Hold-up for the insurers' rally - Don't write off inflation just yet.

Anthony Hilton
The Evening Standard , 21st November 2008

Andrew Smithers is one of those who warned repeatedly from about 2000 onward that Alan Greenspan's policies as chairman of the US Federal Reserve would end in tears, and that the financial world needed to wake up to what was happening around it, if it was not going to come badly unstuck. Inevitably, not enough people listened.

Perhaps we should listen now. In a just-published paper, Smithers turns his mind to what sort of economy we will revert to once the immediate chaos of the credit crunch has subsided and things return to normal. Unfortunately, the normal he describes is not the normal most people in the UK would recognise.

His key point is that the long-term growth rate of the British economy may be much less than has been assumed for the past decade or so. Most Treasury, Bank of England and Government estimates assume the UK can grow at about 2.7% without inflation and overheating. Until recent times, it has indeed seemed to oscillate around that figure - sometimes a bit more, sometimes a little less but never far off.

Smithers warns us, however, that the financial bubble of the past 10 years may have played a great part in getting the rate up to 2.7%. He suggests that, in the absence of a hyperactive financial sector, the rate could be very much lower. Indeed, having looked at the productive capacity of the economy, education levels and all the other supply-side issues, he believes the maximum growth rate in future could be as low as 1.7%.

The consequences are painful. A British economy that is no longer supercharged by excessive financial activity will have to rebalance from consumption to saving, from home markets to exports. Unemployment is rising, and is likely to stay high. The City has paid a lot of tax in the past, but will probably pay much less in future. Without its contribution, revenues may fall, meaning that restoring Government finances will require increased taxes and spending cuts from 2010 onward.

You may have had enough by now, but Smithers has one more pebble to drop in the pond. Though pundits everywhere are warning of the risk of deflation, he is unconvinced. The volatility in world business affairs extends also to inflation, he thinks. Don't believe it is dead. It might well return to bite us with a vengeance.


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