We can’t bank on stellar trade so let’s keep the neighbours sweet
This week’s economic growth figures were disappointing. GDP rose by just 0.2pc in the first quarter of this year. That is equivalent to annual growth under 1pc, less than half the 2pc growth rate we experienced in 2015 and 2016.
One ingredient of this slowdown was very much as expected. The consumer has been squeezed by rising inflation, so consumer spending increased very little in the first quarter. As consumers’ expenditure accounts for over 60pc of GDP, this is inevitably a significant drag on economic growth.
The other negative factor, however, was not so widely expected – a very disappointing contribution from trade. Exports were down in the first quarter, yet imports surged strongly. Some special factors contributed to this result – in particular, the way in which the gold trade affects the UK’S GDP figures. But this is not the first time we have been disappointed by the contribution of trade to UK economic growth.
Since the financial crisis, there has been a widespread expectation that there would be a rebalancing of the sources of growth in the UK economy. This was based on the view that a weaker pound would boost exports and hold back imports. A similar outcome was expected when the pound fell last summer after the Brexit vote. But we have been consistently disappointed. Looking at the latest figures, exports are about 2pc up on a year ago, but imports have risen much faster – by over 4pc. When the world economy is growing well, and our main markets in Europe have been recovering, this is very puzzling.
To understand what is going on, it helps to dig down into the figures in more detail. In the past 12 months, the UK economy has set two new records. Our deficit in goods trade – including manufacturing – is the largest on record, close to £140bn. On the other hand, our surplus in services trade over the same period has also hit a new all-time high, at nearly £100bn.
The difference between these two large numbers measures the overall trade deficit of the UK, which is around £40bn, about 2pc of GDP. That is not a big cause for concern. But it reflects the fact that we import a lot more goods than we export, while the reverse is true for services.
This is a reminder of one of the oldest ideas in economics – the principle of comparative advantage. This concept was introduced into economic thinking 200 years ago, in 1817, by the British economist David Ricardo. His argument was that countries would focus on producing the goods and services where they had the strongest competitive advantage. While a country might end up with a deficit or surplus in specific commodities such as wheat or cloth, this should not be a matter of concern. Countries would specialise in the things that they were best at producing, and this process created large benefits from trade – to both producers and consumers.
International trade is therefore a system of swings and roundabouts. Countries will do best in the products and services where they are most competitive, but may then end up as importers in sectors where they have less advantage.
Ricardo’s idea, along with the views of other exponents of free trade, encouraged the UK and other countries to reduce tariffs and other barriers to trade in the 19th century. This included the abolition of the Corn Laws which had kept food prices in the UK artificially high to protect farmers. The process of opening up markets to international trade was, however, severely disrupted by the two world wars and the Great Depression of the 1930s.
‘Our key export sectors of services and high valueadded manufacturing are not very price-sensitive’
Since the Second World War, we have been gradually moving back towards a much more open global trading system. This emphasis on free trade took a big leap forward in the 1990s when the World Trade Organisation was established, encouraging countries with large populations – including India, China and Russia – to integrate into the world trading system.
In the current system of world trade, however, many economies around the world can produce basic manufactured products more cheaply than the UK. Our comparative advantage lies in two main areas. The first is high value-added manufacturing, like the aerospace industry, pharmaceuticals and specialised engineering products. The second area is services. Our exports of services – including financial and professional services, IT, design, the creative industries, travel and tourism – account for 12pc of UK GDP. This is the highest share of services exports in GDP of any G7 economy. The equivalent figures for other major European economies are 6pc to 8pc and for the US and Japan the services export share is 3pc to 4pc.
These export sectors – high value-added manufacturing and services – have two features which help explain our recent disappointing trade performance. First, these products and services are not very price-sensitive. A big devaluation in the exchange rate therefore does not help us greatly. Second, products and services in these sectors sell more readily to richer economies, which are growing more slowly than the dynamic emerging markets in Asia, Africa and South America.
This helps explain why trade has not provided a strong boost to economic growth since the financial crisis, or since the pound fell sharply after the Brexit vote last summer. We tend to export to mature slow-growing markets like the EU and the US. Meanwhile, currency devaluation provides a limited boost to most UK exporters because they sell their products and services mainly on the basis of skills, expertise and technology.
Two consequences of this situation are very relevant for the UK’S trade prospects in a post-brexit world. First, we should not expect to get too much help from a devalued currency. The economy has experienced many devaluation episodes over the past 50 years, starting in 1967 under Harold Wilson’s Labour government. None of them has provided a sustainable boost to our trade performance.
Second, as the UK is a successful exporter of services – especially financial and professional services – we need good access to markets where these services are in demand. Ensuring we continue to have a close trading relationship with the important markets on our doorstep in Europe will therefore be a key issue influencing the UK’S economic success after Brexit.