Economic View: Weight of the world hangs on the lucky Chancellor

Kenneth Clarke has earned himself a reputation as a good Chancellor of the Exchequer. And one of his marks of success in the office is the fact that he feels no great need to be doing something all the time. This lack of activism recognises an important truth about the UK economy: it depends far more on what happens in the rest of the world than what happens here.

The Government's dependence on external events to set the economy to rights has been partially recognised. A recent article by a Labour peer, Meghnad Desai, stimulated a debate about whether the Government will be able to cash in on an improvement in the state of the economy before the election. Thanks to windfalls such as maturing Tessas and free building society shares, Lord Desai suggested, a consumer spending boomlet and housing market revival could replenish the electorate's reservoir of feel- good just in time to end the Conservatives' drought at the polls.

The question of whether Mr Clarke's famous luck will hold in the run- up to the election, however, depends on far wider events than these stimuli to consumers. The course of business cycles in the rest of the world will both influence growth here directly and set the limits to policy in the UK.

This balance can tilt either way - either a dream or a nightmare for a Chancellor hoping to retain office. For the US and the European economies are tugging in different directions. They are at different stages of their economic cycles, and the timing will be everything in their impact on Britain.

The US is pulling out of a temporary slowdown into what looks like an impressive new spurt of recovery. The American jobs machine is working overtime, with an average of 206,000 new jobs a month created so far this year, compared with 142,000 a month towards the end of last year. Incomes and spending have risen, while survey evidence is turning favourable. The remaining weak spot is manufacturing industry.

Meanwhile, Europe's biggest economy is on the brink of recession. Yesterday's figures for German unemployment and other recent indicators have confirmed expectations that GDP will be flat this year.

Other Continental economies are slowing down along with their most important market. Although they are less ridden with gloom than Germany, high and lasting unemployment across the Continent symbolises its economic woes. Most forecasters predict a European recovery - but not yet.

Mr Clarke's dream scenario will be realised if the US recovery is not too fast and the European slowdown not too severe. If US growth stays around the pace it has set in the first quarter of this year it will have reached the point above which Fed chairman Alan Greenspan normally seeks an increase in interest rates. Mr Greenspan has typically raised short- term rates once the economy is creating more than 200,000 new jobs a month. In a presidential election year he is likely to be extra cautious about policy changes, adding a slight bias towards inaction.

Meanwhile the German slowdown could prod the Bundesbank into reducing its official rates, a move that other European countries including the UK could follow. If lower rates worked quickly, British exports to the rest of Europe would not be too depressed either.

The growth outlook can be painted even brighter when other areas of the world are taken into account. Bullish economists at the US investment bank Morgan Stanley think world GDP growth will be nearly as strong this year as last, and could return next year to its fastest since the late 1980s boom. They predict continuing recovery in Japan, a swing out of recession in Latin America, and further rapid expansion in Asia outside Japan. This last area accounts for a bigger share of world GDP (23 per cent) than Europe (21 per cent).

The final `if' in the dream scenario concerns inflation. If faster growth and lower interest rates later this year did not have any impact on inflation until after Britain's general election, Mr Clarke would be able to carry off for a few crucial months an extraordinary balancing act. He would be able to present growth near his 3 per cent target and inflation within spitting distance of the 2.5 per cent target. This would confound almost all of the economics profession and make the Chancellor look lucky on a visionary scale.

However, a few twists of timing and degree in the world economy would turn the dream into a nightmare. If the American economy accelerates to the point where the Fed feels forced to raise interest rates, and if the Bundesbank thinks recovery will come soon enough that it does not need to cut its rates, there would be pressure for an increase in Britain's base rate. Exports to the US - 13 per cent of the total last year - would perform well, but exports to the EU - 58 per cent of the total - would remain sluggish. Britain's recovery would be delayed.

Tighter monetary policy would become essential if two other things happened. One, inflation might head upwards early. Monetarists have pointed out that policy has loosened across the globe. Although the general level of commodity prices, a classic early inflationary warning signal, is lower than a year ago, food and energy prices are rising again. The Bank of England's UK-specific commodity index has started to climb and was up 3.5 per cent in the year to December. The oil price is at its highest since the Gulf War.

Secondly, there could be a Euro-exchange rate crisis brought on by tensions over the creation of a single currency. The foreign exchange markets see sterling as a weak currency, prone to political risk, and the pound would dive along with the Italian lira and Spanish peseta.

So if the timing went wrong, the Chancellor would face the prospect of having to tighten policy at a time of sluggish growth - or admit that he had given up on his inflation target. (There would certainly be siren voices urging him not to sacrifice growth for the sake of shaving an extra percentage point or two off inflation.)

Which will it be, dream or nightmare for the Conservatives? The straws in the wind are pointing Mr Clarke's way. For every piece of bad news about the strength of the British economy, there is a counterbalancing piece of good news. This means that a decent recovery from the pause at the end of last year is under way.

Yet the pick-up is unlikely to be strong enough or happen soon enough to feed into higher inflation ahead of the election. The most pessimistic forecast for the target measure of inflation at the end of this year - from the former "wise man" Wynne Godley - puts it at only 3.3 per cent compared with the 2.5 per cent target. SG Warburg's economists have inflation rising to a still reasonably modest 4.2 per cent by the end of 1997.

So Mr Clarke could well go down in history as a lucky Chancellor as well as a good one. However, it is far from an odds-on bet that all will turn out for the best. It would take only small changes in the world economy for Mr Clarke to turn out - like Labour's last Chancellor, Denis Healey - to be good but unlucky.