Hamish McRae: Now the eurozone is starting to think the unthinkable, how long has it got?
Sunday 27 November 2011
It was a bad week for all European economies as evidence mounted that the tensions within the eurozone are increasingly damaging business confidence across the time zone.
Fears that the difficulties of southern Europe were spreading to France and even Germany were reflected in the rise in the interest rates on French debt and the shortfall in bids at a German bond auction. When the German government has to pay a higher interest rate than the British one – and that would seem to be the case to judge by bond yields last week – things have come to a pretty pass.
The response of the European authorities has made matters worse, in that each incremental step in resolving the difficulties has been not quite enough to contain them. This continued last week. Whatever view you take of Angela Merkel's call for a fiscal union with tight central discipline on the budgets of eurozone countries, this will not happen quickly. Meanwhile, the previous plan to enlarge the European Financial Stability Facility by allowing it to borrow more under its own name looks increasingly shaky, as potential lenders are uneager to stump up. The truth is that a bond issued by the EFSF is not considered risk-free.
You can see the way in which the perceived credit risks for various European countries compare with the risk for emerging ones on the main graph. These numbers are derived from credit default swap spreads: the amount it costs to insure a country's debt against default gives you a snapshot of the perceived probability of default.
They were done before this latest bout of jitters but as you can see, the probability that Portugal will default was ranked higher than that of Venezuela, Pakistan or Ukraine. The chance of Ireland or Italy defaulting was higher than that of Egypt, or at least it was ahead of the recent riots. And the chance of Spain defaulting was seen as higher than that of India.
You may think these calculations are unreasonable. I would prefer to put my money in Ireland than in Egypt. But this is the world in which we live, and would-be borrowers have to convince would-be lenders that they will get their money back. Italy was struggling on Friday to raise money for six months: it had to pay 6.5 per cent, almost double the rate of a month ago. Earlier last week, Spain was paying more than 5 per cent for just three months money. So the question for all borrowers, not just the dodgy ones, is how to build credibility with lenders.
The answer from Germany would be to impose more austerity. I can see that from a German perspective countries such as Portugal, Spain and Italy should not have got themselves into the position they are now in. I can see that in the medium term there is no alternative to their not only getting back to a balanced budget but to start to pay back debt. But yet more austerity, even if it were possible to sustain it politically, may not work. The adjustment is too big and there is too much austerity already.
The small graph shows this. Germany has managed, admirably so, to recover the ground lost by the recession. Industrial output is back to its previous peak. France and Italy have recovered a bit. But poor Spain has not recovered at all. So would more austerity be likely to increase or decrease industrial production?
Yet more austerity is what Spain, under its new government, is going to get. It will get it via the fiscal and other reforms the government will have to put in place and it already is getting it by the higher rates the government and other potential borrowers have to pay for funds. Not good.
So what happens next? I think in the coming weeks the debate will start to shift from what should happen to what will happen. It is pretty clear that there will be another recession in the eurozone. Most of the forward-looking data points in that direction. But another leg to recession would not of itself lead to radical change in policy, such as an acceptance that the euro is a flawed model and has to be rethought.
It is just possible that the euro will be dead by Easter, but more likely will be months, even years, more of wrangling over policy, coupled with back-door financing of the weaker countries by the European Central Bank. So the euro will be preserved for a while yet. How long? Well I was intrigued by a news item on Friday. It was a statement from the Italian cabinet, chaired by the new Prime Minister Mario Monti, who reported on a meeting he had had with his counterparts in France and Germany: "Sarkozy and Merkel," it said, "expressed their full confidence in Prime Minister Monti and his cabinet, reiterating their total support for Italy and saying that they are aware that if Italy fails it will inevitably mark the end of the euro, leading to a stalemate in European integration with unpredictable consequences."
So you see how far the argument has moved. Three months ago the idea of a country leaving the euro was unthinkable. Then, last month, the threat of pushing Greece out was used to stop the country having a referendum on the new austerity plans, a threat that resulted in the resignation of the then prime minister. Now the end of the euro is recognised as a real possibility, with the justification being that were it to fail European integration might reach a stalemate.
So now the unthinkable is seen as a real possibility, the next stage will be contingency planning for such an outcome, however disagreeable this might be to those doing the planning. We are not there yet. But one of the rules of great economic events is that things take longer to happen than you expect, but when they do start to shift they do so quicker than anticipated.
One last thought. Some of us are old enough to have learned our economics during the Bretton Woods fixed-exchange regime. What was the final event that ended the more than a quarter century of the fixed-rate era in 1972, six months after the Smithsonian Agreement had promised to shore it up? It was the inability of the lira to stay within its specified boundaries. If it was Italy that delivered the final blow to Bretton Woods... .
Pack up your troubles in your old handbag and shop, shop, shop!
When the going gets tough, the tough get ... shopping? Or so it seemed from the reports on Friday of New Yorkers flooding to the shops to celebrate so-called Black Friday, the greatest retail shopping day of the year.
It was a great reminder that despite all that has been thrown at US consumers, they will be given half a chance to indulge in some retail therapy. Consumption in the US accounts for close to 70 per cent of GDP, so, in the short term at least, higher personal spending boosts final demand more powerfully and directly than anything else.
Those shots of cheerful shoppers made me ponder whether something similar might get the British economy through what is going to be an awkward few months. Consumption is only slightly lower as a percentage of GDP and while Britons, like their American cousins, face both a squeeze on real income and the need to rebuild savings, retail sales have been reasonably resilient in recent months. We are also avid online shoppers. As for our retailers, they seem to be coping with the higher VAT this year, having absorbed much of it, and only passing on 1 percentage point or so in higher prices. The picture is uneven, as the voids on our high streets sadly remind us, retail sales figures may be too optimistic, and we don't know what is round the corner. But consumption has not collapsed.
A consumer spree got us into trouble. We supported spending at an unsustainable level by borrowing, particularly against our homes. This rebalancing of the economy that pious ministers urge us to do means in part shifting from consumption to investment. So there will not be another period of excess such as we saw in the run up to the 2009 bust. But as inflation starts to come down next year there will be scope for a modest rise in real consumption. Meanwhile, we should do our patriotic duty... and go shop.
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