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Unsustainable deficit

• Evan Davis | Vital Statistics |
• 20 Dec 07, 03:43 PM

We got , giving us a full picture of the third quarter of this year. And guess what - it didn't contain much Christmas cheer.

The data shows that the UK balance of payments deficit (the broadest measure of our international trading position) is as bad as it has ever been. We earned less from the rest of the world, than we spent in the rest of the world, to the tune of 5.7% of our national income.

To put it another way, our spending in the summer was maintained only because foreigners lent us almost 6% of our national income.

Most shockingly, that means our balance of payments deficit is now bigger in proportional terms than that of the United States. (It's been a very long time since we could say that.) The US deficit has shrunk from 5.6 per cent of national income in the first quarter of this year, to 4.9 per cent in the third.

The only occasion that our deficit was this high was in the third quarter of 1989. The good news then was that the deficit soon came down. The bad news was that it was corrected with the aid of a very serious recession.

Now, I don't want to be alarmist about this. The balance of payments deficit is a funny old measure and it is quite volatile. It might well fall back next year on its own. Quite a large part of the deterioration reflects the fact that our banks have been paying more interest to foreigners and that might adjust automatically.

And we certainly don't have to worry about it as we once did. Back in the 1960s and sometimes the 70s and 90s, we worried about these things because the exchange rate was fixed and deficits literally meant the country could run out of money.

But mostly when the balance of payments deficit is large it is telling us that the British are borrowing and spending heavily, thus relying on imported goods. And that is a good deal of the story at the moment (other data released today showed the household savings ratio falling).

In that sense, the deficit is reminding us of a problem we have already known about.

But even if we are not going to run out of money to buy things, and even if we know that we have had rather low savings recently, the deficit can offer a forewarning of a pretty serious adjustment to come.

This is because our balance of payments deficit is manifestly unsustainable, and as there is a hackneyed saying in economics that if something is unsustainable, it won't be sustained.

The question is how the eventual adjustment will shift to a smaller deficit will come about.

The most obvious two ways are through a slowdown in our own spending (which reduces imports) or through a fall in the value of the pound which promotes exports.

One or both of these look likely over the next couple of years.

How does this play into the already fragile state of our economic nerves at the moment?

Well, the data is already old news. It barely reflects any impact of the credit crunch on the real economy. Indeed, it is probably best viewed as the last guide to what was going on before the storm broke.

And my own interpretation would be that it indicates we are entering 2008 with more serious imbalances than perhaps previously understood.

If the economy is turning away from rising house prices, low savings, high borrowing and easy lending, the balance of payments will improve. But it seems we have a bigger turn to make than we realised.

The US has been in a similar position. It has already started improving its current account, with the dollar falling very significantly.

The UK looks it has had more in common with the US than we thought.

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