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Hamish McRae: As Europe faces up to its troubles, rates can only climb further

Economic View

Sunday 10 April 2011 00:00 BST
Comments

Well, don't say you weren't warned.

The European Central Bank did increase interest rates last week and the Bank of England didn't, at least not yet. Expect that to come in May. But I am afraid my comments about Portugal merely lumped it in with Ireland and Greece as the weakest members of the eurozone, rather than explicitly warning that it would throw in the towel so soon.

It looks now as through severe cutbacks will be imposed on Portugal by the other eurozone members, more severe even than the austerity programme that the present government, now in a caretaker capacity, failed to get through parliament. There will have to be a two-stage negotiation, with the country getting just enough money to stop it defaulting until a new government is in place and then the serious stuff will begin. Yes, the UK will chip in something, but it is important to remember that what we will be offering Portugal is loan money, not a grant. So there is a reasonable possibility that we will eventually be paid back and, meanwhile, we make a turn on the investment as we can borrow more cheaply than we will lend.

But Portugal is a small and slow-growing economy. That is not meant to be dismissive at all, for it has a talented and hard-working population and is Britain's oldest ally. It needs structural reforms to help boost its growth potential and let's hope those are part of the package that is eventually adopted. You can't just pile on austerity and expect everything to be hunky-dory. As you can see from the right-hand bar chart, it has a serious budget deficit (though slightly smaller than that of the UK), double-digit unemployment, slowish growth and a worryingly large current account deficit – concerning because that suggests a lack of competitiveness. But the killer is none of these; it is public debt approaching 100 per cent of GDP and rising fast. There comes a time, and it happens suddenly, when markets look at the debt and say, yup, these guys aren't going to make it. Then the game is over.

This is sad for Portugal, but the harsh truth remains that none of those three economies are big enough to do more than chip away at the eurozone edifice. Spain would be. So the next question is whether Spain can scramble through without a bailout.

The current view of the markets is that Spain will not need a bailout and is unlikely to default. The cost of insuring its debt against a default fell slightly last week. I have no idea what will eventually happen, but in a risk/reward trade-off my instinct is that the markets are too optimistic about Spain and too pessimistic about Ireland. The markets' assessment of risk can shift with astonishing speed – astonishing, that is, for the poor old politicians who are suddenly unseated.

There was a neat irony that Portugal should go for its bailout within a few hours of the European Central Bank putting up interest rates. Some have argued that this just shows the ECB will set its rates to fit the needs of its largest member, Germany, rather than the fringe countries. The case for higher rates, from the perspective of Germany, is strong. Its exports are doing extremely well, it benefits from lower import costs which would come from any rise in the euro, and its personal sector is not heavily indebted. By contrast, higher rates are unhelpful to the heavily borrowed fringe. But I think it is wrong to see the ECB as snubbing the little economies and fixing its policy to suit the big ones. It has an inflation remit and it takes that seriously, unlike our own monetary authorities. What is wrong with that?

Besides, viewed more broadly, the eurozone recovery is going rather well. The Markit survey of purchasing managers for the various main economic regions is set out in the left-hand chart. These surveys are developed by asking companies what they expect to happen in some period in the future – in this instance, what they think will happen to their output. The balance between those who think output will go up and those who think it will go down is then plotted on the graph; consequently, anything above 50 suggests an increase in output and anything below a decrease. These figures are for both manufacturing and services, so they capture a wide range of activities.

As you can see, US companies were overwhelmingly optimistic at the beginning of the year but are quite a lot less so now – though, on balance, they are still positive. By contrast, Japanese companies are almost as deeply despairing as they were at the bottom of the slump. Note that both the eurozone and the UK are also solidly in the optimistic camp, with the UK climbing steadily since last autumn. Chinese companies, while still on balance in positive territory, are quite close to the 50/50 tipping point.

As far as the ECB is concerned, based on these figures, there is no need to worry too much about rising interest rates damaging the recovery – the corporate sector of Europe appears healthy enough to withstand it. By the same token, we in Britain should be able to take a rise in rates, which will still be artificially low, without too much damage. The ECB's increased rate, which can be seen as facing up to a difficult situation rather than shrinking in front of it, is just as likely to boost sentiment as chip away at it.

So what happens next? The only sensible way to look at this ECB increase is to see it as part of a global cycle. We are in the early stages of a recovery in output and we are in the early stages of a recovery in interest rates. It is as simple as that. There are legacy problems as we move through the cycle and these include the debts – personal, national, corporate, whatever – accumulated during the boom and added to during the slump. Some borrowers will default. But policy has to fit the future, not the past, and you have only to look at the price of gold, oil, commodities, etc, to see the concerns of the future. So interest rates everywhere will head on up.

The US has just proved – again – that it is not fit to be the world's financial leader

So the US government has shut down. It has run out of money and is not allowed to borrow more. Catastrophe? Well, no – and yes. The first thing to be clear about is that this has happened before, 18 times, most recently in 1995. So see it not as a financial nuclear weapon but as a device whereby the legislature exerts its authority over the executive. Most essential government services will continue and, provided the shutdown does not last too long, in a few weeks everything returns to business as usual.

But at another level, it matters tremendously. The row that led to this reminds the world that the US finds it hard to take fiscal decisions. Its government has been allowed to borrow more than 10 per cent of GDP and there is no mechanism to correct this. It has been able to borrow partly because foreign governments, notably China, have been prepared to lend it money, and partly because it is now monetising its debt by borrowing from the banking system.

Everyone (except a few "deficit-deniers") knows this. Everyone is aware this is unsustainable. It would not be that difficult to make adjustments to the tax system to raise more revenue and adjustments to spending to cut outlays, but it cannot be done. The political system cannot cope.

Previous financial crises involving the US have resulted in a run on the dollar but in previous crises the dollar was the principal reserve currency and, eventually, after some policy changes, things were brought under control. Now the dollar, while still more important than any other currency, is losing its global role. Things don't change overnight but what has just happened speeds up that loss of authority.

There is something else coming up. If there is deadlock over the requirement to approve an increase in the federal debt limit, then things may get tricky.

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