There are two key questions for 2012, says Graeme Leach. Will the euro crisis ease or worsen? And what will the answer mean for our economy?
This Sucker is Going Down was the title of a report I wrote at the end of last year (IoD Pulse Economic Outlook, December 2011, available on iod.com). It argued that the Club Med economies could be out of the euro in 2012 unless the ECB was allowed to engage in quantitative easing (QE) as lender of last resort on sovereign debt.
The Germans rejected this idea, but that doesn't mean the ECB is helpless. It can act as lender of last resort to banks and it is has started lending to eurozone banks at one per cent for three years. A nice little earner if you then invest the money in Italian debt yielding close to seven per cent.
In normal times a carry trade margin on this scale would ensure funds poured into sovereign debt. But this quasi-QE has little chance
of success in this extraordinary era. Acting as lender of last resort to banks does not provide a guarantee they will use the funds to buy sovereign debt. Why would they, with their balance sheets shot to pieces and the risk of further capital losses on toxic sovereign debt?
Of course, if banks were to purchase peripheral debt on a huge scale and yields then fell sharply on a sustained basis, the grim reaper would be finished. But he isn't yet.
Rating agency downgrades in early 2012 suggest that the euro crisis is far from over, and there's little time to find a solution.
Political union and a single eurozone budget are ruled out. Euro bonds and fiscal transfers from Germany and other northern eurozone economies are a non-starter.
Eurozone banks must deleverage and aren't in any position to help. Massive front-door QE has also been ruled out – although many still think that Germany will eventually allow it. We're left with the wisdom of Sherlock Holmes. If all alternatives have been eliminated, then what remains, however unlikely, must be the truth. The only thing left is a break-up of the euro.
There is a high risk that the euro will disintegrate in 2012, but the how and when remains uncertain. So what does this mean for the UK? Even without a deepening of the crisis the UK growth outlook was weakening due to the impact of the euro strife on consumer and corporate confidence, and knock-on effects such as postponed big-ticket spending and business investment.
The end result of this behaviour is the risk of a slight contraction in GDP in 2011 Q4 and the potential for a further contraction and slip into recession in 2012 Q1. But without a deepening of the crisis any downturn would be limited, temporary and easily reversed by more aggressive QE from the Bank of England.
There is even an optimistic scenario whereby QE works more powerfully to boost the growth rate of broad money supply at the same time that inflation falls more quickly than expected, boosting real incomes and spending power. Unfortunately, this is plausible but not probable.
The euro crisis could get a whole lot worse before it gets better, and that's the problem. The economic effects of a euro break-up would call for massive injections of liquidity into the banking system and a huge extension of QE.
But there is some good news here and it partially explains why the UK hasn't suffered a credit rating downgrade. The governor of the Bank of England can print money – the governors of central banks in Italy or Greece can't. We have a big bazooka in the form of more QE – so all is not lost.
So, yes, the euro crisis may well worsen in 2012, and that is bad news for the UK. But remember, Sir Mervyn King has the weaponry to fight any downturn.
Graeme Leach is the IoD's chief economist and director of policy
