Wednesday, December 08, 2004
The economic headwinds of 2005
Posted by David Smith at 09:25 PM
Category: David Smith' s magazine articles

Whenever I talk to audiences about the UK economy, particularly younger ones, I find it necessary to remind them that it has not always been like this. Such as been the stability of recent years that, not only do I have to pinch myself to be sure it is not a dream, but the memories of the wild volatility of the past start to fade, even for me.

Thus, the economy has grown consistently, quarter-on-quarter, since as long ago as the spring of 1992. By next spring, barring accidents, the recovery will have been in place for 13 years. Thinking about it in terms of the lengths of parliaments – assuming we have a general election about then – the upturn will have lasted three. Put another way, the Tories still had another five years to run in government when the economy emerged from its last recession.

This success is not purely a New Labour phenomenon. The current long run of growth was well-established well before Gordon Brown took the helms at the Treasury, although the Conservatives and Kenneth Clarke were unable to take political advantage of it.

The current run of growth is, as the chancellor keeps reminding us, the longest since quarterly records began in the 1950s, and since annual records started 200 years ago. It is likely, given the natural volatility of the economy in pre-industrial days (the vagaries of climate and harvests) that we are living in the most enduring recovery ever.

Not only that, but it has been combined with stubbornly low inflation. When the Conservative government, in the guise of Norman Lamont, Clarke’s predecessor, gave us an inflation target in the autumn of 1992, it was well chosen. The target was for 1% to 4% inflation on the retail prices index (excluding mortgages). Since then, while the target measure has recently changed, inflation has averaged within a whisker of 2.5%, bang in the middle. Britain’s formerly recession-prone, inflation-prone economy has changed its ways.

The question, as we look into 2005, is whether it can last. In theory, the answer should be straightforward enough. With each quarter, and each year, of economic stability, it becomes more ingrained. This is important. If businesses and consumers think that in general things will turn out fine, and have the confidence to take decisions on that basis, there is a good chance that, indeed, things will turn out fine.

The alternative argument, of course, is that the longer it goes on, the greater the risk that the economy’s run of luck will come to an end. So what are the risks for 2005?

The first set of risks relates to the global economy. Terrorism, global economic imbalances, China’s overheating, and Europe’s sluggish performance are ever-present dangers. The biggest uncertainty, however, emanates from oil prices, which rose to more than $50 a barrel in the autumn.

This is uncharted territory. Oil prices have been higher than this in real terms before, most notably in the early 1980s. Advanced economies are less oil-sensitive than they were in the past, because of the decline of heavy, energy-intensive industries and the rise of more energy-efficient vehicles (although this is offset by the rise in vehicle numbers). That should mean that the effects of high oil prices are to dampen global growth rather than bring it shuddering to a halt. But the risk is of something worse.

Nearer to home, the second big risk relates to house prices and debt. For several months now the Bank of England and others have been working hard to argue that a fall in house prices would not be devastating for the economy. Consumer spending and house-price inflation are linked, but not mechanically. Consumers will carry on, the argument goes, even if there is a crash in housing values.

My view remains that there will not be a crash, although we have already entered what could be a long period of housing stagnation, necessary if incomes are to “catch up” and reduce the extent of the property market’s overvaluation. Housing stagnation is consistent with slower growth in spending by individuals.

But could it be worse? The virtuous circle supporting housing has been one of low interest rates and a strong job market. Remove those props and things could look rather different. Interest rates have already risen significantly. How strong is the underlying picture in the job market?

This, conveniently, brings me to my third point. Fiscal policy in Britain under Brown has fallen neatly into two halves. For the first three years after 1997, when the economy was benefiting from the 1990s’ global boom, he ran a tight ship, keeping public spending under control. After that, however, things changed.

As the global economy slowed, and America slipped into recession, the chancellor’s big relaxation of spending, particularly directed towards the National Health Service but also affecting other public services, came through. That has been the story for the past four years, and the effect has been to add to growth, and transform what would have been a dull job market picture into something very buoyant.

That will change this year. Slower growth in public spending will coincide with a tougher attitude on public sector recruitment, with some 80,000 (net) civil service jobs due to bite the dust.

That is not the only fiscal policy question. There is still a big debate about whether taxes need to rise to pay for past spending increases, and that will become clearer after the general election. Even without new taxes, some fear the damage has been done. Derek Scott, for 10 years Tony Blair’s economic adviser, believes higher taxes and the re-regulation of the economy under Labour will soon begin to have a serious impact on growth.

The headwinds are there. The likelihood is that in a year’s time we will look back on another year of this remarkable recovery. But we might also look back and conclude that it was more disappointing than it might have been.

From Professional Investor, December 2004/January 2005

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