Economic Resilience?
Gordon Brown and his Chancellor, Alistair Darling, have been keen to stress that the economy is ready to weather any storm that hits it. Although the economy remains standing, despite recent turbulence in the financial markets, it does seem like tempting fate to claim that the economy is so resilient, and capable of withstanding any disturbances that might come along. So what supports their statements, and what are the risks to the economy? This post looks at a few of the problems on the horizon.
Gordon Brown and his Chancellor, Alistair Darling, have been keen to stress that the economy is ready to weather any storm that hits it - see Brown’s TV interview on the BBC here, and Darling’s interview on Radio 4’s Today Programme here. Their buzzword has been resilience - something Darling was also at pains to emphasize during his Budget speech last month.
Although the economy remains standing, despite recent turbulence in the financial markets, it does seem like tempting fate to claim that the economy is so resilient, and capable of withstanding any disturbances that might come along.
On what basis do they make their claim, then? The thrust of their argument is that, despite many opportunities for the economy to have taken a turn for the worse over the past decade, it has actually remained on an even keel. As a result, it should also bear up well in the face of any future crises that come our way.
In some respects, the data does support this. The UK economy (when measured by total output, adjusted for inflation) has continued to grow each year since the early 1990s, despite a number of adverse shocks, such as the East Asian financial crisis of 1997/98, the bursting of the dot com boom in 2000/01, and the ongoing fallout of the sub-prime mortgage crisis. All this time, too, inflation has remained low, and stable, in contrast to the boom of the late 1980s, when annual inflation reached 10%.
Even in the housing market, the situation now is very different to that of the late 1980s. Some research by Gavin Cameron, John Muellbauer and Anthony Murphy, economists at Oxford University, has looked at the housing market in different regions of the UK from 1972 up to 2003, and finds little evidence of a recent house price bubble. Their explanation is that once you take into account the long-run evolution of incomes, the size of the population, the housing stock, and interest rates, then the data suggests that house prices were not overvalued. On top of this, the behaviour of the housing market since 2003 does not seem to have changed much, suggesting that their results still hold.
However, there are a number of problems on the horizon.
The first is that economic policy has played a very different role in the current economic cycle than it did in the late 1980s and early 1990s. Back then, there were clear examples of mistakes in policy, such as mis-management of a change in mortgage interest tax relief (which led to a rush of people trying to buy houses, thereby fueling a house price boom) and ill-fated interest rate policy aimed at pegging the Pound to the German Deutschemark (which led to interest rates going up just as a recession kicked in). Once policy started being more sensible (for example, in 1993, when interest rates started to target inflation, instead of the exchange rate) then the economy started its long growth cycle that we are still enjoying today.
The picture today, however, is not one of the same macroeconomic policy incompetence. The main short-run tool of policy - interest rates - has been well managed by the Bank of England, and is out of the hands of Alistair Darling. Since the current problems aren’t due to bad macroeconomic policy, comparing where we stand today against where the economy was in 1991, for example, doesn’t really provide a good indicator of how things will evolve over the next few years.
Secondly, although interest rates are much lower now than they were in the early 1990s, that doesn’t mean to say they can’t still bite! As a recent report from the International Monetary Fund points out, many homeowners in the UK whose fixed-rate mortgages are about to run out, will be facing an interest rate jump of one or even two percentage points, when they renew their mortgages. This is a sizeable jump, and many of these households will be left feeling the pinch - with knock-on consequences for consumer confidence, and overall consumer spending.
Thirdly, one of the major culprits in the financial instability surrounding the sub-prime mortgage crisis is the complex arrangements of financial products traded by investment banks. In principle, these banks can be a force for good in providing finance and managing money, but it seems as though the deals that many made with sub-prime loans were so complex that even the banks themselves have yet to understand them fully. These problems have already brought down two banks - Northern Rock here, and Bear Stearns in the US - and all the major institutions seem to be suffering. This points to poor oversight from watchdogs such as the Financial Services Authority in the UK, which was (along with the Bank of England) recently criticised heavily by the House of Commons Treasury Select Committee for failing to keep an eye on the risk-taking behaviour of financial institutions.
The final point is that no matter how much credit Brown, Darling and others would like to claim for the recent growth in the economy, or low inflation, it is impossible to know how much of the good performance has been sheer good luck. The Bank of England is well-equipped to try and pursue the best interest rate policy if the economy falters, but there is a limit to how much it can do: the experience of Japan, where interest rates have been close to zero for the best part of 17 years and the economy in stagnation, shows that policy can’t always help an economy. And then, there’s always the danger of claiming for yourself, something that would have happened even if you hadn’t been in charge. When bad things start to happen, even if they are out of your control, people start to blame you; at that stage, Gordon Brown might wish that he’d called an election last year.
