Sunday, June 28, 2009
Road ahead is uncertain as talk turns to recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Optimism that the worst of the recession is over is giving way to uncertainty about what shape the recovery might take. The events of the past two years have taken us into uncharted territory. What will the route back to normality be like?

The Organisation for Economic Co-operation and Development concluded in its latest outlook that the worst of the recession for advanced economies was over but cautioned against putting up the bunting.

“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history,” it said. “The ensuing recovery is likely to be both weak and fragile for some time. And the negative economic and social consequences of the crisis will be long-lasting.”

For Britain, which the OECD predicts will see a 4.3% drop in gross domestic product this year, followed by a flat 2010 (though with a pick-up through the year) those consequences will include dealing with a budget deficit it expects to see hit 14% of gross domestic product next year.

Robert Chote of the Institute for Fiscal Studies, at the annual conference of the Society of Business Economists, pointed out that Treasury plans imply fiscal tightening building up to £90 billion, £2,840 per household, over the next eight years.

Some of that, though I will say it quietly unless Gordon Brown hears, involves savage cuts in government capital spending and real cuts just about everywhere else.

Whether departmental spending falls nearly 7% in real terms in the three years from 2011, which assumes the reductions are equally shared, or most departments drop 9.7% (if health and overseas aid are spared), or most drop 13.5% (if schools also escape the axe), we are looking at a dramatic, though necessary, reversal.

The IFS says it represents the biggest real spending cuts in any three-year period since Labour was forced to turn to the International Monetary Fund in 1976. It may even be a little purist in only claiming that much. It is probable, though discontinuities in the data do not allow a definitive answer, that cuts in prospect are more pronounced than in the Healey-Callaghan era.

Spending cuts like this, of course, can only be accompanied by reductions in public sector manpower. A real freeze on public spending for much of the 1990s resulted in a drop in public sector employment from 6m in 1991 to under 5.2m by 1998 (it is now back at 6m). A tightening of fiscal policy - higher taxes as well as spending cuts - is not the only headwind.

Mervyn King told the Commons Treasury committee he had never been more uncertain about the outlook. If the Bank, with its army of economists and agents does not know, what hope is there for individuals and businesses who, through their actions can either make recovery happen or keep the economy becalmed.

The Bank’s particular concern in about the effect of weak bank lending on the supply-side of the economy. If companies cannot get the funds to invest, a state of atrophy could occur or, at the very least, much slower growth in the economy’s productive capacity than we have been used to.

One effect of this, which is occupying the Bank, is that inflationary pressures could re-emerge sooner than normal after a recession. Interest rates are not going to rise for some time but when they do it could be more sharply than people expect.

This supply-side damage, together with drastic fiscal surgery, could have long-term implications. The Treasury assumes once recovery takes hold, growth will return to its “trend” rate of 2.75% a year. Ross Walker of Royal Bank of Scotland, adapting the Treasury’s numbers to take into account of changed circumstances, including the weaker boost to population and labour supply from net migration, argues that a figure closer to 2% is more likely.

We will only know when the economy has been recovering for a while. What kind of recovery can we expect? Cambridge Econometrics looked at three recovery scenarios for the coming years: “renewed confidence”, “sharper cycle” and “doldrums”.

In all three, not much happens until next year but then paths start to diverge, depending on what happens to consumer spending, business investment and global growth, the latter as the driver of UK trade. Public spending cuts and tax hikes are built in, though of varying severity.

What happens to consumer spending, 62% of gross domestic product last year, is pivotal. In Cambridge’s “renewed confidence” scenario, households repair their finances quite quickly and consumer spending resumes. World trade comes back, promoting export growth.

In the “sharper cycle”, it takes longer to get a recovery but when it comes it is stronger, for consumer spending, investment and world trade. A deep fall is followed by an equally impressive bounce.

If the economy stays in the doldrums, however, we are looking at a period in which the world economy is slow to come out of recession, consumer spending falls this year, next year and in 2011 and only picks up slowly thereafter and business investment is feeble. Recovery would only really kick in by 2012, and then feebly. Britain would start to feel like Japan in its lost decade, though with less of a cushion of prosperity to draw on.

Which will it be? There are arguments in favour of all three scenarios. The damage to the banking system and the sheer scale of the fiscal adjustment required argue for a very weak recovery. This would fit with the findings of the often-quoted research by Carmen Reinhart and Kenneth Rogoff that recoveries from banking crises are slower than from normal recessions.

On the other hand, most UK recoveries in the past have been V-shaped and pretty strong, even when circumstances have appeared to suggest otherwise.

The Bank governor does not know and, in truth, nobody else does either. But the difference between slow and weak recovery scenarios is profound; the latter increasing the amount of work needed to repair the public finances. Even a decent recovery will be accompanied by painful adjustments in spending and higher taxes. The slower the recovery, the deeper the pain.

PS: What of Britain’s tripartite system of financial regulation, when the participants are fighting like ferrets in a sack? Lord Turner, chairman of the Financial Services Authority (FSA) does not want his organisation neutered by a transfer of powers to the Bank of England.

Mervyn King, who has developed a fondness for headlines that would make some of his predecessors wince, insists he is not engaged in a naked power grab but a more powerful Bank is one way to stop banks returning to bad old ways.

The Bank’s Financial Stability Report, on Friday, set out five areas of reform: Strengthening market discipline, with more frequent public disclosures by banks and resolution regimes to close down errant institutions; greater self-insurance by financial institutions; improved management of risks arising from dealings with other institutions; limiting the financial system to a size and structure compatible with maintaining financial stability; and explicit principles, set out in advance, to govern taxpayer-funded financial rescues.

Alistair Darling will publish his proposals next month. He thinks it is important not to react to so-called “underlap” before the crisis - gaps in the tripartite system - by creating too much overlap. Banks need to know clearly who is supervising them.

The chancellor’s proposals for a beefed-up tripartite system, crucially, will not take immediate effect, starting a period of consultation taking us beyond the election. That could provide an opportunity for George “twin peaks” Osborne, not a character out of David Lynch, but the shadow chancellor’s plan to give the Bank supervisory responsibility for larger banks and institutions, while leaving the FSA with the rest and with responsibility for protecting consumers. The regulation saga has a a long way to run.

From The Sunday Times, June 28 2009