Friday, April 24, 2009

UK: the sick man once again?

Martin Wolf is worrying about UK's fiscal deterioration (source: FT):

Is the UK once again the economic sick man? Or is it, as Alistair Darling, chancellor of the exchequer, argued in his Budget speech on Wednesday, just one of a number of hard-hit high-income countries? The answers to these questions are: yes and yes. The explanation for this ambiguity is that the fiscal deterioration is extraordinary, but the economic collapse is not.

Let us start with the economy. According to the International Monetary Fund's latest World Economic Outlook, the UK economy will contract by 4.1 per cent this year, followed by a further contraction of 0.4 per cent next year. This, it should be stressed, is far worse than the 3.5 per cent contraction in 2009 and 1.25 per cent expansion in 2010 forecast by the Treasury.

The IMF puts forward the following forecasts for other big economies: -3.8 per cent in 2009 and 0.0 in 2010 for all advanced countries; -2.8 per cent and 0.0 for the US; -4.2 per cent and -0.4 per cent for the eurozone; -5.6 per cent and -1.0 per cent for Germany; and -6.2 per cent and 0.5 per cent for Japan. Thus, the UK's forecast performance is close to the mean for all advanced countries and better than for Germany and Japan.

The striking feature, indeed, is that the worst-hit economies are not those of profligate, high-spending countries, such as the UK and US, but of prudent, high-saving countries, such as Germany and Japan. People in the latter tend to see this as unfair, because it is undeserved. Well, life is unfair.

The serious answer is that the economic and financial health of sellers and creditors cannot be divorced from that of buyers and debtors. If customers are bankrupt, suppliers are likely to be in the same predicament. This is why Japan has suffered a collapse in manufacturing output comparable to that of the US during the Great Depression: a fall of 37 per cent since the start of 2008.

Now turn to the fiscal position. The IMF forecasts the UK general government deficit at 9.8 per cent of GDP in 2009 and 10.9 per cent next year. In the UK Budget, the Treasury forecasts the general government deficit at 12 per cent of GDP, or over, in 2009-10 and 2010-11. This suggests that the IMF forecasts are much too optimistic. Whether it is equally over-optimistic about other countries' fiscal positions I do not know.

In any case, the IMF forecast deficit for the UK for next year is the highest in the Group of Seven leading high-income countries. Only Japan, on 9.8 per cent, and the US, on 9.7 per cent come close. Meanwhile, Germany's deficit next year is forecast at "only" 6.1 per cent of GDP. Moreover, the 8.3 percentage point deterioration in the UK deficit between 2007 and 2010 is also the highest in the G7, with only Japan (a 7.3 percentage points deterioration) and the US (a 6.8 percentage points deterioration) coming close.

Not surprisingly, the UK is also forecast to have a relatively large deterioration in its net public debt, with a rise of 29 percentage points between 2007 and 2010 from 38 to 67 per cent of GDP. This time Japan, with a deterioration of 34 percentage points, is ahead, and the US, with 27 percentage points, just behind. But Germany's rise is only 16 percentage points. Moreover, the UK's net debt is forecast to continue to rise thereafter. It could well hit 100 per cent of GDP.

So why has the fiscal deterioration been so severe in the UK, when the economic deterioration has not been?

The obvious answer is that the sectors of the UK economy that have collapsed – housing and finance – are particularly revenue-intensive. As a result the ratio of current receipts to GDP is expected to shrink from 38.6 per cent in 2007-08 to 35.1 per cent in 2009-10 – a fall of 3.5 percentage points.

A deeper answer is that it is the countries where the debt-fuelled spending of the private sector was highest that have seen the largest swings in the balance between private income and spending. The shift in this balance in the UK's private sector between 2007 and 2010 is forecast (implicitly) by the IMF at 9.6 per cent of GDP (from minus 0.2 per cent to plus 9.4 per cent). The swing in Germany, in contrast, is just 0.6 percentage points.

When the private sector shrinks its spending relative to incomes, either the current account or the fiscal balance must shift in equal and opposite directions. The current account deficit always changes relatively slowly. It is hard to change the economy's structure quickly. So it has been the fiscal position that has deteriorated massively.

Thus, in the crisis-hit countries themselves, the consequence of the private sector cutback has been the fiscal deterioration. In the export-oriented countries, the result has been a massive contraction in exports and output. The huge fiscal deteriorations in the UK (and US) and the huge declines in manufactured output and exports in Germany and Japan are two sides of one coin.

So where does this leave us? The answer is that the next leg in the crisis, for both sides, will come when (or if) the huge fiscal deficits themselves become unsustainable. This is the great economic peril that lies ahead – and not just for the UK.