ECONOMICS:Upturn will have to take place against backdrop of rising interest rates, budgetary tightening and credit in short supply

I ATTENDED two economics conferences recently; one in Kenmare, where about 80 Irish economists participated, the other in mainland Europe.

On reflection afterwards, I realised they had a lot in common, not least the fact that in neither case was there a single mention of the words “green shoots”. It is not just that many economists have misgivings about a term that is routinely abused in the media; there is a profound caution about the shape and nature of the recovery, now that it seems we have reached the bottom.

In Ireland, we expect the recovery to be export-led. This brings its own challenges, to which I shall return. Meanwhile, we need to be alert to the situation among our trading partners, especially in Britain and Europe. The latter are the focus of this article.

Economists frequently debate the shape of the recovery. Traditionally, the V-shaped recovery has found favour. Not surprisingly, this suggests a sharp fall followed by an equally fast recovery. That is what happened here earlier this decade after the dotcom bubble burst. It is the scenario John FitzGerald of the ESRI suggested at Kenmare last weekend.

However, there are other possibilities. Up to now, the most common alternative was the W- shaped trajectory. This means that the recovery gets interrupted because something goes wrong and we experience a second downleg. Frequently, the cause can be a policy mistake such as, for example, raising interest rates too soon or too aggressively.

For anyone who doubts that this is possible, I would remind them that the European Central Bank (ECB) actually raised rates as recently as July 2008.

A new economic lexicon is now beginning to appear. I was introduced to the triple U and the reverse J. The former denotes a series of mini-recoveries, while the latter points to a modest but quite subdued turnaround. The implicit assumption is that a lot of damage has been done, potential growth is much reduced, and that growth rates in Europe will be fairly pedestrian for the foreseeable future.

Naturally, the French were different. They went for the square root (?) shaped recovery. At first glance, this suggests a sharp rebound but, in true Gallic style, leaves open the question of what happens next, and the possibility of a broken economic heart. Suffice to say that the delegate who suggested it did not challenge the conventional wisdom.

Which brings us to the question – why is there such caution? One should acknowledge that economists across Europe are chastened by their failure to foresee the extent and scale of the downturn, so it is possible that they are being over-cautious in compensation. However, up to half-a-dozen fairly convincing reasons can be adduced.

First, the banks are still in poor shape. Balance sheets have yet to be cleaned out, more capital will be required, and confidence is lacking both on the part of the banks and their customers.

Second, employment is a lagging indicator. It has hardly fallen in Germany because of special factors such as government subsidies and car-scrappage schemes. This could easily change next year and would be a shock to confidence, not just in Germany but further afield. House prices have further to fall, and companies will continue to fail for some time.

Third, the public finances are in terrible shape and will have to be rectified. Only the other day, the European Council announced that fiscal tightening will have to begin in 2011. This will retard growth.

Fourth, there are the global imbalances. The G20 recently agreed to rebalance growth, which would involve the Chinese boosting domestic demand while the US consolidates fiscally. The jury is still out on whether this will happen and, in any event, it will take time.

Fifth, there are significant imbalances within Europe. Spain and Ireland, for example, have major adjustments to make and will not be in a position to contribute to recovery. Neither will Britain. There is little sign of wage adjustments in many member states, and this will hamper EU competitiveness.

Sixth, there is the question of the withdrawal of monetary stimulus. Such stimulus is greater now than at any time in living memory. Interest rates are exceptionally low, and quantitative easing – ie, the printing of money – is common. This cannot continue indefinitely.

In fairness to the central banks, they emphasise that a tightening is not on the agenda at present. This is in marked contrast to the financial markets which, as usual, got way ahead of themselves.

It remains the case, however, that this stimulus will be withdrawn as soon as conditions permit. Therefore, the recovery will have to take place against a background where interest rates are rising, budgetary tightening is occurring and credit is in short supply.

Little wonder then that European economists are cautious.

However, they are not entirely without hope. If the euro zone is forecast to contract this year by 4 per cent, there is a view that it might expand next year by, perhaps, 1 per cent. This is well below the recently reduced potential rate of expansion. That means that euro area unemployment is likely to continue to grow, reaching, perhaps, 11 per cent by end-2010.

It also means that the increase in demand for Irish exports is unlikely to be major.