The Recovery – 5 Reasons to be Cautious
Yesterday’s PMI was good news for the UK economy. As Markit (the compiler of the PMIs – which are monthly surveys of business purchasing managers) put it:
Business activity grew at the fastest pace for just over two years in June, according to the UK all-sector PMI, fueled by the strongest inflow of new business for almost six years. In an increasingly broad-based economic upturn, surging growth in the service sector accompanied a resurgent manufacturing sector and modest growth in the construction sector. Overall job creation hit the highest since October 2007 as companies responded to the brighter outlook.
It certainly appears that new Bank of England Governor has good timing – he is taking up the reins at Threadneedle Street just as the economy appears to be picking up.
Indeed, based on the PMI data it now looks like Q2 GDP could come in around +0.5%, following the +0.3% in the first quarter. To give context to that, the OBR forecast for the full year of 2013 is currently just +0.6%, if the UK does achieve +0.8% in the first half then obviously that forecast will have to be revised upwards.
On the face of it then this is good news. The economy is (finally!) showing signs of recovery and rather than OBR forecasts being overly optimistic they may finally have been proved too pessimistic.
After years of bad economic news there is an obvious temptation to leap on any better news but I feel the need to pour a little cold water on the talk of ‘recovery’. If Britain really is about to return to the economic party, then I feel the need to cast myself in the role of ‘Des’, the designated driver, by remaining sober and pointing out some of the excessive exuberance.
I’d argue there are five important reasons to guard against complacency.
First, the pace of the current recovery is nothing to get excited about. +0.5% growth in the Q2 would be an annualised 2%, that may feel good in comparison to recent years but in the decade before 2008 annual GDP growth average around 3.2%. In terms of recent historical experience, 2% would not be a strong result.
In reality, as an economy recovers from recession one would expect growth to be faster as lost output is made up, we should be looking (at this stage in the recovery) at growth much closer to 3.5% than 2.0%.
This is what I have been calling for much of the last two years the ‘soft bigotry of low growth expectations’ or, more simply put, the problem that expectations are so low that any growth is seen as the bar for success.
In reality growth of 2.0% would not be enough. Back in 2010, the OBR expected growth of 2.9% in 2013 and even that was seen at the time as poor performance for an economy recovering from a deep recession.
Second, the size of the hole we are in is very deep. Output remains some 3.9% below its pre-recession level. Even if we managed growth of 2% in 2013 and 104 that would mean GDP was no higher in late 2014 than it was in early 2008. The recovery that was underway in late 2009/2010 was choked off and just restarting it can’t be seen as a major success.
Given population growth, the picture in terms of GDP per capita is even worse. Whilst output may have returned to pre-recession levels by 2014, we face a lost decade of national income per head.
Third, there is the very important question of – what is recovering? Output may be picking up by household income certainly isn’t. We are in the longest real wage squeeze since the 1870s with price rises outpacing wage gains for 40 consecutive months. Real median wages are unlikely to return to pre-recession levels until the early 2020s.
It feels odd to talk about a ‘recovery’ gaining pace even as households become poorer. This is, yet again, an unprecedented situation in modern economic history.
Fourth, there are big question marks hanging over the composition of any growth. Since early 2009 we have been told by politicians of all parties and economists of all ideological persuasions that the UK economy needs to ‘rebalance’. We need growth more driven by exports and business investment and less by household consumption. Growth that is more widely spread across sectors and less concentrated in the South East pocket of the UK.
Well, however you cut the most recent data this is simply not happening. Business investment remains weak, there has been no boom in net trade, the recovery is led by the service sector.
This is hardly a surprise as the most recent OBR forecasts make clear that the government has quietly dropped hopes of a near term rebalancing in favour of what could be called the ‘old economic model’.
Obviously any growth is better than no growth, but surely the composition of that growth matters?
Finally, there is another important question – how sustainable is the recovery? Last quarter growth was underpinned by rising household consumption, consumer spending that was not matched by income growth. Instead this rising spending was propped up by a falling household savings ratio.
Lenders reported that the availability of unsecured credit to households also rose in 2013 Q2, with a significant further increase anticipated in Q3.
Real wages are falling but unsecured lending is on the rise. I warned last year that I could see three potential scenarios for GDP growth in the medium term (in the absence of policy change):
So I foresee three possible scenarios for the UK economy in the next three or four years (in the absence of rapid rebalancing towards a net trade or investment led recovery and in the absence of a change in fiscal or monetary policy):
- First, and most preferable but most unlikely, we get strong growth in real incomes as inflation falls back towards 2% and wage growth increases. If that happens consumption growth will be stronger and the economy will grow at a decent pace.
- Second, and what I think is the most likely outcome – my central ‘forecast’ if you will – household income growth will be weak and the savings ratio will not drop by much. The result will be weak consumption growth and an economy that is growing, but growing slowly – in the order of 1-1.5% a year. In historical terms of recovery from recession this is pretty much a disaster.
- Third, it is possible that we still get weak income growth but that the savings ratio drops rapidly. In this scenario we’d see faster consumption growth and hence faster overall growth. This however would be accompanied by a big increase in household debt. It might give us 3 – 4 years of decent growth, but at the risk of increasing the financial imbalances that got us into trouble in the first place.
I hope for the first outcome, expect the second and worry about the third.
There are worrying signs that the UK is stumbling down the third path – faster growth in the short run but stocking up potential problems for the future.
The slowness with which Japan’s economy deteriorated was in itself a source of much confusion. Because the depression crept up on the country, there was never a moment at which the public clamoured for the government to do something dramatic. Because Japan’s economic engine gradually lost power rather than coming to a screeching halt, the government itself consistently defined success down, regarding the economy’s continuing growth as a vindication of its policies even though that growth was well short of what could and should have been achieved. And at the same time, both Japanese and foreign analysts tended to assume that because the economy grew so slowly for so long, it couldn’t grow any faster.
So Japan’s economic policies were marked by an odd combination of smugness and fatalism – and by a noticeable unwillingness to think hard about how things could have gone so wrong. (My emphasis)
We appear to following the same course.