Between austerity and sovereign debt crisis

Austerity measures do not necessarily have to impede growth and although there are many short term risks, Europe will solve the euro crisis, says George Buckley, chief economist with Deutsche Bank in the UK in an interview with the Journal.

Much of the world’s attention at the moment is focused on Europe’s ability to deal with the sovereign debt crisis and the potential fallout for the global economy should one of Europe’s economies default on its debt obligations in a disorderly fashion. Despite a lot of negative media coverage of the issue, Deutsche Bank expects that there will not be an implosion of the euro area and that the euro sticks together, says Buckley. He argues that European countries have already demonstrated massive political will to get out of the crisis. Greece meanwhile will go through the process of an orderly default.

Buckley concedes that in order to achieve this a lot needs to happen. At the same time the risk of a political mishap has increased and several economic challenges remain.

“That is not to say that we won’t see some worryingly negative trends in the near term and a recession makes it all the more difficult to achieve fiscal balance,” he said.

When looking at GDP ratios, GDP is the denominator and the lower the GDP relative to expectations the greater the ratio and the harder it will be to get the numerator down. “So a combination of those two makes it much more difficult to achieve fiscal balance.”

Risks but no recession

Deutsche Bank’s central model forecast does not expect a recession but sees slowing GDP growth, which makes it impossible for an economist to say that a recession is not a serious risk, Buckley says, adding that the bank’s central forecast is positive, but only relative to a second recession.

What is positive is that there has already been an enormous amount of stimulus injected into economies by central banks globally, including the Federal Reserve and the UK with two rounds of quantitative easing and even Europe which had its own QE and might well restart its covered bond programme.

In addition Chinese, US, UK and Euro policy rates adjusted for inflation are heavily negative.

“One argument is that you cannot borrow at the rates banks are borrowing from the central banks, but the important thing is that if you look at the rates that people do borrow at, they are the lowest on record,” said Buckley. “If you look at the UK mortgage interest rates, they are currently averaging 3 per cent for a three year fix, something we have never seen. Even with the big spread to bank rate and the big spread to official rates you are still looking at exceptionally loose monetary policy.”

One of the key questions is whether the money freed-up in banks by quantitative easing will actually flow to the businesses that need those funds and whether QE will have a significant effect on economic growth.

In the UK, says Buckley, the Bank of England has estimated the impact of QE on GDP to be around 1.5 per cent and ¾ per cent on inflation.

“It had an effect. What is important though is that the more QE you do it has a declining marginal impact,” he says. “Look at where rates are now; they are not far off 2 per cent on 10 year rates. Can they come down more? Yes they could, but would it have the same impact? There is a limit to how much more QE can do.”

Are austerity measures stifling growth?

Buckley believes the markets are understating what some countries have done in terms of spending and says especially the front loading of the measures and a fiscal impulse that is much bigger in the first year than in the following years of austerity programmes are positive for growth in the long run.

He points out that the UK economy in the past was able to produce above average GDP growth during periods of fiscal tightening. “The reason you get that is because every other policy was pulling in the right direction.”

The current situation is not all that different, he says. “We have got huge cuts in rates, we have got quantitative easing, we have a much lower currency [in the UK]. The same fiscal reasons that helped us through fiscal tightening in the past are evident today.

“So you can have strong growth at the same time as tightening fiscal policy.”

To demonstrate this effect, Buckley refers to the “credit impulse”, a comparison of the year on year change in the flow of credit as a percentage of GDP and consumption plus investment. A graph plotted in this way shows that both curves follow each other, which means that either lower credit supply can cause a fall in GDP or that lower GDP reduces the demand for credit.

“The reason that is important is because it tells you that you don’t need to see an outright releveraging of the economy to cause growth. All you need to see is a slower rate of deleveraging,” he says, giving the example of someone who has annual income of $100 and in the first year uses $40 to pay down debt. If in the second year only $20 of the $100 income are used to pay down debt, this leaves $20 more to spend.

“Spending power grows when deleveraging slows. This is why the fiscal impulse works. If you do a lot in the first year in terms of fiscal tightening and then you do less in the years afterwards that is positive for GDP growth.”

Standard economic challenges in Europe

Given that almost every country is tightening policy, fiscal consolidation and its growth negative effect is, in the short term at least, one of the economic challenges.

Aside from the sovereign debt crisis, the strength of the euro is another challenge in Europe. “The strength of the euro and slower global GDP are a bad combination. This obviously risks derailing any recovery which we might get after this rather worrying slowdown.”

The third issue in Europe, but also elsewhere, are high energy prices. Although there has been some weakening in commodity prices, they continue to be high and have brought an unanticipated inflation shock and therefore an unanticipated disposable income shock to people in developed economies especially, he says.

In the UK where inflation currently stands at 5.2 per cent because of higher energy prices, as well as tax increases and the weak Sterling, the situation may get worse in the winter. As energy consumption is not weighted in the inflation figures throughout the year, big energy bills between December and January could make the situation worse, even though the data might not look that bad. In addition the inflation rate will come down in 2012 because of lower VAT.

“So we are worried about inflation and what it does to expectations, but at the moment it has not filtered through into wages and does not look like it is going to do because we are seeing higher unemployment over the next couple of years,” says Buckley.

The final economic challenge in Europe overall is the inventory overhang, which shows that the stocks to orders ratio has been rising. Higher stocks have a negative impact on future production, especially when demand is quite weak. “In fact that is one of the reason inventories have risen because demand has been weak. Production stays the same, demand weakens and so you just build up stocks.”

Another particular concern in the UK is the level of household debt. When comparing the level of household debt as a proportion of income over the past 15 years, Germany and Japan are the only countries where we have seen household debt fall over the past 15 years, because of the housing market, says Buckley.

“What worries us is that the UK has the highest level of household debt as a proportion of income and the change in that debt since 1997. And it is not just the level of debt that we are worried about, it is the fact that it has increased so rapidly.” The concern is that given the huge stock of floating rate debt an increase in interest rates would have a very damaging effect on households and their ability to consume and repay their debt.

Regional outlook

Giving a general outlook, Buckley says, Latin America and Eastern Europe will do reasonably well with 3 per cent to 5 per cent growth rates. Asia is going to do much better, he forecasts, despite a slowdown that can be expected for China with a GDP of 6 per cent to 7 per cent at the start of next year. But Chinese GDP is going to pick up again throughout the course of 2012, he adds.

Overall Buckley is more positive on the US than on Europe. Deutsche Bank is expecting 2 per cent to 2.5 per cent growth in the US, while in Europe growth is currently at 0.8 per cent and the risks are heavily weighted to the downside.

“It looks like the purchasing manager indices, which we think are great surveys, are pointing to a contraction in Q3 and Q4,” he notes, adding however that such a contraction will be relatively brief.

In the UK, in contrast, growth rates will be stronger next year, he says, but this is purely down to base effects.

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