The UK is borrowing more from overseas. Next Friday’s figures are likely to show that the current account deficit on the balance of payments increased at the end of last year, to over 5 per cent of gross domestic product.
History suggests this is bad news. Big and rising external deficits in Greece, Portugal and Spain in the mid-2000s led to severe financial crises there. And in the UK there has been a significant negative correlation (of minus 0.51) since 1948 between the deficit as a share of GDP and subsequent five-year real GDP growth. Bigger deficits lead to slower growth.
To see why this should be, remember that – as a matter of accounting identity – a current account deficit means that domestic investment exceeds domestic saving. This can lead to slower growth through three channels.
One is that if people are borrowing more than they are saving it is likely that bank lending is growing faster than bank deposits and bank capital. That means banks are becoming increasingly fragile – with their leverage increasing or them becoming more dependent upon wholesale funding. For this reason, big external deficits can be a warning sign of a financial crisis: the US’s current account deficit rose in the mid-2000s, too.
Another channel was pointed out back in 1980 by Charles Horioka and Martin Feldstein and remains true today. They showed that capital is surprisingly immobile across borders so that countries simply cannot borrow very much. Big external deficits are therefore unsustainable. And one way for them to come down is for countries to have to save more.
A third channel is more benign, but still means that big deficits lead to slower growth. It’s simply that low domestic savings and high borrowing are themselves only temporary. If we borrow a lot in one year we’ll not do so the next, which means demand will fall. This can be entirely rational. If you borrow to buy a new car this year, you’ll not do so next year. Which means you’ll borrow less and spend less. If enough of us do this, demand will fall. A big current account deficit will then lead to slower growth without actually causing it.
It’s this third channel that might well operate now. In recent years, demand growth has been fuelled in part by a fall in households savings – from around 9 per cent of disposable incomes in 2013-15 to under 5 per cent now. Such a fall cannot continue, because people will need to save for rainy days or for their retirement. And, in fact, the OBR expects it to stop: it forecasts the savings ratio levelling off from now on. This removes one source of economic growth. And while some other sources might strengthen – the eurozone economy might recover later this year and business investment could bounce back if or when Brexit uncertainty diminishes – these will not outweigh the adverse impact on consumer spending of a levelling off in the savings ratio.
For this reason, the OBR – like most forecasters, including the gilt market – foresees weak growth in coming years: the 1.5 per cent per year it envisages over the next five years is significantly less than the 2.8 per cent average growth rate we enjoyed in the 50 years to 2007. Most economists therefore expect it to remain the case that big current account deficits lead to weak growth.
