Imbalance in the economy

Iwas quite shocked to hear last week that Treasury officials have been expressing concern about how to control 'the boom'. Certainly, recent economic data have been indicating that output has started to recover during the current quarter following about a year of flat activity. And of course it is perfectly understandable that the Government is eager to avoid a repeat of the second half of the 1980s, when a sudden burst of excessive activity undid much earlier good work. But a boom, now? As David Blake of the European has remarked, this is a particularly bad case of the 'Been down so long this feels like up to me' syndrome.

Another thing is worrying me. The Chancellor has said, apparently with some satisfaction, that he has no intention of changing interest rates for some time, since these are 'consistent with recovery'. But what sort of recovery?

If we consult the Treasury forecast, we find that overall GDP is expected to rise by 3 per cent between the first halves of 1993 and 1994, apparently a respectable figure. But a little-noticed fact is that this growth rate in the official forecast is to a large extent due simply to a rise in the output of North Sea oil. Excluding the impact of oil, the growth rate in the rest of the economy is expected to be only 2.3 per cent over the next 12 months.

This is roughly in line with the long-run growth rate in the potential output of the UK economy, so the Treasury is officially expecting that there will be no rise in output relative to potential until mid-1994 at the earliest. Many economists would argue that this means no genuine 'recovery' until then. It certainly implies no improvement in unemployment. So the question arises: why is the Chancellor satisfied with such a muted recovery after such a deep recession? Surely he should be seeking something faster?

The official reason, if there is one, for government concern about the speed of recovery is that inflation might pick up if policy is loosened too much. However, Treasury officials accepted in oral evidence given to the Select Committee last Wednesday that the gap between actual and potential output is rather large at present; indeed they quoted, apparently without dissent, the view of the Independent Forecasting Panel, which estimates the output gap at somewhere between 3 and 7 per cent of GDP. If this is true, any threat from inflation must surely be rather remote.

This suggests that a stronger recovery than the Government is planning is desirable. But here is the rub - it must be of a particular sort. One way of illustrating this is to examine the graph, which shows the financial balances of the three broad groupings that together comprise the whole economy - the public, private and foreign trade sectors respectively. These financial balances measure the difference between income and expenditure of the sectors concerned and, because one sector's income is another's expenditure, the three balances must by definition add up to zero.

It is clear from the graph that it is perfectly normal for the private sector to run a financial surplus, while the public sector runs a deficit. The trade position is determined by relative sizes of these two imbalances. If the private surplus is larger than the public deficit, then the trade account is in surplus and vice versa.

There are two aspects of the present situation that are out of the ordinary. First, the private sector is running a particularly large financial surplus, in excess of 6 per cent of GDP. Although there have been surpluses of this size in the past, this has only occurred when inflation was running at double-digit rates from 1975-81. In those years, rapid inflation was eroding the real value of private savings, and this induced companies and individuals to attempt to replenish their savings by running large financial surpluses.

With underlying inflation now only 3 per cent, the private sector's present financial surplus is extremely large. Why is this? Almost certainly, it is because the private sector has been curtailing expenditure to pay off debt. Excessive debt has replaced high inflation as the special factor that has caused such abnormal financial behaviour by the private sector.

To a very large extent, the public-sector deficit is simply the mirror image of the private-sector surplus. The graph shows with sublime clarity that large swings in the private sector's financial behaviour are the main driving force behind changes in the public deficit. However, as we have seen, there is another sector of the economy - the foreign sector - that prevents there being a simple one-to-one relationship between the private and public financial balances. And here we reach the second way in which the current situation is unusual. Considering the size of the private sector's surplus, it is aberrant for the trade balance to be in large deficit.

CRUCIAL IMPLICATIONS

This has crucial implications for the future. On all past performance, the economy is unlikely to recover unless the private sector's surplus begins to decline. In fact, it is reasonable to suppose that it might one day decline from the present 6 per cent of GDP to about 2 per cent, which is where it stood on average in the low-inflation period before 1973. If the whole of this decline were to be reflected in an improvement in the public-sector deficit, with none of it leaking into the trade deficit, then the public deficit would automatically improve from 8 per cent of GDP to about 4 per cent. But even that would still not be enough to produce an acceptable out-turn for the government accounts over the medium term.

Furthermore, this may be a touch optimistic. In the past, a decline in the private-sector surplus has generally leaked partly into a worsening in the balance of payments. Assume that half of the decline in the private surplus leaks into the balance of payments, with the remainder being reflected in a narrowing of the public deficit. Under these circumstances, the trade deficit would rise from 2 per cent of GDP to 4 per cent, and the public deficit would narrow only from 8 per cent of GDP to 6 per cent - an entirely unacceptable out-turn for both the trade and budget deficits.

Policy therefore needs to do two things simultaneously. It must encourage a decline in the private surplus in order to achieve an acceptable recovery in activity. Low interest rates will be needed to achieve this. Policy also needs to ensure that none of this leaks into a worsening in the trade position. If possible, the trade deficit should be encouraged to improve as the economy recovers, so that the public deficit can fall faster than the private surplus drops. The way to maximise the chance of this happening is to keep the exchange rate competitive while simultaneously raising taxes (or cutting public spending).

Each of these policy strands is now quite properly represented in the Government's current strategy. Nevertheless, the Treasury forecast says that the extent of the 'recovery' will be insufficient to bring unemployment down. If this forecast is right, then surely it implies that a further rebalancing of policy - lower base rates and higher taxes - is still required.

(Graph omitted)