Does today's financial turbulence mark the end of the UK's economic miracle?
Is an economy that has enjoyed 61 quarters of positive growth and a cumulative expansion of 55 per cent since the second quarter of 1992 about to sink into recession? This is possible, but unlikely. Above all, if dire times come, the Bank of England has plenty of room to act, provided it retains its credibility over inflation.
The Organisation for Economic Co-operation and Development takes a measured view: in its latest Economic Outlook, it suggests that the UK economy will grow by 2 per cent between 2007 and 2008. It recognises downside risks, notably in the housing market, but opposite outcomes are also possible, not least because the impact of the credit squeeze remains highly uncertain.
Why, then, is the UK economy deemed particularly vulnerable by many observers? There seem to be six reasons: first, the UK's housing bubble is deemed bigger than that of the US; second, the UK is particularly dependent on finance and business services; third, the public sector is no longer in a position to increase employment rapidly; fourth, the size of the fiscal deficit makes it hard to counteract a severe downturn; fifth, in a housing downturn, the effectiveness of monetary easing might be limited; and, finally, the Bank of England is proving far too conservative.
It is, indeed, true that between the first quarter of 1996 and the third quarter of this year, real house prices rose by 148 per cent in the UK, against 127 per cent on the Case-Shiller index for the US (to the peak in the first quarter of 2006). More broadly, UK housing looks extremely expensive. Investment in housing is forecast by the OECD at a 10-year peak this year and well above current levels in the US, relative to gross domestic product. It might fall sharply. Given the role of housing as collateral, steep falls in house prices would surely slow consumption significantly. But, as the OECD notes, recent empirical work suggests that underlying demand might justify these high house prices. It is simply unclear how big is the threat from falling house prices to the economy.
The important of finance and business services for the UK is a fact. High pay in these sectors underpins the London housing market, which is the bellwether for the market in the country as a whole. As important is the way in which the financial sector bolsters the balance of payments. In 2006, for example, the UK earned £19.1bn in net investment income (1.5 per cent of GDP) on a net asset position of minus £305bn (23 per cent of GDP). This, then, is "hedge-fund" Britain: it borrows short, invests long and makes a large amount of money in the process. If this were to prove unsustainable, the current account position would be quite a bit worse.
That the growth of public sector spending is set to slow is well-known: in 2008, according to the OECD, real public consumption will grow by just 2 per cent. The implications for unemployment of slower growth in demand might not be that serious, however, precisely because the UK labour market is so open. If there were a big downturn, some (perhaps many) immigrants would return home, particularly those from other members of the European Union who know they can return in better times.
Probably more important is the fiscal deficit: the UK's general government financial deficit is forecast at 3.4 per cent of GDP next year by the OECD, which is disturbing, to say the least, at such a favourable point in the cycle. While further increases in deficits would be possible, they would only be justified in extreme circumstances, such as those experienced by Japan in the 1990s. In normal times, fiscal policy is, alas, foregone. That is Gordon Brown's legacy to his successor as chancellor, Alistair Darling.
That leaves monetary policy. Contrary to the many critics, I sympathise with the cautious stance taken by the Bank of England in the recent crisis. But it is now quite clear that markets have imposed a persistent and significant monetary tightening, with the interest rate on three-month interbank borrowing still a full percentage point above the Bank's target rate. This is almost certainly far too high for current conditions. The Bank should either lower its target rate further or act even more energetically to close the gap between its official rate and those on interbank lending.
Fortunately, the Bank does have vast room for manoeuvre, since it has much the highest official rate of any large advanced economy. With a floating exchange rate, aggressive monetary loosening would probably lower the (in my view, overvalued) exchange rate against both the dollar and the euro substantially. That would help support and rebalance economic activity across the country.
There is, however, a caveat. But it is also a crucial one: the Bank cannot act aggressively if the credibility of low inflation comes into question. It is precisely for this reason that it must not abandon all caution. It will be able to rescue the real economy if and only if low inflation remains believable. It is as important for the Bank to be seen to stick to its fundamental mandate today as it has ever been. Flexibility is the reward of credibility. The Bank understands that. So should everybody else.
Is an economy that has enjoyed 61 quarters of positive growth and a cumulative expansion of 55 per cent since the second quarter of 1992 about to sink into recession? This is possible, but unlikely. Above all, if dire times come, the Bank of England has plenty of room to act, provided it retains its credibility over inflation.
The Organisation for Economic Co-operation and Development takes a measured view: in its latest Economic Outlook, it suggests that the UK economy will grow by 2 per cent between 2007 and 2008. It recognises downside risks, notably in the housing market, but opposite outcomes are also possible, not least because the impact of the credit squeeze remains highly uncertain.
Why, then, is the UK economy deemed particularly vulnerable by many observers? There seem to be six reasons: first, the UK's housing bubble is deemed bigger than that of the US; second, the UK is particularly dependent on finance and business services; third, the public sector is no longer in a position to increase employment rapidly; fourth, the size of the fiscal deficit makes it hard to counteract a severe downturn; fifth, in a housing downturn, the effectiveness of monetary easing might be limited; and, finally, the Bank of England is proving far too conservative.
It is, indeed, true that between the first quarter of 1996 and the third quarter of this year, real house prices rose by 148 per cent in the UK, against 127 per cent on the Case-Shiller index for the US (to the peak in the first quarter of 2006). More broadly, UK housing looks extremely expensive. Investment in housing is forecast by the OECD at a 10-year peak this year and well above current levels in the US, relative to gross domestic product. It might fall sharply. Given the role of housing as collateral, steep falls in house prices would surely slow consumption significantly. But, as the OECD notes, recent empirical work suggests that underlying demand might justify these high house prices. It is simply unclear how big is the threat from falling house prices to the economy.
The important of finance and business services for the UK is a fact. High pay in these sectors underpins the London housing market, which is the bellwether for the market in the country as a whole. As important is the way in which the financial sector bolsters the balance of payments. In 2006, for example, the UK earned £19.1bn in net investment income (1.5 per cent of GDP) on a net asset position of minus £305bn (23 per cent of GDP). This, then, is "hedge-fund" Britain: it borrows short, invests long and makes a large amount of money in the process. If this were to prove unsustainable, the current account position would be quite a bit worse.
That the growth of public sector spending is set to slow is well-known: in 2008, according to the OECD, real public consumption will grow by just 2 per cent. The implications for unemployment of slower growth in demand might not be that serious, however, precisely because the UK labour market is so open. If there were a big downturn, some (perhaps many) immigrants would return home, particularly those from other members of the European Union who know they can return in better times.
Probably more important is the fiscal deficit: the UK's general government financial deficit is forecast at 3.4 per cent of GDP next year by the OECD, which is disturbing, to say the least, at such a favourable point in the cycle. While further increases in deficits would be possible, they would only be justified in extreme circumstances, such as those experienced by Japan in the 1990s. In normal times, fiscal policy is, alas, foregone. That is Gordon Brown's legacy to his successor as chancellor, Alistair Darling.
That leaves monetary policy. Contrary to the many critics, I sympathise with the cautious stance taken by the Bank of England in the recent crisis. But it is now quite clear that markets have imposed a persistent and significant monetary tightening, with the interest rate on three-month interbank borrowing still a full percentage point above the Bank's target rate. This is almost certainly far too high for current conditions. The Bank should either lower its target rate further or act even more energetically to close the gap between its official rate and those on interbank lending.
Fortunately, the Bank does have vast room for manoeuvre, since it has much the highest official rate of any large advanced economy. With a floating exchange rate, aggressive monetary loosening would probably lower the (in my view, overvalued) exchange rate against both the dollar and the euro substantially. That would help support and rebalance economic activity across the country.
There is, however, a caveat. But it is also a crucial one: the Bank cannot act aggressively if the credibility of low inflation comes into question. It is precisely for this reason that it must not abandon all caution. It will be able to rescue the real economy if and only if low inflation remains believable. It is as important for the Bank to be seen to stick to its fundamental mandate today as it has ever been. Flexibility is the reward of credibility. The Bank understands that. So should everybody else.
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