June 26, 2014 7:07 pm

An unbalanced recovery is no cause for complacency

When interest rates rise in the UK they are likely to hit the economy harder than before

The UK economy is growing strongly – far more strongly, I am pleased to admit, than I expected. Is all well, then? No. The economy is unbalanced and growth prospects are poor. The UK must not mistake a recovery for a triumph.

This is not to deny the good news. Forecasters expect the economy to grow 3 per cent this year, according to data from Consensus Economics, against 2.2 per cent in the US, 2 per cent in Germany, 1.5 per cent in Japan and a miserable 1.1 per cent in the eurozone. The Bank of England has done a better job than the European Central Bank of hitting its inflation target. In the year to April, inflation was 1.8 per cent in the UK, against 0.7 per cent in the eurozone. Unemployment is down, too. In the three months to April it stood at 6.6 per cent; it was 7.8 per cent a year before.

Fast growth, falling unemployment and inflation on target: what is there in all this that one should not like?

The answers are threefold. For one thing, in the first quarter of 2014 the economy was still a little smaller than six years before and a mere 6 per cent larger than in the first quarter of 2010, just before the general election. This has been an extremely weak recovery. Second, the economy is still over-levered, as Mark Carney noted in his Mansion House speech. “The housing market is showing the potential to overheat,” said the Bank of England governor, adding that the current account deficit is now at a record level. Finally, the combination of modest growth with declining unemployment implies that productivity growth has been weak.

All this highlights big challenges. Whether the government’s fiscal policy was the best way of restoring growth we can leave to historians. (I firmly believe it was not.) Two others are very much alive: one is the scale of imbalances; and the other is poor supply potential.

An obvious concern is that house prices have been soaring once again, while households are still burdened with debts that on average amount to 140 per cent of disposable income. Mortgages that represent a high multiple of the borrower’s annual income now account for a higher proportion of new lending than ever before. The BoE’s response is cautious. It is asking lenders whether borrowers could still afford their mortgages if the bank rate were to be 3 percentage points higher than when the loan was created. It is also asking that no more than 15 per cent of a lender’s new mortgages are 4.5 times bigger than the borrower’s income.

These measures are aimed at ensuring that banks remain resilient, whatever happens. So the job of balancing demand with supply will fall on monetary policy. On this the governor has noted that the obligation to achieve such balance “will likely require gradual and limited interest rate increases as the expansion progresses”. He said that the first rises were drawing nearer. Yet that should not mean the start is imminent. Wage inflation is low: in the three months to April total pay was only 0.7 per cent higher than the same period last year. It is also possible there is significant excess capacity, possibly more than recent rises in employment suggest. With investment recovering, capacity should rise faster. Moreover, when rates rise they are likely to hit the economy harder than before, given the mountain of household debt. The BoE must be cautious in tightening.

Unfortunately, even if it does manage to balance demand with supply, it cannot resolve imbalances in the structure of demand or weakness in growth of supply.

There has to be a big surge in investment in housing for both social and economic reasons

On the first, the combination of spare capacity with large current account and fiscal deficits makes rebalancing demand difficult. In 2013 the government spent more than it received to the tune of 5.8 per cent of gross domestic product. Meanwhile, the country collectively borrowed an amount equivalent to 4.1 per cent of GDP from foreigners, to finance expenditure. Suppose the fiscal deficit is eliminated, but the balance of payment deficit is not. Then the private sector must run a deficit of 4 per cent of GDP, instead of a small surplus, as now. The only good way for this to happen is via a huge (and extremely unlikely) investment surge.

Such an investment boom is also a necessary condition for dealing with the second challenge: improving the supply. Yes, business fixed investment has improved. But in the first quarter of 2014 it was a mere 8.2 per cent of GDP. This cannot be enough to generate the growth in productivity the economy will need to manage ageing and the overhang of debt. In addition, there has to be a big surge in investment in housing for both social and economic reasons.

Much less complacent self-congratulation is in order. It is good that the UK is at last recovering. But the issue the country should focus upon is not whether the BoE will manage to balance demand with today’s shrunken current and prospective supply. It is rather whether the pattern of future demand will prove sustainable and also contribute to much faster growth of supply. The auspices are not good. How are politicians responding? They seem to be struck quite dumb.

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