UK: Economic Review - A Bumpy Road To Recovery


John Connolly

In this Review, Roger Bootle, Economic Adviser to Deloitte, turns his attention to how the economic recovery will fare during the new year. While he thinks that the road to health will be a bumpy one, he is optimistic that stronger and better-balanced growth will result eventually.

Roger thinks that the recovery will struggle to maintain its recent momentum in the coming months. In particular, he doubts that the private sector is in a fit enough state to compensate fully for the fiscal squeeze that is set to get well underway this year. He expects GDP growth of just 1.5% in both 2011 and 2012.

But the recovery in some parts of the economy will keep getting stronger. Roger thinks that business investment is the area likely to see the strongest growth over the next couple of years, partly because firms will invest in new capacity in order to exploit the opportunities created by the drop in the pound.

What's more, further ahead the economy will have the scope for a period of faster growth to use up the reserves of unused capacity. And Roger thinks that the current period of deleveraging and belt-tightening will ultimately pave the way for healthier and more sustainable growth than that seen over the past decade.

Once again, I hope that this Review helps you in both your immediate and strategic thinking.

Executive summary

Roger Bootle

  • We doubt that the economic recovery is on the secure footing required for it to maintain its recent pace. It could take until well into 2013 for the economy even to get back to its pre-recession levels of activity.
  • On the face of it, the UK appears to be getting quickly back onto its feet. However, a look at what has driven this strength creates some cause for concern. The recent surge in construction output looks unlikely to last. And the positive contribution from government spending will of course fade.
  • Admittedly, the fiscal tightening will be spread over several years. And many of the major welfare cuts do not come in until 2013.
  • But the squeeze will still get well underway in 2011. Departmental spending is set to fall by over 4% in real terms in 2011/12 – and the Government seems to have no plans, for now at least, to scale back the cuts. Public sector employment is already falling. And VAT and national insurance contributions will soon rise.
  • Given all this, the recovery's prospects clearly hinge on the private sector's ability to continue to pick up steam. Perhaps the first hope is that the direct adverse effects of the fiscal squeeze on the private sector are offset by support from other sources. Private sector employment, for example, has risen strongly in the past few months.
  • But we doubt that this will last when firms still have scope to raise productivity significantly and parts of the private sector are vulnerable to cuts in government procurement spending.
  • Meanwhile, high inflation will further squeeze households' real incomes – which we expect to fall by over 1% next year.
  • At least there are now tentative signs of a re-balancing towards the external sector. And the recoveries in the US and Germany are progressing well. But against that, the euro-zone's peripheral economies – the destination of about 15% of UK exports – will continue to struggle.
  • And although business investment could grow quite strongly in 2011, it is simply not a big enough part of the economy to have a significant effect on overall GDP growth.
  • The overall economic recovery might manage to keep up its momentum for a little while longer – especially if consumers take time to adjust their spending in response to the tax rises. However, we expect growth then to slow to pretty sluggish rates. We expect GDP growth of just 1.5% in both 2011 and 2012.
  • But at least the UK has turned a corner. And, although a difficult couple of years lie ahead, growth should eventually accelerate. It will also be more soundly-based than the growth seen over the past decade or so.
  • Moreover, the prolonged fiscal tightening means that monetary policy can remain extraordinarily loose to compensate. We do not expect interest rates to rise until 2013 at the earliest.

A bumpy road to recovery

The prospects for the economy in 2011

It has now been just over a year since the UK economy emerged from recession and so far, so good. Even though it was the deepest recession in decades – and a recession driven by a banking crisis at that – the UK appears to be quickly getting back onto its feet. GDP growth is back above its long-run average or trend rate and about 40% of the output lost during the recession has been regained. (See Chart 1.)

But, of course, the true test of the recovery is yet to come – namely the looming fiscal squeeze required to repair the damage done to the public finances by the downturn and the measures put in place in response. Indeed, in a sense, the current uncertainty about the economic outlook is even greater than a year ago. In this Quarterly Review, we take a closer look at whether the recovery has the potential to maintain momentum over the next year or two. Is a sustainable recovery now underway? Or will the pick-up seen during 2010 turn out to be something of a false dawn?

What's driving the recovery?

Perhaps the best place to start is with a look at what has been driving the recovery so far.

Do the recent sources of strength look sustainable? Unfortunately, a look at the recovery from the output side of the economy is not particularly reassuring. Chart 2 illustrates how it has been disproportionately dependent on one small part of the economy – the construction sector. Construction accounted for over a third of GDP growth in Q2 and Q3, despite making up just 6% of overall GDP.

Indeed, the surge in construction output has been so strong that some have questioned the accuracy of the figures – suggesting that GDP growth might not have been as strong as the published figures suggest.

And even if the figures are correct in showing a sharp rise in construction output, the sector is unlikely to support this recovery for much longer. For a start, output in the sector has already almost returned to its pre-recession peak, suggesting that the "bounce-back" effect is pretty much exhausted. Output fell by 14% during the recession, but has now recovered by 11%. What's more, public sector works account for about a third of construction output – and investment is the part of government spending set to be slashed the most.

Indeed, the sharp drop in new construction orders in the past two quarters suggests that construction output will soon be falling again on an annual basis. (See Chart 3.)

At least a look at GDP from the alternative spending breakdown is a bit more encouraging, suggesting that the recovery is based on more than just temporary sources of growth. The recovery maintained momentum in Q3, even though government spending fell by 0.4%. What's more, investment posted a robust 3.4% increase, driven by a strong rise in business investment. (See Chart 4.)

But only so much comfort can be taken from this. After all, the drag from government spending could yet get even bigger as the fiscal squeeze intensifies. And stockbuilding is still playing a role in the recovery, accounting for 0.3% of the 0.7% quarterly rise in GDP in Q3. This support is unlikely to last. Accordingly, it won't just be enough for the other parts of the economy to maintain their recent performance (which, in any case, is far from guaranteed) – they will need to step up another gear.

When will the fiscal squeeze really start?

Admittedly, this is all based on the assumption that the looming fiscal squeeze will kick in soon. But just how looming is looming? Does the recovery actually have a bit more breathing space to develop yet?

After all, central government spending is still rising at a rapid annual rate of almost 7%. Remember, too, that the Government's fiscal mandate is to get the public finances back in order over a five year period. And many of the policy changes announced so far do not actually come into effect for up to several years, particularly those relating to cuts in the welfare bill. As an example, one of the biggest changes – a cut in child benefit for higher earners – does not take effect until 2013. Indeed, the social security bill is projected to keep rising, even in real terms, until 2012/13.

But while it is fair to say that the fiscal squeeze will be spread out over a number of years, it nonetheless looks likely to get well underway in 2011. For a start, it is worth noting that government spending growth has recently been boosted by a rise in debt payments compared to a year ago (when negative rates of RPI inflation pulled payments on index-linked debt down sharply).

Excluding debt payments, spending growth has already slowed sharply, from annual rates of over 7% at the start of 2010 to about half that now. (See Chart 5.)

Meanwhile, even though the welfare bill will take time to fall, departmental spending (which is roughly twice the size of spending on social security) is certainly due to start falling sharply in 2011. In fact, 2011/12 is, according to the Government's plans, due to be the year of the heaviest falls. (See Chart 6.)

Admittedly, despite this, the Office for Budget Responsibility (OBR) expects the job cuts in the public sector to be significantly back-loaded, with the biggest cuts not coming until 2014/15. (See Chart 7.)

However, this partly reflects the fact that near-term cuts in the real pay bill will be achieved through the two year public sector pay freeze which starts in April. Accordingly, the incomes of public sector workers will still be squeezed. What's more, we think that the OBR is under-estimating the extent to which cash-strapped departments that are finding it hard to make savings might resort to cutting headcounts sooner rather than later. Note that public sector employment is already falling, having dropped by a total of over 80,000 in the first three quarters of 2010. (See Chart 8.)

Meanwhile, whatever happens to government spending, tax rises are certainly imminent. Most obviously, VAT rises by 2.5% on 4th January – dealing an immediate blow to either firms' profits or consumers' spending power, depending on how much of the rise is passed on in the form of higher prices. And further tax rises are due in April, including the 1% rise in employees' national insurance contributions. Table 1 summarises the main tax rises due to come into effect and shows that altogether, they have the potential to knock about 0.8% off GDP in 2011/12.

Admittedly, their effect on the economy depends on how quickly consumers (on whom the tax rises primarily fall) react. Indeed, one possibility is that they have already adjusted their spending in anticipation of the rises. Although the recent resilience of consumer spending suggests that this is perhaps unlikely, without the looming tax rises, spending might of course have been even stronger.

What's more, we have neglected so far the possibility that the government deliberately scales back the magnitude of the fiscal tightening, perhaps in response to concerns that it will undermine the recovery. However, the recent strength of the recovery has somewhat sidelined this argument, while the continued troubles in the euro-zone periphery have underlined the need for governments to keep a tight grip on their fiscal consolidation plans.

Indeed, rumours ahead of the Spending Review in November that the spending cuts would be "re-profiled" or pushed back amounted to nothing, as has speculation that the VAT rise in January would be postponed.

That's not to say that, further ahead, the government won't have to reconsider its plans if economic growth disappoints, with adverse effects to the public finances. One "Plan B" that has been suggested is for the Government to maintain the programme of spending cuts in order to reassure the markets about its longterm commitment to cutting public sector debt, but also to cut taxes temporarily in order to bolster the economy. But for now, the Government's only back-up plan is to assume that, if necessary, the MPC will come to the rescue with more quantitative easing.

The upshot, then, is that we still expect the fiscal squeeze to exert significant downward pressure over the coming year – albeit perhaps skewed towards the second half of 2011, once consumers have had time to react to the tax rises.

Any relief for consumers?

Given all this, the recovery's prospects clearly hinge on the private sector's ability to continue to pick up steam to compensate for the weaker contribution from the public sector. Perhaps the first hope is that the direct adverse effects of the fiscal squeeze on the private sector – and consumers in particular – are offset by support from other sources.

Arguably the most important question is whether the private sector can generate enough jobs to offset the public sector cuts. And recent news in this regard has been encouraging. In the six months between March and September, the economy generated 350,000 jobs (on the Labour Force Survey measure of employment) – more than the Office for Budget Responsibility's estimate of the total public sector job losses over the next four years. Admittedly, most of these have been part-time roles. (See Chart 9.) Nonetheless, part-time employment is a natural place for the recovery to start. After the last recession, a rise in part-time employment in 1993 was followed about a year later by a strong pick-up in full-time employment. However, we are far from optimistic about the outlook for employment.

For a start, we think that the OBR is underestimating the scale of the public sector job losses. If the public sector paybill sees 12% real cuts – in line with overall departmental spending – savings of about £20bn will need to be made. Some of these will come through the public sector pay freeze and rise in employees' pension contribution. But these measures are estimated to save only £3.3bn and £1.8bn respectively – leaving another £15bn or so. That magnitude of saving would require about 520,000 job cuts.

What's more, employment in those firms directly dependent on government spending is likely to fall. In 2009/10, £196bn of government spending went on procuring goods and services from the private sector. This is equivalent to about 13% of GDP, suggesting that the public sector indirectly supports about 4 million private sector jobs. A cut in procurement spending of 12% – again in line with the cuts in overall departmental spending – could therefore put a further 500,000 jobs at risk. Note that BAE has already announced a further 1,400 job losses as a result of the cuts in defence spending announced in the Spending Review.

Given all this, we think that, just to stop overall employment from falling, employment in the parts of the private sector not directly affected by the cuts in government spending will need to rise by about 1% a year. And to generate the overall employment growth that the OBR expects, it would need to rise, on average, by some 400,000 or 2% a year. (See Chart 10.)

While not impossible (indeed, it was achieved during the fiscal squeeze of the early to mid 1990s), we think that this is pretty unlikely. We have pointed out before that the fairly small fall in employment seen during the recession means that, in theory, firms should still have plenty of scope to produce more using their existing workforces.

In fact, the labour market recovery already appears to be stalling, with employment falling in October and some of the latest employment surveys pointing to a slowdown in employment growth. (See Chart 11.) The upshot is that we still expect overall unemployment to start to climb again in the coming months once the public sector axe starts to fall more heavily.

Rising inflation hits real incomes

What's more, it is hard to see what else might support consumer spending as the job losses mount. If we are right about unemployment, pay growth will stay very weak. And the fact that inflation is taking longer to fall than we expected – and in fact is rising again – will put an additional squeeze on households' real income growth. Indeed, we now expect real disposable incomes to fall by about 1.5% in 2011 and probably drop even further in 2012. (See Chart 12.)

At least the low level of interest rates means that there is still no urgency for households to get on with the deleveraging that still looks necessary in the longer-term. Despite the stubbornness of inflation, the MPC looks unlikely to hike official interest rates any time soon. And if we are right in expecting a further extension of quantitative easing next year, bond yields and market interest rates might come under further downward pressure.

That said, the renewed downturn in the housing market provides a powerful incentive for those households on expiring mortgages to accelerate their debt repayments, in order to boost their housing equity and hence qualify for a lower interest rate. What's more, the continued problems in the banking sector suggest that there is still little hope of consumers borrowing more to see them through their income squeeze.

In fact, if anything, there is a risk that credit conditions start to tighten again. For a start, UK banks have significant exposure to the troubled peripheral euro-zone countries. Admittedly, exposure to the sovereign debt of the so-called "PIIGS" (Portugal, Ireland, Italy, Greece and Spain) accounts for only 1.8% of all UK banks' assets. But add in the UK's holdings of bank and non-bank private sector debt in those countries and the figure rises to almost 5%.

What's more, banks still face significant domestic risks – most obviously the renewed house price falls, but also lingering problems in the commercial property market. Meanwhile, the upward pressure on banks funding costs already stemming from the recent rise in LIBOR rates is only likely to worsen as banks seek to replace the funding provided by the Bank of England through the Special Liquidity Scheme.

The upshot, then, is that consumers are unlikely to get through the fiscal squeeze unscathed. In fact, we still expect household spending to fall in 2011.

Net trade to the rescue?

The onus is therefore firmly on those parts of the economy which are relatively immune from the direct effects of the fiscal squeeze – namely exports and investment – to drive growth instead.

And at least there are now some signs of a re-balancing towards the external sector. Exports are now only a fraction below their pre-recession peak, having risen by about 10% in value terms over the past 12 months. On the face of it, the major factor behind this has been the pick-up in global demand – as Chart 13 shows, goods exports have risen broadly in line with overall world trade.

The key question, then, is whether global demand will continue to provide this support to UK exports. And on the positive side, the recently announced plans for an extra fiscal stimulus in the US clearly leave the outlook for global demand a bit brighter.

But the US accounts for only 17% of the UK's exports. Obviously far more important is what is happening in Europe, the destination for over half of UK exports. And while it is reassuring that the recovery in Germany (the UK's biggest export market in Europe, taking 9% of exports) is still going strong, it remains heavily dependent on exports itself. There is still limited evidence that households there are about to start consuming a large amount of UK goods and services. Indeed, we expect German consumer spending to do little better than stagnate in 2011.

What's more, Chart 14 shows that the beleaguered peripheral euro-zone economies are collectively a bigger export destination for UK exports than Germany – and not that far off the whole of Asia. And after growing slightly in 2010, we expect GDP in the PIIGS to contract in 2011.

Accordingly, we don't see the global demand environment as being particularly supportive for the UK's external sector. But what about the lower pound? While there is little evidence of UK exporters taking a bigger share of the world export cake, that doesn't mean that the pound is having no effect – without it, the UK's export share could well have fallen. Indeed, the UK's overall trade deficit has stabilised after falling for several years. Equally, though, the deficit has not started to narrow at all.

Part of the problem is that there is still little evidence of so-called import substitution – i.e. UK firms and consumers switching from buying foreign to domestically produced goods and services.

In fact, as Chart 15 shows, imports have been growing faster than domestic demand (weighted according to the import intensity of its different components). Reports from the Bank of England's regional agents suggest that this reflects the "lack of appropriate supply capacity in the UK" and, in time, domestic producers are likely to invest in new capacity to correct this. But this process could take several years.

Another spanner in the works could be a renewed appreciation in the pound. In the big scheme of things, the rise so far has been pretty modest – on a tradeweighted basis, sterling is at about the same level as a year ago and still more than 20% down on its peak. But if we are right in expecting the troubles in the eurozone to weigh further on the euro – potentially taking it all the way to parity against the dollar – sterling could yet rise a fair bit further. We expect the trade-weighted index to rise by between 5% and 10% in 2012.

We don't want to sound too gloomy. To be clear, we certainly expect net trade to provide a positive, and fairly decent, contribution to growth over the next couple of years. After all, even if export growth does not accelerate any further, import growth is almost certain to slow from the rapid rates seen recently. We just don't think that the boost – which we would put in the region of between 0.5% and 1% of GDP in 2011 – will keep the recovery going on its own. After all, a boost of this magnitude would do little more than fill the hole left by falling consumer and public spending – which together we expect to knock about 0.5% off the level of GDP in 2011.

Investment just not big enough

At least we've saved the best for last. Business investment is the area of the economy likely to see the strongest growth over the next couple of years.

To be sure, there are some factors set to keep some check on the investment recovery – including the spare capacity that firms still have to use up, as well as uncertainty about the demand outlook. Nonetheless, there are powerful incentives to invest – most obviously to make the most of the opportunities created by the lower pound. What's more, firms have money to spend, having been in financial surplus for almost a decade now.

Indeed, investment intentions have been rising. And it is production of investment goods that has been driving the rises in industrial production recently – accounting for about half of production growth, even though it makes up only a fifth of production as a whole.

Nonetheless, the weakness in the rest of the economy clearly leaves a heck of a lot of work for business investment – which accounts for less than a tenth of the economy – to do on its own. A strong but fairly plausible 10% rise in business investment over the next year or two would take investment as a share of GDP back to more "normal" levels – but would add just 1% or so to GDP.


So can the economy continue to recover? Of course, the answer depends in part on what we mean by recover. If we mean can the economy continue to expand and claw back the output lost during the recession, the answer is yes. The odd quarter of contraction is not out of the question – especially at the start of the year when VAT rises. But, for now at least, the risk of a sustained return to recession has receded significantly.

But if the question is whether the recovery can maintain or improve on the above-trend rates of growth seen in the past couple of quarters, the answer, in our view, is probably not.

Admittedly, the recovery might manage to keep up its recent momentum for a little while longer. After all, we still think that there is a bit of a boost from restocking yet to come, which – if the timing worked fortuitously – could offset any adverse effect from the VAT increase on consumer spending in the first quarter of 2011.

But the key point is that we doubt that the recovery is on the sustainable footing required for it to maintain its recent pace. To be sure, the recovery in some parts of the economy will keep getting stronger. But the relatively small size of these sectors will prevent them from compensating fully for the slowdown seen elsewhere in the economy.

So while the recent momentum in the economy has persuaded us to nudge up our GDP growth forecast for this year from 1% to 1.5%, this would still be well below the economy's potential or trend growth rate. And although obviously much could change over the next year or so – including the fiscal plans – for now we expect growth to be much the same in 2012. (See Chart 16.) The economy could take until well into 2013 even to get back to its pre-recession levels of activity.

Nonetheless, the UK has turned a corner. And, although a difficult couple of years lie ahead, growth should eventually accelerate. Indeed, given the large amount of slack that we think still exists, it could reach pretty rapid rates. What's more, it will be more soundly based than the growth rates seen over the past decade or so. So although the next year or two may be a difficult time, a period of strong and sustainable growth lies beyond it.

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