How the UK should respond to turbulence in the world economy

The following column by Gerard Lyons appeared in The Times on Tuesday, 29th April. It focuses on the turbulence in the world economy and how the UK should respond.

How weak is the world economy and what policy levers can the UK pull to help itself? 

Global trade imbalances have persisted for some time. Ahead of the 2008 global financial crisis (GFC) they were such a problem that in June 2006 the International Monetary Fund (IMF) hosted the first ever ‘Multilateral Consultation on Global Imbalances’. 

The aim was an orderly unwinding of imbalances in a manner supportive of global growth. The surplus countries, namely Germany, Saudi Arabia, Japan and China were called upon to do more of the heavy lifting, with stronger currencies and more spending. Large deficit countries like the US and UK were encouraged to save more. The IMF warned of protectionism. 

Such adjustments to currencies, spending and savings are still valid ways to address imbalances, while there is little justification for the approach taken by the US on tariffs. 

Not only that, but the world economy is not resilient enough to cope with the tariff shock. 

Last week the IMF cut its forecast for world growth this year from 3.3% to 2.8%. To put this in context, ahead of the 2008 GFC their five-year ahead growth forecast was between 4.5% to 5%. It has trended lower since to around 3%. This used to be viewed as a global recession, taking into account population growth, but now is accepted as the norm.

Equally worrying is that the main engines of global growth already looked at risk before this trade war. This century, half of global growth has emanated from China and the US combined.

Although the Chinese economy grew by a stronger than expected 5.4% in the last two quarters its trend rate of growth is slowing. Meanwhile, the US’s strong pace in recent years has been partially propelled by a sizeable but unsustainable budget deficit.  

A global recession is likely unless the trade war is resolved. At a global level, fiscal and monetary policy levers only offer partial help. Debt levels are already close to all-time highs and central banks appear cautious about easing aggressively.

Structural change is also complicating the policy outlook. Globalisation has been replaced by fragmentation, free trade by protectionism, and since the pandemic, national security decisions are indivisible from economic prosperity. 

As the UK is such a large open economy a global slowdown would see weaker growth, trade, investment and confidence. Such uncertainty adds to the margin of error around economic forecasts. The danger is policy becomes coincident, based on latest data releases, and is reactive rather than forward looking. 

Prior to the tariff announcement, financial markets saw the Bank of England cutting rates from 4.5% to 4% this year, now 3.5% is expected. Sterling, too, is stronger against a weaker dollar.

It also exposes the poor state of the UK public finances, with an inability to control public spending and poor tax receipts as the economy slows and a wealth-drain continues. Given her fiscal rules and the need to keep international investors onside, the Chancellor is likely to adopt a pro-cyclical fiscal stance, but she should opt to borrow, not raise taxes further.

This suggests modest UK growth at best and begs the question, are there policy levers to pull?

Domestically, the Government’s changes to planning reform are positive and should feed through soon. Internationally, sentiment may also be helped by signing trade deals with India and the US. With two-thirds of our US trade in services and tariff free, any US deal needs to be mutually beneficial and not tie our hands on policy elsewhere.

Next month sees a reset of EU ties. While better relations are welcome, regulatory alignment should not be seen as a panacea. Germany’s recession, Italy’s stagnation and France’s weak growth reflect the structural problems facing the EU’s major economies. While last year’s Draghi report on EU competitiveness suggested little immediate respite.

Importantly, the UK does not need to rejoin the EU’s single market or customs union, whatever happens with US tariffs. Remaining outside the single market allows the UK to have regulatory autonomy in the area of AI, a key driver of future growth, and to set our own immigration policy. We need to stay outside its customs union to position ourselves in the changing global economy where the bulk of future growth comes from the Indo Pacific, while western Europe remains the slow growth region.

A new industrial policy is also imminent. It used to be said with such policies that governments didn’t pick winners, the losers picked the government as loss-making firms sought support. Thankfully we have moved on, but there is no reason to expect the likely policy approach to address Britain’s low growth, low productivity problem. As the Competition and Markets Authority (CMA) outlined in a timely recent analysis of industrial strategies, the eight sectors chosen are the most productive ones anyway, although interestingly it noted their investment is low.

All these sectors, like the rest of the economy, are suffering under high energy costs. This warrants action, without sacrificing our commitment to the green agenda. Gradualism is needed as we need to have energy prices, at the least, equivalent to European peers.

The focus should be on energy addition, not energy substitution, like many other countries who are also moving to renewables. The economics are that renewables are added to the current mix. Then, as their cost falls, and technology advances including storage allows their reliability to improve, renewables will displace fossil fuels, eventually substituting for them. 

In contrast, the UK is moving towards substitution now, when base load of renewables is low and at the expense of high energy costs. There is a strong case for renewables but the energy mix needs to be diversified and thus we should add to our supply with nuclear.

In an uncertain world, policy needs to control the controllables and provide a credible stimulus that lowers costs and boosts the domestic economy. 

Please note, the value of your investments can go down as well as up.