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*** Marshall Auerback Commentary (2-1-05) ***

International Perspective
by Marshall Auerback

A Euroland Growth Surprise?

February 1, 2005

"One of the issues that clearly is there is that the dollar has been a risk for the global economy in the past year. A lot of focus in financial markets has been the current account deficit in the U.S. I expect even in the next year that situation on the current account will not change fundamentally; therefore, the dollar risk will probably remain with us. The dollar exchange rate can play a part in that adjustment process, but surely the adjustment cannot just take place just by movements in relative price.”
- European Central Bank Governing Council member Axel Weber, Jan. 30, 2005

It’s been repeated so often that it’s almost become axiomatic: the US is a comparative bastion of economic reform, flexibility, and dynamism, whilst the Euroland economies remain sclerotic, slow-growth museum pieces, destined for economic irrelevance in the globalised 21st century (except perhaps as a favoured destination for increasingly prosperous Asian tourists). The latest alleged blow to growth was last year’s sharp rise of the euro, particularly against the dollar, which supposedly snuffed out the incipient beginnings of a tentative, export-led growth revival in the eurozone.

It sounds persuasive. There’s only one problem: the facts are proving uncomfortably accommodative to the theory.

To be fair, it’s hard to make the case that Euroland is on the threshold of a major economic boom. The sheer rapidity of the euro’s rise last year did have an adverse short term impact on economic growth, particularly in the eurozone’s largest economy, Germany. But economies learn to adapt to varying exchange rates (as the UK has learned to live with a stronger pound), and the most recent data suggests that Euroland’s economic “collapse” is not all that it is cracked up to be, notwithstanding the incessant chatter by those anxious to play up the “deflationary” impact of an stronger currency.

In fact, for all of the talk of a region supposedly on the threshold of a recession, the aggregate numbers released in the past few weeks have been reasonable to surprisingly good, and largely eradicated the perception that the European Central Bank would move imminently to lower rates (and, parenthetically, might also explain why the euro has persistently disappointed the expectations of dollar bulls, who were confidently forecasting further declines when the currency hit $1.30 against the greenback last month after reaching a record high of $1.3665 in December). Whilst the data by no means suggests an imminent rise in ECB rates (particularly as eurozone inflation figures remained reasonably quiescent), it ought to put paid to the notion that Euroland remains the terminally sick man of the global economy. If anything, with its moderate growth, higher repository of national savings (in comparison to the US), and a current account broadly in balance, Euroland exhibits far fewer of the economic weaknesses which characterise debt-bloated America, or emerging Asia (where ongoing problems of banking stability pose a persistent threat to growth).

The Belgian business confidence indicator, the bellwether for euro zone economic activity, whilst dropping slightly in January, showed steady industrial production and a purchasing managers' index holding above 50, indicating continued expansion. Lending to eurozone consumers for house purchases was growing at an annualised rate of 10 per cent late last year – the fastest since early 2000 – reflecting soaring house prices in many parts of the region. The ECB figures released last week illustrated the impact of low interest rates and new financial products have had on Europe’s property market and raised hopes that the effects could feed through into stronger consumer spending to boost economic growth. In fact, consumer confidence in Euroland is 3.0 points higher than a year ago and employment expectations have improved consistently since May 2004.

Going more country specific, the Italian retail sales report for December was stronger than market expectations and the ISAE Italian business confidence index rose for the first time in 3 months in January, by 0.3pp to 89.2. The recent softening of the euro made manufacturers more optimistic about export orders and helped improve the economic and employment outlook. An easing in stock levels also helped support expectations.

In France, consumption rebounded in the fourth quarter, as did home construction, as 4Q housing starts posted a 14.7% rise on the year, while 4Q permits were up 21.3% on the year, according to non-seasonally adjusted data released last Tuesday by the Construction Ministry. Although consumer confidence remained flat, household expenditures rose sharply in the fourth quarter. Recent statements by President Chirac and other government officials clearly suggest a move away from fiscal retrenchment with promises of further tax cuts in 2006, in spite of earlier pledges to abide by the rules of the now widely abused and discredited Stability and Growth Pact. Whilst the French government may very well show an improvement in the 2005 deficit, bringing it down to 3.0%, from an estimated 3.6% last year, to a large extent this will be optical as it relies on a one-off payment worth 0.5% of GDP made by the electricity and gas public utility providers (in exchange for future pension liability) and accelerated privatisations. In spite of this bookkeeping ledger main (or perhaps because of it), President Chirac has recently affirmed remaining 20% cut in a pledge income tax (one of the centerpiece pledges of the last Presidential campaign), only 10% of which has hitherto been realized. If the measure is implemented, it will constitute a significant relaxation of fiscal policy and will almost certainly underpin French consumption this year.

Finally, there is Germany. Although growth for the whole of 2004 in Germany came out at 1.1% and the final quarter of 2004 came in at a piddling 0.1%, even the so-called “sick man of Europe” looks set to pick up, judging from the latest IFO survey, the broadest measure of business confidence in Germany. Business confidence in January unexpectedly rose to an 11-month high as the euro retreated from a record and executives became more optimistic about domestic demand. True, part of the source of these optimistic expectations was the euro's 5 percent drop from a record against the dollar last month (which eased concern an export-led recovery may fade). But equally significantly is that consumer spending component “improved somewhat” in the fourth quarter after stagnating or declining for two years, Germany's statistics office said on Jan. 13.

And for all the talk about the euro’s recent decline from last December’s record highs, it is important to place that in the context of a 40 per cent upward move over the past two years. In effect, one should not overestimate the stimulatory benefits of a mere 5 per cent fall. Nevertheless, it is noteworthy that in spite of the euro’s sharp appreciation, German exports still managed to rise to a record level last year. Exports rose 10 percent to 731 billion euros ($953 billion) from a year earlier, according to the Federal Statistics Office. The surge in sales abroad boosted Germany’s trade surplus by a fifth, taking it to a record of 155.6 billion euros. For all of the talk about the dollar’s decline being an essential facet of “global rebalancing”, it has been Euroland, not America, which has continued to experience significant export-led success, largely because its economies still produce things the rest of the world wants.

Contrast this with the United States. It is often suggested that the “problem” posed by the American trade deficit is not a problem at all, since the US can simply devalue and anyhow, as a percentage of GDP, it is not critical. Both of these ideas are silly for a variety of reasons, but two stand out. For a country so dependent on foreign manufactures and resources, to devalue significantly implies an equally significant loss or purchasing power; in other words, a loss of real wealth with all the domestic and international political implications that entails. The second reason is related: the loss of manufacturing jobs and plant closures - in other words, America's deindustrialisation - means that the US has not the capacity in the short to even medium term to redress the problem because it simply does not have anything to sell. This is a significant downside of allowing the economy to become so tilted toward finance. It loses economic flexibility, long deemed to be the strong suit of American economic growth relative to its sclerotic counterparts in Euroland.

One of the striking features of this issue is the breadth and depth of the problem across all sectors of the economy. There are only two trade sectors in which the US is currently running a surplus, and the larger of these, services, is due to move into deficit itself by the end of this quarter present trends. The other, agriculture, fell into deficit in mid year last year for the first time in American history. Although it has since recovered somewhat, the implication is clear, and ominous. Nor is the outlook brighter on a regional basis: the US runs deficits with all significant regions of the world in spite of the overt pursuit of a devaluationist policy, which was supposed to price Euroland exporters out of the global marketplace. So much for vaunted US “flexibility” and “dynamism”.

By contrast, external trade for the eurozone has been a significant stimulus for economic growth, particularly during the first half of 2004. In Q3, the growth contribution from external demand turned negative as imports soared 3.5% quarter on quarter. Since final domestic demand remained weak, GDP growth disappointed. However, monthly trade data suggest that export growth has remained robust in Q4, despite the sharp EUR appreciation. Nominal exports of goods were up 1.1% in October/November versus Q3, whilst robust imports have raised hopes that domestic demand growth may have edged higher, something suggested by Germany’s January IFO survey.

While in Q3 a good part of imports went into inventories, buoyant imports could herald a pickup in domestic demand growth. The fact that, according to the latest European Commission industry survey, firms' assessment of stocks of finished products has remained unchanged in Q4 compared to Q3, together with continuing strength in imports in October and November, tends to suggest that the recent build-up in stocks was not involuntary, but based on expectations of increasing future sales. For instance, the recent strength in imports of capital goods suggests that part of the imports recorded as inventories could in fact be intended for investment. Likewise, the sharp rise in imports of consumption goods raises hopes that private consumption growth could have picked up in Q4. This reinforces the assessment made on the basis of better retail sales. All in all, while the strength of imports in the first two months of last quarter may have reduced hopes of a significant growth contribution from net trade, it could be the reflection of a strengthening in domestic demand, rather than symptomatic of a rapidly strengthening currency snuffing out an incipient economic recovery. This is certainly the perception of the ECB, with chief economist Otmar Issing now conceding that although exports “should increase less strongly than in 2004”, yet domestic demand “gives reasons for hope”.

With this backdrop in mind, the ECB will likely remain on hold for the time being, but the bank has recently reaffirmed its tightening bias. It is a fine call, but for the most part, we believe that Euroland’s “tortoise” policy makers appear to have got the balance right vis a vis the Fed, which tends to be “all hat, no cattle” in regard to its conduct of monetary policy. Instead of embracing the hyper-inflationist “virtues” of America’s electronic printing press, or helicopter money, Euroland’s monetary officials have embraced policies which have sustained household savings, whilst being sufficiently accommodative over the past year to ensure that such savings could be deployed as economic conditions improved in line with easier monetary and fiscal policy. There has been little active official policy encouragement of debt accumulation, as in the US. US consumers have defied past behaviour, and Wall Street therefore believes that household debt doesn’t matter and it can count on the U.S. consumer to just keep on spending. American households have effectively borrowed from tomorrow’s growth, whereas “Old Europeans” have steadfastly refused to buy (or borrow) into this program. The end result might not be the splashy, headline grabbing figures we continue to see trumpeted in the US, but it is ultimately more sustainable because the consumption is predicated on a drawdown of good, old-fashioned savings, rather than fuelled by endless and uncontrollable debt expansion. Sometimes it pays to be conventional and “old fashioned” in economic policy making.

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