Monday, June 16, 2008

A funny view of wealth

Below I have outlined a commentary that I wrote back in November of last year. For some curious reason I chose to email it to Boris Johnson. Why Boris? I am not entirely sure, except that he is a maverick and might therefore be open to new ideas. As one would expect, I received a polite reply (from one of his assistants), and nothing more. My motivation for sending it was that I just wanted it to be recorded, as I made some predictions for the UK economy. If you make a prediction, it helps if you have a record of it from someone who received it. The reason I am posting it here is that the predictions, give or take a couple of months, are largely being shown to be correct.

A couple of notes. As I wanted to put the predictions on record before they occurred, I rushed the writing of the essay, so there are several errors and omissions. Of particular note is that I forgot to mention that UK investments have turned the corner, such that UK Plc's overseas investments no longer generate a surplus. I am aware that there are many other problems. However, I have published it as it was sent, so that you can judge the accuracy of the predictions, without me giving the benefit of hindsight. Why read it? I have also predicted that the UK economy is going to get much, much worse. I have predicted that what will happen shortly will be the worst disaster to befall the UK since WWII.

Where’s the Beef?


I am sitting in China as I write this, and I feel a sense of regret. For the last few years I have had a deep foreboding about the UK economy. In particular my mind has continually returned to the question of ‘where’s the beef’, by which I mean where is the real earning, the real source of wealth in the UK economy. However hard I have looked, I have failed to see it, and now I suspect that the myth of the economic success of the UK economy is about to be exposed. My sense of regret is that I did not write this earlier.

The majority of mainstream economists have remained convinced that some kind of economic miracle has been taking place in the UK. Miracle is a carefully chosen word, as it best describes the fact that only a miracle could allow the growth of the UK economy to be sustainable.

The balance of trade has been in the red for so long that we have come to accept that this is perfectly normal. We achieve growth without either producing more goods for internal or external consumption. Our production of commodities such as oil are in decline. We claim that services have taken up the slack, but we are unable to locate the source of the real wealth that has spurred the growth, and we can not claim that our export of services is sufficient to explain our apparent increase in wealth.

So how has the UK economy managed to continue growing? What does the future hold for the UK economy in the short, medium and long term? These are the questions that I will be trying to answer. If I written this earlier, I suspect that my arguments would have been dismissed out of hand, as the arguments of a rank amateur. Furthermore, some of the important factors that explain the circumstances of the UK economy were not previously visible, and these factors help explain why sections of the UK economy have defied gravity.

Finally, I would like to make an apology. This is written in haste, and I have had to balance time constraints against rigour and writing style. With the storm approaching, and my desire to write this before the storm breaks, I have rushed this essay. There are not the number of references that I would like, and in places I do not provide comprehensive figures which might help support my case. There are many moments of clumsy writing, though I hope not clumsy at the expense of the overall argument. Many of the arguments are not as detailed as I would like.

1. A funny view of wealth

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The following chapters will take a look at the UK economy in particular and the world economy in general, from a fresh perspective. I do not want to stretch the example above too far, but one of the themes that will follow is that the Wilsons look remarkably like the UK, and the Jones look remarkably like South East Asians countries such as China.

In the following two sections I will introduce some of the unusual recent influences on the UK economy; Migration and House Prices. I could have added the growth in debt, but this will be dealt with later, as it is integral to the explanation of the UK economy, and s difficult to separate as a stand alone section.

2. Forever Blowing Bubbles….

All over the Western world there have been prophets of doom, prophets who predict the end of the long house price boom. Each prediction of the ‘end’ or ‘the impending housing crash’ has been disproved with time. All such prophets have, time after time, been proven wrong (including this author, who predicted a crash as early as 2003). There is even a website dedicated to housing ‘doom’ in the UK, rather neatly called

It seems worthwhile to ask what the doomsters actually got wrong, if they have gotten anything wrong at all. So what are the arguments for why house prices are overvalued?

Valuing Property - What is ‘Value’

Let’s start with the idea of value. How do we value a house? The first point is that there is a market value, which I will define the value that someone is willing to pay for a property in real time today. If we use this, then house prices can never be over valued or undervalued, as they are always correct. However, this is not much use to us if we are trying to decide whether there are risks that house prices will rise or fall.

Valuing Property - Incomes

One way of looking at house prices is to compare them to incomes. As people get richer, they can afford to spend more money on property. This is not, however, a straight line relationship. As people get richer, they have greater potential for discretionary spending, as the proportion of their income needed to service basic items such as food, heating and so forth reduces. Housing is an essential and might not be called ‘discretionary’ spending, as we all need housing, but how much money is spent on housing over and above ‘putting a roof over your head’ does have an element of discretion. It is very similar to the student who goes to a cheap pub to eat whilst he is relatively poor, and the same student after graduating and starting a career in banking going to a trendy expensive restaurant. A person needs to eat but, in both cases, has an element of discretion over how much to spend on this necessity. In housing we can see the same mechanism in the first time buyer trading up in to a better house. For this reason, that housing is in part discretionary spending, we can see that spending on housing might increase faster than incomes.

Valuing Property - Supply of Housing

Another important factor, if not the most important factor, in the determination of house prices is supply and demand. In a perfect economic world, supply and demand would match. In the same way that we are never short of washing powder, we would never have a shortage of housing. After all, we never hear of a boom in washing powder prices because of scarcity. The reality is that, in the UK market, there is always a limited supply of housing due to government regulation, and planning laws that restrict the availability of land for building on, and restrict the type of building that can be undertaken.

Value of Property - Supply of Finance

One of the common errors in considering supply and demand in relation to the housing market is to forget the importance of supply of finance into the housing market. The U.S. sub-prime debacle (shortly to be replicated in the UK, possibly in the process of commencing as this is being written), has finally focused attention on this matter. If there is an increase in supply of finance, then it becomes possible for lenders to lend more money to more people. History shows us that, when too much money is thrown at a particular industry or sector, the money starts to be misallocated. The process occurs because, as the ‘good’ investments are used up, money remains unused, and this money needs to be placed somewhere. The ‘somewhere’ is increasingly into ever more risky investments. This process can be seen in the recent bubble in telecommunications or the bubble in Internet stocks, where large investments were made with little prospect of realistic returns. The same process has occurred with mortgage lending, and this can be seen in new methods of lending that include:

Increases in income multiples. Even a few years ago 3 times earnings were considered the maximum, but recently some lenders have offered up to six times earnings. This leads to a situation where people can now borrow ever more money in relation to their income. This process would be quite logical if the increase in multiples related to the increase in income available for discretionary spending, but the level of the increases have outstripped this.

No deposit, 100% mortgages. One of the reasons for deposits is to offer the lender an assurance that, if the borrower fails to pay the mortgage, there is sufficient equity remaining in the property for the bank to recover their money after the costs of recovering and selling the house. In a situation of continuing house price rises, this may not be deemed necessary. However, such a risk is built on an assumption of no end to house price rises, a very high risk strategy. Another reason that is implicit in the idea of a deposit is that the buyer is also risking their own money in buying the house as, in the event of foreclosure, they are likely to lose a substantial sum of their own money. Removing this risk means that the borrower has less to lose in the event of financial problems, removing an incentive to find every means available to keep paying the mortgage. Again, lenders are taking a greater risk in their lending.

Self Certification. Several news reports have showed that self certification has been used by mortgage brokers to secure mortgages that would otherwise be impossible to secure on the genuine incomes of the applicants. This is why, before the current house boom, it was necessary for applicants for mortgages to prove that they were in receipt of the income that they were claiming. The question that self certification raises is why it is that lenders have relaxed their checks? They might claim that it makes the applications process faster and less complicated, but set against the risk of future inability to pay, surely this is a poor trade-off. The cynical view might be that the lenders were intentionally relaxing their lending criteria through a backdoor method.

Affordability based decisions. Some lenders started to review the overall position of the applicant’s finances, rather than looking at income. This, at first sight, appears to be a rational approach. However, the criterion for affordability was based upon an assumption of continuing relatively low interest rates, an assumption that was to lead to the lenders taking very high risks as, if interest rates rose considerably, what was affordable would no longer be affordable.

Interest only mortgages. The trouble with this kind of mortgage is that there is no provision, whatsoever, for the repayment of that actual mortgage itself. Traditionally the lender would require that the borrower demonstrates that they have made an investment plan to eventually repay the mortgage, but this requirement is removed. No doubt lenders will claim that their expectation is that the borrower will take out such an instrument, but the cynical point of view would be that they are just using a ploy to allow borrowers to borrow more money.

So what is the result of these new ‘relaxed’ lending policies on the housing market? The most important effect is that there is more money available to more people, in ever more risky loans. This additional money is then available within the house market and, where more money is chasing a limited supply of assets, the prices of those assets will inevitably rise.

A Small Diversion - Affordability[1]

It is worth taking a small diversion at this stage, regarding affordability. One of the big arguments for relaxation of the lending criteria has been that, in a low interest environment, that housing becomes more affordable. This is one of the great myths of the housing boom and needs to be put to bed once and for all.

The argument goes that, in a low interest environment, the cost of servicing a mortgage has gone down significantly in comparison with a high interest environment. At first sight this is an appealing notion, and appears to be perfectly logical. As interest rates go down month by month, we can see the month on month cost of a mortgage go down.

However, there is an important element of the cost of a mortgage conveniently forgotten in this rosy picture, and that element is inflation.

The best way to illustrate the importance of inflation is to take a trip back in time, for example to the 1970s, when both interest rates and inflation were high. During this time we could see the picture of the young couple buying their first house. In the classic picture of the time, the couple would struggle to save up to put the deposit on the house then, once they purchased the house, they would struggle with the repayment of the mortgage under burdensome interest rates. At first site this picture of struggle appears to support the arguments of low interest rates providing greater affordability, but it is when we see the same couple a few years later that we see the problem in the argument. It is then that we can see that the key to affordability is not just interest rates, but also inflation.

All of the time that the young couple have been struggling to pay the mortgage, something else has been happening too. The high rate of inflation has meant that the value of their debt has been eroded by inflation. As such, after a few years of struggle, the couple will find that their debt becomes easier and easier to service, and the proportion of their income required to service the debt declines year on year, as their earning are rising in line with inflationary pressures. As this occurs the percentage of their disposable income needed to service the mortgage is declining such that, as time progresses, they are left with more and more disposable income.

It is at this point that we should note that there is a relationship between inflation and interest rates. In periods of high inflation, interest rates climb, and in periods of low inflation interest rates drop. So what does this mean in relation to mortgages? It means that one effect offsets the other. Whilst in the real world, the relationship is not perfect, the relationship does exist[2] .

Once we take low inflation into account, which has been the current situation, we then see that, whilst a higher mortgage looks more affordable in principle, in practice it is not actually much more affordable than in the past[3]. What has actually changed is the profile of the payment of the mortgage, not the amount of the mortgage that is finally paid. In the high inflation and high interest example, the mortgage payment is front loaded, with very high initial payments quickly switching to lower and lower payments. In the low interest low inflation scenario, the payment of the mortgage is easier at the start, but only because the cost of the mortgage repayment is spread more evenly through the lifetime of the mortgage.

In this environment, there is no particular problem if, for example, the three times earnings multiple is used in both cases, as the final amount that the borrower pays will remain similar. The real problem arises when the false notion of affordability comes into play in the form of higher multiples of income. In this case the real cost of the purchasing the property for the borrower has increased as, over the lifetime of the mortgage the borrower will end up paying more money than in the past as a proportion of their income.

As mentioned earlier, the relationship between inflation and interest rates is not perfect, but to ignore this in considering ‘affordability’ of housing is, to say the least, rather odd. All of the major mortgage lending institutions employ economists, and it only seems reasonable to assume that the economists were aware that the affordability argument has this rather important problem. This raises a question as to why the lenders continued with an argument that was problematic? A cynical view of this would be that they sought to persuade people into accepting greater levels of debt than was actually necessary, in order to expand the size of their lending portfolios.

Supply of, and Demand for Housing

Classical economics points to supply and demand as one of the key factors in the pricing of assets, and this mechanism has been proven time and time again. Analysts of the UK house market have discussed the question of supply and demand at length. There have clearly been changes in demand, which most people agree are important factors in consideration of house prices. One commonly cited examples is that there has been a change in the profile of home owning, with increasing numbers of single occupancy, and smaller family sizes, and other changes in the way that society has structured itself that have impacted on demand. At the same time it is argued, there has not been a commensurate increase in the supply of housing to meet demand. All of these points are perfectly reasonable.

However, it is only recently that the real issue of importance for demand has started to fully come to light. It has become apparent that the demand for housing has seen a massive increase in the last few years, and this increase is a direct result of massive net immigration into the UK. At this point it would be tempting to start to bandy around some statistics. However, at the time of writing, there is an ongoing controversy over exactly how many people have immigrated into the UK and how many have emigrated, and no one seems to have a firm handle on the exact numbers. What we can perhaps say is that, over the last 10 years, it is possible to reasonably pick a number between one million and three million, and have a reasonable chance of being correct. Even if we were to take the answer of one million, we can still say that the net immigration has been, to use a highly non-technical term, ‘a lot’.

What we can say from knowing that there has been ‘a lot’ of immigration is that, in conjunction with the changes in society, there has been a significant increase in demand for housing overall. How much additional demand is currently unknown and therefore it is difficult to make any rational calculation of how much prices may have inflated as a result. Perhaps one of the most important points to note from this is that current house prices must at least be dependent on the immigrants remaining in the UK, and that continued growth in house prices might require a continuation of the net inward migration.

I have emphasised that the scale of immigration has only recently been coming to light, as I believe that this is why many analysts have wrongly predicted a house price crash over recent years. Whilst they were aware of immigration, they had no idea of the scale of the net inward migration.

Buy to Let

It is impossible to view the UK housing market without also looking at the boom in the ‘buy-to-let’ market. The emergence of this market followed changes in the regulatory framework for landlords, and in particular developed with the introduction of the assured short hold tenancy. Over time this regulatory change allowed a growth in the rental market, particularly as it became apparent that it was possible to safely rent a property whilst having the protection of the law when tenants became troublesome. Whilst the growth in the market lagged the introduction of the legislation few would disagree that the legislation was the spur to the growth in the market. This has now led to a point where, according to a report from the Royal Institute of Chartered Surveyors, 1 in 10 mortgages have been taken out for buy-to-let properties[4].

A report by Bradford and Bingley[5] illustrates some of the drivers for the fever for buy-to-let. In their report they point to a rising population of students and the net inward migration as factors that are driving demand for rental properties. Despite this there have been several reports that demonstrate that many buy-to-let landlords are still making a loss on their investments in property[6]. One of the questions that this raises is; why exactly do landlords continue to invest in the sector? The only rational explanation for this is that they are hoping for continuing appreciation of the assets to provide a long term profit.

According to Mintel, there is also a view that is widely held that ‘bricks and mortar’ when compared with other assets are relatively safe[7]. As such some landlords are using the investment in property as a substitute for pensions and other long term investments. What this means in practice is that money that would have previously been invested into pension funds, unit trusts and other forms of investment is now being diverted into residential property.

This must be having an impact outside of the property market. Where a pension fund would largely invest in the stock market or in new business, and therefore be used to invest in the development of economically productive organisations, the investment into housing represents no long term gain for the economy overall, as the investment is largely used to secure and maintain an already existing asset, without major improvements in the productivity of the asset. The only benefit to the economy overall in the switch from purchase of a home, to rental of a home is the allowance of greater flexibility of labour, in that it is often easier and cheaper to move from a rented house than from a purchased house. Most importantly the buy-to-let market is not a stimulus to new housing development, but an exploitation of the conditions of restricted supply, usurping individual buyers who would otherwise be better able to buy the asset. This is not supply and demand, but utilisation of a supply constraint to extract profits (however hypothetical they are becoming) without delivering any additional value to the purchaser of the property, except flexibility in some cases.

Whilst some people welcome the flexibility, many people do not and would prefer to purchase a property if they had sufficient funds. However, the inrush of buy-to-let money has (almost certainly) been one of the drivers of price inflation, in particular at the lower end of the market. If supply were meeting demand, prices would certainly be lower, and many existing tenants would likely switch to home ownership.

Is Buy-to-let a bubble?

As in all classic cases of bubbles, the bubble is (in part?) growing on itself. The more people funnelling money into the buy-to-let market, the greater the growth in the value of the asset, and the greater the growth in the value of the assets, the more people invest in the hope that the asset will continue to inflate in value. At some point the investors must actually achieve sufficient return on the asset in order to justify the asset. What happens when the asset finally stops inflating, such as the famed South Sea Bubble, or Tulip Mania? It is at this point that the bubble pops, normally very painfully for the latecomers to the investment.

In the event that the current level of house price inflation is unjustified (which is the argument being proposed), this may well represent a disastrous misallocation of resource. This is, after all, allocation of resource that could have been invested into developing businesses, or promoting the development of new businesses.

The aforementioned Bradford and Bingley report goes to some lengths to emphasise that the buy-to-let market is not a bubble. However, in the event of falling prices, and poor rental yields, there is a real question over whether the buy-to-let market can be sustained. This is not an original thought, and it is a subject that is being asked by many analysts who are cynical about the prospects for the property market. The big question that this raises is the big question for the housing market overall. What will be the final impetus to the bubble popping?

There is also another very worrying aspect to the buy-to-let bubble. The worry the bubble raises is why it is that there is so little confidence in investing money in the stock market, investing in new businesses, or all of the other alternative investments? Something has gone badly wrong with the investment market for so much resource to have been allocated to the housing sector. What we are viewing is a loss of faith in the ability of business to provide decent returns, and that does not bode well for the health of the business sector, and does not bode well for long term economic growth.

Market Sentiment

There is another important aspect of pricing within markets, the idea of market sentiment. This might reasonably be described as the ‘herd mentality’ which is a situation where the majority of people will follow what the majority of other people are doing. This has already been referred to indirectly in discussion of the buy-to-let market. In the UK the press and media have been leading the herd into the belief that house price growth is rational, desirable and sustainable. This leadership has taken many forms, ranging from television shows such as ‘Location, Location, Location’, ongoing newspaper analysis of the property markets giving a (generally) positive outlook, through to positive news fuelling the buy-to-let market. At the moment it appears that sentiment is finally turning with an increasing number of reports suggesting that the boom may finally be over. This could be the turning point, and the start of the long predicted crash.

Set against such negative sentiment is the reality of the increase in demand. Where does this leave the market? In order to discuss this it is necessary to actually view the causes and impact of net immigration, which is the subject of the next chapter.

Immigration and the UK economy

Immigration is a matter that is discussed with extreme care because of the potential for the issue to become entwined with racism. This sensitivity has developed to such an extent that it has become, in polite circles, almost impossible to discuss anything but the positive impacts of immigration. This has stunted debate, and prevented a rational analysis of the economics of immigration. This section will look at immigration with no such constraints, and will try to examine immigration from an economic point of view.

Sources of Immigration

Immigration into the UK is, in principle, controlled by the government but the government is heavily constrained in the actions that it can take to limit immigration. International treaties such as 1951 United Nations Convention on the Status of Refugees, The European Convention on Human Rights, EU Regulation 1612/68 on the freedom of workers are just some of the constraints on government action.

The aim in this section is not, however, to review how people immigrate into the UK, but to try to understand the impact of immigration when it occurs.

Before looking at immigration it is worth noting that, as is pointed out elsewhere there is a major controversy over the statistics for immigration. For the purposes of this section we will note that the immigrants into the UK are from the New and Old Commonwealth, and the recent EU accession countries[8]. This means that many of the immigrants are coming to the UK from countries that are less economically developed than the UK, and that presumably they are coming to the UK (at least in part) to enjoy better economic opportunities. As such, this section includes an assumption that many of the inward migrants come with limited financial resources, and this particularly applies to migrant temporary workers from the EU accession countries.

Immigration and Wages

There are some people who argue that immigration does not have an impact on wages. This argument may have some validity if the scale of immigration does not lead to any significant increase in supply of labour in any particular labour market, such that the increase in overall numbers is negligible. However, in the case of mass immigration, as has occurred in the UK in the last few years, this argument does not have any foundation in logic whatsoever.

It seems faintly absurd that this needs to be explained at all. Any reasonable grasp of economics will indicate that, all things being equal, an increase in supply relative to demand will lead to downward pressure on prices. A decrease in supply relative to demand will lead to upward pressure in prices. Few would argue that, if the supply of steel increases relative to demand that there will be no downward price pressure, and few would argue that if steel supply decreases relative to demand that there will be upward pressure on prices (all things being equal). These are widely accepted principles in economics but, despite this, some people still argue that increasing the supply of labour has no negative effect on the price of labour. Apparently, when the word immigration is mentioned, the laws of economics are abandoned, and economists scrabble around trying to redefine the laws for this special case.

One of the reasons for such a fallacy is that some studies have shown what appears to be large scale immigration into a particular area whilst seeing no fall in wages. This suggests that immigration does not have a depressive effect on wages. The only trouble with such a suggestion is that it ignores the possibility of an upward pressure on wages due to supply constraints. The influx of labour may not make wages fall, but it may prevent them from rising. In this case, the increase in supply has a negative impact on the workers who would otherwise be wealthier as a result of wage increases.

In the UK labour market ‘all things are not equal’, as there is a minimum wage system. This means that, at the bottom end of the labour market, there is a level below which wages can not legally drop. It could be argued that this prevents downward pressure on wages but, once again, this does not allow for the idea of upward pressure on wages due to insufficient supply of labour. Furthermore, if an immigrant is illegal, then the constraint of the minimum wage may be ignored by employers in the knowledge that the worker is unlikely to complain about being underpaid. Even for a legal immigrant there is greater potential for them to be paid less than the minimum wage as they may be unaware of the minimum wage, or be ill equipped to complain about not being paid the minimum wage if they are denied it. In these circumstances the employer might take on a migrant labourer in preference to a native labourer, thereby having the effect on the native workers wages of ‘no wages’.

One of the arguments for immigrant labour is that it is addressing shortfalls in the UK labour market. At the very least this is a problematic idea when viewing the unskilled labour market, when there are large numbers of unemployed and economically inactive people in the UK. The numbers of such economically inactive are highly contentious so that a figure will not be given here, but there are certainly large numbers of individuals within the UK who could, at the very least, take the unskilled jobs such as building workers, fruit packers and so on. It would be very hard to argue that there is a skills shortage for this kind of work, as much of it requires minimal training.

Economists such as David Card point out that, in the US labour market for example, there are many more immigrants than unemployed, and therefore the immigrants can not be taking the jobs of the unemployed. They are taking jobs that would otherwise not get done, and are therefore beneficial to the economy[9]. The first question to be asked here is, how is that there are so many unemployed in the first place? The second question is, even if there are more immigrants than unemployed, then is it nor reasonable to say that some of the unemployed are in this situation as a direct result of labour competition from migrants? The final question to ask is what all of the additional immigrants are actually doing, and ask whether they make a net contribution to the economy overall? This last question is complex and statistics are used by varying points of view to justify their positions. However, as will be seen later, they are often forgetting some key considerations that need to be accounted for in measuring the immigrants contribution to an economy.

In the UK, as in the US, there is one other critical question that needs to be addressed and this is the question as to why UK employers are hiring people from other countries? As mentioned before, all things in the UK are not equal due to the minimum wage, but also because the UK employer needs to compete for labour with the UK benefits system (which is an indirect minimum wage that applies to anyone entitled to social welfare benefits). This system allows an individual to remain economically inactive, or to choose an option of accepting a low paid job for very little real remuneration despite a major increase in the expenditure of their labour. In such cases the value of the labour expended is far below the minimum wage as it needs to be calculated as the weekly pay minus the benefits, to give an actual wage for the work done. The rational person in this situation might reasonably ask whether the loss of their free time to work is worthwhile for what will often be little financial incentive as, in this situation, the UK worker is often working for extremely low wages[10]. By contrast, at least initially, the migrant worker may not be entitled to such benefits[11] and is therefore happy to accept the wages that the UK worker will not accept. In accepting such wages the immigrant removes the need for UK employers to raise wages to a sufficient level to give an incentive to the UK worker to choose labour instead of benefits. In short, the immigrant worker is depressing wages to a degree that the dependence on benefits by UK labour continues, despite apparent labour shortages. The result of this is that the inactive UK workers remain as a drain on the state, and a drain on the economy overall.

If we accept that hiring an immigrant worker can lead to a British worker remaining economically inactive, the calculation to the cost of the economy of the migrant labourer might be expressed as the weekly cost of benefits minus the tax input of the migrant labourer who has been substituted for the British worker. In nearly all imaginable and realistic cases the tax will be insufficient to cover the benefits given to the British worker leading to a net loss to the state, and therefore a very substantial net loss to the economy.

What of the skilled immigrant worker? How does this worker impact on wages? Here the argument is similar to the unskilled labourer in that, if there is an increase in supply, there will be a negative impact upon wages for native workers, with a likelihood of reduction in wage levels, or a reduction in the rate of increase in wages. However, in this case, it may be that there is a genuine shortage such that organisations are completely unable to satisfy their requirement for skilled labour, regardless of the wages that they are willing to provide, and there may be a time lag in training new workers that will prevent current demand being met. This could have a negative impact on certain sectors of the economy where the labour is needed, leading to an overall negative effect on the health of the economy overall. In this case the jobs that are undertaken by the skilled migrant labourer would simply not be done without the migrant. It might also be argued that the skills are provided very cheaply, as the immigrants already have the necessary skills with no need to invest in training.

To consider the impact of immigrant skilled workers it is worth considering one of the most discussed examples, the shortage of plumbers that has been resolved with the immigration of large numbers of Polish plumbers. Prior to the arrival of the Polish plumbers the problem had become so severe that the subject was becoming a matter of (at least middle class) humour. Whilst the shortage was leading to expense and inconvenience for consumers, it was also probably more than a matter of inconvenience for industry, where plumbing problems were no doubt going unresolved, systems not being built, or being built late, built to poor standards amongst many other problems. This might lead to the conclusion that the introduction of Polish plumbers brought a real benefit to the economy by filling a very real skills shortage, and a skills shortage that was having a negative impact on the well being of the economy overall.

It would be difficult to argue against the idea that, in the short term, the Polish plumbers offered real economic benefits. However, it is in the long term that the fabled Polish plumber looks a less attractive a proposition for the economy. In order to see why this is the case it is necessary to view the situation prior to the arrival of the Polish plumbers. The cost of plumbing was (inevitably) rising due to the shortage of skilled workers, and the competition for skilled workers was leading to increases in the wages of plumbers. The rising wage levels meant that plumbing was becoming an increasingly attractive area of work, and was attracting new entrants to the trade[12]. This suggests that, given sufficient time, supply and demand would have resolved the plumber shortage without any intervention, or any need for external labour. When considering the impact of migrant labour on plumbing, it is possible to suggest that the introduction of immigrant plumbers provided an alternative to this solution, by the substitution of labour from another market.

This substitution of migrant labour for training native labour has the self evident effect of removing the demand for native labour to be trained, and therefore has the potential for a situation in which a labour market can become dependent on immigrant labour. In a case where the migrant labour is temporary, this might be considered a serious problem on the grounds that it is quite possible that the problem will re-emerge some time in the future, once the immigrants return to their home countries. The alternative is to have a continuous flow of immigrant plumbers into the market place, thus the dependence.

Perhaps the most important point, when considering the case of the plumber shortage, is that plumbing is an area of work that, had the financial incentives continued growing, might have provided sufficient incentive to motivate the economically inactive to have chosen work over benefits. By introducing the immigrant labour wages ceased to rise, or dropped, and the result was that the incentives for entry into the trade were reduced, thereby helping to maintain people in economic inactivity.

This is not to ignore the problem that, had it not been for Polish plumbers, there would have been a shortage of plumbers for several years, whilst sufficient entrants to the plumbing labour force were trained in the necessary skills. However, if designing a better ‘plumber policy’, one free from constraints, this shortage might have been addressed by a transitional arrangement where the immigrant plumbers were permitted to remain in the UK for a fixed period of time, with a period of phasing out the immigration. Such an arrangement would need a clear end date to ensure that the market was prepared, by commencing training ‘native’ plumbers. Of course, the reality is that such a scheme would not be enforceable under today’s immigration constraints, and can only be a hypothetical solution to skills shortages.

Having dealt with skilled workers it is also necessary to look at the impact of highly skilled immigrants on the labour market. If we take the example of an immigrant working as a merchant banker in the city of London, surely here is an example of immigrant labour providing clear benefits by bringing in skills that are of great value in the economy as a whole, and creating real gains for the economy. One argument is that, in recruiting such highly skilled immigrants into the UK, there is a substantial benefit from acquiring the skills without the expense of having to train/educate the people in their skills[13]. As they arrive they are already in the position of being productive workers, with no need for investment by the state or employers.

In addition to the immediate financial benefit of ‘high skills at low cost’, these highly skilled workers may be able to add significant value in the sectors in which they work in other ways, such as their ability to introduce new ideas, new methods, and a host of other benefits, which are related to the combination of high levels of skill in conjunction with their experience of their own home country systems. Furthermore, just increasing the level of high skills, for example taking the case of scientists, will have potential to increase the potential for improvements in technology, process, and other economic enhancements through the sheer presence of numbers. More highly skilled people, increases the prospects of more innovation, more new companies and so on[14].

There is a simple initial attractiveness to this argument but the situation is very much like that of the plumbers, but with considerably longer time scales to develop the necessary skills. However, the case of skilled workers differs from plumbers in one respect; it is an area in which the immigrants are not a substitute for the economically inactive, as very few of the economically inactive would have the qualifications or potential to undertake this kind of labour. As such it would be difficult to argue that there should be restrictions on such highly skilled workers coming to the UK as the benefits are often quite clear.

There is a more worrying underlying question to ask, as follows; ‘Why it is necessary to import such talent in the first place?’ This will inevitably lead to the follow on question of what it is in the infrastructure of the UK that is lacking, such that it is failing to produce such talent internally? Is the requirement for highly skilled immigrants just a sticking plaster that hides a deep wound in the infrastructure of the UK?

The upward pressure on wages resulting from immigration

Whilst supply and demand tells us that immigrants will inevitably have a negative impact on wages in the job market in which the immigrants are working, there is the possibility that immigration may create an upward pressure on wages elsewhere. This will occur in situations where a company can lower the wages of workers, and therefore cut costs of their business as a result. In these cases the company or organisation will free up more cash, and some of that cash may be channelled into the remuneration of other people within the organisation, such as senior managers or business owners. A good example of a formal route for such a process would be in the provision for bonuses based upon profitability.

Whilst such an increase in remuneration may be a positive for those in receipt of them, it is unlikely that this has any positive benefit to the economy overall, as the increase in remuneration is a transfer of money from non-immigrant workers to the recipients, rather than the generation of ‘new’ money through, for example, more efficient production methods. In short it is a case of an increase in wealth differentials between managers/owners and workers, rather than the generation of new wealth.

Remittances and Repatriation of Funds - the Missing Argument

The issue of remittances and repatriation of funds is not heard in discussion of immigration, and yet may be one of the critical factors in considering the economic benefit of immigration. It is not clear whether this is not mentioned because of ongoing sensitivity about the subject of immigration, or whether it is because economists have just simply not considered the issue. As a consequence there is little solid evidence that can be provided and this section is therefore even more speculative than other areas of this discussion, relying on a combination of reason and guesswork.

Note 1: I define ‘remittances’ here as money which is sent by the immigrant to their country of origin to help their family or friends with financial support, and ‘repatriation of funds’ as the situation in which the immigrant returns to their country of origin taking with them their savings and investments that have been accumulated as an immigrant worker.

Note 2: I have written to the ONS to request information on the way that they collect information on migrant transfers (these show up in the balance of payments statistics). Their first answer they gave suggests that no account is taken of remittances whatsoever, and that inwards and outward flows of money of inward and outward migration are based upon the passenger surveys at landing/departure points. This method of calculation requires accurate numbers for migrants (non-existent) and the co-operation of migrants who need to volunteer their financial affairs at the time of embarkation/disembarkation. At first sight this appears to be a poor method of calculation, and my follow on questions to my initial enquiry to the ONS remain unanswered. My suspicion is that they are painfully aware that their methods are probably not much better than wild guesses.

Temporary Workers

These can be anything from a City of London financier, through to a waitress in a bar. In all cases they share the characteristic that they intend to remain in the UK for a finite length of time, whether that is the length of a contract, whether they will leave when they have achieved x value of savings, or until they go home to get married and so forth.

The important aspect of temporary workers is that, on leaving the UK, they will eventually take their accumulated savings with them, and this may have a very negative effect upon the UK economy, if we consider the immigrant’s net contribution.

If we return to the example of the Polish plumber discussed earlier, we can make some ‘back of a cigarette packet’ calculations for the temporary worker. We might surmise that the Polish plumber has decided to work in the UK for two years and has an aim of saving one third of their take home pay to take with them when they return to Poland. In this case we can make a guess that the worker will be saving at least £5000 per year, and this means that the Polish worker will take a cash lump sum of £10,000 when they leave the UK. In real terms this is the equivalent of importing a medium size family car into the UK.

If we take the case of a skilled financier earning £150,000 per year in the city, it is very likely that after a two year contract in London they will be taking at least £50,000 out of the country in a cash lump sum.

Permanent Immigrant Workers

For immigrant workers coming from developing economies, one of the attractions of working in a developed country is the ability of the migrant to earn enough money to help support their family in their home country. One example of this is the Philippines, where remittances provide vital foreign currency for the country’s economy.

There may be many kind of remittances, from fixed monthly payments to the family, or providing one off payments to educate a relative, or to help a family member start a new business. The key point to consider in all cases is that this is cash leaving the UK economy with no return for the UK economy. This is different from investment where the money is sent to another country with a view to gaining a return on the investment. It is a cash gift.

No speculative figures are supplied here as such figures would be even more speculative than the example given in the case of the temporary workers. However, it is possible to assume that the numbers, when viewed over the immigrants lifetime, might be very large indeed, in particular in the case of immigrants who are successful and therefore earn large amounts of money.

Close ties with country of origin

In addition to taking cash sums out of the economy, there is also the possibility that immigrants will be more likely to have a negative impact in other ways, when compared to a person of equal economic status who is a native worker.

One obvious example is that of return visits to the home country. This can be seen as being equivalent to a native worker taking a holiday in another country. Cross border tourism is an industry that sees large amounts of cash being transferred from one economy to another, and is therefore an equivalent to an import of a good. The question that is raised with the immigrant worker is whether the frequency, cost and duration of their trips is greater than that of a native worker who is of equivalent economic status. In this case it might be reasonable to suppose that the immigrant worker (including temporary workers) is more likely to travel out of the country, thereby removing greater cash sums from the economy.

Another area which might see a negative impact is in the purchase of goods and services. There may be a tendency for immigrants to prefer to purchase products and services that originate in their county of origin, for cultural reasons and for reasons of familiarity. An obvious example of this is the introduction of Polish products into supermarkets based in areas with large numbers of Polish immigrants, or the many Asian supermarkets that largely stock products from the Asian sub-continent.

Once again, the impact of this skew towards buying goods from the country of origin is not measured, and therefore the real value of the resultant rise in imports is unknown and uncalculated. It would, however, be reasonable to speculate that an immigrant, when compared to a native of the same economic status, is more likely to purchase greater numbers of imported goods, with the negative impact this has on the balance of payments.

So what do remittances and repatriation of funds mean for the UK economy?

It is here that the question becomes very blurry, as the figures are not known. However, if we were to take the example of Central European temporary immigrant workers and make some assumptions, the figures become rather disturbing.

If we imagine that there are 500,000 Central European temporary workers, and we assume that they will be staying in the UK for an average of two years, with an average savings rate of £4000 per year, we can then say that each immigrant will repatriate £8000. If we then multiply this by 500,000 we can say that, over a period of two years, there will be a cash loss to the UK economy of £20,000,000,000. This is a significant amount of cash lost to the UK economy.

However, when we look at this loss, it is even more severe than it first appears. When a person earns money and spends the money in the country in which it is earned, the money recycles through the economy. Even when a person uses some of their cash to buy an imported good, such as a television, a substantial proportion of the money remains in the economy. In the case of the television there is the UK internal distribution of the television, the promotional costs, the shop that sells the television and so on. At each of these stages UK based companies, and workers, are involved in the transaction, and part of the money paid when the purchase is made pays these companies and workers, who in turn spend their money and recycle the money to others. In the case of repatriation of funds, compared with buying an imported good or service, the loss is greater because it is an absolute loss of that money to the economy.

In the case of remittances, it is far more difficult to make a calculation of the impact upon the UK economy, as there are far too many unknowns to even start to make guesses. However, it would be safe to assume that remittances from immigrants would, in total, add up to significant sums of money.

The Pensions Argument

The UK, as for many Western economies, has a potential problem with the demography of the native population. In short, the population is ageing and this means that the number of retired people, when compared to the number of working people, is going to increase dramatically in the coming years. At the heart of the problem is declining birth rates, and increases in longevity. The problem arises when considering how pensioners will be supported in their old age by the state, as the number of economically active people needed to pay the taxes of retired people is set to decline in proportion to the number of pensioners. The result of this is that there will be less economically active people to support each pensioner.

One of the arguments for immigration is that immigrants add to the labour force, and often immigrate when they are young. This influx of younger workers is seen as a solution as it will maintain the young population at a higher level than would otherwise occur, thereby ameliorating or solving the problem. Furthermore, some studies show that immigrants have larger numbers of children, thereby raising the birth rate and counterbalancing the decline of the birth rate of native people.

The first problem with this argument is to return to the argument about economically inactive native workers. If the cost of immigration is the retention of these workers in inactivity, then the immigration is just substitution, and substitution at great cost.

In the case of skilled workers who are immigrating permanently this is a different argument, and a case may be made for such workers, provided that, after remittances and other factors, they present a net gain for the economy. However, even in this case there is a fundamental problem in the infrastructure (and society) that is being solved by the immigrants from other countries. The first problem needing to be answered is why individual UK workers are not making provision for their own retirement, and the second question is why is the birth rate falling. Whilst highly skilled immigrants might help in this situation, the reality is that immigration is covering more fundamental problems that might be addressed more effectively, and economically, in other ways.

Cheaper Goods and Services

It could be argued that the downward pressure on wages results in cheaper goods and services. For example, if you have low cost fruit pickers, this will make a kilo of strawberries cheaper, thereby offering a real benefit to all of the people who eat strawberries. This appears to be an economic benefit offered to the UK population.

However, if you consider that the immigrant labourer is helping to keep an economically inactive person inactive, then the situation looks rather different. This is because, what the person saves in the price of strawberries, they will pay in taxes to support the economically inactive person, and the higher tax will outstrip the cheaper strawberries creating a ‘dis-benefit’.

In addition, if wages are negatively impacted by an immigrant, the consumer of a good or service that utilises the immigrant labour may feel the benefits of the cheaper good or service, but the benefit is a transfer from the native worker whose earnings are lower than they would otherwise be, to the consumer. There is no net gain but a transfer.

Outward Migration (Emigration)

In viewing outward migration, once again, we encounter the problem of the lack of accurate statistics and we therefore will again need to speculate and reason in place of using research. Whilst passenger surveys may give an indication of numbers and financial information, they are also likely to be very inaccurate. Lacking any other statistics we will at least use the recent ONS statistics for the outflow, a number of just over 200,000 individuals in the last year, and 800,000 have people have left and not returned since 1997[15].

Who are these people that are leaving the UK? One group is that of people moving to Southern Europe, Thailand and other countries for retirement. These individuals will take with them their accumulated wealth and will spend that wealth in another country. This represents a significant outflow of wealth, and an outflow that will continue as these individuals draw on their pensions, and other assets (such as through the sale of their house) to finance their new life abroad. On the positive side, they will also not be using the NHS and other services in the UK economy on a regular basis, though some will still probably return to the UK for severe health problems. Whilst each individual case will be different, the probability is that this outflow is a negative for the economy.

Another group that are emigrating are highly skilled UK workers, who are going to countries such as New Zealand, Canada, the US and Australia. To give a snapshot, over 15,000 people from the UK emigrated to New Zealand in 2004/5[16] and just over 23,000 individuals to Australia in 2006/7[17].

The systems for these ‘immigration’ countries are heavily biased towards immigrants who are graduates and postgraduates, and also heavily biased towards people with experience in careers with specialist and ‘in demand’ skills. If we look at the example of New Zealand the majority of UK immigrants were in the skilled and business categories. These are just the kind of people that would normally be adding value to the UK economy by contributing their combination of education, training and skills. They are also people who will have probably accumulated savings and, in light of the property boom in the UK, will have considerable equity in their UK property. Once settled in their new country, these assets will inevitably be transferred to the new country, once again with a commensurate outflow of wealth from the UK. If we imagine a fairly typical immigrant profile, we will see a 25-35 year old graduate working in a good occupation, living in their own home, and having saved enough money provide some security when they arrive in their destination country. In this case we might make a reasonable guess that, at a minimum, most emigrants will leave the UK with at least £30,000 in cash and assets. If we use the figures for Australia and New Zealand for one year, we can see that this is very large outflow of wealth from the UK Economy representing £1,140,000,000 for just these two countries, and this is using a very conservative estimate of the assets that they are withdrawing. Perhaps more importantly, in addition to taking cash out of the UK economy, these immigrants will also be taking out the investment in their education and training, and their potential to add value to the UK economy.

The final category of emigrant to consider are the entrepreneurial business people, a category that would be impossible to quantify or identify. For this there are no statistics, and no way of determining the numbers or any sense of value of the loss. However, a visit to South East Asia will quickly show that there are large numbers of just such individuals, who can often be found in cities such as Bangkok, Shanghai, or Manila. Strike up a conversation and they will probably tell you how they have given up on the UK, and moved all of their business interests to their new country to avoid stifling regulation in the UK economy, the inflexibility of workers, and how they benefit from the low taxation and quality of life in their new home country. What is the loss to the UK economy of such individuals? It is impossible to say, but it is certainly a significant loss. In one recent case in Bangkok I met an individual who had withdrawn ‘several million’ from the UK economy, and who now just maintained a tiny presence in the UK economy.


There is one category of immigrant into the UK that certainly add wealth to the UK economy, the very wealthy ‘non-domiciles’ who have chosen to live in the UK for a limited period of each year. The UK tax system, in conjunction with the many attractions for wealthy people in London, have attracted large numbers of these individuals. They often bring sizeable amounts of capital, as well as significant spending power, into the UK. It is certainly one of the elements that contributes to the wealthy feel of London, visible through private banking, luxury shopping and entertainments. However, there has recently been a political backlash against the tax concessions granted to these individuals, and the long term future for this category of immigrant is starting to be questioned as a result. Whether these individuals choose to remain is not yet certain, but changes in their tax status may have a negative impact on numbers in the medium to long term. Only time will tell whether the attractions of London will be sufficient to retain these providers of wealth into the UK economy.


The first thing to conclude from this review is that there are some aspects of immigration that need to be studied as a matter of urgency. Without more information the economic consequences of immigration will remain unknown.

The second conclusion is that the immigration of all types of unskilled workers is almost certainly going to have a significant negative effect on the economy. We can also view the case of the skilled worker as a negative in general, but an occasional necessity for a short duration. With regards to the permanent immigration of skilled workers, this is likely to be a negative, in particular due to the negative impact of remittances and the particular skew of the spending. However, this would need to be looked at further in more detail to draw any firm conclusions.

As for highly skilled immigrants, short term immigration may be necessary for a period, though for longer periods than skilled workers. However, if this is necessary question need to be asked about why the UK infrastructure is failing to provide such skilled individuals. For permanent highly skilled immigrants, it is likely that they will have a greater positive overall impact on the economy over their lifetime, than negative. They may also make negative contributions through remittances, and more import orientated purchasing, but it is likely that these impacts will be counterbalanced by the positives that they bring.

For UK citizens emigrating out of the UK, it is likely that the loss to the economy will be substantial in the short term, and even more serious in the long term. The majority of emigrants will be the very people that the UK should be retaining, as they are the people who are most likely to make positive contributions to the economy.

The last point to make is that, even if the negative economic impacts of migration are understood, there is little that can be done to reverse the current patterns of migration without significant changes to the structure of UK immigration rules. As such the best that policy can achieve is to try to ameliorate the negative impacts, though no easy solutions or ideas come to mind.

Where’s the Beef?

For many years now it has been widely promoted that the UK economy has been a story of success. There are, however, some very deeply troubling aspects to the UK economy that have been evident to a small number of cynics for some time (I am one of those cynics). This section is titled ‘Where’s the Beef’ because it is not apparent exactly where the ‘beef’ in the UK economy, meaning real wealth creation, is actually coming from. This section will try to address this question. It will, by necessity, weave around and digress along the way as there is no quick and simple answer to the question.

Wealth Creation

Wealth creation in a broad economic sense is a difficult concept to pin down. When we look at a country, it is possible to have an appearance of growing wealth but, at the same time, have a real reduction in wealth. In the following sections, the possible sources of wealth creation will be detailed.


One of the most obvious sources of wealth is the extraction of commodities, whereby the extraction process adds value - or put another way - creates wealth. This process leads to real output and, provided that the extraction cost is lower than the selling price then real wealth is generated. In the case of the UK the primary source of wealth creation from this sector is oil, though there remains some small scale extraction of coal and other commodities (which have mostly been in long term decline). It is therefore interesting to note that the UK’s most significant source of such wealth, North Sea Oil and Gas, is now going through rapid decline[18], and that this decline started during the recent period of ‘strong’ economic growth. In light of this, it would be hard to find the current ‘success’ of the UK economy rooted in this sector[19].


It will come as no surprise to most people that manufacturing is a significant source of wealth. According to an EMEA report, gross added value from manufacturing in the UK saw a rise in the mid-nineties, followed by a decline in the early 2000 period, a decline that led to the added value falling back in 2005 to where it had been in 1999[20]. The same story can be said of actual manufacturing output[21], which has followed a similar pattern. What is certain is that, manufacturing remains a source of added value in the UK economy, but that the amount of added value that manufacturing contributes may be in long term decline, or at best static. Furthermore the UK has for many years imported many more goods than it has exported, as can be seen in the balance of trade figures over many years (e.g. £58.6 billion in 2004)[22]. The performance of manufacturing in recent years therefore does not appear to be the reason the reason for the growth in the UK economy.


When an overseas tourist arrives in the UK, they transfer significant wealth into the UK economy. The year 2005 saw record numbers of tourists and record spending of £14.2 billion. This looks like a great positive for the UK economy, at least until we see that UK residents, at the same time were spending £32.2 billion on overseas tourism. This means that UK Plc is making a net loss on tourism overall and this is therefore not a significant source of wealth generation for the UK but instead creates a net loss[23].

Inward Investment

I have already started mentioning the balance of trade, a balance that year on year is negative. This apparent ongoing negative balance started as a source of major concern to both the public and economists alike. As time has gone by, and no economic crisis has occurred, the sense of alarm has diminished. One of the explanations for why there has been widespread acceptance of the negative balance has been that the negative balance has been counteracted, in part, by the inflows of investment into the UK economy. This is widely seen as a ‘good thing’ but, in the following section, this view will be challenged.

Few people argue that money being invested in new businesses does not offer benefits for an economy, in particular where the company introduces new products, technologies, processes or systems of management. Unfortunately working out which investment is positive for the UK is not as simple as it first appears. For example, if money flows from another country into the UK stock market, is the money used to develop business, that is to allow the businesses to invest in new opportunities, or is the money simply the purchase of an existing business in order to take a share in the profits? It may be both or a combination of the two options.

In the case of one company buying another, is the intention to bring some added value to the company, such as the introduction of new management systems or technologies, or is it to gain market share through accessing the distribution system, or the technologies of the purchased company? Will the company purchasing the other company create new wealth for the UK by producing more, producing more efficiently, allowing others to produce more (or more efficiently), improve balance of trade through export of goods and services, or will it just operate as a company that provides goods or services that provides internal transfers of wealth? If it is the latter, then it will repatriate some of those profits to the home country, and in doing so reduce the net wealth of UK Plc.

For a moment it may be worthwhile to look at what is seen today as a rather quaint concept, the ‘Buy British’ campaigns that some people may remember from the 1970s. This is an important concept as it will later have relevance to how we may see wealth creation in the context of inward investments.

We smile as we say it…

The ‘Buy British’ campaigns are now a curiosity of history, and most consumers in modern Britain would probably find the concept to be rather silly - if it were to be proposed today. A good starting point for analysis of this kind of campaign starts with the individual consumer. In this case we will use an example of a 1970 consumer who is buying a hi-fi, and has a choice between a British and a Japanese hi-fi (for the sake of simplicity we will pretend that there is just one UK manufacturer and one Japanese). There are two items on the shelf of the shop and one appears to be much cheaper and has better features. It is the Japanese model. The consumer then has a clear choice - follow the slogan and buy British, or follow their immediate self interest and buy Japanese.

If our consumer were to follow the slogan, and buy the British hi-fi, they will effectively be foregoing an increase in their wealth, as they will need to spend more money for less features. The principle here is that their money will not go as far, which surely means that they are less wealthy. This will help the British hi-fi manufacturer, as the company that would otherwise not be able to compete with the Japanese manufacturer. The consumer will have made a small contribution to the survival of the British manufacturer, a contribution that is based upon sentiment rather than the merit of the company or the product of the company.

Is this sustainable in the long term? The answer is, of course, ‘no’. The Japanese company is presumably a better company as it is able to provide a better hi-fi at lower cost, and will presumably continue to develop attractive products. In the short term the purchase may help the British company by giving it a breathing space. If it is a good company it will use the time to respond to the challenge posed by the Japanese company, improving the business such that it will be able to compete in the future. If it is a bad company, it will see that sales are still high, and take a complacent approach, and fail to respond to the Japanese threat. After all, the signal from the market appears to be positive towards their product, as they are maintaining their sales. The trouble arises, in the case of such a complacent company, when the consumer eventually starts losing so much wealth by buying the British product that they will eventually switch to the wealth creating Japanese product.

Alternatively, what would happen if the consumer follows their immediate self interest, and buys the Japanese hi-fi? The first point is that the consumer will have become, at least in the short term, wealthier, as the money that they have used to make the purchase has purchased more and better than the same money would have purchased if the only choice had been the British hi-fi. This is a real form of wealth creation for the individual, as they have just found that their purchasing power has been increased such that, for example, they can afford Dolby sound, whereas before they could not have afforded it.

So, when we look at it from the point of view of this individual consumer, it appears that ‘Buy British’ never did make sense.

The problem arises when we look at the situation not as one consumer, but consumers collectively, that self interest suddenly looks different. At this point, we see lots of British consumers choosing the Japanese hi-fi, and start to see that the British company will very quickly find that sales are declining, and will eventually be forced to shut down (assuming that it fails to rise to the challenge, which is what happened in many cases). At this point, the rational choice of each of the individual consumers will have a long term effect on the wealth of UK Plc. Once the UK hi-fi industry is gone, all hi-fi will be imported from outside of the UK, creating a long term negative impact on the balance of payments for UK Plc.

There are further consequences. The end of the manufacture of hi-fis may also impact upon other suppliers, such as component suppliers. It may be that they specialise in hi-fi components, in which case they may disappear, or it may be that they will become weaker, and lose economies of scale. This weakening may create further opportunities for foreign companies to enter the UK market, where they can leverage the economies of scale by expanding their markets. It should also not be forgotten that this will lead to the loss of jobs for the UK employees in the British hi-fi manufacturer, and also in the related supporting industries. Some of these people will move into other related areas of work, some will move into services, and some will perhaps stop working. In all cases there is likely to be a cost whilst the adjustment is made, and in some cases, such as where they do not find equivalent work, the cost will be their earnings may be lower, or if unemployed, the state will need to take up the slack. All of this has a negative impact upon the wealth of UK Plc, as well as the individual employees.

To create a simple illustration of this, imagine that our imaginary purchaser of the Japanese hi-fi is a pub landlord who lives in the town that manufactures the British hi-fi. He buys his hi-fi, and benefits from the increase in wealth that it provides. On the other hand, a few years later, the British hi-fi company shuts down, and he notices a small (but not insignificant) drop in the sales at his pub. The drop in sales at his pub are not the only thing he notices, as he is also paying more local tax, which is helping to support the increase in the numbers of people on housing benefits. Once again, this is a massive simplification, but I hope that it illustrates the principle. The principle is that when a foreign competitor moves into a sector and removes British companies (or takes away market share), there is a trade off that is being made by consumers. On the one hand, they become wealthier as individuals, as they are able to purchase more or better with their money, but on the other hand they weaken the overall economic circumstances in which they operate. Whilst campaigns such as ‘Buy British’ are doomed in the long term, there remains an interesting rationale for them, in the sense that such campaigns are a recognition of the cost of using foreign companies for goods and services.

If we return to our imaginary consumer, the difference in price between an equivalent UK hi-fi and Japanese hi-fi might be, for example, £30. In this case the individual will be £30 wealthier if they buy the Japanese model. This positive for the individual is easy to calculate. The real problem in the calculation of the consequences of the individual choice of this one consumer arises when trying to calculate the cost of the purchase in the long term. In the example given it is the cost of losing a hi-fi industry, with all of the associated services, and knock on effects. In such conditions it is quite possible that there will be a long term loss that will exceed the gain in wealth that is represented by buying the Japanese model.

Is this an argument for protectionism or ‘Buy British’? It is not such an argument, as the case given illustrates that, in the long term, a company or industry that fails to compete on its relative merits will, in any case, decline in the long term. If an industry is protected from competition by a slogan, or tariffs, then this will engender complacency, and there will be a spiralling loss of wealth to individuals, as they will not have access to better products at keener prices.

The reason for this diversion is to understand that, when looking at different consumer decisions, there are trade offs in wealth that may not be entirely obvious. This is very important when considering foreign investment into the UK and whether real wealth is being created, as will be seen later.

Transfer of technology, management systems and processes

One of the oft cited examples of a benefit to the UK economy of inward investment is the introduction of better management, better systems, processes or new technologies (innovations). This can provide a source of long term long term wealth, as it may be that such introductions will spread beyond the company that introduces such innovations, and dissipate into the wider economy.

We can see this process in the example of Japanese car manufacturers, as they have introduced many new innovations into the UK economy such as lean manufacturing, just in time, and a host of innovations in quality management. Few would argue that UK companies have not benefited from such ideas. Whilst the benefits of such innovation are very hard to estimate overall, the effect is going to be broadly positive, and will help the UK companies that learn from such innovations to better compete in world markets.

Another example of positive inward investment, is that of a company such as Microsoft setting up a Research and Development centre in the UK. This inward investment will lead to a multitude of benefits by providing highly paid jobs, but also training people in Microsoft technologies, new ways of working and so on. It will be highly probable that some of the workers will go on to set up companies that will build on Microsoft technologies, or they may even set up companies that will compete with Microsoft technologies, or go to UK companies and thereby help them better compete with Microsoft. Few people argue that such an investment produces anything but benefit for the country in receipt of such investment.

However, not all investments offer such dramatic benefits and, where they do, the question then arises as to at what point they offer diminishing returns. In the case of the Japanese automotive innovations, once the innovations have already been widely adopted, will the opening of another Japanese automotive plant add anything new, or will it just offer more of the same? The answer is that any company that invests into the UK will presumably enter the market in the belief that they possess strengths that will allow them to make a profit, and those strengths are presumably such that they believe they have a competitive advantage. Competitive advantage often flows from particular innovations within each company, whether it be presenting a unique product mix, a special process, a unique technology or even something as mundane as efficient financial control. Whatever those strengths may be, they will be introduced into the UK market and they will likely be an innovative entrant to some degree. As such it would be reasonable to say that most inward investment (that succeeds) brings opportunities for some kind of benefit in terms of introducing innovation.

So far the examples have only examined one side of the balance sheet, but it is vital to remember that this is not a one way street, in particular where the economy in receipt of the inward investment is at a similar (or higher) level of development. In these cases the innovation will not only flow inwards as a result of the inward investment, but will also flow outwards. A good example is that of the Japanese company that purchased Pilkington glass, a purchase which will lead to the diffusion of Pilkington technologies into the Japanese company. In fact, in most cases, the process of learning is likely to be in both directions, such that the calculation of the benefits for UK Plc is never as simple as it first appears. Returning to the case of the Microsoft R&D centre, it is very probable that some of the ideas and innovations being developed in UK research universities will find their way into Microsoft products. The reason why Microsoft makes such an investment is precisely to achieve this, to gain access to the ideas of UK trained personnel. Furthermore, if we take the example of the Japanese car manufacturer, they will almost certainly have hired people who have skills and innovations learnt in other industries and companies, and these skills (where useful) will again diffuse throughout the Japanese company over time.

The situation is therefore not as simple as it first appears when considering the long term wealth of UK Plc, as the calculation of the benefits of the inflow of ideas against the outflow, are not easy to identify. Does the hiring of a Cambridge university graduate by the Microsoft R&D centre represent a long term loss to the UK economy, if the graduate would otherwise have worked for a UK company, and that company would have taken work from his research and developed a world beating new product? If the Japanese car plants had not been established in the UK, would UK manufacturers have in any case continued to develop their own manufacturing innovations to remain competitive, rather than adopt Japanese innovations? Might such innovations have been better than the Japanese innovations? Such questions are inevitably unanswerable, but they are worth consideration, as they may point to the possibility that the benefits of innovation from inward investment may not produce only positive outcomes for UK Plc.

The assumption that inward investment brings positive gains for an economy through the introduction of innovation is widely held, as it at first appear to be a perfectly logical proposition, but it is a position that just looks at the positive inflow of innovation, instead of the inflow and outflow, and the opportunity costs. For example, when a foreign company takes an innovation out of the UK, there is a long term loss to the UK economy, as the innovation would otherwise be a source of competitive advantage to UK Plc. If a company adopts a foreign innovation it may be that, in doing so, they neglect to develop their own innovation, and such innovations may have been be better than those adopted. It is impossible to calculate the impacts of innovation from inward investment, but it is certain that the benefits are not the ‘one way street’ that is an assumption of many economists (at least when looking at countries at similar levels of economic and technological development).

Repatriation of Profits and Support of Head Office Facilities

Whenever a company invests in another country, their aim is to make a return on the investment. This can be neatly summarised as wishing to extract greater wealth from the country that is the target of their investment than that which they put in. An investment is intrinsically established with this intention and this is simple and vital concept to grasp. All companies that are investing in the UK are doing so in their own interests, rather than in the interests of UK Plc.

In addition to the intention to extract wealth from the UK economy greater than the investment wealth put into the UK economy, there is the repatriation of funds to support the infrastructure of the company, typically in the shape of a head office, R&D facilities and so on. These operations will, in many cases be a substantial overhead, and see a regular transfer of wealth out of the UK into the country where the facilities are located.

The exception to this situation is where a head office uses the UK as a regional headquarters. In this case, it may be that the transfer of wealth from other countries in the region into the UK regional headquarters reduces, offsets, or exceeds the wealth that is transferred to the head office. In this case there is a positive increase in the wealth of UK Plc. However, even in this case, there will be a negative transfer of wealth when compared to a similar UK owned and operated company.

Licensing, franchising, and other transfers

When a company invests in the UK it might, for example, set up a manufacturing facility in the UK. In addition to the profits that are generated on the manufacture of goods, it may be that a licence fee is charged for the technology that is transferred. If this is the case then the profit of the manufacturing operation is supplemented by the license, or similar fees.

It may also be that the company has its own in-house manufacturing systems and equipment, and these will be transferred to the UK as the company sets up operations. In most companies such operations are, of themselves, profit centres, and this means that the UK manufacturing plant’s investment in plant or machinery may be heavily skewed back to the country of origin of the investing company, meaning that the actual investment in the UK is less than it initially appears.

If we take the example of franchising, the investment is even more heavily skewed towards the country of origin of the inward investor. In cases, such as McDonalds, the investment into the UK is partly to establish the infrastructure to support a franchise model (at the time of writing about 30% of restaurants in the UK are franchised). This is an effective way of minimising the cost of the expansion of the business for McDonalds, though it may also reduce long term returns. In the case of a franchise, the investment will often be achieved through UK internal resources, as the franchisee will be making much of the total investment. At the outset the investor will often be required to purchase the franchise rights, thereby creating an immediate outflow of wealth from UK Plc into the country of origin of the franchising company. This outflow continues with the ongoing franchise payments, and also sometimes through commitments to purchase various products and services from the franchising company, and sometimes through profit sharing schemes. In these cases the investment into the UK is minimised, but the wealth extracted from the UK market is maximised.

In the above cases it is possible to see examples where the profits, relative to the level of investment, may be particularly high. In these cases, there would need to be a very significant benefit to counterbalance the outflow of money that follows the initial investment, such as balance of payments benefits through export, in order for UK Plc to see a net gain in wealth from the investment.

Inward Investment for the Manufacture of Goods

Across the world there is intense competition to attract manufacturing companies into countries or regions, in particular when the goods are both for internal and export markets. The most obvious benefit is that of export, which translates into a net flow of wealth, from the country that is the recipient of the export, into the exporting country. When an export oriented manufacturer sets up in the UK, it is therefore most likely a positive for the UK economy. Even where the manufacture is for the internal market it can also provide significant benefits, such as the displacement of imported goods, with the resultant retention of wealth within UK Plc.

Furthermore the manufacturer will spread benefits even further through the recycling of their wealth to other UK companies, such as support services for the operations of the manufacturing facility, not to forget the recycling of wealth from the salaries paid to the employees of the company.

The negative side of the equation is when the manufacturer is displacing a UK based manufacturer. In this case the repatriation of profits, costs of licensing and other associated repatriation of wealth to the home country will compare badly with a UK based company.

The Use of Country of Origin Suppliers

When a company invests in a particular country, they will often import managers and practices along with their investment wealth. This will often result in the company importing its current supplier base, such as component suppliers, support services and so on. This process can have a variety of implications for the long term wealth of the country in receipt of the investment.

For example, if a U.S. packaging company were to invest in the U.K. they might also want to be supplied with speciality chemicals from the company that provides these products in the U.S. In doing so the speciality chemical provider might decide that the volumes are not sufficient to set up a manufacturing operation in the UK, and therefore choose to export the products to the UK, rather than set up manufacturing in the UK. In this case they may still need to establish sales representation in the UK, or at least have sales representation visit the UK on a regular basis. Inevitably, such a support system will become a bridgehead into the UK market, and the company will start to seek other opportunities within the UK market. This will introduce competition to the UK market, with the possible end result that imports will rise in the UK, and therefore there will be an outflow of wealth to the U.S.

Alternatively, it may be that the volume of business is sufficient to provide an incentive for the speciality chemicals company to set up its own operation in the UK. In this case the company invests in the UK, and then commences production of the relevant chemicals. In one case they may limit the investment to production for the UK market, in another they may eventually develop into an exporter from the UK market.

The entry of the speciality chemicals producer then may lead to the entry into the UK market of companies that support their operations, for example in the provision of base chemicals. What started off as one company investing in a market will actually probably commence a chain reaction of activity from more new entrants into the market.

The question that arises from this is whether this is of benefit to UK Plc. It is here that the questions start to become complicated. In the example, if the U.S. company is a major exporter, then it may be that the exports offset any imports, and any displacement of UK companies by the new competition. If the U.S. company is not an exporter, and is just competing with U.K. companies, the market share taken from the U.K. companies will not just hurt them, but will also hurt their suppliers, who will see their sales to the U.K. companies going down as their customers lose market share , whilst the lost sales are replaced by imported goods. Alternatively it could be the case that the UK speciality chemicals companies respond by aggressively competing with the U.S. supporting companies, and win the business of the U.S. packaging company. In this case, this may present an opportunity to open the business of the packaging company in its own home market.

In short, the investment of one company into the U.K. may spur a range of outcomes in the supplier base for their business. The question then remains, as to whether such chain reactions are positive or negative for UK Plc. As ever the issue is so complex as to make it nearly impossible to have any firm conclusion, as each case of each investment will have different outcomes. It is almost certain that the chain reaction will introduce greater competition within the economy, and that the weaker suppliers in the UK will not survive such competition. In this case there will be a displacement of UK companies by foreign owned companies, creating a negative. On the positive side, the companies that do survive will be more likely to be prepared for international business, and will therefore have greater potential to expand their operations.

There is only one certainty that can be taken from the example that is given above, and that is that it would be wrong to assume that the investment into the UK can only be positive, even when the company is an exporter.

So Inward Investment is not all Good?

Perhaps the most dramatic example of inward investment not being ‘good’ can be found in the sale to foreign companies of utilities such as electricity generating companies. The only possible argument for this kind of investment being ‘good’ for the economy would be that the foreign utility companies will be able to offer improved management of the utility, as they are very unlikely to be bringing any new technologies that are not already available to UK utility companies, and unlikely to be bringing any new processes, and so on. In the case of utilities, the outflow of wealth to the country of origin of the holding company will be very substantial, and the improvement in management would have to be quite astounding for UK Plc to see any gain from this inward investment. It is unlikely that any rational person would say that it would be possible for management improvements to be sufficient to justify the sale of an electricity company, when compared to the outflow of wealth from the UK economy.

This raises the question of why the UK has opened its economy to the point where there such apparently ‘bad’ inward investment, such as allowing the purchase of utilities, has been allowed. There are only a few reasons that can explain such an economic policy. One simple answer is that government has not thought through the consequences, and are such following a dogmatic approach to economic policy. The other reason is less likely, but may be possible. This is the notion that successive administrations have realised that inward investment has been the only solution to the ongoing balance of payments deficit. Only through massive inward investment could the UK economy be supported. This is a short term fix to a problem and a fix that will, in the long term, have a negative impact on the UK economy.

The point in discussing inward investment in such detail, and challenging the assumption that inward investment is good for the country is vital when considering the ongoing balance of payments deficits.


Another important method of generating wealth is the development of services. This is a more difficult area to explore. The most simple way that a service can clearly generate wealth is through the sale of one individual to another. In this case there is a transfer of wealth from one person to another. Examples of this might be the case of the taxi driver, the photographer, and so on. The same process occurs when an individual or company, such as an accountancy firm, or a consultant, or cleaning services company sells their services to another company. In each case the service provider has wealth transferred from the recipient of the service to the provider. So far so simple. This is a process that is occurring within all economies on a daily basis. The growth in services is widely seen as ‘the engine of growth’ in the UK economy, and it is therefore in this area of growth that will be where we need to ‘look for the beef’.

Before going on to more detail it is also worth noting that export of services has seen increases over recent years and has a positive trade balance. For example, in 2004 the surplus reached £20.2 billion. This export of services is a real net gain for the UK economy, but still is insufficient to explain the apparent high growth in the UK economy over the last 10 years, despite the fact that services often create greater value than goods.

However, before looking at services it will be valuable to take a detour into the source of money into the economy, and to look at borrowing in particular.

Consumer Borrowing and Transfer of Wealth

To illustrate what is occurring when an individual consumer borrows money, this section will use a person (Mr. Smith) who uses a credit card to pay for a meal at a restaurant. He needs to use his credit card due to his habit of overspending each month. When Mr. Smith pays for his meal, some of that money to goes to the restaurant, and some to VAT (ignored hereafter), and a debit (a debt) will appear on the credit card such that Mr. Smith will now have to pay the credit card issuer (a bank) for the meal in the future.

Does this transaction add to the wealth of UK Plc? In borrowing the money, the bank that lends the money will (presumably) be making a profit on the transaction, the restaurant will (presumably) be making a profit on the transaction. Both of these organisations have provided an added value service. On the other hand, the net worth of Mr. Smith is negative as a result of the transaction, and he is actually less wealthy as a result. How does this transaction of ‘going to a restaurant to buy a meal’ impact UK Plc?

If the bank has used the funds of savers in the UK as a source of the finance, then we have a situation in which Mr. Smith has transferred some of his future wealth to the bank, to the savers who have provided money for the loan and, of course, he has transferred some of his (future) wealth to the restaurant. In this case UK Plc is neither wealthier, nor less wealthy. There has simply been a transfer of wealth from the individual to other individuals/organisations.

What if the money that provides the loan has been borrowed from outside of the UK, and the UK bank is effectively the ‘distributor’? In this case the transfer of wealth from Mr. Smith will go to the restaurant, the UK bank and the foreign bank. In this case, there has been a real transfer of wealth from Mr. Smith in the UK to the overseas bank that provided the finance for the credit. There is therefore a transfer of real wealth to the country of the overseas bank.

It could be argued at this stage that the overseas lender only has a very small amount of the total transfer of the wealth, and that the majority of the wealth goes to the restaurant owner. This is largely correct. However, depending on the status of the individual and the type of loan, the final interest that is paid on the loan might actually be very high, and translate into a large sum of money over the period of the loan. Some of this interest is profit for the UK bank, and some of the interest is profit for the foreign bank. If we say Mr. Smith is an overstretched credit user, with a moderate credit history, and give him a £500 balance on this credit card, an 18% interest rate, and ongoing minimum payments of 5% of the balance, this £500 will cost Mr. Smith a shocking £214 over the life of the loan. This is not an atypical profile for a heavy credit card user with a moderate credit history, but better and worse examples can be created in any number of permutations. In this case a £50 meal will see a transfer in wealth of £21 to the banking system from the restaurant goer, a significant loss of wealth to the individual, and a significant transfer of wealth to both the UK bank and the overseas bank. Different profiles will produce different results, and the example given is just to give a sense of the potential scale of the transfers. In this case we might hazard a guess that Mr. Smith has just transferred as much as £8 of his wealth to another country, in order to pay for a £50 meal, a meal that might otherwise have seen no transfer of wealth outside of the UK.

This is a very expensive transaction for both Mr. Smith and UK Plc, and has a negative impact on the overall wealth of both.

Let’s take the case of Mr. Smith using mortgage equity withdrawal to pay for the restaurant meal (and presumably other items). Surely the wealth of Mr. Smith remains neutral? He has not increased his net debt as his asset (his house) has increased in value, and he is therefore just spending the increase of the value of the asset without actually increasing his overall level of indebtedness. On the contrary, in this case, his debt has still increased in real terms, and only ceases to be an increase in debt when the value of the asset is actually realised. In particular, the interest paid on the loan made for equity release will, over time, erode the gain in the value of the asset. In addition, until the gain from the asset is realised, there is the real prospect that the appreciation of the asset may be reversed, thereby decreasing the wealth of Mr. Smith by the amount of the decrease, and also by the requirement to continue paying interest on the additional loan.

In cases of equity withdrawal, just as with the standard loan, it is also necessary to look for the origin of the finance for the loan. If the equity release is being financed from non-UK sources, then there is, once again, a loss of wealth from the UK. Equity release is just another form of debt, albeit a debt secured against an asset, and therefore normally cheaper to service.

Does the same principle apply when Mr. Smith purchases a product, if he has purchased the product with borrowed money, sourced from another country? The situation is, of course, the same. The real difference here is that the transfer of wealth from UK Plc will be even larger when the product is an import. In addition to the transfer of wealth overseas from the debt interest, there is also the transfer of the cost of the good (calculated as the cost before added value services such as promotion, distribution and retailing which may be UK internal wealth transfers) to the exporting country.

Above is a micro picture of what is happening in the UK Economy. On a larger scale the UK has seen personal debt levels spiral over the last 30 years, such that debt levels have climbed to 150% of disposable income[24], and has long ago exceeded the £1 trillion level .

Perhaps the most interesting question to ask about such debt, is where it is actually held. The U.S. sub-prime crisis has shown the extent of the levels of complexity in the worldwide financial system. It has revealed how debt can be sliced up and sold off in world markets, such that the location of the organisation that is the recipient of the debt repayment is partly obscured from view. The crisis has shown that the debt is not just held in the UK, but will be held in banks and institutions throughout the world. This massive debt mountain almost certainly represents a huge outflow of wealth from the UK. The question that lingers is; just how much money will need to flow out of the UK to service this debt mountain?

So where is the beef?

We will now return to Mr. Smith and look at him in a bit more detail. Mr. Smith has always been confident that he is in a financially sound position. He has purchased a house and, in the time that he has owned the house, he has seen a big increase in the value of his asset. This is one of his sources of confidence, as he can see, year on year, he is accumulating financial reserves. On top of this he has a job that pays well, and he sees a small pay rise every year. The only trouble is that Mr. Smith works hard and feels that he should enjoy the good things in life, so that he quite regularly borrows money to finance a better quality of life - so that he can go to good restaurants, buy nice things and go on holiday on a regular basis. Over the years he has borrowed more and more money through bank loans and credit cards. When he started, the payments were not too bad, but now he is noticing that he is struggling to maintain payments. He is a bit nervous as he has just had to take out another loan to pay his overdraft, which has occurred because his debts and expenditure keep on pushing him into the red. He has felt okay about this situation overall, however, as he has the increase in value of his house to bail him out if need be.

Eventually, he will use the equity in his house to bail himself out, by using equity release to pay of most of his debts, and also taking a bit more to buy a new car. His mortgage payments have increased, but the amount of debt repayment is once again manageable. He feels content and is enjoying driving his new car.

Everything is looking good for Mr. Smith, until he starts to notice a new trend in the newspaper he reads. He is starting to see commentators talking about a ‘credit crunch’ and a slow down in the housing market. He is not too concerned though, as his house has gained in value by such a large amount, that he has a big cushion.

Back to Services - the ‘Engine of Growth’

Why the detour into lending in the middle of a discussion about services? The reason is quite simple. Services have been promoted as the engine of growth in the UK economy. There has been a huge expansion in retail, expansion in restaurants, health and fitness, financial services and so on.

The real question here is, where has the money for such expansion originated from? The answer is long but not overly complicated.

If we go back to Mr. Smith in the restaurant, we can see that he has borrowed money to finance his restaurant visit. In doing so he has decreased his wealth in order to fulfil a short term need. This is, partly, what wealth is for, but this is Mr. Smith’s future wealth that he is spending. This borrowed money that Mr. Smith has spent in the restaurant will then recycle throughout the economy in many ways. The restaurant owner will be a little wealthier, and will then spend some of the money on buying goods and services, the restaurant staff likewise, and so on. Furthermore there will be suppliers to the restaurant who will also be beneficiaries of the spending of Mr. Smith, as his consumption of foods will mean that the stock will need to be replenished, and the process of cooking will require energy, and some of his money may contribute to decorators, maintenance people and so on through all of the restaurant support services. We can then see the same process with each of these support services spending their small share of Mr. Smith’s transfer of wealth in a host of different ways, each further helping to support another layer of businesses.

It is only when we look at lots of versions of Mr. Smith, all borrowing money, all of which dissipates through the economy in a myriad of ways, that we can see what a dramatic effect this has on the economy. Throughout the UK economy there are millions of people who, just like Mr. Smith, are reducing their future wealth daily through the borrowing of money. Each of these individuals supports a multitude of businesses through each of their purchases of goods and services. This massive dispersion of borrowed money is financing large numbers of businesses, and the transfer of their (future) wealth that occurs is apparent in what appears to be a booming economy.

This is all well and good, provided that Mr. Smith keeps on borrowing and spending. The UK economy has now come to a crunch point, where the ability to continue spending borrowed money is starting to diminish. The newspapers and economists have focused on what are fast becoming magical beasts called the ‘sub prime’ crisis and the ‘credit crunch’. These are increasingly taking on the status of self-generated, self-fulfilling beasts with autonomous power in market places. It is here that one of the real dangers lies. In blaming the sub-prime crisis, the UK has collectively fooled itself that the problems that have arisen in the US economy are somehow unique, and that the UK is just suffering the fallout of the US problems.

The reality is that the UK, just as America, is exporting huge amounts of wealth through personal debt and consumption. Furthermore, commentators seem to ignore the fundamental fact that money borrowed today must be paid for tomorrow. My own personal expectation had been that debt would continue to grow, until personal defaults and bankruptcies finally took hold, and reminded people that debt could not be accumulated into eternity. The reality is that the sub-prime crisis has changed the situation, and turned what might have been a rapid slowdown leading to a crisis, into a headlong rush into a crisis.

This then raises the question of how so much debt has been accumulated. One of the core problems has been the oversupply of finance which has led to a credit bubble. Just as in the mortgage markets, if too much money is chasing too few lending opportunities, then it is inevitable that the money will eventually be misallocated. This misallocation can be summarised as ‘cheap and easy’ credit. This finance has been flooding into the UK from all over the world. The UK has been seen as a stable and expanding economy, an economic success, and this belief has attracted the inflows of money available for lending. The problem here is that it is the inflow of cheap money that has supported debt accumulation by consumers, and this in turn has made the economy appear so successful. The question then arises to why lenders are not more careful with their lending.

One of the problems at the heart of the credit bubble is that the risk has been separated from the lender, who can lend with impunity, whilst packaging the debt into financial instruments that can then be sold to third parties. This would appear to be a wonderful way to make money for the banks undertaking this process, but the problem is that, as fast as one division was selling the debt through the front door, another division has been buying similar debt through the back door. This is to massively simplify the mass of transactions that represent debt markets, but the principles are simple and clear. If you separate the issuer of borrowing from risk, then the lender will issue debt that is of much higher risk. The whole situation has been further complicated by the Basel banking rules, such that certain instruments have been used to support a banks capital adequacy ratios. The repackaging of debt into new instruments has probably been a response in part to these regulatory challenges. In repackaging the debt it has been possible, as has been shown by the US sub-prime crisis, to turn low grade debt into high grade debt - right up to the point where the defaults start.

It is very easy to enter into the technical world of banking, and become bogged down in statistics, figures, yields, and all of the jargon of modern finance. What many of the specialists fail to see is the real people behind the jargon, the Mr. Smiths of the world, all of whom, with a false confidence, continue to borrow ever more money, sacrificing ever more of their future wealth, in the belief that the situation is sustainable, that somehow they will muddle through in the end.

The simple truth has always been that, eventually, the credit boom had to stop. People can not continue to finance themselves on credit forever, and when the credit stops and the payback begins, all of the spending from the influx of credit into the economy will disappear. Mr. Smith will stop his restaurant dining, and the restaurant owner will see a real and sustained drop in sales as millions of Mr. Smiths finally tighten their belts.

The knock on effect on the economy of such belt tightening will be profound. For all of the debt that has been accumulated, there will be a continuing outflow of wealth out of the UK. Long after Mr. Smith tightens his belt, money will continue to be repaid, and that money will be paid in part to non-UK financial institutions and investors, who will thereby gain from the transfer of wealth, at the expense of both Mr. Smith and UK Plc.

So what else will happen when all the Mr. Smiths stop spending? Let’s imagine Mr. Smith is manager in a mobile phone shop. He makes a reasonable living from selling the phones and thinks that his job is rewarding and secure. The trouble is that, just as he is tightening his belt, so are many others. In the modern world a mobile phone is increasingly an essential of life, so sales in Mr. Smith’s shop will continue. The trouble is that the latest model no longer looks so essential to all of the other Mr. Smiths in the economy - Mr. Smiths who are busy tightening their own belts. Sales of phones are starting to drop in Mr. Smith’s shop, and Mr. Smith is becoming slightly edgy about the job, and reducing his own spending further. As time goes on, he notices that there are also belt tightening measures from his head office, and then the request that he lay off one member of staff, then another, then another. Mr. Smith tightens his belt even more, and across the service industries the same is happening. It is the start of the downward spiral.

The downward spiral is where the cheap credit stops, the repayments begin and the saving starts. As the economy turns down, the fears of individuals increase, and as the fear of individuals increase, their spending drops, and as their spending drops, the economy turns down further, and as the economy turns down further the unemployment rate goes up, and as the unemployment rate goes up, the defaults go up and the banks tighten credit further, reducing spending further, and increasing and leveraging the downward spiral. And so it goes on, and on, into full blown recession.

The result of this downward spiral will not be a pleasant experience for the UK. In particular, the economy of the UK has become ever more dependent on inward investment to act as a counterbalance to the imports of goods and services that have led to consistent balance of payments deficits. As the UK economy slows there is a realistic possibility that such inward investment will also freeze. One of the reasons for the ongoing inward investment has been the apparent robustness of the UK economy, and in particular the perceived stability of the UK economy. As such, one of the other inflows of money into the UK economy might also dry up, further leveraging the UK economy downwards.

The ‘City’, the Jewel in the Crown of the UK economy

There is no doubt that the City of London is one of the most important financial centres in the world, and has seen real growth in the added value that it has created. A recent report by the Economist magazine points to the astounding success of the City, saying that ‘As a centre for international finance, London heads the league. Its foreign-exchange markets are huge, with over twice New York's share of trading; it dominates off-exchange dealing in derivatives; and last year it hosted the most new share issues, by value.’[25] The growth in the city has been in part because of the tightening regulatory regime in the US in comparison to the more conducive regulatory regime in the UK. The article goes on to point out that the City has enjoyed the benefits of the ‘Network Effect’. This is the idea that financial institutions will cluster where there is expertise, and this clustering then encourages the development of more expertise, in a self fulfilling cycle.

The same economist report goes on to say that the City has now suffered a setback, in part because of the ‘Credit Crunch’, and in part because of the Northern Rock scandal. The overall conclusion of the report is that the City will be going through a period of difficulty but will, in the end, bounce back. There is no doubt that the City remains the jewel in the crown of the UK economy, whatever the short term problems, and no doubt that the services of the City contribute massively to the success of the UK economy.

So far, so good, but there is one question hovering above the apparent massive growth in the City. That is the question of how much of the growth is built on servicing the consumer debt of the UK and US economies. Sub-prime mortgage debt is just one type of debt that is being held by the financial institutions that are operating in the City of London. The painful discovery of the poor quality of the sub-prime debt has seen $billions in write downs from some of the world’s largest financial institutions such as Citibank, and has started the process of the cooling of the financial sector.

In the same issue of the Economist as the report on the City of London, there is another article that highlights the beginnings of concern regarding non-mortgage debt, in this case the debt being credit card debt[26]. The report paints an optimistic picture, showing that non-payment of debt is still not a great problem. Like many other such reports, it fails to see this form of debt in the wider context. In order to understand the risks to consumer debt, we just have to return to the case of Mr. Smith, and watch how he is ever more dependent on debt to continue to finance his existing debt, how he is relying on his continued employment, and (at least) the retention of the increase in the value of his home, to support him. The downward spiral of the UK economy has already been described, and it is in this context, with millions of Mr. Smiths, that the confidence of such reports appears to misplaced. As the economy turns down, debt delinquency is sure to rise, and another pillar of the financial system will to go into crisis.

How will this effect the City of London? Without a doubt, this further blow to the City of London will be extremely damaging. As well as the direct cost to the financial institutions there is the real possibility of an even more damaging consequence, and that is the loss of reputation for competency. If the consumer credit market turns sour, it may well create a ‘double whammy’ in that the money that flows in and out of the City of London may well dry up. As investors lose confidence in the ability of the major financial institutions to manage risk there will be a rapid and painful withdrawal of funds, further adding to the woes of the City.

In this context, the continuing confidence in the City of London’s ability to sustain economic growth in the UK looks like a very remote possibility. It is more than likely that the City, already reeling from the sub-prime scandal, is about to get a kick when it is already down. The trouble is that the City of London has prospered through the creation of the credit bubble, and when the bubble bursts, it is very likely that the damage will be deeper and more damaging than many expect. It appeared that the City was a massive wealth creation machine, but much of that wealth is about to be destroyed, as much of it was in any case illusory. Whilst the power and influence of the city will not disappear, it is likely that it will retrench into a more stable and sustainable position.

The Credit Crisis and the Impact on Businesses

The reports of the difficulty of small and medium sized businesses (SMEs) obtaining credit have already started[27]. As banks have become more fearful of lending to each other and individuals, the effect has also spread to small business. At first site this appears to be a matter of technicality, that the money is no longer available, and a matter of sentiment, that there is fear in the markets. It may be, though, that the financial services sector are simply following a rational course and are just running for safety, as they must be aware of the risks of lending to small businesses when there is a prospect of a severe downturn in the economy.

The results of tightening credit in this sector will be twofold. On the one hand companies that need money for expansion will not have access to credit, or will have to pay a premium for the credit that they receive. This means that there will be a slowdown in the expansion of SMEs. The second impact will be that companies going through a difficult period, will be very unlikely to receive the support that they need. In a period of a downturn, this will be likely to push many companies over the edge into bankruptcy.

Once again this activity will see feedbacks into the economy, with less growth, and increasing numbers of bankruptcy, there will be a growth in unemployment. The growth in unemployment will then have a knock on effect of reduced consumer spending, which will then feed into tougher conditions for the UK economy.

The only way to stop the downward spiral will be for the UK to increase exports, and the only way that the UK will be able to achieve this is to reduce the costs of goods and services that are produced. In order for the UK to do this, it would need to take one of the following options:

  1. Increase productivity - there is currently no sign of a productivity miracle on the horizon so this is unlikely in the short to medium term.
  2. Decrease the costs of inputs relative to competitors, with the only realistic option being the reduction of wage costs. The minimum wage will be likely to limit the depth of such a reduction, though will not prevent it entirely.
  3. Reduce the costs of doing business through changes to the system of taxation. The problems with this option are dealt with elsewhere
  4. Reduce the cost of doing business by reducing the regulatory burden. The UK economy has less and less freedom in this respect due to membership of the European Union, but that is not to say that some reforms could not be undertaken.
  5. Allow a significant devaluation of the currency, which will allow exporters to become more competitive, but at the cost of reducing the relative wealth of UK Plc.

Of all the options the last is the most realistic. The fall in the US currency has seen an upturn in US exports, and a downturn in the level of imports, but the long term costs may be a rise in inflation, and the fact that US consumers, and organisations, will not be able to buy so much for their money. This represents a real decline in the wealth of the country, individuals and consumers.

The Exchange rate of the £GB

For a long time the pound has managed to defy the gravity in the face of negative balance of trade, in part due to the inward investment into the UK. It is worth remembering that currency, like everything else, has its worth dictated by supply and demand in the long run. The simplest logic would therefore say that, if you are importing more goods and services than you import, then the currency will weaken. Although this seems apparently reasonable, it has not been reflected in the real world, and there are several explanations for this.

It has already been mentioned that inward investment can overcome the effects of a negative balance of trade, and the UK has been one of the leading beneficiaries of inward investment for some time. This has been one of the main reasons that the UK balance of payments have managed to stay negative, without a negative impact on the currency. This inward investment relies upon continuing confidence in the management and prospects of the UK economy. If potential investors see the UK economy sliding, and identify that the slide is not cyclical, but structural, then there is a real risk of the inward flow of investment halting. The result of any slowing in the inward investment will be to reduce demand for the £GB relative to other currencies, as one of the counterbalances to the negative balance of trade will be removed.

There is also the matter of sentiment, and it is very likely that sentiment will turn against the UK economy as the economy enters into troubled times, and this will also have a negative impact on the value of the £GB, over and above the more rational influence of supply and demand.

The upside of this will be that the £GB will make exports of goods and services more competitive relative to other countries. The downside, as has already been pointed out, is that this would represent a substantial loss of wealth for both individuals and the country (an obvious illustration of which is that a person will have to pay more for an imported good than they would otherwise have done).

The Government

Another source of money entering the UK economy is, of course, government borrowing. This borrowing has seen official government debt increase by between £34 and £42 billion each year for the last 5 years[28]. Some of this money is internal transfers, but much of it is external borrowing. The government has continued borrowing through what might reasonably be described as ‘the good times’, and the government is now in debt by £574 billion, or 42.6% of GDP. Just to put this in perspective, the entire output of the UK economy would be needed for nearly half a year to pay off the debt of the government. It is like an individual who would need to stop all activity except work for nearly half a year to pay off their debts.

It now seems to be entirely acceptable that this situation exists. ‘Excessive debt’ is seen as being 60% of GDP, so that governments can claim that they are within acceptable boundaries when they report such debt. If an individual (excluding mortgages which are at least in part backed by a saleable asset) were to be so in deep debt it would be viewed as both dangerous and irresponsible. One way that government has overcome this objection is by claiming that the debt is due to ‘investment’.

In the context of government it is very difficult to see exactly where the difference in investment and spending starts and finishes. For example, does borrowing to build a new hospital count as spending or investment. It could be argued that the hospital improves health outcomes of individuals, and therefore enhances the ability of such individuals to be productive in the economy. On the other hand, how does this account for the cost of a pensioner, who uses the hospital? The pensioner is no longer productive in the economy, except through spending pension money, and therefore the ‘investment’ made in treating the pensioner is not an investment but spending.

By contrast, if we look at a business investment, it is normally possible to write a plan which (whether right or wrong) clearly lays out exactly what return is expected on the investment, and has relatively visible ways of measuring the success of the plan. The same might be said of an individual investing in education such as an MBA, where they can commence with an expectation that their investment will yield a return in being able to achieve a measurable higher salary. In both these cases there is no certainty of a return on the investment, but the outcome of the investment will normally have a clear and measurable expectation.

Does this mean that government should not borrow for investment? This is a difficult question, but certainly much of government ‘investment’ is difficult to separate from spending.

Another example of such complexity is the Private Finance Initiative, which combines borrowing, with spending, and thereby is a method of borrowing money without it appearing on the government balance sheet. How much of the finance is borrowing, how much is investment and how much spending? There is potential for a wide range of interpretations, more so than our earlier example of the government directly borrowing money to build a hospital. Even the ONS admits to the complexity of such calculations, by saying that ‘The complexity and variety of PFI schemes poses significant measurement challenges, but ONS and HM Treasury have established that the audited accounts of central and local government and public corporations can be drawn on for the purpose of estimating the finance lease liability.’[29]

The purpose here is not get into the rather arcane and detailed questions of PFI, and how to calculate government borrowing but to point out that government ‘investment’ is not necessarily always ‘investment’ in the sense that it offers real prospects of a return to the economy. As such, if the government borrows, it would be wiser to default to the position that the government is borrowing for spending rather than investment.

It is also an interesting question as to whether the government should borrow at all (except in the situation of national crisis) as there is a facility to adjust taxation to meet all current spending requirements. It could be argued that a company has the same facility, or an individual, but we would once again get into the deep waters of calculating what is an investment, and what is spending, a near impossible task to achieve with objectivity when looking at government investment. For example, no one has ever come up with a reasonable and objective way of assessing the benefits of ‘investment’ that the UK has made in education, in terms of the long term success of the economy. Education would be one of the more obvious examples of ‘investment’, but the actual return is beyond any real measurement for the economy overall.

In summary we have a government that is borrowing heavily in a period of what appears to be strong economic growth. Some of that borrowing, may create a return, as some of it may be going towards genuine investment. The more the government borrows, the greater growth in the UK is necessary to facilitate repayment of the borrowed money, as all of the borrowing requires that the lender make a financial return on their lending. As such, if the government is not very effectively investing this money in measures that will ensure long term economic growth, then the government is in financial trouble.

My suspicion, and it is no more than suspicion, is that the government is actually borrowing to finance spending, as the public sector has grown strongly over the last few years. By spending, I mean that the government is not expecting any kind of measurable return on the borrowing in economic terms. Whilst the spending may enhance the quality of life of individuals in the UK, it is much like a person borrowing money to go on a holiday. It makes them feel better for the moment, but it will later have to be paid for later.

The question of how the government is spending money is not a matter of small concern. In particular, if the government is borrowing money for spending, then the question of how, and when it will be paid back looms large. This question becomes even more pertinent if the UK economy stops growing, which is what may happen in the near future. This has two important implications. The first is that it suggests that any investment element is not actually working, as the only evidence of government borrowing for investment working is that is succeeds in creating the infrastructure for long term growth. If there is a recession then the investment is presumably not working. The second implication of a recession, or depression, in the UK economy is that government spending will almost certainly rise spending in relation to government income, as tax receipts will inevitably fall. In this case the proportion of borrowing going towards spending will rise to pay for unemployment benefits, managing increased crime and all of the other associated ills of a poorly performing economy - unless the government chooses to cut spending overall.

In the event of a recession or depression, the government will have a very difficult choice. It might choose to borrow more, and use the money for spending, or it will need to cut back on spending and, one must assume, investment will also be cut, as the two are difficult to isolate from one another. This effect is double blow to the economy, as the quality of life will fall, along with the potential to make long term improvements to the infrastructure that supports the economy. Furthermore any cut in expenditure will also filter through the economy in a myriad of ways, such as increases in unemployment. If the government cuts back it will act as a downward lever on an already sinking economy.

Does the government have the option of borrowing through a recession? It is, of course, possible that this can be achieved. However, the cost of the borrowing is likely to be high, as during a time of difficulty the ability of the government to pay debt will be worse than during a time of economic growth. Most importantly, this additional debt will go primarily towards spending, and will therefore need to be paid back in future with no potential for a return on investment to be used to pay back the debt.

So what can government do when it has seen debt increase during ‘the good times’, leaving it little flexibility to borrow in the bad times. I am not sure there is any answer that does not contribute to levering the economy further downwards in the short term, or creating long term and expensive liabilities in the medium and long term.

So what actually will happen to the UK economy?

The first signs of what is about to come are already apparent. At the time of writing this there are the first discussions of a recession for 2008.

However, I would argue that recession is not the correct word for what is about to happen, and would suggest that a more accurate description is economic crisis. Up to now I have been describing some of the problems in the UK economy, and have been emphasising the ways in which real wealth has been flowing out of the country. All of this has occurred at a time when the UK has seen apparent growth in the GDP of the country. It might be best described as a drunken binge for which there must be a hangover. What will the hangover be like?

I have already described the downward spiral of consumer spending, and the knock on effects on the UK economy. What I have not described is how this will have some wider impacts that will further feed into the downward spiral of the economy as a whole. At this point I will lay my credibility on the line and give a timeline for what will happen to consumer spending over the coming months.

The first prediction is that this Christmas will see very disappointing sales in the shops, and poor sales for services such as restaurants and other entertainments. As Christmas ends and the heavy discounting of the New Year sales starts, panic will set in and the real depth of consumer fear will become apparent in a slew of profits warnings. As the new year starts, the service sector will start a review of their cost base, taking into consideration their poor performance over the critical Christmas period. The reaction of most companies will be to commence plans for staff layoffs.

These layoffs will commence from a trickle at the end of January and will rapidly accelerate to a deluge in the following months. Consumer sentiment will drop to all time lows. Credit defaults will start to rise rapidly, with the rise in defaults lagging the downturn by about 3 months.

The slow fall in house prices will accelerate into a full blown crash, with February or March being the months where the falls really start to accelerate. In the six months that follow prices will drop by an average of 20 - 25%, as buy to letters panic and sell into a falling market. In part this will be a response to the fall in house prices, in part it will be due to increasing difficulty in renting their properties (though this factor will lag the price drop).

As the labour market tightens there are many possible outcomes for what will occur with the temporary migrant workers. Inevitably, as jobs become more scarce, the inflow will diminish and reverse into an outflow. How many will choose to remain, and how many will choose to return home is an important question that only time will reveal. It may be that, if many media reports are true, that many employers will retain the migrants rather than UK employees because of their perceived flexibility and strong work ethic. In this case there will be a rise in unemployment amongst British workers, and a commensurate increase in the drain on central government resources. The upside of this is that some of the demand for housing that has helped sustain the boom in prices will be maintained, though here it will just help to reduce the severity of the drop in prices. The alternative is that many will go home, and the plunge in house prices will be more extreme. In this event there will, over a period of six months, be a rapid withdrawal of cash from the UK economy, putting further pressure on an already weakening £GB. The other upside is that the exit from the economy of large numbers of workers will help to reduce the effects of the economic contraction on unemployment, though the effect of this may be offset by the negative effects of the acceleration of house price falls on the wider economy.

After about six months the rate of the fall in house prices will decline, as some individuals start to imagine that house prices are now at the bottom. They will, unfortunately, be mistaken. Prices will continue to drop a further 20% over a period of a further year, at which time they will bottom out and stagnate for another one to two years. The real fall in house prices will be over 45% during the period of economic contraction (the IMF estimates an overvaluation of 40% and the drop will overshoot this).

There may also be other negative side effects of the contraction, though these are more difficult to predict. It is likely that, as gloom deepens in the UK, the number of visitors to the UK will decline. As a tourist destination, a country going through a crisis is not likely to be as attractive, though the fall in the value of the pound may offset this. The same can be said of sectors such as education, where there has been a massive expansion in the numbers of foreign students (one of the real wealth creating services), as the reputation of education is at least partly associated with the economic success of the country. Again, the fall in the value of the pound may counteract this loss of reputation. Export of services such as consultancy may also be hurt for the same reason as education, again with the same proviso.

All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy. As the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector.

The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.

Up to now, this discussion has avoided the social effects of the coming crisis. Of a certainty, society in the UK will be deeply effected. The nature of that effect is difficult to predict. A crisis of confidence will certainly take place, as assumptions about the ‘right’ to continue to grow ever wealthier is challenged. How British people respond to the crisis will determine how the UK will recover from the crisis.

It would be nice to end this conclusion with a sunny and positive note for the future, and to say that the UK economy will bounce back. However, this would require major changes in the structure of the UK, changes that will be hard to make. I worry that the politicians will not have the courage to lead the people of the UK through such changes, and therefore wonder whether the bounce back is possible.

[1] The argument here is inspired by an article published in the Economist magazine several years ago. I do not have the reference for it here, but would nonetheless like to acknowledge their contribution.

[2] See The Scottish Government, Scottish Economics Report - June 2006, Chart 2.8: UK Interest Rates and Inflation, 1998 - 2006, as an example.

[3] I am sure that someone must have made this calculation, but I have not seen the results. As such I am just talking about broad principles here.

[4] Appleton Estates, 11 September 2007, retrieved 17 November 2007, from

[5] Bradford and Bingley, Myths about the Buy-to-let Market Undated, retrieved on 17 November 2007 from

[6] Low Rental Yields Bar Investors from the Buy-to-let Market, 8 November 2007, Lorna Bourke, Citywire, retrieved 17 November 2007 from

[7] Buy to let Market: The Number of UK Property Tycoons set to Double by 2010, Mintel, Market Research World, 17 November 2007, retrieved 17 November 2007 from

[8] Emigration from the UK reaches 400,000 in 2006, National Statistics, 15 November 2007, retrieved from on 7 December 2007

[9] Lowenstein, R: The Immigration Equation, 9 July 2006, The New York Times, retrieved from on 18 November 2007.

[10] If we imagine a person who is on a hypothetical benefit of £100 a week, and they accept a full time job paying £140 per week, their hourly rate of pay then becomes £40 divided by 39. There are many forms of benefits and therefore many different scenarios that could be explored. I have chosen a hypothetical example as this is the simplest way of explaining the principle. It is also worth noting that, even if not actively calculating their real wage, people facing the benefits or work choice will be very likely to have a sense of what the relative rewards are in each case.

[11] If they are entitled to benefits and they utilise this facility, very few people would (I hope) argue that they are anything but a negative for the UK economy.

[12] I seem to remember a newspaper publishing the story of a lecturer from a college of higher education giving up lecturing to go into plumbing as the wages were so much better.

[13] It should be added that there is a significant risk in investment in people, as they do not all succeed in their training, some will die or be incapacitated, some will not follow the career direction their training suggests, and others may immigrate into another country. In all of these cases the investment of the state, or other institutions, into their education is a waste.

[14] The same arguments might be made for unskilled and skilled migrants. However, there is an assumption that, rightly or wrongly, that more skilled people are more likely to have far higher potential for positive impacts. It is an assumption that seems perfectly reasonable, as highly skilled people are more likely to intelligent and hard working (as highly skilled people are likely to be where they are through either significant effort, greater intelligence, or a combination of both - notwithstanding that some highly intelligent people do not have opportunities to excel).In addition they already have skills that will allow them potential to utilise their strengths. In short they are more probable candidates to add significantly to economic well being, whereas the unskilled, and skilled are far less probable. This is clearly an area where that could produce significant debate, but I agree with the assumption that highly skilled workers are more likely to generate wider economic benefits for the reasons outlined, as this seem to me to be entirely rational .

[15] Emigration Soars, The Telegraph, 16 November 2007, Retrieved on 7 December 2007 from

[16] Immigration Trends 2004/5, New Zealand Immigration, retrieved from on 7 December 2007

[17] Settler Arrivals 1996/7 to 2006/7, Australian Government Department of Immigration and Citizenship, retrieved from on 7 December 2007

[18] The Economist, North Sea Oil: When the Wells Dry Up, 12 July 2007, retrieved from on 19 November 2007

[19] The one positive point is that the experience in this sector has led to the development of a specialised industry, deep sea oil extraction, which has ongoing potential for export.

[20] UK Manufacturing in Transition, EMEA, Undated, Retrieved from on 19 November 2007

[21] Bank of England Inflation Report, 2006, PowerPoint Presentation, retrieved from www.bankof on 30 November 2007

[22] ‘The Pink Book, ONS, retrieved from on 7 December 2007

[23] National Statistics Online, International Travel, Retrieved from on 1 December 2007

[24] Bleak House, 29 Nov. 2007, The Economist, retrieved from on 30 November 2007

[25] Economist, The City of London’s Fall, November 29 2007, retrieved from on 1 December 2007

[26] Economist, Card Sharks, November 29 2007, retrieved from on 1 December 2007

[27] The Sunday Times, The Gathering Storm, 2 December 2007, retrieved from on 2 December 2007

[28] ONS, Government deficit and debt under the Maastricht treaty, 28 September 2007, retrieved from on 10 December

[29] Including finance lease liabilities in public sector net debt: PFI and other, Adrian Chesson and Fenella

Maitland-Smith Office for National Statistics, November 2006, retrieved from on 10 December


  1. (sorry if this gets re-sent a couple of times but my broadband seems to be on the blink)


    Thanks for a very illuminating piece. You have clearly thought very deeply about some of the things that have been bothering me for years, during which the entire country seemed to have gone mad.

    Do you think that supposedly mega-brained Gordon Brown thinks about these things too? I suspect not. I get the impression that whereas you have worked with ideas, he thinks that enlightenment is to be found in tables of numbers. And if he can only read more of them by not sleeping then he'll be even more enlightened.

    It's a very common tendency to believe that you can direct a system to best effect through feedback from measurements, hence the government's obsession with 'targets'. But as your piece shows, the economy is far too complex a system for this to work. It requires 'intuitive' direction from a higher level and an awareness of what is best for longer term sustainability, rather than just responding to changes of gradients of lines on a graph. I rather think that the government has, for years, worked on the premise of "do what works" (I think Tony Blair used that phrase) without considering that it is impossible to measure "what works".

  2. Power, first and foremost can only be central. The first and foremost consequence of this fact of life is that everything becomes designer, which is to say that everything becomes a brand. Then the issue is contrast. We can appreciate a good brand only if there are bad brands around. Then the issue is what theme to use in branding. On our planet, this theme happens to be genetics. So good genes get good branding and bad genes get bad branding. Then the issue is of justice. If a central power is always reserving good brands for good genes, it could get very suspicious. UK has a higher brand than US. For instance, in US, metal trades can be settled on paper but in UK, they can only be settled physically. Ted Butler can explain this better. For many many years, US has done the dirty work for the actual power UK. The point is that those who have gained from everyone's losses can themselves not appear as winners for fear of retribution so they appear as having taken losses themselves too. And even then, US and UK are only brands for a central power.

  3. Mark, I strongly believe NZ is suffering the same fate as the UK. But on a less severe scale, I suppose. The housing crisis is already a strong indicator. What is your take on NZ's current economy in terms of job opportunities for migrant workers? With the latest layoffs in some 'big' companies in NZ (although most were semi-skilled positions), I cant help but wonder if the repercussions would be felt by the greater part of society - the skilled workers, etc.

  4. Intersting analysis.

    Years ago in the US a laborer could afford a middle class home, food, car, children and a wife. Labor was the solid middle class, people who were part of a union and worked hard to get the equitable wages finally achieved.

    Now the immigrants are the laborers, illegal and legal, and they are willing to work for peanuts. So the unions have no power, labor has been reduced to a poor man's job who is willing to live in one room with wife and multiple kids.

  5. What will be the effect(s) of continued mass unskilled imigration from third world countries?

  6. I like the trend of your comments. If you disaggregate land value from asset value, housing values, etc, you will find it easier to apprehend what is going on - it makes the picture clearly visible. There has been a land price bubble pumped up by over-free lending and borrowing. They happen every 18 years.

    "A New Model of the Economy" by Brian Hodgkinson, is useful. The following gives you a link from which you can download a summary

    I strongly urge you to look at this. Also these videos

  7. Excellent summary of the general issues the West is about to face. The party is over and reality is slowly sinking in.

    A critical remark, though: You argue that immigration as well as emigration is bad for the UK economy. Obviously, ceteris paribus, both statements cannot be true at the same time: You either have too many or to few young workers - given the age distribution of the "native" UK population, I'd rather vote for the latter ...

    Of course, all else is not equal - the main difference, as you pointed out, being a stupid welfare system which makes economic inactivity a mandatory prerequisite for receiving benefits. But instead of demanding a reform of the welfare system (e.g. give everyone a handout, whether working or not, but increase the low-end of the tax progression scale or introduce a flat tax to compensate) you lament immigration.

    Also, if employment is the goal, then it is probably good idea to reduce taxes on work income and increase taxes on energy, wealth and corporate and capital gains instead. The should be really obvious, but strangely never happens.


  8. Mark,

    I think you partly answered many of your questions by calling your essay "A funny **view** of wealth" (my emph.).

    The first thing to note is that national wealth is not the same thing as private wealth. Adam Smith called his masterpiece "An Inquiry into the Nature and Causes of the Wealth of Nations". He was interested why some nations were rich and powerful and some poor and weak. He was not particularly interested in why the Duke of Westminster was wealthy.

    If I own, say, five houses in Central London, I can probably consider myself a wealthy individual. But my wealth consists solely in my ability to claim a (significant) portion of the income stream of five other families. My personal wealth is due to being able to extract economic rent from other members of society, and as such, does not contribute to the overall national wealth of the UK.

    In the XIX century, economists were well aware of the distinction between "value from production" - i.e. "real" wealth and "value from obligation" - various forms of rent seeking activity (debt instruments, bonds, land titles etc.), even though both kinds of value could be exchanged (i.e. had money value).

    For ideological reasons, this distinction was abolished by the neoclassical economists, who:

    1. Extended the concept of wealth to include everything with exchange (i.e. money) value and considered national wealth to be the sum total of the wealth of its citizens.
    2. Lumped rent income with capital income, therefore eliminating the category of "unearned income".

    Thanks to this little change in the "view" of wealth, rentier (unproductive) activities now become part of national "wealth creation" in official GDP figures.

    This is a regression to the early economic view that the wealth of a nation depends on the amount of gold it holds in its treasury.

    What seems to be happening in developed countries is the taking over of the real productive economy by rent-seeking finance capital, which basically tries to "squeeze" it for all its worth. This applies to companies (via M&As and LBOs), prospective landlords (via mortgages) and individuals, who are encouraged to take on ever-increasing levels of personal debt. According to current economic orthodoxy, asset stripping, outsourcing and offshoring, "creates wealth", so its all for the best, isn't it?

    The crunch comes when there's nothing more to strip or send offshore. What happens then?

  9. Funny how my ideas of last few months are almost identical with yours - its great to see that there are somebody that see it the same way I do. I hope there is solution to get our countries out of this mess - but seems that it will be really painfull.


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