Hamish McRae: No fireworks at the G20 please, let's just sort out deficits and banking

Economic view

It is the first Group of Twenty economic summit for our new government, and at a tricky time for all. We inevitably see what is happening to the world economy through the prism of the British fiscal catastrophe, the full extent of which was finally unveiled in the Budget last week.

Put at its simplest, we need global economic growth to help us dig our way out of the mess we are in, and there is a danger that there will be a double dip to the recession. But every developed economy is in some difficulty, with the differences less significant than the similarities.

There are two great issues: what to do about fiscal deficits and what to do about the banking system. Deficits first.

The chart shows what the world has come through, an astounding and vicious collapse in world trade followed by a sharp recovery. It is, as you can see, unprecedented in recent history. However the fall in GDP (not shown) was more limited, only just dipping below the zero, and for the emerging world there was no recession at all. But look again at the graph: the top has started to come down again, suggesting that the initial bounce of the recovery is past. While I could not contemplate another dip below zero, it would be perfectly plausible for there to be a pause. Indeed, that frequently happens.

The case for the pause is bolstered by evidence from the main developed economies. The latest news from the US is disappointing. Paul Dales at Capital Economics notes that the ending of the fiscal stimulus in the US will of itself knock 2 per cent off GDP growth, and adds: "Overall, the US economy may be performing much better than those in Europe, but this is still the weakest and longest economic recovery in US post-war history."

Note that point about the ending of the stimulus. The US is currently lecturing Germany about its plan to cut its deficit but whatever view you take of this, the fact remains that the US is doing the same, albeit more slowly. It is true, however, that the European recovery is looking soft at the moment. Germany is something of a bright spot, as indicated by the Ifo Institute surveys, business confidence is strong, with export prospects helped by the weaker euro. France's business community reported a strong outlook too. But we also had hints last week from President Nicolas Sarkozy that the French budget in the autumn would cut the deficit more swiftly than previously planned. Europe is slamming on the fiscal brakes.

Seen from the UK, this is both comforting and worrying.

It is comforting to see that everyone in Europe is doing the same as we are: getting back to something close to a balanced budget over the next five years. What is worrying is that we are all doing it because we have to. There is a real fear running through Europe that governments might lose control. The "Club Med" countries have, in effect, lost control of policy. Greece cannot borrow from the market. Portugal and Spain have yet to convince borrowers that they will be able to repay their debts. Spain is struggling to pay its monthly bills – a gap is emerging between its tax revenues and the welfare and other cash payments it has to make. Many European banks, which carry a lot of sovereign European debt, cannot borrow from the markets and are being kept alive by loans from the European Central Bank. And we had the Financial Stability Report from the Bank of England last week noting that British banks were threatened by eurozone sovereign debts.

That leads to the second issue in Toronto, what to do about the banks. The problem is, the authorities have two conflicting objectives. One is to create a bank regulation system that prevents a future banking collapse. The other is to keep funds flowing to borrowers, domestic and international.

On the first, there are a whole string of proposals racing along. We have the UK bank tax outlined last week. America's Congress has just agreed on nearly 2,000 pages of legislation that will, as I understand it, force banks to separate risky trading business from sounder lending business – though how on earth legislators can sensibly judge what is risky and what is not I really do not know. Meanwhile, the Basel committee is drawing up new international rules for the amount of capital banks are supposed to have against various types of business.

The big point here is that banks are going to be less important in the future. They will be less able to finance projects and be less attractive places to put deposits. You can already see this happening. Companies that need money issue their own bonds, borrowing directly from the market. Firms that are cash-rich give favourable trade credit to suppliers and customers, while those that are cash-poor do the reverse. It is a world that celebrates prudence but also one that favours the strong.

The key question is to what extent this weakness of the global banking system will hold back growth. To some extent it must. But companies are ingenious and will find other ways to finance themselves. And investors are ingenious and will find other places to park their money. Gradually, a parallel monetary system will grow up outside the conventional banking sector and this development will fund the next phase of growth. But we should not kid ourselves: all these new restrictions on banks will not only curb the banks – they will also curb growth.

So what should we be looking for from Toronto? No fireworks please. There is a trust deficiency between political leaders and electorates, and politicians under pressure tend to do and say silly things. But while I have dwelt on the difficulties facing the developed world, and the likelihood of a double-dip, the more important interaction will be between the developed world and the emerging one.

The most important relationship here is between the US and China. The latter has just agreed to loosen the dollar peg for its currency. That defuses a potential row between the two countries but the tension will remain while the US has to rely on China to finance itself.

It is odd that the world's largest and richest country has to borrow from a communist, and still in many ways, developing country. Capitalism has to borrow from communism? Rich has to borrow from poor, or at least poorer? That is not healthy, nor is it sustainable. Eventually, maybe quite soon, the US will have to rely on its own savings. The important thing is to manage that transition back to a self-sufficient America in an orderly way. China might reasonably say to the US that it should have a medium-term plan to start to pay back its debts. It won't – because that is too early. In 10 years' time, China will be running down its holdings of US debt but for the moment it suits it to go on piling it up. But make no mistake, the big global stresses will not be between Europe and the US, but rather between the US and the emerging world.

We'll be in trouble if George Osborne's spending plan doesn't pan out

There has been so much stuff about our emergency Budget that I don't want to add too much here. Our back-of-an-envelope estimates of the pace of consolidation shown in the chart last week proved pretty close to what the Office for Budgetary Responsibility concluded. Just a couple of points:

The first is that while most of the attention has been on the tax side of the Budget, for obvious reasons, and on the early spending implications, the weakest link I can see is on the spending side during the final couple of years. You can make big spending cuts in years one and two, maybe three, and there is a lot of fat to trim. But after a while, not only will the political will flag; the political calendar will compel a softening of the plan. If – big if – the fiscal numbers turn out towards the more favourable end of the range, the Government could declare a victory and retreat, perhaps by freezing spending rather than cutting it. If not, well, we will be in trouble indeed.

The second is that this idea of rebalancing the economy towards manufacturing has to be seen in the context of what is happening now. A survey out last week from Deloitte ranked global competitiveness in manufacturing. Top five were: China, India, Korea, America and Brazil. Britain was number 17. It gets worse. In another five years, the survey says, we drop to 20th.

You might say this is just another survey, but one thing stands out. Its respondents – 400 manufacturing managers around the world – said that by far the most important aspect of competitiveness was access to talented and innovative workers. So how does Britain become or remain a magnet for talent? Just last week, firms protested to the Government about its plans to cap the number of immigrants. While you can understand public concern, clearly the Government ought to be figuring out how we contract an immigration programme to make sure we, and our businesses, get the people we want.

In short, if we really are "open for business" as the Chancellor said, the sign has to say "open for talent" too.