Stephen King: Why UK economy is a time bomb waiting to explode

Defining moments in the progress of the UK economy? Or statistical aberrations associated with war and the timing of Easter? Whatever the eventual conclusion, last week's economic data leave a nasty taste in the mouth. The Chancellor may be proud of Britain's record as the outperformer in the global economy over the last two years but that halo now seems to be slipping.

Just as athletes that use banned substances eventually fall flat on their face, so the UK economy may now be suffering from an overuse of performance-enhancing economic drugs. Perhaps the authorities will recognise that there is only so much that can be achieved through the stimulus provided by interest rate cuts and public spending increases. Bulking up the economic muscles is one thing but, in the absence of a strong heart, the UK economy will not be able to outperform in the long term.

The charts tell a frightening story. The consumer – hitherto the one true area of support for the UK economy – appears to have hit "the wall", the moment when long-distance runners wonder whether they should ever have embarked on the race in the first place.

The left-hand chart shows the story from the perspective of the housing market. The monthly survey of house prices from the Royal Institution of Chartered Surveyors has fallen at an alarming rate over the last three months. Of course, the Rics survey has fallen before and may have had a "cry wolf" tendency. There has, however, only been one other occasion when the Rics survey fell to a similar degree in a three-month period: that was at the end of 1988, the point of no return for the Lawson boom and, ultimately, the signal for the recession of the early 1990s.

The right-hand chart shows a more direct story. This time, it's the survey from the British Retail Consortium (BRC), which attempts to measure retail sales on a monthly basis. I've tracked the BRC results against the official retail sales series. On the face of it, retail sales appear to be in serious trouble. The Easter effect may, however, be a saving grace. Look back at the early months of 2000. During that period, the BRC survey was all over the place, collapsing one month and rising spectacularly in the following month; ultimately, the BRC survey provided a false indication of trouble ahead for the UK economy. Given that Easter was early last year and late this year, there's a good chance that we'll eventually see a similarly distorted pattern through the first half of 2003.

If the story ended there, perhaps we could give the UK economy a relatively clean bill of health. Yet there are other, equally worrying, signs. March saw the second consecutive increase in unemployment on the claimant count: the rise of 1,800 might have been small but it followed on from an upwardly revised increase of 5,700 in February.

To be fair, other measures of unemployment show a different picture. However, the labour market cannot be defined by unemployment alone. Headline wage growth slowed to just 3.0 per cent in the three months to February, down from 3.5 per cent in the three months to January. Given that headline inflation was also at 3.0 per cent in February – and in March as well – this basically means that we're not getting any better off. In February alone, wage growth was just 2.5 per cent year-on-year, implying that UK workers took a collective wage cut in real terms. Finally, there's the survey from the British Chambers of Commerce (BCC). This showed an alarming deterioration in manufacturing sales in the first quarter of 2003. Services also appeared to hit a brick wall in the first quarter.

So, can we simply shrug our shoulders and hope that lower oil prices and a bounce in global economic activity will provide an economic pick-me-up? Or, instead, should we be questioning the longer-term health of the UK economy?

Optimists will tend to respond to this dilemma by denying the existence of any trigger that could throw the economy into a downward spiral. This view is loosely based on the recessions of the 1980s and 1990s that, as everybody knows, were typically associated with high interest rates and an overvalued exchange rate. Sterling may still be on the strong side – despite having softened against the euro – but interest rates are remarkably low and, if the data that we've seen in recent days is anything to go by, could fall even further.

So, the argument goes, if interest rates are not likely to rise significantly, there is no trigger for a collapse in house prices, no trigger for a collapse in consumer spending and, thus, no trigger to force bad times upon us. Moreover, if interest rates can continue to decline, the chances of falling into a period of sustained economic weakness are even more remote, suggesting that the latest run of poor data can be attributed, pure and simple, to the short-term impact of the war.

In my view, this is a feeble argument. The fact that some recessions have been caused by high interest rates in no way implies that all recessions are caused by high interest rates. Moreover, the assumption that there has to be an immediate trigger to throw an economy into recession or economic downturn is also rather dubious. To use an analogy, you can blow up a bomb using a remote control with immediate effect. Or you can detonate the same device using a slow-burning fuse. Same effect, but a great deal of difference in timing.

Britain's economic difficulties are of the "slow-burning fuse" type. They had their roots in the stock market boom of the late 1990s and a misunderstanding of the implications of much lower inflation. The stock market boom led to insufficient savings not just from individuals but also from companies and institutions. The lower rate of inflation allowed the Bank of England to cut interest rates dramatically in the light of the fall in stock prices and the slowdown in global growth, in turn contributing to the boom in house prices.

If anything, the Bank's actions lengthened the fuse: they didn't necessarily deal with the underlying problem. By keeping the economy afloat in the short-term, the rate cuts provided the illusion of economic prosperity at a time when productivity was poor and when company balance sheets were beginning to deteriorate. And, let's face it, low inflation over the medium term should be associated with lower rates of equity and house price inflation.

The longer-term consequences of these structural effects may now, finally, be beginning to come through. With productivity growth weak, real wages should slow down – and they have. With companies finding themselves with high debts, investment should weaken – and it has. With households no longer achieving the real wage increases they were once used to, house price inflation should slow and retail spending should soften – and they have. Trigger or no trigger, the UK economy could now be in serious difficulty: let's hope, then, that last week's numbers were a response to war because, if they're not, there are grim times ahead.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com