Exposing Britain’s economic fragility

The British economy is in a fragile condition, far from a recovery from the recession. Any hope of export-led growth is wide of the mark. In fact, the Con-Dem coalition’s savage public-sector cutbacks risk plunging it back into a double-dip. LYNN WALSH reports.

A "BUMPY, BELOW-PAR and brittle recovery" – this is how bankers Morgan Stanley describe the wretched state of the British economy. In 2010, real (inflation-adjusted) growth of GDP (gross domestic product) was 1.4%, dragged down by the 0.5% fall in the last quarter. This means that British capitalism has recovered only about a third of the loss of output during the recession (6.4%). Moreover, the outlook for 2011 is far from cheerful. The Office for Budget Responsibility (OBR) optimistically predicts 2.6% GDP growth. But the Confederation of British Industry (CBI) expects "anaemic and sluggish" growth of 1.8%. Morgan Stanley only expects 1.4% growth. This, moreover, is before the Con-Dem government’s deficit-reduction programme (£81bn spending cuts and £33bn tax increases) has really begun to bite.

Unemployment reached 2.5 million last November, and this figure includes nearly a million young people. According to the CBI, "unemployment is forecast to continue rising during 2011, peaking higher than previously forecast at 2.7 million by the end of the year. It will remain stubbornly high during 2012, and be at 2.64 million by Q4 2012". This may prove to be an underestimate, given the sweeping job losses about to hit the public sector (estimated at around 500,000), and the knock-on effect on the private sector.

Consumer spending, which accounts for two thirds of the economy, is weak, running at only half its historic trend. The CBI predicts that household spending will rise by only 0.7% in 2011. Households, in fact, are about to be hit by a whole battery of price and tax rises, job losses, and cuts in public services. VAT (sales tax) was increased to 20% in January, and workers’ national insurance contributions are about to be raised by 1%. Workers’ pension contributions are being raised, while there is the possibility of an interest rate rise later this year which will increase the cost of mortgage repayments and other loans.

Workers’ earnings are trailing way behind price increases. In Q4 2010, average earnings grew by only 2.1%, while prices, measured by the consumer price index (CPI) increased by 3.7%. The increase measured by the more realistic retail price index (RPI), which includes housing costs and other essential items, is running at nearly 5%. In other words, real, inflation-adjusted, wages are falling. Mervyn King, governor of the Bank of England, recently warned that real wages will continue to fall: "In 2011 real wages are likely to be no higher than they were in 2005. One has to go back to the 1920s to find a time when real wages fell over a period of six years". Quite apart from the Con-Dem cuts package, this prolonged decline of real wages will mean a savage cut in living standards for working people.

It appears that Con-Dem economic policy – dominated by its deficit-reduction package – is a recipe for stagnation or even another downturn, a ‘double dip’. A prolonged slump in consumer spending will severely restrict the aggregate market for goods and services. There will be no basis for new investment and expansion of productive capacity. David Cameron and George Osborne, however, have an almost mystical belief in a renaissance of the private sector (seemingly shared by Nick Clegg, Vince Cable and company). They believe that a slash-and-burn assault on the public sector will create new opportunities for profit-making by private firms, thereby boosting the growth of the private business sector. They claim there will be a "rebalancing" of the British economy, with reduced reliance on consumer spending, a growth in the manufacturing sector and of exports. This approach has aptly been described as ‘cut now and hope’.

Fiscal crisis?

SAVAGE DEFICIT REDUCTION is the core of the Con-Dem government’s economic policy. Everything else is window dressing. According to Osborne and co, the British state faces a dire fiscal crisis. Without savage deficit reduction, they claim, Britain would be at the mercy of the international bond markets. Bond traders (representing speculators and financial institutions) could force up bond yields, greatly increasing the cost of financing Britain’s debt. At worse, they could boycott British bonds, forcing the government to go cap in hand to the ECB and IMF, and plead for a bailout package.

Despite its organic weakness, however, British capitalism is not facing bankruptcy at this time – or even a funding crisis on the bond markets. Britain, for instance, is not in the position of Greece. Successive Greek governments cooked the books, systematically concealing the true extent of the state’s debts. On the other side, Greece has a very weak tax basis, because of widespread, large-scale tax evasion. Moreover, Greece has financed its deficit through short-term borrowing (average maturity 7.7 years), while Britain has more long-term funding (average maturity 13.7 years). As Martin Wolf comments, "The UK has had no fiscal crisis. That makes its austerity remarkable". (Financial Times, 8 February)

The fiscal trends that developed during the 2008-09 slump were unsustainable in the medium to long run. The financial crisis provoked a slump in the economy, pushing up expenditure (especially through increased unemployment) and sharply eroding tax revenues. Government spending as a percentage of GDP rose from 41% in 2007/08 to 47.6% in 2009/10. At the same time, tax receipts fell from 38.6% of GDP to 37.2% – a fiscal gap amounting to 10.4% of GDP. Over the same period, GDP fell by £20.6 billion (1.4% of GDP). The government’s budget deficit soared from under 3% (the Maastricht ‘limit’) in 2007/08 to 11% of GDP in 2009/10. The national debt rose from just over 40% of GDP to around 70%.

Clearly, on the basis of the capitalist market, any government would have to take measures to curb the divergence of income and expenditure. Even so, it may be noted that the US and at least seven EU countries currently have a higher level of debt – as a percentage of GDP – than Britain.

The Con-Dem government is going much further than necessary to reduce its spending and debt levels to sustainable levels. Most of the burden of reducing the deficit is going to be thrown onto the working class and middle class through cuts in services and increased taxation. Despite squeals from the wealthy, big business and the super-rich will get off virtually unscathed.

From the standpoint of fostering economic growth, it would be more effective to reduce the imbalance between public spending and government revenue – and the level of debt – over a much longer period than envisaged by the Cameron-Clegg government. Sustained growth is the key to any sustained improvement in state finances. But he immense power of global financial markets—the vehicle for finance capital—exerts remorseless pressure on governments to take short-term measures to reduce their debts. Given its weak manufacturing base and overgrown finance sector, British capitalism is particularly susceptible to this force.

At the same time, the Con-Dem government is driven by hostility to the public sector, to state intervention in the economy and to public services, especially welfare which mainly benefits the poorer sections of society. Cameron and Clegg are also eager to open up even wider sectors of society to profit-making activity through privatisation. The ‘big society’ is flimsy camouflage. This ideological hostility to the public sector reflects, above all, the interests of finance capital, which now dominates British capitalism. Manufacturing business is the poor relation.

For electoral reasons, moreover, the Con-Dem leaders are ‘front-loading’ the cuts, carrying through the biggest tranche in the first one-to-three years of this government in the hope that there will be a revival of economic growth and a subsidence of pain from cuts in the run-up to the next general election. In reality, their policy is much more likely to induce another downturn in the British economy and provoke a real fiscal crisis. According to the Institute for Fiscal Studies (IFS): "The five years from April 2011 are set to be the tightest five-year period for public spending since at least the second world war. Out of 29 leading industrial countries, only Ireland and Iceland are forecast by the IMF to deliver sharper falls in spending".

The Con-Dem government is aiming to transform the current budget deficit of -7.2% of GDP over six years into a surplus of 0.3% of GDP. Annual government borrowing would fall sharply (from 10% of GDP to around 1% of GDP, according to the OBR). However, the national debt would remain at about 70% of GDP

The ‘independent’ OBR assumes average growth over the six years of 2.6%. But this is very optimistic, especially given the new turbulence in the world economy. The IFS green budget includes a "pessimistic" scenario by Barclay’s Bank. This assumes average growth of only 1.43% a year. On that basis the current budget deficit would only fall to -4.5% in 2015/16, while the national net debt would rise to 90.5% of GDP. On the basis of this possibility, the IFS has warned Osborne that the government would need to increase taxes even further!

The financier, George Soros, commented: "I don’t think they [the Con-Dem government] can possibly implement it [the deficit-cutting strategy] without pushing the economy into recession. My expectation is that it will prove to be unsustainable". (The Times, 27 January)

Slashing public spending and ramping up taxes will not correct the imbalance in public finance. That would require sustained growth of the economy. Yet the Con-Dem government’s reliance on a revival of British manufacturing and a growth of exports remains a pious dream. Recently, the retiring director-general of the CBI, Sir Richard Lambert, criticised the government for not having a plausible industrial policy to promote growth: "It’s not enough just to slam on the spending brakes. Measures that cut spending but kill demand would actually make matters worse… So the question is, where is the growth going to come from?". (Independent, 25 January)

Manufacturing revival?

THE CON-DEM GOVERNMENT and its supporters claim there is the beginning of a manufacturing revival in Britain. "One positive aspect is the continuing vigour of manufacturing. This suggests that the long-overdue rebalancing of the economy towards exports and away from consumption is starting to happen". (Daily Telegraph editorial, 26 January) Manufacturing has undoubtedly done better than the service sector over the last year or so. In the last quarter of 2010, for instance, when the service sector declined by -0.5%, manufacturing grew by 1.4%. Nevertheless, manufacturing output is still about 9% below its peak at the beginning of 2008.

The devaluation of the pound (25% since 2008) has helped exports a bit. But manufacturing only accounts for 12% of output (down from 25% in 1980) and around 10% of the workforce (approximately three million workers). This sector is not weighty enough to carry the whole economy.

Moreover, there is no sign of a revival of large-scale investment in manufacturing, essential to sustained growth in this sector. Manufacturing investment slumped in the recession (down 28%) and many big companies have piles of cash in the bank. The financial surplus of the non-financial corporate sector at the end of 2010 was huge, around 5% of GDP. (Martin Wolf, Financial Times, 27 January) They are in no hurry to invest in new plant and equipment.

In a report last year, Oxford Economics (‘Rusting Britain’) warned: "There is a risk that UK producers may not have appropriate capital equipment in place to meet the pick up in demand as recovery strengthens. This will have adverse implications for the competitiveness of UK tradeables in both domestic and export markets".

There is a polarisation between big companies, on one side, with hoards of cash, and small- and medium-sized companies, on the other, which are still finding it difficult to get credit, despite the recovery of the banks and supposedly low interest rates. A revival of manufacturing, comments the Financial Times (editorial, 25 January), "depends on the resolve of cash-rich companies – corporate profitability has held up well – to invest the funds they are sitting on". Most big companies are lending out their cash reserves on the money market, rather than investing in new plant and machinery. "Business surveys record ‘uncertainty over future demand’ as the key factor in constraining investment, along with existing surplus capacity. In a nutshell, firms are not sufficiently confident about the future to warrant a current rise in productive capacity". (Office of National Statistics, Economic Review, January 2011)

Britain’s reduced manufacturing sector is now dominated by high-tech corporations, particularly in pharmaceuticals, aerospace, armaments and high-tech equipment. Many of these industries, however, are dominated by multinational corporations based outside Britain.

The fragility of this sector was underlined recently by the decision of the US pharmaceutical firm, Pfizer, to close its research centre in Kent, with the loss of 2,400 jobs. "The lamentations that have greeted the closure… betrayed the deep concern that exists about the virility of British manufacturing" (Pfizer developed Viagra). (Financial Times editorial, 2 February)

An export-led boom?

THE MANUFACTURING SECTOR has been boosted by a small increase in exports, especially in the middle of 2010, when there was a restocking cycle internationally (as firms rebuilt their inventories of supplies and goods). Actual figures, however, do not justify the exaggerated claims being made for an export-led boom.

British capitalism continues to run a chronic trade deficit in goods and services. There was a brief exception in the second quarter of 2010 when export growth was accompanied by weak import growth, due to weak growth at home. According to the ONS Economic Review (January 2011): "In the early part of the global recession (2008 Q2 to 2009 Q2), net trade made a positive contribution to GDP growth as imports fell at a faster rate than exports. But since the global economy started to recover in the second half of 2009, imports growth has generally outstripped exports growth in the UK. The ongoing weakness in the UK’s net trade position has surprised commentators. It was hoped that trade would be a supporting factor in the recovery from recession. And it had also been touted as a rebalancing in demand away from domestic consumption towards exports that was necessary and beneficial".

Commenting on the third quarter of 2010, the ONS says: "Modest growth in goods exports and services exports were more than outweighed by stronger growth in goods imports". The fourth quarter figures are even worse, recording the largest deficit on trade in goods in the country’s history.

Exporters benefitted from the devaluation of the pound, which makes British goods cheaper on world markets. But the boost has been nothing like as significant as the fillip to exports following the fall in the pound after Britain broke from the European Exchange Rate Mechanism in 1992. The fall in the pound "has failed to provide a catalyst for growth this time around". (ONS Economic Review)

There are a number of reasons for this. Exporters have been "using a weak pound to boost profit margins rather than to increase their overall volumes sent abroad". (Stuart Green, HSBC, 9 February) Instead of reducing the dollar or euro prices of their products in line with the devaluation of the pound – and possibly increasing the volume of sales – many exporters maintain the old foreign-currency prices and boost their return in pounds. At the same time, the advantage of a weaker pound for export sales has been partially cancelled out by the increase in the prices of imported fuel, raw materials, and intermediate products required for manufacturing processes.

No doubt the position of British exporters would be even worse without the devaluation of the pound. But devaluation has not provided a way out for British capitalism, and will not save it in the coming years. The main demand in the world economy has been from the semi-developed economies like China, India, Brazil, etc, and the main demand for advanced economy exports is for manufactured products. The fact that manufacturing now is such a small share of the British economy means that manufacturing exports alone cannot dramatically change Britain’s balance of trade.

Monetary policy

AT ITS LAST meeting, the Bank of England’s Monetary Policy Committee (MPC) held the base interest rate at 0.5% – despite mounting pressure from sections of big business, especially finance, to begin raising interest rates. The clamour for an increase was intensified with the announcement (15 February) of higher inflation. In January the CPI increased from 3.7% to 4%, while the RPI, which includes mortgage interest payments, rose from 4.8% to 5.1%. The base rate, which is the benchmark for other interest rates, has been at the near-zero 0.5% since March 2009. Recently, however, inflation has begun to rise, and is way above the Bank of England’s target of 2% by the CPI measure.

King and the majority of the MPC defend their policy of maintaining a low base rate on the grounds that the inflation is not domestically generated (leaving aside the effect of the increase in VAT). The price increases are mainly caused by the higher import prices of fuel, raw materials and food, amplified by the devaluation of the pound. King claims that domestically generated inflation is only about 2%. Moreover, he points out that broad money growth (cash and credit) is weak, running at an annual rate of about 2%.

The huge amount of credit injected into the economy via the banks under the Bank of England’s quantitative easing programme has mainly flowed abroad, fuelling rapid growth in the semi-developed economies. In this way, British capitalism has been exporting inflation, as rapid growth has pushed up price levels in the developing countries. Then, through higher commodity prices, the inflation has been imported back into Britain.

The majority of the MPC, with the support of many City and media commentators, fear that raising base rates (which would push up rates generally) would squeeze the economy and choke off the current weak recovery. However, two members of the MPC, including Andrew Sentance, have been arguing for higher rates and scaling down quantitative easing (currently running at £200bn). Sentance argues that the recovery of the British and world economy will lead to higher inflation unless interest rates are raised and monetary policy is tightened, restricting credit. He fears that workers will push for higher wages to compensate for the increased cost of living. Moreover, holding the base rate at 0.5% when inflation is way above the 2% target suggests, in his view, that the Bank of England is not serious about the inflation target. The danger, according to this line of argument, is that there could be an explosion of inflation in Britain at a certain point.

This view particularly reflects the interests of finance capital. Inflation favours borrowers, as it lowers the real (inflation-adjusted) value of outstanding debt – and is therefore detrimental to the interests of lenders. Some sections of finance capital accept that they have to live with some inflation until there is a sustained recovery. But other sections fear that low interest rates and quantitative easing are preparing the way for an explosion of inflation, or even hyper-inflation.

In reality, this is not likely in the near future. Most of the credit issued by the Bank of England under the quantitative easing programme has been channelled abroad to the highly profitable ‘emerging markets’ (China, India, Brazil, etc). In Britain, credit remains very restricted, despite the low base rate. Whether it is home-buyers seeking mortgages or small and medium businesses trying to get business loans, they are faced with prohibitive conditions, high fees, and interest rates way above the base rates.

Other capitalist economists still regard debt and deflation as the main problems facing the British and global economy. The argument was recently summed up by Anthony Hilton in the London Evening Standard (18 January): "When debt is the problem, inflation can be the least painful solution… Deflation involves massive belt tightening, and means channelling money into debt repayment at the expense of everything else so that the debt burden is eased… It backfires when the squeeze is too great for the country to bear, and sinks overall economic activity faster than the debt gets paid off. Then social unrest erupts".

While not experiencing price deflation at the moment, British capitalism is weighed down by a huge mountain of debt, both in the public and household sectors. Public-sector deficit-reduction and household-debt repayments are in danger of strangling demand for goods and services and undermining growth.

"Inflation, on the other hand, makes these adjustments [debt repayment] more gentle and more even. Tax revenues rise as people move into higher income bands, businesses can scale back wage costs by pegging pay increases to less than the inflation level, and these measures reduce demand without the additional pain of unemployment. And all the time, the real value of the debt burden is eroded… Inflation running at 4% reduces the overall debt burden by almost 25% in five years and virtually halves it in nine years. Who needs George Osborne? Leave the MPC alone, and it will solve the problem".

In the present situation, it would be counterproductive for the Bank of England to raise rates and rein in quantitative easing. Given the weakness of the recovery, such action would almost certainly provoke a new downturn. Mild inflation of around 4% would be favourable to economic growth. It seems increasingly likely, however, that the MPC will succumb to pressure and begin to raise rates in the next few months.

Hilton admits that inflation "is not a free lunch". In practice, it is impossible for governments or central banks to carefully control inflation, limiting it to, say, 4%. A flood of credit can lead to spiralling inflation, which erodes living standards and destabilises the economy. Inflation is, at best, a temporary expedient for capitalism, and cannot provide a way out of crisis.

Political and economic meltdown

SO FEEBLE IS British capitalism’s recovery that fears of a ‘double dip’ are being continuously raised in the media. Quite apart from home-grown problems, any recovery depends on the continued growth of the world economy. This could be cut across by a new phase of the European financial crisis, a collapse of the investment bubbles in the semi-developed economies, or further geopolitical shocks, such as the revolutionary developments in North Africa and the Middle East (which has recently pushed the price of oil above $100 a barrel).

Cameron and Osborne, Clegg and Cable, claim their austerity package is the road to salvation. They say it will reassure the bond markets and lead to increased private-sector growth. But it is more likely to lead to a period of stagnation, if not provoke a new downturn in the economy. More and more voices are being raised from within the capitalist class for the need for a ‘plan B’, an alternative to the austerity package.

Plan B would, according to Paul Collier, professor of economics at Oxford, "amount to a fundamental reversal of policy, it would happen only in the case of political and economic meltdown". His feeble proposal is for a stealth stimulus package that would not alarm financial markets, a ‘Plan A+’. (Financial Times, 3 February)

British capitalism is heading for a political and economic meltdown. The scale of the cuts, once they begin to take effect, will provoke a deeper economic crisis. Far from reassuring the bond markets, the austerity measures will bring renewed ‘financial turmoil’. The capitalists and their ruling elite will be split in all directions.

Above all, the growing resistance of the working class to draconian cuts, mass unemployment, and the generalised driving down of living standards, will trigger a ‘political meltdown’. Unprecedented austerity measures will provoke an unprecedented movement of the working class. The mass anti-cuts fight will increasingly be linked to a struggle to take over the economy and run it on democratic, socialist lines.