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Tuesday, January 30, 2007

The Eurozone - A Structural Assesment

by Claus Vistesen : Copenhagen

2006 was a good year in the Eurozone, there can be no doubt about that. We do not yet have the annualized figures but we are probably hovering around 2.5% growth in GDP which is well above growth rates for 2004 and 2005 which registered 1.4% and 1.5% respectively. As such 2006 will be marked as the year when the Eurozone broke all growth records. Yet, should we be bearish or bullish on the Eurozone going forward? In terms of the general consensus there seems to be no end to the upbeat mood among market commentators and although Q1 of 2007 is likely to put a dampening effect on the optimism the general perception is that fiscal tightening and a process of interest rate normalization at the ECB won't stop the sustainable recovery.

Nevertheless, there is a subtle underlying point to grasp here and, although rarely noted, it reveals itself if you take a closer look at the quarterly GDP figures for 2006. Q1 and Q2 of 2006 saw an impressive expansion of 0.8% and 1% y-o-y respectively. However, as we reached the Q3 growth had slowed considerably to 0.5% a figure which admittedly should be taken with a grain of salt since France apparently in the same period (Q3 2006) recorded a growth rate of 0%. As such, the Q4 figures for the entire zone should be perhaps expected to be a bit over 0.5% if you make the assumption that France will not record a second consecutive quarter of zero growth. Still, the figures indicate with some force that the business cycle had perhaps already turned in the summer of 2006 and if this is the case the question needs to be asked as to why the ECB subsequently became so stubborn in persisting with the continuation of an interest rate normalization process which had become, at least to some extent, pro-cyclical. Another important piece of the puzzle in this regard is to be found by once more reverting back to July 2006 and taking a look at market sentiment at the time, when, partly on the back of the BOJ's ending of ZIRP, it was expected that the three major central banks (the BOJ, ECB and the Fed) would embark on a joint interest rate hike in order to scoop up excess liquidity and normalize rates. Yet, what has happened to this hike process? In Japan the long expected second rate rise keeps on being put off and put off, in the US a housing slump and general slowdown deterred the Fed from making any further increases in the latter part of 2006, whilst in Europe the ECB has solidly stuck to its ground, but now the question arises whether in fact the ECB can continue with this normalization process and indeed, in the interests of prudence, whether in fact it should?

The Eurozone - One Economy?

In the above section I have discussed the general development of the economy in the Eurozone, yet perhaps the most important point about the Eurozone economy is that it comprises 13 different countries. In my opinion this is an important starting point since it essentially outlines how the ECB's endeavors of interest-rate normalization towards a single-interest rate to accommodate all economies are almost bound to cause significant asymmetrical shocks given the important differences which exist at the structural level among these economies. This argument is not new and is often operationalized as the effect on real-exchange rates (see Chart below) which occurs as a result of the transition towards ever tighter monetary cooperation.

real.exchange.rates.eurozone.jpg 1

The divergences in real-exchange rates occur as a result of differences in the domestic inflation rate and varying rates of growth in domestic demand, and those countries experiencing fairly high rates of internal demand growth generally have seen their real exchange rate rise relative to the countries which have been more dependent on leveraging exports in order to grow. In particular Germany - the zone's largest economy - has been enjoying something of a beggar-thy-neighbour relationship with the other Eurozone countries as a result of the notable depreciation of its real-exchange rate since 1990. Germany's export driven growth path is epitomized in the evolution in real GDP between 1999 and 2005 where Germany saw a growth of 1.2% of which two thirds (0.8%) can be attributed to net exports. This is in sharp contrast to, for example, Spain where real GDP growth was 3.6% over the same period, and where an ongoing trade deficit subtracted 1% from a 4.6% growth rate for domestic demand. So there are indeed big imbalances in the Eurozone and they ultimately materialize themselves in important current-account imbalances within the zone, as exemplified by the Germany-Spain comparison, with the former running a whopping surplus and the latter a large deficit. An important additional point here is then to note that the Eurozone hardly can be said to uniformally contribute to either a rebalancing or imbalancing of the global macroeconomic imbalances. Yet, this of course also fundamentally brings into the question the very idea of the Eurozone and the ECB's single-interest rate policy. This is also mirrored in much of the criticism towards the ECB's interest rate policy since while it is clear that Spain (and of course Ireland and Greece) could indeed benefit from a higher interest rate we are left with the problem of what this does to growth in Germany and indeed in Italy? But of course the most interesting question remains; what are the main drivers of these imbalances?

Ageing in Different Tempi

There are indeed many differences between the Eurozone economies but ironically one of the biggest is to be found in something all Euro countries have in common: namely all Eurozone countries are ageing as a result of the double impact of increasing life expectancy and sustained fertility below replacement level (and ineed well below replacement in the case of many countries). One obvious consequence of ageing populations are changing dependency ratios, and indirectly shifting participation rates, and such changes represent a common challenge not only for those within the Eurozone but also across the entire EU27. However, these are merely the stylized facts and the reality is that the process of ageing is taking place at very different rates across the Eurozone countries. Once again, Spain and Germany are illuminating examples since while both countries indeed are ageing, Spain (with a median age of 39.9) unlike Germany, has been able to fuel economic growth partly as a result of a surge in immigration from the late 1990s onwards. Conversly, if we look at Germany, which currently has a median age of 42.6, the migration figures are not very encouraging given the overall trajectory of ageing of the German population. Germany is indeed still experiencing a net increase in its population as a result of net-immigration but the inflows have decreased 22% from 1994 to 2003 and as a result the net-immigration contribution has also decreased significantly on a five year basis measured from the period 1990-1995 and 1995-2000. This last figure is probably biased though as a result of the notable immigration into Germany after re-unification which would then make the 1990-1995 figure stand out. So where I am going with all this? Basically, I have a hypothesis here, and although I would not wish to claim that it can account for the entire story in Eurozone asymmetries, I am convinced that it does constitute one important aspect. Thus I am arguing that at least one of the drivers of Eurozone imbalances is anchored in the divergent demographics of the Eurozone countries. In fact, I don't have any doubt that the fact that Spain is running a relatively large current account deficit and Germany conversely running a large external surplus is to a large extent is driven by the differential demographics. Indeed, looking at Germany in the two graphs below we find evidence of the rapid ageing of Germany's population and given my discouse on Japan we could expect Germany to display some of the same characteristics in terms of being structurally biased towards running a surplus on the external balances as we move along as a function of excess domestic supply over demand.

germany.labourforce.pop.decline.jpg 2

germany.oldage.dependancy.ratio.jpg 3

So if demographics are important here, how might we further show this in relation to the framework outlined above which shows real exchange rate divergences as a result of the difference in transmission mechanism between the single-interest rate regime and the individual country economies. The figure below which plots changes in real exchange rates and domestic demand is illuminating, especially in terms of the Spanish and German case where the former has seen (between 1999-2005) a notable appreciation in its real-exchange rate coupled with an increase in domestic demand whereas the latter displays the opposite trend. It is of course not possible to speak of a clear correlation but given my argument of how demographics affect the growth path of a country the German and Spanish characteristics are in line with theory in the sense that it seems as if an important life cycle component is in play here.

real.exchange rates.domestic demand.jpg 4

Also, if we take the development between real exchange rates and gross exports the same picture reveals itself with for example Germany displaying a decisive growth path where excess domestic supply over demand has kept inflation lower that the Eurozone average. The decline in German domestic demand relative to the Eurozone average could as such be seen as a proxy for the relatively rapid and ongoing process of ageing that is taking place in Germany. In Spain, on the other hand, the real exchange rate appreciation and decline in exports have, as was argued above, been offset by a growth path driven by domestic demand. It is thus my that this increase in domestic demand largely should be ascribed to the favorable immigration influx to Spain from notably Latin America, Africa, and also Eastern Europe (e.g. Romania).

real.exchange rates.gross exports.jpg 5

Circumstantial Evidence?

In conclusion, I am sure that most people would agree with me that all countries in the Eurozone, as indeed in the entire Europe Union 27, face notable challenges with ageing populations and as such underlying the process there is a region-wide structural phenomenon. However, as I have tried to argue, using Spain and Germany as examples, it is way too simple to lump the whole Eurozone together, especially in the light of the global imbalance discussion. The Eurozone countries will not contribute symmetrically to either a rebalancing or further imbalancing and this is indeed one of the main lessons here. However, as I try to argue above, the importance of demographics and the divergent nature of population developments in the Eurozone also have implications for the whole structural fit and governance of the Eurozone as an economic entity. Yours truly is a great fan of the Eurozone and the idea which is behind the creation of a tight monetary cooperation but as an economist and given my belief in the importance of demographics in macroeconomic analysis the Eurozone markup, with its single interest-rate policy and the macroeconomic demands of covergence, quite simply misses the bullseye by a mile in terms of addressing the real differences between the Eurozone countries. As a result, I am genuinely worried that for example Italy with its rapidly ageing population and mounting public debt at some point will have to surrender to the pressure and leave the Eurozone. I am also not very optimistic on the immediate outlook for Germany precisely because the demographic outlook for this country will cause its growth path to be even more biased towards exports and thus foreign demand. In fact, this has already I believe become rather evident with,for example, the recent persistently dissapointing figures on domestic consumer spending. This is also why I am going into 2007 with some concern that the ECB's interest-rate normalization obsession anchored in future inflation expectations and the money supply could have severe consequences for Germany.

In the end however, I realize that my argument hinges on circumstantial evidence. Yet, I do not think it is wholly unreasonable to argue as I am, and crucially I believe that for example the ECB's inability to see the complexity of this will represent an issue as we move along.

References for figures ...

1, 4, and 5 - Bruegel Policy Brief (2006) - The Euro: Only for the Agile. (PDF)

2 and 3 - Deutche Bank Research - The Demographic Challenge. (PDF)