Sunday, June 08, 2008
Grinding to a halt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


All the news fit to print about the economy is very gloomy. In a matter of weeks the credit crunch's bite has got harder and evidence of a sharp slowdown tangible.

Add in blunt warnings from the Organisation for Economic Co-operation and Development, roughly suggesting Britain has been transformed from model economy into basket case, and it looks like the last rites.

So how bad is it, and are we looking down the barrel of recession? All good things come to an end, so is the record run of 63 consecutive quarters of growth to be consigned to the history books?

Not only have the housing- market data been terrible but survey data for services, manufacturing and construction show either significant growth slowdowns or declines.

Purchasing managers' surveys for the three sectors, published in recent days, tell a similar story. Manufacturing's purchasing managers' index dropped from 50.8 to 50; in services the fall was from 50.4 to 49.8; and construction slumped from 46.1 to 43.9.

Taken literally, given that index levels below 50 are supposed to indicate falling output, the surveys suggest manufacturing has stopped growing and services and construction are shrinking. In practice, the read-across is not perfect but the slowdown message unmistakable. Anecdotally, I have come across few business people recently who would disagree.

We know why this is. The credit crunch's ugly sister, high energy and commodity prices, means the economy is being hit by two big shocks at the same time. All the advanced economies, Britain's main markets, are slowing. The only thing that prevents a global recession is the strength of emerging economies.

If you believe the OECD, Britain is peculiarly vulnerable. Our former strength, a comparative advantage in financial services (remember those boasts about London overtaking New York?) is now a disadvantage. Housing is becoming an enormous millstone round the economy's neck.

The OECD's warnings should be put in perspective. Its record on forecasting UK growth is not as good as the Treasury's. The research it has done on links between the UK housing market and the wider economy scratch the surface compared with the detailed work done by the Bank of England. Its forecast for UK growth this year is above America, euroland and Japan, and next year is faster than America and in line with euroland. This does not suggest an economy uniquely suffering from the credit crunch and housing gloom.

However, some of the OECD's points were well made, and bold for a body that used to be very wary of upsetting member governments. It is indeed the case that under Gordon Brown the government spent far too much in the good times, leaving the public finances vulnerable in a slowdown.

It is a sobering fact that in the recession of the early 1990s the budget deficit (public sector net borrowing) went from a surplus of 0.2% of GDP in 1989-90 to a deficit of 7.8% by 1993-94.

What about housing? The numbers, as I say, look dreadful. New mortgage approvals fell to an all-time low of 58,000 in April. The Halifax house price index, having risen 1% in the three months to February, plunged more than 6% in the three months to May. This is an annual rate of decline of 25%, making even the gloomiest forecasts look optimistic.

House-price falls like this happen in two circumstances. One is when the economy is in recession and unemployment rising sharply. That is not happening, not yet at least. The other is when the authorities lose control of monetary policy. Typically, a loss of control of monetary policy happened in a sterling crisis. This time the loss of control is the result of the credit crunch, which has deprived the Bank of its ability to influence the price and availability of credit.

There are issues about whether the Halifax and Nationwide house price measures exaggerate the slide, though I applaud Halifax's honesty in releasing exceptionally gloomy data when it is trying to get a rights issue away. It will be interesting to see if these falls are reflected in broader price measures such as the Land Registry.

The broad picture is clear, though. Mortgage rationing has cut out a swathe of potential buyers and created a thin market. Price changes are more dramatic in thin markets, exacerbated by cuts in valuations by the lenders.

Do house-price falls in thin markets make it more likely that there will be a serious knock-on effect to the rest of the economy? The slump in housing activity is seriously affecting housebuilders, estate agents and anybody else directly connected to the industry but, without ignoring their pain, the big question is the impact on consumer spending.

So far, the spending slowdown has been modest. The other big-ticket item most people buy is a car and there are plenty of reasons not to buy a new car but registrations in the first five months were down a modest 0.6% on last year, with sales to private buyers down only 3.5%.

An analysis by Ross Walker of Royal Bank of Scotland suggests consumer spending is not heading for a fall as it did in the recessions of the early 1980s and 1990s. While consumer confidence is weak, its relationship with actual spending has been poor in the past.

Of more relevance, according to Walker, are rising real household disposable incomes, set to increase by 2% this year and 2.2% next, supporting consumer spending increases of 2.4% and 1.4% respectively. When consumer spending grows, recession is unlikely. Should the Bank help things along by resolving that other policy dilemma, on interest rates? Economists at UBS, in a presentation last week, argued strongly that in advanced economies the downward risks to growth from the credit crunch far outweighed the upward dangers for inflation from rising food and commodity prices.

That is not the view of the European Central Bank, whose president, Jean-Claude Trichet, warned on Thursday that the ECB could be raising interest rates by a quarter-point to 4.25% next month. If that seems strange, perhaps we should be grateful for the fact that the Bank is merely content to keep its rate on hold at 5%, as it did last week.

Normally I would argue for a cut, but these are not normal times. A rate cut now would be wasted ammunition, costing credibility for little gain, particularly when set against the ECB's hawkishness. Until the usual transmission mechanism for monetary policy is restored there is no point in the Bank doing anything.

PS The job of deputy governor of the Bank looks attractive. The salary is 235,000, there is prestige attached and, as with US vice-presidents, you are a heartbeat away from the top job. Except the Bank is not such a fun place to be, there are two deputies and the battle to succeed Rachel Lomax in one of those jobs has become a public one.

The Bank does not rate shadow chancellor George Osborne's suggestion that Sir John Gieve, deputy governor for financial stability, be moved to Lomax's position so a City expert can have his job. Gieve has been sacked in the media a few times since Northern Rock, but his reputation has grown at the Bank. The idea of recruiting a "banking heavyweight" draws short shrift. The Bank thinks such heavyweights got us into this mess.

Governor Mervyn King wants Lomax to be replaced internally, by Charlie Bean, the Bank's chief economist, and, barring last-minute hitches, appears to have got his wish. That would allow Paul Tucker, executive director for markets, to succeed Gieve early in 2011.

Both the Bank and Treasury deny tensions over the post, though Alistair Darling is determined to beef up the Bank's financial stability expertise by appointing a committee of outside experts to advise the governor. Having met the banks, he has taken their criticism of the Bank in recent months on board.

From The Sunday Times, June 8 2008