Hamish McRae: The euro could survive Greece leaving, but not Spain and Italy

Economic View
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The Independent Online

The paradox of the eurozone continues.

The financial difficulties of its fringe countries continue; indeed, they are getting worse. But the core of the eurozone, most notably Germany, is doing better and better. Indeed it is not just a two-speed Europe; it is a three-speed one, with Germany and its close neighbours racing along, the fringe stock still, and the rest of the eurozone at a slowish trot.

I had not quite realised this until I saw some work by the economics team at HSBC, from which the graphs are taken. As you can see, during the early 2000s it was the fringe that was racing along, with the German club initially struggling. Then everyone hit the wall in 2009, when world trade collapsed with Germany actually dipping a little deeper than the rest. Now the position of the early 2000s is quite reversed, with Germany and its neighbours actually doing even better than they were in the boom years.

How has this come about? There is a great deal of talk about German manufacturers benefiting from the boom in demand for luxury products from the newly rich in the Middle East and Asia. That is certainly part of it. But it is also the result of the grinding down of German costs through the early 2000s, a period when German consumption was also depressed. Arguably, the country joined the euro at too high a rate and, as a result, had to have several years of cost-cutting to make itself competitive again. It succeeded and is now reaping the rewards.

You can see the impact of that cost-cutting on consumption in Germany compared with consumption in the UK in the right-hand graph. We increased our living standards massively through the late 1990s and right up to 2008. The blue line (Germany) does not dip nearly as far below the zero as the orange one (the UK) has recently done, but it is only since 2008 that British consumers have done worse than German ones.

This experience has obvious lessons for us. We were self-indulgent during the long boom, consuming more as individuals and as a government, borrowing to cover the fact that we were not earning enough (or in the case of the Government, not raising enough tax) to pay for that consumption. Germany, by contrast, was hugely disciplined at both a personal and a public level.

We are now repaying debt, paying you might say for our past errors. Homeowners are paying down their mortgages and clearing credit card debts, while the Government is cutting back its borrowing – though the absolute level of debt is rising and will continue to do so for another four years.

The experience, however, is extremely relevant to the fringe European countries that have been bailed out by the EU and IMF and some not-so-fringe countries, including Spain and Italy.

The aim for all three bailed-out countries, Greece, Ireland and Portugal, was to be able to return to the public markets and raise funds there by 2012, or 2013 at the very latest. But all the actions taken by European political leaders have been designed to undermine the confidence of the would-be investors.

Every time a finance minister says bondholders should share in the costs of a further restructuring, or to use the popular expression "take a haircut", they are saying they approve of existing investors losing some of their capital. That is a really great way of encouraging potential investors to put up new capital. Every time European bureaucrats criticise the rating agencies, they are attacking the very bodies whose support the borrowers need if they are to get back into the market.

It gets worse. Because the bailouts for Greece and Portugal will clearly have to be done again, and Ireland may also need more money, investors are getting nervous about other heavily-borrowed countries, such as Italy and Belgium, and those with serious bank exposure, such as Spain. So the interest rates being charged are going up. It looks as though both Italy and Spain will have their debt downgraded. The gap between the rate of interest that Germany and Italy would have to pay is now the widest since the eurozone began.

The relevance of all this to the fringe countries is obvious. Everyone knows that they will have to "do a Germany" but at a much more intensive level. They will have a long period when consumption is held down, as it was in Germany from 2000-2009, as they both pay down debt and hold down costs to become more competitive.

But there are also questions for the still-solvent mainstream European countries. There is no immediate danger that Italy will default on its debts or abandon the euro. But if you look at the high levels of public indebtedness (120 per cent of GDP), the very low birth rate, and the relatively high cost structure of Italy, it becomes hard to see how it can reform both its finances and its society to remain competitive with Germany.

I think this is what the markets are trying, in their incoherent way, to say. "Yes, things are all right now, but if you want to borrow money for 10 or 20 years, it is our fiduciary duty as potential lenders to determine whether you will be able to repay the debt in full on the date that it matures."

I doubt that Greece, Ireland or Portugal will be able to return to the public markets to raise money for several years unless they get some sort of eurozone guarantee. Meanwhile, they remain dependent not just on the formal bailout support but informal support from the European Central Bank.

However, while the funding problem remains, just for a few fringe countries, it is possible for things to tick along. But if the rates at which other much larger countries have to borrow continue to diverge, then the future of the euro really comes into question. The euro could survive Greece leaving; but it would become something utterly different were Spain and Italy to be forced out.

Rising house prices offer a little hope for US as unemployment continues to rise

The other disturbing story of the week was the very small rise in employment in the US, just 18,000, and the corresponding climb in unemployment to 9.2 per cent.

In some ways the pattern is similar to that here in the UK, with the private sector hiring and the public sector firing, but the balance is much worse. Whereas our private sector has been creating four times as many new jobs as the public sector has been shedding, in the US it is barely ahead.

The situation may get worse, because the cuts in the state and municipal workforces are now being added to by cuts in Federal workers. And all this before a proper deficit-reduction programme is in place.

Why, despite the not-too-bad published growth figures, is the US job machine not working any more? I have not seen any convincing explanation for this.

It may well have something to do with the uncertainty over US public finances at every level, and the political grind in Congress over the increase in the debt ceiling cannot be helping.

But the employment level in the US, the proportion of adults with jobs, is now just over 58 per cent, the lowest for nearly 30 years. There just seems to be no confidence in the business community.

So where is the turning point? My hunch is that the indicator to look at is house prices. The moment they start to nudge up consumers will start to rebuild their confidence, spend a bit more, and the service sector will pick up.

But at the moment house prices over much of the country remain pretty flat. It is a chicken and egg situation, of course, for until people feel confident about their jobs they won't move home.

But, there is a bottom to every market and the present despair in the housing market cannot last for ever. The latest quarterly figures suggest a tiny rise after nine months of falls. This might, just might, be the bottom.

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