Page last updated at 01:30 GMT, Thursday, 22 January 2009

How quickly could the UK recover?

Analysis
By Steve Schifferes
Economics reporter, BBC News

GDP forecast

The UK economy is entering a sharp downturn, with most economic signals pointing down.

A junior minister was widely criticised for suggesting that there may be "green shoots of recovery".

But how is it possible to tell when the economy has reached bottom, and what are likely to be the first areas where that would be evident?

Four leading economists told the BBC's Robert Peston what signs they will be looking for to signal that the worst is over.

Given the difficulty in forecasting the future, one approach is to look at "leading indicators" - the bits of the economic picture that change ahead of a recovery.

Although not perfect, they often help to forecast how the economy might change six to nine months in the future.

It can be instructive to see how investors and businessmen view the situation.

That is because as key economic actors, their beliefs are often quickly translated into action, in terms of orders or purchases.

For example, the CBI industrial trends survey often forecasts changes to the economy six months ahead.

Wall Street traders
Share markets still remain downbeat at the moment

The surveys ask business leaders how they expect business conditions to be in the future, and there is a reasonable correlation between their expectations and their actions, for example in placing new orders, or hiring or firing employees.

And traders on the stock market generally look ahead to the next six months of profits and sales by companies in deciding whether to buy stock.

However, at the moment most of these leading indexes are trending sharply lower, suggesting that economic conditions are still weakening.

The OECD's composite index of UK leading indicators has dropped by 6.7 points over the past year to 95.7 (with 100 being the long-term average), suggesting, they say, "a strong slowdown," although not as big a drop as in Germany or the US.

Unemployment and housing

In contrast, two of the key elements in the slowdown that concern many people the most are unlikely to improve quickly.

Job search computer
Unemployment has been rising sharply since the autmn

It is quite likely that unemployment will continue to rise even after other indicators have stabilised.

This is because firms delay making workers redundant for as long as they can, until they are sure of the size of the slowdown. But they are also usually reluctant to rehire until they are sure of the recovery, given the costs they incur both by laying off people and rehiring them.

And don't look to another housing boom to help boost consumer spending power.

For Sale sign
There will be even fewer mortgages lent in the coming months, lenders say

The available evidence suggests the housing market remains sluggish long after property boom collapses, as it did in the 1990s.

Once people expect house prices to fall, this discourages further sales, because of the hope that waiting will lead to lower prices in the future.

This time, the contraction in the availability of mortgages is also a big factor, leading the Council of Mortgage Lenders to predict house sales will halve to 700,000 in 2009, compared with 1.6m just two years ago.

And one commonly-used measure, the ratio of house prices to average earnings, is still above its historic average, despite recent falls in property prices.

Credit market conditions

Given that the current economic downturn started because of severe disturbances in credit markets, another key area to look at is the performance of such markets.

Halifax branch
The banking sector has not fully recovered

At the height of the crisis, the interest rate banks charged each other to borrow (the Libor rate) shot up, reflecting concerns that they were holding "toxic" assets that they might default on.

At the same time, the interest rate on government debt fell sharply, as investors rushed to buy up the safest possible assets.

By these measures, the severity of the crisis, which peaked in the autumn, has eased. But they are quite volatile - and it is much too early to say that conditions have returned to normal.

Key sectors

Another way to look for signs of recovery is to examine which sectors of industry might recover first, and which will be hardest hit.

Closing down sale sign
Some retailers are doing better than others

Given the imbalances of the UK economy, the government is looking to the export sector to lead the recovery.

The UK does have some strong international companies, especially in such areas as pharmaceuticals and aerospace.

And the devaluation of the pound, which has fallen by an average of 25%, has made British goods more competitive in overseas markets.

But at the moment, the global nature of the slowdown has meant that demand is declining across all major markets, despite the advantage of a cheap pound.

So even highly productive Japanese car plants in the UK, such as Nissan and Honda, are cutting back on production.

Meanwhile, the domestic sectors that are most closely related to the housing market, including house builders, home furnishings companies and durable goods manufacturers, are suffering worst.

Meanwhile, food retailers and "value" clothing chains, such as Primark, are doing better.

A shift in this pattern would be another sign of a recovery in economic activity.

Lessons from history

There are many uncertainties in forecasting the future path of the economy, particularly in how long the downturn will last.

During the current crisis, the government has been over-optimistic about both the depth of the downturn and the speed of recovery, and even now many independent economic forecasters are sceptical of the government's forecast for recovery in the second half of 2009.

One way of answering the question is to look at the lessons of history.

Two US economists, Carmen Reinhart of the University of Maryland and Kenneth Rogoff, the former IMF chief economist, have looked at the aftermath of 18 major financial crises around the world.

They suggest that big "financial crises are protracted affairs" with severe effects on asset prices, the real economy, and government finances.

They say that on average after such crises, housing prices declined by 35% over six years, while stock market prices dropped by 55% over a three-year period.

Unemployment rose by 7% over four years, while overall economic output was down 9% over two years.

And government budget deficits soared by 85% as the downturn cut tax revenue.

Of course, the past is not necessarily a guide to the future and governments, both in the UK and elsewhere, are taking major actions to counteract the effects of the downturn.

But this history suggests we should be cautious in expecting many "green shoots of recovery" in the near future.

Budget deficit



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