David Smith has been economics editor of The Sunday Times since 1989. His books include Free Lunch: Easily Digestible Economics
Economics and the economy affect us all. As the great British economist Alfred Marshall (1842-1924) put it, economics is about people engaged in “the ordinary business of life”. It is not just for investors, or businesses, or governments. It defines whether we feel better off or not, whether we can have fulfilling jobs and whether we can enjoy good public services without paying too much in tax to fund them. Let me dig into some key terms.
This is measured by the rise over a given period in gross domestic product (GDP), the broadest measure of economic activity, adjusted for inflation. If GDP in cash terms rises by 5 per cent at a time of 5 per cent inflation, there is no “real” growth. The UK has suffered weak growth for years. The average GDP growth between 1945 and 2008, when the financial crisis struck, was a healthy 2.8 per cent; average annual growth since then has been 1 per cent.
Many think GDP is a better measure of prosperity if also adjusted for population growth. The period 2019-24 saw GDP per head fall, which is unusual. But GDP per head has for some time been subject to weakness. A series of shocks, including Brexit, Covid and the war in Ukraine, has held down growth. In July to September, the latest quarter for which figures are available, GDP per head stalled after six consecutive increases.
Recession
Many economists dislike the definition of a recession as two consecutive quarters of falling GDP. On that basis, two consecutive GDP falls of 0.1 per cent would constitute a recession, while a fall of 5 per cent followed by a rise of 0.1 per cent — a more serious downturn — would not. A more robust definition is when GDP falls from one year to the next. Using that definition, the UK avoided meaningful recessions in the 1950s and 1960s but has suffered five since, most recently in 2008-09 and 2020-21. However poor you might be feeling now, we’re not officially in recession.
Productivity
This key economic concept reflects how much we produce, or “add value”, for what we put in. It is measured by GDP per worker, or per hour worked. The American economist Paul Krugman, now 72, wrote in 1990 that “productivity isn’t everything, but in the long run it is almost everything”. He was right. Many of the UK’s current problems can be put down to the fact that, after growing by 2 per cent a year for many decades, productivity has stalled for more than a decade and a half. If it had continued on its previous path, every one of us would be thousands of pounds a year better off.
Inflation
Inflation is the rate of change of prices, and is perhaps the figure that now has greatest significance for the public. If you look at the period from 2019 to 2024, for most of which Joe Biden was US president, America’s economic growth rate eclipsed that of other G7 countries. On that basis alone you’d have expected success for the Democrats in the November 2024 US elections. But they lost badly and the economic explanation was that high inflation more than offset any political benefit from stronger growth, with voters unhappy about high prices for gasoline, eggs and rent. In the UK poor economic growth and high inflation helped the Tories to a landslide defeat in July 2024.
Because inflation measures the rate of change of prices, rather than the prices themselves, some people confuse the two. A drop in inflation from 4 to 2 per cent just means that prices are rising at a slower rate. Two per cent is the inflation target that the Bank of England is required to meet, which it controls by varying interest rates.
A rise in interest rates means households with mortgages have less to spend on other things, while businesses cut back on investment and employment. This slows growth and eases the upward pressure on prices. The opposite happens when interest rates are cut. It used to be the case that most homeowners had mortgages, so the pain from higher rates was spread across much of the population. Now, however, more people own their homes outright. They tend to be older households, which lose out when interest rates are cut because it reduces the income on their savings.
It was only 1997 when the Bank of England was made operationally independent from government and responsible for interest-rate changes. For the first 25 years inflation averaged 2 per cent, before giving way to a substantial post-Covid rise, with high energy and food prices pushing the rate to 11 per cent. High inflation for regular-purchase items such as food is more damaging for people and the economy than for other categories of spending, not least because it cannot be avoided. If inflation in food prices is 5 per cent, as it has been recently, people tend to think all prices are rising at that rate.
Unemployment
In recent decades unemployment was of greater concern than inflation, and for good reason. In the 1980s a savage manufacturing downturn under Margaret Thatcher meant the unemployment rate reached nearly 12 per cent, with more than three million people unemployed for years. It rose above that level in the early 1990s.
Unemployment is still a hot political and economic issue, but these days the rise in economic inactivity worries governments almost as much. People who are unemployed are available for work, while the economically inactive — the long-term sick, early retirees, carers, those in full-time education — are not. The unemployment rate is 5.1 per cent but the inactivity rate 21 per cent; 1.79 million versus 9.1 million, which has risen sharply since the pandemic.
Trade deficit
Traditionally, the deficit that mattered for the UK was in trade: the difference between export and imports. Trade deficits cannot be ignored, not least since the advent of Donald Trump’s import tariffs, but exports and imports of goods and services have lost importance since the movement of capital — money — has come to dominate flows between countries. In October the UK trade deficit stood at £7.2 billion.
Budget deficit
This deficit — the difference between government spending and revenues; our national outgoings and income — does matter more. In the UK it is known as the public sector borrowing requirement and it hit an all-time peacetime high in Covid, reaching £311 billion, or 14.7 per cent of GDP, in 2020-21. Rachel Reeves is committed to eliminating one part of the deficit, the so-called current budget deficit, by the end of the decade. This would still enable the government to borrow for public investment, such as spending on roads, schools and hospitals.
Government debt
UK government debt — the accumulated value of budget deficits — is currently £2.9 trillion (£2,900 billion), equivalent to more than 95 per cent of GDP, the highest it has been since the 1960s. It was 252 per cent of GDP in 1945 but by the early 1990s was just 22 per cent. It is now of concern because it has risen more sharply than in other advanced economies over the past 20 years and because of the interest that’s paid on it.
Bonds and gilts
The government has a debt-interest bill of more than £100 billion because of the way debt is funded, by issuing government bonds, usually known as “gilts”, on which interest is paid to investors. The rate of interest, or yield, on gilts depends on market confidence in the government’s ability to manage the public finances and control inflation. Gilt yields rose sharply after the Liz Truss budget in September 2022 and remain among the highest of the advanced economies.
Quantitative easing
Gilts are issued by the Debt Management Office on behalf of the Treasury, but the Bank has once again been involved in the purchase and sale of gilts via quantitative easing (QE) and its counterpart, quantitative tightening (QT). QE, first used in the UK in 2009, in the financial crisis, was aimed at boosting the economy when it was believed official interest rates, then 0.5 per cent, could not be cut any more. It was last used in 2021, when the rate was even lower, 0.1 per cent. The Bank “printed money” — it created bank reserves — and used them to buy gilts from investors. The idea was that those investors would use the money to buy productive assets, thus boosting the economy. Before it began selling the gilts back (QT), the Bank had bought nearly £900 billion. Economists believe that the initial phase of QE worked to boost the economy, but the second big operation, in response to Covid, may only have boosted inflation.