If the government does not counter the clamour to save cash, the final outcome may be one where there’s nothing to save, warns Andrew Smith

What is wrong with the UK economy? Whatever you want to call it – a double-dip, or now, probably triple-dip recession after what looks like a relapse at the end of last year – the fact is that this downturn has been the longest, and the ‘recovery’ the weakest, in at least a century (see figure 1). Why is this, and can we expect any improvement this year?

Quite simply, we are not getting a normal recovery because this is not a normal recession. Rather than the result of an overheating real economy, which can be fixed by a relatively short recession to get inflation down at which point the brakes can be taken off, this is a completely different animal – a financial recession resulting from excessive borrowing to purchase over-valued assets in the boom years.

In the subsequent bust, falls in asset prices and drying-up of credit are forcing painful balance sheet adjustments in the personal and financial sectors, with knock-on effects on the rest of the corporate sector, particularly businesses most exposed to consumer demand or reliant on borrowing. Even financially comfortable companies have been traumatised into building cash rather than investing. So with the personal sector wanting to save more, but no-one wanting to borrow, there has been a sharp drop in demand.

Under normal circumstances this imbalance between desired savings and investment would be equilibrated through monetary policy, with lower interest rates reducing saving by making it less rewarding and increasing borrowing by making it cheaper. But given the overwhelming desire to pay down debt and shrink balance sheets, even near-zero official interest rates are not low enough to do the trick, leaving a hole in demand. In the early stages of the recession, the government bridged the gap, spending more, taxing less and allowing its own borrowing to rise.

Effectively it became the borrower of last resort, recycling the private sector’s excess saving into public spending to limit the collapse of demand and output. Since then, though, the emphasis has shifted to deficit reduction – and growth has pretty much stalled. For every saver there has to be a borrower (see figure 2).

This accounting identity must be true ex post, but ex ante does not tell us exactly what will happen given a clash of plans. If the government refuses to act as the counterpart to private sector saving, one outcome could be incomes shrinking until there is no scope left for saving.

With lower economic activity – and tax revenues - the government might also find its deficit reduction plans frustrated and austerity measures self-defeating: in these circumstances, it may only be able to reduce its deficit to the extent that the private sector decides to spend more and save less.

Either way, you can see why it is proving so difficult to combine deficit reduction with healthy growth when the usual way of encouraging more private spending to offset a public sector contraction – cutting interest rates – has hit the buffers. Self-defeating? What could improve the picture? At some point the personal sector should be in a position to spend more. Higher savings have gone some way towards repairing balance sheets and employment has held up surprisingly well. But the squeeze on real incomes, another major factor thwarting a consumer recovery as inflation runs ahead of income growth, looks likely to continue this year.

With Europe, the UK’s major overseas’ market, sinking back into recession, the long hoped-for switch to export-led growth has been postponed (again). This uncertain outlook will continue to dampen business investment.

While the Chancellor has accepted some slippage in his deficit reduction plans, opting to extend the austerity programme into the next parliament rather than claw back the overrun now, public spending cuts are now set to bite in earnest. All in all, 2013 is looking like a re-run of 2012 – bumping along the bottom.

Andrew Smith, chief economist, KPMG