Hamish McRae: UK economy is working thanks to immigration and foreign funds

The data of the past few days brings home what an extraordinary economy the UK one has become, an economy that is profiting from - but also making a huge bet on - continued globalisation.

For a start it depends more than any large economy on income from services and foreign assets. It is one that attracts large flows of inward investment, with foreign enterprises not only setting up subsidiaries but also taking over UK companies. And it is also an economy relying on foreign workers to keep its growth up, for there has been in the past couple of years enormous immigration, with hundreds of thousands of workers coming in from eastern Europe. It is an extraordinary experiment. We are in the middle of it now.

The impact of inward migration was demonstrated yesterday, when we had new figures on unemployment. These showed employment was at a new record high, which is encouraging because the private sector seems to be increasing its hiring as well as the public sector. But simultaneously the claimant count measure of unemployment rose again and the broader ILO measure, at 5.4 per cent in May, was the highest since 1992.

That is just a snapshot of one month, but you don't need to have a maths degree to figure out that if employment is rising and unemployment is also rising there must be a large increase in the workforce. Remember too that these are official figures. Add in the probable growth of the informal sector and it is pretty clear immigration must be playing a huge role in sustaining growth.

The figures, sadly but unsurprisingly, are hopeless. We don't have any proper estimates for the scale of inward migration over the past two years, just as we have no acceptable estimate of the number of unauthorised migrants in the country. But the statistics about employment and unemployment would be consistent with an increase in the size of the workforce of at least half a million over this period. It has been calculated that this wave of immigration, mostly from eastern Europe, is not only the largest absolute number the country has ever experienced. It is also the largest in proportion to the population since the arrival of the Huguenots after the revocation of the Edict of Nantes in the 1685.

It is also consistent with the lack of wage pressure. Headline earnings growth is down to 4.1 per cent and with bonuses subtracted that is down to 3.8 per cent. This is well below the 4.5 per cent level that is understood to cause the Bank of England concern.

I'll come back to inflation in a moment. Another bit of new data this week was the trade figures. These showed a large increase in the trade deficit in May, with the surprise being a sharp increase in imports. This may in part be World-Cup-related - people buying stuff to watch it on - and monthly trade figures are always liable to distortions. But it is slightly disturbing to see the demand created in this country not being fully reflected in a rise in economic activity here. Exports are not bad at the moment, and exports to the rest of the EU have been very strong. But in the first quarter of this year our net trade position reduced growth by some 0.3 per cent.

The rough-and-ready interpretation of all this is that economic demand is strong but we are meeting the extra demand for labour by importing it and much of the additional demand for goods by importing them too. You can see the additional demand for goods in the pick-up in retail sales in the top graph.

What then about inflation? The official figures are fine. Inflation is a touch above the 2 per cent central band but only a touch and for much of the past four years it has been below it. But that is not what most of us feel. Britain has adopted the European measure for inflation, which does not fully take into account the cost of housing. There is a separate debate as to whether the Bank should take into account asset inflation as well as current inflation but there can be no denying the housing boom has inevitably increased the cost of housing. In other words it affects current as well as asset inflation.

The point has been made several times that inflation on the things we have to buy, as opposed to the things we choose to buy, has been much higher than the official figures. The second graph, from Barclays Capital, shows how the price of non-discretionary goods and services is now running up more than 6 per cent year on year. Barclays has also done another calculation that I find fascinating. It has calculated the trend of the Bank of England lending rate and plotted it against excess monetary growth. The latter is the growth in broad money less the growth in money GDP. The two fit very well until recently. But at the moment the Bank would seem to be running too loose a monetary policy.

What does all this imply?

Well, I suppose the first thing to say is that you have to take all this data with a pinch of salt. Our data is designed to tell us about an economy of 20 years ago, before the present bout of globalisation began in earnest. If physical exports cover only half our imports we should, arguably, be more interested in the invisible side of our foreign earnings. As it happens the City's exports were down last year, but we won't have full data on the balance of payments until next month.

What we do know, however, is that net income from foreign investments has become a huge source of foreign income. But that is subject to very big uncertainties. The country has a negative net asset position: the value of our debts and foreign investments here is larger than the value of our assets and of our other foreign investments. Yet we seem to make a profit. We borrow cheaper than we lend.

So the country is relying on large numbers of people to come here to work and it is relying on investing cleverly abroad. But our information about what we are doing is very uncertain. Identifying who is here and who is not is hard enough. Identifying what is invested here, why it is invested, what we own abroad, how we make a profit on it - is harder.

There are several things that we can take comfort from. These include the fact that the UK has become a magnet for hard-working people from the new EU member states. People are voting with their feet and enabling the country to employ more people than before. We can take comfort from the flow of inward investment, which represents another form of vote in our direction. And the official figures for growth, inflation and the current account are not too bad at all.

But we should be alert, none the less, to signs of strain. That middle graph of the price of non-discretionary goods and services is one. And we should be aware how much we need the global economy to continue to thrive. So much of our foreign earnings depend on it.