Hamish McRae: Brakes are on for growth as Britain loses momentum and the eurozone stalls

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The Independent Online

The "will the economy tank?" concerns have clicked up a few degrees this week, for there has been a flood of disquieting data both in the UK and in Europe. This is not hugely unexpected - at least not to anyone with any sensitivity for the way the UK and European economies have been moving, as these columns have reflected. It would be more surprising if the numbers were coming in above the official expectations. But it is worrying, none the less, even to those of us who were already quite worried.

The "will the economy tank?" concerns have clicked up a few degrees this week, for there has been a flood of disquieting data both in the UK and in Europe. This is not hugely unexpected - at least not to anyone with any sensitivity for the way the UK and European economies have been moving, as these columns have reflected. It would be more surprising if the numbers were coming in above the official expectations. But it is worrying, none the less, even to those of us who were already quite worried.

Start with the figures, the UK first. We have just got the revised first-quarter GDP figures, unsurprisingly revised down a touch. Growth was 0.5 per cent in the three months and you don't need an A-level in maths to see that this is 2 per cent at an annual rate. It would have to pick up very smartly to reach the Treasury's range of 3-3.5 per cent this year. Indeed, that forecast now looks even more implausible than it did when it was made, for it implies growth for the remaining quarters running at close to 1 per cent a quarter.

More disturbing than the figure itself is its composition. The domestic economy has virtually stopped, with growth in demand of only 0.1 per cent. At a retail level, growth was just 0.2 per cent and household spending as a whole rose 0.3 per cent. Investment did not rise at all. Were it not for the fall in imports (an even larger fall than in exports), which pushed what demand there was toward home producers, and the 0.7 per cent rise in government spending, the economy would be barely growing at all. You can see this sharp slowdown in demand quarter by quarter in the bar charts.

So what happens next? It is not realistic to expect public spending to prop up the economy for much longer and the lower overall growth is likely to make a tight fiscal situation even tighter. Tax revenues have actually been quite strong in the early part of this year and so too has earnings growth. But VAT tracks spending so if that comes down, expect a fall-off there. If private sector employment falters then income tax and national insurance contributions falter too - public sector employment doesn't help because the money ultimately goes in and out of the same pot.

Nor is it realistic to expect exports to help a lot, given the sober outlook for the UK's main export markets. More of that in a moment.

So the British question is whether consumer spending will recover and that really is a huge puzzle. It could well do so: people say they are confident and earnings are rising solidly. There is a possibility, if the slowdown is confirmed, of a cut in interest rates, maybe as early as August. On the other hand, the effect on monthly household budgets of the rises in interest rates last year has yet to come fully through. The reason is the high proportion of people with mortgages that were either capped or fixed. These people are now having to remortgage at higher rates. There is a lagged effect of changes in Bank of England rates that may not have been fully appreciated.

In the past, stagnation in the housing market has led to subdued consumers. There is a nice "fit", spotted by the economics team at BNP Paribas, between the surveyors' chart on the balance between rising and falling house sales and the trend in consumption (see right hand graph). No relationship holds forever but if that one is any guide you could see consumption going negative for a while, as it did in the early 1990s. Expect people to get pretty ratty if that happens.

This UK situation is tetchy and difficult but not yet disastrous. The corresponding outlook on the Continent, I'm afraid, looks more alarming by the day. This week the OECD has come out with its new half-yearly forecasts. The UK is cut to 2.4 per cent, which sounds realistic, and the OECD made the equally realistic point that if the Chancellor was to cut the budget deficit he would have either to increase taxes or cut his spending plans. No surprise there. The surprise was the call for the European Central Bank to cut interest rates by half a percentage point.

It expects the eurozone to grow by only 1.2 per cent this year, down from 1.9 per cent forecast last November, with Germany now also at 1.2 per cent, France at 1.4 per cent and Italy minus 0.6 per cent.

But cutting rates is hard to justify. Not only is inflation still above the ECB's ceiling but cheap money has led to a house price bubble in several countries. The Finnish member of the ECB board and governor of the Bank of Finland, Erkki Liikanen, noted this and said that the weakness of the eurozone economy, given the reforms that many countries were making, was "inexplicable".

Well, Mr Liikanen, you have been reading the wrong newspapers. There has been almost a conspiracy of silence, at least outside the UK, over the poor performance of the eurozone. For four years the official forecasts at the beginning of the year have been for decent growth and every year they are optimistic by anything up to a clear percentage point. What it is not polite to say in European circles is that the eurozone may be fatally flawed. The one-size-fits-all interest rate means that many countries inevitably have the wrong rate.

Nothing can be done about this, short of a break-up of the eurozone, which feels to me to be probably at least a decade away. So the European economies will continue to disappoint. Even if the ECB were to cut interest rates I can't see that being of more than marginal help. If a 2 per cent interest rate does not boost the German and Italian economies, why should a 1.5 per cent one do so? A tiny cut in rates is not going to make the five million German unemployed rush out and buy new BMWs.

I am afraid the risks for Germany, maybe also for Italy, are on the downside. On the heels of the OECD forecast came another bad survey on business confidence from the German Ifo Institute: sentiment has been falling now for four months and was even worse than the consensus expected. That suggests poor growth for the next six months at least.

Hanging over all this are the global imbalances. The key is the relationship between the US and China. US demand is still cantering along (the OECD expects 3.6 per cent this year) but the current account deficit gets ever-wider. But this relies on the rest of the world financing the US and trade protectionism in Congress not reaching such a level where it seriously squeezes Chinese imports. The US - and China - need a gradual adjustment but that is hard to engineer. The OECD chief economist, Jean-Philippe Cotis, referred to these imbalances and said that the OECD was not saying there would be a doomsday situation tomorrow morning - but of course that very statement carries the implicit warning that there might be one in the none-too-distant future.

The best answer from a narrow UK stance to the "will the economy tank?" question is: "not as such, but expect slower growth, particular in consumption but also in public spending". From a US perspective it is: "not yet, but the dangers are considerable in the medium term". And from a eurozone perspective, I'm afraid it is: "Germany and Italy at least are not going to have a fun-filled year."

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