Eurozone Watch

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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The general perception about the relative merits of the US economy on the one hand and the continental European economies on the other hand is simple: The US is a very dynamic economy which has been growing briskly over the past decade while Europe is sclerotic and always lagging behind. While markets in the US are free to allow for a swift process of innovation and growth, overregulation and a large government sector in Europe keeps growth down.

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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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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 top issue of the past weeks has clearly been the turbulences in money, credit and equity markets and the question in how far the problems might spill over to the real economy. With the first sentiment data having been published last week (German ZEW, the Belgian business climate and European PMIs all declined), and market volatitily having receded somewhat, we can draw first preliminary conclusions on the fall-out from the crisis. Assuming that market volatitliy does not get much worse, but declines further over the coming weeks, the following conclusions seem to be well based in the past week’s data:

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Yesterday, statistical offices all over the eurozone published GDP figures for Q2. As had already been harbingered by the Italian GDP figures, growth slowed significantly in the euro-area from 0.7 percent quarter-on-quarter at the beginning of the to only 0.3 percent, the slowest quarterly growth rate since 2004 (see here for Eurostat details).

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We have just published an article in the German weekly DIE ZEIT calling for a reform of European budgetary rules in order to limit the national governments' pro-cyclical fiscal policies.

We start from the observation that fiscal policy once again is turning pro-cyclical in a number of European countries. Germany is cutting corporate taxes and increasing discretionary spending at a moment when the economy is growing with rates close to 3 percent (see our post here). France's new president Nicolas Sarkozy is cutting income taxes for home buyers and overtime payment in a boom, providing an ill-timed boost to the economy (see post here) and the Italian government has just increased their deficit target from 2.3 to 2.5 percent of GDP inspite of strong tax revenues (the money supposedly will go into more social spending).

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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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From outside Italy, it is often hard to understand what is going on in the country. We have thus asked Benedicta Marzinotto from the University of Udine and Chatham House to explain the current economic and political situation to us.

The latest available data for the Italian economy have surprised on the upside. As early as September 2006, the Italian government was expecting 2007 economic growth to pick up by only 1.1% from the previous year. Now the forecast is for this year's national output to rise by 2.3% from 2006 (updated on 8 June 2007). This comes as largely unexpected, not least because Italy is back into political turmoil against the difficulties in passing any piece of legislation when the government majority is as thin as 3 seats ahead of the opposition (in the upper house).

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This is the second part of our Eurozone Watch outlook on 2007. We discuss the impact of major political events in EMU member countries and assess potential developments in EMU economic governance in the next twelve months. Read our outlook on the EMU's economic developments in 2007 here.

Will the French Presidential elections have an impact on EMU economic governance in 2007?  

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