The Autumn Statement Looks Far Too Optimistic

The Chancellor's recent Autumn Statement generated a number of big-splash headlines with announcements on Stamp Duty, tax and savings. But there are really only two key criteria by which we will judge the Chancellor's Statement in the long term.

The Chancellor's recent Autumn Statement generated a number of big-splash headlines with announcements on Stamp Duty, tax and savings. But there are really only two key criteria by which we will judge the Chancellor's Statement in the long term.

First, will the economy grow fast enough over the coming years to enable living standards to rise significantly? And secondly, will the government deficit be reduced to manageable proportions? Unfortunately, it appears that the projections made in the Autumn Statement will not turn out to be right on either of these two crucial counts.

Economic Growth

The only long-term way in which the economy can grow is for productivity among the country's workforce to increase. With policies in place as they are at present, this looks very unlikely to happen - mainly because we invest so little in our future. The proportion of our Gross Domestic Product (GDP) which we have as capital expenditure is one of the lowest in the entire world. On a comparable basis to other countries we invest 14% of our GDP per year; the world average is 24% and in China it is 46%. By the time provision is made for depreciation at about 11.5% of GDP in the UK, there is only about 2.5% left. This is not even sufficient to keep our existing capital assets from being diluted down by our increasing population. We therefore now have no net investment per head of the population now at all.

What investment we do have is largely confined to the service and the public sectors where returns on investment tend to be low. The really high rates of return, given the right conditions, tend to be found in manufacturing, especially in light industry where the application of machinery and IT can produce much greater returns than elsewhere in the economy. Unfortunately, investment of this type is heavily discouraged by our high exchange rate, which makes it extremely difficult for the UK to compete in highly competitive world markets, especially for low tech manufactured goods. Net of depreciation, investment in manufacturing in the UK is now close to zero.

Because of the consequent weakness of our manufacturing base, there is no realistic prospect of our trade balance improving because our export prices are uncompetitive and any growth in the economy is likely to lead to more and more imports. There is therefore almost no likelihood that an improvement in our net trade position, and export-led growth, will drive our economy towards achieving higher productivity and better growth performance.

With almost no net investment, a still diminishing manufacturing base and an economy heavily constrained by our mounting balance of payments deficit, the prospects for any significant improvement in productivity and growth in the UK economy are both, therefore, very poor.

Reducing the Deficit

The figures and projected outcomes given by the Office of Budget Responsibility (OBR) for government deficit reduction also look implausible for a number of reasons, as interpretation of the figures in the table below makes clear because, as a matter of accounting logic, all borrowing in the economy has to be exactly matched by the same amount of lending.

The table shows that the corporate sector has never been a net borrower from the rest of the economy since the height of the unsustainable book in 2000 and 2001. It therefore seems extremely unlikely to be investing so much by the end of the current decade, as the OBR suggests will happen, that it stops having a financial surplus which has to be lent to the rest of the economy, especially as little economic growth is projected at the end of this decade.

In 2007, at the height of the boom period running up to the 2008 crash, households' net borrowing was 4.6% of GDP, but this was clearly unsustainable. It was the heavy household deleveraging in 2010 that precipitated the very high government borrowing that year and it is far from clear that it is good policy to encourage households to get substantially deeper in debt. Household borrowing may perhaps rise a little from its present level by 2020 but it is very unlikely - in the absence of boom conditions which no-one expects to materialise - to rise again to anything like as high a figure as 3% of GDP given in the OBR report - especially year after year.

As all the main components of the balance of payments - the trade balance, net transfers abroad and net income from overseas - are all trending in the wrong direction at the moment, with the exchange rate as strong as it is at present it seems highly implausible that there is going to be the huge improvement in our foreign payments performance which the OBR hopes will occur. It appears to be much more probable that our balance of payments deficit will grow rather than contract. If this is the case, and the government deficit is effectively the balancing item, then there will still be a deficit running at something like 4.5% of GDP in 2020 - still around £100bn per annum.

It is difficult to avoid the conclusion that the writers of the OBR report started from the position that the government deficit had to come down and then had to fit this goal into borrowing and lending trends which made this objective possible. It seems, however that they could only do so by stretching plausibility badly in the process.

Cuts in Government Expenditure

Clearly sooner or later it is going to become unsustainable for the government to borrow more and more money. The problem is to find realistic policies for getting the deficit down. It may seem obvious that government borrowing could be reduced by cutting expenditure and increasing taxation, policies to which all our major political parties are committed. Unfortunately, however, this approach is almost certain not to work. Increasing taxation and cutting expenditure will not reduce the government deficit, as long as the balance of payments deficit remains as high as it is at the moment.

A foreign payments deficit necessarily entails that expenditure which would otherwise have been received as income by people or organisations in the UK goes to recipients outside the country. This reduces revenues within the UK as demand is sucked out of the economy by leakage abroad, which is exactly what a balance of payments deficit does. Because all income has exactly to match all expenditure, the missing income from the balance of payments deficit has to be reflected somewhere in the economy as reduced expenditure and a corresponding fall in Gross Domestic Product (GDP).

If the government sector did not exist, the reductions in income and expenditure would all have to fall on either households or the corporate sector. There would be nowhere else for them to go. It is then easy to see that the result would be a fall in the incomes spread between these two sectors, which exactly matched the balance of payments deficit. The immediate result, unless something else changed, would be a fall in their revenues which was exactly equal to the foreign payments deficit. GDP would fall by precisely this amount.

Of course the government not only exists but it also does not want the incomes of the household and corporate sectors to fall by the value of the balance of payments deficit. To replace the missing demand, it therefore has to run its own deficit - by having its expenditure higher than its income - which, to stop demand falling, has to correspond in size with the leakage in demand caused by the foreign payments deficit. To the extent which if fails to do this, all the deficiency in demand which results will fall back as income reductions on either the household or corporate sectors - or both - will inevitably tend to make the economy contract. And this is exactly what will tend to happen if the government tries to cut its deficit by cutting expenditure or increasing taxation.

The only way in which this outcome could be avoided is if the missing demand was made up by either households or the corporate sector saving less - or borrowing more to spend. Unfortunately - contrary to what the OBR Autumn Statement report projects - this is also unlikely to happen. As government cuts reduce demand and the economy contracts, corporations are likely to invest less rather than more, leaving them with more cash which has to be lent to the rest of the economy, while consumers, on balance, are likely to be more cautious about running up more debt.

But surely, if the government cuts its expenditure and raises taxation, even if the economy contracts as a result, at the very least the deficit ought to go down. Unfortunately, this will almost certainly not happen either. The normal mechanism to stop this occurring would be that falling economic output would reduce the tax take and increase expenditure on benefits, but even if the government took steps to try to avoid either of these two things happening, the deficit would still remain as high as ever. Something else would have to change to make this occur - very probably even less tax receipts and higher benefit expenditure as the economy contracted to an ever greater extent. All borrowing would still have exactly to equal all lending. Equilibrium between borrowers and lenders would be re-established at a lower and lower level of GDP, but the deficit would still not go down.


The unavoidable conclusion to which this analysis points is that there is no way to reduce the government deficit other than to take realistic steps to get the balance of payments deficit down - by getting the economy rebalanced towards sufficient manufacturing to enable us to pay our way in the world. There is no way in which this can be done other than for the exchange rate for sterling to be reduced sufficiently to enable us to reap the benefits from profitable investment opportunities in import substitution and export-led growth to get our foreign payments position back under control. If this is not done, continuing government deficits and little or no growth for the foreseeable future are - unfortunately - both looking inevitable.

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