Stephen King: Mystic Gordon sees only half the picture

And so it was in the House of Commons last week. Admittedly, it might be reasonable to expect that the Chancellor and the shadow Chancellor might be a little more educated than most when it comes to questions of economics, but when economics and politics collide, it's more often than not that the objectivity of economics falls by the wayside and is, instead, replaced by the hyperbole of political debate. George Osborne, the shadow Chancellor, enquired of Gordon Brown: "For months you stubbornly stuck to those growth forecasts when everyone was telling you you were wrong... the economy is growing slower than the average for other developed economies in the world. Could you tell us when you knew you had got it all wrong?"

Gordon Brown's reply was typically pugnacious: "You've got it all wrong. The British economy is growing faster than Germany, France, the Netherlands, Italy and faster than the EU. Higher oil prices have caused the difficulties all economies face."

So, within this little debate, is it possible to tease out the truth? At this stage, the answer must only be a qualified "yes". We know, and the Bank of England never ceases to remind us, that economic judgements can best be made with the advantage of hindsight. Ongoing data revisions imply that we won't know for a number of years exactly how the UK economy has performed in recent months. Nevertheless, on the basis of the available data, we can at least have a rough stab at the underlying picture.

The growth rate of the UK economy amounted to 2 per cent in the first half of 2005 compared with the same period a year earlier. And if the consensus is anything to go by, there's a good chance that the UK economy will post even slower growth when the third-quarter data is released on Friday. The problem for the Chancellor is obvious: his projections made at the time of the Budget suggested that growth would amount to somewhere between 3 and 3.5 per cent this year, so he's quite a long way short of where he hoped to be.

What about the international growth comparisons? It's true that the UK is growing faster than many countries within the European Union, but whether that's the right comparison to make these days is somewhat debatable. By picking on Germany, France, the Netherlands and Italy, the Chancellor is deliberately excluding the US, Japan, Spain, China, India and others who are all currently enjoying faster economic growth than the United Kingdom.

The United Kingdom is in danger of looking like a batsman who has fallen on a patch of poor form and takes solace in his superior batting average relative to the bowlers in his team. Can the oil price be blamed? To a degree, yes. But it's difficult to take this argument too far. The Chancellor is absolutely right to point to the negative consequences associated with a higher oil price but the fact of the matter is that the loss of growth momentum in the UK has been greater than elsewhere and, for the most part, has preceded the recent, more substantial rise in oil prices. A better explanation surely comes from the travails of the housing market and its impact on retail spending. Consumers are less willing to borrow than was the case a year ago, explaining why the earlier consumer boom has turned into something of a damp squib.

To be perfectly honest, these debates about the cyclical growth rate of the UK economy are a bit of a sideshow. As the OECD put it last week: "the stability and resilience of the economy has been impressive and labour and product markets are among the most flexible in the OECD, but structural economic performance judged against a range of indicators can be further improved." Put another way, the UK may have one of the most flexible economies within the OECD area, but it still only "ranks just above the median across all OECD countries" when it comes to GDP per capita.

Compared with the UK's aspirations, this is a disappointing performance: lots of market flexibility, but only modest economic reward. To be fair to the Chancellor - and to his next-door-neighbour in Downing Street - the OECD points out that some of this disappointment reflects earlier underinvestment in education and transport infrastructure, areas which the current government is trying to address. But the OECD also suggests that the authorities should "ensure that public money is spent efficiently to contain the tax burden". At this point, the Government's position becomes a little shakier.

To see why, take a look at the table. It shows outcomes for economic growth and for the fiscal position relative to the Treasury forecasts back in 2001. The Treasury's record on GDP growth has been impressive: George Osborne might have a point about this year's growth rate, but the longer-term perspective suggests that the Treasury has done better than others at forecasting the UK economy.

However, because the Treasury has done such a good job in predicting the growth rate, it's all the more puzzling that the budget deficit has overshot target year-in, year-out. The Treasury's problem is not one of excessive optimism on economic growth, but rather excessive optimism on the budget deficit. For whatever reason, the Treasury's tax and spending calculations have proved to be wide of the mark. And, as the economy slows down, the Chancellor now faces a difficult balancing act: if the deficit continues to deteriorate relative to GDP growth, and GDP growth itself is slower than expected, the Chancellor's options are not exactly palatable: increase borrowing beyond his golden rule, raise taxes or cut back on some of his major public-spending priorities.

What the Chancellor needs is some form of bail-out. Faster growth elsewhere in the world might be useful, although oil prices might simply end up at still-higher levels. Alternatively, the Chancellor might need to get a little help from his friends at the Bank of England. The consumer's new-found caution is of no great help to a Chancellor who needs extra revenues, so a few interest rate cuts designed to boost domestic demand might be rather helpful.

The problem, however, is that the latest smoke signals coming from Threadneedle Street are not terribly helpful. The irony is that the Bank's caution is, in part, an unintended consequence of the last set of reforms to the inflation target made by none other than the Chancellor of the Exchequer. More specifically, latest data shows that inflation is overshooting the new Consumer Price Index target (see chart). Had the Chancellor stuck to the old retail price index arrangements, inflation would still be below target: more room for interest rate cuts and, hence, more help for a government lacking in revenue. Whoever said that economics was boring?

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com