Europe and inflation will be key to UK's fortunes in 2012
It is time to look forward – and not only 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 most of 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, and that undermines everyone's confidence when looking into 2012.
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 has been far above expectations and this has reduced real growth (people are still spending the money but they don't get so much in the shops for it). And in Europe, even those of us who were pretty downbeat about the eurozone's ability to get to grips with its problems have been surprised by just how inadequate the response has been.
Well we won't make that mistake again next year. There will be a eurozone recession in most of the large economies, the main possible exception being Germany, and there is a good chance that the region's economy will shrink year on year.
The bottom chart shows projections for both next year and 2013 from Goldman Sachs. These are below the consensus but are interesting because this time last year the bank was one of the more optimistic of the pack.
It is very clear that the eurozone will continue to be fraught through next year and the now-common view that at least one and probably several countries will exit it in the next two or three of years will probably turn out to be right. Timing is difficult but the general rule in such matters is that things take longer than you would expect to happen but when they do they move more quickly and more violently. At least the UK authorities are prepared for a complete breakdown of some of the fringe countries' banking systems, an outcome that cannot be ruled out.
There is one thing, however, that we can be confident about, and more confident now than earlier this week. That is if and when things do get really nasty the European Central Bank (ECB) will do what central banks have to do in extreme circumstances: print the 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, with some already facing something close to a silent run.
The difficult thing to predict is how a eurozone break-up would affect the regional economy. Conventional wisdom holds that 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 judgement, partly because the people making it usually have some motive for so doing and 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 it subsequently climbs. 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 that again and again 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? The top graph shows what has happened to real GDP for the four largest eurozone economies, together with some projections for the next two years. As you can see, Germany is already past its previous peak, while Italy has barely recovered at all. If those projections are anything like correct, Italy and Spain will plunge on down for another two years. That is not reasonable. You cannot do this to countries just to preserve what everyone now accepts is a flawed currency union. 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. Look at the way in which people in the UK are still ambivalent about the structural reforms pushed through by Margaret Thatcher. You need a devaluation to spread the burden of those costs as widely as possible, as well as its positive impact on demand. Devaluation without reform is no solution; but reform without devaluation is unbearably painful.
As for the UK, well, a lot depends on what happens in Europe. If the outlook of modest growth next year followed by decent growth in 2013 proves right, then we just about remain on the reduced trajectory now expected by the Office for Budgetary Responsibility. My own feeling is that the key thing to look for – aside from Europe – will be what happens to inflation. If it does fall sharply, then everything will look materially brighter. A consumption-led recovery? Well, 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 a natural condition – most years most economies left to themselves will grow – and second, that climbing out of huge hole of debt was always going to take several years. At least we have flexibility – and we will need all of it.