Sunday, September 28, 2008
If this is the bust, why wasn't it preceded by a bigger economic boom?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


You know something big is happening when people who do not usually get involved in the economic and financial debate start chipping in, whether they are archbishops, bemused Newsnight presenters or politicians of every hue.

I would include taxi drivers in the list but in my experience they are always moaning about the economy.

Three themes seem to be emerging from this. The first is that governments should not bail out bankers for their irresponsible behaviour. There is nothing wrong with such a view. Indeed, the reluctance of Mervyn King, the Bank of England governor, to do anything when the credit crisis broke last summer was based on just such "moral hazard" concerns.

But things have moved on and there is a big difference between preserving the system and bailing out undeserving bankers, as no less an economist than President George Bush pointed out in his address to the nation.

There is also a fundamental difference between using hundreds of billions of government money to preserve the banking system and using it to save car factories or increasing aid to Africa, whatever unions and development charities say.

If the banking system goes, everything else does too.

The second theme is "never again". Everybody wants to lock the stable door after the horse of irresponsible banking behaviour has bolted. That means, according to one of Gordon Brown's five principles last week, "no members of a bank's board should be able to say they did not understand the risks they were running".

That sounds eminently sensible, except when you start to think about it. Is every member of a bank board expected to know the state of each trader's book at the end of the day?

Does the cabinet know precisely what risks every civil servant is taking with information on individuals' personal details or taxpayers' money? Boards can set out broad principles and discourage excessive risk-taking but cannot know the state of every contract.

Rowan Williams, the archbishop of Canterbury, appeared to be advocating an extreme version of the new era with his attack on short-sellers but also on those who are engaged in "trading the debts of others". His article is worth reading (archbishopofcanter but his views are unrealistic, given that trading debt is what financial markets do. Things will change, and are changing fast, but we will still need markets.

The third theme, though, is one I want to concentrate on. It is that while bankers are the main villains of the piece, we are all as much to blame for being greedy. If it was not for people wanting to borrow, the banks would not have lent. So we, too, deserve to pay the price for that greed.

The extreme version of this, staying with religion, is provided by the nearest thing in politics to the grim reaper Vince Cable, the Liberal Democrat shadow chancellor. He has been warning for years that Britain was on a debt-fuelled binge.

His diagnosis, that the government should have restrained bank lending and the Bank of England taken house prices into account in setting interest rates, does not add up to much. As the Thatcher government discovered two decades ago, it is hard to impose controls on bank lending in the absence of exchange controls because there is so much cross-border leakage.

As for the Bank, house prices were formally part of the target inflation measure until 2003 and have hardly been ignored by the monetary policy committee (MPC) since. Given the inherent volatility of house prices, as well as uncertainty over the data, replacing the inflation target with a house-price target would make no sense at all.

But the point remains. Have we, through borrowing, lived high on the hog for too long, so that boom must inevitably be followed by bust?

In the run-up to the last recession, in the early 1990s, the economy was character- ised by runaway growth in consumer spending and soaring wages. At its peak, in 1988, spending was rising by more than 8% in real terms. Average earnings growth moved into double figures. That really was an extreme overheating boom of the kind seen in the early 1970s, just ahead of the first of the big post-war recessions.

This time, however, one striking but unappreciated feature of the economy has been the absence of a consumer boom. Over the past five years the average annual rise in consumer spending has been a very modest 2.4%. The last time consumer spending was even remotely strong was more than four years ago, when it rose by 3.6% between mid 2003 and mid 2004.

What is true of spending is also true of wages, which remain very well behaved in the face of provocation from high inflation. Earnings growth is a modest 3.5%. John Philpott, chief economist at the Chartered Institute of Personnel and Development, says that in contrast to past episodes when recession and rising unemployment were needed to cool an overheated labour market, this is not the case now.

Some will say, of course, that even if there is no boom in the spending and earnings numbers, there was in the housing market, at least as far as prices were concerned, and that is what we are all paying for. If we look across the Channel, however, it is easy to see that even this explanation does not take us too far.

Economies that did not have a house-price boom, and even more muted economic growth than Britain and not even a hint of consumer-spending strength are suffering. A "technical" eurozone recession, in the second and third quarters, looks likely.

It may mean that Europe merely got there a quarter ahead of Britain, though we shall see what revised figures for gross domestic product bring this week. But for the big economies of the eurozone, even more than Britain, there was no boom. There may be a bit of a bust, however.

John Hawksworth of Price Waterhouse Coopers has had a look at what the next few years might bring for consumer spending. In the early 1990s there was a peak-to-trough fall of 3.5% in consumer spending.

Because of the more modest rises in spending in recent years, a smaller fall is likely this time, says Hawksworth. The good news is that, in his main scenario, spending will fall by only 0.3% next year. The bad news, perhaps, is that it will be subdued for some time after, rising by an average of only 1% a year through to 2012.

Much depends, of course, on financial rescues and their interaction with the wider economy. This is a financial recession, rather than a conventional one preceded by an economic boom. The weaker the economy, however, the harder it will be to fix the financial system.

PS: While central banks are taking drastic action to provide liquidity to the money markets, none of the big ones has yet blinked and cut interest rates. Could the Bank of England be first?

Three speeches in the past week from monetary policy committee members
Sir John Gieve, Andrew Sentance and Kate Barker suggested with varying degrees of emphasis that the Bank is inching towards a rate cut but is not panicking. The Bank has pretty good information from its agents on the state of the economy around the country.

The markets think a cut could come as soon as next month, though most economists think November when the Bank publishes its next inflation report more likely. As long as three-month money, currently well above 6%, is so divorced from Bank rate, there may be no point in rushing it.

From The Sunday Times, September 28 2008