Recovery talk blind to structural flaws

In: Uncategorized

10 Aug 2009

This is my comment from this week’s Fund Strategy.

The optimism about economic recovery in the middle of last week was misplaced. Those who proclaimed that an upturn was underway based on a few short-range indicators had it wrong.

Admittedly, by the end of the week pessimism had set in again. But in many respects the pessimists made the same mistakes as the optimists. Both sides tend to be superficial and short-termist. A different approach is needed to grasp the state of the economy.

The first mistake is to extrapolate from limited data. This could be a short-term indicator such as house price changes or vehicle sales over one month. Or it could mean generalising about the state of the economy on the basis of the performance of a few companies.

Both versions of this error were on display last week. Markets and the media reacted on cue to information on rising house prices and better than expected performance from some of the big banks.

However, later in the week there was an equally negative reaction to the worse than expected results from the Royal Bank of Scotland. It was similarly unjustified to extrapolate from the poor results of this company, despite its large size, to the state of the economy as a whole.

The second mistake is to fail to acknowledge sufficiently that the huge stimulus to the economy is likely to have some effect. A combination of high state spending, low interest rates and quantitative easing has inevitably boosted the economy. The question is more about the likely resilience of any recovery given that the economy is currently benefiting from an artificial boost.

The final error is to confuse a cyclical recovery with the underlying structural weaknesses of the economy. Britain is suffering not only from a recession but from a long-term relative economic decline.

Capital investment in the British economy is ­relatively low. It is not much more than is needed to make up for wear and tear. Therefore the basis for long-term growth is weak.

If Britain is ever going to return to strong long-term economic growth it must first acknowledge its present weaknesses. Short-term delusions stand in the way of this task. Ultimately the key problem ­facing the British economy is not recession but long term structural weakness.