Comment: Button up and think of spring

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The Independent Online
At a time like this it is probably best to think long. That is not just because the games on the currency markets have still to be played. Nor is it because there may be a further shock on Monday following the Maastricht referendum in France. Nor is it even because UK policy is all over the place, though it certainly is. On Wednesday night Treasury officials were declaring that the 12 per cent base rate was important to signal that the Government still had an over-riding priority to hold down inflation.

We need to think long because it will take some weeks before the impact on the real economy of Europe becomes at all clear. We know, for example, that confidence is crucial to business and personal behaviour, particularly at this stage of the economic cycle. The chaos of the markets might presumably be expected to damage confidence. But that might be offset by the positive reaction on equity markets: no one knows. It is perfectly possible that confidence will rise as a result of the feeling of liberation that the business community will feel.

So cast forward then to next spring and ask what a reasonable expectation might be for the state of the British economy. It will not have been an easy winter, not so much because the UK economy will have been hard put to manage a spontaneous recovery, but more because the world economic picture will have been pretty sombre.

The fact that the US elections will be past will have taken away some uncertainty but whoever wins, the policies of the president will shift. In any case the debt burden and the budget deficit will remain.

Pressures in Japan

In Japan, pressures already in the pipeline, in particular from the level of industrial stocks, will have held growth to very low levels. Indeed Japan may well be in its most serious recession since the one that followed the oil shock of the early 1970s. The adjustment it needs to make in the coming months is of a similar order of magnitude.

Similar pressures will ensure that the German economy is flat, which will in turn have held back France and (at whatever exchange rate of the lira) Italy. There will be a lot of talk of the world economy being primed for recovery, but not a lot of evidence of anything actually happening.

But for once there is a good argument that the talk will be right. Our own politicians (and most of our economists) have been so hopelessly wrong about the timing of the UK recovery that it has become very difficult to believe that there will ever be any recovery at all. But that is because politicians are inclined to believe their economy forecasters.

All the conventional forecasts are constructed out of econometric equations which are based on past performance. If an economy under-performs, the mathematics of the models tends to push the economy back to its trend path. When there is a big shift in behaviour, such as the rundown of savings in the late 1980s or the surge in savings in the last 18 months, the equations get things wrong. Come next spring the basis for the recovery really should be in place.

Some things are easy to predict. Inflation will be running at around 3 per cent or less. The retail price index may have pushed up a little through the winter, partly as a result of imported inflation from the fall of the pound. But once that has worked through the running, monthly increases will be very small. Were sterling to fall sharply over the winter from yesterday's levels, inflation would indeed be higher, but short of some catastrophic decline in the pound, inflation will remain a disappearing problem.

European interest rates will also be coming down fast, though many may feel not fast enough. The German recession will have been marginally deepened by the rise in the mark taking place at the moment. Short rates may well be down in the 6 to 7 per cent region, allowing our base rates to be at 8 per cent or lower. This will still be high in real terms, and it will be slightly higher than if we had maintained the old mark parity. But base rates will be low enough to stabilise the housing market after some further price falls in the winter.

The main thing putting a floor under house prices is that, come the spring, relative to income they will be the most affordable for a generation.

Demographic help

Unemployment will have crept up during the winter but the rise will be moderated by the relatively small number of school leavers. Demography is working the right way. The first part of the 1990s sees a steady fall in the number of 18-year-olds until 1995, and then only a very slow recovery. The number of entrants into the labour market will be further cut by the rise in the proportion of people going through the universities.

The current account will still be in deficit, but by the spring the devaluation will have started a transfer of resources across into exports. We should be heading up the J-curve, the phenomenon whereby the current account deteriorates initially after a devaluation but then recovers. Occasional surpluses on a monthly basis are possible, though more as the result of curbed imports than of rising exports.

All this is pretty clear. What are the imponderables? The most interesting issue of all is whether individuals will feel they have worked off sufficient debt to allow a spontaneous increase in domestic demand. There will have been some improvement in export demand, but given flat global markets, this is not going to be dramatic. Growth will have to be generated at home as well.

For individuals, the floor under house prices will be the most important determinant of the need to save. Predicting the savings ratio is one of the most hazardous of all economic forecasting, but we do know that people save if they are worried about inflation or see a decline in the value of their assets. Inflation will not be a problem but the falling asset prices, particularly of houses, has been. If house prices fall individuals build up their savings to offset this. It looks probable, therefore, that the savings ratio will continue to rise through the winter, even though it is now close to its post-1970 'high'. But come the spring it should start to fall. When that happens, the recovery is clearly under way.

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