The road to recovery. A review of 2010
How the recession differed from those in the past
Emerging from the recession
The report so far: growth
The report so far: government borrowing
A time of austerity
Will it all work?
From cuts to growth
Rebalancing the economy
The role of money
Commentaries on the economic (and political) events of this past year have been marked by a general recognition of the enormity of its historic nature: the scale of its significance and impact is being measured in the decades.
It has been, indeed, a big year. It saw the end of the recession, described as the most severe economic downturn since - depending on whose analysis or sense of epoch-making theatre you consider the most dramatic - the Great Depression, the 1970s or the 1980s. The General Election witnessed the return of Liberal politicians to the corridors of Whitehall power for the first time since the last coalition government of the 1940s. While the Comprehensive Spending Review was hailed (or condemned) as the most trenchant paring back of state expenditure since the 1920s (or the 1980s).
What is clear is that the economic landscape in which we live and in which businesses operate has undergone a true transformation. All are agreed that things will, in the future, be different.
How the recession differed from those in the past
Not only was the recession virulent, it was also singular. Unlike many previous economic downturns, the nightmare of 2008 and 2009 was principally fuelled not by government efforts to control inflation but by the near collapse of the banking system, poisoned by toxic debts that were accumulated and bundled into other debt packages during the crisis in the US sub-prime market, and the subsequent drying up of private sector credit. If businesses can't borrow, then they can't grow; and if businesses can't grow, then the economy shrinks.
Emerging from the recession
The UK's tentative emergence from the storm of global financial meltdown was given its statistical official blessing back in January. Data from the Office for National Statistics (ONS) showed that in the last three months of 2009 the economy expanded by 0.3 per cent, ending six consecutive quarters of contraction.
Having shrunk by 6 per cent over the course of the recession, the economy was 10 per cent smaller than it would have been had the slump not occurred. Contraction for the whole of 2009 measured 4.8 per cent, the highest single-year rate of decline registered in eight decades.
At the beginning of 2010, pessimism was still the dominant mood. A huge public debt and a pronounced reluctance among banks to lend to businesses weighed heavily around the neck of the economy. A suspicion lurked - one that has not been dispelled in some quarters - that the feeble push into positive territory has only been achieved through the support offered by the Bank of England in the form of very low interest rates and around £200 billion of quantitative easing (money injected into the economy as a way of priming the wells of business and consumer liquidity).
Worries persisted about a double-dip recession. The UK's long-term growth trend is 2.5 per cent; given the financial head winds it is continuing to encounter, some predicted minimal growth of 1 per cent for 2010. And, worse, a rebound, slipping back into recession should the private sector prove not to be strong enough to compensate for any slowing down in public spending.
The report so far: growth
In fact, the economy appears to have proven itself a little more resilient than many had expected. The second quarter of the year chalked up growth of 1.2 per cent; the third quarter growth of 0.8 per cent. Much of the impetus in the third quarter came from the construction industry, which saw growth of 4 per cent during the three-month period. Manufacturing slipped from the 1 per cent recorded in the second quarter to 0.6 per cent, a rate that was nevertheless still up on forecasts. The service sector remained at a 0.6 per cent growth rate. The data indicated that the UK economy had achieved its strongest six-month rate of expansion in a decade and that it has grown by 2.8 per cent in the past year.
There are signs, too, that UK manufacturing, much vaunted as the re-balancing engine of recovery, is in better health than might have been expected. The Markit/Chartered Institute of Purchasing and Supply (CIPS) reported that its purchasing managers' index for manufacturing climbed from 53.5 in September to 54.9 in October. The manufacturing purchasing managers' index has now been in positive territory - any figure above 50 indicates expansion - for 15 months. In another sign of growing confidence, manufacturers boosted stock levels for the first time since November 2007.
Rob Dobson, senior economist at Markit, said: "An improvement in the UK manufacturing PMI for the first time since May's 15-year high will provide reassurance that manufacturing remained a driver of UK economic growth at the start of the final quarter. Rates of expansion in output and new orders strengthened following the sharpest gain in new export orders for five months, with the export performance of intermediate and investment goods producers especially robust."
So good news then? Possibly. There is no doubt that growth has been promising. Where doubts prevail, however, is whether the economy is in a fit enough condition to withstand the impact of the planned four years of cuts in public spending.
The report so far: government borrowing
What hasn't appeared (as yet) is a sure signal that government borrowing is on the wane, although the promised spending cuts have yet to be implemented. According to the ONS, the government borrowed £16.2 billion in September in order to close the yawning gap in public finances. For those Septembers on record at least, it was the highest borrowing requirement yet recorded. In 2009, the equivalent figure was £14.8 billion. The UK's total net debt also broke new records, climbing to 57.2 per cent of GDP.
But, taking the longer perspective, matters may be improving. In the current financial year (as of September), government borrowing reached £73.5 billion, down on the £77.4 billion that had been loaned the UK at the same stage in 2009. Last year, annual borrowing came in at an eye-watering £154.6 billion. The Office for Budgetary Responsibility, in its most recent report, has forecast an overall figure of £149 billion for 2010.
It should also be pointed out that the borrowing data excludes the ramifications of the previous government's intervention in the financial sector. Were this to be taken into account, total government debt is even higher: 64.6 per cent of GDP (or £952 billion in pounds not in our pockets). But net borrowing for September would fall to £15.6 billion.
That government borrowing, whichever the measure, should have nudged up is a cause for concern, given that VAT has already switched back to its old rate of 17.5 per cent (until January 2011 when it rises to 20 per cent) and that the economy has shown an instinct for growth in the middle part of the year. The new Government's response to ballooning national debt forms the next part of our review.
We have had two Budgets this year, one in March, one in June. Alistair Darling's last as Chancellor and George Osborne's first. Both men agreed on the need to tackle ballooning government borrowing. But thereafter they diverged. For Labour, there had to be cuts but not so deep and not so fast. For the Coalition, there had to be cuts, now and stringent, if the UK was to retain its triple-A international credit rating and to avoid the fate of some south European economies.
Mr Osborne promised to eliminate the structural deficit entirely by 2015/16. He also committed the government to reduce borrowing as a share of GDP from its current 10.1 per cent to 1.1 per cent (£20 billion) over the same timescale. Just how this would be achieved was announced in the Comprehensive Spending Review.
A time of austerity
Spending reviews have been part of the governmental landscape since the late 1990s, but none garnered quite the anticipation of the one which the Coalition Government delivered in October. We were entering a new age; an age of austerity; an age when the largesse of government is to be withdrawn.
Mr Osborne told MPs in a packed House of Commons that the reductions in expenditure, totalling almost £81 billion, were needed to draw Britain "back from the brink". What they and the rest of the country then heard was the Coalition's blueprint for tackling the budget deficit in a way that would effectively eradicate government debt in the lifetime of a Parliament.
Total public expenditure, which includes debt interest payments, is forecast at £702 billion next year, then, in the ensuing years, £713 billion, £724 billion and £740 billion, bringing real terms public spending to the same level as 2008. But where would the £81 billion of cuts fall?
Part of the cost will be the loss, as predicted by the Office for Budgetary Responsibility, of some 490,000 public sector jobs by 2015. The changes to the welfare system were perhaps the most marked of all the planned reductions in spending, with some £7 billion more of funding (on top of the £11 billion already earmarked) to be withdrawn over the next four years.
The health budget will rise by 0.4 per cent annually in real terms over the next four years, its annual spend reaching £114.4 billion by 2015. The education budget is also to enjoy an increase in funding each year.
But there the ringfencing ended, with most departments set significantly stringent spending targets for the duration of the current Parliament. The Home Office is to lose 6 per cent a year. Police budgets are to face a 16 per cent cut over the next four years. The MOD must deal with cuts of 8 per cent; the Foreign Office 24 per cent; and the Cabinet Office 35 per cent.
Although the Department of Business is to wave goodbye to 25 per cent of its funding over the course of the next four years, the science budget is to remain at £4.6 billion a year, so protecting the teaching of and research into STEM subjects such as technology, maths and engineering. The government also committed itself to increase spending on adult apprenticeships by £250 million a year, creating an extra 75,000 apprenticeship places.
The Department of Energy escaped with a relatively inoffensive 5 per cent annual cut, and the Chancellor committed the government to setting up a Green Investment Bank aimed at encouraging investment in environment-friendly businesses.
Will it all work?
Like almost every Chancellor before him, Mr Osborne took up the sword against bureaucracy, pledging to recycle efficiency savings, made by reducing the wastefulness of government spending, into better, more productive public services. Whether he will succeed where most others have failed will remain open to question until the cuts have taken their full course.
But there is a bigger question still. Is it possible to reduce the deficit without also suffocating economic growth? Most business groups believe so. The spending review received a generally warm welcome from the CBI, the Institute of Directors, the British Chambers of Commerce and the Federation of Small Businesses.
By the government's own admission, almost half a million public sector jobs are to be eradicated. Private sector firms - at least those that rely on government contracts - will be hit too. The hope is that other private sector employers will rush to fill the gap, expanding at a rate sufficient to make good the losses and, in addition, create a million new jobs on top of that. By no means impossible - the axing of public sector jobs in the mid-1990s prompted the generation of two million new private sector positions - but a challenge all the same. Not least because the conditions that prevailed 15 years ago are absent now. Then the world economy was expanding; the devaluation of sterling following the UK's departure from the exchange rate mechanism meant that exporters found life easier; and the banks were on their feet and prepared to lend.
The cuts will, in effect, mean reducing GDP by 0.5 per cent per year over the next four years. Picking up the slack will make a big demand on business. Yet it's one to which they can rise. With the private sector employing four times the number of people who work in public organisations, the private sector would need to grow by just that same 0.5 per cent a year to achieve the compensation.
And larger private sector employers have cash to invest. Unlike the banks (and UK households), many firms eschewed the orthodoxy of over-borrowing and resisted the temptations of cheap credit in the months leading up to the recession. This despite the fact that they were often urged to bulk up on inexpensive debt as a way of making good use of company balance sheets. One consequence of this prudence was that many firms - not, of course, all - were in a position to navigate the exceedingly choppy waters of the downturn by negotiating pay cuts or reduced working hours in order to minimise job losses.
A further consequence is that, according to a recent Bank of England survey, larger firms have cash holdings in sufficient amounts to resume coherent, well managed investment in both jobs and products and services. Even the debate over the (very real) struggle many smaller employers have been encountering in securing loans or credit is tinged with optimism. Undoubtedly, SMEs have found it tough to convince banks burned by the financial crisis to lend; but a good proportion of them have been paying down debts rather than seeking to borrow. Indeed, the credit famine may not be quite as severe as trade body surveys and popular imagination suggest: credit to UK business overall is down by 6 per cent - the equivalent to the loss in output during the recession - but to small business it is down by only 3 per cent. Besides, the argument goes that the early stages of recovery are rarely marked by sudden surges in borrowing. Loans start to flow once firms have the confidence to invest again, and that tends to happen only when they are more sure of demand.
Following the Comprehensive Spending Review, newspapers enjoyed a game: ask the Nobel Prize winning economist. Some of the luminaries whose views were consulted regarded the reductions in spending as a recipe for Japanese-style deflation and economic inertia (suck money out of the system, and prices and consumer spending stagnate); others applauded an adventurous balancing of the books. Sentiment that clusters around the Bank of England's own rate-setting Monetary Policy Committee (MPC) has shown equal signs of a division of prophecy.
MPC policymaker, Andrew Sentance insisted that the spending cuts would not derail the recovery from recession. He pointed out that public spending as a whole will actually rise in cash terms over the next four years and slightly above inflation. In his view, the auguries, compared with previous efforts at regeneration, are good. Unemployment, standing below 8 per cent of the workforce, is lower than that of the early 1990s. The world economy, though still sluggish, is predicted by the International Monetary Fund to grow by 5 per cent in 2010 alone. He sees inflation ahead not deflation.
But then there's David Blanchflower, a former colleague on the MPC. He believes that the spending cuts are the "riskiest macroeconomic experiment undertaken by any advanced country in living memory" and that the response to a "one-in-a-hundred years financial crisis" is disproportionate.
From cuts to growth
With the spending review out of the way, the Coalition has set its sights on the action it can take to stimulate the counterbalance to the cuts: growth.
Back in the June Budget, the Chancellor set out a series of tax measures aimed at supporting business. Starting from 1 April 2011, the headline rate of corporation tax will be reduced by 1 per cent each year for four years until it reaches 24 per cent. The small profits rate (formerly referred to as the small companies rate) of corporation tax rate is also to be reduced next year, down 1 per cent to 20 per cent. The reduction is going to be offset by a small cut in the rates for capital allowances. For most plant and machinery assets, the rate of allowance is to decline from 20 per cent to 18 per cent. For assets with a longer lifespan, the special rate is to drop from 10 per cent to 8 per cent. The Annual Investment Allowance (AIA) is also to fall. The AIA enables most businesses to cut their taxable profits by the full amount of their annual capital investment on most plant and machinery up to £100,000 a year. That figure will come down to £25,000, although the allowance cuts will not take effect until April 2012.
As from April 2011, the threshold at which employers start to pay national insurance contributions will rise by £21 a week above the rate of inflation. This means there will be a fall in the cost of employing staff on incomes less than £20,000 a year. The Budget also unveiled a new scheme designed to encourage private sector employment in those areas where there is high public sector employment. Firms that set up outside London and the south-east of England will not have to pay employers' national insurance contributions on the first ten employees they recruit during their first year in business. The exemption is to be limited to a maximum of £5,000 per employee or £50,000 per firm, and can be applied for at any time over the next three years.
The Government has consistently argued that, given the financial constraints, there is only a limited amount of work it can do to stimulate growth directly. The Department of Business has seen a swathe carved through its budget. That said, plans are in place to offer business as much succour as the Government believes can be afforded.
Some £200 billion will be invested in public and private infrastructural spend over the next five years as part of the new National Infrastructure Plan.
To give smaller businesses the chance to develop and expand, the government has come up with a series of proposals aimed at supporting entrepreneurship. These include improving access to finance and making it easier to do business with the public sector. Lord Young, the former trade and industry secretary, has been appointed enterprise adviser to the Prime Minister. He is to focus on four key areas: encouraging start-ups; cutting down on regulatory burdens; maximising opportunities by reforming government procurement; and improving communications between government and SMEs.
Elsewhere, the Enterprise Finance Guarantee (EFG) is to continue for the next four years, making around £2 billion available to viable small companies without a credit history or collateral. A further £200 million is to be open to Enterprise Capital Funds supporting equity investments in the highest growth potential businesses.
To encourage private investments, business angels and the Government's SME investment arm, Capital for Enterprise, are to set up a co-investment fund as part of the Regional Growth Fund to support high-growth, early-stage SMEs. The Government is also to work with banks on several areas, including the £1.5 billion Business Growth Fund and a new lending code. On the issue of tendering for public sector contracts, the Government pledged itself to a target of awarding a quarter of all government projects to SMEs.
In the regions, the green light has been given for an initial wave of 24 Local Enterprise Partnerships (LEPs). With Regional Development Agencies (RDAs) due to be phased out in England by 2012, the LEPs will bring together businesses and local authorities in an effort to set local economic development plans. The new LEPS will be able to bid for finance from the £1.4 billion Regional Growth Fund, which can invest the money in areas of the country most adversely affected by cuts in public spending.
The Government has also promised to look at: proposals that would allow local authorities to keep the business rates they collect; a new system of Tax Increment Financing, which will enable local authorities to borrow against future increases in business rate revenues; and a streamlined planning system.
Rebalancing the economy
It is widely agreed now - although it has been widely agreed by most governments of the past 50 years that have presided over the decline of the UK's industrial base - that we need to broaden our manufacturing capacity. That the foundations of the recovery need to be built on the solidity of manufacture. That the economy needs to move away from credit-driven domestic consumption (but not away from domestic consumption itself) and further towards to (export-led) production.
It is, of course, a myth that Britain no longer makes things. We are still one of the world's largest manufacturers, despite the fact that the services sector accounts for some 75 per cent of the economy. And the figures quoted above (the report so far: growth) indicate that the manufacturing base is capable of expansion given sufficient encouragement.
That the Government chose to protect public investment in science is a sign of the understanding in high places that, unable to compete with China and India on labour costs, the UK must achieve this tricky act of rebalancing through innovation and knowledge-intensive industry rather than through cheap production.
The devaluation in the pound should be a help in 2011 to exporters, but more needs to be done to boost trade with developing nations in Asia and South America. This is particularly urgent given the slough in which the eurozone and the US economy are currently mired. By the Bank of England's own estimates, narrowing the gap between the amount we import and the amount we export - imports have long held the upper hand - would generate as many as 500,000 jobs. Yet the fact remains that the UK exports more to Ireland than it does to Brazil, Russia, China and India put together. Little wonder that many smaller firms with ambitions to trade abroad have been urging greater and easier access to export credit guarantees.
Almost half of the new jobs that were created during the period that led up to the recession arrived courtesy of high-growth, innovative, technologically based SMEs. The problem for many such firms is investment or rather its lack. While the Government should not be in the business of choosing which individual small companies will be successes, it is essential that everything possible is done to ensure that such firms have at least the chance of sustainable investment funding. The survival of the Enterprise Finance Guarantee, established by the previous administration and which allows SMEs to free up working capital through government-guaranteed loans and consolidated overdrafts, has been heralded as a positive move.
But the difficulty for the economy as a whole in steering itself back in the direction of production is that the issue is structural not merely cyclical. The reconstruction of the industrial base will demand substantial capital investment, whatever its source, over a considerable period of time. The outcome may be to push industry back to the centre of economic debate, where it truly belongs, but it may not involve the mass creation of employment. Those jobs that are generated will be highly skilled but, possibly, not numerous. Knowledge intensive manufacture is not, by its nature, mass employment intensive. The services sector, in which jobs can pop into existence with much simpler ease, will still have a critical part to play in soaking up the exodus from the public sector.
The role of money
In November, faced with a continuing reluctance on the part of its economy to respond to stimulus, the US Federal Reserve decided to inject another $600 billion dollars into the semi-comatose patient. That was on top of the $1.7 trillion already invested through the Fed's quantitative easing programme. The problems for the US are challenging and are worth bearing in mind as a model. Unemployment is at a 26-year high of 9.6 per cent. Inflation, which is not always the evil it is popularly regarded as, is at a nine-year low of 1.2 per cent (company profits are being squeezed, leaving little scope for investment and new jobs). The latest batch of freshly minted cash is being directed towards buying US government bonds rather than corporate debt, but the question still hovers: if all else fails, can continued quantitative easing be the answer?
On this side of the ocean, the Bank of England's Monetary Policy Committee is wrestling with the same but also dissimilar question. In the UK, the debate rests on whether extra quantitative easing - on top of the £200 billion already made available - is needed to counteract short-term increases in unemployment which, in turn, result in a dampening of domestic consumer demand and further job losses as businesses reduce investment and shed labour: or whether persistent above-target inflation needs to be curbed not by introducing more money into the system but by increases in interest rates.
The Chancellor, George Osborne has suggested that more quantitative easing on the part of the Bank of England - purchasing bad corporate debt - could help to balance the effects of the government's austerity cuts. If huge public debt precludes government spending to help prime the economy, then why not print more money?
Quantitative easing certainly played an important role in the most toxic stages of the recession. In flooding the supply of money, quantitative easing helped to pin down interest rates, encouraged consumer spending and gave firms the chance to refinance. The argument for further additions to the amount of money circulating the economy is that it will support the private sector as it seeks to compensate for diminishing government spending and will prompt consumers and firms to open their wallets. The counter argument is that, in the UK at least, deflation is not an immediate threat. The rise in the cost of living has resisted all efforts of the downturn so far to suppress it. If deflation is not the risk it may be, why churn out yet more money and run the danger of fuelling inflation itself?
The economy is in uncharted waters. While there is no inevitability that the government's fiscal squeeze - the spending cuts - will push the UK back into recession, that assumption does hinge on the ability and willingness of the private sector to begin investing in jobs, products and services. And while there is general acceptance that the budget deficit needs to be tackled - the debt that places the country in hock to international bond holders will only serve to soak up taxes that could otherwise be spent on the public services - that acceptance depends on the goodwill and tolerance of the British electorate. If unemployment rises, if firms fail, if savings are thumped, if pension pots shrivel, then support for the pain needed to gain will fade away.
The world also is in a tough place. The economies of the advanced nations are pursuing the same objective of consolidation, which means that there is little money left over for spending on imports.
Households are under the cosh as well. Or, at least, feel that they are. A survey of 1500 homes carried out by researchers Markit found that a quarter of those polled in October believed that their finances had deteriorated since just the previous month. The power of collective psychology can be as influential, in its own way, as that of economics.
The signs of recovery are most certainly there in the economy. So, too, are the old systemic flaws. So, too, are guarded optimism and reasonable anxiety. So, too, is the will to reduce the deficit and to boost a new entrepreneurial dynamism. So, too, are the debates over policy, its broadest reaches and its subtlest nuances. Yet it could just be that the recovery will rely on that most intangible of economic variables: confidence; the confidence among consumers, businesses and investors alike that things will, eventually, work out. As they usually, in the end, do.