There is a dawning realisation that there has been a structural break in the economic fabric of the world economy. The old world of zero real interest rates, very low inflation, and the peace dividends are gone. The great era of cheap debt, and the financial engineering and gearing up that it caused, is over. The great expansion of world trade, and China’s flooding of world markets with ever-cheaper materials and products, has ended. Those who thought that the end of history had arrived with the implosion of the Soviet Union and that both Russia and China would liberalise into eventual democracies have had rude shocks.
Positive real interest rates are gradually having their impacts, whilst the fracturing of the US–China and EU–China relationships, combined with the belligerence and threats from Russia, have further punctured trade. The effects are everywhere. China’s great growth era is over. US protectionism is now bipartisan. The US and the EU are scrambling to separate out their supply chains. Everywhere more nuclear weapons are being added to stockpiles and the pressure for military spending increases is apparent. The Russia–Ukraine war, now ten years on from the annexation of Crimea, has caused a radical realignment of gas supplies and brought war to the European borders. Taiwan may be next. For Europe (including the UK), the already significantly higher energy prices compared with the US and China have risen even higher.
Much of the above is, in historical terms, a return to “normal”, after the departure in the brief aberration of the last 30 years. Real interest rates are normally positive, or at least when there is positive economic growth. War in Europe has been an enduring feature of its entire history. The twentieth century was the bloodiest, and more recently the Balkan Wars and Ukraine are a reminder of how close the tensions can be.
When, in the words of Bob Dylan’s famous song from the 1960s, “the times they are a changing”, the cracks in the current economic models are revealed. In the case of the UK, these are stark. What is uncovered is that, faced with the “new normal”, the UK has too little production, too much consumption, too little savings and too much debt. Perhaps not surprising, since it takes time for the politics to catch up with the economics, the new Labour government is in the process of doubling down on all four of these.
Not enough production
For all the talk – shared across the political spectrum – of “going-for-growth”, the reality is that, from a very low base, the last of the energy-intensive businesses are closing. “Made in Britain” is becoming a rarer product label, as Grangemouth shifts from refining to importing refined product; Port Talbot shifts from producing fine steel to imports and recycling lower-grade scrap metal; and the car industry braces itself for its second big shock, with Chinese electric vehicle (EV) imports to add to the woes caused to the sector by BREXIT. Even 10% of electricity is already imported. De-industrialisation is entrenched because the main supply chains are foreign.
In the pursuit of net zero by 2030, it is painfully obvious that almost none of the supply chain is domestic. The solar panels are made in China. The wind turbines are made with Chinese steel, the batteries are mainly made in China, and critical minerals are mined in China or controlled by China. Fertilisers, petrochemicals, cement, aluminium and steel are mostly made elsewhere and imported.
To promote economic growth in the UK through the fast-track net zero programme requires a re-industrialisation on an enormous scale, not a piecemeal, subsidy-by-subsidy series of often politically driven locations for assembling foreign-made parts. To imagine this re-industrialisation, think major domestic mining, think refineries for the key minerals like nickel, copper, cobalt and lithium. Think major expansions of the high-quality steel production, think new fertiliser and tractor factories, and major cement plants. Think rebuilding aluminium plants – especially if aluminium becomes key to future electricity cabling. Think the expansion of plastics and more refineries. Then think of major battery factories, major manufacturing of electric cables, large-scale EV production, new solar panel manufacturing plants, robotics manufacture, and the forging and manufacture of wind turbines. All are energy-intensive and all carbon-intensive.
As the Conservative government found, it costs roughly £500 million in subsidy a shot – for a battery plant in Somerset, for a recycled steel investment, and further slugs of government funding for Grangemouth’s recasting. Every major industrial investment now comes with a major subsidy demand.
All of the above is going to be energy-intensive, as are the data centres, air conditioning and AI infrastructures, so a key part of the economic viability of re-industrialisation relies on having enough energy supplies at globally competitive prices. There needs to be lots of electricity to comfortably exceed peak expected demands, on a firm-power and not just an intermittency basis, and it has to be cost-competitive with both the US and China. The net zero dash for 2030 requires a very rapid rollout of new electricity generation, storage and the associated networks, and at globally competitive prices.
This points to one of the great flaws in the UK’s dash for economic growth. Not only are current energy prices extremely uncompetitive with both the US and China (and even with much of the EU too), but the direction of travel is not one that is going to close the gaps. Indeed, there are some serious reasons for thinking it is going to make the gaps even bigger. For the avoidance of any doubt or complacency, the recently published Draghi Report prepared for the European Commission spells out on page 2 the competitive problem in energy costs and prices for the EU (with the UK in a worse position):[1]
“Even though energy prices have fallen considerably from their peaks, EU companies still face electricity prices that are 2-3 times those in the US. Natural gas prices paid are 4-5 times higher. This price gap is primarily driven by Europe’s lack of natural resources, but also by fundamental issues with our common energy market.”
The obvious question to ask is: how exactly is the dash for net zero going to fast-track the closure of this yawning competitive chasm? Simply asserting it will does not cause it to happen
The second part of the government’s dash for growth is building more houses. As with the net zero aspirations, this again depends upon a foreign supply chain. More houses could lead to more GDP, but it depends upon both the composition of those new houses and on the likelihood of success.
The government’s aim is to meet an arbitrary total number of houses built per year. It is an achievable number: 300,000 were built per year in the years after the Second World War. But then half were built as social housing in urban areas and as part of planned new towns, whereas now it is the private sector and private housebuilders and private finance that are able to pick and choose where to build, from an expanding number of areas as and when the government reduces planning constraints and, in particular, opens up the green belt.
It may seem obvious to point out that private housebuilders prefer building on green belt land for more upmarket housing, rather than more difficult urban settings for social rents. Moreover, private housebuilders have no obvious interest in building the maximum number of houses, especially if greater supply results in bringing down house prices – another objective of the government.
Ironically, set alongside the net zero target, housebuilding is energy- and carbon-intensive. Think bricks, cement, machinery. Whilst much of this is imported – and hence the emissions do not count against the territorial net zero target – they all add to global emissions and hence cause more climate change. Building 1.5 million houses cannot avoid increasing global warming.
The more immediate constraints on economic growth in the housing sector relate to rented accommodation. The government is to reform the rental market, placing new controls, restrictions and obligations on private landlords, including on no-fault evictions. This will have two effects: it will raise rents as a result of the increase in risks to landlords; and it will reduce supply. Together this will reduce labour mobility, and in turn have a negative impact on economic growth.
Perhaps the future lies not with production, as described above, but rather with the new technologies encompassed by AI and eventually possibly quantum computing? This bit of the growth strategy is notable by the absence of any substantive measures to enhance digital technologies and R&D, which are prime areas for public goods interventions. R&D requires government support, universities need stable funding, and technological investment requires supporting infrastructure. Squeezing the universities by preventing the increases in student fees, reducing the international openness of universities, cancelling specific interventions like the computer project at Edinburgh University, and not doing enough to ensure that data centres and other major investments have supporting infrastructures are all unhelpful to the growth objective. Furthermore, by adding more and more intermittent generation to the electricity system, the need for 99% security of supply for data industries adds the extra burden that new data centres will need to invest in additional own-generation of electricity.
Economic growth is best encouraged by providing infrastructures with considerable spare capacity: reliable, secure electricity networks capable of speedy new connected growth, including for EV charging; uncongested airports with good air traffic controls; water and sewerage systems that deliver clean and plentiful supplies and can cope with effluent; reliable railways and uncongested roads; universal mobile and fast broadband cover; flood defences; good schools; well-funded universities and skills training systems; and lastly a health system that keeps workers healthy. Given that none of this list is currently being provided, it might be the better place to start, allowing companies to get their goods to market and their workers to work.
In the absence of good infrastructures and given the limited contributions of houses and net zero, the rest of an increase in production is left to the private sector to deliver. This is where taxation and regulation are the name of the game for government interventions. UK business taxation has increased over the last decade and there is little indication of fundamental, pro-industry reforms, whilst the intersection between personal taxation and entrepreneurial incentives is affected by capital gains, the sale of businesses and inheritance taxes.
On regulation, governments have repeatedly set its sights on reducing “red tape” for at least 40 years. What has actually happened is that the rule books and the tax documentation have grown and grown. New employment regulations are about to add considerably to the cost of employment and the regulatory burdens of compliance. These encourage companies to reduce workforces and switch to contracting. The great growth industry now is regulation – more new regulatory bodies, and way more regulators. The Labour government has already added new regulators for workers’ rights, for technology approvals, and for the “guardrails” for more borrowing. Why existing regulatory bodies cannot deal with all of these is unexplained. The latest “cutting red tape” idea, of relaxing competition policy to allow for major mergers and acquisitions (M&A), driven by global companies, is not an obvious way to increase domestic productivity and growth.
If the starting point was one of high levels of production and a thriving manufacturing sector, then these additional constraints might have limited impact. The ecosystem of manufacturing hubs would be in place. But this is not a luxury the UK has.
Re-industrialisation is therefore much harder and in need of a substantial resetting of the government’s relationship to business and a reduction in costs, especially in respect of energy.
In response, it might be claimed that the UK nevertheless has a major advantage for manufacturing in having a large financial sector. But a moment’s reflection tells us otherwise. The financial institutions do not generally finance much new investment in UK business. The financial markets focus instead on providing a second-hand market in equities, in M&As, and in forcing companies to pay higher dividends rather than retain earnings for investment. There is little convincing evidence that the City of London has aided UK manufacturing; on the contrary, it can be argued that it has syphoned off the best talent from universities into finance jobs and reduced the skills supply to industry, and has concentrated on financial engineering not the creation of new and enhanced assets.
Without enough production, the UK has shifted to being an importer, and imports exceed exports. Paying for this gap – living beyond our means by consuming more imports than the exports we produce – requires a capital inflow to offset the current-account deficits. One way this has been done is to sell off UK companies, and it is a contributing cause of the gradual takeover of much of British industry by foreign investors and foreign companies. The family silver has been sold to pay for the excess consumption.
The net zero sector is a case in point. The profits and dividends accrue largely to foreign investors and companies, not to British savers (in part, as we shall see, because there are so few domestic savings). The result is that British workers work for foreign investors and the profits flow elsewhere.
Too much consumption
The corollary of not enough production is too much consumption. If consumption exceeds production, it has to be paid for by borrowing, which is indeed what the UK is and has been doing for some time.
The sustainable level of consumption is net of capital maintenance. The core infrastructures, the schools and the hospitals, as well as the universities and the skills base should be the first call on the current revenues from production. At present, much of capital maintenance is treated as investment, as if it is adding enhanced assets. If it did, on the balance sheet, there would be an increase of assets matched by an increase in debt. Instead, we have increases in debt to pay for the repairs to the roads, the school and hospital buildings, and the water and sewerage assets. This is one reason why consumption is excessive. It is the great accounting trick of the government’s “fiscal rules”.
It is not, however, the only reason. Imports exceed exports, and hence the share of production sold abroad is less than the imports consumed. The sustainable level of consumption is that which equates exports and imports on the current account of the balance of payments. The internal current account and the external current accounts should balance over the cycles. There is a fiscal rule for the former but not the latter.
This contrasts with the Keynesian conventional wisdoms. For Keynes, it is not supply that delivered demand, but the other way around. Higher demand leads to increases in supply. On this theory, borrowing to cover what in the sustainable economy is excess consumption over production is not a bad thing per se, but rather the means to increase production. Whilst in a slump like that in the 1930s, there may be a case for deficits to boost short-term demand, but in the UK the one thing that we are not short of is demand.
A separate and important aspect of consumption is that it should be net of pollution cost. Externalities should be internalised, which, in turn, means that the cost of many of the consumption items goes up. For example, the UK economy is around 75% dependent on fossil fuels for its energy, and these fossil fuels embed carbon. Add to this the carbon embedded in imports, and the two together make up the quantity to which a carbon price should be applied, given the 2030 and 2050 net zero targets (if they are properly measured). To these should be added the pollution costs of the pesticides deployed in food production (again both for domestic and imported consumption purposes), and lots of other forms of pollution.
Too little savings
Remarkably the UK has no savings net of capital depreciation. All finance for net investment comes from foreigners. Since savings must equal investment ex post, the UK relies on the savings of foreigners to finance its investment, and consequentially the profits and dividends that arise from investments in the UK flow abroad.
When combined with the current-account deficit on the balance of payments accounts, this is a capital inflow, and whether through M&As of UK companies or through the ownership of direct investments, the UK increasingly becomes under the control of foreign companies, and the return to the UK is in wages. UK workers are employed by foreign investors, with wages accruing in the UK, but profits abroad.
This process has been unfolding for the period since at least the 1990s. The utilities, including the electricity and energy companies, have mostly passed into foreign ownership, starting with the great M&A boom in water and electricity from the mid-1990s onwards. Many of the high-profile British companies went the same way, from Cadbury’s to Boots. As the state withdrew from ownership, with a few exceptions like the nationalisation of Network Rail and the recent creation of a very small-scale Great British Energy, it has not stopped borrowing. The most notable case is Network Rail where the state is borrowing (with the government borrowing-to-invest approach) from abroad to finance these expenditures (much of which are actually capital maintenance).
Attempts to force UK pension funds into financing UK investments run into some obvious difficulties. First, the amounts are so small as to be less than the capital maintenance requirements. Second, the interests of pensioners are better met by holding a broad portfolio of assets and this means that a significant chunk of the assets are overseas not in the UK. Indeed, had pension funds invested on a “British only” basis, pensioners, actual or potential, would be very much worse off.
The sustainable economy balances savings and investment, and since the investment requirements across the UK economy are very large, this implies a sharp rise in domestic savings. That in turn means a fall in consumption. Higher savings lead to higher investment which leads to higher production, which in turn eventually leads to a higher level of sustainable consumption in the medium to longer term.
Too much debt
Living beyond our means, funded by debt, is behind the growing debt to GDP in the government’s accounts, and is reinforced by the debt that is embedded in the private sector – especially the debt that plays such an important role in the financial engineering of the utility infrastructures. Ultimately it all has to be paid for from customer bills and taxes. It has to be affordable.
This is what funds the government deficits and, to this extent, it is not finance. It is borrowing to spend for day-to-day activities and capital maintenance. The government (and its predecessor) claims it aims to balance the current spending as part of its fiscal rules, but since the government classifies so much that is capital maintenance as if it is investment, it doctors the numbers to cover only part of the current operating costs of government. Capital maintenance is an operating cost not an investment. It is always possible to meet the current spending fiscal rule – just redefine enough current spending as “investment”.
The correct level of debt is that which matches the assets on the balance sheet. New borrowings are balanced against the new assets that the borrowing creates through genuine investment. Adding debt to the balance sheet without creating new assets, as happens in regard to capital maintenance, is a form of capital consumption. Ultimately, this emerges as a growing claim by foreign lenders on the UK, and on future taxpayers.
A better way forward
It does not have to be like this. Current (and proposed) economic policy is perpetuating an unsustainable economy. What is unsustainable will not be sustained. It will have to end, probably in a series of economic crises played out into the future. The next generation will pay the price, notably in the debt that they inherit, created to allow the current generation to live beyond its economic means, and they will inherit the degraded environment.
More production means a revisiting of competitiveness. The UK cannot enhance its production without competitively priced energy, since explicitly and implicitly energy makes up so much of business costs. With the coming of AI and the great growth of communications and data, the cost of energy becomes even more important. It also needs to be firm power. The dash for net zero electricity by 2030, whatever its merits and demerits, is likely to make electricity more, not less, expensive, increasing the competitiveness deficit. Closing off North Sea gas production can only lead to more imports (and worse still, from an environmental perspective, LNG imports), unless something else replaces gas in the domestic energy mix. However, given the endless delays to nuclear, the slow development of large-scale storage and the slow pace of hydrogen development, gas is going to be needed for a considerable time to come.
The production problem is not just about energy supply: a competitive energy price is a necessary condition for addressing it. UK energy policy, under the previous and the current government, has opened up the price gap, and the dash for net zero by 2030 for electricity can only mean that the UK pays top prices for the imported supply chain. The UK needs a new and serious energy policy.
Putting consumption onto a sustainable path is obviously a great political challenge. It will not be well addressed by ruling out taxes on income and expenditure, and putting them on savings instead. Proper pollution pricing is resisted for political reasons too, but this just means that the costs of reducing pollution will be all the higher. A classic example is the subsidising of farmers’ carbon emissions through discounted “red diesel” whilst increasing the carbon price on manufacturing industries.
On savings, the Prime Minister regards the “workers” as those with little or no savings, and the objective of all policy has the mantra of the interests of “working people” at its core. It is not surprising, therefore, that savings are the target of increases in taxation. Changes to the tax treatment of pensions add to the disincentives to save more. Solving the savings problem requires at least tax-neutrality, but, given the scale of the shortfall, it requires additional incentives.
On debt, both major political parties have embraced fiscal rules that are aimed at balancing the current account and reducing debt overall as a percentage of GDP. Yet the direction of travel is quite the opposite, having passed the 100% debt-to-GDP level. What is required is proper rules, but even more important are proper accounts. The scope for fiddling the books is currently very great. The Office for National Statistics (ONS) treats anything the government spends money on as investment if it has an asset life of more than 12 months. That allows a host of items to be called investment that are just capital maintenance, including even fixing potholes. No doubt more and more of health and education spending will get re-classified as “investment” and then the government will play up the benefits as “investment” (as famously did Gordon Brown with his “endogenous growth” mantra).
Even the size of government borrowing can be massaged. The Conservatives proved masters of this, shifting the core infrastructures out of government accounts and into the privatised utilities. Expect much more of this creative accounting in the future, with another spurt in Private Finance Initiative (PFI)-style mechanisms to create new “private” balance sheets, whilst, as with the utilities, relying ultimately on government guarantees to underpin their financing of functions.
The debt position is not sustainable, for the very good reason that customers and taxpayers may neither be able to pay nor willing to vote for governments in the future that try to force them to pay. They may revolt against utility bills and against tax increases. The unsustainable will again hit the brick wall – it will not be sustained.
Taken together, at this great turning point away from low and negative real interest rates, with the end of the great global trade liberalisation, and with the end of the peace dividends, the UK finds itself confronted by its deep structural problems. The emperor has few clothes, and, after BREXIT, sits outside the EU in a rather lonely place. Perhaps the upside of BREXIT is that the UK may finally come to terms with its problems – not enough production, too much consumption, not enough savings, and too much debt.
