Stephen King: Politicians' acts of denial give the game away

When it all begins to go wrong, politicians typically adopt one of three strategies. They deny. They claim it's worse elsewhere. Or they blame others for their woes.

The UK economy must, then, be going horribly wrong. Our political leaders adopted all three tactics last week, thereby betraying their deep-rooted fears.

Gordon Brown, the Prime Minister, offered the denial. In an interview with the BBC, Mr Brown said: "We've seen house prices rise by about 180 per cent over the last 10 years and they have risen by about 18 per cent over the last three years, so a 2.5 per cent fall is something that is containable." He was referring to the latest decline in the Halifax house price index.

Alistair Darling, the Chancellor of the Exchequer, made the claim that things are worse elsewhere. On the BBC Radio 4 Today programme, he said: "The IMF has down-rated every country's growth forecast in the light of what's been happening in the world economy [as if the world economy is something other than a collection of countries]. However, they have lowered their expectations in relation to us by less than other countries."

It was Mr Brown, though, who chose to blame others for the UK's latest economic turbulence. Apparently, the world is "in a difficult situation arising from what's happening in America".

Mr Brown's first quote is a denial of the laws of gravity. While it's possible that house prices have reached a higher sustainable level, history and damaged reputations suggest otherwise. It was, after all, Irving Fisher, the great American economist, who famously (and presumably regrettably) said just before the 1929 stock market crash that "stock prices have reached what looks like a permanently high plateau". While there's no guarantee that what goes up must come down, the history of the UK housing market strongly suggests that the 2.5 per cent decline recorded by Halifax in the latest month will, sadly, mark the beginnings of a major slide.

The reasons are increasingly obvious. The gains in housing were a reflection, more than anything else, of easy credit. Those conditions have now gone away. The supply of mortgages is falling fast. Repossessions will surely rise further. Banks, in turn, will sell the repossessed houses at bargain basement prices because they, in turn, are short of liquidity. These aggressive sales will create more negative equity and, hence, misery for those who scrimped and saved to get on the housing ladder in the last two or three years.

Mr Darling's claims are right, but not in a way that offers much in the way of comfort. While the IMF has slashed its US forecasts for this year and next, those for the UK have come down more modestly. Whereas the US is expected to deliver growth of a dismal 0.5 per cent in 2008 and a paltry 0.6 per cent in 2009, the IMF thinks the UK economy will expand at a 1.6 per cent rate through both years.

The IMF has been commendably brave in its decision to publish a significantly below-consensus forecast for the US. Its longer-term track record in forecasting economic crises, however, is not exactly great. In early-1997, for example, before the Asian crisis, the IMF thought South Korea would enjoy growth of 5.6 per cent that year, followed by an additional 6.3 per cent gain in 1998. The actual numbers were 4.7 per cent and minus 6.9 per cent. The UK is unlikely to trip up in such spectacular fashion, but the absence of a major forecast downgrade so far says little about the UK's actual economic prospects.

Mr Brown's decision to blame the US for the world's economic woes is nonsense. It's certainly true that the US has major economic problems. It's also true that, after the slippage in the US economy over the last few months, people are becoming increasingly worried about economic prospects in the UK. But it doesn't follow that there is a causal link running from the US to the UK.

One, admittedly imperfect, way of showing this is to examine the flows of trade across the Atlantic (exchange rate movements can sometimes distort the underlying picture coming from bilateral trade data but, fortunately for my purposes, sterling's value against the dollar hasn't changed very much over the last year or so). The value of UK exports to the US was up 8.3 per cent year-on-year in the three months to February, whereas the value of UK imports from the US was down 9.8 per cent over the same period. Put another way, rather than Mr Brown blaming the Americans for the UK's economic weakness, it should be Mr Bush blaming the Brits for America's economic problems.

In truth, the shock facing the UK economy is remarkably similar to the shock facing the US economy because both countries chose, a few years ago, to do a deal with the debt devil. For every increase in US house prices, there's been an increase in UK house prices. For every rise in US household debt, there's been an increase in UK household debt. And, for every widening of the US balance of payments current account deficit, there's been a corresponding expansion of the UK deficit.

If anything, the problems in the UK look worse than in the US: house prices are higher, they've risen by more, and the dependency on debt has been that much greater. And, just like the US banks, many British banks became increasingly dependent on the alchemy of securitisation as a way of raising funds to lend to debt-hungry households. With the collapse of the asset-backed securities market, no longer can banks on either side of the Atlantic go down that path.

Pretending, then, that the problems facing the UK economy are somehow someone else's fault simply doesn't ring true. The US and the UK have a shared problem. For Mr Brown, though, this is a problem he cannot easily admit to. After all, he's the man who supposedly was responsible for the UK's prudent policies over the last 11 years or so. His prudence, though, is at risk of being for no purpose at all.

Policymakers in both the US and the UK forgot that economic crises occur for all sorts of reasons. Mr Brown revealed as much in his BBC interview. He said "....because we've got low inflation, we can cut interest rates, because we have had low debt, we can afford to keep our public spending programme in line and to borrow at the right time to help the economy come though difficult times."

Unfortunately, inflation isn't as low as it should be. But even if it were, the assumption that lower interest rates will do the trick may not be right. The big threat facing both the UK and the US economies is a failure of the financial system, the kind of thing that brought Japan to its knees in the 1990s and which contributed to the Great Depression in the 1930s. Under these circumstances, rate cuts don't work very well, inflation or no inflation. A better bet might be to use fiscal policy but Mr Darling chose not to take that opportunity – nor, even, to discuss the possibility – in this year's Budget.

In economic policy, you have to take the rough with the smooth. US policymakers have recognised this. They understand that capitalism sometimes fails. They've collectively acted to do something about it. British policymakers, though, offer only acts of denial. This is both deeply depressing and, for the future of the UK economy, very worrying.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com