Stephen King: Rising rates will put Brown's boast to the test

The UK's avoidance of recession says more about short-term cyclical decisions than it does about long-term structural decisions
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The Independent Online

"And it is because of Bank of England independence, new fiscal rules, the sanctions of the New Deal, and the reduction of national debt - it is because Britain had the strength to take these long-term decisions - that, over the past four years, while economic growth in Germany averaged just 0.9 per cent; Japan 1.4 per cent; Italy 1.4 per cent; France 1.8 per cent; the euro area 1.6 per cent; and the United States 2.4 per cent; growth here in Britain has averaged 2.5 per cent."

"And it is because of Bank of England independence, new fiscal rules, the sanctions of the New Deal, and the reduction of national debt - it is because Britain had the strength to take these long-term decisions - that, over the past four years, while economic growth in Germany averaged just 0.9 per cent; Japan 1.4 per cent; Italy 1.4 per cent; France 1.8 per cent; the euro area 1.6 per cent; and the United States 2.4 per cent; growth here in Britain has averaged 2.5 per cent."

Gordon Brown's proud boast in this year's Budget is very bold. UK growth has apparently been better than in other countries because this Government made sensible long-term decisions that have allowed the UK to surpass the performance of its main rivals. Or so it seems. But we all know - or, at least, we ought to know - that four-year comparisons are rather selective. Over the past four years, the other countries had a recession, which Britain avoided. That, of course, is welcome news in itself. But it is hardly a sign of lasting economic health. The UK's avoidance of recession says a lot more about short-term cyclical decisions than it does about long-term structural decisions.

The Treasury would doubtless argue that the independence of monetary policy and the healthy position of the public finances were precisely the factors that enabled the UK to avoid recession. By removing the politics from the interest rate cycle and by building up a war chest that allowed the Chancellor to use the fiscal levers when he most needed them, the UK economy could be bailed out while all around were slowly sinking.

There are, however, two flaws with this argument. The first is that the US was even more aggressive in using monetary and fiscal policy to support economic growth. Same policies, different scale, but weaker growth. Other factors must, therefore, have been at work. Chief among them was the scale of the earlier bubble in asset prices: the UK had a bit of a bubble but the US had a truly awesome bubble so when things went wrong, there was always likely to be more damage to the fabric of the US economy.

The second flaw is that European policy makers just think that the US and the UK were plain wrong to follow such aggressive policies: why cut rates so aggressively or loosen fiscal policy so aggressively if, by doing so, investors were bailed out when they had been silly enough to take too much risk on board in the first place. Should it really be the job of central banks and governments to provide a safety net for the speculative behaviour that sometimes afflicts the private sector? And, if this bailout is provided, does that not encourage even more speculation in the future?

I'm not a great supporter of this European approach. Doing nothing and sticking your head in the sand doesn't seem to be the most sensible thing for policy makers to do. But European policy makers might have a point.

We've just lived through a period of remarkably low interest rates by historic standards and we've also been through a period of remarkably loose fiscal policy. The policy support provided for the UK and US economies has been phenomenal by past standards, which helps to put the growth numbers quoted at the beginning of this piece into context. UK and US growth rates were higher than in other countries only because they chose to loosen all the policy levers at once. The difficulty now, the great unknown, is what happens when the policy levers are pulled in the other way: can we be sure that these economies really will be able to cope longer-term?

It's a bit like leaving hospital after some major knee surgery: the doctor says you should be alright but you can never really be too sure until you leave your crutches to one side. Some patients will be absolutely fine, others will recuperate only slowly while still others will live the rest of their lives with a pronounced limp.

There are testing times ahead for both economies. Storm clouds are gathering on the horizon. And some of these are very much a result of the earlier policies of very low interest rates, tax cuts (in the US) and spending increases (the UK).

Those clouds are just bad luck, and not directly the result of earlier policies, include the effects of a Chinese slowdown. We can't be too sure of the overall effect of a weaker China but it seems increasingly likely that a great deal of the unexpected global strength last year was fuelled by China's boom: China saw the biggest single increase in imports of any country anywhere in the world so if China now wants slower growth, it's a reasonable bet that world trade growth will be negatively affected.

Another problem is the impact of higher oil prices. Oil prices have spiked up to $40 per barrel before - notably at the time of the first Gulf War - but promptly went back down again (which basically means that, contrary to some rather extravagant claims, the rise in oil prices back then was most certainly not the cause of the 1991 recession). This time, however, there's a risk that oil prices will stick at these kinds of levels, sending a recessionary and inflationary shudder through the western world. Despite Saudi Arabia's promise to start pumping more oil out, the underlying problem may be more associated with an earlier lack of exploration and, hence, a basic shortage of untapped reserves.

And those clouds that can directly be attributed to earlier expansionary policies include the significant rise in consumer indebtedness: Borrowing that makes sense so long as, for example, house prices continue to go up rapidly may no longer make sense should house prices slow. Note that, even if interest rates themselves don't rise very far, a slowdown in house price inflation, on its own, could be sufficient to reduce the consumer's appetite for ever more increases in debt, thereby undermining a key element of domestic demand.

The vulnerability of household incomes in the absence of continued fiscal loosening: The consumer's appetite to carry on spending isn't just a story about consumer borrowing. It's also a story about government borrowing: only by going into sizeable deficits were governments able to provide the necessary support to consumer incomes - either through tax cuts or increases in public employment - that kept economies going. If oil price increases lead to a deterioration in the consumer's terms of trade, the prospects for consumer demand, again, will look less encouraging.

Gordon Brown's boast that the UK's success is all down to long-term policies will be put to the test through the remainder of 2004 and into 2005. In reality, I suspect that he had enough ammunition in his arsenal to provide the UK economy with protection in the light of one major shock - the end of the global equity bubble in 2000 - but it's a lot less obvious that he has anything more in reserve. He has to hope that the storm clouds gathering on the horizon turn tail and head off somewhere else because, should they arrive on these shores, there's a lot less that the Chancellor can do now than was the case three years ago.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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