Expert View: Fault lines threaten British prosperity

Over the past few years, the UK economy has performed well compared with other industrialised nations. But can Britain continue to be the blue-eyed boy?

Over the past few years, the UK economy has performed well compared with other industrialised nations. After some weakness, growth has moved back to its sustainable rate, unemployment is low and inflation fluctuates around its target. But can Britain continue to be the blue-eyed boy?

Our confidence has to erode as we dig deeper and find imbalances. Weak private investment and a continued recession in manufacturing question the sustainability of the recovery. This in turn casts a shadow on the long-term health of the budget balance, while the difference between strong domestic and soft external demand has widened the trade deficit to a level that has previously caused sterling to weaken.

The imbalances stem partly from continued weakness in global economic growth. Two factors underlie this. First, businesses around the world are still adjusting to the bursting of the equity bubble and the subsequent falls in equity prices. This has destroyed wealth, hit confidence and caused companies to cut debt rather than invest. It is not clear that this process has finished. Second, global growth remains heavily dependent on the US. Japan is mired in a deflationary mess, and the weakness in Europe (especially Germany) is particularly important to the UK as Europe is our major trading partner.

Over the past few years, UK policy makers have tried to offset weak global growth by supporting domestic demand. This has been done principally by keeping interest rates low, but an easier fiscal policy has also helped. The side effects of these policies are becoming increasingly apparent. Low rates coupled with strong domestic demand is a prime factor behind the rise in house prices. It is also behind the rise in the trade deficit, which in the past has not widened from its present level without weakening the currency in a way that disrupts the econ-omy. A policy of supporting domestic demand is sustainable so long as the weakness in global demand is not prolonged. The imbalances in the UK economy and the uncertain outlook for global growth suggest the UK's approach has reached its limit.

If this is the case, we should prepare for a less generous economic policy. We already know taxes will rise in April and that the Bank of England is reluctant to lower rates further for a variety of reasons that include the state of the housing market. Indeed, if conditions in the rest of the world improve, prepare for higher rates. After all, the do- mestic economy doesn't need easy monetary policies, and if global growth recovers, some of the strain will be lifted from manufacturing and the trade deficit should narrow.

But will global growth recover? We can count plenty of immediate risks (war, terrorism, rising oil prices) but these are outside our control. The UK will find it hard to offset any shocks, and much depends on whether Europe can grow faster. This is because the ability of the US economy to set the pace is questionable. It faces several imbalances, with consumer spending supporting growth at the expense of rising debt. World growth would be more secure if Europe, the next-largest economic bloc, could provide support. This appears improbable but we are seeing attempts at reform, such as a re-examination of how monetary policy is set.

Developments in Europe will be particularly important for the UK this year. They will affect the assessment of the Treasury's five economic tests for UK entry into monetary union and the timing of any referendum. The case for entry will be easier to make if global growth is secure and the European economy strong.

Ian Bright is group economist at Baring Asset Management (London).

ian.bright@baring-asset.com