MOST economists believe that the UK economy still boasts plenty of spare capacity, by which they mean that factories can still produce more, offices aren’t full, and plenty of people remain unemployed or underemployed. The implication is that unemployment can continue to fall and the economy to grow without triggering inflation.
The Treasury, the Bank of England and most of the City buy into this optimistic view, and that is why interest rates are unlikely to be hiked any time soon. This is a key assumption; it is at the heart of all of the debates about the state of the British economy.
A minority of commentators disagree, however, not least Fathom Consulting. The group argues that the recession caused permanent damage to the economy’s productive capacity; and that even the modest recovery we have seen to date has been enough to eliminate the remaining slack. As the economy continues to grow, and in the absence of monetary or fiscal tightening, inflationary pressures will mount quickly – or so Fathom argues.
It believes that interest rates will only go up after the election, hitting one per cent by 2015; but that this will be pathetically insufficient, allowing inflation to shoot back up to three per cent or above, forcing down real rates, fuelling the housing bubble and leading ultimately to what Fathom describes as a “good old fashioned, common-or-garden” sterling crisis.
I too worry. A version of this scenario feels all too plausible. I don’t buy the ultra-rosy, this-is-a-perfect-recovery scenario so beloved of the establishment. Sure, unemployment remains tragically high, but there is a skills and geographical mismatch between the unemployed and the kinds of vacancies on offer. Office rents are starting to shoot up; and much of the capacity that used to exist was destroyed during the downturn, in manufacturing and even in banking.
But where I depart from Fathom is its solutions: it believes that higher taxes will be necessary to defuse the housing bubble and argues that tighter monetary policy alone cannot prevent the over-heating without causing even more damaging side-effects.
I disagree with the first point: the answer to overvalued house prices is to build far more as quickly as possible, not to confiscate even more of people’s income and wealth through the tax system. I also differ on the second point: the heavy lifting should be done by monetary policy, though the consultancy is right that tightening can’t take place too quickly. Fathom argues that the economically rational interest rate required under its assumptions would be around five per cent by 2015 if all of the tightening came from monetary policy, and it correctly points out that such a massive rise would trigger a property crash and another recession
There is no fully satisfactory answer, but a sensible set of policies over the next few years would include a combination of gradually rising interest rates (starting immediately), faster cuts to public spending, the immediate abolition of Help to Buy, quantitative tightening (the reselling of bonds bought by the Bank of England under QE) and as many supply-side, deregulatory reforms as possible to grow the economy’s productive capacity.
Unfortunately, while Mark Carney, the Bank of England governor, is set to amend forward guidance and ditch his obsolete unemployment threshold (the idea was that he wouldn’t even consider hikes until the jobless rate hit seven per cent, a rate that will be breached imminently) he won’t budge on substance. The Bank view remains that there is plenty of spare capacity; if anything triggers a rate hike, it will be an increase in real incomes. By then, however, it will be too late.
If the sceptics are right, and the economy is already running out of spare capacity, another boom and bust disaster is all too possible. We will find out who was right in 2016 or 2017.