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Conservative Home op-ed – Avoiding recession as the world grapples with high debt

Apr 18, 2023

This was first published on Conservative Home – 18 April 2023

Downside risks dominate, but the economy could prove more resilient than expected as it did in 2022. Household consumption could be boosted by a stock of excess savings and tight labour markets. These comments were made last week by the International Monetary Fund’s (IMF) when it released its updated economic outlook. The IMF was talking about the global economy, but the very same comments could equally apply to the UK.

Since last autumn, the UK economy has defied expectations. The widely predicted recession has not materialised – or certainly not yet. Indeed, it was only last November that the Bank of England was saying that a recession had already begun and that it would last until the middle of 2024 and be the longest ever; effectively a two year-slump.

But even though we have avoided recession, inflation persists, the cost-of-living crisis has continued to bite and the UK economy remains flat. Last week’s release of the latest monthly GDP figures showed no growth in February and that, in the three months to February, the economy grew a small 0.1 per cent compared to the previous three months to November. At least the economy is now finally above its pre-pandemic level of February 2019, but only by 0.3 per cent.

According to the IMF, after being the fastest growing economy in the G7 last year (with four per cent growth), the UK will be the slowest this (contracting by 0.3 per cent). I think this forecast is too pessimistic. The IMF sees the four western European economies that are in the G7 all growing modestly next year: France 1.3 per cent, Germany 1.1 per cent, UK one per cent and Italy 0.8 per cent. Europe is seen as the weakest region of the world economy this year, with the US the slowest-growing region next year, in its election year.

The IMF’s forecasts are not always correct, but are reflective of consensus thinking, and its current projections highlight the difficult global climate we are in. It believes that global growth will have slowed from 3.4 per cent last year to 2.8 per cent this, before reaching three per cent next.

Anything around three per cent or less is very weak and would see parts of the world economy in recession. In fact, fears of a US recession are already gripping financial markets, both because of the tightening in monetary policy that has already been seen there, and because the recent banking crisis could trigger tougher lending conditions.

But across many economies, including the UK, the story is a similar one. People and firms are coping with the aftermath of the pandemic and inflation, while the need for policy normalisation means that there is little room for immediate policy manoeuvre.

Here in the UK, it can often be overlooked that many of the challenges we are facing are also seen across most other countries too. The key turning point was the 2008 global financial crisis. Since then, our growth and that of western economies has been subdued – giving rise to the focus on secular stagnation and low productivity. The US proved the exception, led by its tech sector.

Since 2008 we have also relied upon cheap money – with low policy rates and quantitative easing. The most significant current development across much of the globe – impacting economies and financial markets alike – is the ending of cheap money. The full effects of this will take some time to feed through, but already we have seen problems with the LDI pension fund crisis last autumn, the recent banking crisis in the US and now there is evidence of loans from China’s Belt Road initiative being written off or renegotiated by developing countries.

Also the IMF noted that in 2020, 77 per cent of countries loosened both monetary and fiscal policy, but by last year policy normalisation had led 74 per cent of countries to tighten both monetary and fiscal policy. There was much focus last week on the IMF’s view that, because the outlook is for weak global growth, we will soon return to low global policy rates. I think that would be a mistake, but much depends upon where inflation settles.

Equally important were the IMF’s forecasts for public debt. These demonstrate the difficult fiscal climate impacting a host of countries, not just the UK. The IMF noted that globally, gross debt had improved from 99.7 per cent of global GDP in 2020 to 92.1 per cent last year, but because of weak growth it would creep higher back to 99.6 per cent by 2028. Thus, globally, high public debt may be a constraint on future policy. As with the UK, many countries face the challenge to avoid falling into a debt trap where the ratio of debt keeps rising.

In the March Budget, the Office for Budget Responsibility (OBR) forecast the ratio of UK debt to GDP would exceed 100 per cent during fiscal year 2022-23, and be above or close to this figure for the next three fiscal years. The relationship between growth and interest rates becomes key.

Forecasters assume that UK inflation will return to its two per cent target. While inflation could undershoot this next year, there is every likelihood it may then settle above it in future years. A good future benchmark might be to assume inflation of around three per cent and growth around its 1.5 per cent trend. Then interest rates might need to be nearer 4.5 per cent.

The outlook for any economy depends upon the interaction between the economic fundamentals, confidence and policy. At the time of the Budget, the OBR assumed the UK would contract 0.4 per cent in the first quarter of this year. In contrast, latest data suggests the economy will have grown slightly during this period.

While the UK economy is proving resilient, the fundamentals are mixed. The biggest problem has been high inflation, but as it is set to fall over the next year there will be a recovery in people’s real incomes, which will thus boost consumption. The biggest positive has been the healthy jobs market, and that is despite the labour shortages faced by some sectors, with the unemployment rate at 3.7 per cent.

Meanwhile, the widely followed GfK measure of consumer confidence has recovered in recent months but remains low, with personal finances remaining a major drag. Confidence registered -36 in March and, while poor, this compares with -49 last September.

Encouragingly, business confidence is rebounding. Yesterday, for instance, Deloitte’s survey of chief financial officers jumped from a net -17 three months ago to 25, a large 42 point turnaround. For some time now, other surveys have shown firms more upbeat about their own situation, while expressing concern about the wider economy. Indeed, there has been a noticeable increase in firms reporting a recent increase in their business turnover in March – again consistent with economic recovery.

Monetary policy, having been far too loose previously, has now seen a much-needed tightening over the last year. But there is already a danger that monetary policy has tightened too much in recent months, as previous tightening has yet to feed through. Commentary on monetary policy often neglects its lag time.

In terms of fiscal policy, if the wider economic picture does not allow the debt to GDP ratio to fall, then the focus of the markets will be on the need to keep the public finances in shape. The trend seems to be for ever higher spending and taxes, particularly the further ahead one projects. Unless you raise economic growth – which involves pulling politically difficult policy levers – you must either continue raising taxes or be serious about reforming what the state does and how it does it.