EEF blog

Ireland and Greece have been ‘bailed out’ of their financial woes. Commentators have turned their gaze to Portugal and Spain as the next dominoes in the eurozone sovereign debt saga.

But what does bailing out mean? And does getting a bail out mean you’ve sorted your debt problems? The answer has at least as much to do with growth prospects as it does state-backed financial assistance.

Paul Krugman in the NY Times notes that getting a bail out simply means getting a guaranteed line of credit at a cheaper rate than what the market will provide. It doesn’t mean countries are bailed out of their debts – they still have to pay them back. It doesn’t even mean a particularly cheap rate on debt, which would be a welcome respite for a country trying to manage down its bills. The Irish deal secures credit at 5.8% interest - more than what the markets were charging them as recently as September.

So what does getting a bailout really get you? In short, a bit of time. Time to put in place fiscal reforms to get deficits and ultimately debts down. But just as importantly time to get growth in the economy up.

The growth part is absolutely essential if the fiscal reforms are to stick.

Growth was the aspect highlighted in a Radio 4 interview with Alistair Darling last Friday, where he discussed the perilous prospects for the eurozone periphery.

Perilous indeed.

The Irish numbers don’t even look like they stack up numerically. Ireland is relying on 1.75% growth in GDP 2011 – a number that will flow through into its tax receipts forecast. At the same time they are planning a contractionary (is that a word?) drag from the government equal to 3% of GDP.

Market commentators don’t seem to think such growth is likely. Many predict growth to be flat or even negative in 2011. What then for the bailout, will it be enough? How much more pain can the Irish people take if it isn't?

One of the big claims regarding the eurozone periphery is that they’re uncompetitive because their costs are too high. Becoming more competitive is a path to higher growth. Sharing the euro means currency devaluation is ruled out as an option. That leaves so-called internal devaluation, a long, slow grind of suppressing wage and cost rises in the economy.

Lower costs or even decreasing costs, could lead to lower inflation or deflation. Good for competitiveness maybe – except that will also make the cost of these countries’ debts higher in real terms, potentially necessitating further cuts.

So is that bailout really buying just another strap in the debt-growth straitjacket? And it seems to be tightening in.

As European leaders hammer out a deal on a permanent stability mechanism, they would be well to keep a close on their temporary fixes. Some ideas for boosting growth need to emerge for the periphery and soon. And if the periphery can't sort that out, maybe the core needs to think about it too - after all they're standing behind the bailouts. All this seems to be pointing to closer fiscal/political integration as the only sustainable way out.

Whitehall bureaucrats supposedly working up a Plan B for stimulating growth if the UK economy heads south would be wise to pay close attention.

Look beyond the headline political posturing over extending the Bush-era personal tax cuts and there's some fairly business and jobs friendly tax reforms.

The payroll tax holiday (think a 2p cut in employee NICs in 2011), two-year extension of the R&D tax credit and capital gains tax cuts for small businesses are tax reforms designed to support growth (as is the temporary extension of unemployment insurance).

But the big winner for business is the 100% capital allowance for investments made between September 2010 and December 2011, and then 50% through 2012. Some estimate the reform will add £150bn to corporate cashflows and increase investment by over £50bn.

So even though most manufacturing equipment can be written off (for tax purposes) in seven years in the US, between 2008-2010 there was a 50% first-year depreciation rate for new investments, with 100% in 2010-11 and 50% again in 2012.

Contrast that with the UK.

In 2008, the 25% capital allowance rate (which meant investments could be written off after 22 years), was lowered to 20% (a 30 year write-off) and will be lowered yet again to 18% in 2012 (a 34 year write off).

It's a fairly straightforward equation: depreciation rates rise as new technologies make old equipment uncompetitive - and therefore obsolete - more quickly. The US recognises this and is trying to encourage investment by boosting tax depreciation rates.

Meanwhile, successive UK governments have lowered tax depreciation rates, creating a widening gap between the tax system and investment cycles in modern businesses.

As we and others have said time and time again, this gap adds places a premium on investing in the UK, and leaves UK manufacturers wondering why it's government doesn't understand the importance of cashflow to investment and growth as well as its American counterparts.

Yesterday, EEF published the results of our Q4 Business Trends Survey.

The headline messages were that the manufacturing recovery was powering ahead, with two mechanical equipment and metal producsts coming out of our survey as two of the strongest performing sectors.

Today, National Statistics has published the October Index of Production - the official account of what's happened to output. Here are the headline results:

• Output grew by 0.6% in October, and was up 5.8% from October 2009.
• Growth was broad-based, with 10 of 13 manufacturing sectors showing growth.
• Mechanical equipment and metal products were the two strongest performing sectors.
• But output remains 9.4% down from pre-recession levels.

So yes, manufacturing continues to power ahead. But the challenge is maintaining that momentum into 2011, so that manufacturing can continue to drive the broader economic recovery.

2011 won't be an easy ride - the EU crisis is still in full swing and the rebalancing of the US-China economic dynamic will only begin in earnest next year as China's new five year plan begins in March.

The government's Growth Review, which was launched last week, will hopefully take a look across government to see where it can reform policies that are currently blocking growth, and where it implement new ones to support ambitious manufacturing companies planning for growth.

Last week I noted the low likelihood of Ireland or other distressed PIIGS leaving the euro. Investors would take flight, debt would balloon, default would be likely. The converse of this situation is what if Germany chose to leave the euro? Stephanie Flanders notes that this could make economic sense for both Germany and everyone else.

Germany’s new deutschemark (DM) would likely rise relative to the euro. Therefore there would be no big jump in the value of German Government debt, in fact the opposite, euro-denominated debt would be worth less in terms of DM. Commentators on the German economy claim that their dynamic economy is the main driver of their strong export performance, not the euro. Dumping the euro would certainly test that assertion. Assuming they're right a higher currency would not cripple exports.

And for everyone left in the euro, there would likely be a small gain in the competitiveness of their exports. The relative strength of the new DM compared with the euro should see German consuming more imports from their neighbours. This would help them with the export-led growth they need to climb out of their respective sties.

But I don’t think this will happen.

Whether they want to admit it or not, a lower euro vis-à-vis a theoretical DM does benefit Germany’s export sector, even if we assume that internal dynamism is more important. A lack of currency fluctuation for exporters, particularly small exporters, inside the eurozone is also highly beneficial.

Even contemplation alone of exiting the euro may threaten stellar German business and consumer confidence, which at the moment seems to be sailing straight through the sovereign debt crisis storm. Uncertainty about the impact would be a negative force, even if calculations suggested a net benefit.

And while a fall in the value of euro-denominated debt may benefit the German Government it would be at the expense of many bondholders in the German private sector.

Convincing as all this is, in the long run I think the strongest motivation for Germany to stick with the euro is political economy. Germany is the biggest eurozone economy and the strongest – its bunds are the reference against which peripheral euro members’ widening bond yields are measured.

It means Germany has the biggest say in how institutions in the EU are being designed to deal with the current crisis – but also how they should be designed to put the system onto a stable and sustainable footing. You might argue they’re not doing a great job of that – but they are having a big influence. And if things come right - and even if they don't - that influence is likely to be felt for many years.

Other countries looking for a bailout need to lobby Germany. It’s the biggest donor to these deals. Using this lever the Germans can press for policy reform in their interests. They may not have succeeded in getting Ireland to push up its corporation tax rate – but they got this sacred cow on the table for discussion.

As the biggest player in the EU, the augmentation of institutions along German lines surely is seen as an opportunity by German politicians to increase their power. So for example future sanctions on fiscal recalcitrant behaviour aren’t going to hurt Germany given its record – and look who’s pushing this issue? Germany.

24 days of facts about manufacturing:

Day 6: EEF's survey shows that manufacturing output expanded at a record pace in the last quarter 

EEF's Business Trends Survey shows that a balance of 33% of manufacturers saw output increase in the last three months. New orders are close to records highs as well, with a balance of 32% of companies seeing an increase in orders. (More info: here)

Figure 1: Output and orders are growing strongly (% balance of change in past three months)

24 days of facts about manufacturing:

Day 5: UK Manufacturing is about more than just production: 2/3 companies offer services on the back of their products