Stephen King: Threats remain to our economic well-being

Even the Monetary Policy Committee has been surprised about the persistent absence of inflation

For the most part, the UK economy has performed very well in recent years. When other countries went into recession, the UK managed to expand. When oil prices rose, UK inflation remained very well behaved. When other countries saw continued job losses, UK unemployment remained impressively low. And, although the UK's fiscal position has deteriorated, the numbers still look a lot better than those in Germany, France or the US.

But are these the only yardsticks by which to judge an economy's performance? Certainly they are good enough to confirm that this Chancellor has had, to date, a remarkably successful record. But I increasingly wonder whether these developments truly give the UK economy a clean bill of health.

Let's take the low rate of inflation. The UK's achievement in this area is impressive judged by its own history but it's not so impressive relative to other countries. Low inflation has become relatively commonplace around the world. If every country is broadly committed to price stability, the risk of external shocks upsetting the UK's inflationary apple cart becomes a lot less. I don't wish to diminish the achievements of the Bank of England but even the Monetary Policy Committee has been surprised about the persistent absence of inflation in recent years.

Two things are happening here. First, the Bank of England, and other independent central banks, has been able to establish a credible anti-inflation regime. The greater the credibility, the easier the job becomes. A small flick of the interest rate switch in one direction or another, and deviant inflation expectations are brought to heel immediately. Second, improvements in productivity may have altered the balance between supply and demand pressures within the economy, thereby reducing inflationary pressures for any given increase in the level of activity.

All of this is good news but unless we genuinely believe that inflation is the only significant macroeconomic problem, there's a danger of excessive complacency. Knowing that inflation is low, and likely to remain low, does not guarantee lasting economic success. The US bubble in the late 1990s and the Japanese boom in the late 1980s occurred against a background of remarkably low inflation yet, in both cases, price stability did not prevent unpleasant macroeconomic side-effects. Declaring victory on inflation is all very well, but our obsession with inflation is only a reflection of the macroeconomic problems of the 1970s: before then, policymakers had other things on their minds.

What about growth? The stability of the UK numbers from one quarter to the next is very impressive and certainly the experience points to a smoother and longer economic cycle than before. Knowing, though, that growth has been sustained in the past is not in itself a guarantee that growth will be sustained in the future. In the 1970s and 1980s, higher inflation was the telltale sign that the economic expansion was in trouble. Clearly we haven't got that today. Yet if inflation is only one of a number of macroeconomic risks, its absence is not a sufficient condition to tell us that the economy will continue to expand.

The obvious domestic risk at this stage is the housing market: strong consumer demand linked with the ever-expanding riches associated with a housing boom was one of the key factors behind the UK's relative success at avoiding recession in recent years. A weaker housing market, however, threatens to turn this argument upside-down.

The Bank of England likes to argue that even though the housing market has boomed, there has not been that much impact on demand because consumer spending has risen broadly in line with incomes in recent years. Of course, had it not been for the housing boom, consumer spending might have expanded at a much lower rate than income, so the Bank hasn't definitively proved its point. And there's an obvious "sanity check" for the Bank's claim, notably the behaviour of the UK economy with respect to developments in the rest of the world. If there's been excessive demand in the UK, there are two obvious ways of spotting it: either rising inflation - which isn't happening - or a deteriorating balance of payments position - which is happening.

Last week's trade figures showed the continuation of a worrying trend. The trade gap widened unexpectedly, suggesting that the appetite for higher imports continues unabated. The deficit in goods and services stood at £3.8bn in October, a good £1bn higher than market expectations. Admittedly, there had been a big - and now temporary - improvement in September. The underlying trend, though, appears to be deteriorating.

At this point, it's worth noting the similarities between the UK and the US. Both countries responded to the collapse in equity prices at the beginning of the decade by loosening monetary and fiscal policy. Both countries boosted domestic demand through government intervention - tax cuts in the US, spending increases in the UK. Both countries encouraged rapid gains in house prices via low interest rates, thus supporting consumer spending. And both countries have deteriorating external positions.

The overall UK external position is not quite as bad as that of the US. The key difference lies with the net income balance - the difference between income earned on overseas assets less the income paid on liabilities to foreigners. In the US, the surplus in this area has all but gone and, with continued rapid increases in liabilities, should now rapidly head into deficit, leading to an even more rapid deterioration in the current account position. In the UK, the situation has been a lot better, with the net income surplus continuing to rise in recent years, hitting 2 per cent of GDP last year. So, although the deficit on goods and services stands at about 5 per cent of GDP - not so far from the US position - the overall current account is helped along rather nicely by the income surplus.

Nevertheless, the pace of deterioration is telling. It points to an economy that, at the very least, is unbalanced - too much domestic demand and not enough exports. It also points to an economy that's vulnerable to any prolonged period of dollar weakness: any attempt by the Americans to improve their external position through dollar weakness must, of necessity, lead to a deterioration in other countries' external positions. With sterling having risen significantly against the dollar over the past 12 months, there's a good chance that any improvement in America's external finances will be associated with a deterioration in Britain's.

The economic history of Britain has been heavily influenced by its balance of payments position. For policymakers, it's always difficult working out how much of any current account deficit is sustainable and how much may be contributing to future economic difficulties. Nowadays, it's quite possible to run current account deficits for a long time, reflecting a country's ability to attract the world's increasingly mobile capital. The problem, though, is that the very same capital can swiftly head for the exit at the first sign of trouble.

Should the housing market continue to soften, and should the Bank of England eventually be persuaded to cut interest rates, the UK could be facing a good old-fashioned sterling crisis. The independence of the Bank of England may have contributed to greater price stability but the imbalances that have all too often led to economic crisis have not gone away. Through their effect on housing activity, consumer spending and the level of sterling, economic policies over recent years have, once again, contributed to imbalances and, whether or not inflation rears its ugly head, those imbalances remain the primary threat to the longevity of the economic recovery.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com