Hamish McRae: What a barrage of bad news! Let's just sift through and make sense of it all

Economic View

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The Independent Online

On and on it goes. I am not sure whether I find it more comforting to have the high-ups telling the rest of us to be calm and carry on, or to have them saying that the world will end tomorrow week.

On balance, I think I prefer reassurance to scaremongering, at least from central bankers. When last week Mervyn King declared that "this is the most serious crisis we have seen since at least the 1930s, if not ever", I found myself wondering what his predecessor, Eddie George, would have said. "Steady Eddie", sadly no longer with us, would surely have been more comforting.

The best way to make sense of this constant barrage of information, most of it negative, is to keep asking what is actually new and what is a rehash of stuff we already know. Here goes.

Both the additional £75bn quantitative easing by the Bank of England and the rather smaller similar move by the European Central Bank were new. While not totally unexpected, both the scale and timing of the Bank of England's new bout of QE were surprising. Couple that with King's words and it was potentially important. Come back to this in a moment.

The downgrade of British banks by the ratings agency Moody's was new, but it was unsurprising and as a result did not move the markets much. British banks remain well-capitalised relative to their continental competitors and, while conceivably they might need more cash in the medium term, they appear strong enough for now.

There were bad producer price numbers, underlining the scale of the inflation overrun that the Bank of England seems to have given up on. The main chart shows what a year ago the bank thought would happen to inflation and what actually has happened. As you can see, we are outside the boundaries of its expected range – a year ago it would have given less than a 10 per cent chance that inflation might be as high as it is. This failure is not now a surprise but more a continuing worry, particularly since the next set of consumer and retail price indices seem likely to disappoint too.

The main news from the eurozone concerns the tension between Chancellor Merkel and President Sarkozy over the whole mishmash of Greece, European bank rescues and the future of the zone. But what has been coming out has been a series of stories about their disagreement, rather than anything explicit. I think we all know there is an odds-on probability that some sort of deal will be done in the next few weeks. Detail is less important than substance, but it has to acknowledge the Greek default, recapitalise European banks as necessary, buttress the existing central European support funds, and have the ECB pump liquidity as necessary into the system.

There does, however, remain a minority possibility that this deal will not be done or at least will not be done in a credible way. While there was no significant new information about this, if you look at what the Bank of England did and what Mervyn King said, maybe we can deduce something new.

It is this. Maybe, just maybe, the bank in general and its governor in particular have given up on European politicians. The only way in which the present crisis could be conceived as being worse than the 1930s would be a really messy series of financial fractures, going way beyond Greece and even ending up with the break-up of the eurozone. Even that would surely be less serious than the 1930s. No one is going to go to war. But if pressures on the euro could not be contained, that would certainly validate the extra QE because the key aim has to be to try and insulate the UK in advance from whatever disruption happens in Europe.

I personally do not think the more extreme outcomes are likely. I would give an 80 per cent probability that some sort of deal will be done, and it only needs two people, Angela Merkel and Nicholas Sarkozy, to do it. But if the past three years have taught us anything, it is that we have to be prepared for extreme outcomes.

That leads to two lines of inquiry. One is whether it might in the medium term be better for Greece to have an uncontrolled default and there to a real disruption in Europe, rather than the cracks to be papered over again. Might messy be better than fudge? You can see the argument that it would be better to have an explosion, acknowledge that it is not just Greece with a debt overhang, and redesign the euro, rather than struggle on.

The other line of inquiry is to ask to what extent might the UK be able to insulate itself. For what it is worth, the latest growth forecasts for next year from Goldman Sachs have the UK growing at around 1 per cent whereas the eurozone will hardly grow at all. Obviously our economy would be damaged, though we can take a bit of encouragement that one of our biggest export markets, Ireland, does seem on a clear recovery path. Exports to the emerging world will help too, but they are small. So such growth as we may get will have to come mostly from domestic demand and here the outlook isn't bright as the squeeze on real incomes will continue well into next year. Remember, consumption accounts for two-thirds of the economy.

But while the outlook for consumers is not great, it is not dreadful. One of the QE effects will be to support house prices: the money has to go somewhere and the last bout seems to have helped check the housing collapse. Just now, prices are finely balanced rather than collapsing, so it may be that that extra £75bn will nudge them up a bit.

The other positive point is that our service industries are still expecting growth and, what is more, are still profitable. The little graph shows figures out last week on how services deliver a much better return on capital than manufacturing. It is not the place to get into the manufacturing/services debate – we need both. But service industries are much larger than manufacturing, so sustained profitable growth there is a huge help to the economy.

There are uncertain times and there will be more uncertainty in the weeks ahead. But as far as the UK is concerned, both manufacturing and services are still expecting some growth.

As surprising as it might sound, Ireland offers the rest of us a glimmer of hope

Actually, amid all these concerns about European debts, Ireland is a rare bright spark. Having rather stuck my neck out recently by suggesting that the country might pull through without further help, it is now looking as though my optimism might have been justified.

Three bits of encouraging news. One is that the yield on Irish 10-year debt, which reached 14 per cent, is now down around 7 per cent. That is still high, but if you were brave enough to buy it and got your timing right, you could have doubled your money. A second is that growth this year looks like being around 1 per cent – again not brilliant but roughly the same as the UK, and in contrast to negative numbers for Portugal and Greece. The third is that the fiscal deficit is coming down on track, with revenues coming in slightly ahead of expectations.

There are two big risks. One is that the whole European downturn will have a disproportionate impact on a small open econ- omy such as Ireland. Exports are the vibrant sector, and the eurozone, the US and UK take some 80 per cent of those. So if any or all of these markets falter, Irish projections could be knocked off course. The other is that no one knows quite the extent of bank losses and won't know until the Irish property market settles. It would be nice to be able to say that a bottom was in sight, and it may be. But there is a lot of stock that will overhang the market for years. You hear anecdotal stories of movement, but my guess is that until there is sustained growth in the economy we won't really see sustained growth in property prices.

None of this counts as cause for cheer and the scars will last a long time. Busts happen suddenly, while recoveries take time to get going. But just as it is hard during a boom to realise there may be a bust round the corner, so in a bust it is hard to think a recovery might be in place.

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