Should we be as miserable as we are?
Sunday 01 October 1995
Expectations are absolutely central to economics, and here was a fine example of the entrenched negative view that people now have about property values. Rationally there may be sound reasons to think that British property prices will, at worst, fall no further in money terms, and that they may make a modest recovery during the next couple of years. The principal reason for this is that, relative to earnings, houses are already at about their most affordable level since the war, and earnings are rising at about 3 per cent a year. Sooner or later, rising earnings will be reflected in rising house prices. But this is not what many people expect.
These sober expectations for house prices are reflected in similarly sober levels of consumer confidence. Of course, there is a relationship between the two: people not only feel more like splashing out if they feel they have made money on their houses; they also tend to move more when house prices are rising and accordingly buy more consumer durables to put in their new homes. The weakness of the housing market is one of the two main reasons (the other being greater job insecurity) usually advanced to explain why consumer confidence has failed to recover along with the economy as a whole. True, there has been some rise in confidence from the depths of 1990, but as the left-hand graph suggests, not nearly as much as in previous cycles.
This failure of consumer confidence to recover is usually advanced to explain the failure of the Government to reap any electoral benefit from economic growth. And if the underlying reason for low consumer confidence is the housing market and job insecurity, there is an obvious problem for the Government. It might be theoretically possible to engineer another housing boom if the Government was prepared to overlook the grave new problems that would create; but it would be difficult given the experience of the last seven years. As for job insecurity, that seems to be growing (and hitting new areas of the job market) despite rising levels of employment in general.
But suppose there are other explanations for low confidence. Ian Shepherdson, at stockbroker HSBC Greenwell, has just produced a paper, Are we as miserable as we think?, which argues that there are. His view is that there has been a downward trend in consumer confidence for the last 20 years and that fluctuations about the downward trend can be explained by tax and interest-rate changes. Adjust for the trend, add in the impact of tax increases and rising base rates over the last couple of years, and all is explained.
His conclusion is that if the Chancellor can find pounds 4bn of tax cuts this November, as expected, followed by a small cut in base rates in the new year, confidence will rise quickly and sharply. That will then lead to a recovery in the housing market in the spring (he argues that consumer confidence leads the housing market, rather than the other way round) and the Government's poll rating will probably recover, too.
It is an intriguing prospect, particularly for the battered Government forces, but is it right?
The first thing to be aware of, is that expectations are frequently wrong. It is not just consumers who fail to foresee that they might become more cheerful in the future. Professionals are affected by swings of mood too. Of course, you can see this pattern in a rather unscientific way in stock market booms and busts. But you can actually measure market errors in interest-rate expectations with great precision by looking at the rate for base rates a year or so ahead as predicted by the futures market and then comparing it with what actually happens.
The second graph does that. Back in January, the indicated level of base rates for this December was 9 per cent. Through this year, the rate has progressively declined so that at the moment the futures market is predicting either unchanged rates or perhaps even a slight fall. If the professionals have been so spectacularly over-pessimistic about the course of interest rates (and remember this is not what the professionals thought, it is what they actually did), is it not reasonable to expect the rest of us to be a bit over-pessimistic, too?
One caveat: one of the reasons why the markets got interest rates wrong was because they did not foresee the slowdown in the economy, which is now evident. Were that slowdown to affect employment levels, and unemployment were to start heading upwards again, any benefit to confidence from lower- than-expected inflation might be offset by higher-than-expected job insecurity. But a mid-term pause in a recovery frequently happens (it happened, slightly earlier in the cycle, at the time of the last US presidential election) and that is what the present slowdown looks like. It is, on balance, more probable that growth will pick up in the spring, making it impossible to cut rates, and maybe making it necessary to raise them, than the whole recovery stopping.
That is perhaps the principal weakness of the Greenwell thesis. The argument is solid enough, and the observation that confidence can flip round very quickly under the right circumstances is certainly historically correct. The issue is timing. It may not be possible for the Chancellor to cut taxes by the pounds 4bn this year, given that revenue is running below expectations and borrowing accordingly above them.
And just as the markets were over-pessimistic about interest rates earlier this year, they may be over-optimistic now. It is plausible to expect a fall in short-term rates perhaps towards the end of 1996, but it would be dangerous to try and engineer that in the spring. If growth does indeed recover in the first part of next year, there may well be a rise in rates - they may have to go up before they can come down.
I have another, and quite unconnected, reason for doubting that a recovery in the "feelgood factor" will necessarily benefit the Government to the extent to which it would hope and on the timescale needed to win an election by the spring of 1997. There is a powerful supposition among politicians and political commentators that elections are determined by economics. They draw graphs showing changes in real personal disposable income and support for the government of the day to help prove it. Of course there is some relationship, but is it not equally true that elections are about politics?
So it was possible for the present Government to win an election with the economy very close to the bottom of the longest recession (though not the deepest) since the war. As the first graph shows, we did not feel very good in spring 1992. We may well feel better in spring 1997, indeed I think we will, but I am less sure that we will be inclined to give the credit for that to Her Majesty's Government. We may prefer to take the credit ourselves.
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