Politics points to the wrong Budget strategy
Monday 27 November 1995
A much more important principle is to take economic decisions at the last possible moment from an administrative point of view, so that policy can always incorporate the most up-to-date information. Under the new arrangement, tax plans are announced four full months before they need be and, in those four months, much can change. The unnecessary four-month lag is particularly important this year, since there is a severe risk that the behaviour of the economy could change markedly over that period.
Not that the Budget documentation will recognise this risk. It is usually quite easy to forecast what will be contained in the Treasury's forecast. Tomorrow's official view is likely to show real GDP growth of 2.5 per cent in 1996, with underlying inflation at the end of next year also at 2.5 per cent. But while this will be the central expectation, it has probably been entered into the Budget Red Book with a rather shaky hand by Alan Budd and his Treasury team.
The problem is that output growth may be about to take a severe dent from a sharp turnaround in the stock-building cycle. Goldman Sachs has just downgraded its 1996 GDP forecast from 2.7 to 1.7 per cent, and many other forecasters are probably just on the point of doing something similar.
A serious setback to activity would catch politicians on both sides of the fence unawares. It is my strong impression that Westminster is basically assuming the economy is performing well, and that it will continue to do so right through to the election. All hell would break loose in the Tory Party if there were a prolonged period of rising unemployment during the winter. This is no longer a remote possibility. At minimum, the next few months could see some really gruesome manufacturing output figures. As this column pointed out last week, the word from firms in continental Europe has become increasingly grim in recent weeks, and this is bound to impact UK export sales soon.
Much of the downturn in European activity has stemmed from the inventory cycle, and the same is now true of the UK. During 1994, when Britain's GDP grew by 4.3 per cent, the accumulation of stocks was responsible for about a third of this growth. At that stage, companies were eager to build stocks for two reasons. First, there were fears of continuing rises in commodity prices, so companies decided to stockpile primary goods. Second, there was increasing confidence that final demand would accelerate in 1995, and companies began to build up stocks of finished goods in anticipation of rising sales. In the first half of 1995, changing perceptions about commodity prices and final demand caused firms to rethink stock levels; ever since, they have been trying to reduce the quantity of goods on the shelves.
Unfortunately, they have not yet succeeded. Over the past year, the level of stocks has actually risen by 4.4 per cent, more than double the rate of growth in output. As a result the stock/output ratio has risen in a worrying fashion. For example, in manufacturing, the stock/output ratio has risen by 4.1 per cent in the past 12 months, compared with a long- term trend decline of 2-3 per cent a year. Most recently, things have become even worse. During the third quarter, the rise in stocks accounted for the whole of the 0.4 per cent increase in GDP. Other components of demand contributed nothing at all.
A rise in the stock/output ratio is quite normal in the upswing phase of the cycle. But the CBI survey, and other business surveys, are clearly showing that companies are increasingly eager to get rid of these excess stocks. The November Monthly Trends Enquiry by the CBI recorded a balance of 18 per cent of companies saying the stocks of finished goods are too high, against 6 per cent in the spring.
More worrying still, the gap in the CBI survey between what firms say they want to see happening to stocks in future, and what has actually happened, is even higher than it was when the economy entered recession in 1990. This suggests a near-record build-up of unwanted inventory. It is anyone's guess how fast these excessive goods on the shelves will be whittled down to more normal levels. If companies expect 1996 to be a good year for sales, they may be tolerant about the current level of stocks. If they begin to doubt the sustainability of growth,they might decide to curtail stocks rapidly, and they could only do this by slashing output for a while.
What is a reasonable central estimate of the speed of this adjustment? The good news is that companies have a strong cash flow position and the cost of financing stocks is not excessive.
The bad news is that the pervading sense of pessimism in the economy, especially in the consumer sector, could make them unwilling to hold stocks in the hope that final demand may eventually revive. According to the new Goldman Sachs forecast, the most likely out-turn is that the decline in stocks will reduce the growth rate of GDP by about 1 per cent on average in the 1996 calendar year, and by somewhat more in the next six months. Like all forecasts which are crucially based on a guesstimate of how stocks will behave, this projection should be seen as having a particularly wide margin of error. But the chances of a period of declining output in the manufacturing sector, with a clear renewed rise in unemployment, are definitely rising.
It would still be surprising if this turned into a serious recession, but policy now needs to take account of this possibility - especially since the drop in manufacturing activity will greatly increase the chances of the Government hitting its inflation target in two years.
In the absence of an impending election, the correct macro-economic strategy would be to leave the overall level of personal taxes unchanged; to increase public spending on the infrastructure, taking advantage of the slack in the construction sector; and to reduce interest rates for the duration of the stock shake-out, probably increasing them again in 6-12 months.
Sadly, political imperative points to the opposite - personal tax bribes, financed by further cuts in public infrastructure spending, and with a path for the PSBR that will make interest rate cuts harder to achieve than they need be. But then no one ever said that good politics and good economics need always coincide.
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