The economy: A Q&A guide

Recessions were supposed to be a thing of the past. But with both unemployment and inflation rising, and house sales tailing off, some worrying questions are in the air

Are we heading for recession?

IT DEPENDS where you are standing. Britain's manufacturers are already on the brink of recession and peering over the edge of the abyss. Their problem is that export orders are slumping because the strong pound has priced them out of overseas markets and sucked in cheap imports, making it harder to compete at home too.

Some retailers are also finding the going tough, able to shift goods only if they cut prices. Other straws in the wind indicating the economy is slowing include, this past week, news of the first rise for two years in the number of people claiming unemployment benefit. Although this could yet prove to be a blip, the rate at which the unemployed are finding jobs has certainly tailed off.

These are the reasons some pundits have started predicting recession or worse, but that is not the whole story. Serious economists put the risk of an outright decline in the economy - as opposed to much slower growth - at about one in four.

But won't the Asian crisis harm the British economy?

THE ultimate effect of the economic catastrophe that has hit Asia - where they can teach us the real meaning of the word recession - is one of the great uncertainties. The direct impact on Britain is probably limited. For instance, Japanese investment in the UK is high-profile but accounts for a very small share of the total, and the jobs created in new greenfield factories come at a cost to the taxpayer. Companies that export to Asia will suffer most. UK exports to the region are already dropping off.

However, until the Asian financial markets and economies - especially Japan - have managed to grasp at a measure of stability, it is impossible to rule out a global financial crisis. If Wall Street crashes, all bets are off.

Why is the pound so strong?

NOBODY knows for sure, not even the speculators who have been driving it up. Part of the explanation is that interest rates in the UK have been on an upward path, while European and Asian interest rates have been flat or falling, making sterling more attractive to international investors. Another explanation is the fact that the currency markets have so far seen the pound as a safe haven from the future euro and from Far Eastern turbulence. Yet a third explanation is that the British economy is so much improved that foreign investors naturally want to put more of their money here.

Unfortunately, there is no easy lever to pull in order to alter the level of the pound. It will probably fall when the Bank of England starts to cut interest rates, but not definitely and probably not enough to bring relief to exporters. Besides, it wouldn't make sense to reduce loan rates in order to bring the exchange rate down - however happy it would make manufacturers - if the price is overheated growth and higher inflation.

Has the housing bubble finally burst?

The mini-boom in parts of London and the South-east has not exactly turned to mini-bust, with prices in most areas still well above their levels of a year ago. But the housing market has started to look rather frayed at the edges. Latest figures from the banks and building societies indicate that growth in mortgage lending has slowed, thanks to the increases in interest rates since last May. The banks are losing custom to the remaining mutual building societies because of the gap that has opened in the mortgage rates on offer.

Buyers' caution is also demonstrated by the fact that the number of property sales is falling slightly, and has dropped below their level at the same stage last year. House prices in general are not expected to fall this year, but nobody is expecting a repeat of last year's increases. Luckily, the housing market never got out of hand in the way it did in the late 1980s, with negative equity (when the price of a property drops below the value of the mortgage on it) still fresh in the memory.

If it's all so gloomy, why are interest rates still going up?

BECAUSE it isn't all gloom, no matter how loudly some industry lobbies and pundits complain. Other parts of the economy are still rocketing away. Finance, business services like accountancy and management consultancy, transport, communications, information technology, food retailing, construction - all are still enjoying the boom. Try hiring a computer programmer if you run an IT company, or an electrician to work in your house, and you will soon see the link between strong demand and pay pressures.

Even areas of business that have started to slow - such as sales on the high street as last summer's spree to spend building society share windfalls ebbs away - are still displaying signs that alarm the Bank of England. For instance, sales volumes are not turning down the way they should after six interest rate increases. Headline retail price inflation has jumped to 4.2 per cent, and underlying inflation excluding mortgage costs climbing to 3.2 per cent, further away from the Government's 2.5 per cent target.

The symptom that is really worrying the experts whose job it is to keep inflation on target is the sharp pick-up in earnings growth. Despite a still uncomfortable level of unemployment, there are skill shortages and too much demand for suitable employees to stop pay inflation taking off.

Isn't the problem just City bonuses?

IT would be nice to blame the City fat cats for all of the economy's woes, but it isn't that easy. Pull out the higher bonuses this year, and it trims the figures for earnings growth, but they are still on a steep upward path. Besides, bonuses are part of the pay package too, and also reflect businesses' need to retain and attract employees. What's more, bonuses have gone up across business - in manufacturing as well as in financial services and IT. An awful lot of us have more money in our pockets, not just the champagne-swiggers in the Square Mile.

How did we get into this mess?

THE short answer is that Kenneth Clarke got us here. The former Chancellor turned down Bank of England advice to raise interest rates repeatedly in the months running up to the General Election. All credit to the man with the brown suede shoes: he did not indulge in the usual pre-election public spending spree. But he did cut income taxes, giving people the biggest boost to their after-tax purchasing power since the late 1980s, and he refused to prevent a boom by raising mortgage rates. That would have caused uproar amongst Conservative backbenchers.

Remember the Tories' election campaign slogan? "Britain is booming. Don't let Labour blow it". But Mr Clarke knows well that he would have had to spoil the party too if the election result had gone the other way.

Isn't Gordon Brown to blame too?

BY THE time Gordon Brown took over his desk at the Treasury, it was far too late to prevent last summer's boom. Internal Treasury forecasts at that time were showing inflation heading speedily for the 4 per cent barrier. The Chancellor's first two acts were to raise the cost of loans, and to give the Bank of England the freedom to set rates from then on. The theory is that independent central banks do not succumb to the same political temptations. If the Bank's Governor, Eddie George, had been in charge a year earlier, there would have been less of a boom, and therefore less of a risk of bust.

However, handing over control of interest rates to the Bank has been controversial. One set of critics thinks it has been trigger-happy, while another set thinks it should have been much tougher, much earlier, to get the economy and inflation back on an even keel.

What is the Monetary Policy Committee?

IT IS the group of nine experts at the Bank of England appointed by the Chancellor to set rates. All are eminent economists and bankers. The catch is that since the new year they have disagreed with each other more and more. Their debate reflects the split evidence from events on the ground. At one end of the spectrum, DeAnne Julius, formerly chief economist for BA and Shell, reckons there will be a sharp downturn triggered by the strong pound and weak exports. At the other Willem Buiter, an academic economist, has voted since January for higher rates in order to nip the pay and inflation pressures in the bud.

The division on the MPC reflects the flaw in Gordon Brown's plan. The Chancellor expected the committee to act more decisively last summer, and Eddie George, chair of the MPC, admits that with hindsight it might have been a mistake not to. But, as the old joke goes, you always get more opinions than you have economists. Between the Clarke legacy and the Bank of England splits, Britain looks set for the worst of both worlds: slow growth and higher inflation.

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