The role of luck in the Bank's policy dilemma

It was frequently argued before the election that the long-term fundamental position of the economy remained extremely weak, but that this was being disguised by a temporary period of excellent short-term performance. Actually, the truth could easily turn out to be the other way around. Goldman Sachs is just completing a study of long-term growth prospects for about 50 countries around the world, and the preliminary results suggest that the underlying growth rate of the UK may have increased to around 2.5-2.8 per cent per annum, fractionally higher than the European average and at least a quarter point above its 20-year historic rate.

This should not be taken as definitive, only as provisionally encouraging. However, what should be taken as definitive is that the short-term performance of the economy is shaping up as a huge headache, with every opportunity for a major policy misjudgment in the near future.

The policy dilemma is, of course, intimately connected to the building society windfalls, which this column argued last week should have been prevented by the last government. Since then, people have asked why, if this was so important, the new Government did nothing to control the spending of these windfalls in the July Budget. Unfortunately, this was not really practicable.

The problem with announcing administrative changes in July was that many people would already have spent their Halifax windfalls, or at least booked their summer holidays on the proceeds. Also, a windfall tax on the building society accounts would have very odd distributional effects - it would be like a wealth tax applied to the relatively poor people who happen to hold these accounts, while leaving the most wealthy households completely untouched.

An alternative would have been to have given new PEPs-like tax incentives to encourage investors to leave their windfall gains in savings accounts, rather than using them to finance extra spending. The problem with this idea, however, is that many households would have been able to take advantage of the tax incentives, while using other forms of savings to finance additional expenditure. The Government would then have simply made a further donation to boost the savings of these households, while having little if any effect on their spending patterns. Again, the only people likely to have been affected would have been the poorest households, who could not have found other means of financing their extra spending. It is easy to see why Gordon Brown rejected these options.

With all this extra spending power hitting the economy, many would claim that the policy "dilemma" is not a dilemma at all - monetary policy should simply be tightened further as soon as possible, whatever the consequences for the exchange rate. After all, data out last week showed consumer confidence remaining at the remarkable peak levels that were recorded immediately after the election in June, and there has been no sign yet from business surveys that there has been any meaningful slowdown in any sector of the economy, despite the rise in the exchange rate. When the economy was last in a comparable position to the present - which was shortly after Mrs Thatcher's third election win in the summer of 1987 - it would take another 12-18 months (with a 5 per cent rise in base rates) before consumer confidence peaked, and yet another two years before inflation began to decline. In other words, once the economy works up a real head of steam, the situation generally proves much more extreme, and takes far longer to control, than anyone initially expects. The same could easily be happening again now.

Nevertheless, there does exist a real dilemma for the policy makers at the Bank. Unlike in the equivalent period in 1987-88, macro-economic conditions have already tightened very significantly in the past few months, and it is acutely difficult to judge whether this is already sufficient to produce the necessary slowing in the economy next year. The tightening is much larger than is commonly acknowledged in the policy debate, mainly because so many commentators have allowed themselves to become mesmerised by the absence of consumer tax rises in the Budget. The fact is that the Chancellor's decision to freeze the public spending plans at the Ken Clarke levels in each of the next two years has imparted into the system a much bigger fiscal brake than anything which could feasibly have been contemplated in the Budget.

The squeeze on public spending plans, measured in real terms, actually tightened a notch in the Budget, because the Treasury left the nominal spending plans fixed while increasing its inflation estimate by 0.75 per cent in each of the next two years. As a result of this combination, there will be no growth at all in the real control total for the first two year's of this Government's term.

Consider the impact of this on the economy. The public sector accounts for roughly 40 per cent of national income, either through the direct purchase of goods and services, or through transfer payments (pensions, etc) which support private consumption. That 40 per cent of GDP will show no growth at all in real terms for two years, if the Treasury sticks to its plans. That means the other 60 per cent of the economy must grow at a 5 per cent annual rate to keep overall GDP expanding at a 3 per cent clip.

What is the chance of this happening? Under normal circumstances, it would be quite high, since it is not uncommon for privately financed consumption and investment to grow by at least 5 per cent per annum at the peak of a boom. However, there is another crucial factor we need to consider this time - the strength of sterling, which will severely curtail export growth and, more important, redistribute the strength of domestic demand away from the UK and towards imports from other countries. In other words, the UK economy will not grow at anything like the same rate as the growth in consumers' expenditure and investment at home. According to recent estimates by Goldman Sachs, the worsening in net trade will depress GDP growth by about 1.75 per cent next year, if sterling stays at its present level.

Thus, if GDP next year is to grow by 3 per cent, overall domestic demand would need to grow by 4.75 per cent to make up for the trade loss. But in order to achieve this, privately financed domestic demand would need to grow by about 8 per cent in real terms in order to compensate for the absence of any growth in the public sector. This is not impossible - in fact it happened in 1988 - but it does give some idea of the degree of policy tightening which is already in the system.

It also gives some idea of the acuteness of the dilemma facing the Bank of England, since if sterling stays where it is, and if the Government can stick to its spending plans, then the Bank is already risking overkill. But if either of these "ifs" does not come to pass, then interest rates almost certainly need to rise much further - or, more accurately, will have needed to have increased some time before.

To successfully negotiate this one, the Bank will need, in the words of Cilla Black, "a lorra, lorra luck".