This week Knowledge Shop looks at the state of the economy, future global economic indicators, and the political consequences of Britain’s first prospective recession in almost a seventeen years.

Can the British economy withstand the tremors emanating from across the Atlantic? Will the Bank of England finally succumb to pressure from the High Street and cut interest rates? Or are we about to see an abrupt end to 61 quarters of economic growth – and Gordon Brown’s favourite sound bite that goes with it?

Northern Rock continues to head south

Just as Alistair Darling was announcing the Government’s Northern Rock rescue plan, Sky News simultaneously broadcasted the plummeting FTSE. Just as the Government was seeking to save Northern Rock’s depositors – the economy appeared to be heading south.

The polemic that ensued was almost reminiscent of the 1980s or mid-1990s, but most certainly not an issue regularly debated under the Labour Government. New Labour has often come under scrutiny for its stance on such issues as immigration or crime, but “economic incompetence”? Having won two elections on the buoyant state of the economy, this is new ground for the Labour Government – and Gordon Brown.

Even at Prime Minister’s Question Time, David Cameron persistently attacked the Government over Northern Rock claiming that Brown was more interested in a “rescue package for his own reputation”. The leader of the Liberal Democrat’s Nick Clegg even accused Brown of refusing to nationalise Northern Rock because he was “running scared of the Conservative party”.

An economic slowdown has long been expected, although it may have arrived sooner than anticipated. With the housing boom on both sides of the Atlantic grinding to a halt and with the seizure in the credit markets – or ‘credit crunch’ – the Bank of England’s pre-credit crunch growth prediction of 3.1% has now been lowered to be between 2% and 2.5%.

The Government has been quick to claim that the problems facing the economy are not from their own making, but rather stem from Wall Street. This may well prove to be the case, but analysts have claimed that the housing market was long showing signs of a slowdown, whilst Northern Rock’s business strategy was described as “reckless” and “taking it to the edge”. Still, several options still exist for the government to help mitigate the economic slowdown.

Sovereign Wealth Funds

Perhaps one of the most controversial actors in international markets, Sovereign Wealth Funds (SWFs) are thought to control assets worth more than $3,000bn. To put in some context, the FT revealed that this is about the same as the amount invested in hedge funds and private equity combined.

Now, in times of crisis, Western firms can now turn to foreign Governments and SWFs rather than suffer the indignity of pleading with central government for a bailout. SWFs have already made inroads in Britain with the China Development Bank buying a 3.1% stake in Barclays for £1.6bn. Singapore’s Temasek has also acquired a stake in Barclays worth £2bn – although it lost a reported £150m when the RBS beat Barclays and acquired ABN Amros.

However, due to their lack of transparency, SWFs have come under scrutiny on both sides of the Atlantic. In the past week New York Senators Chuck Schumer and Hillary Clinton voiced their concerns about SWFs transparency, with the Democratic Presidential frontrunner stating “I am very concerned about this. We’ve got to know more about them, they’ve got to be more transparent.” Despite their initial support, Clinton and Schumer had witnessed the reputations of Citigroup and Merrill Lynch plummet as Citigroup raised over $20bn from investors including the Abu Dhabi Investment Authority and the Government of Singapore Investment Corporation, whilst Merrill Lynch received over $12bn from investors such as Singapore’s Temasek and the Kuwait Investment Authority.

Robert Kimmit, the Deputy Secretary of the Treasury, commented that “Both fund management and investment decisions we have seen have been made on commercial not political grounds. We welcome that kind of investment in the United States. We don’t fear such investment.” However, Kimmit added that “The growth in the size of these funds…means vigilance is required.”

Nevertheless, with doubts comes opportunity. Having witnessed SWFs injecting much needed capital into the markets, Gordon Brown has appealed to SWFs to make London their overseas base. During his trip to China the Prime Minister offered such an opportunity to the China Investment Corporation, which is reported to have $200bn of assets. The Daily Telegraph claimed that Brown believes Britain “can cash in on America’s reluctance to accept the state-sponsored fund.” Similarities can be seen in Initial Public Offerings (IPOs), where London has witnessed the number of IPOs soar, benefiting from Sarbanes-Oxley in the US.

To cut or not to cut?

As the World Economic Forum in Davos commenced, the worlds top 2,500 “schmoozers” immediately had food for thought with the news that the US Federal Reserve had made a drastic 0.75% cut in interest rates. Although the cut had long been called for, commentators have claimed that the Fed now has “nothing left in the locker” in the event of a further downturn. Analyst Jeremy Stretch of Rabobank, went as far to describe the Fed’s move as “a sign of panic”. “Having nothing left in the locker” may be exactly why the Bank of England has been reluctant to cut rates. The Governor of the Bank of England, Mervyn King, is thought to be increasingly concerned with inflation – despite Ed Balls’ reassurances that inflation would remain low.

In the face of rising energy and food prices, inflation is at 2.1%, 0.2% above the BoE’s target. Although a rate cut looks like a shoo-in at the next Monetary Policy Committee on February 7th, the BoE is likely to resist further cuts, in order to keep inflation in check. The BoE’s Inflation Report, due to be made public on February 13th, is likely to confirm that inflation remains a perennial threat to economic stability. However, a 0.25% cut may be enough to appease the high street, which has long called for a reduction in rates after a lacklustre Christmas. Recently the Deputy Governor of the Bank of England, Sir John Gieve, stated that the case for cutting interest rates “had been greatly strengthened by the disruption of global credit markets and in our own banking system, which brings a risk of a deeper downturn.”

However, this is where there’s room for a political conflict. This week the Chancellor claimed that the BoE has “room for manoeuvre on interest rates in order to support a flagging economy”. Yet, Trevor Williams, of Lloyds TSB claimed that the Government should stop intervening and “leave it to the bank to decide.” Mic Mills of TradIndex.com echoed these sentiments, noting that the Government may be tempted to exert some political pressure on the BoE: “It used to be the Government that set interest rates and perhaps they feel they should still be able to put pressure on the BoE.”

Light at the end of the tunnel?

The state of the economy is likely to be a perennial threat to New Labour’s claims of embodying both economic stability and healthy growth. If Brown continues to pass the buck and blame the economic downturn on the events across the Atlantic, the Conservatives may question how he can then claim the credit if or when the economy shows signs of recovery? After all, the resilience of the British economy in the face of turbulent global markets has been a hallmark of Labour’s electoral success. Thus, with a new Prime Minister and Chancellor, the electorate may question what has changed?

As the flow of capital continues to dry up, the City and the Government are likely to court SWF. Ernst & Young’s Item Club has even gone as far to claim that SWFs will “prop up the British economy.” However, this is will not be without political repercussions. Already the European Commission is investigating ways of regulating SWFs, whilst MPs may be slightly less sanguine than the Prime Minister, especially when it comes to transparency and corporate accountability. 

To add to Brown’s problems, as consumers increasingly feel the pinch, calls for an interest rate cut will persist. As a result the Government will look to prevent a direct conflict with the BoE. However, if the Government was seen as intervening, BoE independence – the totemic symbol of Brown’s era as Chancellor – will most certainly be threatened. The real test of the BoE’s independence would most certainly be the ‘r’ word – recession. The Conservatives would again charge that the Prime Minister is, as branded by Lord Turnbull, a ‘Stalinist’ who has “little respect for institutional sovereignty.” Brown, Darling and Labour’s relationship with the City would also suffer, perhaps irretrievably.

Nevertheless, at present, Brown still has a robust record to run on. Never before has a British Prime Minister – or Chancellor for that matter – been able to boast of low inflation, low unemployment and buoyant economic growth. It is to Brown’s credit that Britain’s economy has outperformed the G8 and most of Western Europe for well over a decade.

It cannot be disputed that Prime Minister has inherited an economy far weaker than his predecessor. It’s what he makes of it that will decide his future.