Hamish McRae: The bigger picture suggests there is cause for concern

If the economy can grow at about 3 per cent the Chancellor's sums begin to add up
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The Independent Online

Pause for breath after the pre-Budget report - and let's think about the way the economy may unfold during the next year. On Monday the Chancellor confirmed what we knew: that slower growth had done some damage to public finances but that he could probably scramble along a bit longer without imposing substantial new taxes.

But his fiscal difficulties have also clarified some of the big questions facing the economy. For example, to what extent will it be able to continue its relatively brisk growth without a continuing stimulus from rising house prices? There were some bad figures for manufacturing on Tuesday, suggesting that we should not expect too much additional growth from that quarter. But then I don't think we really expected that. The more disturbing recent information was the very poor expectations from the retailers about future demand, as revealed in the CBI survey last week.

There does, on the other hand, seem to be some modest revival in the housing market, which should boost demand. It is not clear how lasting this will prove.

To be clear: the past few days have sharpened perceptions of the dilemmas facing the UK policymakers: monetary fiscal and structural. First, there is a short-term issue as to whether growth will pick up of its own accord. That is the core of the dilemma facing the Bank of England's monetary committee, meeting yesterday and today. On the one hand it must be very worried about the poor outlook for consumption, but on the other it cannot sensibly cut interest rates until it has evidence that the last cut was insufficient to stabilise the housing market.

Second, there is the medium-term question as to the level of growth the economy is likely to sustain in the next two to five years. And third, there are a string of structural questions about the underlying competitiveness of the UK economy, the drag created by over-regulation and over-complicated taxation and so on.

You can see something of these dilemmas in the graphs. Everyone seems to agree with the Treasury that growth will recover next year. What happens after that is open to question.

The first graph highlights the fiscal problem. It shows its projected range for growth through to 2008, plus last month's Bank of England forecast, which is very similar. It also shows the forecast of Barclays Capital, which reflects the somewhat more sombre mood of the independent forecasters. This also shows the rebound but suggests that peak growth in 2007 will remain less than 3 per cent, not the 3 to 3.5 per cent of the Treasury and the Bank of England.

This small difference matters because if the economy can grow at about 3 per cent the Chancellor's sums begin to add up; if trend growth is lower, they don't.

The second graph shows part of the relationship between the housing market and consumption and highlights the monetary question. Mortgage approvals, in theory at least, should give a leading indicator as to the state of the housing market, which in turn hits consumption. In this graph, prepared by GFC Economics, the mortgage approvals line is advanced six months. It is a pretty good "fit" with retail sales. As you can see, since approvals have recovered, there ought now to be a corresponding recovery for retail sales. But you have to be careful here. As Mervyn King, the governor of the Bank of England, pointed out, one reason for the weak consumption may be higher taxation. Taxes may not have gone up much but they have risen by about one percentage point of GDP, and the fear of further rise will also inhibit people.

The Christmas season sales will be a key test. The Bank cannot do anything about tax but it can cut rates. If Christmas is weak, the next cut in interest rates will come in February. If not, then a plateau at their present level is the most likely outcome.

And the structural dilemma? It is complicated. One of the big features of the past decade has been the extent by which the UK has improved its terms of trade. We have been exporting goods and services that have gone up in price - most obviously financial services - and importing things that have gone down, such as cars and clothing.

The temptation is to assume this can continue, if not forever at least for the foreseeable future. Maybe it can. But economic growth does still depend to some extent on reasonable growth in manufacturing, and exports are very dependent on it. This year the UK has not increased its exports as much as expected. If you look at the right-hand graph you can see that manufacturing is back in negative territory. In fact, its profile coincides with the growth profile, perking up on 2003 and coming down thereafter. What is happening to manufacturing is just one of many aspects of the debate about UK competitiveness. No country can be competitive in every aspect of economic endeavour. Nevertheless, the tough time of this sector does lead into a wider debate about the competitiveness of the economy as a whole, and in particular whether its solid position five or 10 years ago has eroded. The perception in the business community is that quite a lot of ground has been lost and it is the fault of this government.

This view is so widespread that there must be some truth in it. This then feeds back into the debate about the sustainable growth rate of the country. The only way the UK can grow at 3 per cent a year, or near that, is if it can achieve higher productivity. But it cannot do that if its businesses think the country is losing its competitive edge.

This big picture suggests the UK is heading into a period of introspection, fuelled by the fact that for the first nine months of this year it grew more slowly than the eurozone. But whether that is principally because of the waning of the consumer boom, or because of a weakening competitive edge, I don't think we can say. But if business is concerned, then so should the rest of us be.