Economic Commentary: Britain's biggest headache since 1945

When I saw a report last week describing the present situation as the 'worst economic crisis since the (Second World) War', I thought at first that this was an absurd exaggeration. What about the devaluation crisis of 1967? The miners' strike and the three- day week of 1974? The IMF crisis of 1976? The split in the Thatcher Cabinet over the public spending cuts of 1981? All of these were surely far, far worse.

Yet on reflection, I am not so sure. While the present conjuncture lacks the political drama of the occasions just mentioned, and while there is no sense that the Government's finances are spinning out of control (as there was in the UK in both 1967 and 1976, and there is in Italy now), there has never been a worse time for the real economy since 1945. Certainly, no British government has ever seemed so powerless to make any policy adjustment in the face of a rising tide of unemployment and business failure.

The term 'economic crisis' should not only be applied to periods of intense financial or inflationary pressure. The government faces a crisis in the real economy, and that is certainly just as bad as, and arguably worse than, a financial crisis of the familiar sort.

There was a mild frisson of optimism last week, actively promoted by a Treasury press office desperate to prevent the pervasive gloom in the media from causing a further collapse in consumer confidence. Manufacturing output, retail sales volume and non-oil GDP were all fractionally up in the latest three months, and in a technical sense the Government can now claim that the recession is over, or at least has been temporarily interrupted. But the Bank of England Quarterly Bulletin published on Tuesday was extremely sceptical about the chances of recovery in the second half of this year, correctly pointing out that manufacturers will not continue to produce goods that consumers are refusing to take off the shelves.

External catalyst

The Bank, like other economic analysts, may be bending over backwards to avoid repeating the mistakes of last year, when an end to the recession was called far too soon. But it is hard to identify any sort of external catalyst that is likely to kick-start the economy in the immediate future. The lagged effects of the decline in base rates from 15 per cent to 10 per cent should by now have worked their way into the system, and the confidence- boosting effects of the Tory election win have faded quickly. If these two catalysts, and the easing in budgetary policy that has taken place in the last two years, have all left the economy languishing, what hope is there for a significant recovery in demand now?

The truth is that the longer the recession drags on, the more deeply will confidence be impaired, and the more difficult it will become to generate a spontaneous recovery in demand. In fact, in recent weeks, activity indicators have started to slip back from the levels reached during the second quarter of the year, and the Goldman Sachs models of leading indicators (which are based on financial variables and business surveys, and which were moderately optimistic when they were introduced in this column a few months ago) are now predicting that the economy will grow by only about 1 per cent in the next 12 months. This will feel indistinguishable from stagnation.

Against this back-drop, the failure of the combined efforts of the major central banks to regain control of the currency markets on Friday was not good news. Any budding economic theorist could easily demonstrate that central bank intervention in the foreign exchange markets that is not backed by other changes in monetary policy will not have much permanent effect on the equilibrium level of an exchange rate, but the combined efforts of the central banks have usually in the past managed to cow the markets at least for a few days.

On Friday, by contrast, heavy dollar purchases by the central banks were simply shrugged aside by the markets, which immediately proceeded to push the US currency to new lows against the German mark.

This is a big worry for the authorities, since their ability to manage the currency markets by periodic bursts of intervention has always been based mainly on bluff, and that bluff has now been called. From now on, traders will feel slightly less concerned about potential ambushes from the central banks, and the potential for selling the dollar against the mark will be that much the greater. And the stronger the mark is against the dollar, the stronger it tends to be within the exchange rate mechanism, which adds to the upward pressures on UK interest rates.

Much has been made of the role that the impending French referendum on the Maastricht treaty has played in the currency markets. It has indeed been important, and there is little doubt that a 'no' vote will cause a severe bout of market speculation against sterling, the lira and the franc. Anticipation of this has been partly to blame for sterling's latest bout of weakness, and this is likely to intensify in the two weeks before the vote on 20 September, during which period no opinion polls will be published.

Contingency plan

The ERM can probably survive the pre-referendum period, but a detailed contingency plan for the aftermath of a 'no' vote will surely need to be worked out in advance by the EC finance ministers, who will all conveniently be in Washington for the annual IMF meeting when the result is announced. They need to choose in advance between two potential courses of action.

The first would be to announce a realignment of the ERM before the markets open the following morning, with the mark being revalued against most other member currencies, including the franc and sterling. This would be by far the happiest result for the UK, which would then see exchange rate pressures subsiding without incurring a damaging loss of policy credibility.

But for this to take place, the French would have to agree to allow a change in the franc-mark parity, which is something they have not been willing to countenance for five years. In the more likely event that the French and others will wish to dig in with the present parities, even in the event of a 'no' vote, then the UK will probably have to go along with them.

That will mean putting Plan B into action: massive and concerted foreign exchange intervention, backed up by immediate interest changes anounced on the Monday after the vote. At a guess, I would say the France would need to increase interest rates by 1 point, the UK by 2 points and Italy by 3 points if the parities are to hold even for a short while after a 'no' vote, such would be the intensity of the market response.

And how much better would things look with a 'yes' vote? Certainly, market pressures would subside for a while. But several more problems would still be lurking round the corner: the prospect of a German Lombard rate rise in the autumn, the Maastricht ratification problems in the UK and Germany, and the continuing weakness of the dollar. Faced with this formidable series of trip wires ahead, no one should for one minute assume that the Government and the economy will be out of the woods if the French say 'yes' in September.