Expert View: Consumer boom could end in bust

Consumers have been having a rather good time of late, but if you ask the average company director how life has been, he will give an impression of near recession in recent years. How can the economy seem so two-faced?

Consumers have been having a rather good time of late, but if you ask the average company director how life has been, he will give an impression of near recession in recent years. How can the economy seem so two-faced?

Meet the consumer: our typical shopper has now enjoyed 11 consecutive years of rising expenditure. Since 1991, his spending has increased 44 per cent in real terms while his disposable income has risen by 40 per cent, again in real terms. Although he has borrowed more than in previous cycles, low interest rates mean the costs of servicing that debt have fallen sharply in relation to income.

Mr Average also feels much wealthier. Despite being a little perturbed by headlines telling him that the stock market has halved in the past three years, he is convinced that his real wealth is in his house – and the value of that has doubled since 1991. He believes he has never had it so good.

But the man who pays his wages is not so certain. He runs an industrial and commercial conglomerate. True, he did quite well between 1993 and 1997, but since then things have gone downhill. Demand in the domestic economy has been reasonable, but there has been increasing competition from overseas; and in export markets he has struggled. In the past five years the improvement in his profits has only just exceeded inflation. And he has had tough decisions to take.

In the three years to 2001, Britain's industrial and commercial companies registered a total financial deficit of £25bn. At the start of 2002, to prevent the situation deteriorating further, managements slashed capital spending. Despite knowing that investment is crucial to future improvements in productivity and profitability, companies cut their investment budgets by 10 per cent in real terms.

So, while the overall economy has grown by 2.5 per cent a year on average over the past five years, most of the proceeds have been grabbed by households, leaving only a small proportion to trickle through to corporate profits.

The principal criterion by which a government judges the success of the economy is inflation. And inflation has been low, due largely to the strength of the pound and high levels of supply-side competition. At the same time, a tightening labour market has forced up employment costs. While other costs have also been pushing up, it is the price of labour that has done most damage to margins – something that will not be helped by the imminent increase in employers' and employees' national insurance payments.

Because of the strategy adopted by the Monetary Policy Committee (MPC), excess demand is a more severe problem than ever before in the UK's economic history. What is more, you can trace back the recent surge in property prices and simultaneous collapse in business investment to the impact of low interest rates. The problem is simple: a combination of falling international prices and a strong pound have put downward pressure on prices.

Since the MPC has an inflation target fixed at 2.5 per cent, plus or minus 1, it has been forced into the bizarre position of having to cut interest rates so as to force up domestically generated price increases – otherwise inflation would have been deemed to be too low. The impact of this policy can be seen in unit labour costs and also in the costs of services included in the retail price index, which are rising at 4.6 per cent a year.

Eventually, the UK economy will come back into balance. The risk is that this process will occur too quickly and that consumers who had been enjoying a boom will suddenly be faced with a bust.

Richard Jeffrey is head of research at Bridgewell Securities. Richard.Jeffrey @Bridgewell.co.uk