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Governor and Chancellor face a credibility test

COMMENT: It is hard to see how the Governor can retain credibility if he doesn't advise an increase in interest rates
Kenneth Clarke may already be rueing the day he agreed to publication of the minutes of his meetings with Eddie George, Governor of the Bank of England. The picture of gloom on the high street painted by the latest retail sales figures intensifies the policy dilemma facing the Chancellor. A weak domestic economy needs a rise in interest rates like a hole in the head. The impact of the pound's weakness on inflation prospects, on the other hand, calls for a further turn of the monetary screw. Just how Mr Clarke resolves this dilemma seems certain to put the new monetary arrangements that bestow a semi-independent status on the Bank of England to their first serious credibility test.

Minutes of their meeting in early March, released this week, show that Eddie George accepted that the retail sales figures for January were evidence of a further slowdown in the economy - but warned against placing too much weight on one month's figures. Now, retail sales, after bouncing back in February, have fallen again in March. On a three-month rolling basis, the volume of retail sales has been flat since September of last year.

A single swallow doesn't make a summer; but it isn't just soggy retail sales that are pointing to a slowdown. Official figures also show manufacturing output virtually unmoved since last autumn. That traditional bane of post- war economic management, wage inflation, also still seems in check. There I rest my case, the Chancellor might well say to Mr George when they meet next in early May. And indeed, the economic argument for keeping interest rates on hold seems a strong one. Set against that, however, is the threat posed to the Government's inflation target by the pound's recent slide: the trade-weighted index is down over 4 per cent since the last increase in interest rates at the beginning of February.

That fall has more than undone the monetary tightening of the last interest- rate rise, if the usual rule of thumb that equates a 4 per cent move in the exchange rate to a 1 per cent change in interest rates holds true. And it comes against a background of rising inflationary pressure, with the Government's chosen target rate - the annual increase in the retail price index excluding mortgage payments - rising in March to 2.8 per cent. Meanwhile, factory gate inflation, the prices charged by manufacturers, has risen still more sharply to 3.8 per cent.

The minutes of the 8 March meeting showed Mr George already anxious about the impact of the fall of the exchange rate, and warning that he might need to come back to the Chancellor "if the situation were to deteriorate". Since then, the situation has deteriorated: the trade-weighted index has fallen by nearly 2 per cent.

The decision last year to publish the minutes was generally regarded as qualitatively different from earlier moves to loosen the Treasury's leash on the Bank. If a Chancellor were to be seen overruling the warnings of a Governor, the result could be a run on sterling and a crisis in the financial markets.

After his warning in early March, it is hard to see how the Governor can retain credibility if he doesn't advise an increase in interest rates. For the first time, the political price of conferring a greater degree of independence on the Bank of England may be about to be paid. But in keeping with the halfway house of new-style monetary arrangements, the decision will be taken conveniently after the local elections.

Labour is making a risky investment

When it comes to economic policy, being out of office seems to be no better than being in it, judging by the tangle Labour is getting itself into. The difference is that Kenneth Clarke's difficulties are practical, Gordon Brown's theoretical. While Mr Clarke wrestles with his present policy dilemma, Mr Brown is proving that to seize on fashionable economic theory to support your policy objectives is not always a good idea.

If there is one central plank to New Labour's economic thinking it is the need to boost growth through investment. Gordon Brown seldom misses an opportunity to lambast the Conservative record in running a low-growth, low-investment economy.

Old Labour was keen on growth and investment, too. But New Labour has a new, magic ingredient. The phrase "post-neoclassical indigenous growth theory" may not come tripping off the tongue of the shadow Chancellor again after the derision that greeted it last time, but it is nevertheless something that lies behind the fresh emphasis on investment. The trouble is, it may not necessarily support New Labour's point of view. Surveying the evidence this week at a meeting organised by the Centre for Economic Policy Research, Professor Nick Crafts suggested that the moral drawn by Gordon Brown is certainly not the only one - and may well be the wrong one.

The new theories certainly place investment centre-stage in the drama of economic growth. Traditional accounting for growth found that most of it came from general advances in productivity rather than from capital formation. The new thinking starts by redefining investment to include not just additions to the stock of capital like new machines but also improvements in the skills and expertise of the labour force. More important still, this new concept of investment is now cast as the principal means whereby advances in productivity are incorporated into economic growth. So far so good for Mr Brown.

Here, however, the consensus ends. There is more than one flower in the garden of new growth theories. And they do not point unanimously to the idea that boosting investment is the key to higher growth.

Professor Crafts argues that new theory also teaches that piling up investment, whether in machinery or skills, would run into diminishing returns if it was more of the same. That is "not the route to permanently faster growth". By contrast, the branch of new growth theory that highlighted the importance of innovation was "much more instructive for policy makers". This is where new theory seems to part company with New Labour. Entrepreneurs will only sink capital into new processes and new products if they are able to appropriate the gains in higher profits. Poor industrial relations until the labour reforms of the 1980s were instrumental in holding back innovation because they stopped industrialists from being able to reap the necessary returns.

That sounds much more in tune with Thatcherite thinking on economics. New growth theory turns out not to be the simple endorsement of growth through investment offered by New Labour. Back to the drawing board.