The economic outlook for the euro area is deteriorating fast: This week has brought a number of new indicators pointing at a sharp slow-down ahead. Not only are signs mounting that the first countries on the fringe of the euro area such as Ireland and Spain may now be in recession, but there are now also some first indications that Germany, long seen as the most robust economy of the euro area at the moment, is also heading for a significant slowdown.
The Irish business cycle usually does not meet much interest in the rest of Europe. After all, the country with a population about the size of the Berlin area (4.3 million) is just not big enough to influence the business cycle or the interest rate decision of the ECB. But, as we have seen, the small republic still has enough weight to cast EU politics in a disarray. And the recent economic data might help us understand why the Irish have voted “No” in the referendum on the Lisbon Treaty. If we take GDP data from Ireland for real, the country has entered recession already at the end of 2007. EMU which once used to be the biggest boost to the country’s economic performance is now becoming a strait-jacket.
According to data from the Irish Statistical office, GDP contracted by 1.5 percent year-on-year in the first quarter of 2008. While the Irish GDP series is known to be extremely volatile (as is the case for basically all of the small EMU countries), there are signs that the contraction is for real: Unemployment has been on the rise for almost a year now, tax revenue is slumping and the leading economic research institute ESRI now projects a contraction of GDP for the whole year of 2008 of 0.4 percent (see Philip Lane’s post on RGE Monitor).
The Irish story follows the by now well-known script-book for EMU’s rotating slumps: An overheated economy has led to excessive wage increases which have interacted with rising housing prices and a construction boom. Deterioration in international competitiveness then lead to a sharp deterioration of the current account balance. Once the boom comes to an end, growth slumps and the country in question has to struggle to regain competitiveness as domestic demand slows sharply. Usually, this is the moment when also the budget deficit unexpectedly shoots up and hits the ceiling set by the Stability and Growth Pact, taking away all room for expansionary fiscal policy. Given our past experiences, growth will not recover very quickly, but the slump might drag on for several years.
Ireland might not be the only country to experience a recession this year. While the Spanish government is still dismissing the possibility of a recession, all indicators except headline GDP indicate that the country is quickly approaching that state: Survey indicators have hit record lows, unemployment is growing quickly and house prices and construction activity are in free fall.
Unfortunately, the trouble seems no longer be limited to the fringes of the euro area. For a while, a number of economists had hoped that Germany might provide some locomotive function for the rest of EMU, given that industrial production and business climate in Germany had held up very well for a long time. Well, they might have to rethink their position now: As we learned on Friday, manufacturing orders in Germany contracted again in May by 0.9 percent after a 1.7 percent drop in April. The drop has been the sixth in a row, leaving overall orders about 5.5 percent below its peak from last November and only slightly above the level from May 2007.
More important, the driving force behind the fall in orders is a continuous fall of domestic and EMU orders for capital goods, which run now 5.5 percent and a whopping 26.6 percent below their respective peaks. Both German tax policy (see posts here and here in which I predicted this development), a deterioration in financing conditions and the deterioration of the demand outlook for the months ahead seem to be at work here. The investment cycle might hence come to an end or at least weaken substantially. Moreover, orders from outside the euro area took a hit as the strong euro now seems to take its toll on the German economy (see post here and here).
As German growth over the past years has almost exclusively been driven by exports and corporate investment with private consumption remaining almost stagnant, this bodes ill for German economic growth and labour market developments going forward. Second quarter GDP will almost certainly be negative due to technical factors, but the leading indicators now point toward a rather week second half of the year as well. While the large statistical overhang might still leave overall GDP growth above 2 percent for 2008, 2009 will most likely turn out to be very weak again even if Germany. The increase in consumption which could provide a self-sustained upswing even in an environment of a slowing world economy for which a number of economist had hoped has not materialized. At the moment, it is becoming more unlikely to materialize every day with labour market dynamics slowing and high oil prices depressing real wages.
So, prepare for a rough ride of the euro-economy ahead. It is well possible that things deteriorate so quickly that before the end of the year, pressure on the ECB will be mounting to take back the latest interest rate increase and possibly to cut even further – something probably not exactly improving the credibility or the trust in the economic judgement of the still young central bank.
This piece has been co-posted on Eurozone Watch in a series on how to proceed after the Irish No.