Hamish McRae: Winds of change are blowing over the eurozone – and the UK
Published 17/05/2010 | 01:47
And now to that disagreeable process called “fiscal consolidation”. That will be the governing theme of public affairs for the next decade throughout the developed world.
It has already begun. Things have moved on from a week ago, and not just in Westminster or indeed the UK. There was of course the emergency package of support for Greece and potentially for the other weaker eurozone economies, too. The headline number was huge – the thick end of a trillion dollars – for the rest of the eurozone seemed to be guaranteeing Greece’s debts. In the short run, it seemed to work in the sense that the interest differential between Greek and German debt narrowed. But thiswas at the cost of undermining the euro, which plunged on down.
From a British perspective we should, I suppose, be grateful that we only have to guarantee a small amount of Greek debt. As the then chancellor, Alistair Darling (gosh, don’t things change fast?), pointed out, the UK was liable for only about £8bn of Greek debt through our IMF commitment and then only if Greece were to default entirely on its debt. The widespread view in the markets is that Greece cannot possibly repay 100 cents in the euro, so let’s say we are only going to be down a couple of billion and what is that between friends. But in the case of Germany, the number would be 10 times as big, and if Spain, Portugal and Italy were also to get into trouble, the losseswould start to undermine the credibility of the country itself. Even Germany isn’t rich enough to bail out all of southern Europe.
That is the fear. As I have written already, Greece is the canary in the mine, giving an early warning of toxic gasses that threaten the entire project. This matters for us, despite our having managed to avoid the trap of being lured into the euro. We will be able to service our debts, even if we have to devalue the real value of our currency by inflation to do so. It matters in two ways.
First, the southern flank of the eurozone will hold back the region’s growth. Seen as a whole, the eurozone has managed a slightly better recovery than the UK, as the main graph shows – but only slightly. Now the region’s recovery will be helped a little by the fall of the currency, for as you can see from the right-hand graph, the euro is back to its trough of spring 2009 against the dollar. But that will be offset by even slower growth in the Club Med countries, and that will be a drag on the region as a whole. This matters to us because the eurozone remains the UK’s largest market for exported goods.
Second, the mood sweeping over southern Europe that countries must cut their budget deficits will affect us here. One of the reasons why the UK is making an earlier start than the previous government planned is that once one country is forced to consolidate, others are bound to follow. Mervyn King recognises this; Vince Cable recognises this; and George Osborne spotted the danger of being seen to delay some months ago.
The idea that we have any choice is for the birds. The really interesting issue will be the extent to which other countries with somewhat smaller deficits, Germany and France in Europe, Japan and even the US, will be forced to cut their deficits faster than they currently plan. There is a wind of change blowing over the world’s markets at the moment. They sense their power over governments, for the latter have to go to them to get the money to finance their deficits.
But they also sense some fear. The fear is that if they do lend money to weak governments, they will not get it back. Money managers have a fiduciary duty not to blow their clients’ money by buying bonds that will go into default. They have done that recently on all those AAA-rated bonds that turned out to be rubbish. They will be more careful next time.
So what we have now is a rerun of the sub-prime crisis of confidence of two years ago; but the new sub-prime borrowers are sovereign governments. Formany people, this will seem ridiculous. Politicians certainly find it distasteful and there have been several commentsfrom European leaders to this effect. But look at it this way: the anonymous investors that have been refusing to lend to Greece are in the same position as the people who queued round the block trying to get their money out of Northern Rock.
If you fear the borrower, whether it is Greece, Spain, Italy of even the UK, won’t be able to repay, you want yourmoney back as soon as possible – and you certainly won’t lend them any more of your hard-earned savings. My guess is that the UK will be quite successful in the months ahead in persuading the world’s savers that we will deal with our debts in an honourable way.
There have been some suggestions that we should ease the inflation target, andsomepeople believe that we have, in practice, already accepted that inflation will be higher than the 2 percent Consumer Price Index central range. Were either true, we would still be able to borrow money but we would have to pay quite a bit more than we do now. Indeed, we will have to pay more anyway because quantitative easing has artificially cut long term interest rates. If you print the stuff, you don’t have to borrow so much of it. But my instinct is that there is enough goodwill to give the Government the benefit of the doubt until such time as its emergency Budget is unveiled. Actually, given the mess in Europe, I think sterling will probably strengthen somewhat further vis-à-vis the euro, another sign of returning confidence.
The big point here, though, is that the developed world is entering a new era, where governments will have to behave differently. They will have to behave differently not so much from the way they have done during the recession, for in an emergency you can get away with emergency policies. No, they will have to behave differently from the way they behaved in the run-up to the recession, the bubble years.
Remember, it was weak policies that enabled the bubble to puff itself up. The developed world had weak fiscal control, with sizeable deficits even during the boom years. It had weak monetary control, allowing asset prices to soar far above sustainable levels. And it had weak regulatory policies, particularly of the banks, but also of personal credit. In the coming years, all three sorts of policy will go into reverse. We have seen the early stages of that in regulation, though it has hardly begun. We are seeing the early stages of that in fiscal policy, in Europe’s southern fringe and soon in the UK. And we will eventually see it in monetary policies too, though that is at least a couple of years away. The world has changed, and we on our little island are changing with it.
Lib Dem input in coalition could help push Scotland towards home rule
One of the less-noticed aspects of this coalition Government is the potential for opening up a new arrangement for financing Scotland. The present situation is clearly unsatisfactory. The country raises directly only 11 per cent of the money it spends (council tax and business rates). Other taxes are set and raised by Westminster and then redistributed back to Scotland via the Barnett formula. This is bad for the Scottish Parliament, as it faces the charge that it has power to spend money without any responsibility for raising it. It is also unsatisfactory for the rest of the UK because it will be attacked for imposing cuts on Scotland as part of the general fiscal squeeze that is to come.
The present solution is an unsatisfactory patch satisfying no one. Suggestions that it should be given somewhat greater tax-varying powers, as suggested by the Calman Commission last year, have been criticised as adding complexity and uncertainty.
But there is a more radical alternative on the table, in the shape of a paper written by Professor Andrew Hughes-Hallett of St Andrews University and Professor Drew Scott of Edinburgh University, and published by Reform Scotland. Scotland would set all tax rates other than VAT, which can't be varied within an EU country. It would collect the money and then pay Westminster for shared services such as defence and foreign affairs. The paper explains how this would work in detail, and how it could be set up. Several Scottish business leaders have spoken out in support.
So where does the Government stand on this. Well, the new Scottish Secretary, Danny Alexander, did call for "full home rule for Scotland" in his March Lib Dem conference speech. But he was also in favour of Calman's ideas, which are far from "full home rule". In any case, the world has now changed and we don't know what our new PM thinks. But if you really believe in handing power down, th