Positive thinking
The world economy should continue to grow this year
Economists are typically a pretty gloomy bunch. Paraphrasing Winston Churchill, you could say that they have much to be gloomy about. The coming year is no exception. There are serious geo-political risks that could upset the world economy. There usually are. But I propose to put these aside on the impressively scientific grounds that (a) they may not materialise; (b) even if they do, their economic impact may be minor; and (c) they are extraordinarily difficult to assess.
So I am going to concentrate on the pure economics. I reckon that the world economy is returning to full health. This is perhaps most clearly evident in the United States. Even so, critics are saying that the US upswing is already very old and accordingly that a downturn may be imminent. Yet US expansions do not normally die of old age. Rather, they are killed off by the Federal Reserve.
I reckon that the Trump tax cuts will amount to a fiscal relaxation of about 0.8pc of GDP, when the economy is already growing at a decent pace. True, the boost to aggregate demand will not be as high as 0.8pc as a considerable proportion of the increase in disposable incomes will be saved rather than spent, and some of the increased spending will leak into imports. Nevertheless, the result will be US growth this year of about 2.5pc, some 0.3pc faster than last year.
In the eurozone, we are also likely to see continued growth as even the weaker economies are dragged along by stronger activity in the core, helping to bring unemployment down and to lift consumer real incomes.
Admittedly, China will probably slow to an underlying (but not reported) growth of about 4.5pc but Japan should continue to do pretty well, with a growth of just over 1pc. The consensus is still expecting UK growth to be slower this year than last but I think people are in for a shock. The strong global backdrop will give UK exporters a major boost as all our main markets, including in the eurozone, expand significantly. On top of that, the competitive pound should ensure that the UK more than holds its own in these markets. I expect goods exports to grow by between 10pc and 15pc.
Meanwhile, inflation should fall back from its current level of just over 3pc to somewhere near the 2pc target by the end of the year. And I expect average earnings growth to start to pick up and to exceed inflation by the second half of the year, thereby allowing real earnings to rise once again. The combination of consumers recovering from the squeeze on earnings and strong net export growth should deliver GDP growth this year of about 2-2.5pc. If I am right, then government borrowing should come in a good deal below the OBR forecast.
As the world enjoys a co-ordinated expansion, I expect there to be signs of rising inflation – albeit not in the UK, as the post depreciation spike in inflation subsides. This may prompt the Federal Reserve to increase US interest rates faster than either it or the markets currently expect. After a decade or so of extremely low interest rates and easy money, they are becoming increasingly aware that distortions will have been building up in both the financial system and the real economy. In other words, they are likely to become more “Austrian”, that is to say, following the school of thinking led by Friedrich von Hayek.
The Austrian school argued that public policy intervention, including well-intentioned monetary laxity, can cause serious distortions, often in corners of the financial system that you are not necessarily keenly aware of. This is a real danger now.
With equity markets having enjoyed a wonderful run, many commentators are anxious about the possibility of a crash. I suspect their fears are somewhat overdone, particularly in the UK where valuations do not look as stretched as they do in the US. But rising interest rates may cause problems in other markets, notably bonds where yields are at levels that, in normal economic circumstances, would be ludicrously too low.
And then there is property, which is particularly sensitive to movements in interest rates and bond yields. In this country, as interest rates rise, the housing market is going to be challenged – to put it politely.
It is quite possible that the move to higher interest rates will spark the next economic downturn. Since 1960, every US recession has been preceded by a significant rise in real interest rates. At the moment, of course, the markets expect only a modest increase, taking real rates from their current negative level to just about zero. That is what I would call a comfortable, if not complacent, view about the future.
This may well be a reasonable central assumption. But you must take account of the risks and, in my view, the predominant risk for rates is upwards. If real rates are again pushed into significant positive territory this may cause the real economy to weaken markedly and the stock market to wilt. If that were to happen in the US, we must presume that the consequences would be felt over here.
Fortunately, though, I think such a prospect lies beyond this year. Probably. Fingers crossed, 2018 may prove to be another year of favourable surprises.