Economic View: How worried should we be?

It is a not-so-happy New Year, to judge by the warnings of our Prime Minister and, more prosaically, the lacklustre mood on the high street.

It is a not-so-happy New Year, to judge by the warnings of our Prime Minister and, more prosaically, the lacklustre mood on the high street. Most of us are worried and grouchy, concerned that things may get a bit out of hand in the months ahead ... and those of us who aren't haven't been paying attention.

But how should we know whether our discomfort is justified? We have had plenty of experience of worries that have proved unfounded. What should we look for so that we can calibrate the concern? Let's take five obvious issues facing the world economy – not the only five by any means but five of the most important – and try to make a judgement as to where the crunch points might come.

The first, I fear, is the coming war in the Middle East. This raises, of course, huge humanitarian and security issues but this is not the place to get into a discussion about those. Focus instead on the key economic issue: to what extent might war derail the world economy?

There are two issues here: confidence and oil. Economic confidence is quite fragile at the moment and a war does not encourage people to go out and splash money about. One sizeable chunk of the world economy, travel and tourism, will inevitably be hard hit. Since that constitutes 11 per cent of the total and there will be knock-on effects too, were the war to become drawn-out then concerns would mount. As a rule of thumb, any conflict lasting more than six weeks would be very negative, but a swift success would be equally positive.

As for oil, there is a single marker, the oil price, which takes concerns about damage to the Middle East oil fields, political instability elsewhere in the region and other energy-related worries into account. Some rise is likely: you can already see it in the forward markets. But a rise to, say, $40 a barrel should not be a serious concern.

If, however, it were to go to $60, the level often cited as the top end of the possible range, then the probability is that the US would experience another leg to its recession. As a result, the rest of us in Britain, continental Europe and Japan would have a tough time too.

The next area of worry is UK domestic demand: can the consumers keep up their spending, or rather can they cut back in a slow and reasonably controlled manner? An economy growing at 2.5 per cent a year cannot indefinitely sustain consumption rising at 4 per cent plus a year. But the transition is a difficult and dangerous manoeuvre.

The key here is house prices, for they have been underpinning the boom as people extract part of their additional equity in their homes and spend it. Prices are over-stretched in relation to income (see first graph above), though low interest rates have held debt-servicing charges down.

Roger Bootle, who drew attention to this in a recent paper for the accountants Deloitte & Touche, thinks house prices could fall by 20 per cent from the peak. That looks plausible for at the top end of the market it has already happened. That would only be shaving the top off the bubble and I am not sure it would be enough to lead to an actual fall in consumption, but it would certainly curb its growth.

So: a fall of up to 10 per cent this year would not be a disaster, but one of more than 20 per cent would be worrying indeed.

The third issue is US consumers, who on a quick back-of-the-envelope tally I reckon account for some 35 per cent of world consumption. They, too, need to carry on spending until US corporate investment picks up and takes over the torch of growth.

But will they? The Conference Board's index of consumer confidence has been a good predictor of future trends and (see second graph above) it has been discouraging of late. If it does not recover in the next three months, or worse, if it falls again, there could be a second leg to the US recession towards the back end of this year.

Four is the eurozone and, in particular, Germany. It is on a knife-edge between stagnation and slump. The best forward indicator here is the IFO index, which as you can see from the third graph, has gone negative again. Industrial production is likely to carry on falling, though thanks to services, the economy as a whole may just squeak by and remain in growth. But if that is wrong and Germany is back in recession this spring, then this is very bad news for the entire eurozone. Indeed, it is hard to see how Germany can dig itself out, given that it has an ECB monetary policy that is too tight, and is experiencing a fiscal squeeze too.

So the test there is: does Germany have another leg to its recession?

Finally, there is Japan and the issue here is deflation. Growth is terrible and the leading indicator (final graph) is now negative again. But Japan cannot escape until it can manage to create some inflation. The debt burden of its company sector is so great and companies themselves so unprofitable that debt has to be reduced in real terms by inflation.

My test there is whether prices in Japan at the end of this year are higher or lower than they are today.

Deflation in Japan has global significance, for this may be a pointer to what will happen elsewhere. We may be moving to a falling-price world, which would not be a disaster in itself, but would be very different from the world that anyone under the age of 75 has known. Interesting times indeed.