The UK economy: Despite remarkable performances, several challenges lie ahead

UK is the first economic partner of many Euroland countries. On many aspects, it can be seen as a model, but it is facing several challenges.

The success of the UK economy is too well known to be described in detail here. Two of the most commonly highlighted strengths – strong growth and low unemployment –illustrate the UK’s capacity not only to adapt and more importantly, to seize the opportunities created by globalisation. Even so, there are still a number of key issues that the government must tackle. Without trying to be exhaustive, we can cite a few examples: lagging productivity, insufficient labour mobilisation among the unskilled population, structural foreign trade deficits, and a household financial situation undermined by massive debt. Services and a few high-tech industries fuel strong, steady growth UK growth has averaged 2.8% a year since the mid 1990s, which is 0.7 points higher than in the previous 25 years. This performance places the UK just behind the US and Canada (about 3.2%), but well ahead of France (2%), Italy and Germany (1.5%). The UK has also broken with the “stop and go” pattern of previous cycles: the volatility of growth, as measured by the standard deviation, is limited to 0.53 (1995-2006) vs 2.27 in the 25 previous years, which is much lower than the figure for fast-growing countries (1.15 in the United States and 1.22 in Canada) as well as for countries with more moderate growth (1.08 in Germany and 1.18 in Italy). This regularity reflects an economy dominated by services, where growth is less jagged than in manufacturing, and tends to be strengthening. Yet the stability of demand has generally been fuelled by consumption. In contrast, the contribution of foreign trade has been very erratic and more often than not negative over the past ten years. The recurrent vigour of consumption is naturally due to the increase in real disposable revenues, fuelled by both job creations and real wages, which have risen significantly faster than in many continental European countries. The purchasing power of weekly wages has increased 1.7% a year since the beginning of the decade, even though this trend has tended to slow in the past three years (0.7% a year). Even so, job creations are still going strong (1.1% a year in 2003-06). The unemployment rate did pick up slightly recently, from 4.7% in 2004 and 2005 to 5.4% last year, where it has held ever since, but this is largely due to the rebound in the activity rate (active population/working age population), which rose from 76.2% to 76.7% during the same period. In any case, it is one of the lowest rates in the OECD. Furthermore, the composition of unemployment has changed: there has been a sharp decline in the share of long-term unemployment (over one year), which dropped to 23.7% from 43.5% over the 10-year period. These trends have bolstered household confidence.

We must also add the impact of the wealth effect, especially the housing component. From this perspective, there is a net correlation between house price inflation and consumer spending, which has resulted in a decline in the savings rate and an upsurge in debt. An economy that has met the challenges of globalisation – The UK is very competitive in the goods market due to a light regulatory environment and very flexible job market. As a result, the UK reports strong labour mobilisation, both in terms of hours worked and the employment rate. The employment rate climbed to 72.7% in 2006 vs 66% for the EU-15 and 62.3% for France. Labour mobilisation was particularly high at the extreme ends of the age distribution of the working aged population: the activity rate in the 15-24 age group is 69.1% in the UK vs 51.3% in the EU-15 and 63.3% in the United States. The same goes for the 55-65 age group, with an activity rate of 68.3% vs 58.1% in the EU-15 and 69.6% in the United States). – Strong direct investment inflows and outflows  illustrate the co-existence of an outsourcing movement and the attractiveness of the UK. Direct investment inflows have provided strong support for productivity gains in manufacturing industry, which amounted to 4.5% a year for foreign subsidiaries vs 1.2% a year for the sector as a whole. – Productive specialisation is focused on services and a few industrial sectors with strong value-added (aeronautics, defence, pharmaceuticals, etc.)

– The inflow of migrant workers has limited pressures on the labour market without resulting in a deterioration in unemployment. Inflows which accounted for 0.1% of the population in the 1st half of the 1990’s reached 0.3% from 2000, with a large proportion of migrants coming from Eastern Europe. Weaknesses We will not dwell on such well-known issues as the weakness of the education system, transport infrastructure and healthcare. For many years, they have become the focus of government efforts. – High debt levels have eroded the financial situation of households. Higher interest rates in recent years combined with swelling debt loads (for which most interest charges are linked to short-term rates) have driven up the debt servicing charge, which has increased to 23.5% of revenues in H1 2007 from about 15% in 1997.

Structurally, the foreign trade accounts have become negative. Without a surplus, the current account balance would show a deficit similar to that of the United States. The net external debt is just over 20 points of GDP. Fortunately, however, the UK does generate a current account surplus, illustrating the stronger return on assets held abroad than the return on assets held by non-residents. – Despite the high activity rate, the mobilisation of unskilled labour leaves much to be desired, with an employment rate of 53%, vs 56% for the OECD average, 57% in the United States, and 67% in Sweden and Japan. Despite job market reforms, the unskilled population still faces an inactivity trap. The implicit tax rate (income tax, social security taxes, loss of social welfare transfers and childcare expenses) linked to returning to work reaches 90% for beneficiaries of a second revenue (vs an OECD average of 60%). For single parent households, the rate nears 100% (vs an OECD average of 80%). Inactivity results notably from the increase in the number of people unable to work, which rose from 4.5% in 1990 to 8% in recent years (vs 6% and 6.6%, respectively, for the OECD). – Public finances are converging with those on the continent. The weight of the state has switched from a downward trend to a clearly upward movement: public spending as a share of GDP contracted from 46% in the early 1990s to 37.5% in 2000 (vs 39.1% in the OECD) before swelling again to 45% last year (40.4% for the OECD and 47.1% for the Eurozone).

One Response to "The UK economy: Despite remarkable performances, several challenges lie ahead"

  1. Guest   November 21, 2007 at 2:47 am

    The optimistic tone underlying this article is asking for some more black paint…”We will not dwell on such well-known issues as the weakness of the education system, transport infrastructure and healthcare.”One can not get on enough about this. Essential infrastructure is widely in a condition which can only be described as rotten. Often pre-WWII and just beaten-down since. This is going to be a disadvantage at least and is going to cost, sooner or later. Looking at the public spending (already very similar to the Euro Zone) one has to wonder where this money shall come from?As everybody in Britain knows, Britains exemplary official unemployment rate is to quite an extend the result of – counting a bit different? (No worry, other governments are learning).The impact of housing on felt wealth cannot be overstressed. “Investing” in properties is a nationwide hype, among all income levels, and the enormously growing visible wealth of the British is mainly based on second mortgages and credit card debts, used to finance another priceinflated flat, another car, a (never used) priceinflated property in Spain, holidays. As America just demonstrates, there´s an end to such things, and looking at the numbers, peoples spending habits and their naive believe that all of this is normal, there´s no reason Britains landing should be any softer than the US, actually to the contrary.