The UK: Demand, Supply, the Deficit & Rebalancing
Since we learned that GDP grew by only 0.2% in the second quarter of 2011, we’ve had a blizzard of further bad economic data. The CBIindustrial and distributive trends surveys last week pointed to an economy slowing in August, the manufacturing PMI is pointing towards actual contraction, the construction sector is still weak whilst the money supply is falling.
The question becomes – what on earth is going on? Specifically does the UK have a demand problem or a supply one?
The answer is a depressing one – both.
In the short term the immediate problem is one of poor demand. Domestic demand is extremely weak:
- The consumer is over indebted, cautious and not spending.
- Corporations are constrained by banks not lending, pessimistic about their prospects and not investing.
- Government is embarked on the largest fiscal tightening in decades.
Meanwhile external demand for exports is weak for reasons that a casual glance at the recent economic headlines coming out of Europe and the US will easily reveal.
But the UK does have a supply problem. Trend growth is almost certainly lower than the OBR estimate, we still don’t know quite how much the credit bubble led us to over estimate sustainable growth – but we do know that investment in the real economy has been low for a long time and that much of the finance productivity miracle was actually a mirage.
All of this matters for government policy. George Osborne’s plans to eliminate the structural deficit in this Parliament are now hanging by a knife edge. Another large downgrade from the OBR and the more cuts or tax rises will be required to meet his own targets – as the IMF has now noted.
Meanwhile the Government’s second major macro aim – a rebalancing of the economy, also looks in jeopardy as the manufacturing sector slows down.
What is required is a combination of short run policies to maintain aggregate demand coupled with a medium term agenda to address supply side issues – in the long run this is the best way to both balance the budget and rebalance the economy.
Interestingly enough the State Investment Bank idea (long backed by me and supported by Robert Skidelsky and Gerry Holtham amongst others) may help to address both these issues by raising domestic demand in the short run and increasing investment in the medium term.