Elisabeth Dellinger
The Global View

The UK’s Imaginary Growth Problem

By, 04/30/2013

The UK’s entrepreneurs, like Sir Richard Branson, have helped the country create an extraordinary amount of wealth over time—and there’s no reason they can’t keep going. Photo by Chris Jackson/Getty Images.

Good news: The UK economy grew 0.3% in Q1, avoiding the dreaded triple-dip recession!

Bad news: It was the wrong kind of growth.

At least, that's the sentiment underpinning much of the commentariat's reaction to last week's GDP numbers. Apparently, since the service sector drove growth, consumers did all the work, which isn’t real economic growth—real growth comes from manufacturing and exports.

I suppose I can't blame the punditry for this reaction—it's largely the government's fault. Since the coalition took office in 2010, policymakers have tried to engineer a shift from a services-based economy to a manufacturing-driven, export-led model. It's an odd aim, considering it U-turns from the typical economic progression from agriculture to manufacturing to services. Logically, I'd expect the progression to continue forward—commercial space travel! Lunar colonies! An extraterrestrial services-based economy! This is the future, people! But officials seemingly aren't looking forward—they're looking backward to 2008, when the financials-led downturn wiped £65.8 billion off real GDP, and they're trying to fight the last war. Make the UK economy less dependent on financial services and domestic demand and more dependent on something tangible, like manufacturing and exported goods—be more like Germany—and maybe you achieve more sustainable long-term growth.

Underpinning this effort is a faulty assumption—that the UK's domestic demand is no longer a viable source of growth. Or that the heady growth of the Thatcher, Major and Blair years was a mirage, propped up by cheap credit, and post-2008 consumers are forever tapped out no matter how much money the BoE prints. Clearly, were it otherwise, quantitative easing (QE) would have lifted the economy from the doldrums long ago.

No offense to anyone who shares the above view, but I'm rather tired of this argument. It assumes the UK economy is a fixed pie—that people and businesses can't create wealth and keep right on spending without going into unmanageable debt. I'm not talking about the mythological "wealth effect," which suggests folks spend more when they feel wealthier due to higher home prices, but actual wealth. Like when someone starts a business, creates a new product, taps a market for a good or service that never existed before, builds a brand, makes money, hires people, develops more new products and repeats the process again and again. As that business grows, its value grows, and the wealth of its investors grows. So does the wealth of its employees as they make more money and invest it in equally dynamic firms. And all that investment fuels more growth as businesses keep researching, innovating, creating, developing and selling new products and services. And implicit in this process is spending—not just consumer spending, as folks get more disposable cash, but business spending as firms contract various vendors and service providers who in turn grow, invest, hire and engage with other businesses.

As long as the private sector's free to compete and not bound by red tape and arcane regulations, this process can continue ad infinitum, making the country richer and richer. That's not a fixed pie—it's a living, breathing organism that grows and spawns new offshoots.

If the government stopped trying to engineer a shift backward—if it just got out of the way—I suspect the UK would have an economic renaissance.

Here's why. The cornerstone of the manufacturing-slash-export shift is a weaker pound, and policymakers' tool of choice is QE—having the BoE buy gilts from the banks to pull down interest rates and flood the economy with new, cheap money. Granted, most of that money's not circulating, but supply still outstrips demand, so the value's down. Problem is, that's not a net benefit. Exports may be cheaper on the global market, but imports are more expensive. With today's globalized supply chains, where firms import many of the raw materials or intermediate components they manufacture into final goods, pricier imports are a negative—they raise firms' production costs and often limit the amount of goods they can produce (generally, if something's more expensive and you have a fixed amount of money to spend at a given time, you have to buy less of it). Essentially, firms end up making less for more, and the higher costs and supply shortages often raise the final good's price, offsetting much of the benefit of the cheaper pound. Moreover, there are firms who sell primarily imported goods—but much of the profits remain in Britain. For them, weaker pound equals lower profits. How’s that for stimulus? Those who export more do not necessarily win.

Compounding matters, the weaker pound whacks consumers—they get less bang for their buck (err...quid). It also means the UK imports inflation—another whack. Consumers aren't struggling because they've hit an economic ceiling—they're hurt by price increases that outstrip wage increases. That's not a permanent structural issue—it's easily fixed.

In fact, somewhat higher inflation wouldn't much hurt spending if the economy were growing right along with it. But for that to happen to at a sustained faster pace, banks have to lend. But QE has the nasty side effect of flattening the yield curve—the difference between short and long rates—and, by extension, shrinking banks' net interest margins. So lending isn't too profitable. Plus, as officials try to prevent another 2008, they're declaring regulatory war on the industry they've deemed responsible—banking. Regulators have slapped banks with higher capital requirements, proprietary trading limitations and measures to “ring-fence” retail and investment banking, and they’ve suggested further changes are in the fore. So instead of assuming additional risk for a low potential profit by lending more, most banks have stood pat. Bank lending’s well under its March 2009 peak, and businesses can’t get the cash they need to invest and expand.

Small and medium firms are the most credit-starved in this environment—firms that likely would be spending and growing if they could get financing. If banks were free to support these firms, the UK would likely see a much faster expansion, workers would see higher salaries, and the economy would enter a virtuous cycle of private spending, investment and growth.

In short, the UK doesn’t have a permanent demand problem—it has a solvable political problem. The coalition has made a number of small moves to cut red tape and encourage private sector growth, but as long as policymakers are trying to engineer a certain kind of growth and regulators continue handicapping the banks, the economy likely can’t grow to its fullest potential. If officials would step back, allow businesses and banks to operate freely and capital to flow where it’s most needed, they’d likely get the growth they crave.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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