Hamish McRae: A few tweaks may ease euro muddle
Sunday 24 June 2012
The upcoming European leaders' summit this week will be the 19th since the Greek collapse and there will doubtless be many more before there is much idea of how Europe will resolve its tensions. This one will go on and on, and the UK and, indeed, the rest of the world will just have to live with uncertainty. Come to the implications of that for the UK in a moment; meanwhile it might be helpful to clarify the three elements of the crisis that the eurozone faces.
First, there is the banking problem. Most eurozone banks are undercapitalised and some are in effect bankrupt. Spain's banks are in the most acute position, with the most recent estimate being that they might need €62bn (£40bn) in additional capital. But common sense says that is not nearly enough, partly because no one can trust the banks' figures and partly because they have bought huge amounts of Spanish government bonds.
If Spain needs a sovereign bailout, which seems pretty certain, those bonds will not be worth their face value: the banks will be forced to take a "haircut". So the losses will be even larger. This is not a problem that can be dealt with at one summit. All this talk of a European banking union is a smokescreen, focusing on a long-term objective instead of an immediate crisis.
Next, there are the sovereign bailouts for Spain and Italy. You can see the divergence of bond yields for Spain and Germany in the right-hand graph. Between 2005 and 2008 the yields were almost exactly the same. Spain was ranked as safe an investment as Germany. That now seems absurd and the banks that bought Spanish debt deserve to be kicked around the block. The banks that encouraged gullible investors to buy the stuff deserve to be kicked around the block several times.
Third, and much less discussed, there is the divergence of economic performance within Europe. One measure of that has been the growing current-account imbalances within the single currency area. Go back 20 years and these imbalances were minimal. Largely as a result of the strains following unification, Germany was actually in deficit for much of the 1990s. Spain was in balance. Now, while there has been some correction in the current-account deficits of Spain and, even more so, Ireland, Germany's surplus is enormous and has failed to fall at all. As a result Germany has huge claims on the rest of the eurozone; it has, so to speak, been forced to lend the other countries the money to live beyond their means. These balances now exceed €600bn.
So what gives? The answer is nothing yet. Europe will muddle on in all probability for some years. I said that to some banking experts last week and one replied: "Yes, but won't the markets bring things to a head more quickly?" Well, that may be right. But I get the feeling, listening to the leaders of Germany, France, Italy and Spain, who held a mini-summit in Rome on Friday, that they will struggle on a while yet. The result will be a eurozone recession this year, and I have put in the main graph some forecasts from HSBC for key elements of that.
So what can we do? Well, there is the view which seems to be being adopted as policy by the opposition that our Government should borrow more, with the idea that more government borrowing would increase demand. Actually, we may well end up doing that if tax receipts come in below estimates this year. But anyone arguing that we should deliberately increase government borrowing as a policy has to confront some disagreeable possibilities.
Some of those were cited in the latest assessment of the world economy by HSBC, called – and it is a quote from John Maynard Keynes in 1930 – "A colossal muddle". They are that an increase in public borrowing might decrease private-sector demand for two reasons.
"First, it might push government bond rates up, which if it fed through to private-sector interest rates, could encourage rather than prevent deleveraging … Second, if rising government debt makes households and corporates worry about their future tax burden or future interest rates they may increase their savings today, offsetting any rise in government spend."
HSBC concludes the scope for a fiscal boost is very limited. Certainly if you look at the long-term effects of the huge deficits run up by the Japanese over the past two decades, it is hard to argue that much larger deficits can have a strong positive effect on growth. The case for more public borrowing does look pretty thin.
Maybe, however, governments are tightening policy in the wrong ways. The main burden, here in the UK as well as in Europe, has been imposed by increasing indirect taxation and cutting public investment. HSBC argues that these are two of the worst ways of correcting a deficit in the sense that they have the greatest negative impact on demand. The authors think that tax policy should be directed to increasing employment: one of the few tax cuts that do really pay for themselves. And they think that company taxation does not have much of an impact on output, though here I suspect that there may be a difference between the short-term and the longer term.
Where does this leave us? We cannot do much about our current trading relationship with Europe. The proportion of our exports to the eurozone has been falling steadily over the years, not as a result of any policy, but simply because it is a slow-growing market. Anecdotally, our exporters are putting resources into building new markets but rebalancing from Europe will take years.
Nor can we do much about the big numbers of fiscal policy for the reasons noted above. But we could look at the detail of policy to see whether we could remove roadblocks. One seems to be in access to capital for medium-sized businesses and we will have to see whether the new initiative is effective. There may be a case for the idea being pushed by the Chambers of Commerce for a business bank. And within taxation policy, there may be things we could do to encourage hiring by the private sector. No magic wand; just a few tweaks.
Fed up with the eurozone crisis? Look out for this week's new data
If you would like some relief from the EU summit angst, there will be two quite different bits of economic news that you might instead look at.
One is the UK public accounts for May, which will show tax revenue this financial year. In April, it did not look too good, but it was a funny month, partly due to the weather, but also because the financial year's first month often has distortions. If, come May, tax revenues – particularly national insurance contributions and VAT – are weak, that would be a real worry. If they are strong, the reverse.
The reason is that, officially, the economy shrank in the first quarter and that will be confirmed by the so-called "final" revise of GDP – the true final revises not coming through for up to five years. But that fall is implausible because in the three months to the end of April the private sector added nearly a record number of jobs, retail sales have been OK, and the purchasing manager surveys are reasonably positive. So we need the hard numbers for tax receipts to give a better feeling for what is really happening.
The other extremely interesting thing will be oil prices. Brent is now back down to $90 a barrel, an 18-month low, and that feeds across the economy from the fuel pumps to other industrial costs. Opec has committed its members not to cut production and the market seems to be settling at this lower level. If it does, expect further declines in inflation. It is not impossible that CPI could be below 2 per cent by the end of the year, which would mean the great squeeze on family budgets would be over and we would start to see a modest increase in our standard of living – at last.
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