Are Things Improving ? Economic Outlook

by Andrea Boltho

The turn of the year has seen some return to moderate optimism in the world economy. The United States witnessed the achievement of a last minute compromise on budgetary policy which appears to have avoided the economy plunging off the so-called fiscal cliff (the automatic expiry of the Bush tax cuts and other expansionary measures, together with reductions in government expenditure, which were all to kick in on 1st January 2013). Partly as a result, Wall Street has climbed to levels not seen since late 2007. Several recent indicators also suggest that activity in China has rebounded and a hard landing no longer seems on the cards. Finally, in Europe financial market tensions have eased significantly. The interest rate differential between Italian and Spanish bonds on the one hand and German ones on the other, has declined sharply from the 4½ to 6 percentage points recorded in the Summer to levels (2¾ to 3½ per cent) that, while still high, do not really threaten the two countries’ public finances.
This being said, some of the present euphoria may be misplaced. While it is true that the Chinese economy looks set to return to 8 per cent growth, or even more, over the coming year or two, its imbalances are still severe. The recent recovery has been mainly fuelled by investment spending which, all observers would agree, at well above 40 per cent of GDP, is far too high already. Consumption growth remains subdued. Equally, debt accumulation by the private and local government sectors seems to have reached levels that in other countries have often been associated with real estate bubbles. The authorities are well aware of these issues and have sufficient instruments to avert a major crash, but the outlook for the country is, nonetheless, one of gradually decelerating growth.
In the United States, private sector activity is clearly improving. The housing market is giving signs of renewed vitality after a five-years long hibernation; job growth, while hardly dramatic, is solidly positive and confidence indicators suggest modest increases in expenditure over coming months. Fiscal policy, however, despite the confirmation of the Bush-era tax cuts for most households, will remain restrictive, not so much because of the marginally higher taxes that will be imposed on the richest families of the country, but because of the expiry of the payroll tax cuts. This could well have a negative effect on GDP growth of 1 percentage point or more in the course of 2013. In addition, of course, new hurdles loom ahead. The issue of future expenditure cuts has been postponed by only a few months. Some cuts will be inevitable, even if a potential compromise might postpone the necessary reductions in the generosity of health and pension schemes to a more distant future. And the debt ceiling negotiations which must be concluded by the Spring, to avoid and open default by the Federal government, promise a nail biting confrontation between Democrats and Republicans with no certainty of a positive outcome. All this is bound to temper private sector optimism and make for a few very fraught months in the near future.
In the Eurozone, Draghi’s promise to “do whatever it takes” to preserve the Euro has clearly had a dramatically positive effect on expectations. Though the ECB has not printed a single euro to buy the government bonds of governments in difficulty, the so-called “spread” has shrunk significantly. However, the OTM programme that would put Central Bank bond purchases into effect has so far not been tested. Should it be one day if, say, Spain were to apply for a bailout, it is unclear how far the ECB would be prepared to help the country. According to the programme, such help would be conditional on Spain fulfilling certain obligations, but the definition of these obligations and, even more so, their fulfillment will be a matter of imperfect judgments. To get an idea of the scope for ambiguity, one has just to recall how often the so-called Troika (the group made up of EU, ECB and IMF officials supervising the Greek bail-out programme) has changed its views on whether Greece did, or did not, fulfill the various requirements that were imposed on it. Financial markets could thus return to turmoil, with predictable consequences for interest rate differentials and confidence. And Italy could also suffer from renewed uncertainties, should the forthcoming elections give Berlusconi (Heaven forbid !) the power to block sensible government decisions in the country’s Senate.
But even in the absence of renewed turmoil, Europe’s economic prospects look weak. It is true that an improved American and Chinese outlook would be helpful for exports. On the other hand, however, bank lending is still declining, unemployment is rising and consumer and industrial confidence remain depressed. Most importantly, fiscal policy continues to be very restrictive both in the Eurozone and in the UK. The IMF (in October) and the OECD (in December) estimated that the recessionary impact of programmed fiscal austerity could average some 1.5 per cent of GDP in both the Eurozone and in the UK over the years 2013 and 2014, with the bulk of the squeeze on the Continent occurring this year and in Britain next year. And in the recent past at least, the restrictive effects of announced fiscal policy tightening have often been underestimated.
The four main Eurozone Southern countries (soon to be joined by Cyprus) are already in recession and this recession is highly likely to continue this year and, possibly even into the first half of 2014. Britain and France have skirted with recession and will likely continue to do so. More worrying are the prospects for Germany. Until recently, the country was able to buck the negative European trend, and, thanks mainly to its export performance, exhibited relatively buoyant growth figures. The recent weakness in the global economy and the worsening picture in the Eurozone are now beginning to affect the German export machine. Though a fully fledged recession is not on the cards, semi-stagnation in 2013 has become a distinct possibility.

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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.
Source: Info REAG