Walking on glass: Why we’re facing another half decade of recession

The UK economy is stagnant, and is facing nominal stagnation and real terms recession for the next five years, at least according to aggregate growth estimates. One per cent growth in a quarter that prices in the Olympic games is concrete evidence of this, not countervailing data.

The “growth” rate for 2012 is predicted to be 0.3 per cent. For 2013 the median prediction is 1.1 per cent, but more sensible projections are at 0.5 per cent. The ONS five year prediction is about 3 per cent, but leading economists such as James Carrick at Legal & General provide substantial analysis that shows it’s likely to be more like 1.5 per cent – again, real terms recession.

Why is the economy still receding, over fours years after the beginning of the financial crisis?

Well, one thing we know is that the problem isn’t one of labour. UK labour is in fact highly versatile – far more so than US labour. This is not for pretty reasons. The UK labour market is one of the least regulated on earth, and it shows. Since 2008 around 700,000 full-time jobs have been lost. At the same time almost 1 million part-time and self-employed jobs have emerged and been filled. Essentially there’s been a huge blow to general job security.

Fig.1 – Source: Reuters Ecowin, via L&G

From the point of view of national employment, however, this “flexible” workforce is meant to be positive. The graph above [fig.1] is a Beveridge curve. It shows the stark difference between the UK and US on this point.

In America, vacancies are up in the last few years, but labour hasn’t responded. Why? The prevailing theory is that Americans are less likely to relocate (entirely understandable), or change professions. The UK workforce is much more willing to do so, and of course the geographical implications are, well, smaller.

The basic point is this: unlike the US, the UK seems to have a cyclical, not structural, employment problem.

It’s also important to add that other fundamental economic indicators are strong. The best example comes from imports. Since 2008, UK companies have stopped or radically reduced outsourcing production. The reason is clear. Imports negatively track non-energy consumer prices. Through the mid-nineties, when prices were high, import penetration was low [fig.2]. In the early noughties prices dropped and imports rose substantially. That trend is now reversing. Oil and shipping costs have skyrocketed, wages in countries like China are rising, and UK inflation is higher again.

Fig.2 – Source: Reuters Ecowin, via L&G

This is good news for UK manufacturing. It’s not for no reason that the government just announced a 200,000 job textile manufacturing scheme – that market is clearly well placed for UK manufacture.

Contrary to the dominant post-industrial commentary of the last 10-15 years, manufacturing is still extremely important for the health of the economy. The UK is no longer the workshop of the world, as it was in the 1860s and 70s, accounting for 34 per cent of global trade in manufactured goods (note that China’s peak was about 17 per cent), but manufacturing still accounts for at least 10 per cent of UK employment. That figure is also rising, not falling.

So given these two key indicators are good, and the trends predicted by the data positive, is it true to say that the UK economy’s fundamentals are strong? Almost. There is one indicator, exports, that has weakened this year despite a general upturn since 2008. The UK’s non-EU exports have fallen by £1.5bn (around 11.5 per cent) over the last three months – a substantial drop which means for now the UK is a net importer. This is a real problem, and certainly needs to be carefully monitored.

An honest assessment of the indicators, then, would say this: fundamentally the UK economy is not broken, but its output appears to be. Why is this, and what solutions can we propose?

In a speech last month governor Mervyn King emphasised that “rebalancing” remained the central challenge of economic planning. “Despite the probable rise in output in the third quarter, the big picture is that GDP is barely higher than two years ago, and remains some 15% below where steady growth since 2007 would have taken us.”

The concept of rebalancing is useful; it contains a carefully implied preference for a movement back toward manufacture, first at home and then through export. L&G’s Carrick employs the same concept in likening the economy to a child “learning to walk” and finding its balance.

But these descriptions of “rebalancing” don’t address the underlying problem – that is, that there don’t appear to be any underlying problems. (Or at least not enough of them for the poor output figures.)

So why is the economy still receding? An answer becomes clear if one looks at the sectoral accounts. The bland fact is that despite zero interest rates UK corporations are still either retrenching (this quite possibly includes using more of that disposable short-term labour) or running a surplus.

Historically this situation is not that uncommon; much the same thing happened in 90s Japan for over 10 years. Capital deployment is usually more difficult a commitment to get out of than taking on low-cost temporary labour, and it isn’t happening.

Fig.3 – Source: Reuters Ecowin, via L&G

There are two necessary consequences of this. The first is that monetary policy will be mostly ineffective, because companies aren’t borrowing and banks aren’t lending [fig.3] regardless of the rate. It will depress gilt yields,making some asset managers buy a few more equities, but that’s about it.

The second consequence is that fiscal austerity policies will be self-defeating, even in purely fiscal terms. This is the crux of the matter, and the only sensible answer to the question ‘why are we still in recession’. So long as the corporate sector is retrenching, as it still is, any and all reductions in government spending can serve only to contract the economy.

If neither the private nor public sector is spending, the fact that the fundamental economic indicators are good is beside the point, because there’s too little for all the economic agents to act on. The only result is a spiralling demand problem and stagnation.

Fiscal policy since 2008/9 has been to make mild cuts to government spending in order to cut the state spending deficit. The result we would expect, given private sector retrenchment, is the result we see: despite no deep structural problems the economy continues to contract, leading to larger not smaller deficits.

The picture Carrick paints of a child struggling to balance as it learns to walk is accurate, but omits a key factor. The child has strong legs, but repeatedly falls because it’s in an impossible environment. It’s as if the child were being forced to walk on a highly polished glass surface that makes gaining any traction impossible.

But fiscal tightening is not a law of nature. It could and should be reversed. The standard argument against this is from solvency. But that argument is demonstrably weak. Developed countries which have full control of their own currency, as the UK does, have always been able to borrow in that currency at very low rates.

To hope that the commitment to cutting public spending in the name of deficit reduction will be reversed in the face of continuing recession and little effect on the deficit currently seems highly optimistic – the major political parties united as they are in almost unwavering support for it. So long as it continues so will recession.

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