It’s not the deficit per se, but the absence of a Grand Economic Plan that is more worrying for the UK
The UK economy has structural imbalances. It is heavily dependent on a narrow set of sectors and sub-regions. It so happens that those same sectors are hit by the double whammy of Covid-19 and Brexit.
If this were a game of Battleship, the British ships would be clustered together, susceptible to one unfortunate strike.
As a result, the overall drop in UK GDP is sharper than most others’ and the subsequent uptick much shallower than many others. GDP is expected to drop 11% this year and grow 5% next year. It could take up to five years for it to return to pre-pandemic levels.
Not surprisingly, the government is borrowing at a record pace: By the end of this fiscal year, they could end up borrowing up to £400 billion pounds or 19% of GDP. That would take the stock of debt to 105% of GDP.
Having said that, because interest rates are so low at the moment, the government’s interest expense as a ratio of revenue (1.7%) is at a historical low.
So, with interest rates at record low levels, inflation expectations relatively muted, and external demand holding up for UK assets, the government has the capacity to carry more debt for now.
The size of public debt, on its own, should not be a cause for alarm. What matters is what the government does with that money.
Frankly, there is no alternative to keeping the purse strings loose right now.
The only option is to spend the money wisely, in a concerted effort to build productive capacity (growth potential), fostering investments, helping with skills and job transitions, helping to re-configure the economy and restructure the engines of growth for a post-Covid, post-Brexit world.
To be fair, some of it is underway: there’s a Green economy plan, a “kick-starter plan” for jobs for the under-25s, and a “levelling up fund” that will receive the £4 billion diverted from overseas aid.
However, all of this should be part of an imaginative, ambitious, and coherent industrial strategy that is more deliberative and interventionist than what may have been entertained so far. War-time levels of deficits might require Marshall Plan levels of investment, in both hard and soft infrastructure.
There is effectively no further space in monetary policy (negative interest rates are a non-starter) and tinkering with tax and public spending without seeking to counter the scarring of current resources or alter the shape of the economy would not bring about material change.
In fact, re-configuration was the great promise of Brexit.
It is not guaranteed that the fruits of Brexit would come from the same trees that bore fruit in the single market. Looking at the exports basket, about half of the existing trees are still leaning towards the EU.
Brexit provides the freedom to plant new trees but not enough of those trees have been planted, nor has there been sufficient investment in building expertise to climb those trees.
The weakening of the pound (20% since the referendum of 2016) may have created a false sense of security. With global trade expected to slow in 2021 and EU trade expected to meet frictions (with or without a deal), existing channels of international trade may not contribute as much to UK GDP as it has in recent years.
The landing strip for a UK-EU trade deal is now quite narrow. Unlike the celebrated continuity agreements that have been struck with Japan and Canada, there will almost certainly not be continuity with the EU.
A quick reminder that Services make up almost 70% of UK GDP. Half of all trade in non-financial services is with the EU and four-fifths of trade in financial services is with the EU. Manufacturing is a smaller part of UK GDP (9%) but even there, half of manufacturing exports go to the EU. The agri-food sector is only 2% of GDP but three-quarters of exports of that sector go to the EU. For good or bad, the current shape of the economy is such that financial services make up 7% of UK GDP whereas fishing is 0.1%.
Overall, the UK runs a current account deficit which is expected to widen over the next couple of years. The UK cannot afford to lose the confidence of overseas investors who finance this deficit.
To illustrate the compounding effect of Covid-19, it is instructive to recall that UK GDP is disproportionately impacted by what happens to London. London’s GDP per capita is more than double that of the North East of England and ordinarily, it grows at more than double the speed.
London’s is also a “density economy”, dependent on agglomeration benefits that do not work with distancing. Distancing, working from home and various tiers of lockdown are kryptonite for the current shape of the economy.
That is one more reason why the only strategic option for the UK government is to proactively help reconfigure the economy with a front-footed, full-hearted industrial strategy. Not unlike some of the countries of the Far East, it needs to operate at a structural level, rising above the political divide of Left and Right. At a time of radical uncertainty, market forces alone and market discovery may not deliver quickly enough.
