Home's where the hurt is

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Sep 4th 2008
From The Economist print edition

There have been far worse times for the economy but few for a chancellor
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IT WAS, perhaps, frustration at his own helplessness that prompted Alistair Darling’s dire prognosis. The chancellor of the exchequer told the Guardian, in an interview reported on August 30th, that economic times were “arguably the worst they’ve been in 60 years”. His remarks raised fears of a harder economic landing for Britain than predicted and helped push sterling to new lows against the euro. His slip may have had more to do with his own anxieties (see article) than with the fate of the economy.

Only the terminally gloomy expect a downturn to match the deep recession of the early 1990s, or a repeat of the grim 1970s. Yet Mr Darling had a point, even if he made it clumsily. It is rare to be hit by so many problems in such a short space of time. A spike in the cost of oil and food has poked a big hole in consumers’ pockets, leaving less money for other spending. Meanwhile the banking crisis has cut the supply of credit, hastening a collapse in the housing market.

This unusual combination makes it harder to repeat the policy tricks that banished the two previous recession scares, in 1998 and 2001. The Asian crisis and the later dotcom bust affected GDP growth and inflation in much the same way. The Bank of England could safely cut interest rates to support spending then because the “shock” to the economy was likely to push down inflation too. Today’s noxious mix of commodity-led inflation and tighter credit makes relaxing policy far trickier. Though the bank initially cut interest rates from 5.75% to 5%, it has not reduced them further for fear of stoking inflation.

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That worry would limit the scope for fiscal stimulus too. In August the bank’s monetary-policy committee (MPC) forecast that consumer-price inflation would fall back to its official 2% target, but only after a period of economic weakness had drawn its sting. If the government tries to stave off that adjustment by massive fiscal means, it might delay the further interest-rate cuts that financial markets expect in coming months. “The more the government does, the more the MPC can’t do,” says Geoffrey Dicks, an economist at the Royal Bank of Scotland.

The rickety state of the public finances also argues against a big fiscal fillip. The rules brought in by Gordon Brown when he was chancellor were meant to limit borrowing during prosperous times, but Britain went into the downturn with a yawning budget deficit instead. It widened to £35 billion ($70 billion)—around 2½% of GDP— in the year to March, and Mr Dicks reckons this year’s deficit could be double that.

Against this backdrop, on September 2nd the government announced a number of modest measures to support the housing market and help its victims. The threshold at which stamp duty applies to home purchases was raised for a year from £125,000 ($222,000) to £175,000. A shared-equity scheme, financed jointly with property developers, will offer some first-time buyers a five-year interest-free loan of up to 30% of the price of a newly-built home. Councils and housing associations will be able to help struggling homeowners by buying all or part of their homes and leasing them back. And the safety net for the hardest-hit homeowners was extended.

These measures may cost around £1.6 billion, a trifling figure. But their modesty is cause more for relief than regret. While the schemes to help debtors in distress are harder to fault, many question the wisdom of coaxing first-time buyers into a falling market. House prices have already dropped 11% in the past year, and David Miles, an economist at Morgan Stanley, an investment bank, reckons they may lose a further 10%. In any case, it is banks’ reluctance to lend, not a buyers’ strike, that has the housing market on its knees.

The puzzle about the British economy is not that it is doing badly but that it is not doing worse. The financial sector, now slowing, accounts for a fair chunk of GDP. Britain’s housing boom was one of the world’s largest; its household debt-to-income ratio is higher than America’s; and, as in America, a long consumption boom left a large current-account deficit. All this makes Britain more vulnerable than most to a credit crunch.

Yet other big economies are faring just about as badly. Figures released on September 3rd confirmed that the euro area shrank in the three months to June. Of its three largest economies, only Germany’s grew more quickly than Britain’s over the past year, and then only just. France and Italy have struggled harder, and are hampered by large fiscal deficits of their own. The OECD this week pointed to Britain as the only big rich-world economy that will suffer a minor technical recession—two quarters of falling GDP—this year. But its full-year forecasts suggest that Britain will do better than many of its peers (see chart).

That the euro area is struggling too may be little solace to Mr Darling, since more than half of Britain’s exports go there. Still, there are signs that sterling’s slump is lifting the domestic economy. Firms and households have cut back on pricier imports, and the British Retail Consortium says retail sales in London have bucked the gloomier national trend, thanks partly to tourists lured by a cheaper pound.

Britain is more likely to avoid a nasty economic downturn if inflation fears fade quickly and wage claims remain muted. The recent sharp fall in oil prices (and indeed Mr Darling’s apocalyptic comments) will help. The euro zone has more to worry about, for many of its pay deals are explicitly linked to prices. It must comfort Mr Darling to reflect that even the most confident economic forecasts often turn out to be wrong. At the start of this year, recession in America seemed a near-certainty to many. Now America’s economy looks the best of a bad bunch.