The menace of the trade gap

IT HAS been amusing to watch the new Chancellor, whose native tongue is far from econospeak, coming to terms with his Treasury briefing in the past fortnight. There is little doubt, from everything Mr Clarke has said so far, that his briefing papers have been dominated by the budget deficit. The Chancellor has described this as an 'iceberg' in the way of the economic recovery.

The Treasury is pressing hard for significant savings in social security, but even Mrs Thatcher, armed with a Parliamentary majority of over 140, failed to make significant reforms to the welfare state a decade ago. Quite why anyone expects the present government to do more is beyond my comprehension. Nevertheless, we will hear a great deal this summer about spending hairshirts, starting with the Mansion House speech this week.

This will be a tricky occasion for Mr Clarke. Naturally, he is keen to stamp his own personal imprint on economic policy as quickly as possible, but his room for manoeuvre is heavily circumscribed. The post-ERM framework for monetary policy set out last autumn is too recent a development to allow major changes to be made. Nor can the Chancellor risk tinkering with the 'form of words' on sterling in the current political climate.

This leaves the possibility of amending the 1-4 per cent inflation target, perhaps by adding to it an unemployment or real GDP objective. The official line continues to be that demand management should be concerned only with the control of inflation, and this long-standing approach would change only over the dead bodies of some senior officials.

One day, Mr Clarke could make such changes - they would appear to be consistent with his general philosophy - but it would be an unusual Chancellor who made such a fundamental switch in strategy against official advice so early in his term. So, almost by default, public spending will be the main topic of the Mansion House speech.

It will be very interesting though to see whether the Chancellor spends much time talking about the trade deficit. It remains most unclear whether the Treasury has a strategy for reducing the trade deficit over the medium term, and if so what this may be.

For the moment, the problem seems a little less threatening than expected. I was struck last Friday by the relative lack of concern in the financial markets before the publication of the first-quarter trade statistics, which had been delayed by the introduction of the Single European Market in January. A sterling crisis was definitely not, it seemed, looming.

In the event, the trade figures showed the deficit running at pounds 1.5bn a month, or 2.7 per cent of GDP. This was one of those occasions, puzzling to many outside the City, when an obviously 'bad' figure was actually taken as quite reassuring by the markets, which had been braced for something worse. Since the sterling devaluation last autumn, export volume has jumped by 4.3 per cent, despite the recession in continental Europe, and this has cushioned the trade account from the impact of much higher import prices as the devaluation has fed through.

Most of this gain in export volume happened late last year; more recently, exporters have been raising prices to rebuild their profit margins. Nevertheless, trade prospects for the next few months do not look too bad, since the helpful effects of the devaluation on trade volumes should continue to build up, while the adverse effects on import prices should now be fully reflected in the figures. Sterling should therefore continue to trade quite comfortably.

But what about the longer term? The trend deterioration in the trade figures has been quite remorseless for several decades, and there is no real reason for thinking that it has ended (though it does now seem to be happening mainly via import penetration, with exports holding their own in world markets).

If the exchange rate remains at anywhere near its present level, and the economy enjoys a normal recovery in domestic demand, then sooner or later the trade performance will deteriorate markedly. These things are subject to huge uncertainty, but several models suggest that a continuous period of GDP growth at 3 per cent per annum would produce a doubling in the trade deficit to 5-6 per cent of GDP by the end of this Parliament.

Probably the single most difficult strategic question facing Mr Clarke is whether this deficit can be comfortably financed. As the graph shows, Britain no longer has a healthy 'nest egg' of foreign assets on which to draw - the overseas assets built up during the era of large oil surpluses has already been used to finance the trade deficits of recent years. The path for the trade figures outlined above would require the UK to build up net overseas liabilities equivalent to about 20 per cent of GDP in the next five years.

Therefore, the key question is whether the rest of the world will wish to acquire assets in the UK to this extent. Of course, this will not be determined collectively, but will depend on the separate decisions of millions of individual economic agents. It has always been argued by those who believe that the trade deficit is irrelevant that, as long as all this is left in the hands of the private sector, the process of financing the deficit is automatic.

What they mean by this is the following. In order to produce a trade deficit in the first place, people or firms domiciled in the UK must be buying more goods from overseas than they are selling there, and they must simultaneously be financing their purchases by overseas borrowing. Otherwise they could not afford to buy the extra goods in the first place. Thus, the argument runs, the trade deficit could not exist unless foreigners were willing to finance it in advance.

This may be logically true, but it does not in my view imply that the trade deficit is a matter of no concern. Foreigners will only be willing to accumulate sterling-denominated assets if they believe that the returns on these assets will be attractive.

They are likely to believe this in two circumstances. First, as long as economic growth in the UK remains robust, there will probably be domestic assets capable of generating attractive returns, measured in sterling. Second, as long as inflation here remains low, foreigners will feel secure that these returns will not be subject to currency depreciation. Consequently, in a high-growth, low- inflation environment, no financing problem should arise.

But as soon as growth falters, or inflation threatens to rise, the existence of a large trade deficit becomes menacing for the economy. Quite suddenly, the flow of foreigners willing to acquire UK assets, and lend to British citizens, can dry up. Sterling will then fall sharply, forcing interest rates up. Or the sudden unavailability of foreign lending will lead to severe dislocation as domestic spending has to be curtailed. Either way, the correction of the trade deficit involves a recession.

In other words, any attempt to 'finance' a chronic trade deficit will eventually end in tears. The objective of a broadly balanced trade account has been ignored for too long by the Treasury, and a new Chancellor hailing from the manufacturing workshop of England is hopefully the man to end this neglect.

(Graph omitted)