing surprising so far. But Godley’s point was that government budget forecasts, which were projecting to “cut the federal deficit in half during the next four years”, were simply untenable: as the previous paragraph shows, Godley was expecting something closer to a deficit of 8%, otherwise “United States will, at best, encounter a prolonged growth recession under the (conservative) stated assumptions about international trade and the private sector balance.” The balance of payments was a powerful constraint on the ability of government to cut its deficits, if a recession had to be avoided. And, as it happens, he was quite right about the gloomy prospects for the US, especially at a time when apparently the “state of macro” was good and depressions were supposed to be a thing of the past.
UK at a crossroads – or some lessons from recent history
Ten years after Godley’s report the UK economy faces similar dilemmas. The recently elected conservative government has promised, among other things, to reduce the government deficit from the current -5% (ballpark figure) to nil by the year 2019 – 2020 (see the OBR report, page 12, for the projections). It has even pushed for a law to ban government deficits in “normal times” and it seems to be actively involved in the sell-off of many assets. The overall government plan has already received the disapproval (to put it mildly) of several leading economists. To get an overall sense of what the Tory government plan really means, it may be worth taking a look at my update of the financial balances of the UK and GDP growth up to the first quarter of 2015 (see a previous post for additional explanations):In terms of financial balances, the situation in UK is strikingly similar to the one described by Godley ten years ago for the US economy. First of all, the deficit in the current account is completely out of control since 2012: as soon as the economy grows at a bit faster pace, the current account deteriorates enough in order to prevent further sustainable expansion – and that’s why, maybe, I think we have seen some improvement in the latest figures of trade deficit, because of lower GDP growth. Second, Godley’s observation that “there has been a furious housing boom” certainly applies to the UK. And third, the government is running a deficit and will try to eliminate it in the next few years; however, it seems that the projected path is much more aggressive than the one planned at the time for the US – eliminating around a 5% government deficit in 4 years in the UK. Actually, we can already see the first effects of the reduction of government deficit: the private sector has been worsening its financial position lately and is already running a 2% deficit. Now, if you are a superstitious person, you will see that private sector deficits have always coincided with bad times – and because of a natural reason, for it means that private sector is taking on debt. However, one important difference regarding the US is the role played by the exchange rates: whereas the US enjoyed a prolonged period of a declining dollar up to the crisis (and, apparently, with little effect on the ever-increasing current account deficit), the UK is now starting to suffer the consequences of the appreciation in the pound. Both stories can be seen in the following graph:
I think that the real estate bubble (which I dubbed in a previous post, quite poetically, the “exorbitant burden of living in Mayfair”) is playing a major role in sustaining a high level for the pound despite the lacklustre performance of UK exports of goods, and therefore on the big deficit on the current account. Europe, with its new German economic model of keeping surpluses with the rest of the world at any cost and exporting deflation abroad, is surely playing a major role too. But the main point is that if, for whatever reason we assume (as Godley did for the US) that the UK will be unable to reduce its foreign deficit by at least 3-4% in the short-term (a reduction that would be quite something by historical standards), then it follows that by the end of its term the government will be unable to reduce the government deficit much more. Actually, I think that a more conservative (and probably accurate) assumption would be to assume that, given rates of unemployment of around 6%, the deficit will be around at least current levels by the end of the government term – no matter how hard the current government tries to push for fiscal consolidation. The unemployment generated by tough fiscal consolidation would be enough to deter government in pursuing additional rounds of fiscal consolidation. And finally, any attempt to rein in the real estate bubble could produce some improvement in the medium term in the balance of payments (and in other important issues such as income distribution), but with unpredictable consequences for the economy – well, you know, bubbles never have a happy ending. It will be interesting to see then how the UK economy will fit (or how it won’t) all the pieces of the puzzle together.