Stephen King: Consumers may at last be recognising their apparent riches were an illusion

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Between 1997 and 2004 - the first seven years of Labour's period in office - the UK consumer did Britain proud. Over this period, consumer spending rose at a robust 3.5 per cent a year in real, inflation-adjusted terms. That's quite a lick. Since 1948, consumer spending growth has averaged a mere 2.6 per cent growth a year. So UK consumers - other than those who are scared of the Bluewater hoodies - have truly never had it so good.

The economy has enjoyed an unparalleled period of steady economic expansion. The inflation genie is firmly back in the Bank of England's bottle. Interest rates have been low. Public spending has boosted employment. The housing market has been strong. It is no surprise, then, that consumers have been rolling around in credit, as happy as pigs in the proverbial. They have really been living it up. Seven years of feast, you might be tempted to say.

And, as with that first biblically recorded business cycle, perhaps we are now about to get the famine. The underlying problem with consumer spending has not been its strength but, rather, its robustness relative to the economy as a whole. Over the same seven-year period, GDP has expanded at an annual average rate of 2.7 per cent. It doesn't take a mathematics genius to recognise that this state of affairs cannot go on indefinitely. Since Labour came to power, consumer spending has risen from 61.6 per cent of GDP to 64.9 per cent of GDP. If this continues, we will end up consuming more than we're producing.

Which is another way of saying that, in the future, consumers won't have it so good. The latest data suggests that consumers may already have reached this conclusion. Suddenly, being in debt doesn't seem quite so attractive. Credit card bills are being paid off. Mortgage equity withdrawal has slumped. Retail sales have weakened. All of a sudden the consumer seems to have gone on strike. And, if there's a reason behind this newly Scrooge-like behaviour, it probably lies with the housing market: assets that once looked so liquid suddenly look decidedly illiquid, stymieing the consumer's willingness to continue climbing the debt mountain.

There's no doubt that this shift in behaviour has caught some by surprise. After all, it was only a few months ago that some in the Bank of England were curling their fingers around the interest-rate trigger, ready to fire another monetary bullet into an overly exuberant economy. Yet the gun is now back in its holster and rate increases no longer seem to be on the agenda.

Of course, it could be the case that consumers will be newly resurgent later in the year. Retail sales slowed during 2003 only to bounce back in 2004. Somehow, though, I doubt it. John Butler, HSBC's UK economist, estimates that 70 per cent of the jobs created in the UK since 1997 have been directly related to the consumer and property boom, through high-street retailing, banking and construction. The slippage in the housing market, presumably a response to the Bank of England's earlier monetary tightening, may have been the trigger for the latest period of weakness, but we may now be on the verge of a classic downward multiplier, whereby an initial shock leads to weaker consumer spending, lower employment and, hence, even more consumer retrenchment.

That the consumer may be vulnerable really shouldn't be that surprising. The UK economy's strong outperformance in recent years relative to its European neighbours, has depended in part on the use of performance-enhancing policy drugs. Monetary policy was loosened more aggressively than in the eurozone after the bubble burst. And, having stuck to the Tories' spending plans during the first two years in government, the Chancellor was able to loosen fiscal policy just when it really mattered: other countries may have had recessions but Britain pulled through, seemingly unscathed.

Perhaps, though, the UK's better performance is drawing to a close. Maybe the changed policy framework was never enough to justify the consumer's rampage through the high street. Conceivably, the UK consumer, unwittingly, has simply "borrowed from the future", encouraged by low interest rates and a sudden boost to public spending. After all, without any significant increase in productivity growth, the consumer was bound to hit the buffers sooner or later: with unemployment already low and with companies keeping a watchful eye on wage increases, there simply wasn't anywhere else to go.

Optimists may well say that, in the absence of inflation, there is little reason to be despondent. This, though, misses the point. While it is true that inflation within goods and services has been very well behaved, it may well be that the Bank of England's inflation target is too narrowly defined. Think back to the beginning of this century. The fall in share prices proved to be bad news for company spending, hitting investment and exports. As companies retrenched, the obvious risk was a fall-off in demand that, in turn, could have left to an undershoot of the inflation target. Thus, the Bank of England was compelled to cut interest rates in an effort to persuade - perhaps even bribe - consumers to continue spending.

The Bank of England presumably didn't quite expect consumers to be so enthusiastic about spending. Nor did it anticipate the degree to which house prices were set to rise. Yet there is little doubt that these were reactions to the loosening of monetary policy that took place after the collapse in share prices. And those rate cuts helped foster an illusion. Falling share prices revealed, in a way, that we weren't quite as rich as we thought. By offsetting their decline through low interest rates and rising house prices, the illusion of wealth was somehow maintained.

Consumers may now, at last, be recognising that their apparent riches are more illusion than reality. Having borrowed on the basis of the dream, they are now waking up to a reality that's more hangover than hope. Asset-price gains can make any of us feel rich. But unless the output comes on stream to justify those gains, our wealth will be no more than a house of cards, a transitory moment of monetary froth.

From now on, life is likely to be considerably tougher for the Bank of England and for the Government. The past seven years have been easy. The next seven years will be a little more challenging. For the Bank, the key problem will lie in engineering a soft landing for the economy when the consumer appears to be going into reverse: to do this, rates will eventually have to come down and, to offset weak consumption, sterling may have to fall to encourage more exports. For the Government, the fiscal arithmetic will be the real challenge: if the Chancellor sticks to his fiscal rules, he may have to contemplate tax increases, stealthy or otherwise, or spending cuts.

Maybe, though, the ban on hoodies is a stroke of genius: perhaps it will prove to be the trigger for timid consumers to return to the high street and the shopping mall. In which case, in hitting its inflation target, the Bank of England should stop thinking about interest rates and start thinking about headgear.

Stephen King is managing director of economics at HSBC