The storm to come

From The World in 2008

Britain’s economic horizon is fast darkening

For the first time in 15 years, Britain is facing the prospect of a serious economic slowdown. After the longest period of uninterrupted economic growth in modern British history—and a world-beating decade of price stability, rapidly rising living standards and low unemployment—the era of prosperity is not completely over. But consumers, homeowners, workers and financiers are entering a leaner period than anything they have experienced since the Labour government came to power in 1997.

An outright recession is still unlikely, unless the credit crunch and the weakening in the American and European economies turn out to be much more severe than suggested by the evidence up to the end of 2007. But the nice, gentle slowdown assumed by Gordon Brown’s government, and required by the Treasury to prevent a serious deterioration in Britain’s public finances, seems almost as unlikely as the other, pessimistic extreme. Alistair Darling, the chancellor, was technically correct to say in his October economics report that his budgetary assumption of growth ranging between 2% and 2.5% was consistent with private-sector “consensus” forecasts, but he neglected several important caveats.

Economist Intelligence Unit

Economists typically get their forecasts wrong at cyclical turning-points or periods of major structural change—and it looks increasingly as if 2008 will be just such a year. To make matters worse, private forecasters have mostly been clustered near the bottom of the Treasury’s 2-2.5% range. Moreover, several of the forecasts completed after the summer credit crunch and the Northern Rock crisis were producing results of 1.5% or below. If growth ends up anywhere near this low figure, then 2008 will be by far the worst year for the British economy since the end of the last recession in 1992.

Of course, Britain will not be alone in suffering some economic hardship. But in contrast to every previous slowdown since the early 1990s, Britain could well do worse than America and continental Europe in 2008. Britain’s unaccustomed difficulties stem from four separate sources.

Four horsemen of the apocalypse

The first is the 2007 credit crunch, which is likely to have an even greater impact on Britain than on the United States or any other G7 country. This is partly because house-price inflation in Britain has been even faster than in America, while consumer leverage is higher than in most European countries. According to The Economist’s index, real house prices rose by 205% in Britain in the ten years since 1997, compared with 103% in the United States, 137% in France and 184% in Spain. Meanwhile, British households’ mortgage debt stands at 125% of disposable income, compared with 104% in America, 65% in France and considerably lower figures in other European countries. There are other factors, such as strict restrictions on land use, that partly offset the vulnerability of house prices to an American-style meltdown. But the threat of a significant correction is clear.

What makes Britain even more vulnerable to the specific form which the global credit crunch has taken is the importance of the financial sector to the broader economy. The banking and insurance industries account for 6.5% of gross value-added in Britain, compared with a share of only 4-5% in other European countries. And, significantly, the parts of the business which have grown the fastest—hedge funds, wholesale finance and international securitisation—are the ones due for the biggest setbacks in the year ahead.

The phenomenal gusher of wealth that Britain has enjoyed from the City is bound to slow down

According to the Centre for Economics and Business Research (CEBR), wholesale finance and the related high-value business services based in the City of London have accounted for around 16% of the growth in the British economy over the past four years. These activities are not about to collapse, since Britain still enjoys an international comparative advantage in wholesale finance—and will probably continue to do so even after the Treasury’s tax raid on foreign workers announced in October 2007. However, the phenomenal gusher of wealth that Britain has enjoyed from the City of London is bound to slow down in the year ahead. According to the CEBR, which makes a speciality of tracking financial employment, London’s 350,000 high-end jobs in finance and business services will fall by about 5,000 in 2008. This may not seem much, but it will still represent a shock after four years of growth at 10,000 annually. Much worse, the City bonuses which have powered the London housing market and consumer economy are likely to fall by 30% over two years, according to the CEBR—to £6.2 billion ($12.4 billion) in 2008 from £7.4 billion in 2007 and £8.8 billion in 2006. This would represent a much bigger loss than the 12% decline in bonuses experienced between 2000 and 2002.

As the hedge funds and investment banks start firing staff and reducing bonuses, the London economy, which represents roughly 20% of national GDP, will suffer a significant loss of income. The damaging effects will quickly trickle down to the rest of the country through the housing market and retail sales. Moreover, the Brown government’s unexpected attack on the generous tax treatment enjoyed by foreign-domiciled workers could do long-term damage to Britain’s comparative advantage in this sector and turn what should have been a temporary cyclical slowdown into a permanent structural decline.

The third threat to the British economy is closely related to the problems of the City. For the past 15 years Britain has enjoyed an enormous terms-of-trade benefit from the fact that the exports in which it specialised (largely business services) were going up in price, while its imports (largely commodities and mass-produced manufactures) were getting cheaper. In 2006-07 this terms-of-trade gain, which has lifted Britons’ real incomes and consumption without the need for them to work any harder, was reduced by rising commodity prices. But in 2008 the terms of trade could even go sharply into reverse, as financial incomes start falling, while the cost of imports from China and the rest of Asia goes up.

The final problem will be partly the result of weaker incomes and spending: government finances will suffer an even tighter squeeze than the Treasury assumed in its downgraded forecasts—and as a result the boom in public-sector spending which has spread wealth from the City of London to the rest of the country will subside or even reverse. According to the official forecasts, public spending should rise by 2.1% annually in real terms from April 2008 onwards. Presumably there will be some overshooting, as a result of which budget deficits will keep on rising and the government’s fiscal rules will have to be torn up. But public-sector workers and managers cannot even dream of a return to the 4%-plus growth rates they enjoyed from 2001 until 2006. With housing, consumption, financial services and government spending all slowing abruptly, one can see why Mr Brown was tempted to call an early election—and why he is very unlikely to do so in 2008.