UK Economic Recovery: The Bonnet Shines But is the Engine Going to Break Down?

It's official: the UK economy is healthier than we thought. The Office for National Statistics (ONS) revised its previous estimate of GDP growth in the second quarter to 0.9%, from 0.8%. And the economy is on course to grow by more than 3% in 2014, the fastest rate in the Western world.

But there are, in economist-speak, a number of headwinds facing the recovery. While the headline GDP data may say boom, other figures beneath the gleaming bonnet suggest the engine may be bust. And there are bumps forming in the road ahead.

Interest rates are low but they can't stay low

The Bank of England has held its base rate down at 0.5%, an all-time-low, since 2009 to keep credit cheap and support the economy while it was struggling.

But, as the headline economic recovery strengthens, monetary policymakers want to start raising interest rates again to prevent people taking on excessive debt while it's cheap and to give savers some respite after years of dismal returns.

Mark Carney, the central bank's governor, has repeatedly said a rate rise will be gradual and the base rate will settle well below historic norms of around 5%.

Policymakers' timing is everything. Act too early and they could choke off the recovery by draining away consumer spending as indebted households funnel their income towards monthly loan repayments, such as mortgages or car payments. And it will mean higher credit costs for many firms already struggling to get a loan from the bank.

It all depends on whether the underlying economy is healing as fully as the headline GDP figures imply.

The level of household debt in the UK is high

The level of household debt in the UK is one of the biggest headaches for policymakers eyeing a rates rise. A larger debt pile means a greater risk of defaults and more money trimmed from consumer spending when rates rise.

According to research firm Verum, citing data from the ONS and Bank of England, household debt in the UK has soared 314% from 1990 to 2013 to a total pile worth £1.437tn. It estimates that for every 0.5% increase in the base rate, £4.8bn will be slashed from consumer spending. Of the debt, 89% is from mortgages, a portion creeping up as house prices rise.

Others put this figure lower. Conlumino, a retail analyst, believes a 0.5% rise would trim £1.9bn off consumer spending. Either way, a higher base rate means bigger debt repayments and, probably, fewer consumers willing or able to splash out.

Wage growth has been terrible

Wages have been in real-terms decline since the end of the financial crisis. Despite the stronger headline recovery, wage growth including bonuses was just 0.6% on an annual basis in July 2014, said the ONS, against inflation of 1.6%. And disposable income per person is still 2.7% below its pre-crisis peak.

This appears to have been a trade off in the labour market. Firms have kept wages down rather than sack staff, something seemingly reflected by the robust employment rate, which has been hitting fresh highs.

Unless wages pick up, the recovery may come off the tracks. Higher wages are needed to offset a rise in interest rates, so household incomes can absorb the bigger monthly debt repayments.

And higher pay will help ease the burden of the welfare bill, much of which is spent on topping up the low incomes of the working poor.

The self-employment boom isn't necessarily a good thing

The government has hailed the boom in self-employment, choosing to present it as a burst of entrepreneurialism during times of economic hardship. But this isn't automatically a good thing. The self-employed often struggle to make ends meet.

They rely on things such as working tax credits to sustain themselves. And they also tend to pay less in tax, meaning lower revenues for the Treasury. It needn't be said that not every self-employed person becomes Bill Gates.

Self-employment in the UK is at a 40-year high. The ONS said that there were 4.6 million people who worked for themselves as their main job in 2014, accounting for 15% of those in work. But the average income from self-employment had fallen by 22% since 2008/09, down to £207 per week.

Underemployment is rife

It isn't just soaring self-employment behind a recent increase in underemployment (those in work but who need more hours). The proliferation of zero-hours contracts and temporary employment has also left many people earning less and working fewer hours than before the financial crisis.

Some hail the flexibility of the UK labour market. It is better, they say, to have someone in work than out of it, and low pay and few hours is a price worth paying if it means lower unemployment, the scarring effects of which are well-documented.

But if as the economy recovers this doesn't translate back into secure full-time permanent work again, then there will be a problem. It will leave many households unable to plan financially, secure loans, or even save.

There's still more austerity to come

The deficit in UK public finances is coming down but it's not gone yet. In the 2013/14 fiscal year, it still amounted to 6.5% of UK GDP.

There's a political consensus among the three main Westminster parties in favour of public sector austerity, though some disagreement on the details of where the spending cuts and tax rises should be made.

So that means whoever wins the general election in 2015, there's still billions of pounds more in austerity to come: further welfare cuts, for example, so even less money in some people's pockets, as well as pay restraint in the public sector.

Geopolitical crises hang overhead

The two biggest geopolitical concerns for the UK at the moment are the Ukraine crisis and the advances of the Islamic State (also known as Isis) in the Middle East.

A sanctions war between the West and Russia, over the latter's military interference in troubled Ukraine, will disproportionately hit Europe.

There's a lot of trade and capital that flows between Russia and Europe, including a significant amount of gas. Any dents to this will hit the European economy and further worsen the eurozone's financial ailments.

In the Middle East, militant fundamentalists operating under the IS banner have conquered swathes of northern Iraq and southern Syria, including key infrastructure such as oil refineries.

Not only does this threaten the stability of the Middle East, which provides much of the oil the global economy needs, but efforts to fight IS will cost governments – including the UK's – billions.

Markets are concerned about such geopolitical risks, as are businesses, and the uncertainty they bring. This can deter some from investing, limiting growth.

The eurozone is slowing down. Again

It's like the never-ending porridge pot of problems. The eurozone sunk to zero economic growth in the second quarter of 2014. Bank lending is collapsing as the financial sector restructures because of tighter regulation following the crisis.

The Russia-Ukraine crisis is hurting Europe. Austerity programmes are still scything through eurozone government budgets. Italy is back in recession, France is stagnating.

All of this matters for the UK because Europe is the country's biggest trading partner. Any weakness in the eurozone automatically weighs down on the domestic UK economy. Unless the wheels start turning again in the eurozone economy, the UK recovery may struggle to maintain its momentum.

The UK's trade deficit is bloating

The UK has a bloating current account deficit. Put simply, we import far more than we export. The deficit was £23.1bn (5.2% of GDP) in the second quarter, up from £20.5bn (4.7% of GDP) in the previous three-month period.

But the value of the sterling has increased, making UK exports less competitive. This could pose a problem for the UK economy because foreign investors, suspecting the pound will have to be devalued in order to boost exports, may pull their money out before it loses value.

It also implies the economic recovery has been fuelled by domestic consumption, which is not necessarily sustainable, particularly if it is funded by debt. This will also hinder exports and so the long-term sustainability of the economy because it will be less competitive globally.

The general election might be inconclusive

It has surprised many that the coalition government of Conservatives and the Liberal Democrats has lasted the course, having been formed out of a hung parliament in May 2010. The polls imply a narrow Labour victory in the 2015 election but the race will be close and another hung parliament is likely.

There will be doubts about the sustainability of yet another coalition government, as well as its effectiveness in doing the necessary, if politically difficult, economic legwork to get the budget deficit down.

If markets and firms are nervous about the political situation in Britain, they may put off or scrap investments in the country until the uncertainty lifts.