The Chancellor George Osborne has said that a resolution of the euro zone’s debt crisis would be the “single biggest boost” the UK economy could get. I’m not sure I agree.
Intuitively, it seems reasonable. The euro area is our single largest export market, so anything that improves its prospects would naturally boost our exports. And in doing so, it would also raise business confidence and hence capital spending.
However, exports of goods and services to the euro area only represent around 13 per cent of UK GDP. So we shouldn’t expect a massive uplift from this source – especially as the debt crisis isn’t the only thing holding back euro area growth.
What’s more, the UK economy faces several headwinds for the next few months:
- The squeeze on households real incomes won’t go away. Yes, inflation should fall next year. But given high unemployment, it’s unlikely that wages will rise much more than prices. This will continue to hold back consumer spending.
- The public spending squeeze will intensify next year. The government expects that current public spending will fall 0.5 per cent in real terms in 2012-13, having risen 0.9 per cent this year.
- It’s not just worries about the euro are that are holding back capital spending. So too are spare capacity in some industries; a lack of bank finance; and a shortage of profitable investment opportunities.
In light of all this, it would be very optimistic to expect GDP growth to pick up much if the debt crisis is resolved.
In fact, it’s theoretically possible that a resolution would actually by bad for the UK economy.
One effect of the debt crisis has been to reduce gilt yields, as investors have sought a safe haven. Any resolution of the crisis should therefore raise gilt yields by reducing this safe haven demand; this would be the counterpart of any equity rally such a resolution causes.
But of course, higher gilt yields mean higher costs of servicing UK government debt. And higher debt servicing costs mean higher future taxes. If Ricardianequivalence is true, the anticipation of higher future taxes will cause spending to fall now, as people save in preparation for higher tax bills.
You might object that businesses and consumers are not this hyper-rational and far-sighted, and don’t save today in anticipation of higher future taxes.
Maybe you’re right. But if so, the case for fiscal austerity loses a lot of its power, because high future debt servicing costs are not so much of a burden on the economy now.