Eurozone Watch

Over the past week, the German economy has shown first real signs of an economic slow-down. Data from the labour market has been much less upbeat than before. Yesterday, also manufacturing orders took a hit, pointing to a further growth moderation starting in the second quarter of 2008. The strong euro and the investment backlash from the tax reform enacted on January 1 of this year are finally felt in the economy.

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Next Wednesday, May 7th, the European Commission will put forward a long-awaited report on the Eurozone. A few months ahead of the Euro's 10th anniversary, this report is unlikely to trigger a debate the EMU should go through, given recent developments, such as the increasingly observed cyclical divergence and prolonged business cycles that EMU is experiencing, and the economic tensions that are coming up e.g. for Spain. There is a (very) slight chance that the report is somewhat more ambitious regarding external issues, such as the international representation of the Euro, but it is again improbable that it will tackle the issue of what to do with the external value of the euro (i.e. how to manage relationships with the EMU’s major economic partners, the US, China, the UK, …). But let’s concentrate on the question what there is to expect for the internal aspects of EMU governance for the moment.

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With the euro having jumped above the mark of 1.60 $ for the first time in history, recent macroeconomic data shows that the strong currency is taking its toll on the continental European economy. The advance manufacturing PMI for the euro-area for April published today fell by 1.2 points to 50.8 points and thus is only marginally above the 50-points-mark the fall below which would signal a contraction of the manufacturing sector. This is the lowest level since August 2005.

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The French Finance Minister Christine Lagarde last week announced that Paris would use its Presidency of the European Council starting on July 1, 2008 to push for a common corporate tax base. Despite its looks, this is yet not another brand new initiative by Nicolas Sarkozy - in addition to the other French EU Presidency priorities in the fields of European Security and Defence, Environment/Climate Change, Energy, Immigration and the Union for the Mediterranean.

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Reading today's newspapers, one could get the impression that the 1970s are back in Germany. "9 percent more for the public sector" writes FT Deutschland. Wolfgang Munchau and Susanne Mundschenk in their Eurointelligence news briefing sound similarly gloomy when they title "The second round effect arrived yesterday" and write about a "8% pay rise stretched over two years".

However, looking more in detail into the wage agreement (available in German at the public sector's union's website) shows that these numbers look much more impressive than they are. In fact, if this pay deal were to be applied to the whole economy, unit labour costs would not increase by more than 2 percent (the ECB's inflation target) annually for the period 2008 and 2009.

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On Eurozone Watch, we have repeatedly written about possible consequences of divergence in EMU business cycles (and possibly connected debates on EMU exit of single countries) and that at some point this might turn up in higher spreads of government bonds. David Milleker, chief economist of Union Investment and regular contributor to Eurozone Watch has now prepared a nice chart on the topic (click on the chart to see it full size).

David writes:

Since late summer 2007 financial markets have been in a state dubbed by the ECB as a “reappraisal of risk”. This has been most pronounced with respect to the credit market but seems now to have reached EMU government bonds as well.

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A year ago we published our forecast on Eurozone Watch that after years of decline (see here), unit labour costs in Germany would start to be back on a rising trend after the wage bargaining round in 2007. This forecast has proofed to be almost dead on target. Our model indicated that unit labour costs on a per capita basis would rise by 1.1 % year-over-year in Q4 2007 due to a) a significant tightening in the labour market in the preceding year and b) some of the VAT-induced rise in consumer prices would be passed on to wage increases.

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In the economic policy debate, Germans tend to extrapolate their current situation indiscriminately into the future. When the economy hardly grew at all in 2002 and 2003, German economists and journalists were quick to estimate potential growth to be "below 1 percent". Now, with exports having grown strongly over a number of years, it is argued that the strong euro will not hurt German exporters even at a level of 1.60 $. Unfortunately, the arguments for complacency towards the euro are as dubious as those on the structural inability of the German economy to grow were five years ago.

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Today, I received an e-mail as a reaction to an interview which I had given the left-leaning German daily "taz" last week (see here for the German text). In this interview, I had claimed that the recent actions by the US Fed to calm markets do not create inflationary pressure. My argument was that the US economy will most likely go into recession and banks will not extend their credit portfolios, so aggregate demand will remain weak which will put downward pressure on wages and prices.

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Last weeks' news about the Eurogroup meeting and the ECB Board meeting revealed a clear rift between the political leaderships in the eurozone and the European Central Bank. For the first time since the euro started its race for ever new historical heights, all Finance Ministers of the Eurozone agreed to voice unanimous and strong concern about this development. Previously, at least the German Finance Minister, Peer Steinbrück, had notoriously taken some distance to the others' concerns and had claimed that a strong exchange rate was no problem. Obviously with the euro quickly approaching 1.55 $, the pain is also starting to be felt in Germany. Both the European Industrial Federation and the European Trade Unions voiced similar concerns recently.

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