Sunday, April 20, 2003

Eurozone Economy "May Have Shrunk"

The eurozone economy may have shrunk in the first quater 2003 according to the European Commission. The suggestion comes in the Spring 2003 economic forecast:

The Commission said on Thursday it had trimmed its estimates because of sluggish demand and uncertainty linked to the Iraq war, forecasting first quarter growth of minus 0.2 to 0.2 per cent and second quarter growth at 0.1 to 0.4 per cent. The gloomy estimates were released as the European Central Bank warned in its April monthly bulletin that the economic outlook was uncertain.The central bank said it expected "only a modest rate of economic growth for 2003" after recent data and surveys suggested the eurozone economy "remained weak" in the early part of this year.Economists said the tone of the bulletin signalled continued concern about the downward risks to growth and suggested the ECB was keeping the door open to another rate cut in coming months.
Source: Financial Times

What the Worst Performing European Economies all Have in Common

This one seems obvious. Sad, but true. Only one question: when will we understand why?

What is the single factor uniting Europe's worst performing economies? The answer is: they all use the euro, while those countries still using their own currencies are doing rather well, according to the European Commission's spring forecasts published on Tuesday. The euro was supposed to free up markets, encourage inward investment and generally pep up the economy, but almost five years after 12 EU members fixed their exchange rates some of the benefits remain elusive. The eurozone economy has been virtually stagnant since 2001, with average growth of little more than 1 per cent. Those predicting that Britain, clinging to the pound, would enter a period of decline have so far been proved wrong. Denmark and Sweden, the other two EU members still using their own currencies, have also outperformed the eurozone. Another feature of the Commission forecasts is that the 10 countries set to join the EU next year are also doing much better than the 12 members of the eurozone.There are many factors explaining why the eurozone is doing poorly compared with the rest of Europe other than the fact that it shares a currency. The structural problems in Germany and Italy in particular have held back growth. Meanwhile Greece and Ireland, which use the euro, have the fastest growing EU economies. But it remains true that membership of the fledgling euro is clearly not a precondition to economic health - in the short term at least.
Source: Financial Times

Euro Growth Forecasts Down

There seems to be a dearth of real economic news this week as everyone struggles to digest what the implications of the post-Iraq-war will mean (and what the impact of SARS may turn out to be). I must admit that even while blogging this piece I had the feeling of deja-vu 'yawn yawn'. I think we all have a fair idea of what is happening in Europe, so until we actually see it in the figures there is likely to be a sense of eery unreality about the sitaution (to echo Steven Roach's post of last week). Nonetheless there are a couple of details asociated with the new EU growth prospects report ( here ) which are worthy of mention. Firstly the situation in Italy keeps rearing its head. I think the Commission really are starting to get brassed-off with the prevarication and lack of reality being shown by the Italian Government, and if any of the excess-deficit procedures are well-earned it will be the one being threatened now against Italy. In all the euro navel-gazing, Italy's preoccupying economic and fiscal future is the one which seems to attract least attention. Secondly the little detail about the 'bright spots in the report arise from countries outside the 12 member eurozone'. Is this simply a coincidence? What value can we place on being able to control your own fiscal and monetary policy, and having the capacity to address directly balance of payments deficits (even if the UK does not seem to be using it much right now). Going back to the Harrod Balassa Samuelson effect for a moment, if this argument has validity, then surely it should be applied to the current growth trajectory of the 10 enlargement countries as they approach EU lock-in.

Also of note is the throwaway comment about Italy's "transitory" measures to massage down its deficit, and the urging that it confront its "high levels of national debt and looming pensions crisis". The Italian national debt is now around 105% of GDP, and the pensions situation, despite two reforms, is still 'unresolved'.

On more general matters, one of the criticisms that I suspect may be levelled against me is that while I may score highly on analysis of the EU-euro problem, I am, with the exception of the immigration proposal (and possibly the Turkey and other third world enlargement one), a little short on remedy. I would say that this point is a fair one. I have no 'insta-pundit-insta-cure'. We are facing a new situation, and we need bold and unorthodox remedies: but this does not mean reckless ones. We have, in my opinion, a long way to go before we start to find our way forward, and it is not realistic to expect solutions tomorrow. This doesn't mean we shouldn't keep looking. This is what the internet, and all the debates that are taking place in the innumerable comments columns, are all about.

But one 'solution' which is not a solution in the accepted sense of the term is the one which is currently being presented as 'structural reform' in Europe. This brings me to the point where I have most reservations about the Stephen Roach argument. He is absolutely right about the imbalances being produced by a US-centric global economy in my view, but is completely unrealistic in imagining that this can raise the pressure for strucural reforms in Japan and the EU in a way which will produce alternative growth engines. This is, in my book, a non starter. Of course, the EU reforms are necessary: without them we would have the universal bankruptcy which Keynes so feared. But they will not produce a re-run of the 1980's, the panorama we face moving forward just isn't going to be like that. If we consider the labour market and pension reforms which are currently on the agenda in both Europe and Japan we should be able to see that effectively they will have all the hallmarks of a massive default. Firstly, the pensions reforms will effectively mean the devaluation of all the 'forced savings' which an entire generation had been preparing for its retirement. The money being devalued may not, as in Argentina, be in fixed-term deposit accounts, but the difference is only a technical one. A huge quantity of notionally accumulated wealth is going to be written-off on behalf of a large number of people.

Secondly, the labour market reform has a similar look to it. What is about to be written-down via this reform is the market value of all that accumulated workforce experience which resides in Europe's larger corporations. This writing down takes two forms. First lower salary expectations, and secondly lower compensation when jobs are 'bought out'. This is where the European situation is similar to the Japanese non-performing loan one. In Japan the majority of businesses are overvalued due to the fact that they hold equites and debt within their asset portfolio which is being counted at face, and not market, value. Part of the reform in Japan is to reclassify this debt. Well in the same way many Europeans have their own individual non-performing loans: the ones they made to the government pension scheme and the ones they made by dedicating their working life to a single company. For the baby boomers the time is now rapidly approaching when they hope to collect, and the reform is there to make clear to them that the glass is half empty. Now who can hope in these circumstances for a serious revival in European consumption and productivity. For starters just think - Irving Fisher style - of the debt dynamics provoked by this enormous write-down. It's gonna be much bigger than the bubblenomics Steven.

Europe's growth forecasts for 2003 tumbled on Tuesday, with warnings that the continent could fall into recession if tensions over Iraq endure and consumers suddenly lose confidence.The gloomy spring forecast by the European Commission cut baseline eurozone growth predictions from 1.8 per cent to 1 per cent. Italy risks joining Germany, France and Portugal in breaching the EU's budget rules.

Gordon Brown, the British finance minister who presents his 2003 budget on Wednesday, will be pleased that the Commission believes the UK has weathered the downturn "rather well", albeit with a rising budget deficit. The 10 EU candidate countries, mainly from the former communist bloc, also continue to outstrip the performance of the eurozone countries, with growth predicted to be 3.1 per cent this year and 4 per cent or more in 2004. Pedro Solbes, EU economy commissioner, said Europe needed to pursue tough policies to "inspire confidence" at what he described as "a crucial juncture" in the EU's history. "If anything, the EU's weakness in the face of a global downturn has underlined the need to further strengthen the economy's growth capacity and resilience to shocks," he said. But he warned of recession in 2003 in the US should Iraq continue to cast a shadow, oil prices reverse their recent fall and consumer confidence worsen. The forecasts were unremittingly downbeat, with unemployment in the EU expected to rise by 100,000 in 2003, the first rise since 1994, with joblessness at 8 per cent.

While the Commission accepts that many of Europe's problems are homegrown, it also points a finger of blame at Washington, arguing that the twin US budget and current account deficits create instability.It also says international tension over the likely role of the United Nations in administering a post-Hussein Iraq could also knock European economic confidence. Mr Solbes believes EU member states are now starting to realise the seriousness of their predicament. He offers support for the reforms already proposed by Gerhard Schröder, German chancellor.Francis Mer, French finance minister, has also signalled that he is now prepared to backtrack on election promises not to alter course, so as to meet France's obligations under the EU's stability and growth pact. But Italy is accused of taking "transitory" measures to massage down its deficit, and is urged to confront its high levels of national debt and looming pensions crisis.
Source: Financial Times

On Harrod-Balassa-Samuelson and European Inflation

A post from Brad Delong of late last week has started all kinds of bells ringing in my head:

As time passes, and as the European periphery becomes richer and richer, its real exchange rates vis-a-vis the European industrial core have to rise. This is the Balassa-Samuelson effect: poor countries have low real exchange rates because international trade is concentrated among the capital- and technology-intensive goods in which rich countries' absolute advantage is greatest, and so as countries catch up to the industrial core, their real exchange rates rise. In the case of poor countries inside the euro zone, convergence and the consequent rise in real exchange rates requires faster inflation than in the industrial core.

If development on the European periphery is successful, and if growth on the European periphery is rapid, then inflation on the European periphery will be rapid too. This means that, if eurozone-wide inflation is to be low, there must be deflation--falling prices--in the German-Belgian-French industrial core of the euro zone. Deflation is, in general, a bad idea for lots of reasons, one of the chief of which is the catastrophic consequences of nominal wage cuts for worker morale.

Yet as long as the ECB takes its goal to be low inflation eurozone-wide--rather than low inflation in the eurozone's industrial core, with the developing periphery seen as a special case--it seems that the ECB has committed itself to a much more contractionary monetary policy than even the Bundesbank would have ever dared impose on the Bundesrepublik.
Source: Semi Daily Journal

The more important bell relates to the use and abuse of the Harrod-Balassa-Samuelson effect, but I will try and post something on this when I've had more time to think the topic over. Meantime another topic relates to the HICP methodology and how the country weights are determined. After a little investigation I discovered that they are in fact based on national consumption expenditure shares, chain weighted two-years-post as the data come in from national income accounts. Anyone else whi is interested in the arcane world of Eurostat statistical deliberation might find intersting this paper from the Dallas Fed.

Among the jewels that may be found there are:

"Where does this place the HICP in the classification scheme proposed by Diewert? (Diewart is one of the luminaries of index number theory: EH) Eurostat states quite explicitly that the HICP is not a cost of living index, so its conceptual framework presumably lies in either the fixed-basket, axiomatic or statistical approaches to index number construction. However, Diewert shows quite convincingly that this cannot be the case, since all three of these approaches (as well as the economic approach) would rule out the use of the Laspeyres formula for the calculation of the HICP. We will return to the issue of the conceptual framework of the HICP below. For now, it suffices to note that the HICP does not easily fit into any existing approach to the index number problem."

What should be clear is that the methodology used is far from self-evident, and the inflation composite has to be an extremely dubious number for economic policy purposes. When you consider that there's been no Europe Boskin, and that methodology varies widely from one country to another, fine tuning on this must be a bit like taking the 'big hammer' for Um Quasr. In fact the degree of uncertainty regarding the validity of the individual country figures is significant given the lack of quality adjustments in most of them. I would say there is as much possibility that the German figure is 1% too high as there is that it is 1% too low. In which case we don't really know whether or not the German economy is already experiencing deflation. My only conclusion from my investigations is one I reached long ago: deciding whether monetary conditions are too tight or too loose on the basis of the HILP is a fools errand. So it's time to throw away the cucumber sandwiches and the fine lace and go to work to try to clutch Germany from the jaws of deflation before it's too late (assuming, that is, that it already isn't). Those interested in consulting these invaluable inflation numbers can find the latest set here

On the uses and abuses of Harrod-Balassa-Samuelson I think that what's really worrying me in the way the argument is being used is this. Brad Delong (and I think in this he is only reflecting what he feels is the Brussels 'conventional view') in an earlier post (here) says: "As time passes, and as the European periphery becomes richer and richer, its real exchange rates vis-a-vis the European industrial core have to rise". Now this idea of the periphery becoming richer and richer (relative to the core) is based on some growth theoretical assumptions which might well be extremely suspect. Rather than the model of all countries converging to a common homogeneous type, what we may have is a centre/periphery dependence based on an inter-relation of economies with different structural characteristics. The Southern Three (Spain, Portugal and Greece) have economies which are driven by construction and tourism, Germany and France have large machinery, equipment and technology components in the traded sector. These economies are not 'converging' in any meaningful sense of the word. A look at the 'Asian' model, Japan, the four 'tigers', and now China, is instructive in this sense. This model exports manufactured products to acquire strategic capacity which is then put to good use. This is not happening with the Southern Three whose structural dependence is inbuilt.

If you look at the tradeable and non-tradeable sectors you will see that, as theory predicts, productivity is higher and inflation lower in the tradable sectors. But it is what is happening in the non-tradeable sectors - low productivity growth and high inflation - that is preoccupying, since these form an important part of the cost structure of the tradeables, and their impact must be felt eventually, as non-tradeable sectors gradually get traded by importing from cheaper sources (look at Spain's ballooning current account deficit for one). Normally this problem would be resolved by a devaluation of the currency, but with EMU.......?

Equally the orginal rich-getting-richer argument could now be displaced to the new 'Eastern' entrants (who remember are not in the euro). The standard use of the H-B-S effect could serve to justify the idea that price deflation should now also take place in the Southern Three as the new entrants close to converge. This argument would have a lot more logic to it as they may well be more direct FDI competitors with the Southern Three. In fact the main impact of the euro in the Mediterranean countries (where, remember, negative real interest rates exist, and the savings accounts are quietly emptying-out as everyone sinks their money - possibly irretrievably - in concrete) is that the central core economies serve as guarantors for debt liabilities on the perifery. If Europe was one state this might work, but in a Europe of rising political tensions and lacklustre economic performance it is hard to see the centre being held fortune to the moral hazard presented by the perifery. One day the markets will wake up to this fact, and the willingness of the core to sacrifice for the periphery will really be put to the test.

And if you still have lingering doubts, remember Japan is a country with high tradeable productivity, low internal productivity with high prices, and ageing population. This will soon also characterise the much poorer Mediterranean three. But look what is happening to Japan. If you still feel I haven't made my case, as I said, check back another day, I'm sure I'm going to have more to say on this one.

Monday, April 07, 2003

Inflation: Is What we See What we Get

Morgan Stanley's Eric Chaney raises some interesting questions about whether perceived inflation affects consumer activity, and if it does, how this might help us understand the so-called 'teuro' effect. On the way he makes some depressing comments on the state of mind of the French consumer.

In two months time, French households' morale lost more ground than it did during the 1991 Gulf War. Categorised as assets in the European growth equation since 1997, French consumers are turning into liabilities. If this were only a swing of the growth pendulum across Europe, we would not care. But this is not the case. French are indeed catching up, or should I say catching down, with the European crowd, which already looked miserable. With European companies allocating their cash to debt repayment rather than to capital expenditure, with governments forbidden to press the fiscal pedal by EMU rules, there is no doubt that a downturn in consumer spending would put the region on a recession track. Against the consensus view of slow but positive growth in the second quarter, we have already priced in a GDP contraction, in the euro area at least (0.2%Q in Q2). Then, the question is, could be the correction be more serious -- I am afraid this could be the case -- and, more importantly, how long consumers will stay in the doldrums..................

Macroeconomists are supposed to be cold number crunchers, shielded from the real world by a wall of elasticities and multipliers, and I will play this role later on. However, we must not forget that the real world is made of human beings taking individual decisions. As far as consumers are concerned, decisions are based on their perception of current and future real income, but also on their perception of a wide set of risks, such as their job, their future pension or their wealth, but not only. Because layoffs are accelerating now, there is a risk that wage earners could suspect companies of using geopolitical tensions as a pretext for restructuring and thus raise precautionary savings if the war does not end soon. Unfortunately, quantifying the link between confidence and actual spending is not straightforward. Over the last 15 years, consumer confidence in the euro area and actual real spending show a modest 62% correlation. Nevertheless, a simple regression indicates that a 10-point fall in confidence is typically associated with a 1% cut in real consumer spending, which, other things being equal, implies a 0.5% cut in GDP. From Q3 2002 to date, confidence has dropped by 11 points. At 21, it now stands exactly 10 points below last year’s average. Since we expect consumer spending to grow 0.7% this year, after 0.5% last year, it is clear that even our gloomy forecast might err on the side of optimism if confidence does not improve in the coming months. In any case, second quarter consumer spending is likely to disappoint and I would not exclude an outright contraction in consumption and thus a deeper dip for GDP than the two tenths envisaged so far.

Since consumers were more sensitive to perceived inflation than to actual inflation when euro banknotes and coins arrived, they must have saved more than they would have done otherwise. Here are the maths. Using the high correlation between real spending and inflation, we have estimated that a one-percentage-point rise in the inflation rate typically cuts spending growth by 0.9 p.p. (since this coefficient is statistically not different from unity, it will be rounded to one in the following section). In fact, during the sampling period (1992-2002), consumers behaved as if their future income would not discount inflation changes and thus considered that gains or losses in current real income due inflation or disinflation were permanent. Until mid 2001, the link between real spending on the one hand and actual or perceived inflation on the other was the same, as consumers proved to have a very accurate perception of inflation. Then, price tags were switched from good old lire, D-marks or francs to strange euro numbers. Consumers quickly understood that something was wrong, especially in January-February 2002, when euro banknotes appeared. On our estimate, the "Teuro", as the new currency was dubbed in Germany, resulted in a 0.5-1% price increase (see "From Stag-flation to Stag-disinflation", December 5, 2002). On Eurostat estimates, it was only 0.3%. However, for Euroland consumers, the perceived rise of inflation was much larger. Using the excellent econometric relationship between actual and perceived inflation between 1992 and 2001, we reckon that, since the introduction of the euro, perceived inflation has averaged 4.6%, whereas actual inflation has been only 2.2%. This 2.3 p.p. gap between reality and perception is massive, in a low inflation world. However, for once, I see a positive aspect in this otherwise very negative story. Consumers must have continued to take their spending decisions based on their perception of inflation, not on actual inflation -- they do not believe in official numbers. Since they feel that inflation is 2.3 p.p. higher than it is in reality, they have refrained from spending by the same amount, given the unitary elasticity of consumption.

I am not talking about small numbers. The euro area generated €7,200 billion of value in 2002 GDP accounts, 58% of which went to consumer spending. Our calculations suggest that the optical inflation illusion generated by the euro resulted in an exceptional and temporary rise of Eurolanders' savings worth €95 billion (2.3%*58%*7,200). On our estimates, the personal saving rate increased from 14.7% of disposable income in 2001 to 15.5% in early 2003. This was at odds with traditional macro relationships. In the context of real disposable income slowing down, the natural shock absorber that is the savings rate should have decreased, not increased. Our analysis of the Teuro effect provides a credible explanation for this surprising event. Looking forward, consumers' misperception of inflation will not last forever, and the savings rate will come back to its "normal" level, freeing up at least two points of income. As always, this wealth now hidden in savings accounts will go to discretionary spending, mainly to big-ticket items such as cars and home equipment goods.
Source: Morgan Stanley Global Economic Forum


One topic which doesn't receive as much comment as it should is the current plight of the UMTS mobile phone situation, and the rapid rise of wCDMA. Two or three years ago we were being told that the technological future of Europe was being guaranteed by its UMTS lead. Whatsmore the superiority of the Brussels based 'central planning' uniform-standards model was clearly being demonstrated. Now there's an eery silence. Obviously the small-components-loosely-joined argument was not 'well understood'. This is an especially preoccupying situation as it throws some light on what 'structural reform' in the euro-zone may really mean in practice in the context of a technology market based on dynamic competition.

A record-breaking 12 million users signed up for mobile phone services using CDMA technology in the fourth quarter of last year, bringing total CDMA subscribers to nearly 147 million as of the end of 2002, according to the CDMA Development Group (CDG), a US-based trade association. The total figure for CDMA subscribers included 33 million 3G CDMA2000 users, the association said. North America is the biggest CDMA market, with 62 million subscribers. The Caribbean and Latin America market comes in second, with 27 million users. CDMA subscribers in China contributed significantly to CDMA expansion in the Asia-Pacific region, where more than 13 million CDMA subscribers were added last year. Asia also has the highest proportion of 3G subscribers, driven mainly by CDMA2000 services in South Korea and Japan, according to the association. Aiming to penetrate the CDMA market, Nokia unveiled five new CDMA handsets – the 3586i, 6585, 2270, 2275 and 2285 – at the Cellular Telecommunications and Internet Association’s (CTIA) wireless conference in New Orleans last week.Nokia held a 35.8% share in the global handset market last year, but only has about a 10% share of the global CDMA market. South Korea’s Samsung Electronics and LG Electronics (LGE) are the world’s two largest CDMA handset vendors, with approximate 27% and 20% shares of the global market, respectively.
Source: DigiTimes

More Euro Gloom

This time from Eric Chaney and Anna Grimaldi:

Updated with fresh data coming from March polls, our survey-based model -- call it the MP model -- is unequivocally negative. It says that manufacturing posted an initial contraction in Q1 (-0.9%Q) and, mind the steps, is likely to post another one in Q2 (-0.5%Q). This might well be true and, as a matter of fact, our general rule is to trust the MP model rather than hard data, as long as only the first month of the quarter is available. However, we take the MP model Q1 estimate with a grain of salt, because manufacturing production actually jumped 1.1% in January. Although susceptible to revisions, this strong entry point implies that, in order to validate our model's prediction, production would have to drop by 1.5% in February. Although not impossible, we think that such an outcome is at odds with the quasi-stability of opinion on current output in the February surveys. At this stage, we think that a fair compromise is to assume that actual manufacturing GDP growth in the first quarter dipped into negative territory, but by less than indicated by our MP model -- say a 0.5% contraction. Note that the important point here is that, even with this discretionary amendment, manufacturing production is contracting for two quarters in a row, unless business conditions change radically in the coming weeks.

A manufacturing recession does not necessarily imply an overall recession. When the Asian crisis hit Europe, manufacturing contraction lost 0.5%, in Q4 1998; this did not prevent GDP growth from growing a solid 0.3% rate. Our early GDP indicator, which is based not only on surveys but also on interest rates and US cyclical indicators, is nevertheless highly sensitive to manufacturing production, which it takes from the MP model itself. Then, if fed the raw results of the latter, our GDP model would print 0.0% in the first quarter, followed by 0.1% in the second. Alternatively, fed with our compromise manufacturing production estimate, it would say 0.1% in the first quarter and 0.0% in the second. Given the very relative precision of econometric models, these differences are totally insignificant. If there is one message to take away from quantitative tools, it is that euro-area GDP growth came to a standstill in January and did not show any sign of taking off since then. Of course, zero growth implies higher unemployment and higher government deficits, but that is another story.

Nonetheless, our quantitative tools do not yet indicate that GDP is going to contract in the second quarter, as indicated in our economic forecasts. One of the assumptions we used to build our full-fledged GDP forecast (see "Recession Alert", February 24, 2003, by the European economic team), namely that crude oil prices would shoot up to $40/bbl in March, did not materialise. Instead, oil quotes declined enough to bring the 30-day average to the vicinity of $30. For this reason alone, we could find a justification for a forecast change on the upside, for the first time since 2000. However, we are not yet ready to take this step. Gloomy we are, and gloomy we are likely to stay for a while, even though market conditions are slightly better than they were three weeks ago. Put simply, the volatility caused by inconsistently reliable news from the front in Iraq makes us very cautious about the markets' judgement.
Source: Morgan Stanley Global Economic Forum

Petro Dollars or Petro Euros?

I have a mail from Maynard this morning asking me about seignorage on the dollar, and the importance of a dollar-euro switch. He also informs me that: "internet conspiracy theorists....claim that operation Iraqi Conquest is based on a fear of oil sellers switching to selling in euros rather than dollars". I have a number of comments. Firstly this area is a good deal outside my competence. On currency questions I normally limit myself to listening to what those who know more say, and citing those comments I feel are intelligent and to the point. In this sense I feel you cannot do better than Morgan Stanley's own Stephen L Jen. On the other hand, whilst I am sure conspiracies abound everywhere, I am equally convinced that few of them ever succeed in obtaining the results intended. Since the future is not ours to see, I find the whole idea absurd. Imagining, just for the moment, that the euro were a conspiracy, then it surely seems like one that is destined to fail. Or take the late 90's 'new economy boom': there seems plenty of evidence that consultants contrived to sell products they themselves didn't believe in. But I can hardly believe they intended to produce the market crash which was, in fact, the end product of their best endeavours.

In this sense I am deeply manichean: if there were to be a god, we would undoubtedly be a totally unexpected outcome of his or her endeavours. So following Occam and Einstein on the simplicity front: I am sure there may be conspiracies, but theoretically speaking their existence or otherwise is an entirely extra-to-requirements assumption. We have enough to think about by considering the repercusions of the activities of well intended men and women. Those in doubt should read Borges, and if you're still not convinced try his Argentinian colleague Roberto Arlt.

Now on the substance. Stephen Jen among others reminds us time and again that the Asian dollars are in fact more important than the petro ones - he estimates by a factor of ten to one. Secondly, bringing down the price of oil by bringing Iraqui oil on-line after the war would probably reduce the importance of the petro dollars even more. Thirdly, it seems to be a US Treasury mid-term objective to bring down the value of the dollar (among other reasons because of fears about deflation, but also to correct the current account deficit). None of this would seem to suggest that US strategic thinking is motivated by dollar seignorage arguments. Additionally the greatest threat on this front may well come from global central bank currency reserve holdings. Here is what Jen recently had to say on the issue

In light of the geopolitical developments in recent months, it is possible that one of the factors weakening the USD may have been a growing share of petrodollars being re-invested in non-USD assets. In this note, we revisit this issue, and conclude that re-direction of petrodollars is likely to have had a positive effect on EUR/USD, reflecting more the rising concerns about the USD and the nature of the geopolitical tensions, rather than the higher oil prices per se. However, this is not likely to have been a ‘dominant’ factor behind the descent in the USD in recent months but, more likely, only a modest USD-negative.

Tracking the petrodollars to help us think about the evolution of the G3 currencies is not new. In fact, we first analysed this issue back in October 1999, in ‘Tracking the Petrodollars’. While how petrodollars are re-invested is very important for the USD, the absence of data on these flows has always posed the most serious obstacle to us in reaching unambiguous conclusions. At the same time, the paucity of data has also fuelled many ‘conspiracy theories’ about how petrodollars may be redirected away from USD assets. In the various pieces of analysis we have conducted since then, and including this piece, we have only been able to draw tentative conclusions that are conditional on specific assumptions. Having said this, there are several aspects of the flow of petrodollars that are worth remarking on.

There is the argument that, in fear of funds being confiscated or frozen by the US, petrodollar owners have shied away from USD-assets, and that this has been a major factor driving the USD lower. We don’t find this argument convincing. First, there is a difference between investing through US-based funds and investing in US Dollar-assets. These investments in question could be shifted to off-shore accounts and still be invested in USD-assets. Further, suspicious investments would not be ‘off the hook’ just because they are not in USD-assets. Second, this argument presumes that most of the petrodollar investments are ‘suspicious’ in nature, and that the US is feared to indiscriminately freeze funds. Both of these presumptions are not reasonable, in our view.

There is no mystery to the 12% decline in the Fed’s major USD index since the beginning of 2002. Not only was the USD very over-valued, but the cyclical fundamentals of the global economy permitted the USD to correct in three mini-phases (‘USD Twin Deficits — USD No Longer Lord of the Currencies’ Stephen L Jen, 16 Jan 2003). We believe there are compelling ‘conventional’ justifications for the USD to correct. Even petrodollar owners themselves may have limited their holdings of USDs and increased their exposure to the EUR, not for fear of being investigated by the US intelligence services, but simply because they think the USD is overvalued. In other words, there could be nothing special or mysterious about petrodollars. This is not to say that such a re-direction away from USD-assets did not take place, but a redirection due to petrodollars was most likely of secondary importance, being only part of the general USD selling seen over the period.

Whatever the true story on petrodollars, they are not large enough to significantly move markets alone, in our view. Petrodollar receipts are large, but not that large. OPEC oil export revenues are estimated by the EIA (US Energy Information Administration) at US$179.6 billion for 2002. This amount is dwarfed by the total export receipts of the Asian countries (around US$1.6 trillion in 2001), and which are also predominantly denominated in USDs. Even though the sharp oil price increase could push total OPEC-10 export revenues above US$300 billion this year, a change in the re-investment pattern of Asian exporters is, on this basis, potentially much more important than that of the petrodollar owners. The Asian exporters and central banks divesting from USD-assets alone would be powerful enough to drive the USD weaker.

This is the ‘flow’ aspect of the discussion. There is also a ‘stock’ aspect we need to consider. Most Asian economies have been capital-surplus economies (indicated by running a current account surplus) in recent years, as have most of the OPEC-10 (according to OPEC estimates). Looking at cumulative current account (C/A) balances can give an indication of an economy’s cumulative gross foreign assets (a ‘stock’ concept). Cumulative C/A balances for the OPEC-10 over the period 1981-2001 are US$110.5 billion, while those of the Asian economies sum to US$1.9 trillion. Hence, this suggests that gross foreign assets held by Asian economies are likely far larger than those of the OPEC-10. The point here is that the Asian exporters and central banks deciding to raise the weighting of the EUR at the expense of the USD, because of the structural negative trend in the USD, would be a powerful enough USD-negative to dominate the decision by petrodollar owners over whether to do the same.
Source: Morgan Stanley Global Economic Forum

Which brings us to Europen government strategy. It is I suspect a widely held belief here in Europe that a significant part of contemporary American prosperity is based on the fact that the rest of the world is prepared to subsidise US consumption by holding dollar denominated assets. This, like most theories, is partly true. But only partly, and begs the real question as to why many in the world, including many Europeans, have been prepared to hold dollar denominatd assets. The reasons for this may be many and complex, and this is not the time to go into them in any depth, but suffice it to say that the performance of many of the leading US corporations, in comparison with the rather lacklustre showing of their European equivalents, in particular in the so-called 'new economy' sector (where, for example, are the European Amazons, Googles and Yahoos?) may offer some part of the explanation. The cart is again being put before the horse, and the relations of cause and effect reversed. America is not wealthy because it is powerful, but powerful because it is wealthy, and rich because of it's wealth creating capacity.

So what worries me most about the euro in this context is that its very existence may be based on an illusion, the illusion that runs along the lines of an 'if only we too could only get some of the additional seignorage action'. It is a moot point today whether the rise in the euro will encourage central banks worldwide to rebalance their currency holdings by accepting more euros. It is another moot point whether short term tendencies (like the fall of the dollar) will be reversed mid -term if the European economies cannot hold the weights to do the heavy lifting. It is a complete unfathomable whether any of the euro zone governments may or may not have been influenced, either individually or collectively, in their Iraq war allignments by the prospects of more favourable euro receptions in the third world. And it is the mootest point of all whether the rise in the euro/dollar rate that any such pro-euro sentiment might provoke would be beneficial or downright harmful mid-term for the European economies. Finally, and without prejudice to any of the above, it is extremely doubtful whether 'conspiracies' which have no idea if the end result of their intended actions would be beneficial or harmful for the 'conspirators' really deserve the name of conspiracy at all. Confederacy of Dunces sounds more like it.

Neil Kinnock Predicts No UK Euro Vote Before 2005

My own feeling is that I'd be surprised if the euro passes the five tests, but I'm always willing to be proved wrong. If it does, then I think the arguments used to justify the result will be interesting. Only to be expected really as an opinion since I'm not sure how much economics ol' Neil really understands, and the argument could be read as a diplomatic postponment. Still if there is not going to be a referendum before 2005, and with the problems associated with EMU getting clearer every day, I'd be extraordinarly surprised if there was a yes vote. Still the future could bring two or more surprises, the past already has. But I'm still sticking to my view: Britain won't join the euro, period.

Britain could delay holding a referendum on joining the euro until late 2005 or even 2006, according to Neil Kinnock, vice-president of the European Commission. Mr Kinnock, who has close links to Tony Blair, believes the British prime minister will still try to hold the vote in the lifetime of this parliament. But he says the "five tests" on British euro membership, due to be completed by June, will conclude that more time is needed to gauge convergence between sterling and the single currency. "I think the answer to the tests will be Yes, but when certain things have been accomplished," he said in a Financial Times interview. "I think the assessment will be positive. But what we won't have in June is Yes, and here's the date for a referendum."

Mr Kinnock rejects any suggestion that Mr Blair had contemplated holding a "khaki referendum", if a swift and successful war in Iraq had brought him a boost in popularity. "That demonstrates a complete misunderstanding of the psyche and politics of Tony Blair," he said.Instead Mr Kinnock believes that a referendum in late 2005 or early 2006 - within months of the June 2006 deadline for a general election - is the most likely scenario."It would give you just a bit of extra time to focus public opinion on the facts," he said. Mr Kinnock, the former leader of the British Labour party, retains close ties to Mr Blair, as well as to Gordon Brown, the finance minister. Many of Mr Kinnock's former lieutenants hold senior positions in Downing Street and in the government. But the EU administration commissioner says Mr Blair has not done enough to prepare British public opinion for a euro referendum. "Not enough opportunities have been taken to provide dispassionate and objective information," he said.
Source: Financial Times

Eurozone Economic Confidence Hits Low

Eurozone Economic Confidence is at a six year low. Hardly surprising, and consistent with the outlook that the coming months are going to offer a bumpy ride.

Business and consumer confidence across the eurozone dipped to a six-year low in March, according to a survey released on Monday. The European Commission's report, mainly carried out before the start of military action in Iraq, showed sentiment fell to 97.8 in March, compared with 98.4 in February. "Such a drop in confidence has not been observed since the events of September 11," the Commission said. Analysts had predicted the index would fall in March, partly for war-related reasons. Business confidence fell to -12 compared with -11 in February, the lowest level since September 2002, while consumer confidence dropped from -19 to a nine-year low of -21. "A further deterioration in the expected developments of the general economic situation and the financial situation of households coupled with an anticipated rise in unemployment are behind the worsening of consumer confidence," the European Commission said. Consumers' expectations about the general economic situation deteriorated in all EU member states with the exception of Ireland and Luxembourg. The news of deteriorating economic sentiment coincided with official figures that suggested eurozone inflation stayed above the European Central Bank's 2 per cent ceiling for the eighth month in a row in March. Eurostat, the EU's statistics arm, said annual inflation was expected to be 2.4 per cent in March according to a flash estimate. That is unchanged from February's figure.
Source: Financial Times

German Growth Forecasts 2003

How much will the Germany economy grow in 2003? The intelligent answer, I suppose, really should be that this is a fools' question, and the answer is anyone's guess. That of course is not the position adopted by the German government who, if the reports are correct, are busy debating whether to drop the anticipated growth forecast from its current 1% to the 0.25% - 0.5% range, or to make only a more 'moderate' reduction. And how many camels can you balance on the end of a needle you may well ask? My own view is all of this is full of plenty of downside risk. I wouldn't want to stick my neck out too far yet, but negative growth 2003 in Germany would not surprise me at all. Of course I don't have all those fancy government models to play around with (but then neither do I have to convince anyone that I'm staying within a 3% deficit limit), so this is based pretty much on looking at the information coming in, especially the February figures, and applying my 'animal instincts'.

The German government will next month bow to the harsher economic climate caused by the war in Iraq and slash its growth forecast for this year. The size of the cut from the 1 per cent estimate for gross domestic product growth remains unclear, amid a stand-off between senior ministers. Hans Eichel, the finance minister, favours a sharp reduction to between 0.25 per cent and 0.5 per cent. By contrast, officials say Wolfgang Clement, the economics and labour minister, prefers a smaller cut to avoid weakening already shaky business confidence. Either way, 1 per cent has appeared increasingly untenable in the light of much less optimistic predictions from Germany's six leading economic institutes, and private sector economists, some of whom expect growth to be little better than last year's 0.2 per cent.

A formal revision had been expected by May, when a specialist government tax forecasting panel produces its latest report. But officials said the announcement would be brought forward in view of forthcoming, separate reassessments of the economy by the institutes, the International Monetary Fund and the Organisation for Economic Co-operation and Development.The revision will have repercussions for this year's budget and Germany's expectation of holding the deficit below the 3 per cent ceiling set out in the rules for the euro.Mr Eichel has said he expected the budget deficit to be 2.85 per cent of GDP this year, but warned that matters could deteriorate through unforeseen circumstances, such as prolonged economic instability because of Iraq.

Economists, who had already said the figure was optimistic, added that new spending measures announced this month made it inevitable that Germany would exceed 3 per cent of GDP for a second year running. In 2002, the deficit was 3.6 per cent of GDP.The new growth forecast would mark the second downward revision in two months after the government cut its former 1.5 per cent estimate to 1 per cent in January. Growth of just 0.5 per cent would mean tax revenues alone would be about €2bn ($2.14bn, £1.35bn) below expectations. Official figures for January and February showed revenues had already fallen 5.9 per cent below last year's already weak level. Lower growth would also have ominous implications for government spending, already subject to some bold assumptions this year. The government's aim - questioned by many economists - to eliminate subsidies to the Federal Labour Agency, responsible for unemployment benefit, would appear more doubtful than ever. Forecasts for pensions would also have to be revised, all leading to a likely rise in borrowing.
Source: Financial Times

The Future of EMU

Even while the war rages around us in all its bloody reality, it is still important to try to take stock of some of its likely economic consequences as and when they become a little clearer. Today it is the turn of Morgan Stanley's Joachim Fels to start to ask some of the pertinent questions. Whatever the final outcome it is clear that the post-Iraq war EU will look somewhat different to the pre-war one. In the first place everything is happening against the backdrop of an important structural change: the entry of ten new members into the community. In and of itself this will produce changes, and some of the possible lines of evolution of those changes are already discernable. Firstly there will be a political re-alignment. Those with long enough memories cannot fail to remember that one of the main backers of the EU enlargement process was in fact Mrs Thatcher. The then British prime minister, in my opinion, took this view for two reasons. Firstly in an attempt to make any move towards European political union (and the creation of a Euro super state) much less likely, and secondly to break the back of the Franco-German axis by creating the possibility for new political alignments.

Regardless of whether one considers this a good or bad thing, it is impossible for the thoughtful observer of the European scene today not to have the feeling that Mrs Thatcher was the most prescient of the then politicians. The enlargement seems now destined to take place without the political reforms which were widely regarded as being indispensible (not tackling the veto situation, as we have just seen in the UN case, might be considered as something of a 'lethal dose'). At the same time Jaques Chirac's recent outburst against the new Eastern members should not be regarded as anecdotal, but rather as an indication of what may well be to come. If, from the time of De Gaulle, rough and ready anti-Americanism has been the handmaiden of French foreign and domestic economic policy, with the EU as a political structure being merely an extension of this policy by other means, then this bubble has now, suddenly, burst. The political divisions which have emerged around the Iraq war only serve to underline this new reality. Perhaps the only really surprising thing, and I, like almost everyone else here in Spain, am having great difficulty in interpreting this, is the political stance of the present Spanish government.

Europe really is divided into four components: a South (Greece, Portugal, Italy and Spain), a North (UK, Sweden, Finland, Denmark, Holland (?), Ireland (?)), an East (principally the so-called 'transition' economies, and in particular Poland, Hungary, and the Czech Republic), and a central component around the Franco-German axis (France, Germany, Belgium, Luxemburg, Austria). In my view the weakest of these components is the southern group, and this is the component with the most to lose if Joachim Fels is right and the growing political rivalry spills over into increased economic competition. This is especially true for one reason not mentioned by Fels: the principle competitors of the Mediterranean four will be the Eastern group, and these, since they do not belong to the euro group, will have far greater room to manouevre in the newly competitive environment. They are also, if Fels is right in predicting widening yield spreads, the most at risk from negative public debt liabilities given their demographics and lack of adequate pension preparation.

On the other hand the likelihood of UK euro participation seems to have faded considerably, and this may have its own impact on the other principle axis of economic and political competition, the North/Central one. Here, among other factors which should be taken into account, are the different levels of penetration of the English language, and internet take-up and participation rates, both of which could in some ways be seen as proxies for capacities to realise available externalities in the so-called knowledge-based economy.

All-in-all, Not a pretty picture I feel. Perhaps the most ominous of Fels' forecasts: that market participants need to begin to factor-in an EMU break-up probability assessment. As Fels says, this seems extremely unlikely. But the mere fact that he even mentions it, and the fact that the markets may begin to recognise it as a conceivable possibility, this fact in itself means that it is just that little bit more possible today than it was yesterday.

The rift that has emerged within Europe between those countries backing the military intervention in Iraq and those opposing it has made one thing crystal-clear. The idea of an ever-closer political union culminating in the United States of Europe will remain a pipe dream for a very long time, especially now that the European Union (EU) looks set to expand towards Central and Eastern Europe with ten new, self-confident members scheduled to join next year. These developments have some important economic and market ramifications. Markets will have to get used to the notion that national governments will increasingly pull in different directions on important foreign or domestic (economic and non-economic) policy issues. In short, the country factor will loom large for investors, the risk of a break-up of the EU and/or EMU, while small, will be non-negligible, and the ECB could be pressured into producing higher inflation. However, a diverse and diverging EU that moves at different speeds in different policy areas may actually produce better economic outcomes than a monolithic United States of Europe governed by a single government in Brussels ever could. In my view, economic and political diversity, combined with a huge single market for goods, services, capital and people, provides for a healthy competition of national or regional entities for mobile resources. The result would be a less regulated, more dynamic and faster-growing European economy............

Make no mistake: the current and potential future divisions within Europe will make national governments, parliaments and voters less and less likely to cede more sovereignty to Brussels. This has important consequences for the EU Convention, the assembly led by Valerie Giscard d'Estaing which is currently seeking to draft a European constitution to be finalised next year. European federalists will deplore the fact that Europe seems unable to build a political union that can speak with one voice and match the status of the United States. In my view, however, this has been an unrealistic and unworkable vision all along, especially for an enlarged EU comprising 25 or more members....... I rather try to see the positive side of Europe's disunity.....
Yes, this kind of competition may look messy or even chaotic at times, some countries may run in the wrong direction for a while, and internal disagreements and even institutional crises will ebb and flow. However, as long as the common market for goods, services, capital and people rules, this kind of competition should produce better economic outcomes than a single government for the whole union, which would be far detached from its diverse citizens in 25 or more member states. Countries that pursue the right tax, welfare and labour market policies in this set-up will be rewarded with capital inflows, stronger growth and lower unemployment and can serve as a role model for others who are doing less well. Eventually, the process of "dynamic benchmarking" will lift the boat for all members willing and able to play the game and should result in a less regulated and stronger-growing European economy.

Growing divisions on budgetary policy and a possible slow death of the Stability and Growth Pact could lead to a significant widening of government bond yield spreads between the more and the less virtuous countries. Partly, this would reflect the actual fiscal policy divergences and partly it would reflect the fact that a financial bail-out for a member state that runs into serious fiscal difficulties will be less likely in a dis-united Europe. Second, in this changed environment, markets will have to attach a higher probability to a break-up of EMU and/or the EU at some future date. While I believe that the economic benefits from participating in both are sufficiently large to make such an event unlikely, we simply cannot neglect the possibility of fraction and secession. Everything else being equal, this suggests a higher risk premium on European financial assets and the euro. Third, a disunited Europe won't make the ECB’s job any easier. As the ECB has no policy instrument to address economic divergence between the euro participants, a growing divergence of budgetary and general economic policies would likely lead to increased political pressures for an easier monetary policy to grease the wheels. Whether the independent ECB would cave in to such pressures is uncertain. Yet, history shows that even the most independent central banks are not immune to the political environment in which they operate.
Source: Morgan Stanley Global Economic Forum