Wise men and the deficit

I make no apology for returning this week to the familiar subject of the trade deficit, since it is all that jeopardises the sustained economic recovery the Chancellor promises us.

Forget the theme songs of the gloomsters - the recovery is not going to stall, inflation is not going to run away with itself, the world's financial markets are not going to collapse. But the trade deficit might just cause problems, so for the moment it should be centre stage.

A few weeks back, this column focused mainly on supposed inaccuracies in the trade statistics, which some analysts claim to be serious. The government statisticians recently completed a study of this problem, and pronounced themselves broadly satisfied with their data. But they are probably too complacent.

I reiterate my previous conclusion - albeit reached after a certain amount of sticking wet fingers in the air - which was that the trade figures were indeed flattering to the genuine situation, but only by a trivial pounds 3bn or so.

Properly measured, the trade deficit last year was about 2 per cent of national income, and it usually tends to grow during economic upswings.

This leaves it in a twilight zone - too large to be lightly dismissed, but not large enough to imply an inevitable early crisis. Hence the debate on whether anything should be done to correct it.

Perhaps the leading protagonists on either side of the argument are Wynne Godley and Tim Congdon, two of my colleagues on the Treasury Forecasting Panel. At the panel's recent series of meetings, we did our best to hammer out a common framework that could at least elucidate why the two sides differ, even if we could not hope that the disagreement would actually be reconciled. (This, incidentally, is the kind of unspectacular but useful work that the panel should do, though even this is proving harder than one might think.)

Professor Godley's key point is that the deterioration in the UK's trade deficit has been inexorable for several decades, and has forced Britain to endure not only a series of inflationary devaluations, but also a growth rate much lower than the average for the developed economies, with a consequential rise in unemployment.

He points out that recent current account deficits have been financed at the expense of eliminating almost all of Britain's external assets built up during the oil years.

Britain will soon become a net debtor to foreigners, and when that happens a logical result follows. Essentially, we will start to pay interest on the debt, and sooner or later we will need to earn a surplus on the rest of the current account of the balance of payments to offset the interest outflow. If we do not do this, debt will simply continue to rise in an unsustainable manner.

And the longer we wait to correct the situation, the more debt we will have to service and the greater the eventual adjustment will need to be. The implication is: make the adjustment now, get back into surplus quickly.

As far as I am aware, no one disputes the logic of the debt arithmetic behind Prof Godley's thinking.

But almost everyone else on the panel took the view that his conclusions were too apocalyptic, and concluded that the trade deficit does not, for the moment, constitute much of a threat to the recovery.

The optimists, led by Tim Congdon but with some support from most others on the panel, make two main points in reply to Prof Godley. First, they point out that Britain has almost no foreign debt, so that a trade deficit of the present size can be run for many years before debt interest payments become at all significant.

This gives us plenty of leeway to see whether the long-term effects of the 1992 devaluation, and the eventual recovery in our European export markets, will cure the trade problem without further policy action.

Second, the optimists claim that the trade deficit is entirely a private sector phenomenon, and say that it is none of the Government's business to interfere with the free market decisions of individuals and companies.

This point follows from the obvious, but sometimes forgotten, truth that a build-up in foreign debt must have, as its domestic counterpart, a rise in the debt of the private or public sector.

Provided that public sector sector debt is in a sustainable position - which it is, after the 1993 budgets - then any rise in foreign debt must be driven by the private sector.

And, say the optimists, the private sector is perfectly capable of looking after itself. If foreigners are willing to lend to British residents, they must be expecting to be repaid.

This means that they will actively monitor what the UK private sector is up to: they will lend only if British borrowers have an acceptable balance sheet, and can be expected to service their interest payments in the future.

External debt may rise for some time, but it will automatically be brought under control if it threatens to rise unsustainably. Trade deficits will therefore also correct themselves autonomously.

In my view, though, the problem with these arguments is that private sector debt markets cannot be relied upon to make all these adjustments smoothly. Private debt markets are subject to periodic bursts of excess optimism, during which both borrowers and lenders lose any sense of caution.

It may well be that the lenders expect their loans to be comfortably serviced, based on their assessments of the future income of the borrower, but sometimes they can be proved very wrong indeed.

When they are proved wrong, the subsequent adjustment can be sudden and painful, as we discovered in 1990-91.

I therefore have no doubt whatsoever that the borrowing behaviour of the private sector - and therefore the trade deficit - is a legitimate matter of government concern.

But this begs the question how the Government is going to know any better than the private sector when an unsustainable debt explosion is taking place.

After all, politicians and civil servants are not immune from the same irrational swings in sentiment that plague the private debt markets (as was amply demonstrated from 1986-89). When the private sector is indulging in a debt binge, the public sector is usually given to talk of economic miracles and the like, which encourages private sector errors rather than the opposite.

This is a real problem, and it of course applies to any activist government economic policy. But there is no need for total despair, since there are certain symptoms that can objectively be used by the Government as warning signals.

For example, if a build-up in external debt is accompanied by domestic consumption rather than investment - as at present - there may be cause for concern. Another reason to worry would be if the private sector were rapidly increasing its short-term liabilities, as it is right now. A build-up of short-term debt to pay for excess consumption will almost certainly prove unsustainable sooner or later, and this will trigger a painful adjustment.

This is why the present trade deficit, though privately induced and financed, is a subject for real concern.

(Graph omitted)