Britain Long Read

The state of the UK economy

‘With both inflation and unemployment rates falling, the UK economy has never been healthier.’ Is this fact or mere propaganda?

The UK economy is 34 quarters into its recovery from the recession which it experienced following the 2007-08 financial crises. During this period it has grown and strengthened significantly. Inflation is low and stable, compared to historical norms, unemployment has reached record lows, and GDP continues to grow. However, Britain is in an uncertain fiscal position, has a detrimental balance of payments and has experienced rising inequality.

Although inflation is currently falling, the UK economy, from the perspective of price levels, has been more healthy in the past. Inflation is at 3.0% [CPI], which is far from the highs of double-digit inflation experienced during the 1980s but is not at the Bank of England’s 2% target. Prices have been far from stable during the recovery from the financial crises, with CPI hitting 5.2% on two separate occasions and then falling to -0.1% more recently. This lack of price stability harms business investment and consumer spending along with trade since the volatility of prices tends to cause uncertainty. In contrast, during the 15 years which preceded the financial crisis, the economy experienced inflation which very rarely went beyond the BOE’s 2±1% inflation target. In the immediate term, the rise in CPI can be attributed to imported inflation due to the sharp depreciation sterling in the summer of 2016, which caused the value of imports to increase. This has been detrimental not only because it has eroded real wages but also because it has harmed aggregate demand in the economy. Inflationary risks also persist into the future because of the possibility of a change in the UK’s trading relationship with Europe, following its eventual withdrawal from the EU. The labour market is also very tight, with unemployment at 4.3%; this would usually result in demand-push inflation, however, due to subdued productivity and stagnant wages, this has failed to materialise. Thus in the future, a sudden pickup in productivity and thus inflationary pressures could push CPI even higher. Overall, although inflation is low for historical norms, it is far from stable and has a substantial risk of rising in the future.

The labour market has been stronger in the past. The fall in unemployment since 2011, which currently stands at 4.3%, a low not reached since the mid-1970s, has been beneficial to the economy. This aspect of the labour market is healthy and as a result has allowed consumption in the economy to grow, driving demand for goods and services and leading to higher business investment. This has boosted aggregate demand and has been a driver of GDP growth in the recent years. The more weak area of the labour market is the persistently stagnant wage growth and poor labour productivity. The 5-year moving average for productivity growth has hit a historic low of around 0.5%, feeding into poor wage growth that remains at 2.4% compared to a pre-crisis level of 4-6%. Stagnant wage growth has diminished the benefits of unemployment on the economy since lower wage growth, albeit with low unemployment, has not led to a drastic change in disposable income. Furthermore, wage growth has been so muted that inflation, which rose to 3.1%, has eclipsed it and led to shrinking real incomes, further suppressing consumption in the economy. The labour market is also threatened by the ageing population of the UK, the prospect of Brexit and the subsequent collapse in immigration. The combination of these factors would lead to shrinking in the workforce and thus to consumption and output falling. A decrease in migration would also result in a reduced number of skilled workers entering the British economy, suppressing productivity growth and perpetuating its detrimental effect on wages. As a result, although unemployment has fallen to record lows, the lack of resulting wage growth, the likely fall in migration in the near future and the ageing nature of the UK workforce all point towards a labour force with structural weaknesses.

The UK’s fiscal position is also in poor condition and in the past has been much more helpful to ensuring a healthy economy. The national debt has risen significantly over the past decade, due to increased expenditure and falling receipts associated with economic slowdowns. Currently, only 5% of government expenditure is appropriated to paying the interest on the debt, and with both national debt and interest rates, which are correlated to UK bond yields, set to rise for the foreseeable future, this expenditure is set to grow. Furthermore, the increase in the rate of debt accumulation indicates that the UK’s growth is unsustainable and leads to a lack of business and investor confidence, to the detriment of the British economy. This amount of debt is a record in recent history. The UK’s budget deficit has been sizeable, which although has lead to the problems mentioned above, does have a beneficial impact on economic growth since aggregate demand is elevated. With the budget deficit decreasing over the past decade from 10% of GDP to 3% due to austerity, this added impetus in the economy has steadily declined while the added impact of instilling greater confidence in the economy has been minor. The UK also faces the challenges of an ageing population, and as a result, the dependent members in the economy will have relatively less working-age people to rely on, leading to falling tax receipts relative to non-discretionary spendings, such as on healthcare and pensions, meaning that the UK’s fiscal issues are set to persist.

Although unemployment and inflation have fallen, the British economy is far from being healthier than ever before. Inflation has recently been unstable and volatile; the labour market faces numerous threats along with stagnant wage growth; the UK’s balance of payments is detrimental to growth and its fiscal position is problematic. Furthermore, inequality is well above historical norms, household debt is high, consumer and business confidence is low and political instability persists.

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