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Big deficit, small problem

The UK is still borrowing billions from abroad. This is not a problem – yet
December 12, 2019

Those of you of a certain age might feel a little puzzled next week.

Official figures on Friday are likely to show that the UK had a current account deficit – that is, borrowing from abroad – of over £20bn in the third quarter. That’s over 4 per cent of GDP. And the reaction to this will be – well, nothing. To anybody formed in the 1960s, when politicians and investors obsessed about much smaller deficits than this, such insouciance will seem weird.

So what’s changed? One big difference between then and now was that deficits back then put pressure on sterling – leading to the devaluation of 1967. Now we have a floating exchange rate we needn’t worry on this score.

This, however, isn’t the only story. There’s little correlation between current account imbalances and sterling. For example, the deficit rose steadily in the 1997-2007 period, but sterling’s trade-weighted index stayed stable. It was the financial crisis of 2008 and Brexit vote of 2016 that hit the pound, not the deficit.

Nor is it the case that deficits don’t matter today because greater capital mobility means they are easier to finance. As Nick Ford and Charles Horioka point out, financial markets cannot in themselves deliver any net capital mobility at all simply because every seller of a pound, an equity or a bond requires a buyer.

Instead, there’s another reason why nobody cares much about the deficit. It’s because it is not really the UK’s deficit at all, but rather foreigners’ surplus. Our deficit is the counterpart to a massive current account surplus in Germany – which the IMF expects to be almost $270bn this year – as well as big surpluses in Japan and in oil exporters. Because a current account surplus is (by definition) equal to the excess of domestic saving over domestic capital formation, the UK’s deficit is therefore a symptom of the ongoing global savings glut.

One big fact tells us this – that gilt yields have fallen this century as the UK deficit has increased. This is the exact opposite of what we’d expect to see if the UK had trouble financing the deficit: if this were the case, interest rates would have to be higher to encourage foreigners to hold UK assets. But it is exactly what we’d see if the deficit were a sign of a global savings glut.

None of this, however, means that the current account deficit will never matter. The UK is an ageing nation – albeit not as much so as Germany or Japan. This means we should prepare for our dotage by saving more, which means having a smaller external deficit.

What’s more, deficits can be a sign of excess demand: more imports than exports can mean that demand is outstripping supply. The fact that we are running a deficit at the same time as having mass underemployment – with 3.3m working fewer hours than they want alongside 3.2m out of work – is perhaps a sign of a mismatch between what we are spending as a nation and what we are capable of supplying. Which is a sign of numerous structural problems with our economy.