You would be forgiven for being confused about the state of the British economy. The recent economic news is mixed and experts are divided in their views of the future.
On the positive side, the Bank of England’s latest inflation report forecasts a bumpy, but sustained pick-up, in economic growth in 2012. However, Moody’s recently changed its outlook on the government’s triple-A rating from ‘stable’ to ‘negative’ indicating a 30 per cent chance of a downgrade over the next 18 months. In the face of this uncertainty, UK companies are hesitant to invest the £730bn on their balance sheets as of last September, as Martin Wolf notes in his column on Friday.
The contrasting perspectives given by “stock” versus “flow” analyses contribute to the confusion. This difference is particularly relevant after a financial crisis when the stock of debt has ballooned and is not yet on a sustainable path. Britain’s public debt was an easily manageable £500bn in 2008 but it had doubled to £1,000bn – about 75 per cent of gross domestic product – as of last month. It will continue to grow as long as the budget is in deficit. While the fiscal squeeze is now reducing the deficit, this year the government will still have to borrow about one-quarter of what it is spending. It is hardly surprising that a credit-rating agency such as Moody’s warns that the economic signs it watches are more likely to get worse, than improve, over the medium term.
However, for most people, most of the time, economic flows are more important than stocks. British households took on a lot of debt during the housing boom of the last decade. The household debt-to-income ratio rose from 115 per cent to 160 per cent. However, the lower interest rates and inflation during this period meant that the share of household income spent on interest payments only rose from 13 per cent to 18 per cent. Since then, falling interest rates have brought the debt service ratio down to 11 per cent, although household debt has fallen much more slowly. In short, the higher debt was sustainable because servicing the debt was affordable.
The same dynamic is now at work with Britain’s public debt. The combination of tight fiscal constraints – to slow the growth of debt and then reduce it – and the Bank of England’s asset purchase programme – to keep interest rates on gilts low – is giving Britain the breathing space it needs to both deleverage and grow. The signs of revival in consumer confidence surveys and growing corporate interest in mergers and acquisitions may be the ‘green shoots’ that show this strategy is working.
Meanwhile, imminent budget decisions loom for the Chancellor. His first priority must be to keep his side of the policy bargain. There should be no relaxation in the aggregate fiscal stance. Any giveaways must be funded by new taxes or cuts elsewhere. Second, he should use his public platform to reverse the unfortunate perception that the coalition is anti-business and more concerned about redistribution than growth. This means pressing ahead with reform of the planning system which has been identified through independent research as the single biggest obstacle to small business expansion and job creation. It also means providing more certainty – perhaps a moratorium – on taxes that affect internationally-mobile investment and high-income professionals and entrepreneurs.
Finally, he should use whatever scope he has within his fiscal envelope to support retraining and apprenticeships for the motivated unemployed. This will help the short term rise in unemployment and address the long term skills gap which constrains Britain’s productivity and worsens income inequality.
The writer is chairman of Chatham House and a former member of the Monetary Policy Committee of the Bank of England