Most economic forecasters were wide of the mark. Where did we go wrong?

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The Independent Online
WHAT WILL we get wrong next year? A year ago the economic forecasters were almost universal in expecting either a recession or at least a sharp downturn in the UK this year. They were wrong. Even the relative optimists (like myself) were wrong, for though we thought the economy would avoid recession, we reckoned that it would struggle to reach much more than 1 per cent growth.

There was indeed a slowing of the economy in the first half of the year but at no stage did it stop growing altogether. Then there was the mini- boom we are experiencing now. While we do not of course have final figures yet for 1999, it looks as though growth will turn out to be around 2 per cent, not far short of the 2.2 per cent growth achieved the year before and higher than any forecast I can recall a year ago.

So why did we goof? Mainly I think because we paid too much attention to British industry. Last year there was a collapse of confidence by industrialists, who were being squeezed by the combination of the strong pound and highish interest rates. The pound made exporting tough, while high rates were squeezing demand at home. The result was they were almost as gloomy as they had been in the depths of the recession in the early Nineties.

As it turned out there was indeed a year of declining manufacturing output (see top left graph), but companies responded to the pressure by increasing productivity in a dramatic way. Unit labour costs in manufacturing (top right graph) plunged, though the costs of the rest of the economy continue to climb.

Meanwhile the Bank of England's rate cuts started to pull up domestic growth and, eventually, thanks to a modest recovery on the Continent, exports recovered too (bottom left graph). So it all came right in the end. Now think about the prospects for next year. The near-universal view is that it will be one of string growth. Forecasts vary, as you would expect, but according to The Economist's most recent survey the range is from 2.7 to 3.7 per cent, with an average of 3.1 per cent. That is a boom - even the bottom end of the range would be above the long-term trend growth rate.

So I suppose the question is really "what can go wrong?" If last year we were too gloomy, maybe this year we will turn out to be too cheerful. Let's first see the reasons for the cheer. The forecasters see a number of bull points. UK domestic demand will remain robust, fuelled by the wealth effect of strong house prices, falling unemployment and rising real wages.

External demand will be strong too, thanks to decent growth on most of the Continent - though it is interesting that the consensus holds that this year Britain will yet again have faster growth than Germany or Italy and almost as fast as France.

This robust growth will push interest rates higher, which will in turn support sterling. The high pound, coupled with the collapse of pricing power in the goods market, will in turn keep inflation more or less under control. (That collapse of pricing power in goods is shown in the bottom right graph.) Result? A year of strong growth without any serious surge in inflation.

Right. What can go wrong? I would list five prime candidates. One would be a sharp fall of share prices, starting in the US. That could be driven by any number of things, but a loss of confidence in hi-tech stocks would be one obvious trigger. Candidate two is associated with number one: rising world interest rates in the face of higher inflation. It is fascinating how little inflation there is in the world, given the length of the boom in the US, but there are signs of pressure. Look at commodity markets or the oil price, both of which have shot up in the second half of this year. Next year will be one of rising rate anyway. If there were a sharp rise in inflation, the rise in rates would have to be all the greater.

Candidate three leads on from that: a collapse of the dollar. The size of the US current account deficit is already causing alarm and while it has been easily financed, thanks to the perceived investment opportunities in the US, at some stage it will have to come back. Associated with that deficit is the personal deficit of US households, now net dis-savers. There have been periods in the past when other countries' households have been dis-savers, but these have never lasted for more than two or three years. I suppose the US could go on for another year or so in this way, but the longer the adjustment is delayed the greater the shock when it comes.

Candidate four is the return of the East Asian crisis. Most of the countries in the Far East have staged a solid recovery this year, but Japan remains terribly fragile. It has just had another quarter of negative growth and may be back in recession. The budget deficit this year look like exceeding 10 per cent of GDP, an utterly unsustainable level. The rest of the world managed to shrug off Asian crisis number one, so presumably it would cope with a re-run. But it is a danger.

Finally candidate five, the millennium bug. Remember him? The consensus now is that this will turn out to be pretty much of a false alarm, thanks partly to the fact that we were all so worried about it. But we don't know until the year begins. I suppose I am less worried about the bug itself and more about post-millennial exhaustion - that people will feel that it has been a great party but they would just like to rest a bit, recoup their savings, ponder rather than spend.

There is no rational reason to expect such a flop in confidence, but then if reason enabled economists to call the future correctly we would not have cocked up last year.

For what it is worth I think none of those five concerns noted above will cause growth here to drop below the bottom end of the expected range: we will get growth of at least 2.7 per cent.

Some of these may well happen: there may, for example, be an Internet crash. But there is so much momentum in the economy that we will carry through 2000 OK. Not so sure about 2001, though.

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