Summer of discontent: Peter Torday, Economics Correspondent, answers the questions that are troubling the country - and which are tormenting the Government

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What went wrong?

IN THE 1980s the economic philosophy of Ronald Reagan and Margaret Thatcher dominated Western economic policy- making, with many governments accepting that the only way to achieve sustainable growth without inflation was to reduce the role of the state and cut taxes. Firms would be free to invest, while people would work harder and spend more.

This creed helped to create a boom in the so-called Anglo-Saxon economies and in Japan. Britain, the US, Canada and Australia swept away long-established curbs on personal credit and regulations governing financial markets, and there followed an unprecedented - and unsustainable - personal and corporate borrowing spree in all these economies.

Japan joined this club only under international pressure. The short-term result was spectacular: the property market boomed and share prices soared.

Continental Europe was more cautious about the Reagan-Thatcher line. Deregulation there was much slower. Europe also had a formal and coherent anti-inflation policy, in the shape of the European Monetary System. The most well-founded expansion in the 1980s occurred here, with growth based on low inflation and growing investment. Unfortunately for us all, this solid edifice began to crack after German reunification. The collapse of the eastern economy and steps to rebuild it began to push up German inflation, and the Bundesbank reacted by forcing up European interest rates. It is the combination of these events - the ending of the Anglo-Saxon credit binge and rebuilding of eastern Germany - that has caused world growth to slow so sharply.

Is it worse here?

Much worse. A recession is defined as a sustained period in which an economy fails to grow, and actually contracts. The British recession began in 1990 and is still in progress. In Germany, France and Italy it has still to begin. The Japanese economy has suffered more than two years of plunging property and share prices, but it is still expecting to grow this year. Even the US seems to be getting off more lightly, so far. Its economy experienced a shallow nine-month recession in 1990-91. Since then it has expanded slightly, and fitfully, but there are now fears of a dip back into recession. Some sectors and some regions of the US have, however, been in recession since the late 1980s, and it is certain that the economic problems of the US are no less deep-seated than ours.

Are the Tories to blame for the depth of the recession?

Yes, largely. The boom was created by policy changes - and the boom led to bust. The Government deregulated the access to credit, ending, for instance, the practice of rationing mortgages by making people queue for them. By the mid-1980s, we were raising 100 per cent mortgages, often far in excess of our ability to service them if interest rates were to rise. We borrowed to buy houses, cars, consumer durables - or just to go on holiday. Companies also borrowed easily to finance expansion, often through expensive and dubious take- overs. Property and share values, it seemed, could move only upwards.

The boom would not have been so spectacular - or have created so many problems - if we had had a clear navigational guideline to keep us on an anti- inflationary course. But there was none: the orginal attempt to steer the economy by money-supply targets failed because they gave misleading and confusing signals. Then Margaret Thatcher repeatedly vetoed Nigel Lawson's attempts as Chancellor to join the European exchange rate mechanism, which was used by much of Europe to ensure low inflation and stable growth.

In 1987 and 1988, the boom got even more out of hand as Mr Lawson tried to keep the pound low by cutting interest rates. As demand outstripped supply, companies put up their prices and bought more goods from overseas. Then in March 1988, with imports and prices rising , the Chancellor and the Prime Minister cut the top tax rates from 60 per cent to 40 per cent, and the basic rate by 2p, stoking the boom even more.

By summer the party was over. The Government had to start raising interest rates. In a little over a year, they were doubled from 7.5 to 15 per cent. There followed the longest monetary squeeze since the Second World War, forcing people and companies to cut spending to service their debts.

Are there signs of an upturn?

No, not really. There was a flicker of increased activity last summer. Then the economy looked as if it might pick up this spring. But these were false dawns. Worryingly, after several years of improved export performance, there are now signs of a relapse, largely due to weaker markets abroad.

Meanwhile, last week's Confederation of British Industry survey suggests that manufacturers will remain mired in recession for months. Unemployment has climbed to 2.72 million from 1.6 million in the late 1980s, and is expected to reach at least three million. Some 300,000 mortgagees are more than six months in arrears, while another 35,000 homes were repossessed in the first six months of the year.

But there are some grounds for hope. The rate of increase in unemployment seems to be slowing, and service employment rose in the first quarter, for the first time since the recession began. The five-point fall in mortgage rates has given people a lot of extra cash, although much of it is simply being saved.

Industry, meanwhile, is well placed to benefit from recovery. Productivity and competitiveness have improved, investment in plant and machinery remains high by historical standards and investment in training has risen.

Could recession

become slump?

Very unlikely. A slump is a sustained fall in output over several years, such as occurred in the early 1930s. In the Depression of 1929-33, US gross national product tumbled by 30.5 per cent. In Britain it contracted by only 4.9 per cent. However this followed two deep British recessions in the 1920s: 13 per cent during 1920-21 and 3.5 per cent in 1925-6. So we are not there yet.

The housing market, however, is in a slump. Falls in prices of up to 30 per cent are not uncommon in some regions. And plunges of 50 per cent have been reported. In addition, the construction industry is close to depression - construction output has shrunk by almost 14 per cent since the first quarter of 1990 and is still shrinking.

Are interest rates about to rise?

Maybe. A strong outflow of funds from the building societies is putting upward pressure on mortgage rates. This is partly due to competition from National Savings, but also reflects a traditional summer outflow as consumers draw on savings to finance holidays.

In addition, Britain was one of the few EMS member states that failed to raise rates after the Bundesbank's recent increase. There are also signs of upward pressure on rates in Britain's money markets. And worst of all, the threat of a further increase in German rates will linger.

Would a devaluation within

the EMS help?

Probably not. Proponents of devaluation argue that the high pound is hurting our exports, but in fact exports have been growing well. The only area where exporters are finding it particularly tough is the US, thanks to the fall in the dollar, and the Government cannot affect what happens to the dollar.

The other argument for a devaluation is that it would allow lower interest rates. But the case is weak, and it might even result in higher rates. In the markets, a stigma attaches to countries that devalue. International investors might think that we would devalue again, and demand higher rates to compensate. The experience of France, which devalued several times in the 1980s, shows that it takes years to restore market confidence. France last devalued in 1987, and it is only in recent years that the markets have allowed French rates to fall close to German levels.

Another option - favoured by the CBI and the Labour Party - is to adjust the German mark upwards against all other EMS currencies (which is the same as adjusting the others down, but sounds better). This might allow lower German import prices and inflation, and encourage the Bundesbank to cut interest rates. As a result, interest rates could come down throughout Europe. The catch here is that the French and the Benelux countries are against letting the mark rise, preferring to lock their currencies together. They want a single currency, and fear any change against the mark would undermine their hard-won reputations and push up their interest rates.

Should we leave the EMS?

Other critics of the Government argue that we should allow the pound to float, abandoning the EMS altogether. This might allow lower interest rates, but only if the pound fell so far that people thought that it could only go up. That could push up the price of imports so much that inflation would soar.

Membership of the EMS exchange rate mechanism has given Britain a guideline for its anti-inflationary policies, whereas previously there was none. If Britain were to leave, it would have to find a new guideline and none seems to be available.

Should the Government spend more?

Spending your way out of a recession may have become a heresy, but it is also possible to go too far in the other direction, and make things worse by restricting public expenditure. The Government has made much of its new measures to hold down spending, but in fact some leeway has been left to spend more if the recession worsens. Most notably, if unemployment continues to rise, so can spending on benefits.

In other ways, too, the new controls are modest and still allow for considerable growth in public expenditure. But there are dangers. The Treasury's revenues from tax are falling because people are earning and trading less, so the expansion of spending could leave the Government facing a budget deficit of up to pounds 40bn by 1993-94. Beyond that, tax increases would be certain - the last thing we need in a recession.

So spending priorities need to be chosen carefully. There is a strong case for spending on imaginative schemes to halt the housing depression, which is crucial if a recovery is to emerge. The Government should also be careful to avoid cuts in capital programmes which improve the infrastructure and hence Britain's ability to compete.

Can't we stop worrying about inflation?

Not yet. The rate of inflation stands at 3.9 per cent and the Government forecasts it will drop to 2.25 per cent in the next two years. Manufacturing prices are rising at their slowest pace in 25 years and there are almost no natural upward pressures on prices. Yet inflation rates in the service sector still run as high as 8 per cent. Some commercial property contracts still contain provisions in which rent reviews can result only in increases. Services are often immune to international competition, and thus take longer to respond to any downward pressure on prices.

Is Britain simply in long-term decline?

It may be. The Thatcher years broke the power of the trade unions and encouraged business people in a way that should help the country to take advantage of the next recovery, but there is no denying that the economy's potential performance has slipped back. Even during the boom of the 1980s, average annual growth rates failed to match those of the 1960s. But they were decisively better than the 1970s. From 1960 to 1973, the average annual growth rate was 3.2 per cent. From 1973 to 1979, it dipped to 1.4 per cent. And from 1979 to 1990, the rate was 2.1 per cent. The Treasury thinks that potential growth rate - in which the economy can grow without inflaming inflation or deepening the trade deficit - has dipped to between 2 and 2.5 per cent. In other words, we are incapable of growing as quickly as we did in the 1960s.

Some economists argue that, when the recovery comes, we will be much better placed to take advantage of it. The greatly improved shape of manufacturing industry was underlined by the strong rise in export growth as domestic markets weakened. But even if all this is true, many other economists argue that our factories may be fitter, but they are also smaller and fewer in number. We simply do not make enough. In spite of recession, we are still running an underlying trade deficit of around pounds 1bn a month. When recovery comes and we start to spend again, imports will rise and the trade deficit will deepen.

Would it help if I spent more?

You must ask some searching questions. Are you fairly secure in your job? Have you cut back your credit-card debt? Is your mortgage manageable? Is your house still worth a lot more than your mortgage? If so, buy a new car, take a holiday, and replace your computer. You will never be able to buy such bargains as at the bottom of a recession, and you will be helping the recovery. After all, no upturn since the Second World War has taken root without increased consumer spending.

Saturday night is always the time to do it

THE 1967 devaluation was like an earthquake, albeit one preceded by many tremors and a fair amount of panic. At 9.30pm on 18 November - a Saturday, so that the markets could not react immediately - James Callaghan, the Chancellor, announced that the value of the pound would be cut from dollars 2.80 to dollars 2.40, the first such adjustment in 20 years.

Devaluation was an attempt to break out of a nightmarish downward spiral of bad trade figures, foreign loans, runs on sterling and haemorrhages of reserves. The government had denied any intention of taking such a step. Edward Heath, the Conservative leader, calculated that there had been 20 denials in 37 months.

The next night Mr Wilson, in his famous 'pound in your pocket' television broadcast (above), called on the nation to 'take with both hands the opportunity now presented to us'. He ended: 'We're out on our own now. It means putting Britain first.'

Mr Heath, on television on Monday night, declared: 'As Mr Wilson himself said a few years ago, devaluation is an acknowledgement of defeat.'

If the pound were devalued again now, the shock would be immeasurably smaller, not least because the value of sterling has travelled up and down so much in the intervening years - it has been very close to one-for-one parity with the dollar, and is now worth nearly dollars 2. The formal change would come, not in the rate against the dollar, but against the mark and possibly other EMS currencies.

In the early days of European monetary co-operation, long before the pound was admitted, these 'realignments' were by no means unusual. In the mid-1980s, however, discipline improved and the EMS gained credibility. A cruel rule applies: the longer the regime holds, the greater the shock of a change. A realignment now would still be dramatic.

There would be market speculation and denials. Then, one Saturday, either without advance announcement or in the guise of a routine informal meeting, finance ministers would gather, probably in Brussels, to begin haggling. If problems arose, they would go on until the last moment before the foreign exchange markets opened. On Sunday evening everyone present would declare a victory; oppositions would denounce a defeat and there would be calls for the nation to put its shoulder to the wheel and get things moving again.

(Photograph omitted)