Economic Outlook 2

Stagflation
We therefore have a contracting economy with a reduced money supply tending to produce falling prices and a contracting economy. On the other hand we have a weakening exchange rate tending to cause inflation and which will help make our exports more competitive but not necessarily by enough.

In effect we have an economy finely poised between two different and very unpleasant outcomes.

We may even have stagflation where the economy contracts but prices continue to rise. We have had a major fall in the value of Sterling, which will feed through into prices. The economy is contracting and something positive will have to happen for that to be reversed.

Which Future
The only part of the future that is reasonably clear is the falling living standards, which must inform your investment strategy. However that is of limited use. It would be nice to know how long the economy will take to bottom out and what will happen to inflation.

The government’s plans so far have been to cut taxes and increase spending with a view to kick-starting the economy out of recession. The government was going to finance this initially by issuing debt in the form of Gilts and then repaying them with increased taxes. The problem here is that to the extent that the money is raised in the UK, it is taking money out of the economy in order to put it back in. It may therefore not kick-start the economy at all because it is taking with one hand almost as much as it is giving with the other.

Given that governments have a tendency to inefficiency the policy carries a very real risk of making the situation worse.

Whether the policy works in the short term or not, eventually there will be higher taxes, which will either deepen any depression, delay any recovery or reduce the rate of recovery.

A different solution is now being considered. Instead of borrowing the money the government simply prints it. This is likely to work in so far as it will kick-start the economy. However the solution has been tried before many times. I have heard of it described as the Zimbabwe solution. In Zimbabwe the annual rate of inflation has been reported as 231,000,000% (two hundred and thirty one million per cent)

In case you think that that couldn’t happen in a European country, in 1922 in Germany prices increased by a factor of 16 between June and December. This is equivalent to an inflation rate of 25,600%.

It is all too easy for the government to spend any new money created on some immediate benefit but that is certainly inflationary. To avoid the horror scenario of hyperinflation any money created has to be spent on creating real assets of long term value. This is what Roosevelt did in 1930s America.

There are lots of such projects that would achieve this objective. Extending European rail links to the rest of the country. Creating a transport hub outside London so that not so much traffic had to go through the capital. Improving transport links both between London and the rest of the country and within London itself.

Rebuilding our water and sewage systems, which are about 150 years old, is another option. We could also improve the infrastructure for other utilities such as replacing metal telephone wires with optical cable. Although most utilities are privately owned, they are in effect self-contained taxing authorities as water and electricity is not optional purchases. This is likely to be more efficient than the government doing it but it will create private rather than public wealth.

The problem with all these sort of projects is that local opposition is likely to be intense because of the disruption involved. The question must be asked whether the government is prepared to make politically hard choices.

Possibly easier would be to pump money into the educational system and improve our human capital. However, to be effective the focus of our educational system will need to be on economic rather than cultural or social objectives. That requires a focus that we have never previously achieved. In the past we have attempted to do them all at once, and failed to achieve either our economic, cultural or social objectives.

The political and economic reality of all these projects is that it will take five years for the economy to get any benefit from them. Until then all we have are building sites or maybe some better-educated kids. It would take even longer to create a better-educated workforce. This would involve the current government bearing the cost of something that will befit the next government or the one after that. It would be nice to think it will happen.

A few things are certain. As a nation of consumers we are in debt with our mortgages and credit cards. Although possibly not as bad as in America we have financed that by borrowing against the ever-growing value of our property. Ultimately that debt has to be repaid.

In the past the world’s economy has been driven mainly by US consumer spending and to a lesser extent by European consumer spending. In the UK the consumer has more than done his part in driving the economy. Both these drivers are probably dead for the foreseeable future. If the consumers are revitalised somehow it will only make the situation even worse in the long term. The best hope is for the Asian consumer to take some of the strain but even that will in the short term only make the banking crisis worse.