The Anglo-Saxon twins part company

There has been greater fiscal and monetary tightening in UK, and a rising real exchange rate
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The Independent Online
THE CBI survey, which was published last week, confirms that the UK has now embarked on a familiar end-of-cycle experience. The virtuous circle of the last few years - which has involved rising GDP growth, capital inflows, higher equity prices, a rising exchange rate and subdued domestic inflation - has clearly come to an end. Base rates should now have peaked, and the Bank may soon need to contemplate cuts as the economy slows.

This disappointing awakening, following several years of misplaced optimism about the underlying behaviour of the economy, immediately raises the far more significant question for the world economy of whether the US might be about to suffer a similar disenchantment. Several points of comparison are relevant here.

First, there has been surprisingly little evidence that the underlying supply side behaviour of the US economy has been superior to that of the UK during the 1990s. Although the growth in productivity in the manufacturing sector has been much higher in the US over the past three years - which is very unusual - this is probably because the growth in both UK manufacturing output and productivity has been severely understated by the official British statisticians. For the economy as a whole, which is obviously more important than the manufacturing sector, there has been no sign of any significant divergence in productivity performance between the two economies.

Essentially, both have recorded overall productivity growth of around 1.5 per cent per annum since 1995. There is no sign here of an underlying supply-side miracle in either economy.

Second, there is the question of the growth rate in real fixed investment, which has been very substantially higher in the US than in the UK in recent years. The cumulative growth rate in real fixed investment in the US over the past four years has been almost 40 per cent, as compared to under 20 per cent in the UK. This may to some extent explain the superior productivity performance in the US manufacturing sector. However, there are a couple of offsetting points to bear in mind.

First, the path for real investment in the UK has probably been under- estimated as a result of an over-statement in the price deflator for investment goods in Britain.

Second, and somewhat surprisingly, there is no evidence from the behaviour of capacity utilisation that the UK manufacturing sector has been operating at higher levels of capacity than its American counterpart. In fact, both US and UK manufacturing sectors have been working moderately above their normal capacity utilisation continuously over the past five years.

A third element of supply side performance concerns the structural level of unemployment, or NAIRU, in the labour market. Goldman Sachs economists estimate that the NAIRU in America may have dropped from around 7 per cent of the labour force in the late 1980s to around 5.5 per cent now. In the UK, it is more difficult to derive precise estimates for the NAIRU, but a sensible guess is that there has been a similar drop, from around 10 per cent of the labour force in the late 1980s to around 8 per cent today.

Overall, it appears therefore that there is relatively little evidence to suggest that the underlying supply side performance of the US economy has improved sharply relative to that of the UK in recent years. This, in turn, suggests that the US economy may be no better protected from the adverse effects of a strong cyclical upswing than the UK economy has been. What, then, does account for the difference between the two economies?

The main factor is that the intensity of the cyclical upswing has been greater in the UK than in the US, so that resources have been under greater strain. UK GDP relative to trend has risen from a negative output gap of around 3 per cent in 1993 to a positive output gap (allowing for likely data revisions) of perhaps 1.5-2 per cent now. Therefore the upswing in the cycle, relative to trend, has been of the order of 4.5-5 per cent of GDP.

In the US, the upswing has been less intense, with the output gap rising from around -2 per cent in 1992 to about plus 1 per cent now, making a swing of 3 per cent in total. Thus, while the current levels of the output gaps in the two countries are broadly comparable, the change in the output gap in the UK has been much the greater.

In addition, the UK unemployment rate has dropped by almost 6 percentage points in the course of the recent upswing, while in the United States the decline in unemployment has been only half as large, at around 3 per cent. This difference has been clearly reflected in the behaviour of both earnings and prices. In the UK, private sector earnings have accelerated by around 3 percentage points over the last two years, while the equivalent acceleration in the US has been only around 1 percentage point.

Similarly, the underlying rate of consumer price inflation in the UK has continued to run in the region of 3 per cent over the past two years, while in the US the same measure of inflation has fallen from around 3 per cent to about 2.25 per cent over the same period.

As inflation pressure has emerged, there has been a much greater fiscal and monetary tightening in Britain than in America, and a much larger rise in the real exchange rate. For example, the Goldman Sachs monetary conditions indicator for the UK has tightened by around 400 basis points in the past two years, compared to a tightening of around 150bp in the US. Meanwhile, the fiscal impulse in Britain has swung towards tightening by around 5 per cent of GDP, as compared to a swing of only about 1.5 per cent in the US. Finally, the effective exchange rate has been much more overvalued, relative to equilibrium, in Britain than in America.

Based on these comparisons, I conclude the following. First, the underlying supply side behaviour of the two economies has been surprisingly similar.

Second, the UK has been subject to a more intense demand-led upswing than the US.

Third, this has led to greater inflation pressure in the UK, both in the labour market and in the consumer price index.

Fourth, in response to this worsening in inflation, there has been a much greater policy tightening in the UK.

Fifth, it is this clash between worsening inflation pressures and much tighter macro-economic policy which has led to the end of the cyclical upswing in Britain.

The clear implication for the US is that it may one day be subject to the same end-of-cycle problem that now faces the UK, if the US authorities make the mistake of allowing the pick-up in domestic demand to become too intense, leading eventually to the re-emergence of inflation pressures.

Once that happens, a familiar vicious circle can easily set in, involving tighter monetary policy, weaker equities, a reversal in the strong exchange rate, and the manifestation of inflation problems which had hitherto been disguised by the rising exchange rate.

It does not appear that the US economy is yet generating enough inflation pressure to induce this problem in the near future.

However, it is equally clear from British experience that nothing has happened in the 1990s to make this outcome impossible in the years ahead.