The canary in the mine

Aug 4th 2005
From The Economist Global Agenda

Long the envy of its peers in continental Europe, Britain’s economy has hit a soft patch. Consumers, no longer buoyed by rising house prices, have cut back their spending, and so far nothing has come forward to take its place. The Bank of England has announced a rate cut in the hope of softening the landing, but will it be enough to keep the economy on track?

OVER the past decade, Britain seemed to have achieved a sort of Goldilocks effect: an economy that was not too hot, not too cold, but just right. The country that was the “sick man of Europe” only a few decades ago has now become one of the lodestars of the “Anglo-Saxon” economic model, derided by policymakers in continental Europe for its heartlessness—but envied by those same policymakers for its low unemployment and rapid growth. As countries such as Germany, France and Italy have struggled with slow-growing or stagnant economies and groaning welfare states, Britain has sailed serenely into a long stretch of uninterrupted growth (see chart). Even America, where the growth rate has often been faster, turned envious eyes Britain’s way when it managed to avoid the recessions that plagued other industrialised countries after the collapse of the dotcom bubble.

Now, however, that economic strength seems to be flagging. In the 12 months to the second quarter of this year, the economy grew by only 1.7%, its slowest rate in 12 years; the manufacturing sector is now in recession. Surveys report low levels of business confidence, mounting household debt and slower consumer spending.

Against this background, and the news that four members of the Bank of England’s nine-person Monetary Policy Committee (MPC) had voted for a cut at their last meeting, analysts had been predicting that the Bank would lower interest rates on Thursday August 4th, even as other central banks raise rates (America’s Federal Reserve) or hold steady (the European Central Bank). It did just that, cutting its benchmark rate by a quarter of a percentage point, to 4.5%.
The Bank of England was one of the first central banks to begin raising interest rates after the slump that followed the bursting of the bubble. Now it is an early mover in the other direction.

While the move is not unexpected, neither is it uncontroversial. The Bank’s statement indicated that inflation was running at 2% (the Bank’s target rate) in June, and that higher oil prices may be expected to push that number up in the short term. But while the MPC must concern itself with the current rate of inflation, the object of its policy is to keep inflation on target over the medium term; it takes up to a year for higher rates to cool the economy, and a similar length of time for the slower growth rate to push down inflation. If the economy is truly stalling, future inflation becomes much less of a worry.

More pressing are fears that lower interest rates could re-inflate Britain’s housing bubble. Since 1997, house prices have risen by over 150%, despite relatively low inflation in the rest of the economy. This has been a key pillar supporting consumer spending—even in the depths of the global doldrums, British consumers were feeling flush thanks to brisk appreciation in the value of their homes. Their expression of those feelings, on the high street, has been a key factor in Britain's long expansion.

But this particular form of self-expression has required the build-up of staggering levels of household debt, both by consumers treating their home equity as a cash machine, and by first-time homebuyers accepting ever-riskier levels of indebtedness in order to get a foothold on the housing ladder. Debt now stands at 150% of household income, up from 110% in 2000. Recent data from the Office for National Statistics show just how dangerously dependent on unsustainable levels of spending Britain’s economy has become: consumption growth was a racy 3.7% in 2004—a year when real household disposable income grew by only 1.9%.

The Bank of England’s aggressive interest-rate policy would, it was hoped, take some pressure out of the bubble before even more consumers got themselves dangerously indebted. But this may have worked too well. According to Morgan Stanley, debt service now accounts for 12% of disposable income, the highest level since 1992, when the Bank's benchmark interest rate was a heady 10.5%. The housing bubble has stalled relatively gracefully—prices have stagnated rather than collapsing, and even the Council of Mortgage Lenders’ new, more pessimistic forecast is for prices to fall by 2% this year and level off in 2006. But consumers have not reacted so gently.
Growth in household spending all but evaporated in the first quarter of 2005 as overstretched Britons retrenched. According to the Confederation of British Industry, retailers have not seen an increase in monthly sales (year-on-year) since the end of 2004.

Eyes across the Channel

Unfortunately, this comes at a tricky time for the economy. When consumer spending flags, it is generally hoped that business investment and exports can pick up the slack. But investment by companies has been, and remains, lacklustre. And the euro area, which soaks up half of Britain’s exports, remains itself dangerously dependent on external demand to drive even the mediocre growth it has seen in recent years. High oil prices will only make things harder on both sides of the English Channel.

Despite these worries, it is unlikely that Britons are in for a series of interest-rate cuts. The Bank of England knows that no good will come of re-inflating the housing bubble, which would only result in worse pain down the road, as more consumers fall into the trap of too much debt. And there are reasonable hopes that further cuts may not be necessary. Though the International Monetary Fund has just cut its forecasts for euro-area growth this year and next, some recent indicators have been rather encouraging. And the value of Britain’s currency against a basket of its trading partners’ currencies fell by 4% between the end of April and the end of July, which should provide additional stimulus.

If Britain’s economy does not perk up, however, this could spell trouble not only for the Bank, which will have a tough time steering between the Scylla of stagnation and the Charybdis of inflation, but for the world at large. The world remains far too dependent on American consumer demand for its economic growth. And American consumer demand, like that in Britain, has in recent years been far too dependent on rising house prices and steadily increasing debt to finance spending. Britain could turn out to be the canary in the mine that tells central bankers—especially the Fed’s Alan Greenspan and his yet-to-be-named successor—what happens to an economy when consumers finally reach their credit limit.

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