Economics: Not much in the stocking for economy

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The Independent Online
MY GLOOM about the state of the economy is far from being dispelled by seasonal cheer. The latest Economic Outlook from the Organisation for Economic Co-operation and Development contains a special analysis of the problems facing the developed debtors such as Britain. It is dispiriting reading.

Most of us will be relieved when there is convincing evidence that national output is rising again, as there has been in the United States for the last two years. But the OECD rightly argues that this does not mark the end of the recession. The real end occurs when the growth of the economy is rapid enough to outstrip the natural increase in the productivity of those in work. Britain probably needs to grow by more than 2.5 per cent a year merely to begin to absorb the existing pool of unemployed people and machinery.

The first graph shows the depth of our problems. It expresses national output as a percentage of this potential output for each of the three biggest Anglo-Saxon debtor countries - the United States, United Kingdom and Canada. It explains why President Bush lost: the United States appears to have become stuck with such slow growth that national output has remained about 3 per cent below potential. It also explains why the recessions in Britain and Canada have been so painful.

In Britain, output is continuing to decline both absolutely and relative to trend. Indeed, the 'output gap' - the shortfall of actual from potential output - is now huge even by the exceptional standards of the 1979-81 recession, which was the worst downturn since 1921. The OECD calculates that the output gap for Britain is now 6.9 per cent of potential (or some pounds 47bn, worth pounds 820 each year for every person in these islands). This is nearly double the worst output gaps recorded in post-war recessions: 3.2 per cent in the first quarter of 1972 and 3.6 per cent in the fourth quarter of 1982.

Moreover, the risks and uncertainties are legion. The overwhelming factor in our troubles is the legacy of the financial liberalisation and easy credit of the Eighties. In Britain, total personal liabilities (mainly mortgages) are 115 per cent of incomes compared with 57 per cent in 1980. By contrast, the proportion is 80 per cent in France, 13 per cent in Italy, and 19 per cent in Germany.

The likely path for the British economy is thus surely very similar to that of the United States, where liabilities are 103 per cent of personal incomes, or Canada, where they are 96 per cent. Despite the very sharp and timely cuts in interest rates, shown in the second graph, the US economy has still not managed to close its output gap. Part of the reason is that more US mortgages have fixed interest rates, but it is also partly because property prices have fallen, net wealth has shrunk, and people want to pay off debt.

Alan Greenspan, the chairman of the US Federal Reserve, has argued that low interest rates are necessary to repair balance sheets. But a dollar used to repay debt cannot be spent, so it follows that low interest rates will have relatively little immediate impact on spending and activity. No one knows how long it will be before people are comfortable with their finances again.

As the OECD says: 'Since the beginning of 1990, short-term interest rates have fallen by over 4 percentage points in the United States and the United Kingdom and by over 8 percentage points in Canada . . . In the past, interest rate reductions of this scale have been sufficient to generate recovery within two years, but this time the response has been more muted.'

The interest rate weapon is also blunted by the problems of the property sector. Construction has traditionally been one of the most interest-sensitive sectors, leading recoveries as rates come down. But the wild over-building during the Eighties in both residential and commercial property has left such a large overhang of empty property that construction activity is bound to be depressed for many years.

Falling asset prices - 25 per cent since the peak in south-eastern starter homes and 45 per cent in London commercial property - have another insidious effect: they destroy collateral that borrowers can use to secure loans from the banks. With the banks also required to find more of their own capital to make each loan, there are now serious question marks over whether the Anglo-Saxon financial systems will finance the rise in working capital which many smaller businesses will need during a recovery.

Another risk lies in the effects of widespread job losses on consumer confidence. Redundancies are more extensive across different industries and regions than they were in 1979- 81, when the burden fell on manufacturing and hence on the Midlands and the North. For the first time in our economic history, London now has an unemployment rate which at 11.3 per cent is higher than the 10.3 per cent national average. This downturn is scaring people that other recessions failed to reach.

People in work will soon have the additional worry of rising prices: the OECD projects that the devaluation will push up consumer prices by 6.1 per cent over the year to the first half of 1993, rather more than the 3.6 per cent projected rise in the compensation of employees. The devaluation thus reduces real incomes and damps down consumers' spending.

There are also profound structural changes that can only add to the feeling of unease. The most important is the run-down in the defence industries, which is worth maybe 1 per cent of national output over a five-year period: British Aerospace, GEC and other contractors cannot be immune. Although the Rosyth dockyard is now busy renovating London Underground trains, there are limits to defence conversion.

The second big structural change is the completion of the EC's single market. In theory, increased competition between businesses was meant to cause job losses in the mid-Eighties that would then be offset by rising investment as companies took advantage of the larger market. In fact, companies invested in anticipation of the market, and the shake-out is still happening.

Other changes are not helpful: normally, factory output begins to rise simply because companies can no longer run down stocks of unsold goods. However, stock levels are steadily coming down relative to sales thanks to just-in-time manufacturing, computer-controlled stockrooms, and the incentive of financial pressure. The consequence is that stocks will not need to be rebuilt, which may remove some of the bounce from the first stage of recovery.

Against all this gloom, there are some positive factors. There should be some initial boost to British net exports next year from the devaluation, and any acceleration in the US recovery may offset the deterioration on the Continent.

The OECD also gives some telling evidence for the power of public spending and tax cuts to stimulate the economy. Since British fiscal policy injected more than 2 per cent of total spending into the economy this year, it is unlikely that output will continue dropping. But that is a low standard by which to measure our economic progress. Ahead of the Budget, the Chancellor needs to raise his sights.

(Graphs omitted)