France: Euro Strength Leaves Its Footprint

Morgan Stanley's AnnaMaria Grimaldi and Eric Chaney look at the results of the latest French INSEE survey, and admit their surprise, things appear to be worse than expected and downside deflation risks growing.

In contrast with the German IFO and the Italian ISAE indicators, the INSEE index took a dive, instead of improving slightly as had been expected. At 90, the synthetic indicator is now almost as low as it was in October 2001 (89) and 10 points lower than its spring 2002 high. The French manufacturing sector is experiencing its own double dip. Is it a consequence of the wave of social unrest related to the pension reform (which, by the way, is making good progress in the national Assembly)? The INSEE survey does not confirm this hypothesis. For instance, the non-weighed diffusion index ("general" assessment) was stable at -32, the same level as in January-February. Also, opinion on recent output improved, dismissing fears that transportation strikes had a very negative effect on production. So where was the catch?

It was on the demand side, indeed, and especially the overseas one. Opinion on orders declined to a level not seen since June 1996, during this "mini recession" that followed the forced fiscal convergence in the euro-area-to-be, ahead of EMU. More importantly, domestic demand was not the main culprit, since foreign orders dropped 9 points, to their lowest level since the 1993 recession, versus 3 points for total orders. Beyond the strength of the euro, the most likely explanation for this setback is the weakness of domestic demand in Europe, in particular in Germany, the biggest export market for France.

However, the (passed?) strength of the euro left a clear footprint on manufacturers assessment. Personal price expectations dropped to -18, from -2 in January, underlining the negative impact of currency moves on pricing power. We are now close to the historical low reached in December 1998 (-23). Notice that Brent crude quoted 9.9 $/bbl then, whereas it is close to 28$ today. This time, the deflation threat is more serious.

Coming on top of negative news from Belgium and the Netherlands, and mixed news from Italy and Germany, the INSEE survey does not make things any better. Our Euroland manufacturing model is now pricing -0.9%Q in Q2 (it was at -0.7% before the INSEE survey), still consistent with a flat GDP reading. Looking forward, the full set of June surveys is providing a preview of what could be the third quarter in the real economy: Our manufacturing model is hinting to another contraction (-0.6%Q), which our GDP model turns into a meagre 0.2%Q GDP growth. At this stage, these estimates are founded on expectations only and are still very fragile. However, the diagnosis from the model is broadly consistent with our macro scenario: no significant pickup is expected in Europe before the fourth quarter, in the best case.
Source: Morgan Stanley Global Economic Forum
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The German Battle Looms

My feeling is that nothing about the present German crisis is going to be simple, and this news confirms my impression:

Gerhard Schroeder, German chancellor, was on Tuesday heading for a showdown with the European Commission over his plan to boost the German economy by bringing forward tax cuts. Pedro Solbes, EU monetary affairs commissioner, warned Mr Schr?der the proposals could breach Europe's budget rules and urged him to focus on reforming pensions and healthcare. Mr Solbes has been irritated by reports from Berlin that he would endorse the personal tax cuts even if it meant Germany breaking the EU's stability and growth pact for the third successive year in 2004. "The German government should not count on support by the Commission if their budget proposals are not compatible with the fiscal rules," he said. He could recommend heavy fines or other sanctions if Germany's budget deficit exceeds the stability pact's ceiling of 3 per cent of GDP in 2004. The Munich-based Ifo institute on Tuesday highlighted Germany's economic problems when it lowered its 2003 growth forecast for the eurozone's biggest economy from 0.5 per cent to zero. Ifo warned unemployment would rise further, increasing the burden on state finances. It said the jobless rate would average 10.4 per cent this year but rise to 10.8 per cent in 2004, the highest since reunification. As the economic problems crowded in on Mr Schroeder, the European Commission suggested his plan to bring forward unfunded tax cuts was ill-conceived.
Source: Financial Times
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On Europe and Its Values

Eamonn has a piece on the Habermas-Derrida proposal which i think I agree with in spirit. Somehow, either because of disconnection, or because of my obsession with Bulgarian immigrants I seem to have missed out on this one. My sympathy is with the idea that we don't need more Europe vs America stuff. On the other hand I think I need to read these pieces in a quieter moment before I go much further:

Rainy Day visitors will need no reminding of where we stand on the call by Jürgen Habermas and Jacques Derrida on 31 May to form a "core Europe" — the founding members of the EU plus Spain — to act as a counterweight to the USA. "Profoundly Atlanticist!" is the Rainy Day motto, which means an outright rejection of the Habermas-Derrida notion. In today's Süddeutsche Zeitung, Paul Kennedy, Director of the International Security Studies at Yale University, adds his considerable weight to the debate and rebuffs the Habermas-Derrida proposal in no uncertain terms.

Titled "Taten statt Worte" ("Deeds instead of words"), Kennedy says that the Habermas-Derrida "core-Europe" initiative is condemned to failure because neither Great Britain nor Spain will play ball, ditto possibly Italy and the Netherlands, and certainly the majority of the middle- and East European states. The latter, incidentally, didn't even earn as much as a mention in the Habermas-Derrida paper of 31 May. So much for their vision of Europe.

To counter those visions that have no basis in reality, Kennedy makes six suggestions for the establishment of a stronger Europe that would have a cohesive identity and would then enjoy respect on the world stage.........
Source: Eamonn's Rainy Day
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Bleaker By the Day


More and more depressing news from Germany. There now seems to be a distinct possibility that Germany will have negative GDP growth through the whole of 2003.

Economists are expecting Germany's economy to plummet further this year.

Recent forecasts offered some hope that Germany’s ailing economy would grow in 2003, even if only by a fraction. But several leading institutes now say they expect growth of zero percent or, worse, a contracting economy. Signs that Germany’s ailing economy may be falling into a full-fledged recession intensified on Tuesday as a handful of the country’s leading business and economic institutes revised economic forecasts from marginal growth to a possible contraction of gross domestic product. "An economic recovery during summer 2003 isn’t in sight," said Martin Wansleben, president of the German Chambers of Industry and Commerce (DIHK). "Instead, the German economy is in a persistently stagnant phase." Using the dreaded term "red zero," as in red ink, DIHK is forecasting that the German economy will contract to below zero growth this year. This winter, the institute said it expected a marginal growth rate of gross domestic product of less than 1 percent. During the first quarter, Germany’s $2.3 billion economy shrank by 0.2 percent over the previous quarter. And the bad news just keeps on coming.


The news comes as little surprise to the 21,000 firms polled by the institute, who are expecting the worst business conditions in 10 years. Not since 1993’s recession has the confidence of German executives been so shaken. Only 17 percent of the companies polled said they had positive expectations for the economy this year, while 42 percent said they expected business conditions to be worse this year than last. "Fears are increasing that exports, the foundation of economic growth (in Germany), are starting to crumble," said Wansleben. "The disappointing global economy following the end of the Iraq war as well as the speedy rise of the euro is shaking confidence in exports." Businesses are particularly concerned about the United States, Germany’s second-largest trading partner. The weak dollar and skyrocketing euro threatens to make popular, high-quality German products – from automobiles to household appliances – prohibitively expensive and less competitive on the American market. But there are also signs of weakness in the traditionally strong export market for Germany’s neighbors. "France, Italy and the Netherlands purchase nearly a quarter of all German exports, and their economies are also faltering," Wansleben noted.

DIHK’s report was compounded Tuesday by the latest forecast from the Hamburg Institute of International Economics (HWWA), which said it was expecting zero growth for the German economy this year. As recently as March, the institute was predicting 0.7 percent growth. Looking ahead, HWWA offered a slightly more optimistic prognosis of 1.5 percent growth in 2004. HWWA said its adjusted calculations were largely attributable to the euro’s rapid climb. The currency’s value has risen markedly above the baseline used by HWWA in its previous forecast, and the institute warned that its further climb could hinder any turnaround of the German economy. HWWA said its current prediction of zero growth was based on the euro remaining stable at its current value. Tuesday’s developments come on the heals of a similar report from the Kiel Institute for World Economics, which also recently revised its growth estimate downward to zero. Nonetheless, the federal government is maintaining its forecast of 0.75 percent growth in GDP for the year – and it points to the April report released by Germany’s six largest economics institutes as justification. The two-month-old report predicted 0.5 percent growth for 2003 and 1.8 percent growth for the following year.
Source: Deutsche Welle
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And Euroland Forecasts Go Downwards


The European Economics team at Morgan Stanley are busy revising euro wide growth forecasts downwards. 0.4% this year for the whole zone. This is why Chinese exports are starting to boom, increasing pressure on European companies, who need to compress prices following the euro rise, leading to Chinese outsourcing. The problem is not in China, it is in Europe, I think Andy's logic is impeccable here.

We are cutting our Euroland GDP growth forecast for 2003 from 0.9% to 0.4%. As for 2004, we are trimming our forecast from 2.3% to 1.9%. Note that the 2004 forecast is discounting an unusually strong and positive calendar effect -- non calendar adjusted GDP growth would be 2.1%. In addition, we cut our average inflation forecast for 2003 from 2.1% to 1.9%, and from 1.5% to 1.4% in 2004.
Source Morgan Stanley Global Economics Forum
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Germany's Euro Test


Glass half full, or half empty? In this case a question asked only half seriously, or half in jest: should Germany leave the euro? Of course the economist in raising the tabou issue hides behind the mask of humour (a strategy already well explored here at Bonobo Land), but the problem is real enough, and despite the comic veneer for once the economist doesn't fudge things.

THE interminable debate in Britain over whether to join the euro reached a new peak this week, when Gordon Brown, the chancellor of the exchequer, delivered his verdict. Mr Brown based his judgment on five economic tests, of which Britain, he announced, had failed four. Yet perhaps this is the wrong debate about euro membership. Only partly in jest, The Economist suggests that a better question is not whether Britain should join the currency zone, but whether Germany should leave.

Take Mr Brown's five tests and apply them to Germany. The first is convergence: are business cycles and economic structures sufficiently in step that Germany can live comfortably with euro-area interest rates? The clear answer is No. Since the euro was launched in 1999, Germany's GDP growth has been by far the slowest in the euro zone, causing its output gap (the difference between actual and potential GDP) to widen by more than anywhere else. Real domestic demand has barely risen at all in Germany since the start of 1999; in the rest of the euro area it has gone up by 9% (see chart). Germany is technically back in recession: many economists think that it is now in its third consecutive quarter of shrinking GDP.

Indeed, a study by HSBC finds that, although Britain's growth rate and output gap have converged with the euro zone in recent years, Germany's economy has diverged from other members. This suggests that Germany may be worse suited than Britain to live with a one-size-fits-all monetary policy. Since Germany has the biggest output gap within the euro area, it needs lower interest rates than its fellows. Instead, Germany has the highest real interest rates, because it has the lowest inflation rate. This, in turn, further depresses growth. Moreover, Germany's lower inflation rate is not just cyclical. Differences in productivity and price levels within the euro zone mean that inflation is structurally lower in Germany. This implies that real interest rates may be permanently too high.

The second test asks whether the economy is sufficiently flexible to deal with “asymmetric shocks”, changes in the economic environment that affect some countries more than others. Flexibility matters because members of the euro zone cannot adjust national exchange rates or interest rates to cushion their economies, and fiscal policy is also constrained. Again, the answer is No. Look, for example, at Germany's struggle to cope with the effects of reunification. For all the recent talk of reform, the labour market remains sclerotic. Levies on wages to finance social security, health care and pensions are painfully high. There are strict laws controlling the firing of workers, and wages are rigid.

Test three is: will the euro encourage companies, especially foreign ones, to invest, by eliminating exchange-rate risk within the zone? If Germany's economy remains weak, it should surely fail this test too, because firms will be wary of expansion. Mr Brown's fourth test, the impact of the euro on the financial-services industry, may be less important in Germany than in Britain. However, foreign banks have slimmed down in Frankfurt, even though the city is home to the European Central Bank.
The fifth test is whether the euro will boost growth and jobs. Over the past couple of years, unemployment has increased by far more in Germany than in the rest of the euro area. Worse still, a recent study by the IMF warns that the country faces a serious risk of deflation, which could further depress output and jobs. Inflation is running at only 0.7% (well below the euro-area average of 1.9%), and increasing excess capacity and a stronger euro will push it lower still.

Deflation would be dangerous in Germany, given firms' heavy burden of debt and the fragile state of the financial system. Bank credit has already ground to a halt. Yet Germany cannot cut interest rates, because these are set by the ECB according to economic conditions across the whole euro area. Europe's stability and growth pact is forcing the German government to tighten fiscal policy too. Ironically, the rules for both the ECB and the stability pact were designed largely by Germany.

The IMF argues that monetary policy can prevent deflation, if it is pre-emptive and forceful. Those are not words that describe the ECB. At his May press conference, Wim Duisenberg, the bank's president, said: “In the 16 years that I was the governor of the central bank of the Netherlands, there were two years in which we had deflation of ½%. I publicly declared then that I lived in a central bankers' paradise.”

Whatever the economic arguments for Britain's joining the euro, the case for Germany's quitting looks stronger. The idea that Germany will do it is, of course, the stuff of fairy tales. However, the country's present predicament also has a fairy-tale feel, with the ECB in the role of the wicked witch who lured Hansel and Gretel into her gingerbread home with the aim of eating them. In the story by the Brothers Grimm, Gretel pushes the witch into the oven. In the real world, Germany is being roasted, and risks living unhappily ever after.
Source: The Economist
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ECB: Revolution in the Boardroom?


Apart from the disquieting legal background to M. Trichet's entry on the international banking scene, one other detail does seem worthy of note. The lack of discussion about what kind of policy impact he might have. This absence is all the more noteworthy in the light of the blaze of publicity and discussion which accompanied the change of watch at the Bank of Japan earlier this year. It is also noticable by its absence in the debate on deflation fighting, now that it appears some of the main European economies may be flirting with the 'Japanese' problem. Paul de Grauwe, academic economist, and Belgian nomination for membership of the ECB managemnet body, reflects on M Trichet's qualities in today's FT. As far as I can see he is expecting a personality clash with Otmar Issing (the ECB Chief Economist) and that Tricet will lean more towards capping inflation than fighting inflation. If this is the case the best that can be said is that we may be in for 'more of the same'.

Now that this uncertainty seems to have been cleared..........it is appropriate to ask what difference Mr Trichet would make at the helm of the ECB. The cynical answer is: very little. The ECB is not the US Federal Reserve, where the chairman is clearly in charge. The institutional structure of the eurozone system of central banks is very different. The national central bank governors exercise considerable influence over eurozone economic decision-making, and will continue to curtail the power of the ECB president. In addition, at present it is the chief economist of the ECB's governing council - not the president - who prepares its meetings and formulates the policy options that are to be discussed. In such an environment, the new president will have limited freedom to impose his views. For the cynics, the difference between Mr Trichet and Mr Duisenberg will amount to very little.

Yet strong individuals can sometimes make a difference. There can be little doubt that Mr Trichet will be a more forceful leader than Mr Duisenberg - which, according to some, will not really be difficult. He is likely to want to be more involved in the preparation of the governing council meetings and in the formulation of the policy options. A power struggle with the chief economist is therefore a strong possibility............

The start of the new presidency is an opportunity to define a strategy that comes closer to best practice and that will create less confusion..................Will this change in strategy also include raising the inflation target to, say, 2.5 per cent or 3 per cent? Many economists would welcome such an increase, especially at a time when some eurozone countries have structurally higher rates of inflation, and are therefore pushing other members dangerously close to the zero inflation limit, creating a deflationary bias in those countries. In addition, as the critics have argued, the maintenance of a target that says inflation should not exceed 2 per cent has led the ECB to react too slowly to growing recessionary pressures.

It is unclear whether Mr Trichet will want to change this part of the ECB's strategy. After all, he made his reputation forcing the rate of inflation in France down to the German level amid howls of protest from French politicians, economists and intellectuals. He stood firm and earned a reputation as a hard-nosed inflation fighter - quite a feat in France. Will he want to endanger this reputation by raising the inflation target? Or will he be the "Nixon who goes to China"? I expect that Mr Trichet will want to preserve his hard-fought reputation. But I may be wrong. Sometimes the quality of great leaders is to do the unexpected.
Source: Financial Times
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Is the Very Structure of EMU so Flawed.........?

Morgan Stanley's Eric Chaney examines EMU five years on. As he declares at the end, euro bull I was, and euro bull I remain - even if he does confess to being a disillusioned bull. Nevertheless his reflection involves some very interesting points. He does ask the question: "is the very structure of the monetary union so flawed that participating countries would be better off if they hadn't joined?" As he informs us this question "among others....was debated at the Euro-50 roundtable in Tokyo on June 12." Chaney is still convinced the EMU experiment had been a net plus, I am not so sure. One of the arguments presented, lower real interest rates, seems a lot less valid in a world were rates generally are declining towards zero. He does, however, set out some important objectives.

1. Lock-in exchange rates were not economically founded. The final exchange rates did not reflect economic fundamentals, in particular did not reflect the relative levels of unit labour costs. They resulted from a guessing game between markets and central banks, and were largely pre-determined by the central parities in the exchange-rate mechanism (ERM), themselves resulting from tortuous political negotiations. As a result, Portugal, the Netherlands and to a lesser extent, France, benefited from a competitive advantage. On the other hand, Germany entered into EMU with a large overvaluation of its real exchange rate. Coupled with wage rigidity, this is now creating serious deflationary pressures in the German economy. Initial conditions matter a lot. This is one of the painful lessons of EMU, which the UK seems to have well understood.

2. The mission of the European Central Bank was not enough specified in the Treaty. The EMU Treaty says that the ECB must deliver price stability and, provided that this target is achieved, must support the economic policy as it is decided by the Council of finance ministers. However, neither "price stability" nor “supporting economic policy” were precisely defined in the Treaty, which, by default, let the ECB have its own interpretation. In particular, an explicit inflation target should have been specified and its value open to revisions.

3. Without fiscal federalism, the lack of fiscal co-operation is deflationist. There are no fiscal stabilisers in the euro area and there will be no such thing in the foreseeable future, as long as federal taxes are not levied. Only domestic stabilisers can be used. The sharp rise of deficits in 2002 and 2003 is a good reminder of the importance of fiscal stabilisers. However, the Stability Pact does not allow countries to let stabilisers play neutrally. Hence, fiscal policies are becoming pro-cyclical, which, in current conditions means deflationist. Symmetrically, during the 1998-2000 boom, governments had no incentives to use the opportunity of the good years to cut their deficits more than cyclical factors implied. The Stability Pact should thus be re-negotiated and ideas such as creating market mechanisms to allow governments to trade "rights to run deficits" should be given a chance. A pre-requisite is that the finance ministers of the euro area must have an institution of their own.

4. Creating a single capital market is an urgent necessity. Whereas capital mobility is largely achieved, European companies cannot reap the full benefit of the monetary union as long as capital markets remain fragmented and divided by subtle regulatory differences. As long as currency risks were incentives to keep savings at home, capital markets could not be unified, despite the unification of most product markets. This restriction does not hold anymore and the obstacles to a single capital market should be ironed out as soon as possible. At stake is a lower cost of capital. With hindsight, I believe that monetary union and capital-market unification should have been implemented together.
Source: Morgan Stanley Global Economic Forum
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Rising Angst in Euroland

Stephen Roach has been visiting Europe, and is getting extremely pessimistic:

It’s been an extraordinary time to be in Europe these past two weeks. After visiting 12 cities in 9 working days, my European straw poll speaks of nothing but angst over the pitfalls of a dysfunctional global economy. Europeans freely admit that their economic model is in serious trouble -- that their economy has all but abdicated its role as an engine of global growth. Nor do they see any real possibility of an overhaul at any point in the foreseeable future. But Europe also feels it is getting blamed for more than its fair share of the world’s problems. Everywhere I go I hear complaints that two other culprits are being let off the hook -- America, for its worrisome twin deficits, and China, for its “unfair” currency peg and. Resentments are building in Europe that may even make it even harder for the world to pull together and come up with a collective fix.

There is no getting around the sad state of the European economy. The data flow from the big continental economies -- Germany, France, and Italy -- point to the emergence of recession-like conditions this spring. Moreover, this downside tilt predates the impacts of the strengthening euro, which will undoubtedly crimp export growth. For a region lacking in internal demand, that could well be the coup de grace. Germany is clearly the weakest link in the chain, yet Europe’s policies are ill-equipped to deal with this serious asymmetrical shock. Although the ECB has now slashed its policy rate to 2.0%, Germany’s 0.8% core inflation rate implies that real short-term rates in Euroland’s biggest economy are still a positive 1.2%. By contrast, with core inflation an estimated 2.4% elsewhere in Euroland, that means real short rates are a negative 0.4% in the non-German portion of the region. That underscores the ultimate inconsistency of Euroland’s monetary policy: Policy is most restrictive in the country that is most vulnerable (Germany) and most stimulative in nations that are in the best relative shape. Such are the pitfalls of an increasingly dysfunctional United States of Europe.
Source: Morgan Stanley Global Economic Forum
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Fearful of.......a radical change, however economically justified


While I find the Economist to be very soft and 'wishy-washy' on many of the important economic topics of the times, there is one controvesial problem on which they have more or less consistently held up the flag of decency and economic common sense: immigration. It is also very interesting to note that the Greek government is proposing to challenge the current 'obsessions'. Actually this does not surprise me, since the Mediterranean countries (with the apparent exception of Italy) seem to be being extremely 'flexible' on the question of undocumented migration. Basically I feel that they are saying the thing they think will go down well in Brussels, and doing another. Undocumented immigration is pouring in like a river right now here in Barcelona, and no-one official seems particularly preoccupied. What concerns me are the inevitable human and social problems that are caused by 'organising' immigration in this way. It is also worth pointing out that undocumented labour cannot be unemployed, since it is: no work, no food, so putting down the problem to fears based on social security sponging seems a little off target. However the question of pushing everybody into becoming an asylum seeker is part of the problem, and typical of far too many Euro-admin solutions. Of course, it is also interesting to note that while so much ink is being spilled on the need to undermine our pensions, and to get us to make all kind of disagreeable sacrifices, an economically coherent policy of encouraged migration is considered simply too 'radical'.

A report published on Tuesday June 10th by the International Organisation for Migration shows that the numbers abandoning their home country in search of a better life elsewhere are soaring: since the mid-1960s the numbers of migrants worldwide has more than doubled to 175m, or almost 3% of the world population.

Across the world, rich countries are struggling with the question of illegal migration, though the reasons why it worries governments differ from country to country. The United States of America was built on immigration and remains relatively open to skilled migrants. Moreover, the country turns a blind eye to huge swathes of illegal immigrants, especially Mexican migrant labourers, who have enough legal compatriots to affect electoral outcomes in key states like California and Texas. Moreover, since America has a more restricted welfare system than those in most European states, there is no feeling that taxpayers’ money is being lavished on asylum-seekers, and thus no widespread resentment that the country’s hospitality is being abused...........

However, it is in Western Europe that the issue of migration is most contentious. Europe needs migrant labour because of its ageing population. Britain’s National Health Service, which is one of the European Union’s largest employers, would collapse were it not for the large numbers of immigrant doctors, nurses and ancillary staff that keep it going. However, despite needing foreign workers, many Western European countries maintain such tough anti-immigration policies that many migrants from poorer countries resort to claiming asylum, seeing it as their best chance of being allowed to stay and work. Because many are not really fleeing persecution, the general perception that many asylum-seekers are “bogus”, in the words of one British politician, is an accurate one. Moreover, the asylum system is hugely expensive: Britain alone spends £3 billion ($5 billion) each year, more than four times the entire budget of the United Nations High Commission for Refugees. And many immigrants, particularly Muslims, are seen as not sharing liberal Western values, such as those encouraging the education of women. This feeling of intolerance of others’ perceived intolerance was a main reason for the rise of the late Pim Fortuyn in the usually ultra-liberal Netherlands.

The European Union is trying to work out a coherent immigration policy to be applied across its 15 member states................Greece, which currently holds the rotating presidency of the EU, and which therefore largely influences the agenda, has said that it wants the block to abandon its obsession with keeping unwanted migrants out and concentrate on how to attract the workers that its ageing population needs. But many EU leaders will be fearful of the popular backlash that such a radical change, however economically justified, might cause.
Source: The Economist
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Germany's Fall Looks More Like a Tumble


The bad news from Germany continues. This provokes speculation of another rate cut (which there should be, please!!) and some 'now you see me now you don't' shuffling from Duisenberg.

German industrial output fell sharply in April, fuelling mounting concern over the fragile state of the eurozone's largest economy and increasing pressure on the European Central Bank to cut rates again soon. Production dropped by a bigger than expected 1.0 per cent in April after declining by a revised 0.1 per cent in March, the economics and labour ministry said on Wednesday. The fall in output, triple what had been forecast by private sector economists, was driven by a 1.1 per cent drop in manufacturing, hard hit by the soaring euro, and a 0.6 per cent slide in construction output. Economists said concern over the slowdown in Germany was deepening amid fears stagnation in what was once regarded as the engine of European growth could soon infect the other big eurozone economies. France and Italy are already feeling the drag of the German economy, which is technically in recession after two quarters of contraction. It is expected to shrink again in the second quarter of this year and show growth of little more than zero for the full year, depressing eurozone growth prospects further.
Source: Financial Times
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More On the Euro Test


Brad Delong has three posts about the euro-no decision ( here , here , and here ). This obviously qualifies the topic as news of the week - although it was hardly breaking news, since we all expected it.

Brad is surely right in suggesting that since the principal objections to joining now - the greater correlation of British with American than European business cycles, and the greater vulnerability of Britain to interest rate shocks - aren't going to disappear any time soon this is more like a diplomatic never phrased as a 'not now'. Indeed, if any of the Treasury economists have been giving thought to how the eurozone will ever be able to collectively drag a deflation-mired Germany out of the mud, they probably realize that a 'not just now' should be all it needs.

I am much more at a loss to understand the thinking of such a venerable collection of economists as David Begg, Olivier Blanchard, Diane Coyle, Barry Eichengreen, Jeffrey Frankel, Francesco Giavazzi, Richard Portes, Paul Seabright, Alan Winters, Anthony Venables, and Charles Wyplosz, who are apparently suugestion that the UK has more to lose by staying out than by going in. This sounds more like moral pressure than clear reasoning to me.

Finally there is Michael Prowse of the Financial Times making the argument that it makes sense for Britain to enter the euro zone if and only if the European Union is committed to a long-term program to create a real United States of Europe: only if European political integration is going to proceed much farther will Europe become an optimal currency area, and the euro make sense. As Brad says: "It's an interesting argument. It may well be a correct one", indeed it is one I have been using continuously from the start of this blog. But we are oh sooooooo far away from this

Crossing the Gate of Deflationland


Right, I believe putting your money up on the table time is getting near. What is happening now in Germany is clearly a turning point of a kind. The big ship has struck rock, water is coming in, and no-one really knows how to plug the leak. Of course, suggestions abound, mainly of the structural reform kind. Others commentators suggest more aggressive monetary policy, and yet others relaxation of the growth and stability pact. In some measure all of these are necessary, the problem is to what extent, when and how? Most discussion seems to me to suffer from the shortcoming that they assume that Germany has for some reason (normally this remains strangely unexplained, but occasionally it is put down to the impact of re-unification on Labour prices: this is cleary one case where it is asumed that Harrod-Samuelson-Balassa hasn't worked), anyway, as I was saying Germany has come unhinged from a nice clean constant equilibrium path, and therfore what is needed now is the right policy mix to get things nicely back into place. The problem with this line of thought is that it may well in fact be the case that the German economy might is following some kind of 'equilibrium' path, just not a nice one, and one to which it may well revert after the impact of any government induced endogenous shock has subsided.

What I am suggesting is that we may be looking at all this upside down, or through its reverse image. What we take as divergence from normality, may in fact be normality as we are likely to know it, and what we may be trying to do is shift the path to an 'abnormal' and unsustainable one. (Now I know I don't believe in 'paths' in the naieve sense, but I think my meaning is clear: if not please hit me with questions). If that is so we will surely fail to correct a problem we have misunderstood whatever the medicine we apply. The difficult question is where to begin to peel this particular onion. In my book, unfortunately, EMU is part of the problem, not a route to the cure. Whatever else may be said, Germany needs unshackling from the euro. This I take is the point about loosening the growth and stability pact. Without the euro Germany would be free to sink or swim on its own terms. Like Japan it could commence a skywards run-up in government debt. This alone would not resolve anything. But it would open up the option of 'unconventional' monetary policy and fiscal stimulus to try and get the magneto to turn (imagine trying to get the EU institutions to agree to inflation targeting for Germany). Whether this would make and difference or not would depend whether at its advanced age, German society is capable of coming to terms with its identity problem and opening itself and its labour markets to the world. All this may sound very drastic, but it would be a shot, maybe a long one, and maybe the only one available. For make no mistake about it, the deflation which is already arriving will not be benign, and it will be extremely difficult to shake off. It will need courage, imagination and determination. There is no 'easy' solution, but we are still a long way from taking full measure of the problems which lie in front of us. Are our politicians up to making the change, that is the question?

Now over to Steven Roach and the Morgan Stanley crew who have been applying themselves to exactly these topics in a timely and interesting debate.

Stephen Roach: In a recent Forum dispatch ("Euro-Wreck" dated 2 June), I raised what I believe are some serious concerns about the state of the European economy, fearing that an asymmetrical shock in Germany could tip this key region into outright deflation. I also raised the related point that the EMU-based recipe of fiscal and monetary policy, which focuses on average performance in the euro-zone, may be inappropriate to deal with severe country-specific shocks in the region's biggest economy.

Eric Chaney:

There is an asymmetric shock in Emuland, and it's a big one. Your conclusions Steve are fairly consistent with my own (see State of Emergency Calls for Emergency Remedy, May 16, 2003) proposals: giving Germany (and only Germany) its fiscal freedom temporarily (this is possible under the Stability Pact provisions) under the condition of a complete overhaul of the wage negotiation system. These ideas have circulated among policy makers circles and somebody I met at the G30 last Friday told me: "It's a good idea, Eric, which makes a lot of economic sense, but — this is a big but — it is impossible to sell it to politicians". I will try again.

............the risk I see is that we are not witnessing just another recession. Instead, we might well be crossing the gate of Deflationland, without knowing whether this will be benign and temporary (maybe necessary, as Joachim thinks) or the first symptom of the “quagmire” described by Paul Krugman, the last thing Europe needs. In addition, I am very far from advocating a fiscal stimulus in Germany. I am just saying that circumstances are indeed exceptional and that Germany should only recover the full use of its fiscal stabilisers, instead of trying pathetically to plug gaps in order to get a satisfecit from Brussels. At the end of the day, Germany will enter deeper in deflation and have an ever bigger public deficit. That is the cruel lesson of the Japanese debt deflation. The Pact (this brainchild of Theo Waigel, as you had wittily named it, if I remember well), mentions an outright recession, measured on an annual basis, as a case for not capping deficits. I am sure that you would agree with me on the fact that what matters is not the annual growth number, but the cumulated change in the output gap. German GDP growth was 0.6% in 2001, 0.2% in 2002 and, on our estimates will be around 0% this year. Even assuming that German potential growth is only 1%, then the increase in the output gap since the end of 2000, will be 2.2% at the end of this year. If all that had happened in one year, it would have been much more spectacular and even our dear Mr. Solbes would have conceded “extraordinary circumstances.” The most unrealistic part of my story is to free up Germany while keeping France and others under the Caudine Forks of the Pact. Impossible to sell it to politicians, I am told in Paris. The law is Nash, not co-operative equilibrium. Don't ask me why, maybe because there is another law saying it is forbidden to be intelligent. That is why I think we will go to deflation, and live a re-foundation crisis. Either the EMU will break up, or we will be wise enough to re-think the macro management of EMU. The theoretical solution to cases of externalities is to create a market where the causes of externalities can be traded. A refunded and innovative Stability Pact would allow governments to trade “rights to pollute,” sorry, I meant “rights to run excessive deficits.”

Stephen Roach: What a great debate. The intensity of the exchange is very gratifying. It shows how much we all agree on the importance of this problem and the stakes it holds for Europe and the broader global economy. In the great spirit of free and open intellectual engagement that we have long cherished at Morgan Stanley, you certainly won't find the pabulum of consensus thinking in this group. While I don't pretend to have the final word, I would like to offer just one point of clarification:

The German-specific policy efforts that I support reflect my deep concerns over the risk of a serious asymmetrical shock that could quickly spread to the rest of Europe. They do not represent a wholesale retreat from the long-term discipline of EMU. But one-size policies do little to deal with the extremes that are now evident if Germany is treated the same as Ireland. I would welcome runaway inflation in the latter if that is what it takes to pull Germany away from the abyss. The American analogy that is often used to assess the stresses and strains of Europe is not appropriate. The United States of Europe is very different from the United States of America. California, America's largest state, accounts for 10% to 11% of the US economy. Germany is fully one-third of Euroland and accounts for about 30% of the cross-border linkages that knit Euroland together. As Germany goes, so goes Europe. The risk of a destabilizing shock in Germany is growing larger, in my view. As insurance against that risk, the rules of EMU should be temporarily suspended while Germany gets some powerful medicine. My sympathies to the "Irelands" of Europe, but under the circumstances I'm afraid that such a concession may be well worth the price.
Source: Morgan Stanley Global Economic Forum
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Germany in Worst Crisis Since 1945


This is one opinion, and it gives a flavour of the atmosphere which is devloping here in Europe now. One would alsmost say a sense of resignation was setting in.

Germany is in danger of breaching the European Union's budget deficit rules next year because of the country's "worst financial crisis since 1945", finance ministers from Germany's 16 federal states said on Thursday. The warning reflected heightened concern over the country's severe financial problems, following indications by Chancellor Gerhard Schr?der on Wednesday that Germany might overshoot the 3 per cent budget deficit limit for the third consecutive year, in 2004. In a unanimous statement issued after a meeting in Berlin, the finance ministers, who include both Social Democrats and Christian Democrats, said: "Adherence to the 3 per cent budget deficit ceiling. . . is in danger". In contrast to Mr Schr?der, Hans Eichel, finance minister, has insisted Germany will comply with its commitments to Brussels. Barbara Hendricks, Finance Ministry state secretary, admitted on Thursday, however, that it would be "very difficult to return below 3 per cent" in 2004, and it would only be possible if economic growth reached 2 per cent next year.
Source: Financial Times
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At the same time Germany now has the lowest short term interest rates since 1875:

The European Central Bank on Thursday cut interest rates by half a point to 2 per cent, their lowest level since the second world war, amid growing gloom at the state of the eurozone's economy.

Amid fears of deflation in Germany, short-term interest rates in the country have fallen to their lowest level since 1875, when records began. Ten-year US Treasury bond yields briefly fell to a 45-year low, dragged down by poor data on demand for unemployment benefits and factory orders, and expectations of matching Federal Reserve rate cuts.The cuts had been foreseen by markets and were praised by political leaders. Wim Duisenberg (pictured), ECB president, said there had been a "high level" of agreement on the cut, but an even larger one had been "mentioned" during the governing council's meeting.
Source: Financial Times
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And obviously there's more to come. Note the subtle nuance: no liklehood of sustained deflation in the 'eurozone' (as a whole). But, of course, if Germany and Italy enter forcefully, this remains to be seen.

Wim Duisenberg, the European Central Bank's president, dismayed many economists on Thursday by playing down what he called the "hypothetical risk of deflation" in the eurozone, and in Germany in particular. In what is expected to be one of his last appearances explaining an interest rate decision, Mr Duisenberg raised hopes of further cuts when he said he expected inflation to remain at about its current level of 1.9 per cent, and then "fall significantly" next year. With the ECB committed to keeping inflation close to 2 per cent, the prospect of a significant fall should prompt further cuts. However, Mr Duisenberg also said there were no forecasts indicating any risk of deflation - a sustained fall in prices - in the eurozone. He said ECB policy aimed to "anchor" inflation expectations close to 2 per cent.
Source: Financial Times
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Euro Emmigration on the Rise


Interesting detail this from Germany about how young people are responding to the growing pessimism about the future of the German economy by packing their bags:

Andreas Sammereier never dreamed it could be so easy to get a job. The 34-year-old electrical technician had been laid off, joining the ranks of the more than 10 percent unemployed in Germany. But one hour after showing up - unannounced - at a company that presses CDs and DVDs and having an impromptu interview, he walked out with an offer for a job he'll be starting next month.The catch: The job, working for Dex Audio Pty. Ltd., is in Australia.

Mr. Sammereier is part of what observers in Germany are calling a new wave of emigration. The most recent numbers available, from Germany's central office of statistics, show that close to 110,000 Germans left the country in 2001. Based on the number of people coming to them for advice, however, the Raphaelswerk, an organization associated with the Catholic Church that offers practical advice and counseling to people considering emigration, says that numbers are skyrocketing and estimates that the figures for 2002 will be twice as high. Peter Thul, author of an emigration how-to book that will be published this month, predicts that the numbers will double again in 2003.

These emigrants, says Martina Luedecke, a counselor with Raphaels-werk in the western German city of Essen, are mostly young, well-educated professionals frustrated with the lack of opportunity in their homeland."I meet more and more young people who have lost their belief in Germany," says Ms. Luedecke. "It seems very clear that this new wave of people heading out of Germany is a result of the current economic situation. Not all of them, of course, but a significant number of them just don't see a future here anymore." Luedecke could be describing a number of European countries. France, too, is witnessing a growing rate of emigration, with the percentage of French living overseas rising 30 percent between 1998 and 2002, according to France's Office des Migrations Internationales. The reasons include France's old-guard business culture, high taxation, and youth employment - 21 percent for those under 25. Young professionals are heading to Canada, the United States and other European Union countries. Italy is also seeing an increase in emigration, experts say.
Source: Christian Science Monitor
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