Is Britain Really On The Mend?

In his 30 years building homes in Britain, Duncan Davidson has never had to weather a recession as long as the current three-year slump. Now, the chairman of Yorkshire-based Persimmon PLC has seen sales shoot up 30% so far this year. With the British economy seemingly on the mend, Davidson is pinching himself to make sure the good news is real. "This rebound is going to be sustained," he says. "I think."

Davidson's guarded optimism sums up the prevailing mood in Britain these days. With retailers, car dealers, and exporters all seeing sales increases, the economy may finally have turned a corner (table). The upbeat feeling has spread to the City, where stocks are hitting record highs. "Some sort of recovery is under way," says Howard Davies, director-general of the Confederation of British Industry.

SWIFT KICK. Signs of life come not a moment too soon for Prime Minister John Major, whose popularity has taken a big tumble. His moves last fall seem to be the reason for the brighter economic picture. After Britain was booted out of the Exchange Rate Mechanism, he set the country adrift from the rest of the European Community by letting the pound depreciate up to 20% against other currencies. He pushed through an easy-money policy by lowering interest rates and abolished the sales tax on new cars. "It was a high-risk policy, and it worked," says David Kern, chief economist at National Westminster Bank PLC.

British companies are also looking healthier. Productivity is up after a layoff binge in the past two years. Wage settlements are averaging 2.6% across the whole economy--the first time since 1980 that pay increases have been below 3%. The pound's drop makes British exports competitive in the American market, where companies such as Cadbury Schweppes, BAT Industries, and SmithKline Beecham are reporting sales increases. Exports for the three months ending in January are up 11% over the same period a year ago.

ARM UP. On top of it all, the British base interest rate of 6% is the lowest in Europe. With inflation still tame at 3%, conditions are right for rates to drop further. And since nearly all British mortgages are adjustable, the rate cuts can provide an additional boost to the economy. In April, a downward adjustment of 25% of all mortgages will free up $4.5 billion of consumer spending.

Even so, Britain is unlikely to have a rollicking recovery. Growth in bank loans is still flat, and unemployment, now at 10.6%, will continue to rise. That's because companies--in fields from banking to telecommunications to energy--are investing more in new information technology that will replace clerical and other workers. "Until companies stop sacking people, consumers will resist borrowing and instead will pay off old debt," says David Owen, an economist at Kleinwort Benson Securities Ltd. "It's not going to feel like a recovery for many."

With lots of businesses still working off inventories and manufacturing output static, the consensus among economists is that growth will be an anemic 1% this year and 2.5% next year. "We're out of the freezer and into the refrigerator," says Liverpool University economist Patrick Minford.

The comeback also is likely to be erratic because of problems across the channel. Just as Britain appears to be clawing out of its recessionary pit, France and Germany are slowly sinking into one. Continental Europe is Britain's biggest export market. But many think the recession on the Continent shouldn't derail Britain. "It won't stop the recovery," Owen says.

Major still faces some delicate maneuvering. He must come up with a budget that lowers an expected deficit of $70 billion, or 8% of GDP, without snuffing out the fledgling recovery. He may try a Clintonesque combination of spending cuts and value-added tax hikes, plus new excise taxes on gasoline and tobacco. It's possible that the tax hikes will be delayed a year to prevent a relapse. And with the pound's devaluation, the threat of inflation still lurks. But that's another problem for another day.