A few weeks ago, at a small private dinner, I watched a handful of the biggest names in British business ganging up on a Treasury official trying to defend his department’s optimistic UK growth forecast. The industrialists were adamant that the underlying British economy was one of the weakest in Europe – a fact disguised in recent years by high public spending, personal borrowing, massive immigration and soaring house prices.
The man from the Treasury accused them of being London-centric, reading too much into the financial crisis in the City. He said the rest of the economy was in good enough shape to meet the 1.6% forecast.
I think it’s pretty clear this week who has won that argument: Britain is in the grip of a full-blown economic and financial crisis to the extent that some in the City are now asking whether the UK authorities have lost control of both monetary and fiscal policy.
The first bit of shocking news out this week was the latest inflation figures, which came in at 3% – a full 1% above its official target. To make matters worse, the Bank of England then warned on Wednesday that inflation could rise above 4% this year if oil prices remain high – and that assumes interest rates stay at 5%.
I suspect even these forecasts are too low. Once the inflationary genie is out of the bottle, it is hard to put back in. Every boss I’ve talked to recently says he plans to put up prices this year. That’s surely put paid to any hopes of a rate cut. Rates may yet have to rise. That in turn leads the Bank to warn that growth may now fall to zero in the second half of the year. In the 1970s, they invented a useful word for this: stagflation.
The second bit of bad news concerned the crumbling housing market. House prices are now in freefall across the country. Surveyors report the worst conditions in more than 30 years and mortgage defaults are now approaching early 1990s levels. It emerged this week – when a long camera lens picked up housing minister Caroline Flint’s briefing document – that the Government’s best-case scenario for house prices is that they fall only 5%-10%. That already looks over-optimistic. To bring house prices back in line with long-term multiples of income, they would have to fall nearly 30%.
Meanwhile, existing homeowners are so deeply in debt that Morgan Stanley calculates a 20% fall would force 1.9 million people into negative equity. And with banks sharply reducing the multiples of income they are prepared to lend, it’s hard to see where any market support might come from.
But perhaps the worst economic story of the week was the Government’s astonishing decision to borrow £2.7bn to get itself out of a political hole over the scrapping of the 10p tax band. The problem here was not so much the policy as the manner in which it was introduced. Hard on the heels of Government U-turns over capital-gains tax, non-dom tax, Northern Rock and corporation tax, Brown has underlined his willingness to take giant risks with the public finances to save his political skin.
The full economic consequences of this will become clear over time. British Government debt is already within a whisker of the Government’s own target of 40% of GDP – and with tax receipts falling, that limit now looks sure to be breached later this year. The markets must decide how the Government will respond: will it put up taxes, cut saving, or abandon its rules? If the markets conclude that Brown has lost control of the public finances and can no longer be trusted, the result will be a further slide in sterling, rising inflation expectations and ultimately higher interest rates.
Britain is now in a parlous condition. It’s been fashionable over the last few years to joke that the UK has become a giant hedge fund. And we know what happens to them when investors lose confidence. The tide of immigrants that buoyed the economy has gone into reverse. Sterling had already fallen further against the dollar since the credit crunch than it did after it fell out of the EU Exchange Rate Mechanism before Brown started playing fast and loose with public money this week. What can be done to restore confidence in Britain? Not much, I fear – and certainly nothing while a weak and desperate Brown remains in charge.
Is Goldman Gordon’s biggest fan?
It’s fair to say that Brown does still have some supporters in the City. I was surprised to hear he recently found time to attend the Goldman Sachs partners’ conference in London. The links between Goldman and Brown’s Government are well-documented. Number 10 is already well-staffed with Goldman alumni and Goldman was the firm Brown turned to to try to get out of the Rock mess.
Even so, I thought one of Goldman’s top honchos in London was laying it on a bit when I asked him how Brown had been: lucid, erudite, wise – superlatives tripped off his tongue. I know Goldman’s motto is famously “Our clients’ interests always come first”, but that surely doesn’t extend to this kind of cheer-leading?
Simon Nixon is executive editor of Breakingviews.com