The myth of the two-tier economy

If you have been following the discussion about the threat of recession in Britain you might have noticed something odd. Behind the headlines about falling stockmarkets and rising house prices there is a strange assumption that Britain has a ‘two-tier economy’.

The idea is that the consumer sector is healthy, as consumers are buying goods and services – but the manufacturing sector is weak, as it is not exporting enough. So the domestic economy, represented by consumers, is fairly vibrant – but falling demand from a slowing global economy threatens to tip Britain into recession.

This was the official view put forward in the Bank of England’s August 2001 Inflation Report. ‘The juxtaposition of weakening global conditions and firm domestic demand’, said the report, ‘has intensified divergences within the economy’ (1). Mervyn King, the bank’s deputy governor, has even noted that the gap between demand and the output of the economy is at its widest since the 1870s.

But this is a strange way to talk about the British economy and the threat of recession. In reality, the strength of an economy is determined by the efficiency of its productive sector, not the appetite of consumers.

A more balanced view of the British economy would take as its starting point the chronic weakness of the productive sector. From here the question becomes, how can such a weak productive sector support relatively strong consumer demand? And the answer lies in Britain’s relationship with the outside world. Far from threatening Britain with recession, ties to the global economy have subsidised the domestic economy. In particular, Britain has used its large role in global finance to help shore up domestic consumption.

To understand what is really going on in the British economy it is best to start with a simple model. Imagine a closed economy – one that has no ties with the outside world – which only produces goods that are then bought by domestic consumers. In such an economy the level of production would directly determine how much could be consumed. If the economy was productive then consumers could enjoy a high standard of living – if the economy was not productive consumers would live in poverty. They’d have no chance of buying televisions or DVD players if the economy was not developed enough to produce them.

From this simple model, the importance of productivity – the amount produced by each worker in a given time – becomes clear. An economy where it takes a week for a worker to produce a car is obviously preferable to one where it takes a month to produce a car. The standard of living within a given country will also depend on the level of productivity. If cars are produced more efficiently, then people within that economy are more likely to be able to afford them.

There is a more extreme example that illustrates how the state of the productive sector is key in determining the health of an economy. Take countries like Ethiopia or Mozambique, where people would probably like to buy mobile phones and personal computers. Unfortunately, their economies are not productive enough to allow the mass of consumers to buy everything they desire (though, in countries like these, the local elite can usually afford to import luxury goods).

International trade and investment play an important role in the modern globalised world – goods that are produced in one country can be exported to another, and there is a complex web of different types of investment flows between nations. Such global links modify rather than override the basic laws of economics. A country still needs to be relatively productive to allow consumers a high standard of living – it’s just that many goods might be imported rather than produced internally.

So in the real world, even developed countries may produce some goods but not others. But it still remains true that the most productive economies will also be the ones where the inhabitants enjoy the highest standard of living. For example, Sony Playstations may be produced by a Japanese firm but US consumers are rich enough to buy them.

The paradox today is that Britain maintains such high levels of consumption, despite having a relatively weak productive sector. Britain’s economy today is heavily dependent on international financial flows. Since the inflow from abroad is greater than the outflow, the economy is essentially subsidised by the speculative activities of the City of London.

There are a number of activities that generate such financial flows, including straightforward bank lending, fund management (managing pools of bonds or shares), insurance, and advising companies on mergers and acquisitions. And these kinds of international financial flows have played an important role in subsidising the British economy. According to Smithers & Co, a respected economic consultancy, such flows added an annual average of 0.5 percentage points to British GDP growth in the second half of the 1990s (2).

But Smithers & Co goes further in pointing to the peculiar character of such flows. Britain has net negative foreign assets – in short, foreigners have more assets in Britain than Britain has abroad – yet it still enjoys a positive financial inflow. How come?

This remarkable feat has essentially been achieved by Britain successfully engaging in highly speculative activities, which is why Smithers & Co refers to it as ‘hedge fund Britain’ – in other words, Britain has successfully taken big bets on financial transactions, while foreign holders of British assets have taken a more conservative line. For example, a British pension fund might make strong returns by investing £80million in relatively high-risk American shares. At the same time, an American pension fund might make a lower return by investing £100million in a lower risk portfolio of British shares. So although the British fund invests less than its American counterpart, it can theoretically make a higher return.

Britain might have done well from its international financial transactions, but it is also acutely vulnerable. If the markets turn against it – or even if it simply runs out of luck – then the weak productive sector would lose a valuable crutch.

So the popular image of a strong British domestic economy threatened by a global downturn is misleading. Without the financial subsidy from the rest of the world, the economy would suffer more as a result of the chronically weak productive sector. And without the current obsession with consumers rather than the productive economy, it would be much easier to see through the nonsense of the ‘two-tier economy’.

Daniel Ben-Ami is the author of Cowardly Capitalism: The Myth of the Global Financial Casino, John Wiley and Sons, 2001 (buy this book from Amazon (UK) or Amazon (USA)). He is also a contributor to Cultural Difference, Media Memories: Anglo-American Images of Japan, Continuum International Publishing Group, 1997 (buy this book from Amazon (UK) or Amazon (USA)).

Read on:

A bold critique, by Phil Mullan

New Labour’s economy: healthy, sluggish, dull, by Daniel Ben-Ami

(1) The Bank of England’s August 2001 Inflation Report is available at the Bank of England website

(2) See Smithers & Co report 156 on “The risks for hedge fund Britain”, 5 January 2001 and report 141 on “Britain: The world’s largest hedge fund?”, 14 January 2000