The euro economy in 2008

in collaboration with Daniela Schwarzer

One year ago, we forecast on Eurozone Watch the economic developments in the Euro area for 2007 with a surprising accuracy (see our ex-post analysis here ). As promised, we would like to present now our predictions for 2008, with this first post covering economics and a second post over the coming days covering the politics of the euro area.

Will the credit crisis push the Eurozone into a recession in 2008?

No. The growth momentum in Europe is still strong enough to withstand even a minor recession in the US and keep overall growth in the positive territory. Job creation is still strong and consumption, investment and exports growing. At the same time, in most countries, companies have solid balance sheets so that they can continue their investments.

That being said, the credit crisis its taking its toll in Europe and European growth performance in 2008 will be significantly worse than in 2007. Overall, GDP growth in EMU will not be more than 2 percent with much of that growth being a statistical overhang from 2007. There is even the possibility that some of the larger euro countries will come close to stagnation in quarter-on-quarter terms and there that single countries will experience a technical recession (defined as two consecutive quarters of a quarter-on-quarter GDP contraction). Italy might see significant weakness as the country will feel the consequences of the past euro appreciations more strongly than others due to the already weakened competitiveness. Germany is set to experience a weak start into 2008 as the changes in the way how companies can depreciate their fixed assets has been changed and this will depress investment despite the sizable cut in the corporate tax rate (see analysis here ). All this is aggravated by the slowing economic growth in the US and Great Britain and the high oil prices which weigh on consumption.

Will the euro appreciation continue with the speed experienced in the past months?

Probably not. While forecasting exchange rates is a very risky business, there are some factors which actually point towards a stabilization of the euro-dollar-exchange rate. First, the mood in financial markets against the US dollar seems to have moderated somewhat. Traders do not seem to convinced anymore that speculating on a further dollar drop is a save bet. Given the fact that the momentum in foreign exchange market is very important for explaining exchange rates in the short run, there is now muss less reason to expect a further depreciation than a year ago.

In addition, we might soon see some improvement in the US current account deficit. With US growth slowing, imports will grow less while exports will be boosted by the depreciation of the dollar (you need to remember that the US dollar has lately even depreciated against the Chinese renminbi).

Moreover, the depreciation of the US dollar has already significantly improved the net foreign asset position of the US: As the US is mainly indebted abroad in US dollars while US citizens and corporations hold plenty of assets denominated in foreign currency, the depreciation we have seen has improved the net foreign asset position and hence the expected income flows which help to narrow the current account deficit.

Finally, with the euro approaching $1.50, the risk for speculators increases that at some point the ECB actually thinks about limited interventions which makes betting on a falling euro much more risky.

Will the ECB increase interest rates in 2008?

No. Even though the ECB has sounded quite hawkish lately, the further loss in growth momentum in the coming months will provide arguments for the doves in the central bank. However, do not expect an interest rate cut anytime soon by the ECB. The ECB has always proved to be very slow and not very decisive when it comes to cutting interest rates in a crisis. As at the moment the monetarists in Europe are gaining ground who claim that the current US subprime crisis shows that it is dangerous to try to use monetary policy to stabilize the business cycle or provide the economy with a strong stimulus in the crisis. Hence, this inclination of the ECB to linger before cutting rates will probably even increase.

Will Spain finally underperform the rest of EMU in 2008?

Not yet. True, Spain is the most vulnerable country of the euro area to the current credit crisis. Not only have real estate prices risen strongly, the corporate sector has also experienced an impressive increase in its debt level over the past years. Private households by now are heavily indebted as well. Moreover, much of the GDP and employment growth recorded over the past years can be ascribed to the construction boom. Add to this the recent downturn in building permits and you have the necessary conditions for an ugly economic downturn.

Moreover, we already see a significant slowdown in the Spanish growth dynamics as is evident by the recent fall of the Spanish manufacturing PMI below the expansion mark of 50 points. In the course of the year, more cracks in the economic performance will appear and chances are that this is the beginning of a long and painful correction.

However, reported GDP growth in 2008 for Spain will still profit from the strong growth momentum (GDP growth in 2007 will most likely turn out to be in the magnitude of 3.8 perecent) and the resulting statistical overhang as well as some robust consumption growth. Thus, while the Spanish economy will clearly take a turn to the worse, we probably will not see the result fully in the annual GDP figures for 2008 yet.

Will the German consumer finally become the growth engine of the euro area?

No. If you look at the standard German growth forecasts, the story is that in 2008, finally the German consumers will open their wallets. The Kiel Institute for example forecasts a real private consumption growth of 2.2 percent, after a small contraction in 2007. This would also provide a boost to the rest of EMU with higher German imports and a slow correction of German undervaluation. In fact, not a single of the German growth forecasts for 2008 which comes to a growth rate of around (or slightly below) 2 percent does so without pencilling in a strong increase in consumption.

We disagree with this assessment. While a consumption growth of 2.2 percent does not sound impressive relative to other countries, for Germany it would in fact be the highest increase since 2000 and a fundamental shift in the behaviour of the German consumer.

While it is plausible that at some point the German consumer will react to better job creation and slightly slower wage growth with increased consumption, the question is whether this strong improvement in 2008 is plausible. Given the VAT increase in 2007, the increase in administered prices and the record-high energy prices, real wages are not really growing yet. Even if you read about some quite substantial wage demands in the British FT, you need to keep in mind that those are first demands, not settlements. Actual wage agreements have been much lower so far. A good guess would be that economy-wide, effective nominal wages will grow by 2.5 percent in 2008, not much above the rate of inflation.

Even if employment continues to grow with a rate of slightly above one percent, we should be happy if we see an increase in real private consumption by 1.5 percent in 2008. Given a slow-down in investment, this would leave us with a GDP growth rate of probably around or slightly above 1.5 percent in calendar-adjusted terms (which would translate into around or slightly above 1.8 percent in unadjusted terms as it is reported by the German statistical office), with consumption growing slower than overall GDP. Exports will again grow faster than imports and external trade will again in net terms contribute to German GDP growth (this again is at odds with the consensus view). The rest of EMU cannot yet rely on Germany as a growth engine for their exports.

By the way: Happy New Year!

7 Responses to "The euro economy in 2008"

  1. Guest   January 2, 2008 at 3:12 pm

    Nice post. In my opinion, since the German consumer and continental European households in general rely less on credit driven consumption, the only way internal demand can pick up is through higher disposable income. Germany is in the best position to jump start internal growth now after years of hourly wage growth below productivity – ULC growth has been negative since 2003. Inflationary second-round effects are thus not an issue. It is certainly worth a try as the stakes in the Eurozone are high.

  2. Ulrich Fritsche
    Ulrich Fritsche   January 3, 2008 at 3:34 am

    Nice post, Whereas I agree on the general tone, I would add some remarks:@ Credit crisis effects. The most important re-percussion might come from third-country effects — an effect, which is usually underestimated in forecasts. Whereas Europe in itself might be seen as crisis-prone to a large extent, Asia and Latin America are not. Therefore it can be reasonable to be more pessimistic in this field.@ Euro appreciation. You should specify if you argue about the US-Dollar/Euro rate or the effective rate and you should specify how the burden sharing looks like. The actual US exchange rate helps to improve the current account but very slowly. Most estimates about the necessary exchange rate adjustment to return to an equilibrium exchange rate suggest a much more dramatic fall in the USD value.@ German consumption: An interesting point about German consumption, given by DIW Berlin into the actual discussion yesterday, is the fact that German consumers do not seem to react to wealth effects. In contrast, traditional Keynesian consumption functions work, that is consumption is a function of disposable income only (bi-variate cointegration holds in the medium run). In turn, that would mean that the chances for a consumption lead locomotive effect are not bad.

  3. Sebastian Dullien   January 3, 2008 at 11:45 am

    Dear Ulrich, thank you for your comments.@German consumption: I would not argue against a Keynesian consumption function for Germany. The question is that disposable income is not increasing enough to get a big push for consumption. The DIW only comes to the conclusion of a significant boost from consumption by predicting that the household saving rate will fall from 10.8 to 10.0 percent – something I do not see any indications for yet.@Exchange Rate: Of course you are right, we should have stated more clearly that we are talking about the bilateral US/euro exchange rate.

  4. Nouriel   January 4, 2008 at 10:33 am

    Given that the US is now headed towards a recession it is not clear how Europe can disentangle and decouple itself from this major shock; also the US financial crisis has already had severe contagion to Europe; so i am much more pessimistic than you are about the European growth prospects for 2008

  5. Sebastian Dullien   January 5, 2008 at 11:24 am

    Nouriel, two things: First, our assessment for GDP growth in EMU is not very optimistic when compared to other economists: We are both in our assessment for EMU as a whole as well as for Germany in fact below the concensus call.You need to keep in mind that an overall growth rate of roughly below two percent means an annualized growth rate in the course of the year of only between 1 and 1.5 percent given the strong statistical overhang from 2007. We believe this is still realistic. While the credit crisis will certainly dampen growth significantly in Spain and the UK and will have some influence on the rest of EMU, there is an underlying domestic dynamic in Europe now which in our view might be able to keep growth in positive territory.For evaluating this forecast you should note that the diverging cycles in EMU usually help to hold the growth rate in positive territory. So, even in the 2001/2002 period, EMU did not experience any quarter with negative growth rates (and thus technically, no recession), but only a series of quarters with very low growth or stagnating GDP, even though Germany and other countries in fact experienced recessions.In addition, I have some doubts on the general perception that Europe is always completely dependent on the US business cycle and needs to follow the US in a recession. In fact, Europe did not experience a recession in 1991 when the US went into recession and not in 2001, but in 1992/3 after its home-made crisis of the European Exchange Rate Mechanism. Moreover, the bust of the New Economy followed by September 11 were global shocks while the current shock originates from the US financial system and thus should hit Europe less than the US.By the way: Compared to the forecast made by major German institutions, the union-financed Institut fuer Makroökonomie and Konjunkturforschung (IMK) comes closest to your assessment of the fallout of the US subprime crisis with forecasting a negative GDP growth for Germany by the end of 2007. Most major institutions are more optimistic than we are: The consensus call for Germany and EMU for 2008 is still above 2 percent. But we will see in one year’s time who has been right…

  6. Detlef Guertler   January 6, 2008 at 4:22 am

    @ Spain:I really don’t know where the “robust consumption growth” in Spain shall come from. The bars are empty, the “reyes magos” brought less presents today than last year, shopping in the christmas season was a rather relaxing experience for buyers and must have been a disaster for the retailers. It seems that Spaniards have just stopped spending in the 2nd half of 2007. I don’t have any idea how they should start again, given their over-indebtedness and real estate markets falling off the cliff (last year in volume, this year in prices). Do you?

  7. Sebastian Dullien   January 6, 2008 at 6:24 am

    @Detlef Guertler:I completely agree that Spanish consumption growth will slow considerably over the coming year given the dire situation in the Spanish real estate market. What we meant by „some robust consumption growth“ is that this will rather be happening gradually and that there still might be some impulse from consumption early in the year (and a significant statistical overhang), so that overall consumption growth in 2008 in Spain will probably still high enough to provide some positive contributions to GDP growth. That being said, the retrenchment of the Spanish consumer will be extremely painful to the Spanish economy. 2008 will only be the start of a long period of sub-trend growth, with more weakness late in the year than at the beginning.And you are right: Retail sales at the end of the year seems to have been weak (which is also reflected in INE’s figures for November). Surveys in the service and retail sector, however, do not yet point to an outright contraction of overall consumption. In Q3 of 2007, consumption still increased at an annualised 1.6 percent. Given that the retail figures are volatile and that usually shifts in consumer sentiment take a while to completely feed through into spending, our call is still that the worst will come rather later in the year than at the beginning and overall Spanish GDP growth still not being significantly below that of the rest of EMU. By 2009, in contrast, we would not be surprised if Spain would be seen as one of the problem cases of EMU. But getting the timing exactly right for developments like this is the hardest thing in making economic forecasts.