Why The UK economy is heading to Recession but the US is Booming?

Why The UK economy is in Recession but US is Booming

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Whilst the UK economy slips into recession, The American economy is booming. Latest figures show US growing at nearly 5%, but the UK economy seems stuck in a near perpetual stagnation. (Germany is doing slightly worse.

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In the past five years, there has been a stark contrast between the US and European economies. But, why is the US doing much better and the UK so badly? Is the US growth based on smoke and mirrors or are there real reasons for better growth that we could learn?

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Now, there are many differences between the two economies, the US is much bigger, with higher real GDP per capita than the UK. The US also has plenty of problems like declining life expectancy But here we are focusing on relative economic growth.

Reasons why the UK is slipping behind the US

In 2022, the US signed the Inflation Reduction Act, which was really an industrial strategy offering large subsidies to firms who invest in green technology. The $370bn green subsidy package was big, bold and effective. It has caused a surge in manufacturing investment and firms have raced to take a lead in new green technologies such as electric cars and batteries.

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Not only has it stimulated demand, but also stimulated production, investment and the long-term capacity of the economy. If you dominate solar power and batteries, it is a long-term advantage to the economy. The UK by contrast is being left behind. Investment has fallen, hit by Brexit, weak growth and uncertainty. Low investment is a long-term problem, but has worsened in recent years.

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Interestingly in 2022, just a few months after the US stimulus budget, the UK also tried a dash for growth budget. Liz Truss and Kwasi Kwarteng offered large tax cuts to high earners, hoping this would provide a boost to economic growth the country badly needed. Unfortunately, the £100bn of extra borrowing crashed the bond market, interest rates soared, Sterling tanked and the budget had to be reversed.

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The US stimulus has seen a large rise in government borrowing, and the deficit is forecast to grow, but bond markets are much more relaxed about US borrowing, the UK had less room for manoeuvre. The US bond market is the biggest in world, and there is no shortage of people wishing to buy US treasuries. By the way, Germany’s very low growth is because they are doing the opposite to the US, pursuing austerity and lower spending.

Tax Cuts vs Investment

But, the approaches to growth was very different. The UK was a short-term hope that tax cuts would create magic and solve long-term structural problems. The US budget was more interventionist, directly encouraging investment in an emerging sector of the economy. Income tax cuts can provide short-term higher incomes, but more is needed for long-term growth prospects.

The UK also suffers from highly volatile decision-making, we’ve swung from big tax cuts to big rises, and now promises of cuts. Business don’t feel any stability when policy is changed so frequently. It hasn’t helped that post-Brexit the UK economy, heavily reliant on trade has been undergoing a revolution on trade rules and customs with Europe. It’s no wonder investment is lagging.

Labour Force

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Another difference between the economies is that the UK has seen a rise in long-term sickness which has reduced labour productivity and labour supply. The US by contrast has seen record levels of employment. People leaving the labour market reduces wages and hits firms ability to produce goods.

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In the past two years, a big contrast between Europe and the US has been gas prices. Europe was really hard hit by the loss of cheap Russian gas. When prices shot up in 2022, it caused a big inflation headache. It had many knock on effects for electricity and food prices. The UK is particularly dependent on gas for electricity. This inflationary shock was a big problem for the UK. It meant interest rates were increased to choke off demand. So we had a rise in the misery index – high inflation and low growth.

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The US had similar inflation rate to the UK, but there was a big difference, US inflation was mainly caused by rapid economic growth, government spending and the pandemic boost to money supply. Therefore, higher interest rates in the US rates have slowed down the US boom, in the UK higher rates have worsened the cost of living crisis and pushed the economy close to recession.

cost-push-inflation

The UK had the wrong kind of inflation – cost push inflation which reduces living standards. Reducing this kind of inflation leads to lower growth. It is debatable whether the Bank of England has followed the right approach to prioritising the inflation target – but that is another question.

This is one reason the mini-budget crisis of 2022 was a disaster. The Truss stimulus would have caused more inflation, which is why interest rates rose so sharply. In the US, higher borrowing has only had a muted effect on higher rates.

Another issue about the surge in gas prices is that it has actually benefited the US fossil fuel industry. The biggest replacement of Russian gas was American natural liquid gas. However, now that gas and oil prices have fallen, this reason to explain the difference has fallen.

Mortgage differences

Another contrast between the two economies is the mortgage market. After the credit crunch, the US moved towards 30 year mortgages, whearas the UK moved mainly to 2 year mortgages. What it means is that many households in the US have been protected from higher interest rates. Whearas the UK has seen a sharp jump in mortgage payments, with even government ministers on £120,000 struggling to pay. In 2024, over 1.5 million will remortgage to the higher rates. This rise in interest rates has caused significant financial distress – more so than in the US

Real GDP per capita

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Another contrast between the US and European economies is the growth of the working age population. In the past 20 years, US real GDP growth has been much higher than Europe, but a large part of this is higher population growth and higher immigration. Per capita growth is more similar. However, this doesn’t explain the difference between UK and US in recent years. The UK is also experiencing high levels of immigration and population growth. If we look at UK real GDP per capita the outlook is even more grim.

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For many months, US consumer confidence was pretty poor. Falling inflation rates did little to boost confidence when workers still felt the after-effects of a higher price level and squeeze on living standards. It is a similar story in the UK, where inflation has exceeded wages for a significant share of recent time period. However, the higher growth in America has finally started to cause rise in real wages, which is helping to boost spending.

However are things as rosy in the US as it appears? One difference between UK and US is the savings ratio. In the US, households have run down savings to a near record low (3.7%). US consumers have been willing to keep spending and borrowing.

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There has been a sharp rise in borrowing and delinquency rates on consumer credit has doubled from 1.5% to 3% in Q3 2023. The UK savings ratio has fallen since the pandemic, but is still much higher, reflecting perhaps a greater pessimism over the future of the UK economy.  It does raise the question of how much this kind of economic growth in the US can be maintained without further rises in real wages.

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Another difference is that the UK has seen a significant rise in taxes as a share of GDP. This is partly a result of very low growth plus the combined rise in demand for social spending. The US has not seen the same kind of tax rises. Despite all the political wranglings about the debt ceiling, the US is running very expansionary fiscal policy and this is a major factor in stronger US economic growth. The UK is caught between meeting fiscal targets and needs to increase spending on pensions, social care and an ageing population.

Related

The big question is will the US economy still be running hot, come November 2023? It will be a pivotal election and the state of the economy will have a bearing on the election result. Can US growth be maintained, or by then will the economy run out of steam?

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