Anew year brings a new opportunity for economists to humiliate themselves by getting the forecasts utterly wrong. No major forecasting body caught correctly the scale of the slump in the UK last year – all were too optimistic – so why should people take seriously any commentaries, including this one, about the likely path of the economy this year?
There is one thing that we can be very sure about: the need to come to terms with the catastrophe of public finances, of which more in a moment. But as for the likely path of the UK economy, or indeed the world economy, the most we can offer is intelligent guesswork. Please regard what follows in that spirit.
The starting point is that some sort of bounce has taken place during the past few months, here in the UK but also across the developed world. Things are no longer going down. However that modest recovery is in a sense artificial in that it has required monetary and fiscal policies that have been unprecedented in peacetime. These include near-zero interest rates, quantitative easing or "printing money", huge fiscal deficits, one-off schemes such as the cut in VAT, and the car-scrapping programme. These cannot continue. Indeed those last two devices have now come certainly to an end and the "QE" programme probably has. Similar schemes in other countries are also being wound down.
So within a few months the economy will, so to speak, be on its own. The policy stimulus will have ended. Interest rates will have started to rise and fiscal policy will have been tightened. That goes for us here but it also applies to other developed countries. The only issue is timing: does policy go into reverse in the next few months or towards the end of the year? While that may have political significance, it is hard to see it having much economic significance. If everyone knows something is going to happen, they adjust their own behaviour in advance.
You can see that already. One of the really interesting things that has been happening in recent months has been the way in which people have been paying back debt. Home-buyers seem to have been using the period of very low interest rates to reduce the size of their mortgage. The household savings ratio, which went negative two years ago as people borrowed more and more against the value of their homes, is now back to nearly 9 per cent. That is rather higher than the long-term trend. We have in the space of few months gone from being spendthrifts to models of prudence. Why? Presumably because we know that these economy-boosting policies will not last and we had better get our finances in shape while we can.
In any case, the normal pattern for the downward chunk of an economic cycle is for recovery to be uneven. We know quite a lot about economic cycles and for all the claims that the present cycle is unprecedented, the fall in output from peak to trough may turn out to be slightly less than the fall that took place in Britain in the early 1980s. So there are precedents and if you look at these previous cycles, you often see an initial recovery, then some falling back of activity, and only after that does steady growth resume. If there were some kind of stutter in the economy in the coming months, as I rather expect there will be, that would be absolutely normal.
Normal is not nice. We may now be starting a period where things seem to be slipping back. Retail sales may well be quite soft in the coming months; the recovery in house prices may pause and prices fall back for a few months; the unemployment figures, which did seem to be turning round, may be disappointing. And there may, more generally, be a weakening of sterling and a significant rise in long-term interest rates.
The reason for the last two points here would be a loss of confidence in the willingness of the country to get its finances back in order after the election, most probably because of fears that the next government will not get a working majority and, accordingly, will have neither the authority nor the confidence to tackle the deficit.
That will indeed be very difficult. As you can see from the first graph, which shows what has happened to public spending in real terms (i.e. adjusted for inflation) during the past decade, the problem is not so much that spending is shooting up now, but rather that the Government in reality lost control of its spending between 2002 and 2006. The economy was growing at a trend rate of 2.5 per cent, maybe a little higher. But spending was rising at between 4 per cent and nearly 8 per cent. Yes, spending has risen in response to the pressures of recession but the real damage was done between 2002 and 2006.
The gap between spending and taxation was covered by borrowing. As you can see from the other graph, tax revenues in real terms were actually quite strong between 2003 and 2007, rising by around 4 per cent a year. That strength concealed the underlying weakness in public accounts. But then revenues collapsed. In the year to November, they were running 11 per cent down on the previous year.
The central difficulty the next government will face is that these revenues may take a long time to recover. You can put tax rates up but you may not get much more money. Indeed, you may even get less. In the view of the independent Institute for Fiscal Studies, the rise of the top rate of income tax to 50 per cent will probably bring in no additional revenue.
People do not seem to understand this. I find it bizarre that they attack bonuses when it is the tax revenue from the people who get big bonuses that helps keep down the tax rates for the rest of us. Can the next government explain to voters that it needs more tax revenue and it may actually receive more revenue by cutting some rates, while increasing others? Tricky.
The key point here is that the first half of the year will be very difficult. It is very hard to see any way round that. Whether the second half turns out to be better is still to play for. A bit will depend on the new government but more will depend on luck. We need a sustained world recovery. We need global interest rates to remain low. We need a competitive sterling, but not a run on the currency, which would push up long-term interest rates and increase the cost of servicing government debt. The trouble, of course, is that when you need luck you tend not to get it.
What I am reasonably sure about, however, is that by the end of this year, the recovery will be in place and we can look to 2011 being a much brighter prospect. The public-sector deficit will take several years to correct but the better the growth, the more quickly it can happen. Remember that in the bumpy months ahead.Reuse content