In the second quarter, the UK's deficit on goods trade was £28.3bn. That's a record both as an absolute amount and as a share of GDP (7.4 per cent). This is odd because you'd usually expect a big trade deficit to be associated with an economic boom that sucks in imports. But, of course, the UK is not booming. Instead, what's happened is that the relationship between the trade balance and the state of the domestic economy has changed.
Between 1997 and 2006 there was a strong correlation (-0.84) between the trade gap and the unemployment rate; low unemployment was associated with larger deficits as stronger economic activity raised imports, and higher unemployment was accompanied by lower deficits. If this relationship had continued to hold, the 8 per cent unemployment rate we have today would be accompanied by a small surplus. Instead, we have a record deficit.
A similar thing is true, albeit not as dramatically, if we look at the overall current account deficit. The 1997-2006 relationship between the deficit and unemployment predicts that we should have a surplus now, rather than a deficit of almost 3 per cent of GDP.
The trade-off between external balance and 'internal balance' (decent levels of economic activity) has therefore worsened. Why?
The obvious explanation is simply that the weakness of our main trading partner, the eurozone, is depressing both exports and employment. This is some of the story, but not all. Imagine our goods exports were 10 per cent higher, with no change in imports (which is improbable, but let that pass). The trade deficit would then be 5.5 per cent of GDP and unemployment would, at best, be 6.2 per cent*. This would still represent a worse combination than we had in 1997-2006, when a 5.5 per cent trade gap was associated with sub-5 per cent joblessness.
Nor is it easy to attribute this worsening trade-off to an overvalued exchange rate. Sterling's trade-weighted index has fallen 20 per cent since 2007, but this hasn't stopped the trade-off worsening.
Nor is it easy to blame the recession for starving exporters of credit or for shaking up the patterns of supply and demand and so causing a mismatch between labour supply and demand. The trade-off began worsening in 2007, before the recession and credit crunch.
Instead, I suspect something else is happening which the recession has exacerbated - deindustrialisation, the relative decline of UK manufacturing and export capacity.
In truth, there's nothing new about the worsening trade-off between internal and external balance. In the early 70s, a trade balance was associated with 4 per cent unemployment (which was considered a problem at the time!). By 1997-2006, balance required 8 per cent unemployment. And now, it requires even more.
One problem here is that a lot of low-skilled manufacturing work has migrated to the Far East. This means that if low-wage jobs are to be created - a precondition for high employment - they must be in the services sector. But this means that higher employment will be associated with larger deficits in goods trade.
Does this matter? I think so. To see why, remember that a current account deficit means - by definition - that we are borrowing from overseas. A poor trade-off between this balance and unemployment therefore means that we cannot pay our way in the world unless we have either high enough unemployment to depress imports or unless the overseas demand for our exports rises improbably strongly.
Now, this is not an immediate problem. Our relatively healthy international investment position means we can borrow from overseas for some time; our net external liabilities are only just over 8 per cent of GDP. But, of course, we cannot borrow much from overseas forever. This means that the UK's long-run growth prospects are poor. And this in turn should require low valuations on those shares dependent upon domestic earnings growth.
*I say 'at best' because this calculation assumes that employment rises proportionately to the rise in GDP implied by a 10 per cent rise in exports, and that the growth in employment causes an equal drop in unemployment. Both assumptions are strong. In practice, higher exports would be associated with some rise in productivity rather than employment, and some of the rise in employment would be met from a fall in economic activity rather than in unemployment alone.
