The economic news these past few days and weeks has reminded me of a 60’s Western film called “The Good, the Bad and the Ugly”. This time the roles are filled by the U.S. in the role of the Good, UK in the role of the Bad and Europe in the role of the Ugly. Let me try to explain why.
The U.S. in its role of “The Good” is fortunate to be abundant in shale gas and trades relatively little with Russia. So, when it comes to the shutting down of gas pipelines and trade sanctions on Russia, these have a much less direct impact on the U.S. economy. While the U.S. economy is clearly facing a growing risk of recession, it still continues to exhibit remarkable strengths, particularly in the labour market with a strong job creation performance. However, nothing in life comes without its downside – not even good news.
The strength of the U.S. economy has its downsides (some may say it is presently more of a curse than a blessing). This is because with every sign of strength from the U.S. economy, the Fed will have stronger arguments to keep raising interest rates aggressively in its attempt to rein in persistent and broad-based inflation. The risk, here, is that while inflation is high today, it is still unclear if we should expect such level of inflation in the longer term. The current U.S. macroeconomic results are quite unique – on one hand with many signs of strength and on the other signs of weaknesses stemming from inflation and how to deal with it, leading to the U.S. GDP contracting in the first half of the year. All this makes economic predictions very difficult.
The UK on the other hand, painted themselves in the role of “The Bad” when the new Prime Minister Liz Truss and her finance minister, Chancellor Kwasi Kwarteng, announced their tax and spending plans – the so called “mini-budget” on Friday 23rd September, 2022. This “mini-budget” put a cap on energy prices for households and businesses, and it scrapped increases in corporate taxes.
What shocked everyone were the additional income tax cuts that were particularly generous to the wealthy. These measures would result in having the UK government increase its borrowing heavily. The financial markets soon delivered their own judgement on all this, and it was harsh. The value of UK government bonds collapsed and the sterling fell at one point to only $1.03. The fall in the value of bonds signals higher mortgage repayments, because it reflects the expectation of higher interest rates, but it also meant that many of the pension funds who hold about $1 trillion of these assets became financially unstable. Within a few days the Bank of England was forced to reverse its “quantitative tightening” policy and start buying these bonds en masse (£65 billion) to avoid a financial meltdown. By Monday Oct. 3, Prime Minister Truss was forced to backtrack, reversing the plan to get rid of the UK’s highest tax bracket. The damage was done as bond market is still jittery on UK debt paper.
On the 10th October, 2022 there was another sell-off of long term UK sovereign bonds, with the Bank of England having to widen its bond buying programme to include index-linked gilts in an effort to counter all this.
While I can understand that the UK government wanted to protect its economy and stimulate growth, but such fiscal policy decisions still need to be taken within the parameters of what is sustainable. Stimulating growth for the UK economy is surely needed as like other European economies it recovered much slower than the U.S. economy following the pandemic.
This leaves us with Europe in the role of “The Ugly”. Europe is much more dependent on Russian gas and oil than the rest of the world. Europe’s largest economy – Germany - received 55% of its gas from Russia, just before the Ukraine war.
Europe has also been slower to recover from the pandemic than the U.S. economy. This is mainly due to slower productivity growth, meaning that Europe badly needs to increase productivity and economic growth.
On the political front, these economic troubles are helping to generate a surge in voting for populist parties. Parties with fascist roots such as Sweden’s Democrats and the Brothers of Italy have seized power in their respective countries. Such parties only spew rhetoric with very few sustainable solutions.
What many European economies need is a focus on structural policies to help deliver sustainable productivity growth. These require supply side reforms for product, labour and financial markets, as well as investments in skills, infrastructure and innovation. This is at the heart of the European Union’s post-Covid €807 billion Recovery Fund, which has made progress in prompting EU member states to make serious reform plans. It includes funding things like digitising government services, investing in clean energy and funding scientific research — all of which are evidence-backed ways to improve productivity.
Italy’s government under ex-ECB boss Mario Draghi had such a plan, too. The problem is political: Many voters and politicians do not seem to want to accept the need for such reforms. So, Europe’s slow growth — partly due to slowing productivity and partly due to a rapidly aging population — makes it much less of an attractive destination for multinationals. If the trend towards inward-looking populism increases in many European countries, this could slow down (or even reverse) the falling costs of doing business across the EU single market.
While the EU’s crown jewel is the single market, if populist parties start re-building barriers to the movement of people, goods and services, this will make doing business within Europe harder, as Brexit has so vividly shown.
The final take-away message is this: to tackle effectively both climate change and low economic growth (in Europe) requires a partnership between business and political leaders to make the long-run investments needed for prosperity and changes in policy backed by much needed reforms. We must all realize that policies for good and sustainable economic growth take time as they would be based on difficult reforms. Difficult as they may be, this is what we need and not mad plans based on unsustainable and populist polices.