Dark Clouds Persist

By Andrea Boltho

Despite some recent easing of tensions in Europe, the world’s economic picture has not really improved in any significant way since the last note was circulated in July this year. Indeed, most of the estimates and forecasts for 2012-14 GDP growth in the major economies have been revised downwards, with the Eurozone now expected to be in recession both this year and next.
The situation has changed least in the two single largest economies: the United States and China. American growth, while positive, has remained subdued in recent months, even though a number of important variables have moved in a favourable direction. Thus, household finances have continued to improve as families have reduced their debts; house prices may have touched bottom; the labour market, if hesitantly, is adding jobs, and unemployment is declining. Together, these various developments ought to make for accelerating growth in the near future. But the near future is still clouded by the uncertainty surrounding the so called “fiscal cliff” (the expiry of the Bush tax cuts and other expansionary measures, together with reductions in government expenditure, which all kick in automatically on 1^st January 2013). In the absence of a political compromise (which may be difficult to achieve given the continuing divisions between the two main parties), the US economy could be hit by a negative shock equivalent to 4 per cent of GDP. If this were to happen, a new recession would be virtually inevitable. While most observers do expect that some compromise will, after all, be reached, the uncertainty is weighing on investment decisions and adding to economic sluggishness.
In China there are numerous indications of slowdown. The country will almost certainly avoid a hard landing (an encouraging sign is that house prices in the major cities have stopped falling after a period of decline that goes back to mid-2010), but growth will certainly fall below 8 per cent this year. Thereafter, much will depend on whether the authorities take concerted action to help the economy. On the monetary front some steps have already been taken. There seem to be greater hesitations on the fiscal front, even if the public debt and deficit situations give plenty of scope for action. It is conceivable that taking decisions in a year of major political changes is hampered by infighting between various factions of the party. Be this as it may, it is clear that the longer-run outlook for China is that of a gradual slowdown in growth as labour supply begins to shrink and the exchange rate continues on its upward path.
The European situation has, ostensibly, improved. Since the President of the European Central Bank, Mario Draghi announced in July that he would put in place “all it takes” to preserve the Euro and unveiled in September the OTM (Outright monetary transactions) programme designed to achieve this, spreads on Italian and Spanish bonds have narrowed sharply. In addition, some measure of agreement has been reached to give Greece more leeway and time to meet its targets. This, in turn, has diminished fears that the country may be forced out of the single currency and, for the time being at least, has shelved, the widespread fears that monetary union might collapse. In addition, at the last Brussels Summit, a timetable for an eventual banking union was provisionally agreed upon (even if there are still important differences on the contents of this union).
Yet, most of the underlying problems still remain. Greece is in deep recession and so is Portugal. The continuing austerity demanded by the bail-out providers only makes this worse, without solving the public deficit and debt problems. Indeed, Greek debt, as a percentage of GDP (and despite the restructuring carried out in Spring 2012) is expected to rise from some 145 in 2010 to nearly 200 in 2015. In such circumstances, it is doubtful, to say the least, whether the country can achieve by 2020, in the absence of another default, the 120 per cent level desired by the IMF. The Italian and Spanish situations are less dramatic, but even here a sharp recession is already occurring this year and can be expected to continue into 2013. This will, in turn, make it much more difficult to reduce deficits and debt levels. For the time being, the “announcement effects” of the Draghi plan have been sufficient to convince markets that there is no point in selling Italian and Spanish bonds. This, obviously, helps but may be insufficient should complacency set in.
And as spreads decline and tension diminishes, there is a strong temptation to ignore potential future difficulties. Spain, for instance, might ease up on its fiscal commitments. This is, after all what the Berlusconi government did in Italy in similar circumstances in the Summer of last year (fortunately, the present Italian government is behaving in a much more coherent way). As for Germany, the country is already in pre-election mode, and is, therefore, keen on procrastinating and postponing any major decision on future disbursements or on future policies. Eventually, however, markets are bound to test the ECB’s resolve, particularly in a world in which Rajoy hesitates on whether to ask for a bail-out programme for Spain and decisive moves towards a banking union are, de facto, blocked by German intransigence (or by French-German disagreements) . Should markets resume speculation against Spain (and, possibly, Italy), it is difficult to know how far the ECB can go. In theory it has the firepower to preserve the Euro. In practice, given the strong opposition of the Bundesbank and others, its room for manoeuvre is, inevitably, limited.

Andrea Boltho is now an Emeritus Fellow of Magdalen College, University of Oxford, where he was Fellow and Tutor in Economics from 1977. His areas of interest are international economics, economic policy and applied macroeconomics. In 1966 he began his career at the OECD’s Department of Economics, where he was also editor of the publication Economic Outlook. In 1973-74 he spent a year as a researcher at the Economic Planning Agency in Tokyo.
He has been Visiting Professor at the Collège d’Europe in Bruges, at the Universities of Venice, Turin, Paris, Siena and Rome Tor Vergata, at the Bologna Center of the Johns Hopkins University, at the International University of Japan and at INSEAD. He served as a consultant to the World Bank, as a researcher for the Ente Einaudi, as a member of the Academic Board of the IFO Institute in Munich, was a member of the Board of Finmeccanica between 2008 and 2011 and is a Director of Oxford Economics. He has collaborated with numerous multinational corporations such as ABB, FIAT, IBM, KPMG, Pirelli and Siemens.
He has written books on the Japanese and European economies, including an edited volume comparing Italy and Japan. After high school in Italy he studied at the London School of Economics and at the Universities of Paris and Oxford.
He is a member of REAG’s European Advisory Board. His main task is to monitor and analyze macroeconomic trends in Europe and assist operating management in their business development activity.