An alternative perspective

01 February 2010

Britain’s Economic Problems: Can it Recover?

PROF. DIETER HELM, UNIVERSITY OF OXFORD

But it did not turn out like this: Britain entered the worst economic crisis since the 1930s with a structural spending deficit, a housing bubble, falling productivity in both health and education and an economy heavily dependent on financial services. The spending did not improve the quality of the labour force, but rather encouraged ever more meaningless targets to be pursued. It absorbed more of the labour force within the public sector. The growth turned out to be in large part the corollary of ever higher levels of consumer spending, itself the result of ever higher borrowing.

It is hard to conclude anything other than that the British economy is in a very deep hole very much of the government’s own making. Its independent Bank of England fuelled the debt bubble with very low interest rates and the scale of the Brown spending spree after the 2001 election created a very large structural deficit.

HOW NOT TO SOLVE THE PROBLEMS

Faced with such deep-seated structural problems, prudence might be thought to dictate a set of structural solutions. Yet the very misguided economics which got us into this mess is being applied to get us out. Instead of recognising that the leverage is unsustainable – that consumption has been based on writing an ever larger mortgage on the future – the policy response has been a crude Keynesian one: borrow and spend even more. So two years after the credit crunch broke, Britain has borrowed an even more astonishing amount of money.

In normal times, the market would have rumbled this strategy. That was what happened the last time Britain faced a major structural deficit back in the 1970s. Callaghan famously told his Labour party colleagues that “you can’t spend your way out of a recession”. Yet so far the market response has only come on the exchange rate, which has sharply devalued. It has not hit the domestic bond market hard yet, for the simple reason that the government has printed what it has borrowed.

This cannot go on: the spending has natural limits, since the interest will have to be paid and a credit downgrade awaits if it is pursued much further. A good old sterling crisis might lurk in the background too.

PUBLIC SPENDING AND STRUCTURAL REFORM

Getting public expenditure back under control is now universally agreed across the main political parties. A few unrepentant Keynesians think otherwise, but they have no explanation as to how the interest will get paid and in reality their advocacy of yet more borrowing is no more than a policy of default. And indeed, default is one very real option – either by design through inflation or by force of circumstances through interest moratoriums and more printing.

But fixing the borrowing does very little to sort out the underlying problems. It stops the bleeding, but doesn’t address the underlying causes. These are multiple and deep seated. Within the public sector, the case for reform to address its chronic inefficiencies was lost by Blair to Brown after the 2001 general election. Brown stressed that there were “limits to markets” in the public sector and opted for more spending without reform. Now we can see that more spending does not equal more output. Productivity has gone down. So the obvious conclusion is that there needs to be a root-and branch rethink of the structure of the public sector, its design and management. The option of throwing yet more money at the NHS and education is no longer available.

CONSUMPTION, INVESTMENT AND INFRASTRUCTURE

Focusing on what the money is spent on, rather than simply propping up aggregate consumption is not something Keynesians naturally worry about. But aggregate demand consists of consumption plus investment (plus exports, minus imports). Consumption spending is, in the Keynesian world, supposed to be multiplied through the economy. Keynesians rarely talk about the “divider” – the tendency of people to react to yet more government expenditure by saving more in the anticipation of both the extra taxes to pay for the debt and the fact that it will be inefficiently spent by the public sector. Indeed, personal saving has gone up a lot in response to the massive expansion of government borrowing.

The difference between consumption and investment is that the latter leaves something on the balance sheet – there is a double entry in the accounts. Consumption leaves only the uncertainty of the multiplier. Amongst Britain’s structural problems, there is a big investment need. But much of this is best left to the market and the private sector. The exception is the one area where government can make a difference not only to the short-term macroeconomic problems, but to the longer-term competitiveness too. This is infrastructure. The asset sweating of the existing infrastructure and the failure to invest in transport, energy and even communications has left Britain with congested roads, railways for which information technology is a foreign country, and even a failure to roll out broadband. Estimates suggest some £500 billion needs to be invested in energy, transport, water and communications in this decade. Most of this creates domestic jobs and it has an obvious domestic multiplier.

Infrastructure is between the macro and the micro and it is the key area where governments can improve the performance of the economy. Having airports which are connected to the surface transport networks without congestion, having high speed train networks, an efficient London Underground, facilitating energy security and lower emissions through smart grids, electrifying transport and giving access to broadband are all public goods with great private sector payoffs. In France and Germany, this is just obvious: here it is almost heresy to suggest the state should be involved in the context of a faith in liberalised markets. Markets do some things very well, but they do not produce optimal public goods without a guiding hand.

BANKING, OIL AND DIVERSIFICATION

Investment in infrastructure is one necessary condition to put Britain back on track. But we also need to revisit what it is that Britain produces – what goes through these infrastructures. In the last two decades, the British economy has been distorted by two separate sectors – North Sea oil and gas, and banking. The former has meant that the balance of payments has not mattered. Britain could run a deficit on ordinary goods and services because oil and gas would make up the difference. Now it doesn’t – Britain has to face up to the balance of payments realities that Germany and France have never escaped. Energy has to be imported and the economy has to produce a sufficient surplus from other activities to pay for its energy imports.

Part of the consequence of running down the North Sea is already apparent – the exchange rate has fallen back. But hitting the end of the petro currency era at the same time as the economic crash has had a further unpleasant consequence: a major source of trade earnings – banking and financial services – have been hit hard too. This sector may recover somewhat, but it faces major hurdles. London thrived in the petro currency years when sterling was stable against both the euro and the dollar. That can no longer be taken for granted. It remains to be seen whether a financial centre outside the euro can survive a falling currency at a time when the euro’s international role is expanding. Its prospects are at best uncertain.

So without the North Sea, and with a more subdued financial sector, what can Britain produce? The answer is not one for government to define in detail. This is for the private sector – the market. What government can do is to create an environment within which major structural change in the economy can take place. Part of that task is to focus on the infrastructure. But it also includes the broader incentives – the tax regime in particular – and the quality of the labour force. Whilst it is clear now that more spending has not led to a more competitive labour force, it remains to design policies which translate educational policy into an appropriate set of skills.

RETAINING THE TALENT

The right place to focus is on the young. There are going to be fewer of them relative to older, more dependent people. They are going to inherit a lot of debt – both personally because despite all the spending they have to pay for university in a way that previous generations did not. They start out working life with a debt burden. But it is the public debt which bears most upon them: they face years of (much) higher taxes. And if the exchange rate remains weak, earnings will have a lower international value. Amongst the best, the temptation to emigrate must be almost overwhelming.

So how are their life chances to be improved? The starting point is to deal with the debt head on: to cut back public expenditure hard. Lower taxes can only be achieved if the cut backs in the public sector are serious. It makes sense to give them very high quality universities, so at least they stay for their university education. If the economy is not designed to make Britain attractive, then the young will follow the path of other countries which offered few opportunities and incentives – Ireland before its boom is the classic example.

WHAT WILL IT TAKE?

Most societies faced with a mountain of debt find it hard to face up to the consequences. Voters are beguiled by politicians who promise to keep spending and not to put up taxes. Usually it takes a crisis and an external hand. The IMF plays this role – as it did in Britain in 1976 – forcing governments to act. In Europe, as Greece is now finding, it is the Commission and the ECB. Just occasionally – as in the 1980s – politicians act before rather than after a full blown crisis. But in the late 1970s, the population had seen the rubbish in the streets and the unburied dead. It remains to be seen whether Britain will act ex ante or ex post.

Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

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