German Output and Exports

This is more like working notes than an analysis, but just to point out two things about the October data:

Firstly German industrial output fell in October:

German industrial production fell unexpectedly in October, with construction and energy output hardest hit, but economists said the data were probably a blip and that the outlook for the fourth quarter remained good.

Output declined in October by 1.4 percent month-on-month in seasonally adjusted terms, undershooting all forecasts, preliminary Economy Ministry data showed on Friday....

The output drop, the second monthly fall in succession, comes two days after data showed German manufacturing orders unexpectedly declined by 1.1 percent in October.

On the other hand:


The output figures contrasted with trade data from October released earlier on Friday. These showed Germany’s trade surplus hitting a record high, driven by strong demand for goods from around Europe, but especially from outside the European Union.

Indeed October seems to have been a really good month for German exports:

German exports unexpectedly rose for a fifth month in October, suggesting sales in Asia will help Europe's largest economy cope with a U.S. economic slowdown.

Exports climbed 2.6 percent from September, when they gained the most in more than four years, the Federal Statistics Office in Wiesbaden said today.

And just look at this:

Exports climbed 23 percent in October from a year earlier, with sales to countries outside the European Union jumping 31 percent, according to the statistics office.....Germany's trade surplus rose to 17.3 billion euros ($23 billion) in October from 15.6 billion euros a month earlier, the statistics office reported. Imports slipped 0.2 percent from the previous month.

The explanation for the difference between the industrial output performance and the strong export position is of course two fold:

1) In the first place there is a structural transition away from manufacturing and into services taking place.

2) In the second place domestic consumption still remains weak. October retail sales actually FELL year on year. In terms of my ageing society analysis this is hardly surprising:

German retail sales declined slightly in October, confounding expectations of rising consumer sentiment, according to government figures released Thursday.

Sales declined by 0.2 percent from September to October adjusted for calendar and seasonal effects, the Federal Statistics Office said. Compared with October 2005, sales declined by 0.8 percent.

So assuming that some of these sales were actually being brought forward from 2007 - to avoid the VAT rise - I'm really not sure I can agree at all with Sebastian Dullian at Eurozone Watch Blog when he says Honey, I shrunk the German VAT shock, since my feeling is that this is going to turn into a much bigger deal than most are imagining, and that when the shouting is all done, we will look at tax hikes as a means of addressing deficit problems in a very different light.

The French Enigma

There's a lot of interest focusing on the future evolution of the Eurozone economies at the moment. Claus Vistesen has been following the debate closely on his blog (and in particular this post).

Many observers are at this point fairly optimistic about the future of the eurozone economies as a group, but, as I keep pointing out, domestic consumption in both Italy and Germany continues to remain weak, and there may be sound theoretical reasons for assuming that this situation isn't going to change, and at the same time these two countries also face fiscal tightening problems as we enter 2007, due to the costs imposed by their rapidly ageing populations.

As Claus says:

Many Eurozone countries indeed need structural reforms .....Yet the thing we must ask ourselves is whether this will be enough? And this dear readers is where demographics come in and more specifically why we need to look at the population structure of for example Germany and Italy in order to really understand what is going on before our eyes. Why for example is consumer spending persistently low in these two countries and why is Germany running a trade surplus of 6% of GDP.

Of course, the ageing population in Europe is not a topic which has just appeared on the center stage of economic discussion and neither is the need for structural reform in Europe. In fact, these two aspects are often tied together; in order to amend the effects of an ageing population we need structural reforms on the labour market (to free up ressources), pension systems (cost cutting), and health care systems (cost cutting). The last two cannot be accomodated by slashing benefits all together and as such fiscal tightening is an integral part of this; just look at Italy and Germany at the moment.

But will structual reforms really neutralize the effects of ageing population effects in Europe? The bets are still out but I would argue that this is highly unlikely.

Now there is a lot of talk about Germany and Italy here, and there are of course other countries in the 12 nation zone, in particular Spain and France.

In fact France is an interesting case here, since in theory France's ageing problem is a lot less severe in the short term than that of either Germany and or Italy, and indeed in recent years, and despite having carried out a lot less in the way of structural reforms than Germany, French GDP growth has consistently outperformed the other two.

Which is why it was really something of a shock when France turned in a zero % third quarter GDP growth reading. Not that it should have been a complete surprise, since the slowdown in the rate of increase in industrial production in France in June and July was already something of an early warning for those who were watching.

However growth across the zone generally has been so strong through 2007 that one would have expected France to pick up again, but apparently this was not to be:

French industrial production unexpectedly fell in October after economic growth stagnated in the third quarter. Production at factories, utilities and mines fell 0.1 percent from September, when it fell a revised 0.8 percent, Insee, the national statistics office, said today in Paris. Economists expected a gain of 0.5 percent, according to the median of 22 forecasts in a Bloomberg News survey. Manufacturing of machinery and equipment fell 0.2 percent.

As I suggest, personally I was surprised when France came in so weak in the third quarter:

France's economy failed to grow in the June-September period, resulting in the smallest job creation since the second quarter of 2005. The 8.8 percent jobless rate, though down from 10.1 percent in May 2001, remains the highest in the 12-country euro region, according to Eurostat.

Now domestic consumption as I have also suggested is endemically weak in Italy and Germany, but they have been able to leverage exports to some extent (Germany a lot more than Italy):

``Industrial production in France isn't taking off,'' said Sylvain Broyer, an economist at Natixis in Paris. ``Growth in Europe is being pushed by investment, and France isn't strong with investment goods like other countries, such as Germany and Italy, are.''

So we could draw the conclusion that the French economy could survive better if internal consumer demand in some other eurozone countries was stronger, but since this isn't the case the weakness in consumption in Italy and Germany then feeds back into France.

This is just a hypothesis at this stage, but it did receive a bit more support from today's trade data from France:

France's trade deficit widened in October for the first month in three as the rising euro undercut exports and boosted imports. The shortfall grew to 2.71 billion euros ($3.6 billion) from 1.51 billion euros a month earlier, the Trade Ministry in Paris said today.

and this whole evolution has now lead INSEE to substantially revise downwards its growth estimate for 2007:

French economic growth will slow in the first half of 2007 as foreign demand cools, the national statistics office forecast.

The world's economic expansion will fade in 2007 to its weakest in four years, dragged down by a U.S. slowdown, the Organization for Economic Cooperation and Development said last month. Insee sees exports of manufactured goods rising 1 percent in each of the first two quarters, down from 2 percent in the last three months of 2006. Import growth will also slow to 1.5 percent from 2.2 percent, it said.


So what we have at the moment is indeed a curious situation as the two weaker economies continue to outperform what has, until now, been thought to be the rather stronger one. My own view is that in the course of time things will return to their natural order and Italy and Germany will underperform France in 2007 (and possibly by a wide margin) but for the time being we remain with the enigma, which is undoubtedly in some way associated with continuing euro strength. So it will now be interesting to watch this situation moving forward, and particulary over at the ECB where we may reasonably expect enthusiasm for further rate rises to begin to cool notably.

German ZEW Index Drops Significantly

Investor sentiment in Germany - as recorded in the ZEW index fell for the ninth straight month in October, dipping to its lowest level in over 13 years. I have really nothging more to say at this stage, this was all soooo predictable. For a good example of someone who saw it coming try Claus Vistesen (and here , and here).

Well, here we go:

The Mannheim-based economic think tank said its economic expectations indicator for Germany, based on a survey of 298 analysts and institutional investors, fell to -27.4 from -22.2 in September.

That was lower than the -20 reading expected by economists in a Reuters poll and the weakest level since March 1993. The euro slipped briefly against the U.S. dollar in response to the figures.

ZEW President Wolfgang Franz said rising orders and lower oil prices should have helped the indicator in October.

“Economic expectations were, however, overshadowed by a possible cooling of the U.S. economy, by a likely further rise in ECB interest rates and above all by the decreased consumer buying power through the VAT increase and other tax measures n 2007,” Franz noted.

The poor sentiment reading came amid growing optimism about 2006 growth in Europe’s largest economy.

Productivity In Europe

As was to be expected the rate of productivity increase in the US now seems to be slowing somewhat. Maintaining the rate of increase means maintaning the pace of a technological and organisational revolution, and it isn't immediately obvious that this is always possible (hence all those arguments about whether the cruising speed of the US economy had been raised in the long term or not).

On the other hand Europe is now catching up somewhat in the productivity game:

``Labor productivity, the holy grail of economic welfare and stock-market performance, has significantly accelerated,'' says Eric Chaney, Morgan Stanley's chief European economist in London and a former forecaster at the French Ministry of Finance.

Morgan Stanley economists calculate that productivity increased in the dozen euro nations at an annual rate of 2.6 percent in the first half of 2006, double the pace of the prior six years.

So while tyhere is obviously a first mover advantage with new technology, there is also a second mover 'catch-up' advantage if the pioneer doesn't keep moving forward. This is what we may now be seeing. Over a longer period of time there is absolutely no reason whatsoever that the EU economies cannot find ways to leverage ICT just like in the US, who have, at the end of the day, shown the others the way.

What the macro economic implications of this will be is another matter altogether. Here I don't go with the Bloomberg reading at all, but this is for another post.

Eurozone: One More Indicator To Add To The List

The Royal Bank of Scotland services index fell yesterday to 56.7, a 10-month low, from 57.4 in August. As Bloomberg wryly note, this is the biggest part of the economy. In that sense people may have been far too focused on industry and construction.

Growth in European service industries such as telecommunications and banking, the biggest part of the economy, slowed more than forecast in September after borrowing costs and unemployment climbed.

With interest rates increasing, a planned tax rise in Germany and a U.S. slowdown clouding the outlook, the International Monetary Fund expects euro-area growth to slow to 2 percent next year from 2.4 percent in 2006. Unemployment in the dozen countries sharing the euro rose in August for the first time in almost three years, a report showed yesterday.

One more little finicky detail, oil is falling, but if the economies didn't slow *that* much as it rose, then that does provide some sort of context for thinking about how much benefit we will see as it falls. My feeling is that many people seem to be challenged when they have to think about more than one thing at a time. Oil fell yesterday, and stocks rose. But if oil fell because growth was looking weaker for 2007, why should this be good news for stocks? I would be watching what happens next in the equity markets.

Quandry At The ECB

Last week I suggested that the global interest raising cycle may now have peaked. There is an important caveat to this: we may still see one more rise from the ECB this Thursday. (the graphic and the comments below come from the linked FT article by Ralph Atkins).

The ECB really are faced with a hard dilema. They seem to believe that growth in the eurozone is fairly sustainable - even though they recognise that 2007 will not be a strong growth year - and are anxious to raise the level of their refi rate in the longer term. Eurozone politicians, however, undoubtedly see things differently:

How high will the European Central Bank dare to go? Barring upsets, the ECB will announce another quarter percentage point rise, to 3.25 per cent, in its main interest rate on Thursday after its governing council meets in the Banque de France’s imposing Paris building – one of its twice-yearly meetings outside of Frankfurt.

By central bank standards, this will be almost an act of provocation. French politicians, such as Thierry Breton, finance minister, have been among the noisiest in urging the ECB not to jeopardise growth prospects in the 12-country eurozone by raising rates.

The issue is complicated by two factors:

i) The inherent difficulty in running a 'one size fits all policy' for a collection of economies with very different underlying fundamentals.

ii) The obsession the ECB has with the idea that liquidity conditions in the zone are excessively lax (an argument which has been being strongly pushed by MS economist Joaquim Fels who seems to now be pretty influential in Frankfurt):

The ECB can certainly find reasons to push interest rates significantly higher. Credit and money supply figures are flashing red alarm signals: M3, the broad money measure it (unlike other central banks) regards as a good longer-term inflation indicator, remains close to the highest levels seen since the 1999 launch of the euro.

ECB interest rates may be some way from a “natural” rate – judged by economists to be consistent with an economy running at full capacity without generating higher inflation. Estimates occasionally cited by the ECB suggest that the eurozone’s inflation-adjusted natural rate is between 2 per cent and 3 per cent, implying nominal rates (adding inflation) should go as high as 5 per cent.

Caution is likely to be the ECB’s watchword, however. Joachim Fels, economist at Morgan Stanley, argues that the inflation-adjusted natural interest rate might have fallen by a percentage point to around 1.5 per cent in the past decade because of structural changes in the economy and increased central bank credibility.

In practice, such uncertainties make the ECB reluctant to attach much weight to natural interest rate estimates. It prefers to take decisions based on an assessment of medium-term price pressures.


I think Fels exaggerates the underlying inflation problem (although clearly we will all have to learn to live with higher trend energy and commodity prices). Inherent weaknesses will still tend to limit the 'pass through' process, although this will vary from one economy to another. Undoubtedly some zone economies - Ireland, Spain, Greece - have a significant inflation problem, but how do you address this while catering for the needs of those economies with a long run growth challenge (Italy, Germany). Difficult decisions, and what happens on Thursday will be well worth watching.

More Signs The Eurozone Is Slowing

Todays eurozone unemployemnt figures - unemployment across the zone rose very slightly - appear to be consistent with the idea that the economies are slowing:

Unemployment in the dozen countries sharing the euro increased in August from a record low as signs of a slowdown in the global economy prompted companies to curtail hiring.

The jobless rate rose for the first time since November 2003, increasing to 7.9 percent from 7.8 percent in July, the European Union's statistics office in Luxembourg said today. Inflation at the wholesale level slowed in August as energy prices declined, the office said in a separate report.

``The downward trend in the unemployment rate that began in 2004 appears to have stabilized,'' said Dominic Bryant, an economist at BNP Paribas in London.

German Retail Sales

Well August retail sales in Germany don't look any too happy (and here).

The German consumer showed no sign of springing into life last month, despite the strong growth in Europe’s largest economy, official figures showed on Friday.

Retail sales in German were unchanged in August after a revised 0.8 per cent fall in the previous month, according to the Federal Statistics Office.

Sluggish consumer spending has long been the Achilles’ heel of Germany’s economy, dragging down the eurozone’s overall performance. But the latest figures surprised analysts who had expected a rise on the back of one of the strongest German growth performances for years in the first six months of 2006, powered by the country’s industrial sector.

Bloomberg suggests that the last quarter may be stronger:

``Retail spending growth looks to have slowed noticeably in the third quarter, which will contribute to a slowdown in economic Growth,'' said Sandra Petcov, an economist at Lehman Brothers International in London. ``But we do expect spending to pick up in the fourth quarter ahead of the VAT increase.''

But isn't that just the point, if they pick-up before the rise, what will they do after it? Actually the 'disappointment' may come from the fact that people expected more bounce before the VAT rise, and not getting it makes next year look even more complicated.

Also, according to the FT, and tucked away at the bottom, unemployment in France seems to have risen ever so slightly:

"Separately, France reported an unexpected rise in unemployment in August. The jobless rate rose to 9.0 per cent in August from 8.9 per cent in July."

This is not deeply significant, but again it is hardly good news. The French economy is consistently outperforming the German one, and the whole prognosis there is different. France may slow, but I doubt they will have a recession in 2007.

Italian Economy Watch Revamped

The Italian Economy Watch Blog has just been given a facelift. Almost literally, since we now have two new faces who are about to start posting. Below is the latest piece which I have just put up. Don't miss the part about Japanese debt which is worked into the middle section.

The Battle Is About To Commence

The FT this morning has a piece about the looming battle over next years budget:

Romano Prodi, Italy's prime minister, struggled on Wednesday to keep intact his planned deficit-cutting 2007 budget as moderates and leftwingers in his ruling coalition fought each other over his proposals to slash public spending.

Communists and other radicals insisted they would not endorse cuts in expenditure on schools and local government, while centrists voiced concern that the budget was drifting in the direction of higher taxes rather than spending cuts.

Bloomberg also covers the story.

As the FT also points out:

Italy's budget, due for cabinet approval on Friday, is the country's most important since it joined the eurozone in 1999, because the nation's public finances and international competitiveness have significantly deteriorated over the past eight years.

So 2007 is going to be a very hard road for Italy to travel. In some ways the moment of truth time is coming. Again the FT:

"Italy remains at risk of seeing its sovereign debt downgraded by credit rating agencies if its forthcoming budget is not rigorous enough."

Really it is very hard to just at this stage the importance of this threat. Much more than the credit rating agencies it is the response from the ECB which will be important if Italy fails to keep to the terms of the new version of the Stability and Growth Pact. Last year, we should remember, the ECB asserted that it would not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. So the threat may not be a hollow one, since if the ECB stop treating Italian paper at par, then this could easily, in and of itself, send Italy off on a default path.

These are not little issues.

Precisely for this reason I am rather sceptical that the ECB would be in any rush to actually carry out its threat. News from Japan though suggests that the climate may be changing. Japan, as is reasonably well known, also has a rapidly ageing population and a large government debt problem. In principle Japan was programmed to take some important steps (like Germany) to begin to correct the situation. The election of Shinzo Abe as prime minister has begun to put question marks over this process, and Standard and Poors have not been slow in reacting:

Japan may slow the pace of fiscal reforms under its new Prime Minister Shinzo Abe, ratings agency Standard & Poor's said on Wednesday, a day after he formed his new cabinet with a "no growth, no fiscal consolidation" policy.

The ratings agency questioned Abe's preference for growth policies over fiscal consolidation, saying his stance may lead to a deceleration of the pace of fiscal consolidation.

S&P currently has a positive outlook on Japan's rating.

But the direction of the sovereign rating depends largely on Abe's government's ability to pursue public sector reform pushed by his predecessor, the agency said.

"The two biggest constraints on the rating are Japan's fiscal position, which though improving remains weak, and its outstanding debt," said the report.

"Critical factors are therefore the pace of fiscal consolidation, the stability of the Japanese government bond market, and interest rates," it said.

Citing Japan's aim to achieve primary account balance in fiscal 2011 through spending cuts and revenue increases, the agency said how the new government meets the target is a major issue for the future direction of the sovereign rating.

So I would say that the issue of sovereign debt is now well up and over the radar, and that the agencies will be serious about downgrades.

The big problem is that EU institutions cried wolf for so long about the Stability and Growth pact that they have been left with a credibility problem. This has been doubly undesireable since it meant that during the relatively good years of 2002-2006 many countries were running deficits when they should have been aiming for balance or even - god forbid - surplus. Now the headwind may have changed, and may well be about to turn negative. The next two or three years ,may well be much harder than the last two or three.

I know that this view seems to go against the prevailing wisdom, but frankly many of the people making the 'euro growth engine call' simply haven't been thinking about the demographic dynamics of the situation. Claus Vistesen has been admirably covering all this, and a very useful point of entry is this post.

So the real question we are left with is what exactly is to be done? This is a very hard question, and I don't have any simple answers handy in my back pocket to pull out at the appropriate moment. Clearly Italy needs to move onto a sustainable fiscal path. It also needs to attach itself firmly to the EU Lisbon Reform agenda, and generate a consensus among the Italian population that the reforms are needed by getting across to the Italian people just why they are needed.

Naturally the political class in Italy isn't exactly an asset here.

Immigration undoubtedly forms another part of the picture, but this immigration (which is largely unskilled) needs to be coupled with an expanison of the high value services and new technology business sectors, so that a labour market environment can be created where the best of Italy's young talent can find work appropriate to their abilities, and thus help pull Italy out of this mess.

Over the summer I saw a film from the Italian director Paolo Virzì entitled Caterina va in città. The plot is summarised as follows:

When her father, Giancarlo (Sergio Castellitto) is transferred to Rome from the small country town of Montaldo Di Castro, Caterina (Alice Teghil), a 12 years old girl, discovers her new classmates, a totally new world, an ambient extremely divided politically. She starts developing her friendship with the "left side", represented by Margherita(Carolina Iaquaniello), and the right, Daniela (Federica Sbrenna) side of her class. She will lose herself, without knowing who she really is.

This is the problem I think, an ambient which is extremely divided politically where young Italians do not know 'who they really are'.

The Eurozone Is Slowing

Despite all the apparent optimism you can find round and about, the Eurozone is in fact slowing, the latest industrial output data from France seem to make this abundantly clear. What I find hard to understand is how so many people can have been wrong-footed on this. Claus Vistesen has a useful review of the arguments on the blogs, and New Economist has also been suitably cautious, but the rest seem to have missed the big picture. (Just as they have done with Japan really).

The worst offenders are definitely over at Morgan Stanley. Steven Roach leads the way, but Eric Chaney isn't far behind. And Brad Setser - and in particular his guest poster Charles Gottlieb of the Center for European Policy Studies (CEPS also seems to be way off target here) - seems to have fallen hook line and sinker.

Are we all putting our credibility on the line here gentlemen?

French Business Confidence Falls After Output Drops

French business confidence fell in September from a five-year high it reached in July, after industrial output declined.

Insee's index of sentiment among 2,000 manufacturers in Europe's third-largest economy dropped to 107 from 109 in July, the national statistics office said today in Paris. Economists expected the index to fall to 108, according to the median of 22 estimates in a Bloomberg News survey.

``This summer hasn't been that good, and things aren't as exuberant as they were in the first quarter,'' said Laurence Boone, a Paris-based economist with Barclays Capital. ``As we go towards the autumn, confidence is weakening.''

France's economy, which expanded at the fastest pace since 2001 in the second quarter, may be cooling as the cost of oil and the euro's gain against the dollar threaten purchasing power and exports. There already are signs growth in Europe has peaked after the European Central Bank raised its key interest rate four times since early December. Slower U.S. growth may also damp demand.

``According to entrepreneurs, past business has slowed down in the manufacturing sector,'' the report said, with orders from abroad thinning. Executives from the car industry remain the most pessimistic, the survey showed, after automobile production fell 1.4 percent in July.

French industrial production unexpectedly fell for a second month in July as manufacturing of cars and electronic equipment slumped, adding to evidence that economic growth may slow.

Incidentally, this Bloomberg piece is another classic example of how to get it wrong:

Europe, Japan Wean Themselves From Dependence on U.S. Consumers

Europe, Japan and emerging economies around the world are weaning themselves from dependence on the American consumer, and economists say it's just in time.

Demand in the world's largest economy is slowing as the U.S. housing market falters, a development that the International Monetary Fund on Sept. 14 called a key risk to global expansion. If so, it's a risk that the biggest exporting nations are better prepared to weather now than five years ago.

``Domestic demand in so many other parts of the world is picking up,'' says Jim O'Neill, head of global economic research at Goldman Sachs Group Inc. in London. ``If there ever was a good time for the U.S. to slow, this is it.''


Wishful thinking is not a substitute for sound economic analysis.

Difficult Times Ahead?

I have a post on Afoe about the dangers of contamination across Eastern Europe following the recent turbulence in Hungary.

Now one of the worries that must arise in these circumstances is whether a sudden downturn in some of these 'Lynx' economies could produce a haemorrage of you educated people outwards in search of work. If this were to happen this short-term crisis could have important long term supply-side consequences. Again, something else to watch for.

On this topic, the FT have details of an interview they had with Romanian Prime Minister Calin Tariceanu. Tariceanu is really at pains to re-assure Western Europeans (especially in the UK) that there will not be a sudden influx of Romanians after EU accession. My feeling is that the West Europeans have little to fear here (as he says the educated Romanians will head North, and the less educated ones will head South, and this doesn't seem to me to present any kind of problem). What he maybe should be considering is the impact of this on Romania itself: needless to say, in the current climate I think his growth expectations for the Romanian economy are way too high.

Romania dismisses EU emigration fears

Romania will win approval on Tuesday to join the European Union on January 1, but the country’s prime minister has denied that it will spark a massive wave of emigration from the Black Sea state.

Calin Tariceanu claims his country is in the middle of an economic boom that could see its gross domestic product double within 12 years, drawing migrant workers to Romania.

Speaking to the Financial Times, Mr Tariceanu also appealed to the British media and public – racked by a debate about the recent arrival of hundreds of thousands of migrant workers from Poland and other new EU member states – to remain calm: “People with higher educational levels might go to the UK but I don’t see too many.”

He said most poor Romanians would head to Italy and Spain, where they would have less trouble with the language, and only those with better schooling would go to the UK.

Italy and the Eurozone

John Kay had an article in the Financial Times earlier in the week, and this seems to have caused quite a ripple around the blogsphere (Eurozone Watch, Economonitor, Claus Vistesen at Alpha Sources). The article was about whether or not it was technically possible for Italy to leave the Eurozone. (Update: Sebastian has a fresh post over at Eurozone Watch Blog continuing the discussion).

John Kay's conclusion, and it is supported by a very reasoned commentary by Sebastien Dullien at Eurozone Watch Blog (welcome Sebastain and Daniela), is that there is no in-principle technical difficulty in exit. The most authoritative piece of work on this topic that I know of comes from Harvard International financial law specialist Hal Scott. The paper was written back in 1998, and was provocatively entitled "When the Euro Falls Apart". Despite the title the paper is a tightly reasoned piece of work whose main conclusion is that not only is euro-exit technically perfectly feasibe, in fact the mechanisms which would make this possible were incorporated from the start (in particular keeping independent central banks with their own reserves). I think those who were able to think clearly back then - and were able to use some emotional intelligence - were always aware that there were question marks over Italy's ability to go the distance.

So the problem is not a technical one. But as John Kay indicates it *is* a political one:

"But what of financial and commercial contracts made in euros before A-day but not yet completed?

The simple answer is that an agreement in euros stays in euros. But this is not politically feasible. Italians would not accept that their mortgages and credit-card debts, denominated in euros, would cost them one-third more to repay: and it would be absurd if the bank deposits of Italian residents were revalued by a similar amount.

The relevant principle of international law seems to be that debts are denominated in the currency of the place where they are to be paid. But in the modern world, that question often has no clear answer."

This then is going to be the question *when* Italy leaves (I say *when* since I have no doubt that she will, the demography makes that inevitable, and here, and here, and here). So it is perfectly coherent to argue that Italy can leave. This however is the moment when the debate normally veers off in a southerly direction - towards Argentina - and Argenitina seems, as usual, to generate more heat than light, since the argument tends to move away from Italy and its specific problems, towards a 'what really happened to Argentian debate" (welcome new blogger Felix), which is, of course interesting, but sometimes it is helpful to discuss just one thing at a time. So going round a rather more circuitous route, let's think for a moment about what just happened in Turkey and in Hungary. Two economies which were on an unsustainable external deficit course were brought back sharply into line by a sudden, large drop in the value of the local currency. Judging by posts and comments on this site we seem generally to be agreed that having such flexibility was a good thing, since it enabled these economies to correct and adapt before a big crisis (hard landing) situation built up.

So what about Italy? Well Italy as we know cannot go down this road, and Italy has, in fact, used the cheap finance made available by the eurozone not to reform, but to avoid reforming. This, at least, was the conclusion reached by two highly respected European economists (Romain Duval and Jørgen Elmeskov) in a widely quoted paper entitled The effects of EMU on Structural Reforms in Labour and Product Markets

So Italy is unable to correct, and the inbuilt problem is growing. The Italian economist Francesco Daveri (who is a specialist in technological change and ageing) makes the important point in this podcast for Radio Economics that Italian economic growth *peaked* in the 1950's at around 5% per annum. Since that time it has dropped steadily at the rate of about 1% per decade, and in the 1990s was at an annual rate of about 1% per annum. Following this trajectory, and what we already know, it is not unreasonable to imagine that this decade the Italian economy will flatline (an average of 0% growth) and possibly enter negative territory in the next one (say -1% pa 2010-2020). Of course this situation makes a complete nonesense of the neoclassical theory of 'steady state' growth, but that is a problem for that particular theory, it doesn't mean that what is happening isn't hapening (I have a post about this issue in the context of Germany, Japan and Italy on Demography Matters). So the question is, where does that leave the problem of Italian public debt currently running at 105 - 110% of GDP? Unsustainable, that's where it leaves it. And the only way for Italy really to get to grips with the situation is to recognise that it cannot resolve this problem and default. This default is unlikely to be possible inside the eurozone, and hence Italy will leave. This is a question of simple economics, not popularist politicians.

Which brings us to the last point before the last: won't this cause chaos? Well of course it will, this is why it would be better that people come to terms with this rationally rather than making it an emotive topic.

Now for the last point. John Kay rightly laments:

Any international bank or business should contemplate these issues. But the consequences of such contemplation are grave: in financial markets, actions to protect against a contingency make that contingency more likely. That is why a debate on the fragmentation of the eurozone is a debate that no one dares have.

And John Kay is right, debate on this topic will probably make default happen sooner. I remember the heartsearching Paul Krugman went through when it became obvious Argentina was going to default. Such situations pose special problems for those economists who can, to some extent, see what is happening. But my conclusion was in that case, and it remains the same today, that if something is unsustainable it is better to recognise this sooner rather than later: quite simply the damage is less. If Argentina had defaulted one year earlier, then the politics of the default transition would have been much easier. Basically, if you ask people to make a lot of sacrifices for a project that can't work you can hardly blame them if they are not in the mood for another round of sacrifices after it turns out that the earlier sacrifices were in vain. This is as true for the Italy of 2007 as it was for the Argentina of 2000. I think we would all do well to remember that.

Eurozone Inflation

Oil, as is well known has been generally dropping in recent days, and are now somewhere around the lowest prices seen since last March. It is hard to know how much of the correction is due to the fact that it was previously over-valued, how much is due to the anticipation of a developing slowdown, and how much simply reflects relief that there were no serious hurricanes this year.

In any event the drift is down, although the thing which could upset the whole apple cart is an 'up the anti' in the argument about Iran's nuclear programme.

So it is hardly surprising to find that inflation in Eurozone countries is also taming somewhat. According to German the Federal Statistics Office in August German consumer prices rose 1.8 percent from a year earlier after increasing 2.1 percent in July. In France, the annual inflation rate in August fell to 2.1 percent after increasing 2.2 percent in July, according to the national statistics office Insee.

What I would say is that if oil prices hold either steady or drift down then we are unlikely to see any significant upsurge in inflation here in europe, especially with a high euro, and record imports fromChina. Which puts the ECB in a rather embarassing situation.

Certainly I think the idea of a surge in passing on costs is very unlikely, internal demand (even in France) just isn't sufficiently robust, so I think this argument is a mistake:

Euro-region inflation may accelerate in coming months as faster economic growth gives companies room to pass on rising costs and workers leeway to seek more pay. At least four European Central Bank council members signaled in the past week that interest rates may keep rising into 2007 to counter higher prices.

``Temporarily, we'll see an easing of inflation because of oil prices,'' said Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt. ``The ECB realizes only too well that higher inflation rates need to be expected again next year. It's under pressure to continue normalizing interest rates.''

And on the central banking front, will they be embarassed at the end of the day if all this turns out to be completely off the mark:

ECB council member Nicholas Garganas said in an interview in Basel, Switzerland, on Sept. 11 that there's ``no evidence'' of easing inflation pressures with more signs of a ``greater pass- through of past oil price increases.'' His German counterpart Axel Weber said Sept. 5 that ``no decision has been taken to end the process of normalization at the end of the year.''

``Obviously we are very worried'' that inflation is no longer expected to slow in 2007 on average,'' Garganas said. ``That is why we are strongly vigilant.''

The Eurozone and the US Downturn

Over at Afoe Mark Thoma had an interesting guest post last week on whether the eurozone will be affected by any possible downturn in the US. This same post was picked up by New Economist,as it is by Claus Vistesen at Alpha Sources.

Personally I think I think that Nouriel Roubini's view (which comes up in the post) that the rest of the world may not be able to decouple from the US is a mistake. In a sense the world already has decoupled. If you look at the fact that global growth this year is likely to be in the 5% region, while the US might grow say 3.5%, and Japan say 2.5% and the eurozone say 2.0%, then it is clear that someone somewhere else is now doing the heavy lifting. Most likely candidates are places like China, India, Brazil, Turkey and a string of other developing countries like Argentina and Chile who are to some extent riding the commodities boom generated by the aforementioned.

This is a sea-change from the 1995-2000 period, when US growth did account for a huge proportion of global GDP growth. I think this de-coupling will become even clearer after the next recession (which could be 2007 or 2008, we have no crystal balls, but I would pencil something in for 2007, especially if the collsion with Iran continues its course). The next upswing will surely be pulled by the new Growth Pandas (or if you like growth giant pandas).

The big issue is going to be how you square the circle on trade and capital flows.

Of course recognising that there are new growth engines at work isn't quite the same thing as saying that it doesn't matter to the rest of the world what happens in the US. Obviously if consumption in the US is sufficiently affected then this will be noticed in Germany, Japan and China.

One important point that isn't being noticed (or isn't being given sufficient importance) is that three of the G7 economies are going to have severe fiscal tightening in 2007 to accompany high oil prices and raised interest rates (Japan, Germany and Italy).

So the machine isn't going to be pulled in this direction. This tightening isn't, as Rogoff suggested frustrating, it is, unfortunately, entirely in the logic of things since these three economies have lived through the good times of this upswing with sustained fiscal deficits, and their budget liabilities with their aged populations mean that some time or another they have to change course. At least for the time being the plan is to change course in 2007 (this may, of course, be revised in the face of inclement weather).

But the big underlying issue is that these elderly economies cannot sustain strong internal demand, and can only live by trade exports and by the export of capital which is a spin off of the high savings rates. (In the case of Italy this is less clear, since the trade surplus has collapsed, but the gap is currently being made up by cheap finance from the eurosystem which goes to pay for Italian government spending).

Anyway, the real probem as I see it is this one. Most of the developing countries need to be export driven, and when they are not buying raw materials and equipment they will have an in-built tendency towards deficit during the development process. At the same time the elderly part of the G7 needs to run surpluses for quite other reasons. So this leaves us with very few countries to balance the books. The UK is undoubtedly one that can run a deficit, France could too, but the big big customer is undoubtedly the United States.

And this is the importance of the argument about housing, since if people stop recycling equity then demand for goods from abroad is likely to drop. This can then have a whole domino impact across the global economy, which far from encouraging investment in the US to take up the slack can have exactly the opposite effect as companies across the globe slash prices to offload unwanted excess output, thus discouraging further investment in the US. The recent surge in capital investment in Japan should fill one with a little foreboding in this regard. As should the recent marked fall in machine orders in Japan serve as a warning.

Back From A long Sleepy Summer

OK, I'm just dusting the rust off, since this blog is about to ramp up again after the extra-long sleepy summer. Actually I have been quite busy, but with non-Euro issues. Hence the silence here. Of course there won't be a post everyday. Maybe once a fortnight.

Firstly I'd like to welcome a new blog: Daniela Schwarzer and Sebastian Dullien over at Eurozone Watch Blog. Daniela has a post today about Mr Euro, Jean-Claude Juncker. But see this George Parker piece in the FT:

Jean-Claude Trichet, European Central Bank president, on Friday delivered a stiff warning to eurozone finance ministers to back off in an escalating dispute over the bank’s independence.

Mr Trichet pointed out that it was his signature on euro banknotes and that it was unlawful under the EU treaty for finance ministers to give instructions or try to influence the bank.

His comments came at a strained news conference in Helsinki with Jean-Claude Juncker, Luxembourg prime minister, who was on Friday given a second two-year term as political head of the eurozone.

Mr Juncker said he had only agreed to carry on chairing the eurogroup – the political arm of the single currency – after finance ministers supported his plan to have an “intensified dialogue” with the ECB.

As I say in a comment on Daniela's post. This is about the only topic I am currently in agreement with Trichet on: I simply don't see what he and Trichet have to talk about.

Meantime over at Afoe Mark Thoma has an interesting guest post on whether the eurozone will be affected by any possible downturn in the US. This same post is picked up by New Economist,as it is by Claus Vistesen at Alpha Sources.

Personally I think I think that Nouriel Roubini's view (which comes up in the post) that the rest of the world may not be able to decouple from the US is a mistake. In a sense the world already has. If you look at the fact that global growth this year is likely to be in the 5% region, while the US might grow say 3.5%, and Japan say 2.5% and the eurozone say 2.0%, then it is clear that someone somewhere else is now doing the heavy lifting. Most likely candidates are places like China, India, Brazil, Turkey and a string of other developing countries like Argentina and Chile who are to some extent riding the commodities boom generated by the aforementioned.

This is a sea-change from the 1995-2000 period, when US growth did account for a huge proportion of global GDP growth. I think this de-coupling will become even clearer after the next recession (which could be 2007 or 2008, we have no crystal balls, but I would pencil something in for 2007, especially if the collsion with Iran continues its course). The next upswing will surely be pulled by the new Growth Pandas (or if you like growth giant pandas).

The big issue is going to be how you square the circle on trade and capital flows.

One important point that isn't being noticed (or isn't being given sufficient importance) is that three of the G7 economies are going to have severe fiscal tightening in 2007 to accompany high oil prices and raised interest rates (Japan, Germany and Italy).

So the machine isn't going to be pulled in this direction. This tightening isn't, as Rogoff suggested frustrating, it is, unfortunately, entirely in the logic of things since these three economies have lived through the good times of this upswing with sustained fiscal deficits, and their budget liabilities with their aged populations mean that some time or another they have to change course. At least for the time being the plan is to change course in 2007 (this may, of course, be revised in the face of inclement weather).

But the big underlying issue is that these elderly economies cannot sustain strong internal demand, and can only live by trade exports and by the export of capital which is a spin off of the high savings rates. (In the case of Italy this is less clear, since the trade surplus has collapsed, but the gap is currently being made up by cheap finance from the eurosystem which goes to pay for Italian government spending).

Anyway, the real probem as I see it is this one. Most of the developing countries need to be export driven, and when they are not buying raw materials and equipment they will have an in-built tendency towards deficit during the development process. At the same time the elderly part of the G7 needs to run surpluses for quite other reasons. So this leaves us with very few countries to balance the books. The UK is undoubtedly one that can run a deficit, France could too, but the big big customer is undoubtedly the United States.

And this is the importance of the argument about housing, since if people stop recycling equity then demand for goods from abroad is likely to drop. This can then have a whole domino impact across the global economy, which far from encouraging investment in the US to take up the slack can have exactly the opposite effect as companies across the globe slash prices to offload unwanted excess output, thus discouraging further investment in the US. The recent surge in capital investment in Japan should fill one with a little foreboding in this regard.

Polish Productivity Surges

A report by the Conference Board has found that Poland’s productivity growth accelerated by 7.7 per cent last year, second to China and much higher than the rich economies of western Europe or the US. It calculated that gross domestic product per hour worked was $19.90 for Polish workers, outpacing the $19.40 for South Korea.

But Polish productivity is still less than half the average of west European countries, and trails most of its ex-communist neighbours.

David Yoon, human resources director at the LGE factory about 100km north of Warsaw, says that Polish workers were initially unhappy about some of his company’s management techniques, such as hanging large signs above the production line exhorting workers to “Get it right the first time”, and “Don’t say ‘No’ but seek alternative solutions”.

“Some of the older workers said it reminded them of communist times, but now they are used to it,” he says.

The Korean company is setting up training programmes as it starts to exhaust the local talent pool of workers for the factory, which has become LGE’s main European flat-screen television set producer.

“The fundamentals of Polish workers are not bad,” says Mr Yoon. “And once they have been taught a technique, they stick to it exactly. Every month, we break production records.”

The Koreans are not the only ones impressed with the quality of their Polish workers.

A recent study by KPMG, the auditing company, found that most foreign investors were impressed by the high level of qualification in their Polish workforces.

Poland’s rapid leap in productivity is taking place in spite of the drag caused by the 20 per cent of the Polish workforce that is employed in agriculture – producing only 3 per cent of GDP. The country also has the highest level of unemployment in the European Union, at 17.8 per cent, and the lowest level of labour participation in the OECD, the world’s most industrialised countries.

Many of those out of work are unemployable in a modern economy and some Polish companies are experiencing difficulty in finding qualified workers. A recent study by Poland’s central bank found that 42 per cent of firms had trouble finding qualified workers.

The booming city of Wroclaw in western Poland is trying to lure expatriates working in the UK to return home to take up jobs with the many foreign companies relocating there.

Although Polish companies restructured following the slump in the economy in 2001-2002, the fastest productivity growth is found in businesses owned by foreign investors.

“Productivity is higher for most foreign investors than for the average Polish company, since investors build new, modern facilities using the latest technology and operations design know-how” says Michal Kwiecinski, of McKinsey & Company, the management consultants.

“Very often, their productivity is even higher than in their home country facilities, because companies tend to optimise their processes in parallel to transferring production or service centres to Poland.”

That is the case with LGE, which has expanded so rapidly in Poland that it quickly outgrew the factory built in 2004, when it began production in Mlawa. It has now moved into a much larger new factory.

Other plants are being built by the company near Wroclaw in a joint venture with Philips of the Netherlands.

Polish salaries, although much lower than western Europe, are 200 per cent higher than in LGE’s factories in China and Indonesia, and went up 6 per cent last year.

But LGE has no plans to reduce its Polish investment.

“We can overcome wage differences by productivity,” says Mr Yoon.

Welfare Costs Threaten German Reform Agenda?

My feeling is that the honeymoon days of Angela Merkel's government are not too far from over. What we have seen is an excess of euphoria, based on the idea that the German economy is now, at last, about to finally take off, and a lack of any real appetite to get down to the serious agenda of reform which is, more urgent than ever. Some measure of the magnitude of the what might be referred to as the submerged part of the iceberg can be seen in this article in the FT today detailing how welfare speding continues to accelerate:

Spiralling welfare costs could add €4bn to Germany’s 2006 budget deficit and undermine Chancellor Angela Merkel’s efforts to bring her country’s finances under control, members of her coalition have warned.

Confidential government statistics show that a faster-than-expected rise in the number of households claiming long-term unemployment benefits could bring this year’s deficit from a planned €38.3bn to well above €40bn ($49bn, £27.7bn).

This would dash consensus expectations among economists that the deficit will fall below 3 per cent of gross domestic product – or back in line with European fiscal rules – this year for the first time since 2002.

While Ms Merkel could still meet her cautious pledge to abide by the rules by next year, the spending explosion could lift the 2007 deficit above planned public investments, putting the budget in breach of the constitution.

“The cost explosion is threatening to blow a hole in the budget,” said a coalition insider who asked not to be named, adding that Franz Müntefering, the labour minister, “must come up with an answer”.

Figures published by the Federal Labour Agency show the number of households claiming “unemployment benefit II”, the most basic form of welfare support, comparable to the UK’s income support, has risen from 2.9m to 3.9m since its introduction 15 months ago.

According to a labour ministry document obtained by the FT, the actual number is even higher. The document shows the agency’s monthly reports, based on samples, had underestimated the number of claimants by 200,000 a month throughout last year, suggesting today’s figure was around 4.2m.

Extrapolating from the benefits paid so far this year, aides to Peer Steinbrück, the finance minister and like Mr Müntefering a Social Democrat, estimate total payments in 2006 could reach €28bn, well above the €24.4bn provided for in the budget.

Ironically, the benefit, also known as “Hartz IV” and introduced by Gerhard Schröder, Ms Merkel’s predecessor, as part of his social security and labour market reforms, was meant to cut welfare support and sparked loud protests at the time.

But, as Mr Müntefering conceded in an interview with the FT three weeks ago, loopholes have since appeared in the system that have led to a flood of claims.

Young jobseekers, for instance, have moved out of their parents’ homes and into their own flats in order to claim generous rent subsidies. Many workers whose monthly wage is lower than the basic benefit have yet to claim the top-up welfare payments they are entitled to.

“Even today, I am told, people are finding out that they have claims,” Mr Müntefering told the FT three weeks ago. “There is nothing criminal there, but it is a grey area we must look into.”

The labour ministry says benefit payments over the first quarter are a poor guide to the rest of the year because unemployment is expected to fall as economic growth accelerates in coming months.

A ministry spokeswoman said an “optimisation” bill to be drafted by the summer would cut spending on long-term jobseekers by about €1.2bn a year from 2007 onwards. Other measures already enacted should generate €500m-€600m in savings from next year.

Based on current trends, however, this would not suffice to offset the rise in claims.

“Another problem,” said a finance ministry official, “is that we doubt the labour ministry is serious about cutting spending. The guys at the lower levels are dragging their feet. Their culture is to give stuff away, not to clamp down.”

In one respect alone, news that her fiscal consolidation plan may be in jeopardy could be a blessing for Ms Merkel. It should make it easier to justify a hefty, three-point increase in value-added tax planned for next January.

Who Will Be The First To Blink?

Methinks the first serious test of the eurosystem is now looming on the horizon. The title of this post refers to an earlier point made by Nouriel Roubini. The FT this morning is reporting that:

"The German cabinet will on Wednesday endorse a 2006 budget that breaks the European Union's fiscal rules for the fifth year in a row, amid criticism that Angela Merkel’s coalition government is failing to meet its own target to cut spending."

If this is confirmed the EU Commission and the ECB will then have to respond. One of these fine days all hell is going to break loose in the financial markets. Will that be sooner or later? We await developments.

Is The ECB Measured-Pace Cycle Over?

Well, not unexpectedly, the ECB decided to leave its main refinancing rate unchanged at 2.25% yesterday. Rather more surprisingly (for some at least) the German Federal Statistical agency reported that German economic growth ground to a halt at the end of 2005.

According to the Financial Times:

Johann Hahlen, president of the federal statistics office, said that growth last year had been based largely on exports, with domestic demand remaining weak. “Broad and self-supporting growth is still not being observed”.

Again according to the FT, Herr Hahlen's comments "surprised economists, who had expected growth to continue and have become increasingly upbeat about the outlook in 2006". I'm surpised the FT can be so blazé in saying 'economists': they certainly didn't surprise me. I think it was reasonably clear that this was coming. If I am surprised by anything it is that it has come so quickly.

So where do we go from here? Well Jean-Claude Trichet, the ECB president, has been trotting out the party line to the effect “we have to be vigilant as regards inflation”, but with inflation now falling back (in December the harmonised rate slipped back a fraction to 2.2% from the 2.3% in the year to November) and with virtually no 'second round oil rise' effects in evidence this argument is going to sound increasingly hollow. Couple this with the ongoing 'low- growth' environment in the Eurozone (we're still awaiting the sort of news from Italy which will again I imagine surprise 'economists') and you can see that there will be few reasons to justify any serious interest rate rises. At the limit we may just see one more quarter point rise squeezed-in before year's end. Aside from that the ECB tightening cycle is, as I suggest, just about done.

Since it has recently become fashionableto try to predict the future, here are my 2006 forecasts.

In first, and most prominent, place: the dollar will not decline sharply in 2006. Change on the margin is a much harder call, but, on balance, I expect the euro to nudge down during 2006. The principal factors here will be the interest-rate and growth differential with the US.

Global growth will be a touch slower than in 2005.

Germany and Japan will not have sustained, internal-demand driven, recoveries.

Japan will not 'break-lose-decsively from the chains of deflation.

China and India will continue to grow pretty much as they are currently doing.

Turkey will continue to be the principal growth tiger in the EU orbit.

Ireland and Spain will continue to have property bubbles.

The US will grow a tad more slowly in 2006. It will not enter recession. The CA deficit problem may well grow.

There will be time enough to forecast 2007 when we have had time to see just how near the mark our 2006 forecasts are.

The Perrenial Euro Story (or lack of it)

Brad Setser has a post, the perrenial dollar story, which IMHO, has one large and significant ommission: it doesn't really mention the euro. Personally I don't really see how you can consider the future evolution of the dollar without taking the euro into account. This realisation provoked a rather long comment from me on Brad's blog, and it is this comment, in a slightly modifed form, that I am now posting here. (Update: incidentally, I notice that Claus Vistessen has two highly relevant summaries of the great greenback debate (here, and here) which. among other things, serve as an excellent introdiction to the issues involved).

In reponse to a Bloggin Wall Street post which suggests that "folks who worry about the trade deficit are in denial", Brad hits back with:

"My answer: trade deficits can be a signal of future trouble. Can be. This is different than always are. "

I think Brad is, as they say 'flexibilising his argument'. I welcome this and absolutely agree with him.

In fact I would put it this way: imbalances, including trade imbalances, which have no obvious and direct automatic stabilisers to put to work to resolve them, are *normally* a sign of trouble to come in the future. It's just that, following Keynes, the term structure is the key: we need to distinguish here between the long and the short run.

Now according to Brad those who are not in 'the US trade deficit matters' camp tend to argue:

Either "the trade deficit is a sign of US strength, so it doesn't matter"

Or "the trade deficit is not as bad as it seems".

Well I can think of a third option (at least), and this would be:

The US trade deficit is in fact worse than it seems, but there is no easy way to correct it, and any significant attempt to correct it from inside the US would cause a lot more pain ex-US than it would cause inside, ie the correction would be, global speaking, non-optimal.

That is, more or less, what I feel. But then I am not in the US :).

I think the comparisons of individual and collective indebtedness (which Brad examines at some length) do have a certain validity, but, as in any debt calculation, it all depends what multiples of present GDP per capita you estimate for the US 20-30 years from now, and what multiples you expect for the 'rest of the world'. If the US values exceed the 'rest of the world' ones, then the indebtedness could indeed be a rational response, if you don't (and I'm inclined not to, especially with big players like China and India around) then of course........

The problem here is that it is the Bretton Woods system itself (either in its version 1.0 or its version 2.0) which is a little short of the necessary automatic stabilisers. The natural support points should be the euro or the Japanese yen, but for other reasons, both of these are currently 'missing', and so the system itself cannot correct.

Something similar is actually happening inside the euro system itself: let me explain.

Let's take Spain as a good mini example. Spain has a shocking housing bubble. Arguably the worst on the planet. Spain also has a whopping trade deficit, and extraoradinarily high (and rapidly rising) rates of private indebtedness coupled with very little saving.

The reason is obvious: Spain has a circa 4% inflation rate, and a 2.25% ECB-set base interest rate. This means that people can contract 40 to 50 year mortgages, on an initial interest-only basis, for anything from 3%.

Now not borrowing at 3% when inflation is at 4% just doesn't seem rational, so most people do.

Thanks to the euro system Spain is effectively spending German savings (in the same way the US is spending Chinese savings).

Can Spain correct? Well it has no control over its virtual exchange rate (the virtual pesseta) since it is pegged to the euro, so it can't do much about the trade deficit, and it has no control over the interest rate since this is set in Frankfurt, so it can't do much about the housing bubble.

How long will this ridiculous situation continue? I really don't know. There is no obvious reason why it needs to end anytime soon. What will happen when it does all come to an end? Again I don't know, but one can imagine it won't be anything too nice.

Now really I think this analogy can be applied directly to the US and its role in the global currency markets (via Bretton Woods I and II) and its limited control over its own interest rates (read here the yield inversion) which is at least in part a consequence of globalisation and the financial 'big bang' of the late 80s.

So what can't be happening in fact is, and continues, and will continue until it really can't any more. I imagine that this end-state will be reached when India and China are fit-enough and strong-enough to take the strain.

Finally a quick word in closing on a recent argument from Marty Feldstein. (New Economist also covers it here).

Brad understandably says:

"It is nice to have some of the arguments I have made backed by someone on the short-list to replace Alan Greenspan."

Well I could also say the same about my arguments about the euro (or rather Marty Feldstein's arguments about the euro - and here, and here). Indeed, I could go further, and say (if you look carefully at the arguments Bernanke actually puts in euro at five ) "It is nice to have some of the arguments I have made backed by someone on the short-list to replace Alan Greenspan, and by the person who has actually replaced him".

Feldstein's view in the linked article is puzzling, since, regardless of whether or not you think the dollar is about to fall, one of the considerations in your judgement should also be your appreciation of whether the euro is up to the task which would fall to it, and indeed whether euro denominated government paper is any way an attractive alternative to US government paper. Since Feldstein has perhaps been one of the most outspoken critics of the euro, you can certainly accuse him of not being exactly 'consequentialist' here.

Bernanke is much more 'subtle' in his 'euro at five' article than he was on the global savings glut issue (where again, of course, he agrees with me, whoops, I agree with him).

Bernanke is the art of diplomacy, calling the introduction of the Euro a 'remarkable technical achievement'. But if you read the fine print, he more or less agrees with Feldstein:

"Rather than pursuing the question of whether Europe is in fact an optimal currency area in Mundell’s sense, I think it is useful simply to recognize that the European experiment in economic and monetary union has not been motivated primarily by Mundellian factors. .........Political factors, rather than economic ones, have played the dominant role. "


So, in any event, both Brad and I can have recourse to arguments from 'authority' here. Of course non of this makes any of these arguments right. Personally, rather than the US dollar, I would be watching Italian public debt.