City Comment: For growth, we need inflation to fall

Europe will muddle on. That is the only realistic expectation to have about the European Union summit this week, the 19th since Greece’s collapse. Whatever view you take about what Europe should do about the euro and the sovereign debt crisis, the reality is that Britain, and indeed the rest of the world, will just have to live with the uncertainty.

That uncertainty is likely to persist for several years, and during that time the eurozone will continue to be, at best, a slow growth area.

So what can we do to maintain growth in the UK, given that the eurozone taken as a whole remains our largest export market?

Well, the obvious response is that we have to maintain domestic demand. Yes of course the eurozone markets have to be replaced with faster-growing ones and that is actually happening.

The proportion of exports going to the eurozone has fallen steadily over the past 20 years, not as a result of any policy, but simply because other markets have grown faster. Anecdotally, our exporters are putting more resources into building up new markets and there been individual examples of great success, such as Jaguar Land Rover under the ownership of Tata. But this will be a long process: rebalancing away from Europe will take years.

Meanwhile we have to look to the home market. But how? There is the view which it seems is now being adopted as policy by the Opposition that the Government should borrow more, with the idea that more government borrowing would increase demand. Actually we may well end up having to do that if tax receipts come in below estimates this year. But anyone arguing that we should deliberately increase government borrowing as a policy has to confront some disagreeable possibilities.

Some of those were cited in the latest assessment of the world economy by HSBC. The bank argued that an increase in public borrowing might end up cutting private-sector demand for two reasons. “First,” HSBC said, “it might push government bond rates up, which if it fed through to private-sector interest rates, could encourage rather than prevent deleveraging… Second, if rising government debt makes households and corporates worry about their future tax burden or future interest rates they may increase their savings today, offsetting any rise in government spend.”

I would add a third, more empirical argument. It is that when you get to extreme levels of borrowing — 8% of GDP or more — there is evidence that changes in fiscal policy become much less effective. Certainly if you look at the long-term effects of the huge deficits run up by the Japanese over the past two decades, it is hard to argue that the 20 years of vast annual deficits have had a strong positive effect on growth. There are other reasons for Japan’s stagnation, including demography and lack of structural reform, but the case for more public borrowing does look pretty thin.

Maybe, however, governments are tightening policy in the wrong ways. The main burden, here in the UK as well as in Europe, has been imposed by increasing indirect taxation and cutting public investment. HSBC argues that these are two of the worst ways of correcting a deficit in the sense that they have the greatest negative impact on demand. The authors think that tax policy should be directed to increasing employment: one of the few tax cuts that really does pay for itself. And they think that company taxation does not have much of an impact on output, though here I suspect that there could be a difference between the short term and the longer term.

Where does this leave us?

Well, we should not be too dismayed by what is happening right now. Officially we are in recession but no one trusts the official figures for GDP.