Why Britain’s economy will change

By Martin Wolf

What does the economic turmoil mean for the UK economy? This is not a question about prospects for the next year. It is deeper than that: how well can an economy long characterised by soaring house prices, exploding debt and a dynamic financial sector adjust to a new world?

Attitudes to the new “special liquidity scheme” for banks tell us how little politicians want to consider the worst possibilities. Thus, Alistair Darling, chancellor of the exchequer, told the Commons on April 21 that the scheme would “help alleviate the problems that have seen banks reluctant to lend to each other and in turn support the provision of new mortgage lending”. But Mervyn King, governor of the Bank of England, says “the scheme is not designed to send the mortgage market back to the rather wild lending before the turmoil began last summer”. On the contrary, there “needs to be some adjustment in the housing market”.

Mr King is closer to the truth, not least on what the scheme is likely to achieve. Its beauty is that it makes only existing high-grade assets liquid. It is not a commitment to creating a market for future fruit of the financial sector’s imagination. But it should eliminate concerns over illiquidity of existing high-grade mortgage-backed securities. Early evidence suggests that it is working: spreads between rates at which banks lend to one another and expected official rates have contracted by about 10 basis points, though they remain very high.

Mr King states that “the objective is not to protect the banks but to protect the public from the banks”. The two can never be separated, alas: it is because banks are so important to the public that they are supported by the government, on the public’s behalf. But this scheme is a decent attempt to draw this line. It leaves the banks to cope with the illiquidity of low-grade paper they now hold. It also provides no bail-out of long-term losses for solvent institutions. So more capital is needed. Recent moves to raise it are welcome.

Accept, then, that these official efforts are not going to bring back the credit boom and should also not do so. The last thing the UK needs is more highly leveraged purchase of overpriced houses. But how bad is the let-down for the economy then going to be? In a recent speech, Charles Bean, the Bank’s chief economist, offers an answer*.

Surprisingly, Mr Bean argues that even though house prices are likely to fall, possibly significantly, this does not itself guarantee a sharp slowdown in consumer spending. But this point may not matter since, as he admits, reduced growth in credit seems certain to slow growth in consumer spending. The ratio of household liabilities to disposable income jumped from 105 per cent at the end of 1996 to 164 per cent at the end of 2006. This is much the highest ratio in the Group of Seven leading high-income countries, the US equivalent being just 138 per cent. Such a rise cannot be repeated.

To this fact must be added the negative shocks to prices and real incomes from oil prices at close to $120 a barrel and a doubling of prices of non-fuel commodities since 2004. The fall in sterling will ultimately boost real output substantially. But it will also raise inflationary pressure in the short to medium term. The combination of rising inflation with the impact of the credit squeeze on consumption and investment creates a mild stagflation – the combination that makes the monetary policy job of a central bank most difficult.

The right thing for the Bank to do is to anchor inflationary expectations, even at the risk of a sharp economic slowdown. That is also what it is mandated to do. The UK may indeed be following the US economic path, as David Blanchflower, a member of the monetary policy committee, argues. But the Bank cannot follow the Federal Reserve in its aggressive slashing of interest rates. The role of the Fed is different, because of the greater importance of the US to the world economy and the benefits of the doubt the world still gives it. Nobody has to invest in the UK and nobody outside the UK has to trust sterling.

Pressures from politicians and businesses on the MPC will grow. These must be resisted. The MPC must focus on keeping its balance on Mr Bean’s tightrope. This is one of the reasons the special liquidity scheme is so important: it allows the Bank to separate general monetary policy from its measures to unfreeze the financial system. It maintains the room to focus its monetary policy on stabilising inflation and so the economy, at least in the longer term.

Thus, after 62 quarters of positive growth and a rise of more than 50 per cent in gross domestic product, the UK confronts difficult times. But are these short-term or much longer-term economic difficulties?

The UK is a country in which financial intermediation grew by 126 per cent, in real terms, between 1992 and 2007. If the growth of debt is now to slow, as it must, this explosion of the financial services industry cannot continue. The challenges ahead, therefore, are far more structural than merely cyclical. A new economy will emerge. The transition will be more painful than the government cares to admit. It is unavoidable, all the same.