Is Britain's wealth an illusion?

Many people in Britain are perplexed by UK's apparent prosperity. How can we enjoy such a rising standard of living while at the same time we do not seem to produce anything? City and town centres, even in the formerly depressed industrial regions of the north, are buzzing with busy shopping complexes and restaurants. Out-of-town supermarkets and D-I-Y superstores are springing up everywhere as are new private housing estates. People dress well, eat out more often and drive bigger cars.

When whole swathes of manufacturing industry closed down in the early 1980's and the coalmines were shut down in the second half of the decade, a bleak future of economic decline beckoned with mass unemployment, boarded up shops and crumbling amenities. Somehow Britain has, in most parts, escaped this outcome of economic hardship. But people still harbour nagging doubts that their apparent prosperity is built on sand. This Easter there will be a credit-fuelled spending spree on D-I-Y goods made in China, Swedish furniture and Australian wine, while our wealth is somehow based on homeowners bidding up the value of each other's property. It is understandable that people who measure their own wealth in terms of material possessions tend to see prosperity based on services like entertainment as some kind of statistical trickery.

UK wealth: scepticism rooted in 1970s

Scepticism about our economic prosperity is deep rooted particularly among those endured the trials and tribulations of the 1970's. This miserable decade included a three-day week, power cuts, a near 70% fall in share prices in the 1973-75 bear market, inflation at 26%, an IMF loan and the winter of discontent. Sir Nicholas Henderson, the British Ambassador to Paris, sent a telegram to the new British Prime Minister Margaret Thatcher in June 1979 saying "our economic decline in relation to our European partners has been so marked that today we are not in the first rank even as a European one".

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He supported the message with a table which showed how Britain's GDP per head had fallen to 46% below the German level and 41% below that of France. Britain's economic success particularly in relation to Europe over the last 15 years bucks a century old trend, which is still embedded in the psyche of those who suffered in the 1970's. It is indeed difficult to believe that in 2005 British per capita income was over 8% higher than France and 6% above a united Germany, despite the fact that Britain no longer makes anything that one can lay one's hands on.

UK wealth: made in China, banked in Britain

While it is true that almost everything we buy today has a "made in China" label, this does not mean that the all money we spend on these goods ends up in China and drains jobs and resources from our economy. Here is an example that may seem trivial but it makes a point.

Later this month the shelves of toy shops will be flooded with Spider-man merchandise ahead of the launch of Sony Pictures third block buster movie "Spider-man 3" in May. A simple action figure toy will have "made in China" embossed on it. Say for example it retails at £10.00, roughly half the retail price will go to the UK retailer and distributor, with another 20% or so paid to Hasbro, a US toy company which will spend much of this on advertising, promotion and distribution in the UK. A further 10% or so will go Sony Pictures Limited, which owns the Spider-man film rights and additional royalties will be paid to Marvel Enterprises Inc. Furthermore £1.49 will go to the UK Treasury in VAT, and there's the cost of shipping and insurance too, leaving a small remnant of the purchase price going to the toy manufacturer in China, who has to buy materials and plastic moulding machines, probably imported from Korea or Japan.

In the end less than 5% of the £10 you paid for the Spider-man toy will end up as wages for Chinese workers or profits for Chinese manufacturers. Meanwhile the retail and wholesale margins, advertising and promotion will probably contribute around £7 to Britain's GDP.

UK wealth: changing terms of trade

In the 1960's and 1970's the economic success stories were West Germany and Japan. These countries enjoyed strong growth led by manufactured exports. The nature of the world economy has been turned upside down since then. Manufactured goods, whose production can be readily transferred to the lowest labour cost economies like China, are falling relentlessly in price. This process of outsourcing has created a new type of business, called a "platform company" which sell everywhere but do not own factories. Examples include Dell, Nokia, L'Oreal, Ikea, GSK and Apple. These companies subcontract almost all their manufacturing to other businesses, mostly in developing companies. A generation ago production and manufacture was the key to business success. Today design and marketing add the most value, because manufacturing is in the hands of subcontractors in developing countries that compete intensely to drive down costs.

Moreover if there are changes in demand for goods, it is the manufacturing part of the business that bears the brunt of the adjustment, so the volatility of the business cycle is outsourced to developing countries while mature economies enjoy greater economic stability. This new found stability has in turn made higher levels of borrowing safer and more attractive for businesses and consumers in advanced economies. And it is the countries which are financially the most deregulated like the UK that have benefited most from the processes of globalisation and outsourcing.

The new world order has played into the hands of Britain, which throughout the last century always struggled to compete in manufacturing goods, but has always enjoyed a comparative advantage in finance and other knowledge based services. The prices of manufactured goods have collapsed in the last 15 years, while the prices of knowledge based services like finance, law and entertainment have risen in price. In economics jargon Britain has enjoyed an improvement in the "terms of trade".

To illustrate this point, an international lawyer earning £250,000 a year today probably works no harder than his counterpart in 1990 when he probably earned less than half this amount. Although the lawyer's productivity has not doubled, his contribution to the British economy from his foreign income, his taxes and his consumer spending has.

UK wealth: key domestic economic changes

However for Britain to be in a position to benefit from this new world order, it had to lick itself into shape domestically. Two events are crucial to the story: the election of Mrs Thatcher in 1979 and the ERM debacle of September 1992. The trade union reforms, deregulation and privatisation of the Thatcher era created a truly competitive market economy in Britain for the first time since before the First World War. Cast your mind back to the world of the 1970's when you had to "queue" for a mortgage, have restrictions on how much money you took out of the country and the nationalised telecoms industry lacked funds for investment because the government was too busy backing losers like British Leyland.

But Thatcherism alone was not enough, the government was still making a mess of the economy by using interest rates to target the exchange rate. This resulted in the Lawson boom and bust of 1988-90 and the unnecessarily long recession that followed. It took the climactic events of 16th September 1992, which I like to call "White Wednesday"

to bring economic policy makers to their senses. Thereafter interest rates were set according to the domestic needs of the British economy and our decision to stay out of the euro has ensured that this framework that has delivered economic stability has remained in place.

The market reforms of the Thatcher era, the sane monetary policy framework after White Wednesday and fall in the prices of manufactured goods relative to knowledge based services have helped transform Britain's economic performance and reverse a 100 years of relative decline.

How long Britain's economic renaissance lasts depends on the wisdom of policy makers and the evolution of the world economy. But for now, Britain's prosperity is no illusion.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk