Hamish McRae: 'Tis the season to be merry: things aren't (quite) as bad as you may think
Sunday 20 November 2011
So what can we do to insulate ourselves against contagion from Europe? We have to accept that what will happen in the eurozone is beyond our control and plan for a range of outcomes.
As of last week, the situation in the financial markets was deteriorating further, with the interest rate on Spanish 10-year debt almost touching 7 per cent, and the gap between French and German debt the widest since the euro was launched, in effect double the German rate: France would have to pay nearly 4 per cent for 10-year money, whereas Germany could borrow at less than 2 per cent.
Things will not turn quickly. We have to assume that financial stress will continue in Europe for many months, more probably years, and that the outcome is unknowable. It could be anything between a full fiscal and political union and the EU going back to individual currencies. We can all have different views about how they got themselves into this mess, how they might dig themselves out and our preferred outcome. But our views don't matter one jot. What will be will be.
Our starting point should be to recognise that we have not been doing too well ourselves. It is tempting to blame our lack-lustre recovery on events across the Channel and looking ahead it is indeed true that the impending eurozone recession will be a drag from now on. But over the past year, if the figures are right, we have under-performed against the eurozone as a whole.
The main graph shows growth over the 12 months to end-September with the UK near the bottom of the European pack. Even if our growth numbers are revised upwards, as I expect they eventually will be, this is not a great performance. Part of the reason, as Capital Economics has noted, may be that the pace of fiscal consolidation has slowed us down. The authorities' defence that they had no option having inherited a larger deficit than any European country bar Greece is fine as far as it goes, but the fact remains that the recovery has been disappointing.
So what can we do? There are three elements to economic policy: fiscal, monetary and structural.
Fiscal policy we will learn more about in 10 days' time, with the Autumn Statement. There is not much that can be done to the broad thrust of policy, particularly since the borrowing numbers are coming down only achingly slowly, and if growth disappears the coalition will be struggling to keep this decline in borrowing on course. Within the broad numbers there may be room for fine-tuning to reduce the drag on growth but the impact will not be big. Should, in the light of what is happening in Europe, the fiscal consolidation plan be eased? That is difficult. To those, such as the Labour Party, that have been urging more borrowing, you have to ask what interest rate penalty they would estimate we would have to pay for this. I suspect that the lower-than-expected interest costs will just about offset any slowing of tax receipts as a result of slower growth. The cheap rates at which the government can borrow are all the more surprising given higher-then-expected inflation, but they are a welcome surprise. This does cut the debt burden and the fact that the coalition is trusted by the markets is not something to be tossed aside. So it may be that there is a little room on fiscal policy, but not much.
On monetary policy, the foot is flat down on the accelerator. Notwithstanding the dreadful inflation figures, we have negative real interest rates and are getting billions more of quantitative easing. There is some evidence this is working: house prices are stable enough and the flow of money into mortgages has recovered a little. Retail sales have been surprisingly strong in the past couple of months, as the smaller graph shows.
Indeed, given all the gloom heaped on us it is surprising we are still shopping at all. But the transmission mechanism between easy money and higher output is most uncertain and there are the costs in higher inflation.
It seems we should see monetary policy as a back-stop. It is classic economic theory that in extreme situations a central bank may have to flood the markets with liquidity, to lend without limit. The European Central Bank may find itself in that situation soon. We have the Bank of England as our lender of last resort and it may be that it too has to go far beyond its stated plans. But since we are still in more-or-less normal times it is hard to see the Bank offsetting any fall-off in demand from Europe as part of its day-to-day activities.
So, if neither fiscal nor monetary policy can help much, it has to be structural policies. Here we come to the promised growth strategy, to be unveiled shortly, which may have some fiscal element to it. Structural reforms are the key to sustainable growth, for while you can puff up an economy for a while, by giving it a fiscal or monetary boost, the longer-term performance depends on having an efficient industrial and commercial structure. But the lags are uncertain. Policies that are seen as business-friendly may quickly increase business confidence. But most policies take years to take effect; for example measures to lift skills.
The sad thing is that many employers feel we have had an anti-business climate under this government and during the final years of the previous one. Whether this is right or not is irrelevant. If that is what the business community feels, turning this round will take years.
All this need not sound dispiriting. The UK has a competitive exchange rate; inflation is likely to ease as pressure comes off energy and commodity prices; wages are under control; and most important, consumers have been extremely resilient. Consumption accounts for 65 per cent of total demand. Realistically it will take a year longer than we hoped to get back to the previous peak in output: some time in 2013, rather than late 2012. As for our European markets, remember that while the eurozone accounts for some 15 per cent of the world economy it is only 15 per cent, and the other 85 per cent is where the growth is.
Yes, we should rage against the machines – and rely on our common sense
Something different. I have been reading two books over the past few days, which together give a new, surprising, but ultimately comforting perspective on all this financial turmoil. One, just out in the US, is by Michael Lewis and was brought over from New York by a friend. Called Boomerang, it is a series of essays for the magazine Vanity Fair, stitched together in a book. The common theme is that the financial world became far too complicated for most mortals to understand and that eventually and painfully common sense reasserted itself. The people who kept their heads were right and the people who were overly clever were wrong.
So we should cling to simple common sense? The second book is by Bryan Appleyard, called The Brain is Wider than the Sky, and with the subtitle Why simple solutions don't work in a complex world. His original theme is that we live in a world where technology is used to track our every movement, report on every search we make on computers, to steal information about us, categorise us, simplify us, strip away our humanity – or at least try to do so. But of course technology itself can be idiotic and no more so than when it is applied to finance.
Appleyard cites Long-Term Capital Management, the hedge fund founded by Nobel Prize-winning economists and built on complex mathematical models, which duly collapsed in 1998. But the banking community did not learn from this and trusted the AAA ratings on what was really sub-prime debt. That, as much as anything else, got us into this present mess.
His thoughtful message is this: human beings are immensely complex, capable of great artistic and intellectual feats, and we must celebrate this quality and challenge the dumbing down inflicted by machines. Ultimately, both books simply tell us to trust our instincts.
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