The UK has a trade deficit problem/Tilbury Docks, wikimedia

The economic policies pursued by the Coalition government, despite current appearances to the contrary, look extremely unlikely to generate economic growth on a sustained basis. The UK economy is too weak and unbalanced for this to be possible. A number of key ratios give the game away.

The proportion of our GDP which we devote to investment, at 14%, is barely sufficient to cover depreciation of existing assets - 11.5% - plus a further 2.5% needed to avoid these assets – everything from roads to schools, factories to productive machinery - being diluted down by our rising population. Almost uniquely for any developed country, we now have no net investment per head of the population at all, which is why productivity increases have ground to a halt. 

Our manufacturing output - 32% of our GDP as late as 1970 - now accounts for barely 10%. We simply do not produce enough goods to sell to the rest of the world to pay for our imports, which is why we have such a large trade deficit. Add in the fact that our net income from abroad, previously strongly positive, has now turned negative, largely as a result of the huge sell-off there has been of UK assets, and combine this with increasing transfer payments overseas, and it is hardly surprising that we have a balance of payments deficit running at about 5.5% of GDP – one of the highest ratios in the developed world.

On top of this, we have government borrowing which has stuck at just under £100bn per annum, leading to total government debt projected to rise to about 100% of GDP by May 2015. The government deficit largely mirrors trends in our balance of payments deficit – which reached £66bn in 2013 and which is still rising. The government deficit is therefore unlikely to decrease significantly, if at all. Meanwhile, according to the IMF, our net foreign asset position as a nation has deteriorated from a positive $43bn in 1980 to a negative $873bn in 2012, again reflecting the massive sale of UK assets there has been to finance our foreign payments deficits. Nevertheless, despite all these longstanding adverse trends, there has been an increase in consumer confidence, which is driving the current modest growth rate. Unfortunately, however, this has been very largely made possible by our ultra-low bank rate and consequent asset inflation, both of which are clearly unsustainable over anything but a fairly short period.

With this sort of background, there is every chance that the economic policy being pursued by the current Coalition government is going to unravel although - as always - it is very hard to predict when this is going to happen, and whether it will occur before or after the general election in 2015. Here are the warning signs, however, that within months rather than years, serious trouble will be brewing:

Asset Inflation Several factors have come together to produce increases in assets values - particularly housing - which clearly cannot continue to rise at their present rate. Nationally, house prices have risen by nearly 10% over the last 12 months and by much more - close to 20% - in London. In the meantime, the FTSE 100 Index, having plunged from 6,722 in October 2007 to 4,038 in February 2009, has now risen by 70% to 6,855 in May 2014.

To be fair, there are special reasons for the very rapid rate at which house prices have been growing in London – notably demand from abroad – and a very important underlying reason for house prices going up generally is that we are building far too few new housing units. The main reasons for the huge increases in asset values we have seen, however, are the ultra-low bank rate of 0.5% which we have had since March 2009 and the very lax monetary policy pursued by the authorities, reflected in Quantitative Easing over the same period.

Booms in asset prices at times when the economy is barely growing and inflation is at low levels have a long history of imploding. There is no reason to believe that this time it is going to be any different. Once the bubble in asset prices bursts, however, it is very likely that consumer confidence will wane and that the main driver for current growth - rising consumer demand - will stall.

Interest Rates Borrowing rates for most individuals and businesses have been in most cases fairly low recently in nominal terms although, as inflation has also been low, real rates have not always been particularly favourable to borrowers. This leaves many of them vulnerable to interest rate increases, however, and unfortunately, the main weapon which the Bank of England has available to curb asset price inflation is to put up interest rates, as the Governor is now indicating will have to be done before very long.

While raising the base rate may slow down the pace of asset price inflation, increasing interest rates also has a generally dampening effect on economic activity, increasing the likelihood that the present growth in the economy will peter out as both consumers and businesses retrench.

The Exchange Rate Raising interest rates will also tend to make the value of sterling on the foreign exchanges higher. Sterling has already risen recently by 12% against the US dollar - from £1.00 = $1.50 in July 2013 to about $1.68 in June 2014 - partly as a result of anticipation that sterling interest rates will start to rise earlier than those in either the USA or the Eurozone. The rise in sterling has also been buttressed by a further wave of sales of UK assets to foreign interests, prime property in London probably leading the charge at the moment.

The impact of a higher exchange rate - or a lower one - always takes time to manifest itself fully - typically two to three years. Just as, if the exchange rate goes down, the balance of payments tends to deteriorate for a while before it improves, because higher import prices come through more quickly than increased export volumes and import substitution, so the reverse effect applies when the exchange rate goes up.

We can therefore expect to see a higher exchange rate taking months for its full effect to become apparent on our net trade position. It will, however, inevitably worsen the imbalances in the UK economy and its impact will surely come through eventually as the strengthening exchange rate makes manufacturing even less profitable than it is already, investment in the most productive parts of the economy falls away, exports languish and import penetration becomes even greater.

The Balance of Payments During the last half of 2013, the UK’s overall balance of payments deficit was running at 5.5% of GDP. The total deficit for the year was £66bn. In 2014, this deficit will almost certainly be greater – possibly as much as £80bn. Part of the problem is that our trade deficit, which was £27bn in 2013, might be a reasonably manageable figure if it was on its own. Unfortunately, however, it is not. There are two other major components to our balance of payments deficit and these add very substantially to the problem.

One is our net income from abroad. For many years this had been a substantial positive figure. In 2013, however, it turned strongly negative, at £17bn for the year. As a result of the continuing net sale of UK assets to finance our payments deficit, this trend looks like getting worse. In addition, the UK makes substantial net payments abroad, partly remittances from those who have migrated to the UK, partly for aid programmes, but mainly net payments to the European Union. These net payments abroad, which totalled another £27bn in 2013, are also trending upwards.

As our balance of payments deficit becomes increasingly clearly unsustainable, this will put further pressure on the Bank of England to raise interest rates for three reasons: to dampen down the economy to reduce the deficit, to try to stop the value of the pound falling because they believe – arguably wrongly - that a lower pound would increase inflation, and to discourage capital flight as the economy becomes closer to being unable to meet all its financial obligations.

Investment The UK economy is never going to grow on a sustainable basis unless we have much higher levels of net investment, particularly in those parts of the economy with the highest rates of return and the greatest export potential, which is largely, although not exclusively, in manufacturing and especially light industry. Of course, there are also major needs for investment in public sector assets – roads, schools, hospitals – and for public and private investment in other areas such as high speed fibre-optic networks and housing. Manufacturing and exports are still key, however, because it is these activities which generate the most rapid productivity increases, the best distribution of high quality jobs regionally and the most export potential.

The biggest single problem with the UK economy at the moment is that investment in these key areas, as a result of long-standing downward trends, is almost unbelievably low. Even as late as 2007, total gross investment in the UK as a percentage of GDP was 17.9%. At 14%, which it was in 2013, it is one of the lowest in the entire world – ranking us equal with El Salvador at position 142 out of 154 countries surveyed in 2012. This is why, by the time depreciation and our rising population are netted off, there is nothing left.

The problem is that the higher the value of sterling on the foreign exchanges, the less profitable investment in the parts of the economy which need it most becomes, the less investment will then take place and the weaker our economy and particularly its manufacturing base becomes.

What needs to be done

To run any economy successfully, it needs to have not only its fiscal and monetary policies run in a co-ordinated way, it also needs to have an exchange rate policy which enables a reasonable balance to be maintained between key sectors of the economy to ensure, apart from anything else, that we can pay our way in the world. This is what we have utterly failed to do for many decades, but especially since the late 1970s when first monetarism and then inflation targeting became the lodestones by which the economy has been guided.

By simply ignoring the exchange rate as a vital tool of economic management and, instead, letting the parity of sterling find its own level - however inappropriate this might be in the interests of the economy as a whole - we have condemned ourselves entirely unnecessarily to decades of economic mismanagement. This is why our growth rate is so low, incomes have stagnated, unemployment is so high, huge government and national deficits have accumulated, and why we cannot pay our way in the world.

None of this is necessary and all of it could be avoided if we had fiscal, monetary and exchange rate policies all pulling in the same direction. As long as this does not happen – as it clearly isn’t at the moment – there is no prospect of sustainable growth and no chance of the Coalition’s current policies not falling apart as the underlying realities catch up with the weak and unfortunately unsustainable growth, which we currently see on the surface.

This article is part of the There is an Alternative series. An economist and entrepreneur, John Mills is Chairman of JML. He recently established The Pound Campaign to raise awareness of the uncompetitive exchange rate and the effect it is having on UK manufacturing and the wider economy.

John Mills is a donor to openDemocracy.