Tuesday, 7 September 2010

Structural weakness of UK GDP

By Mick Burke

The British economy grew 1.2% in the 2nd quarter of this year, following a rise of 0.3% in the previous quarter. It was the strongest quarterly growth rate recorded since the beginning of 2001, prompting the Daily Express to talk of a ‘mini-boom’ continuing into next year.

A more sober consensus is that this may be the strongest growth rate for some time and many commentators, some of whom are very far from the political left, continue to point to the danger that the government’s fiscal policy is increasing the risks to the recovery. Thus for example, according to David Kern, economist at the British Chamber of Commerce: ‘The huge scale of the retrenchment that the government wants to implement, and the decision to cut the fiscal deficit at an accelerated pace, will inevitably increase dangers of double-dip recession. In spite of the relatively strong recent UK performance in the second quarter, the recovery is still fragile and risks of a relapse are high.’

State of the Economy

The cyclical upturn in the economy follows the sharpest British recession in the post-World War II period, a contraction of 6.4% taking place over 18 months (six quarters). The economy has been expanding now for nine months and yet GDP remains 4.5% below its peak.

There is nothing ‘V-shaped’ about the recovery. In monetary terms the real decline in the economy, measured in constant 2006 prices, was £88bn, while the subsequent expansion has been just £20bn - £16bn of that in the latest quarter.

Even this rebound is not a token of renewed underlying strength, but above all a restocking of inventories. The quarterly change in business inventories accounts for 1.0% of the 1.2% growth in the quarter. Even if the restocking has further to run, which seems probable, it is not a sustainable basis for economic recovery without a rebound in consumption and investment.

The slump in fixed investment was a key contributor to the recession and remains its main area of weakness. The charts below highlight this Figure 1 shows the changes in the components of GDP over the six quarters from the beginning of the recession to its deepest point.

Figure 1

10 09 06 Mick Burke Chart 1

GDP contracted by £88bn. This was driven almost equally by a fall in personal consumption and in fixed investment (gross fixed capital formation) which were down £42.9bn and £40bn respectively. Declining inventories also subtracted from growth. Statistically, net exports rose but this was only because the decline in imports exceeded the fall in exports. The only substantive positive contribution to growth came from rising government consumption spending which was up £9.5bn. It should be noted that the latter important government prop to growth has led to a reduction in the budget deficit, not an increase. As SEB has previously shown, government income have risen in response to increased government spending.

Chart 2 below shows the same components of GDP from the beginning of the recession in 2008 to the second quarter of 2010. The main feature is that the decline in investment has continued, falling again in the 2nd quarter of this year even while other components such as personal consumption have recovered and dragged aggregate GDP higher.

Figure 2

10 09 06 Mick Burke Chart 2

As a result, the decline investment now accounts for nearly two-thirds of the entire decline in GDP to date, £40bn within a total decline of £62.7bn. In consequence, net exports make a reduced contribution to growth, as exports have barely recovered and remain 9.4% below their peak while imports have risen faster. Among the many fantastical forecasts made by the Office of Budget Responsibility was that a 6.1% rise in world trade this year would lead to a growth in British exports of 4.3%. Yet the rebound in world trade already exceeds that forecast, up 7% according to the IMF. Yet British exports are up just 2.7% in the 1st half of this year, despite a fillip from Sterling’s depreciation.

Since investment is the key determinant of long-term growth the persistence of this private sector investment strike will transform a cyclical weakness into deepening structural one.

Private firms cannot be certain of achieving a profit when demand is subdued. Their response is to cut investment programmes and to attempt to reduce costs. They also look to government to reduce their external costs via lower tax rates and other means (reduced pension contributions, lower entitlements to sickness and maternity pay, abandoning equality provisions, etc.) and above all, lower wages.

The chart below shows the main income categories of GDP; compensation of employees, the gross operating surplus of firms (GOS - akin to profits) and taxes (all in nominal terms). As the chart shows, the GOS fell in the recession, down by 8.3%. It has since recovered but remains well below its peak, whereas taxes have risen and the compensation of employees, initially flat, has recently risen. (This rise is not a significant increase in wage levels but reflects the increases in pay and bonuses in the financial sector).

Figure 3

10 09 06 Mick Burke Chart 3

Political Response

From the perspective of many individual capitalists, all this is a disaster. Profits have declined, but taxes and compensation have risen. Aside from reducing investment and hoarding cash, the response demanded is that the government reduce taxes and take measures to reduce wages. The hue and cry about the deficit masks this central thrust of economic policy. Corporate taxes are being lowered towards 24% (even as VAT rises, hitting the poor) and all types of welfare benefits are reduced in an effort to drive incomes lower.

This is the thrust of government policy. It has the effect not just of increasing short-term risks to the economy but ensuring long-term damage via the continuation of the investment strike. It enshrines a lower level of wages and benefits to the poor in return only for the prospect of increased profits.

But recently, David Milliband argued, echoed by Tony Blair in the BBC interview with Andrew Marr on his biography, that this government economic policy should be accepted!

David Milliband even claimed:"The closest parallel [to Labour’s current situation] I can think of is the Tories’ rethink under R.A. Butler after they lost the 1945 General Election". "Rab" Butler was the prime mover behind the post-War Conservative acceptance of the 1945 Labour government’s reforms, the introduction of the welfare state, the NHS and nationalisation of major bankrupt industries. In this speech, David Milliband signals he is willing to accept the ferocious assault now being organised against workers and the poor. It would condemn the whole economy to prolonged slow growth, with the poorest suffering the most.

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