Comment: Europe faces its turn for recession
Tuesday 19 January 1993
To the question why the US recession proved worse than expected and the recovery later and more muted, the commonsense reply would be that there were serious structural imbalances in the States, in particular the debt burden, which have to be worked off. The UK economic situation is not an exact carbon copy of the US, but one could make the same reply for Britain.
Japan is at a different stage of the cycle from the Anglo-Saxon economies for it is still slowing but, since it also has a serious debt problem, it too can be expected to stage only a modest recovery once that gets under way.
Ask the same question of Continental Europe. Until a few months ago it would have seemed the wrong question, for by general consent the Continent was going to avoid outright recession altogether.
Late last year it was still being argued that it would escape the most severe effects of recession because it had avoided the excesses that the Anglo-Saxon market-driven economies had experienced in the late 1980s. Debt, both of individuals and of businesses, was proportionately lower so that the borrowing capacity of both was higher. As the financial sector had avoided much of the excesses of property lending, it was better able to provide finance for the expansion.
That, at least, was the conventional wisdom. Not any more. The forecasts, as in the case of the US, UK and Japan, are taking a while to catch up with reality, but the latest predictions are signalling recession this year for Germany, Italy and Spain and 1 per cent or less growth for France, the Netherlands and Belgium.
Every day that passes reveals some further bad news. Yesterday it was that French industrial production fell 4.5 per cent in November, with manufacturing output down 2.1 per cent after an October decline of 1.8 per cent. There will be more bad news on the way.
What has changed? Two things - the level of real interest rates and the growing realisation that Germany's economic problems are far greater than had previously been thought.
Last summer not only were real interest rates across the Channel much lower than they are now, there was a general expectation of an early drop in line with falling German rates.
Now real interest rates are really very high by any standards and extraordinarily high for this stage of the economic cycle. Warburg calculates real French short- term rates at 9.5 per cent.
Even Italy, freed from the exchange rate mechanism, has real short-term rates of around 8 per cent, and while German real rates have come back from about 6.5 per cent they are still above of 5 per cent.
In contrast, real short-term rates in Britain are around 4.5 per cent - and below 4 per cent if you take underlying inflation as the measure rather than the more flattering RPI, which has been distorted by the fall in mortgage rates. Real US interest rates are 0.5 per cent, though in practice once you get down to these levels the actual amount charged to most borrowers fails to fall much.
Interest rates are an uncertain weapon, but an extremely powerful one. They have been likened to pulling a brick with a piece of elastic - nothing happens for a while, then suddenly the brick slides and may well pinch your fingers when it does so. We also know that interest rates frequently have an asymetrical effect.
They work more immediately in restricting demand when they are put up than they do in boosting demand when they are brought down. Couple with it the absence of expectation of an early fall in German real rates - money rates will come down, but so will inflation - and the restrictive effect is magnified further.
And Germany? It looks quite plausible that the German budget deficit this year, at 6-7 per cent of GDP, will be even larger than Britain's despite the fact that the German economy will be running closer to capacity than the UK's - though that may have changed by 1994.
At some stage there will have to be measures to curb the deficit, but it is difficult seeing these being put in place until the financial markets force such a policy.
At the moment the markets are happy to finance the debt, as shown in the fall in 10-year bond yields from 9 per cent at the beginning of 1991 to a little over 7 per cent at the moment.
Moreover, as German interest rates fall there is no reason to suspect that they will be more speedy in stimulating the German economy than they have been in boosting the US one. If the US experience is any guide, a gradual fall in German rates that started last autumn and will continue through this year and next will not have much effect until perhaps late 1995. The other EC economies are so closely integrated with the Germans' that Germany will inevitably export its recession to its neighbours.
Given this outlook it is very difficult to see the ERM holding together, for the pressure for a change in policy, particularly in France, will be inevitable. So there will be a further ERM realignment soon. But, in the view of most people in the markets, that is old hat. More interesting is the question: what happens in economic terms after that?
In so far as people have thought about this they have assumed, correctly, that escape from the ERM is a necessary precondition for recovery. Few people have focused on the fact that a necessary precondition may not be a sufficient one. If Germany does not recover, cutting free from the mark will not help that much. Most Continental economies cannot cut free from the German economy, for it is their largest export market.
It is Britain's largest single export market, too, but relatively speaking we are less dependent on it than just about any other EC country. The UK recovery is still extremely fragile. British public finances are in a serious mess, but a year from now in purely relative terms the UK economy could look quite healthy . . . relative, that is, to most of the Continent.
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