After the flood: The markets have stabilised but the risks to our recovery remain significant, whatever George Osborne may say


Click to follow

Much as Britain enjoys a reputation for insularity, this country still depends for a third of its national income on exporting. Our pension funds and companies are widely invested overseas, and our larger companies, financial services and property markets are intimately linked to the rest of the world. So it should be no surprise that the recent turmoil in global stock markets, though originating in China, should have had such a rapid and dramatic effect on confidence in this country, too.

Nor, indeed, has there been any absence of other causes for concern. The flare-up in tensions between the Koreas was as serious as anything seen in recent years, and the Greek debt crisis continues to deliver fresh unwelcome twists – this time another general election. Iran’s rapprochement with the West is a rare bright point, and even that was driven by the existential threat of Isis. All in all, then, the world is finding plenty to worry about.

What happens next depends on the reaction of the authorities here and abroad. The immediate reaction, especially from the People’s Bank of China, is to throw money at the markets, forcing pension funds to invest in Chinese equities (unwise) and reducing interest rates and allowing banks to lend more (wise, on balance).  Western central banks may well follow suit, or at least postpone the rises in rates expected later this year to next year. Again, those would be prudent responses.

The problem is that Western governments and central banks are running out of room for manoeuvre. Interest rates set by central banks are at historic lows in every major economy, with money being injected into economies also running at record levels. Meanwhile, many governments have, practically, run out of room to borrow significantly more, having seen deficits and national debts balloon after the banking crisis and the subsequent recession.

Britain is not alone in having seen disappointing progress in debt reduction, despite (or perhaps because of) austerity. Sooner or later, the authorities will simply run out of ammunition to save plunging stock markets, failing banks and stalling economies.

A random shock, such as this precipitous fall in Chinese share values, can have a much magnified effect in a closely interlinked global economy still weighed down by public and private debt, both on financial markets and real economies. It represents a threat to employment levels, the profitability of business and prosperity generally. George Osborne may have wanted to reassure the nation when he reflected on how remote the bursting of a speculative Chinese equity bubble is, but this very complacency provides its own reasons for alarm. Mr Osborne, after all, can create as many warm words as he wishes, but he has less freedom of action over the real economy that would help ward off a fresh recession.

In the short term, the general slowdown in the world economy, as well as the shale gas revolution in the US, has led to cheaper petrol and lower energy bills. Inflation is at, or close to, zero. When this was accompanied by economic growth and job creation, as over the last year or two, this was a benign phenomenon. Hard-pressed households hit by the squeeze on living standards, tax rises and unrelenting cuts in public services have had some relief. That positive progress will slow and could, quite conceivably, turn into a deflationary spiral, every bit as pernicious as the bouts of inflation that have hurt the economy in the past.

As they say in China, we are living through interesting times.