Hamish McRae: Different strokes for different folks - the only conclusion for the summit

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The Independent Online

So the Group of 20 finance ministers are in England to prepare for the summit of their heads of government next month. Yawn. There is an inevitable presumption that international meetings matter on the grounds it is better to coordinate economic policies, but in this case it would probably be better if the different countries followed different policies. They are, after all, in different situations. All face the global slowdown this year, but their economies have different structures and their underlying fiscal and monetary situations are different, too. So they need different approaches.

As a result, we should not be too fazed by the string of stories about rifts between the G20 nations and about how the summit is likely to be a failure. That the participants are going separate ways is a healthy sign, not the reverse.

On Friday, it was the turn of German Chancellor Angela Merkel to voice opposition to the further stimulus proposed by the US. She argues, as does President Nicolas Sarkozy of France, that they have both taken action to boost their economies and that another fiscal boost would be wrong.

There are at least two main points of disagreement. One is over additional funding for the International Monetary Fund; the other is the overall size of fiscal boost that is appropriate. On the IMF, the board want an additional $250bn (£180bn) of capital to help countries in difficulties over balance of payments to get through the downturn. The new US Treasury Secretary, Tim Geithner, wants double that. Germany is resisting, and while some sort of deal will be done, it will be a compromise that highlights the differences of opinion.

To increase the size of the IMF pot, you need agreement. For the size of the fiscal boost, you don't. Countries can just go ahead and do what they like. The US and UK look like running fiscal deficits of around 10 per cent of GDP this coming financial year and next –, levels that have never been reached before in peacetime. That reflects the weak underlying finances of both countries as a result of policies during the past eight years, with the US cutting taxes too much and the UK increasing spending by too much. By contrast, most eurozone countries go into the downturn in a sounder position. And while deficits will rise above the 3 per cent Maastricht ceiling, most should be contained to about 5 to 7 per cent of GDP. HSBC has some new forecasts that suggest the peak in Germany will be 5.4 per cent, France 7 per cent and Italy 5.8 per cent. Continental Europe is being much more cautious than the US or UK, and seeks to remain so.

Arguably, it should therefore be easier for the big European countries to increase their deficits, as they have more leeway to do so. It seems the reverse is likely to happen. But then, why should Germany and France listen to countries whose policies they despise? The moral high ground that the US has occupied, or at least thought it occupied, has been ceded, while I know European leaders have long been fed up with being lectured by Gordon Brown (I have been told that personally) and I suspect take a modest pleasure in seeing him humbled by the turn of events in Britain.

The difference between the US and UK, on the one hand, and the eurozone countries, on the other, is not just over fiscal policy. Monetary policy is very different, too. If you look at the combination of changes in interest rates and changes in the exchange rate, Europe and Japan have both been running relatively tight policies over the past couple of years, the US (and China) have been relatively neutral, whereas the UK has had a big monetary boost. This is mostly the result of exchange rate shifts, rather than interest rate ones, because everyone has been cutting interest rates. The euro and the yen have been strong, the yuan and the dollar have been in the middle, while sterling has been extremely weak. The pound is now at least 10 per cent undervalued, and the euro overvalued by around the same amount.

Unsurprisingly, this has led to very different trends in industrial output. Only China has managed to increase production over the past year, while Japan and, even worse, Taiwan have both taken a massive blow. The US and UK have done badly, but not as dreadfully as most of the others.

Does it matter that policy is in disarray? It depends on what you think moves the economy. Obviously, confidence matters enormously; and if it were in the power of governments to influence confidence, then a messy G20 meeting would do damage. But we seem to have got beyond that. The markets have no confidence because asset prices have collapsed and wealth has been destroyed. Calculations vary, but the comment by the head of the private equity company Blackstone Group, Stephen Schwarzman, last week seems about right.

"Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half," he said to a conference of the Japan Society in New York. "This is abso-lutely unprecedented in our lifetime."

Well, perhaps not quite, for that was the sort of amount of wealth that was destroyed in the great inflation of the 1970s, though I suppose the timescale then was a little longer. But what is quite clear is that a meeting of global leaders in England is not going to have more than a marginal impact on restoring that wealth. This thing does not correct easily.

One essential thing for restoring confidence will be establishing some sort of base for asset prices. It is the moment when, to take the simplest of examples, the price of UK homes appears to everybody to have fallen too far. At some stage, all these so-called toxic assets will reach a floor value, just as Latin American debt reached a floor value in the 1980s.

The general view seems to be that we are not there yet, but are approaching that point. But beware the inevitable asymmetry. Confidence goes suddenly, but returns gradually. So even when asset prices start to turn upwards, it will be a long time before their recovery will be trusted.

The next few weeks are going to be very messy. An inevitably disappointing G20 summit will be followed by the Budget, which, if it is honest, will be devastating in its implications for both public spending and taxation. The raw economic numbers will continue to deteriorate for some while yet, the only issue being whether the bottom in the economy comes at the back end of this year or some time next. But you know, I think I would be more troubled if all the world's leaders agreed on a set of policies than if they continued to disagree. Better to have somewhat different policies and see which ones work than have them all race off in the wrong direction, as they have in the past.

Even with pay freezes, living standards are going to rise as prices fall

In one regard, firms seem to be coping with this downturn more successfully than in previous cycles – they are being more flexible in cutting labour costs. While unemployment sadly continues to rise – there will be bad numbers this coming week – firms are coping with shorter hours, more flexible work practices and pay freezes, often developed with the help of unions and other worker representatives. Thus Toyota has gone for a pay cut, Jaguar for shorter working and a freeze, and BT and others just for a freeze.

It makes sense, for employers as well as workers, because it leaves them better placed to respond when demand returns. But it is also possible because of one feature not applicable during pervious downturns: falling prices. Last month the annual increase in the retail price index was down to 0.1 per cent and this week should show it going negative, thanks to lower mortgage payments. The consumer price index does not pick up the fall in housing costs because the European statisticians have not agreed how to measure these. But since the RPI is what reflects changes to people's monthly budgets, that does not matter. Result: living standards for people in jobs will probably rise this year even if they do not receive a pay increase. They will get their increase in real wages from lower prices, not higher money wages.

One loser from this change in transaction is the taxman. If you receive an increase in your standard of living from lower prices rather than higher wages, you make a double gain: no more tax on the income side and less tax on the spending. The Government makes a double loss. This happened to Japan in the 1990s when deflation took hold there and will, in part, be behind the alarming increase in the Government's deficit this year.

Before you cheer, though, at the thought of HM Treasury taking the hit, reflect on the fact that sooner or later the taxes will have to be paid, so less revenue now means more later.

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