Safely hanging in the balance?

The size of the UK's external deficit could once break a government.

To people of a certain age in Britain, one of the more confusing questions about the economy is why so little attention seems to be paid to the balance of payments? In the old days, the size of our external deficit was a number that could cost a government an election (as in 1964) or create panic in the corridors of power (1970).

Today, however, a deficit that has reached near record levels barely registers on the economic Richter scale. In 2004, the headline figure climbed to £25.7bn, up from £18.7bn 12 months earlier and close to the previous record of £26.3bn set in the Thatcher-Lawson year of 1989. Relative to the size of GDP, the 2004 share of 2.2 per cent still has some way to go to match the 5.1 per cent recorded 15 years earlier, and we still compare favourably with the US, where the current deficit is a massive six per cent of GDP.

This overall balance is only one of a number of figures published about our trade with the rest of the world. Last year we imported a whopping £57.9bn more than we sold. When Labour took office in 1997, the equivalent figure was £12bn. This increase reflects the strength of demand in the UK and the fact that our domestic manufacturing base cannot supply everything that we want.

A series of more positive factors helps to reduce the massive £57.9bn deficit. There is a healthy surplus on our trade in services, such as financial, legal and architectural, worth £14.6bn in 2004. We also have an income of almost £24bn on UK companies’ overseas investments. With other adjustments, this produced the UK’s current account balance of minus £25.7bn last year.

The fact that the UK is able to fund the current account deficit so easily reduces the ability of the balance of payments to shock the markets or force the government into a change of policy. It also reflects the confidence external investors have in the UK’s future ability to pay its way and generate profitable returns.

Another key reason why the balance of payments figures no longer have the impact they once did is that up until the early 1970s we lived in a system of fixed exchange rates. A large deficit would signal a loss of competitiveness and raise the prospect of a formal devaluation of the pound. This could precipitate holders of sterling to sell, and a ‘run on sterling’ would force a policy response to protect the currency. This defensive action is no longer necessary with floating exchange rates. Sterling has not, however, been seriously weakened by the recent run of deficits, which comes back to the confidence issue.

This does not mean the balance of payments will never matter again. As is clear from the current US experience, a large deficit combined with other factors can lead to a loss of confidence and serious downward pressure on the currency. At the same time, more inward investment will increase the outflows, thus reducing the scope for coping with the deficit on the current account. The balance of payments might have been on the back burner for a number of years, but it certainly has not gone away.