Will the European malaise drag Britain down?
'The near-term outlook for the German economy, and therefore the whole of Europe, is much better if we attribute the current malaise to cyclical forces rather than entirely to structural factors'
Monday 12 February 1996
There is nothing much wrong with our own economy that cannot be solved by a few months of stock shedding by companies which are still struggling to cope with excess inventory. The Treasury is, quite rightly, confident that the stock cycle will not on its own be powerful enough to derail the recovery, especially since there are now clear signs that the consumer is emerging from last year's doldrums. Two more sluggish quarters is about the worst that we can expect from the stock shake-out, and then a series of windfall gains will kick start both the consumer and the rest of the economy.
Unfortunately, this relatively encouraging pre-election picture could yet be upset by a collapse in our export markets. As explained in this column last week, the German economy is clearly suffering from a structural "hollowing out", with investment and jobs being shipped abroad because of the burden of an overvalued exchange rate, and excessive labour costs. But structural problems usually result in a gradual and long-term worsening in the climate, not an outright hurricane of the sort which is currently blowing on the Continent.
A few months ago, it looked like an absurd over-reaction to suggest that Europe might be falling into a recession (defined as two successive quarters of declining GDP). Now, this does not look absurd at all. As the graph shows, the recent behaviour of the OECD's leading indicators for Europe are consistent with a period of declining output in the first half of this year (though the Goldman Sachs economists have not yet built this into their main case forecasts).
Last week, Germany announced that unemployment rose to a record 4.16 million in January, equivalent to 10.8 per cent of the labour force. The rise in unemployment last month was 59,000 on a seasonally adjusted basis, only a little better than the "shock" rise of 65,000 which caused such an out-burst of angst in December. Although part of this rise was due to the ending of special job schemes in east Germany, there is no disguising the extent of the deterioration in the labour market in the western sector of the economy. There, unemployment has recently been rising at an average monthly rate of 30,000, a pace which has only been exceeded in three episodes since the war - and each of these was during a major recession.
It is hard to believe that such a sudden acceleration in the rate of increase in unemployment is solely the result of structural forces. There must surely be some cyclical element operating as well, though it is admittedly very hard indeed to identify any major trigger points for this. In the past, recessions have generally been caused by a clash between rising inflation pressures, a private sector which is financially over-stretched, and a central bank which suddenly decides to slam on the brakes. None of these developments was present last year. In fact, entirely the opposite - inflation was falling, the private sector was in good financial shape, and the Bundesbank progressively cut short-term interest rates.
So what caused the cyclical element of the German downturn, if indeed it is true that structural forces are not entirely to blame? The best we can do is to point to the unintended monetary tightening triggered by the 3 per cent rise in long-term interest rates during 1994, along with the fact that inventories were built up too rapidly in the short phase of economic growth in 1993/94, only to be cut back sharply by the latter part of last year. A drop in construction spending after the unification boom then clearly exacerbated the problem.
Why does this distinction between cyclical and structural forces matter? Surely a recession is a recession is a recession, at least as far as the unemployed are concerned. Perhaps, but the distinction is still relevant because the near-term outlook for the German economy, and therefore for the whole of Europe, is much better if we attribute the current malaise partly to cyclical forces, rather than entirely to structural factors.
Cyclical factors have a habit of turning round rapidly, allowing economies to bounce back quite suddenly, especially if the stance of monetary policy is supportive of growth. Structural forces, by contrast, take many years to reverse, even when there is a revolution in the policy environment, which there certainly has not yet been in Germany. Consequently, if we choose to attribute the German downturn solely to structural factors, the chances of any significant recovery in the near future are quite bleak.
It is much more likely, though, that cyclical forces will prove strong enough to stimulate a recovery in output in the next few quarters, despite the fact that the long-term structural forces will limit the strength and durability of this recovery. Of course, it is always risky to call the bottom of a downturn (as the unfortunate Norman Lamont discovered in 1992), because even if the judgment proves correct, it is almost certain that it will be thought wrong for several more months as the published data lag behind reality. Nevertheless, at the risk of falling into this trap myself, there are now a few glimmers suggesting that the sharpest decline in activity in continental Europe may now be coming to an end, and even that output may stop falling in the current quarter.
The OECD leading indicators for Europe are beginning to stabilise, and business surveys published last week by the European Commission show that the pace of inventory shedding may have slackened a fraction in recent weeks. If this proves to be the case, there will be an automatic bounce- back in output as the drag from inventories diminishes. And with further aggressive easing to come from the Bundesbank in the next month or two, the conditions look right for a cyclical recovery later this year.
Admittedly, there is a risk that output will have fallen by more in the current quarter than most forecasts currently show. And there is a risk that European companies will adopt a "once bitten twice shy" approach to increasing their spending on stocks and capital equipment once the recovery does start. But easy monetary conditions usually find some way of boosting economic growth, even when it is difficult in advance to identify the precise routes through which this will work.
Britain is in better shape structurally, relative to Germany and France, than it has been at any time since the War. Our production costs are lower, and we show no sign of frittering away this advantage with the usual splurge of inflation. If Europe can muster some sort of cyclical up-turn later this year, as it probably will, Britain stands to benefit more than most. But that may not become visible for a few more months yet.
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