Thoroughbred or Plough Horse
With the UK’s economic performance better than feared in the last half year, fuelled by robust consumer spending, but with a number of clouds on the horizon, it is a good time to look ahead and see how the economy stands.
The economy is rather like the Grand National horse race. It’s an endurance test with a number of barriers to overcome where the steeds generally move forward carefully. Sometimes the gallop cannot be sustained for long without problems building up: an overheated horse (economy) may well get pulled up. Over a racing career (the economic cycle), the horse needs to be fed (by investment) and it needs occasional periods of recuperation (rebalancing) but, once the race is on, it only stops if there is a reason to make the horse falter. Usually, this occurs because hurdles are put in the way that are too high for the racehorse to jump or the jockey is too heavy for the horse to carry over the distance.
There are four ways the hurdles and jockeys of economic policy can slow the horse down or, indeed, make it fall.
Monetary Policy: Monetary policy, guided by the Bank of England, is about setting interest rates to influence the demand, and setting reserves to influence the supply, of money. Monetary policy can slow the economic horse by setting interest rates too high, too quickly and by restricting access to funds or speed it up by being “loose” on the reins. Effectively, monetary conditions influence the height of the fence to be jumped and the style of the jockey.
Theoretically, base interest rates should relate closely to the nominal growth of GDP, linking money to the real economy. In the UK, given an inflation target of 2% per annum and a trend real growth rate of about the same (as estimated by the OBR), ‘normal’ nominal GDP growth would be about 4.0% per annum. With official interest rates at 0.25%, the Bank is very far from putting interest rates anywhere near this ‘normal’ rate, largely because of excess savings (driven by an ageing population) and a period of persistent slow growth. The UK’s poor productivity performance since 2008 reflects ongoing low interest rates, because these encourage the survival of inefficient enterprise.
In addition, after Quantitative Easing and other efforts to supply money to the economy, we have huge excess reserves in the banking system. These could be a major threat to the horse’s stability (high future inflation) if left intact. Already, they create a ‘brake’ on interest rate increases. Right now, the monetary fences for the horse to jump are almost imperceptible. Moreover, in the foreseeable future, there is little expectation that interest rates will rise and reserves will fall, sufficiently to significantly slow or ‘pull up’ the economic horse. Unless or until inflation accelerates (above target indefinitely), the monetary fence will remain low and, surely, no barrier to growth (completing the race).
Trade Policy: Trade policy sets the conditions of international exchange and regulates access to markets. It is another potential hurdle for the economic horse. Economics teaches us that barriers to trade are ‘bad’ and free trade ‘better’ for keeping the horse running. Trade creates more jobs through supporting a sustained faster running pace of/for output growth.
BREXIT and the policies of President Trump raise the spectre of more protectionism – higher barriers, taxes and tariffs on trade. The key point is that all parties in the global economy are interdependent. Economic rationality suggests both importers and exporters will not wish to put the trading system at risk. Many ‘policy jockeys’ get this. There is clearly, however, some present danger that political actions, couched as popular nationalism, will undermine the global trading system. There is a risk that this trade fence goes up sharply and, at best, may slow and, at worse, unseat the economic horse in the years ahead. There is a clear downward risk to growth from trade protectionism. But, this is not a given. If all the negotiations go well, there could be a big upside – the promised land of the UK as a multi-agreement trading partner with all parts of the world could increase the sustained and sustainable speed of our horse.
Tax Policy: Taxes on business are used to fund public policies that intervene in the economy in order to address market failures and fund socio-environmental priorities. The political debate about how big the public sector should be relative to the wealth creating private sector is a long-established and hard-to-resolve chasm. But, note, public funding comes from taxation or borrowing – both require a drag on the payers. Essentially, high corporate or sales taxes and a complicated tax code are like having a heavy jockey on the back of the business horse.
UK administrations have been reducing some corporate tax rates in recent years. Indeed, there has been a competitive race to the bottom by some of our competitors (notably Ireland) on corporate taxes. Furthermore, President Trump vows to join in (cutting the tax burden – rates and rules – on US corporates). BREXIT raises the possibility of business, sales, or other UK tax rate changes in future. It may mean UK governments have scope to simplify the system or they could be looking for ‘new’ sources of revenue. At present, it is unclear how the UK’s competitive position on tax will evolve post-BREXIT but it is not expected to hinder the horse too much in the near future. The tax jockey is not expected to overburden the business runner – but these could be famous last words.
Spending/Regulation Policy: New technologies and process innovations are fuelling economic growth. Excess regulation and non-productive state spending can hurt this growth process by putting a heavier jockey on the horse. Too much or misdirected state spending or regulation can change a business thoroughbred into a plough horse – cutting its potential speed (of growth) over the medium term. Alternatively, reducing business regulation could be an important mitigation for any negative BREXIT effects through trade policy. Rebalancing from government consumption to government investment could be an important part of a new “Modern Industrial Strategy” in the years ahead.
Overall, then, monetary policies seem set to continue to support the economic horse whilst tax and regulations policies could go either way and trade policies risk hurting it. The net balance of these factors, as the terms of the UK’s new trading relationships emerge, will be key to how the stamina of the economic horse develops in the next five years. There is a risk that trade protectionism sets higher fences: turning our steed into a plough horse – worst case, recession. However, there is an opportunity for a thoroughbred to emerge from good training, especially if trade deals can be done and tax/regulation policies can support growth just as monetary policy becomes ‘less loose’ or even makes a welcome return to ‘normal’.
Place your bets …. But, remember, the Grand National is a lottery. Uncertainty is the main risk right now and the main dictator as to which horse comes first over time.
 Based on a similar approach to the US economy by Bryan Wesbury, Chief Economist, First Trust Portfolios, Chicago, USA