It's been a bad 12 months for the UK economy. 2010, should see some kind of economic recovery. But, few are expecting a rapid rebound. These are some of the problems facing the UK economy, into 2010.
Depth of the Recession.
Typically, the UK economy expands at an average underlying trend rate of about 2.5%. Even zero growth will lead to a growth in spare capacity and unemployment. After 6 consecutive quarters of falling GDP, the output gap is significant. This means output is significantly below potential, firms will be reluctant to hire. There is a danger that the recession will lead to a permanent loss of output and jobs and shrink the UK's productive capacity .
The Bank has an inflation target of 2%, but it is unemployment which creates the most social / personal misery. So far, the rise in unemployment has been relatively muted, at least, given the scale of recession. However, this slow rise in unemployment means it will be slower to fall. After the 1992 recession, unemployment fell relatively quickly, but after this recession, the fall in unemployment is likely to be slower - more like the experience of the 1980s where unemployment remained close to 3 million for several years. In particular, it is young workers who have been hardest hit. The fear is that prolonged youth unemployment could lead to a return to the unemployment related social unrest, characteristic of the early 1980s.
In the past few years, the UK's public finances have taken a real battering, leading to record peace time deficits. We relied on bubble taxes (property taxes, income tax on bonuses e.t.c) to help fuel inflation beating rises in government spending. Yet, these tax sources have dried up leading to a budget deficit approaching £200bn.
The dilemma is that, although the budget deficit continues to rise towards 100% of GDP, reducing the deficit too early could push the economy back into recession. For example, if the Conservatives were to implement their plans for spending cuts next year, the deflationary effect could well push a fragile economy back into recession.
Problems of Prolonged Borrowing
Economic necessity will make it difficult to tackle the budget deficit. But, this means the budget deficit will continue to grow and this brings future problems. If debt grows too quickly towards 100% of GDP, it may effect the UK's credit rating. This would make it more expensive to borrow and pay the debt interest payments.
In the longer term, there is a also a fear relating to the size of the debt and quantitative easing. Increasing the money supply, rises the prospect of future inflation and a weaker sterling. At the moment, there is little real fear of inflation and a weak pound is helping the economy to recover. But, there is a danger continued high levels of borrowing could weaken pound and could create future inflation.
Trade Deficit / Unbalanced Economy
The UK has been running a current account deficit, more or less since the recession of 1981. The economy has relied on services and the financial sector. We have struggled to remain competitive in the manufacturing / industrial sector leading to a trade deficit. Often the problems of trade deficits / decline in manufacturing are exaggerated, but the UK economy does still feel unbalanced and this is one reason why the UK economy was hit by the recession much more than other countries.
Propensity to Boom and Bust
I have written about the problems of UK housing market in more detail here. Yet, the continued shortage of supply means the UK will be sensitive to future booms and busts. It is hard to believe house prices have risen so much in the middle of a recession - a sign of the fundamental imbalances which exist in the housing market.
At the moment, I don't see the weak sterling as an economic problem. The depreciation has helped to limit the fall in economic growth and, over time, will help to rebalance the economy and reduce trade deficit. But, if sterling continues to be weak over the longer term, there could be inflationary risks and a decline in living standards as imports become more expensive.
Demographic Changes - An ageing population and unfunded pension deficits, will make the governments public finances more difficult in the future.
These problems, could equally be applied to the US economy. I think one important issue is to be clear on which problem is the most serious. For example, government borrowing is a definite problem. But, although it is very serious, it is more important to worry about the loss of output and unemployment first.
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