Hamish McRae: Low interest rates are hiding problems that will only emerge as growth returns

Economic View
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The Independent Online

Will this Christmas season be seen as the last hurrah, the final days of cheer before VAT rises and the spending cuts start to bite?

Or will 2011, like 2010, surprise by delivering rather faster growth than expected? While concerns about a double dip have retreated, except with regard to house prices which do seem to be heading down, there is widespread uncertainly as to the extent to which cutting the deficit will slow growth.

On the one hand there are the "deficit deniers" who still believe the government has made a serious error by correcting the deficit over five years rather than, say, seven. Most of these are in some way associated with the previous government, though there are also commentators who look to US policy, where fiscal consolidation has yet to begin, and feel it should be applied here.

On the other hand is the more mainstream view, which is that it is on balance less risky to get to work quickly on cutting the deficit because the credibility gained more than offsets the mathematical impact of fiscal tightening. That the Britain's borrowing costs have fallen partly supports this. Back in March, the yield on UK 10-year gilts was higher than the equivalent debt of Italy. Now it is more than 1 percentage point lower. But it is not just this simple calculation that justifies the Government's stance. The further point is that by establishing confidence that the coalition is getting public finances under control, it could credibly ease policy a bit if circumstances demanded.

I happen to think that the deficit deniers are completely wrong – and also rather arrogant in their refusal to learn from what is happening in the weaker countries in Europe. The European sovereign debt crisis is by no means over and I would be astounded if further rescues are not needed next year. But we will see.

Meanwhile, let's focus on what is going to happen in the UK. The best starting point is to look at the National Institute graph, shown here, which plots what is happening during this recovery compared with previous ones. As you can see we are close to the profile of the recovery from the 1980s recession. That does not mean what we will stay on that trajectory but I have just been looking at some projections by Goldman Sachs that suggests that we pretty much will.

That's the good news: the recovery is probably intact. Now for the less good. While the economy will go on growing, incomes will be squeezed. At the moment, the retail price index is rising by 4.7 per cent a year and will almost certainly top 5 per cent when the VAT rise comes in. But incomes are going up by more like 2 per cent, with the incomes of many people being frozen. So if people are to maintain their living standards, they will have to cut down on savings. Worse, while until November it did seem that unemployment was falling, the relatively good jobless numbers concealed the fact that most of the new jobs being created were part-time. As you can see from the right-hand graph, full-time employment has yet to recover.

Better, you might think, for people to have part-time jobs than to have none at all, and for many people the lifestyle case for part-time working is strong. But some of these jobs are being filled by people who would prefer to work longer hours and earn more and from a macro-economic point of view, lower earnings means less spent in the shops and lower economic growth from this source.

So, I think the pattern next year, after a blip when the VAT rise hits, will be of resumed growth but with people feeling they are running hard to stay in the same place. There will be no feel-good factor in the private sector and a sense of rising pressure in the public sector as fewer workers have to deliver the same or better services. People in the private sector, accustomed to having to increase productivity all the time, will say "welcome to the club". Squeezing a public sector that has had an unprecedented increase in resources over the past decade may be quite popular in the country at large, but it would be naive to think that there will not be some dent to overall demand.

I have a further concern, albeit an obvious one. It is that inflation will be sufficiently bad to force an early rise in interest rates. Obviously, at some stage, monetary policy has to get back to normal; the question is when? As Capital Economics noted in a recent paper, consumer price inflation is now 3.3 per cent. A year ago, the Bank of England's central forecast was that it would be 1.5 per cent. One member of the monetary policy committee, the US economist Adam Posen, forecast last week that in two years' time inflation would be below 1 per cent. But that is an extreme view and while the committee should have mavericks on board, this does seem a bit rum.

Professor Posen has also ruffled feathers by suggesting to the Treasury Select Committee that Mervyn King was being "excessively political" in his support for the coalition's fiscal plans. The Opposition inevitably seized on this to attack the Government. My own view is that it is odd that a foreigner should feel it appropriate to enter into British political debate in this way. Imagine the outcry were a Briton on the open market committee of the Federal Reserve to criticise Ben Bernanke for being too political. Of course, they would not have a foreigner there. Non-nationals who have jobs in the UK should surely strive to be absolutely apolitical. I do recall a few years ago an Irish head of a UK-based multinational arguing that Britain ought to join the euro – he must feel a bit of an ass now.

Whatever your view about UK monetary policy, the fact remains that many depend on ultra-low interest rates to stay afloat. As the Bank itself warned last week in its report on financial stability, there is latent distress being concealed by these low rates. People need to start preparing for higher rates, recognising that near-zero rates are no more normal than a fiscal deficit of 11 per cent of GDP. And the better the recovery, the earlier likelihood of an increase in rates.

In a busy week for EU news, it's the eurozone which still holds the attention

A bit of clarification on Europe. On Friday, the EU leaders agreed to create a "permanent crisis mechanism" that will take over in 2013 from the bail-out fund that rescued Greece and Ireland. The UK is not involved as this is only for the eurozone, though there will need to be EU treaty changes. Details are hazy but the plan will be hardened up in the spring.

While it is easy for non-eurozone countries to criticise the plan, the general line makes practical sense. There are lots of details to be settled, including rather big matters such as if the EU should issue bonds in its own name, with some sort of guarantee from member states, to help the bail-outs as needed. There is huge opposition to this from Germany in particular. Further, at the EU meeting there was a reassertion that eurozone countries would be urged to get their deficits down to 3 per cent of GDP by 2013, something the UK cannot possibly achieve.

Separately, a couple of other things have happened. Ireland's debt has been sharply downgraded, which most people will recognise as a bit of a "stable door" reaction. Perhaps more significantly, it looks as though there will also be downgrades of Spain and Belgium, as there were warnings about both last week. The rating agencies reflect market opinion rather than lead it but it will be hard to get through the rest of the winter without more ructions. The ECB increased its capital last week in preparation for more instability.

So, it has been a messy week – a lot of news but hard to pick out which bits matter. The next few months will give a clearer idea as to what will happen to the eurozone, the huge issue being where the bailouts stop: is it just Portugal or will other bigger economies need help? My instinct is that the eurozone will scramble through for a few years, but will not be in any shape to face the next recession when it comes.