The re-elected government will face a familiar problem; diverging movements in manufacturing and service sectors

Barring a nearly impossible poll upset, Tony Blair will start on Friday at the pinnacle of his authority as the first two-term British Labour prime minister with a more than adequate majority. He will have greater power over both the government and its policies than he had before or will have afterwards, when disillusion and factional fighting are bound to emerge. It is not entirely an enviable position. For he will ever after be asking himself: could I have used the opportunity better?

As far as the mundane problems of managing the British economy are concerned, the issues are less dramatic but nonetheless difficult. Many of the decisions now rest with the independent Bank of England. But as never before, the government and Bank have to work together, even though neither can veto the other.

There are two main things to be said about the outlook they face. First, the US recession is likely to be more deep-seated and difficult to pull out of than most commentators assume. Here I am doing no more than voicing the sentiments of Alan Greenspan, chairman of the US Federal Reserve. The optimism of US consumers is unlikely to hold in the face of further bad news from Wall Street. Moreover, the linkage between the US and the British economies is greater than most models, which concentrate on trade dependence, assume.

There is a direct linkage via the financial markets and confidence factors. But there is also a linkage via Europe, which is now by far Britain's largest export market. Here too the effects of the US recession will be larger than often assumed and for similar reasons. European growth forecasts will be trimmed further.

Second, however, UK domestic demand is buoyant; and in spite of the sluggishness of manufacturing, there are signs of domestic overheating. I agree with the dissident minority on the Bank's monetary policy committee that both productivity and the rate of unemployment that the economy can sustain have improved. But I disagree with them about the immediate outlook. There is every sign of excess demand, whether one looks at house prices, the optimism of consumer sentiment or soaring retail sales. The main opposing indicator is a slight cooling off in the labour market, visible in some surveys. Even here, it is cooling from a level that would have dictated a wage explosion in years gone by.

Optimists may say that the two influences cancel each other out. Any tendency for excess demand in the UK will be offset by a flagging world economy. Therefore the MPC need not adjust interest rates by more than trivial amounts in either direction.

Unfortunately, this rosy picture is spoilt by a closer look at the British economy. The long-term expansion of UK output is the product of a buoyant service sector that accounts for about five-sevenths of the total and a stagnant manufacturing sector that accounts for the other two-sevenths. There is nothing new here, as the divergence has been highly visible since at least 1994. There has been a worldwide trend in the developed world in favour of services as against manufacturing. But it has gone much further in the UK.

Moreover, exports are still heavily concentrated in the manufacturing sector; and the sluggishness of the latter reflects a growing current balance of payments deficit. Last year the current payments deficit came to 1.7 per cent of gross domestic product and it is likely to exceed 2 per cent this year.

There is no need to rehearse the debate that took place at the end of the 1980s about how far a current payments deficit "matters". Anyone who could say how much of the deficit reflects sustainable overseas investment in the UK, how much volatile and reversible short-term funds and how much domestic overheating would deserve a golden guru award. The foreign exchange market is likely to make its own decision without waiting for refined estimates. There are similar problems of diagnosis facing the US.

Governments and central banks have been waiting for years for the dollar and sterling to turn down and for the euro to turn up. These developments are most likely to happen when they are least expected and least welcome. One can say, however, that it is prima facie unlikely that the UK can sustain as large a payments deficit as the US. It can also be said that the more speculation there is of British membership of the euro, the more vulnerable sterling will become; and if it falls from grace, discussion will no longer be about how much to reduce interest rates but how much to raise them.

The more expansionary-minded members of the MPC can validly point out that inflation did not rise in the way expected when sterling was forced out of the European Monetary System nine years ago. But it is uncertain how far these members will prevail in the face of financial market jitters and the orthodoxy of the rest of the committee.

What is pretty certain is that there is no way in which the government can announce a referendum on the euro without giving some public indication of the rate at which it would like to join. Existing euro-members are adamant that, in contrast to what happened with the EMS, the entry rate would have to be negotiated. But before official negotiations begin there would have to be enough agreement in unofficial talks that the British preference is not too outrageous.

In any case Gordon Brown, the finance minister, will not alter the Bank of England's mandate to encourage it to take risks with domestic stability in order to make it easier to join the euro. Sir Edward George, governor of the Bank of England, has publicly argued against such a change. If sterling were to fall as a result of market forces in a way that made euro entry easier, this would be good luck for the advocates of entry. But the finance minister values his own sound money record too much to take risks with it for the sake of the euro. My own guess is that there will be no referendum in the new parliament.

The government and Bank are still therefore left with the problem of what to do about a divided economy. Many economists will say "tighten fiscal policy", which in present political circumstances means raising taxes by even more than they will any case have to rise to satisfy the demand for supposedly "free" public services. One does not have to be an advocate of fiscal fine-tuning to accept that the projected loosening by 1 per cent of GDP in the government's fiscal stance over the next year has come at precisely the wrong time for economic management.

What is there left to do? Fall down on our bended knees to thank foreign exchange speculators for having put Britain on a floating rate of exchange and thus ruled out old-fashioned sterling crises.