It may be a hard rain that's gonna fall
Sunday 28 September 1997
To say this is not to proclaim that the boom will end with a bump; but not to be aware of the danger is as wrong-headed as to proclaim that the hard landing is inevitable.
So how does the argument go? As a frame of reference, compare the inheritance of Tony Blair with that of Margaret Thatcher. The graphs, dug out by the investment management boutique, Smithers & Co, compare the two periods of political transition. Of course the long-term structural position in 1979 was much less favourable: there was rising inflation, rising labour unrest and a deteriorating competitive position vis-a-vis other countries. Now the long-term trend of inflation is down, there is very little labour unrest and our underlying competitive position (sterling aside) is probably still improving. But you can have a favourable structural position and a disagreeable cyclical one and the Smithers' case is that we are sliding into the latter.
The graph on the left suggests that it is possible for a recession to start without there being any increase in growth from its present level. There are certainly considerable deflationary pressures in the wings, which have not really been showing themselves because of the extraordinary surge in domestic consumption which occupies centre stage. Much of that surge is driven by the windfall gains from the building society conversions, but by no means all. Most of us have not noticed (as Lehman Brothers point out in their latest newsletter) that even stripping out the windfalls, real personal disposable incomes rose faster in the second quarter than at any time since 1979! The conclusion would be that even when the one- off stimulus fades, consumption will still be rising at an unsustainable rate. That would make the hard landing more difficult to engineer.
In any case, there are these deflationary forces around. They include, of course, the exchange rate, which is now in real terms as high as it was during 1980-81 and during the ERM period in 1990-92. The exchange rate is, so to speak, at recession-inducing level. Real interest rates, shown in the second graph, are also at the same sort of level that contributed to the 1980-1981 recession. While nominal interest rates are much lower, because inflation is lower, the level of interest rates is squeezing companies, which already are moving from being cash-strong towards being cash-weak, as the right-hand graph shows. On top of all this, there is the squeeze from the public sector, with Gordon Brown tightening fiscal policy even faster than Kenneth Clarke planned to do.
While consumers canter on, and with consumer confidence as high as it was at the top of the late 1980s boom, everything will seem all right. Companies can make up for the squeeze on export prices by increasing production to meet the strong home demand. The surge in share prices will, at the margin, contribute to the general level of confidence, while strong house prices will directly have that effect.
Eventually though, the economy becomes over-stretched. Thanks to the reforms of the labour market which have taken place over the last 18 years it is certainly possible to run the economy with much lower unemployment than was possible at the beginning of the 1980s, without leading to wage inflation. Nevertheless at some point wage pressures will inevitably build up - in fact they are already doing so in several specialist areas like computer programing. The economy created nearly 500,000 new jobs in the year to June which in one sense is wonderful. But eventually there are not enough people to fill the jobs, and the brakes will go on. Engineering the transition from over-rapid growth to sustainable stable growth was always bound to be difficult, but it has become all the more so because of the scale of the boom engineered by Kenneth Clarke's refusal to allow interest rates to be increased early enough.
We can now see the nature of the economic inheritance of the Labour government. In structural terms it was brilliant, and it will be quite hard to muck that up. But in cyclical terms it was a pig, and it will be very difficult to manage in the months ahead. The danger is that things race on too fast, then suddenly everything comes to a halt at the same time. Fortunately we have flexibility on interest rates, so in theory they can be nudged up now to choke off the top of the boom, and then cut very rapidly as demand falls away. But it is tricky to get this one right. Had Britain still been in the ERM and therefore had its general level of interest rates controlled from Frankfurt and suited to German and French conditions, we would be facing a real disaster. It would be absolutely impossible to shave the top off the boom, or avert the slump.
So what happens next? It would be lovely to be able to assert confidently that growth of consumption will peak soon, that it will be possible to sustain an unemployment rate of below 5 per cent, that inflationary pressures will ease off and that we will make a gentle transition to trend growth of, say, 2.6 per cent (i.e. 0.3 of a percentage point higher than the Chancellor currently envisages). It would be helpful, though dispiriting, to be able to assert with confidence that there will indeed be the dreaded hard landing. The truth is, we simply don't know.
We don't know partly because there may be errors of policy: it would be ludicrous to assume that the Treasury and the Bank of England will make the optimal decisions in the future, given their record in the past. (That may seem a bit of a cheap point, but they are bound to make some mistakes.) In any case even if our policy-makers were profoundly wise, those of other countries might not be. The more integrated the global economy, the stronger the risk of a policy error by, say, the Chinese, damaging economic activity elsewhere in the world. Even if all policy- makers were wise, the financial markets are not. The markets will make errors and these will de-stabilise economic conditions. Finally all economies are subject to shocks: things come along which no one expects and the effects of which cannot be predicted.
What we can sensibly say is that there is still an economic cycle and we must be reasonably close to the top of it. At some stage within the next three years there will be a period of below-trend growth, with rising unemployment, and falling consumer and business confidence. Things will feel more glum. Politicians will be less smug and more frightened. Voters will feel more grumpy. It will not necessarily be a full-blown recession akin to the early 1980s or early 1990s. But there is a possibility of that. Hardly anybody talks about it, even as a possibility - and that must be wrong not to acknowledge the danger. Paradoxically the sort of mood behind the surge that took place on the stock market at the end of last week makes another recession more likely, not less. Sorry.
Copyright: IOS & Bloomberg
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