Eurozone slump derails Britain's economic strategy

Written by Simon Tilford, 28 January 2013

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.

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Issue 88 - 2013

Issue 88 February/March, 2013

Leaving the EU will not set Britain's economy free

By Philip Whyte

Why the EU should support France in the Sahel

By Rem Korteweg

Can Turkey and the UK learn from each other's EU strategies?

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Europe places too much faith in supply-side policies

Written by Simon Tilford, 18 January 2013

Supply-side thinking now dominates European economic policy. Most governments, and the European Commission, argue that attempts to boost demand would be counterproductive, achieving little but a delay to the necessary consolidation of public finances. With close to unanimity, they believe that structural reforms offer the only hope for depressed European economies: these reforms will improve competitiveness and confidence, leading to stronger growth, a rebalancing of trade between European countries and sustainable public finances. But are policy-makers and the Commission putting excessive faith in the power of structural reforms? Is there a risk that a strategy weighted so heavily towards supply-side measures could actually end up further eroding Europe’s growth potential? And is it right to argue that structural reforms will help bring about sustainable rebalancing?

Few doubt the need for structural reforms in Europe. The region needs faster productivity growth and this requires, among other things, more flexible and competitive markets: labour and capital must be freer to move from slow growing sectors to faster-growing ones. But structural reforms alone will not achieve this. Indeed, in the short to medium term such reforms will further depress demand. Only in the long-term could they have the desired effect and only then if businesses invest in new organisational structures and new products, and if workers (especially young ones) have the right skills and experience. But business investment is at historic lows in Europe as firms worry about the lack of demand.

And unemployment is back to levels last seen in the early eighties and set to remain chronically high for years. In short, the damage done to Europe’s supply-side by very low investment and mass unemployment is likely to offset the potential benefits of the reforms. For example, all the academic evidence shows that persistently high unemployment does lasting damage to economies’ human capital and hence growth potential.

A further problem is the nature of the structural reforms underway in Europe. Supply-side reforms in the context of the eurozone largely mean labour market reforms, or more particularly, labour market reforms that erode the bargaining power of labour. By contrast, there is much less emphasis on opening up markets for goods and services to greater competition, which is arguably more important from the perspective of economic growth. This is perhaps unsurprising. Germany’s Hartz IV reforms, which are the inspiration for much of what the eurozone is doing, led to a weakening of workers’ bargaining power, but did little to promote reform of Germany’s domestic economy. Indeed, according to the OECD, Spain’s product markets are considerably more competitive than Germany’s. This helps explain the persistent weakness of German domestic demand: it fell in 2012, with all of the economy’s 0.9 per cent growth down to net exports.

The European Commission argues that the structural reforms underway in the peripheral eurozone economies are boosting their trade competitiveness, and points to the narrowing of their current account deficits in 2012 as evidence of this. But this improvement is mainly the result of unprecedentedly weak domestic demand (and hence declining imports) in these economies, rather than rising exports. Faced with stagnation at home, some firms have successfully scrambled to boost exports. However, a sustained rise in exports requires investment in new capacity and products and stronger export demand. Neither is happening: investment in manufacturing is at all-time lows across Europe, but it is especially weak in the periphery. Demand across the European economy, meanwhile, is chronically weak.

Three years ago, the Commission argued that rebalancing within the eurozone needed to be symmetric if it was to be consistent with economic growth. It followed that the onus needed to be on the economies with big trade surpluses to rebalance their trade as much as the deficit ones. In reality, very little emphasis has been placed on rebalancing the surplus economies. And in a report published in December 2012, the Commission downplayed the role that stronger demand in the region’s surplus economies would have on the exports of countries such as Spain, Greece and Portugal. The Commission illustrated this by showing the limited impact a 1 per cent increase in German domestic demand would have on the exports of the country’s eurozone trade partners: the peripheral ones do less trade with Germany than the country’s immediate neighbours, and would hence benefit less from stronger German demand for imports. The Commission acknowledges that there would be second and third round effects – for example, stronger demand in Germany would boost the French economy, which in turn would boost the Spainish one – but almost certainly underestimates the significance of these.

However, the bigger problems with the Commission’s analysis are the narrowness of its focus and its use of such a modest increase in German domestic demand to illustrate its point. There is no doubt that a 1 per cent increase would have only limited impact on peripheral countries’ exports. But if domestic demand in Germany (and in other surplus economies such as the Netherlands and Austria) expanded by 4 per cent per year over a five year period, the impact on their trade partners would be significant, even on the assumptions employed by the Commission. Moreover, if their demand were to increase by this amount, the surplus economies’ ‘marginal propensity to import’ (that is, the proportion of any increase in demand spent on imports) would rise: their domestic industries would lack the domestic capacity to service the increased demand and a rising share of it would be met by imports. Firms would be likely to step-up investment in the domestically orientated-sectors of these economies, reducing their trade surpluses, and with it the drag they impose on the rest of the eurozone economy. The flip-side would be stronger investment in the export-orientated sectors of the peripheral countries.

On their own, the structural reforms underway across Europe will bring neither economic recovery nor rebalancing. The current reforms focus strongly on labour markets, and risk leading to similar results across Europe to those seen in Germany: very weak consumption and investment. Europe needs to do much more to strengthen demand, which requires symmetric structural reforms and stimulus. While there is no doubt that Spain needs to reform its labour market, Germany would also benefit from reforms of its product markets. Those governments that have the scope to provide stimulus need to do so: Germany actually posted a budget surplus in 2012. Stronger demand in the countries running trade surpluses will not suffice to rebalance the eurozone economy and return it to growth, but it is an indispensable element of what is needed. The European Central Bank, meanwhile, could redouble its efforts to boost credit growth. As it stands, demand is likely to remain very weak across Europe for a prolonged period of time, further eroding growth potential and the sustainability of public finances.

The Commission’s readiness to place so much faith in structural reforms as a solution to Europe’s economic ills is a product of the region’s political realities. The surplus countries have successfully resisted pressure to take steps to rebalance their economies and there is little appetite among eurozone governments for simultaneous reflation involving fiscal stimulus and quantitative easing by the ECB. The current strategy is not without political risk: the more European policy-makers talk about growth, the less growth there is. Whereas unpopular national governments can be voted out and replaced with ones that do not shoulder responsibility for unsuccessful policies, this is not the case with the Commission, whose standing could suffer long-lasting damage.

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

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Added on 21 Jan 2013 at 06:20 by Heri

A leadership must have a policy, but that policy must be useful or that can bring good at something.

Added on 18 Jan 2013 at 17:05 by K Bledowski

Greater competition in products markets, lower cost and higher supply of labor and other measures would surely support growth. Yet import-, consumption- and overall spending elasticities vary widely across the continent. The impact of either supply- or demand-side measures is uneven. The ideal vehicle to help rebalance trade and demand is through floating exchange rates. What a pity that those are fixed across much of the continent …

Asia's fading economic miracle

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Sound public finances require more than low budget deficits

Written by Simon Tilford, 04 January 2013

The European Commission and the European Central Bank like to compare the eurozone's budget deficit and overall level of public indebtedness favourably with the US and the UK. Senior policy-makers from both institutions cite the allegedly superior fiscal performance of the eurozone to justify their outspoken support for austerity. They claim that the eurozone has acted more decisively to put its public finances on a sustainable footing and will reap a growth dividend for this, as confidence returns more quickly to the eurozone than to the US or UK. Is the Commission’s confidence justified? Or is it guilty of using data selectively to justify policies that are not working?

The eurozone as a whole has certainly run smaller budget deficits than the US or the UK over the last five years. Whereas the eurozone deficit averaged 4.4 per cent of GDP per year in 2008-12, the UK's was 8.4 per cent and that of the US almost 10 per cent. However, an economy’s budget deficit only says so much about its debt dynamics. The sustainability of a country's fiscal position is less about the size of its budget deficit at a particular point in the economic cycle, and much more about the size of its debt stock, the cost of borrowing and the trend in nominal GDP (that is, economic growth plus inflation). And here the picture becomes less clear.

The eurozone budget deficit may have averaged less than half the US's over the last five years, but the eurozone’s ratio of public debt to GDP has grown only slightly less rapidly than the US's. The eurozone's debt stock has increased from 70 per cent of GDP in 2008 to an estimated 94 per cent in 2012. Over the same period, the comparable US ratio rose from 76 per cent to 107 per cent, and that of the UK from 52 per cent to 89 per cent.

Moreover, around five percentage points of the rise in the US debt stock reflects the cost of recapitalising the country’s banks (the comparable figure for the UK is around 8 per cent of GDP). It is hard to put a figure on the cost to the tax-payer (so far) of bank recapitalisations in the eurozone, but it is certainly less than 2 per cent of GDP. It is legitimate to include the costs of bank recapitalisation in the three economies' debt stocks: eurozone governments (individually or collectively) will eventually have to pump large amounts of public money into their banks, pushing up the level of public debt across the currency union.

If the cost of bank recapitalisation is excluded, public indebtedness has only risen slightly more quickly in the US than in the eurozone. The UK's debt ratio has increased significantly faster than the eurozone, even after taking into account the expense of recapitalising banks. However, the rise in the UK's debt stock has outpaced that of the eurozone's by less than suggested by the UK's much bigger budget deficit.

Why has the ratio of eurozone debt to GDP risen almost as much as in the US, despite the US running a budget deficit of twice the size of the eurozone over this period? One factor is nominal GDP or the 'denominator', which has grown more quickly in the US than in the eurozone, reflecting a much stronger economic recovery. This has contained the expansion of debt to GDP in the US relative to the eurozone, where the expansion of nominal GDP has been much weaker. Nominal GDP in the UK has also risen more rapidly than in the eurozone, although this reflects higher inflation rather than a superior growth performance. Inflation is no panacea, of course. Eventually investors will demand a higher premium to compensate for it. But they are only likely to do so once economic recovery is underway (and other assets become more attractive than government bonds). At that point fiscal deficits should fall rapidly in any case, as tax revenues rise and social transfers fall.

The crucial importance of nominal GDP to a country’s debt dynamics is illustrated by Italy. Despite managing to run a small deficit, Italy has experienced a very large rise in the ratio of debt to GDP over the last five years. One reason is that Italian nominal GDP actually fell slightly between 2008 and 2012. Greece, Ireland and Portugal, together with Spain, have all run much larger deficits than Italy, though only in the case of Ireland has the deficit been significantly bigger than in the US (reflecting the scale of Ireland’s bank recapitalisation programme). But Greece and Ireland have experienced huge falls in nominal GDP (14 per cent in both cases), whereas Spain and Portugal have posted declines of around 3 per cent. Falling nominal GDP is a major reason why they have all experienced dramatic increases in their debt ratios, far in excess of the US or the UK.

Another factor explaining why the eurozone's debt stock has risen so quickly despite a relatively small deficit is higher real borrowing costs. Quantitative easing by the US Federal Reserve and the Bank of England, combined with concerns over weak economic prospects (which undermines the attractiveness of other assets), have pushed down government borrowing costs. Both the US and UK have been able to borrow (and refinance debt) very cheaply. Crucially, borrowing costs have been below the rate of inflation in both countries, which slows the accumulation of debt relative to GDP.

By contrast, average borrowing costs across the eurozone have been considerably higher. While Germany, the Netherlands, Finland and Austria have been able to borrow as cheaply as the US, and France has only had to pay a bit more, struggling eurozone economies such as Italy and Spain and, of course, the three small peripheral economies, have had to pay far more to borrow funds. Investors have questioned whether their membership of the currency union is sustainable and have demanded a premium to offset the convertibility risk. Since the ECB indicated in mid-2012 a readiness to purchase potentially unlimited quantities of struggling eurozone countries’ debt, borrowing costs have fallen. However, they still remain well above the rate of inflation.

A combination of stagnant or declining nominal GDP and borrowing costs in excess of inflation is poisonous for many eurozone countries' debt dynamics. It is all but impossible to prevent a rapid accumulation of debt to GDP when the nominal GDP is not growing, irrespective of how much fiscal virtue a country demonstrates. Indeed, from the perspective of debt dynamics, fiscal austerity can be counterproductive. As Italy demonstrates, running a primary budget surplus (the budget balance before the payment of interest) is no guarantee of fiscal sustainability if interest rates are high and nominal GDP stagnant or falling.

What about the future? The European Commission forecasts that eurozone public debt will barely rise as a proportion of GDP in 2013 and actually start falling in 2014. Economic forecasting is necessarily imprecise, but the Commission’s strain credibility. Every six months it has to revise down its growth forecasts and revise up its forecasts for debt. The coming year’s revisions look set to be even bigger than those we have seen over the last few years.

Even assuming the ECB continues to hold down borrowing costs, there is little indication that they will be below the rate of inflation in the struggling eurozone countries. And the outlook for economic growth is extremely poor. Assuming that austerity in the current economic climate is as bad for growth as the Commission and the IMF now acknowledge (but do not incorporate into their forecasts), real GDP will fall steeply in 2013 across much of the eurozone, pushing down inflation with it. Nominal GDP will do little more than stagnate (falling steeply in the south, stagnating in France and the Netherlands and rising somewhat in Germany). Assuming further austerity (on top of that already announced) is avoided, the eurozone could eke out a bit of nominal GDP growth in 2014. The risk, however, is that the deepening of the slump brought on by austerity will weaken public finances further and be used to justify more austerity. This, in turn, would weaken nominal GDP further.

There may be a miracle, but in all likelihood the eurozone is going to combine the worst of both worlds: stagnant or falling GDP and rapidly rising debt. The prolonged slump threatens to further weaken the eurozone's banks, increasing the amount of money that eurozone governments will eventually have to borrow in order to recapitalise them. It is impossible to say whether by 2017 (ten years after the start of the crisis) the eurozone or the US will have experienced the bigger build-up of debt relative to GDP. However, what can be said with a high degree of certainty is that the US economy will be substantially larger in 2017 than it was in 2007.

Not only is the eurozone likely to experience a lost decade, but the growth potential of its economy will almost certainly have eroded further as mass unemployment and weak business investment damages the supply side. The UK’s experience is likely to be much closer to the eurozone's than the US's. Notwithstanding its euroscepticism, the strategy of the British government has more in common with the rest of Europe than it does with the US. It is stepping up the pace of fiscal austerity in the face of extremely weak consumption and business investment and a worsening outlook for exports.

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