Being flexible will allow economy to grow at last
It is time to look forward — and not because 2011 has been a deeply disappointing year.
It has been disappointing in a general sense for what has happened — the serious slowdown in growth across the developed world but most seriously in Europe. But it has also been disappointing because most of us did not fully see this slowdown coming.
So why were most forecasters wrong? The answer depends on which bit of the world you look at. In the US I think it was mostly that the housing overhang has been taking longer to correct than anyone expected and the political gridlock over the deficit remains as difficult as ever.
Here in the UK the main problem has been that inflation was high, and this reduced real growth (people are still spending money but they don't get so much for it). And in Europe, even those of us downbeat about the eurozone's ability to get to grips with its problems have been surprised by the inadequate response.
Well we won't make that mistake again next year. There will be a eurozone recession in most economies, with the possible exception of Germany.
The now-common view that at least one country will exit the eurozone in coming years will probably be right. Timing is difficult but the general rule is that things take longer than you expect to happen but when they do they move quickly and violently. At least the UK is prepared for a breakdown of fringe countries' banking systems. There is one thing that we can be confident about. That is if and when things get really nasty, the European Central Bank (ECB) will do what central banks must: print money. The huge loans made available to European banks this week — nearly €500bn (£416bn) — show that the ECB is very aware of the fragility of the banking system. It is a measure of the distress of the banks that this action, though greater than expected, did not revive the markets. It reminded people of just how difficult many European banks are finding it to attract deposits.
The difficult thing to predict is how a eurozone break-up would affect the economy. Conventional wisdom holds there would be a loss of output at least as large as occurred after the US sub-prime debacle.
Well maybe. But I don't trust that judgment, partly because the people making it usually have a motive for so doing, partly because the break-up of other currency unions has not always led to large losses in output. The experience for countries that suffer a forced devaluation is that overall output may initially drop but then climb. And for the remaining “hard euro” countries, while there might be an initial loss of competitiveness, after a period of adjustment, they will manage to cut costs and become super-efficient. Germany has done repeatedly since the Second World War. So my feeling is a eurozone break-up would not only have lower costs than the fear-mongers suggest, it would lead to a more efficient Europe. Besides, what is the alternative?
Certainly, both Italy and Spain need to carry out structural reforms, but these take a long time to show positive effects and in the short-term impose costs.
You need a devaluation to spread the burden of those costs as widely as possible. Devaluation without reform is no solution; but reform without devaluation is painful.
As for the UK, a lot depends on Europe. If the outlook of modest growth next year followed by decent growth in 2013 is right, we just about remain on a trajectory expected by the Office for Budgetary Responsibility. My own feeling is that the key thing to look for will be what happens to inflation. If it does fall sharply, then everything will look brighter. A consumption-led recovery? Not exactly, but consumption accounts for two-thirds of GDP so what happens to it is extremely important to the overall outcome.
The two big things I find helpful to remember are, first, that growth is natural — most years most economies left to themselves will grow — and second, that climbing out of a huge hole of debt was always going to take several years. At least we have flexibility — and we will need all of it.