Stephen King: Will Brown sacrifice prudence to win votes?

It increasingly looks as though the areas of upside risk are becoming downside reality
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The Independent Online

What tone will Gordon Brown adopt at the Despatch Box when he delivers his pre-Budget report on Thursday? Will he strike the triumphant pose of the seer who gets things right more than most? Or will he take on the worried look of a politician who is no longer quite so sure that everything is going according to plan?

What tone will Gordon Brown adopt at the Despatch Box when he delivers his pre-Budget report on Thursday? Will he strike the triumphant pose of the seer who gets things right more than most? Or will he take on the worried look of a politician who is no longer quite so sure that everything is going according to plan?

A glance through the pages of this year's Financial Statement and Budget Report (FSBR) suggests that the Chancellor would be justified adopting either position. When the report was released on Budget Day (17 March), one section noted that "at the time of last year's Budget, independent forecasts for 2004 UK GDP growth averaged 2.4 per cent ... since last summer (ie summer 2003), over 90 per cent of forecasters included in the comparison have revised up growth projections for 2004. The independent average [is now] consistent with the unchanged Budget forecast range of 3 to 3.5 per cent." Since the Budget, the numbers have continued to support the Chancellor's initial view: for the first three quarters of 2004, latest data suggest that GDP was up 3.3 per cent compared with the same period in 2003 so Mr Brown now has a very good chance of hitting the forecaster's equivalent of a bull's-eye.

Then again, the FSBR also highlighted a number of risks. "Sudden, sharp movements in major exchange rates could potentially disrupt the ongoing recovery in the global economy ... there remains the risk that house price inflation will slow by more than expected ... on the upside, the strengthening in growth could reveal more short-term momentum ... business investment has, in the past, tended to accelerate markedly once a pick-up in growth gets under way."

It's at this point that the Chancellor's problems become a little more obvious. He can look back with satisfaction at a job well done. The economy didn't keel over as many feared. The growth rate was a lot better than most expected. Yet, it's not quite so obvious that he can look forward with the same degree of equanimity. Of the risks referred to in the FSBR, the balance is now decidedly unhelpful. And much of the bad news has materialised only recently, suggesting some late nights for the unlucky economists whose job it is to set the residuals on the Treasury model.

The most obvious recent development is the sharp decline in the dollar. To date, the fall-out from this potentially crippling process has not been great: sterling may have strengthened against the dollar but it's softened against the euro, leaving sterling's trade weighted exchange rate lower now than it was in the summer. Bigger problems might come should the US become frustrated with the lack of progress in balance of payments adjustment, a topic I addressed in this column a week ago. The dollar could then fall a lot further, accompanied by rising bond yields, falling equity prices and, possibly, a move towards greater global protectionist pressures. None of these would be good for Mr Brown's peace of mind.

Next on the list of potential worries is the housing market. Both the Treasury and the Bank of England were rather hoping for a soft landing for the housing market, because otherwise their consumer spending calculations could end up being rather too problematic. Recent data suggest that, already, the soft landing might have slipped from their grasp. Last week, for example, the British Bankers' Association (BBA) published data showing a remarkable slowdown in housing activity. Loans for house purchase were down 32 per cent in October 2004 compared with October 2003. Mortgage equity withdrawal was down 45 per cent. Loans approved - an indicator of future housing activity - fell 35 per cent. This all looks rather too early-1990s-ish to be shrugged off as a temporary aberration.

So, it looks as though the Chancellor was right to have some downside risks on his radar screen. What about upside risks? At Budget time, the Treasury made a lot of the investment story, based on the textbook "accelerator" effect. But, if anything, businessmen seem to have taken their feet off their accelerators and, instead, applied the brakes, albeit at a gentle pace so far. In the third quarter of 2004, business investment rose just 0.1 per cent on the quarter. Admittedly, this followed a robust gain of 2.6 per cent in the second quarter but, nevertheless, it's a lot weaker than the Treasury would have hoped for. Add to this the disappointments from the CBI's Industrial Trends Survey, where output expectations are the weakest in 11 months, and it increasingly looks as though the areas of upside risk are becoming downside reality.

Even the consumer doesn't look quite so healthy. Retail sales are still reasonably strong, but the recent trend is still a lot softer than earlier in the year. In the latest three months, retail sales volumes rose 1.2 per cent compared with the previous three months, whereas earlier in the year, volume gains were running at approaching 2 per cent. And, faced with a softening housing market, there must be doubts about consumers' willingness to maintain even this rate of retail spending growth in 2005.

To be fair, the Chancellor never expected to rely only on consumer spending. Although his Budget forecast pointed to GDP growth in 2005 of 3 - 3.5 per cent, unchanged from his 2004 expectations, he nevertheless expected a slowdown in consumer spending. The problem, though, is that there isn't anything obvious waiting in the wings at this stage to take up the slack. The Chancellor was relying on investment and exports but both the data and the surveys seem to be saying "think again!"

And there's also an issue about the degree to which consumer spending will slow in response to falling house prices. Charlie Bean, the Bank of England's chief economist, argued in a speech last week that "during the past few years, [the] correlation between house price inflation and consumer spending growth has largely disappeared ... Instead, consumer spending has grown pretty much in line with income."

Obviously, the Bank of England is keen to argue that housing weakness need not lead to a consumer spending collapse but there is, nevertheless, something slightly odd about the argument. The so-called "counterfactual" - what would have happened to consumer spending in the absence of surging house prices - is unknown. Given, though, that there's been a substantial increase in consumer indebtedness in recent years helped along by higher house prices, and given that mortgage equity withdrawal is now slowing rapidly in line with softer house prices, there's a very good chance that weaker housing will be associated with an increase in the saving ratio and, hence, a possibly substantial slowdown in consumer spending.

So what should the Chancellor do? Should he leave his 2005 growth forecast unchanged at 3 - 3.5 per cent, given his excellent track record in 2004? Or, should he heed his own, correctly anticipated, risks and cut his 2005 forecast, justifying the move through his devotion to prudence? Prudence should dominate, I would have thought, but if there's an election in May, the obvious question is "why bother?"

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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