Stephen King: Trade correction may have more import than we think

Demand has held up because consumers have been fed an illusion

Interesting times. Last week's rate cut from the Bank of England wasn't totally unexpected, but it came at a time of increased uncertainty over the structural health of the UK economy. Earlier last week, the Office for National Statistics (ONS) published newly-calibrated figures suggesting a far weaker UK trade position than anyone had previously expected. The reason? VAT fraud across Europe, which had led to a significant under-recording of imports.

Now, you might think, "So what?" After all, no one worries too much about the trade position between, say, England and Wales. That, however, misses the point. We don't worry because we don't know: no one has bothered to collect the data. That doesn't mean to say, though, that the relationship between England and Wales doesn't matter. For the UK as a whole, however, the data is collected and, as a result, we think we know quite a lot. So when there are major revisions, it's time to re-assess the situation.

According to the ONS, imports into the UK are now deemed to be a lot more buoyant than earlier estimates. For 2002 alone, imports are now estimated to have been £11.1bn higher than before. For 2001, the error amounts to £7.1bn. These are big numbers. In percentage terms, imports in 2002 are now 3.8 per cent higher than previous measurements suggested. These revisions are important because they change the shape and feel of the UK economy. There are three main ways of measuring national product: through output, expenditure and income. Imports feed into the expenditure measure. On this definition, GDP is made up of private consumption, government consumption, investment, stock-building and exports less imports. It follows, therefore, that an upward revision to imports, other things equal, implies a downward revision to GDP.

There is, however, a catch. The differing approaches to GDP measurement should give - roughly - the same results. To the extent that the expenditure measure has not given an unusually high reading relative to either the income or output measures, there doesn't seem to be a strong case for revising down GDP as a whole by any significant margin. Instead, to make the numbers add up, the ONS will probably revise up some other expenditure components. Given the weakness of the global economy, investment spending doesn't look like a very promising candidate. More likely, given the strength of the domestic housing market over the last couple of years, are upward revisions to consumer spending.

We won't know for definite until 30 September, when the ONS gets round to making some benchmark revisions to past data. But let's say that my hypothesis is right. What would this say about the health of the UK economy? The most obvious point is that the UK is living beyond its means to an even greater extent: lots of consumption fuelled by ever-rising imports. It doesn't sound like a recipe for sustained economic development.

Higher consumption and higher imports might also reveal something about the role of sterling. Companies have been complaining for a long time about the pound's ability to defy gravity. For consumers, however, sterling strength is no bad thing. It lowers import prices and, hence, implies higher real household incomes. This "terms of trade" benefit implies that consumers feel richer and are able to spend more.

But the situation is ultimately not sustainable. An overvalued exchange rate may imply that consumers are spending more but it also probably implies that companies are producing less. These conflicting developments cannot continue indefinitely: if producers aren't producing, consumers will increasingly find themselves living beyond their means. That means higher debt which, eventually, might come back to bite.

Given this situation, has the Bank of England done anything wrong? Not really. It has an inflation target to meet and, if companies are unwilling to provide any decent level of demand, the only option is to persuade consumers to spend: otherwise, demand might be too low and inflation could undershoot its target. And if sterling is strong at the same time, this policy has to be pursued with even greater vigour: otherwise the economy would be too weak to generate the required rate of inflation.

The problem lies with the inflation target itself. An inflation target might be transparent but it over-simplifies the policy-making process. Let's say, for example, that the gains in consumer spending really are unsustainable, that it's not possible to persuade consumers to carry on spending against a background of relatively weak investment and low productivity growth. If this is so, eventually the story that we've seen in recent years will have to unravel one way or another.

The Treasury and the Bank are hoping that the solution will come from stronger external demand: if the world economy picks up, then the need to rely on ever-increasing amounts of consumer debt - and ever-increasing imports - will begin to fade. More growth will come from exports, less from consumption and the economy will be able to re-balance itself. This solution, however, looks increasingly like wishful thinking. Although hopes are now growing of a stronger bounce-back in global economic activity in the second half of the year, there are no really convincing signs as yet of decent recovery. I reckon that, by the end of 2003, people will look back at another year of disappointment for the global economy.

So what are the other ways out of this conundrum - a conundrum that now seems rather bigger as a result of last week's trade revisions? Five routes - not mutually exclusive - spring to mind. First, companies will be forced to lower their costs in the absence of a decent rebound in profits. That implies a squeeze in real wage growth - already happening - together with a sustained rise in unemployment. Second, consumers faced with deteriorating incomes will be more reluctant to take on debt: as a result, the housing market will weaken a lot further than it has done so far.

Third, a weaker housing market will reduce still further the consumer's sense of well-being, leading to further downward pressure on income and consumption. Fourth, the government will be faced with an increasingly difficult dilemma: lower revenues and a bigger budget deficit that could easily threaten the Chancellor's fiscal rules: the rate of fiscal expansion may have to slow. And, fifth, to top it all, a major further decline in sterling could be required- the obvious way to ensure that the nation produces more but consumes less.

None of this sounds too clever. But that's not really so surprising. Demand has held up because consumers have been fed an illusion: the strength of sterling has kept import prices low and fiscal expansion has kept unemployment low: consumers have felt rich even though not an awful lot is being produced.

But you cannot run an economy over the medium term on this basis. I suspect we're likely to see not just difficult times ahead but also a complete re-examination of the instruments and objectives of economic policy. There is a price for the pursuit of inflation targets and we're perhaps only just beginning to see how high it really is.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com