Remaining Vigilant in the Eurozone?

EUROCOIN.KOMMISSIONEN.jpgThe data coming in from the Eurozone is by and large unchanged. Business confidence surveys show positive signs across the board and corporate lending is at an all time high. However, inflation is also at an all time low which seriously questions the ECB narrative on how excess liquidity still lingers in the system. So how far will the ECB's folly go here?

(from the FT)  

Eurozone inflation has fallen to its lowest level since November 1999 and economic confidence has reached a five-year high. However, German consumers have again spoilt the upbeat picture with September’s retail sales down on a year earlier.

The overall upbeat data on Tuesday highlighted the strength of economic activity in the final months of the year. However, the fall in the inflation rate, to 1.6 per cent in October from 1.7 per cent in September, added to the presentational problems facing the European Central Bank.

The ECB will almost certainly keep its main interest rate unchanged at 3.25 per cent on Thursday but has signalled that another quarter percentage point rise is highly likely in December – even though inflation is within its target of a rate “below but close” to 2 per cent.

The ECB fears falling oil prices have only temporarily cut inflation and that rapid economic expansion is adding to longer-term inflationary pressures.

As we can see the ECB is still not sure that headline inflation pressures, which after all prompted the inflation level's drop below the target 2% rate a month ago, are entirely gone. Moreover, the coporate and private lending spree still worries the ECB ...

The ECB data highlight the eurozone’s strength, with strong business lending probably reflecting buoyant corporate investment spending as well as merger and acquisition activity.

But the rapid credit growth is likely to worry the ECB and heighten speculation that its interest rate raising cycle may extend into 2007.

So the business environment is looking perky which is also underpinned by business surveys. So everything is well and good then? Not quite; the outlook for 2007 still looks ... well as it always has been looking; quite bumpy with a slowing US, fiscal tightening in key member countries (Italy and Germany) and oh yes a vigiliant central bank bend hell on raising rates well into a period which most likely will have a strong cushioning effect on growth rates. This is brings me to another crucial part of the Eurozone's apparent recovery; consumer spending or rather the lack of it. Germany is a good place to begin.

Germany’s economic rebound has yet to persuade the country’s consumers to open their wallets, according to official figures showing an unexpected fall in high street spending.

In spite of Germany’s newly-refound industrial strength, retail sales in September were 1.2 per cent lower than the same month a year ago, the federal statistics office reported. Compared with the previous month, they were 1.7 per cent lower.

Data on German consumer spending trends are notoriously volatile and subject to significant revision. But since the economic upswing in Europe’s largest economy began to gather pace earlier this year, with investment and employment growth picking up, signs have been scant of any significant feed-through effect on retail sales.'

This is mighty weird is it not? So, howcome consumers in Germany are this thrifty in the midst of a period an apparent economic upswing/recovery? Many explanations could be offered here but one initial hint should come from life-cycle theory which tells us that older populations tend to save more; in fact this would fit well with Germany running a trade surplus of about 8-9% of GDP coupled with buoyant corporate investment; that is to say largely export driven growth. But does this go for the whole Eurozone then ... not at all, Spain is running is running a huge trade deficit but with a quite different population structure from that of Germany and Italy for that matter. This brings us to the inevitable question; is in fact the Eurozone one single economic entity? Far from it, in fact arguing this would be nonsense on stilts. Wolfgang Munchau from the FT had a telling commentary on this recently.

Against the rest of the world, the eurozone runs a negligible current account deficit. But inside the eurozone, huge internal imbalances have built up. One measure of imbalances is the current account. Spain is heading for a current account deficit of close to 10 per cent of gross domestic product. Western Germany’s current account surplus is approaching 9 per cent of GDP.

The history behind these numbers is largely undisputed. Germany has regained the competitiveness it lost after unification. More interesting is how Germany’s relative competitiveness will evolve in the future. The consensus is that Germany will eventually lose some or all of those gains and balance will be restored. That assumption is quite wrong. On present evidence, the competitiveness gap is still likely to widen in Germany’s favour, albeit not at the same pace.

Why does Eurozone imbalances matter then? First of all they matter in relation to the idea of the ECB's single interest rate policy which in this light becomes an impossible task. However, more generally it matters because it shows us that the idea of economic convergence in the Eurozone is perhaps good in theory but not (yet) a reality and this is and will be the course of many troubles as we move ahead; a good place to look for this trouble would be in Italy.