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Further Signs of a Slowdown?

2005-09-13T065756Z_01_NOOTR_RTRIDSP_2_OFRBS-FRANCE-PRIX-DETAIL-BS-20050913.jpgJust a couple of days ago I reported on how growth in Eurozone manufacturing was probably slowing down in the fourth quarter of 2006. We are admittedly talking about pretty small flucutations in the indexes but still it does seem as if we are slowing down if only moderately. This time we we are looking at the expansion in service industries and as Bloomberg reports also here did we see a slowdown in Decemeber which consequently might be evidence of furhter slowdown in the 4th quarter relative to the 3rd quarter. Once again the fluctuations in the index are pretty small and remember also that anything over 50 indicates an expansion, but still we are not going up here.

Expansion in European service industries, the biggest part of the economy, unexpectedly slowed in December, a sign economic growth may have peaked.

Royal Bank of Scotland Group Plc said its services index, which gauges growth in industries from telecommunications to banking and is based on a survey of purchasing managers by NTC Economics Ltd., fell to 57.2 from 57.6 in November. A reading above 50 indicates expansion. Economists expected the index to remain unchanged.

Economic growth may moderate from the fastest pace in six years after the European Central Bank raised interest rates and as a cooling global economy crimps European exports. Expansion in the manufacturing industry also lost momentum last month.

We also need to look at the different Eurozone countries and here we can see that Germany is going out of 2006 with good pace relative to the other Eurozone countries.

While service-industry growth slowed in Italy and France, it accelerated in Germany, Europe's largest economy, today's report showed.

``The strength of the reading in Germany suggests that the euro-zone economy is in very good shape,'' said Guillaume Menuet, an economist at Merrill Lynch International in London. ``It's very unlikely that we'll experience a significant slowdown this year and that means that interest rates will probably increase.''

All this obviously has investors betting on the Euro as a function of the expection of how the ECB will raise more than the Fed. The question remains though about just how much the infamous fundamentals of a slowing US, a hawkish ECB, and fiscal tightening can be denied.  

Incidentally, the OECD also has a survey out on the Eurozone today which also emphasizes the need for the Eurozone to address its problem ('achilles' heal') of low potential/trend growth. The FT has the important points from the survey ...  

The eurozone economy must reform to address its “Achilles heel” of slow economic growth if it is to capitalise on the benefits of a single currency, the Organisation for Economic Co-Operation and Development said on Thursday.


On current trends, and with an ageing population, growth in per capita output in the euro area would fall from an annual 1.5 per cent to 0.5 per cent per annum in the 2020s, the report warned.

The OECD said: “Extrapolating the low growth of the past decade is bound to produce a bleak outlook for the future. But it highlights the point that member states will need to take further steps to boost labour supply and productivity growth in order to avoid falling further behind.”

Anyone who at this point has the audacity to argue that demographics don't have anything to do with economics clearly need to think twice. Consequently, it is pretty obvious that any talk about trend growth needs to begin with the actual input to the economy in terms of the labour supply and with the current demographic trend in key member states this component is going to negatively affect trend growth all things equal as we go along. On the other hand we should not be fundamentalists and structural reforms in whatever way we might conceptualize these are also welcome in the sense that their absence also affects the potential growth rate. The real pertinent questions however then becomes what in fact trend growth in the Eurozone is or more specifically how much the trend growth rate in fact differs across member countries? And following from this whether it is in fact plausible to speak of one single neutral interest rate for all member state?


Just About Right on the Eurozone ...

2005-09-13T065756Z_01_NOOTR_RTRIDSP_2_OFRBS-FRANCE-PRIX-DETAIL-BS-20050913.jpgIn general terms we need to be happy about economic growth in the Eurozone in 2006, very happy actually. In overall terms, GDP growth will probably come out between 2.5% and 2.8% which is well above the figures of 1.7% and 1.5% of 2004 and 2005 respectively. However, what are we going to see in 2007 then? Economists are of course persistently wrong in their year-to-year analyses but I still think that the analysis/forecast made by Sebastian and Daniella over at the Eurozone Watch (hat tip; Dave Altig) is fairly spot on. I am not talking about the specific numerical forecasts but more about the description of the general dynamics which are going to drive growth in the Eurozone. 

Essentially, what I like most about their analysis in terms of general dynamics are the following ...

  • Will the ECB really be able to raise if the Fed goes south? Many analysts have already predicted this but Sebastian and Daniella are much more careful and rightly so. Remeber that this essentially feeds directly into the de-coupling and re-balancing discussion and how we perceive the Eurozone's ability to shake-off what happens in the US.
  • On the Euro then ... well there is whee problem with the cause and effect here but still I think that the basic analysis is right. Interest differentials matter but as I have been arguing recently there is perhaps a structural barrier here as to how much the ECB can raise as and if the Fed goes south; that is to say a structural barrier to just how much interest differentials will move to cause relative appreciation of the Euro to the Dollar. Once again, the idea of de-coupling and re-balancing is crucial here and we really need to begin with this discussion before going out rambling about how the ECB will raise three or four times in 2007 as the Fed lowers its rate two to three times ... or something.
  • Turning to the idea of reserve diversification we need to understand as also implicitly noted by Sebastian and Daniella that such diversification essentially will be Euro-biased which again means that such dynamics represent grosso modo a proxy for the narrowing and essentially divergence of interest differentials. Yet, once again decoupling is the key here and if a major diversification were to happen the shock would initially hit the US as a severe depreciation of the dollar would spawn inflation but that shock would be immediately transmitted to the Eurozone in terms of strong deflationary pressures and Italy and Portugal would come sliding out of the Eurozone. Even Germany would clearly also be struck by the lightening here. Remember that such a deliberate 'Plaza Agreement' move would perhaps entail a sudden leap to about 1.60 Euros to a Dollar! Ultimately, this kind of scenario then becomes very unlikely I would say. Clearly, the alternative to this happening from one day to another would be a gradual process but it still brings us right back smack into the fundamental question of how long and far such a process can be sustained, not because we don't see the need and reason for the Dollar to fall but essentially because we also need to consider the Euro's ability to take up the slack.
  • I also think that Sebastian and Daniella are right to point to Portugal and Italy and how these two countries most likely will continue to fair well below the Euro growth average. The endogenous effects from fiscal consolidation are important here but also the essentially exogenous effects from a hawkish ECB and an appreciating Euro are likely going to dent growth significantly.

Consequently, I think that Sebastian and Daniella have all the right components in their analysis and now as Dave Altig also notes we will see how it plays out and in terms of growth in the Eurozone also the US situation is of great importance.

I do however have a couple of objections though ...

My first one is on the actual GDP forecast of slightly above 2% in 2007. Numbers are almost impossible to predict of course but still this would be a prediction clearly on the upside I would say, especially given the potential negative effects outlined in Sebastian and Daniella's own analysis. Following from this is also the discourse on Germany which is not clear I think. I mean, Germany is the biggest economy here and much depends on what happens to German exports as the Euro appreciates and the ECB stays hawkish. Especially, the expectation of wage inflation as the German labour market tightens is really something prompting vigilance in Frankfurt. 

In the end we will see as always I guess but as I said in the beginning Sebastian's and Daniella's analysis contains most of the right components and causal links I think.