The British have the least living space per head, the most expensive office rents and the most congested infrastructure of any EU-15 country. Thanks to a rapidly growing population –  the result of a healthy birth-rate and immigration – these trends are worsening steadily. At the same time, the British economy is languishing in a prolonged slump brought on by a collapse of demand. The answer is obvious: Britain needs to build more. Unfortunately, the obstacles to development are formidable. Britain’s supply-side problems are of a different character to those holding back other struggling European economies, but arguably no less serious.

Britain is generally considered a flexible, economically liberal economy, in which insiders have few opportunities to rig the system for their own benefit. To the extent that supply-side problems are considered a significant obstacle to economic growth, attention generally centres on the country’s patchy skills base. A high drop-out rate from secondary school and weak vocational training are no doubt real constraints on the UK economy, but there is an equally, if not more, serious one. Housing, commercial property and infrastructure are central to a country’s economic and social well-being. The UK’s essentially rigged market for land and its restrictive planning system are as big an obstacle to economic growth as restrictive labour markets and protected professions are in Southern Europe.

The number of new homes built each year in Britain has lagged far behind demand from a growing population for 30 years. Despite faster population growth, house construction is currently running at half the level of the 1960s. At the same time the average size of homes built in Britain is now the smallest in the EU. The result of these two trends has been a steady fall in the amount of living space per head. Property prices relative to average household incomes have come down a bit since 2007, but remain very high. Moreover, the problem is not just restricted to the residential sector: Britain has the highest office rents in the EU. Firms in cities such as Manchester pay more than in Frankfurt or Milan. And transport infrastructure is very expensive to build in Britain, which is one reason why there is too little of it.

Britain is small and densely-populated, but does not suffer from particularly acute land scarcity. Around 13 per cent of the UK is built on, a lower proportion than in countries with a similar population density such as Germany, Belgium or the Netherlands. Britain’s problem is that the supply of new housing and commercial space is uniquely unresponsive to increases in property prices. Alone among the countries that experienced a house price boom in the run up to the financial crisis, Britain had no construction boom. The number of houses being built picked up only slightly, despite UK house prices rising by more than in any other developed countries except Ireland.

This situation has far-reaching economic and social consequences for the UK. Massive house price inflation has aggravated the UK’s already high levels of inequality by shifting wealth from the young (and property-less) to the old (and propertied). The poor availability of affordable housing undermines labour mobility – people are unable to move to where jobs are available because they cannot afford accommodation. Those on welfare are discouraged from working (as they then lose access to subsidised housing).  Congested, expensive infrastructure combined with pricey commercial property pushes up the cost of business, depresses investment and holds back economic growth.

The two reasons for Britain’s land-use woes – a complex planning system and insufficient land for development – are inter-related. A major constraint on the supply of land is the existence of a protected ‘greenbelt’: land around cities on which development is very tightly controlled. There are also strict controls over building on other so-called green-field sites. The market for land is essentially rigged in favour of landowners, who pay no tax on their land holdings and hence pay no penalty for sitting on it, waiting for the artificially-created scarcity to push prices up further. With no revenue from land taxes, local authorities are unable to capture any increase in the value of land that takes place when planning permission is granted. As a result, they have little incentive to open up land for development. 

The UK should, of course, redevelop so-called ‘brownfield’ sites – vacant or derelict buildings and land. But this will only ever comprise part of the solution to its land use crisis. By its very nature, brownfield land is concentrated in parts of the country where people do not want to live. And it is often very expensive to redevelop, not least because the government has stipulated that 60 per cent of new homes must be built on brownfield sites. There is no alternative to building on the green-belt, much of which is neither beautiful nor green. The greenbelt was originally established to combat urban sprawl, but is now an obstacle to sensible development. For example, allowing London to expand by between two and three miles in each direction would easily solve the city’s land-use problems. Increasing that proportion of the UK’s surface area under development by between 1 and 2 percentage points would address the country’s  land constraints  and would not involve concreting over England’s ‘green and pleasant land’. Urban sprawl could easily be prevented by good quality town planning.

The sanctity of the greenbelt, and green-field land more generally, has much to do with vested interests perpetuating a system which rewards speculation. Many Britons have profited from land scarcity (and the tax-free property price gains it has led to), and are determined to defend those gains. They may complain about their children being unable to buy a house, but at the same time will staunchly oppose new development. For their part, landowners are a powerful and politically well-connected lobby; many of the biggest sit in the House of Lords (the country’s upper house). They have a big stake in inflated land prices and are well-placed to resist the taxation of land.

A land tax would involve property owners paying a percentage of the value of their land in tax each year. If the value of their property rose, so would the amount of tax paid on it. This would achieve a number of things. First, local authorities would have a financial incentive to change land from agricultural to residential (and commercial) use as they would profit from the increased value of the land this would cause. Second, it would make it more expensive to speculate on future rises in land values, and some of those gains would be captured by the government. Third, construction companies would not be able to sit on large amounts of land (so-called land banks), and drip feed the market, maintaining prices at artificially high levels. Instead, land would have to be developed or sold, which together with the increased availability resulting from the freeing up of greenbelt land, would bring down the price of developing land and with it the cost of housing, commercial property and infrastructure. Lower land costs would also increase competition by reducing barriers to entry to the construction sector: for example, at present housing building is dominated by a small number of big players.

Supply-side measures are rarely a quick solution to a demand-side crisis. That is certainly the challenge facing other struggling European economies. Spain and France suffer from inflexible labour markets, Germany from over-regulated product and services markets, Italy from both. Academic research shows that addressing such problems improves economic performance in the longer term, but it provides no immediate boost to demand. However, the UK is almost certainly an exception. Addressing Britain’s biggest supply-side problem (its rigged market for land) could provide a more immediate economic stimulus by releasing massive pent-up demand, as well as lift growth potential.

Britain should turn its weaknesses into strengths. Other struggling European countries have a surfeit of housing and infrastructure and poor demographics. For example, boosting construction in Spain would do no good – Spain has far too many unsold houses and it is now suffering from net emigration (more people are leaving the country than arriving). In Italy and Germany, populations are stagnant, although there is more scope to boost spending on infrastructure than in Spain. France’s population is growing, but as a result of persistently strong public investment, it already has very good physical infrastructure. And thanks to a rational planning system and plenty of land, it does not suffer from a housing shortage. Unlike Britain, these countries have few low-hanging fruit.

Far-reaching reform of the greenbelt and the introduction of land taxes could open the way for a boom in housing and commercial development. Local authorities and the national government could agree to set aside a proportion of the funds raised through land taxes to fund investment in infrastructure. Moreover, land taxes would make the tax system fairer by taxing unearned income. And by redistributing money from the wealthy (who save a high proportion of their income) to construction sector workers (who save little of it), it would provide a further boost to economic activity. The current Conservative-Liberal government has pushed through modest reforms of the planning system, but has shied away from opening up the greenbelt and has no intention of introducing a land tax. 

An economy in which speculation is rewarded and wealth is increasingly concentrated in the hands of those with property risks stagnation. It faces an uphill battle to hold on to its young or attract skilled immigrants. Britain needs to strike a better balance between the interests of existing property-owners and the rest of the country. This includes acknowledging that the value of land is determined by the activities of society as a whole and not the landowner, and hence needs to be taxed accordingly.

Simon Tilford is chief economist at the Centre for European Reform.

The British government's attempt to rebalance the UK economy has failed. In 2012, the deficit on the country's current account (the broadest measure of foreign trade) was larger than in any year since 1990. Britain's problem is not its trade performance with non-European markets: exports to these are rising strongly and the country runs a small surplus with them. The UK's problem is the weakness of its exports to the EU, and the huge trade deficit it runs with its EU partners. As the eurozone’s biggest trade partner, the UK is bearing the brunt of the eurozone’s neglect of domestic demand.

The UK's current account deficit narrowed from 2.3 per cent of GDP in 2007 to 1.3 per cent in 2011, before jumping to an estimated 3.5 per cent of GDP in 2012. There is no doubting the scale of the challenge posed by this deterioration. After all, a key element of the government’s growth strategy is to rebalance the economy away from an excessive dependence on private and public consumption in favour of business investment and exports. It was relying on a positive contribution to economic growth from net trade (exports minus imports) to help offset the impact of fiscal austerity, and to narrow the country’s external deficit. 

The UK's persistently weak trade position is often attributed to British firms' failure to tap fast growing markets outside Europe. This narrative does not bear scrutiny. The truth is that British exports, and with it chances of rebalancing the economy, are being held back by the country's trade with the rest of Europe rather than with the supposedly hyper-competitive economies in Asia or the Americas. The value of exports to non-EU markets is growing quickly: between 2006 and 2012 they increased by half (a 65 per cent rise in goods exports and a 35 per cent rise in exports of services). The value of exports to the EU, meanwhile, rose by just 5 per cent over this period (a 5 per cent fall in goods exports and a 23 per cent rise in services). As a result of these trends, the UK earned almost 60 per cent of its foreign currency earnings from non-EU markets in 2012, up from under a half in 2006.

With imports from the EU easily outpacing exports, the trade position with the EU has deteriorated steadily. Despite exports to the EU accounting for little over 14 per cent of GDP in 2012, the UK is estimated to have run a current account deficit with its EU partners equivalent to 4.5 per cent of GDP, double the deficit of five years ago. The value of goods exports to the EU are estimated to have fallen by 5 per cent in 2012, led by declines of 18 per cent to Italy and 12 per cent to Spain.  Exports of services to EU markets also fell, as did the returns on British investments in the eurozone, pushing the balance of income with the EU deeper into deficit. By contrast, exports of goods and services to the rest of world rose 5 per cent in 2012, and trade with these markets remained in surplus. 

The UK runs a surplus with the non-European world, which accounts for almost three-fifths of its foreign current earnings, but is massively in deficit with the EU, which accounts for just over two-fifths. This is not because the UK is 'competitive' with the rest of the world and uncompetitive in Europe, but because of the collapse in demand across the EU. UK exports are rising to the rest of the world because demand is rising in the rest of the world, and are falling to EU markets because demand for imports is falling across the eurozone. The reason why the UK's current account deficit rose sharply in 2012 and those of Italy and Spain fell is not because the latter have improved their 'competitiveness' more than the UK. Spain's and Italy's current account deficits have shrunk because demand in their economies has declined dramatically, leading to a steep fall in imports.

The eurozone’s decision to eschew symmetric adjustment of trade imbalances within the currency union in favour of asymmetric rebalancing (where domestic demand contracts in the deficit countries but there is no offsetting rise in demand in the surplus countries) has serious implications for the UK. Britain was criticised for allowing its currency to fall in value following the onset of the financial crisis in 2007, on the grounds that it constituted a competitive devaluation. But it is the eurozone, not the UK, which is pursuing a mercantilist strategy. 

What can the UK do about its increasingly unbalanced trade with the EU? It would make no sense for the UK to leave the EU. As the data show, membership of the EU has not undermined Britain’s exports to non-European markets. And leaving the union would have little impact on the trade imbalance with European economies; the UK outside the EU would not be able to erect significant trade barriers against imports from EU countries. Not only is EU membership no obstacle to increased trade with the rest of the world, it is probably facilitating such growth: with the growth of bilateral trade deals in place of multilateral ones, it pays to be part of a heavy-weight negotiating bloc.

The British government could emulate the Italians and the Spanish and tighten fiscal policy by so much that import demand implodes. This would lead to a sharp narrowing of the UK's trade deficit with the EU and a rising trade surplus with the rest of the world (as the British imported less from non-EU markets). Such a strategy would be politically impossible in the UK. The coalition government would suffer a huge defeat at the next general election and for good reason: this approach would depress investment and push up unemployment, eroding the country's growth potential.

David Cameron and George Osborne could mount a campaign for more expansionary economic policies across the eurozone. However, even if the British government were not increasingly isolated and resented within the EU, such pleas would fall on deaf ears: the rest of the eurozone could also justifiably argue that they are only doing what the British government has routinely argued that every country must do: cut public spending and 'live within its means'.

The British government should give up on any hope that stronger EU demand for British exports will help rebalance the UK economy. In all likelihood, demand across the eurozone will remain chronically weak for a very long time. Instead, Cameron and Osborne should concentrate all their efforts on boosting domestic economic activity. They should slow the pace of austerity and kick-start a large-scale housing and infrastructure programme. Combined with aggressively expansionary monetary policy – the incoming governor of the Bank of England, Mark Carney, has indicated that monetary policy is set to remain very loose – this should be enough to drive an economic recovery.

If the UK government were to opt for this approach, the British economy would no doubt suck in imports from the rest of the EU, leading to a further widening of the bilateral trade deficit. However, the worsening of the country's trade position, together with the Bank of England's more inflationary strategy than the ECB, would almost certainly prompt a fall in the value of sterling. A significant devaluation would probably suffice to halt the rise in Britain's deficit with the rest of the EU, although the shortfall is unlikely to narrow much while demand remains so weak across the eurozone. Eurozone governments would no doubt accuse the UK of engaging in a competitive devaluation. Given the recent trend in the EU-UK trade balance, such accusations would ring hollow. 

Simon Tilford is chief economist at the Centre for European Reform.

On July 26th 2012, European Central Bank President Mario Draghi told a London conference of bankers: “the ECB is ready to do whatever it takes to save the euro”. He paused, somewhat theatrically. “And believe me, it will be enough.” His comments were an exercise in expectations management. The ECB was trying to convince financial markets that betting on the euro’s downfall would be a fool’s errand.

To all appearances, the plan seems to have worked. In the first half of 2012, investors had been withdrawing capital at an accelerating pace from Spain and Italy. Banks had been finding it increasingly difficult to get funding. Borrowing costs for the Spanish and Italian governments had risen to unsustainable levels. After Draghi’s comments in July, the ECB announced it would buy government bonds in Spain and Italy in unlimited quantities, if necessary (a plan it dubbed Outright Monetary Transactions, or OMT). This plan has not yet been activated, but Spanish and Italian borrowing costs have fallen by a fifth. This has led some to claim that the worst of the euro crisis is behind us. José Manuel Barroso, the European Commission’s president, said that “the existential threat to the euro has essentially been overcome”. The Italian prime minister, Mario Monti, said the crisis is “almost over”. Is this so?

Before the ECB announced its plan, markets had been pushing for it to act more like the US Federal Reserve or the Bank of England. Countries whose central banks had bought government bonds in exchange for newly created money – quantitative easing (QE) – have not suffered from capital flight, unlike the euro’s periphery. In 2009, the British government faced a banking bust and public sector deficit of a similar scale to those of Spain, Portugal and Ireland, but has since avoided their financial woes.

QE provided monetary stimulus, even as central bank interest rates could not go any lower. Moreover, it served to put a ceiling on government borrowing costs. This helped governments to fund their deficits in the short term. It also helped domestic banks get cheaper funding: they use government bonds as collateral and as safe assets that they can easily sell in exchange for money or more risky assets. When government borrowing costs rise, government bonds fall in value. This covers the balance sheets of the banks that hold them in red ink. QE also changed expectations: investors knew that if they dumped American or British government bonds, the Fed or the Bank of England would simply buy them up, swapping them for new money. So there was little point in trying it.

Thus, the Federal Reserve and the Bank of England defined investors’ expectations, and made government borrowing safe and financial markets stable. The ECB’s interventions so far have been less far-reaching. It has lent money to banks at very low interest rates, and it has continued to accept the periphery’s government bonds as collateral. It has bought some government bonds – but exchanged them for money already in the system, so that there was no further monetary stimulus. But it has not done as much as its counterparts to make government debt safe.

The ECB’s OMT plan amounts to a promise to do QE, in a limited way, at some point in the future. The central bank said it would buy up the bonds of troubled governments if the integrity of the euro were threatened. The quid pro quo: governments must sign up to budget management by the Commission, the International Monetary Fund and the ECB. Spain and Italy have so far been reluctant to do so: borrowing costs came down after Draghi’s announcement, and governments have preferred to wait and see.

Will the current rally continue without the plan being activated? It seems unlikely. The eurozone as a whole is in recession. Spain and Italy’s economies are likely to shrink for most of next year: the European Commission projects GDP to fall by 1.4 per cent and 0.5 per cent respectively. The Commission has consistently underestimated the impact of austerity on growth, and so these figures may turn out to be quite a lot worse, further undermining government finances. Little progress has been made on banking union, which would help to shore up banks’ and governments’ books. Given these conditions, markets are likely to test the ECB’s commitment to hold the currency together.
If Spain and Italy’s borrowing costs spike again, they will quickly sign up to budgetary oversight and the ECB will start buying bonds. If the ECB buys enough, it should secure the currency from immediate break-up. But there would still be grinding economic stagnation, years of high unemployment, and a fraught federalising process to create a currency union that works. A party committed to withdrawal from the single currency could win power and fulfil its mandate, pulling the eurozone apart. And this possibility, even if it failed to materialise, would hold back economic growth, because private investors would be deterred. The peripheral countries, which desperately need investment if they are to grow, would still be forced to pay premiums by financial markets to cover the risk of exit, even if those premiums were smaller than they are now. The eurozone would still be caught in a trap.

Is there anything the ECB could do in such a situation? Not by a narrow interpretation of its mandate. The ECB’s role, as currently constituted, is to keep inflation low and stable. All other objectives – unemployment, economic growth, financial stability, and so on – are subordinate.  Draghi has interpreted the mandate flexibly, to mean that prices will not be stable if the single currency breaks up or if financial markets are not working. This makes the OMT plan legal. But the OMT is primarily a plan to keep the single currency together, rather than to promote growth.

However, other central banks have made growth the priority. The Federal Reserve, the Bank of England and the Bank of Japan have indicated that loose monetary policy will continue, irrespective of (moderately) higher inflation. The Federal Reserve is committed to monetary stimulus until unemployment falls to 6.5 per cent of the workforce, which it expects to happen in 2015. This shifts its priority from inflation to unemployment, although it has a mandate to tackle both. The Bank of England has been silent on what it will do in the future, other than its commitment to set policy to meet its 2 per cent inflation target. But it has consistently allowed inflation higher than this – it has averaged 3.5 per cent over the last five years – without tightening. The Bank of Japan has raised its inflation target, and is considering more QE. A consensus is forming: central bankers should favour employment over inflation, at least for now.

The ECB is the odd man out, because it was constructed in the Bundesbank’s image. Germany, given its corporatist wage-setting process and high savings rates, is allergic to price rises. Unions and businesses have agreed to keep wage growth low to maximise employment – and higher inflation would reduce living standards. German employees and businesses have very high savings rates, and savings are eroded away by price rises. But the eurozone faces years of low growth, not high inflation. Inflation in the eurozone is just above the 2 per cent target, but it has been pushed up by high energy prices and governments raising value-added tax rates, not higher wage demands by workers. The gap between the current rate of growth and its potential rate is large. There are 26 million people unemployed in the eurozone, which should hold wages and prices down. All of these reasons suggest that if the ECB eases monetary policy further it will not push inflation to unsustainable levels. By starting a QE programme – buying up all government bonds in proportion to their economies’ contribution to eurozone GDP – it would raise the bloc’s growth rate. And it would make clear to investors that the ECB will keep monetary policy loose until growth is restored, which would allay fears of break-up.

Political opposition from the Bundesbank and the German public would have to be overcome. A legal fix would have to be worked out to get over the prohibition on the ECB financing member-states. But the alternatives are far worse. Looser monetary policy through QE, with an explicit focus on growth, must be an important part of any plan to make the eurozone escape the trap of constant speculation about its future.

John Springford is a research fellow at the Centre for European Reform.