What should we expect from the UK economy?

It’s election day in the UK, but from an economic perspective does it actually matter who wins?

The economy is always the subject of frequent, often intense, debate during a General Election and this campaign has been no exception. Regardless of the result of today’s election, the closest political contest in decades with numerous potential outcomes, we believe the UK economic outlook remains somewhat subdued. We haven’t been particularly impressed with the quality and sustainability of the domestic economy’s recent outperformance.

The purpose of this article is to explore the UK’s current economic predicament and examine what we might expect from the economy over the course of the coming parliament. There are many different ways of slicing and dicing an economy but one of those most favoured by economists is by ‘category of expenditure’.

Gross Domestic Product, or GDP, can be defined as the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

In terms of category of expenditure…

Consumption accounts for the lion’s share of the UK economy (much more so than most other developed economies, in fact) with almost two-thirds of our economic activity accounted for by households. Government spending and business investment account for approximately 20% each, and courtesy of our massive current account deficit, net exports (with the value of imports significantly exceeding that of exports) currently detract from overall UK GDP.

Let’s take a look at each of these economic segments in turn.

Consumer spending

It’s a sweeping generalisation but, we Brit’s famously love to spend. Collectively, in the good times, we have developed a habit of living well beyond our means, accumulating a substantial burden of household debt in the process. Prior to the financial crisis, household debt peaked at almost 170% of disposable income, substantially higher than normal levels. Debt levels did moderate in the immediate aftermath of the crisis, as illustrated by the increase in the household savings ratio below. Household debt remains at an elevated level in the UK, however, and somewhat worryingly, the household savings ratio has declined again as consumer confidence has returned.

The burden of household debt in the UK appears manageable when interest rates are close to zero, but would look increasingly unsustainable if and when interest rates start to normalise. It is therefore slightly disturbing to see debt-fuelled, consumption-led economic growth returning in recent quarters. Some would argue that any growth is better than no growth but we are not convinced. In effect, debt-fuelled consumption is borrowing economic activity from the future — at some stage it will need to be paid back.

Household spending may continue to contribute positively to the UK’s economic performance but we would worry if it were to do so as a result of a further increase in debt levels. The rapid decline in energy and food prices both represent something of a recent windfall for UK consumers but it would be healthier for the economy in the long run if this windfall was saved rather than spent, not least because, all other things being equal, savings should equate to investment. Higher savings should therefore lead to higher investment — something that all political parties agree we need more of.

Moreover, the benign economic conditions forecast by the Office for Budget Responsibility and embedded in George Osborne’s recent budget, are built upon a staggering increase in household debt of £800bn over the course of the next parliament (to put that into context, household debt has increased by £100bn in the current parliament). We are not convinced that such an increase in debt levels is possible let alone healthy and, without it, we believe it would be wrong to expect the consumer economy to deliver anything more than modest growth over the next few years.

Government expenditure

Historically, public spending has been used as something of a counterweight to private demand, with relatively low government expenditure (characterised by a budget surplus) when private demand is buoyant, and increased government spending when private demand comes under pressure. This is classic Keynesian ‘pump priming’ with the government standing ready to substitute private demand when it falters in a recession.

The fiscal response to the recession that followed the financial crisis was somewhat different, however. A prolonged period of low volatility in economic growth rates had lulled politicians and central bankers into a false sense of security and the idea of “no more boom and bust” crept in to policy-makers’ thinking. In the years leading up to the financial crisis the UK government of the time consistently ran a budget deficit in the good times, rather than a budget surplus. Coupled with a significant and critical injection of capital into the UK’s failing banks which took the burden of government debt to even more precipitous levels, this meant that when the business cycle ultimately (and violently) reasserted itself, there was nothing in the public coffers with which to substitute the collapse in private demand.

As a result, we saw a rapid deterioration in the public finances, followed by a prolonged period of austerity as the long process of healing the public finances was commenced. This process is not yet complete and, regardless of the outcome of today’s General Election, it seems inevitable that another wave of austerity awaits us over the next five years. This doesn’t necessarily mean the government spending will actually fall — after all, it didn’t decline over the last five years — it just means that public spending will be less than had been previously planned. By definition, however, it does mean that we should not expect the government expenditure portion of GDP to contribute much in the way of growth in the medium term.

Business investment

In contrast to the rest of the economy, debt levels for British businesses are quite low — balance sheets are in good shape, at least they are among the largest British companies. For the FTSE 100, the average net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio is less than 1. In other words, the average FTSE 100 company could theoretically use profits and existing resources to pay off all of its outstanding debt within 1 year if it wanted to. Prior to the financial crisis, this ratio stood at 5.5x, suggesting that large corporates have been risk averse — in an environment of muted final demand, they have generally been reluctant to invest, paying down debt and hoarding cash.

Although at face value, this suggests that business investment could deliver reasonable growth from here, there are three main reasons why we remain cautious on the outlook for this part of the economy too.

  1. Companies remain, quite rightly, risk averse. Companies don’t tend to embark on ambitious investment projects in anticipation of an improvement in final demand. They prefer to wait for solid evidence that the environment is sustainably improving before committing capital. As far as most of the economy is concerned, we are still waiting to see this evidence. It is therefore plausible that businesses will continue to hoard cash. This not just a UK problem, but one that afflicts all developed world economies.
  2. While large UK businesses are generally in good shape financially, the same is not true for many small and medium sized businesses. This is a part of the economy that is much more reliant on the banking system for growth capital and evidence suggests that smaller businesses are still struggling to gain access to bank finance. Bank of England data highlight that the total amount in loans extended to non-financial businesses has contracted every month since 2013. This is indicative of a banking system still in rehab and further reason to be cautious on the outlook for UK investment.
  3. The political uncertainty that surrounds the current election process may well act as a deterrent to overseas businesses investing in the UK. The fragile state of the Union and question marks over the UK’s relationship with Europe could also put a brake on business investment growth in the near-to-medium-term.

Net exports

Britain’s manufacturing and engineering expertise of old has been in decline for decades, with services and, in particular, financial services, becoming more dominant. Nevertheless, we still sell plenty of goods and services to the rest of the world, with exports equating to about 30% of UK GDP.

The trouble is, we import substantially more than we export, so ‘net exports’ actually subtract from UK GDP to the tune of about 2% at present. For a long time now, the UK has tended to run a current account deficit but in 2014, this deficit was the largest it has been since records began, and it is difficult to see how net exports can contribute in any significant way to the UK economy any time soon. The notion of ‘rebalancing’ the economy has been much discussed since we emerged from the financial crisis but it is a very long process and it simply hasn’t started yet. In the near term, the most conceivable way in which our exporters could be given a boost is through a rapid depreciation in sterling but that would be accompanied by a great deal of pain elsewhere in the economy.

Total factor productivity

So, through the ‘category of expenditure’ economic lens, it is difficult to paint a rosy picture of the UK’s economic outlook. We are not suggesting that a recession lies round the corner but, realistically, it seems more sensible to expect economic growth to remain muted in the years ahead.

There are of course other ways of evaluating the economy and, in order to introduce a more optimistic assessment of the outlook, it is worth looking at the concept of total factor productivity.

Total factor productivity attempts to capture the other, less tangible influences on long-term economic growth, which work in tandem with other more measurable inputs such as capital and labour.

Obviously, if you increase the amount of capital or labour deployed in an economy, you should expect output to rise. Indeed, one of the key reasons why the UK economy has performed well in recent years is because of inward migration. If GDP is measured on a per capita basis, it remains below the pre-crisis peak.

But total factor productivity is the variable that captures how much value these extra inputs add to the economy — how productive they are. Unfortunately, a key problem for the UK economy in recent years has been that productivity has been falling. Indeed, declining productivity has been a problem across the western world in the post-financial crisis period but it seems to be a particularly severe problem for the UK.

For example, a recent FT article focused on the productivity performance of the UK versus France, highlighting that GDP per worker is 13% higher in France than it is in the UK. If we factor in the longer hours that British employees tend to put in, the productivity gap is even greater, at 27%. The article also points out that this is not the “result of French exceptionalism. Output per hour worked in France was roughly on a par with Germany and just below the US. In the league of the world’s seven most advanced nations, Britain is behind every one except Japan.”

Part of the explanation for this productivity shortfall in the UK appears to be a result of British employers’ response to the post financial crisis recession. Rather than lay workers off, which has historically been the response to declining demand, British companies have tended to engage in the practice of ‘labour hoarding’. This is why the UK economy didn’t see as dramatic an increase in unemployment numbers in 2008–09 as had been anticipated, nor as large as that seen in other western economies such as France. Instead, our companies seem to have preferred to retain workers but have worked them less hard, hence the decline in productivity.

Many workers have consequently become part-time contributors to the labour force. Approximately two-thirds of the jobs created since 2008 have been part-time roles, and part-time workers now make up 27% of the UK’s workforce. Another important piece of the productivity problem jigsaw can potentially be found in our policy of subsidising these part-time jobs with an expensive in-work benefits system. There are four times as many part-time workers than there are unemployed people in UK, but the cost of the in-work benefit system is ten times that of unemployment benefit.

Clearly, there is good intent behind the in-work benefit system but there is growing evidence to suggest that it is actually deterring workers from contributing more fully to the economy and may therefore be exacerbating the UK’s productivity problems.

According to data from The Conference Board, UK total factor productivity declined by -0.1% in 2014, having declined by -0.4% in 2013 and -1.5% in 2012. Over the course of the parliament just ending, Britain saw total factor productivity decline on average by -0.1% per annum. It is therefore disappointing that none of the major parties have focused majorly on this issue during the election campaign.

Innovation is the key

We believe productivity advances are key to long-term economic health and, although this hasn’t been a particularly upbeat article thus far, unlocking productivity is what makes us most optimistic about the long-term economic outlook.

Ultimately, productivity is driven by technology and innovation in the long run. In turn, therefore, technology and innovation drive economic growth.

We are very fortunate in the UK to have all the ingredients to benefit from innovation. We have four of the top 10 universities worldwide in the UK, generating world-class academic research. We also have one of the most advanced capital markets in the world and a rich history of leading the world on innovation. In recent history we haven’t mixed these ingredients particularly well and, arguably, our policy makers could do more to encourage entrepreneurialism and to foster the development of a vibrant ‘knowledge-based’ economy.

Nevertheless, we are optimistic that we can do a better job with these ingredients going forward than we have done in the recent past. In turn, this would help return the UK economy to a more attractive and sustainable growth trajectory in the long run. Turning innovation into commercial reality can deliver successful, scalable new businesses, new industries, new jobs and help to deliver the much needed economic rebalancing with a ‘knowledge economy’ at its heart.

In conclusion, for the term of the next parliament at least, we believe the UK economic outlook remains challenging. Beyond this, however, our confidence in science, innovation and technological advances affords a much more optimistic view of the UK’s economic future.