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A Marathon Challenge

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It was great while it lasted. For two weeks the London Olympics provided welcome respite from the economic gloom, political travails and banking scandals that have become a depressingly regular part of the news agenda since the Great Recession of 2008-09.

Positive legacy effects from the Olympic experience may emerge, but over years (and possibly decades) rather than weeks and months. As golden memories gradually fade and attention returns to the daily grind, the state of the UK economy remains a concern for all.

Recent economic data have done their best to try to prolong the "feel-good" factor. Figures this week showed the largest quarterly rise in employment for two years and the lowest level of unemployment since July 2011. Retail sales data were perkier than expected in July, while upward revisions to the June numbers--mirroring a trend seen for industrial and construction output--support the widely held view that the first estimate by the Office for National Statistics of a 0.7% contraction in second-quarter GDP overstated the current weakness and will be revised higher over the coming months. And although inflation rebounded in July, the headline rate of 2.6% is now well below the 5%+ levels of late last year, providing a little respite for squeezed household incomes.

And yet, a brief spate of encouraging data cannot--and should not--divert attention from the structural fragility of the British economy. This time, things really are different. Over the past two years, despite the cumulative stimulus effects of historically low interest rates, unprecedented central bank intervention, government spending still far in excess of tax revenue, and huge financial sector support, GDP has continued to flatline.

One thing that is clear is that the economy is being held back by the weakness of business investment. Despite a steady fall in corporate taxation and labour-market reforms that have boosted the power of capital relative to labour, the ratio of business investment/GDP stands at a 60-year low. Instead of investing their profits, companies are sitting on huge piles of cash. This hoarding is depressing activity and forcing the government to run large budget deficits. Unfortunately, government policy is exacerbating the problem.

The coalition maintains that business investment will bounce back once the public finances have been put on a sustainable footing. In short, investment is weak because of the weakness of the public finances. But this argument does not bear scrutiny. The widening of the deficit followed, among other things, a collapse of investment--not the other way round. Business investment fell by almost 25% between the final quarter of 2007 and the final quarter of 2009. Business investment as a share of GDP stood at 14.2% in 2011, down from 20.4% in 1990. Weak public finances are the counterpart of low levels of business investment. Until investment recovers, public finances will remain weak.

What explains British companies' unwillingness to invest? One reason is leveraging. Firms built up high levels of debt in the run-up to the crisis, which they are trying to reduce to more manageable levels. Another reason is that banks are now reluctant to extend revolving credit lines, forcing companies to accumulate cash as a buffer.

But the more important reasons for the weakness of business investment are corporate governance and economic policy. First, executive remuneration in the UK is now largely driven by short-term movements in share prices. Senior executives have little to gain personally by boosting investment that would hit profits over the time horizons that determine their financial compensation.

Second, companies will not invest unless they are confident about the outlook for demand. And here two issues are crucial. One is fiscal austerity, which has inevitably acted as a constraint on any recovery. The other is that Britain has experienced a big shift in the relative proportions of national income accounted for by capital and labour. A protracted period of lower corporate tax rates and labour-market reforms aimed at reducing the bargaining power of labour have raised the income of the corporate sector and depressed that of households.

While firms continue to save much more than they invest, either households or the government will have to spend more than their incomes, or the UK will have to export more than it imports, if the economy as a whole is to expand. Unfortunately, prospects remain grim. Declining real wages, household indebtedness, labour-market weakness and constrained credit availability will continue to hold down consumer demand. The government, meanwhile, is still in the early stages of its fiscal consolidation programme, with most spending cuts still to take effect. As for exports, the UK has run a persistent trade in goods deficit with the rest of the world since 1997, and with the euro zone--by far Britain's biggest export market--mired in a prolonged recession, it is hard to see how Britain can engineer a trade surplus anytime soon.

If investment is to stand any chance of recovering, the government probably needs to do a number of things, including easing the pace of austerity, taking steps to avoid a further erosion of labour income as a share of overall national income, and resisting lobbying pressure to make further cuts in business taxes.

In addition, the perverse incentives facing executives must be tackled. Too many companies are being run for cash rather than growth, with damaging implications for economic activity. Finally, the government must do more to restore confidence in Britain's banking sector: businesses are reluctant to increase their reliance on banks, and the banks are disinterested in lending.

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