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Economics & Finance

UK economy: Trimming the fat or incipient anorexia?

Barbara Stelzner |

When the new government swept into power in the UK, the mandate seemed clear: get out of debt fast. Now, it’s not so easy.

Belt-tightening is never easy. The UK government is finding that out today as it seeks to pull the British economy out of recession by paying down the highest peacetime public debt in history in just four years – a move which involves billions of pounds in spending cuts. Some are calling the move “draconian,” especially as it comes on the heels of an economic reality which is worse than the budget-drafters realised.

Data released recently by the Office for National Statistics make for gloomy reading: the economy contracted by 0.5 percent in the fourth quarter of 2010. What’s worse, the independent Office for Budget Responsibility was forced to revise downwards its growth forecast for this year from 2.1 percent to a mere 1.7 percent. Other data shows that unemployment remains a stubborn problem while consumer price inflation is escalating to levels last seen two years ago.

Given these numbers, the move to wipe out the deficit by 2015 (the timeline of one Parliament) seems a monumental task - or even a pipe dream. And many are questioning whether the human suffering – resulting from the combination of fewer jobs and higher prices – is worth it.

Will Hutton (MBA’ 79J), executive vice chair of The Work Foundation in the UK told INSEAD Knowledge that “the pace of lowering the structural deficit is the fastest in the OECD, bar Iceland and Ireland. Both countries are bust.” He calls the UK’s fiscal adjustment “completely unsustainable” and adds that “this is the most extraordinary act which is driven entirely by politics and not by economics. I think it may end in tears.”

Hutton could be right. In addition to £81 billion of cuts over four years, Whitehall announced a rise in standard-rated value added tax (VAT) on goods and services from 17.5 percent to 20 percent which kicked in at the beginning of the year leading to fears of a drop in consumer spending and more difficult trading conditions for small businesses in particular.

And while an increase in VAT adds money to the government coffers, it also adds to the rate of inflation – causing the UK consumer price index to jump to more than double the Bank of England’s target at the beginning of the year. Other factors cited by the BoE for the rise of inflation were the weakness of the pound and the boom in commodity prices driven in part by demand from emerging economies.

Is it any surprise that in the light of all this, the Bank of England’s governor, Mervyn King, is hinting that interest rates may have to rise soon, though the monetary policy committee members remain deeply divided as to how and when to act. While one member - Adam Posen - has been arguing consistently in favour of providing more stimulus via additional bond purchases, other members advocate tightening monetary policy as soon as possible. (The European Central Bank raised interest rates from 1 percent to 1.25 percent on 7 April.)

Hutton is not convinced that there is a need to raise interest rates. He says there is “no domestically generated inflation pressure … inflation is largely imported through rising commodity prices worldwide …[caused by demand from emerging economies such as China]…to make money more expensive because Asia has come to the economic table is a rather self-defeating thing to do”. The problem with tightening the money supply by raising interest rates is the timing: do it too soon and you risk dipping into another recession; too late and you face inflation. And this doesn’t even begin to address the question of how to stimulate economic growth.

The most passionate advocate of spending one’s way out of a crisis is, of course, the Nobel Laureate Joseph Stiglitz who has expressed his views in a number of articles and interviews to the British media. However, he doesn’t have many learned followers of his Keynesian theories in the UK at the moment.

Hutton says the solution is not just a question of rebuilding on the past; it’s about creating a new future.“ There is an emerging consensus that the country has to build an innovation and investment ecosystem to rebalance the economy away from financial services, construction, property, excessive reliance on retailing and distribution to value added activity across the knowledge domain,” he opines.

Whatever additional training and education are necessary for such moves will come at a much higher price. Another line item in the new UK budget increases annual tuition fees in England to a maximum £9000 starting in 2012. These are the things of which riots have already been made in the UK, and the passionate debate continues: It ranges from those who argue that the hike is the only way for the UK to remain a competitive player in higher education to those who fear that Britain will end up with a lost generation who can’t afford a place at the academic pantheon.

The job market is another cause for concern. The UK unemployment rate has been creeping up towards the eight percent mark and is expected to rise even higher once the spending cuts filter through completely. That’s not an ideal scenario when Chancellor George Osborne is trying to convince the British electorate that the private sector will compensate for the forthcoming loss of 490,000 jobs in the public sector as proposed in the austerity plan.

Hutton argues that this may have worked in the 1990s when the private sector in Britain generated over a million jobs of which 800,000 were in business services. “That’s not going to happen in the 2010s”. Why? “The public sector itself is providing jobs in business services as it contracts out. What remains is low margin [low salary and low ranking jobs, for instance] which the private sector doesn’t want to do very much.” He says that the kind of fast rebounds known after previous recessions are a thing of the past as the private sector is not as capable of generating substantial numbers of jobs, “I agree with Tyler Cowen who has written that book ‘The Great Stagnation.’ We actually don’t have any wave of new innovations that we can industrialise. That’s why we won’t have the kind of industrial level of employment and wealth generation which we had in the 40s, 50s and 60s”.

With long-term unemployment deteriorating, what is Hutton’s recommendation to stimulate the labour market? Move away from high redundancy payments and toward a system of livelihood insurance. He looks at the Nordic model of flexicurity which “acknowledges that people can do many jobs in their lives and transition from one to another. They can’t get huge pay outs every time they get unemployed. Instead, there should be an insurance where they can retain a good measure of their previous earnings but also can be retrained and reposition themselves in the labour market”.

Hutton comes to the conclusion that in this kind of environment the public sector has to play a role as an employer of last resort. “This is a bit like in the 1930s, with the New Deal and the Works Progress Administration, but that’s not what we see today. People are still locked in this paradigm that was built up from the 70s to the end of the last decade and the economics around it - which we know are inappropriate at best and downright wrong at worst.”

From the business perspective, Lebanese-born, internationally-educated and trained Samir Brikho, CEO of the UK based engineering services firm Amec [a graduate of the INSEAD Young Managers Programme in 1991] argues that the private sector has an important role to play when it comes to getting the economy back on track. “At the end of the day, business is going to be driving the growth in any country in the world”.

Brikho agrees that the UK needs to beef up the level of talent and skills in the country, which means continued investments in R&D and an increase in the levels and the degrees of innovation. But he warns that the government has to do more to maximise the opportunity to retain talent: “We attract good students. They get out of school with very high degrees but we are not able to keep them here. The government will have to think about this because we haven’t been doing the right thing. We need to see how we can foster skills locally and foster imported skills, keep them and help the industry grow.”

Brikho is upbeat about the UK’s medium to long-term prospects and draws comparisons with corporate business cycles. “When you are running a company you need to accept that before you get to growth you need to go to the bottom before you see the hockey stick again. I think that’s what we are seeing in the UK.”

Hutton is a bit more optimistic. “With the right policy mix and if the exchange rate remains as competitive as it is, I think, gradually, the UK economy will start to look stronger and stronger and of course the public finances will look more balanced”, says Hutton. ”In the short to medium term, a very depressing outlook, beyond that (there are) signs of potential green shoots”.

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