By Chris Dillow, 06 July 2010
There's one curious feature of the recession that hasn't had the attention it deserves - it has not led to any significant reduction in the UK trade gap. In the first quarter (Q1) of this year, the UK had a deficit in goods trade of £21.8bn, just over 6 per cent of GDP. This is much the same as it was in the first half of 2007, when the economy was booming.
My chart shows how odd this is. Between Q1 1997 and Q4 2007 there was a strong correlation (0.76, R-squared = 57.7 per cent) between the trade deficit as a share of GDP and the unemployment rate. High unemployment was associated with a small deficit, and low unemployment with a big one.
There's a simple reason for this. High unemployment is usually a sign of weak aggregate demand, and weak demand means low imports.
Alternatively, we can think in terms of financial balances. High unemployment is generally accompanied by high domestic saving and low investment. As an accounting identity, a surplus of domestic saving over investment must equal a current account surplus, which implies only a small trade deficit. Conversely, unemployment is usually low when investment is high and savings low - which implies a large current account deficit and hence a big trade deficit.
Common sense, then, tells us that higher unemployment should be accompanied by a smaller trade gap.
But just recently it hasn't been. Since 2007 unemployment has soared while the trade gap has barely changed. By contrast, if the 1997-2007 relationship had continued to hold, our current 8 per cent unemployment rate implies that we would now be seeing small trade surpluses.
You might think there's a simple explanation for this breakdown. This has been a global recession, so our exports have fallen at the same time as domestic demand has fallen, causing unemployment to rise while the trade gap stays large.
There are two problems with this. First, the correlation between economic activity in the UK and overseas did not start in 2008. The boom of 2006-07 was a global boom, and yet our exports didn't rise so much then as to break the stable relationship between unemployment and the trade balance. So why should it be the recession that broke the relationship?
Second, exports would have to be vastly greater than they are to maintain that 1997-2007 relationship - some one-third higher. It's unlikely that weak overseas demand explains all this huge shortfall.
So, something else must be going on, but what?
One obvious theoretical possibility is that we've lost some international competitiveness; in making UK exports unattractive, this would raise both the trade deficit and unemployment. But, in fact, the opposite has happened; sterling slumped in late 2008, which should have improved competitiveness. This just deepens the puzzle.
Herein, though, lies a queer thing. My chart looks a lot like the relationship between US unemployment and inflation. In both cases, there was a strong and stable trade-off between the mid-90s and 2007. And in both the unemployment rate rose after 2008 without a commensurate fall in inflation or the trade deficit, implying a worsening in that trade-off.
In this respect, then, the UK and US recessions have something in common.
There are two (non-exclusive) possibilities here. One is some kind of supply shock, which both throws folk out of work and stops firms expanding - expanding exports in the UK case, and expanding supply sufficiently to reduce prices in the US case. The obvious candidate here is a reduced availability of bank finance. One reason why UK exports have not (yet?) responded to sterling's fall in 2008 is that firms that might have stepped up their export drive have been stymied by a lack of credit - or (what amounts to the same thing) have been reluctant to borrow for fear that credit lines might be withdrawn.
To see the second possibility, remember a fact that, although utterly trivial, is overlooked by most macroeconomic thinking - that the economy produces more than one good. The late Fischer Black - of Black-Scholes fame - described how this can produce economic fluctuations. Imagine, he said, just the two of us. I make dolls; you make art books. Now, if I want art books and you want dolls, there will be a boom. We'll both work hard to supply each other's wants, and to raise the cash to buy what we want. However, if I want science books and you want action figures, there'll be a bust.
Booms and busts, then, can happen not merely because of changes in aggregate demand or supply, as conventional macroeconomics says, but because of changes in the extent to which the pattern of technologies - my ability to produce dolls, your ability to make art books - matches the pattern of tastes. A high match gives us a boom, a low match gives us a bust.
And here's the thing. These mismatches can produce inflation and trade gaps alongside unemployment. There can be unemployment because some people's skills are badly matched to what people want to buy. And there can be inflation or high imports because there's insufficient domestic capacity to produce those things that people do want.
Perhaps, therefore, the recession - in both the US and UK - is, in part, a mismatch recession; the match between tastes and technologies has worsened. This is consistent with worsening trade-offs between unemployment and inflation or trade gaps. Conventional demand-induced recessions do not have such an effect.
Whatever the cause of the worsening trade-off between the trade gap and unemployment, there are two implications of it.
First, sterling could fall. This worse trade-off implies that if the economy were to recover sufficiently to reduce unemployment, the trade gap would probably increase as higher demand sucks in imports. This, though, would imply that the current account deficit would increase; it's unlikely that the surplus on trade in services or investment income would increase to offset this. This in turn would mean that we would borrow more from overseas. Which is unsustainable; a current account deficit of much more than 2.5 per cent of GDP would mean that our overseas debt would increase relative to GDP, which cannot go on forever.
In other words, external balance (a sustainable path for overseas debt) would be inconsistent with internal balance (acceptable levels of unemployment). The standard solution to such an inconsistency is for the exchange rate to fall to a level low enough to reduce the trade deficit.
How low is this? History gives us a clue. In the late 80s and early 90s, the unemployment-trade balance trade-off was worse than it was in 1997-2007. If we are returning to that position, our real exchange rate - the nominal rate adjusted for price differences - should also return to its early-mid 90s levels. According to OECD figures, this would require a fall of around 15 per cent.
There's a second implication - that the Bank of England might be too optimistic about inflation.
It thinks that a "persistent margin of spare capacity" will force inflation down. However, the huge trade deficit suggests there might not be so much effective capacity; if firms really have such capacity, why aren't they using it to step up exports or to replace imports?
Indeed, you can think of a trade deficit - especially one in goods and services put together - as a sign that demand exceeds supply. And this is inflationary.
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