Sunday, May 30, 2010
The world's glass is more than half full
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Is the glass half full or half empty? I am indebted to the Organisation for Economic Co-operation and Development (OECD) for giving us both options in its twice-yearly economic outlook.

Its central message was that growth prospects around the world have improved, as evidence of recovery has come through faster than expected. But this was partly balanced by the fact that the risks, particularly on sovereign debt, are higher than they were.

For glass half-full types, the OECD's new forecasts are positively mouthwatering. Last year world trade plunged 11%, easily its biggest annual fall in the post-war period. This year it will grow 10.6%, almost making up the loss in 12 months. Next year it will grow 8.4%.

This does not look like a global economy battered by wave upon wave of protectionism, which was one of the fears at the height of the crisis. Indeed, world trade over the next two years will be stronger than its pre-crisis rate of growth of 7.3%.

Global economic growth, 4.6% this year, 4.5% next, does not regain the heights of 2007, when it was very strong at 5.1%, but still bounces formidably. OECD members in the advanced economies do not reach these heady heights, but 2.7% growth this year, 2.8% next, are in line with the 1997-2007 average. With numbers like these, you might be tempted to say: crisis, what crisis?, though I wouldn't advise David Cameron, the prime minister, to do so.

For the glass half-empty school, which also lurks within the OECD's headquarters, and in the wider world, these optimistic numbers will never be attained because that global crisis will come back and bite us. Mervyn King, the Bank of England governor, has said we are only halfway through it and the behaviour of the markets deepest despondency one moment, wild-eyed euphoria the next is testimony to an underlying instability.

What are the risks? "A first is related to developments in sovereign debt markets," the OECD warns. "While originating in some euro-area economies, instability has spread to other members and sovereign debt markets in other parts of the world.

"Overheating in emerging-market economies also poses a serious risk. A boom-bust scenario cannot be ruled out, requiring a much stronger tightening of monetary policy in some non-OECD countries, including China and India, to counter inflationary pressures and reduce the risk of asset-price bubbles."

There is also a choice of glasses when it comes to the outlook for Britain. The OECD's financial conditions index measures whether such conditions are conducive to economic growth on the basis of changes in real interest rates, bond spreads, credit conditions, exchange rates and wealth. The index for Britain, which stands at more than five, compared with a minus number of almost that much in the autumn and winter of 2008-9, is stronger than elsewhere, partly because of sterling's depreciation. Each point on the index is consistent with an increase in GDP of between 0.5 and 1 percentage points after 12 to 18 months. Taking the mid-point of that range would give a growth rate of 3.75%. It could even be higher.

This is the Bank of England's private response when accused of presenting over-optimistic growth forecasts, which are for growth to pick up to about 3% next year and maintain that rate in 2012.

You have to ask what would happen in normal circumstances with a Bank rate of 0.5% alongside a substantial fall in the pound. Normally, with such a stimulus, the economy would be booming like billyo, so 3% is, if anything, restrained and allows for quite a lot of pain in the form of tax rises and spending cuts.

There is a bit of that in the OECD report. Indeed, it spells out the possibility of something like a golden scenario for Britain. "The normalisation of financial conditions could underpin a stronger rebound in household consumption which, together with an even swifter recovery in exports, could spur investment and raise growth further," it says.

"Furthermore, the substantial improvement in banking sector health has also diminished fiscal risks associated with the large stakes the government had to take in the banking system during the crisis."

For every bit of economic optimism there is an equally pessimistic view, a Dr Doom for every Dr Pangloss. The "but" in this case is easily defined. The dog that has not barked since the election rising gilt yields as investors flee from government bonds could start howling.

"If bond yields rise faster than expected or inflation expectations stray further from the Bank of England's target, fiscal and monetary policy may have to tighten faster to maintain credibility," it warns.

If the Treasury and Bank have got it wrong over the amount of spare capacity left by the recession, "the underlying fiscal position could be even worse and inflation pressures would build up quicker than expected, forcing swifter and more dramatic policy tightening".

So what will it be? As far as the world is concerned, I would tend to go with the stock-market view at the week's end, rather than the armageddon at the beginning. The global upturn, in other words, will be bothered from time to time by the banking crisis's aftershocks, including periodic panics about sovereign debt, but they will not be powerful enough to halt the recovery.

Britain is more delicately placed. The OECD favours higher interest rates and for the Bank to start reversing the process of quantitative easing so selling gilts back into the market in the second half of this year. It thinks Bank rate should be 3.5% by the end of next year, on its way to full "normalisation", which I would take to be 5%.

There is a way out. If the new government's fiscal plans are for "more rapid fiscal consolidation", this would allow the Bank to raise rates more slowly, which is what I would expect. Slamming the fiscal and monetary brakes on at the same time would risk stalling the engine.

Financial conditions in Britain are conducive to recovery. We should try to ensure they stay that way, at least for a while.

PS: On its cover, Prospect, a magazine for people with very large intellects, asks Is Europe Bust? It is a question people in the markets, and in the hedge-fund gully in London, have been asking.

Let me leap to the eurozone's defence. Consider two large economies, both with reserve currencies. One is America, the other the eurozone. This year, on OECD figures, America will have a budget deficit, adjusted for the cycle, of 9%
of GDP. The eurozone's is 4.1%. America will have a current account deficit of 3.8% of GDP, while the eurozone will have a surplus of 0.3%. There is little to choose on unemployment (9.7% America, 10.1% eurozone) or inflation (1.6% America, 1.4% eurozone).

So why such a downer on poor old Europe? One answer, of course, is that America is an economy with a federal fiscal policy, while the eurozone is a collection of individual countries, whose dissimilarities outweigh their similarities. When those dissimilarities are exacerbated by the "one size fits all" monetary policy, there is no European-wide fiscal policy available to offset it.

The other is that, for all the damage done to America by the crisis and recession, it has retained its ability to grow, by 3.2% both this year and next, according to the OECD, compared with 1.2% and 1.8%, respectively, for the eurozone. Europe has plenty of bright and creative people and successful businesses but it still lacks America's dynamism.

From The Sunday Times, May 30 2010