UK, Germany face very different risks

This is the final installment of a three-part report on IHS Global Insight’s discussion on the Eurozone sovereign debt crisis. It covers IHS chief European and U.K economist Howard Archer’s assessment of the economic situation in the U.K., and IHS senior economist Timo Klein’s look at Germany’s prospects as the Eurozone’s key growth driver.

Top economists at IHS see slow growth prospects in the U.K., while Germany is expected to be the Eurozone’s “key force for growth impulses this year and next.”

Limited growth in the U.K.Howard Archer says the recovery in the U.K. will in all likelihood be “gradual and bumpy.”

Britain’s coalition government has made fiscal consolidation a priority: its emergency June 2010 budget put £40 billion of extra fiscal tightening on top of the £73 billion already in place from the previous Labour government. The tight fiscal stance was reaffirmed in the October 2010 spending review.

“This extended, major fiscal tightening will increasingly kick in through 2011,” Archer says. “That’s likely to lead to substantial job losses in the public sector, and we’re dubious that the private sector will be strong enough to offset these losses…. So the likelihood is that unemployment will rise further or at the very least will not fall, and that’s going to keep the ceiling on consumer spending.”

Archer also suggests the current “softness” of the labour market will cap wage growth despite expectations of higher inflation. These muted wage figures, “along with higher inflation, will squeeze consumer spending. We forecast it to rise 1% in real terms.”

The Eurozone’s debt issues clearly pose a threat to the U.K.’s prospects for growth. “Soft Eurozone growth will limit U.K. exports despite the competitive pound. And if there’s repeated flare-ups in the Eurozone situation that could impact on the U.K. by affecting confidence and keeping credit conditions tight,” Archer explains.

The Bank of England is facing a “huge dilemma” on monetary policy. Recent inflation data shows a 3.7% spike in December, almost twice the BOE’s target of 2%.

“That’s really putting pressure on the BOE to start raising rates. However, the bank is very well aware that a lot of the inflation is being pushed up by factors outside its control, and temporary factors such as the VAT increase,” Archer says. “It’s worried that if it really starts tightening monetary policy now, just as the fiscal tightening is really kicking in, that could risk putting the U.K. back into recession.”

Archer suggests there is some likelihood the BOE will slightly raise rates to “send the message” that they’re intent on tackling inflation. “But the danger is even if they intend to do only a small increase, that affects psychology. People in businesses will expect it’s the first of several increases, and that affects their behaviour.”

“So I think the BOE is going to be looking very carefully to see if current inflation levels are having second round effects, leading to wage increases; if they are, they will probably have to tighten sooner rather than later. But if wage growth stays muted then I think the BOE will try holding off raising interest rates for a few months to come.”

Archer expects growth in the U.K. to be limited to about 1.8% this year, a modest increase from last year’s 1.6%. “And we expect it to benefit slightly in 2012 from the staging of the Olympics, which is expected to see growth pick up to about 2.2%.”

Strong German domestic demand Timo Klein says Germany has “very good prospects” of playing the role of Eurozone growth driver.

German domestic demand is strong, and Klein expects it to stay this way in 2011-2012. One reason is that the ECB’s monetary policy “continues to be geared towards the much weaker average Eurozone economy. Interest rates from the central bank will actually be too low for Germany’s domestic conditions, thus fuelling an upswing in Germany.”

Klein also notes “long-term interest rates remain fairly low on flight-to-quality flows as the Eurozone debt crisis lingers. That boosts capital available for investment within Germany.”

On the fiscal policy front, there is some tightening in Germany, but relative to the southern Eurozone periphery, “it is much smaller in scale as public finances benefit from above-average growth,” Klein observes.

Klein also cites 20-year lows in unemployment, which “really boosts underlying consumer confidence. There is also the expectation that wage growth will increase.”

Finally, Klein points to the long period of subdued residential and non-residential construction. The numbers here are well below long-term averages, “so there is a lot of catch-up potential.”

Broader implicationsStrong German domestic demand “directly boosts the export potential of European partners,” Klein says. This holds both for “intermediate goods required as input for German exports and for consumer goods,” he adds.

Germany’s strength also “has a stabilizing effect on European economies currently suffering from the harsh austerity programs required to improve public finances—improved economic activity in those countries reduces the need for further austerity measures.”

Klein also suggests Germany’s position “enables the ECB to depart from its presently very expansionary monetary policy stance at an earlier stage than otherwise, thus supporting the euro and containing risks of imported inflation from the emerging world. This allows a smoother adjustment of the Eurozone periphery to structural challenges.”

“If you look beyond the next one or two years, strong German domestic demand will tend to reduce its current competitive advantage vis-à-vis most European partners, offering potential for a more balanced European economic development,” Klein adds.

If European authorities are able to keep the Eurozone debt crisis from spinning out of control, Germany will act as the engine of European growth this year and next, Klein concludes.

“The conditions we see at the moment—persistently improving labour market conditions, unusually low interest rates, and only limited need for fiscal tightening—will ensure a sustained momentum of consumer and investment demand. Solid export growth to non-Eurozone countries due to strong competitiveness and, additionally, the relatively weak euro will help finance even stronger import growth, thus also supporting the remainder of the Eurozone.”