In a recent post, Philippe d’Arvisenet suggested that econometric evidence pointed to an increasing convergence of the business cycle over EMU member states. The caveat, however, was that he found a continued divergence of trend growth rates. By contrast, Walter Molano, used quite drastic terms to describe the impending underperformance of EMU’s southern countries and introduced the term PIGS for Portugal, Italy and Spain.
While we would not dispute either of those findings in general for they are published at a time when a) growth divergence as measured by the Commission’s overall economic confidence indicator is at its highest since German reunification and b) even the convergence of European government bond yields, i.e. the factor that is second to only the money market at the very heart of European monetary union. Recently the spread of all 10yr government bond yields relative to the German benchmark has hit the highest level since 1997.
The most likely suspect for these developments is the dreaded asymmetric shock, i.e. an external development that affects economic activity in different EMU members if not in an opposite fashion, so at the very least to very different degrees.
Currently there are three different such shocks affecting EMU:
- The credit crunch: The weaker an economies financing position, the more this one should hurt. A very simple proxy for this measure is an economy’s current account position. Due to this measure Spain, France and Italy should be most negatively affected on this score, Germany least. Another proxy would be the relative prevalence of adjustable rate mortgages in the housing market. Again Spain would be most affected on this scale. In this respect, the differing development of interest rates on (new) mortgage contracts offers some degree of evidence. This has been most pronounced in Spain and France, Italy and Germany (where interest rates have even declined a wee bit since summer 2007) trail by a wide margin.
- The rise in oil prices is draining purchasing power from Europe’s economies which are net-importers of this commodity. The degree of which is determined by both the aggregate level of energy efficiency in the economy and – to a lesser extend – the energy mix used. Germany due to efficiency grounds and France due to its use of nuclear power (for good or bad) are least dependent on oil consumption to produce a unit of real GDP, while Italy and Spain have far worse scores on this account.
- The appreciation of the euro against the USD – however, for now in contrast to 2002 to 2004 not on a very broad basis – should hurt those economies the most with either the highest share of direct trade with the US or a relatively low degree of denominating traded goods in euros. On both counts, Italy should be most negatively affected via the important role of the textile industry for its exports. This sector – while shrinking for years now – is heavily exposed to competition from Asia.
A fourth reason for the current divergence is of a distinct endogenous nature rather than exogenous: tax policy. As one of his first measures Nicolas Sarkozy administered considerable cuts on income tax thus giving the French economy a positive stimulus. Germany had no such positive stimulus but at least the drag from the 2007 tax hike should be subsiding. Relatively clear-cut evidence for this comes from the breakdown of the ifo index. In a nutshell the two components retail and wholesale, each of them making up 14% of the main index, account for the rise of the aggregate since January 2008. By contrast the manufacturing component has been flat since end-07, and the construction component declined somewhat. As all ifo components correlate to year-over-year changes in economic activity and the administered VAT hike created a massive base effect in early-07, the recent rise jump in retail confidence should not come as quite a surprise. In effect, you could as well argue that the main ifo index was artificially depressed by 1.2 points due to the rise in VAT and all that has occurred over the past three months is simply a snap-back from this. This does not qualify Germany’s relative outperformance to the rest of EMU but points to the fact to what extent the German economy has been restrained by fiscal policy in 2007.
Bottom line: On aggregate the EMU economies are slowing but to very different extents as the current shocks affect the economies to varying degrees. Furthermore apparent divergence is furthered by – for the moment – differing degrees of fiscal easing/less restraint.