[A-List] UK state: financial brinkmanship

["Michael Keaney" <michael.keaney@xxxxxx>]

A chancellor still in control of events. But only just

Larry Elliott
Thursday November 28, 2002
The Guardian

Gordon Brown brazened it out. He stood up at the dispatch box and admitted
that his growth and borrowing forecasts made in the spring were wildly
optimistic, but adopted his normal Commons persona - self-confident
bordering on smug. There was, the chancellor insisted, nothing really to
worry about. The economy was going through a bit of a sticky patch but it
was all Johnny Foreigner's fault. And it was merely a temporary blip.

Beneath the surface, however, it is likely that Mr Brown is a lot more
worried than he appears. The fact that the rabbit pulled out of the Treasury
hat was the announcement that Mervyn King would replace Sir Eddie George as
governor of the Bank of England was meant to reassure the financial markets
at a time when the chancellor was announcing a doubling of borrowing.

Moreover, Mr King has made it abundantly clear in the past couple of weeks
what he thinks about the underlying state of the UK - an unsustainable
housing market and the weakness of manufacturing reflect an economy that is
dangerously unbalanced.

Mr Brown's analysis is that the recovery he anticipated in 2003 will now
take place in 2004. He has cut 0.5 of a percentage point off his growth
forecast for this year and next, but added the same amount to his prediction
for 2004. Growth is expected to be between 3% and 3.5% in 2004, and a robust
2.75%-3.25% in 2005, the date pencilled in for the next election. How likely
is this? There is one good reason for thinking the chancellor will be right,
but two important reservations that need to be aired.

On the upside, the chancellor's decision to let borrowing rise during a
period of weak growth is absolutely the right thing to do, straight out of
the Keynesian textbook. While much of the rest of Europe seems intent on
impaling itself on the sort of economic orthodoxy that went out of fashion
in the early 1930s, the chancellor is allowing fiscal policy to act as an
automatic stabiliser. Previous Labour governments have never had the luxury
of relaxing fiscal policy during a global downturn, but have instead been
forced to retrench, as in 1931 and 1976, with disastrous political
consequences. Mr Brown deserves credit for being able to increase public
spending at precisely the right time.

Should the global economy pick up next year, there is a chance that Mr
Brown's forecasts will come good. But that is the first concern.

The chancellor is correct to point out that the global economy is in one
heck of a state, even though the strong figures coming out of the US
yesterday may be a sign that the Federal Reserve's cut in interest rates is
working. To coin a phrase, there has been a global boom-bust of stupendous
proportions over the past five years, and most countries are still living
through the after-effects of the collapse of the bubble economy. The global
economy is awash with spare capacity, which is resulting in a freeze on
investment, falling prices and weak profitability.

Only the most heroic optimist would assume that this period of adjustment
will be over in a year's time. The US stock market still looks hideously
over-valued, the German economy is on course to be the new Japan. That is
without even mentioning a possible war against Iraq.

Since Britain had its last full-blown economic disaster a decade ago, the
global economy has had a succession of crises, from Thailand to Argentina
and from Russia's debt default to America's dotcom sector. To assume that
this era has come to a close and that the process of adjustment to all the
previous problems will be over in 12 months is heroic.

It is really not much comfort, then, to hear from Mr Brown that while the UK
has been doing badly this year, the rest of the world has been doing worse.
On that basis, should the rest of the world continue to struggle, so will
we. The chancellor is remarkably proud of the fact that Britain has the
lowest inflation and interest rates for 40 years, and says so at every
opportunity. What he never mentions is that the rest of the world has
historically low inflation and low interest rates as well. We are living in
a age of disinflation bordering on outright deflation.

The second cause for concern is what you see when you scratch below the
surface of Mr Brown's much-vaunted "stability". A mountain of consumer debt
shows that we are all shopping for Britain, but the fall in investment over
the past year was the biggest since records began in 1965. Productivity, for
all the chancellor's prodding, is growing half as fast as it was when Labour
came to power. Mr Brown's belief that the economy can grow rapidly in 2004
and 2005 is based on the assumption that productive capacity has risen; the
figures for investment and productivity hardly bear that out.

As a result, this statement showed the chancellor still in control of
events, but only just. The big increases in public spending have left him,
unlike in previous years, with little room for manoeuvre. He needs
everything to turn out right. The lesson of history - particularly British
economic history - is that it rarely does.

-----

King of the Bank wins an early coronation to settle City nerves

Hawkish insider takes top job with brief to stabilise the economy

Larry Elliott and Charlotte Denny
Thursday November 28, 2002
The Guardian

Mervyn King has spent the past couple of months fretting. Gordon Brown often
keeps candidates for top office on tenterhooks, and after years in which the
Bank's deputy governor has been seen as the obvious choice for the top job
at Threadneedle Street, he was concerned that the chancellor would keep him
hanging on.

Had Mr Brown done so, he might have found that the bird had flown. Rumours
had been circulating that Mr King, an academic of international renown, was
in the running to succeed Anthony Giddens as director of the London School
of Economics when his five-year term at the Bank came to an end next May, a
month before the scheduled departure of Sir Eddie George.

As it was, Mr King need not have worried. The deteriorating state of the
public finances caused by weaker than expected economic growth and the
knife-edge state of the housing market meant that Mr Brown could not indulge
in his usual chronic procrastination. The chancellor needed to convince the
City that his pro-stability credentials remain untarnished despite the
doubling in borrowing. Mr King's appointment fits the bill perfectly.

In other ways too, Mr King is an ideal New Labour choice. The days when Bank
governors were grandees of the City, plucked from illustrious merchant
banks, are gone for ever. With the Bank stripped of its powers of financial
supervision, the job now requires a policy wonk - someone who has the
ability to understand the mechanics of macro-economics rather than the
ability to raise an eyebrow at imprudent lending practices.

The fact that Mr King is a die-hard Aston Villa fan did him no harm either.
Football is part of New Labour's lingua franca, and when presenting the
Bank's quarterly inflation report, he has been known to draw parallels
between the performance of the economy and that of the Villa.

Last night, the City seemed happy with the choice. "I think it is a very
good move", said Gerard Lyons, chief economist with Standard Chartered. "He
was the best choice for the job and the markets were relieved that there has
been a clear endorsement of the current macro-economic stance. It also
suggests that there is less enthusiasm for rushing into the euro".

The vexed question of monetary union was probably the one factor that might
have prevented Mr King's appointment.

A sceptic in the true sense of the word, he once said that it would require
100 years of data to prove conclusively that entry into the single currency
was beneficial. There had been speculation that Tony Blair might want a
governor more favourably inclined towards the euro to smooth the passage to
a referendum.

Sir Howard Davies, the chairman of the financial services authority, the
City's watchdog, was one name mentioned; another was Andrew Crockett, a
former Bank official who is currently general manager of the Bank for
International Settlements in Basle.

"We were keen to show that there would be continuity," the Treasury said
pointedly last night.

As far as the domestic economy is concerned, Mr King is at the hawkish end
of the spectrum. Shortly after the 1997 election, the last Conservative
chancellor, Kenneth Clarke, said: "I remember him well. He was the one who
always wanted to put up interest rates".

Hawkish

Mr King's hawkish tendencies are unlikely to endear him to manufacturers,
even though he is proud of his West Midlands background. With rates at their
lowest for 40 years, he is one of those warning about the risks of pushing
them still lower. Like other Bank officials, he had to man the defences when
waves of speculation broke over Threadneedle Street on Black Wednesday in
1992.

The chancellor's obsession with the perils of boom and bust are fully shared
by the new governor. Some City economists believe the early announcement
reflects Mr Brown's concern about the borrowing binge sustaining the housing
market and his desire to strengthen Mr King's hand in the battle between
hawks and doves.

What is certain is that Mr King never forgot what happened on Black
Wednesday, and appeared to relish the opportunity to take public revenge on
the man who broke the Bank of England when asked for his views on George
Soros's critique of global capitalism. The arch-speculator may have cleaned
the Bank out of its foreign reserves, but he was, Mr King said, "ignorant of
economics" and - the ultimate insult from an academic - "lacking in
intellectual rigour."

Mr Soros is not the only one to have felt the sharp end of Mr King's tongue.
He has won a reputation at the Bank for being a control freak and two years
ago was involved in a damaging row with the four members of the nine-strong
MPC who were appointed from outside the Bank. The new governor wanted to
keep all research conducted by the Bank's team of in-house economists under
his control. He only backed down only after two of the independent members
made their strong objections known, and even then not especially graciously.

Bank insiders say it was thought that the row could be a fatal blow to Mr
King's ambition to take the top job at the Bank, since the row shone an
unflattering light on Mr King's lack of management skills.

In the end, however, these doubts were outweighed by Mr King's undoubted
credentials as an economist and policy maker. When British economic policy
was in ruins in the wake of Black Wednesday, it was Mr King who set about
constructing a new and workable model.

Within a month, the framework that is still broadly in use today had been
set up. Instead of targeting the money supply, the budget deficit or the
exchange rate as a way of keeping inflation low, as the Conservatives had
done between 1979 and 1992, Mr King said that the government should simply
target inflation instead.

The new model established an inflation target of between 1% and 4%, a
quarterly inflation report and a monthly rate-setting meeting between the
chancellor and the governor of the Bank. When Labour took over, it gave the
Bank independence to set interest rates and set a symmetrical inflation
target of 2.5%, but otherwise left Mr King's blueprint untouched. The past
decade has proved its effectiveness, with the longest period of sustained
economic expansion since the war.

Those who knew Mr King when he was a Cambridge undergraduate say they are
not surprised by this record, since he was earmarked as an economist of rare
talent. But the City believes he has just been handed the hardest task of
his career.

One economist said last night that Mr Brown is relying on the new governor
to engineer the "perfect soft landing" for the highly unbalanced British
economy over the next three years.

Mr King must slow Britain's runaway housing boom, persuade consumers to end
their spending spree, though not too abruptly, and business to start
investing again if the chancellor is to meet the ambitious growth forecasts
underpinning spending plans for the next three years.

It may be that it is just as well that he has seven months to prepare for
it.

The words of a King

On the role of the Bank of England

'In the end a central bank is doing its job when no one notices that it is
there'
December 1998

On Britain in the euro

'You would need probably 200 or 300 years of data ... You will never arrive
at a point when you will be confident the cycles have genuinely converged.
It will be a matter of judgment'
May 1999

On his tenure at the Bank

'When I came here, I had no intention of staying more than two or three
years. But the change came when we left the exchange-rate mechanism and then
there was a real challenge. And the ability to contribute to that and to
build something rather special in the Bank was a tremendous challenge'
November 2002

On need for caution at the time of dot com bubble

'We should be cautious about those who speak of new paradigms ... a word too
often used by those who would like to have a new idea but cannot think of
one'
May 1999

On house price inflation

'It is likely to slow soon. But the honest answer is nobody really knows
what could happen'
November 2002