Eurozone Watch

3rd part of our series on the EU after the Irish No to the Lisbon Treaty  

The economic outlook for the euro area is deteriorating fast: This week has brought a number of new indicators pointing at a sharp slow-down ahead. Not only are signs mounting that the first countries on the fringe of the euro area such as Ireland and Spain may now be in recession, but there are now also some first indications that Germany, long seen as the most robust economy of the euro area at the moment, is also heading for a significant slowdown. Negotiations on an new protocol to complement the Lisbon Treaty or on a revised version of the Treaty will hence take place in a difficult economic setting. This could turn out to be particularly problematic for Ireland, which may face a second referendum on the Lisbon Treaty.

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Today, GDP figures for Germany, France and the Euro-area as a whole were published. While the figures by itself might have been distorted by some one-off factors, the underlying divergence in the data is rather frightening. What has for quite a while been one of the top issues on Eurozone Watch is increasingly taken up by bank analysts: The growind divergence within EMU.

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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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While the German government and German economists do not even dare seriously thinking about economic stimulus packages (with some rare exceptions – see Ulrich Fritsche's post), some other European countries are moving quickly ahead.

In most crisis scenarios for European countries with real estate bubbles to burst such as Spain or the Baltics, economists now argue that the downturn will not be overly sharp as these country's governments have ample room to manouvre. In plain English: These economists expect governments to cut taxes or increase expenditure to soften the fallout from the real estate crisis.

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Roughly ten days ago, I discussed the differences in the policy debates concerning fiscal stimulus on both sides of the Atlantic in this blog, stating that there is an enormous intellectual gap between the European and US debates. While US economists are becoming increasingly comfortable with using discretionary fiscal policies to stabilize the economic cycle, German and European economist are still opposing this idea for fundamental ideological reasons. Some readers, including Daniel Gros, have claimed that the divide is mainly a result of a more sound situation in EMU which still seems to be far away from recession.

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One year ago, we forecast on Eurozone Watch the economic developments in the Euro area for 2007 with a surprising accuracy (see our ex-post analysis here ). As promised, we would like to present now our predictions for 2008, with this first post covering economics and a second post over the coming days covering the politics of the euro area.

Will the credit crisis push the Eurozone into a recession in 2008?

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Almost a year ago, in the first days of the then young year 2007, we posted two contributions on Eurozone Watch making five predictions each on the economics and politics of the Eurozone for this. Before we will present our predictions for 2008 in the first days of the next years, it is time to look back and see how we did in 2007.

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This week has seen another number of downward revisions of the growth outlook for the German economy and in consequence for EMU as well. The council of economic advisors ("Sachverständigenrat") is now only forecasting a GDP growth for the German economy of 1.9 percent in 2008, the EU commission cut its forecast yesterday to 2.1 percent.

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Last Thursday, the leading German economic research institutes have published their semi-annual diagnosis of the state of the German economy. Similarly to Michael Burda's post on RGE Monitor, they warn that the Grand Coalition must not fall into a "reform pause". Just like Michael Burda, they credit part of the German turnaround to the Agenda 2010 reforms (never mind that they did not see any significant growth impact from them when they were passed – see this comment by Thomas Fricke at FT Deutschland's website).

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Today, the German tabloid "Bild" ran a story that a number of top German employer federations have written a joint memorandum warning the government of rolling back even parts of the "Agenda 2010" reforms enacted by the Schröder government. According to them, the recent upswing in German can at least partly be credited to these reforms, much as Michael Burda has argued. Any change would thus endanger the recovery.

We have already written a post on Monday in which we question this wisdom, stating that such an interpretation of the origins of the German turnaround is not covered by developments into the German labour market.

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