Britain in his debt

Who would have thought that the 10th anniversary of the Bank of England’s Monetary Policy Committee would be marked by an overshoot of the CPI inflation rate? Many commentators are claiming the credibility of Gordon Brown’s creature has been seriously undermined and that now we are all in for a rough ride. Can this be right?

I don’t think so. The Bank of England’s Monetary Policy Committee saw the inflation problem coming and started to raise interest rates back in August 2006, to most people’s surprise. The factors that underpinned Mervyn King’s NICE decade (of Non-Inflationary Consistent Expansion) decade remain in place. However, we have been pushing our luck and need to pay much more attention to our finances both as individuals and as a nation. Otherwise it will certainly end in tears.

You only have to take a look across the channel at the legacy that Jacques Chirac left Nicolas Sarkozy to see how invaluable Gordon Brown’s Inheritance was. He was handed a new model economy. This had emerged from the debacle of Black Wednesday in 1992 growing vigorously, yet adhering to the new 2½ per cent inflation target with low interest rates. It took two severe recessions to achieve that non-inflationary nirvana. We are all seeing the gain from the pain, but Gordon Brown has been the main beneficiary. Moreover, the labour market had been transformed by a succession of Employment Acts and, although we perhaps did not realise its significance at the time, the Big Bang Reforms of 1986 had opened the capital markets up to competition from foreign players.

Insiders have been very critical of Gordon Brown’s management style and this undoubtedly led to some bad policy decisions, starting with his initial raid on the occupational pension schemes. In the main, however, those early decisions were well judged, allowing him to enhance and preserve his inheritance. Even after the inflation overshoot, everyone accepts that his decision to hand over monetary policy to the MPC will preserve the low inflation environment he inherited. The same is surely true of the parallel decision to hand over supervision of UK financial industry to a single regulator, which helped pave the way for its dominance of European and ultimately world financial markets.

It may be hard to agree on the dating of the economic cycle but it is generally agreed that the NICE era actually began in September 1992 rather than May 1997. It was the reward for those painful recessions and the hard-fought reforms which accompanied them. The stable macroeconomic environment we have enjoyed since then is founded upon the low inflation platform, buttressed by the inflation target and the MPC. The theory that macroeconomic volatility depends upon the rate of inflation is now well established. It can be traced back to Arthur Okun and Milton Friedman, who argued in his 1977 Nobel Prize speech that the rise in inflation and output volatility in the global economy was primarily due to the rise in secular inflation, and would fall back if inflation was defeated. It explains the initial rise in output and inflation volatility in the 1970s as well as its subsequent fall. These swings have also been marked in economies such as that of the US which have not formally changed their monetary policy arrangements, but they have been particularly pronounced in the UK.

Various theories help to explain this relationship. High rates of inflation confuse the relative price signals that regulate an efficient market economy. They confuse and constrain monetary policy. We now take it for granted that the monetary authorities will cut interest rates if the economy is threatened by a downturn. Yet it is important to remember that this flexibility is only possible if the rate of inflation is low and anchored by expectations. If inflation is threatening to spiral upwards as the economy turns down, as was typically the case in the 1960s and 1970s, interest rates simply have to go up.

Whatever the reasons for this, the stable economic environment has had a dramatic effect on financial market confidence, inflating asset values and transactions, and boosting borrowing and spending. Long-term interest rates fell by over two per cent within months of Gordon Brown’s move to Number 11, as confidence in his monetary and fiscal arrangements grew. Investors, lenders and borrowers began to believe that high inflation and severe economic fluctuations were a thing of the past and that the MPC would be able to support financial markets and the economy come what may.

Banks and building societies have been able to relax loan multiples and other lending criteria relatively safely because the kind of inflation, interest rate and unemployment shocks that would have lead to financial distress in earlier cycles are no longer on the radar screen. Yield spreads have narrowed dramatically. Private equity operators have used the cheap and plentiful supply of credit to lever up and make massive inroads into UK plc, handicapped as it has been by its cumbersome governance and financial reporting structures. Nearly a fifth of the workforce now find themselves working for a private equity-financed company.

Many of us have taken advantage of the attractive offers coming through the letterbox and have geared up accordingly, not just to support investments like buy-to-let but in many cases to support current consumption. The Chancellor has been lured into exactly the same trap. His golden rule only allows him to borrow to finance investment. Over the economic cycle — if that can still be identified — current spending should be financed from tax revenue. However, when you put aside the arguments over the definition of the economic cycle, it is abundantly clear that he is still borrowing billions to finance consumption despite the strength of the economy and tax revenue. The tax burden is also approaching record levels. A prudent Chancellor would be running a surplus on current account at this stage, to meet the kind of contingencies he had to face in the early part of the decade. Like many of us, he has been far too complacent about these risks.

The bottom line is that the UK is now running a large current account deficit, worth 3½ per cent of GDP in 2006. We are living beyond our means, prone to a sharp reversal in financial market confidence. The burgeoning current account deficit is a symptom of repressed inflation as well as excess demand. The steady expansion of domestic demand has been matched by a steady expansion of output, apparently without much inflationary pressure. However, that impression is deceptive, because much of this output has been supplied by foreign rather than British workers and producers. The current immigration wave is just one of a myriad of ways in which global suppliers meet excessive UK demand and restrain inflation. These effects can be seen right across the skill-pay spectrum. At the top end, the market for CEOs and executives has always been an international one. In the middle of the spectrum, off-shoring means that call centre, computer, legal and accounting and a raft of other services can effectively be supplied from overseas. And at the lower end, cheap consumer imports and supply chain efficiency, like immigration, has been a major factor in meeting demand and constraining wage inflation.

At some stage these debts will have to be repaid. Moreover, it may not be at a time of our own chosing — overseas bankers and investors have an awkward habit of foreclosing on their loans when UK borrowers and the economy can least afford it. That may seem fanciful with the US economy weakening and the pound riding high at the $2 level, but it is nevertheless true. At the moment the strong pound is helping to suppress inflation by reducing the cost of imports and putting UK producers and the workforce under pressure. But as Europe pushes ahead, the US recovers and the public and private borrowers begin to retrench, interest rates and the exchange rate will fall back and the inflationary spring that is the current deficit will unwind.

Unfortunately these exchange rate risks are very hard to assess. That is because the strong pound reflects the transformation of the economy from manufacturing to financial services as well as the high level of borrowing. Both have exchange rate implications that are powerful but hard to quantify. As we saw in the early 1980s, the sudden success of exporting industries like North Sea oil drives up the real exchange rate and crowds out other exporters, in particular manufacturers. The success of the City has perhaps been more gradual, but it has the same effect.

The exchange rate has risen by nearly a third in real terms (adjusted for relative inflation) since 1996. This appreciation began before Labour came to power. Nonetheless, the real exchange rate has remained higher than in the early years of Mrs Thatcher’s administration when manufacturing experienced its dramatic shakeout. Manufacturing output is still at about the same level as it was in 1997, with manufacturing jobs reduced by over a million. In the meantime, business and financial services have pushed ahead strongly and now make up nearly a third of GDP. This phenomenon is not just confined to the south east of England. Remarkably there are only two regions in the UK, namely Wales and the West Midlands, where manufacturing has a bigger share of the economy than business and financial services. You don’t have to be a Physiocrat to worry about the dependence of the UK economy and exchequer upon the financial industry.

It will be some time before we can conclude this story properly, but I don’t share the view that it will come to a quick and sticky end. On balance, Gordon Brown’s stewardship has been a creditable and a competent one. He has built a strong economy on the low inflation platform and his legacy will surely prove at least as valuable as his inheritance. However, this stability has induced a false sense of complacency which could prove to be its own undoing, not just at the Treasury. The risk of high levels of borrowing and taxation should not be underrated.

Peter Spencer is Professor of Economics and Finance at the University of York. He is also Economic Adviser to Ernst & Young ITEM Club.