Sunday, August 17, 2008
A bed of nails we all have to lie on
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


After the gloomy combination of soaring inflation, rising unemployment and a downbeat assessment from the Bank of England, there was nothing for it but to travel back in time to 1990.

The summer of 1990 marked the beginning of the last recession, a downturn that was to last until the spring of 1992, making it the longest, though not the deepest, in the post-war period.

What was the Bank saying 18 years ago, in the summer of 1990? Then, of course, it was a mere agent of the Treasury, and not the interest-rate-setting body it is today. But it had a view, and it expressed it in its August 1990 quarterly bulletin.

Then, as now, oil and other commodity prices had risen, pushing inflation sharply higher. There was talk of a credit crunch as the banks reined back lending.

But the Bank of 1990 was quite hardline and, as it turned out, quite wrong. So concerned was it about inflation and rising wages that it dismissed business worries about impending recession, saying that the gloomy surveys then being published "don't add up to a strong risk of recession".

We have all changed in 18 years. Before independence, it was almost the Bank's statutory duty to warn on wages and try to keep politicians, who took the economic decisions, on the straight and narrow.

Now that it has to take some of those decisions itself, things are slightly different, not least because the Bank has to take part of the responsibility for what Mervyn King, the governor, described as the "difficult and painful adjustment" the economy is undergoing.

Only time will tell if its assessment now of a "broadly flat" economy over the next 12 months, followed by an upturn, is accurate or, as 18 years ago, too upbeat. Many of the surveys now are also warning of grimmer times ahead than a merely flat economy.

Nor will we know for some time whether the Bank is right to put its faith in inflation coming back down sharply after it has hit a peak of 5% or so later this year.

Let me take growth and inflation in turn, accepting, of course, that the two are related. I wrote at the beginning of July that after 64 quarters of economic growth, avoiding at least a quarter of declining gross domestic product (GDP) over the next year will be an enormous challenge.

How big a challenge is revealed by looking at what is happening elsewhere. America's GDP, we now know, fell in the final quarter of last year, while both the eurozone and Japan experienced falling GDP in the second quarter of this year.

This was euroland's first GDP fall since the single currency began in 1999 and included declines in Germany, France and Italy. If Britain succumbs, it will have done so later than most competitor economies, which makes it slightly hard to see why the markets are so downbeat about sterling at the moment.

The other challenge is in the Bank's view of a "broadly flat" economy. Economies generally obey the bicycle theory if they are not moving forward they are at risk of falling over. They can grow slowly but as a rule they cannot have no growth at all.

The problem is that stagnation generates its own downward momentum. Rising unemployment, already evident in the latest statistics, makes consumers cut back further. Weak sales make businesses retrench and cut jobs. Flat economies do not tend to stay that way for long. Either they snap out of it quickly or those downward forces have a habit of pushing them into outright recession.

Looking at the historical record, the last time the kind of scenario sketched out by the Bank happened was nearly half a century ago, in the days of "stop-go" economics. In the early 1960s, between the first quarters of 1961 and 1962 to be precise, the economy was flat, before it embarked on a vigorous upturn. The Bank is not necessarily wrong, but what it is predicting is unusual.

What about inflation? King was candid last week in admitting, not only that the Bank failed to predict the present rise in inflation but that, even if it had known, there was little it could have done. But for a body that needs to forecast inflation accurately, its recent record has been awful.

Two years ago it expected 2% inflation in 2008 and even its gloomiest prognosis did not foresee a rise much above 3%. That was also true a year ago. Granted, there was something highly illogical in commodity prices booming in the wake of the credit crunch, which no rational economic forecaster would have predicted. The Bank has also been taken by surprise by aggressive increases in the price of household gas and electricity by the utility firms.

To be fair, its latest forecast, of an inflation peak of 5% or slightly higher this year, followed by a sharp fall as past increases in energy and commodity prices (some of which are being reversed) drop out of the 12-month comparison, looks perfectly plausible. But then so did its prediction of a much lower peak made three months ago.

The current high for inflation severely tests not only the Bank's monetary-policy credibility but also its forecasting reputation. It has to endure its bed of nails for the next few months and so do the rest of us.

The big issue is not, it seems, wages, which are well-behaved and will remain so as long as the job market stays weak. Average earnings are rising by a modest 3.4%. The question is whether firms, while paying lip service to the national need to keep inflation low, try to force through as many price increases as they can. A flat economy and declining domestic demand should in theory constrain them. If not, life will get even more difficult.

The sunlit uplands that King and his colleagues see in a year's time rest on inflation dropping sharply, boosting the growth in real incomes and, while the Bank does not say so, giving room for lower interest rates. The risk is, long before we get there, that the economy will have been dragged down much further than is comfortable.

PS: After a couple of weeks in America, I have one or two observations. Americans are more concerned about the level of petrol prices than about house prices. And in general, for a country going through a more severe adjustment than here, there is far less economic gloom, including in the media. Maybe we enjoy wallowing in it while they don't.

You also get a sense that the American economy will not stay flat on its back for long. Television stations carry ads on how to make money out of foreclosures repossessions to us. One person's misery is another's opportunity. The latest figures for so-called pending home sales, up strongly, suggest this is happening.

Ian Shepherdson of High Frequency Economics, who has been rightly bearish about the American housing market, even thinks we might be seeing the beginning of the end of the crash.

For a country on the eve of what could be one of the most significant presidential elections in its history, there is little sign of poll fever outside Washington. Barack Obama comfortably wins the T-shirt contest but who would want to wear a John McCain T-shirt?

Otherwise, ordinary Americans seem more engaged in the myriad local elections they get, for the offices of sheriff, judge, county commissioner and the rest, than in the presidential race. Poll fever may build, but it is not there yet.

From The Sunday Times, August 17 2008