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Thursday, December 6, 2007

Eurozone Blues and ECB Dilemmas

by Edward Hugh: Barcelona

Well Claus is currently up to his eyes in exam preparations, that and recovering from his incredible tour-de-force yesterday, so I will take over the eurozone tiller momentarily, and give a brief lead-in to today's interest rate decision over at the ECB. (Update: since this post was published the ECB have announced - as expected - that they are keeping rates on hold. Euro values are not taking the news well - or perhaps they are taking them too well, depending on your view - since Trichet has said that some board members actually wanted to raise, but for the rest, I think this post stands up fine as is).

So, if it is the eurozone we are talking about, then why not start with Germany? And what better place to start than with German retail sales, which fell fell at the fastest rate in more than three years in November according to the Bloomberg purchasing managers index, which fell to a seasonally adjusted 43.6 from 48.6 in October.

Any reading below 50 on this index indicates contraction, thus retail sales have only managed an increase - as measured by this index - in four months this year. Retail sales across the entire 13-nation euro region also fell in November according to eurostat data released yesterday, dropping by 0.7 per cent from October to a level which is just 0.2 per cent above the November 2006 level. Of course this average hides considerable variance, with the weakest performance coming from Germany, Italy and Belgium.

Also worthy of note is the performance of retail sales in Spain (the zones 4th largest economy) since strong growth in Spain has previously offset weaknesses in Germany and Italy at critical junctures. But this time it will be different, since Spanish retail sales have fallen in both October and November, and while the year on year readings are still in positive territory, they will not remain there for long since the earlier strong readings will eventually drop out of the data.

And since the spring the story in both services and manufacturing has been one of one long and sustained declined, as the data from the monthly Bloomberg/NTC Purchasing Manager Indexes reveal.

Meanwhile the consumer confidence index prepared by the Instituto de Credito Oficial continues to plummet the depths, registering at 76.1 in November a historic low for the third consecutive month.

This drop in confidence is also reflected in the data for new mortgages issued (latest data still only September unfortunately), where the slowdown is clear if you compare the numbers for 2007 with those for 2006 (and especially since the spring, although my feeling is that when we get numbers for October and November we will see the slowdown accelerating, as buildings contracted in 2006 reach competion. Of course we should remember that those buildings and flats sold on the basis of architects plans in June and July - ie prior to the August sub-prime "bust" - will still be giving work until next summer, even if the would be purchasers may be increasingly looking for an "escape clause" as property prices steadily decline).

If we turn to the employment sub-component of the Spanish index we will see that the outlook has changed dramatically in the last three months.

and the underlying situation again becomes clear if we look at the unemployment numbers, where a comparison between 2006 and 2007 is again revealing. We can see that in the early months of this year the employment situation was up over 2006. Then the situation turned (around July), and since then it is "down hill all the way" unfortunately.

Italy is Creaking At the Door

Italy of course isn't in much better state, and Italian retail sales declined for the ninth month this year in November as the bleaker economic outlook continued to damp consumer demand, according to the Bloomberg retail purchasing managers index monthly survey. The reading has been below 50, the level that signals a contraction in sales, every month except January and February. And at 50.6 (January) and 50.4 (February) sales were barely increasing (on a seasonally adjusted basis) even then.

Of course Italy has long been regarded as the "sick man of Europe" so this result is not too surprising. Business confidence is non-too strong either, and the ISAE Italian business confidence index declined in November to the lowest level in almost two years as the euro's gains have continued to acting as a curb on exports. The Isae Institute's business confidence index fell to 92.2 from a revised 92.8 in October, the lowest reading since December 2005.

In addition the Italian services sector purchasing managers index fell to a seasonally adjusted 50.8 in November from 55.3 in October. So Italian services are still ekeing out a small expansion, but they are creaking.

While the Italian manufacturing sector purchasing managers' index remained at a seasonally adjusted 51.3 in November the same level as registered in October. So in both cases, the expansion continues, but only just, which is the same thing as saying that- since the negative exports balance is now a net drain on GDP growth, and government spending should be under a tight rein to bring down the debt - the the Italian economy may now be near to a contraction phase.

German Employment

Returning now to take another look at Germany, what is most curious is how German consumers are reining-in spending and becoming ever more pessimistic even as the jobs market remains reasonably buoyant. Earlier last the week we learnt that German consumer confidence, as measured by the GfK AG's index had fallen to the lowest in almost two years.

Business confidence is not much better, with the IFO index - which managed a very modest recovery this month from last month's low - in very negative sentiment mood (and the ZEW index isn't any better).

Meantime German unemployment declined for a 22nd straight month in November, falling to the lowest level in more than 14 years (using ILO methodology), as companies took on more workers to meet increased demand. The adjusted number of people out of work fell by 53,000, according to the Federal Labor Agency in Nuremberg. The jobless rate, adjusted for seasonal swings, slid to 8.6 percent in November, the lowest since April 1993, from 8.7 percent in October.

In fact the total, unadjusted number of unemployed is the lowest for the month of November since 1992, when it was 2.97 million, according to Labor Minister Olaf Scholz. In addition the number of those employed continues to rise.

Also the number of those paying social security contributions continues its rise:

which is again worthy of note, since for some years the absolute number was falling:

So looking at these numbers, you might wonder what all the pessimism is about. Well the problem basically revolves around why increases in German wages and salaries have, despite this exceedingly positive general situation, remained generally weak.

What is notable about the above chart is the way in which the tightening labour market has not produced any substantial upward pressure on wages. Of course, one version of the story would tell us that this is because the German workers have been behaving like very good boys and girls. But is the more too all of this we might like to ask ourselves, especially since all of this is more or less a repeat performance of what has been happening in Japan.

And of course the weak earnings situation is passed on to consumption, with the consequences we can see in the chart below, which if for the quarterly development of private consumption in Germany since the start of 2005. No economic locomotive to be seen there, I fear. And before you leave the chart do note just one more time that spike in consumption in the last quarter of 2007. That's the VAT effect, you know, the one everyone tried to tell us didn't exist. Well it did, and just look what happened next to German consumption after the 3% hike. Relative prices, like relative exchange rates, do of course matter, and anyone who tries to tell you otherwise missed something in their basic economics course, I think.

Unfortunately one detail we don't have relates to the role of part-time employment in these numbers. I have been looking in detail at the Japan data, and there we do have this breakdown, and it is clear that the growing disconnect whereby we have significant GDP and employment growth by comparatively weak earnings and consumption performance may have something to do with this, and with the skill composition of the work being undertaken. Of course here I would see an age related dimension, but I guess for some that would be quite a tendentious point. Nonetheless we do have data from the recent past about the share of part time employment in total employment in Germany, and as we can see it has been steadily rising.

Be all this as it may, it seems that the path of Jean Claude Trichet will not be blocked, and that our stalwart central bank president - like the ubiquitous Ms Thatcher before him - is not for turning. This gentleman is not going to let himself be brow-beaten by mere fact.

Trichet in fact once more emerged from his un-announced early within-cloister retirement from the high-media-profile stage yesterday to give a talk in Berlin (in preparation, one imagines, for his ECB performance today) where he singled out Finnish nurses and German postal workers for particular criticism, holding they not taking sufficient account of their social responsibilities. What he means is, of course, that inflation is putting the ECB in a very clear double bind when it comes to taking a decision on interest rates.

But wages, as we have seen are not the pricipal issue here, at least in the German case (and the Finnish one is not that much different). The real culprits in the eurozone inflation surge - the last flash estimate from Eurostat put the eurozone average HICP rate at around 3% for November - are energy and food prices, and this inflation has more to do with global structural factors than it ever does with minimum wages in the eurozone (ie it is a result of the fact that the BRIC economies etc are driving the growth, and their rates of energy consumption are rising rapidly, while their population spends a higher part of their rapidly rising income levels on food products - maybe 25% of the extra income - than is the case in the developed economies).

Other explanations for the pessimism to be found in Germany (ie beyond the employment and wages data), of course, abound. Two prime candidates, oil and food price induced inflation and the rising euro tend to head the list. The euro, which rose to a record $1.4967 on Nov. 23 before dropping back slightly, has gained more than 12 percent against the US dollar so far this year and is trading at around $1.4673 as I write. Crude oil rose to a record $99.29 on Nov. 21 and was trading at $89.42 in electronic tradiong on the New York Mercantile Exchange earlier today.

The rising euro may well have an impact on Germany's export performance, while oil prices influence inflation, and through this consumer purchasing power. In fact inflation jumped in Germany in November to 3.3 percent according to the EU harmonised index, and this is the highest level registered in Germany since records began in 1996.

To Cut or Not to Cut?

The European Central Bank, which has raised the benchmark interest rate eight times since the end of 2005 as part of a "normalisation" and anti-inflation process, meets today to decide on interest rate policy . So far the bank has been buying time by arguing we still cannot adequately judge the impact of the financial turbulence spin-off from the U.S. housing slump and in exercising this caution they are almost certainly right. As Claus indicates in this post, there are indeed tough times ahead at the ECB.

And indeed there are. Only yesterday the Italian Vice Minister for the Economy Vincenzo Visco was informing a parliamentary panel that "The economic situation and world markets are very uncertain and present risks. It is expected that the Federal Reserve will cut interest rates and it would be suicide if the ECB didn't do the same thing for the euro zone." And it is not only the politicians this time round, ECB council members Christian Noyer and Jose Manuel Gonzalez-Paramo have been indicating that they are prepared to start talking interest rate reductions in a not very distant future. Noyer is saying that there has to be a "question mark" over whether or not Europe can dodge the fallout from the U.S. sub-prime generated turmoil (and see this post for an examination of the extent of the credit shock in the European banking system), while Gonzelez-Paramo rejected the idea that cutting rates would amount to a bailout of investors who lost money on bad bets. Central banks are not encouraging risk taking if they lower borrowing costs "when financial turbulences develop into a fully fledged crisis and eventually affect growth prospects" he stated at a conference in Milan earlier this week. So while we may well see a stand firm "on hold" posture on rates today, a change in the air cannot be far away now.

Even on the euro front "the times they are a changin", and rapidly rapidly, with even German Finance Minister Peer Steinbrueck - who as recently as Nov. 27 was expressing his confidence that Germany had "become much more resilient to negative economic impetus" and was going through a "robust recovery" is now suggesting that what we have is "a disorderly adjustment and unwinding."

In fact German leaders generally are now expressing a mounting unease over the euro's rise against the dollar and other currencies , and especially as survival warnings from European planemaker Airbus ring through their ears.

And remember, the weaker dollar can help American exporters at a time when the U.S. economy is suffering from a housing slump, trouble in mortgage markets and a going-global credit crunch "Exports are a huge bright spot in the economy ... and a source of strength going forward," Janet Yellen, president of the Federal Reserve Bank of San Francisco, is quoted as having said on Monday. As I argue in this post, the longer term problems in the US economy aren't anything like what they are currently being made out to be.

Of course the euro is now more than 20 percent over its dollar value two years ago and has been hitting record peaks recently against the yen, while China's currency has lost ground to the euro even while it has gained it against the dollar. Yet despite this, the trade-weighted rise in the euro this year has been limited to just 4 percent.

But this is just the point, what we need to ask ourselves is where the exports are currently headed, and what the prospects are in those countries. It is very important to take note of the fact that Germany's strong export performance has been to countries like the UK, and Spain, who may now struggle in the wake of the sub-prime crisis, and to large chunks of Eastern Europe, where some key economies may now be on the point of undergoing a major correction. The fact of the matter is that German exports to the Czech Republic were roughly equal in value last year to German exports to China (and both of them were less than, say, German exports to Poland). That is a good measure of the importance of the Czech Republic for the German economy, but it is also a measure of just how poorly positioned Germany actually is in China, and generally throughout emerging Asia as we move forward. At the end of the day exchange rates do matter, and perhaps the recent visit of EU dignitaries to China (and what they have realised during their visist) has as much to do with Mr Steinbrueck's change of heart as anything.

Postcript: the astute reader will note that out of the eurozone big four - Germany, Italy, Spain and France - there is no real mention of the Frech economy in this post. This is largely becuase, important as it is to the eurozone, Claus and I by and large take the view that the French economy is "Monsieur Average" in eurozone terms. By this we mean that the French economy - despite an ever present need for adaptation and reform - is very far from being the European sick-man some ideologues would make it out to be, just as the US economy - and see this excellent piece from MacroMan - is far from being the global economy sick man another group of ideologues would have us believe (isn't it curious how most of the ideologues like to line themselves up around an axis which goes from France to the United States?). So growth in France will be what? Well guess - average, neither powering the euro economy forward, like Spain has done in the strongest moments of its housing boom, nor acting as a sheet-anchor drag like Italy tends to do in the worst of her downswings. Indeed, given this Monsieur Average quality a good argument could be made that France is the one eurozone economy that has been exposed to more or less appropriate monetary policy and interest rates since the inauguration of the euro. And guess what, interest rates, just like exchange rates, do matter.