Looking Bad in the UK

As I explained last week, I'm starting to feel cautiously optimistic about the US economy in 2011. I wish I could say the same about the UK.

First, we learned this morning that the recent (and probably ongoing) contraction in the UK's economy was a bit deeper than initially revealed. It appears that the British economy was actually contracting at a 2.5% annual rate at the end of 2010:

GDP Growth
Contracts by 0.6% in Q4 2010

Gross domestic product contracted by 0.6 per cent in the fourth quarter of 2010, revised down from the previously estimated fall of 0.5 per cent. GDP in the fourth quarter of 2010 is now 1.5 per cent higher than the fourth quarter of 2009.

...Output in the service industries was revised down to a fall of 0.7 per cent in the latest quarter from a fall of 0.5 per cent reported in the preliminary estimate. The decline this quarter was driven by a fall in business services of 1.1 per cent, together with a fall of 1.4 per cent in transport, storage and communications services.

Household expenditure fell 0.1 per cent following a rise of 0.1 per cent in the third quarter of 2010.

The fact that a significant reason for the slowdown in economic activity in Britain at the end of last year was the result of a reduction in spending by businesses tells me that companies are deeply worried about the economy in 2011. Based on some conversations that I've had with upper management in a couple of UK companies, as well as plain old common sense, I feel quite certain that this pull-back in spending by businesses is primarily a reaction to the "austerity measures" that the UK's government is implementing. There is a widespread and reasonable concern among businesses that this year's substantial tax increases and cuts in government spending will make a serious dent in the recovery. After all, thanks to the austerity measures, economic forecasts for the UK for 2011 have been revised down in recent months. So naturally, businesses are pulling back on their spending, waiting to see how strong demand for their goods and services really is this year.

And then, as if to kick the British economy while it's down, we learned this week that sentiment on the Monetary Policy Committee ("MPC") of the Bank of England is trending toward higher interest rates, not lower:

More MPC members vote for a rate hike

UK interest rates could rise soon following news that the number of policymakers in favour of a hike increased during the last Bank of England Monetary Policy Committee (MPC) meeting.

Minutes published by the bank show member Spencer Dale joined Andrew Sentance, who has long been voting for a hike, and Martin Weale in pushing for an increase.

While six MPC members voted to keep rates frozen at 0.5 per cent, the three thought it was time to change them, with Mr Sentance preferring a 0.5 per cent hike for the first time, having previously advocated a 0.25 per cent increase.

I must confess that I am truly mystified by this. Yes, inflation in the UK has risen in recent months. But this is almost completely explained by two very temporary factors: the recent spike in commodity prices (led by the price of oil), and the increase in the VAT in Britain, which feeds through to higher prices for nearly all types of consumer goods. Absent these temporary forces, it seems clear (even to the Bank of England's governor Mervyn King) that underlying inflation in the UK is not a problem.

Alas, I take this as evidence that economists and policy-makers in the UK have forgotten as much about how the macroeconomy works as they have in the US. A Dark Age of Macroeconomics has descended upon both sides of the Atlantic.