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  • Published in Analysis

U.S. Federal Reserve Chair Janet Yellen. Photographer: Andrew Harrer/Bloomberg

Two big announcements on economic policy are due this week - one from New York and one from Whitehall. James Meadway looks at how they will shape the future of this country

Two big announcements on economic policy, due this week, will shape the future of this country. One, the less important, is George Osborne’s Budget. This will occupy huge amounts of airtime here as it’s his last big chance to try and set the terrain of the debate for the election. There may also be a pre-election giveaway of some sort, in traditional style, although it’s unlikely to amount to much. Osborne will want to pull the argument towards grand abstractions like rising GDP, and keep away from a more meaningful conversation around living standards – which have fallen, in general, on his watch.

But nothing much will change from all this. Short of a Damascene conversion somewhere on Whitehall, Osborne won’t deviate from his austerity plans. The squeeze on public spending will continue. And unless that changes, the Budget will be something of a side-show with surprises reduced to a bare minimum.

The other, more important, is the outcome of the US’ Federal Reserve Board meeting. The Federal Reserve is the US’ central bank, charged with looking after the banking system – and therefore with a key role in setting economic policy. Its preferred lever, traditionally, is to try and set interest rates. Like the Bank of England, the Fed has spent the six years since the crash of 2008 holding interest rates as low as possible, and pushing the experiment of quantitative easing (QE) – creating new electronic money – on an astronomical scale.

The stated intention was to try and stoke up the US economy after the severe shock of the financial crisis. By keeping interest rates low, and flooding the system with new money, it was hoped that that the system could be kept moving. But since at least late 2013, it’s become clear that the economy is indeed stoked, at least to the satisfaction of the Federal Reserve. GDP is up and jobs are being created. The US stock market is at record highs. Normality seems to be returning, after a difficult period. And, if we’re back in normality, the six-year ban on interest rate rises will have to go.

This won’t mean immediate increases in interest rates. It may not amount to much more than dropping the Fed’s use of the word “patient” when describing its stance. Yellen has refused to be drawn before the meeting, but there is speculation that a rise may occur as early as June this year, assuming US job growth continues.

When the US sneezes, the rest of the world catches a cold

This may all seem quite extraordinarily nuanced. But there is a good reason for the tip-toeing. The US remains the world’s largest economy. What it does can turn, rapidly, into what everyone else has to put up with. Strikingly, the period of record low interest rates and quantitative easing – of ultra-loose monetary policy – seems to have made the rest of the world more sensitive, if anything. When previous Fed chair, Ben Bernanke, announced a “tapering” of QE, steadily reducing the amount of money being pumped in, month by month, it provoked turmoil across financial markets in the global South. Speculators had become used to ready access to cheap dollars, enabling them to buy up financial assets across emerging markets. Any tightening of the money market, with dollars becoming more expensive and more scarce, led to something of a panic.

Financial markets in the newer parts of the system tend to be more volatile than those in the old. The underlying economies are smaller and the currencies they use considered to have less intrinsic value. The result is that, whilst “hot” money can flow in when times are good, those flows of financing can reverse rapidly on little more than speculators’ whims. The most spectacular recent example of this reverse was the East Asian crisis that began in 1997, when changes in market sentiment about the so-called “Tiger” economies provoked a currency crisis that spiralled off into a massive crash.

Reductions in the US QE programme, beginning this time last year, provoked a miniature version of this across much of the world. Actual interest rate increases will produce a similar impact. And there’s one large, heavily –indebted, poorly-managed economy that could take a direct hit.

The UK’s current account deficit

As I’ve argued before, the UK’s current account deficit is becoming ominous. Will Hutton made the same point in last week’s Observer. This country has run a deficit on its trade in goods since 1983, and (as the graph below shows) the whole current account (goods trade, services trade, and then net income from abroad) has been in deficit for 15 years. This means that, year in and year out, we have collectively been sending more money abroad than those from abroad are sending here.

Until recently, the main culprit here has been the goods trade. With the loss of manufacturing here, the major shock occurring in the early 1980s, we have ended up importing much of what we buy from the rest of the world. The deficit on goods is quite spectacularly large: we imported nearly £120bn more than we exported over last year. This abyss has been somewhat bridged in the past by the trade in services (which remains positive) and earnings from the rest of the world. It was never quite enough to entirely close the gap, but it went some of the way to doing so.

The graph below shows this, with “trade”, in blue, including both goods and services and “income”, shown in red, representing the difference in earnings from abroad, and what those from abroad earn here – net income, in other words. (“Transfers” are mostly made up of our payments to the EU – politically controversial, but economically less interesting.)

What should be immediately apparent is that the whole current account (the black line) has worsened sharply in recent years. The culprit here, however, is not trade, which has remained in deficit throughout the entire period shown. It is income. Since the end of 2012, we have collectively been earning less on our investments in the rest of the world, than we have had to pay out here.

There is a particular difficulty with this. The current account deficit has to be paid – you can’t simply spend more in the rest of the world than you earn. You have to make good the difference. This can be done by either borrowing from the rest of the world, or selling assets to the rest of the world.

This is what the UK has done, in spectacular style, for decades. We have one of the largest external debts, relative to GDP, of any country on the planet, total liabilities coming to around 400% of GDP. And we have sold off assets here at an extraordinary rate, from prime London properties to Eurostar, the government’s remaining stake most recently sold to a Canadian investment company.

All this borrowing and selling, however, has come at a price. Interest must be paid on debts. And income from assets owned abroad must be paid to abroad. As a result, the income now going abroad is far higher than what those in the UK earn from their assets and lending in the rest of the world – which, given the UK’s huge stock of assets abroad (the legacy of Empire, as much as anything), is kind of impressive.

Why the Federal Reserve decision matters here

The current account deficit is now 6% of GDP, the highest since official records began in 1955. This still needs financing. For as long as assets here seem valuable, relative to those elsewhere, or borrowing is profitable, the flow of financing from the rest of the world can continue.

If, however, US interest rates rise, this flow may suddenly reverse. An increase in US interest rates would, other things being equal, imply that lending there would be much more attractive than here. The US is massive, safe economy. With investors globally still scrabbling around for safe assets, the US could suddenly appear far more attractive. Flows would redirect themselves there; and it is worth noting that, unlike the boom years of the 2000s, capital flows have slumped - by nearly 60% according to McKinsey. There is simply far less internationally mobile capital around, and economies have to work far harder to attract it.

Should this pressure on the UK emerge, two things can happen. The first is that the pound slumps, rapidly, in value. With UK assets and lending less attractive, and flows drying up, demand for the pound sterling will drop off, causing a fall in its exchange rate. This could have the perverse effect of reinforcing the unattractiveness of UK assets, since being paid in pounds from holdings in the UK will now mean earning less for those in the rest of the world. And there are direct inflationary consequences from the falling value of the pound, with imports becoming more expensive.

To prevent this, the Bank of England will have to push up interest rates, too. But this will immediately squeeze millions of mortgage holders, with about two-thirds of mortgages on a variable rate – attached to the Bank of England rate. A good fifth to a half of mortgage holders would “struggle” with even a small base rate increase, up to 2%. It’s possible the Bank of England could pre-empt the Fed with its own rate rise, but it seems unlikely to move whilst deflation is still threatened. Its own forecasts do not expect a domestic rise before the end of the year at the earliest.

This is an unenviable choice, between a spiralling international imbalance, or trashing the domestic economy. It is one that may appear – if the US hawks are correct – as early as June this year, shortly after the election. Of course, the Board of the Federal Reserve will (we assume) take this into consideration. A June rise is still unlikely and, if it does occur, will be only very gradual. But it illustrates the sensitivity of our reportedly robust economy to external factors.

Looking ahead

So what to do about it? The macroeconomics suggests three solutions. One of them is unpalatable. One of them will only work very slowly, if at all. And one of them will mean shaking up our economic structure.

The first is, as Chris Dillow says, a massive increase in austerity. The current account deficit, by definition, is equal to the gap between savings and investment domestically. Austerity implies a reduction in spending, and therefore an increase in savings. Dramatically increased austerity should, after a while, lead to a closing current account deficit.

The second is to allow the falling exchange rate to reduce the price of UK exports, and increase the price of imports. This should lead to a reduction in the trade deficit, as we sell more abroad and buy less from abroad. But this adjustment only takes place very slowly. And, whilst the trade deficit is a chronic problem, the immediate issue is the deficit on incomes.

Note that both of these imply a reduction in domestic living standards – for a long period, in the case of increased austerity, or at temporarily, with an adjustment on exchange rates. The only option that mitigates this is to tackle the income deficit head on. This could happen automatically: one reason those in the rest of the world are happy to buy assets here is that there are fewer investment opportunities in their own countries. So if the recovery picks up globally, specifically in Europe, that can change. But without an automatic adjustment, we will need to become far less free and easy with the disposal of assets to the rest of the world: fewer empty London apartments owned by oligarchs, to be blunt. Mansion taxes and more active taxation of empty properties could move towards this. Clamping down on avoidance and closing some of the more glaring loopholes around property would be a further step. Renationalisation of utilities and infrastructure, and the promotion of wider forms of domestic ownership, like co-operatives, would be another.

There’d still be a need for adjustment – the exchange rate needs to come down and the current account deficit needs to close. But domestic savings could be boosted with more effective taxation of the wealthy, and domestic incomes protected from the falling exchange rate if domestic investment was directed into creating better-paid work. A nationally-enforced Living Wage would help.

Adjustment, at some point, will happen. It will either be the result of a deliberate plan, or it will be forced on us. A decision by bankers in New York may have a far wider impact than any amount of posturing by politicians in London.

Tagged under: Austerity Economics Crisis
James Meadway

James Meadway

Radical economist James Meadway has been an important critic of austerity economics and at the forefront of efforts to promulgate an alternative. James is co-author of Crisis in the Eurozone (2012) and Marx for Today (2014).

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