Any economic measure given too much prominence starts to misbehave. By David Smith.
During Britain long recession and, its seems, interminable wait for economic recovery, one subject has received more attention than most. Confidence, among businessmen or consumers, has been seen as a key factor in determining when, if not whether, the upturn is to come.
Norman Lamont, in citing the rise in business and consumer confidence of last autumn, clearly thought that he was on to something. The Treasury, which goes over the Confederation of British Industry's quarterly trends survey with a fine tooth comb, and pays close attention to other business and consumer surveys was convinced that, with optimism increasing, recovery could not be far behind.
Most economists agreed. I remember suggesting the Bank of England, at the time, that this heavy emphasis on confidence, particularly in the official forecasts, was risky. Might it not be another manifestation of the phenomenon whereby any economic measure that is given undue prominence mysteriously starts to misbehave? It was a former Bank of England economist, Charles Goodhart, who gave his name to Goodhart's Law - any measure of the money supply chosen as a target by the authorities automatically becomes subject to distortion.
But to return to the matter of confidence. Economists have long been aware that it is a vital ingredient in the recovery recipe. You can lead a horse to water by establishing the right conditions for an upturn but you cannot make it drink. John Maynard Keynes, in his General Theory, wrote of the "animal spirits" which cause businessmen to invest and consumers to spend. "There is the instability due to the characteristic of human nature that a large proportion for our positive activities depend on spontaneous optimism rather than on mathematical expectation ... Most, probably, of our decision to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction."
Lamont and his Treasury officials were on fairly solid ground when they thought that last autumn's recovery in business and consumer confidence was a harbinger of a general economic upturn. Why, then, was I suspicious, and why did rising confidence that time not translate into orders, deliveries and new investment?
One reason, I think, was that the business and consumer surveys of September, October and November of last year were tainted by the Chancellor's own optimism. There was a self-feeding process at work. The more that Lamont and his cabinet colleagues told the country that recovery was under way, the more that people and business started to believe it. Intentionally or otherwise, the Government was involved in what one might describe as a confidence trick. If everyone could be persuaded to feel more optimistic, then that increased optimism could be expected to show through in increased economic activity.
What we have learned, I think, is that recoveries have to be built on stronger foundations than it is. Businessmen duly filled in their survey forms, and expressed their belief that things were getting better, and waited for the orders to come in. When they did not, they had reason to feel disappointed, hence the subsequent drop in confidence as we came to the end of 1991 and in the early weeks of 1992.
Another reason that it is easy to misunderstand the nature of confidence, as it is recorded in questions in business and consumer surveys. Most survey questions are framed in terms of relative confidence. Companies are asked whether they are more or less optimistic than they were four months ago. Individuals are invited to say whether they expect the next 12 months to be better or worse than the last 12.
The point, often forgotten, is that confidence can improve but still be low. As the chart (p27) shows, the CBI's quarterly trends survey showed declining business optimism from 1988 through until October 1991, before there was a small recovery. When the October 1991 results came out, the Treasury declared that business confidence was at is highest for three years, but this was clearly wrong. All that had happened was that after a long period of declining optimism, the business mood had stabilised. It had not bounded back. And was clearly wrong to suggest that businesses were as optimistic in the recession of autumn 1991 as they were in the boom year 1988. Rising consumer confidence also had to be treated with caution. After a grim 12 months, most people would be inclined to expect some improvement. But this may not be saying much about the overall level of confidence. If this analysis is correct, and confidence, while up, remained at very low levels, then it is not hard to see why there was no follow-through into economic recovery managers need to feel, not just that things have stopped getting worse, but that there is a prospect of a decisive improvement, if they are to authorise new investment spending. You and I, similarly, may feel emboldened enough after a long period of gloom to go out and buy a shirt and tie. But we may still be some way from committing ourselves to a new house, car or even a suit. We, and our businesses, may feel confident enough to stop retrenching, but we are not yet ready to embark on an expansion. Thus an improvement, or a stabilisation, in confidence may be consistent with an economy which is merely bumping along the bottom.
Finally, confidence has not worked very well as a predictor of economic recovery because of the role of interest rates in this recession. Last autumn's rise in the business and consumer confidence measures followed a period of falling interest rates - base rates fell from 14% in February to 10.5% by early September. The dip-back in confidence over the winter, similarly, came after a prolonged pause in interest rate reductions and, equally importantly, amid worries that the Bank of England could be forced to follow the German Buundesbank in raising rates.
We know that last year's interest rate cuts had somewhat different effects than their predecessors, people and companies had lived through the recession with some guiding principle: that if they had a chance to pay off debt they would do so. Lower interest rates provided just such an opportunity. They stimulated debt-repayment rather than higher spending. Eventually, when everyone has got his or her house in order - and both consumers and businesses strengthened the financial positions during 1991 spending will follow. But the delays, the famous policy lags, could not seriously be expected to be short. On the contrary, the lesson of the recent boom and bust cycle is that interest rates take time to come through. Barring accidents, the 1991 interest rate cuts should provide for economic recovery later in 1992 and, more convincingly, in 1993. Miracles, even when optimism is increasing, take a little while longer these days. David Smith is economics editor of The Sunday Times.