Britain will need a global recovery to keep growing

Andrew Sentance: Economic Outlook

The Bank of England released its latest Inflation Report last Wednesday. Since the previous report in May, the Office for National Statistics has produced new estimates for GDP showing the recession has been deeper than thought. But looking ahead, there are grounds for optimism.

The big shock to confidence inflicted by the banking crisis last autumn appears to be fading and consumer and business confidence have recovered significantly during the first half of this year. The stock market has risen strongly since March and the housing market appears to be turning. We may also be seeing an easing in the rundown in stocks of unsold goods in key sectors of manufacturing industry.

I expect to see a return to growth in the second half of this year, as the UK economy responds to the stimulus from low interest rates, a competitive exchange rate, government tax and spending measures, an improving global economic environment and the Bank’s policy of quantitative easing. However, there are two big uncertainties over how quickly Britain will recover.

The first is the extent to which constraints on bank lending will hold back spending and business activity. In recoveries from previous post-war recessions, the banking system was in a much better position to boost lending than it is now. As banks remain cautious about new lending and seek to rebuild their balance sheets, there is a risk they could dampen consumer and business spending. The second big uncertainty is the momentum of recovery across the global economy.

Throughout my time on the Monetary Policy Committee, global economic developments have had a significant impact on the UK economy. The recession created by the global financial crisis is the most striking example — though this earthquake was preceded by a series of tremors in the international economy going back to the late 1990s: the Asian crisis; the bursting of the dotcom bubble; the impact of global terrorism and war; and a wave of energy and commodity price inflation in the mid-2000s.

Britain has always been a highly international economy, influenced strongly by its trade and investment links to other parts of the world. But in the increasingly globalised world economy of the 1990s and 2000s, these economic links became broader and stronger. Global manufacturing supply chains have linked the fortunes of Asia and other emerging economies to the spending patterns of consumers in America and Europe. At the same time, global financial markets have transmitted sub-prime losses in the American mortgage market to banks around the world.

These global economic links have not only played a large part in triggering the recession. They are also an important influence on Britain’s recovery prospects and the outlook for inflation. So what does the latest evidence suggest about the prospects for global economic recovery?

Three key points stand out. First, most advanced economies are showing evidence of a bottoming out that we have seen in Britain. In America and the eurozone, the downturn has eased significantly, according to GDP data for the second quarter, with Germany and France actually recording small rises in output.

Second, there has been a general turnaround in business surveys and confidence indicators. Surveys of purchasing managers, which are well-established barometers of business activity in leading economies, bottomed out in the early months of the year. As the chart above on the left shows, in manufacturing industry these indicators are now close to signalling modest growth. Other business surveys are consistent with this general picture of stabilisation and the prospect of a return to growth later this year.

Third, the upswing in the global economy is being led by Asia. The strongest economic indicators in recent months have been in Asian economies. China recorded a pick-up in annual growth from just over 6% in the first quarter of this year to nearly 8% in the second quarter. Both South Korea and Singapore have also recorded strong bounces in output. This week, India reported industrial production up nearly 8% on a year ago with strong readings from its latest business surveys.

It is tempting to be sceptical of these developments as the product of unreliable data (in the case of China) and a bounce in output driven by the stock cycle. But I believe there is a good case for a much more positive interpretation of Asia’s recent recovery. The negative influences that might pose a drag on growth in America and Europe — weak banks and large government deficits — are less likely to constrain Asian economies.

These economies did not suffer from the banking crisis directly. Rather, they were indirect casualties of the confidence shock that is now unwinding. Asian governments have also built up strong public finances over the past decade, which puts them in a good position to use fiscal policies to support demand, with China leading the way. Many Asian economies also have strong supply-side fundamentals that are supportive of growth — large supplies of labour, flexible economies and considerable potential to catch up with productivity levels in richer countries.

Forecasters are generally expecting the Asian economies to power ahead next year (see chart above on right). The prospects for global recovery depend on whether Asia can become a true engine of global growth, not simply by meeting demand originating in America and Europe but propelled by consumer spending and investment in this key region that is home to 60% of the world’s population.

Against this background, it is possible to envisage two scenarios for the world economy, which will in turn affect the British economy. In the first, the recovery in confidence from the shocks last autumn is not sustained and growth in America and the leading European economies is held back by the weakness of the financial sector. And because Asian economies are looking to export markets for growth, they are not able to provide an alternative engine for the world economy. In this scenario, growth is likely to disappoint at home and abroad. UK inflation will tend to remain below target, justifying a prolonged period of loose monetary policy.

However, recent growth trds in Asia also raise the prospect of a second scenario in which the recovery from the confidence shock to the global economy creates a stronger and more sustained momentum of growth. Recovery in some over-indebted economies — notably America — may be subdued by the legacy of the financial crisis. But consumption and investment in economies less directly affected by these problems — notably China, India and other Asian economies — provide an alternative engine of demand that can get the global economy moving.

In this scenario, global growth prospects would be more positive, though we risk a return to some of the price pressures we experienced in the mid-2000s. The resilience of the oil price, picking up from $40 early this year to about $70 on just a few glimmers of recovery, is a reminder of this risk. With stronger growth and more inflationary impetus, monetary authorities would need to tighten policy more quickly.

At this stage, it is not possible to predict with any certainty which scenario will unfold. Hence the wide fan charts around the forecasts in the latest Inflation Report. But as we go through the next couple of years, it will be clearer which economic world we are in, and monetary policy in Britain and around the world will need to respond accordingly.

Andrew Sentance is a member of the Bank of England’s Monetary Policy Committee (writing in The Sunday Times)


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