A time for resolutions and a taste of humble pie

The worst is behind us, the rate of deterioration in economic growth last year was extraordinary
Click to follow
The Independent Online


IT'S A new year and time, once again, to make a few resolutions. One useful resolution for economists might be to eat a bit of humble pie and reflect on past errors. A quick glance at the record of the forecasting community over the past few years suggests that the ability to get things right is pretty poor.

On Wall Street, the generally accepted view a year ago was that the US economy would achieve growth of 3 per cent in 2001. A year later, the outcome looks more like 1 per cent. In Frankfurt, economists thought that Germany would see growth of 2.8 per cent. Again, woefully too optimistic: the outcome is going to be about 0.7 per cent. At the end of 2000, a lot of economists in Tokyo were still quite excited about the Japanese technology boom, forecasting growth in 2001 of 2.0 per cent. Minus 0.3 per cent now looks closer to the truth. UK forecasters have had a better track record with a forecast of 2.7 per cent and a likely outcome of about 2.2 per cent. Even here, however, there are reservations: would forecasters have performed quite so well if they'd known how bad the rest of the world was really going to be?

Given this less-than-glittering performance, it's perhaps a little unwise to take the prognostications of the forecasting community – of which I'm a part – too seriously. For non-economists, perhaps a useful resolution is to put less weight on the economists' forecasts and ask them, instead, about the risks to their forecasts. Where might things go wrong? What could upset the applecart? Where is the weakest link?

Let's start off at home. The UK economy is flavour of the month, if only because of the comments from the Governor and Deputy Governor of the Bank of England last week. The consensus view for the UK this year is growth of 2 per cent, little different from last year's likely outcome. What's more interesting is the extent of agreement on this view. The gap between the highest and lowest forecasts that make up the consensus for this year is lower than in each of the past three years.

Yet we know there is a good chance of things going wrong. What's happening in the UK today is simply not sustainable. As we have seen from the US experience, unsustainable paths have a nasty habit of heading up the proverbial creek with an ineffective policy paddle. But which way to jump? We know that consumer spending has to slow down. The mechanism for that slowdown, however, is unclear.

One possibility – the short-term risk – is that consumer spending and the housing market weaken sharply in the event of rapid increases in unemployment. Under these circumstances, current growth expectations may be too high and interest rates may have to fall further. Another possibility – the longer-term risk – is that global growth picks up in the second half of the year, consumer spending remains strong and the Bank of England is forced to raise interest rates aggressively. Eventually, consumers capitulate under a mountain of debt and the economy ends up underperforming, rather than outperforming, the rest of the world in 2003. Either way, growth may not be secure. It's just a case of comeuppance this year or next.

Moving to more global themes, the most obvious danger is that hopes of a decent economic recovery this year begin to fall by the wayside. There is almost complete unanimity within the forecasting community that things will get better. Yet, in my view, there has been little debate about the strength and sustainability of the expected upswing.

I agree that the worst is probably behind us. After all, the rate of deterioration in economic growth last year was extraordinary by anybody's standards. There must still be doubts, however, about the pace of recovery. Over the past 20 years, it's been the American consumer that has bailed out the US economy. Yet the consumer today is awash with debt, has seen a major erosion of wealth and may choose to rebuild savings.

Moreover, it's not just consumers that are in trouble. I suspect that US companies overinvested in the late 1990s, seduced by the siren voices of technology. If that's true, capital spending is also not an obvious candidate to lead the US economy out of recession. And, unless growth picks up strongly elsewhere in the world, thereby boosting US exports, that leaves fiscal policy as the only real source of strength. Meanwhile, there are still niggling doubts about the persistence of housing market strength, an area which has, to date, given a shot in the arm of an otherwise struggling economy.

There's also the risk of an economic false dawn. It may be the case that economies pick up more quickly at the beginning of this year than generally expected, only to head back down again later on. This kind of up and down pattern is hardly unprecedented. After all, America's 1990 recession was followed by a renewed dip – not quite a true recession – in 1992 while the 1980 recession was followed by the recession in 1982.

What else should we be worrying about? Well, deflation is an obvious candidate, a subject I wrote about at length on 17 December. But, at the opposite extreme, some people are worried about a return of inflation. What if policy has been loosened too far? What if the rebound is very strong? What if pricing power returns?

Personally, I find these fears rather unconvincing. For starters, inflation typically falls in the first one or two years of recovery. Second, globalisation has eroded pricing power, possibly in a decisive fashion. Companies are now better at slashing costs than raising prices. Third, the environment now is not like the early 1970s. Back then, a climate of rising price expectations was well-established even before the oil price increases in 1973. It is difficult to argue that a similar climate exists today.

Other risks must include a dollar decline – a perennial favourite but one that never seems to come to pass – and a collapse in the yen, which may be just the ticket for Japan but, unless handled carefully, could be a problem for some countries elsewhere in Asia.

Finally, there are European dangers. Within the consensus, eurozone forecasters have huddled closely together. There is little room between the most optimistic and the most pessimistic. The assumption is monetary policy will do the trick, enough to ward off a fully-fledged recession. However, it may be that the European economy is more exposed to developments elsewhere in the world and has been more affected by global technology trends than has generally been thought. Moreover, Europeans have significantly increased their holdings of foreign assets over the past few years, suggesting a greater financial exposure to developments on the other side of the Atlantic. All of this is very difficult to quantify but it may be the case that the downside risks are bigger than most economic models would currently suggest.

Now, all of this might sound a bit like I'm turning into the famous two-handed economist: "On the one hand, on the other hand". I do, however, have some convictions. For what it's worth, I think the key stories for the year ahead are going to be the disappointing pace of recovery, the threat of deflation and an environment in which interest rates remain lower for longer than the market currently expects. However, I've got my humble pie in the freezer, just in case I have to help myself to a large slice at the beginning of 2003.

Stephen King is managing director of economics at HSBC.

Comments