Rather like waiting for the pronouncements of the oracle at Delphi, the modern world waits upon the pronouncements of central bankers to learn what fate has in store for it. In Britain, the Governor of the Bank of England reads the runes every three months and this week Mervyn King has issued his latest prophecy. We are in for a “choppy recovery”, he says. But how much should we trust his judgement? And could the future turn out to be even worse than he predicts?
The entrails make for more depressing reading than they did three months ago. The Governor has marginally reduced his forecast of economic growth for this year from 1.7% to 1.6%, but for next year he has cut it substantially: from 3.4% to 2.7%. Growth forecasts for 2012 have been cut back too and he says it will be “many years” before the economy gets back to anything like normal.
The reasons for the increased pessimism since last May are threefold. First, Dr King cited the "softening of confidence" both here and abroad. In Britain we have seen this in recent figures showing a fall in house prices, retail sales being in the doldrums and consumer confidence in general being subdued. Abroad, the United States has seen falling confidence in its own economy with its own central bank, the Federal Reserve, taking further measures this week to shore up demand. And Britain’s other main export market, the eurozone, faces its own continuing economic and fiscal woes.
Secondly, the Governor pointed to the continuing problems in the credit markets with many businesses and individuals finding it difficult to raise loans to finance their spending. The banks claim the problem is not so much their unwillingness to lend as their clients’ unwillingness to borrow. The reality is that both are true. Banks, having been profligate in their lending before the financial crash, are now much more cautious, imposing higher interest rates and tighter conditions on their loans; but potential borrowers are more cautious too, preferring to reduce their exposure to debt rather than enlarge it further.
And thirdly, the one big event since the Bank of England’s last bulletin has been the Budget, and the chancellor’s plans to impose the toughest public spending cuts for a generation. These cannot be implemented without reducing demand in the economy and that is reflected in the Governor’s greater pessimism about economic growth.
So this new gloominess pours cold water on what had been quite a cheery picture up to now. Growth in the second quarter of the year had surprised everyone with its buoyancy, rising at a rate of 1.1%. Manufacturing and exports had been reporting good figures. And even as the Governor was speaking, the Office of National Statistics published encouraging figures on jobs. Unemployment had fallen by 49,000 in the three months to June and employment had increased by 184,000 in the same period, the biggest quarterly rise since 1989. The trouble is that jobs figures are an indicator of what’s been going on rather than of what is about to happen. It is the ominous increase in the long-term unemployed that casts the dark shadow forward.
But how much faith should we be putting in the Bank of England’s forecasts? Not much, say its critics. They point out that even if, in the past, the Bank’s forecasting record has been as good as, if not better than, that of most of other forecasters, its recent performance has been dreadful. It failed, they say, to see the crash coming (as well as being slow-footed in responding to it). And even afterwards, they argue, the Bank has been consistently too optimistic both on economic growth and on inflation, the very issue for which it has responsibility. For example, only last November the Bank was forecasting growth in 2011 of 4.1%, a wildly optimistic forecast which it has now twice had to scale back.
And that is the charge being made now: that notwithstanding the reining back of its growth forecasts, the Bank is still too optimistic. The consensus among other forecasters is for growth this year to be 1.2% against the Bank’s 1.6%, for 2.1% in 2011 against 2.7% and in 2012 for 2.4% against 3.1%.
In particular, critics say the Bank has underestimated the effect of the Budget on growth. Alan Clarke, economist at BNP Paribas, said: “The Bank has not taken sufficient account of the likely drag on growth from fiscal tightening. I’m increasingly convinced growth will grind to a halt at the start of next year.”
The Governor’s defence of the Chancellor’s plan to cut spending is that it has removed another potential constraint upon economic growth. Without such fiscal tightening, the argument goes, the financial markets would have demanded higher interest rates to fund the government’s untamed deficit and this would have stifled recovery.
The reason why some economists are more pessimistic than the Governor is that they believe that when the spending cuts are actually made – and few have been yet – they will have a huge knock-on effect in the private sector as public sector contracts dry up. Already, they say, the fear of this is what is knocking consumer confidence and leading people to save rather than spend in case their own job is one of those that gets lost. Hence the talk of a double-dip recession, of the economy plunging back into a second recession.
The government, like the Bank, says this is very unlikely. Chris Huhne, the energy secretary and one of the Liberal Democrats’ main economic policymakers, argues that historically a double-dip recession is most unusual and he takes heart from the factors fuelling recovery including, in his view, the government’s firm line on reducing its own deficit.
But what if Mr Clarke and other pessimistic economists turn out to be right and growth does peter out early next year? One option facing the government would be to reverse its policy of raising VAT to 20%, a tax rise that will hit the economy just at the moment when these economists think things could start turning sour. The danger with that, however, would be that it might freak the markets into thinking the government is not serious about tackling its own financial problems after all.
Alternatively, it could look to the Governor to come to the rescue yet again. The Bank’s monetary policy committee cannot reduce interest rates any further because they are already as low as it is possible for them to be. But it could extend its policy of ‘quantitative easing’ or, as it is more popularly known, ‘printing money’. But this could raise fears that inflation will take off again and at least one member of the committee is already on public record as believing the Bank needs to take action to curb inflationary expectations. Printing more money would stoke those expectations.
No wonder the Governor sees the future as “choppy”. Back in Delphi, those who wanted the oracle to give a pronouncement had first to make a sacrifice. In our case, it looks as though the sacrifice comes afterwards.
What’s your view? Do you think the economic outlook is “choppy”? How much faith do you put in the Bank’s forecasts? Do you think it is being too optimistic or not? Of the reasons given for the downgrade in the growth forecast, which do you think is the most important? Do you think the low level of bank lending is due more to the banks’ unwillingness to lend or to clients’ reluctance to borrow? Do you think the plans for drastic public spending cuts do more to harm recovery by constraining demand in the economy or more to help it by lessening the pressure to raise interest rates? Do you think we are heading for a double dip recession or not? And if growth falters next year, what do you think the government should do: reverse the rise in VAT, expand the policy of quantitative easing, or what?