Saturday, 24 July 2010

How Robust Is The Recovery?

The flash figure for UK Q2, GDP blew the socks of estimates, coming in at 1.1% higher, as against forecasts of just 0.6%. The FTSE, however, fell on the day. Why? Firstly, the figure is not all it seems. As CNBC reported, much of the rise was due to a massive rise in Construction. However, as one contributor pointed out, not only did this figure partly reflect on the fact that in the first quarter Construction activity was depressed due to the very bad weather, but also, which not many commentators have picked up on, it also reflects the fact that the ONS have changed the way they calculate this figure.

All that being said, if you take out the Construction figure, you still get an increase of 0.7%, which is still better than forecasts. Given the period under review, it is testimony to the fact that the previous Government's policy of stimulus was working, just as it has worked in China, Brazil, the US and elsewhere. The problem is, as Paul Mason pointed out on Newsnight, a significant portion of that GDP growth came from that stimulus. The Government is now proposing to take away that very large part of where the growth came from, and under conditions where the UK's closest trading partners are taking similar actions that will contract their economies, where China is taking action to slow its economy, because it has been growing TOO fast, and where the US stimulus is beginning to unwind, and right-wing politicians in the US are taking their cue from Europe, and demanding at least no more stimulus, if not budget cuts. The GDP figure, is backward looking, nearly all the forward looking indicators are pointing in a definite downward direction. The effect of the Liberal-Tory Budget has been to severely dent confidence, because the most likely consequence is a severe retrenchment, and under those conditions no business is going to rush out to invest, which is the sole hook the Government's economic policy hinges on.

Worse still, is that the growth figure is a double-edged sword. It comes at a time when inflation is stubbornly high, and has confounded the bank of England's predictions for it to fall for more than a year. With loads of money washing around the economy, the level of increased activity that the GDP figure suggests, is likely to result in further rising prices. And, as I've pointed out previously, the inflation that will be imported from China, and the rest of Asia, along with the rising prices resulting from the Government's Budget measures on Vat etc., will push up prices even further. Already, Andrew sentence on the MPC is demanding that interest rates be raised to head off the danger of inflation. At the moment he's a lone voice, and is likely to remain that way. But, at some point unless the bank wants to risk hyper-inflation it WILL have to raise rates. Given their current level of just 0.5%, any rise will have a dramatic effect, on businesses borrowing costs, and on mortgages, which could rise 10, 20,30, or even 50%. No wonder the FTSE did not rise.

But, there was another reason the FTSE would not have risen, and that is that the European bank Stress Tests were not going to be released until after trading closed. Traders would want to see how that panned out before making any bets. In fact, the Tests were a bit of a con. As David (Danny) Blanchflower told CNBC. The one thing they avoided was the effects of a sovereign default, of say Greece on all or part of its debt. Yet, that is precisely what has been spooking markets for the last few months, and many economists believe is inevitable at some point! In fact, if some of the other factors included in the tests were to occur, its difficult to see how such a default would be avoided. Other than, as I have pointed out in the past, defaults could be avoided if the EU simply printed money to monetise the existing debts of Southern Europe. But, that would imply introducing all the other measures I have spoken about, effectively it means the creation of a single European State, the issuing of single EU Bonds, central control over Budgets and so on. It also means a Federal Fiscal Policy with massive amounts of redistribution from the centre to the periphery. With current political conditions, none of that seems very likely in the immediate future.

And, in the meantime massive problems remain in that periphery as Paul Mason sets out in his blog in relation to Spain. If as I've written elsewhere house prices in the UK need to fall by half or more, in Spain, with 1 million empty homes, and an economy that was built almost entirely on debt and property speculation, then with unemployment at 1930's Depression levels already, and more to come as a result of the austerity measures, house prices need to fall by more like 80 or 90%. In fact, under these conditions, and the same applies to Greece, Portugal, Italy and Ireland, then the last thing they need is austerity, because the only way they could deal with the debt, the only way they could rebalance their economies away from the previous dependencies, is through growth. Instead they are going to get recession and deflation.

To use David Blanchflowers phrase if the PIIGS could fly, then Europe's problems could be resolved. If instead of a fiscal contraction they could get a major fiscal boost then the existing liquidity already in the system, would begin to be taken up. Some of the construction firms that have almost completely stopped working in Spain and the rest of Southern Europe, could get work, building not more houses, but roads, schools, hospitals etc., and could provide jobs in the process, which would have a rapid effect on stimulating aggregate demand. In the meantime, it would mean that breathing space would be provided to expand investment in other industries. Spain has been developing alternative energy systems to take advantage of its plentiful sunshine. Investment in these industries could provide the basis of a significant export industry rather than reliance on Tourism – which is likely itself to be undermined in the future as Asia, and Africa become developed as tourist destinations. But, such development could also ensure that the rest of an integrated European economy had markets for investment and sales too. Without it, EU trade is likely to contract, and Europe is likely to catch a bad dose of Swine Flu from its PIIGS.

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