Osborne's scissor hands: A cut-and-grow job?

The economy is made up of four sectors: households, companies, government and the rest-of-the-world (import/export) sector. The outgoings of any one sector are reflected in the income of the others. Thus, taxes paid by households are income for the government and the money they spend on goods and services are income for UK companies, or for the overseas sector if they are imported. This means total spending across the four sectors must equal total income. It also means that if one sector has net savings (its income is greater than its spending), then the opposite must be true for at least one other sector, and that the balance of net savings (positive and negative) across the four sectors must sum to zero.

These net savings balances are not just interesting for their arithmetical properties, however. Their development over time tells us a lot about the economy. Here is the UK's track-record over the last 17 years. We can clearly see the shift in the corporate sector from deficit to surplus after the turn of the century, mirrored by government deficits.

Figure 1: UK financial balances by sector (% of GDP), 1998–2014

Source: Office for National Statistics, Quarterly National Accounts Q2 2014
Note: The chart shows four-quarter moving averages to smooth out volatility in the data.

Developments in these balances help us to understand calls to rebalance the economy. If the government wants to further reduce its deficit, one or more of the other sectors will have to reduce its surplus or move into (larger) deficit. One possibility is for households to borrow more. But UK households already have one of the highest debt-to-income ratios in the world, and their borrowing tends to push up house prices, creating the potential for a future price fall. Better options, therefore, are (a) a shift into deficit for the company sector, as a result of strong business investment spending, and (b) a reduction in the surplus of the overseas sector through stronger UK exports.

In the past few years, however, the UK has scored only one out of three on the rebalancing front. Business investment spending has accelerated in recent quarters and was up 11 per cent over the year to the second quarter of 2014. As a result, the company sector's surplus has contracted, offsetting some of the reduction in the government's deficit.

But over the last three years the rest-of-the-world surplus has got bigger: imports have increased moderately in real terms over this period, but exports are actually lower than they were in the second quarter of 2011. The hope was that the fall in sterling's exchange rate that occurred during the financial crisis would lead to an improvement in the UK's trade position. In fact, the reverse has happened. And the household sector has again moved into deficit, spending more than its income and running down savings or taking on debt.

So much for the past, what about the next five years? Is there any prospect of an economic recovery that is better balanced? We will get the OBR's latest projections at the autumn statement, but here are the most recent figures from the Office for National Statistics:

Figure 2: UK financial balances by sector (% of GDP), actual and forecast to 2019

Source: Office for National Statistics, Quarterly National Accounts Q2 2014
Note: The chart shows four-quarter moving averages to smooth out volatility in the data.

If the OBR is right, the economic recovery will not be driven by investment and exports but by households taking on more debt. By this account, the period from 2008 to 2019 is characterised by two shifts in debt: the first was from households to government, and the second will be from government back to households.

If this seems implausible, then it reveals the limits of this type of analysis. The OBR is constrained by the chancellor's fiscal plans to forecast that the government deficit is eliminated, and so it has to make projections for the balances of the other sectors that are consistent with this outcome. It already has an optimistic forecast for exports, and arguably for business investment too. So, within their analysis, the household sector has to take the strain.

If, on the other hand, the OBR started with a projection of the most likely outcome for the household sector's financial balance and added in its current forecast for the company sector and a more reasonable forecast of exports, thus leaving the government sector as the residual element, then it would end up with a forecast for a much more modest reduction in the government deficit.

And here is the nub of the issue. If the next government insists on trying to stick to the timetable for deficit reduction set out by the chancellor, the risk is that the adjustment will take place in the other sectors, through weak growth. The household deficit will increase due to lower incomes not higher spending; the company sector surplus will move into deficit due to poorer profits not higher investment spending; and the rest-of-the-world surplus will shrink not due to strong exports but because of weak imports as a result of a weak UK economy. And weak growth will in turn blow the government's deficit elimination plan off course. This is precisely what happened in 2011 and 2012, and it could happen again in the first half of the next parliament.