Eurozone Watch

On Eurozone Watch, we have repeatedly written about possible consequences of divergence in EMU business cycles (and possibly connected debates on EMU exit of single countries) and that at some point this might turn up in higher spreads of government bonds. David Milleker, chief economist of Union Investment and regular contributor to Eurozone Watch has now prepared a nice chart on the topic (click on the chart to see it full size).

David writes:

Since late summer 2007 financial markets have been in a state dubbed by the ECB as a “reappraisal of risk”. This has been most pronounced with respect to the credit market but seems now to have reached EMU government bonds as well.

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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 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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Today, I received an e-mail as a reaction to an interview which I had given the left-leaning German daily "taz" last week (see here for the German text). In this interview, I had claimed that the recent actions by the US Fed to calm markets do not create inflationary pressure. My argument was that the US economy will most likely go into recession and banks will not extend their credit portfolios, so aggregate demand will remain weak which will put downward pressure on wages and prices.

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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 reporting – at least in the German press – raised the impression that Monday’s dinner in Hanover between the German chancellor Merkel and French President Sarkozy lead to new peace and love in the German-French couple which has demostrated its very deep divisions recently. How credible is this news?

First of all, contrary to some media’s reporting, it is unlikely, that all disputes over the Mediterranean Union (MU) have been buried over dinner. Given the fierce and public dispute between both sides over fundamental strategic and structural decisions of the new Mediterranean policy France wants to launch, it is simply not credible to assume that the French side totally surrendered to German requests to make the initiative more or less simply a re-launch of the Barcelona process (i.e. the current EU Mediterranean policy within the EU framework).

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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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