Britain, the world and the end of the free lunch?

Stephanie Flanders
Former economics editor


They say there's no such thing as a free lunch. But for many years, Britain has been enjoying something similar when it comes to its international investments.

Year after year, as a country we have somehow made a lot more on our investments abroad than the rest of the world has earned on its investments in the UK, even though - in cash terms - foreigners have more invested in us than we have invested in them.

But not last year. More than any other factor, it is the collapse in our foreign investment earnings in 2012 that explains why today's balance of payments figures show Britain's current account deficit last year was an eye-popping £58bn, up from £20bn in 2011.

In case you were wondering, £58bn is a big number. It means the gap between what we earned in the global economy last year, and what we spent, was 3.7% of GDP. That's the highest since 1989 and only the fourth time since 1948 that our current account deficit has been greater than 3% of GDP.

Export drop

It's not news that the economy is failing to re-balance. I've mentioned it often enough in the past, along with the likely rise in the current account deficit last year.

But, forecasts are one thing. It is still shocking to see the deterioration in black and white in today's release. Shocking, and rather puzzling.

Everyone knows that the growth in our manufacturing exports has been deeply disappointing. But just as important has been the sharp fall in exports in the area we traditionally run a large surplus - namely services.

As the Office for Budget Responsibility (OBR) pointed out in the economic report published with the Budget, Britain's market share in the export of global services was broadly steady after 2007, but since the start of 2012 it has fallen sharply. Our surplus in financial services exports, for example, was just under £34bn last year - £3.6bn lower than in 2011.

Even larger is the collapse in foreign investment earnings I mentioned at the start. Last year, we only earned £1.56bn more on our investments abroad than foreigners earned on their UK holdings. In 2011 that investment surplus was nearly £26bn.

What's driving all this? The honest answer is no-one is really sure.

Falling global demand is part of the explanation for falling financial services exports. There is also a supply side to that story - not unrelated to today's call from the Bank of England for banks to raise more capital.

Ever since 2010, UK banks have been under pressure to strengthen their balance sheets. As we know, there is a massive tension between that and the equally heartfelt pressure on banks to boost their lending to UK companies and households. How do you square the circle, if you're a bank? You stop lending to foreigners.

Clearly, that's a generalisation. But, as the Bank of England explained in its February Inflation Report, regulatory pressure has led banks to reduce their "risk-weighted assets" across the board. You can see why they might find it politic to cut foreign assets proportionately more than domestic ones. And you can't earn money on foreign loans you haven't made.

Defying gravity

None of that explains why income from Britain's foreign direct investments also fell in 2012 - by roughly £20bn - while foreigners' earnings on their investments in the UK were broadly flat.

Pessimists would say our investment earnings have simply caught up with our declining net asset position - the fact that our claims on the rest of the world are now worth less than the world's claims on us

In effect, our global investment earnings have defied gravity since the start of the century - and helped to make up for the fact that large parts of our economy were no longer paying their way.

Perhaps we shouldn't be surprised that they have come down to earth. At least for now. But it would be a serious blow to our international economic hopes if this turns out to be a permanent shift.

The coalition came in promising to put an end to Britain's "something for nothing" culture. But this is definitely one area where they would have liked it to continue.