What next for the British economy?

In order for the economy to recover and thrive, we need a revolution in political thinking and some serious risk-taking.

Rob Killick

24th February 2009

‘The era of soaring borrowing and the associated boom in finance is over. The government should indeed act as borrower of last resort at this traumatic time. But the aim cannot be to tide the economy over until households start borrowing madly again. For the same reason, attempts to pump up the mortgage market, however understandable, are largely misguided. No sane person would borrow to buy houses whose prices are so likely to fall. Even if the government does get away with its heroic gamble, the longer-term path of the economy must be quite different from that of recent years. Do the government or the British people understand the implications of such a shift? I doubt it.’ (Martin Wolf, Financial Times, 24 November 2008.)

When this recession comes to an end, what kind of shape will the British economy be in? While we cannot answer this question exactly, there have been some significant trends in recent years that will limit some possibilities and encourage some others. Some of these trends are economic; some are political.

What kind of crisis is this?

As Phil Mullan and others have pointed out, the current crisis hinges on the changed balance of global production (1). The decline of manufacturing in the West relative to the East has created a disequilibrium which underlies the global credit crisis. How this disequilibrium is resolved, and over what period, is impossible to predict. However, it seems unlikely that we will return to the status quo ante. Politics is concentrated economics, and the changed nature of global production and the production of wealth has to cause changes in the distribution of world power.

If we wanted to summarise what has happened to the British economy in the past 10 years, it would be as follows:

Investment and growth have remained relatively subdued, compared with previous periods and with more dynamic growth areas, while at the same time being fairly stable;
The UK has benefited from high levels of foreign direct investment;
The finance sector became more important to the UK in both an absolute and a relative sense, and both domestically and in relation to the world economy, while manufacturing continued its long-term decline;
Household wealth grew mainly as a result of the housing bubble and the rise in the stock market, which along with easy credit and cheap imports led to a boom in retail consumption;
Total employment grew mainly as a result of the growth of the public sector, funded partly from the growth of the finance sector and partly from government borrowing.

Looked at in this way, we can see that the crisis has taken a form that presents almost the worst of all possible worlds for Britain. The recession has hit Britain hardest in its most exposed parts:

The crisis began in the financial sector, the most dynamic part of the UK economy, leading to a knock-on process through the rest of the economy;
The crisis has become a crisis of credit, thus affecting the ability of businesses, homebuyers and individual consumers to continue to borrow;
Public finances were already deep in the red, limiting the ability of the UK government to use fiscal policy to combat the crisis.

Before we look at each of these points in detail it should also be noted that the political response to the crisis has been shaped by the political culture of the past 10 years, too, both from the point of view of governments and from the public.

In many ways this recession has been a crisis of politics as much as of the economy. We shall return to this in the conclusion.

A low-growth, low-investment economy

As can be seen from the graph below, business investment growth in the UK has reached a lower plateau in the past 10 years compared with the previous 20 years (2).

Total business investment percentage change, quarter on corresponding quarter of previous year

The UK economy grew for 63 quarters prior to the third quarter of 2008. GDP grew at this time at an average of three per cent. While this may seem a respectable growth rate, the growth has been increasingly debt-financed and in unproductive sectors of the economy. Also bear in mind that the current fall of GDP growth to 7.5 per cent in China is considered a potential crisis.

It is clear as well that there has been a flattening out of growth and retraction through this period. It is this flattening which British prime minister Gordon Brown cited in his claim that there would be an ‘end to boom and bust’. Another way to look at this flattening, however, is as the sign of an economy which had no great engines in it to make it leap forward. Indeed, the credit crunch reveals this very fact.

Quarter-on-quarter gross domestic product growth (per cent) in market prices since 1955

Productivity has improved against Western-based competitors but remains at a lower rate (3).

Output per hour worked and per worker relative to the UK
Source: ONS

Foreign Direct Investment

Britain is the second-largest recipient of foreign direct investment in the world, behind the US. In the past year it received $224billion (4). A recent survey by KPMG predicts that Britain will be second preference for financial services investment, first for property and first for transport. It listed the factors involved in making these decisions, in descending order, as follows (5).

access to new customers
political stability
impartial rule of law
infrastructure
regulatory climate
tax regime
quality of labour

In the past year, investment in UK technology, media and telecoms has risen threefold, largely as a result of investment from the US, and now stands at £12.6billion. This compares to £40billion at the height of the dot com boom in 2000.

The service economy and the financial sector’s key role in GDP

It is true that the reputation of both British-based and American finance houses has been seriously affected by recognition of the processes leading up to the credit crunch, and the inadequacies of the regulatory system in managing both the problems in the wholesale market and more general lending behaviour (6).

The main long-term trend in the UK economy has been a shift away from manufacturing towards services. Services in total now make up 75 per cent of the output (gross domestic product, or GDP) of the UK. In 1975 it was 55 per cent. Manufacturing is down to 13 per cent from 21 per cent in 1986 (7).

Changes in sector shares of output – broad industry sectors
Source: ONS

Within the services sector, there has been an increase in the weight of financial and business services. Between 1996 and 2006, these services rose from 25 per cent to 34 per cent of GDP. Within the services sector, financial services now represent 10 per cent of GDP, up from six per cent in 1996 (8).

Net exports of financial services have grown from £3billion in 1991 to £23billion in 2006, to become the largest part of services exports (9). The UK is the global leader in the export of financial services, having 24.4 per cent of the total (10).

London holds the top spot as the world’s most important international financial centre, ahead of New York City. In all segments, including cross-border lending, foreign equities turnover, foreign exchange turnover, exchange traded derivatives turnover, over-the-counter derivatives turnover, marine insurance net premium income, international bonds, fund management, hedge funds, private equity and initial public offerings (IPO), London holds the largest share (11).

The London effect

London depends heavily on the success of financial and business services, and the UK depends heavily on London – although Edinburgh, Glasgow, Leeds, Manchester, Birmingham and Bristol are also emerging as important financial centres.

London’s role as a financial hub for world finance is reflected in the weight it has within the UK economy. London has 12 per cent of the UK population, but produces 19 per cent of GDP and 15 per cent of UK jobs. London is a net contributor to the UK economy by around £15billion per annum and contributes 18 per cent of all tax revenues (12).

However, the economy of London is heavily dependent on the health of the financial and business services sector. These services make up a third of all jobs in London, while all forms of manufacturing together represent only nine per cent. The rest of London’s jobs are in different forms of support and personal services or in the public sector (13).

What shape will the financial sector be in after the recession?

The UK economy has depended on the growth of financial and business services for its dynamism in the past 10 years. Other sectors of the economy, particularly retail, benefited directly and indirectly from this. The UK government got deeper into debt on the assumption that growth would continue indefinitely (no more ‘boom or bust’). Most of the extra jobs created in this period were in the business or financial services or in the public sector.

This means that a permanent decline in the importance of financial and business services would have a disproportionately hard impact on the UK economy. Bluntly, if growth in this sector goes backwards there is no other sector of the UK economy which could pick up the baton in terms of growth.

The City of London plays a key role in many aspects of international finance. A former deputy governor of the Bank of England summed up the City’s position as follows:

‘London benefits from English as an international language of commerce, and from its time zone, which means the working day overlaps with Asia in the morning and America in the afternoon. London also has well-established financial infrastructure and telecommunication networks.

‘Many of those surveyed point to the regulatory and legal environment. This is partly a matter of the regulatory style – the ‘risk-based and proportionate’ approach that the Financial Services Authority has adopted based on general principles where possible. It is partly the simplicity of dealing with a single regulator.

‘English law, which is also the basis for financial services law in the United States, prevails here, with the added advantage that practitioners are less likely actually to invoke the legal system. And what has been called the Wimbledonisation of the UK financial markets – the sale of nearly all the British merchant banks and stockbrokers and the dominance of foreign players – gives confidence to prospective market participants that the competitive environment is genuinely open to all comers.

‘London is also a growing centre for Islamic banking. Finally, London may be benefiting from measures elsewhere; certainly in the years since the Enron and WorldCom scandals, commentators have suggested that the application of the Sarbanes-Oxley legislation to foreign firms listing in New York may have encouraged some firms to list here instead.

‘But the single most important factor is the first one suggested by economists: London’s comparative advantage lies in its skilled labour and financial know-how both in the financial firms and in the professions which support them. The free movement of labour within the European Union, and relative openness to immigration by those with specific expertise from outside it, has also meant that employers in the financial sector can access the world labour market. And the relative flexibility of the labour market here in the UK compared to others in Europe may also be a factor.

‘That concentration of skilled labour has spurred competition and innovation. We have seen a very striking illustration of this in the last few years with the rapid growth of hedge fund management and private equity firms in London. Many have been established and are staffed by people who acquired their skills and earned their capital at the more established investment banks and fund management firms of the City. Being at the heart of world markets helped them spot the opportunities and assess the competition. Once they struck out on their own, they could draw on a network of former colleagues and contacts for staff, information and expertise.’ (14)

Some debate about London’s role as a financial sector has begun (15). At this stage it is too soon to know to what extent the financial sector in London will recover. However, in the short- to medium-term it is contracting, and this will have a deleterious impact on the London economy in particular.

House prices, debt and the credit crisis

I believe that new net mortgage lending is very likely to fall below zero in 2009 (compared to around £40billion in 2008 and £108billion in 2007) with only a modest recovery likely in 2010. No new net mortgage lending across a full calendar year would be unprecedented and is likely to be associated with further weakness in consumer spending and an increase in unemployment. In the housing market it is difficult to see why this would not also involve further house price falls and fewer housing starts (16).

The bubble in house prices has been unwinding over the past year. How important was it for the prosperity of the past 10 years?

The value of residential housing as a percentage of total UK non-financial asset values rose from 50 per cent to 61 per cent between 1999 and 2007 (17). Over the past two years home owners have been withdrawing equity at a rate equivalent to about five per cent of post-tax income, or around £42billion per annum, in order to spend on other things. This helps to explain why, despite only moderate wage rises, there was a growing sense of prosperity in the UK.

By the second quarter of 2008, equity withdrawal had reversed and homeowners paid back into their mortgages or paid for housing by cash to the tune of £2.8billion, thus reducing their spending power (18).

Saving and debt

Household saving fell from 10 per cent of income in 1997 to two per cent in 2007 (19), while personal debt in the UK, comprised of mortgages, loans and credit cards, rose to £1.444trillion by 2008. This compares with household wealth of £3.7trillion of housing assets and over £4trillion of financial assets (20).

Household debt represents more than one year’s total GDP rising at a faster rate than GDP, by 7.3 per cent compared to 5.1 per cent for GDP (21). We would all have to work for more than a whole year without consuming anything to clear the debt.

By the end of 2005, UK banks were no longer financing lending from customer deposits but began to borrow from the wholesale markets. In an attempt to spread the risk from this over-borrowing, debt was sold and resold. As The Sunday Times (London) pointed out:

‘Everything from mortgages to credit card debts to multi-billion loans given to private equity companies were packaged up into bonds and sold to hedge funds, pension funds and other large institutions.’ (22)

It was from this point that the UK became over-exposed on the debt front. Essentially we were living beyond our means. Currently, the amount owed by UK banks to global markets is around £740billion.

Growth of the public sector

Between 1999 and 2007 manufacturing jobs in the UK fell from 4.5million to 3.3million. In the same period jobs in the financial and business services sector grew from 5.3million to 6.5million, and jobs in the public sector grew from 8.4million to 9.9million (23).

The Financial Times claims that around two thirds of jobs created since 1998 have been in the public sector. Most strikingly, within that figure, of the 1.07million jobs created in the public sector, 963,000 were taken by women in health, education, social care and social administration (24).

There are at least 10 areas of the UK, all outside London, where 40 per cent or more of those working are in the public sector (25).

Flexibility

‘Evidence suggests the UK is now more resilient to economic shocks… due to flexible product, labour and capital markets.’ (26)

The UK government has claimed that the prosperity of the past 10 years has been built upon three factors: flexible products, flexible labour market and flexible markets (27). While a detailed examination of this claim is outside the scope of this article, we should note the following:

Flexible products

The government claims that intervention in anti-competitiveness, as in the energy utilities, has helped free up UK economic activity and made it more competitive and innovative. In addition, it claims to be reducing regulations which inhibit enterprise.

Yet research and development intensity is lower than the Organisation for Economic Co-operation and Development (OECD) average. Business research and development (R&D) intensity has declined from 1.5 per cent of GDP in the 1980s to 1.1 per cent in 2006, way below the OECD average. The OECD attributes this to ‘the structural characteristics of the British economy, with 75 per cent of GDP produced in the services sector, and few large R&D intensive activities in key sectors such as motor vehicles, information technology and electronics’ (28).

Flexible labour market

The government claims that flexible labour markets have contributed to prosperity. The main way that this may be true is in the contribution of immigrants to the economy. They require less social spending, are more entrepreneurial and more flexible in what they will do. However, one of the first effects of the recession has been to reverse immigration and this has been endorsed by UK immigration minister Phil Woolas. The positive effects of immigration may now be reversed, with a decline in working-age people.

The labour market is not so flexible as claimed, and this is because of regulations making it difficult for employers to sack people and leaving them open to claims of racial and sexual discrimination which can be very damaging.

Subdued wage demands may be largely attributed to the disappearance of an organised working class rather than being the product of government action.

Political responses to the recession

For a long period after the financial crisis began, the UK government’s only intervention was to bail out Northern Rock. There was no attempt to boost the economy through fiscal means, as the US government attempted via tax rebates in early 2008. Nor was there any recognition of the need to cut interest rates until the autumn of 2008. The predominant attitude was that the market should be allowed to sort itself out, thus continuing the managerial approach to the economy which has typified New Labour.

The failure of leadership during the recession has roots in the decline of politics. For example, an out-of-touch political establishment was afraid that inflation would provoke struggles for higher wages, thus leading to a delay in making interest rate cuts beyond what was desirable.

Since the onset of the recession proper in the last quarter of 2008, most public discussion has largely taken place around the issue of consumption rather than production, with the emphasis on stimulating consumption via public spending.

Too little consumption?

Anatole Kaletsky writes: ‘The essential message can be summarised in three sentences: if an entire nation decides to cut spending and increase saving at the same time, the result is not an increase in saving but an increase in unemployment. This means that households can only increase their savings or reduce their debts if someone else spends and borrows more to keep the economy afloat – and in a recession that normally has to be government. And finally a government that spends and borrows in a recession can usually repay much of this borrowing without raising tax rates, because recovery automatically yields higher revenues and reduces spending on the unemployed.’ (29)

Now that the recession has become real, the government has been panicked into action on both the fiscal stimulus side and on interest rates. Almost overnight its rhetoric shifted from ‘hands off’ to a fully fledged neo-Keynesianism.

Amidst a lot of talk about ‘putting the fire out first’, the government’s explicit approach is to restore lending to 2007 levels and to try to pump up the housing market again. Critics of this approach, such as Tory leader David Cameron, have focused on the likelihood that it will lead to necessary cuts in public spending in the future.

Or too much consumption?

One reaction to the neo-Keynesian response to the recession has been the claim that the problem is, in fact, over-consumption. Some politicians and sections of the middle-class press in particular have been in the forefront of championing personal austerity as a response to the recession, arguing that the need for sustainability has been given a new imperative.

The focus on consumption does not help to clarify the serious weakness at the heart of the UK economy. As was pointed out above, most of the growth in the UK economy in recent years came in the financial, housing and retail sectors. Now that these sectors have been badly damaged it is a dangerous strategy to pin hopes of recovery on them. Instead, the focus should be on where productive investment should take place, and how it can be encouraged.

Public response

The most alarming feature at present is the fatalistic public mood. The slump is being discussed as if it were a natural catastrophe, like the arrival of the comet that is said to have destroyed the dinosaurs (30). Given the semi-paralysis of political leaders it is hardly surprising that the overwhelming public response to the recession so far has been passive acceptance. As long as this is the case then it is unlikely that public debate will turn to finding ways out of this catastrophe and looking to the future.

This passivity has gone side-by-side with an outburst of hedonism and escapism; rates of sexually transmitted diseases shot up in Canary Wharf once the downturn set in (31) while the 118 telephone directory services reported that they had experienced ‘a sharp increase in number of requests for sex shops, lap dancing clubs and escort agencies’ (32).

More regulation

The Financial Services Authority will be beefed up in response to the credit crunch. It is planned to take on an extra 218 jobs, giving it a total of 3,000. It is clear that for the time being, at least, the message is that the finance sector needs to be both externally and internally policed more thoroughly.

‘In terms of finding the new people the banking downturn has helped only a little since the worst hit sectors include traders and bankers, and neither group is exactly what the regulator is looking for. Those it does want – risk managers, product controllers and compliance officers – are still needed by the banks. In fact, the FSA wrote to the industry earlier this year warning them against making any cutbacks in these areas.’ (33)

It is already clear that attempts to move forward government spending on capital projects are limited by the extensive regime of planning agreements and consultations that have become an integral part of modern government.

Focusing on the digital and creative industries

Stephen Carter has been appointed to oversee digital development in the UK. The government sees this as a key part of the future development of the UK economy. The report Innovation Nation (34), and more recently the National Endowment for Science, Technology and the Arts (NESTA) report, Attacking the Recession (35), have attempted to develop a strategy for innovating the UK out of its current difficulties. Neither report deals with the risk-averse and over-regulated climate of low expectations which makes a culture of innovation unlikely to develop.

Green new deal

The Financial Times says: ‘What about a “Global Green New Deal”?… The industrial and service sector-led growth “at any cost” may have hit its limits – in terms of job creation and in terms of its ecological footprint on the world’s increasingly scarce nature-based assets. Gross domestic product as a measure of real wealth and as a bell-weather of economic success or failure may also have had its day in its current, narrow configuration.’ (36)

An emerging response to the recession is to call for a Green New Deal. This response has the advantage of appearing to offer a way out of the recession by encouraging a switch to investment in green technologies, rather than a return to the credit-based boom of the past decade.

Some environmentalists go even further: ‘Unless economic growth can be reconciled with unprecedented rates of decarbonisation, it is difficult to foresee anything other than a planned economic recession being compatible with stabilising the climate.’ (37)

While it is unlikely that the call for more recession will achieve great resonance outside the ranks of hardcore environmentalists, there will be resonance for seeing the recession as an opportunity to speed up green economics, which could end up with declines in growth rates and consequent reductions in living standards.

Lord Stern, who produced the Stern Review Report on the Economics of Climate Change for the UK government, explains it like this: ‘We will have to pump up demand [for renewable energy]– by cutting taxes and increasing transfer payments and making investments that can take place quickly and are labour-intensive – all of those will matter. But we should be thinking about these things in a way that can start to drive forward a form of growth that is really well-founded and sustainable.’ (38)

Currently in the UK what the Treasury defines as ‘environmental goods and services’ grew from £16billion to £25billion between 2001 and 2004, employing 400,000 people (39). However, Stern recommends that ‘it extends to new types of cars and other transport, new building materials and designs, energy transmission systems, new packaging for retailers, the redesign of manufacturing techniques, different farming methods, and a host of other developments in nearly all sectors of the economy’.

The struggle for democracy and for growth

‘Some countries, such as Britain, which has hitched its prosperity more completely to the wealth generated by the City of London, may wish that their economies were more “real” in 2009. The idea that Britain’s economy can rely solely on finance – exporting banks and importing goods – is surely dead.’ (40)

In the UK we have been living beyond our means. We have been consuming the product of somebody else’s labour rather than investing in it. The instinct of UK politicians is not to confront this but to put off the day of reckoning in the hope that something will turn up. When that day comes, it will mean cuts in consumption for the poorest.

The failures of the UK and other Western governments to react effectively to this crisis are a product of the lack of real democracy and leadership in the West. In a sense this recession marks the point where the crisis of politics, which has infected the world for many years, has now spread to the economy. It is not only political leaders who are bereft of ideas; business leaders, economists and academics are equally at a loss. We should see this recession as an opportunity to develop arguments for a new type of politics based on real democracy.

The relative over exposure of the UK to the global financial system means that within the current parameters the UK is over-dependent on international developments. While there is always scope for the economy to recover – for example the falling value of the pound may accelerate foreign direct investment – the real problem of a shrinking productive base will not go away. The UK requires a political and cultural revolution in order for the economy to recover and thrive in the future. A more innovative business environment cannot thrive in a generally risk-averse culture that is wedded to welfarism, state intervention and regulation.

Rob Killick is CEO of cScape. Read his blog on ‘UK after the recession’ here.