Hargreave Hale’s George Finlay: Europe is the new Japan

Finlay George Hargreave Hale 2014

Europe is in a state of political flux and – unlike the US – remains in an economic mess.

There is now an increasingly urgent requirement to find a solution in Europe before extremist political parties become unexpectedly powerful.

One major problem is that even if quantitative easing is scaled up next year it might not work as it has in the US.

Conditions in the US and Europe are entirely different. The US economy is far less dependent on world trade than Europe. It exports less than 14 per cent of GDP. By contrast, Germany exports over half its GDP, Spain 34 per cent, France 27 per cent and the UK 31 per cent.

The US is a large importer with a traditional reliance on oil, but with the advent of shale gas, reliance on foreign energy imports has reduced. 

By contrast, Europe literally lives or dies on exports. The US domestic economy can get along nicely without its global friends. This has been proved by the recent marked divergence between GDP growth in the US and Europe and the rest of the world. 

The US Federal Reserve recently ended the quantitative easing experiment as the US economic recovery continues.

In 2014, the budget deficit shrank to $483bn from $680bn in 2013. Not since the aftermath of world war two has there been such a sustained fall in the US deficit and it has been fuelled not just by budget cuts, but by higher tax revenues as the economy recovered. 

However, if Europe receives a US-style QE boost in 2015, the overall impact will be much less.

This is partly because of the significant difference between the US and the European banking systems.

The US banks were much quicker than their European counterparts to write down the value of their loan books post the 2007-08 crash. Not only that, the US banks had much more stable sources of funds, with loans sourced from deposits rather than the much more unstable wholesale markets.

In addition, unlike the Europeans, the US banks have been benefitting from a broadly based US economic recovery, enabling them to dispose delinquent loans from their balance sheets. In fact, in the second quarter of this year the US banks in aggregate reported their highest net quarterly income ever, some $42bn.

By contrast, not only have European Banks survived in a much less favourable macro environment, they have also suffered from the requirements being mandated by Basel III. Post crash the average tier one ratio of the European Banks was just 8.7 per cent, compared with 10 per cent for the US banks.

US banks have had a number of years when an improving economy enabled them to repair their balance sheets. European Banks must now work hard to tighten up their own capital rations; Basel III imposes demanding targets. 

There is also the massively deflationary impact of the fines continuously imposed on banks by the regulators.

US banks and their European rivals have paid out over $100bn (£63.6bn) in fines and legal settlements since 2008, and could face a further $151 billion. If you give a bank £10 it could lend out £20 or more. Take it away and the multiplier works in reverse. The ability of the banks to lend is sharply reduced, putting a significant dampener on recovery.

As a result, the chances of a US sized QE triggering a recovery in European bank lending in 2015 seems limited. And certainly, one of the hidden agendas of QE, to create some inflation, is even less likely. There remains a distinct danger of a Japanese style economic non recovery. 

George Finlay is an investment director at Hargreave Hale