Ali’s blog

Mostly quant stuff with occasional digressions

The British economic miracle

Posted by alifinmath on February 25, 2008

During the late ’80s the Thatcher government used to boast about the “British economic miracle”; on how the Tories had managed to turn around a moribund economy under the previous Labour government and achieve growth rates of — gasp! — 2.25%. There was a televised debate between Norman Tebbitt — a Tory attack dog (and possibly Chairman of the Conservative party at that time) and Peter Jay (a former economics editor of The Times and also (I think) son-in-law of the previous (Labour) prime minister, James Callaghan). One of the experts brought in to testify by Peter Jay was an American academic (sorry, it’s been twenty years and I don’t remember the name). The expert opined that the question was whether the Thatcher government should get a C- or D+ and compared the British economy to a very sick man given a shot of steroids, running a few laps, and then collapsing. And that the *real* economic miracles were those of East Asia — the “Asian tigers.” Shortly thereafter Britain entered a protracted slump.

How little things have changed — my favorite refrain. The British government has been enjoying strong “growth” over the last ten or twelve years or so yet the foundation has not been any more sturdy than that of two decades ago. From Wolfgang Munchau, a columnist at the FT:

Axel Leijonhufvud, the Swedish-born economist, once made an insightful observation about inflation targeting. It worked better in practice than it did in theory, he said. I feel the same about the UK economy. Given what we have long known – about the country’s relatively low productivity growth rate and the erosion of its scientific and engineering excellence – the British economy should clearly not have performed quite as well as it did for the past 15 years. Economic theory would suggest that this was not possible.

In the next few years, I expect the UK economic miracle to be exposed for what it was: an overlong joyride on the back of an overlong asset price bubble. The UK economy is about to undergo a downturn at least as large as that of the US – maybe even worse, because of an even more inflated housing market and because the financial sector constitutes a larger share of gross domestic product.

According to my calculations, UK residential property prices are about 30 per cent above their trend in real terms. If the trend has not changed in the past few years, that would suggest that inflation-adjusted prices could fall by up to 40 per cent from peak to trough.

The UK financial sector is in no less trouble. The credit crisis has a lot further to run, as it moves from one subsector to another. As I have argued previously, credit default swaps pose very serious risks to financial stability and the City of London has been the centre of the European CDS market. One consequence of the credit crisis could be that banks become subject to highly intrusive regulation on the types of product they can offer, perhaps even on the profits they distribute or the salary packages they can award. The greater the extent of public bail-outs or bank nationalisations, the greater will be the public’s regulatory revenge.

Perhaps the worst thing will be that working in finance will no longer be regarded as cool, as it has been over the past 15 years. Finance will be once again what economic theory always told us what finance should be: a necessary activity, requiring some technical skills, but rather dull in the absence of bubbles.

The macroeconomic implications of the downturn in the financial sector are serious. In the UK, the financial sector is the largest contributor to the balance of payments. Its decline comes at a particularly inopportune time, as the country is running a current account deficit of 5.7 per cent of GDP. To get that deficit down to a more sustainable level will require a big fall in consumption and a big rise in savings – all the more so if the country’s largest export industry is in recession.

The adjustment ahead will put the previous 10-year performance of the UK economy into some perspective. My own guess is that Britain’s heavy reliance on financial services and housing, until recently seen as a great strength, will in future be seen as a structural weakness, similar to the French labour market or the Italian public sector.

Britain used to be known as the “workshop of the world.” Once upon a time. But it started to lose its edge after 1875 to the uppity Germans and Americans. Balance-of-payments problems (i.e., current account deficits) have afflicted the country throughout the post-WW2 period until the discovery of North Sea oil (before WW2, Indian trade surpluses were used to balance British deficits). Various postwar governments have attempted to address Britain’s eroding technological base. In 1964, the incoming Wilson government announced a “white-hot technological revolution,” which among other things consisted of urging Britons to “Buy British.” But even the “Buy British” stickers were manufactured in Japan. Today Britain remains afloat on what’s colloquially known as “bullsh!t industries”: business services (consulting, accounting, advertising), education, entertainment, tourism, and financial and insurance services. As such the British economy is acutely sensitive to downturns in the global economy.


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