An overvalued pound and the Asian economic crisis have finally led to a manufacturing recession, as David Smith predicted. Will the rest of the economy follow suit?
Take a currency which, on some measures, is more overvalued than when it devastated British manufacturing in the early '80s. Add a newly independent central bank determined to win its spurs by keeping inflation firmly under control. Stir in the tax increases of a recently elected government obsessed with getting the bad news out of the way early in the parliament. Finally, apply a large helping of Asian economic and financial crisis, which looked bad when it first broke last year and looks even worse now. What do you get? An economy that looks as if it's heading for a hard landing.
Politicians tempt providence
I don't know about you, but whenever I hear Gordon Brown or Tony Blair insisting that, thanks to New Labour's policies, 'there will be no return to boom and bust,' I shudder. Just like when the cricket commentator says someone is playing flawlessly and you just know he has to be out next ball, so a politician should not tempt providence in this way.
Back in October 1990, when sterling entered the European exchange rate mechanism (ERM), the then Conservative government was confident that, in the long term, ERM would result in a stable economy. Sadly, the one sure thing about economics is that the long run is made up of a series of short runs. If all these short runs are un-stable, the promised land of long-run stability is never actually reached.
So how big is the risk of a hard landing, or outright recession, for Britain's economy? Last year, I predicted that, thanks to the overvalued pound, we would certainly get something close to a manufacturing recession - hardly a fashionable view considering that everyone was still more worried about unsustainable boom. Earlier this year, the manufacturing recession duly arrived in a technical sense (two quarters of declining output). But is it inevitable that this recession will now spread to the rest of the economy?
Let me play devil's advocate for a moment. Manufacturing may be in technical recession, but the real story of the last year has been how well industry has coped with the various horrors that have come its way. There have been no maps on News at Ten pinpointing factory closures. The pay freezes of the early '90s have become a distant memory. Indeed, the Treasury and the Bank of England have been worried that manufacturing pay is growing too fast. Exporters have suffered a big squeeze on margins but, other than in Asian markets, they have not experienced the feared export collapse.
Slowing down the economy
Meanwhile, British consumers, teased out of their shell in the mid-'90s, have returned to normal spending patterns. Service industries relying on domestic, mainly consumer, demand are doing very nicely. Information technology and business and financial services are booming. Far from facing a hard landing, the real question for the economy, as the Bank of England keeps telling us, is whether it is actually slowing down sharply enough.
The problem with this kind of analysis is that we have seen it all before.
In the first half of 1990, when base rates stood at 15% and the Bank of England was urging a rise to 16% or 17%, industry was suffering. But British consumers appeared impervious to attempts to rein back their spending. Then, with a suddenness and savagery that remains fresh in the mind to this day, the economy dived into a recession from which it took years to recover.
What shifted things so rapidly from boom to bust was a sudden loss of confidence and that is what will determine the hardness of the economy's landing now. Until the Bank's monetary policy committee raised base rates from 7.25% to 7.5% in June, a move backed by both the Treasury and the prime minister, I was reasonably confident that officialdom understood the risks facing the economy and that a soft landing could be achieved.
But, for three reasons, I am no longer sure.
First, the rate rise gave a clear signal that monetary policy is not anticipatory but reactive. In other words, the Bank of England will carry on raising rates until the signs of distress become manifest. By then, of course, we would be locked into a more serious outcome. It can take 18 months to two years for the full effects of a rate rise to come through, however, and just as we see the effects of last summer's rate rise, the Bank of England is adding to the dosage.
The second concern is over the exchange rate. Despite ministerial lip service to worries about manufacturing, this Government appears to like an overvalued pound. Perhaps this is because too many Labour governments in the past have been derailed by the consequences of a weak pound.
The third big worry is Asia. Smaller Asian currencies, such as the Korean won, may suffer big devaluations, but when the Japanese yen, the region's currency giant, drops to little more than half its level of three years ago, we really should be concerned. Asia's only way out of its crisis is through exports, at highly competitive exchange rates. That must, therefore, mean a loss of markets for British firms, both at home and overseas. Add to this the consequences of Asian financial turbulence for global stock markets and the risk then multiplies.
One sector, all sectors
Perhaps most importantly of all, the idea that one sector of the economy - manufacturing - can be under serious stress, while the others sail along in a trouble-free way, is seriously flawed. The links between industry and the rest of the economy are strong and it would be a mistake to conclude that services are immune from the consequences of a high exchange rate, over-tight monetary policy and the crisis in Asia. Events and officialdom have served up a recipe for a hard landing. I thought the chances of it were relatively small but I would now put it at 50:50 - which is very worrying.