ECONOMIC VIEW: Markets may be over-reacting to the beef crisis

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The Independent Online
Beef is a health issue; a political issue; an economic issue; and now it is becoming an issue for the financial markets, too. With hindsight, they have been surprisingly slow to take on board the full consequences of the British beef catastrophe. There was some weakness towards the end of last week, but it was clear yesterday the markets may still have some way to go before the costs are fully discounted.

This is partly because of the range of imponderables - the government and EU statements yesterday narrowed those down, but there is still a wide range of commercial effects which are still completely unclear. But it is also because financial markets have little experience in assessing an entirely new economic shock like this. There is no previous experience to go on. In that sense the beef blow is more akin to the shocks that have hit the Lloyd's insurance market - unprecedented in all its earlier history - rather than, say, the commercial property crash of the late 1980s, where what was happening could be set in its historical context.

So it is new ground. When you move into new ground the best discipline is to go back to first principles: what we do know about the way a market economy will respond to any unexpected shock. Some of the macro-economic effects are charted in the news analysis on page 13, but it might be helpful here to check the different types of effect, starting with the impact on output and inflation, then looking at the balance of payments and public finances.

Market forces will dictate that the output of UK beef and dairy products will fall dramatically over the next year, whatever the official policy of the Government and the EU. The likely order of magnitude in terms of loss of continuing output seems to be pounds 2bn-pounds 5bn in the first year. This is made up of the loss of all beef exports (pounds 600m), and a substantial switch out of domestic beef purchases into imported beef. Even with some off-set in greater production of other meats, it is hard to see the decline in output being less than pounds 2bn, while pounds 5bn, not the most extreme estimate, seems large enough to cover most eventualities.

There will also be a smaller loss of output in year two, perhaps some beyond that because of the more general loss of confidence in British agricultural methods. The faster the industry responds in defining output which, as far as is possible to say, is unquestionably free from disease, the faster it will be rebuilt.

To put this into some sort of context, GDP this year will be rather more than pounds 700bn, so the loss in year one will be something of the order of 0.25-0.7 per cent. A quarter of one per cent of GDP is not enough to notice - it is a month's growth - but three-quarters is quite a lot. However, providing that the cost is really one-off - and that the beef industry moves quickly to restore public confidence - even the higher figure should not be too alarming. The worrying thing would be if, after three or four years, we were still a beef importer rather than a beef exporter, or that we had become a substantial net importer of dairy products.

The impact on inflation will depend on the extent to which imports respond to domestic scarcity, and to what extent people substitute other meats for beef and cut out milk and other dairy products. James Capel, the London brokerage arm on HSBC, suggests the impact on inflation could be more than 1.5 per cent on the RPI. But that assumes a doubling of the price of dairy products which account for 1.7 per cent of the goods in the RPI basket. If that were to happen there would be substantial shifts out of these products.

So while the headline RPI might well rise sharply - the basket of goods is not changed to account for short-term changes in relative prices - the impact on living standards would be much lower. In any case, a doubling of the price of dairy products seems too large. Besides, the price of beef will remain low. A guess would be that the RPI will rise by less than half of 1 per cent, maybe on balance not at all.

Balance of payments? Assume we lose all beef exports for three months and that exports are rebuilt only gradually after that. Assume there is some increase in domestic production of other meat. Assume some fall in meat consumption overall and a smaller fall in consumption of dairy products. Assume, too, a sharp rise in beef imports and some rise in imports of dairy products. Now put some guesswork numbers of these, and my own tally would again come to an adverse impact of pounds 2bn-pounds 5bn.

It may seem strange but such are the telephone numbers on the balance of payments, and the uncertainty that has to be attached to those numbers, that this balance of payments cost does not appear significant, provided it is a one-off. Were it to be a constant drain, then it would become a more serious burden.

Finally, the impact on public finances. It was not immediately clear from the Commons statements yesterday, what compensation terms will be available, if any. There will inevitably be some loss of revenue because the business will be less profitable: all commercial losses are in that sense met in part by the taxpayer. The question is whether this loss, plus whatever compensation is ultimately paid, is material in public accounts.

It is hard to see this happening, since the losses ought entirely to be one-off. Assuming the industry rebuilds itself and there is therefore no on-going cost to the exchequer, a rise of a couple of billion in the PSBR in any one year ought not to be of concern to the financial markets or to the taxpayer. There will be some rise in borrowings, but the idea that the beef crisis should postpone tax cuts that might otherwise take place is not really credible.

Now to translate all this into market terms. There will be a sharp impact on the feed manufacturers, as was evident in the share price of some yesterday. But the impact on the gilt market and on sterling appear overdone, were it not for one dynamic factor, which we will come to in a moment. It is unfortunate that the borrowing requirement seems to be running rather above the level expected even last November, so any adverse impact on public finances comes at a bad time.

But the deterioration attributable solely to this crisis will be quite small in relation to the disappointments of the last five years. So any impact on the gilt market ought to be manageable.

Likewise sterling. The levels of uncertainty are so large and the current account is so close to balance that this of itself should not rationally have much impact. If sterling deserves to be weak, there are many other justifications. What all this ignores, however, is the political dynamics of this crisis. It is very damaging not just for the Government, but for many of its natural supporters in country districts. At the margin it may make it more difficult for the Government to survive beyond the autumn. Political uncertainty is already evident.

This crisis increases it. The real explanation for the adverse market reaction may not be a cool calculation of the hard numbers but an emotional response to a further dose of uncertainty in an uncertain time.