Eurozone Watch

The global downturn has now hit Europe with its full force. Today, not only PMIs fell across the euro-zone. Also the German ifo-index took a bad hit, experiencing the largest one-month-drop since the recession of 2001. Both the expectations as well as the current conditions index dropped sharply. The expectations component is now not far away from levels seen during the last recessions.

Suddenly, even the German economy does not look as resilient any more as it was long claimed by some observers (see my post here on false complacency concerning the strong euro). Nevertheless, Germany still looks strong compared to the rest of Europe: According to the PMI surveys, the German manufacturing sector is merely stagnating while the sector in most of the rest of Europe already is in recession.

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Next Thursday, the ECB will most likely increase its interest rate by 25 basis points to 4.25 percent. Its president Jean-Claude Trichet has all but pre-announced this move and other members of the governing council have been busy underlining the message over the past weeks. This move could prove to be the most risky move ever done by the ECB – economically as politically.

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Two important political developments in the EMU surfaced on the ECB's tenth anniversary celebrations. Firstly, the EMU's fiscal policy coordination mechanisms are more in flux and under pressure than the EMU institutions would like to have the public believe since the reform of the Stability and Growth Pact. And secondly, the issue of lower than expected economic convergence within the Eurozone is receiving more and more attention: pro-longued business cyclces and cyclical divergence are now longer issues reserved for the macro-economic academic debate but are increasingly picked up by policy makers.

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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 discussion about the origins of the US subprime crisis, the overhelming number of explanations contain one predominant element: According to most economists (be it academic or from the financial sector), the crisis it at least partly the US Fed’s fault. Since the US central bank has kept interest too low for too long a period, banks were forced to invest in more risky assets in order to at least get a return a little above the meagre return on treasuries, according to this interpretation. As a consequence, the banks extended loans to people who in fact where not able to pay back there mortgage. Had the Fed increased interest rates earlier, returns on Treasury bonds would have increased and the bank’s would not have been forced into risky lendings.

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Roughly six weeks ago when the turbulences in the financial markets came to the attention of the general public and the ECB pumped the money market with special overnight tender of roughly € 100 bn, we highly praised the ECB’s reaction. Looking at the ECB now for its latest management of the tensions in the money market, it unfortunately deserves much less praise.

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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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Over the past weeks, the ECB has confused markets in how it will react to the recent market turmoils. When the cut in the discount rate by the US Fed triggered speculations that the ECB might abandon the interest rate hike it had signalled for September 6, European central bankers tried hard to dispel them. On Monday, ECB president Jean-Claude Trichet then finally hinted at a conference in Budapest that the ECB might delay their rate hike after all. If one looks at it from a political economy perspective, an interest hike at the moment would clearly be a very risky decision for the ECB.

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Today, for the second day in a row, the ECB acted as a fire bregade for financial markets. After running a special tender on Thursday and pumping an extra €95 bn of over-night money into the market, it today again provided banks with €61 bn of extra liquidity. [Just to put those figures into perspective: Total euro base money adds up to about €800 bn, of which a little above €400 bn is borrowed by commercial banks from the central bank. The ECB on Thursday thus temporarily added more than 10 percent to the monetary base and almost 25 percent to the borrowed base.]

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