The state we're in

Finbarr Bermingham speaks to Nick Bate, UK Economist at Bank of America Merrill Lynch to get a status report on the UK economy and some predictions for our future

We've all seen the headlines: "Billions wiped off FTSE 100!" "Unemployment soars after record job cuts!" "Broken markets driving up food prices!" While the press are rarely masters of restraint, it's clear that all is not right with the UK's economy. Nick Bate, UK Economist for Bank of America Merrill Lynch, though, is reassuringly calm. He admits that "there are a range of problems facing the economy at the moment", but is also hopeful that "things will get somewhat better through 2012".

The list of problems faced by the UK economy is, however, long and comprehensive. Many of them can be attributed to a combination of domestic and international issues, alongside a slower than expected recovery from the 2008 financial crash. Higher unemployment, strong inflation, large fiscal deficits and muted growth are all, says Nick, part of the fallout from the events of three years ago, or in part direct results of the government's attempt to remedy the situation.

No jobs, too small

"Unemployment is up from around 5.4 per cent in 2007 to about 8 per cent now," Nick explains. "All of those people have had a cut in income and are, therefore, spending less. Additionally, because there is also a larger pool of available labour out there, people that are working are finding it harder to push for a wage increase - there are other people that employers can employ in your place." A significant cause of the sharp rise in unemployment figures is the government's shedding of around 290,000 public sector jobs since the start of 2010. These job cuts have been a central part of the government's attempts to slash public spending, a move which has made them greatly unpopular in some quarters, but is one which Nick says was made inevitable by the state of the UK's finances.

"The UK's GDP fell about 6.5 per cent from peak to trough from early 2008 to mid 2009. Before the general election, the government was borrowing 11 per cent of GDP, which was almost the highest in the world. The government's credit is rated as "AAA" (the healthiest attainable) by the various credit rating agencies, the benefit of which is the low cost of debt. With borrowing levels so high, though, there were risks that the UK would face a credit downgrade. The current government was therefore forced to tighten fiscal policy (public spending and taxation) in order to keep the cost of borrowing down. The negative impacts of doing so included the public sector job losses, and also a rise in VAT. There's been a debate about whether the measures taken by the government have been too harsh, but it's clear that they couldn't have carried on borrowing over 10 per cent of GDP."

Life is dear...

The 2.5 per cent hike in VAT ("value added tax", which is built into the price of goods) from 17.5 per cent to 20 per cent at the beginning of 2011 has left those who work to a fixed budget getting significantly less for their money. This change is described by Nick as "the most noticeable impact of the government's fiscal changes for many", which has been compounded by higher prices for other items too (eg petrol, utility bills) and stuttering wage growth. Says Nick: "Prior to the crisis, the average annual wage growth was roughly 4.5 per cent, and the Bank of England's inflation target was 2 per cent. So, in real terms, people's wages were going up about 2.5 per cent every year. At the moment, though, things are the wrong way around. Inflation is 4.5 per cent and wage growth is 2 per cent, so people are having wage cuts of 2.5 per cent at the minute. The real income position of households is a lot weaker, and that's a considerable drag on the economy."

Usually, when the economy is as weak as it is, you wouldn't expect inflation to be so high for so long. It seems particularly strange when you consider the Bank of England's current fixing of interest rates at 0.5 per cent - low interest rates normally lead to low inflation.

A fall in the value of the pound is a significant contributor to today's high inflation. The sterling exchange rate fell about 25 per cent in 2009, and has remained broadly stable since then. This dramatic decrease drove up import prices, and as a result, the price of consumer goods. Instability in the price of commodities such as oil and crops has compounded the problem.

Big business?

While the British man on the street is undoubtedly feeling the pinch of this economic turmoil, so is British industry. In September, disappointing financial results were announced for the manufacturing, service and retail sectors, shortly after the British Chamber of Commerce had downgraded its forecast for 2011 growth. Part of the reason for these numbers, claims Nick, is an "increasingly globalised supply chain". Not only has the ability to produce things cheaper abroad damaged these sectors, but the turbulent socioeconomic landscape across the world has also had an effect. If the activities of these sectors were entirely based in the UK, then the impact of events in other countries wouldn't be so keenly felt domestically. But nowadays, because the operations, suppliers and customers of many businesses are spread around the globe, trouble in one country can easily affect the economic health of companies based in another. Specifically, Nick highlights events in the Middle East, the ongoing uncertainty in the eurozone, the Japanese tsunami and the US debt ceiling stand-off as being particularly costly to UK industry.

In the future...

Talk of "green shoots" undoubtedly sounds hollow to people out of work and businesses going bust. The measures taken by the authorities have come under scrutiny, but Nick sees them in a positive light. "The Bank of England," he says, "has been supporting the economy quite significantly. They've been engaging in quantitative easing (printing more money to buy up financial assets and so injects funds into the economy, which helps boost the prices of the assets' bought, encourage confidence, and increase spending) and have kept interest rates at a very low level (0.5 per cent). If interest rates were still 5 per cent and they hadn't printed £200 billion worth of money, then the economy would be in a materially worse state than it is now."

Amid all the doom and gloom, Nick suggests there are positives visible on the horizon, too. Inflation should come back to the Bank of England's target of 2 per cent by the end of 2012, meaning the cost of goods to you and I won't continue to rocket. This reduction will be attributable to a number of factors: "There is no plan to put VAT up again, so that'll drop out of the inflation numbers early next year. Similarly, oil prices have stabilised -and have actually fallen back a bit over the last few months. That, too, will help lower inflation."

However, things could get worse before they gets better: "In the near-term, though, inflation is probably going to rise again and hit roughly 5 per cent, as higher utility bills feed through."

Double trouble

The doom merchants of Fleet Street have for years been fixated on the prospect of a double-dip recession, which they claim would be the final nail in the coffin of the UK's economy. Nick admits another recession is possible, but calls for perspective: "Growth is relatively soft at the moment and a double-dip recession is clearly plausible. But there are vast differences between different recessions. For example, in the early '90s, the economy contracted about 2.5 per cent from peak to trough. In the recent financial crisis, the economy contracted 6.5 per cent from peak to trough. So one recession can be more than double the size of the other, and I wouldn't get hung up on the word. If the economy grows by 0.1 per cent per quarter for two quarters, then it's not a recession. If it shrinks by -0.1 per cent for two quarters then it is a recession - but there's not a vast difference between those two different scenarios."

A recession's cause may give a clue to its likely severity. If it's a result of an event like the Japanese tsunami, which disrupted some supply chains, concerns over the US debt ceiling,or higher oil prices due to events in the Middle East, then the outlook, says Nick, "is somewhat better". Events like these usually only have a temporary effect on our economy. But an event such as the Greek government defaulting on its debt could have much more severe implications because of the potential impacts across financial markets and the links between the UK economy and the eurozone: these factors might "differentiate between a mild recession and a severe one".

Industrial revolution

So how are we to pull ourselves out of this malaise? UK industry is arguably at its lowest ebb, with figures being reported far inferior to the ones expected. There is potential in Britain, though, and Nick says we should be focusing on what we do well. "We have some very specialised industries within the manufacturing sector," he says. "High tech engineering, and aerospace are areas in which the UK has been historically good. We've also got some very good car plants up north. We are also relatively successful in various professional services: law, accountancy and consultancy, for example. So there are areas of relative strength in the economy. Going forwards, export-orientated industries should benefit from the fact that the sterling has gone down in value by 25 per cent. So all else equal, that means that their prices are 25 per cent more competitive in foreign markets. Higher profit margins could encourage more firms into the export sector."

If we are to stabilise going forward, though, the onus is on the international community to pull together. Nick says: "Pre-crisis, many people advocated more joined-up thinking about where the global economy was headed. Individual countries, however, were trying to look after their own interests. The result for the global economy wasn't optimal. Some countries were continually running surpluses, and others were consistently running deficits. If you continually run deficits, your debt will eventually build up and that can cause problems. So perhaps a more balanced economy between deficit countries and surplus countries could have prevented the build up of the imbalances which hit the global economy massively. This should be earmarked as an area for improvement globally."