The most damning assessment yet was published on the prospects for the UK economy by the economics consultancy Capital Economics this morning. Their central projection is for the UK economy to contract modestly next year – and recover only very gradually in 2010. But their report also hints at the possibility of a much more serious economic slowdown than that.

It was told here yesterday how many economic forecasts seem to base their projections on data which itself is often flawed. Maybe that is why there has been a total failure to predict the story that has now unfolded. The application of common sense, however, would have yielded much more pertinent conclusions.

Capital Economics seems to take greater account of the more anecdotal type surveys – that’s the type that ask consumers or manufacturers if things are better or worse than a year ago. They also seem a little more willing to use a dollop of thinking, and as a result their projections are often quite different from the forecasts produced by the likes of the IMF or OECD. On the downside, they have been predicting a major fall in house prices for so long, that it could be argued that it was inevitable they would be right eventually. But on the other hand, they did successfully predict a major slowdown in the US economy a year or so in advance, and their predictions for the UK and Eurozone were fairly close to the mark too.

The UK seems to have three types of problem, goes their rather downbeat assessment. Firstly, the various business surveys also seem to paint a picture of growing gloom. Secondly, the economic slowdown in the Eurozone, and growing likelihood that the US will slow again later this year, is making it harder for the UK to export its way out of trouble.

Thirdly is the area of bank lending, and this is the area which the big concern relates to.

Capital Economics argues that unless banks raise more capital, or sell off more assets, they may have to curtail lending by about 7 per cent. This would be a highly significant development. In fact, bank lending has not contracted since 1965. In the US in the early 1930s bank lending fell by more than 50 per cent; in Japan between the late 1990s and early 2000s, bank lending contracted by 30 per cent. So while a 7 per cent contraction in bank lending in the UK will be serious, it won’t apparently be in the same league as the contraction that helped create the US depression and Japan’s lost decade. However, in Finland, between 1990 and 1996 bank lending contracted by 11 per cent, and the result was a 12 per cent drop in real GDP over that period.

If banks do see their asset base contract by 7 per cent, Capital Economics predicts a 1.5 per cent contraction in GDP, meaning the UK slowdown will be as serious as the recession of the early 1990s.

But at last, here is some good news. It is assuming banks will have some success in repairing their balance sheets – and no doubt this is right. They may struggle to raise all the money they require, but it seems likely they will raise more than they have secured to date.

Based on this less pessimistic, but more realistic, assumption, Capital Economics reckons the UK will contract by 0.2 per cent next year, with this contraction sandwiched between 1.2 per cent growth in 2008 and 1 per cent growth in 2010.

It is the most negative forecast published so far, but, frankly, it is probably the most realistic. It will surely be a surprise if the UK does now manage to avoid an outright recession. It seems, instead, the key will be how bad the recession is.

But at least a recession will lead to lower demand for goods and services, which will curtail inflation – and hopefully will make things more affordable in the longer-term. The recovery will surely depend on how soon the improvements in affordability occur.

© Investment & Business News 2013