The UK has squandered its fiscal strength relative to the rest of Europe, argues Holger Schmieding – and talk of a ‘Brexit’ will only make things worse
Britain tends to see itself as an economy apart. Blessed with its own currency and central bank, and its very own traditions, Britain has the freedom to run its economy to suit its own needs. In the wake of the euro crisis, the impression that Britain is in better shape than the continent seems natural. But it pays to have a closer look.
Since the start of the euro on 1 January 1999, British GDP has expanded by a cumulative 28%, well ahead of the 20% growth in the euro-zone. While unemployment has gone up by almost the same amount on both sides of the Channel, Britain preserved its structural labour market advantage, with a rise in its unemployment rate from 6.1% at the end of 1998 to 7.8% now versus an increase from 10.0% to 11.9% in the euro-zone.
However, Britain did not live within its means. Instead, it boosted the ratio of gross public debt to GDP by 38.3 percentage points, from 46.7% at the end of 1998 to 85% at the end of 2011. Despite the ravages of the financial crisis, the euro-zone lived much more prudently, with an increase in its debt ratio of only 14.5 points, from 72.8% to 87.3%, over the same period.
With a reckless fiscal policy, Britain increased the share of public outlays in GDP from 39.3% in 1998 to 49% in 2012, while the euro-zone largely held the line with only a minor increase from 48.5% to 49.5%, according to OECD data.
Before the euro, Britain had been in much better fiscal shape than continental Europe. But in order to artificially support demand for a while, it then squandered almost its entire fiscal advantage.
The British GDP advantage has also started to narrow. Since the great British credit bubble burst in late 2007, the British economy has contracted by a cumulative 3% (to end-2012). Euro-zone GDP is down by only 2.5% on its end-2007 level.
The comparatively low level of UK unemployment also has a dark side. UK productivity growth has stalled. To some extent, the sharp rise in euro-zone unemployment since 2008 reflects serious economic reforms and restructuring that will yield benefits in the future, just as the Thatcher reforms initially raised British unemployment before showing up in stronger economic performance.
Despite the euro crisis, Britain has no obvious economic edge over the euro-zone. Using its independent macro policies to ruin its budget up to 2008, Britain instead dug itself into a deep fiscal hole. Britain will need to tighten its fiscal position considerably more than the euro-zone over coming years if it wants make its position as sustainable as that of the euro-zone.
Britain ran a fiscal deficit of roughly 8% of GDP last year, far above the euro-zone’s 3.2%. While the euro-zone will not need much additional austerity in the future, Britain will have to save more in 2013, and beyond, than it did in the last two years. As a result, demand could soon expand faster in the euro-zone than in Britain.
In addition, concerns that Britain might leave the EU – the biggest market in the world – could weigh on British investment. Prime minister David Cameron has proposed to hold a referendum on EU membership by 2017. A British exit would hit Britain much harder than the rest of Europe.
Helped very much by the Thatcher reforms, London has successfully turned itself into the services centre for Europe, which depends on a guaranteed and fully-free access to its major market. It is an illusion to believe that Britain could maintain this access if it were to turn itself from an onshore into an offshore financial centre for Europe.
In an age in which financial markets are regarded with suspicion by many in the public and policy makers across the Western world, Paris, Frankfurt and Berlin would not allow a financial centre outside EU jurisdiction to dominate their markets. London has no alternative to Europe – it is simply in the wrong time zone to be the services centre of Asia.
The British debate about Europe carries a further risk. Scotland looks inclined to vote to remain within the UK in its referendum on independence in 2014. But anti-European sentiment is very much an English affair. North of the border, many see Brussels as a counterweight to London rather than a threat. If Britain were to leave the EU, chances are that Scotland would choose to re-enter it as an independent country.
Political forces clamouring for ‘UK independence’ may well end up with a Little England beset by the serious economic problems that could ensue if London loses its pre-eminent status in Europe.
Holger Schmieding is chief economist with Berenberg Bank