What Next For The UK Economy?
Slow growth, more austerity and constitutional uncertainty.
Despite polls suggesting no party would win a majority, the Conservative party have won a surprisingly clear victory in the UK election. The basis for the Conservative campaign was the idea that they were best-positioned to run the UK economy. My guess is many voters are going to surprised and disappointed with the economic performance that will be delivered by this new government. Three areas are a particular cause for concern: Slow growth, austerity and constitutional uncertainty.
The Conservatives identified a number of clear positive economic trends during their campaign. The UK economy grew by 2.8 percent last year and the fraction of people in employment has reached an all-time high. But the flip side of these positive trends is that recent growth rates are unlikely to be sustained.
GDP is determined by two factors: The number of people employed and the average amount of GDP produced by those in employment (i.e. labour productivity). The UK’s recovery has been almost completely based on increases in employment, with growth in labour productivity being incredibly weak.
The unemployment rate is now at a historically low level of 5.6%, so the UK is unlikely to continue recording employment growth at the pace of recent years. With little reason to expect productivity growth to improve (and very little in the Conservative manifesto’s proposals likely to do much about it) the likelihood is that UK growth will be slow in the coming years.
This conclusion is further reinforced by the fact that household savings rates are again down to low levels and the UK is running the largest current account deficit in its modern history. Despite Conservative claims that they are putting Britain “back in the black”, the UK as a whole is borrowing more heavily from the rest of the world than ever before. The room to temporarily counter weak productivity growth with borrowing-fueled spending thus seems very limited.
The Conservative-Liberal Democrat coalition of the last five years deflected much of the criticism of its austerity policies by arguing that they inherited an enormous budget deficit from their predecessors and significant austerity was thus inevitable.
The new Conservative government will likely attempt to repeat this story but the truth will be different. The UK is set for a second full government term of substantial austerity but, this time, there is nothing inevitable about it: The election of the Conservative government will result in far larger cuts than would have taken place under any alternative government.
The independent Institute for Fiscal Studies produced a report illustrating the fiscal plans of each party. While all parties proposed reducing the budget deficit, the Conservative plan a far bigger reduction in the deficit than the other parties had. Indeed, the planned reduction in the deficit in the upcoming parliament is as large as the reduction implemented over the past five years.
The difference in deficit reduction profiles reflects the Conservative plan to radically reduce the size of government in the UK. Their plan to reduce government spending to 34 percent of GDP by the end of the next parliament would see the size of government reduced to its lowest levels in the post-War period.
The plan for deficit reduction will leave little room for fiscal policy to counteract any recession that may occur over the next five years. I also suspect the spending plans will prove to be more radical than many who voted Tory will realise.
The Conservative victory means that Britain will be having a referendum on EU membership in 2017. David Cameron plans to negotiate changes in the UK’s relationship with the EU and, having successfully concluded these negotiations, to campaign for the UK to stay in the EU.
In reality, it is highly unclear whether Cameron can actually negotiate substantive unilateral “concessions” from the EU and whether this renegotiation can satisfy his own “Eurosceptic” MPs. It is even less clear how Britain will vote after two years of debating EU membership.
Even if the UK ends up voting to stay in the EU, the uncertainty caused by a possible Brexit seems likely to damage the UK’s reputation as a destination for foreign direct investment and the City of London’s position as Europe’s leading financial centre.
Even if the longer-run economic damage from a UK exit from the EU turns out to be small, the considerable economic uncertainty associated with Brexit would last longer than two years if the referendum resulted in the UK leaving the EU. The terms of this exit and negotiations on how the UK would relate to the rest of the EU could take years to conclude and their outcome would be very uncertain.
The Conservative victory also presents constitutional issues inside the UK. The new government will have almost no Scottish members of parliament, and a huge block of Scottish National Party opposition MPs will be a constant reminder that the Conservative government is deeply unpopular in Scotland. There will be uncertainty about potential changes to Scotland’s devolution arrangements and a more serious question about whether a second referendum on Scottish independence will come sooner rather than later.
The Conservative party are delighted with their unexpected victory. But poor productivity, years of spending cuts, constitutional uncertainty and a tiny majority will most likely make this a decidedly rocky term for the new government.