Hamish McRae: It's the economy, Mr Cameron. It can't suddenly be 'transformed'

Economic view
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The Prime Minister's assertion that the Government will "transform" the economy carries the danger that it will sit alongside his predecessor's boast that he had abolished "boom and bust".

Governments do, over time, have the power to nudge the economy one way or another, and they certainly have the power to muck up the public accounts. But to transform the economy sounds over the top: ministers can pull the levers of power, but they will discover, as did their predecessors, that there is nothing connected at the other end.

Nevertheless, there are things already happening to the economy – not as a result of public policy, but simply in response to market signals – that point to a rebalancing of output. In other words, the economy is already being transformed and in a way that is both necessary and helpful.

You can see the big message from the two graphs. As anyone who is planning a trip to the US will have noticed, the pound has fallen very sharply over the past 18 months. Even trips to Europe, which have become a little more reasonable in recent weeks, are still expensive compared with the pre-recession world. According to economic theory, a material fall in the currency should, after a time-lag, boost exports and cut imports. Exports become cheaper and/or more profitable so we export more; imports become more expensive and so we substitute home output. Up to now, there has been some concern that demand in the UK's main markets was so weak that we would not be able to take advantage of the low pound. But the very latest surveys of exports seem to suggest something big is happening. As you can see from the graph on the left, exporters are now more optimistic than they have been for several years. Actually, it may well turn out that they're becoming as optimistic as they were in the mid-1990s, after the pound was kicked out of the European Exchange Rate Mechanism.

The other graph shows the flip-side, austerity at home. Until recently, consumption has held up not too badly, given the squeeze taking place on real incomes. Many people have not had a pay rise at all in the past year and the retail price index is up more than 5 per cent year on year. But as you can see, the very latest numbers are very soft, and anecdotal evidence from the high street suggests sales may be weakening further. There may be a little burst of big-ticket items being bought ahead of the forthcoming emergency Budget, to get the purchases in ahead of the probable rise in VAT, but expect a weak autumn.

At one level, this is worrying. Consumption is around 65 per cent of the economy. Overall demand has clearly turned up, but we are experiencing a weaker recovery than most other countries, so you really don't want consumption to fall off too fast and make it weaker still. There is an obvious possibility, or even a probability, of a double-dip recession.

The feeling I have been getting from economists I would trust suggest the second quarter will be reasonably strong, but no one I have spoken to is confident about the autumn. A lot will turn on the emergency Budget, not just in what is in it, but how it is received. We are walking on a tightrope. Fiscal policy must be tightened, but not too swiftly. Monetary policy will have to be tightened, but not too swiftly either. Both have to be credible in the medium term. I was talking to a senior policy-maker the other day who felt the UK has been incredibly lucky in the extent to which we have been given the benefit of the doubt that we would fix our deficit and not try and inflate away our debts. So keep your fingers crossed.

Meanwhile, each new policy statement by the Government is being picked over for clues as to future policy. The row about capital gains tax has led to assurances that enterprise will not be damaged. There have been vague assurances on company taxation and somewhat stronger ones on regulation. But the statements that I personally find least credible are the promises to rebalance the economy away from London and the South-east and away from financial services and towards manufacturing.

"Government must get out of the way where it is inhibiting enterprise and it's got to get active in those areas where it is needed," Mr Cameron said. "Our economy has become more and more unbalanced, with our fortunes hitched to a few industries in one corner of the country, while we let other sectors like manufacturing slide."

At one level, that is fine. In an ideal world, you want a diversified economy, both structurally and geographically. The UK does have an "eggs in one basket" problem. But the plain fact is that London, the South-east and East Anglia are the only three regions in the UK that have, over the years, made a positive contribution to the public purse. Every other region is subsidised by the tax from these three. This happens because productivity in this part of the country is much higher than elsewhere.

Now there will be some rebalancing because financial services are unlikely to grow as a proportion of the economy as swiftly as they have in the past. But as that happens, the tax revenues from these industries will stagnate – and remember that banking is only one part of the entire financial and associated services industry. So the rebalancing of the economy may, initially at least, have the unfortunate effect of cutting tax revenue, just when the Government needs revenues most.

You see the problem. Yes, in an ideal world it would be much better were the economy to be more broadly-based. Yes, it would be much better if London and the South did not subsidise the rest of the country. But implying that the Government wants a smaller financial sector is to imply that it is prepared to have much less tax revenue. Actually, I rather think this will be the great problem: that tax revenues will come in far below expectations, for many reasons. But I would not wish this outcome at all. Governments need revenue and if they get less from rich bankers they will have to take more from us.

So do not, in reality, expect the Government to transform the economy. Expect instead the ever-greater tilt of economic activity towards London and the South-east to ease and the areas of success elsewhere in the country to expand further. Expect exports to continue to do well, as they did in the mid-1990s, when the country was in current account balance. And let's hope a more thoughtful and less prescriptive government than the last one will be able to encourage the private sector to improve its effectiveness. But this is not going to be an easy transition and, if the early 1990s are any guide, it will be several years before we can give a sigh of relief and can feel that balance has been restored.

Always look on the bright side of life...dum, di dum, di dum di dum di dum

Optimism is not in fashion. Those of us who try to see the glass as half-full rather than half-empty find it hard to make converts. And those who assert that everything is doomed are hailed as sages. So it is a pleasure to report that Matt Ridley, writer on the genome and other parallel topics, has turned his hand to economics. His new book, The Rational Optimist – How Prosperity Evolves (published by Fourth Estate) makes not just the case for optimism about the direction of the world economy but also makes us recognise how economic and technical advance has transformed people's lives over the past few centuries and almost entirely for the better.

This advance is the result of market capitalism, something that otherwise sensible people seem to find very hard to accept. The market is not a necessary evil but rather a civilising force, making people behave better. If you don't deal properly with people they won't deal with you. As Adam Smith noted, the market turns strangers into honorary friends.

Many other fashionable ideas are knocked on the head. The global trend towards living in cities is liberating, which is a bit of a relief since more than half the world now does so. The world will be able to feed itself, as the trend towards smaller families will cap the world's population at a level that it can cope with. He is positive about the continuing role of and benefits from the use of fossil fuels. (I did not know there was a scare about "peak coal" in 1866, one that mirrors our present concerns about "peak oil".)

Most encouragingly of all, he tackles the two great pessimisms of today: Africa and climate change. He concludes that the most likely outcome of the rest of this century is that Africa will get rich and there will be no climate catastrophe. The model for the former is China. In 1978 China was roughly as poor and as badly governed as Africa is now. It is now set to pass the US as the world's largest economy within another 20 years. As for climate change, well, you need to read the argument. Let me just pick one point: global food supply will probably rise as carbon levels increase because high carbon concentrations mean plants grow faster.