Hamish McRae: The pause in the world economy's growth is just that

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The Independent Online

"A soft patch" - that seems to be the new expression being used in the financial markets to describe both the weakness in the financial markets and the mounting evidence of the slackening of growth in the world economy. What we cannot tell is whether this is merely a few months' pause in the middle of continuing global growth or an early sign that the growth phase that started in 2001 is drawing to a close.

"A soft patch" - that seems to be the new expression being used in the financial markets to describe both the weakness in the financial markets and the mounting evidence of the slackening of growth in the world economy. What we cannot tell is whether this is merely a few months' pause in the middle of continuing global growth or an early sign that the growth phase that started in 2001 is drawing to a close.

The evidence has come in a cluster in the past few days. Here in the UK we have had falling retail sales for a couple of months. In the US just yesterday there was a sharp decline in durable goods orders for March. Yesterday too there was a fall in business confidence in France, and this follows news earlier this week of a fall in the Ifo index in Germany to a 19-month low. (On the top graph you can see the trend of the Ifo index plus that of the equivalent index for Belgium, which has always been a good lead indicator for eurozone activity in general.)

The European slowdown looks particularly serious. The six influential German institutes have this week cut their forecast for the country's growth from 1.5 per cent to just 0.7 per cent. The economy may already be technically in recession and the risks for that forecast are on the downside. Nor is there much hope in the prospect for 2006: the forecast of the institutes is only 1.5 per cent, which would not be fast enough to make a dent on the unemployment rate of 12 per cent.

The bottom chart shows some growth figures for last year together with estimates for 2005 and 2006: these come from HSBC but they are not so different from the other forecasters. For example HSBC is a touch more optimistic about Germany this year than the German institutes, expecting 0.9 per cent growth, but a touch less so for 2006, forecasting only 1 per cent.

The big message that emerges, though, is that there will be some slowdown: even China is expected to come down from the 9 per cent gallop to a brisk canter of 7 per cent.

To put this in perspective there was bound to be some slowing this year. We have just had global growth at 4.6 per cent, the highest for a decade. You have only to look at the oil price to see the pressure that this has put on resources. It had to slow or things would have gone "pop". This does, however, raise two troubling questions. The first is what will happen to the present underperformers, in particular Germany and Japan? The second: will a combination of higher energy prices and higher interest rates enable the world economy to manage a soft-ish landing?

Germany and Japan? I think we probably have to acknowledge there will not be much growth in either country for the foreseeable future. That is not because neither country is incapable of growth nor because either lack commercial competence. Germany became the world's largest exporter last year, passing the much larger US. Its companies, thanks in part to vigorous outsourcing to the lower-wage economies of Eastern Europe, have held down costs and gained global market share. Japan's best companies - most obviously Toyota, but many others too - will continue to dominate their fields.

But it is possible to have good companies, run by clever people, and have a stagnant economy. The problem, insofar as anyone understands it, is more political and social than purely economic. The core of the problem in both countries is lack of domestic demand.

To anyone in Britain it might seem strange there should be shortage of demand. There could be a shortage of money to buy things, perhaps because of too-high interest rates as in the early Nineties. There could be a shortage of supply, as there is in homes, resulting in soaring property prices. But if people in the UK or even more so, the US, have money they will go and spend it, even if it is on interest payments on a mortgage.

Not so in Germany or Japan. There was a famous occasion a few years back when Japan, in a desperate effort to get their citizens to loosen up, gave back some taxation revenues in condition that the money was spent. It was spent all right; the trouble was that the cautious families saved another portion of their income so that there was no net increase in overall spending.

At any rate, Japanese and German domestic consumption has not risen significantly for several years. Resources are stashed away for a rainy day and the longer the period of stagnation extends, the greater the pressure to be cautious and set aside yet more for the potentially yet tougher years ahead.

I don't think there is a lot the German or the Japanese authorities can do about this. In theory the structural changes Germany has made to its labour market should eventually result in higher employment but in the short-term the reverse has happened. The dispute between Chancellor Schröder and business leaders bodes ill. But even if there were more substantial reforms, it would take several years to change attitudes to spending and crank up demand. Demographic trends in Germany and Japan reinforce this political and social paralysis. So expect nothing much to happen. The growth story is and will remain elsewhere.

The second question is whether the rest of the world - the growing chunk - can manage the transition to slower growth without tipping into recession. Pressure comes at the moment from oil and interest rates. The first is a market response and cannot really be controlled by the policy-makers; the second to some extent can but within limits set by the markets.

Most of what can sensibly be said about the oil market has already been said. The best working assumption is that oil will remain quite expensive for ever, the issue being whether or not there will be a sudden spike to more than $100 a barrel. The world can live with expensive oil and there are many environmental reasons why we should welcome it. Adapting the world economy, as we know from the Seventies and early Eighties, takes time, and growth is damaged.

The most interesting issue is to what extend interest rate policy can be fine-tuned to maintain more-or-less even growth in the global economy. The world's main monetary authorities are leaning against the burst of growth last year. The Fed will increase rates further, though if the weak data continues to accumulate, it will move very cautiously as it does so. If there is further weak data here there may be no further increases in UK rates. The European Central Bank is stuck: it cannot put up rates because of the stagnation in demand in Germany, but cannot cut them because of inflationary pressures on the fringe of the eurozone.

The bottom line is that there will be huge pressure on the monetary authorities to get their interest rate decisions right. The softer the patch the more they will hold off any increases. But it is a very uncomfortable situation to be dependent on the vagaries of the oil market and the interest rate decisions of a few central bankers. My guess is that this pause is just that: a pause rather than a signal that the growth phase is near its end. But it makes an intriguing background to our political decision next week, does it not?

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