Hamish McRae: Any deal is good, for now, but catharsis is still needed
Economic Life: You do more to boost growth by cutting bureaucracy than you do by cutting taxes
Friday 28 October 2011
Well, that is that, or at least sort of that. What's next? All experience should teach us to be very wary of first reactions to any new chunk of financial information and we should see the outline European deal in that light. In the short-term there is no doubt that a deal, however flawed, is better than no deal. What has been agreed is pretty much what was foreshadowed in these columns and elsewhere: the way European politics work is that something is cobbled together in the end.
There will, in the days ahead, be a huge focus on detail. As the facts become clearer, we will be able to work out how the burden of the Greek default will really be shared, how the beefed-up EFSF will work, the form that economic surveillance of the weaker eurozone nations will take and so on. However, the way banks' shares shot up yesterday demonstrated that the markets had been fearing an even more negative outcome. You can agree with Sir Mervyn King, who ahead of the deal reckoned it would only buy 18 months or so – a judgement with which I would agree. Still, there is a breathing space and during this time attention will switch to the real economy both in Europe and elsewhere.
The first question is whether the eurozone will move back into recession. The general view now seems to be that this is more or less inevitable. The most recent surveys of business opinion for Germany, France and Italy have all been pretty negative, as you can see from the first graph. That does not mean that there will be a recession but it suggests that in Italy and perhaps in France, that would be the most likely outcome. This would be consistent with the lacklustre European share markets of recent weeks, insofar as the markets have any consistency at all.
That leads to a second question: is this agreement likely to depress activity in Europe by forcing the weaker countries, in particular Italy and Spain, to correct budget deficits more quickly? The conventional view is that it will to some extent but we cannot know for sure. There will be some mechanical reduction in demand if governments cut back their spending or increase taxes but there should also be some boost from increased confidence, as was evident in European shares yesterday. My instinct is that the fiscal consolidation is more or less neutral in its effects, while the real problem is lack of structural reform. In other words, you do more to boost growth by cutting bureaucracy than you do by cutting taxes. But we will just have to wait and see.
As far as the UK is concerned any deal in Europe is better than no deal, and so the Prime Minister and Chancellor were right to welcome it. But opinion is divided as to whether the UK is nevertheless likely to experience another recession. The Bank of England evidently thinks it is on the cards but this is not the mainstream prediction of the consensus of economists, leading to the question of whether the Bank is simply being alarmist or whether it knows something the rest of us don't.
If you prefer to see the glass as half-full rather than half-empty, look at the second graph. It has been prepared by Simon Ward of Henderson Global Investors and shows a recession indicator derived from a series of indicators including short-term interest rates, the exchange rate, money supply, inflation and so on. It has nudged up, as you can see, but is still far from recession territory. By making some assumptions about, for example, inflation falling next year, you can project the indicator forward, as Mr Ward has done – and it shows a sharp decline.
This does not prove anything; it merely underlines the possibility that the UK will escape recession next year. There is a small caveat, in that recession here is defined as GDP falling over a year, whereas the conventional definition is two consecutive quarters of negative growth. Still, the outlook for the UK is considerably better than for the eurozone, where on Mr Ward's view there is a danger of prolonged recession. There is a savage monetary contraction taking place on Europe's periphery.
And that surely is what will determine the success or otherwise of this latest euro package. Can a rising tide float off even the heaviest-laden of ships? If there is to be a modest Europe-wide economic recovery then that will contain the internal pressures for a while, as even the slowest-growing countries will be able to make a bit of headway. If, on the other hand there were to be prolonged recession, no financial engineering would conceal the internal tensions. The "normal" procedure for a country bailout is for the currency to be devalued as part of the deal but, of course, that is not happening to Greece. The big test will be whether investors will willingly lend, not to Greece because no one in their right mind would do so, but rather to Spain and Italy. Both countries can borrow short-term, say for up to two years, because few people think they will go down the slot on that time-frame. But can an investment manager in charge of someone else's pension justify the risk of lending to Italy for 10 years? Not easy. Indeed, telling the banks they have been fools to lend to Greece and that they must suffer as a result must surely make them even less inclined to lend to Italy or Spain.
The G20 economic summit in Cannes next month will give some sort of endorsement to this deal and that's good. There may be some cash from the Chinese and maybe others and that would be good too. In the short-term order is better than chaos. But in the long-term Europe needs catharsis and this deal by no means brings that.
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