IT HAS LONG been an article of faith among the Tories that Labour’s economic successes were an illusion. Ever since 1997, the Tories have been waiting for the long overdue recession, for the inevitable “day of reckoning” that would follow Britain’s debt- financed consumer boom.

For more than a decade, I have been ridiculing this Jehovah’s Witness economics. As soon as British economic policy was freed from the straitjacket of the European exchange-rate mechanism in 1992, I became an optimist — and for most of the subsequent 13 years, this contrarian optimism proved absolutely right. Towards the end of last year, however, I started having doubts. What with interest rates rising, the property market stalling, oil prices soaring and public finances veering out of control, the economy seemed to be heading for trouble.

These misgivings turned out to be amply justified, as evidenced by the downgrading of Gordon Brown’s growth forecasts and the crumbling of his reputation for fiscal prudence. But could there be much worse to come?

To judge from the bullish behaviour of financial markets and the swaggering confidence of Labour politicians, the answer is no: the economic disappointments are nearly over and next year should see an acceleration of growth, an improvement in public finances and a restoration of the halo over Gordon Brown. But such optimism seems hard to justify. In saying this, I do not suggest that the benign forces that have powered the British economic miracle are now exhausted.

Competition, flexible labour, immigration, proactive monetary policy and the global demand for knowledge-intensive services will all help Britain to prosper in the long term. But in the year or two ahead there could be serious economic setbacks.

The British economy today is struggling against four powerful headwinds: an oil shock, a downturn in the global business cycle, a decline of consumer confidence linked to high interest rates and weak housing, and a loss of control by the Treasury over Britain’s public finance. And these headwind forces are likely to intensify, rather than weaken, in the year ahead.

Take oil. Everybody understands that a $60 oil price is a serious impediment to growth. But what seems to be forgotten, even by Treasury and Bank of England officials, is that the worst is yet to come. A further weakening of high-street spending is almost inevitable in 2006 because consumers take a year or more to respond fully to a loss of purchasing power.

The same is true of the cooling of global economic activity this year, caused not only by oil but also by the tightening of monetary policy in America and China. The increase in US interest rates, which started about a year ago, will not exert its maximum effect on the global economy until late 2006. It is therefore wishful thinking to forecast growth in British exports next year or to hope that stronger business investment will compensate for flagging retail sales.

In fact consumption will be more than ever the driving force of the British economy in the year ahead. This means that the only way to revive economic growth and employment will be by deliberately stimulating consumer demand, either through tax cuts or lower interest rates. And this is where we come to the real cause for concern about Britain’s economic future. Until recently it would have been reasonable to assume that economic policymakers would manage the cyclical downturn, responding with a timely and well-judged stimulus to demand. But the framework of flexible, proactive macroeconomic management that has served Britain so well since the ERM exit in 1992 seems suddenly to be falling apart.

Consider taxes. The 2006 Budget would be an ideal time for some tax cuts, in terms of macroeconomic management. But in reality, a tax increase is much more likely, since deficits have widened alarmingly and Mr Brown wants public spending to continue growing much faster than the economy as a whole.

Monetary policy is also in limbo. Lower interest rates are, in principle, the best way to stimulate consumption and accelerate economic growth. And sometime next year the Bank of England probably will cut rates quite sharply, perhaps all the way back to their 2003 low of 3.5 per cent. But the Bank is proving surprisingly slow and reluctant in cutting interest rates and this hesitancy can partly be blamed on Mr Brown’s mistakes.

One was his foolish decision to change the official inflation target to a new euro-harmonised measure that overstates energy costs and completely excludes house prices. As a result, inflation is now well above its official target and rising fast, making it difficult for the Bank to justify lower rates. Had Mr Brown resisted the temptation to fiddle with the statistics, the official measure of inflation would still be below target and the Bank would find it much easier to cut rates.

The second and much more serious impediment to drastic rate cuts is the confusion created by the Chancellor in public finance. Mr Brown has redefined his “fiscal rules” almost out of existence but, because he refuses to admit that the old rules are now redundant, he cannot put a new, and more sensible, fiscal framework in their place. The apparent breakdown in fiscal discipline has caused understandable confusion at the Bank of England.

Worst of all, Mr Brown remains doggedly attached to his long-term plans for public spending, especially on health. These always seemed over-ambitious and now look completely impossible to finance. To return Britain to sustained prosperity and to restore order to the Government’s finances will require more than just some token cuts in public spending. At some point, economic pressures will require a profound rethinking of the role of government, the scope of public services and the future of the welfare state.

If Mr Brown refuses to consider these issues today as Chancellor, he will have to face the challenge when he is Prime Minister, just before the election. And the Tories could yet end up taking the decisions for him.

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