Nothing to smile about

The prime minister faces a deteriorating

economic outlook
Jan 24th 2008

DURING his decade-long stint as chancellor of the exchequer, Gordon Brown relished one
achievement above all others. That was his record in delivering economic stability, not just by
keeping inflation down but also by maintaining growth. Towards the end of his time at the
Treasury, Mr Brown even asserted that Britain was enjoying its longest period of sustained growth
for centuries. The historical figures had to be tortured to buttress this claim, but the prime minister
remains inordinately proud of his success as chancellor. He told MPs on January 23rd that Britain's
economic stability was acknowledged around the world.
The trouble is that Britain's record as a financial regulator was also once greatly admired
before Northern Rock blew that reputation apart. Mr Brown has spent much time recently finding
ingenious ways to avoid the political embarrassment of taking the stricken mortgage lender into
formal public ownership. Yet if the economy slips badly, the prime minister will find that a far
more serious mishap than nationalising Northern Rock.
The dangers of an economic reverse appear to be mounting. Mervyn King, the governor of
the Bank of England, struck a sombre note on January 22nd when he addressed a group of
businessmen in Bristol. To put it bluntly, the central banker said, this year we are probably
facing a period of above-target inflation and a marked slowing of growth.
 Tempering this bleak message, official statistics published this week showed that the
economy was still growing respectably in the final three months of 2007. GDP expanded at a
quarterly rate of 0.6%, more or less in line with trend growth and only a little less than in the
previous quarter, when it increased by 0.7%. The latest labour-market figures have also been
encouraging. Employment jumped by 175,000 in the most recent three months (to November)
compared with the previous quarter, and the jobless rate fell.
Yet economic momentum is quickly dissipated if it meets strong-enough counterforces.
Worryingly, these have now emerged and appear to be gaining in strength. For one thing, as
America's woes intensify, Britain is bound to start feeling some of the pain. Historically the two
countries' business cycles have tended to move together, not only through trade flows but also
because of especially strong financial and investment links.
More important, Britain will be hit hard by the credit crunch. Conditions in money markets
have eased a lot since the end of last year, thanks to central banks' decision in December to pump
cash into them. The benchmark three-month rate at which banks borrow from one another has
fallen sharply over the past month. But the financial crisis remains grave and is increasingly
affecting the wider economy. Lenders slashed the amount of credit they were prepared to make
available late last year, and they intend restricting it again in the first quarter of 2008.
The housing market is already wilting, as banks tighten the terms on which they make
mortgage loans and would-be buyers take fright at the possibility of instant losses on their
purchases. That augurs ill for consumer spending, which has been buoyed over the past couple of
years by another bout of rapid house-price inflation. Rising housing wealth has offset a dismal
period for living standards as, despite a strong economy, rising inflation, taxes and interest
payments have eroded growth in real disposable incomes. Now this prop is about to be removed.
Indeed, the first signs of a consumer slowdown are already apparent. Official figures for retail
sales in December were weak, contributing to the falling prices of retailers' shares earlier this
month. As consumers grow more cautious about spending and borrowing, it seems unlikely that
other sources of demand will come to the rescue. The euro area, Britain's main export market, will
itself be slowing. Businesses will be in no mood to invest in a weakening economy, and will in
any case be constrained by tighter credit.
 If the economy is to make way against these
counterforces, it needs either a budgetary or a
monetary stimulus. Mr Brown was lucky that the last
global downturn, precipitated by the dotcom crash,
coincided with a surge in public spending that had,
handily, already been planned. But after that he failed
to put the public finances in order, and the latest
figures tell a sorry tale (see chart). The budget deficit
looks set to widen to 43 billion ($84 billion) in 2007-
08, according to Citigroup, a bank. Mr Brown's imprudence has left his chancellor, Alistair
Darling, with little scope to provide a fiscal boost.
That leaves monetary policy. The Bank of England cut the base rate from 5.75% to 5.5%
in December. But earlier this month only one of the nine-strong monetary-policy committee
backed another quarter-point cut. Mr King hinted in his speech this week that a cut was on its way
next month when he said that the current base rate was probably bearing down on demand. The
governor also stressed pointedly, however, the risk that inflation will rise this yearnot least
because of the recent sharp fall in sterling's exchange rate, which will push up import prices.
It was Mr Brown who gave the Bank of England freedom to set interest rates in order to meet an
inflation target. Now that same independent central bank is grappling with an ugly conjuncture of
rising inflation and falling growth. The prime minister must be praying that Mr King and his fellow
rate-setters make the right call. His political future as well as his economic reputation may depend
upon it.