Eurozone Watch

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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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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The past week or so has brought a mixed bag of indicators for the euro-zone with both sceptics and optimists finding bits of their likings. Among the most important positive (and surprising) developments were:

• Business climate actually recovered somewhat in November. Both the German ifo index as well as the French INSEE index recorded increases in November. Manufacturing PMIs for the Eurozone also recorded some slight gains, moving for the whole of the area further away from the 50-points-mark a fall below which would mean an outright contraction of the sector. Companies were even reporting renewed growth momentum in export orders.

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If you read the press these days (see for instance the daily press review on Eurointelligence), the common and right impression is that the Eurozone is suffering a crisis which may deepen further in the coming months. Inflation has risen to 3% in November, the highest level since 2001. Growth in the Eurozone may slow down to 2.2% of GDP next year, according to the latest Commission forecast. Germany and France, the two largest Eurozone economies, both see their growth outlook deteriorate.

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Ten days ago still, the German Finance Minister Peer Steinbrück stood in strong opposition against several of his Eurozone partners: during a meeting of the Eurogroup, some countries had raised strong concerns over the appreciation of the Euro, backed by their industry. The German government took a relaxed position on this matter,  arguing both that the German industry had no export problems due to their succesful efforts to improve productivity, and that the strong Euro also had economic advantages, notably due to the low prices this brought about for imports, e.g. energy.

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For those who were hoping that the euro economy would get through the global credit crisis unscarred, the past week has brought bad news: Survey data in Europe instead point to a significant dent in growth. Now the interesting question is whether the economy will recover quickly or whether the consequences of the credit crisis will linger on.

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With the euro today having finally breached the mark of $1.40 and the Fed having cut its interest rate by 50 basis points, it is now clear that the interest rate hike originally planned by the ECB for September will not be made up for quickly. Instead, there might not be another hike for a long time now.

Until very recently, ECB officials had still publicly insisted that their interest rate hike was merely postponed, but not cancelled. With the changes of the economic environment over the past weeks, there is now little argument left for a rate hike and their is little indication that this will change quickly.

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After the downward revision of the GDP forecast by the OECD roughly ten days ago, we have seen another round of downward revisions this week (much as Eurozone Watch has predicted roughly three weeks ago): The EU commission, Dresdner Kleinwort and the Kiel institute all revised their forecasts down, as well as some smaller banks. By now there is a new consensus that the French economy will not grow by more than 2 percent this year – some bad news for president Nicolas Sarkozy who is still defending his growth projection of 2.25 percent. The German economy is still set to grow by 2.5 percent or a little more and the Italian Economy by roughly 2 percent.

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The mood in Europe is increasingly upbeat. After the economy seems to have easily  weathered the German VAT increase in January, now even the last sceptics seem to have bought the story of a sustained and stable cyclical upswing in the euro-zone. 

When the euro hit an all-time high yesterday (and continued to rise today), business leaders and economists where quick to state that even a level of $ 1.40 would not hurt growth in Europe as the upswing was well engrained and the appreciation only gradual. They also seemed quite relaxed when questioned about the recent price increase of crude oil which is again traded only slightly below $ 80 per barrel. 

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As a reaction of Sebastian's latest post on the euro at a record high, our colleague and occasional co-author Ulrich Fritsche has written down a few thoughts on the reasons for the young currency's strength and possible policy options:

First question: Why did the US-dollar start to depreciate? Might this be part of a necessary adjustment process? The question of correcting global imbalances has been discussed intensively in the last couple of years. Far from reaching consensus on this issue, most experts agree on the following points:

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