This is the fourth in ConservativeHome’s series of posts counting down to the Autumn Statement. On Tuesday, Tim Montgomerie said that George Osborne’s economic narrative is taking shape. Yesterday, Peter Hoskin urged Mr Osborne to ditch his current fiscal rules, and Tom Frostick argued that the Chancellor must target wealth.
The British economy has not grown well in recent years, and in particular since late 2009 the government’s forecasts for economic recovery have been woefully inaccurate. Ed Balls and certain Keynesian-oriented economists like to blame the Coalition’s deficit reduction plan. The Coalition likes to blame the Eurozone crisis. Personally, I always argued that, although there might be temporary periods of faster growth (as, for example, the third quarter of 2012) the underlying capacity for the economy to grow was much lower than government forecasts had it so any rapid growth would be inflationary and reversed in subsequent recession anyway. It’s the slow growth that creates the need for deficit reduction – it isn’t the deficit reduction that’s creating the slow growth.
International events since 2010 have, however, been fairly unhelpful. That’s not, as sometimes suggested, because international growth has been poor meaning UK exports have been lower than hoped. In fact, world growth has been fairly strong since the contraction of 2009, growing a rapid 5.3% in 2010, 3.9% in 2011, and probably above 3% again in 2012. And exports from the UK have indeed grown – up 6.4% in 2010, a further 4.5% in 2011 – though over the first three quarters of 2012 they were up only 0.5% on the equivalent period in 2011. Clearly some of this export growth is likely to have been associated with the marked drop in the international of the pound – down more than 30% at peak – but it is also a reflection of a reasonably favourable international growth environment.
The way in which international conditions has impaired growth has not been via trade, but via finance and investment. Specifically, the Eurozone crisis has created an ongoing risk of total disorderly collapse in the euro – an event that would be likely to induce total disorderly collapse in the EU and something of the order of a 20% contraction in Eurozone GDP, including multiple sovereign defaults and thence the collapse of much of the Western banking system. In such an uncertain environment, UK businesses have been unwilling to risk investing and instead have built up huge precautionary cash piles – which on some estimates could be as high as £750bn.
In thinking about how the international environment creates risks and opportunities, then, we need to think not only of trade but also of other linkages. I shall here sketch issues arising in five kinds of areas: the Eurozone, the US, China, Oil, and Shipping.
The Eurozone is in recession again, which is not especially helpful for UK exporters, but is far from the worst aspect of the Eurozone crisis. As noted above, the main threat of the Eurozone crisis is via financial linkages. There are those that claim that with Draghi’s “Outright Money Transactions” (OMT) “bazooka” announced recently, the Eurozone crisis is over. In my view the OMT materially further increased the risk of total Eurozone collapse – by which I mean any scenario in which Germany, France and Italy cease to be in a currency union together.
At the same time the Eurozone offers the second-greatest opportunities for upside risk – things going better than the base case – of the areas I shall sketch here. For the European Union has finally understood that the Eurozone cannot function healthily without political union, and is now rushing headlong towards ever-more-explicit such political union, in the form of a confederacy (the “EU Federation”) to be established from 2014 on. If that plan proceeds – as I expect it will – and if it is not derailed by the Germans being pushed into so much debt pooling that Germany withdraws from the euro (which is much the greatest potential source of risk of euro collapse), the EU federation could, with the confidence of a new country, enter an era of flourishing from the 2020s on, emerging as a new world power to challenge the United States. This is potentially the most significant political event since the second world war – perhaps even more important, in the long run, than the fall of the Berlin Wall (though obviously in a sense not separable from that).
For the Eurozone, my current prognosis is: base case (political union secures the euro and leads to a period of rapid growth from the 2020s on) – 60%; downside case (total disorderly collapse of euro leading to 20% recession across Eurozone and 10% additional recession in UK) – 40%.
Moving to the US, there are three key types of risk against a base case of an accelerating recovery. These are:
- The economy does not achieve internal momentum and is only delivering the modest growth it is because of extreme and unsustainable policy settings. If this is the case the US will eventually stutter, with particularly bad consequences for Chinese exporters (see below) and thence the broader world economy.
- The economy does accelerate but that when it does the extreme expansion in the money supply through the Fed’s QE programmes then drives a rapid rise in inflation. This could drive international inflation, with implications for oil prices (see more below) and impose severe losses on financial institutions and sovereign wealth funds that have invested heavily in US government bonds.
- The US fails to address its significant medium-term debt issues and political stasis and Keynesian mis-analysis drags it into a sovereign debt crisis. At present there is a false discussion about the risk of a “fiscal cliff” predicated on the notion that there is no limit to the stimulus from deficit financing and that it is just as growth-damaging to cut spending as to raise taxes. There is a considerable risk that this “fiscal cliff” is “addressed” by rapid tax rises with little to no spending cuts, locking in the massive spending rises of the late Bush and Obama eras with catastrophic consequences for the US medium-term sustainable growth rate. If the US sustainable growth rate drops whilst US debt remains so high, there is a non-trivial risk that, without inflation the US would face creditworthiness issues.
On the other hand, the US being the US the “upside” case is as ever the base case – that growth resumes and all turns out well.
My current prognosis for the US: base case (all turns out ok) – 25%; inflationary recovery case (there is decent growth but it comes with at least one year of significant inflation (perhaps double digit inflation)); 35%; no recovery case (growth never really gets going) – 20%; fiscal crisis (20%).
Next China. Some analysts write as if China had been unaffected by the world recession of 2009. It did not. Instead, it opted out, deploying a massive stimulus package and central direction to keep things running much as if there had been no world recession. I think of China as like a company that, when its largest customer went into Chapter 11 bankruptcy, decided to respond by keeping its machines running full pelt and filled up its warehouse. Now that’s all very well if its big customer restructures and comes out of Chapter 11 healthy and demanding the same stuff, or if it finds a new big customer. But if it doesn’t, that stuff in the warehouse is soon going to rot. In much the same way, China has gambled on its big markets – Europe and the US – recovering quickly. If they don’t recover fast enough, the great Chinese gamble will go bad.
The OECD is forecasting a drop-off in Chinese growth as exports to Europe are weaker than hoped. The Chinese are unlikely to be able to maintain political stability for long without growth of above 8% unless there is a considerable diversion of economic development into increased consumption. Such a switch would have implications for world prices (they would rise as Chinese products became more expensive) but would also create new opportunities for Western exporters.
On China, my prognosis is: base case (decent growth under current pattern) – 55%; alternative good case (decent growth under new more consumption-oriented pattern) – 30%; bad case (things go ugly) – 15%.
The next issue is oil. Here there are upsides and downsides – where by “downsides” I mean high oil prices. Oil prices could rise in the near-term as a consequence of the spreading of the Syrian civil war to include Iraq, Iran and Turkey, or because Iran nuclear ambitions eventually trigger a response from Israel and the US. They could rise if world growth accelerates again, as they did in 2007-8 and 2010-11, choking off sustainable recovery in oil-dependent economies. They could rise as part of a spreading of inflationary pressures from extreme monetary easing.
Or they could fall back, as the opportunities of shale-based energy are exploited, as trans-caucasian supply confidence increases, and as there are new finds in the Falklands and elsewhere the exploitation of which is made economic by sustained higher prices.
For medium-term (say next five years) my prognosis is: base case (prices average around $80-$105 per barrel) – 60%; prices average a bit higher than that (say $110-$135) – 25%; prices average a lot higher (say $135 plus) – 15%. Over the longer-term I would expect prices in real terms to fall back into what would today be a $50-$80 per barrel range.
Lastly for this piece I observe that the international financial crisis has drowned out news of potentially the most significant event in maritime trade since the introduction of the screw propeller, namely the opening up of the Northwest Passage from sea ice, making it accessible to ships from 2007 on and used for commercial shipping from 2009. This event could transform world trade, considerably reducing the costs of goods and raw materials transport from Europe and Brazil to the West Coast of the US and across the Pacific to Japan and Northern Australia (and vice versa), and considerably enhancing the prosperity of Canada. If the Arctic Sea ice does not return, commercial shipping along this route could expand rapidly over the second half of the 2010s and early 2020s.
Mightn’t be too bad a time to get friendlier with the Canadians, start to really understand how their economy works and how things might develop there in the future. If only there were, say, a Canadian central bank governor available to hire…