We're in for a hangover in the year 2000

THE MOST dangerous time in economics is when everything seems all right. Domestically, the background to Gordon Brown's first full-year Budget appears uniquely favourable: high confidence, low inflation. Internationally, the threatened fall-out from the collapse in East Asia has yet to be felt seriously elsewhere, Europe is starting to grow again and the US continues to thrive. But all our past experience suggests that we should now be particularly alert, for it is the time when the policy-makers stop worrying and make mistakes.

A year ago, for example, most of us were not worrying about East Asia. The stock markets were cantering along, foreign money was flooding in, everyone was assured that the changes in Hong Kong would have no impact on the economy, and so on. A lot of us, however, were worrying about the level of the US stock market and the durability of the US boom. Wrong on both counts. Of course on a longer-term view it was always likely that there would be severe reverses in East Asia, simply because economies never carry on expanding at 7 to 8 per cent a year without periodic discontinuities. On a long-term view the innovation and quality of the best American companies was always likely to ensure that the US economy would retain its excellence. But getting the timing right is extraordinarily difficult.

Where now are the dangers? Where are the things which might, a year from now, put a totally different and less agreeable gloss on whatever Mr Brown has to tell us on Tuesday? Here are my candidates for possible unpleasant surprises, tempered by a few possible pleasant ones.

First, the UK public finances. They are terrific. Do not expect the Chancellor to admit it yet, but it would be perfectly possible to run a surplus in the coming year. Now you would expect that, given the strong economic growth that has taken place. But the underlying deficit, that is adjusted for the swings in the economy, is also down to around 1 per cent of GDP - the lowest it has been for nearly 30 years. So what should be the first concern of any Chancellor - are the government's books OK? - is not a worry.

The second concern should be the state of the economy. So much has been written about the present dual economy, with manufacturing held back by the high pound but services cantering ahead, that there is not much point in trying to add to the pile. But it is worth making the point that at some stage in the next two years things are going to slow down sharply. They will have to slow because if they don't the economy really will hit capacity ceilings. You can argue that the ceiling of a service economy is much less rigid than the ceiling of a manufacturing one. It is true, too, that there may be more spare capacity than is at present evident. Nevertheless, somewhere there is still a ceiling, and we will eventually reach it.

There is another reason for expecting a UK slowdown and that is described in the left-hand graph. We have experienced a really tough monetary squeeze over the last year, partly from higher interest rates (and expect them to go up at least one more click) but more from the rise of sterling. The rule of thumb is that four percentage points on the sterling index are equivalent to one percentage point on interest rates. HSBC, which put together that graph of monetary conditions, has then plotted it two years in advance of the economy. So you can see the way in which the monetary squeeze last year seems likely to squeeze demand in 1999.

Two years sounds a long time but the lags with monetary policy are long, and while the link is not exact, there has been a decent fit over a very long period, as you can see. So in another 18 months expect the present squeeze to have damped things down. A recession? Well no one can know, but it would be unwise not to expect a year or two of very slow growth.

Now turn abroad. Within the developed world the clear candidate for the hospital remains Japan. It looks certain that it will return to recession this year, something that it just about managed to avoid in the early 1990s. Industrial production went negative (see right-hand graph) but the economy as a whole just managed to creep upwards. Now that looks almost impossible, for the East Asian blows have come at absolutely the wrong moment. Every time the Japanese economy starts to perk up, along comes something that knocks it back down again.

It is hard to say anything definitive about the East Asian collapses because the story is still moving very fast. We have not seen the outcome in Indonesia, but it seems reasonable to assume that whatever happens there will turn out to be towards the less pleasant end of the scale.

Elsewhere, Korea is going at best to have three or four very difficult years, while Hong Kong will gradually become a less important economic and financial centre. As some of us suspected, the pre-June 1997 position of being culturally and economically part of China, but legally and administratively a British colony, may well turn out to have been a uniquely favourable historical accident. But the crucial issue is China itself, now going through wrenching economic changes, with millions of people who thought they had secure jobs being laid off. It is impossible from this distance to make any sensible judgement on the changes that will take place in the Chinese economy over the next three to five years, except to say it is unlikely to be the vibrant growth zone it has been for most of the last 18 years.

The Hong Kong story does carry a further worry, for you can almost see it as a proxy for the world economy at this juncture. For what it is worth, I reckon that the developed world economy over the next couple of years will be like that of Hong Kong last year. The party will carry on until the Millennium, sustained by the sort of momentum evident in the US and here, and by rising activity (partly associated with all the spending on the euro) in continental Europe. And then there will be a flop. The US and UK will already have been slowing. East Asia will still be flat. There will be some disruption as a result of the Millennium bug, though we don't know how much. As a result of all this the year 2000 itself will be a real struggle.

All this is a bit dispiriting, not the sort of environment in which Mr Brown, assuming he is still in the job, would hope to be presenting his pre-election budget of 2001. It would be wrong to sound a wholly negative note, for there are a few things happening in the world economy which should help ensure that general prosperity here will continue to rise through the next decade.

One is the disappearance of inflation. It is going to continue on a downward path worldwide; and a sustained period of stable prices, coupled with freedom of capital movements, will enable the market economy to allocate resources much more efficiently than at any stage since 1914.

Another is the burst of technological advance taking place as a result of the information revolution. It looks, fingers crossed, as though productivity in US service industries is starting to rise as a result of the investment in IT. The world needs to get productivity up in service industries if it is to continue to raise living standards; increasing productivity in manufacturing is operating on too small a base.

There is also something happening in the UK economy: a combination of a catch-up in areas where we have lagged (like mass manufacturing) and a pushing ahead in areas where we have some sort of lead (like communications and cultural services). It is conceivable that we may have lifted the trend rate of growth - the rate at which the economy can grow without showing strain. No one should take that for granted, certainly not the Chancellor, but it is an intriguing possibility and even more important than anything we will learn on Tuesday.