(click on the image to see a larger version)
For years, the UK has been living beyond its means, importing more than it exports. Last year was one of our most extravagant, we ran up an external deficit of ₤50 billion, which was about 3.9 percent of GDP.
Over the last year, the spend fest accelerated. Between July and September, the last quarter for which we have data, we ran up an external deficit of ₤20 billion, which on an annualized basis is approaching 6 percent of GDP.
How do we get away with it? How do we pay for these huge deficits? It is not amazing how little press coverage is devoted to this extraordinarily important question.
An answer can be found. However, it needs some time and effort devoted to examining the UK's net investment position. Once this data is tracked down on table 8.1 of an obscure ONS publication called the Pink Book, the answer comes screaming back at you. We have been building up debts and selling our assets.
Comparing what we own to what we owe, the UK economy is about ₤340 billion in the red, which amounts to about 26 percent of GDP. Moreover, our net investment position has deteriorated to a level unseen for at least 40 years.
(click on the image for a larger version)
The above chart illustrates the dire state of UK external finances. Until the mid-1990s, the UK had a positive net investment position. Then, we entered the glory years of "no more booms or busts". We engineered a consumption-led economic upswing, and we sustained it with a massive domestic borrowing binge, coupled with assets sales to foreigners. Since about 2003, things have really spun out of control. As the above chart starkly illustrates, our spending has become increasingly dependent on reducing our net asset position.
Without dipping into the dreary accounting details too far, a country's net investment position comprises of three types of financial transactions; a) foreign direct investment, b) portfolio investment (comprising of debt issuance and equity transactions) and c) other investments (mostly bank deposits, bank loans and trade credits).
The importance of these categories towards paying for our external deficit varies from year to year. Sometimes, foreign direct investment provides the largest financial inflow (like in 2005). Other times, it is bank deposits and loans (like in 2006) that pays for our import bill.
However, these accounting categories obscure a simple truth; if a country is spending more than it earns, then its citizens are either selling their assets to foreigners or they are borrowing from abroad. This is what the UK has been doing on a massive scale for the last decade. This is what is captured by the sudden decline in our net investment position.
Tracing out a direct line between the housing bubble and the UK's net investment position is not easy. However, at the centre of this relationship is the UK financial sector. On the one side, it has provided the easy credit to households that pushed up house prices. This sudden increase in "housing wealth" encouraged households to massively reduce savings and increase consumption, leading to large increase in imports and a deteriorating current account. On the other side, the financial sector also facilitated the sale of UK-owned assets to overseas residents. It has also arrangeed for new debt issuance, and bank loans that financed this huge current account deficit.
The UK economy is one comprising of charts surging off to the limits of the page. House prices rocketed into absurdity a long time ago; the savings rate crashed to zero, credit growth is well into double digits; while personal sector debt is out of control. Our external deficit and net investment position are two classic examples of how we have pushed the economy to the edge. Our consumption binge is at the mercy of foreigners; it can only continue so long as their buy our assets and lend us money.
There is one further question that keeps bothering me; how long can we get away with this lark? Could it go on for another ten years? Could we string it out for another five?
The answer comes down to how much forbearance our foreign friends have for our reckless spending ways. How much longer will they keep buying our assets and lending us money to pay for our deficit? No one can know the answer to this question for sure, but somehow I suspect that the answer is not ten years or even five.
Recently, the UK mortgage industry has complained about a funding crisis. The wholesale money market is no longer prepared to bankroll the housing bubble. This is a clear message from those that have funded the 10 year spend fest. The message is "no more partying; it is time to clean up the mess".
17 comments:
the trade deficit has been around a long time and so far has not really effected the middle or upper classes, so their is no electoral support for any strategy to increase exports, decrease imports.
Another thing to keep in mind, is that allot of assets in Britain are now owned by offshore trusts (think of how Branson has all his Virgin assets own by trusts based in the Switzerland)
If you are really worried about the trade deficit,you should move your savings out of Sterling into Yen, Euros, Reminbi and Rupee.
Amigauser
The post is about the current account deficit and the net international investment position, and not the trade deficit.
The chart illustrating the net international investment position is very shocking. It does seem to suggest that the current account deficit has been financed by a run down in assets. I eyeballed the magnitudes and the cumulative current account deficits do appear to be of the same order of magnitude as the decline in the net international investment position.
On one point, at least, I agree with you Amigauser. It is time to sell sterling.
Ged
But the USA has been burdened with a trillion dollar deficit for years now and no matter how many dire warnings are broadcast, the American economy thrives. Isn't the shortfall something to do with so much overseas business being conducted by UK companies' subsidiaries, which are not set against the domestic deficit? Although this graph looks shocking, it may mean very little. And are we supposed to believe that during the 70s--probably the UK's most dismal financial era for a hundred years!--the UK was actually in the black?!?
Anonymous,
The US isn't running a trillion dollar current deficit, I believe it some somewhere in the region of $600-$800 billion. Actually, it is about the same size, in terms of GDP, as the one in the UK.
Both charts need to be taken together in order to understand their importance. The first chart - the current account deficit - tells us that the UK is spending more that it is receiving. The second chart - the net investment position - tells us how it does this; it is selling assets and borrowing. The location of UK subsidiaries doesn't tell us much.
So,the chart is shocking because something shocking has happened. We are overspending and we are eating into our net wealth.
The UK's experiences during the 1970s are often misunderstood. The oil price shock and the subsequent policy response meant that inflation was high, but unemployment remained low and the economy grew during most years of the decade. It was also the time that North Sea oil arrived and towards the end of the decade, UK finances improved dramatically.
If I was to point to the most dismal financial periods for the UK during the last 100 years, I would look at the two world wars, when the UK were forced to sell many overseas assets to the US to pay for the war effort.
Alice
UK current account deficit. Wow, what a difference three years makes! Up until then the trend was toward a decreasing CAD. Have you got figures for ´07?
You mentioned Oil, I recall sometime back perhaps about 2005 or so, we started to be net importers of oil, a result of the declining output of the North Sea. I wonder if that accounts for the turn around?
Of course and I know it is a drop in the ocean, but one wonders if the £10 billion or so of contributions to the European Union over the last thirty years might have made any difference?
UKHB: ¨The above chart illustrates the dire state of UK external finances. Until the mid-1990s, the UK had a positive net investment position.¨
It would be interesting speculation to superimpose significant political events to this graph. 1979 - 1989 we actually seem to have a positive net investment position.
Then we are fighting two wars in two different countries, that must be costing a PACKET.
apl
scroll down, the '07 figures are in an earlier post.
Josh,
Thanks.
APL: ¨but one wonders if the £10 billion or so of contributions to the European Union ¨
Slight correction. £10billion per year, and 1972 - 2008 - thirty six years.
Total £360billion - give or take.
Another great post. This sort of information is widely discussed on US blogs about the US but it's hard to find discussion of the UK so thanks for doing the legwork.
A note on the 'oil shock'. A barrel of oil cost 12oz of gold in 1971. At the peak of the oil shock it still cost 12oz of gold. Oil did not go up in price. What happened was the fiat currencies of the West went off the gold standard and massively devalued. Oil, gold, silver and other real assets stayed more or less the same price they always were it's just that the paper money we priced them in was worth alot less. Good discussion of this in "Gold: The Once And Future Money". I think it's an example of why it's best to use the Austrian definition of inflation as increase in the money supply rather than the idea inflation is an increase in prices.
Nick
Nick: "What happened was the fiat currencies of the West went off the gold standard and massively devalued."
Here is an excellent site to see the value of sterling, Euro, and US$ in terms of gold.
http://www.lbma.org.uk/statistics_historic.htm
For example on 2 Jan 1985 1oZ gold would have cost you £267.18
By 2 Jan 2001 it had dropped to £183.25
But at the begining of this year (2 Jan 2008) it would set you back £424.80
What exactly is selling sterling? And how does one do that?
(learning all the time)
¨What exactly is selling sterling?¨
It is exactly what it says.
But in this case you would use any spare sterling to buy another currency or asset denominated in another currency, preferably one that might be likely to appreciate against Sterling.
Essentially you are betting that other economies will devalue their currency less and hopefully do better than the UK - Assuming you plan to stay in the UK.
You could also buy a currency agnostic commodity like gold, silver if you don´t mind paying the UK government 17.5% -wheat, oil or natural gas.
If you really want to know what's coming for the UK economy, pick up the book "Crash Proof" by Peter Schiff:
http://en.wikipedia.org/wiki/Crash_Proof
Published almost exactly 2 years ago, it correctly predicted the current US housing crash, the credit market crisis, the fall of the US dollar, the dramatic rise of gold, and the current recession. And the one factor underlying all of it is the US current account deficit of 6%.
And although the book is about the US economy, almost all of the underlying problems (massive trade deficit, budget deficits, consumer debt) apply just as well the the UK economy.
Peter's advice? Sell your house and all US-denominated assets and buy assets in Euros, Swiss Francs or Asian currencies. I'd say the same advice would apply to savvy Brits who are smart enough to see the writing on the wall..
Schiff's advice isn't directly applicable to the UK. He's made good predictions about what would happen so far and the reasons why. However is strategy to deal with it is based on a prediction on how the authorities would react. Put simply, he expected the Fed to print money and the ensuing inflation to destroy the dollar.
In the UK the Bank Of England has not been as keen to reduce interest rates as the Fed and it also looks like the deflationary impact of vapourising credit would more than offset the inflationary effect of money printing. So not directly comparable to the US and Schiff's strategy has only been proved half-right so far - namely that the dollar goes down and commodities and gold go up.
He also relies on the 'decoupling' idea, that there's enough Chinese and Indian producers earning $1000 a year to buy all the products Americans currently buy. For that to be true (and it's still a big 'if') it will take time. Deflation might happen first.
I keep labouring the point, but you have to be precise about what 'inflation' means:
Is more money being printed? - well, not really. Look at the Fed monetary base stats. It's actually reduced.
Is MZM increasing? - it did but now it's contracting because credit is disappearing and the velocity of money has ground to a halt
Are asset prices going up? - definately not
Are commodities and other basic expenses going up? - yes
Are services going up? - no
The inflation / deflation debate has not been settled and it depends alot on policy. There's no question UK house prices will crash in real terms. There still some debate whether they will in nominal terms. It's extremely uncertain whether the Pound will crash relative to what it's used to buy.
Nick
Nick,
I enjoyed reading your recent comments. It contained some very interesting and intelligent observations.
Alice
Thanks Alice. Something I've been trying to figure out is which 'money' is to be counted. Think of the problem this way:
All transactions are carried out in money. When you buy some bananas for £1 you hand over £1. The money supply has not changed. The coin still exists, it just belongs to the vendor.
Debt is a promise that is created out of nothing. You give me bananas, I promise to pay £1 later. No money created or changed hands but a £1 transaction took place and bananas were eaten.
The vendor has a £1 asset of a debt. If I don't pay that debt disappears as a write off, again with no impact on money.
However, the price of bananas will go up if the vendor will accept either the money or the promise. The more people willing to make the promises, the more 'demand' competing for those bananas. So we have price 'increases' but NOT monetary 'inflation'.
Or try another example. Let's say a condo block of 100 houses. Each house could sell for £100k based on credit standards of 20% down and 25 year mortgage at 3.5 times earnings. That condo block is worth £10m.
Now imagine lending standards drop, a housing mania takes hold and one of those apartments sells for £200k. The transaction takes place in money (and the bank holds the promise to be repaid). Now every apartment is valued at £200k and the condo block is valued at £20m
A £200k sale hs 'created' £10m paper profit. But that's all it is, a number on a piece of paper. It was only possible because only a few apartments were for sale.
What happens if everyone tries to cash in their £200k apartment? God forbid, what happens if they do it in a market that has returned to 20% down and 3.5 earnings? Even worse, what if they took a MEW, can't afford a reset and must take whatever they are offered?
How long does it take for that £10m of asset value to vapourise?
How long does it take for the debt on the banks books to vapourise as the collateral value plummets?
The important thing here is when asset values are created out of thin air, they evaporate the same way. It is not a monetary phenomenon.
However, money is always competing with credit for purchasing power. So long as a vendor will accept money or credit for his bananas.
Aggregate demand of money + credit will decline if credit disappears, even if it's offset somewhat by inflation (in money supply).
Hence the deflation or inflation debate.
Nick
Nick
It is perfectly possible to have hyperinflation with a declining money supply. This happens when the demand for money collapses faster than the falling money supply. This often happens in the latter stages of a hyperinflation.
Obviously, my point here is not to suggest that we are on the edge of a 1923 Weimer meltdown. However, if you read the BoE's latest analysis on M4, one is struck by their incomprehension regarding monetary growth. In fact, I have been thinking of highlighting this issue.
My feeling is that if there is a serious banking crisis, then money demand could become somewhat unstable and it may have some surprising results, one of which could be inflation. It would come through various channels, particularly the exchange rate and import prices.
Alice
Alice,
I'm with you on the importance of monetary demand. That's why the 1980s supply siders got it wrong. Money has a 'price' that is determined by supply and demand like any other good. The monetary base it the supply, I think, not M3 or any of the other cash+other stuff measures.
That's one reason the Fed and BoE are fairly impotent - they can increase or decrease supply but they have no impact on demand. Once they print enough money its "pushing on a string"
That's also why the gold standard works so well. You don't need any estimates of demand. You simply redeem notes for gold when presented and accept gold for notes when asked. It's self-regulating.
But yes, you raise important points.
Nick
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