Economics: Is golden age tied to a lead balloon?

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The Independent Online
IT HAS become fashionable to argue that Britain is entering a new golden age of sustainable growth and low inflation. The 'boom- bust' cycle, in which growth has to be aborted as inflation surges and the trade gap widens, is being relegated to the history books.

This complacency is understandable after a year in which national output has grown twice as strongly as the City expected, but in which inflation has also been twice as subdued. Price wars are raging in the high street and pay settlements and earnings growth have yet to pick up, despite a big fall in unemployment.

Inflation may have behaved surprisingly well, but the balance of payments - the other potential constraint on growth - is moving in mysterious ways. If the economy has any nasty surprises in store for 1994, it is in the trade figures that they are most likely to appear.

So far there has been little to panic about. A year ago independent economists were expecting the current account deficit - the gap between exports and imports of goods and services - to exceed pounds 14bn in 1993. But in the first nine months of the year, the deficit totalled only pounds 6.6bn. In November's Budget, the Treasury forecast a pounds 9.5bn deficit for the full year, with no further deterioration in 1994.

But eyebrows have already been raised. The Ernst & Young Item Club, a group of independent economists, has run the Budget forecasts through the Treasury's own computer model of the economy and has discovered that the numbers do not add up.

Item argues, for example, that the Treasury's forecast of 4.25 per cent growth in export markets this year is inconsistent with its pessimistic forecast for the German economy, an important market for British goods. The Treasury may also be relying on an unrealistically rapid rise in overseas wage costs to make British goods more competitive relative to foreign ones.

As if forecasting was not difficult enough, we have to take the trade figures already published for 1993 with a bucketful of salt. Since the beginning of last year VAT returns have been used to calculate trade with other countries in the European Union, following the abolition of customs declarations in the single market.

As the graphic shows, this coincided with a remarkable and implausible divergence between the behaviour of imports from EU countries and those outside. Having moved in parallel since the beginning of 1988, import volumes from outside the EU rose sharply last year, while those from within supposedly dropped away. Given the revival in domestic spending that has come with economic recovery, the fall in the number of goods from the EU looks too good to be true.

Robert Lind and John Marsland, economists at UBS, believe imports from the EU have been dramatically underestimated. They suspect importers are trying to avoid paying VAT and are therefore under-recording goods they bring in from abroad. Another possibility is that the statisticians are still having difficulty distinguishing between changes in the quantity of goods imported and changes in their price.

The two economists calculate that the value of imports from within the EU would have been pounds 7.5bn higher in the first nine months of last year had the previous relationship with non-EU imports been maintained. This means the current account deficit for the first three quarters of 1993 would already have topped pounds 14bn. If the Central Statistical Office comes to the same conclusion, the financial markets will be in for a nasty surprise and the so-called golden age will look a good deal less durable than it does now.

A healthy international trading performance is crucial to the strength and sustainability of the recovery. Balance of payments deficits have to be paid for by an outflow of capital, running down the country's stock of assets and pushing it into debt. Eventually the markets might take fright and push the currency lower, forcing a rise in interest rates sufficient to stop growth dead in its tracks.

But it is far from clear when this balance of payments constraint would bite. The optimistic view is epitomised by Tim Congdon, one of the Chancellor's 'wise men', who argues that Britain resembles a risk-taking, active investor who has amassed a big portfolio of financial assets. The value of this portfolio is volatile and hard to measure precisely, like that of any wheeler-dealing investor. The value of the assets may also be under-recorded, because of the way the CSO treats capital gains.

Mr Congdon argues that countries can run current account deficits indefinitely as long as their citizens do not mind foreigners owning a large part of their capital stock. He points to the example of Singapore, which for more than 20 years ran a current account deficit averaging more than 10 per cent of national income, but enjoyed enviable financial stability. But would the markets give Britain the same benefit of the doubt?

A less sanguine view is taken by John McCombie and Anthony Thirlwall in a mammoth study of the relationship between economic growth and the balance of payments published last week. They argue, in the tradition of the great Cambridge economist Nicholas Kaldor, that the growth rate a country can sustain is determined by the growth of its exports and by its propensity to import goods as the income of its citizens rises.

They believe that by the 1980s Britain could only grow at about 1 per cent a year if the balance of payments deficit was to remain manageable - much too slow to keep unemployment down. To raise the sustainable growth rate to 2 per cent a year would require a continuous devaluation of the pound of 5 to 12 per cent a year, which would soon burn itself out in higher inflation.

McCombie and Thirlwall believe the balance of payments constraint may have loosened in the 1980s. Having fallen sharply through the 1970s and early 1980s, Britain's share of world trade in manufactures stabilised after 1988. The quality and reliability of British manufactured exports may have improved because industry was leaner and fitter after recession early in the decade.

A less charitable interpretation is that industry had been so battered by recession that sharply increased investment was needed to meet the demands of the unsustainable boom that followed. This in turn meant introducing more reliable and technically advanced products and production techniques. It is notable, however, that while UK manufacturers have stopped losing their share of world markets, they have failed to hold their ground against imports.

McCombie and Thirlwall argue that if the improvement in Britain's export performance since 1986 is maintained, growth of around 2 per cent a year may be sustainable. But even this is worryingly slow. The Treasury estimates that the economy's output is currently running between 3 and 7 per cent below its potential, and that potential output itself grows by between 2 and 2.5 per cent a year. This means the balance of payments constraint would not allow us to close the 'output gap' and may even see it widen.

In the short term this would be good news for inflation and bad news for unemployment and living standards. But in the long term the gap between potential and actual output would be closed, as potential output would begin to grow less quickly. The under-utilisation of capacity would discourage investment and damage productivity. A vicious circle would develop as slow technical progress hit the quality and reliability of British goods relative to those made overseas, further tightening the balance of payments constraint.

Britain's long-term balance of payments problem is still underestimated. When times are good, we spend more of any increase in income we receive on imports than most other countries. Even our exports need more imported components than those of most of our competitors. The growing importance of trade in services, which Britain is better at supplying than manufactures, is one point in our favour, but we still have a lot of work to do before we can enjoy an enduring golden age.

Economic Growth and the Balance of Payments Constraint, J McCombie and A Thirlwall, St Martin's Press, 1994.

Christopher Huhne is on holiday.

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