What Will the UK Look Like: The Extremely Dismal Scenario

Image Source: Clay Bennett's "The Rescue Plan" in Chattanooga Times Free Press

The United Kingdom, also known as the sick man of Europe, has a strong reputation for all the wrong reasons: we have slow productivity growth, even slower population growth after Brexit, and an over-financialised economy - all of which are stunting the country's full potential.

All of these are not new issues, however, they have been ones which have been brewing over a long period of time. One can say that an array of the UK’s problems first manifested during the 1980s episode of stagflation. The tight monetary policy of the Thatcher years paired with poor industrial policy had sowed the seeds for the collapse of an already dwindling manufacturing sector. With this, we saw the UK economy move towards finance. London quickly became the financial capital of the world, which many saw as a new age of specialisation for the UK economy. However, a not-so-bright aspect of the UK’s new specialisation has been exposed after the 2008 financial crisis, since UK productivity growth has now lagged behind that of previous trends. Such an outcome can be attributed to three factors, namely insufficient demand (partly due to austerity), poor labour markets, and a lack of investment.

Yet, all of these may be exemplified by the over-financialisation of the British economy. During 2007, the asset-to-GDP ratio of the UK’s financial sector reached 500%, compared to 50% during the ‘70s. This financial behemoth centred primarily in London has many detrimental effects on the UK economy. The first is a within-border brain drain effect. With 1.1 million people working within the financial sector, many of these talented individuals could have worked in other fields that contribute more to UK productivity.

Second is the impact that the financial sector has on investment. Of course, the financial sector does facilitate investment by allowing for services such as the provision of loans. Does this mean that a larger financial sector would yield greater investment as loans would become more plentiful and cheaper? No, UK investment has not grown with the financial sector and is still below the pre-2008 trend. The financial sector has become too large given the size of the economy. This is getting to the point where the financial sector is becoming self-serving, and, with this, short-term behaviour rules, financial innovation occurs, and loans for real investment are pushed aside. As such, the UK’s long-term productivity prospects remain dismal.

Moving onto population and demographics, we see that the UK’s population growth has seen a decrease since Brexit. In itself, this is not the biggest of my worries. The concerns of this article lie with the UK’s ageing population and, particularly, how such a change in demographics will impact the UK’s public finances. The innovations in modern medicine mean that we can now all live longer, and (hopefully) more fulfilling lives. Many would say that such an outcome would be rather beneficial, however, I remind you that this article is written by someone studying economics - a subject with a reputation for being rather cynical.

We must be aware of the trade-offs occurring with an ageing population; the one which I choose to focus on is that of increased dependency ratios. In short, as the population ages, the demand for services such as state pensions, healthcare, and other UK-exclusive benefits such as the winter fuel allowance will increase. This means that there will be greater pressure on the government to spend more to support these services. Yet, to balance the budget, the government is equally forced to increase taxes, whilst also changing them to tax younger (and probably more productive) workers.

While this may seem like a very sufficient solution to a potential setback, I still have my reservations. First, it is bold to assume that tax increases for younger individuals will be an easy political move to pass. Second, an ageing population brings lower productivity and innovation, all of which slow economic growth - a necessity for a stable debt-to-GDP ratio. Third, it is unlikely that the UK government will be able to balance its budget completely. Historically, the UK has rarely run a budget surplus for a significant period. With an ageing population, this means that we will likely continue such a trend of consistently running deficits. As such, I say that the UK’s debt-to-GDP ratio and overall public debt will likely continue to increase, a trend that is congruent with the experiences of other advanced economies such as Japan or Italy.

With the UK being a monetarily sovereign nation that can create its own money through QE to repay bonds, swelling public debt is not a pressing issue: the government is a monopoly issuer of its own domestic currency and as such, it cannot ‘run out’ of its own money. That being said, this is only the case if the percentage of bonds owed in foreign currency stays low. This is currently the situation that the UK finds itself in, however, with a current account deficit, the UK acts as a ‘net borrower’ to the rest of the world, since a current account deficit forces a capital account surplus. This means that over the long run, the UK will see increasing foreign ownership of bonds and as such, this may create severe debt sustainability risks similar to that of Argentina in the future as a balance of payments crisis occurs.

All of this poses a grim outlook for the UK economy, but there is a way out.

Proper industrial policy is necessary, and the UK’s priority should like in balancing our current account deficit to ensure that debt sustainability risks do not arise in the long run. Fortunately, recent government policy is attempting to divert resources towards new specialisations such as green technology, which, the UK will be able to export. Perhaps it will be possible to avoid this dismal scenario. Ultimately, it is one that should be feared.