European economies: a hitch to recovery

Date: 15/11/03

The euro-area economies are reviving at last. But a strong currency may yet set them back again

THE economies of America and Japan have picked up speed recently; now the euro area seems to be following in their wake, albeit more sluggishly. After three consecutive quarters of decline, Germany's GDP rose by 0.9% at an annual rate in the third quarter of the year. France's rose by 1.6%. Growth for the euro area as a whole is likely to have been only slightly higher, well below America's stellar 7.2%.

So far, this has been yet another year of disappointment for Europe. Last December the euro-area economy was widely expected to grow by 1.5% in 2003; the latest estimate from The Economist's poll of forecasters puts it at only 0.4%. In contrast, America and Japan are now forecast to grow by 2.8% and 2.6% respectively, faster than originally expected.

The fourth quarter may produce a stronger performance. Recent business indicators suggest that a bigger rebound is under way; several confidence surveys have surged upwards. J.P. Morgan Chase now forecasts that GDP in the euro area will grow at an annual rate of 3% in the fourth quarter - the fastest for over three years. But that may still lag America.

One popular explanation for the euro economies' relatively poor performance is that companies have been slower to cut costs and repair their finances. Corporate America has certainly moved faster. However, the American economy has also had a helping hand from big interest-rate and tax cuts. The European Central Bank has moved less than the Federal Reserve. And although Germany, France and Italy are all breaching the 3% ceiling on budget deficits set by the EU's stability and growth pact, fiscal policy in the euro area will be slightly contractionary in both 2003 and 2004.

Some economists argue that America's economy has such huge imbalances that its recent rapid growth will prove unsustainable. It certainly looks more precarious than Europe's. America has a current-account deficit of 5% of GDP, whereas the euro area has a surplus. America's budget deficit (including state and local governments) will be close to 6% of GDP this year, twice as big as the average in Europe. American consumers save only 3% of their incomes, and they have debts amounting to 85% of GDP; euro-area households put aside more than 10% of their incomes, and their debts are only 52% of GDP.

These differences suggest that a recovery in the euro area might prove longer-lasting than in America. David Owen, an economist at Dresdner Kleinwort Wasserstein, points out that consumer spending in Europe, unlike America, has stagnated over the past couple of years, leaving big pent-up demand for consumer durables such as cars and electrical goods. Once consumers' confidence picks up, there could be a sharp rise in spending.

Another difference between America and Europe is that, during the slowdown, employment has held up better in the euro area than in America. Critics say this is further evidence of inflexible European labour markets, as it reflects the difficulty firms have in laying off unwanted workers. Yet it may also testify to a newly emerging flexibility, after recent reforms. Deregulation to permit more part-time work and short-term contracts, and tax changes to reduce labour costs, have all made output more job-intensive. So firms have hired more low-paid, low-productivity workers. One short-term cost is slower productivity growth than in America. But in the longer term, as more people enter the labour market, there should be permanent uplift for Europe's economies.

The reforms being painfully pushed through by the Chirac and Schröder governments in France and Germany should improve their countries' longer-term performance. But in the short run, there is also a risk that greater uncertainty caused by cuts in unemployment benefits and more job insecurity may cause households to save more and spend less.

Any analysis of growth in the euro area conceals as much as it reveals: differences within Europe are larger than differences between the euro area and America. In the year to the second quarter, for instance, GDP grew by 4.5% in Greece, but fell by 2.3% in Portugal. Over the past couple of years, growth has been consistently slower in the big three countries, Germany, France and Italy, than in the smaller ones. But even the smaller economies now disappoint. The Netherlands, once a star performer, has seen output fall by more than Germany over the past year. Ireland's growth has slumped to 2.1%, from 7.5% a year ago; Finland's has slowed from 4% to 0.8%.

Spain has remained the fastest-growing of the larger economies, but it is now looking especially vulnerable. Eric Lonergan, an economist at Cazenove, argues that Spain's growth is increasingly based on a housing bubble and excessive borrowing. If house prices falter, spending could slow. And although Spain makes up only 9% of euro-area output, it accounts for more than one-fifth of the growth in consumer spending over the past 12 months.

A bigger threat to the whole of the euro area is a stronger currency. The euro has eased against the dollar recently, but it is still up by 35% over the past two years. America's current-account deficit suggests that the dollar has further to fall. And because most Asian governments are resisting a sharp rise in their currencies, the burden of adjustment could fall on the euro. Economists at Citigroup estimate that a 5% rise in the euro's trade-weighted value reduces euro-area GDP in the following year by up to 0.5%. It would be ironic if Europeans who have hailed their new currency's ability to look the dollar in the eye now find that it clobbers their best chance of catching up with America's star.

The euro-area economies are reviving at last. But a strong currency may yet set them back again.

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