Europe’s Growth Problem

Economic growth across the European Union has been feeble as compared to the USA and Asia for two decades now – in fact since the inception of the euro as Europe’s single currency. Euros began to circulate as hard cash on 01 January 2002 and the eurozone now comprises 28 member states. Whether there is a connection between the advent of the monetary union and the loss of Europe’s growth mojo is a question that can no longer be avoided.

Monetary union was facilitated by the Stability and Growth Pact (SGP) which came into effect on 01 January 1999. By the terms of the SGP, which had been hammered out by the European Commission from 1997, prospective members of the eurozone were obliged to maintain fiscal deficits not in excess of three percent and national debt levels not exceeding 60 percent of GDP. Obviously, these rules have been honoured more in the breach than the observance over the years: virtually all eurozone member states now have debt-to-GDP ratios way above 60 percent – in the case of Italy it is currently around 160 percent. But although the SGP has been suspended numerous times, it has never been officially cancelled.

Thus, the euro began life against the backdrop of contractionary fiscal policy – aka austerity – as all member states sought to put their finances in order in preparation for the big day. This austerity policy was intensified during the European Sovereign Debt Crisis of 2011-15 during which several of the so-called “PIIGS” countries, most notably Greece and Ireland, were compelled to impose savage spending cuts.

Currently, the economic weather in Europe is inclement. The eurozone contracted by 0.1 percent in the third quarter of this year. S&P Global’s composite purchasing managers’ index (PMI) survey of manufacturing and services fell to 46.5 in October, where any number below 50 indicates a negative outlook. Despite inflation having fallen to 2.9 percent – the European Central Bank (ECB) has raised the discount rate by 450 basis points in 15 months – Germany’s members on the ECB’s governing council are still muttering about the need for further rate rises. Arguably, the ECB started to raise rates too late; and it could compound that error by raising rates further even as they ease in the USA.

The IMF expects the German economy to contract by 0.3 percent this year. Demand for loans – an indicator of business investment intentions – has fallen dramatically. The eurozone money supply is contracting at a rate of 1.2 percent per annum, which, given inflation, is more like five percent in real terms. A contracting money supply is a harbinger of recession.

Mario Draghi, the man who as Chairman of the ECB did “whatever it takes” to save the euro, told the Financial Times forum last week that: “It is almost sure that we are going to have a recession by the year-end”. He went on to say: “The European economy has been losing competitiveness in the last 20-plus years. In many, many technological fields, we have lost footprint.”

The eurozone was in recession over 2008-09 and 2011-13, and experienced outright deflation in 2009, 2014-15 and 2016. Until now, the eurozone had been living off “excess savings” (the increased money supply arising from monetary expansion), generated by successive waves of quantitative easing (QE) initiated by the ECB to pay for Covid-era fiscal deficits. However, since September 2022, nominal bank loan growth has been falling.

Unemployment across the eurozone rose from a record low of 6.4 percent in September to 6.5 percent last month, according to Eurostat, the bloc’s statistics agency. Danish logistics giant AP Møller-Maersk plans to axe 10,000 jobs as the post-Covid container shipping boom gives way to weaker demand. The German steel distributor, Klöckner announced last week that it was to cut 300 jobs. Job vacancies on the Indeed website have been trending downwards in France and Germany. The ECB expects unemployment to rise to 6.7 percent next year. To put this in context, the bloc’s unemployment rate peaked at 12 percent in 2013 at the height of the debt crisis. And pay is rising across the eurozone at a rate of 5.3 percent – well above the level of inflation, although the ECB expects the pace of wage growth to slow.

For Euro-federalists the problem with monetary union is not historical austerity but that it was not accompanied by a full banking and fiscal union. A fiscal union would entail a European ministry of finance which would have powers of taxation as well as the ability to make fiscal transfers from the surplus-inclined north to the deficit-inclined south. In the first instance, it might be handed control of VAT across the eurozone. But that would represent a massive transfer of sovereignty from national capitals to the new supra-national body which is, to put it mildly, politically contentious.

It may be that this is the moment when new structures become inevitable – certainly that is what Emmanuel Macron thinks. Critically, the German mercantilist model does not work anymore. To support its world-class manufacturing base, Germany needed a constant supply of cheap energy to maintain its competitiveness – hence Angela Merkel’s Faustian pact with Vladimir Putin to buy cheap Russian gas. That resulted in the Nord Stream gas pipeline in the Baltic Sea which is now (as far as we can tell) kaput. Furthermore, China’s policy is now to buy fewer machine tools from Germany, as I discussed here three weeks ago. Germany, for its part, has raised two fingers to the EU state aid rules and is now subsidising chip-makers – lavishing €10 billion on Intel and another €1 billion on Infineon.

Times are a-changing, even as Europe stalls. There is no consensus for radical reform; but things seem to be moving in Macron’s direction.

What about the UK?

Despite our being out of the EU and never having been a member of the eurozone, things are not much better on this side of the Channel, and possibly worse.

The Bank of England (BoE) accelerated annual money supply growth from a sedate 3.8 percent at the end of 2019 to 13.8 percent by the end of 2020 in a bid to finance the Covid lockdowns. The UK government’s 18-month furlough scheme benefitted 9 million claimants at its peak, each being paid 80 percent of their regular wages by the state. UK government debt rocketed by £772 billion, from an already high 84.5 percent of GDP to over 100 percent today.

Yet now, the UK’s money supply is also contracting at a nominal rate of about four percent, partly due to a 2.9 percent fall in bank lending, and partly due to a programme of quantitative tightening (QT – the reverse of QE) by the BoE, which disposed of £80.6 billion of its gilt portfolio in the year to September.

Unemployment has been rising over the last year and was up from 3.5 percent in July 2022 to 4.3 percent in July 2023. We eagerly await the latest quarterly number, but it is likely to reveal a further deterioration, given a spate of announcements of job losses recently, not least in the financial and consulting sectors. PwC is letting 600 of its staff go; Reach (formerly Mirror Group) will make, 450 of its staff redundant; Barclays is shedding 300 people; and Tata Steel is considering job losses of 2-3,000 at its Port Talbot plant in Wales.

Last month, UK inflation, as measured by the CPI remained stubbornly at 6.7 percent. But on Wednesday this week (15 November) we learnt that inflation was down to a lower than expected 4.6 percent – partly, no doubt, because the government has been massaging domestic energy prices. At the beginning of October, the OFGEM price cap which governs gas and electricity prices, was reduced by seven percent. This alone accounts for a reduction in the consumer price index (CPI) by 0.3 percent. Also, food prices are softening, at last.

This means that Prime Minister Sunak’s target to halve inflation by the end of the year, made in January when inflation was running at over 11 percent, has now been achieved. The London equity markets gained more than one percent on Wednseday. And the Q3 UK economic growth figure came out last week at around zero – dismal, but better than negative. Moreover, the UK residential housing market, which we were told by the Cassandras was sure to collapse, has proven to be remarkably resilient.

According to the think tank the Centre for Policy Studies (CPS), in order to keep pace with the rising cost of the welfare state (state retirement pensions, plus the NHS and transfer payments), the UK will need to grow annually at a rate of 2.9 percent over the next 50 years. But this is a rate that we have achieved just twice in the last two decades, excluding the exceptional post-pandemic rebound of last year. The BoE, in a report published early this month, thinks that Britain is heading for a protracted period of weak growth. The Bank thinks that the economy will flatline next year, with a 50-50 chance of recession. In an economy driven by consumer spending, the impact of an inflationary shock and higher taxes was inevitably going to impact growth.

What is to be done? The British Chambers of Commerce (BCC) wants a “skills bill” to upgrade in-work training, a planning bill to stimulate housebuilding and reform of trade policy to smoothen post-Brexit trade frictions. The latter is a pitch for a new trade accord with the EU – which will probably come about in 2025 when the current arrangements come up for review.

One growth-oriented measure which came out of the King’s Speech on 07 November was to hold North Sea oil and gas exploration rounds annually. But remember that the Treasury still takes a 75 percent “windfall tax” on any North Sea oil profits, which renders many prospective oil fields unviable.

Undoubtedly, record NHS waiting lists are contributing to more working-age adults leaving the labour market. For some, the solution is always to spend more money on the NHS; others, like me, believe that only by changing the model to some form of insurance-based system will we achieve health outcomes equal to our European neighbours. But that is not even on the political agenda.

The Growth Commission, a pro-market think tank set up by Liz Truss over the summer, wants to slash corporation tax. In a report published on Tuesday (14 November), it showed that foreign direct investment in the Republic of Ireland, where corporation tax is set at 12.5 percent, is running at 285 percent of GDP – four times the EU average.

Unfavourable demographics mean that by the end of 2026 (early in the next parliament, then) the UK will have more people aged 65 and over than under 18 for the first time in its history. On current trends, the workforce is set to start shrinking in absolute terms as soon as 2043, potentially ushering in an era of negative growth. By 2072, the UK will have 1.9 citizens of working age per pensioner, down from around 3.3 today.

It may well be that, thanks to robotisation and artificial intelligence, we will be able to meet that challenge – that is what the Japanese, who have even more negative demographic trends than we do, are planning for. They certainly do not believe that the answer is to open the gates and to admit more migrants, as certain people here do.

Changes in monetary policy take 12-18 months to manifest themselves. There is much more pain to come for mortgage holders as they refinance mortgage deals at higher rates. With the exhaustion of Covid “excess savings” (the excess money supply which arose as a result of QE), and the combination of tightening monetary policy (QT), some analysts foresee a deflationary recession, although the consensus expectation is for a “soft landing”.

The Brexiteers foresaw that, once unshackled from the sluggish European Union, Britain would be able to turbo-charge its economy and become “Singapore-on-Thames”. Nearly seven and a half years after the Brexit referendum, and nearly four years after leaving the European Union, Britain’s looks more like a European economy than ever – only with slightly higher inflation. Post-Brexit, we are still part of the European mainstream with poor growth and worsening national finances.

The American Exception

Meanwhile, the US economy is powering away. US inflation is down to 3.2 percent and unemployment is at below four percent. But with a 30-year mortgage rate of 7.9 percent, many home-owners are feeling pain. The most astonishing statistic, however, was the growth rate for Q3 this year which came out on 26 October – at a whopping 4.9 percent. This exceptional figure was achieved as a result of increased consumer spending, business re-stocking, increased US exports thanks to a weaker dollar, huge increases in Federal government spending flowing into the system, and new housing starts.

This growth figure is unlikely to be repeated any time soon and indeed many Americans do not feel any better off under President Biden, as is reflected in recent opinion polls. I’ll have more to say on this shortly – but the contrast with the EU and the UK could not be starker.

Looking Ahead

Next week I’ll be trying to digest the Chancellor’s Autumn Statement which will be delivered on Wednesday (22 November – Saint Cecilia’s Day). It is widely touted that the Chancellor has more “fiscal headroom” than anticipated because tax receipts have been robust. But, on the other side of the equation, according to a recent analysis by the Resolution Foundation, the Chancellor will have to make spending cuts given the burgeoning cost of servicing the national debt and the rising costs faced by spending departments. Spending on areas that have not been “ringfenced” – such as the Ministry of Justice, which runs the courts service and our prisons – will have to be slashed in real terms.

There is therefore very little likelihood of tax cuts next week. In any case, if there are to be tax cuts, the Chancellor will present them with a flourish in the Spring Budget (next March) when they will have more political impact. Moreover, the downside risks ahead are daunting. The World Bank warned last week that the oil price could spike to $150 a barrel if the Israel-Hamas conflict escalates. Early this morning, Brent crude is trading at £77.49. For now, the markets remain sanguine.

Afterword – Of Foreign Ministers And Deckchairs

David Cameron is by no means the first ex-prime minister to return to the government as foreign secretary.

Lord John Russel served as foreign secretary under Viscount Palmerston during 1859-65, having been prime minister from 1846 to 1852. He then returned as prime minister for a brief second term, serving from 1865-66.

Arthur Balfour, having served as prime minister from 1902 to 1905, became foreign secretary in Lloyd George’s wartime coalition government in 1916. During his three-year tenure he issued the famous Balfour Declaration (1917) on the future of Palestine, the consequences of which are still reverberating.

Lastly, Sir Alec Douglas-Home served as foreign secretary in Edward Heath’s 1970-74 government. He had been prime minister between 1963 and 1964. He had previously been foreign secretary under Harold Macmillan from 1960 to 1963 when still a member of the House of Lords. He had renounced his earldom in 1963 in order to become prime minister and was elected to the Commons, where he remained until October 1974.

These three grandees were all regarded as successful and blameless statesmen who had nonetheless lost office at a general election. They were safe pairs of hands. In contrast, David Cameron’s premiership was controversial, with a legacy of austerity and underinvestment; and he resigned the morning after defeat in a referendum he had called unnecessarily, and which has left irreconcilable fissures. Out of office, he was implicated in the collapse of Greensill Capital and may have been an advisor to certain questionable Chinese interests.

It was David Cameron who hollowed out the Tory Party with his tendentious candidate selection process. A party which once had talent and flair – if also its fair share of aristocratic eccentricity – is now largely populated with people who are not dissimilar to their Labour analogues. He inaugurated a colossal but poorly administered foreign aid budget even as he cut spending on courts and schools and indeed on the foreign office itself.

David Cameron’s record on foreign policy when Prime Minister can be summarised as follows. He supported the interventions in Iraq and Afghanistan, believing that democracy could be imposed by force. He bombed Libya, in collaboration with the French president, Nicolas Sarkozy. Libya is now a failed state where warlords and people smugglers hold sway, thus aggravating illegal migration across the Mediterranean. He presided over a “golden age” in relations with China, just as China was subverting the Sino-British treaty which guaranteed democracy in Hong Kong. He lost a parliamentary vote to intervene in Syria after Al-Assad used biological weapons because not even his own MPs trusted his judgment. He failed to influence the European agenda and seemed to have nil traction with Angela Merkel who controlled it. He called the Brexit referendum as a tactic to pull the rug from underneath UKIP – and lost it with a lacklustre campaign. Then he ran away – and made no effort to influence the final form that Brexit took.

In fact, Sir John Major would have been a better choice for foreign secretary. At least he successfully negotiated the Maastricht treaty in which the UK won an opt-out from monetary union, while remaining a full member of the EU. He also piloted the country through the First Gulf War (1991) with aplomb.

In the past turbulent and dangerous seven years Britain has had seven foreign secretaries. All told, this appointment looks like an act of desperation. Even if voters feel a bit better off one year hence, that will be too late to save the Tories. No wonder people have been mouthing that old trope about re-arranging the deckchairs on the sinking Titanic.