Axel Leijonhufvud, the Swedish-born economist, once made an insightful observation about inflation targeting. It worked better in practice than it did in theory, he said. I feel the same about the UK economy. Given what we have long known – about the country’s relatively low productivity growth rate and the erosion of its scientific and engineering excellence – the British economy should clearly not have performed quite as well as it did for the past 15 years. Economic theory would suggest that this was not possible.
In the next few years, I expect the UK economic miracle to be exposed for what it was: an overlong joyride on the back of an overlong asset price bubble. The UK economy is about to undergo a downturn at least as large as that of the US – maybe even worse, because of an even more inflated housing market and because the financial sector constitutes a larger share of gross domestic product.
According to my calculations, UK residential property prices are about 30 per cent above their trend in real terms. If the trend has not changed in the past few years, that would suggest that inflation-adjusted prices could fall by up to 40 per cent from peak to trough.
Of course, it is possible that the trend has changed, that cool Britannia has attracted so many foreign buyers that the trend line may have shifted higher forever. But foreign buyers can leave just as quickly as they arrive and their presence is related to the health of the financial sector. My guess is that the half-century-old trend line is still approximately right.
Moreover, the trend is consistent with several other indicators, such as the ratio of house prices to rents achieved, which in the UK has recently been about two-thirds above its long-term average. Whatever explanations one might come up with in defence of higher house prices, they cannot conceivably explain why house prices should be out of line with rents forever.
A house price crash would take time to unfold. Assuming a constant inflation rate of 2 per cent a year, nominal house prices would have to go down by about an unprecedented 25 per cent if the decline stretched over six years. Remember: the first stages of a housing downturn consist of denial followed by anger. A fall in actual prices is a relatively late-stage phenomenon of a housing crash.
The UK financial sector is in no less trouble. The credit crisis has a lot further to run, as it moves from one subsector to another. As I have argued previously, credit default swaps pose very serious risks to financial stability and the City of London has been the centre of the European CDS market. One consequence of the credit crisis could be that banks become subject to highly intrusive regulation on the types of product they can offer, perhaps even on the profits they distribute or the salary packages they can award. The greater the extent of public bail-outs or bank nationalisations, the greater will be the public’s regulatory revenge.
Perhaps the worst thing will be that working in finance will no longer be regarded as cool, as it has been over the past 15 years. Finance will be once again what economic theory always told us what finance should be: a necessary activity, requiring some technical skills, but rather dull in the absence of bubbles.
The macroeconomic implications of the downturn in the financial sector are serious. In the UK, the financial sector is the largest contributor to the balance of payments. Its decline comes at a particularly inopportune time, as the country is running a current account deficit of 5.7 per cent of GDP. To get that deficit down to a more sustainable level will require a big fall in consumption and a big rise in savings – all the more so if the country’s largest export industry is in recession.
Could the Bank of England end this nightmare by cutting interest rates? I suspect the answer is no. This is a different kind of downturn from previous ones. It was caused by an exploding bubble, not by high interest rates. The outlook for inflation reduces the Bank of England’s small room for manoeuvre, which may already consist of rate cuts of only another quarter percentage point or two. But this is not going to persuade a rational investor to return to the housing market, let alone a bright young university graduate to seek a career in investment banking.
The adjustment ahead will put the previous 10-year performance of the UK economy into some perspective. My own guess is that Britain’s heavy reliance on financial services and housing, until recently seen as a great strength, will in future be seen as a structural weakness, similar to the French labour market or the Italian public sector.
Funny that, given what we have been told about economies in the 21st century succeeding through services and the like. But then, economic fashions are subject to violent swings. As for the gap between practice and theory, theory may on occasion provide more lasting insights.
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