Hamish McRae: Time for the Chancellor to heed King's warning and pay attention to detail

When the new Governor of the Bank of England starts to get worried so should we.

Or at least up to a point. Mervyn King used his first speech in the job to set out a series of concerns. He warned that interest rates would rise, that the economy would not be able to carry on growing above its long-term potential, and that the world economy would face shocks in the years ahead.

All this is wholly sensible. It is clear that we are at or close to the bottom of this global interest rates' cycle. That does not mean that rates will race up, for they could remain fairly low for some years to come. But with the possible exception of the eurozone, no region is likely to see much lower rates until the next cycle comes around, in anything up to a decade's time.

It is equally true that the UK economy has grown faster than its ultimate long-term potential. Further, consumption has grown at about double the rate of overall growth and this has been financed by personal borrowing, which cannot carry on at the present rate for ever. Real take-home pay will also be hit by the decline in the pound. One could make the further point that government borrowing cannot carry on at this rate either.

And, yes, there will be shocks to the world economy that by their very nature cannot be foreseen - though here I would be a little less concerned. It is certainly possible to envisage greater shocks than the bursting of the dot.com bubble and the destruction of the twin towers. But those were pretty big ones by any standard and the world economy has scrambled through.

One could give further reasons for concern. Demography will become increasingly adverse: the size of the eurozone workforce will start to decline after next year and the eurozone remains a hugely important market for the UK. Some of the comparative advantage enjoyed by the UK seems to have been whittled away and there are further threats in store. So the big message of the governor, that there are tougher times ahead, must be right. It will come as no surprise to readers of this column.

But it is important, in thinking about these tougher times ahead, to distinguish between problems of this particular cycle and the structural problems that will remain as we move through the cycle and beyond. I have been looking at some longer-term forecasts from HSBC that are summarised in the illustration. The bar chart shows GDP growth this year and next for the United States, UK and the big three eurozone economies, Germany, France and Italy, that dominate the region's output. It also shows HSBC estimates for average annual growth for the second half of this decade and for the following decade too.

As you can see, they make disturbing reading for anyone concerned about the economic prospects for the eurozone. The US will continue to grow swiftly and the UK and France manage a credible enough performance. But Italy and Germany seem to have a potential rate of growth of only about 1 per cent a year, and this is the middling scenario. HSBC warns that growth could be even worse on slightly more adverse assumptions.

The result is that the gap between eurozone living standards and US ones will continue to widen. The line chart shows what might have happened by 2029. A separate projection for UK living standards is not shown but it would be somewhere between the eurozone and the US.

It is vital, in looking at all economic forecasts, not to take them too seriously. Looking at 2029 does seem to be pushing things a bit. Had one projected UK and European GDP per head forward 25 years ago you would not have predicted that the UK would have a higher GDP per head than France or Germany. (Though, to be fair the German figure is depressed by the former East German provinces.) Still, these forecasts do provide a useful reality check. Even if Europe were to adopt optimal economic policies, which would be a triumph of hope over experience, the growth in living standards is bound to be slow.

The same applies to a lesser extent to the UK. Continental European countries will eventually make the tough choices to reform themselves because they have no alternative but to do so. But it will be very difficult, as we are seeing in Germany now, because the pain of reform cannot be softened by devaluing the currency, cutting interest rates or having an expansionary fiscal policy. In Britain the problem is different. We will have to be much cleverer in two ways. We must keep developing the various factors that have led to this improved performance. And we must use the more modest increases in resources that will become available less wastefully.

Apply those thoughts first to the cyclical problem. Somehow we have to keep living standards rising despite the twin burdens of high personal debt and rising taxation. Adjust we must but we have to adjust slowly. So the inevitable rise in interest rates has to be phased in very carefully, making it clear that this is the most modest reining back of demand, not a stamping on the brakes.

If the Bank of England has to be sensitive as it tightens, so too has the Chancellor. The budget deficit will have to be corrected but he has to be extremely cautious not to over-correct either on the tax side or indeed on the spending side. The fact that he has made a mess of his figures is past history. We all make mistakes. The important thing now is to learn from them. The Treasury will have to abandon its efforts to micro-manage on both its revenue raising and its spending, something that will not come easily to Mr Brown, as well as having more realistic revenue forecasts in future.

In a way, though, the long-term structural issues are more important than the short-term cyclical ones. Mervyn King is a brilliant economist, perhaps the best we have in the country. The value of his warning should be to encourage this Government, and the next one and the one after that, to think strategically about the long-term prosperity of this country.

There are some obvious things that have to be done, such as persuading an even higher proportion of the population to enter or remain in the workforce. It is quite high by international standards already but given the demographic outlook it will have to rise further.

We need to look at where our comparative advantage lies and remove obstacles to obvious potential points of growth. We have to lift the efficiency of the public sector, for productivity there (in so far as it can be measured) seems to be falling fast. We have to worry about our universities, which are attracting vast numbers of foreign students but suffer from under-funding and seem to be slipping down the global league - at least against US competitors. And so on.

There is no magic in this, just attention to detail. The more we can remove the structural barriers to growth, the better we can cope with the cyclical pressures - which, as Professor King points out, will rise in the months ahead.

But we should not be too glum. The fundamental competitive advantages that have - more by luck than by judgement - been developed during the past 25 years are still evident. The trick is to keep the momentum going.