Hamish McRae: Yes, the euro is bad news, but this side of the Channel is almost as bleak

Economic View

Click to follow


Let us, for this week at least, declare this column a eurofree zone and focus instead on what has been happening here. The reason is not that what happens to the euro is unimportant to us, though I am not sure that the break-up of the eurozone, while messy, would be an economic disaster – maybe better to get rid of the tensions now, than let them fester for several more years. The reason is that our problems matter too, and they have tended to be pushed out of the news by the turmoil across the Channel.

The sky over the British economy has undoubtedly darkened in recent weeks, as many of us hoped it wouldn’t but feared it might. Growth has clearly slowed. The private sector is still creating new jobs, but whereas nine months ago it was creating three or four for every one lost in the public sector, now it is creating only about half a job for each one lost. So overall employment is falling, not rising. Unsurprisingly, consumers remain subdued, with retail sales just about level year-on-year. Instead of increasing their spending, people are using what cash they have to pay off debts.

But – and this is a big but – much of the reason why retail sales are so flat is because prices are so high. If you look at the increase in retail sales by value, they are up around 5 per cent on a year ago.

The problem is that people are not getting much for their money: if it costs £50 instead of £40 to fill the car that is £10 not available to spend on something else. Were inflation at European levels – a little below 3 per cent – and people still spent the same amount of money, consumption would be up by 2 per cent or more. Since consumption accounts for two-thirds of GDP, overall growth would be much more respectable too.

That leads to a practical question and a more theoretical debate.

The practical question is – when will inflation come down? Since the Bank of England’s boffins failed to predict the scale of the present surge in prices we should take all forecasts with a pinch of salt. However, it may be right in its thinking that inflation will indeed come down next year after the present peak, and the righthand chart shows an independent forecast from Capital Economics that suggests that headline consumer price inflation may be close to 1 per cent in another 15 months’ time.

If that proves right, and wage increases continue to show modest increases in money terms, then it is plausible that consumption will be rising solidly come 2013. A long way off? Yes, indeed, but correcting the errors of the past few years was always going to take a long time.

The theoretical debate is whether this failure to control inflation is the principal reason for current slow growth. Put another way, the very low interest rates and two bouts of quantitative easing were intended to boost demand by pumping money into the economy. But maybe because the policies led to a sharp increase in inflation, they have been at best ineffective and at worst have actually had the perverse effect of cutting real demand?

It is an important debate because there are currently calls for another bout of “QE” if growth continues to disappoint, but I don’t think there is as yet any definitive conclusion. You would expect if you suddenly create more money that some of that would have the effect of increasing asset prices – property, bonds, shares and the like – and to some extent that may have happened.

You would expect it, in isolation, to cut the exchange rate; but since other central banks have been following similar policies maybe that effect would not be large. It does not seem to have any influence on wage increases, which remain very low, so there seem to be few second round inflation effects. But the fact remains that we have significantly higher inflation than the US or the eurozone, even allowing for tax increases, and it is hard to see why that should be.

At any rate, there is a dilemma: if growth flags further, might policies intended to boost it actually have the opposite effect?

Myown feeling, for what it is worth, is that earlier bouts of monetary easing had some positive effect, particularly by checking the plunge in house prices, and are only marginally responsible for the surge in inflation. But those were extreme policies for extreme threats and another bout of QE is not likely to be effective. It should, however, be held in reserve in case there were to be some catastrophic loss of confidence in the coming months.

So is there anything that can be done to boost growth? People who call for a growth strategy make the implicit assumption that there are levers a government can pull that will result in faster growth: a cut in VAT, for example. The problem is that any easing on the path back towards a balanced budget may also have a perverse effect.

Long-term rates might well rise and as a result not only would the Government find its interest charges rising but fixed-rate mortgages would climb.We tend to forget that Britain is still running a fiscal deficit that is larger, relative to the size of the economy, than that of Greece. It is only raising £4 in tax for every five it spends. The deficit so far is down a little on last year, but not much.

That is not to say that the Governmentispowerless. It can and should, at the very least, not bring in policies that actually damage growth. It can maintain infrastructure spending. It cannudge the banks into keeping up their flow of loans for smaller businesses, for growth both in output and employment will be driven by the private sector.

Ministers should be careful not to beseen as anti-business, which I fear someof them are. But it is unrealistic to expect a sudden surge in business confidence – and with it, economic growth – in the months ahead. Confidence by its very nature evaporates suddenly and then regenerates slowly, as we have seen in recent weeks.

Only Europe seems to matter to the markets just now – and it's all very odd

One of the strange things about the financial markets at the moment is the extent to which they are dominated by a single story: Europe. You can measure it. The normal events that you would expect to move share prices up and down – changes in company profits, data on growth in the world markets and so on – have virtually no impact.

Instead, if Europe seems to be sorting itself out, shares go up (and that is everywhere in the developed world, including the US). And if there is some new bit of negative news they go down.

Now you may attribute this to the generally twitchy times, for the early stages of a global recovery are always tense. But it seems to me to over-stress the importance of one chunk of the world economy, a chunk that would never account for more than some 10 per cent of the incremental growth of the economy. But that is what is happening.

So what happens next? Two thoughts. The first is that even a partial resolution of the Greek mess would be strongly positive for shares. The second is that if you compare this share-price recovery with recoveries from previous big bear markets, what has happened is very much middle-of-the-pack.

I have been looking at some work by Simon Ward at Henderson Global Investors, where he tracks this recovery of the Dow against six similar recoveries of the past century. What is remarkable is that while there is obviously a variance, if you exclude the recovery that started in 1901 (this is long-distance stuff) this one is quite typical.

We have had most of the recovery already so there is not likely to be any great bull market round the corner, but on average there should be some further ground to make up over the next year or so.

Buyers should make a profit on a 12-month view, but not, it seems, a very big one. Of course, if only those Greeks would sort themselves out ...