Thursday, 4 September 2008

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.


roym said...

if the fall in the pound leads to higher import prices and thus higher prices on the high street, shouldnt that reign in excessive consumer credit spending? bank borrowing has become much more expensive over the past year so one can only hope people will start paying down household debt.

just as many castigate the govt for fanning the flames under the overheated housing market, surely they must attempt to keep the decline in prices orderly?

powerman said...

A few points:

Certainly, the cost of living rising faster than wages would achieve this. But it would achieve this in a way that hurt many of the most vulnerable the most (those on the lowest incomes tend to see their wages rise the slowest, and pensioners don't generally see theirs rise in line with inflation at all).

What do you mean by 'orderly' ? Do you mean a slower decline, or a lower absolute decline? why are either of these things desirable?

I'd prefer interest rates to rise, the housing market to be allowed to clear so it readjusts to a sane multiple of average income, and the government to be cutting spending to allow tax cuts to compensate for the higher interest rates.

roym said...

i mean a gradual decline without hysterical poisonous tabloid headlines to the natural market rate. I just dont think that the sort of panic that may precipitate as a result of a sharp crash would be helpful. think of all the ancillary industries that are linked

looks like interest rates have been held again. i agree that govt spending needs to be reigned in. but where?

MAB said...


Here in the U.S., we generally don't address economic problems until a crisis arises. Then we hastily institute a "Rube Goldberg" scheme that at best won't make matters worse.

BTW, it is during thes perceived times of "crisis" that Washington D.C. lobbyists really earn their keep. All kinds of unrelated and furtive spending measures are added on to these Rube Goldberg bills without any debate or scrutiny. All in the interest of expediency.

Scams beget scams.

Keep up the good work.


Anonymous said...

I think we have ascertained from 11 years of New Labour they do not give a toss for the poor, the old and the weak. And in that spirit I urge all Britains to do the following: to ramp the pressure up on all members of the Labour Government,and their enablers in think tanks, consultancies etc., and push them to have heart attacks and tip into clinical depression. They need to hurt the way they have hurt and will hurt everyone else. They need to SHARE the pain.

dearieme said...

It looks as if Norman Lamont was a pretty good Chancellor.

Anonymous said...

From: Roym

"i agree that govt spending needs to be reigned in. but where?"

During the 1980's Thatcher cut spending in society and coined the term 'Rolling Back the State'. This involved cutting hospital beds, loss making industries such as coal mining, made claiming benefits harder and the biggy was the cut in Local Council budgets.

Complimented with a cash injection from selling off anything that wasn't tied down, before you know it spending is dramatically reduced.

It takes real balls to deliver that much pain and ask to be re-elected. I doubt however that Gordon Brown has any idea how to handle spending cuts like these, and as for balls, all he has is that bollock named Balls who's more interested in a good media campaign than hard political decisions.

sobers said...

Ullrakesh: I think you'll find that govt spending under Mrs T never actually fell in cash terms, possibly in real terms. It fell as a percentage of GDP. Check out the figures at
From 1950 onwards (the period I have data for) there has never been a reduction in govt spending in cash terms in any year. That is the nature of the beast we are up against. Read C Northcote Parkinson's 'Parkinson's Law' written in 1957 to see the nature of the problem and how it never changes. The figures always rise.

powerman said...
This comment has been removed by the author.
powerman said...

We could start by cutting back on the following areas:-

1) Stop invading and occupying places that aren't any threat to us. It's really expensive.

2) Systematically fire all public sector workers whose job title includes the word 'diversity'.

3) Start firing public sector workers for taking liberties with sick leave. If they had the same absence level as the private sector they wouldn't need so many people to do the same job.

dearieme said...

You wanted a new blog title, and you've nearly got one. "Alice's Unmentionables".

Anonymous said...

Sobers: I think you'll find that govt spending under Mrs T never actually fell in cash terms, possibly in real terms. It fell as a percentage of GDP.

Good point and something I've come across before, and I'll admit that I was quite surprised when I originally found out. I did also get to realising that the cash amount will always probably rise, but its in % GDP terms that's important. Inflation alone would eat into any spending the government does, and to stop increasing spending in the way the previous government had, would feel like a cut in spending. Holding your budget entirely and allowing inflation to cut into the cash outlay as well, would really have produced a massive swing, especially if the economy grows on top of this.

I suppose the big point to my comments though was to highlight the massive change in thinking that happened in 1979, and needs to happen again in 2008.

The stated aim up until then was to take tax money from the rich, add a massive amount of borrowing, and spend it in the economy like Keynesian policy instructs. In doing so you will have successful government intervention in the markets and prevent a slide into recession.

Not only is the idea of government intervention in markets a bad plan, the idea of spending your way out of trouble is also never going to work, especially if its based on borrowing. (Borrowing isn't part of the Keynesian plan, just a consequence of not generating the surplus during a boom, which is the plan).

The fact is however the change in ideology from a situation where the government keep looking to intervene in markets and artificially prevent a recession, is proven as very bad policy. Its a difficult pill to swallow that as a government you can't step in and fix this problem with cash, and further more you have to step away from the situation and look to cut your budget back, so as to reduce inflation and borrowing.

It's a shift in thinking that Thatcher did succeed in making, and given the latest package of help for home owners, is a shift that still eludes Labour governments 25 years later.