Why UK risks a worse recession than its rivals

Business stymied as the number of people in work has failed to recover to pre-covid levels, write Tim Wallace and Tom Rees

Britain is leading the rich world’s plunge into recession. The economy shrank in the three months to September, even as every other nation in the G7 managed to eke out growth.

Global factors are at play: inflation is sweeping much of the world, Russia’s war has unleashed an energy crisis across Europe and interest rates are soaring as the cheap debt of the post-financial crisis years evaporates.

Yet the UK has found itself at the forefront of the crunch.

GDP fell by 0.2pc in the third quarter of the year, the first drop in what is likely to be a prolonged recession.

By contrast the US, Canada, Germany, France and Italy all managed to grow over the same period. Japan – the last remaining member of the G7 – is expected to report a decent expansion next week.

On a quarterly basis, the UK had not even returned to its pre-pandemic level of GDP, unlike the rest of the group. If Britain’s output falls again in the final three months of the year as widely expected, it will be the quickest return to a recession since 1975, after the Covid-induced downturn in 2020.

Why is Britain suffering more than peers? One factor is the labour market.

On the face of it, the nation is in a strong position: unemployment is at lows not seen since the 1970s. There are more vacancies on offer than there are job seekers.

However, Britain is unusual in that, despite demand for staff, the number of people in work has failed to recover to pre-covid levels. Employment stalled at around 34m people over the summer, stopping short of the 34.4m peak reached in the three months to February 2020.

Almost 9m people of working age are classed as “economically inactive” – that is, neither in work, nor looking for work – a rise of more than 600,000 since the pandemic began. This includes an increase in early retirement and a sharp jump in long-term sickness. By contrast, the employment rate has risen in France, Germany, Italy, Canada and Japan when compared with the end of 2019.

“The skill shortage issue isn’t unique to the UK but I think the rise in inactivity is and maybe some of the reasons behind it seem to be quite specific to us,” says James Smith, economist at ING.

“The trend of rising inactivity rates is completely different to say France or Germany where inactivity has continued its downtrend.

“The rise in inactivity we’re still seeing does seem to be a very Ukspecific issue. One explanation is that the crisis in the NHS seems to be fairly unique to the UK, in terms of how acute the waiting list for treatment is.”

The shortage of workers leaves businesses unable to expand as they wish, and means Britain’s economy is stymied. Those who can afford to are having to lure workers with offers of higher pay.

The tight jobs market is one factor pushing the Bank of England to raise interest rates more quickly than its eurozone counterpart, as policymakers seek to avoid a dangerous wage-price spiral that could embed inflation. This too weighs on Britain’s economy by making borrowing to invest more expensive.

Andrew Goodwin, at Oxford Economics, says: “The impact of higher debt servicing costs and fallout from the housing market correction are key factors underpinning our forecast for a sharp fall in GDP next year.”

Jagjit Chadha, director of the National Institute of Economic and Social Research, says Britain’s vulnerabilities also stem from its unstable policy environment, a long-running issue that contributed to the slow recovery.

The country “needs to stop these games and shenanigans with corporate tax so firms can properly plan for their investments and training of their staff ”, he says.

“There has been so much political volatility and economic volatility in this country it is a wonder we have not done worse.”

Britain’s descent into recession does not mean the rest of Europe will remain unscathed, however.

“We’re quite comparable, mainly because of that gas reliance,” says Smith. “We’re looking for about a 2pc hit from UK GDP. In terms of the eurozone as a whole, our outlooks are actually very similar.”

Economists think that many of the hardest hit European countries, particularly Germany, will suffer a recession as deep and prolonged as the UK’S.

Much of Europe shares a dependence on gas with the UK, the current inflation rate is even higher in many parts of the eurozone, and the region’s households and businesses are suffering a similar downward turn in sentiment. City forecasters expect a 0.5pc contraction in UK GDP next year, compared with a 0.6pc fall in Germany and a 0.1pc drop across the eurozone as a whole.

Gfk’s household confidence indicator in the UK has slumped to record lows not even reached in the financial crisis and pandemic. But it has also reached record lows in Germany and the eurozone as a whole since the war erupted in Ukraine to transform the economic and inflation outlook.

“We’re looking for recessions in both and we’re looking for them lasting about the same time,” says George Buckley, economist at Nomura.

“It could be worse in some countries than others – look at Germany, for example.

“The data in Europe, the surveys, are still suggesting that we’re going to see a notable downturn.”

The UK’S economic fate still hangs in the balance. Forecasters say that much will depend on the future of the energy price guarantee and the scale of tax rises and spending cuts at Jeremy Hunt’s Autumn Statement.

In the quest to restore the UK’S wounded economic credibility, some fear that Hunt may go too far, raising taxes too quickly and announcing harsh austerity that deepens the downturn.

However, he could do the opposite, backdating most of the pain until after the next election. It would leave Labour in a sticky spot if they entered power but markets may not see it as a credible plan.

Goodwin says there is a “clear risk that the Government will move more quickly” with front-loaded action threatening to cause a “deeper downturn”. However, he adds that even backloading action can be damaging too, highlighting the “corrosive impact on confidence” of the 2010s austerity rhetoric.

Buckley says: “What will probably be more important for economic growth and monetary policy in the near-term is the speed with which the Treasury aims to fill the fiscal hole.

“Cutting real-terms investment spending in particular could mean slower productivity growth in the future, however, potentially further weakening trend growth and the public finances over the medium term.”

The successor to the energy price guarantee that is shielding households from soaring gas and electricity bills this winter is seen as crucial.

Smith says: “One thing which will determine where we rank compared to other countries in Europe will be what happens with energy support and what decision is taken over the energy price guarantee. That has the number one potential to change things next year.

“That will probably determine the league table of economic growth.”

With the support ending in April, the Chancellor is yet to decide how generous and far-reaching any new scheme will be. Hunt has committed to significantly decrease the scheme’s hefty price tag, which had, alongside Liz Truss’s sweeping tax cuts, unnerved markets before the U-turns.

All that means Britain may not be the worst performer in the rich world for long – but that will be cold comfort as our neighbours join us in recession.