Sunday, April 25, 2004
Is there something nasty lurking round the corner?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

THE first political duty of a chancellor is to ensure that the economy is bowling along nicely at the time of the general election. Tenants of 11 Downing Street are always concerned with the economic cycle but they have to make sure they also get the electoral cycle right.

The late Lord Jenkins, Labour chancellor from 1967 to 1970, was blamed for keeping the economy under too tight a rein, the absence of a “feelgood factor” allowing Sir Edward Heath’s Conservatives to sneak into office.

Electoral economics is not always straightforward. The Tories under John Major won the 1992 election despite a long recession, the voters’ view being that an inexperienced Labour government might make things worse. But the Tories lost in 1997, despite five years of economic growth, low interest rates and income-tax cuts from Kenneth Clarke.

Assuming normal service this time, Gordon Brown appears to have done his colleagues in government proud. After surviving the global downturn, which bottomed out in 2001, Britain’s economy is benefiting from the world recovery. Inflation is low, just 1.1% on the new measure, and unemployment is falling. The “misery index”, which combines the two, has not been lower since Harold Macmillan was telling voters they had never had it so good nearly half a century ago.

The chancellor was even able to celebrate a particularly sweet moment last week. Public borrowing for the 2003-4 fiscal year came in at £34.8 billion, below the £37.5 billion forecast published in the budget just last month. The black hole in the public finances may not have disappeared, but at least there is now an element of doubt about it, and the outcome was one up for Brown over his critics.

That’s not all. The Ernst & Young Item Club, which publishes its new forecast this week, said annual growth this year and next will be 3.25%, “perfectly timed for a May 2005 election”. The International Monetary Fund, in its world economic outlook last week, predicted 3.5% growth this year, more than double euroland’s projected rate of growth (1.7%), and the fastest in the Group of Seven with the exception of America (4.6%).

The chancellor, who has been preening himself at the IMF’s spring meetings in Washington and who, unlike his Downing Street neighbour, would never do something as undignified as a U-turn, has every reason to feel pleased with himself.

What could go wrong? What could yet turn the chancellor’s golden scenario into base metal? There are some significant risks along the way.

* Economists at the IMF and the Treasury are hewn from the same timber. When the IMF warned last week of “shocks stemming from a sharp decline in housing prices” it was echoing a fear held by some in the Treasury. Not everybody agrees; economists inside and outside the Treasury are split on the issue. For Brown, the great worry would be a housing crash that began around the end of this year and was in full swing by the time of the next election. His carefully crafted run-up to the election could be scuppered by headlines telling of “negative-equity misery”, not to mention the wider economic implications. My view, to repeat it, is that this will not happen, although last week’s clutch of housing-market figures were a little too strong for comfort.

* Higher oil prices could push up inflation and derail the global recovery. All bets would be off for housing and the world economy if current high levels of oil and other commodity prices were harbingers of a sharp upturn in inflation. Oil prices now seem to have locked in at well over $30 a barrel — West Texas crude is around $36 — and have virtually doubled in two years. In the old days, a doubling of oil prices meant inflation and recession. The world economy has become less sensitive to oil but there are concerns, which would be heightened if the instability in Iraq spreads to Saudi Arabia, as it is in danger of doing. China, in a decade, has come from being a net exporter of oil to accounting for 5% of world imports, and rising.

* America’s economic imbalances could unwind in a damaging way. The IMF thinks the US current- account deficit, which last year hit $542 billion (£306 billion), or 4.9% of gross domestic product, is here to stay. Even by 2009 it will be 4% of GDP, it said. That is a lot of red ink, and it is combined with a big budget deficit, estimated by Goldman Sachs at $500 billion for the 2004 fiscal year. It isn’t going away either. Goldman Sachs estimates the cumulative deficit for the 2005-14 period at $5,500 billion. If America were Britain, a change of government would result in a big increase in taxes or cuts in government spending to bring the deficit under control. For America it is not clear that there will be a change of president, or that John Kerry would see cutting the deficit as his priority. The consequences of these twin deficits could be, as the IMF warned, a collapse in the dollar and huge instability in financial markets.

There is a short-term concern about America and the markets — which is how Alan Greenspan manages the rise in interest rates from the present 1%. On Tuesday he spooked the markets by saying deflation was no longer a concern. On Wednesday he reassured them by saying inflation was not much of a worry either. At some stage, probably in August, rates will rise. Greenspan’s challenge will be to do this without a big fallout in the financial markets.

These are not, of course, the only risks. What the IMF calls “geopolitical uncertainties” covers everything from further Al-Qaeda outrages to Iraqi anarchy, and more. In Britain, as we have seen before, it is possible to have too much of a good thing. Consumers have kept the economy going during a sticky period for the world economy. The Item club says such exuberance might not fade of its own accord and that, in the absence of higher taxes, much higher interest rates would be needed.

There is probably just more than a year to go before the election. As things stand, the chancellor’s path to the polls is strewn with flowers. But he should beware the potential banana skins hidden underneath.

PS: When the chancellor said last year he was considering a switch in the inflation target to a new-fangled European measure, I argued strongly against it. Sure enough, he went ahead. Now, to judge from his speech to the British Chambers of Commerce, he wants wage bargainers to base settlements on it.

That looks like a tall order. Not only has the switch barely registered with the public, or even human- resources specialists, but it suffers from a serious credibility problem. Last week inflation on the new measure, called the consumer prices index, dropped to 1.1%, well below its 2% target. By comparison, the raw retail prices index showed a 2.6% rise on a year ago. I know which seems to me a better reflection of inflation, and it is not the new one.

Because nobody outside policy circles and the financial markets has taken much notice of the switch in target, low inflation on the new measure is not yet a problem for the Bank. As we report today, Paul Tucker does not see it as a bar to rate hikes, and the rest of the monetary policy committee is likely to agree with him.

But it could turn out to be troublesome. Last week the Bank unveiled its new model for the economy, the Bank of England Quarterly Model, or BEQM. It is known as the “Beckham” in the Bank. It suggests inflation will rise steadily from the current low point. But the new measure has on many occasions been below 1% in recent years, and as low as 0.5%. If it drops below 1% again, the governor would have to write a public letter of explanation to the chancellor. Raising rates after doing that might be difficult.

From The Sunday Times, April 25 2004

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