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notes_on_real_life

2008: Looking ahead

Tis the season for predictions again. Yesterday you'll have read my reflections on what I said this time last year - and whether it was useful or not. But now it's time to look ahead...

If you asked how I’d like 2008 to go, given where we are now, I would be looking for

• a consumer slowdown;
• offset by a rise in exports;
• driven by a falling pound.

The overall economy would slow, but only to 1.5 to 2.0 per cent growth.

There are two interesting questions about 2008, that should tell us whether that scenario is achievable.

The first is whether the seed of inflation has already been planted in the economy and is now going to grow into a significant problem. If it has, economic life will be very much more complicated than my scenario outlines.

If we have already let inflationary pressure start building, then we can’t allow a falling pound to drive up prices, so we can’t promote more exports, so any slowdown in domestic spending is unable to be offset and becomes more serious.

Or to put it another way, the authorities will need more than a mild slowdown to kill the inflation.

The second question is whether the turning point now reached in the housing market combines with banking and financial problems to form a self-reinforcing downward spiral in asset prices, confidence, spending and growth.

The key words here are “self-reinforcing”. If we get to a point where a bit of slowing sets in motion more slowing, then the authorities will struggle to keep the economy on a desirable path. You need to hang on to your hat.

With those points in mind - here are my observations and forecasts for next year.

1. On inflation, my guess is that it will rise but then fall back and it won’t turn out to be a serious problem. I say this because a mild slowdown will be sufficient to tame the inflation, and at least a mild slowdown seems very likely. I wouldn’t say I’m sure of this, but that would be my guess. Inflation seems less of a threat than it did in 1989.

2. On the slowdown, my guess is that it won’t be self-reinforcing; but that it will be very significant. I expect the UK economy will probably grow less than most forecasters currently estimate (1.9 per cent is the current consensus). This slowdown will derive from the fact that consumers will start being more cautious, increasing the savings ratio. As a result, domestic spending and demand will grow rather modestly. I wouldn’t think consumers will stop spending in a very abrupt way - shopping habits die hard.

3. On house prices, they now appear to be falling. I expect they will continue to fall, by 5 to ten per cent over the year. This is not because of the credit crunch; it is simply that once people lose the sense that house prices are rising, they don’t want to buy them anymore and the demand for houses falls. In addition, the oversupply of city-centre flats and the inevitable sale of buy-to-let properties will lead to downward price pressure. I wouldn’t rule out the falls being much bigger, but the market tends to turn quite slowly (remember the US housing market started turning in 2006, not 2007).

4. On the pound, my guess is that it will fall alongside the dollar. The UK economy has to switch its emphasis from domestic consumption to exports; that requires the pound to fall, and the authorities will let it do so. If I’m wrong about inflation, the falling pound will cause problems and may be curtailed by interest rate rises.

Incidentally, I expect China will let its currency drift up significantly further against the dollar, and this will significantly ease the path to global re-balancing.

5. On interest rates, I expect the bank rate to fall, ending the year at 4.75 per cent. If I’m wrong about inflation or the severity of the slowdown, I’ll be wrong about this too! But my view is that rates can come down to contain the slowdown to the level just necessary to deliver falling inflation.

6. The government finances will probably turn out to be worse than Alistair Darling has forecast. The current balance (borrowing in excess of investment) for the 2007/08 year should exceed the pre-budget forecast by about four billion. It will be quite a problem as the chancellor’s forecasts for future years will look more and more shaky.

Those are my forecasts and observations. But let’s face it, there is a lot to go wrong. The US could slide into recession, China could overheat, oil prices could soar or banks could collapse. I’d love to predict that these will or won’t happen, but none can be foreseen with certainty, and none can be dismissed.

Mervyn King said he wanted to make monetary policy boring. He failed in 2007, and it looks like he’ll be struggling to do so in 2008 as well. My final prediction is that Mervyn will be reappointed to make it boring again – at least by 2013.

notes_on_real_life

2007: A look back

Tis the season for predictions again. Predictions of what the world holds in store for 2008.

For me in fact this is the time of year when I publish a list of useful observations and am forced to attach some forecasts to them. My observations are usually more important than my forecasts, which are worth approximately nothing - i.e. about the same as everyone else’s.

Tomorrow I'll publish my thoughts on how the year ahead is likely to pan out. But today we have to face the difficult bit - how did I do last year?

These are the forecasts I made, which I described as uninteresting. (The full article can be found here.)

• Base rates to end the year at 5.25%
• House prices to rise by 5 to 10%;
• Inflation to edge back down towards its target;
• The economy to grow by 2.5% or thereabouts;
• There would be a new chancellor by this time next year.

On base rates, house prices, inflation and the chancellor I was close enough. On the economy I underestimated the growth of the UK (it grew at about 3.1%).

But anyway, those forecasts, as I said, were uninteresting. The meat of last year’s article looking ahead to 2007 was that although the economy would probably chug along as normal, it might not. The argument was summarised in this paragraph:

“...the seismological analogy is a good one, because in many respects, you might think of the world economy as residing in a place like San Francisco. A place where the climate is benign, and the lifestyle comfortable, but a place located on top of a rather ominous fault-line, of global imbalance. 2007 will probably be quite normal in the world economy and in San Francisco for that matter. But if those fault-lines get disturbed in some way, it could turn out rather differently.”

The point was that 'business-as-usual forecasts' are mostly right, but rarely interesting. Just occasionally, the economy reaches a turning point and is genuinely interesting, but is then particularly hard to forecast accurately.

2007 is a year that we reached a turning point, although it didn’t turn enough to affect my core forecasts of inflation and house prices. So while I didn’t forecast the turning point, I did at least anticipate the possibility.

Come back tomorrow for my thoughts on 2008.

vital_statistics

Unsustainable deficit

We got a large wadge of data this morning, giving us a full picture of the third quarter of this year. And guess what - it didn't contain much Christmas cheer.

The data shows that the UK balance of payments deficit (the broadest measure of our international trading position) is as bad as it has ever been. We earned less from the rest of the world, than we spent in the rest of the world, to the tune of 5.7% of our national income.

To put it another way, our spending in the summer was maintained only because foreigners lent us almost 6% of our national income.

Most shockingly, that means our balance of payments deficit is now bigger in proportional terms than that of the United States. (It's been a very long time since we could say that.) The US deficit has shrunk from 5.6 per cent of national income in the first quarter of this year, to 4.9 per cent in the third.

The only occasion that our deficit was this high was in the third quarter of 1989. The good news then was that the deficit soon came down. The bad news was that it was corrected with the aid of a very serious recession.

Now, I don't want to be alarmist about this. The balance of payments deficit is a funny old measure and it is quite volatile. It might well fall back next year on its own. Quite a large part of the deterioration reflects the fact that our banks have been paying more interest to foreigners and that might adjust automatically.

And we certainly don't have to worry about it as we once did. Back in the 1960s and sometimes the 70s and 90s, we worried about these things because the exchange rate was fixed and deficits literally meant the country could run out of money.

But mostly when the balance of payments deficit is large it is telling us that the British are borrowing and spending heavily, thus relying on imported goods. And that is a good deal of the story at the moment (other data released today showed the household savings ratio falling).

In that sense, the deficit is reminding us of a problem we have already known about.

But even if we are not going to run out of money to buy things, and even if we know that we have had rather low savings recently, the deficit can offer a forewarning of a pretty serious adjustment to come.

This is because our balance of payments deficit is manifestly unsustainable, and as there is a hackneyed saying in economics that if something is unsustainable, it won't be sustained.

The question is how the eventual adjustment will shift to a smaller deficit will come about.

The most obvious two ways are through a slowdown in our own spending (which reduces imports) or through a fall in the value of the pound which promotes exports.

One or both of these look likely over the next couple of years.

How does this play into the already fragile state of our economic nerves at the moment?

Well, the data is already old news. It barely reflects any impact of the credit crunch on the real economy. Indeed, it is probably best viewed as the last guide to what was going on before the storm broke.

And my own interpretation would be that it indicates we are entering 2008 with more serious imbalances than perhaps previously understood.

If the economy is turning away from rising house prices, low savings, high borrowing and easy lending, the balance of payments will improve. But it seems we have a bigger turn to make than we realised.

The US has been in a similar position. It has already started improving its current account, with the dollar falling very significantly.

The UK looks it has had more in common with the US than we thought.

notes_on_real_life

Apocalypse now?

Bank rate down... No surprise there, given the evidence that market interest rates are higher than intended and a slowdown is gathering pace.

Is the world saved? Can we now all relax?

Bank of EnglandProbably not. The main challenges remain, and the risks are sufficiently worrying that even if one tries to disregard apocalyptic language about recession, this is a pretty good time to allow oneself a bit of scary hyperbole.

For the most cogent example of that, see Anatole Kaletsky in The Times today.

My own personal view is that things may well go quite well next year. However, there is a sufficient risk they will go badly or very badly.

At the outset, it should be said that whether things go well or not, the economy seems to have reached a turning point, with an end to an era of rising house prices, rising borrowing, strong consumer spending, a deteriorating trade deficit and relaxed bank attitudes to lending.

Those had to end at some point and they have probably now done so. No problem there.

However, there are two reasons to worry that the turning point we've arrived at may result in significant problems.

Interest rates graphFirst, there is a risk that a small degree of incipient inflation has been allowed to creep into the economy, which will make it hard to manage the changes occurring.

It's not obvious yet, but with inflation starting this difficult period just above target, and with energy and food prices rising fast, we can't dismiss it.

Indeed, if inflation is an issue, a mild repeat of the 1990s experience may be necessary to get rid of it.

But secondly, even if inflation is not a problem, we might be in for a difficult period. The Bank of England will have more room to cut interest rates, but lower interest rates are not a very powerful lever against certain forces. It can be hard for the Bank to engineer a controlled slowdown.

Once falling house prices take hold and consumers decide to save, there may be nothing monetary policy can do to get them spending again. In fact the best proof of that is that monetary policy has struggled to contain the boom in house prices enjoyed over the last few years. If households believe they need to save, to repair their personal balance sheets, there will be little point in trying to get consumers out into the shops again.

Now this raises the risk that even with more interest rate cuts, the economy can run out of steam, and then get itself into a downward spiral. A slowdown causes job losses, which causes more slowdown and more job losses.

On my recent trip to New York one economist, Jan Hatzius of Goldman Sachs, made the point that we should regard the words "vicious circle" as a pretty good definition of what a recession is. Once it takes hold it can be hard to stop, as the Japanese found out when their own share and property price bubble burst in the early 90s.

This is where the credit crunch and the difficulties of the banks come in. I suspect these are not causing the economic turn we are witnessing because the turn had to occur at some point anyway.

But credit problems may well end up being an accelerant, transforming the economic drama of an inevitable house price correction into a full-blown crisis. If the banks are unable to lend, the economy will probably slow more than it needs to for the various imbalances to correct.

If things do go into a tailspin we have no idea how deep or how long they could last. If confidence collapses, there is no good economic model to tell us when it will be restored. That's the apocalypse scenario we need to worry about.

Now for the good news.

Things might go actually quite well.

The economy has momentum, companies in general are profitable and so have a little cushion to fall back on, the labour market has not yet suffered (and even if it does, unemployment may not rise because there is a large supply of migrant workers who may choose to move to other more successful economies instead).

Inflation may not turn out to be a problem and interest rate cuts may put a floor under the housing market, the credit crunch and the slowdown.

And it might be that a gentle fall in the value of the pound allows the economy to steam ahead, built on exports rather than on domestic consumer spending.

It doesn't all have to go wrong.

Does that mean we should not allow ourselves to be apocalyptic? Well, I've tended to use the earthquake analogy. If you live on a fault line, you should be wary of the horror of an earthquake, even if there may not be one.

And in the economy right now, we can hope for the best but need to prepare for the worst.

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