The chancellor is predicting a gentle slowdown this year. He's gravely mistaken, says Douglas McWilliams, as surveys indicate that we're in for a full-blown recession.
Question: what is the difference between an optimist and a pessimist? Answer: a pessimist is in possession of all the facts. This cynical old joke is not entirely without a grain of truth, especially when it comes to predicting the economic future of the country.
The optimistic vision of the prospects for the UK econ-omy in 1999 was set out by the chancellor, Gordon Brown, in his pre-Budget statement in early November last year. Brown is looking for a gentle slowing down, with economic growth falling to 1.25% before starting to recover later in the year. He is certainly not predicting - or even admitting that we might be facing - a full-blown recession. This, he argues, would be a typical 'soft landing' for the economy, which in practice would see an extra 150,000 out of work. The Bank of England's Monetary Policy Committee, though slightly less optimistic, broadly agrees.
The pessimistic view emerges from the business surveys carried out by bodies such as the CBI, the British Retail Consortium, the Chambers of Commerce, the Chartered Institute of Marketing and the Chartered Institute of Purchasing and Supply. The accountants, BDO Stoy Hayward, produce a 'poll of polls' where these surveys are weighted together and compared with past rates of economic growth. The latest poll of polls is pointing to negative growth of about 0.5% for 1999. This would be a 'hard landing' - a recession in other words - with an extra 500,000 or possibly even more unemployed by the year 2000. Pessimistic? Or just in possession of all the facts?
Most of the UK's 41 groups of economic forecasters, including my own team at the Centre for Economics and Business Research (CEBR), are somewhere in between these two poles of opinion. But both optimists and pessimists alike are agreed that 1999 will be a year of falling mortgage rates - indeed some are talking about mortgage rates of 4-5% by December, the lowest levels for 35 years. Where they disagree is over how many people will still have steady jobs providing incomes to pay even the low interest rates on their mortgages by the end of the year.
The optimists and the pessimists differ in their views on three main points. First, there are differences in opinion about the robustness of the present state of the UK economy; second, they differ about the state of the world economy; and third, they differ about the extent to which the Bank of England's Monetary Policy Committee can counteract any slowing down in the economy by cutting interest rates.
The optimistic chancellor believes that UK companies have reasonably robust order books which will sustain their production levels until the impact of falling interest rates starts to boost the economy in the second half of the year. He also expects only a slight slowing down in the world economy. In addition he argues that Continental Europe, the area which is most important for UK exports, should escape relatively unscathed from the world's economic problems.
I have to admit that I disagree with the chancellor, and side with the pessimists' view of the UK economy that, rather than companies having robust order books, sales and orders have fallen back during 1998 and that production will also do so after a delay. In fact, the pessimists believe that production will fall especially sharply because businesses have filled up their shelves and their warehouses with excessive stocks of raw materials, components and finished goods. These inventories can only be liquidated by cutting production and purchases from suppliers, which is why the pessimists expect UK growth to be negative in 1999.
The pessimists also see a very fragile world economy. Japan, despite £120 billion of tax cuts and extra government spending of £118 billion (which included shoving £100 shopping vouchers into the pockets of every citizen in a vain attempt to get them to start spending), may remain in economic decline for the next two years. The rest of Asia is dependent on the Japanese market and will also be affected by the collapsing banks, businesses and local stock markets.
As for the rest of the world, the US economy is predicted to slow down, perhaps sharply if stock markets weaken and banks' losses limit their ability to lend money. Although Europe looks to be in better shape, many European banks have suffered large losses stemming from the Russian default last year.
The other strand to the pessimists' argument is that they believe that the Bank of England's Monetary Policy Committee, which sets interest rates, will have its hands tied during the year and will not be able to kick-start a weakening economy.
Even the gloom-mongers expect that interest rates will be cut further, but they argue that the falls will be limited. Some think that the Monetary Policy Committee, filled with public officials and academics, is bound to be slow to recognise what is going on in the real world and will provide the classic mixture of 'too little too late' when cutting rates. Others argue that inflation will fall only slowly, pointing out that wages appear to be rising at close to 5% and that it may take until mid-1999 before skills shortages disappear.
Another concern is that the National Minimum Wage and the EU Working Time Directive will keep inflation near or above the Government's target of 2.5% for most of the year. The Minimum Wage is set to be introduced at £3.60 an hour from April 1999. The Monetary Policy Committee estimates that it will boost wages for around a fifth of the workforce and may increase overall average earnings by between 0.6% and 1% during the year. These figures, however, make little or no allowance for 'differential' effects, which will occur as higher paid workers respond by making more ambitious wage claims for themselves. In addition, the Monetary Policy Committee expects that the implementation of the EU Working Time Directive at the end of 1998 will add an extra 0.5% to labour cost inflation in 1999.
It is important, however, not to paint too black a picture - even the most doom-laden pessimists are only expecting growth to be slightly negative.
This would be a much less severe landing than any of the last three economic cycles. In the early '90s, there was a full-blown recession, with growth bottoming out at -1.5% in 1991. In the early '80s, the recession was even worse, with GDP falling 2.2% in 1980 and 1.3% in 1981. In the mid-'70s, there was yet another recession, with growth bottoming out at -1.7% in 1974.
My own view is that the pessimists are almost certainly right and the chancellor almost certainly wrong about the fragility of the UK economy.
Businesses know how overstocked they are and what their order books show and this influences their responses to business surveys. History shows that when business surveys and government forecasts disagree, the business surveys are right more often than not.
Either camp, however, could be right about the world outlook. The Asian economy is certainly likely to remain in trouble for some time and most of the indicators show Europe slowing down. Yet the US continues to perform remarkably well and cleverly timed cuts in interest rates keep prodding the economy forward. Much will depend on whether confidence can be sustained at a time when the US stock market is very fully valued.
Where the optimists are probably right is to expect that UK interest rates will eventually fall to levels not seen since the early 1960s. All being well, even if the economy does slow to a standstill in mid-year, falling interest rates will provide a safety net and prevent the bumpy landing from turning into a fully fledged, buy-gold-and-hide-it-under-the-bed recession.
Most of us have spent our entire working lives in an inflationary environment. But, after peaking in the mid-'70s, inflation has been falling consistently. Now, not just falling inflation but falling prices are a reality in many parts of the world economy. For the high-tech sectors this has been the norm for 30 years. But the information and communications technology sectors now account for nearly 10% of the economy in the industrial world and so the falling prices for high-tech products are an increasingly important phenomenon.
Meanwhile, the prices of oil, metals, agricultural raw materials such as rubber, and food are all now lower than they were in 1990 and are still falling. In addition, in a world facing excess capacity, prices of industrial products are collapsing. Imports of cheap goods, benefiting from the devaluations in the Asian currencies, will boost this trend.
Against this background of falling inflationary pressures, it is difficult to see UK prices holding up enough to prevent the Monetary Policy Committee from cutting interest rates time and time again during 1999. The National Minimum Wage and the Working Time Directive might hit jobs by making them more expensive but the market is likely to be too weak for the extra costs to be passed on in higher prices.
With this unusual mixture of thunderclouds and silver linings, 1999 will be a year for the sharp-witted; a year of living dangerously. Employment prospects will be less sure than at any time in the past seven years, although lay-offs, bankruptcies and plant closures on the scale of the early '90s are unlikely.
Except for those affected by government policies such as the Minimum Wage, pay increases will at best be modest. On the other hand, for many people the cost of living may not rise at all, and may even fall. Indeed there are likely to be bargains around in the shops as retailers and manufacturers try to run down their excess inventories. In addition, the near certainty of much lower interest rates will create opportunities for refinancing mortgages and other loans at much lower interest rates.
Investors are likely to find that the prices of their shares will be affected by the slow growth. Some sectors will be affected more than others.
In most parts of the world the service sector will do better than the industrial sectors. Also companies depending directly on the consumer market should outperform companies selling to other businesses.
Eventually the recovery, when it comes, is likely to be driven by the high-tech sector, although the successful companies will probably not be today's top performers. In the meantime investors should aim to be overweight in bonds, since low (or negative) inflation and sluggish growth means falling bond yields and hence rising bond prices, despite governments returning to deficit.
Managing a business in 1999 may be a bit hair-raising. Demand for most products is likely to be weak. All businessmen will be playing some form of pass the parcel, trying to make sure that their suppliers or their customers are the ones stuck with excess inventories when prices fall. But at the same time, very low interest rates will eventually enable those businesses with recession-proof projects to finance them extremely cheaply. Banks may initially be cautious about lending. But at some point in this cycle - and possibly by the end of 1999 - there will be a time when they are falling over themselves to lend money to anyone brave enough to borrow at very low interest rates.
For both businessmen and private individuals, negotiating with foresight will help take best advantage of the situation. Anyone who is selling should try to get the price fixed and guaranteed as early as possible in advance. Potential buyers should hold off, or set up deals that enable them to pay less if the market falls.
The chancellor is optimistic, and understandably so. Confidence is a factor in the health of an economy and so he has a vested interest in preaching optimism. He is also basing his hopes on achieving a soft landing. But history is against him. The last successful soft landing was as long ago as 1962. Paradoxically, the less the public and the Monetary Policy Committee believe his forecasts, the more likely it is that interest rates will fall fast enough to cushion the economic slowdown.
Professor Douglas McWilliams is chief executive of the Centre for Economics and Business Research
FORECASTS FOR 1999
REAL GDP GROWTH
Pessimists - 0.5%
RETAIL PRICE INDEX
BASE RATES BY YEAR-END
SOURCE: Centre for Economics and Business Research.