We have been here before. It is the story of the post-war British economy. We saw it worked out, par excellence, over the 1980s. But the scope to indulge in the collective self-delusion that engulfed us then is now much smaller. For, as the first chart shows, when the economy emerged from the last recession in 1981, the balance of payments was in substantial surplus. Because of this favourable starting point, domestic demand was able to grow faster than net exports for several years before the deficit had grown to a size that posed a real problem. But if we again have a recovery strongly driven by domestic demand (and especially consumption), we will hit the balance of payments buffers very soon.
If this result is to be avoided then the growth of domestic demand, and especially consumption, will have to be restrained to the growth of net exports. But how? Raising interest rates is the classic British response. But it would be wholly inappropriate now. The British economy requires a sustained period of low interest rates to boost investment and help the revival of small firms. Moreover, the need to raise net exports argues for the maintenance of a competitive exchange rate. To increase interest rates now, when all of continental Europe is cutting them, would be to risk a strong rise in the pound that would undo the prime factor responsible for the nascent recovery. Yet siren voices within the authorities are calling for a stronger pound to offset inflationary pressures in the British economy. That is why Norman Lamont has recently taken every opportunity to say he is not planning to cut base rates.
But inflation is not about to take off. Sustained price inflation requires inflation of pay, yet as the second chart shows, the figures for pay inflation are spectacularly good - the best for a generation - and set to become even better.
Moreover, the temptation to believe that a stronger currency does not inhibit export growth is not supported by the facts. Look at the experience in Japan, some say. A continually rising yen, they claim, has had no impact on the country's export success. Yet Japan has been able to succeed in export markets despite a rising yen because of wage restraint, strong productivity growth and product innovation. Indeed, given these factors, the yen has arguably been persistently undervalued. It is interesting that the Japanese authorities are now concerned about the strength of the yen against the dollar. Not for them the idea that exchange rates do not affect competitiveness or that the balance of payments does not matter. It is only in poor old Britain that these ideas have a following.
Accordingly, as the continentals continue to cut interest rates and the pound strengthens, the right thing to do is bring our base rates down further. How, then, to stop the recovery getting out of hand? This is where fiscal policy comes in. The serious weakness of the public finances makes it clear that if there is any tightening to be done, it should be on the fiscal front - by cutting government spending and raising taxes.
Yet it is not only net exports that need to grow if the British economy is to be rebalanced. Investment needs to expand, too. But not any old investment. Even when business investment has been strong, it has been dominated by motives of cost reduction rather than expansion of market share. It has been labour saving. Yet if Britain is to have the capacity to bring about a dramatic improvement in her trading position consistent with anything like full employment, she will have to sustain high levels of capacity-boosting investment.
What holds companies back from making such an investment? The real problem now is lack of confidence that British industry has a sustainable future - even at existing market shares, never mind enhanced ones, across whole swathes of activity. The reason is clear: the experience of the last 20 years, when British industry has been on the retreat. What role does the Government have here? It is not to provide detailed direction or support for particular industries or sectors. It is to create a suitable, stable framework in which industry can flourish and confidently invest for the future. That much in the present government's approach is right. But, as far as macro-policy is concerned, that is precisely what it has not done over the last 14 years. It has presided over two phases of distinct overvaluation of the pound, two phases of sustained high interest rates and two sharp recessions. During this period, it has told industry that manufacturing does not matter, the current account does not matter and that hope for employment in future was not even 'low-tech, but no-tech jobs'.
After all this, with the first real signs of recovery now emerging, would you expect industry to invest heavily in capacity expansion? Something now needs to be done not only to ensure the Government gives stable conditions in which industry can prosper, but which helps industry to believe it will do so.
In 1980, the Government faced a similar problem with regard to inflation. After such a disastrous inflationary history in the 1970s, how could the Government mend its ways and stop itself being blown off course by the usual political pressures? And how could it persuade the markets of this? The solution it adopted was the Medium-Term Financial Strategy, which laid down target paths for the money supply and the PSBR. The Government now needs to do a similar thing with regard to the real economy, setting out a target path for the improvement of net trade and the growth of investment over several years. This needs to be accompanied by a long-term plan for containing government spending and raising taxation, with contingency measures spelt out if things go wrong.
The important thing is to convince industry that the exchange rate will not again be forced to uncompetitive levels as first resort and that fiscal policy rather than interest rates will be adjusted if inflationary pressures pick up.
Politicians naturally tend to avoid anything that might restrict their room for manoeuvre and make them look foolish or deceitful if they change tack later. But we need a medium-term economic framework precisely to limit their flexibility and keep them on the straight and narrow. Without such a sheet anchor, the danger is that the current revival of optimism will prove short-lived as we once again set out on the familiar road of consumption boom, balance of payments and inflationary crisis, and recession.
Roger Bootle is chief economist of Midland Montagu.
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