Hamish McRae: Don't be dispirited: recoveries do happen, but they take time

Economic Life
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The Independent Online

So there is a date at last for the first of the Budgets this year, 24 March. You might think it a strange business that the Treasury is only able to confirm the date two weeks ahead, the shortest lead time I ever recall, but that will be the least strange aspect to it all.

For this will not be the real Budget. That will come after the election. The Tories have promised an emergency Budget within 50 days of taking office, and that is the most likely option. Were by any chance Labour to get back, this pre-election Budget would have to be modified later in the year. Indeed, there is a real possibility that there will have to be three Budgets if the election does not bring a majority government: this one, a post-election emergency one, and then the real deal in November, perhaps after a second election, when whoever is in office then is forced by the financial markets to bring in a sustainable programme.

It might seem a bit unkind to be suggesting that neither an incoming Tory government nor a still-hanging-on Labour one will produce a credible plan for cutting the deficit, but we do have to accept that possibility. I don't think most people quite realise the financial peril the country is in. For what it is worth, though, there are two reasons to suspect that the Tories will get a majority, albeit a small one.

One is the calculation done by Simon Ward, economist at Henderson, relating the Government's position in the polls vis-à-vis the principal opposition party, with changes in various economic numbers, including the retail price index, house prices, unemployment, and so on. His model predicted that the Tory lead would narrow to 2 per cent as more favourable data came through, but that it will widen to around 11 per cent by early May. It is only an economic model, and it does assume that people vote with their purses and wallets, but it has been pretty accurate in the past.

The other is what has been happening to spread betting. The best way of seeing where the serious money is going on the election is not so much the bookies' odds but the spread on the number of seats that each party is expected to win. The Tories are quoted on 331-336 seats, Labour on 232-237 seats and the Lib Dems on 55-58. These results would mean a narrow majority for the Tories.

The economic background to the Budget has deteriorated slightly in the past few days, with some bad trade figures, bad industrial output figures and the new monthly estimates of GDP showing the economy only inching forward. These monthly figures are calculated by the National Institute for Economic and Social Research and have proved pretty accurate, in some cases more accurate than the first official estimates, for these are frequently revised.

As you can see from the top graph, which compares this recession with those of the 1930s, the 1970s, the 1980s and the 1990s, this one seems more like the 1990s than any other, with about the same fall from peak to trough, falling a bit faster but bottoming out a little earlier. If it continues in that mode, there should be some sort of continuing slow recovery, but it would be quite possible for there to be another dip. Indeed, I rather expect that to happen, and it may be happening right now. But we should not jump out of the window at this prospect: it is normal, if dispiriting. What seems virtually certain is that, as the NIESR argues, the country will not get back to the previous output peak reached in early 2008 until 2012.

Will there really be a double dip? The bottom right-hand graph shows one reason why there might be. One of the key drivers of the economy, actually by far the most important single one, is consumption. One of the most important drivers of consumption is house prices. Ultimately real personal disposable income matters more, but in the short-term at least, rising house prices boost consumption. Since last spring house prices seem to have bottomed out. That happened around the same time as quantitative easing was brought in. Indeed, one of the aims of QE was to boost asset prices.

However that programme is coming to an end, and there is the prospect of an eventual rise in interest rates. Some commentators, such as Capital Economics, feel there will now be a fall in prices, and there does seem to be some softening happening right now. Put it this way. Whether or not prices start falling again they are unlikely to climb by much, for if they do start to do so, a lot of people who have been holding back will put their houses on the market. Bottom line: house prices are unlikely to give much support to consumption in the months ahead.

The bottom right-hand graph highlights another somewhat discouraging feature. The fall in sterling has been similar in nominal terms to the fall during the early 1990s, after sterling's expulsion from the European Exchange Rate Mechanism. But in real terms it has been even greater. This ought to be boosting demand for UK products by increasing exports and cutting demand for imports. This may well have been happening on the services account – you would, for example, expect more people to visit the UK and spend more when they do, and Britons to spend less abroad – but it has not been helping on visible trade. That is discouraging. Peter Westaway, economist at Nomura, comments that the markets are extracting their pound of flesh. In other words we need this devaluation to make the necessary adjustment, cutting consumption relative to output, and boosting demand through exports.

There are two possible reasons why this does not seem to be happening. One is that demand in the main UK export market, continental Europe, is still very weak. It is unfortunate that we have orientated our physical trade so much towards what will inevitably be a slow-growing market, rather than faster-growing ones such as India and China. Fortunately invisible (ie, service) exports tend to go to the rest of the world rather than to the EU. Europe will recover, of course, and the weak pound will help when it does, but there is not much to be done in the meantime.

The second reason is that there are time lags before a fall in an exchange rate affects trade patterns. It may well be that come another few months exports really will start to beef up demand. I expect that to happen, but have to admit that meanwhile there is little evidence of this.

All this makes discouraging reading in the run-up to the first Budget. But there is a silver lining. It is that by the summer, come the next Budget, things should be rather clearer. We will probably have had the double dip, and may be seeing more growth, and by then the fall in the pound should be feeding through into more demand. This is not going to be easy, and I do believe that most people have no idea of the scale of the squeeze on public spending that is about to hit the land. But comfort yourself with that top graph. Recoveries do happen, even if they take a long time to get going.

h.mcrae@independent.co.uk

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