Hamish McRae: This downturn may not be deep, but it could be unusually long

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The Independent Online

The OECD caused something of a stir yesterday with its new forecasts* for the world economy. Its message is straightforward. Things have proved more resilient this year than many expected, given the hits that financial institutions have taken from the sub-prime crisis in the US and the more widespread falls in house prices in many developed economies. But, and this is a huge but, the damage will be felt more strongly next year.

For people who have been reading these pages this will come as little surprise. It has been an almost embarrassingly frequent refrain that 2009 is the year to worry about, not 2008. So I suppose I feel a certain sense of comfort that forecasters with much greater resources should now be reaching similar conclusions to those that have been set out here for the best part of a year. The OECD economics team reflects competent and measured opinion, conventional sure, but there is nothing wrong with that. With the IMF forecasters it gives about the best cut that the professional economic community can manage about the shape of what we all now recognise will be a significant economic downturn. Some thoughts about this view first, and then some thoughts beyond.

Start with Britain, because what happens in 2009 will have inevitable political significance. The slowdown this year is significant, but not particularly grave: growth at 1.8 per cent would actually be just within the Treasury's range of 1.75-2.25 per cent. Next year things get interesting. As you can see in the graph, growth is predicted to slow further, to 1.4 per cent, which is way off anything the Treasury is contemplating because it expects a recovery. Within that number is even worse news: growth in consumption slowing to 0.6 per cent. That will feel like recession, and will be the lowest growth since the early 1990s, when consumption briefly stalled.

There is, however, still some growth. Despite this squeeze on consumption, employment is still expected to grow a little. Unemployment will creep up, thanks to an increase in the size of the labour force, but there will for most people be jobs. We will go on working, but we won't enjoy the fruits of that work in higher living standards. Of course that is bound to result in hostility to the Government, because it will in some measure be held responsible. You can see already why the increase in the tax burden has become such an issue.

That does put the Government in a particular bind because the deficit is already likely to top 3 per cent of GDP, and according to calculations by the OECD is the second highest (after Japan) among the large developed economies. I can't quite see how they will dig themselves out of this one – or rather, it does look as though that will be the task of the next government, not this one. The Tories, if they were wise, should want Labour to go through to 2010, just to get as much of the bad news out of the way.

Of course this is a world problem, not just a UK one, as the OECD report makes clear. The second graph shows its forecasts for the US, Japan and the euro area. The main point here is that the US has two years of sluggish growth, not one, while the euro area slows further next year too. In fact the forecasts for the euro area are almost exactly the same as the UK. I have been flipping through the various European country numbers and there is very little optimism around. Basically France will do about the same as the UK, with Germany and Italy doing a bit worse. Spain, which has been particularly dependent on construction, will do particularly badly in 2009.

Quite how big a hit the various economies are taking from the end of the housing boom is set out in the final graph. These are not forecasts – they are what is actually happening to housing permits: plans to build new homes. As you can see, the US and Spain are particularly hard hit. We are not, or at least not dreadfully so, because we were not building that many new homes in the first place. Spain was building as many as France and Germany put together. What is happening is that home-building, one chunk of our economies and a bigger chunk in some countries than in others, is being switched off. There will be other construction work, for resources will need to go on going into infrastructure, but we cannot ignore the scale of the blow. And it is not going to recover quickly.

That leads to an observation and a question. The observation is how universal the blow from declining residential investment has become. Even a country such as Germany, which has not had a housing boom, is seeing a decline in planned construction. This is, however, a picture of the developed world, not the fast-growing emerging economies of the Middle East and Asia. The OECD does have some forecasts for the rest of the world, though this is not its core business, and these unsurprisingly show continued strong growth. At some stage in the future growth in China and India will undoubtedly slow, but that is not on the radar yet.

The question is: what will the world economy look like beyond the forecast period? If 2009 is likely to be a worse year than 2008, is it plausible that 2010 will be worse again? Conventional forecasting does not really help at all here: it is hard enough to look a year forward, let alone two, three or more. We can look at previous post-war cycles and see what a "normal" cycle would look like, but unsurprisingly each cycle is slightly different. This one does not look at all deep compared with the 1970s, 1980s and 1990s, at least so far, even in the US, the country that has been hit hardest. In world terms it is not deep at all, with on my quick calculation China this year supplying as much incremental demand to the world economy as the US and Europe put together.

But if it is not going to be deep, maybe it will be long. The banks will be scarred (and scared) for a decade. Squeezing out this burst of inflation will take three years at best. The about-turn by the US Federal Reserve this week suggests that the next move in interest rates will be up, not down. The scope for interest rate cuts in the UK and in Europe is limited at best, even though rates are much higher than in the States. Were this a normal cycle you would expect the recovery to be pretty evident by 2010, but somehow I feel a growing concern that this might be wrong: that though this downswing will not be particularly deep, it will be unusually protracted. It will certainly be unusually uneven.

To say that goes far beyond conventional economic forecasting. We don't have the tools to help us envisage what economic growth and inflation will look like in 2014, when presumably our next government will come up for re-election and the next US president will be in his second term, or not. But I am pretty sure the next few years will be difficult for governments in all western democracies. Voters will expect higher living standards and it will be tough to deliver them – tougher even than it is now.

* OECD Economic Outlook, June 2008

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