Hamish McRae: Getting Europe out of the growth trap

And now, what’s next? British politics may settle down a little now that it is clear that the United Kingdom will continue to exist, but economic issues will not settle down at all. The big question through the autumn will be whether the European economy will continue downwards into a triple dip.

We were so preoccupied last week with our own stuff that the failure of the European Central Bank’s attempt to pump more cash into the eurozone economy was barely noticed here. One big element of the ECB package to bolster the economy is to offer cheap four-year loans to banks — funds that they can then lend on to European businesses. The low take-up of the offer, €82 billion (£65 billion) out of a total of €400 billion, surprised and disappointed the markets, and supported the view that the main reason banks are not lending more money is that their clients don’t want to borrow it. You can take a horse to water but you can’t make it drink.

The tentative conclusion that people seemed to draw from this was that the ECB would have to resort to full-fat quantitative easing. It would have to start buying the bonds of European governments and pump cash directly into the system that way. This is what the Federal Reserve, the Bank of England and the Bank of Japan have done, but the ECB’s charter makes this at best difficult, and maybe impossible. But rules can be broken, as we discovered with the Maastricht curbs on fiscal deficits. Ultimately, the decision will be Germany’s as to what the ECB is allowed to do.

But to focus on rules and ECB intervention is to miss what is surely the bigger story. That story is the great puzzle: why on earth is the European economy not growing? The natural state of economies should be to grow. Human ingenuity and desires should normally generate growth. We all have to cope with the business cycle, although wise policies may be able to reduce its amplitude. But what is happening in Japan, and now maybe much of Europe, is not cyclical. There ought to be a strong cyclical recovery in Europe, as there is in the US, UK and the other English-speaking economies. But there isn’t. Last year, the eurozone economy shrank by 0.4%; this year it is projected by the OECD to grow by only 0.8%; and next year by 1.1%.

If these forecasts prove right, this will be pretty bad — but there is quite a bit of evidence that things may turn out worse still. There are perky bits of the eurozone, for example Ireland, but the overall picture is dire. German growth has stalled, and if the eurozone’s largest economy does not grow, what hope is there for the rest? The prospect of another leg of recession is worrying enough but what is surely more troubling is the idea that this entire region will barely grow for the next five years. What does that say to young people hitting the job market for the first time? The notion that Europe would be the new Japan did not seem realistic five years ago, even at the bottom of recession, still less 10 or more years ago. Now I am afraid it does.

But why? There may be a partial explanation in the creation of the euro and the design of the eurozone. I have been reading a controversial book, The Euro Trap by Hans-Werner Sinn, head of the highly regarded Ifo Institute in Munich, about this. His argument is that the design of the eurozone was fundamentally flawed. It encouraged huge capital flows into southern European countries, which undermined their competitiveness and made them vulnerable to the US-provoked global crash. Bailouts and austerity followed. But now the combination of the huge burden of debts and the rigidities of the eurozone prevent countries from escaping. His solution would be to write off public and bank debt and bring in a two-tier euro, allowing countries to devalue — but with the prospect of re-entering the eurozone at some later stage.

For what it is worth, this is rather what I expect will happen, but not for another three or more years and with even more pain on the way. Professor Sinn’s vision of the eurozone is of something between the Bretton Woods fixed exchange rate system and the progressive creation of the US dollar as a common currency of emerging America. But meanwhile countries have to have the escape route of devaluation.

This is strong stuff. The D-words devaluation and default are not polite ones to use — we Brits use them but we are not house-trained to European specifications. So Sinn deserves credit for his candour. But lurking behind his criticism of the eurozone is the even more unpleasant possibility that European stagnation is not just down to the euro. It is that the European political and economic model actually undermines long-term growth prospects in a way that the Japanese model seems to have done.

That is too huge a subject to tackle here, but it is one we will, I expect, hear much more of over the next two or three years — particularly since there is another referendum on the horizon.