Recovery credited to ERM exit: An internal Treasury study disputes government claims, writes Robert Chote
Sunday 25 July 1993
They might well be interested in a recent internal exercise by economists at the Treasury. They found - contrary to the Government's public claims - that Britain's current economic recovery is almost entirely the result of the pound's exit from the ERM last September. We can thank the failure of a policy in which the Treasury invested both its reputation and billions of pounds of taxpayers' money in fruitless intervention to prop up the currency.
The results have certainly been impressive. Figures for economic growth in the second quarter, released on Friday, confirmed that Britain's economic recovery is firmly under way and, as the Treasury never tires of telling us, is broadly based. A resurgence in inflation - the reason for resisting devaluation for so long - still seems a distant prospect.
The Chancellor of the Exchequer, Kenneth Clarke, told the Treasury and Civil Service Select Committee on Wednesday that recovery was not a direct result of the pound's devaluation - what his predecessor, Norman Lamont, described a year ago as the 'cut and run option; cut interest rates and a run on the pound'.
Mr Clarke said the recession had reached its trough in spring last year, well before sterling's expulsion from the ERM. He said the economy had been boosted by the substantial cuts in interest rates that occurred inside the ERM, although there had clearly been an extra boost from the further cuts since September, which had been accompanied by a fall in the pound.
But this is at odds with the Treasury's internal study. 'The signs of recovery in spring and summer last year would probably not have survived without the dramatic change in monetary policy that followed departure from the ERM,' said one Treasury official. A meaningful recovery would still not yet be under way, he added. The Treasury economists recreated a pessimistic scenario in which the pound was kept in the ERM at the cost of interest rates stuck at 10 per cent.
A more optimistic alternative assumed rates could fall in line with those in Germany. By leaving the ERM, Britain has been able to cut its rates well below Germany's, although the gap has narrowed recently.
The exercise concluded that national output - gross domestic product - would have fallen sharply rather than risen in the last three months of 1992. Since then, it would have risen only fractionally under both scenarios, rather than showing the 1 per cent growth we have actually seen.
There would only have been significant growth in the third quarter of this year if British base rates had followed German rates, and only in the fourth quarter if rates had stayed at 10 per cent. Excluding North Sea oil production, which contributed most of the economy's growth in the second half of 1992, there would still be little evidence of an upturn.
By early 1994, GDP would have been 2 per cent lower than current Treasury forecasts if interest rates had stayed at 10 per cent, and 1.5 per cent lower if British rates had followed those in Germany. Inflation would probably have turned negative.
This sort of exercise is fraught with difficulties. Forecasting what is going to happen under current conditions is difficult, but more so when assuming alternative policies.
Crucially, the exercise probably ignored the damaging effect of the collapse in business and consumer confidence that would probably have occurred had the recession continued. In reality, the consequences of staying in the ERM could have been even worse than the Treasury's exercise suggested.
The 0.5 per cent second quarter GDP gain announced on Friday was in line with City expectations, which had been boosted by two weeks of unexpectedly upbeat economic indicators. Recovery in Britain now seems safely under way, with no reason yet to expect a setback. The French should be so lucky.
(Photographs and graph omitted)
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