Wednesday, July 23, 2008

How to restore European resilience - FT

Game over. After braving a barrage of global headwinds for two years without veering off course, the eurozone economy is now finally running aground. The surge in oil prices by $45 per barrel over the first six months of the year and the further 4.5 per cent spike in the effective euro exchange rate at the same time have gone beyond what the region can bear. Unless oil and currency markets turn around soon, the eurozone may grow hardly at all for the next three quarters. Leading indicators now point south. Adjusted for inflation, narrow M1 money supply is already contracting, signalling a recession risk. Unfortunately, real M1 is one of the best and most forward-looking guides to future growth. Standard business confidence indices have also come off sharply. Fundamentally, the eurozone is still in better shape than either the US or the UK. But while the US is being kept afloat by lax monetary and fiscal policy and an undervalued exchange rate, the eurozone has a modestly restrictive monetary policy, a roughly neutral fiscal stance and a wildly overvalued currency. Both the US and the eurozone are likely to scrape by with semi-stagnation, that is with growth so far below trend that we will need a magnifying glass to see it. But the risk that any additional shock could cause a recession is now as high for the eurozone as it has been for the US for more than a year already. The travails of Spain and Ireland, where real-estate driven booms have turned to Anglo-American style busts, have received a lot of attention. The pair matters. Although they jointly account for just 12 per cent of eurozone gross domestic product, they lifted the growth rate by 0.25 per cent on average over the past nine years. If they both succumb to recession, as they probably will, they could subtract 0.2 per cent from eurozone growth for the next two years instead. But for the main drivers of the downturn, we have to look at the giants, not the minnows. France and Germany have both exhausted their cyclical recovery model. France had relied on buoyant consumer demand, helped by various tax cuts. However, the surge in oil prices has eroded the gains in nominal disposable income. French consumers no longer have the means to spend more. In Germany, the strong euro and weaker demand from within Europe are now crimping export growth. Worse, record oil prices are preventing the rebound in long-depressed private consumption which otherwise would have followed last year’s gains in investment and employment. The biggest domestic risk for the eurozone is a full-blown confrontation between monetary policy and wage policy. Ultimately, workers have to accept that they will have to pay their higher energy and grocery bills themselves. Pretending that they can pass the costs on to their employers via offsetting wage increases or their governments via offsetting petrol tax cuts will only boomerang back on to them with a vengeance as companies lay off workers and governments are forced to raise other taxes or cut spending in response. In the eurozone, the partial wage-indexation mechanisms in countries such as France and Spain as well as the 5 per cent wage increase that Germany granted many public servants in April have sent exactly the wrong signal. For the European Central Bank, 4 per cent inflation and less subdued wage pressure present a huge challenge. But almost two thirds of the rise in the price level can be traced back to higher oil and food prices. To keep headline inflation at its de facto target of 1.9 per cent in the face of such imported inflation, the ECB would have had to push the domestic economy into deflation. Fortunately, it has not done so yet and will not have to do it now. Market forces are already gearing up to beat wage inflation back down again to a sustainable level some time next year. Eurozone unemployment started to rise in April. With a near-stagnant economy, the ranks of the unemployed could swell from a trough of 11.1m this winter to almost 12.5m next summer. This should put the lid back on wage inflation in 2009 without a need for the ECB to nudge the economy closer to recession by further rate increases. Fiscal policy is not in a position to steady the economy directly. France and Italy cannot afford a stimulus programme. Spain has already used up much of the latitude which it had earned in years of prudence. Only Germany, which hit its citizens with a higher value added tax while the economy was coasting on a cyclical high 18 months ago, has some room to cushion the blow. A cut in payroll taxes, which are borne by workers and employers alike, would raise disposable incomes and reduce wage costs at the same time, making this stimulus acceptable to the ECB. By and large, eurozone policymakers cannot do much about the oil and food shock, although a root-and-branch reform of the European Union agricultural policies and a market-opening World Trade Organisation deal would certainly not go amiss. But they could at least try to avoid mistakes such as the rise in the healthcare payroll tax that Germany is planning for 2009. Abolishing wage-indexation mechanisms, or relinking them from oil-driven headlines to the much steadier core measures of inflation, would help. Ideally, policymakers could see the growth pause as a sombre reminder that the eurozone needs further labour market reforms to make it even more resilient against future calamities.

No comments: