Sunday, January 31, 2010
Lending is the cloud on the recovery's horizon
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Sometimes I wish I wrote about sport. There is plenty of debate before and after the match but, except in extremely rare circumstances, the score stands. Whether or not the Russian linesman was right to say the ball crossed the line in the 1966 World Cup final, England won.

In economics, on the other hand, the score rarely stands. Data revisions are as much a part of the game as groin strains in football or tendonitis in tennis.

Thousands of column inches were devoted last week to three things. One was that the economy grew by a mere 0.1% in the final quarter of last year, the second was that this is the deepest post-war recession and the third was that it is the longest.

One is definitely untrue. Even on figures we have, this is not the deepest post-war recession. It shares a 6% peak-to-trough fall with the slump of the early 1980s.

The 0.1% figure will not be true for long, and probably not survive the next couple of months, when the Office for National Statistics (ONS) gets more data in. The bigger revisions, which should show that recovery started in the middle of 2009, and that the peak-to-trough gross domestic product (GDP) decline was 4% rather than 6%, will not come until the middle of the next parliament. I will care, as will economists at Goldman Sachs, who have charted past data revisions, but I am not sure many will.

That is one reason why it is at best premature to describe this as the longest post-war recession. On preliminary data, likely to be revised, it is the longest continual period of falling GDP, six quarters. But the recession of the mid-1970s dragged on for the best part of three years and that of the early 1990s for two, even though GDP did not fall continuously.

The GDP numbers have brought to wider attention some deep underlying problems in UK official economic statistics. Those who labour on full-scale macroeconomic models, including my near-namesake David B Smith of Beacon Economic Forecasting and the University of Derby, have been exasperated for years by national accounts data, and the huge discontinuities and inconsistencies they throw up. The Bank of England, aware of the ONS's record, took to "backcasting" the official figures.

But, to go back to my yearning to write about sport, it gets a bit tiresome always shouting at the referee, and attacking what looks like the ONS's pessimistic bias. Economists at Fathom Financial Consulting got the 0.1% figure right and not just because they thought it was sensible to aim low.

The fact is that if we were bounding out of recession, even the ONS could not disguise it. Given the pace at which we plunged into a recession with a drop in GDP of more than 4% in the space of six months a year ago there was a hope that when the economy turned, it would do so dramatically.

The "Zarnowitz rule", after the late, eminent American business-cycle economist Victor Zarnowitz, said that the steeper the descent, the more rapid the bounce-back into recovery. This, what you might call the trampoline theory of recessions, had some sound thinking behind it.

Most recessions are driven by destocking, a run-down of inventories, and this contributed to the steepness of Britain's decline last year, at least according to the figures. You might expect that once there were signs of stability, this process would go into sharp reverse, which could easily have produced quarterly growth rates of 1% or more, not a feeble 0.1%.

That has not happened, either because firms have learnt to get by on permanently lower stocks or are not sufficiently confident to rebuild to normal levels.

Why is the recovery not stronger, given the stimulus the economy has had? Some people say it is due to Britain's large financial sector but financial services are only 8% of GDP and appear to be growing as fast (or slowly) as the rest of the economy.

Another "sectoral" explanation is that Britain has too small a manufacturing sector, and exporters too focused on the rest of the EU, to benefit from growth in the emerging economies, in contrast to, say, Germany. There is something in this.

The truth, however, is probably more straightforward. UK households and businesses were more dependent on credit than their counterparts in many other countries. When credit crunched, and its supply was abruptly cut off, the effects of that were severe. Now, while things have picked up from their low point, the economy is still hugely credit-constrained.

Another widely reported statistical story a few weeks ago, following the ONS's revelation that the saving ratio jumped to an 11-year high of 8.6% (of income) in the third quarter, was that Britain had rediscovered the virtues of thrift.

That is not the case, as a new paper from Mark Cliffe and James Knightley of ING points out. The amount households set aside in savings actually fell dramatically during the recession. But borrowing fell even more sharply. Netting these out gave the rise in the saving ratio, driven by the fall in borrowing, and some repayment of debt, rather than an urge to save.

"There is no sign of a convincing increase in saving in bank accounts or other assets," they write. "If we are right in expecting income growth to slow sharply in 2010, savings are likely to fall afresh."

It is a good point and one that is relevant to the weakness of the recovery. It may be that even if households did not discover the urge to save, they suddenly became debt-averse. I think, however, the main reason borrowing fell was because credit was not available. That applies to small and medium-sized firms as well as households. Bank of England figures show that the growth of so-called M4 lending, adjusted for financial-sector transactions, is at its weakest since 1994.

Andrew Haldane, the Bank's executive director for financial stability, has hit out at bank behaviour that is "unlikely to support banking stability", notably paying out too much in bonuses and dividends. The banks have their own debt hangover to deal with. One way they are doing so is by not lending enough into the economy.

PS: Will they or won't they? Inflation figures 12 days ago argued against extending the Bank of England's 200 billion quantitative easing programme but the weak GDP numbers brought it back into play as far as the markets are concerned. I would not do any more. What will the monetary policy committee (MPC) do?

Two of its members, Spencer Dale and Andrew Sentance, should be in the "no" camp. Dale voted to stick at 175 billion and Sentance made clear his belief last week that the economy is recovering pretty well and further evidence of that recovery will build in coming months.

What about the rest? The shadow MPC, which meets under the auspices of the Institute of Economic Affairs, may shed some light. On interest rates, two shadow committee members think the process of raising should begin now, with a rise in Bank rate to 1%. That would certainly shock the markets.

On the other hand, four members say quantitative easing should be extended, three by 50 billion. Three opt for a pause but a further two say the Bank should base its easing decisions on delivering an appropriate path for broad money, M4.

Broad money, adjusted for distortions, so-called M4x, is weak, and that would argue for extending easing at this week's meeting. So it could be close, and a split vote. The City, on balance, expects the Bank to stop. The announcement at noon on Thursday will be interesting.

From The Sunday Times, January 31 2010