Hamish McRae: Let's impose a little order – and divide our problems into past, present and future

Economic View
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The Independent Online

It was another difficult week for anyone trying to understand what is happening to the world economy, and when there is confusion there is dismay – at least as far as the financial markets are concerned.

There was of course the continuing issue of the terms under which a Greek rescue might be assembled, the outcome of which is not yet at all clear. More money is being dangled at Greece from the poor eurozone taxpayers but it is not yet evident whether the terms under which it is being offered will prove too steep for the Greek government to get it through parliament. Even if it can, this only postpones the problem; it does not solve it.

In the US there were mounting worries about the state of the country's finances, a hot topic in Washington as the Administration and Congress clash over spending cuts and tax increases. An increase in the country's debt limit has to be agreed in the next few weeks as the US runs out of its borrowing capacity at the beginning of August, raising the albeit small possibility that the US government may not be able to pay interest on its debts or its other bills. Were this to happen the shock would be far greater than any of the shenanigans in Europe, for US Treasury securities have been perceived as a safe haven for investors seeking to avoid risk.

Then, on Friday, a further stone was thrown into the pool, this time by the International Energy Agency, which unexpectedly released oil from the strategic reserves held around the world by various governments. That temporarily cut the oil price and that will be helpful to the world economy. But the decision paradoxically increased longer-standing fears that the global oil market might be even tighter than the authorities at present concede.

All very confusing – but then it always is in the early stages of a recovery, for there is still a lot of stuff to be dealt with. So it is perhaps helpful to classify such issues into those that are principally legacy problems, the result of past errors; those that are current problems, the result of failures now; and future problems, those that are currently manageable but threaten prosperity in the future.

Greece is mainly a legacy problem in that it results from mistakes made both in the imposition of the euro (always a political project rather than an economic one) and in the lack of financial discipline in Greece. To say that the problems are of the past does not mean they are solved; far from it. Nor does it mean that the present approach – dribbling out money to Greece in exchange for reforms – will work; it won't, or at least not in anything other than the short-term. But at least we know the range of possible outcomes, with at one end of the scale a return to solvency at the cost of a decade of austerity, and at the other a default of Greece and perhaps other eurozone countries, and Greece and perhaps other countries dumping the euro.

The US fiscal issue is more a current problem. Alone among the large developed countries the US has failed to produce a credible plan to reduce its deficit, currently running at close to 10 per cent of GDP. It has been able to finance this at very low interest rates partly because the rest of the world, particularly China, has been prepared to lend it the money and partly because the Federal Reserve has been printing the money. The largest holder of US Treasury debt is the Fed itself. Among foreign holders the largest is China, followed by Japan, and then, a long way behind, the UK.

Were there the political will to do so, the US could cut the deficit. Eventually it will have to. You can have a debate as to whether cutting the deficit would reduce growth or increase it. The conventional view is that cutting the deficit reduces growth but there is a growing body of opinion that the damage to confidence from seeing a government following unsustainable policies is greater than the arithmetical effect of higher deficits. But the actual disagreement is not about cutting the deficit as such. It is about how to do so, with the Republicans wanting the emphasis on spending cuts and the Democrats on tax increases. That is what has blocked progress. The good news in all this is that there is a real time limit, the first week in August. The bad news is that were the US in some way to default, the consequences for the world financial system could be very serious indeed.

And oil? Well, I find this the most interesting issue of all: not so much the narrow point about the release of some oil stocks, but rather the way in which energy markets have tightened so early in the economic cycle and the threat to growth in the years ahead. Quite suddenly the world is energy constrained, and that is with demand in the West still well below the previous peak. True, Libya has pretty much stopped producing, and, true, Opec members were unable to agree an increase in quotas to offset that loss. But oil remains the largest single source of primary energy for the world and if it is expensive now, think what might happen as growth gets moving again and demand perks up. This is a problem for the future that we have hardly begun to resolve.

The story is told in the graphs, taken from BP's "Energy Outlook 2030", published earlier this year. On the left you can see how fossil fuels are to remain the principal source of energy for another generation at least. Gas will increase relative to oil and coal will go up somewhat. But the other sources, though growing, remain small. Renewable energy, the little green bit at the top, grows very fast but is still tiny relative to fossil fuels.

On the right-hand side you see where the demand is coming from: the yellow bit, the emerging world, rather than the green bit, the developed world. We still have not got our heads round this, but, if you think about it, this global expansion is different from any previous one in that it is one where the emerging world is the great driving force, not the rest of us. There is enough oil and other fuels now, but what of the future?

Don't expect any fireworks in the data this week, just a little less fog

The coming week should give us a little more information of the progress of the UK economy, if we can hear the signals over the background noise from the international turmoil.

Among the more important ones are the Nationwide house-price numbers, which will probably confirm that year-on-year prices are still down a tiny bit – 1 per cent or so – but that there is no further deterioration in the market. On Tuesday comes the so-called final estimate for first-quarter GDP, giving a clearer breakdown of the different sectors. This will not be the final word on the economy because these figures will be revised over the next three or so years. Still, the detail may help explain why employment and hours worked seem to be rising much faster than output: a big puzzle still to be resolved. We also get first-quarter current-account figures, which fit in with the GDP ones and help explain whether demand being created here is leaking away into buying more imports, or vice versa.

On Wednesday there will be money-supply numbers, which sound a bit nerdy but are interesting because money supply has been flat year-on-year, leading to suggestions that the Bank of England's efforts to pump up the economy have failed. Actually, the country seems to be finding ways of growing while holding less cash, a common-sense response to lousy rates of interest.

And on Friday, we get the manufacturing purchasing managers' index for June, which will help number-crunchers work out what has been happening to growth during the second quarter. Expect them to conclude that the economy is still growing, but slowly.

So no fireworks in any of the data – just a little less fog. I think when we look back on this period in three or four years' time we will be surprised to see that there was a little more growth than appears now. But not much.

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