The UK must spend, lend and change to drive upturn in the economy

Economists are not always good at predicting turning points in an economy. But if there is one group that finds it even trickier, it is business people.

One consequence is that when economies start to turn around, it can often take people by surprise, as the economists weren't predicting it and business was not expecting it.

Judging by the still pessimistic tone at the beginning of this year, it would seem few are expecting things to go well in 2013. Yet I just wonder whether this may be the year the economy surprises on the upside.

But if it is then the UK needs three things to spend, lend and change. The economy is suffering from a lack of demand. There needs to be more spending by the Government on both infrastructure and construction and people and firms with the ability to spend need to be given the confidence to do so. There has to be more lending by the banks. And the supply side of the economy needs a helping hand and thus there has to be change which is all part of repositioning the UK in the changing global economy.

The ratings downgrade by Moody's reflects concern about the growth outlook. That is understandable but we should not panic. The UK has gone from the highest to a still high rating and its borrowing rates will stay low.

There have been three parts of the economic and political debate that have caused much discussion. One is why a weak pound has not helped exports so much? A second is why low interest rates and an aggressive monetary policy have not led to higher lending? The third, in contrast, is positive, and that is why employment is so high, if growth is so weak?

Let's take each in turn. It should be no surprise a weak pound is not working. While the UK must be competitive this has to be as much about boosting quality as lowering price. Someone, somewhere, will always do something cheaper, but it doesn't make it better.

In the last five years world trade has been two speed: imports by western economies are virtually flat while imports by emerging economies are rising sharply. Forecasts from the European Commission that the eurozone will be in recession this year suggests another tough year for British exports. Meanwhile, we are now making inroads into fast growing emerging markets, but from low levels. Hence the importance of David Cameron's visit to India last week, which followed Boris Johnson's successful trip there in December. These, and other such visits, will provide opportunities, such as new markets to sell into, new sources of potential inward investment and new partnerships.

A weak pound is also importing too much inflation, especially as food and energy prices are rising steadily, being driven by strong demand from the likes of China. All of which is hitting disposable incomes, as higher imported food and energy prices dent consumer spending at home. Yet the pound looks set to weaken further following the downgrade.

If a weak pound policy isn't working, neither is the aim to get more lending into the economy. Lending has been weak across western economies in recent years but change is now being seen. In particular, lending in the US is starting to rise, which helps explain why last week the US Federal Reserve talked about ending its quantitative easing. In contrast last week it became clear that pressure is building at the Bank of England to boost quantitative easing, a clear sign that the transmission mechanism of monetary policy here is not working.

Lending is still down on a few years ago. There are many explanations. Until lending rises the economy won't recover properly. Forcing the banks to recapitalise is one option, or extending the existing Funding for Lending Scheme with the Bank of England lending directly to firms and assuming the credit risk another. I don't think the Bank of England should change its inflation target but given that it keeps missing that target for reasons outside its control, perhaps it should pre-announce the conditions under which it would raise rates. In the process this would make clear to everyone that low rates are here to stay.

Further news last week of a healthy jobs market is welcome. But wages are not rising much and there is much part-time work and under-employment, with people overqualified for many jobs. Trends in the labour market also show that despite talk of a triple-dip recession, a number of different sectors of the economy have rebounded since the end of 2009 areas like business and professional services as well as manufacturing. This is good news. Yet many firms may be hoarding staff, particularly skilled workers, in the hope of stronger growth. Hence the need for demand to pick-up soon, else the good jobs market may not last.

The Chancellor should take credit for having retained the confidence of international investors in recent years when it would have been easy to lose it. But Friday's ratings downgrade shows that this may now be changing.

International markets are moving from rewarding austerity to rewarding economic growth. Debt dynamics mean the best way to reduce the deficit further is stronger economic growth.

Some of the changes already announced for this spring will help, such as cuts in income tax and higher allowances. And while big firms will welcome cuts in corporation tax for small firms it is lower business rates that are needed. I believe that if governments borrow and spend for the right reason markets will reward them. All this justifies increased infrastructure spending now, of the type evident across London, with the public and private sector working together to provide more affordable housing, better transport links and an enabling environment in which jobs are created.

I think you need to get three things right for an economy to be moving in the right direction: the fundamentals, policy and confidence. Of these confidence is vital in order to encourage people and firms with the ability to spend to do so.

In the years ahead of the crisis, there was an age of excess. For the last four years this has become an age of austerity, but until this year it focused too much on tax hikes. What is now needed is an age of enterprise, where taxes are cut, bureaucracy is eased, demand is boosted and firms encouraged to invest.

Dr Gerard Lyons is the chief economic adviser to Boris Johnson, the Mayor of London