Despite all the troubles besetting the world economy this year, Britain has
nothing much to worry about. That is the official Treasury view, as
presented last
week by Alistair Darling in his first big speech on economic policy
since he became Chancellor: “The global economy is facing its biggest test
in more than a decade. But we know that we will get through this difficult
time. We have good reasons to be confident.”
The Bank of England seems to agree, to judge by its minimalist action last
week. Thursday's quarter-point rate cut, to 5.25 per cent, left British
interest rates more than a full percentage point above the level prevailing
in every leading economy apart from Australia. This means, presumably, that
the Monetary Policy Committee is far more confident about the national
economic outlook than any other monetary authority in the world, with the
sole exception of the Reserve Bank of Australia.
As regular readers of this column may be aware, I do not share this sanguine
view. Since the start of financial turbulence last summer, I have believed
that Britain, because of its exceptional dependence on finance and housing,
would suffer more than other big economies and certainly more than the
United States. Why does the Government disagree?
Mr Darling gave essentially three “reasons to be confident” in his speech last
week. First that, in the past ten years, Britain has proved more resilient
to financial shocks than other leading economies; Britain was “the only G7
economy to grow continuously throughout the past decade”. Secondly, the
Chancellor maintained that there were “important differences” between the
British and US housing markets that make our economy far less vulnerable to
a US-style credit crunch. Thirdly, he argued, “the UK business environment
remains one of the best in the world” and the Government was determined to
keep it that way. As evidence of such good intentions, Mr Darling boasted of
the Government's record for low taxation, for avoiding burdensome
regulations and especially (since he was speaking to the Engineering
Employers' Federation) for encouraging high-productivity manufacturing
industries, including aerospace, pharmaceuticals and advanced automotive
engineering.
Let us consider these arguments. The Chancellor's first point, about Britain's
unique economic stability in the past decade, is valid. However, the main
reason why Britain avoided the recession that hit Europe and America from
2001 to 2003 was that British finance and construction grew rapidly during
this period, while the rest of the economy stagnated or declined. If the
main problem this time is in the financial and housing sectors, it is hard
to see reassurance in the precedent of 2001-03.
Mr Darling's claims about housing invulnerability are even more dubious. He
listed three “important differences” between the British and American
housing markets: many US mortgages were “sold at hugely discounted rates,
leaving people unable to meet repayments when rates increased”; British
lenders “have been more responsible” in taking account of an individual's
ability to pay; and British demand for housing outstrips supply. The
Chancellor's speech did not substantiate any of these statements, which is
understandable, since none of them is factually correct. In Britain,
discounted rates as low 1 per cent or 2 per cent are common, while in the
initial “teaser” rates on US sub-prime mortgages typically were 6 or 7 per
cent. Mortgage loan outstanding at the beginning of 2007 were 125 per cent
of disposable income in Britain, compared with 103 per cent in the US - and
British banks have been at least as enthusiastic as US lenders in offering
100 per cent and even 110 per cent mortgages. Northern Rock has been a
global leader in this reckless trend. As for demand and supply in housing,
these are not independent factors but depend on the level of house prices
and interest rates and on the strength of economic growth. It is true that
demand outstripped supply in both America and Britain in the ten years to
2007, but as the American credit cycle has turned, so housing demand has
collapsed. There is reason to expect the same to happen in Britain. Indeed,
according to the monthly Halifax index, house prices in London have fallen
by 7 per cent since their July peak - about the same as the decline in US
house prices in the first six months of the present bust.
What about the Chancellor's third reason for reassurance - to which he seemed
to attach most importance - the “flexible economy” and “competitive business
environment” fostered by tax, regulatory and financial policies in Britain?
Let me focus on one critical - and revealing - economic difference between
the economic structures in Britain and the US. Britain and America are both
widely viewed as post-industrial economies that have abandoned manufacturing
in favour of consumption and “hyper-finance” -a parody of the economic
reality in both countries, but it is nearer the truth in Britain than in the
US. In Britain, the growth of finance and housing over the past ten years
has coincided with a decline in manufacturing from 17 per cent to 13 per
cent of gross value added and from 17 per cent to 11 per cent of total
employment. In America, manufacturing employment has fallen far less steeply
than it has in Britain, while manufacturing output has remained stable,
generating the same 16 per cent of total output today as it did 20 years ago
(see charts). Why has US manufacturing output remained steady despite the
slow but steady decline in employment? US manufacturers have increased their
productivity and moved into high-value niches more rapidly than most of
their British counterparts.
The upshot is that America has a thriving manufacturing and export sector,
which in the past 18 months has largely taken up the slack - in terms of
economic activity and employment - created by weaker housing and financial
markets. But Britain's manufacturing sector, which contributed more than
America's to national output as recently as ten years ago, has shrunk so far
since then that a revival of manufacturing and exports is very unlikely to
offset weaker financial activity, housing and consumer demand.
Why this has happened is a profoundly important question that will command
increasing attention if Britain's financial driving forces begin to run out
of steam. An excellent presentation of this question was offered in a
lecture at Imperial College by Sir John Rose, the chief executive of
Rolls-Royce, one of the few large British manufacturers to have been truly
successful on a global scale. Sir John's analysis persuasively explained the
failure of successive British governments to promote the “clear sense of
direction”, the recognition of “national priorities” and the “supportive
business framework” that have underpinned the growth of high-value
manufacturing not only in France and Germany but also in the US.
Even Sir John's analysis offered no real answers on what British governments
should do now to create a more balanced economy with a stronger
manufacturing sector. After last week's speech on economic prospects from Mr
Darling, I can, however, make one modest proposal for a contribution to
Britain's economic revival: less complacency from the Treasury and fewer
ludicrous boasts from the Chancellor.
www3.imperial.ac.uk/media/onlinelectures/2007onlinelectures
