Fears of Labour may stop the boom

Economics

It really is whizzing up. Until a month or two ago it was possible to reach the intuitive judgement that the British economy was starting to grow rapidly - that the winter and spring pause was over - but the hard evidence to support this was thin on the ground. Now the evidence is piling up, and this raises the intriguing question: what will stop the boom?

Last week, in particular, saw a surge in retail sales, jumping 2.4 per cent between April and June, the sharpest rise for eight years, with growth gathering pace. A CBI survey earlier in the week showed manufacturers at last reporting better sales and a sudden jump in expectations both of output and of exports. And the Nationwide cut in mortgage rates, bringing these to the lowest for more than 30 years, underpins what does seem to be a secure recovery in house prices.

Against this there was some contrary evidence, in particular the lowish rise in second-quarter GDP at 0.4 per cent and a slight fall in mortgage lending. But the first is a backward-looking indicator, and in any case may well be revised later, and the second was a tiny decline from a high level. Given all this, it was unsurprising that the International Monetary Fund should have warned on Friday that interest rates might have to be increased and that there was no scope for tax cuts while the public sector deficit remained so large.

It is conceivable, but unlikely, that the Chancellor will heed these warnings. Instead he is much more likely to try and engineer another cut in base rates, given his own evident bias in that direction. And he is much more likely to find some way of justifying tax cuts, given his government's evident bias in that direction. It may be that a rise in US interest rates (now pretty confidently expected in August) will hinder the rate-cutting ambitions, but then any such rise might equally be offset by cuts in continental European rates. As for tax cuts, these are entirely within the Chancellor's scope, even if the borrowing forecasts have again to be massaged in order to justify them.

So let's accept that there will be a pre-election consumer boom through the autumn and winter and that growth will continue to be strong next year - not a runaway boom like the late 1980s, but growth above the sustainable long-term trend.

What then? We can stop fretting about the durability of the recovery, but we need to start concerning ourselves about something else: how the brakes are going to be applied next year. Sure, in one sense this is going to be the problem for the next government for it will have to formulate the policies to curb the boom. But in a rather more real sense it is also going to be the problem for us, for it will be our lives, our jobs, our taxes, our house prices that will be affected.

A glance at the economic forecasts looking forward to the end of the century might seem reasonably reassuring. The Treasury collates the consensus of economic forecasts, and these show growth expected to run between 2 and 3 per cent (actually, a bit above 3 per cent next year), inflation between 2.5 and 3.5 per cent, the current account remaining in modest deficit and the public sector borrowing requirement gradually getting better. Those forecasts are shown in the white bars on the charts.

The trouble is, they may be wrong. Indeed, on past form they are certain to be wrong, though which way we do not know. I've put alongside these consensus forecasts a rather less agreeable prospect, developed by the economics team at Union Bank of Switzerland, which discusses in a recent newsletter what might happen to markets under a Blair government.

These UBS forecasts are the black bars. They show growth slithering back to less than one per cent in 1998, inflation gradually getting worse, and both the current account and the PSBR shooting into grave deficit. Now I am not at all convinced by this particular outlook, largely because were inflation, the current account and the PSBR all to deteriorate as suggested, policy action would have to be taken to correct this. But it is worth starting from these forecasts for two reasons. First, they are drawn up on the premise that Labour will get in next year and will inherit an over-stimulated economy and an over-large budget deficit. Second, that at some stage there will indeed be a dip in growth, though if US experience is any guide that will come rather later in the cycle: perhaps in 1999 or even 2000, rather than as early as 1998.

If, come next spring, the economy is growing too fast and the PSBR is too high to be financed comfortably, a mixture of two things will happen. First, there will have to be cuts in public spending and a rise in taxation. And second there will have to be higher interest rates. The slower and more limited the policy response the more likely it is that the inflation outlook will deteriorate, pushing up the long-term cost of servicing government debt and thereby increasing the size of the spending cuts/higher taxation outcome later. There really is no escape from this.

The question then will be how might the Labour government respond? It has promised to be fiscally prudent, and, naively perhaps, I think it right to take it at its word. The reason for this is that politically it would be wise of the new government to get the bad news out of the way, blaming whatever unpleasant things it has to do on its predecessor. If that were so, inflation and interest rates would not need to rise much as most of the burden for damping down the economy would be borne by cuts in spending and increased taxation.

But this expectation of a swift tightening of fiscal policy may be wrong. It may be politically impossible to act as promised, and the consensus among business economists is certainly that a Labour government would mean higher inflation and interest rates than a Conservative one. If so, the burden of tightening will be more on monetary policy, and however much the new Labour chancellor did a Clarke and resisted the judgement of the Bank of England, eventually rates would have to go up. In practice we would have a sharp rise in interest rates at some stage next year, either early in the life of the new government, or some months later after some kind of sterling crisis.

Let's go back to the question at the beginning: what will stop the boom? None of these options noted so far appear very attractive. One is a quick rise in taxation coupled with cuts in public spending. Another is an early rise in interest rates. And a third is a few months of dither, followed by an even sharper rise in rates. The three are not mutually exclusive, for we could have a mixture of all of them. Is there any other way out?

If this autumn and winter does indeed see a consumer boom, I can only see one other candidate which might stop it. This would be a rise in savings. Suppose instead of using all the extra spending power we were to save more of it. That would take the edge off the consumer boom, and take pressure off inflation and the current account. Growth going into next year would be lower, but it would be more sustainable.

But what might encourage people to be more cautious about their futures? There is one obvious candidate: fear of higher taxation and/or higher interest rates under a Labour government, the fears which cost Labour the last election. It is a curious paradox, is it not? The more frightened people are of a Labour government, the more likely they are to bequeath it a benign economic inheritance.