UK economy in uncharted waters

The economy is booming, consumer spending went through the roof at Christmas and inflation and unemployment are at record lows. But it is not all wine and roses for the Chancellor Gordon Brown.  

House prices are still rocketing ahead at an unsustainable rate, the Pound is hugely overvalued, the country’s trade deficit is at a record high and so is personal debt – the underwriter of the high street boom.

How can these statistics be balanced? They cannot, according to Peter Spencer, economic adviser to Ernst and Young’s Item Club.

‘Item’ is an acronym for ‘Independent Treasury Economic Model’ and for the last two decades, the Item club has used the Treasury’s own figures to appraise whether its forecasts are born out by the statistics they are supposed to be based upon. 

Optimistic assumptions

Britain’s Chancellor of the Exchequer Gordon Brown

Spencer is not impressed with the Chancellor’s math. “The assumptions being made about economic growth translating into tax revenue are very optimistic indeed,” he told Aljazeera.net. 

“They’re at the very fringe of what I consider possible and the kind of tax revenues they’re projecting are not at all realistic.”

Spencer believes after the next election, the Chancellor will be forced to raise income tax, but that in the short term he will have to raise borrowing rates.

“Because the Chancellor is not raising taxes now, at a time when he’s in deficit and the economy is growing strongly, the rise in interest rates will come much sooner and be much larger than it would otherwise have been,” he said.

House prices

There has been much economic debate about the extent of a predicted upwards swing in interest rates and its likely effect. Nationally, house prices are still racing ahead at 15% a year, about three times the rate of wage rises.

The economy is booming, consumer spending went through the roof at Christmas, and inflation and unemployment are at record lows.  But it is not all wine and roses for the Chancellor, Gordon Brown.

But increasing the cost of borrowing, when it is borrowing that has financed the recent boom, may be a blunt scalpel for surgery.

“At the moment, the vast majority of people are able to service their debt, by and large,” Bernard Clarke, spokesman for the Council of Mortgage Lenders said. “What would make it difficult for them to do that would be if interest rates were to rise significantly.” 

How high interest rates may go is a vexed question, and one that an army of crystal ball gazers is paid handsomely to forecast. Bernard Clarke wagers 4.5% by year’s end. But it will be 5.25% by next spring, according to Peter Spencer. 

Perhaps the key factor in the equation will be what effect the incremental rises have on the housing market throughout the year, and what knock-on impact these have for the economy as a whole. 

Downside risk

Phillip Shaw, the chief economic adviser to Investec Bank is one of those concerned about the prospect of a sharp fall in house prices.

“I think there is a downside risk to the British economy over the next two to three years coming from the vulnerability of house prices,” he told Aljazeera.net. 

“If we were to see a sharp retracement in house prices, it could have a big impact on consumer confidence. The problem wouldn’t be so much that households couldn’t pay the mortgage lending as that they would feel worse off.”  

Economists argue that intangibles like consumer confidence – the optimism shoppers feel for their financial futures – can play a key part in determining how much they spend. 

“A reasonably brisk pace of consumer spending is necessary to drive the UK economy along,” Shaw said. “If that were knocked, it would have serious implications for the economy as a whole.” 

Peter Spencer though, was sanguine about his forecast of 0% growth in house prices for 2005. “It would help to rebalance the economy,” he averred. “It wouldn’t be a disaster by any means. It would just mean that house prices don’t go up for a year.” 

Robust growth

In a housing market as over-valued as Britain’s, many would argue that prices need a more comprehensive rebalancing. But how even zero percent growth would affect a consumer confidence pumped up on Jack and the Beanstalk house prices is anyone’s guess.

In a housing market as over-valued as Britain’s, many would argue that prices need a more comprehensive rebalancing. But how even 0% growth would affect a consumer confidence pumped up on Jack and the Beanstalk house prices is anyone’s guess.  

For the moment though, the UK economy is continuing to grow robustly. In the third quarter of 2003, it expanded by 0.8%, even if that in turn, created a record trade deficit of £13.2 billion ($24 billion) between September and November. 

Unprecedented levels of government debt in the US too, could have consequences for British business, given the degree to which the Anglo-Saxon economies now move in sync. 

“The size of the US’s current account deficit is a potential fly in the ointment,” Phillip Shaw said. “If the deficit continues to widen and investors lose their appetite for dollar denominated assets, then the currency could fall even more sharply.”  

“That would have implications for global stock markets and the world economy.”

More complex

One thing all economists seem agreed on is that 2004 will be a more subtly complex year to predict than was 2003. At this time last year, models of past Middle East wars were being wheeled out to try and analyse the ‘known unknown’ factor of war in Iraq.

The difficulty this time, according to Peter Spencer, is that we are facing “unknown unknowns”.

“We’re looking at a new CPI (consumer price index) inflation figure which is at a historic low, and going off the chart. There are also historically high levels of debt everywhere you look, which makes it extremely difficult to calculate the effect of interest rates.”

“In all of these areas, we are moving into uncharted waters.”