Eurozone Watch

Ever since the end of the German coalition negotiation between Christian Democrats and Social Democrats in late 2005, the standard forecast for 2007 has been full of gloom. Following the increase of the standard VAT rate from 16 to 19 percent, most economists had been projecting a sharp slow-down in growth in 2007, if not an outright end of the economic recovery. Deutsche Bank even forecasted an outright fall of GDP in 2007 compared to this year. Papers in Germany were full of articles lamenting “the largest tax increase in history” with commentators claiming that the upswing would be extremely short-lived.

Recently, the attitude towards the VAT hike has changed markedly. A number of important banks have revised up sharply their forecast for Germany for 2007. Citigroup now projects a GDP growth of 1.7 percent, up from 1.1 percent. Morgan Stanley corrected it forecast from 0.7 to 1.5 percent. Yesterday, the OECD revised it forecast for 2007 to 1.8 percent. Moreover, both current GDP details as well as business surveys hint that growth will not take as much of a beating as has been feared: Last week, the Ifo index rose the second consecutive month, with both the sub-index for current conditions as well as for the business outlook increasing sharply. Obviously, the companies do not believe that the VAT increase will derail the economy. This might well turn out to become a self-fulfilling prophecy: With businesses expecting continuing brisk growth in 2007, they will continue to increase capacities and to hire new employees, thus providing disposable incomes to consumers who in turn can continue to shop even when the VAT increases.

Behind this shift in attitude are two reasons: First, the upswing has gained more momentum than many had thought possible. Especially fixed investment, both in machinery and construction, has recovered strongly. According to the KfW, business investment should rise by 7.9 percent this year, roughly the same amount as in the boom year 2000. Since the beginning of the year, in seasonally adjusted terms, more than 300,000 new regular jobs have been created. In Q3, even consumption contributed strongly to growth, with the fall in inventories pointing to strong production going forward.

Second, the grand coalition has relatively stealthily increased the planned cut in social security contribution, offsetting much of the VAT hike. For example, it is now planned that contributions for the unemployment insurance are cut from 6.5 to 4.2 percent in January, more than originally envisioned. While there will still be some 20 bn Euro in net increase in tax and social security contribution burden, the relief will be big enough that government revenue, measured as share of GDP, will roughly remain constant in 2007 according to most current estimates (see here for example the EU commission’s forecast which predicts a marginal increase from 43.5 to 43.6 percent). A “tax shock” as many had dubbed the VAT increase surely looks different.

This puts German budget consolidation into stark contrast with the Italian policy which relies much more heavily on increased revenues that the German consolidation. In Italy, the share of government revenue in GDP is projected to rise from 44.9 to 45.7 percent in 2006, after an increase from 44.0 to 44.9 percent this year (see figure).

The brighter outlook for Germany is not a merely national issue, but has positive consequences for the rest of the eurozone. Just as the German economy has dragged down the rest of the region for a number of years, it now provides a welcome boost at a moment that the US economy is slowing. Due to its brighter outlook for the German economy, Morgan Stanley has also revised upwards its Eurozone forecast (from 1.5 to 2 percent for 2007).

What might be more important, however, is that the German upswing might provide necessary breathing space for countries such as Italy which have lost competitiveness in the past years. Not all of Italy’s slow export performance can be attributed to the country’s poor unit labour cost developments. Much seems to have been a consequence of poor consumption demand at one of its main trading partners, Germany. If now internal demand in Germany is recovering, so should Italy’s exports, making divergences in the Eurozone less of an issue – at least until the recovery in Germany comes to an end.

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