Hamish McRae: Recovery of the European economy matters more than its weakest links
Sunday 17 April 2011
The eurozone crisis continues; but the eurozone recovery continues, too.
It is hard to retain a sense of balance in the face of the stream of contradictory statements about the state of the weaker eurozone members. It would be nice to think that the bailouts of Greece and Ireland, and the forthcoming one for Portugal, would have led to a state of relative calm but the opposite seems to have happened.
For example on Friday, within a few hours of Moody's downgrading the Irish government's debt to one notch above junk status, the country's finance minister, Michael Noonan, said that the review of its financial condition carried out by the EU and IMF had been "very complimentary". My own view would be to side with the Irish authorities, which is that Ireland will avoid a default on its debts, but that is not the view of the markets, which give a 40 per cent chance that Ireland will only pay back 50 cents in the euro on its five-year debt. Oh dear.
The markets are even more confident, if that is the right word, that Greece will default. Last week, the gap between what Greece would have to pay for 10-year money over and above what Germany has to pay rose to more than 10 percentage points – with Greek debt trading at 13.5 per cent. That is the nominal yield of existing debt, rather than a rate at which Greece could raise new money, for the simple reason that the country could not afford to pay anything like that rate. So the bond markets are closed to Greece.
The government cannot borrow at all, so it cannot pay for its purchases. I heard last week that it is paying foreign suppliers in bonds rather than cash, so the suppliers have to carry the risk of a default, something they are not thrilled about.
The importance of this is that when people talk about the need for Greece to default or the bond holders to "take a haircut", they should realise that the lenders that would suffer are not only investors who were foolish enough to trust the Greek government three years ago, but companies who are being forced to trust it now.
The Greek government is trying hard to persuade investors that it will not need to default, announcing a ¤76bn austerity plan last Friday. It plans to sell stakes in its state-owned phone company, its power utilities and Athens airport, with the aim of reducing the budget deficit to 1 per cent of GDP by 2015.
"Greece's problems won't be solved by restructuring its debt but by restructuring the country," the Prime Minister George Papandreou said on Friday. "Even if with the wave of a wand the debt disappeared, Greece in a few years would have debts again without these reforms."
That is quite sensible. But the debt burden may simply be too great. The German Deputy Foreign Minister, Werner Hoyer, said that a Greek debt restructuring "would not be a disaster" and at one level he is right – if it stops there. But his saying that increases the chance of it happening and of further contagion.
The eurozone authorities have to create some kind of firewall between Greece, Ireland and Portugal and the other weak members: Spain, Italy and maybe Belgium. For the moment, the market rates suggest that the first three will default in some way, while the others probably won't – though in the past few days Spanish debt has started to slither a bit. Yet, all our experience of such events tells us that once one borrower goes down, pressure switches to the next one: remember what happened to the banks. Moreover, keeping the process orderly is hard: remember what happened after the collapse of Lehman Brothers.
So it is all a rather dismal story that will run for some while yet. My own view remains that some members will eventually leave the eurozone but the timing and circumstances are hard to predict. However, other countries within the zone are prospering and seem set to continue to do so.
That is the positive story about Europe that should surely receive more attention. The main graph shows the eurozone recovery compared with previous cycles, together with a projection from Goldman Sachs about the growth of future output. As you can see, this recession is much worse than previous post-war recessions. But the slope of the recovery – the rate at which Europe is growing – is pretty much on track. Europe has had an abnormal recession but is having a normal recovery.
It is because this is a normal recovery, albeit from a low base, that the European Central Bank felt confident enough to increase rates this month and some economic forecasters, such as Capital Economics, now expect another rise in eurozone rates maybe as soon as July. The reason is that there is a steady upward move in eurozone inflation (right-hand graph), which though not as serious as inflation in the UK, exceeds the 2 per cent ceiling for the eurozone. There were some bad numbers on Friday. Back in 2007, and indeed for several years before that, Britain had a similar or even better performance on inflation than Europe or the US. Now we are radically worse, and if the ECB does increase rates again, soon the pressure on the Bank of England to take action will be all the greater.
The big message for us in Britain – and it is worth saying this again and again – is that what happens to the European economy as a whole is much more important than whether individual eurozone members need further bailouts or restructuring of their debts. It makes a better headline to say that Portugal is going down the pan and a better photo op to see humbled politicians heading for the exit. Protesting that the UK should not be joining in a bailout for Portugal may also be a good line for British politicians but in reality it is irrelevant.
The fact remains that Europe takes a lot of our exports and if the UK is to continue rebalancing away from domestic demand to export demand we need a growing market across the Channel. Fortunately, despite the shock-horror stories about the eurozone in crisis, the European economy as a whole is doing none too badly.
A study of economic research could help cure the world's ills
Want to know why taxis in Athens cheat people from out of town by taking detours? Or why banning ultra-thin models from the catwalk makes eating habits even worse? Or why people who feel cheated are more likely to be cheats themselves?
These are all studies among the cornucopia of research to be presented to the Royal Economic Society's annual conference, which starts at the Royal Holloway campus of London University tomorrow. It is a way of putting the economics profession on display, as papers come from all over the world on subjects – macro and micro – with relevance to much of the world.
Flipping through the work what strikes me is that the economics profession has answers to a host of policy questions and we should look at these studies, as we look at medical research, to find better treatment for our ills.
For example, to take a topical matter, should Greece default? Well, there's a study looking at all the sovereign defaults since 1978, 200 in all, and it concludes that on average investors lose 36 per cent of their capital. But borrowing costs rise. The study concludes: "Common wisdom states that 'debts which are forgiven will be forgotten'. Our study shows these claims do not hold. High haircuts are not forgotten quickly. And a reputation as a 'good debtor' seems to matter."
Or to take a quite different issue, a study in the Netherlands suggests that fewer than half of people have basic financial literacy and that those who do have a higher net worth on average of €80,000 than those who don't. Having an economics education is a strong predictor of financial literacy as an adult – so I am glad you are reading this column.
But, if you think this meeting might be self-congratulatory, try this. Economic forecasters are no better at predicting inflation than those who assume it won't change. Message there for the Bank of England?
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