Eurozone Watch

The current woes in the US housing market have also drawn attention to the situation in Spain. The reason for this is that is not hard to see: There are striking similarities between the two countries with respect to the development in both house prices and construction activity over recent years. The current problems in the US market for Residential Mortgage Backed Securities (RMBS) have also been mirrored – if to a lesser extent – in the market for Spanish Cédulas where spreads have widened since the start of this year. Furthermore stock prices – measured on a total return basis – also seem to be discounting some kind of underperformance of the Spanish economy to come: While Germany's DAX30 has risen by 20 % since the start of 2007 and EuroStoxx50 by 11 %, Spain's IBEX35 has gained a relatively meagre 6 %. The consensus of economic forecasters puts the economic outlook for Spain at a rate of real GDP growth at 3.8 % for 2007 and 3.0 % for 2008. That would be some deceleration but not a lot below the average rate of expansion by 3.4 % per annum for the 2001 to 2006 period.

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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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Sarkozy did not move on fiscal policy – but Germany starts debating a Eurozone summit. This week may, with hindsight, turn out as being a crucial episode in the development of EMU governance.

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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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Tonight, Nicolas Sarkozy will be the first President of a member state ever to attend a Eurogroup meeting. The European press these last days devoted ample space to this unusual event. By the pure announcement of his visit to the EMU finance ministers, Sarkozy has already achieved two things: He again made it into the top news with his very own EU-activism – and he revealed how unprepared the other EMU leaders are to discuss the future of the Eurozone.

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This week, the German government has been debating its budget for 2008. While everyone in the grand coalition seems to be content that finance minister Peer Steinbrück has managed to increase spending, cut taxes and cut the deficit at the same time, there are signs that the government is repeating the mistakes of the red-green government: As I argue in today’s Financial Times Deutschland (full German text here), fiscal policy is turning pro-cyclical once again.

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