The private sector’s refusal to invest ensures that household and business suffer inflation, while the economy stagnates
Some City economists are discussing the possibility of a “triple-dip” recession and the both the British Chambers of Commerce and the Ernst & Young Item Club, which use the same model of the economy as the Treasury are urging a cut in interest rates to zero.
After last week’s dire GDP data for the second quarter of this year there are sound reasons to be alarmed. But much greater clarity is required about the causes of the economic slump and how to remedy it.
Professional opinion at the end of last year was overwhelmingly that the British economy would grow in 2012. The consensus estimate compiled by the Treasury was that it would grow by 0.6% this year. This now looks wildly optimistic. In addition, the prospect of an Olympics bounce would have been far greater if the mayor of London had not cut the budgets for all the agencies promoting tourism, international students and foreign direct investment to London. These cuts in public spending are magnified at the national level and only exacerbate the crisis.
The British economic slump has now lasted four years, and output is still 4.5% below the previous peak level. The decline in gross fixed capital formation accounts for nearly 80% of the fall in output. The slump is driven by an investment strike, that is, a refusal by the private sector to invest. As a result, a cut in interest rates is unlikely to have any material effect. Firms are saving, not borrowing.
The investment strike has also curbed growth in key sectors. The pound fell by around 30% in 2008 and has recovered only a proportion of that ground since. Yet exports have barely risen in the intervening period. In a cautionary tale for all those advocating currency devaluation as a panacea, the performance of the British economy shows that the positive impact has been negligible. Instead, the decline in imports has been three times greater than the rise in exports. The improvement in net exports (exports minus imports) is because British consumers and British firms have simply been priced out of world markets.
One consequence of a plummeting currency and reduced investment has been that the British slump has been far greater than in any other major economy, when measured in international purchasing terms – that is, US dollars. What both households and businesses will have experienced is a sharp rise in inflation even as the economy was stagnating, the combination known as “stagflation”.
In an economic expansion firms borrow to invest. This borrowing is from the savings of the household sector, although it is mediated through the banks. Currently firms are increasing their savings, or paying down debt which amounts to the same thing. The household sector is unable to increase its borrowing. Therefore the government is forced to increase borrowing on its own account. The investment strike is therefore both the source of the slump and the source of the government’s budget deficit. As a result, and despite all the attacks on the incomes of the most vulnerable via welfare cuts and the government slashing its own investment, the budget deficit has started to rise once more.
Since both the cause of the slump and the cause of the deficit are the same, the investment strike by firms, economically the remedy is very simple. Government policy should aim break that strike and release sufficient resources to fund an investment-led recovery. Politically, however, we seem to be some distance from this rational outcome to the current crisis. As a result, it seems set to persist some time longer.