Darling's Double Dip Disaster

The UK has released the latest GDP numbers: on 40% of the data, the statistics show that the British economy finally returned to growth... of 0.1%. The consensus forecast was for 0.4%, so there is no doubt that these growth numbers are disappointing, and there is still the scope for them to be revised downwards. Meanwhile next months numbers are likely to be worse, given the slowdown in retail spending that the increase in VAT is likely to bring about.

So it may be that the British economy has not even come out of recession, and even if it has, it may go back into negative territory at the next data point.

This comes despite the fact that the British government is continuing to run a double digit deficit; A deficit that is not sustainable and which must be reduced sharply. The fact is that those who are seeking to put a positive gloss on the situation of the British economy are missing the point: the country has still not escaped from its fool's paradise where property is always a one way bet and that it is legitimate to borrow as much as possible at today's "low rates" in order to get on the property escalator for the future.

However, the rapid increase in inflation is not just a function of base effects: the whole structure of the British economy is now paying the price for the devaluation of Sterling over the past two years. The Bank of England is signalling that it will not increase rates even if the inflation numbers over the next two quarters are worse than expected. The Bank is trying to avoid the blame for tipping the economy back into recession by raising rates too soon.

Yet all that is happening is that the low rate environment is keeping the UK housing market at an unsustainable peak. The imbalances of the British economy can not be corrected while House Prices are 20% above any sustainable level. As CQS observes in their latest briefing: the outlook is for considerable turbulence in the UK economy.

The risk that the Bank of England runs be keeping rates low is that the erosion of Sterling that high inflation causes becomes a collapse in confidence in the currency.

As I have noted before, the choice is stark: either keep rates low and risk a Sterling collapse or increase them and trigger a house price fall, with a risk of further problems in the banking sector. For the time being, the market believes that the Bank of England will have to raise rates quite soon. If they are disappointed then there is a real risk that the Pound becomes permanently dislocated from its previous trading range and drops to parity with the Euro, or even below.

There is a certain amount of patience still in the market, because the expectation is that a new government will take effective action against the deficit, but the UK is running out of road. If, despite the massive deficit spending, the double dip actually happens, then the policy choices are all very unpleasant indeed. The government after the next election may find that it has to make pro-cyclical cuts in government expenditure even though the economy has returned to recession. Under those circumstances the longest recession since 1945 which we have supposedly just emerged from will look like a phony recession: the impact of Great Recession II will involve the painful restructuring that the Brown government tried to avoid and it will be all the worse for having been delayed. The imbalances in Housing may finally be addressed, but the consequences for millions of mortgage payers will not be pretty.

So, it is not a wonder that there are growing mutterings about the outlook for the British economy over the next few years: and those mutterings could become a roar quite soon. The day of reckoning will come very soon unless there is real leadership at the Treasury and the Bank of England.