Third Quarter Data from the Eurozone and Related Thoughts

2005-09-13T065756Z_01_NOOTR_RTRIDSP_2_OFRBS-FRANCE-PRIX-DETAIL-BS-20050913.jpgDespite France's surprising break the signals from the 3rd quarter of the Eurozone are not surprising at all, at least not if you are deploying the right analytical tools that is, ahem ok - more about that below :). First off let us do a quick run-through of the general data shall we? As I mentioned above France came out of the third quarter very badly which kind of took the economic consensus by surprise which in this particular case includes me as well. Consequently, Bloomberg narrates the third quarter slowdown as primarily being driven by France. Perhaps but in any case all this is of course beginning to sink in and anyone going into to 2007 with optimism and faith in a sustainable recovery would be wise to re-visit their position I think.

(from Bloomberg linked above - bold parts are my emphasis)

European economic growth probably slowed in the third quarter more than previously estimated after French expansion stalled, a survey of economists shows.

The economy of the dozen euro nations may have grown 0.6 percent from the second quarter, when it expanded 0.9 percent, the fastest pace in six years, according to the median of 40 economists surveyed by Bloomberg News. Before the French report published Nov. 10, economists had projected growth of 0.7 percent.

Rising interest rates, a sales-tax increase in Germany and a slowdown in the U.S. economy threaten to damp growth in the euro region next year. A more moderate pace of expansion limits companies' room to raise prices and weakens the case for more interest-rate increases by the European Central Bank.

``The 2007 slowdown could be bigger than expected,'' said Sylvain Broyer, an economist at Ixis CIB in Frankfurt, who expects growth to cool to 1.7 percent next year from 2.6 percent in 2006. ``It's likely we are near a peak in the ECB's tightening cycle.''

In terms of Germany growth dipped below the 1% mark (1.1% in the second quarter) to 0.6% against a consensual prediction of 0.7%. Furhtermore the ZEX economic sentiment index also dropped. Also in Italy, growth was reduced to a measly 0.3% against 0.6% in the second quarter. So all in all the so-called sustainable recovery (ok, who is still arguing this?) is certainly losing steam as we head for 2007. In terms of the more uncertain indicators(?) the European yield curve also inverted last week as 10 year yields fell below two year yields.

Don't mistake me here, none of this makes me particularly happy or cheerful. I am merely trying to make a point about how to read and analyze the current economic situation in the Eurozone. What point is that then? Well, for the sake of argument I need an advisary and given my views I could not find anybody better than Melvyn Krauss from Stanford University (I sure know how to pick them eh?) writing in his latest column from Project Syndicate about the misguided European 'growth pessimists'. My yardstick here is very clear; any economic analysis of the Eurozone at this stage which does not mention the economic effects of demographics is not worth much and thus it already puts Krauss in a dire situation I am afraid. But what is Krauss' argument then?

For starters he turns the situation upside down. Where I have continously pointed to the fundamentals of the Eurozone going into 2007 Krauss takes these exact same factors and well; have a look ...

What motivates – or frightens – the growth pessimists, in particular, are (1) higher European interest rates, (2) the slowing US economy, and (3) the increase in the German value-added tax (VAT) from 16% to 19% set for the beginning of the year.

But they are wrong to be frightened by these factors.

So why should we not be worried?

First off Krauss presents us with a classic; the need to distinguis between real and nominal interest rates. As such we are quite far from the 'neutral' interest rate (the interest rate at which the economy grows without building up inflation) in the Eurozone. Of course no one believes in that kind of economic fine-tuning but given the difference between the current interest rate and the perceived neutral rate (between 4.5 and 5%) Krauss concludes;

The truth of the matter is that interest rates – both nominal and real – are too low in Europe, not too high.

This is of course must be sweet music in Frankfurt where the ECB is reverting to monetarism in order to justify raising rates but more importantly which country(ies) are Krauss talking about here; Spain and Ireland perhaps, France? Or What about Germany or better yet Italy? Consequently, we are back to a fundamental fallacy here. Treating the Eurozone as one single economic entity; in fact, the discussion of one single (neutral) interest rate in the Eurozone makes little sense once you step outside in the real world because the Eurozone contains structural imbalances directly related to the differing population structures of the member countries.

Krauss however, does not get it all wrong though. Many Eurozone countries indeed needs structural reforms and I also like his argument about how this (all things equal!) would have an effect on potential output ('the growth ceiling') and then ultimately free up some slack. 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. Japan might just become a lesson here? On this topic, The Economist's new weblog Free Exchange has a timely post about Europe's Demographic Doom based (among other things!) on a Tyler Cowen (Marginal Revolution)  piece from Crooked Timber in which the issue of Europe pulling 'an America' is discussed. I am sympathetic to this I really am but this argument implicitly concedes that for example the demographics of ageing is a structural European phenomenon and quite frankly I don't buy it. Look for example at Japan where the same process is occuring with indeed more force.