Why is the UK external deficit so large?

When New Labour were elected back in 1997, the UK's external deficit was close to zero. Back then, we were paying our way in the world, exporting sufficient goods and services to cover whatever we needed to import.

Since then, our external accounts have steadily deteriorated. Last year, we ran up the third largest deficit in the world in dollar terms, after the US and Spain. It amounted to close to 4 percent of GDP.

Last year's dismal performance was not a one-off. The UK has run up a large external deficit in every year since New Labour were elected, repeatedly imported far more than it exported.

What is behind these huge unsustainable black holes in our external accounts? The chart below breaks the current account deficit into its three main components; a) the trade balance, which measures imports and exports of physical goods; b) the services account which measures our trade in non-tangible products like insurance and tourism, and c) the income balance which captures our net earnings on our foreign investments.

The story is clear. On the services account, we always record a steady surplus of 2-3 percent a year.

Our investment income is more erratic. We have had some good years and some bad ones. We had two lean years in 1999-2000. During the early part of the decade, income flows recovered to almost 2 percent a year. More recently, our investment income appears to be declining.

Declining investment income is not main cause of our appalling external performance. The real reason for our deteriorating external performance is the trade balance. For the last ten years, the UK economy has gone on a crazy spendfest. Back in 1997, the trade defict was less than 2 percent of GDP; last year it was close to 7 percent of GDP.

The story behind this huge external deficit is straightforward. Rising home values allowed people to lend against their rapidly accumulating home equity. Banks were happy to provide these loans because they thought that these credits were fully secured. With this home equity withdrawal, people went out and bought huge amounts of imports. The government also helped boost the deficit by increasing public expenditure which also helped draw in large volumes of imports.

One thing is for sure, our external deficit is about to fall. Home equity withdrawal crashed to a halt during the second quarter of 2008. Since last summer, sterling has crashed, which means that import prices have risen sharply.

The danger, however, is that the external deficit might fall through a disorderly collapse in sterling. With the UK economy slowing fast, foreign investors who have largely financed this ten year spendfest, might decide that the UK has become a little too risky. This might cause a sudden capital outflow and an exchange rate crisis.

You think this seems a little far fetched? Think on; there is already banking sector data showing that non-residents are pulling their cash out of UK banks.

There was a time when a UK banking crisis once seemed implausible, yet look where we are now. An exchange rate crisis could be the next act in this horror show.