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Hamish McRae: The Treasury's predictions of recovery might just be right

Economic Life

Friday 08 May 2009 00:00 BST
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A turning point for the UK economy in the autumn? Most commentators now feel that the latest data coming through – in particular the purchasing managers' survey earlier this week – does suggest that some sort of economic recovery is in sight. That would square with the recovery in equities, which began in early March, for if that was indeed the low point of this cycle, then you would expect an economic bottom about six months later.

However, while there is a fair measure of agreement that the economy will have bottomed by the end of this year, there is much less agreement about the probable strength of the recovery. There are similarly some doubts about the durability of the present recovery in share prices, for there are bound to be some set-backs after the pretty much straight-line climb of recent weeks. But as far as the economy is concerned, the central issue is whether the rapid recovery expected by the Treasury or the much more muted one expected by most economists is going to be right.

Up to now the majority view, that the recovery will be lacklustre, has held sway. But while we have a right to be suspicious about all the chatter of "green shoots", particularly since the turnabout in house prices still seems a long way off, I don't think we should completely dismiss the possibility that the Treasury might be right about the pace of the recovery. It has in recent years been quite good about predicting economic growth. It got the depth of the recession wrong, but so did everyone else. What it has been terrible at has been predicting and then controlling public finances.

There are two broad reasons for supporting this relatively positive view. One is that the forward-looking data is encouraging. The output of the service industries, according to the latest PMI figures, has just about stopped contracting, and manufacturing output is falling at a much slower rate than before. The expectations of both service and manufacturing companies have turned up too. In fact, business expectations are the highest they have been since last May, the point at which we now know the last cycle peaked. The sensible conclusion from all this is that we are not at the turning point yet, but in another six months we should be there.

The second reason is that past recoveries have been both strong and sustained. I had not realised that until I looked at some recent work by the economics team at Goldman Sachs. The Treasury, far from being wildly optimistic as a lot of people including myself thought, is actually being quite cautious. The recovery it projects is actually slightly slower than that of previous cycles.

Of course, this cycle may not follow the pattern of previous ones. There are a number of reasons to suspect that this one is indeed likely to be slower. In the 1980s demand was supported by rising housing prices, as it was eventually in the 1990s. The most recent housing boom pushed house prices to a level that will take some years to be justified by rising incomes. The economy is more heavily dependent on financial services than it was during previous cycles, and since that industry seems unlikely to recover swiftly it will be less of a motor this time.

Most notably, the drag on growth from the need to correct the fiscal deficit will be more evident now than before. You can have a debate as to how quickly a deficit that seems likely to exceed 12 per cent of GDP should be brought under control, but you cannot have a debate about the need to do so. The Goldman Sachs forecasts on the deficit, interestingly, are almost exactly the same as the Treasury's, with net debt peaking at 79 per cent of GDP, against 77 per cent by the Treasury.

The further interesting point made by the Goldman team is that the current account corrects swiftly this year and next, thanks to the collapse of demand at home and the competitive rate for sterling. Indeed, on its calculations we will be just about back to current account balance by 2011, a situation we have not found ourselves in since 1997.

The big message I take away from this mildly encouraging work is that while the public finances remain a catastrophe, the economic problems are manageable. The Goldman Sachs projections square with my view that this will turn out to be a less serious downturn for the UK than the early 1980s one, though more serious than the 1990s. If this does indeed turn out to be a V-shaped recession, output should be back to its peak of the second quarter of last year some time around the middle of 2011. That would make this downturn within "normal" post-war recessions. It would be a bad recession, but not one completely outside all our experience.

If that turns out to be the case, we can reasonably expect "normal" financial relationships to be rebuilt. Banking will be more like banking in the 1980s and 1990s before the derivative-driven boom. The Government should be able to extract the taxpayer from the banks in which it owns shares by 2013 or so. The tone of finance will be different, with home lending restricted to much lower multiples of income. Companies will be cautious about taking on debt and rely more on shareholder funds and retained earnings to fund investment. Personal savings will be higher. We will not, however, feel particularly prosperous, and household consumption will not get back to the peak of last year until around 2012. So we will have four years with little or no rise in living standards, which will not be a bundle of fun. It will be the price we have to pay for the excesses of the private and public sectors over the past few years.

I suppose what worries me about this "not wonderful but not terrible" scenario is that it assumes the adjustment can take place gradually and steadily. In particular, it assumes that the public sector deficit can be financed. That cannot be assured. There is a possibility that this Government could lose the confidence of the people who have to lend it the money. That could happen in a sudden and catastrophic way. There are signs that bond yields around the world are nudging up, suggesting that savers at home and abroad are starting to feel that the low rates of return do not adequately compensate them for the risks of inflation and default. The British Government is vulnerable because of its very high running deficit, though the actual stock of debt is pretty much middle of the pack. Do you remember Gordon Brown saying in his early Budgets how he had saved money on interest payments and was able to spend it instead on improving services? Well, even if there is no catastrophic loss of confidence in UK government securities, the reverse of that will be happening for many years to come.

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