Hamish McRae: Here's some good news at last – but we still have a steep road to travel

Economic View
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The Independent Online

Phew! Some decent growth for the UK economy at last.

Bit of a change, eh? And what was all that stuff about a double dip? As you may have noticed, the first official estimate for the UK economy that came out last Friday showed that it was growing at an annual rate of more than 4 per cent. It came as a surprise, just as the estimates of lacklustre growth for earlier periods also came as a surprise. And just as these low initial estimates have subsequently been revised upwards, expect this high one to be revised down. Still, there is decent growth going on out there, which, frankly, is a bit of a relief. We need it because we have a long way to go before we dig ourselves out of all this.

So, while welcoming this growth, some warnings. One is that this second quarter may have benefited from a number of one-off factors. For example, we had a new government that had promised to have an emergency Budget shortly after taking office. Expectations of an increase in taxes in that Budget may well have brought forward some consumer spending. As it turned out, the increase in VAT was delayed until the end of the year, but strong retail sales in June, particularly of household goods, would fit in with the people buying big-ticket items earlier than they otherwise would.

Another, more general, point is that this quarter benefited from the boost to confidence resulting from the change of government and an attack on the deficit, without being held back by the policies that the Government would bring in to carry out that attack.

A third concern is that what we are seeing is the inevitable bounce from what were really depressed levels of output, particularly in manufacturing. As my economics tutor in Dublin told us all those years ago, it is easy to have a great leap forward provided you start from far enough back.

If you accept all this, you would welcome these numbers but you might wonder whether this is as good as it will get. You can see in the main chart both the trend of GDP and company expectations of future demand, as measured by the Chartered Institute of Purchasing & Supply. In June, the latter fell sharply, albeit from a high level, which does suggest that things will slow during the rest of the year. Capital Economics notes that this points to weaker growth in the third quarter and feels that these strong growth numbers do not change the big picture of a fragile recovery. My own concern is that the difficulties will come later, round the back end of this year, or maybe in the first part of 2011, but, if there is one thing we really know, it is that trying to predict the precise path of the recovery is a mug's game. I still think there is likely to be a pause in growth, maybe even a decline in activity for a quarter, between now and the end of 2012. This often happens and we should not allow ourselves to be too fazed about it

That leads to a further point. You may have noticed that there is a violent debate going on between economists and politicians about the speed at which the fiscal deficits should be cut. There is, for example, an argument being made by former Labour ministers that the coalition's plans risk derailing the recovery. I find this debate a bit absurd because it is based on the presumption that the government has a choice. Most people in financial markets agree that, had the previous government won the election, it too would have been forced to bring forward its deficit-cutting plan. Every other European government has brought forward its plans so why should we be different? Given that we have a larger deficit than anyone else bar Greece, we would actually have been very much in the line of fire.

In any case, except in the very short-term and assuming it is done sensibly, cutting the deficit may not have that much impact on overall demand. Germany is interesting here. It has been criticised for tightening policy because, thanks to generally sound fiscal management, it has less need to do so than most other large economies. But, at the moment at least, the German economy is powering ahead. You can catch a feeling for this from the small chart. This shows what has been happening to the economy plotted beside the IFO index of business sentiment – roughly the same index as the Cips one for the UK. The IFO index is at a three-year high and Hans Werner Sinn, the president of the IFO Institute, commented that German companies were in "party mood". The combination of strong export demand from Asia and a relatively strong fiscal position at home does indeed put Germany in a strong position to benefit from the recovery. However, the economics team at UBS, which put together this chart, feel that things won't get any better from now on, and they may be right there.

So what should we look for next? The coming few weeks inevitably see the summer wind-down, but I am worried that the response to these new European bank stress tests may be more negative than the markets expected. This will take a few days to settle down so do not take the immediate market reaction on Monday as a final judgement.

Actually I feel the concern should be not so much about the banks but about European sovereign debt. The weaker eurozone countries may scramble through but there is at least a decent possibility that some government will make a mistake in the coming weeks with its financing programme, and that confidence, so carefully rebuilt, will ebb away. So keep your fingers crossed.

The more general issue is the extent to which Europe, and the UK within Europe, will be able to get a greater share of the global growth through the next bit of the cycle. Germany is doing so, but it is exceptional. (Did you know China is now the third-largest market for Mercedes-Benz cars?) Within the eurozone, the issue will be whether the North-South split widens further, for there is a limited trickle-down effect from German corporate prosperity to living standards around the Mediterranean. Within the UK, the question will be whether the devaluation of the pound, which is being only slightly reversed, will really boost export demand enough to replace relatively soft consumer demand. It would be nice to be able to say that the new GDP figures suggest that rebalancing is happening, but I am afraid they don't.

Still, growth is better than no growth, 4 per cent plus at an annual rate is better than the measly 1 to 2 per cent rate so far. And it is a relief to have a positive surprise for once, even if the mountain ahead is still as steep as ever.

Bank stress tests will lead us back to a world where cash is king

And on those stress tests? Look, if governments have to rescue banks all around the world it is reasonable that they should carry out a "worst case" exercise to make sure that they are not likely to have to do so again. So submitting European bank books to closer examination and publishing the results is a natural and proper consequence of the banking disaster. More importantly, it does no harm, whereas some of the re-regulation of the industry will do damage to the financial system in the years ahead.

As far as the detail of this exercise is concerned, we should, as noted above, stay judgement until things settle down. What has been set out is not a worst-case scenario, more a "pretty-bad case" one, but that is probably good enough. Given the timing of the world economic cycle, we are not likely to have even a pretty-bad banking collapse for another five or 10 years. There will be one-off difficulties, probably associated with a sovereign default, and there will be a long slog by all banks to work off their duff debts, particularly in the property sector. But I can't see another systemic collapse. Been there; done that.

The underlying significance of this exercise, and that of the US and UK authorities, is to push banking back towards its roots. It will be more of a public utility, less of a risk-taker. We will be back to a world where the statement "my bank manager wouldn't like it" will mean something.

So any firm needing risk capital will have to go to the market, or to private equity, or to a sovereign wealth fund, or to another firm, to get much of the finance. Banks won't disappear but they will, correctly, be more risk-averse. That is a much healthier approach to finance, but it means the coming growth cycle will require an innovative response in the capital markets. Even with that, it will be an expansion where cash is king and funds for capital-hungry projects will take more time to assemble and be more expensive.

Will that inhibit the recovery? Probably, yes. But will it make the recovery, when it does get going, more sustainable and secure? Well, maybe yes too – less stressful anyway.

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