Hamish McRae: We'll get another eurozone deal, but this is no way to do business
Sunday 23 October 2011
They keep at it, don't they?
Yet another weekend of anguished discussions about how to let Greece default without busting the eurozone: they started on Friday and they apparently continue until Wednesday. You might think that any set of negotiations that last six days are unlikely to produce an optimal outcome – and you would be right.
This is not a great way to do business as Luxembourg Prime Minister Jean-Claude Juncker acknowledged. Speaking before the meeting he said that Europe's international image was "disastrous." He added: "We're not really giving a great example of a high standing of state governance."
But if similar past discussions of the EU are any guide, we should assume that some sort of agreement will be reached next week. We know the main elements: the write-down of Greek debt by some 50 per cent, recapitalisation as necessary of European banks that hold this debt, and an expansion of the European Financial Stability Facility, perhaps by allowing it to guarantee part of the sovereign debt of the weaker states.
The biggest imponderable will be the extent to which Germany is prepared to take on contingent liabilities for the rest of the eurozone. Put bluntly, if Spain and Italy were to default on their debt, for how much would the German taxpayers be down the slot?
Italy now has to pay close to 6 per cent for 10-year money, while Germany pays just over 2 per cent. So investors are demanding a 4 per cent annual premium to cover the risk of not getting their money back. It follows that a default by Italy is seen as a significant possibility. Indeed even French debt is being downgraded by the markets, yielding around 3 per cent, so the premium over Germany is close to 1 per cent, the highest since the euro was introduced. With France likely to lose its AAA in the coming weeks, only Germany has the financial firepower to make the enlarged European bailout fund credible.
As a result there is great pressure on Germany to step up to the plate, and not just from Europe. I was talking with a former British cabinet minister a few days ago, who argued that by being overly cautious, the German Chancellor, Angela Merkel, was actually taking a bigger risk than she would by giving full backing to the enlarged bailout fund.
I can see the argument but I think it is wrong. Leave aside the political issue: to what extent it is reasonable for Germany to be expected to pay what could be seen as reparations to the rest of Europe. It is wrong because it assumes that Germany has got the financial ability to do so. It may not.
Germany has staged an impressive recovery from recession, faster than any other large European economy. But the outlook for next year is less encouraging. The main graph shows the latest forecasts for 2012 from the economics team at Goldman Sachs. Their central forecast is for the eurozone as a whole to dip back into recession, with Italian and Spanish economies shrinking for the year as a whole. France does not do much better. As for the UK, the pretty dismal prospect of just 1 per cent expansion is at least better than any other large European economy.
Germany does have its fiscal position under good control, with a forecast deficit of only 1.5 per cent of GDP (ours is forecast at 6.3 per cent of GDP). But its stock of debt, as opposed to the annual deficit, is close to 85 per cent of GDP. Were it to have to make significant contributions to bail out weaker nations you could see that rise towards the danger level of 100 per cent of GDP.
Just assume that by 2019 Italy is able to pay back only 60 per cent of the face value of its debts – not an unreasonable assumption given their size and the borrowing premium it has to pay. Assume Germany is responsible for half of the shortfall. Again this is not unreasonable: who else is there? That would add on my quick tally some €400bn (£350bn) to Germany's national debt, which, other things being equal, would take the debt above 100 per cent of GDP. I am not saying this will happen: simply that there could come a point where even Germany would not be strong enough to support the rest of Europe.
Is there any other way out? Well, were Europe to do what Britain is doing – cut the real value of the national debt by devaluing the currency – then maybe the eurozone's debts could be gradually worked off. But the largest shareholder in the European Central Bank is Germany (see right-hand graph) and there is huge pressure on it to produce a currency "as good as the mark". Two German members of its board have resigned in recent months, firing a warning across its bows should it ease up on its mandate.
Short of devaluation, the only way through will be for most European countries to run surpluses. In other words, year in, year out they will have to take more money in taxes than they pay out in benefits. The common currency is not to blame for this. What it does do is to make explicit some fiscal maths that was previously hidden.
It gets worse. The poorer the state of a country's finances the more it costs to service its debts. The only way to reduce that is for there to be a central guarantee for some or all of those debts – and that comes back to the contingent liability on Germany. Indeed the whole idea of a fiscal union, where the bulk of borrowing is centralised, hinges on Germany's credit-worthiness.
So what will happen this week? There will be enough of a deal to settle the markets for the rest of this year. But it will not be a final fix. Europe is not yet ready to acknowledge the inevitable Greek default. Next year there will be further crisis talks and another patch will be found. And then there will be another stumble and another set of crisis talks. And all this will continue to undermine confidence and dampen European growth.
It is very important to celebrate the competences in Europe – we do have some wonderfully competitive companies. But when politically driven projects clash with financial realities, finance wins. Fixing the Continent's sovereign debt crisis will take more than six days of talks in Brussels.
UK borrowing is on track, but it's still way higher than Spain, France and Italy
Some slightly better news in the September borrowing figures. The monthly run of revenue and spending figures now show that the UK fiscal plan has been more or less on track for the first half of the financial year: a deficit of £63.5bn against £71bn last year.
This keeps the target of £122bn of borrowing in sight, which must be a relief given the slower-than-expected published growth figures. Revenue in September was running up on last year with the higher VAT and National Insurance chipping in.
But income tax revenue was actually down and while it would be far too early to suggest that the 50 per cent tax rate is cutting revenue rather than increasingly it, that is quite possible.
My own quick tally is that the 50 per cent rate will cut revenues by around £5bn a year, maybe a little more.
The fact that the deficit is coming down on track but growth is below track could mean several things. One is that economic activity has been under-recorded. A rather less agreeable conclusion could be that these favourable figures flatter the underlying state of public finances and that the next few months will show deterioration. Remember, too, that the high September inflation number boosts pensions and other outgoings linked to it. Still another is that there might be a tiny bit of wriggle room for the Chancellor to ease policy in politically contentious areas, such as delaying the planned rise in fuel duty.
But you have also to see the numbers in absolutes rather than simply in relation to the proposed fiscal plan. The harsh fact remains that this year the Government is still borrowing more than 8 per cent of GDP, far more than any other major European country, more even than Spain, France and Italy. Notwithstanding the widespread perception of relentless tax increases and massive spending cuts, we are only a quarter of the way along the road to sustainability.
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