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A Special Relationship

How Britain's economic future is tied to ours.

12:00 AM, May 3, 2005 • By IRWIN M. STELZER
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Anyone who doubts the role the U.S. economy plays in the domestic affairs of other nations should consider Britain's general election campaign. As they head towards the May 5 polling date, all three parties--Labour, Conservatives, and Liberal Democrats--are promising to spend, spend, and spend some more. The money for this governmental binge is to be provided, it seems, by an economy that the chancellor predicts will grow at an annual rate of 3.5 percent, pushing more and more taxpayers into the top rate, and making other tax increases tolerable. Chancellor Gordon Brown has been right before, and might well be right again, but this time only if the American economic locomotive remains on track.

In addition to the overall lift provided by America's appetite for the world's products, Britain depends on America to absorb about 18 percent of the United Kingdom's exports (including 24 percent of its exports of services), and to provide an average of about 23 percent of the foreign direct investment flowing into Britain. More important, if Wall Street is alive with what John Maynard Keynes called "spontaneous optimism," London's City is likely to be a happy place where bonuses abound and high-earners write large checks to the Treasury.

Should American consumers decide to take a long holiday from the malls, British Treasury officials will be scrambling to revise their projections of growth and Treasury receipts downward, which will leave the chancellor, no matter of which party, with the unhappy prospect of reining in spending or increasing borrowing. All of which explains why Britain's free-spending politicians might be just a trifle anxious as they review the latest data from America.

Consumers have stayed away from the shops in recent weeks, causing inventories, which began to rise in January and February, to pile up still more all along the factory-to-store pipeline. A decline in orders for cars, computers, and aircraft last month resulted in a drop of 2.8 percent in durable goods orders, the largest single-month fall in more than two years. And manufacturing output dipped a bit. Chalk it up to high petrol prices and steroid withdrawal.

Until recently, the muscular performance of the economy has been due in part to the stimulating combination of loose monetary and looser fiscal policy. Short-term real (inflation-adjusted) interest rates have been around zero, and long-term rates have been held down by the glut of world savings. At the same time, large budget deficits, partly in the form of tax refunds paid directly to consumers, have pumped money into the economy.

Now come the withdrawal symptoms, reflected in the fourth quarter growth rate of 3.1 percent, the slowest in two years. The Federal Reserve Board's monetary policy committee has been raising interest rates, and plans to go on doing so until it finds that "neutral" interest rate that allows the economy to grow at an annual rate of about 3.5 percent, but no faster. Just where that "neutral" rate is, no one knows, but the guess was that something around 4 percent would produce the Goldilocks economy--not so hot as to overheat, not so cool as to freeze the economy into a no-growth mold.

That meant the Fed would continue to increase the federal funds rate from its present level of 2.75 percent until steady-state growth of 3.5 percent was reached. But things might--and it is only "might"--have changed. Economist John Makin says "clear signs have emerged of a sharp slowdown in real economic activity worldwide. . . It is beginning to appear as though the current rate of 2.75 percent is at or above neutral." In short, the Fed has, at the very least, cut off one source of steroids.

Congressional budget negotiators last week cut off the other source. They reached an agreement that includes $40 billion of mandatory savings, not a lot in the scheme of things, but enough to move fiscal policy from stimulative to neutral.

So we have a shift of monetary and fiscal policy from go-go to neutral, a slowdown in retail sales, a rise in inventories, a drop in sales of cars and other durables, lower factory output, and continued high oil prices. Throw in a political atmosphere that is nastier than any since the Vietnam war, and it is no wonder that small investors are so skittish that share prices fluctuate with every bit of news, and big investors are so nervous that it is becoming more difficult for investment banks to finance their private equity and other deals.

Nor is it surprising that businessmen, uncertain about the future and made risk-averse by active regulators and increasingly vocal shareholders, are choosing to sit on large piles of cash, their animal spirits dampened, at least temporarily.