Christopher Smallwood: Time for Brown to get out before the slowdown catches up with him

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The Independent Online

On entering the Treasury in 1997, Gordon Brown famously remarked that chancellors of the exchequer fall into two categories - those who fail, and those who get out in time. Two parliaments later, those words may return to haunt him for it looks increasingly as though, after an exceptionally good run, the world is finally turning against him. Unless he gets out soon, his carefully cultivated reputation for "prudence and caution" could be left in tatters.

In saying this, I am not thinking of the warnings of inflationary pressures which Mervyn King, the Governor of the Bank of England, issued at the beginning of the week. The Governor was concerned that a long period of falling import prices could be coming to an end, and that labour costs could be on the rise.

Such factors may certainly delay the cut in interest rates which until a few days ago the markets were confidently expecting before the end of the year. But they should not be allowed to mask the underlying reality that a significant slowdown is on the way, one which is likely to carry interest rates well below current levels.

In assessing the outlook over the medium term, it is important to escape from the chatter surrounding the issue of daily statistics, and look at the broader picture. In the great sweep of history, it is obvious that "prudence and caution" is the last phrase which can reasonably be applied to the progress of the British economy over the past decade or so.

The main driver of what has been an exceptional period of economic expansion has been a powerful consumer boom financed by an unprecedented increase in household debt. In the course of the last parliament, the economy was given a huge further boost as the Government's finances performed a £50bn about-turn, swinging from a £15bn surplus in 2000-01 to a deficit of about £35bn now. This plunge into the red was mainly to finance rapid growth in public spending, particularly on health and education.

The two motors of British economic growth since 1997, both fuelled by borrowing, are rapidly losing power. Most strikingly, consumer spending increased only 0.2 per cent and 0.3 per cent in the final quarter of last year and the first quarter of this, compared with an average quarterly rise of 1.3 per cent over the previous four years.

This shouldn't really have come as a surprise, since debt payments as a proportion of household incomes have reached record levels and five interest rate rises are having their effect. The Treasury used to argue that consumer debt was no problem, because interest payments accounted for only a small proportion of household incomes. This is true as far as it goes, but ignores all the other debt-related payments which people make, including the premiums on endowment mortgages and capital repayments.

Chart one, compiled by Capital Economics, shows that the total of all debt-related payments now represents as big a burden as it did during the crisis years at the start of the last decade. Plainly, people have as much debt as they can handle, are opting to save more and consume less, and in so doing are undermining the main factor which has provided most of the economic impetus since Labour came to power.

Equally, the Government, following the great splurge of the past four years, recognises that it too has to rein back, and plans to halt the rise in public borrowing (chart two) by bringing the growth of public spending more in line with the growth of the economy. The boost to the economy provided by the public sector is also at an end.

As these two motors splutter to a halt, what will take their place? Increased demand from abroad? Hardly. Not with US growth in decline, Chinese domestic demand falling to low single figures as Lombard Street Research recently pointed out, Euroland continuing to stagnate, and oil prices showing no sign of returning to historic levels. It is not difficult to believe that growth over the next few years could be markedly lower than it has been during Mr Brown's tenure at the Treasury so far.

Part of the reason for expecting quite a protracted slowdown is that the process of unwinding excess borrowing, whether by consumers or by government, is a slow business and likely to make things worse before they get better. On the Government side, that reassuring profile of declining deficits projected at budget time and illustrated in chart two, is unlikely to be achieved without further tax increases and spending cuts if growth in the economy falls away. The official forecasts rely on GDP growth exceeding 3 per cent this year and 2.5 per cent next. If growth turned out instead at say 1.5 per cent over the next few years, the budget deficit would rapidly rise, driving towards £60bn, according to Treasury estimates.

The Government would need to resist this, and if it wished to protect its public-spending programmes would have to raise taxes substantially, further depressing household spending. Trimming the growth of public spending below current plans would also hit households - another Capital Economics calculation suggests that the public sector has accounted for almost half the growth of household spending since 2000. It is really not difficult to construct a case that growth could be heading for something more like that 1.5 per cent figure than the Chancellor's 3 per cent.

But then there are offsetting mechanisms. As the economy weakens, the exchange rate can be expected to fall, but it is doubtful that this could make a substantial positive contribution if - as seems likely - overseas markets are also depressed.

Most importantly, we should expect a fall in interest rates. The most likely outcome is that the Bank will ride to the Government's rescue and that rate cuts will, after an uncomfortable year or two, in the end restore an adequate rate of growth. They will, however, need to be substantial if they are to keep the economy expanding at anything like the rate required to enable the Government to keep its deficit in check. Bank of England modelling suggests that a 1 per cent fall in interest rates is needed to boost GDP by between 0.3 and 0.4 per cent after a year. To return growth to its 2.5 per cent trend could therefore require a decline in interest rates of as much as 2 per cent.

But it is not clear how effective interest rate cuts are in stimulating activity when confidence is low: Keynes used to say that attempting to stimulate an economy by cutting rates in these circumstances was like pushing on a string. Moreover, after a while, the effect of the rate cuts fades away, so that a continuing series of reductions could be needed over a period of years, taking base rates to very low levels indeed while the public finances are being stabilised.

Whether or not the outcome is as extreme as this, it does not seem likely that Mr King need spend much of his time worrying about inflationary pressures during the next parliament. As for Gordon Brown, I can only refer him to his own piece of wisdom: it's important to get out in time.

Christopher Smallwood is the chief economic adviser to Barclays Bank

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