How Can We Avoid the UK's Next Recession?

07/04/2016 11:43 | Updated 07 April 2016

The recent budget again shone the spotlight on the UK's precarious economic position. Despite years of austerity, public spending cuts, Quantitative Easing and some limited stimulating activity such as taking the lowest paid out of tax, the country is still in grave danger of falling back into recession. But we're not alone. The global economic outlook is poor. And western countries have hardly recovered from the last great recession.

But why do recessions occur at all? The fundamental cause of a recession is when the supply of goods or services outstrips the demand; when a country has too many employees making products customers don't want to buy anymore - or can't afford to buy; and too few companies want to spend money investing in the latest new equipment. The result is a recession.

This does beg the question, however, as to why does demand suddenly fall short of what is needed to keep everyone busy and a county's growth on a steady and gradual upward curve?

Why do recessions happen?

The conventional economic explanation is that, across the world, there is a 'savings glut'; people would prefer to save money, rather than spend it - especially in Pacific Rim countries.

The reasons this happens, however, is not because people plan it that way but because they are forced into this position. All borrowing has to be matched exactly by all lending - and all surpluses have to be matched by corresponding deficits. So if there is a balance of payments surplus (where a country exports more goods than it imports), to balance it out, there must be excess saving going on in the system, otherwise the figures don't add up, whatever everybody's prior plans and intentions might have been.

The position in much of the West, particularly in the USA and the UK is the reverse of the situation in the Pacific Rim where much of the world's staple goods are manufactured and then exported. The big western countries mostly have balance of payment deficits - they import far more goods than they export. The consequent balance of payments deficits suck demand out of their economies which has to be replaced by increasing debt, if demand is not to plummet. As a result of mounting debt, net saving goes down - and borrowing rises.

The reason why there is insufficient demand across the world now becomes apparent. The West cannot increase demand because adopting reflationary policies to replace the demand sucked out of the economy by its foreign payments deficits would push up the amount of borrowing required both externally and internally to unsustainable levels.

The East then finds its exports to the West falling, or at least slowing, depressing demand in their own economies. Confidence in the future then declines everywhere, depressing investment and future growth prospects, as planned saving runs ahead of planned investment, providing further deflationary pressure. That's when you're heading for a recession.

What if we look at recessions in a different way?

What, if instead of blaming people in the UK for spending rather than saving, we try to figure out why we have the big foreign payments deficit which is what depresses saving? Could it be that the goods we produce in the UK are just too expensive? If so, then how can we tackle this challenge?

The problem is that our economy is uncompetitive because our exchange rate is so high. Indeed, we now have one of the most overvalued currencies in the world. That means our goods, and to a lesser extent, services, are incredibly expensive compared with their equivalent manufacturers or delivered outside the UK. The recent raft of factory closures is the direct consequence of having an exchange rate that's so high our industry sectors cannot compete on the world stage.

And this is not a new phenomenon. The UK has deindustrialised to a point where nowadays only about 10% of GDP comes from manufacturing compared to almost a third as late as 1970. As a majority of our exports are still goods rather than services, hardly surprisingly we cannot pay our way in the world. We have not had a visible trade surplus since 1983 or an overall balance of payments surplus since 1985.

What do we need to do to avoid another recession?

The crucial requirement is to produce an economic environment which reduces the incidence of very large balance of payments surpluses and deficits, because these have been the fundamental source of all the other imbalances.

To do this, at least among Western economies, there would have to be extensive exchange rate adjustments to produce more evenly balanced cost-bases among all the world's major economies. If we could do this, developed economies would have sufficient exports of goods and services available to sell to the rest of the world to pay their way without excessive deficits or surpluses.

Since a majority of world trade is in goods rather than services, it would be vital that all countries involved were sufficiently competitive - although not excessively so - to allow them to have sufficient manufacturing capacity to enable them to pay their way in the world. For a country such as the UK, this would probably involve the percentage of GDP coming from manufacturing having to rise from about 10% to around 15%.

Hazards to be overcome

A key element of any reform of this kind would be the need to curb, wherever possible, excessive balance of payments surpluses - to avoid exporting more than we import. We need to do this because the current depressed state of the world economy has much to do with the surpluses of countries such as Germany which in 2014, as a ratio to GDP, had a surplus of 7.5%, Switzerland with 7.0%, China 2.1%, Taiwan 12.3% and the Netherlands 10.8%. All these surpluses have to be exactly matched by deficits elsewhere, which have to be reduced, if not eliminated, if the world economy is to have a more balanced and secure future.

Obviously, there are major problems in the Eurozone where large exchange rate changes are needed to even up competitiveness, which cannot happen as long as the Single Currency remains in being. There is no ideal solution to this problem, but it would be substantially reduced if countries such as Germany and the Netherlands, with large surpluses, could be persuaded to adopt more expansionary policies.

How much difference would this actually make?

The answer is that it would be potentially transformative. If the world could return to an average growth rate of 4% or 5% - which should be relatively easily achievable - millions more people could be lifted out of poverty in the poorer parts of the world. In the West, it would be possible for average incomes to rise again after years when they have remained static. Hopefully, in addition to improving greatly the economic environment, more prosperous conditions would go a considerable way to restoring the battered reputations of the moderate left and the moderate right in western countries.

Would changes along the lines proposed above be possible? Of course, securing agreement would be difficult, but in the end everyone would gain. Part of the problem, however, is that there is a lack of recognition as to what the fundamental problem is and, therefore, what needs to be changed. If some agreement could be secured on this front, getting the necessary changes made might look a lot more feasible.