Hamish McRae: Britain will find it very difficult to detach itself from struggling Europe


It is, for our politicians at least, a long weekend for reflection. There is the specific matter of the gains by the UK Independence Party in the elections last Thursday, a sharp enough advance to affect the policies of all parties towards Europe in the months ahead.

[Click on image above to enlarge graphic]

There is also the further downgrading of the economic forecasts for the eurozone by the European Commission, with the bloc now expected to shrink for two years running, the first back-to-back contraction since its inception. Then, there was a paper from the influential Ifo Institute in Munich about the flood of jobseekers and other immigrants into Germany. And there was the shift in policy by the European Central Bank to try to inject some demand into the economy by cutting its key interest rates, with the suggestion that it might even run negative interest rates if these are needed.

So a lot of stuff. From a British perspective a number of things have become clearer. One is that the ECB has shifted its objectives. The parallel is the initiative last year by its president, Mario Draghi, to do "whatever it takes" to save the euro. Insofar as one element of what it took was to cut the borrowing rate for Italy and Spain, that has succeeded. Thus the yield on Italian 10-year bonds on Friday was down to 3.738 per cent, and while Spain is paying quite a bit more, the immediate threat of meltdown has receded.

But the economy has got worse, much worse. The EC forecasts now show the eurozone is expected to decline by 0.4 per cent this year, following a 0.6 per cent decline last. Eight of the 17 eurozone economies are expected to shrink: France, Italy, Spain, the Netherlands, Portugal, Greece, Slovenia and Cyprus. The Cypriot economy is now expected to decline by 8.7 per cent, which is just about as bad as any developed economy performed at the bottom of the last cycle. Even Germany is expected to grow by only 0.4 per cent this year.

To put this in perspective, the most recent figures suggest that the UK grew by 0.2 per cent last year, and further upward revisions are expected. For this year forecasts are mostly in the 0.5-1.3 per cent range. So we will have a year when the UK does grow quite a bit faster than the rest of Europe, though our performance will undoubtedly be disappointing by past standards.

That leads to the question as to what extent the UK economy can detach itself from Europe. That is not meant to be a political statement, simply an observation that it will be in our self-interest to move the focus of our economy away from slow-growing markets to faster-growing ones. The short answer is that for manufacturing at least, it will be very hard to do so.

The main graph tracks the Purchasing Manager Indices for manufacturers in the UK and the eurozone since 2006. At present the UK index is a touch higher than that of the eurozone, but as the economics team at Berenberg Bank observed when it made this its "chart of the week", even in the dark days of the euro crisis last year the UK did not manage to decouple from its major market.

It also observed that the UK economy has been damaged not so much by excessive European regulations, for we compare well with the rest of Europe on market openness and flexibility, but rather by the macroeconomic failures of the last government.

Our public spending soared from 39 per cent of GDP in 1998 to 49 per cent in 2012, whereas the eurozone's spending crept up from 48.5 per cent to 49.5 per cent. UK debt to GDP ratio rose from 47 per cent to 90 per cent, against the eurozone's rise from 73 per cent to 91 per cent. The legacy was squandered, the bank observes.

So why is the UK expected to grow faster than any large country in the eurozone this year? It is because of our strength in services. You can see that in the right-hand graph, which compares UK PMIs for manufacturing and for services. Manufacturing is a whisker below the 50 point which signifies contraction or expansion, but services are 52.9, suggesting reasonable expansion.

The Centre for Business and Economic Research, commenting on this, reckons that service-sector growth will enable the UK to grow by about 1 per cent this year.

What should one make of all this? We will in all probability have a year when the UK economy does relatively well by European standards, but quite poorly when compared with its own historic performance. We will however been seen along with Germany as the place to go if you want growth – and jobs.

The Ifo paper notes that just as capital has flowed from the stricken fringe areas of Europe, so too is labour. Last year a net 410,000 people came to Germany, providing employers with well-qualified and willing-to-integrate staff. But of course the German welfare system has also attracted people who can get from the state far more than they could earn at home. This naturally is causing concern, and the Ifo paper suggests that the system is shifted so that welfare payments are paid by the home country rather than the host one.

A similar situation occurs here in the UK, leading to similar political pressures. The big economic point, however, for both Germany and the UK is that relatively successful economies will inevitably attract immigrants. A big point indeed to ponder.

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