The Other Debt and the Other Deficit
As ever, much of the attention around the Autumn Statement has been firmly on two numbers which define the coalition’s mission — the government’s debt and the government’s deficit (the gap between spending and tax receipts).
But stepping back from the immediate growth statistics and the public finance forecasts, there were two things I found especially striking in the new OBR forecasts. They relate to what I think of as the ‘other debt’ and the ‘other deficit’.
The Other Debt
The other debt is household debt and, as the chart below makes clear, the OBR yesterday revised up its forecasts.
The household debt to income ratio is now expected to surpass its pre-recession peak in the coming years and keep on climbing.
Some of this reflects higher house prices (higher prices means larger mortgages and more debt). Some is weaker earnings forecasts and some of it represents ONS to household debt obligations. But those factors alone don’t explain the entire increase.
The OBR has also revised up its forecasts of unsecured lending (personal loans, credit cards and so on) by £41bn. This because of what they call a “greater momentum in consumption relative to income”.
One of the big questions around the post-2008 economy was on so-called ‘deleveraging’ — the idea that households were engaged in reducing their debt burdens.
Debt balances were high relative to household incomes on the eve of the crisis. But these fell away from 2008 until 2011: the household savings ratio (the percentage of their income that households save (or pay off debt) rose from a low of around 5% to a high of over 10%.
Of course higher levels of personal debt relative to incomes might prove to be entirely sustainable. Interest rates are expected to remain low for the foreseeable future and much of the debt is backed by an asset in the form of home. But I can’t help but feel a little uneasy about this chart. Whilst asset prices can fall, debt is an obligation and higher levels of debt increase households’ vulnerability to economic shocks.
The Other Deficit
And then there’s the other deficit: the current account deficit. That’s the difference between the amount of money that the UK receives from the rest of the world and the money we pay out.
Here’s the OBR view:
There are two important things to remember here.
First, the current account balance is different to the trade balance (which is our exports of goods and services minus our imports of goods and services), it’s made up of three distinct elements, which are set out in the chart above. I’ll go through those in a moment.
Second, the current account deficit currently stands at almost 5% of GDP. That’s high. In fact last year’s current account deficit (which looks to have worsened in 2014) was the highest since 1989.
On one basic level — the fact that we are sending more money abroad than we are receiving from the rest of the world — the UK currently isn’t paying its way.
Looking at the three elements of the current account and the OBR assumptions for them is instructive.
First there’s ‘transfers and other’, that’s money send overseas (or received from abroad) for which nothing is really expected in return. Much of it is things like international development spending and remittances sent home by migrant workers.
Then there’s the ‘trade balance’, the one most people are familiar with –what we export versus what we import. That’s also been in deficit for a long time and is expected to remain so. Hopes of ‘export-led growth’ — very much in vogue in policy circles from 2008–2011- have receded as our largest trading partner, the Eurozone, has stagnated.
Finally there’s ‘net investment income’. This is the really interesting one. It comprises the difference between the income on the UK’s overseas investments and the income from overseas investments in the UK repatriated abroad.
There is nothing especially virtuous about a current account surplus and nothing especially vice-like about running a current account deficit. If we want to live in a globalised world then goods, services and investment flows will cross borders and some countries will have a positive balance and some a negative one.
But large and persistent deficits can cause a problem. (As in a different way can large and persistent surpluses!).
Take a look at the OBR chart above and you can see very clearly that what has changed in the case of the UK is net investment income — the red bar.
The ‘traditional’ pattern of the UK current account was been to run a deficit on trade (importing more goods and services than we sell abroad) and a deficit on transfers and to fund some of that deficit with positive overseas investment income. But in the last three years something has changed — net investment income has turned negative and dragged the current account deficit down from a reasonable 2.5% of GDP to an eyebrow-raising nearer 5% of GDP.
The exact reasons why our net investment income has fallen so quickly are still debated. It may be that the depressed state of the Eurozone is lowering the returns on British investments there whilst our own recovery has boosted the returns available on investments in the UK.
Or it could be that the global pullback of banks like RBS, Barclays and the rest is having an impact.
Whatever the reason, the OBR expects this to turn around in the coming years — the current account deficit falls as ’net investment income’ rises. This, as they say, “is based on an assumption that relative rates of return have been temporarily depressed”. They may be right, it might be that net investment income is about to rebound and once gain reduce, rather than add to, the current account deficit.
But, and again as they say themselves, their “income account forecast is subject to significant uncertainty”,
So the question that has been bothering me is this: what if the net investment income doesn’t turnaround and what if the current account deficit stays high?
That would mean we are continually running a deficit with the rest of the world and eventually the rest of the world might start to lose faith in our ability to really pay our way. We fund this current account deficit through a combination of selling assets and debts overseas and these financial flows can be subject to a sudden stop.
A large current account deficit, like high household debt, leaves the economy more vulnerable to sudden shocks.
Putting them both together
The nightmare scenario — one you’ll occasionally hear from city types and which whilst almost no one’s ‘base case’ is worth not totally ignoring — runs something like this.
Overseas investors see a current deficit that isn’t coming down, they see a government deficit that is still a high and they maybe start to pay attention to polls predicting a very messy outcome in next year’s general election.
Their reaction is to start sell sterling and push down the value of the pound. A moderate downwards move in sterling could prove helpful — it might make UK exports more competitive and help reduce the trade deficit and it could help push up inflation, which is currently below the Bank of England’s target. Sterling was devalued hugely between 2008 and 2009 in a move that was quietly welcomed by UK policymakers.
But the extreme scenario goes further, it sees disorderly sell off in sterling and sterling assets as international investors begin to dump anything connected to the UK. Assets prices fall and sterling depreciates quickly pushing up inflation to well ahead of the Bank of England’s target.
The usual policy response to this would be to hike interest rates — that would make holding sterling more attractive and push down domestic demand (hopefully crimping imports).
And this is where the interaction of the ‘other deficit’ and the ‘other debt’ comes into play. Because hiking interest rates rapidly when household debt is so high would have serious consequences for people’s ability to meet their obligations.
That nightmare scenario isn’t, as I’ve said, the central view of many. But it does highlight the kind of problems that the interaction of high household debt and a large current account deficit can bring.
The rest of the world matters too — or why some bad news might be good news
The main reason why it isn’t immediately likely is that the UK doesn’t exist in a vacuum. Our economy has all sorts of problems that might cause international investors to eventually take fright. But compared to the Eurozone, compared to Japan or compared to some of the big emerging markets, it looks like a relatively safe bet at the moment.
Ironically enough the ‘flashing warning lights’ of global economic troubles do cause problems for our exporters and may hit consumer confidence, but they also make a loss of confidence in the UK less likely. It’s a beauty contest in which we, in the eyes of investors, are amongst the least ugly.
But the global situation can of course change. The point is that things like high household debt and a large current account deficit add to our vulnerability to economic shocks.
The government’s debt and deficit may well dominate the next Parliament as they’ve dominated this one, but we also might be forced to stop and consider the other debt and the other deficit too.
