Which forecast do you believe?

In recent days governments around the world have come up with proposals for large reflationary packages of extra spending and lower taxes. At the same time we have heard about an additional potential $800 billion of support for the US banking sector, as the Paulson plan morphs for the fourth time. Governments are making it quite clear they will use every weapon in their armoury to try to lift the recession. We should expect more interest rate cuts, more financial support for banks and more adjustments of general economic policy.

The actions being taken are large and extreme. Markets remain very volatile, but still gripped by more fear than greed. Pessimists point to the continuing sales of shares from redemptions of hedge funds and other collective investment vehicles. They rightly warn us of more losses, dividend cuts and bankruptcies ahead. Commodity prices are well and truly punctured, and the private sector is generally slashing capital spending, seeking to conserve what cash they have. The western banks are still reluctant to lend.

There are limited reasons for some optimism. It now seems clear no more major banks will be allowed to go bust. Markets usually start to rise well before the bad news of the recession is over, discounting a year or so ahead of any upturn. Inflation is falling rapidly as predicted, interest rates will come down more, whilst the Asian economies will carry on growing regardless.

There are at least three possible scenarios from here.

The first is the official view of the UK and US authorities. They state that the recession will be short and relatively shallow. They assume the banks will soon start lending again, thanks to the extra capital and lower interest rates, the injections of liquidity and the supply of money. They expect inflation to undershoot, and then for the main economies to emerge with growth within their natural capacities.

The second is the pessimistic view that because the banking problems are not yet resolved, the recession is going to be much longer and deeper than the authorities claim. It is worrying that so far none of the conventional weapons of lower rates, more capital, more liquidity and government support have worked. The UK banking sector is still withdrawing facilities and putting up the price of credit. Partly this is because the regulators have demanded higher capital ratios, forcing banks to rein in their lending. Partly it is because bankers are now themselves frightened by the outlook and being understandably cautious about prospects for businesses and individuals. We could go into an era like Japan post 1990 where banking weakness negates many of the reflationary benefits of higher public spending, low interest rates and extra liquidity.

The third scenario is that at some point all the reflationary medicine will start to work, in a way which could trigger a new inflation. There are always lags between changing interest rates and an economy responding. The UK and US authorities were around a year late in cutting rates, as wI warned at the time. It will take several more months before you would expect much response. Because both US and UK banks were so weak, it takes time for those banks to repair their balance sheets and regain confidence to lend, but on this analysis it will happen in due course. If the banks did start to work properly again, there are huge amounts of liquidity out there which could start to pump through the system. Meanwhile Indian and Chinese demand for commodities of all kinds will continue to rise, exerting upward pressure on raw material prices. Both the UK and US authorities, so heavily encumbered by new debt, will have an interest in inflating their way out of some of it.

It is difficult to be sure which of these latter two will happen. The government scenario is the least likely of the three. What we can say with some certainty is the UK is running too much risk, and the authorities are making too many mistakes to be sure of a happy outcome. Their decision to demand more banking capital long after the problem had changed to shortage of lending from over lending, the delays in interest rates cuts, the massive overborrowing by the public sector and the poor decision to cut VAT instead of boosting people’s incomes all point in the direction of a worse outcome than the government forecasts, by a large margin. We could end up both with a deeper recession, and the makings of an inflation once we come out.


  1. Monoi
    November 28, 2008

    Methinks you're a bit optimistic on the Chinese/Indian resilience.

  2. Brian Tomkinson
    November 28, 2008

    JR: "Both the UK and US authorities, so heavily encumbered by new debt, will have an interest in inflating their way out of some of it."

    I have a strong feeling that inflation will rise horrendously and that this is in fact the intention of these governments to clear their massive debts, but they will never admit it until it is a fait accompli. We shall all suffer as a consequence. Does it not seem to you that we are on track to become one of the poorer nations of the world by a significant margin?

  3. T Dorlas
    November 28, 2008

    Dear Mr. Redwood,
    It seems to me that one of the main factors in this crisis has been the omission of
    property prices from inflation figures.
    Now looks like a good time to argue for reinstating the old indicators before
    inflation takes hold again.

  4. Dr Dan H.
    November 28, 2008

    The problem I have with believing the current Government figures is this: at no time in the past have any predictions made by Gordon Brown proved to be correct, or even vaguely near the mark. All his predictions regarding finance have all been wrong, so I doubt he'll suddenly grow a brain now.

    Further to this, everything I'm hearing from the Government sounds like "We're in a hole, so let's grab some pick-axes and dig harder!". The current financial strategy is deranged and impossible, the government shows no signs of trying to curtail its outgoings (cancelling ID Cards, freezing benefit payment increases, curtailing the restrictiveness of EU edicts) and also show no signs of getting a clue where the future energy supplies of the UK are concerned.

    Right now, it is all looking like we're in for a snap-election in the spring of next year, before PFI debts (mostly held by now nationalised banks) come onto the UK balance sheet and sap financial market confidence once again. Leading up to this I'd expect a marked change in the public behaviour of Brown, as his aides drug the man to cut down on the dithering and belatedly give the man a backbone, albeit temporarily.

    If he fumbles the spring election, that's it; Labour are sunk without a trace.

    1. jean baker
      November 28, 2008

      Brown's a proven 'confidence trickster' focussed primarily on 'votes'. He has no long terms policies for the historic mess he's created because his party has no intention of changing it's anti-democratic, destructive ways if re-elected. Nulabor wants more of the same – highly profitable labour unionist command of taxpayer funded PFI's. 'Champagne socialism' – based on three generational debts to taxpayers.

  5. mikestallard
    November 28, 2008

    There is the fourth possibility: melt down.
    If Labour win the next election because of boundary unfairness, Scottish and Northern England support and a general swing leftwards, then public spending will carry on regardless. Today Mr Cameron, completely rightly, mentioned cutting public service pensions and there are a LOT of public servants at the moment. Labour's record on two Scottish banks and Northern Rock worked well at Glenrothes. "Public spending cuts" means hurting two million people and their families on the dole and could be seen as affecting the sacred "schools'n'hospitals." there are also a lot of pensioners who vote.
    Once the eldction is won by Labour, more and more people will be unproductive in a rapidly aging society. Immigration already has stopped round here. Who will do the work then to repay the debts?
    The public payroll will swell and the debts grow simply to pay for the government's monthly bills. Meanwhile the electricity and gas will be cut off as "wind power" and 15% "renewables" are "put on stream".
    The economy will look more and more iffy as the debt grows higher and higher. The pound will start to sink lower and lower. Eventually, of course, the whole thing will judder to a halt. (Remember the winter of discontent?)
    At that point people will discover that the IMF is now (Nov 2008) down to its last £100 billion pounds…….

  6. Matthew Reynolds
    November 28, 2008

    A 30% tax cut bringing rates down from 45p,40p and 20p to 31.5%,28% and 14% on incomes and a 50% corporate tax cut lowering them from 28% & 21% to 14% & 10.5% with two-thirds of the money found from smaller government and the rest from an anticipation of the Laffer-Curve doing its work could get the economy going again if phased in over six years on the back of virtually zero public spending growth for at least three years.

    The basic personal allowance could be £10,000 p/a for all taxpayers irrespective of age or income and the only business tax break would be a simple one for companies who annually reinvest at least 30% of their before tax profits into their business.

    Public spending cuts on aid for rich countries like China, welfare dependency, civil service numbers , QUANGO's , RDA's , EU monies , New Deal , Transport , government procurement etc should not be too tough to find…

    As Big Government & high taxes have failed how about the opposite policy to sort out this mess….

  7. Mr C
    November 29, 2008

    Slightly O/T I know but it's often said that when a politician becomes the object of widespread ridicule his or her days are numbered. In this connection, you might find the following take on Brown's economic competence, funny but perceptive.

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