Germany is in Recession


Yesterdays figures leave little room for doubt. Germany entered recession during the last quarter 2002 - growth for the quarter was fractionally below zero, with the possibility of downward revision. Part of the reason the downside wasn't stronger was an inventory buildup in anticipation of a possible Iraq war. Y on Y inflation came in at 0.9%, so only fractionally out of deflationary territory now. Bad news all round. The only remaining questions are how deep, and how long. After months of pontificating, I fear they are now, finally, catching the Japanese illness.

While overall GDP growth was a notch above market expectations, at a reading of -0.0%Q, GDP went into negative territory at the end of last year. Final domestic demand slowed down slightly in Q4, coming almost to a standstill as consumer spending stagnated and government spending even contracted. At the same time investment spending, both capex and construction, surprisingly recovered during the quarter. Next to the upside surprise in investment spending, the main upside surprise amongst the components came from the volatile inventory component, which boosted overall GDP growth by 0.4 percent. Meanwhile net trade weighed heavily on growth, shaving half a point off overall GDP growth as export growth virtually came to a standstill and imports rose markedly.

The GDP deflator slowed down again in Q4, rising 0.1%Q after a 0.3%Q increase in Q3. This takes the annual rate down from 2.0%Y to 0.9%Y. Unit labour costs rose at a steady rate of 0.3%Q during the final quarter of last year. Gross operating margins thus narrowed in Q4, after having remained stable previously. Meanwhile the gross operating surplus fell 0.4%Q in Q4, after an impressive rise of 1.2%Q in Q3 and a massive 7.0%Q rebound in Q2. The decline in the German gross operating surplus suggests that corporate profits have likely weakened in Euroland over the winter as the economy slowed down markedly.

For the year as a whole this would leave us with our new downwardly revised a full-year growth rate of 0.0% -- it could be a 'black zero', could be a red one -- which would mark a further slowdown from the meager 0.2% recorded last year. Only in the second half of this year, do we expect a noticeable pickup in economic activity in Germany on the back of abating geopolitical uncertainties, falling oil prices and aggressive ECB rate cuts.
Source: Morgan Stanley Global Economic Forum
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Germany: This One Looks Scary


Under the heading 'Germany's Stagnation is Beyond its Control', two JP Morgan economists argue the case today, Germany's short-term difficulties are not about the need for mid-term structural reform, they are about the absence of control over fiscal and monetary policy. And where does this loss of control come from, why from the participation in a common currency better known as the euro. Well, as regular readers to Bonobo Land will already know, I wholeheartedly agree. One minor caveat: it is unfair to blame all the loss of control over fiscal policy to the euro and the stability pact. Control was effectively lost by earlier German governments (Kohl??) who failed to see the demographic time bomb, the large unsecured liabilities of the German welfare system, and the impact of IT and the internet on the way we workand play. It is the failure to change tack and reform and change mentality earlier - especially in the area of welfare funding reforms, working and contractual practices, attitudes to individual risk-taking, and above all national identity and immigration - which has now left Germany a hostage to fortune on the fiscal deficit problem. Also note the suggestion that monetary conditions are far too loose for Spain and Italy, that in the case of Spain applying a Taylor rule would produce an interest rate nearer to 7%, remember the Spanish housing bubble, and watch out for the crash.

Structural rigidities are widely blamed for Germany's economic stagnation. But although it suffers from a number of structural problems, notably in the labour market, these do not explain the contraction that started in the fourth quarter of last year. Market rigidities explain why Germany has a very low potential growth rate: the latest Organisation for Economic co-operation and Development estimate is 1.5 per cent. But recessions come about owing to a lack of demand. To understand what is going on in Germany, look at the traditional drivers of the business cycle: monetary and fiscal policy and the exchange rate. All these are helping to depress German demand relative to that of its neighbours: monetary policy is tighter in Germany than elsewhere; fiscal policy has tightened, while it has remained neutral in France and Italy and has eased slightly in Spain; and, given its greater trading links to the rest of the world, the higher exchange rate is hurting Germany more than its large neighbours.

Although a common interest rate applies to the whole of the eurozone, this does not mean that the monetary stance in each country is the same. The best way to compare monetary stances is to look at Taylor rules. These were originally developed by John Taylor - now undersecretary for international affairs at the US Treasury - to indicate how a central bank should set policy rates given the extent to which actual inflation has diverged from the central bank's target, and the degree of spare capacity in the economy. Applied to individual countries in the eurozone, Taylor rules show what level of policy rates would be appropriate if each country still had an independent central bank looking at growth, spare capacity and inflation.

There are three clear messages. First, before 1999, monetary policy in Germany (and for the region as a whole) was set on the basis of macroeconomic conditions in Germany. The gap between policy rates set by the Bundesbank and those implied by the German Taylor rule was very small. For France, Italy and Spain, interest rates were higher than their respective macroeconomic conditions required, in order to keep exchange rates stable. Second, since the launch of the single currency, the monetary stance set by the European Central Bank has been too tight for Germany but too loose in Italy and Spain. The gap between ECB rates and the Taylor rule for France has been very small. And third, the divergence in monetary stances has increased. Since 1999, the ECB's policy rate has on average been almost 1 percentage point too high for Germany. But by the fourth quarter of last year, the ECB's policy rate was almost 2 percentage points too high.The implications are dramatic. If the Bundesbank were setting rates purely on the basis of conditions in Germany - as it did before 1999 - they would be close to 1 per cent, rather than the ECB's current 2.75 per cent. Similarly, the Bank of Spain would have raised rates close to 7 per cent. Inappropriate monetary stances are pushing growth rates apart. Meanwhile, in response to pressure to comply with the stability pact, German fiscal policy is tightening this year by 0.5-1 per cent of gross domestic product. The degree will depend in part on the centre-right opposition that has strengthened its control of the upper house. But whatever the outcome of the political negotiations, Germany's fiscal position is tightening after a modest easing of 0.5 per cent of GDP last year, while elsewhere in the eurozone policy is closer to neutral.

Last, of all the big eurozone economies, Germany is the most sensitive to the exchange rate. Although global trade growth will eventually return to a healthy pace, the trade-weighted euro is now 20 per cent higher than its trough in October 2000. This currency appreciation will further widen the growth gap between Germany and the other large economies in the region. Since German weakness is a result of negative shocks to demand rather than greater structural rigidities, only an improvement in demand will get the economy going again in the near term. Here lies Germany's predicament: there is no silver bullet. Even though the ECB is expected to cut rates in the coming weeks, they will still be too high for Germany. And the pressure on fiscal policy will remain intense: with its budget deficit stuck above the 3 per cent ceiling, Germany may be forced by the EU to go further in cutting spending and raising taxes.The only ray of hope is the possibility of a powerful upswing in global growth that is not offset by further appreciation of the euro. This seems unlikely. The outlook for Germany is grim indeed.
Source: Financial Times
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France Confirms 2002 Deficit


Yesterdays confirmation that the French budget deficit exceeded the 3% limit in 2002 and will continue to exceed it in 2003, coupled with the refusal of the French government to take any specific measures to reign back the deficit can only make the controversy surrounding the growth and stability pact grow worse. Clearly one of the essential conditions for a coherent monetary policy from the ECB is a common commitment to adhere to agreed principals. For the euro to have any mid-term possibility of survival as a common currency, it is clearly necessary to find a way to steer the twelve separate economies to a position where they act, in principle, with one voice. I personally doubt this is possible (which means, I suppose, that I doubt that the euro can survive in its present form). Certainly the response of each of the national governments to the arrival of a more difficult economic climate does little to convince that this is going to happen. And to all my American friends who are so pronounced about criticising the Bush deficit at home, but seem somehow to imagine an alternative, more growth oriented policy, is readily available here in Europe where the underlying 'fundamentals' are even worse, I would add that what's sauce for the goose is also sauce for the gander, and that growth based simply on trying to borrow your way out of trouble isn't real growth at all, it's growth now at the price of bigger problems later. This, as is often noted in the Bush case, is fine by politicians who are around now, but who won't be around later to pick up the pieces. Of course 'all good men and true' (not to mention the good women) agree that you shouldn't apply dogma rigidly, and that hard times need flexible attitudes. But hard times sometimes also need hard decisions, simply borrowing money to put offf taking decisions is no answer. Borrowing money to facilitate the changes you need to make to be able to repay later would be another question. But take a hard look at what is actually on the table. Europe, like Japan, is postponing change rather than confronting demographic realities. "When growth is uncertain you do not lower spending more than necessary." Raffarin informs us. That is true enough, but when exactly is growth going to become more 'certain', this is the tricky bit.

France on Tuesday launched the most serious challenge yet to the EU's economic rules by ruling out austerity measures to plug its growing budget deficit. The French government admitted for the first time that its deficit for 2002 was likely to top the EU stability and growth pact limit of 3 per cent of gross domestic product. Jean-Pierre Raffarin, prime minister, told business leaders that it was "probable France's budget deficit exceeded 3 per cent as early as 2002". He also indicated that the deficit could remain above 3 per cent this year. However, Mr Raffarin - who heads a right-wing government haunted by memories of an unexpected defeat in 1997 after a failure to honour election promises - said there would be no austerity measures. The government last year promised to reduce taxes by 30 per cent over five years. "I won't conduct a policy of austerity," he said. "When growth is uncertain you do not lower spending more than necessary. That would depress the economic climate even further." The French response to its likely breach of the stringent economic rules underpinning the euro will test the credibility of EU economic policy. A defiant stance by France, which has recently clashed with other EU members on other issues such as Iraq and Zimbabwe, would make it easier for other countries to disregard the pact. The Commission said it would "have no choice" but to take action against the French government if the pact's breach was confirmed when final figures were submitted at the end of this week.
Source: Financial Times
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Euroland: All Numbers Down

All numbers down: this in the opinion of the Morgan Stanley European Team is the likely impact of a war in Iraq, all numbers excepting, of course unemployment, but including a 1 per cent cut in base rates, and eurozone wide economic growth at its lowest level since the recession of 1993.And, in my book, watch out for those downside risks

Two months ago, we cut our EU GDP forecast for 2003 from 1.6% to 1.2%, on the basis of disappointing business surveys and rising uncertainties, both geopolitical and related to unclear economic policy options in the euro zone. Our forecasts were still based on relatively soft oil price assumptions, $24.8 for Brent on average in 2003, and a moderate rise of the euro, from $ 0.95 in 2002 to parity in 2003. Both assumptions now clearly look too low. Our currency team is currently expecting the euro to average $1.08 this year, and our new baseline scenario for oil prices assumes that the barrel of crude Brent should average $28.8 this year, 16% higher than previously assumed. By itself, this increase in oil prices is likely to cost 0.15 p.p. to European GDP growth, the same factor holding for both EMU and non-EMU countries.

In the end, and pricing in a positive effect from additional monetary easing (see below), we estimate the full cost of a war in Iraq at 0.7% of GDP, spread over 2003 and 2004, two-thirds of this impact being concentrated in 2003. Practically, we cut our GDP growth forecast for 2003 from 1.2% to 0.8%, and our forecast for 2004 from 2.6% to 2.3%. For the euro zone only, things are even worse: we now expect GDP growth to reach only 0.6% this year. If our prognosis were correct, this would be the worst year for continental Europe since the infamous 1993 recession.

With a war and even higher oil prices having become our central case, hitting confidence and economic growth further, we now look for a total of 100 bp of rate cuts from the ECB during the first half of this year, taking the refi rate to an unprecedented low of 1.75%. Forecasting the timing and the size of the cuts is trickier than ever, given that the fluid geopolitical situation is likely to loom large in the ECB Council's decision-making process. Assuming a war starts during March, the two most likely rate cut scenarios are as follows. First, the ECB may already be ready to cut rates at the March 6 meeting, even if a war hasn't started yet, justifying the cut with the euro's appreciation, the adverse impact of the prevailing uncertainty on confidence and economic activity, and the likely easing of inflation pressures later this year. In fact, comments by ECB President Duisenberg at the G-7 press conference this past weekend suggest that the Bank no longer believes in a meaningful economic recovery this year and has reduced its sighting shot for inflation further. Following these comments, a rat cut in March would no longer come as a surprise for markets. And if it happens, we continue to think it is more likely to be a 50 bp rather than a 25 bp cut, in order to make an impact on confidence. A second move would then follow soon after the start of a war.
Source: Morgan Stanley Global Economic Forum
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All Does Not Seem Well With German Banks

This doesn't look too promising. The fact they've gone so far as to come out to deny the plan seems to indicate all is far from well. After all, they are hardly likely to come out publicly and admit the problem. My response, like that of Christine Keeler in an earlier epoch: they would say that, now wouldn't they.

The European Central Bank on Monday sought to allay fears of a banking crisis in Germany amid reports that the government and senior bankers had discussed emergency measures to bail out the financial system. In a hurriedly called press conference to launch an ECB report on banking stability in the European Union, Edgar Meister, who heads the ECB's banking supervision committee, dismissed talk of a Berlin-backed bank rescue plan. Mr Meister, who also sits on the board of the Bundesbank, said he was confident Germany's beleaguered banks could "resolve their specific weaknesses on their own" without needing taxpayers' money.His comments came in the wake of a meeting at which top bankers met Chancellor Gerhard Schröder and discussed setting up a government-backed "bad bank" to take on the bad debts of the big commercial banks.German banks have taken billions of euros in loan loss provisions and seen profitability collapse, as corporate insolvencies have jumped to record levels amid the steep downturn in the eurozone's biggest economy.HVB Group and Commerzbank reported big losses for 2002 and investors fear they may face further heavy losses this year, fuelling concern over the resilience and stability of the German banking system. Mr Meister said he was not aware of any government plan for a bad bank, adding:"I don't think German banks are in a condition that they would need such a plan." He said 2002 had been very difficult for German banks and the outlook for this year was "not good either". But he insisted that neither the stability of the financial system nor bank liquidity were in question.His remarks echoed comments by Hans Eichel, the German finance minister, who said the banking system was not in crisis and denied the government was considering any emergency measures. But speculation over a bail-out plan is likely to be fuelled today by a report from credit analysts at HVB, who say the bad bank idea is "a step in the right direction". German press reports said the proposal was raised at the meeting with Mr Schröder by Deutsche Bank chief Josef Ackermann, although he insisted Deutsche itself would not take part.The HVB analysts said the plan amounted to "an admission that there are very serious challenges facing German banks", but pointed to Sweden's success in using the model to overcome a banking crisis in the early 1990s.
Source: Financial Times
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More Argy-Bargy Looming in Euroland

The eurozone never did promise to be a quiet place. First there was all the criticism of the ECB as an 'anti-growth' institution, then there were Prodi's 'stupid' stability pact remarks, now it's the turn of Solbes's deficit-relaxation proposals, with the UK serving as the whipping boy. The problem this time is that with weakening economic growth, UK Chancellor Gordon Brown's for a major investment programme in schools, hospitals and transport, have led to a significant rise in Britain's budget deficit. Brown defends the rise by arguing that Britain should be allowed to run small deficits in the medium term because its public finances are strong, with low levels of national debt and minimal pensions liabilities. Here he is backed by EU Commissioner Pedro Solbes who thinks the stability pact should be relaxed to allow those with a relatively sound underlying financial position should be able to increase the deficit in times of low, or negative, growth. This 'licence' to create medium term deficits understandably irks those who have struggled to comply with the more rigid interpretation of the pact, hence all the fuss. The trouble is that with all the underlying friction floating around over the Iraq war issue it's hard to see any of these issues having a smooth ride, and without a smooth ride anti-euro sentiment in the UK can only rise. It's difficult to see either Gordon 'five-test' Brown, or Mervyn King giving the thimbs up to euro entry, but don't miss the poll result at the end of the article: 35% of voters now favour entry.

As Gordon Brown sped away from the meeting of European finance ministers in Brussels on Tuesday, his officials shied away from claiming victory, but at least suggested that the result was at least not as bad as it could have been. One called it "a satisfactory outcome". But the call by the Ecofin council for Britain to aim for a budget that is "close to balance" creates problems both for the chancellor's reputation for prudence, and for Britain's chances of joining the euro in the near future. Mr Brown's success, such as it was, was that the meeting did not conclude explicitly that Britain was in breach of the stability and growth pact, the set of rules intended to restrict borrowing by European Union member governments. Most countries rejected a statement backed by Denmark, Belgium and Spain that Mr Brown's planned deficits were "significantly above the close-to-balance position required by the stability and growth pact". But the agreed statement took a tougher line than the European Commission's view this month. In particular, it recommended that "the UK authorities should aim for a medium-term budgetary position that is in line with the 'close-to-balance' requirement" of the pact. The EU has in the past defined "close to balance" as meaning a deficit of no more than 0.5 per cent of gross domestic product. Mr Brown plans to borrow 1.5 per cent of GDP in five years' time. The implication is that he must cut public spending or put up taxes by 1 per cent of GDP - worth about £10bn at today's prices - to deliver the recommendation. The tax rise would be the equivalent of about 3p on the basic rate of income tax.

The doubt cast on Mr Brown's plans is an embarrassment for the chancellor, and would be a greater em- barrassment should Britain try to join the euro. Philippe Legrain, chief economist of Britain in Europe, the pro-euro group, pointed out that there was no penalty for failure to comply with the recommendation. "There's no need for Gordon Brown to change his spending plans as a result of anything the council said, whether or not Britain joins the euro," he said. But the statement, which is similar to the opinion of Mr Brown's plans delivered last year, suggests that despite talk about reform of the pact, the British interpretation of the rules is not generally accepted. A potentially bigger worry for Mr Brown is the requirement that government borrowing should be kept below 3 per cent of GDP: a limit backed up with fines for countries inside the eurozone. "I expect a deficit of 2.7 per cent of GDP next year. Allowing for the normal margin of error of plus or minus 1 per cent, a breach of 3 per cent is certainly possible," said John Hawksworth, of PwC. "It would be a very difficult time to join the euro if the government was trying to win a referendum at the same time as being threatened with sanctions."

Countries such as Germany and France, which have tacitly supported Mr Brown, have both fallen foul of the EU's deficit rules but are pushing for more flexibility in the application of the pact's 3 per cent limit. But the result is more confusion about what the rules would mean for Britain. As Mervyn King, who is to take over as governor of the Bank of England, put it: "If you can explain to me in detail precisely what the stability and growth pact is now, then I might find it easier to answer on that, but I'm not entirely sure what status it is now." That confusions looks like one more reason why the assessment of the euro tests will conclude they have not yet been passed. A poll for Barclays Capital has found 48 per cent of people said that if the government said the five tests had been passed, they would still vote against euro entry; only 35 per cent said they would vote in favour. Adam Law, of Barclays Capital, said: "It's a sensible inference that people are less trusting of the government's policies, given their concern over Iraq."
Source: Financial Times
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Eurozone Manufacturing Continues its Decline

Industrial production in the eurozone suffered its biggest monthly drop on record in December, confirming some hefty output falls shown at national level. Germany, the eurozone's biggest economy, registered a month-on-month fall of 2.4 per cent in December. France, the second largest, was down 1.7 per cent. Portugal was the only member to manage a monthly rise. It gained 0.7 per cent.

Eurostat, the EU statistics office, reported a month-on-month fall of 1.5 per cent and an annual fall of 0.5 per cent in the harmonised figure for the eurozone. This was worse than many analysts had feared and represented a sharp fall from November's revised 0.7 per cent rise in the monthly figure and 2.8 per cent annual gain. Ian Stannard of BNP Paribas said the outlook was looking increasingly gloomy for Germany and therefore also for the eurozone. "The Association of German trade and manufacturing (DIHT) has acknowledged that the country is slipping into recession," he said. "The significant reduction of December industrial production points in the same direction, and if Germany slips into recession, side effects in euroland must be feared."
Source: Financial Times
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UK Business Jitters Over Euro Delay

The recent results of an FT survey about inward investment intentions in the UK serves once more to underline just how complicated the euro decision really is. The effect of the euro on inward investment is one of the Treasury's five tests, but only one. The euro decision may have one look from the perspective of corporate decision making, and another from a general macro one. High on the list of corporate decision makers is the question of currency valuation (sterling is at present still relatively expensive in relation to the euro), currency fluctuation risk and transactions costs These are the strong plus points for the euro. On the negative side are the problems of losing control over monetary, fiscal and exchange rate policy. These, as we can see from the present German predicament, are not to be taken lightly. Then there is the famous vulnerability to asymmetric shocks problem. In the UK case this is especially relevant given the importance of financial services, and the dependence of this on the ability to attract external funds (read interest rate policy here). Clearly the Treasury and the BoE have to give priority to the general macro arguments, whilst company preferences tend reflect more specific and focused concerns. That is, after all, why we have governments.

Substantial sums of inward investment could be at risk if Britain delays joining the euro, according to the most comprehensive analysis yet of attitudes among large foreign investors. Sony, Bosch, Siemens, Caterpillar, Philips, Pechiney and PSA Peugeot Citroen are among those in a Financial Times survey of 40 foreign companies with manufacturing bases in the UK that warn they would be less likely to invest here if Britain decides against euro entry. The study offers a snapshot of how membership of the euro will affect inward investment, one of the five economic tests governing euro entry set by Gordon Brown, the chancellor. The Treasury is to publish its assessment by June. The companies that say future investments may depend on the UK's commitment to the single currency have combined sales of some £6bn a year from their UK operations, in which they employ 62,000 people. In the FT survey, 61 per cent of the 31 companies prepared to give their views said they were less likely to invest in the UK if it failed to decide whether to join the euro. The remaining 39 per cent said the single currency would make little difference. Nine companies declined to offer an opinion. Manufacturing has provided 40 per cent of all the new jobs created in Britain by inward investment over the past five years. The UK is still Europe's most-favoured location for inward investment of all kinds, although its share has been slipping.
Source: Financial Times
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This One Looks Dodgy

Well I thought I'd just about heard everything there was to hear about the possibility of war with Iraq, but this one certainly takes the buscuit: it's going to be a handy excuse to get round the embarassing details of the growth and stability pact. In case you think this is me exaggerating I'll quote the venerable Financial Times: "A war in Iraq would at least provide the EU with a way of retaining some credibility for the stability pact in the face of Germany's chronic economic problems", quote, unquote. Come to think of it with so many 'experts' pontificating that the war with Iraq is already priced into the markets, we might ask ourselves whether the possibility that the underlying economic problem may have nothing to do with the war has been 'priced in' yet.

Hopes that Europe's biggest economies would eliminate their budget deficits by 2006 were receding on Tuesday, amid renewed concern about the economic impact of a war against Iraq. The European Commission refused to rule out the possibility of suspending the European Union's stability pact - the eurozone's budget rules - in the event of war. Meanwhile, Germany said it was seeking talks with Britain and France to discuss a programme for balancing budgets across the eurozone. There are now rising expectations that the EU might be forced to postpone again its deadline for reaching "close to balance" budgets within the zone. Last June, EU finance ministers agreed to give France, Germany, Italy and Portugal until 2004 to balance their budgets; that deadline was later moved to 2006.But with sluggish growth across Europe and finance ministers seeking to blame the Iraqi crisis for a worsening outlook, even that deadline may have to be revised. On Tuesday the European Commission said: "If there were to be a war we would look at any measures that were appropriate and might need to be taken". A war in Iraq would at least provide the EU with a way of retaining some credibility for the stability pact in the face of Germany's chronic economic problems.
Source: Financial Times
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Eurozone Deficit Forecasts

The numbers on deficit and debt level forecasts for some key eurozone players do not look promising. Last Tuesday, the French Treasury Department announced a 2002 central government deficit of 49.3 billion euros. This number exceeds the official target by 2.5 billion euros and is a long way above the 32 billion euros recorded in 2001. Once other elements - like social security and local spending - are added in, this should run France in with a defiicit level at around 3% for the year. Germany’s budget deficit was above 3.7% in 2002, and despite a major consolidation effort already put in place by Berlin, most commentators expect that the deficit will remain above the 3% mark through 2003. All of which gives gives Morgan Stanley's Vicenzo Guzzo plenty of food for thought since, as he notes, continued hiking of the deficits could "leave the euro area with high deficit (and in some case very high debt) ratios, low growth, apparently widening differences among country performances, and an appreciating currency". Not the most palatable combination to consider, and not too promising for the kind of policy mix it might allow:

If, as we expect, Germany fails to drive its deficit back below the 3% mark, other governments would soon start questioning the rationale behind their own consolidation efforts. In an environment of deteriorated initial conditions and protracted economic weakness, we think that France would let its deficit slip temporarily above 3% in 2003, confident that, once growth is back, fiscal virtue could easily be restored. Italy would probably follow suit. In this case, we do not see the 3% line being breached, but the amount of one-off measures recently adopted suggests that a truly structural measure of the budget deficit is in fact on a steeply ascending trajectory.

Some could argue that a bit of flexibility is welcome and, if any, should have come at an earlier stage. We would tackle this issue from a different angle. Basically, we are saying that in early 2004 Germany and France could be under the Excessive Deficit Procedure and Italy could keep playing with the fire of its cavernous debt. With growth expected to recover barely to trend, any substantial improvement would have to come again at the cost of further fiscal restrictions. But the major economies in the continent by that time would have moved further on along their political cycles, and the chances of significant corrections are slim. This would leave the euro area with high deficit (and in some case very high debt) ratios, low growth, apparently widening differences among country performances, and an appreciating currency.
Source: Morgan Stanley Global Economic Forum
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Eurozone Deficit Forecasts

The numbers on deficit and debt level forecasts for some key eurozone players do not look promising. Last Tuesday, the French Treasury Department announced a 2002 central government deficit of 49.3 billion euros. This number exceeds the official target by 2.5 billion euros and is a long way above the 32 billion euros recorded in 2001. Once other elements - like social security and local spending - are added in, this should run France in with a defiicit level at around 3% for the year. Germany’s budget deficit was above 3.7% in 2002, and despite a major consolidation effort already put in place by Berlin, most commentators expect that the deficit will remain above the 3% mark through 2003. All of which gives gives Morgan Stanley's Vicenzo Guzzo plenty of food for thought since, as he notes, continued hiking of the deficits could "leave the euro area with high deficit (and in some case very high debt) ratios, low growth, apparently widening differences among country performances, and an appreciating currency". Not the most palatable combination to consider, and not too promising for the kind of policy mix it might allow:

If, as we expect, Germany fails to drive its deficit back below the 3% mark, other governments would soon start questioning the rationale behind their own consolidation efforts. In an environment of deteriorated initial conditions and protracted economic weakness, we think that France would let its deficit slip temporarily above 3% in 2003, confident that, once growth is back, fiscal virtue could easily be restored. Italy would probably follow suit. In this case, we do not see the 3% line being breached, but the amount of one-off measures recently adopted suggests that a truly structural measure of the budget deficit is in fact on a steeply ascending trajectory.

Some could argue that a bit of flexibility is welcome and, if any, should have come at an earlier stage. We would tackle this issue from a different angle. Basically, we are saying that in early 2004 Germany and France could be under the Excessive Deficit Procedure and Italy could keep playing with the fire of its cavernous debt. With growth expected to recover barely to trend, any substantial improvement would have to come again at the cost of further fiscal restrictions. But the major economies in the continent by that time would have moved further on along their political cycles, and the chances of significant corrections are slim. This would leave the euro area with high deficit (and in some case very high debt) ratios, low growth, apparently widening differences among country performances, and an appreciating currency.
Source: Morgan Stanley Global Economic Forum
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Solbes Warns Germany on its Deficit

EU monetary affairs commissioner Pedro Solbes today warned Germany not go back on its promise last month to cut its deficit by one per cent this year. The interesting detail about this piece is the suggestion that the warning is aimed as much at the Christian Democrat opposition as it is at Schroeder's government. All-in-all the German picture is not a pretty one, with few attractive short term alternatives, but the 'shot-across-the-bows' aimed at the Christian Democrats seems to confirm my view that the recent election results do not automatically lead to a stronger reform agenda, such easy interpretations miss the real dymanics of the political process since they fail to understand the specific weight of older voters in an aging society.

Germany was warned on Sunday by the European Commission to stick to its plans to cut its budget deficit, in spite of mounting political opposition and the economic uncertainty caused by the Iraqi crisis. The message was a shot across the bows to Gerhard Schröder's government, grappling with sluggish growth and trying to push through unpopular tax rises.But it was also partly aimed at the opposition Christian Democrats, who are threatening to use their grip on the upper house of parliament to block Mr Schröder's attempts to curb the deficit."It is a politically difficult task and I know that economic reforms are not easy in the current climate, but they are also not impossible," Mr Solbes said in an interview with Bild am Sonntag newspaper. "It is essential that Germany this year implements measures to cut its deficit by one per cent of gross domestic product, as it agreed to do in January." Mr Solbes fears that even if Mr Schröder succeeds in forcing through his reforms, Berlin could be in breach of the pact for a second year running in 2003.He warned on Sunday that unless Germany put its public finances in order, it faced serious problems in the medium term, particularly as the pensions crisis starts to bite.Mr Solbes also said Germany must accelerate reforms to boost growth and employment.
Source: Financial Times
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German Output Falls Again

Figures released today by the German Finance Ministry show that German industrial output fell sharply in December, reinforcing the view that the eurozone's largest economy is now close to declaring its second recession in little over a year. Today's figures will again reopen the debate about whether the ECB rates are way too low for Germany's current situation, and about what specific weight to give the needs of the German economy in the eurozone calculations.

The finance ministry said on Monday that output fell 2.6 per cent month-on-month, offsetting November's rise and dragging the year-on-year rate down to 0.6 per cent. It was the sharpest monthly drop since February 1999, and comes hard on the heels of last week's bigger than expected decline of 4.1 per cent in industry orders for December. Economists said the data were consistent with continued stagnation, if not slight contraction, in the German economy and warned that the stronger euro could make matters worse. The euro has risen around 8 per cent against the dollar since the beginning of December and fears are rising it could soon hit German exporters by making their products uncompetitive. Economists said the poor output data, along with sagging consumer demand and the euro's appreciation, would increase pressure on the European Central Bank to lower interest rates. "The ECB may fear that a rate cut may drown in a sea of uncertainty... but the Germany economy is in need of a lifeline swiftly if it is not to sink further," said Daragh Maher of ING. Most economists expect the ECB, which cut rates by half a point in December to 2.75 per cent, to ease monetary policy in March or April.
Source: Financial Times
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German Unemployment at Five Year High

As if to confirm my recent preoccupation about what is happening in Germany, these latest figures paint a pretty grim picture:

German unemployment rose significantly more than expected last month in a further sign of the gloom overshadowing the eurozone's biggest economy. Seasonally adjusted unemployment jumped by 62,000 month-on-month to reach 4.27m, or 10.3 per cent of the workforce. The unadjusted figure, which is more closely watched in Germany, soared by almost 400,000 compared with December to reach 4.62m - the highest level in five years. The figures showed a particularly steep climb in western Germany, normally seen as a more accurate barometer of the economy than the economically depressed east. The Federal Labour Agency said on Wednesday that seasonally adjusted unemployment in the west climbed by 46,000 to reach 8 per cent of the workforce. In the east, the jobless total rose by 16,000 to reach 1.6m, or 18.2 per cent of the total.

This week's electoral routs have pushed the SPD-led coalition government into intensifying calls for economic and social reforms to boost the labour market and reduce the financial pressures on the stretched welfare state. However, in the short term, the sharp rise in unemployment will most likely hit private consumption, while raising the funding pressures on the welfare state. In particular, the sharp increase could make the government's budgetary goal of eliminating subsidies for the state unemployment insurance scheme more difficult than ever this year. "The implications are straightforward", said Holger Fahrinkrug, eurozone economist at UBS Warburg in Frankfurt. "Today's data exert more downward pressure on German growth forecasts, especially for private consumption, and increase the pressure on the budget".
Source: Financial Times
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Germany: Biting the Bullet?

So it seems reality-check time is approaching. All the major commentators agree that this time Germany is going to have to bite the bullet. The only remaining question is which one? According to a widely held theory the reason the German economy is in such bad shapeis because is has failed to implement a series of universally recommended structural reforms. High on the list of these proposed reforms are changes in the system of unemployment and pension benefits, and changes in employment law to enable greater contractual flexibility. This is the mantra that seems to serve for each and every occassion:

A day after Chancellor Gerhard Schröder suffered a humiliating rebuke in state elections, politicians and economists here said today that the defeat might liberate his government, at long last, to undertake a wholesale reform of Germany's hidebound economy. With little left to lose politically, several analysts predicted, Mr. Schröder may revive the reformist agenda that guided his first two years in power but fell by the wayside as he fought for re-election last fall.

The first order of business is likely to be a rollback of the taxes that Mr. Schröder imposed last fall. He said they were necessary to close a hole in the budget. Mr. Schröder stays in power because a majority in the lower house of Parliament supports him, but now the conservatives hold an even larger majority in the upper house, thanks to Sunday's victories, and have threatened to block him. The chancellor now acknowledges that he must retool his proposals. Some of the taxes, he said, were not "closely enough assessed for the economic consequences." Any effort to reform the economy, experts say, must begin with Germany's labor laws and its welfare system. Ms. Dückert said the government would seek to lower the burden of social security on taxpayers. The labor market, she said, must be made more flexible.The government would achieve those goals by cutting the benefits that allow some Germans to be comfortably unemployed for years, and stripping away the job security of those who do work.
Source: New York Times
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Now important and inevitable as some of these changes are, it is worth first of all trying to understand why they may be important, and why it is that they are now seen as being so urgent. I would like to identify three factors which seem to be of some importance. Firstly the question of the current asset value of the accumulated experience of the German labour force. Secondly the problematic nature of the German welfare and pensions system at a time of rapid aging, and thirdly the problem of achieving optimum output and growth in the context of a currency union (ie the Euro).

Starting with the labour force: one of the factors which has received little comment, but which is clearly of great importance, is the role of accumulated experience during times of rapid change. During the late ninetees it became fashionable to wax lyrical about the enormous significance of the 'creative destruction' phenomenon (since the NASDAQ crash, strangely enough, we've heard relatively little about this, even though the gale seems to have been blowing through wall street more strongly than ever). One of the aspects of this Schumpeterian process which attracted relatively less attention was the effect of the creative destruction process on accumulated human capital. This takes on increasing importance in a services and knowledge-based-industry biased economy like that of the US, Germany, the UK etc. The shift to high value activity has meant that the proportion of the firm's value contained in its workforce has become more and more important, as has the devaluation of that workforce under the impact of technical change. Commenting on the continuing high levels of productivity increase achieved in the US during what he terms the 'jobless recovery', Brad Delong asks the following key question:

Rapid American productivity growth has continued through the recession. What conclusions should we draw from this? This question has two possible answers. The first answer is that changes in America's labor market have eliminated the old pattern by which firms tried to hold onto productive and experienced workers through the trough of the business cycle, because they knew they would be wanted soon and would be very expensive to replace. Such "labor hoarding" meant that measured productivity dropped in American recessions. Perhaps this institutional factor has now been erased from the American economy. However, if it has not been erased--if "labor hoarding" still exists--that means that the underlying productivity growth trend of the American economy has continued to accelerate, and that the future of American growth for the next ten years is very bright indeed.
Source: Semi-Daily Journal
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Now what if......? What if the value of those workers which were previously 'hoarded' has now, suddenly, diminished. It is clear that in times of slow change learned behaviour has, in Darwinian terms, a 'fitness' premium: hence the importance we attach to grandparents, older workers, or collective "wisdom". But in times of rapid and accelerating change - like the present - the premium for learned behaviour drops, and the advantage goes to rapid reactions on the fly. It is this delicate process of value transformation, now proceeding more quickly, now more slowly, that underlies the devaluation of the existing workforce. The impact of this is especially important in countries like Germany and Japan where economic success was based on the accumulated experience of an entire workforce. It is the dramatical devaluation of the worth of that experience which is one of the factors which helps to explain the recent years of slow growth in Germany.

Secondly the German population is rapidly getting older. In fact, if you discount immigration, and children born to parents of non-naturalised immigrants, Geramn mortality is now higher than fertility. Put in plain English more people die every year than are born: the population is shrinking. Of course, the effect of immigration is to mask this reality, as when you add-in the net annual migrant inflow the population appears to be more-or-less stable. This aging process has two important effects in the current context. Firstly if we were to attempt to derive a function to indicate the capacity of a society to change (its flexibility to use the contemporary argot), then surely age would be one of the key parameters to look at. Bluntly put: as we get older the more we have invested in what we have already learnt, and the less we have to get from new learning. Our capacity to learn, as I've unfortunately been discovering myself, also tends to decline with age (although Brad Delong and I are among those who seem determined to try and resist the ravages of time). And what is true for the individual is true for the firm, and is true for the country. In addition the unfortunate system of PAYGO pensions, which is a legacy of an earlier demographic profile, has left the majority of European states, Germany among them, lamentably short of acquired resources to fund future anticipated liabilites (this phenomenon could be even worse than even the pessimistic actuarial provisions estimate since many demographers argue that the calculations are based on a serious underestimation of the way life expectancy is likely to increase over the next fifty years. This then is the fiscal trap that lies behind the growth and stability pact, and which means that the German government is attempting to raise taxes at a time of impending recession. (To be continued..........).

Is There a Critical Level For The Euro?

What is the level beyond which the rising Euro means things start to turn nasty, or, indeed is there such a level in sight? Morgan Stanley's Stephen Jen argues that there is - and that that level is 1.08 dollars (pretty much the current level). Jen's argument, and it looks pretty sound to me, is that any further Euro upside would have to be met by the ECB with an extremely aggressive bout of rate cutting, a bout which would be more than welcome in Germany, but would leave the euro zone's inflation prone mediterranean fringe looking helplessly skywards. This is all the more the case since the tacit acceptance by all parties of a more-or-less stable dollar-yen parity means that the euro is about to do the heavy lifting.

We believe the US dollar's structural descent will continue, and expect the euro to be one of the biggest beneficiaries. This euro/dollar ascent is decidedly a rally by default, not by merit, in our view. Because this rally in the euro reflects capital repelled by the US rather than capital attracted to Euroland due to Euroland-specific factors, a strengthening euro will have important economic and policy implications. At this juncture, the investment strategies of the two major groups of currency players -- (1) the Asian central banks and (2) the owners of petrodollars -- are likely to remain positive for euro/dollar for some time, despite the inferior cyclical fundamentals in Euroland. This rise in euro/dollar is so far rather "healthy." However, we note that euro/dollar has already reached an important level for the Euroland economy. Not only is $1.08 what we believe to be the PPP fair value of euro/dollar, it is also a level, if maintained for the rest of the year, that could in theory force the ECB to push the refi rate below the federal funds target rate of 1.25%.

In our view, the main reason that the Euroland policy makers prefer a strong and appreciating euro is to help contain inflationary pressures. However, in light of the extraordinarily weak cyclical economic fundamentals in Euroland, the only source of persistent inflationary pressures is structural. (We would classify high oil prices as a cyclical pressure.) For most of the rest of the world, the challenge of the monetary authorities has shifted from fighting inflation to forestalling outright deflation. In a sense, Euroland is forced to fight "yesterday's war" only because it has unresolved structural issues.

Euroland’s strong-currency bias is one reason why the euro may rally against both the dollar and the yen in the coming months (though we believe that eventually the yen will catch up to the euro in this dollar descent). Since the beginning of 2002, the Fed’s major dollar index has declined by some 11.3%, while the broad dollar index has shed some 3.5% of its value. So far this year, this ratio of 3:1 has largely held. In addition, we recall the result of our back-of-the-envelope calculation that, if dollar/yen is held fixed by the Japanese Ministry of Finance, then, all else equal, to achieve a 1% decline in the major dollar index, a 1.8% rise in euro/dollar is required. Combining these two ratios, we find that to generate 1% decline in the broad dollar index, euro/dollar will need to rise by 5.4%, with all the assumptions mentioned above.

My colleague Joachim Fels and I have pointed out that interest rate cuts could potentially offset the effects on growth of a strong euro. As a rule of thumb, a 10% trade-weighted appreciation of the euro is equivalent to a 150 bp hike in the refi rate. Since euro/dollar averaged $0.95 in 2002, if the euro remains at current levels for the rest of the year, the ECB, in theory, would need to trim its refi rate by some 150 bp just to neutralise the contractionary effect on GDP growth. Such cuts would bring the refi rate in line with the federal funds target rate, currently at 1.25%. That said, the ECB is officially an inflation targeter, not a growth targeter. Using the same rule-of-thumb approach, however, suggests the ECB would need to trim its policy rates much more aggressively to offset the impact on inflation of a 10% euro TWI appreciation. Theoretically, the bank would need to cut the refi rate more than three times more aggressively than if it only tried to offset the effect of a strong euro on growth.
Source: Morgan Stanley Global Economic Forum
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Euro Rise, Curative Therapy or Very Bad News?

The dollar's decline brings with it the euro's rise. But is what may be good news for some bad news for others? Certainly a falling dollar will produce a bit of much-needed inflation in the US, but in the same way will tend to have a deflationary impact in Germany. According to Joachim Fels & Elga Bartsch of Morgan Stanley (here) the euro has appreciated by 10% against a trade-weighted basket of currencies, and an appreciation of the euro of this magnitude should shave roughly 0.7 percentage point from euro-area GDP growth, mainly via the dampening impact on exports. Using another rule of thumb they calculate that it would take about 150 bp of ECB rate hikes to produce the same effect on GDP. Hence, they estimate the appreciation of the euro over the past year as being roughly equivalent to a 150 bp tightening of monetary policy (in which case the 4% appreciation since early December has already more than fully eaten up the expansionary impact from the 50 bp ECB rate cut). In other words the euro rise is a form of monetary tightening. Add to this the likely impact of such additional tightening on the CPI in Germany and it's easy to see where we might be headed. Let Morgan Stanley's Stephen Jen explain:

On our estimates, a 20% depreciation of the trade-weighted USD (major index) generates around 2.4% import price inflation in the short run, and this translates into 0.75% CPI inflation in the long term for the US economy. Although limited, this should help to alleviate deflationary concerns to some extent, together with the cumulated monetary easing and the ongoing fiscal campaign in the US. On the global balance sheet, the USD depreciation is likely to transfer a similar amount of CPI inflation from the major economies to the US economy, despite the fact that this is unlikely to be a zero-sum game.

Canada’s import price deflation seems to be the most vulnerable to the USD depreciation. If the CAD appreciates 20% against the USD, this results in 8.4% import price deflation in the short run, translating into 2.8% Canadian consumer price deflation over time. Similarly, Italian consumer prices decline about 2.1% in the long term, while the impact for the UK is around 1.1%. For the Euro-3, the overall impact is relatively muted. A 20% USD depreciation causes about 0.86% consumer price deflation for Germany and 0.95% deflation for the Euro-3 in the long term (on a GDP-weighted basis). The impact of USD depreciation is significantly low for French consumer prices.
Source: Morgan Stanley Global Economic Forum
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So German prices could be pushed down 0.86% by a 20% dollar rise, or just enough to go below water. Meantime the situation could be even worse in some countries (Italy, Spain?) if we start to thing in terms of asymmetric impacts. What may be seen as positive for the euro zone en bloc, may well be much less so when you go country by country.

A strong currency is rather like cod-liver oil; it might be unpleasant but it is ultimately good for you. By making it harder for an economy to export, a strong currency requires greater productivity. Once the short-term discomfort of currency strength has passed, an economy is in fighting-fit shape and ready to take on the world. That, at least, is the theory - a theory that is about to be put to the test in the eurozone. This week the euro touched $1.0907 against the dollar, within a whisker of its highest level since March 1999 and not far off its starting point in January 1999 at $1.17.

In a relatively closed economy such as the eurozone, where exports make up just 15 per cent of gross domestic product, it is generally better to have lower interest rates than an undervalued currency. Pedro Solbes, European monetary affairs commissioner, yesterday said that, while the fall in the dollar was too rapid, the eurozone could "adapt to the new context". European exporters have already shown they can cope with some strengthening in the euro. Its 15 per cent rise last year did not prevent eurozone exports from rising 1.1 per cent. But to some economists, such arguments appear strikingly complacent. Exchange rate changes only affect exports with a time lag, and if the recent rise in the euro continues, they argue, it will soon start to hit eurozone exports.This threatens to strike the eurozone at its Achilles heel - Germany. The country was only saved from recession last year by net exports, which grew around 1.4 per cent. By contrast, domestic demand contracted by 1.1 per cent.

Weak internal demand in the eurozone overall has resulted in an increasing dependence on exports. For smaller businesses, which tend not to hedge their exposures, this is already a problem. "Some exporters are suffering," said Ludolf-Georg von Wartenburg, director general of the Federation of German Industries. "They are fighting in dollar markets with very thin margins." Many also doubt that a stronger euro will really spur faster structural reform.

Statements from council members are less than encouraging. Otmar Issing, the ECB's influential chief economist, told the BBC recently that he did not currently see a risk of deflation, and suggested that a bigger danger might be letting inflation stay too high. John Llewellyn, global chief economist of Lehman Brothers, argues that it is deflation, not in-flation, which is the greater threat. "Our estimates suggest a 10 per cent rise in the exchange rate causes a 1 per cent fall in prices. So if we get a 20 per cent rise from where we were at Christmas, inflation would be roughly zero. In some places, prices would be falling." If they fail to respond adequately with rate cuts and structural reform, eurozone policymakers could turn the long-predicted and unavoidable correction of the currency markets into a serious problem for Europe.
Source: Financial Times
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Sweden Delays Euro Entry Date

In a decision which for once speaks of wisdom and sense of judgement Sweden on Tuesday ruled out an early move to join the euro, even if voters give their backing to the single currency in September's referendum.Gunnar Lund, the minister responsible for euro issues, said the country would adopt the euro in 2006 to give its banking system, government agencies, and large companies plenty of time to prepare for the currency switch in the event of a "yes" vote in the referendum. The government had previously indicated that January 1 2005 was its preferred date for joining the single currency, with notes and coins to be introduced a year later. It is now planned that, in the event of a referendum yes both events will take place simultaneously. A bit more time for the institutions to prepare, and a bit more time to see whether the Euro's current ills are (as many of us fear) endemic to the system, or whether they are mere teething problems. In any event the opinion polls offer no clear forecast for September, with opinion divided roughly 50-50.

Mr Lund said the central bank and the country's leading banks had indicated that a 15-month transition period between the referendum and January 2005 was too short for them to change their IT systems and test them fully.He said: "A big bang solution will be smoother and more secure for everybody involved. It will also be cheaper because banks and companies will not have to invest in systems that only need to be in place for a year."Klas Eklund, chief economist at SEB, one of Sweden's leading banks, said that it was impossible for banks and companies to start preparing their systems before the referendum, given that the outcome of the September 14 poll was likely to be close.The latest opinion polls have shown the "yes" and "no" camps running neck-and-neck.A Temo opinion poll last week gave euro opponents 44 per cent support, and supporters 43 per cent. Another poll gave the "yes" camp a 39.5 per cent to 39.3 per cent lead. Swedish opposition to the single currency increased during the autumn before stabilising this month. The "no" side is benefiting from perceptions of Germany's economic weakness and the fact that the Swedish economy is doing better than the eurozone's. Opponents also expect to benefit if Gordon Brown, the British chancellor (finance minister), decides the time is not right for the UK to apply to join the euro, when he presents the results of his five economic tests by June.
Source: Financial Times
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