Wednesday 12 December 2018

Euro economy is on the rise but long-term risks remain

The British economy must battle against the uncertainty brought about by the prolonged stagnation of real incomes and spending cuts
The British economy must battle against the uncertainty brought about by the prolonged stagnation of real incomes and spending cuts
Brendan Keenan

Brendan Keenan

Keynes called it "animal spirits", which seems an appropriate word during a bubble. Then there is "confidence", which is what keeps a bubble blowing. When there is a bust, "uncertainty", follows - which is what we have now.

Whatever it is called, and however economists put it into their equations, its effects can be felt and seen. We are at a strange juncture, where the uncertainty which gripped the eurozone during its currency crisis is turning into something which might well be called confidence, while uncertainty over Brexit slows the British economy.

In its latest UK forecast, the EU commission did not incorporate any disruption of trade because of Brexit, but it still cut its estimate for growth this year to 1.5pc and saw further slowdown to come, with 1.3pc next year and just 1.1pc in 2019.

That is a good deal more pessimistic than the Bank of England's estimate of 1.7pc growth in each of the next two years. Uncertainty is more of an assumption than a forecast but, considering the furore over one government defeat in the UK parliament last week, it seems reasonable to assume that the next two years will provide lots of reasons for investors to pull in their horns and customers to close their wallets.

In fairness, it was not all gloom from the UK. The most recent figures showed employment holding up, with more than 75pc of those aged 16-64 in work. Along with the size and depth of the UK's financial market, the data was cited by the DBRS ratings agency as a reason for maintaining the country's AAA rating.

More importantly perhaps, average weekly earnings rose by 2.3pc in the third quarter compared with the previous year - more than had been expected, but still less than the inflation rate of 3pc; itself the sharpest rise in prices for almost six years.

The British economy must battle against the uncertainty brought about by the prolonged stagnation of real incomes and spending cuts which have been large enough to damage public services, but not drastic enough to persuade people that the public finances are coming under control.

It can also be assumed that the political chaos in Westminster will damage confidence and economic performance, while it requires no assumptions to recognise that, if there is actual disruption to trade, the forecasts will take another knock.

Across the Channel, opposite forces seem to be at work. It has been a long hard decade for the eurozone, with fears for the currency's future and the tide of refugees creating enormous uncertainty; not helped by the ECB's tardy response to recession and the absence, whether justified or not, of government stimulus.

The ECB arrived in the nick of time and the political uncertainty around the refugee crisis has abated, at least for now. Economists call this kind of thing "cyclical" recovery but it is a very human cycle. People are infinitely adaptable. They adjust to difficult times and begin, of necessity, to spend and invest more. If external conditions improve at this stage, the results can be dramatic.

This appears to be what is happening in the Euro area. Its economy is expected to grow at its fastest since 2011. Consumer spending is rising by around 2pc and there will be particular satisfaction over the investment expansion of more than 4pc, after several moribund years.

For once, a sharp rise in imports can also be regarded as good news, matched as it is by a 5pc increase in exports, as a sign of lively economic activity.

It is more difficult to know whether to regard eurozone inflation of less than 1pc as good news, especially for those in debt. Irish prices have been rising even more slowly than that, although there is a marked contrast between the falling cost of products and some hefty increases in services. Nevertheless, it has helped preserve living standards when wages were falling and taxes rising.

To judge from last week's ECB press conference, not much is going to change. A rise in the cost of borrowing might well reignite uncertainty, and would do little to push inflation towards the desired level of above 1.5pc.

This is in marked contrast to the US Federal Reserve, which was remarkably definitive last week. As the US economy continues to strengthen it raised the base 'federal funds rate' to 1.5pc, which is at least in the range of historical normality and it wants to continue until the rate reaches a fairly normal 2.8pc in 2019.

If both central banks stick to their plans, the results could be striking. The euro would weaken against the dollar, which would add something to eurozone inflation, as well as supporting growth via exports. Whether the ECB could hold its nerve, with a gap of two percentage points between the base rates, is another matter.

The Bank if England's nerve is already being tested. Since the euro was founded, sterling has tended to track it rather than the dollar, although not completely. But all is changed, changed utterly. It will be some time before we can detect a new pattern, assuming there is one at all.

The BoE can hardly afford to follow the Fed's aggressive stance. The condition of the UK economy argues against any increase in interest rates but it will also be sensitive to any further rise in inflation caused by a weaker currency.

Far be it from me to forecast currency movements but if logic is any guide (which on past form it isn't) a fall in sterling against the euro and the dollar can be expected. Irish firms, both exporters and importers, may face consumer uncertainty as the Brexit negotiations heat up, coupled with pressure on profits from a stronger Irish effective exchange rate.

Over time, Britain may look more and more like an outlier, both in law as a non-member of the EU and in fact, as an economy ill-suited to its new regime and unable to make up the lost trade caused by Brexit.

Brexiteers are already taking the long view, since it is now impossible to argue convincingly that there will be short-term gains - but they may have a point.

A grim analysis in the recent ESRI quarterly by Kieran McQuinn and Karl Whelan suggests a shrinking population and weak productivity will reduce the eurozone's potential growth to one per cent a year over coming decades.

Britain has better demographics than Germany or Italy (as does France) but its productivity performance has been worse. Perhaps, eventually, that can be improved and a more stable, younger workforce allow it to outperform most of the eurozone which would, however erroneously, be credited to Brexit.

Perhaps: on the other hand, we all know what Keynes thought about the long run.

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