Hamish McRae: If you think British consumers are gloomy, just look at the Continent

Economic View

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It has been another of those weeks, for the run of bad economic news has continued.

That news, however, has been largely related to the policy arena, for the actual data coming through for the major economies has been poor rather than dreadful. So what has been happening is more a crisis of confidence than anything else, confidence in particular about the competence of US and European monetary and fiscal governance.

This is a bit unfair. The problems that the developed world is wrestling with were not, in most cases, created by the people in authority at the moment. They did not create the debt-fuelled boom, encourage the surge in fiscal deficits or design the euro. Coping with the consequences of these errors was always going to take most of a decade. The issue is not whether policy has been optimal, for of course it hasn't, but rather whether it has been and will be good enough. Six months ago the consensus was that policy was adequate, whereas the current consensus seems to be that it isn't. Which is right?

Well, I don't think we should be disappointed that the Group of Seven meeting did not produce any solid policy response, or that there was a lacklustre response to President Obama's jobs plan. It is not realistic to expect policymakers to pull some lever that fixes things. They can pull the lever but there is nothing attached at the other end – or insofar as there is anything attached, the links are weak and the time lags long.

What I think we did learn last week was that were the present slowdown to deteriorate, then the world's major central banks can and will take action to counter the downturn. They did not say so as such, but the feeling from the European Central Bank is that they cannot cure the budget deficits, nor can they solve the structural problems of the weaker economies, but they can, in a short-term crisis, avert catastrophe. They can flood the world with liquidity and that liquidity buys time.

They did this after the collapse of Lehman Brothers and some progress has been made since. If you look around the world, most budget deficits are being corrected. People in the US and here have started to save again. The crash of house prices in most countries has hit bottom and there are signs of a modest uplift in a number of major markets. The banks have started to rebuild their capital, though some have a long way to go.

Two things have come along that have unnerved people. One is that the US recovery has been much slower than thought: the figures for the past performance and hence the expectations for the next year or so have both been radically revised down. The other is that tensions in the eurozone are greater than appreciated, while the policy response has been weaker.

The latest info on the US is not all bad: for every negative statistic, such as industrial expectations which are down, there is a positive one, such as mortgage applications, which are up.

I have been looking at some comments from a number of investment banks, together with last week's forecasts from the OECD, and they seem to point to a slowing of growth rather than outright recession.

In the main chart you can see some forecasts from the economics team at ING Bank for growth in the three main regions of the developed world – the US, the eurozone and Japan. The US recession was almost as bad as the eurozone one, though the recovery seems to have been a little faster. But now, while US growth is projected to dip below 2 per cent year-on-year, eurozone growth is projected to dip almost to zero. Of course zero for the region as a whole means a negative number for some countries within it.

Europe really has become mesmerised by the problems of sovereign default, problems that have been made vastly more serious by a lack of candour by the various national authorities. This is not just about Greece, Portugal and Ireland. The worrying new development has been the deteriorating mood of the bond markets towards Spanish and Italian debt.

Both countries are in the process of approving or implementing new austerity programmes, driven by real fear among the political leadership that the countries will simply not be able to fund themselves. Banks in both countries may be coming under pressure to maintain their deposit base. It is hard to know precisely what is happening but in some cases people seem to have started to take their money away. This is not yet another Lehman Brothers, or indeed a Northern Rock, situation. But it could become one.

And the UK? Our Chancellor presents the UK as an island of calm amid a sea of troubles, and in the narrow sense that our government stock is at historically low interest rates that is correct. Somehow we have managed to retain this safe-haven status despite having a government that is still borrowing one pound for every five it spends, raising only four pounds in tax. But if investors in gilts show confidence in the UK, British consumers remain relentlessly glum.

The smaller graph shows consumer confidence on the right-hand scale with changes in consumer spending on the left-hand scale. As you can see, we are not yet in the profoundly gloomy territory of 2009 but the mood is pretty dire. Intriguingly the mood of consumers seems to be worse than their behaviour and I have not seen any good explanation why this should be.

What we do know is that people are busily paying off debt and they are being helped by the very low mortgage rates. Fixed-rate mortgages are at historically low levels for the creditworthy. I feel that a turnabout in consumer sentiment will only occur when inflation falls, and that is some months off. In the next couple of months inflation will rise further, with some bad numbers expected this week. The medium-term outlook remains not too bad; the short-term rather worse.

What happens in the UK is a bit of a side show to what will happen in continental Europe. There will be no speedy return to stability there. I fear things will get worse before they get better, for the tensions that have been undermining the bond markets are now undermining the real economy.

The markets are a lead indicator, and they're more pessimistic than economists

One of the ever-interesting and ever-confusing features of economic life is the interaction between financial markets and the real economy. The links are at best tenuous and at worst bizarre. But there does seem to be some vague link between swings in growth in the main developed countries and swings in their stock markets. The markets are a lead indicator of sorts.

The turnabout in share prices in March 2009, for example, preceded the turnabout in the world economy by three months or so, while the recent weakness has signalled the weakness in growth that is now becoming evident.

How weak is weak? Number-crunchers at Goldman Sachs calculate that share prices in the US are consistent with a very mild recession or a prolonged period of sluggish growth, say, 1 per cent a year for a couple of years. That is significantly lower than the consensus forecasts of growth at or above 2 per cent. That is, the markets are quite a lot more gloomy than the economists; not quite sure what we should make of that.

However, I did spot another economist perspective on share markets in Japan, that deserves a wider airing. Andrew Smithers, of Smithers & Co, who has been very cautious about shares on most major markets for a long time, now believes that Japanese shares are undervalued. You may recall that both share and land prices there became absurdly overvalued at the end of the 1980s, and the long stagnation has been associated with the debt hangover, as asset prices collapsed and debts remained. So it has taken 30 years, but now a case can be made that Japanese shares are worth buying again.

That is the good news. Now the bad: Smithers calculates that US shares are still 30 per cent or more overpriced. He also thinks a mild recession is probably desirable as it will reduce the danger of a more serious one later on. So there.