Grim is the new Nice for the economy
ECONOMISTS at Morgan Stanley have coined a great phrase to describe what we will be living through over the next few years: it will be Grim – Growth Really Is Mediocre. That is in stark contrast to the Nice years – the Non-Inflationary Consistent Expansion originally described by Mervyn King. It is also in stark contrast to those who are forecasting a double-dip recession, a prediction I rejected in yesterday’s column.
Morgan Stanley’s Graham Secker’s argument – that the markets are over-reacting to the realisation that growth over the next few years will be sharply lower than during the bubble – is one that I share. There has been no material collapse in economic indicators – yesterday’s services purchasing managers index in the UK fell to 54.5 from 55.4, suggesting that the economy is growing just a little more slowly. But to many analysts that isn’t the point: they appeared to be way too optimistic and were probably hoping for continually higher survey readings and eventually a massive bounce. Hence their bitter disappointment.
Secker calculates that Japanese GDP growth in its own post-bubble period (1990-2007) was two-thirds below that in its bubble years (1980-1990). The US, UK and European economies won’t perform as badly as Japan did over the next few years but there is nevertheless a decent parallel to be drawn here.
On top of the uncertainty surrounding the Eurozone crisis and its banks’ stress tests, another big unknown will be the impact of getting banks to hold ever larger amounts of capital to ensure their solvency. The policy is partly sound – financial institutions were operating on ridiculously low levels of capital, under previous regulations – but the authorities seem determined to force this to happen too soon, which would choke off the supply of credit. As Andrew Lilico of Europe Economics and Policy Exchange points out, past research indicates that huge increases in capital requirements will result in banks contracting their balance sheets in approximately equal proportion to the hike in their capital holdings. If capital holdings are boosted from their previous 8 per cent to a hypothetical 15 per cent (compared with the current typical values of approximately 10 per cent prevailing in the industry), that would imply a contraction in risk-weighted balance sheets of one fifth – in other words, banks would reduce their outstanding loans by a fifth, choking off credit. Forcing banks to slash their balance sheets so drastically, even if there is a period of transition, at a time when the international financial sector remains fragile, could be one of the worst decisions in regulatory history and trigger a fresh collapse. We must hope that common sense prevails.
There have been two recent occasions in the UK when fiscal policy has been tightened substantially during a downturn. The first was in 1976, after the IMF?bailout; the second was in 1981 when Lord (Geoffrey) Howe was Chancellor of the Exchequer. The first time, Jim Callaghan, then the prime minister, was terrified Britain might become ungovernable if cuts were imposed and Keynesian economists cried blue murder; the second time, 364 equally Keynesian economists wrote their infamous letter to the Times predicting a catastrophe as a result of the tightening. Both times, the doom-mongers were proved wrong and the economy recovered; it will do so again this time, but it will nevertheless be Grim.
allister.heath@cityam.com