Sunday, May 01, 2005
As cooler winds blow, we get that sinking feeling
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

An unseasonable chill has descended on the economy. Britain’s once-rampant consumers are minding the pennies, proof to me at least that there is a link between the housing market and people’s willingness to spend. The flatter the former, the more subdued the latter.

Businesses are also glum. Business confidence normally rises in the spring as the sap rises but, according to the Institute of Directors, it has fallen sharply since January. The CBI reports a slump in industrial orders in its latest quarterly survey, alongside the sharpest rise in costs for a decade.

All this could be temporary, a reflection of the soft patch the global economy appears to be experiencing, itself the product of the gradual removal of an extraordinary policy stimulus — ultra-low interest rates and huge budgetary expansions — and $50-a-barrel oil.

But it is possible, too, that we have reached a turning point, and that this general election will mark the end of the period of apparently easy economic success that Britain has enjoyed since the early 1990s.

I am not making a party-political point. On broad economic policy there is not enough to choose between the three main parties — deliberately — to make a difference. All have assumed that the economy continues on its untroubled growth path, and have built their tax and spending plans around that assumption. That leaves no room for error and the worry is that a rise in unemployment, coupled with the discovery that most of the supposed savings on government waste are a fantasy, will leave the public finances badly exposed.

Why might we be on the cusp of a change? One reason, described here last week and developed in more detail elsewhere in these pages, is the prospect of a much more subdued outlook for consumer spending.

The seven fat years in which spending has grown faster than the economy as a whole may be followed by seven lean years, as financial insecurity, tax increases and the need to service the debt built up over the past few years hits home. Mervyn King warned of this two years ago, in his first interview on taking over as Bank of England governor. He may now be proved right.

It is hard to overstate the importance of the consumer in Britain’s recent growth story. In the past 10 years, gross domestic product has risen by an average of 2.8% a year, consumer spending by 3.6%. Contrast that with the lumbering giant of Europe’s economy, Germany, where GDP growth has averaged 1.3%, consumer spending 1.2%. Germany, it should be said, has a far superior record over the period when it comes to exports and industrial growth.

It would be an exaggeration to say that more reluctant consumers could cut economic growth in Britain to Germany’s paltry rate, revised down again last week by leading research institutes. But a spending slowdown to more normal levels would make growth here look very ordinary.

But the big worry comes not on the demand side but on the supply side. Britain’s tax burden is fast converging with Europe’s, as the Engineering Employers’ Federation points out in its business manifesto. In 1997 there was an eight-point difference between Britain’s tax burden (revenues as a proportion of GDP) and the EU average. By next year, according to OECD figures, it will be down to three points, and closing.

Some might say that the economy was taking this extra taxation in its stride, without any discernible effect on its ability to grow. That, however, ignores two things. Most of the increase in the tax burden has yet to come through; Treasury figures suggest that only 40% of the planned rise in the burden between 1996-97 and 2007-8 has so far occurred.

The other problem is the “petrol on a bonfire” argument, which should be familiar to economic policymakers. You add another dose of tax or business red tape — of which the running total since 1998 is £39 billion and counting, says the British Chambers of Commerce — and nothing much seems to happen. Then suddenly, with a “whoosh”, the economy goes up in flames.

The National Institute of Economic and Social Research, in a new assessment of Labour’s economic record, finds much to praise. But in comparison with France and America, the two other countries it looks at, the record is not that special. Britain has had the highest inflation rate of the three; growth has been slightly higher than in France but weaker than in America; productivity growth has merely matched France but, again, has lagged America.

And, according to another recent report, longer-term prospects for Britain are far from bright. Deutsche Bank in Frankfurt, in a report entitled Global Growth Centres 2020, says the top five emerging-market economies between now and then will be India, Malaysia, China, Thailand and Turkey.

The top five among OECD countries, it says, will be Ireland, America, Spain, Canada and France. Where’s Britain? Limping along in 21st place in Deutsche’s 32-country table, with a growth rate averaging just 1.9% a year, well below those of Ireland (3.8%), America (3.1%) and France (2.3%).

Britain, according to the analysis, is running out of “growth-positive” factors, the job-market flexibility and other supply-side measures introduced in the 1980s, and is running into a series of “growth- negative” headwinds. They include, as well as higher taxes and the re- regulation of the economy, factors such as education, openness to migrant workers and the degree of dependence on imported energy.

Some argue that economic prospects are so poor that Thursday’s election will be a good one to lose. I don’t agree with that, although I am sure we will hear it from somebody come Friday morning.

But the outlook, plainly, is more sombre than the politicians are letting on. Consumers have picked that up, and know they face the need to save more, or be taxed more heavily, or both. Businesses and the financial markets have also picked it up. Did somebody say things can only get better?

PS: The shadow monetary policy committee (MPC), which meets or communes by e-mail each month under the auspices of the Institute of Economic Affairs, has a more hawkish bias than the actual MPC. It is encouraging then, that in its vote this month its members do not yet see the case for a rate rise.

Five shadow MPC members say rates should be left on hold at 4.75%. One, Patrick Minford, thinks conditions are weak enough to warrant an immediate cut. This leaves three, including Tim Congdon, who think a rise is needed this month, mainly because of their worries about the pace of money-supply growth. Adding all that up gives a 6-3 vote against higher rates at this stage.

There will be time next week for further consideration ahead of the Bank’s May decision. Unusually, perhaps uniquely, the meeting will straddle the weekend (beginning Friday ending Monday), to avoid a clash with Thursday’s general election.

The key issue, which I will look at in more detail next week, is whether the actual MPC’s new inflation forecast will be above the official 2% target by a greater or lesser degree than it was in February.

Last month’s rise in inflation to 1.9% means the new forecast will begin from a higher base, but the weakness of consumer spending and industrial activity provides a clear steer in the opposite direction. My guess, on balance, is that the forecast will not provide the MPC with a clear-cut case for shifting rates, putting the onus back on the data. And the figures, with one or two exceptions, are weak.

From The Sunday Times, May 1 2005


In spite of recent panics, the US economy seems to be bubbling along and should stay close to its long-term growth rate for the rest of the year (according to leading indicators).

If nothing extraordinary happens in the US then there’s every reason to expect four or even six more 0.25% interest rate rises this year from the FOMC.

If US interest rates rise by at least 1% then surely the MPC will have to raise UK rates at least once or sterling will fall (given the state of our deficits), raising inflation.

The high, March UK inflation figures were no aberration – the RPIX figure of 2.4% was similar to December’s 2.5%. So inflation for the past twelve months has been very close to target.

But inflation in the months of April to September 2004 was actually below the long-term average. Therefore if inflation for those months in 2005 is just equal to the long-term average, the annual rate will rise. Plugging in the long-term average numbers gives RPIX inflation rising to 2.8% by September.

Unless the oil price drops significantly, the MPC could find itself between the rock of rising inflation and the hard place of a falling currency.

But then a single UK rate rise could bring the whole housing market down like a ton of bricks. If that happens, UK consumers that have already stopped borrowing-to-spend might even start saving.

Oh, poor retailers – for you, the nice nineties are well and truly over. (And that's before the other worries about tax rises and unemployment.)

Posted by: David Sandiford at May 1, 2005 12:43 PM