Stephen King: What diagnosis for the economy's health?

Imagine you're a physician. Imagine, also, that you're on some kind of physicians' game show. Let's call it What Diagnosis? You're in competition for the top prize with other physicians. Each of you has the opportunity to examine a particular patient. Towards the end of the show, you all have to offer your best judgement of what, exactly, the patient is suffering from.

Unfortunately, you don't have the usual tools at your disposal. You have a stethoscope, a thermometer and one of those funny torches that doctors are so fond of sticking in your ear. Beyond this, though, you are relying mostly on your wits: no X-rays, no MRIs, no urine samples and no blood tests.

At the end of each show, having made your diagnosis, you sometimes leave on a high, having had your reputation enhanced. Occasionally, though, you leave in a wretched state, either because someone else got to the right diagnosis ahead of you or, even worse, because you've recommended for cranial surgery a patient who turns out to be perfectly healthy.

But there's really no reason to feel so despondent. After all, the programme is rigged to ensure that you will sometimes get things right and, on other occasions, get things wrong. The problem lies with the absence of sufficient information. You can, at best, make a provisional diagnosis. That the diagnosis turns out to be right or wrong is, in truth, more a matter of luck than good judgement.

If you were at a dinner party with a group of economists (can you imagine what fun that would be?), you'd be forgiven for thinking that you'd found yourself in the middle of the economists' version of What Diagnosis? Each economist would offer his or her views, each view might sound perfectly reasonable, yet each view would seemingly contradict the views of others.

On the rare occasions that I get invited to dinner parties (as you might expect, being an economist, this sort of thing doesn't happen very often), I sometimes find myself being asked about the state of the economy.

More often than not, my fellow diner is really asking me whether it's a good time to move house, but on a few occasions there's genuine interest in economic developments, whether they be in the UK or elsewhere.

Like the competitive physician, I have to provide a diagnosis. Sticking to the UK economy, what should I say?

As an optimist, I could point to growth in the second quarter and emphasise that, despite the persistent increase in oil prices, the UK economy is performing remarkably well. A gain in GDP of 0.8 per cent on the quarter is nothing to be sniffed at: after all, this is the biggest rise in two years.

I might also point to the persistent gains in employment in recent times: in the three months to May, total employment rose 59,000 compared with the previous three months and 223,000 compared with a year earlier.

Yet despite these employment gains, there is scant evidence of wage inflation: in May, average earnings, excluding the distorting effects of bonuses, rose 3.8 per cent on a year earlier, in no way a threat to the Bank of England's inflation objective.

And I might also stress the persistence of low interest rates, at least by the standards of previous economic cycles: low rates are, surely, an indication that long-term inflationary expectations are permanently lower.

As a pessimist, I might choose a different line of argument. Loose monetary and fiscal policies may have lifted the growth rate but, at the same time, may have led to indigestible household and government debts: maybe we've all been living on borrowed time.

To prove this, there have been the first signs of a rise in inflationary pressures: goods prices, which were falling in the early years of this decade, have started to rise, suggesting that inflation as a whole is about to lift off. And, because of this, maybe the Bank of England will have to shove interest rates up, leading to contractions in both consumer spending and the housing market.

To cap it all, the UK's balance of payments position is showing a persistent current account deficit associated with an export performance that, relative to the UK's main competitors, has been fairly dismal. It's not that UK exports aren't rising: rather, the UK has been unable to take full advantage of the global economic boom that appears to be providing huge benefits to the likes of Germany and Japan.

Of course, what I've done so far - as any good physician would no doubt stress - is merely to describe the UK's economic symptoms. I haven't yet offered a diagnosis. So what are the possibilities? The Ernst and Young Item Club has just released its latest analysis of the UK economy (Item stands for Independent Treasury Economic Model, which basically means that the Club uses the same black box as the Treasury).

Professor Peter Spencer, Item's spokesman, states that "although France and Germany have made only modest productivity gains since 1997, labour costs in both countries have remained virtually static because of relatively high unemployment. As a result, they are doing much better in export markets than we are."

So there you have one diagnosis, an economic version of cranial surgery. All Britain has to do is to raise its unemployment rate to German or French levels. Its labour costs would then be lower, allowing exports to surge. Perhaps Gordon Brown is listening (or, more likely, laughing).

The problem with Professor Spencer's diagnosis is, of course, the assumption that a country's economic success can best be measured through exports alone. Although German economic performance has no doubt improved over the last few months, the longer-term story has been fairly miserable.

Exports may have picked up but only because labour incomes have been severely squeezed - primarily because they were way too high in the first place. The truth of the matter is that Germany's export success has done little to support the welfare of German households in recent years.

So what about my own diagnosis? The volatility of UK inflation is a lot lower than before, despite big energy price moves, and this has no doubt contributed to a more stable path for economic expansion. Bank of England independence has clearly helped.

The pick-up in goods price inflation doesn't seem to be too worrying because, simultaneously, we're seeing a slowdown in service sector inflation, exactly what you'd expect if you have both a credible inflation target and flexible market structures.

Productivity performance has been poor - a view I share with Professor Spencer - but it seems to me that a partial explanation lies in the rapid expansion of the labour supply associated with immigration, increasingly from central and eastern Europe (why get existing workers to do more when you can hire additional workers relatively cheaply?)

Economic growth is probably too skewed towards domestic demand but, if the Chancellor is to be believed, the fiscal support of recent years should soon be fading, suggesting room for some rebalancing. Ideally, productivity will surge, paving the way for competitive improvements that, in turn, will raise both domestic spending and exports.

Failing that, the obvious ways out are through a hit to incomes coming from a higher oil price - leading, in time, to slower consumer spending - and a lower value for sterling. The pound has been remarkably resilient in recent years, no doubt helped by the relatively high level of UK interest rates. As the gap between UK and foreign interest rates narrows, though, maybe sterling won't be able to tread water for too much longer.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com