Hamish McRae: The euro should survive this crisis, but it won't get through the next one

Economic Life: When politics and markets clash, markets win in the end. There may, however, be a lot of collateral damage on the way
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The Independent Online

Well, I am not sure what Angela Merkel will have done for the future of the euro but she has certainly managed to put the cat among the pigeons as far as global equities are concerned. When politics and markets clash, markets win in the end. There may, however, be a lot of collateral damage on the way.

Those of us who thought that the massive Greek rescue plan of a couple of weeks ago would buy a period of calm have been proved wrong. The markets have seen through the inherent weakness of the plan. Though it solved the immediate liquidity problems of Greece and the other weak eurozone members, it did nothing to solve their solvency problems. So Greece, and maybe the other weaker states, either have to default on their debts, or submit their citizens to a drastic fiscal squeeze. The latter is probably unacceptable, but even if it were, the result would be depressed demand from much of the eurozone for the foreseeable future.

The performance of the leaders of both France and Germany has further contributed to the unease. With hindsight it probably was not a good idea for President Nicolas Sarkozy to threaten to leave the eurozone, and it was not a good idea of Chancellor Merkel to bring in the short-selling ban. But there is nothing in the background of either leader that would prepare them for this: they do not intuitively understand markets. Ms Merkel was not even brought up in a proper market economy, for most of her childhood was in East Germany. Contrast that with the way that David Cameron's background would allow him to do so: he comes from a long line of stockbrokers.

Do not, however, underrate the power of political will. My own view has long been that the euro will get through this cyclical crisis, the first major downturn since it came into being, but it will not get through the second one. If the normal pattern of economic cycles carries on, the next downturn should come between 2016 and 2020. So as a working date, assuming that the euro does pull through now, expect the great euro crisis to come in 2017.

There are reasons to be more cheerful, however. Greek debt will have to be rescheduled and, in some measure, forgiven. If a country cannot repay its debts, there is no point in pretending it can. But that is some way off. Meanwhile, thanks to this crisis of confidence in the currency, it has returned to reasonable levels. The top chart, from the Ifo Institute in Germany, shows how the euro is still way above its previous low point and actually a little above its purchasing power parity with the dollar. In that sense, it is still a little over-valued.

That does not mean that it won't fall further – indeed, I expect that to happen – and it may well become and then remain undervalued for some time to come. The furore about Greece will reduce its attractions as a reserve currency, for it has become more difficult for central banks to justify increasing their euro balances at the moment. Moreover, this is not just a Greek thing; having the President of France threaten to pull out does not exactly inspire confidence for the future.

What has clearly happened, though, is that the benefit euro membership brought to countries with weak currencies, in the form of lower long-term interest rates, is now past. The bottom graph, from HSBC, shows how the run-up to Greek membership in the period of 1997 to 2001 brought its borrowing costs down sharply. Between 2002 and 2006 it could borrow almost as cheaply as Germany. Now its costs have soared back up, as to a lesser extent have the costs of Portugal, Spain and Italy. Europe has a single currency but different interest rates.

Actually, in the long term that is much healthier than the situation of five years ago. There should be an interest-rate advantage for countries that have sound fiscal policies and a penalty for those that don't. But in the short term the fears are that sovereign debt risks will spread and that this will push the world economy into a double-dip recession. If the problem were just southern Europe, that would be one thing. But consumer confidence everywhere is weakening, even in the US. And whatever you think of Mrs Merkel's comments about tighter financial regulation, that too hits business confidence. One of the reasons why financial markets are so twitchy at the moment is over fears that European banks have lent too much to weaker eurozone members and that their own stability is threatened.

That may be true. One of the most worrying aspects of recent weeks is the way the money markets are starting to gum up again, with banks unwilling to extend credit to each other. The situation is not nearly as bad as the state of affairs immediately post-Lehman, but banks that don't trust each other find it harder to commit to lending to customers, which in turn makes would-be borrowers more cautious too.

So, a double dip? Quite probably. But this would be normal. In most economic downturns there is an initial bounce, then some rise in output, then further bumps on the way for some months until, after a couple of years, a sustained recovery gets going. Why? Well, it would be lovely to be able to explain every twist in economic outturns just as it would be lovely to explain why cycles occur at all. It is just worth observing that you frequently get the odd quarter when output declines, even though the medium-term recovery remains in place. This would happen even with optimal policies, and we certainly don't have those in Europe.

That leads to a final question. Can the UK economy continue to grow despite this weakness in Europe? We will have some difficult months ahead and this makes it more difficult, for half the UK's physical exports go to Europe – fortunately a much smaller proportion of our "invisible" exports, exports of services, goes there. A stagnant Europe adds to our problems but we have two bigger ones. First, can we manage to engineer our fiscal consolidation so that it does not threaten the pace of recovery? And second, might a jump in inflation force and earlier rise in interest rates make the unwinding of qualitative easing more tricky?

On the first, there is an obvious worry. What we have to hope is that the positive impact on confidence will outweigh the negative drag from lower public spending and higher taxes. But the second may prove more alarming. If we are to have tight fiscal policy we should try and relieve that pressure from a loose monetary policy. That is common sense. But if inflation stays where it is, we can't continue to have such a loose monetary policy. Having spent the best part of 30 years getting inflation under control post the catastrophe of the 1970s, no government or central bank can let it rip again. For the moment, trust remains. But it is fragile; and more fragile now than it was even a week ago.

h.mcrae@independent.co.uk

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