A year of economic uncertainty lies ahead

The following 12 months will be the year where the consequences of policymakers' decisions and indecision are felt by all. Five questions will dominate economic discourse in 2011.

Will Straw reviews the economics of the year ahead

After the rollercoaster of the financial crash of 2008 and global recession of 2009, the last 12 months have been dominated by a fierce debate over the role of policy in delivering economic recovery.

In Britain, the Tory-led Government is pursuing a policy of fiscal austerity coupled with loose monetary policy. The industrial policy revolution, commenced by Lord Mandelson, appears to have ground to a halt with little – aside some would argue from a programme of corporation tax cuts – appears to be aimed at encouraging growth.

The following 12 months will be the year where the consequences of policymakers’ decisions and indecision are felt by all. Five questions will dominate economic discourse in 2011.

 

1) Can the private sector create enough jobs to more than offset the losses in the public sector?

The June Budget set out spending cuts of £22 billion in 2011-12 on top of the £5.2bn in 2010-11. Some of this will come directly through public sector job losses but the read across from the recent CIPD report suggests that 400,000 jobs could be lost next year in total.

If this happens, it will compound the bad employment news earlier this month. While the jobless total rose for only the first time in six months, employment has fallen for six consecutive months. Youth unemployment is another persistent problem while the number of people forgoing hours by taking on part-time work is at a record 1.16 million.

George Osborne’s economic philosophy, known as ‘expansionary fiscal contraction‘, suggests that the private sector will step in where the public sector is withdrawn. So far the signs do not look good. Even after a year of recovery, private sector employment growth has only been 296,000 – just 0.5 per cent. The key metric in 2011 will be whether unemployment does or doesn’t rise above 2.5 million.

 

2) Will rising inflation further erode living standards?

The Bank of England’s Monetary Policy Committee has effectively ignored rising prices in 2010 with inflation above target in every month. The increase in VAT to 20 per cent on January 1st and rising food and oil prices is likely to exacerbate the problem.

The Government has a perverse incentive to retain modest inflation since it erodes the value of government-held debt. And loose monetary policy is effectively acting as Osborne’s Plan B in light of the biggest fiscal policy tightening since World War II. But as inflation heads towards 4 or 5 per cent it also erodes living standards – especially as many people in work are facing pay freezes or reduced hours. The ‘squeezed middle‘ are particularly badly affected. The Resolution Foundation think tank have shown that real wages will fall for three years for this group. Expect growing calls for higher interest rates, if inflation stays above 3%.

 

3) Where will growth come from?

Economic activity comes from either consumption, investment, government spending, or net exports. The signs are not good. The most recent figures show that consumer confidence is at a 20-month low and likely to worsen following January’s VAT rise. The latest business investment figures showed a 0.2 per cent fall in the third quarter of 2010. We all know the direction of government spending which leaves export-led growth as the country’s main hope for growth.

George Osborne has talked up the importance of trade. The OBR has predicted a 0.7% contribution from net trade next year, reversing a 0.9% negative contribution in 2010. This view is not universally held. Simon Kirby, economist at the National Institute of Economic and Social Research, said “We think [the OBR’s] projection for GDP growth next year is still too strong given the weak prospects for Europe.” If further eurozone instability caused a further strengthening in sterling’s value, this could drive down exports. Duncan Weldon has set out an alternative and arguably more realistic strategy of “re-balancing domestic demand and, in the final analysis, being less import-reliant.” The first estimates of Q1 growth at the end of April will take on huge political importance coming as they do in the middle of the Scottish, Welsh, and local election campaigns.

 

4) What will happen to the eurozone?

Although the pain caused by the straight-jacket of euro membership is clear for all to see, a break-up could be even worse. In either scenario – weak members like Greece or Ireland leaving or Germany restoring the Deutschmark – “the costs would be enormous” according to The Economist. Former French Prime Minister, Laurent Fabius, predicted earlier this month that if Germany withdrew, the new Germany currency would “multiply in value by two compared with the present level” resulting in drastic consequences for German exports.

But the pain shows little sign of letting up. After Greece and Ireland, Spain has been warned that it’s debt may be further downgraded while Portugal is also in trouble. The head of the International Monetary Fund has said that EU leaders’ piecemeal approach to Europe’s debt crisis has encouraged markets to pick off weak countries one by one. EU leaders agreed to set up a permanent ‘bail-out’ system akin to a European Monetary Fund at the December summit, but no details have been provided on where the money will come from or how it will work in practice.

What happens matters for three reasons. First, as Britain’s major trading partner, there is little scope for export growth while the eurozone remains unstable. Second, further bailouts are likely to have fiscal implications for Britain. Finally, default in other European countries will have a knock on effect for British industry. For example, Spanish companies own Britain’s airports and a large portion of our banking sector.

 

5) What will China do?

Exacerbating, and in many ways overshadowing, domestic and regional economic uncertainties are the tensions between China and US. The spectre of currency wars overshadowed the G20 summit in Seoul. The US wants further Chinese appreciation of the renminbi while China is concerned about the impact of the US’ quantitative easing policy.

A meeting in mid-December between U.S. Treasury Secretary Timothy Geithner and Chinese Vice Premier Wang Qishan appeared to calm tempers. But the key question is whether both parties can be persuaded to accept a gradual, managed and peaceful transition of economic power and rebalancing or whether there will be flashpoints with unpredictable economic and political consequences. The ultimate economic power duel is unlikely to be resolved in 2011, but we should know more about the direction of travel as the year unfolds.

With thanks to Duncan Weldon, Adam Lent, Tony Dolphin, and Ben Fox.

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