Hamish McRae: Questions of confidence that haunt the global economy

I spent the early part of this week in Paris at the annual OECD forum about the world economy. It was a sombre and thoughtful gathering that helped me define some of the present economic uncertainties – for these are huge, perhaps greater than at any time for the past decade.

The end of the Iraq war should have heralded a revival in consumer and business confidence but it does not seem to have had any material impact on either. The Sars virus may be in retreat outside of China but that too does not seem to have led to much of a return of business to the regions most seriously hit. The world's main equity markets, with the exception of Tokyo, have managed a reasonable recovery, though they are still only about 60 per cent of their peak levels of 2000. But again there has been no widespread return of confidence. But these are all general uncertainties, a general sense of unease. It is impossible to calibrate the unease, still less see how it might be fought, unless you can separate its various strands. Here are some.

Start at home. Here there are three main uncertainties. One is the euro. You may reasonably expect that the Treasury tests will kick this one into touch, saying the time isn't right. That is almost certain: intellectually it would be impossible to declare that the case for entry was clear and unambiguous. But to play for is the tone in which the matter will be tackled, and maybe the position of the Chancellor. Even when the results of the tests have been duly revealed, the uncertainties will continue.

Next, there is the credibility of the Treasury growth forecasts, not just for the economy but more particularly for tax revenues. This leads on to uncertainty about tax rates: will the recent round of increases prove sufficient and, if not, what then?

The final uncertainty here is the housing market and, in particular, the link with consumption. The link is the strongest of any country in the world: if house prices fall by any significant amount, then it would be astounding if the consumer boom were to continue. The only question would be the extent of the retrenchment. But we don't know what will happen to prices. My own guess is that they will fall by at least 10 per cent but that is only a guess.

On the Continent, the key uncertainties are about Germany. If the eurozone's largest economy continues to struggle, the rest of the eurozone can only produce lacklustre growth. The latest Ifo survey of business opinion is dire (see first graph), and if the strong euro does more damage to German exports, will probably become more so. This leads to uncertainties over German economic policy: continued near-paralysis seems the most likely. That leads to the prospect of Germany catching the Japanese disease of deflation.

If Germany cannot grow, can the rest of the eurozone manage better? Here it is possible to be a little more optimistic. Even if France and Italy remain depressed (more poor French unemployment figures yesterday) it still should be possible for fringe Europe to show decent growth. But that won't help global demand because the fringe countries are too small to matter much.

In Japan, still the second largest economy in the world, there is just one uncertainty: is there any turning point in sight? Sadly, the probable answer is no, given the extremely depressed condition of consumer confidence (next graph) but I would not completely discount the possibility that the coming year will start to see some sort of turning point. Even the Japanese economy is ultimately self-correcting and many of the excesses of the 1980s bubble have been worked off. Financial reform, if it ever came, would unleash this potential for recovery.

If all this sounds dispiriting, there are some signs of hope in the United States. The uncertainties include the oil price, which is probably more important to the US than share prices (next graph), and cheap-ish oil will give a spur to growth in the coming months. Consumer confidence (final graph) has recovered since the end of the war, in contrast to consumer confidence in the eurozone or Japan.

The question for the US is whether it can sustain a recovery when it has still to work through the unresolved imbalances left over from the late 1990s boom. We know that the Federal Reserve will pump in money and we can probably assume that there will be no further collapse of asset prices. So it is plausible that the slow and hesitant recovery will continue. But we don't know.

Then there is the rest of the world, all to often forgotten in discussions of the G7, and Sars. The working assumption here must be that the region most seriously hit by Sars, China and the rest of east Asia, will recover by the second half of this year. But whereas smaller economies such as Singapore, Taiwan and Hong Kong will suffer lasting damage similar to that of the Asian financial crisis of 1997, mainland China will not be so seriously affected. That might seem odd, given the dire stories from Beijing. But the Chinese economy is so vast and the interaction with the rest of the world so limited that it may avoid lasting damage – if, and it is a big if, the epidemic comes under control quickly.

My concern is not so much there the recovery in the region will be aborted but rather that the fastest-growing region in the world will lose some edge in the longer term. We will see.

Finally, there are two other uncertainties. One is that the world will mismanage the transition from inflation to price stability and slip into deflation. If interest rate cuts do not stimulate demand, what then? The Japanese disease would go global. The US cannot really reduce rates any more, while cuts by the ECB are unlikely to boost Germany's economy.

It would be silly to say that monetary policy has failed. But I don't think we can be confident that it has succeeded. The world's central bankers may have to think of ways other than cutting interest rates to boost the global economy.

Finally, the other great shift that the developed world has to manage is to move from one of population growth to population stability – and in the case of much of Europe (and of course Japan) to population decline. This has not happened before in Europe, or at least not since the Black Death. At least it is being discussed, which I suppose is a start. But action? Uncertainty abounds.