Over the past two weeks, I have met dozens of bankers, investors and economists who are increasingly worried that we are about to fall back into a full-blown recession. According to the closely watched Purchasing Managers Indices (PMIs), the Euro area may even already be there. The advance reading on the composite PMI for September fell to 49.2, below the 50 level that marks the difference between expansion (above 50) and contraction (below it). And while the PMIs were far from the best guide to the European recession the first time around, there are signs in other data that they may not be far off the mark this time.
The bottom line is simply that Western economies have failed to grow as quickly as policymakers expected when they emerged from recession in 2009. The US and the UK have not seen the rebalancing that they required, while the travails of the euro area periphery are well documented. Even Germany and France, the engines of growth for the European project, have stuttered.
Some commentators think that all it would take now is confirmation of a Greek haircut (or default) for the West to be plunged back into full-blown recession. Interbank spreads are already back to their pre-Lehman levels in Europe, indicating that banks are increasingly nervous about lending to one another. The further writedowns that would ensue from a Greek default and the related fallout would require banks to be recapitalised. And with private investors wary of committing further funds, European governments would have to step into the breach, either directly or via the Financial Stability Facility (FSF). That would increase debt stocks and heighten market concern about sovereigns’ creditworthiness. The US is not the only (ex-)AAA country that S&P could downgrade before the year is out.
However, we don’t actually need a Greek default for recession to take hold. European policymakers could happily bumble along for a while provided the second bailout is fully approved, as in theory it should buy Greece time until 2014. But we could end up in recession all the same. In particular, the very fear of recession could become self-fulfilling. Households may be so nervous about keeping their jobs, and companies about future demand for their products, that both could engage in renewed belt-tightening to build up precautionary savings and strengthen balance sheets. With fiscal deficits falling around the world as governments retrench, we would be back in negative territory very quickly.
This harks back to the notion of ‘animal spirits’ that some Keynesian economists love to harp on about. And certainly confidence has been fragile for a long time in many countries. Even larger businesses, who might have access to capital markets but have certainly enjoyed strong cash balances for some time, have been reluctant to splash out over the past two years. That is part of the reason that the recovery has been so slow. Renewed and more widespread reluctance to spend, exhibited as another jump in household saving or corporate cash balances, could mean that in waiting for things to get better we really do end up waiting ourselves back into recession.
In fact, we could see a near-perfect domestic storm hit the UK without Greece defaulting at all. A weak GDP reading for Q3, followed by a negative number in Q4, would present a dilemma for the Office for Budget Responsibility (OBR). Thus far, the OBR has stuck by its assessment of the damage to potential supply – the permanent scars on the UK economy from the banking crisis. But another dip into recession would heighten fears that those scars are deeper than first thought. In turn, under Chancellor Osborne’s own fiscal rules, that would mean that the Government would be required to increase taxes and cut spending further to bring the current budget back into surplus at the end of the parliament. If the MPC agreed with the OBR, it would also have to raise interest rates more quickly than previously thought, due to there being less spare capacity in the economy. And with the private sector already in recession by then, things would get a lot worse very quickly.
So, although Greece is still in the headlines and European policymakers are still under pressure, things are far from great in the UK either. Hold onto your hats – the next 18 months could be very grim indeed.