Hugo Radice: There's no clear path through economic fog of uncertainty

The Government can still hope for continued recovery, while its critics – now to be led by the redoubtable Ed Balls – can still provide reasons to be fearful. The small fall in GDP now reported for the final quarter of 2010 can be taken as a sign of trouble ahead, or dismissed as the temporary consequence of severe weather. But in the unlikely event of harmony across the floor of the House, we would still have to grapple with uncertainties in the wider world.

The unexpected rise in the inflation rate to 3.7 per cent per year has led the monetary policy "hawks", mainly in the City of London, to call on the Bank of England to begin raising their base rate from 0.5 per cent towards a more normal level. This is based on the fear that, unless credit is restricted, high inflation will become embedded in the economy. The hawks believe that a rise would reassure the financial markets that the Bank was still serious about regaining its long-term inflation target of 2 per cent.

The recent decision of the Monetary Policy Committee to hold fast to their present rate shows that within the Bank the "doves" remain in charge. They argue that the rise in inflation over recent months is almost entirely down to higher import prices for food, oil and other raw materials. Global prices are unlikely to continue climbing: the Chinese are expected to rein in their headlong growth a bit, while Saudi Arabia and some other producers have been quietly expanding production to keep the oil price stable.

In any case, conditions in British labour markets will surely not support higher wage demands, given the reported rise in unemployment, and the expected impact of public spending cuts. Private-sector job growth has stalled, consumer confidence is low, and the sharp rise in youth unemployment is especially worrying given the coalition's intention to scrap the Educational Maintenance Allowance. The risk of a return to recession is still very much with us. However, the course of a future recovery also depends on developments in the wider world economy. In the 1930s, international trade and investment collapsed, and it was entirely reasonable for Keynes to put forward his new approach to fiscal and monetary policy as if the rest of the world did not matter. But in a world in which investors can move vast sums of money across borders at the touch of a button, we can no longer do this.

In this regard, the past week saw two other important events. The first was Chinese President Hu Jintao's state visit to Washington. China has recently overtaken the US as the largest exporter of manufactured goods. In the last 10 years or so, China's trade surplus with the US has risen enormously, and that surplus has been largely recycled to the US in the form of purchases of financial assets. This has in turn allowed the US to run large fiscal and trade deficits, and especially to continue to buy Chinese goods.

As the US begins to look towards the 2012 elections, Obama's opponents on both left and right argue that he has allowed his country to become dangerously dependent on a strategic rival, and that China must be forced to raise its exchange rate, open up its markets fully to imported goods, and "rebalance" its economy towards domestic growth. Such arguments find ready support, not least among blue-collar American workers who have borne the brunt of the sharp rise in unemployment since 2007. However, US corporations, including the banks, have a very different strategic agenda on China. They want to expand their sales and investments in China, but they are afraid that a confrontation with China's leaders on exchange rates could lead to their exclusion in favour of more compliant partners in Europe, Latin America and newly-dynamic Africa. In the end, it is always Wall Street and the boardrooms of Microsoft, GM, Exxon and the like that have dictated US economic policy.

It is therefore extremely unlikely that the coming year will see a shift towards protectionism in the US, whatever the electoral rhetoric may be. Given the role of the US in international policy coordination, this in turn means that the world economy as a whole will continue to see solid growth, reducing the risk of recession in Britain.

The second event last week was Sir John Vickers' lecture on Saturday, which amounted to an interim report on the work of the Independent Banking Commission which he chairs. He strongly suggested that the Commission would recommend major reforms, especially measures to increase the banks' levels of share capital, and to segregate risky investment banking from routine commercial banking. Predictably, Angela Knight of the British Bankers' Association immediately raised the threat of banks leaving the UK, which would lead to a massive loss of jobs and tax revenues.

This is exactly the same crude blackmail as we have heard from the City in relation to bankers' bonuses. The proper response is close co-ordination with similar reforms being undertaken in the US and the European Union. If Ed Balls really wants to make an impact as shadow Chancellor, such coordination should be very high on his agenda.

Hugo Radice is a Life Fellow in the School of Politics and International Studies, University of Leeds