Hamish McRae: The people understand the 'seven years of plenty' are over - even if Whitehall doesn't

We are ahead of Gordon Brown in changing our behaviour
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The Independent Online

Can this be right - a pick-up in the growth of the British economy and a simultaneous surge in government borrowing? Or is it the borrowing, by the Government and by the rest of us, that is indeed responsible for this surge?

On Friday we got the first estimates for growth in the second quarter. These show GDP up 0.8 per cent, equivalent to an annual rate of increase of more than 3 per cent. Service sector output was up 1 per cent on the quarter and manufacturing 0.5 per cent. Now these GDP figures are invariably revised later, so you need to be careful in interpreting them. Still, they are completely consistent with other evidence that the pause in growth of the past year is over - in particular with the recovery in the housing market this spring.

The pattern of growth since the present long boom began in 1993 is shown in the left-hand graph, together with an estimate of the growth of the private sector. More about the implications of that in a moment.

These GDP numbers came just after the figures for the Government's finances to the end of June. These show that public borrowing is already running ahead of last year, notwithstanding the Chancellor's aim for borrowing to be lower. The right-hand graph shows what has been happening here.

Of course it is too early in the financial year to panic, but there are two causes for concern. One is that this follows a pattern: public borrowing has repeatedly exceeded Budget forecasts for several years. Spending is consistently higher than forecast at the time of the Budget and tax revenues are lower.

The other concern is that given the solid growth performance, the deficit should be coming down. Instead it is stuck at 3 per cent of GDP, or a bit above.

When economies grow above trend ,they ought to improve their government's fiscal position. Tax revenues ought to be strong and public spending on welfare benefits weak. The long boom in the US has resulted in a surge in tax revenues, with the result that the federal budget deficit is now around 2.5 per cent of GDP - lower than that of any of the large EU economies. All right, you can argue that because US growth is above its sustainable trend, this isn't low enough. But given the uncertainties about what trend growth actually is, that's not bad. The US current account deficit is a problem but the fiscal one is not.

Now look at Europe. You would expect the large continental countries to be struggling with their fiscal deficits because they have such poor growth. But here we have decent growth and we still have a deteriorating fiscal position. Indeed - and this seems to me to be the key point - it looks as though we are having good growth largely because of our deteriorating fiscal position. If that is right, it is not sustainable. You cannot go on increasing borrowing for ever.

Go back to the graph on the left. We have had a huge increase in public spending since 1997. HSBC has calculated what growth would have been had it come solely from the private sector. Whereas during the period from 1993 to 1997 the two grew in line, since then they have diverged. You would expect that during the 2001-03 dip but not now. Last year, overall growth was 1.9 per cent but without the spur from the public sector it would have been less than 1 per cent - as bad as Germany.

This view that our position is not sustainable is supported by the new Item Club report to be published tomorrow. The club, now sponsored by Ernst & Young, uses the Treasury's own model (Independent Treasury Economic Model, hence the name) but with its own inputs to forecast the economy. It projects growth at 2.5 per cent this year, 2.5 per cent again next, and 2.8 per cent in 2008 as the world economy recovers from the period of high interest rates.

If that does not sound too bad, it does require some shift of resources into exports and both individuals and government tackling their level of borrowing. Actually, we ordinary punters have started to do so, with consumer borrowing in decline and the savings ratio rising. The latter has doubled from a trough of 3 per cent during 2004 to 6 per cent now. In a sense we are ahead of Gordon Brown in starting to correct our behaviour.

So what does all this mean? Peter Spencer at the Item Club reckons we will "muddle through" and I think he is right. But he also believes that because we can no longer rely on consumption and public spending to drive the economy forward, the "seven years of plenty" are over. That must be right, too. So growth has to come from exports and private investment and both have been rather disappointing. We ought to be doing better in the booming markets of East Asia, in particular China, and we are not when compared with Germany and Japan.

I suppose we are intuitively aware that the fat years are over. The notion that people collectively make better decisions than the experts was described in a brilliant book, The Wisdom of Crowds, by the economist James Surowiecki. This is caught in the sub-title: "Why the many are smarter than the few and how collective wisdom shapes business, economies, societies and nations". That is a bit of a mouthful but you can see the idea. Crowds don't always get things right but they are more likely to do so than other decision-making processes, provided they have certain features. The key ones are that they are independent, have a diversity of view, are decentralised and so can tap into local knowledge, and have some way of bringing together their wisdom.

By contrast, hierarchies tend to make bad decisions, as do crowds that operate within narrow national boundaries or who are swayed by an individual charismatic speaker. I suppose you could say that what we call the market - but which is actually just aggregated individual decisions by millions of people - is a good example of such wisdom.

Now apply that to the UK economy at the moment. To take a rather different example, no one planned that some half a million workers should come into the UK from the new EU member states. But they have, and they have enabled growth to continue without inflationary strains

Similarly, to save more and borrow less (but still buy a home if you need one) is an example of the crowd being wise. People are deciding that the party is nearing its end and it is time to don the bullet-proof vest in case things turn tough.

If only we could persuade the Treasury to heed the crowd rather than have this bossy "Whitehall knows best" approach, then maybe the public sector would have started to bring its finances into order more swiftly. But it hasn't and that is a shame.

China moves to rein in runaway growth

If Europe is still worrying about growth being too slow, China is worrying about it being too fast. Its economy grew at an annual rate of 11.3 per cent in the second quarter and there was a record trade surplus. So last week it brought in new measures to try to curb the scale of the boom.

The People's Bank of China said commercial banks would have to hold a larger proportion of their deposits as reserves from 15 August - the effect being that they would have less to lend. It was the second such tightening in two months.

The central bank warned that the trade surplus was too large and that investment had grown too quickly. China's efforts to hold down its currency have resulted in its reserves reaching $941bn (£506bn), the largest in the world. And it is hard to sterilise these funds and stop them leaking into domestic demand. It has, however, chosen to try to curb this demand rather than allow the exchange rate to rise.

Will it work and does it matter anyway? The second part of that question is easier to answer: what China does matters hugely because it has become the main driver of commodity and oil prices, as well as being one of the two countries (the other is the US) contributing most to global growth. It passed the UK as the world's fourth-largest economy last year and, on my rough calculation, is set to pass Germany into third place in 2008.

But will it work? Yes, in the sense that by reining in credit hard enough, you can always bring an economy to a halt. The trick is to do so gradually and that is much harder.

What I found most interesting about the authorities' action last week was the "jaw-jaw" - trying to talk both borrowers and lenders into more cautious behaviour. Thus the statement from the vice-governor of the central bank, who warned against "the blind expansion and building of redundant, low-value-added industries".

And announcing those growth figures, the National Bureau of Statistics said: "An economic model based on excessive fixed-asset investments and exports is not sustainable.'' Exactly the opposite problem to the UK then.