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What can we do about our massive annual financial deficit with the EU27?

By John Mills

In 2016, the UK had a total foreign payments deficit of £115bn. Of this huge sum, which is nearly 6% of our national income, however, £111bn was solely with the EU27 and not with the Rest of the World, where we had a deficit of only £4bn.The Bulletin which is below provides detailed figures.

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Brexit or no Brexit, our massive balance of payments deficit with the EU27 is a very serious problem for us. Because all current deficits have to be matched by equal and opposite capital movements, as a nation we have had to sell assets or borrow over £100bn every year to finance the foreign payments deficit thus caused, losing control of more and more of our economy in the process.

Our massive balance of payments deficit also sucks demand out of the UK economy, transferring claims on UK output to people on the continent. The lost demand has to be replaced to stop the economy tanking by the government and consumers spending more than their incomes and running up debt. This encourages fruitless austerity programmes because it is the balance of payments deficit not government overspending which is primarily responsible for government borrowing.

What can be done about this situation?  The attached Bulletin reviews the options. It concludes that the only realistic way of rebalancing the UK economy to overcome these problems is to adopt policies which will enable us to sell more goods abroad and to save on imports. The only way to do this is to have the UK economy operating on a much lower exchange rate, to make manufacturing in this country profitable again and thus to reindustrialise to the extent required to enable us to pay our way in the world.

The table below sets out what happened to our financial relationship with the EU27 over the years between 2008 and 2016, compared to the rest of the world

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These figures present a very alarming picture from a number of different individual aspects, before they cumulate up to completely unsustainable total annual deficits, now running at over £100bn per annum. This is almost 6% of our GDP – before any consideration is given to the “divorce payments” associated with Brexit which are currently under discussion. The problems we have with the underlying imbalances are not caused by Brexit and to a very large extent they will not be cured by it. They stem from chronic lack of competitiveness in the UK economy compared to most countries in the EU27.  

In particular: UK Trade with the EU

Our trade balance with the EU27 has moved dramatically further and further into deficit over the last few years. Over this period, our visible deficit has more than doubled while our much smaller surplus on services has stayed roughly static. Between 2008 and 2016 our total cumulative trade deficit with the EU27 was £413bn.

UK Primary Balance with the EU  

These figures are mainly made up of net investment income and net remittances by migrants. Investment income has gone deeper and deeper into the red over recent years mainly as a result of the huge scale on which UK assets have been sold to EU27 interests. We have financed our foreign payments deficit with the EU27 by selling them our ports, airports, rail franchises, utilities, power companies and much else. The result is that profits on UK operations paid to the EU27 are now much higher than those coming the other way.  In addition, net remittances abroad have added to our income deficit as a result of the rise in the number of EU born citizens now working in the UK – currently totalling over 3m – being a far larger number than the 1.2m UK born citizens living in EU27 countries.  

UK Secondary Balance with the EU  

Secondary balances reflect the net payments by the UK to EU institutions. The lower figures which are often quoted are those paid to the main EU budgets and exclude payments to other EU organisations. These payments have doubled since 2008, totalling £88bn over 2008 – 2016.

Total EU Balances  

The total deficit which the UK has with the EU27 has been over £100bn for each of the last four years.  The total since 2008 comes to £705bn – not far short of 50% of average UK GDP per year during this period. Of course the total is made up of deficits of different sorts, but each of them sucks demand out of the UK economy, transfers resources out of the UK and reduces UK incomes. Total UK sales to the EU27 are currently running at about £240bn a year, so a deficit of over £100bn a year is a very high price to pay to facilitate these sales being made. The prospects of large additional divorce payments being incurred on top of the already huge deficit which we have with the EU27 is enough to make one wonder how we ever allowed ourselves to find ourselves in such a hugely disadvantageous situation, with so little being done to rectify it, as the figures have steadily worsened.

Rest of the World  

Our financial relationship with the rest of the world – which in trading terms now comprises about 56% of the total compared to 44% with the EU27 – presents a totally different picture.  Over the nine years covering  2008 and 2016 we came close to breaking even on our foreign payment balances with the rest of the world. Our huge overall balance of payments problems do not, therefore, stem from our relationships, at least in aggregate, with countries outside the EU.  Almost entirely for the UK they are an EU27 problem, to which we very urgently need to find a solution.

What can be done?  

Leave things as they are?  

We could simply ignore the payments situation we have with the EU27, which is essentially the policy which has been pursued up to now. There are two problems with this strategy. The first is that it is unsustainable. We cannot go on for ever with a deficit running at nearly 6% of our GDP. The second is that, by drawing demand out of our economy, forcing us to run debts and consequently to implement austerity programmes to try to contain them, these huge deficits have been pulling down our growth rate On this basis, we will never get productivity and the growth in output per hour up to a point where most of the population will have any real wage increases in the foreseeable future.

Negotiate a better deal to reduce transfers?  

As a result of Brexit negotiations we should in due course be able to reduce our payments to EU institutions down to a much lower figure, although very probably not to zero. In the meantime, however, we are faced with the prospect of agreeing to pay substantial divorce payments to the EU which will make the transfer problem substantially worse over the next few years.  The position on Secondary Income, therefore, is that it is likely to get substantially worse before it gets better.

Reduce our negative net income?  

Every year we have a deficit of £100bn with the EU27, financed by borrowing or sale of assets on which there is likely to be a return of around 3%, our annual negative net income from abroad is therefore likely to suffer from a trend deterioration of about another £3bn every year. Since these payments are contractual there is nothing directly we can do about them. A lower exchange rate would help by making the value of returns in sterling lower compared to those coming the other way in euros, but a lower exchange rate would also make transfer payments, nearly all of which are denominated in euros, correspondingly more expensive.

Sell more services?  

We could try to sell more services. The figures in the table above, however, show how difficult this is likely to be. While our deficit on goods has gone up by 150% since the late 2000s, our surplus on services has done little better than to fluctuate round a nearly flat mean. Exports of services both suffer from non-tariff barriers - and Brexit is unlikely to make the position on this front any easier - and are relatively insensitive to the prices charged for them, so that a lower exchange rate is unlikely to be much help on this front.

Protectionism?  

A possible short-term solution, once we are outside the EU, might appear to be to consider raising tariffs to discourage imports and thus to reduce the balance of payments deficit.  This approach, however, is fraught with problems. There is no intellectually sound overall case for adopting this kind of policy. It would flout World Trade Organisation norms, which we are strongly obliged to support. It would encourage retaliation, with the risk of promoting just the sort of trade war which proved so damaging in the 1930s. This is not an approach we should consider adopting. Indeed, given the right environment, we should be fighting to get tariffs reduced, not putting them up.

Sell more goods?  

This leaves only one realistic alternative, which is to sell more goods. This is a possible solution because, given the right environment, manufactured goods are much more price sensitive than services. To make this work, however, we would need a much lower exchange rate – probably around parity with the US dollar – otherwise manufacturing in the UK would not be profitable enough to be viable. The only way to make a competitive currency strategy operate is to get the cost base – all the costs incurred in the domestic currency and charged out to the rest of the world in export prices – down to a point where it becomes worth siting manufacturing facilities in the UK rather than elsewhere. It is making manufacturing competitive in this way which produces much higher increases in exports – and import substitution – possible. A policy along these lines would entail reindustrialising the UK so that the proportion of our GDP coming from manufacturing rose from its current 10% or less to around 15%. In 2016 UK exports of manufactured goods came to about £250bn. If exports grew in line with increased output, as a first approximation manufactured exports would rise by about £125bn, of which around one third would be import content, leaving a net gain of around £80bn – which is what we need for sustainability.

High Tech?  

Would a substantial measure of reindustrialisation entail the UK relying heavily on high tech manufacturing to achieve this goal?  It can’t.  There is not a big enough world market for high tech products to make this possible, which is why, for example, the proportion of German exports which are high-tech is only 18%. We need to make a broad spread of both low- and medium-tech industries viable again in the UK – exactly as they are in countries like the Netherlands, Switzerland and Singapore – as well as Germany – all of which have as high or higher standards of living than we do, but with much sounder balance of payments records than we have.  

Conclusion  

We have a choice. We can muddle on the way we are currently, in which case the UK is likely to see so little growth for the foreseeable future that there will be static or declining incomes for most people – accompanied very probably by ever increasing regional, generational and income/wealth/life chance inequalities. Alternatively, we can come to grips with our lack of competitiveness, using a major exchange rate reduction to enable us to trade out of our current impasse, and to get our economy rebalanced onto a sustainable footing for the future. We will never get productivity and real wages up without much more investment and manufacturing output. We have to be able to pay our way in the world; to get output per hour up, to live without ever-mounting debt and foreign payments problems and to avoid growth driven only by ultra-low interest rates, equity withdrawal and consumer demand, It could well be that that fraught Brexit negotiations will provide the occasion for another steep fall in the value of sterling, just as happened after the EU referendum. This will not be a disaster as all the pundits will predict. On the contrary It could well provide exactly the environment required to get the UK economy rebooted again.

Labour Leave shares a number of viewpoints from external commentators, both Leave and Remain, without necessarily endorsing any of the viewpoints therein.


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