HC Deb 20 March 1990 vol 169 cc1011-4

First, the economic background. The year 1989 saw continued buoyant growth in world trade despite some slowdown in the main economies, particularly in the United States. However, increased inflation and fears of overheating in continental Europe led to higher short-term interest rates in most major economies during the year. More recently, we have seen a rise in long-term interest rates—particularly in Germany, where uncertainty about the effects of unification has been an additional factor.

This general tightening of monetary policy is likely to mean lower growth in 1990 than last year and, in due course, a fall in inflation. We are likely, therefore, also to see slower growth in world trade in the current year, although the astonishing developments in eastern Europe improve the longer-term prospects.

High interest rates also reflect very strong investment growth over the last two years in all the major industrialised economies. This rise in investment is to be welcomed—and indeed may be intensified by the emerging investment opportunities in eastern Europe—but it also emphasises the need for a healthy level of savings to finance it.

The need for higher saving is greatest in the United States and the United Kingdom, where the shortfall is reflected in current account deficits, whereas in Japan and Germany domestic savings have remained more than sufficient to finance their own investment. In the medium term, the United Kingdom's savings and investment need to come closer into line and we must ensure this occurs through a rise in savings rather than a fall in investment.

During the last year, business confidence in Britain has remained a good deal stronger than many expected. New businesses have outnumbered closures, by around 1,500 every week; a larger figure than we expected and a record never before approached. Employment has continued to rise, and unemployment to fall. Almost 27 million men and women are in work today—a larger number than ever before and 1.5 million more than at the beginning of the 1980s. Business investment has risen by a further 9 per cent. in the last year, making a total rise of 40 per cent. over three years and taking it to its highest level ever, and a great part of this investment has been financed from rising company profits. In the last few years, profitability has recovered to the levels of 20 years ago.

As companies have become profitable, they have been investing in more than just plant and machinery. Their spending on research and development has also risen in real terms by almost 50 per cent. in the five years to 1988. They now spend over £5,000 million a year on research and development, nearly all of which is allowable against tax. Similarly, in the five years up to 1989, the numbers of employees receiving training has increased by over 70 per cent.

These are all favourable developments which reflect well on businesses' preparation for the future, but recently, they have been accompanied by the return of inflationary pressures. That, beyond any doubt, is the most urgent problem before us today. To a degree, it is a problem common to all nations. Since its low point in 1986 and 1987, inflation has risen significantly throughout the Group of Seven—the leading economies of the western world—but our affliction has been sharper. There are a number of reasons for this—some welcome and some not. The record rise in business investment is obviously welcome; but it has been accompanied by a rapid growth in borrowing and in consumer spending. Thus, investment has been rising but the savings to finance it have not. This has led to excessive growth in domestic demand, a revival of inflationary pressures and a current account deficit, a good deal of which itself represents suppressed inflation.

Policy was therefore tightened, and interest rates have now been in double figures for 20 months. This tight monetary policy has been backed by large Budget surpluses throughout the last three years. So monetary and fiscal policy have acted together.

Squeezing out inflation is always difficult, but there is now clear evidence that demand is slowing down. High street sales are now only 2 per cent. up on a year ago. The housing market has cooled off noticeably. New car and vehicle registrations are down, and import growth has been sharply reduced. As demand has fallen back, so has output growth, to just over 2 per cent. in 1989.

No one likes to see the economy slow, but it is inevitable if we are to push inflation downwards. I now expect the economy to grow by only 1 per cent. this year, compared with the above-trend growth of 4.5 per cent. in 1987 and 1988. The size of this slowdown shows the extent of the downward pressure on inflation. But growth should return in 1991 towards its sustainable rate of around 2.75 per cent.

I am confident that the period of low growth will be short-lived—not least because of the permanent improvements in in the underlying economy in the 1980s. For example, investment has grown more than twice as fast as consumption over the last eight years. As this additional capacity comes fully into use, inflationary pressures will lessen and more growth will resume. No one need have any doubt about that.

Last year also saw a record level of foreign direct investment into Britain. Overseas investors see the potential for investment in this country in the 1990s. These investments are particularly welcome as they are in industrial sectors like cars and electronic goods, where a high proportion of the output is traded. For example, Britain already runs a trade surplus in colour television sets, and by the mid-1990s there will be a dramatic improvement in the trade balance on cars.

Increased investment will enable British industry both to meet domestic demand and to respond to export opportunities. Indeed, that is already beginning to happen. The current account deficit for 1989 as a whole was over the £20 billion I forecast at the time of the autumn statement, but the deficit in the last three months was substantially lower than in the previous quarter and, in particular, the manufacturing deficit is now improving. Exports have been growing faster than imports since the early autumn.

The reason for this improvement is twofold. In recent years, rapidly expanding domestic demand sucked in imports to meet a market that fast-growing manufacturing output simply could not satisfy. Moreover, that same demand absorbed British goods that would otherwise have been exported. This pattern is now reversing.

Exports are now growing rapidly, regaining the share of world markets they lost in 1988. Last year, the volume of exports of manufactures grew by 11.5 per cent.—the highest recorded rate for nearly 20 years. So British industry is responding extremely well to export opportunities. The fact that it is doing so clearly shows that the present trade deficit is not caused by poor industrial competitiveness. It is caused by excess demand, and as that is reduced, the current account deficit will fall—initially to £15 billion in 1990 and further thereafter.

But we cannot afford to relax policy, notwithstanding the prospect of lower growth. The buoyancy of past demand means that inflation has been far more stubborn than anyone expected. A significant fall is still some months away, and a number of factors will mean that the position will worsen noticeably before it improves. That will be reflected in the retail price index during the next few months.

The largest single factor is the increase of some £5,000 million in local authority revenue spending next year. This is mainly responsible for the expected growth of more than 30 per cent. in average community charges compared with domestic rates. This will add more than 1 per cent. to the retail price index next month. Similarly, the further rise in mortgage rates last month will also increase the retail price index.

As a result, I now expect that retail price index inflation may still be a little over 7 per cent. by the fourth quarter of this year, compared to the 5.75 per cent. I had previously expected. Beyond that, as the effects of these one-off increases drop out and the lagged effect of monetary tightening builds up, I expect inflation to fall below 5 per cent. during 1991.

To summarise, the economy—both consumption arid investment—has been very resilient in recent years. Adjustment so far has been gradual, but this is not necessarily a good guide to the future. The gradual adjustment may continue, but equally, the downturn may become quite sharp. It is against that uncertaiin background that I must set monetary and fiscal policy, to which I now turn.