January 21, 2008 | posted by Michael Baxter in UK economy |

Now all eyes turn to abroad. The British consumer is out of puff, the government can no longer afford to boost the economy with spending, but at least there are our foreign partners.

Well, we can’t rely on the US of course, Uncle Sam is sneezing like no one’s business, but this time around, it seems as if the UK can avoid catching a cold, maybe just a mild headache for a year or so, fixed by the economic paracetamol of reducing interest rates, and the flow of investment from abroad. At least that’s what the ITEM Club appears to be saying with its latest economic forecast.

The ITEM Club, from Ernst Young, which by the way is highly revered, reckons economic growth will slow to 1.8 per cent this year, down from 3.1 per cent last year, and then pick up slightly in 2009, with growth of 2.4 per cent, before it fires along on all cylinders in 2010.

Here’s the good news: the ITEM Club says, “Despite the credit crunch, a rebalancing of the economy – as personal savings increase and consumer spending and house price growth slow – will in the longer term be good for the UK.”

It says that, “With the weakness in the High Street likely to hold down inflation, there is room for interest rates to be cut to prevent the abrupt reversal in the credit markets leading to a reversal in the economy.”

It also says the UK markets for credit are being frozen of supply, rather than demand. Presumably, then, as credit is restored, it expects us go out spending again.

“Fortunately,” says the ITEM Club, “It looks as though Sovereign Wealth Funds (SWFs) are coming to the rescue by providing the banks with more capital. However, this is no panacea. So far, the US banks have raised about $25 billion from the SWFs, which is only about a quarter of the total losses so far announced. Moreover, these funds are expensive. They push up the banks’ cost of capital and thus the interest rate margins they will expect on new business. In any case, in the UK the biggest problem seems to lie elsewhere – with mortgage banks and building societies that are now finding it difficult to borrow from other banks. It is not yet clear how this situation will resolve itself.”

The ITEM Club also says business remains in good shape and is in a position to pick up the baton from the consumer. Manufacturing – or what is left of it after 10 years of living with an overvalued currency – is set to benefit from a lower exchange rate and the expansion of overseas markets. ITEM forecasts manufacturing output to grow by 1.4 per cent in 2008 and 2.5 per cent in 2009, after flirting with recession for years.

But here is the catch. With the prospect of slower growth this year, and hence slower tax revenues, ITEM forecasts a grim outlook for the public finances. The current deficit over the first eight months of the financial year came in at £23.1 billion – £8.6 billion worse than last year. Net borrowing was £36.2 billion, £10.2 billion worse.

Peter Spencer, Chief Economic Adviser to the Ernst Young ITEM Club, said, “Now that the economy is slowing sharply, the public finances will deteriorate equally rapidly…The Treasury failed to take advantage of years of good growth to put our public finances on a sounder basis, so our ability to respond by easing fiscal policy has been compromised. The Government should have begun to sort out the national finances three or four years ago. Brown’s famous self-imposed ‘golden rule’ was meant to stop us getting into this kind of bind but I’m afraid it will now make matters worse.”

Mr Spencer summed up, “This is the time for new resolutions and this year is going to be a year of adjustment. We are facing serious problems as a nation of borrowers, particularly the Chancellor. However, it is important to put these into perspective. The economy is fundamentally sound, the problems in the inter-bank market seem to be resolving themselves, employment is high and inflation under control despite the inflationary threats from world commodity and currency markets.”

All in all then, a kind of “not bad” report. But, the ITEM Club is basing its assumptions on the belief that house prices will not crash this year. On one hand it says, “We are facing serious problems as a nation of borrowers,” but on the other hand says demand for credit is still strong, and that lower interest rates, presumably by leading to more borrowing, will create the recovery.

Mr Spencer says, “We have been living beyond our means, lured by the offers of cheap no-questions-asked credit, and tempted by the high prices that the family silver will fetch in international markets. In the future, most families have no option but to tighten their belts. They can no longer afford to dip into housing equity to keep up the growth in spending.” And yet the ITEM Club reckons we will see only a mild slowdown.

With the world’s biggest importer in such dire straits, we are not sure how the economy can experience such a soft landing, unless, that is, lower interest rates mean we carry on borrowing too much, making us even more vulnerable to the next economic crisis. Remember this, the latest data revealed that actually average earnings before bonuses are lagging behind the changes in the Retail Price Index – the average worker is getting worse off.