Why I don't believe in Goldilocks

 

I never liked that stupid expression – which reflects a tendency among financial economists to stick to tired old metaphors. But even allowing this, a “neither too hot, nor too cold” scenario does not apply to the euro area. The 2001-2004 downturn was definitely too cold, and the 1999-2000 and 2006 upswings were probably too hot. Output growth in the euro area has been fairly volatile. It is high time for an another metaphor.

The economic recovery in the euro area is presently strong, and has been for a year now. But it would be foolish to extrapolate from the current short-term trends. Let's look at the good and bad news respectively. The good news from the euro area is relatively simple to identify. It is the strong Germany recovery, driven by an improvement in competitiveness, but not by economic reforms. While Germany also improved its competitiveness vis-a-vis other European countries, the net effect is positive, as they strongly benefit from German demand. There is also another structural effect at work. Germany has overcome i15 years of economic weakness following unification. We are now back in more normal territory of economic growth rates. The pessimists have in particular underestimated the labour market effect. German trade unions have accepted an unusual degree of pay restraint – but this is not going to last forever, nor is it replicable by others. While I underestimated the short-term effects of the rise in competitiveness, there is no way that cost cutting can constitute a lasting strategy.

And now for the risks. Here are five:

The first is a global slowdown, which could follow from a slowdown in the US economy due to problems in the housing market and subprime mortgage sector. Since the German and euro area economies are highly export-dependent – and since our economic growth model resists almost entirely on export competitiveness – this poses a serious external risks for an economic like ours, with no plan B. The German economy, in particular, is very bad at shifting resources from manufacturing to services, which is what it would need to do if faced with a fall in demand for its export goods.

The second is regional distress, for example in Spain or Ireland, where property price inflation is fast receding, and may turn into a crash – depending on the development of euro interest rates. The recent rate rises have already affected demand for mortgage loans. Since the rate rising cycle continues, the consequences for the Spanish economy could be quite severe – especially if this coincided with problem number one. Spain in particular runs a huge current account deficit, which is a reflection of a lack of competitiveness.

The third risk stems from an overshoot in European interest rates. I am a little more optimistic about interest rates than some of the investment banks, who are now looking for rates of 4.5% by year-end. But if they are right, and if I am wrong, the consequences for the euro area could be quite severe. So far, the rise in interest rates has had no effect on business loans, but these effects will eventually show through. If the ECB is wrong on inflation – its own staff forecasts suggest that it is wrong – than an excessive monetary tightening alone would be able to choke off the present recovery.

Risk number four relates to the euro's exchange rate. See also the interesting simulation exercise by the Peterson Institute. (for a brief review see here), which shows that the euro/dollar rate is likely to appreciate by close to 20% even under a benign scenario. Since a benign scenario is unlikely, much of the adjustment burden will fall on the euro.

The fifth risk stems from a resurgence of pro-cyclical fiscal policies. Italy last year missed its once-in-a-lifetime opportunity to agree to significant structural budget reforms. As we have learned today, Germany faces a gap of up to €50bn by the year 2011. Spending ministries are asking to consume half of the government's windfall tax receipts, which came with the economic upswing. In France, all presidential candidates have made promises that will inevitably blow up the deficit. If and when the downturns comes, Europe will have once again missed an opportunity to get its public finances in order. This also means that fiscal policy will not be able to compensate the next downturn.

If none of the risks materialise, the euro area could continue to grow at above potential rates for another year or two. If one or more the risks materialise, economic growth would fall back again to below potential growth. But even if you like the expression, this is no Goldilocks.

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