Among professional forecasters 2007 started on a very interesting note: Could EMU economies grow on uninterrupted from the slowdown in the USA? At least the standard indicators of economic confidence ranging from the EU Commission survey, the PMIs to ifo did suggest so. Furthermore, Germany did seem to have weathered the VAT shock surprisingly well. Another bunch of structural factors also seemed to support the decoupling story such as that EMU as a whole was running an export surplus relative to the Gulf States therefore insulating it from negative oil effects. But what a difference a few months do make: Just in line with the normal lag of six to nine months on US performance, confidence indicators in EMU have started to decline and have emerged from this summer’s financial market turmoil on an even more subdued note than their US peers. The reason for this marked slowdown – seemingly in line with previous experience – could have to do with a number of factors specific to EMU member countries: For example, the state of Spain’s housing market was always quite precarious. Just to give an off the cuff comparison with the US with that respect: At the height of the construction boom in the US housing starts have been sufficient to provide 0.8 % of their population with new housing units. For Spain the corresponding number has been 2 % until recently. France has seen elevated construction activity too. But the underlying theme there is that corporate profitability there has never caught up to what declining interest rate advantage in the convergence process in the run-up to EMU would have demanded (Germany has accomplished this adjustment with a decade of wage restraint). One potential source of this has been the introduction of the 35 hour work week and some relatively strong increases in the minimum wage. Italy’s economic performance suffers on a regular basis whenever the euro appreciates with the main transmission channel here being the textile sector which faces strong competition from Asia that traditionally denominates its produce in USD. In Germany, the consumer still has not recovered from a decade of low wage increases, and the VAT hike at the start of the year seems to have driven the savings rate onto new heights that – at least as of autumn 2007 – seem to be not only of a temporary nature. All this is a relatively unpleasant mix of problems. However, they have most likely been exacerbated by the ECB’s reaction to market turmoil this summer. The US central bank has first taken down the discount rate (to 50 bp above the Fed Funds Target Rate) and than lowered the Fed Funds Rate by 50 bp. It has thus safeguarded that the 3months Libor rate is exactly where it had been before the credit crisis. The ECB, in contrast, has just refrained from the hiking rates further. However, the money market has done much more that all by itself. The 3months Euribor has gone up by some 75 bp since summer, thus tightening monetary conditions to an extent that is equivalent to three full hikes in key rates. To put it bluntly: While US money rates are still roughly at “neutral”, European rates are at levels that are outright tight. So even if it were not for unpleasant problems in EMU economies themselves, the ECB’s policy stance in the face of the market turmoil is contributing to the very likely outcome of disappointing economic growth next year.
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