The unmentionable problem

The Halifax has just published its house price index. The trend is now well established, with price declines approaching one percent a month.

If only a collapsing housing market was the only problem the UK economy faced. There are bigger issues than a correcting asset price. The huge current account presents a far greater threat to living standards than disappearing home equity.

Last year, the UK ran up an external deficit of $115 billion, or about 4.2 percent of GDP. In dollar terms, it was the world's third largest deficit. It was also the third largest deficit recorded by the UK in 60 years. However, it is housing market gets all the press; the current deficit never gets a look-in; it is the unmentionable problem.

The external deficit, or as it is sometimes called - the current account - is not a hard concept to understand. It simply represents the difference between what the economy earned relative to what it spent. Since we are running a massive deficit, it means we are spending massively more than we are earning.

Just like any household or firm, the UK economy can not keep this up indefinitely. An adjustment is heading our way. The question, however, is the journey. How will the UK reduce this massive deficit?

There are three ways we can reduce this deficit; spend less; earn more; or change the price of what we sell relative to what we buy.

Spending less

UK households are profligate spenders. That huge pile of debt lying on the balance sheet of our quasi-insolvent banks loosely corresponds to years of unbridled spending on imports. Could we find the collective willpower to stop spending? Yes, it sounds silly when you say it aloud.

It is not just households that are reluctant to exercise any self control, the government is also spending madly. Fiscal deficits are rising, and just like household expenditure, this puts pressure on our external deficit. The government seems to have little inclination to calm down and stop.

Earning more

This would be the ideal way of digging our way out of this mess. However, we face an obvious question; what would sell in order to earn more. Our manufacturing base has all but disappeared. Our traditional export earner, banking, is in deep trouble. It is hard to see how we could graft our way out of this hole.

Change prices

We could always changes the terms of trade, this is the most likely outcome. It is a simple enough thing to do; allow the value of sterling to fall. This makes our exports cheaper,while making our imports dearer. In fact, this has happened since the credit crunch started. The value of sterling has fallen against both the euro and the dollar.

However, a falling exchange rate adds to inflationary pressure, and we have plenty of that right now. In very real sense, an exchange rate devaluation reduces our standard of living. Allowing the exchange rate to slide is very much like giving ourselves a wage cut. Nobody likes to see the real value of wages falling.

What next

One thing is for sure; this problem will resolve itself, one way or another. Like any difficult problem; we can try to do this on our own terms, by taking decisive but difficult actions now. Or we can have the solution forced upon us.

An orderly resolution would require some difficult demand reduction policies from the government and the bank of england. This would require lower a fiscal deficit for this year and next. Interest rates would have to go up. UK households would quickly get the message; spend less, save more. The economy would slow; unemployment would go up, and living standards would suffer. However, inflation would fall; while the external and government deficits would fall to more sustainable levels.

Alternatively, we can wait until the rest of the world forces a solution upon us. Foreigners would stop offering us credit to pay for our deficits. Sterling could go into free fall; inflation would initially shoot up; a sudden painful recession would follow and of course; the external deficit would rapidly fall.

A failure to respond

Either way, we get to the same place. The question, however, is whether we have the political leadership to explain the hard choices before us.

The government's recent response to the housing crash offers us a guide. Everyone knows that house prices are grotesquely overvalued. Rather than promoting a gradual and orderly adjustment, the government has tried to stop the correction, vainly using scarce taxpayer's resources to hold up the unbearable weight of the housing crash. It is stupid, short sighted, and counterproductive policy.

Later today, the Bank of England will decide interest rate policy. The hard but correct choice would be a rate hike, which would focus on the external deficit and growing the inflationary threat. The MPC doesn't do "difficult policy choices"; it does "balancing acts".

We are all about to learn a difficult lession; the external deficit is not a problem that sits easily on the scales; if we do not do something about it, this deficit will come crashing down on the heads.