Two hikers in the Rockies come face to face with a huge bear. One of the hikers quickly swops his boots for trainers. The other gasps out “you can’t outrun a bear”, to which the first replies “I can’t outrun him, but I can outrun YOU”. This story may be familiar to you but provides a neat introduction to the outlandish notion – at least to regular BBC News viewers – that the UK may grow faster than the EU and the US in 2024 and 2025. Here is a table of the growth rates for the US, UK, the EU and the three largest EU economies for the two years 2022 and 2023 (the 2023 growth rates used are IMF forecasts, based on data up to Q3):
Cumulative Real GDP Growth in 2022 and 2023 (% change)
The general reader may be rubbing his eyes – the UK is already outperforming the EU and the US! Admittedly the UK figure is flattered by a strong 2022 bounce back from a very weak 2020/21. Conversely, however, recent strong US growth has been powered by an unsustainable fiscal expansion (more on that later), while the ECB was slower than the US and UK in raising interest rates, not that this stopped Germany from massively underperforming. The legion of UK pessimists expects that structural economic weakness will drag the UK back to the foot of this growth league table – not that they imagined we would top it in 2022/23. What are these weaknesses and how do they compare with the US and EU?
The UK’s structural problems in perspective
Among key UK economic weaknesses are a record high tax burden, a government debt to GDP ratio approaching 100%, poor productivity growth, and low business investment. These problems are of course strongly interrelated. They lower the UK’s potential growth rate, but do they imply weak growth relative to our competitor economies?
Taxes are now almost 38% of GDP, about 5% higher than the post-war average and a clear disincentive to economic growth. This is higher than the US tax burden but is lower than the Eurozone average of 42%. Furthermore, the UK company tax rate is still relatively low while the new system of “full expensing” of capital investment is highly competitive (the Treasury might extend this system to leased capital equipment, which would make it even more so. The UK continues to receive higher levels of foreign direct investment, particularly in new high growth industries, than any EU country, and can still attract highly skilled workers from around the world.
UK Government debt has risen very sharply since the Global Financial Crisis, from 35% of GDP in 2007 to 89% currently. This is a disturbing trend but is not out of line with current international norms, or our own history. The UK government debt/GDP ratio was well above 100% for the entire period from 1916 to 1960, as well as for the 100-year period from 1750 onwards. The current Debt/GDP ratios for the US and our trio of key EU countries are:
Government Debt to GDP (%, IMF and OBR data)
Not only is the UK debt ratio relatively low, there is also a clear 5-year plan to stabilise and then reduce it by cutting the annual deficit from 4.5% in 2023/24 to 1.1% in 2028/29. The UK government has gained some fiscal credibility – unlike the other countries on this list – by significantly increasing taxes. Italy’s debt problems are well known and pose a longer-term existential threat to the EU. In terms of the 2024/25 outlook the US debt trajectory is the more significant.
To some degree the US can “afford” higher debt levels, given that the $ is the global reserve currency backed by immense military and economic power, but recently US fiscal policy has become increasingly irresponsible. President Trump built up large fiscal deficits even before Covid struck. As in the UK policymakers overreacted to the pandemic by temporarily running huge deficits of around 15% of GDP. Unlike the UK though, US policymakers have made no attempt to reduce the deficit back to sustainable levels. On the contrary, President Biden’s Inflation Reduction Act (IRA) – the most misnamed legislation in history? – is a massive open-ended tax credit and subsidy programme to turbo boost the Net Zero transition and American re-industrialisation.
It is a highly protectionist policy in thin disguise and like all such policies will have the long-term effect of increasing inflation and reducing growth. The current US budget deficit is 8% of GDP, this at the top of the economic cycle with an inflation rate only recently in double digits. The Congressional Budget Office projects deficits of this order every year from now until 2030 even assuming no recession. The IMF expects the debt/GDP ratio to rise from 123% now to 137.5% by 2028 – it was only 30% as recently 2002. Neither of the two likely Presidential candidates plans to do anything about this, although Trump wants to partly replace the IRA with a 10% import tariff – thus revealing the true nature of the policy. This is completely unsustainable. Normally the Fed’s rate hiking programme and the associated plunge in money growth would have already caused a major US slowdown or recession. Huge increases in deficit spending have prevented this so far, but maybe not for much longer. Given the enormous and unrelenting supply of new US Treasury bonds, a US financial markets crisis is inevitable, a crisis in which the Fed will have little flexibility.
Germany – formerly the EU’s economic engine – has different but equally grave problems. As recent poor growth numbers already show, the German economic model – based on cheap energy from Russia and capital exports to China- has collapsed. The energy links with Russia are probably permanently severed. The Chinese economy had already moved away from an investment-led to a consumption-led model before being hit by its disastrous Zero Covid strategy. It is also now apparent that China is in the early stages of an unprecedented demographic collapse, in which the population simultaneously falls rapidly and ages fast. A similar though less dramatic collapse faces Germany, and much of the EU. In normal circumstances Germany’s relatively low debt ratio would enable a large increase in deficit spending to cushion the economy. Even this option has been placed in doubt by the powerful German Constitutional Court’s ruling that much of the government’s stimulus plan is unconstitutional. The government is trying to overcome this obstacle, but the uncertainty generated is a major setback to German recovery prospects.
UK Productivity growth has been weak since the GFC, but this is in line with most western economies. It has however been particularly weak since the pandemic. This post-pandemic weakness is due to a stunning collapse in public sector productivity of the order of 10% – private sector productivity has risen over this time. The main causes seem to be high levels of public sector strike activity and excessive working from home. The need for the “smack of firm government” is clear given the obvious scope for a recovery in public sector productivity.
Economists are unsure what has caused low western world productivity growth. I believe a crucial factor has been sustained low and zero (even negative in the EU) interest rates, which have resulted in a diversion of resources into excessive speculative activities, a gross misallocation of capital to unsound projects, a disincentive to saving and the proliferation of “zombie” (i.e., fundamentally unviable) companies. It is therefore a blessing for the UK (and all western economies) that there has been a ‘normalisation’ of interest rates, which if sustained will help raise productivity.
UK business investment as a % of GDP has been around the 10% level for the last two decades, several percentage points below the western world average. This partly explains low UK productivity growth, although the less capital-intensive nature of the UK’s dominant services sector will also be keeping the ratio lower. “Keynesian” economists wrongly expected ever lower interest rates to stimulate investment. UK business investment remained flat throughout the period of low rates, but just became less efficient. The dramatic rise in UK insolvencies in the last 18 months shows that unviable companies are going under. Encouragingly, this process has not resulted in a recession – indicating new companies are being created and already viable ones expanding. This process is impacting on the public sector too, with the decision to scrap the last leg of HS2 and divert the spending to smaller scale and higher return railway and other projects a case in point. The Autumn Statement’s new incentives for capital investment, and the opportunities offered by new trade deals, investment zones, free ports, and the UK’s leading role in many new growth industries are grounds for expecting stronger UK business investment in coming years.
Brexit Freedoms and Flexibility
This author has consistently argued in previous articles that the pessimists (including some Brexiteers) underestimate the degree to which the UK is steadily but surely taking advantage of Brexit freedoms to improve economic prospects. There is not space here to re-hash previous analysis, but just in the last few months we have begun talks with South Korea and Turkey to extend our trade agreements to cover services. Such talks were already underway with Canada and Mexico and have been completed in the case of Switzerland and Singapore. New Memorandums of Understanding (MoM’s) to boost trade and investment have been reached with another two US states – Florida (with an economy about the size of Spain) and Oklahoma – to add to the five already existing MoM’s. Negotiations continue with other US states including Texas and California. In June President Biden and the PM signed the Atlantic Declaration, covering economic, commercial, technological, and trade relations and launching talks on a Critical Minerals Agreement to ensure UK access to the US market for this strategically important sector. In early November the UK and US also signed a major partnership to accelerate development of nuclear fusion technology, both countries being world leaders in this field. Early November also saw a £4bn deal between the defence industries of Poland and the UK to help build Poland’s air defence programme, with the UK’s leading role in supporting Ukraine playing a key role in securing this partnership.
The UK’s response to the President Biden’s IRA fiscal bazooka again demonstrates the advantages of independence of action provided by Brexit. The EU is matching this protectionist challenge with similar tax incentives and subsidies, albeit on a necessarily smaller scale. If the UK were still in the EU, we would have been expected/required to play our part. We have instead taken a different and more effective approach, providing limited fiscal help only to selected sectors where we have a leading edge. According to the Business and Trade Secretary, Kemi Badenoch:
“Other countries have embarked on large tax and spending sprees to claim a share of the global market…the UK will not be drawn into a distortive subsidy battle” …. but will instead pursue an approach of “removing obstacles” to the private sector.
The OBR forecasts UK economic growth of 0.7% in 2024 and 1.4% in 2025. There are at least three grounds for expecting growth to be notably higher:
- The OBR only sees UK inflation returning to the 2% target level by Q2 2025, and thus forecasts UK Bank Rate at 5.25% to stay for most of 2024 and only fall to around 4% by 2028. This inflation/interest rate forecast is more pessimistic than their previous forecast even though sterling has appreciated by 5% since then. More crucially, broad money growth has declined by 4.2% in the last year and has been below 5% for more than two years. On this basis I am even more confident than I was in my June B4B article that UK inflation will reach the 2% target level by mid-2024. Consequently, Bank Rate should reach 4% or lower much earlier than forecast by the OBR. Money growth is key factor in the inflation process – “as any fule kno” – so economists who pay attention to money growth have been much more accurate in their inflation forecasts than the OBR (or the BoE). Nevertheless, there is no mention of money supply in the entire 170 pages of the latest OBR Outlook! Group think is alive and well…..
- UK Business Investment has been rising sharply in recent quarters and by Q2 23 was 9% higher than its pre-Brexit high. Despite this and the new incentives for investment described earlier the OBR forecasts business investment to fall back to the historic level of around 10% of GDP. This seems too pessimistic.
- Apart from a derisory estimate of the impact of the trade deals with Australia and NZ the OBR entirely ignores all the other trade deals and economic partnerships that have been achieved since the Trade and Cooperation Agreement with the EU came into effect. It also assumes no benefits from the UK’s increasing regulatory divergence from the EU. (The OBR goes into the most microscopic (arguably futile) detail in some areas but never mentions the small but now revitalising fishing industry either).
If the US and/or the EU were to suffer serious recessions in 2024/25 this would negatively impact on the absolute levels of growth achieved by the UK, but this should not prevent the UK growing faster than them. There seem two key risks that might result in UK underperformance:
- Opinion polls suggest there is a high probability of a Labour government taking office next year. This would usually be viewed negatively by financial markets and business, but the Labour leader and Shadow Chancellor Rachel Reeves have bent over backwards to reassure them that fiscal prudence will prevail and radical economic change eschewed. Even if one doubts the sincerity of these assurances a new government will inherit such a constrained fiscal outlook that there is little scope for radical change. Having eviscerated the Tories for raising taxes to a 70-year high Labour could not credibly increase taxes even further – indeed Reeves has supported the new full expensing policy as well as the NI tax cut. Neither can it go on a Biden-style spending spree given their commitment to a lower debt ratio over time and fear of re-igniting Truss-style bond market chaos. It is probable that they will slow or stop the free trade and deregulation drive, but a reversal seems unlikely at least in the near term.
- The bigger risk is that the BoE has already overdone the monetary tightening and compounds this by being slow to reverse the error. The Bank’s rhetoric of interest rates staying “higher for longer” may in practise be “too high for too long”. The Bank is paying too much attention to still high annual wage growth, which is a lagging indicator, and not enough attention to plunging money growth, which is a leading indicator. Furthermore recent “unofficial” labour market data show a major slowdown in wage growth. According to economist Julian Jessop early HMRC tax records suggest annual pay growth slowed to 5.9% in October with pay growth in the months since June much lower than that.
Assuming the BoE proves nimble of foot I therefore confidently predict that the UK will grow faster than the EU and the US in the next two years. Hence, we can look forward in due course to the OBR, the BoE, the IMF, the BBC and many other pessimists eating humble pie in Christmas 2025!
Robert Lee 1st December 2023