2011: The economic prognosis

As we enter 2011 there is little doubt that the UK economy is slowing from the heady grow rates recorded in the middle of last year. But this is only to be expected as those growth rates reflected special factors that are highly unlikely to be repeated. However, this should not be a reason for complete gloom. The economy probably grew by a better-than-expected 1¾% last year and it can be expected to grow by a similar magnitude this year. Such is the momentum of recovery a double dip seems most unlikely. But there will be many risks and there are many reasons to be cautious.

Growth is, of course, driven by the four major components of demand. The first is consumers’ expenditure, which will probably flag this year. Real incomes are being squeezed by a combination of higher taxes and prices inflation running ahead of earnings inflation. CPI inflation will probably be around 3% to 3½% for much of this year. Indeed it may hit 4% in spring, with higher utility prices, rail fares and commodity prices take their toll. RPI inflation is nearer to 5%. In the meantime, earnings inflation is a very modest 2½% and shows few signs of picking-up despite the higher prices inflation. There are no signs of a 1970s-style “wage-price spiral” developing and I do not expect one to develop given the high unemployment rates. If I am wrong on this point then the implication for interest rates is very serious indeed.

Unemployment will also bear down on consumers’ spending. And even though the impending public sector losses are estimated to be a relatively modest 40,000 in 2011/12, according to the Office of Budget Responsibility, unemployment will surely stay around the 2½ million mark. A stagnant housing market is also a negative. House prices look set to weaken further this year, given the dearth of mortgage lending, and could end 5-10% lower than at the end of 2010. And, finally, tight credit conditions and an overhang of debt from the pre-crash years still weigh down the consumer.

Public spending, especially in Gordon Brown’s early 2000s “glory days” of throwing public money at the unreformed public services in the vain hope they would transform them, contributed significantly to GDP growth over the past decade. This is now being reversed. General government spending will ease back this year as the Coalition government struggles to get on top of the £150bn black hole in the public finances they inherited. The mid-1990s provide something of a precedent. Public spending was curbed then and the private sector not only replaced that loss, but grew so buoyantly the economy did very well indeed.

But the mid-1990s were more favourable than now for three main reasons. Firstly, the international background was rosier then. Secondly, the British economy was arguably more competitive in terms of taxation, regulatory burdens and competitive energy prices. In particular, Britain’s current green energy policies are expensive and wealth-destroying. Already our “green” energy policies are adding a 20% “stealth tax” to industry’s electricity costs, thus undermining competitiveness, but this could rise to 70% by 2020. Businesses will simply migrate overseas. And, thirdly, the banking system was in rude good health. This is not the case today in the wake of the financial crisis. Tight credit conditions will inevitably hold back private sector recovery.

The third and fourth components of demand are investment and net exports. The government is expecting big dividends from both. But I have some doubts. Even though business investment performed well this year and the corporate sector is awash with cash, tight credit conditions for SMEs and a subdued growth outlook will surely hold investment back. And net exports have disappointed to date, despite the pound’s weakness over the past 2 years. Granted exports have grown, but imports have tended to grow faster.

But for all these caveats I do still expect growth in 2011. The recovery will surely survive the higher taxes and the spending cuts. Assuming this to be the case, then the Chancellor will do little by way of macroeconomic steering in this year’s budget. His budget will be about “growth” and doubtless introduce measures to improve growth, although they will be modest.

And interest rates? Well, despite the poor outlook for prices inflation, it is vital to note that the higher prices are being driven by globally-determined commodity prices (at least partly). And there will be more to come as looming shortfalls in supply, reflecting production difficulties and/or rising demand especially from the emerging economies, drive up prices. Oil prices are heading for $100pb. There is little prospect of a near-term respite.

But I expect the Bank’s MPC to tread cautiously on monetary tightening unless an inflationary “wage-price spiral” starts to develop – in other words, if there are signs that inflation is becoming internally generated. Whilst there are those who already accuse the Bank of losing credibility because the 2% target is being robustly overshot, I expect the Bank to be pragmatic and weigh up the implications for growth before they act precipitously on interest rates. I would be very surprised if the Bank increased the Bank Rate much this year – possibly to 1.0% or 1.5% by the end of the year. I do not, however, expect further Quantitative Easing.

The Eurozone will continue to worry this year. The European Commission said recently that there are “increasing differences across EU countries, particularly between the core and the periphery”. These differences are tearing the Eurozone apart, despite the bail-out packages. At the core Germany is bounding ahead. But the peripheral economies of Greece, Ireland, Portugal and Spain are being crippled by the Eurozone’s straightjacket, coupled with tough austerity packages. It can surely only be a matter of time before Greece, and possibly Ireland, Portugal and Spain, leave the Eurozone, default on their debts, take the short-term pain and go for growth.

But when will this be? The answer is political rather than economic. It will depend on when the respective governments put the future prosperity of their people above their dogged adherence to the euro. My guess is that the countries will struggle through 2011 with their economic difficulties becoming increasingly, painfully obvious.

Of course there is another way out of the Eurozone crisis. Specifically, there needs to be a permanent mechanism for transferring resources from the relatively competitive member-states to those that are less competitive. Yet the political will is missing, for all the leaders’ rhetoric stressing their willingness to do whatever it takes to secure the euro. As long as a commitment to fiscal integration is missing, the future of the Eurozone as currently configured looks bleak.

Turning to the US, there is rising optimism. Even though the US economic data towards the end of last year were no better than mixed, upbeat business survey results suggest improved prospects. The Fed seems determined to encourage household and business spending with QE2, irrespective of any inflationary implications. Growth could surprise on the upside, perhaps chalking up 3% in 2011. Meanwhile a unified global campaign against China’s cheap currency policy will continue to elude Washington, though the pragmatic Chinese will probably let the yuan appreciate this year against the dollar as part of their attack on inflation.