Economic View: Eddie's pre-emptive strike

It was an obvious reaction but none the worse for that. When the Bank of England unexpectedly cut interest rates last Thursday, most people reckoned that Eddie knew something the rest of us didn't. That, at least, would be the best explanation for cutting at this time, only a few days after Sir Edward George had told the world that there was a danger of talking ourselves into too much gloom.

As it happens, I don't think it is true that some nasty new piece of information is about to be unleashed. What I think the Bank wanted to do was make the markets aware that it would be sensitive to the dangers of a collapse of consumer and/or financial market confidence in advance of a Middle East war. Whether or not it makes tactical sense to fire the guns early, rather than conserve ammunition, is a matter for debate. But if this assessment of its motive is right, we ought to ponder whether there is indeed a serious threat of either a collapse of consumer confidence, or a further meltdown in the markets.

So much has been written about the link between house prices and consumer confidence that there is not much to add. We know equity take-out is huge and we know house prices seem to have hit a plateau, with some decline at the top end. But there is not much evidence of a significant fall in consumption, at least in Britain.

The graph on the left shows some projections for consumer spending growth this year in the Group of Seven countries (plus figures for 2001 and 2002). I had not fully appreciated how strong our spending had been, and is, compared with other developed nations. This year it is top of the pack.

But projections are only projections. Is there really any danger of a collapse?

Here you have to think about the impact of conflict. The Gulf War in 1991 is a useful guide as a starting point: consump- tion did dip during the actual conflict but it picked up immediately afterwards. The main difference on the positive side is that the imbalance between military capability, enormous then, is even greater now. The main differences on the negative side are the looser coalition against Iraq, the greater perceived danger of terrorist attacks, and the financial burden of a long-term engagement rebuilding the country.

So while the balance of probability is that there will be only a short-term blow to consumers, it would be dangerous to be too confident of that. As far as Britain is concerned, note too that we will be having a large increase in taxation come April and consumers will not been too encouraged by that either.

What about financial market confidence? The Gulf War again provides a guide, and in the case of share prices there was a dip followed by a recovery. Again there are differences, in particular that financing the conflict will bear much more on US (and presumably UK) taxpayers. Last time Kuwait and other allies paid 80 per cent of the bill. But even so, it is hard to see impending war as the principal cause of the current market malaise. There is surely something else.

The principal candidate – the thing markets are really worried about – is, I think, that we will mismanage the transition from a world of inflation to one of price stability, and follow Japan by slipping into deflation.

You need to realise that having three consecutive years of falling share prices is very, very unusual. Having four years, the direction we seem to be heading in, only occurred in Britain once in the last century, from 1937 to 1940. Rationally, however concerned one might reasonably be by the situation in the Middle East, it is not threatening as the time of Munich and the Battle of Britain. Indeed the only previous occasions when shares have fallen for three years were during the First World War and the early 1930s depression.

So what is up? Last Thursday was one of those intriguing crossover days when gilts, for the first time since 1955, yielded less than the dividends on shares on the London Stock Exchange. Ten-year gilts yielded 4.22 per cent, the FTSE 100 index 4.34 per cent. This may turn out to be a great historic moment, though we won't know for some years. In any case, such calculations are distorted by different tax treatments of the two income streams. But consider what it suggests – that we have gone back to the world of the 19th and early 20th century when the risk of inflation was minimal, but the risk of companies being unable to make sufficient profits to hold their dividends was considerable.

Before 1955, people believed that gilts were the safest investment and equities were risky. So the former yielded less.

Now, those of us who have lived through the second half of the 20th century know gilts were a catastrophic investment because they gave no protection against inflation. Prices have risen 25-fold during the past 50 years, so anyone who held fixed-interest securities will have seen their capital virtually destroyed. Equities have been a much better investment.

You can see this in the right-hand graph, showing the total real return on gilts, shares and cash for the past century. The only period when gilts outperformed shares was in the very early part of the century, though the superior performance of equities really took off after the Second World War.

Markets are not coherent articulators of anything, but insofar as they seem to be trying to say something, I suggest it is that we are going back to the financial conditions of before the First World War. That was a world of zero inflation.

It is very easy to slip from zero inflation to deflation: it happened often in the second half of the 19th century. The Bank, like the US Federal Reserve, wants to buffer the transition. Companies and markets are not yet ready for price stability, let alone deflation. The Bank does not know anything special, but it is worried and rightly so. So it cut rates.