Economic view: Don't let policy errors lead to a return to old ways

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The Independent Online
Let's assume that they have indeed made a policy error, and ask how much it matters.

We do not yet know that the authorities have yet again relaxed policy at just the wrong point in the cycle, but the balance of probability is shifting that way. The evidence is steadily mounting that monetary policy is being eased at the moment when the economy is about to put on another spurt of growth.

Yesterday's figures showed a jump in money supply, the Nationwide reported a jump in house prices, and a rise in the purchasing managers' index. While consumer spending was down from the high levels of April, there is still a lot of drive there. And all this comes against a background of a looser-than-intended fiscal policy, for the fiscal deficit is falling more slowly than expected because of low tax receipts, and a still weak sterling.

So there is clear evidence that by the autumn there will be, if not a consumer boom, certainly a boomlet. Last week we learnt that real personal disposable income is growing at the fastest rate since 1989. While the first half of this year and the second half of last saw relatively slow growth, just about everyone expects growth to pick up in the second half - driven by consumers. Yet the Chancellor persists in driving down interest rates, almost certainly (though we will have to wait until the minutes are published) against the advice of the Bank of England.

Of course, as always in economics, there are counter-signals. The continental European recovery, important for exports, is still precarious. Manufacturing here is still depressed, partly as a result of that. The warning signals that might have indicated a surge in inflation, like rising pay awards, are not there. The balance of payments last year, thanks to revisions announced last week, is so close to balance that it hardly matters. If it were not for payments by the Government to the European Union, we would be in surplus. Nevertheless, the balance of evidence points in one direction: that policy probably ought to be being tightened now, rather than the reverse.

Does it matter? There are three main areas of potential damage: the two well-known pressure points in the UK economy of inflation and the balance of payments; then there is the possible structural damage to the economy.

Inflation first. Anyone trying to kindle fears of renewed inflation has to persuade people that he or she is not crying wolf. For the last four years, ever since sterling was ejected from the Exchange Rate Mechanism in face, inflation has pretty consistently come in lower than forecast. Nearly everyone then predicted that the depreciation of sterling would feed through into higher prices. Wrong. It didn't. The Bank of England forecasts have almost invariably over-estimated the inflation our-turn, but the Bank is in good company for the markets have invariably over-estimated the rise in interest rates that would take place as a result of inflationary pressures.

Looking around now there are quite clear signs of a burst of inflation in asset prices but far fewer of signs of a surge in the price of current goods and services. One rise of asset prices is very evident: the quite strong performance of shares, though political worries have held the UK market back against Wall Street. The other place to look, house prices, is now at last beginning to point in the same direction. The graph of the left from the Halifax, showing the possible rise in house prices through the next couple of years, suggests that while there will be no return to the late 1980s, we will see the strongest performance in eight years.

House prices were, in the last cycle, an important force stimulating consumer demand in a several ways. People borrowed against the spare equity in their homes and used the money to maintain or increase their living standards. When they moved house, they tended to buy more kit to put into the new home. And the confidence induced by knowing that they were becoming rich through home ownership probably affected their spending in other ways.

As a result house price inflation fed through to general inflation. The key question is whether, assuming there will indeed be a solid performance in prices, the rise in asset prices feed through to general ones. I think, though I may be wrong, that it won't, at least to any great extent. Why?

There are two ways of answering this. One, a general answer, is to point to the perceived insecurity of most people, insecurity about their jobs, about UK politics, about the EU, about competition from low-wage East Asian countries and so on. Leave aside whether this perception is justified or not. That is not relevant. What matters is whether it exists, and it is hard to deny that something is different from the late 1980s. Look at the way expectations by industry of price increases have fallen over the last year. That really does not suggest that there will be a surge in producer prices, and if producer prices do not come up it is hard to see retail prices doing the same.

The other answer is to point to Japan's experience in the late 1980s. It experienced catastrophically high asset inflation, the so-called "bubble economy" the aftermath of which is still felt. But it did not experience any surge in the price of goods and services. Inflation of those remained very low. So it is not just theoretically possible to have a boom in asset prices without a boom in the price of goods and services; it actually has happened and happened recently in the second largest economy in the world.

What about the current account? It is all right. A current account deficit last year of pounds 3bn is, in effect, a current account in balance because the deficit is smaller than the margins of error in the calculation. Further, the stock of net overseas assets seems to have continued to rise in the first quarter of this year, so both the country's "profit and loss" and its "balance sheet" are fine. True, this consumer boom has yet to get under way, but if there were a serious potential problem here we would surely be seeing something of it by now.

Given the traditional delight British consumers show the moment they are feeling a little more flush, in rushing out and buying foreign consumer goods, the threat of an unsustainable import boom should always be a concern. But there is no evidence yet that this is taking place.

So, even if policy is too loose at the moment, there is a decent case to be made that it does not matter too much. Come next year, policy can always be tightened. The climate of insecurity means that the penalty for a mistake is much smaller than it would have otherwise been.

But there may be another worry. Loose monetary policy, low interest rates, and in particular a mini-boom in house prices, will encourage a revival of the 1970s and 1980s attitude that people became rich by owning houses, rather than by working hard and earning a good income, and saving from that. This will be particularly encouraged if taxation on earned income, and income from savings, rises after the election.

Thus a rise in asset prices would be damaging, not so much because it would feed through into a rise in consumer prices, but damaging in its own right. Seen in this light, the policy error which now may well be happening is not so much a catastrophe on the scale of the late 1980s. But it is more likely a bit of a pity because it will encourage too many of us to go back to the "better a borrower than a saver be" attitudes that we need to dump.

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