Friday, September 26, 2008

The Eurozone Is In Recession, But Where Do We Go From Here?

Well, it's official, or at least its as near official as it's going to get at this point: the Eurozone is in its first recession. And how do I know this? Well Frankfurt-based Financial Times European economy correspondent Ralph Atkins told me it was, in this article last Tuesday. Joking aside, this line-judge ruling (we will remember the eurozone doesn't have an official referee with the authority to call recessions like the US NBER) from Ralph is significant, both due to the fact that he is about as plugged-in as it is possible to get - without, that is, electrocuting yourself on all that high voltage cable knocking about over there - to mainsteam ECB thinking over on Kaiserstrasse, and also because he has been one of the most stalwart journalistic defenders of the idea that the German economy was finally - after many years of sub-par growth - "recovering", and indeed was now, finally, in a position to take front spot on the bright and sparkling High Speed Train which was going to pull all that recently "decoupled" European growth out of the station sidings where it had been parked for so many years. Unfortunately none of this was ever really to be, and I think that behind Ralph now folding his position lies another, and much more troubling unfolding, that of a highly export-dependent German economy (as forecast by me, on this blog back in July) in the face of a steady slowdown in all its main customers, one after another. Signs of the times, Johnny, signs of the times.

Falling PMIs

Really the straw which broke the camel's back in this particular cave-in was the latest round of flash eurozone PMI readings. The composite index –which covers services as well as manufacturing – fell from 48.2 in August to 47 this month. Since any reading below 50 indicates contraction it is clear that the rate of contraction accelerated in September, and indeed as Frank Atkins himself points out, this was the steepest contraction rate since the aftermath of the September 11th bombings, and indeed represented the fourth consecutive month in which the index has found itself in contraction territory (and, of course, three of these months actually constitute Q3 2008). And it isn't just the composite index that is showing contraction - both the services and manufacturing components are contracting, with the manufacturing index registering the steepest contraction rate, with a 45.3 reading this month, meaning that the backward march of European industry has gathered speed from the 47.6 August pace. In the meantime European services decline at a more senyorial pace - with the index only dropping to 48.2 from 48.5.

At this point we only have detailed estimates for two of the big four - Germany and France - but it isn't that hard to guess what has been happening in Spain and Italy.

Really the most important single piece of information I think we have on the table is the fact that Germany's manufacturing sector contracted for a second straight month, with the index falling to 48.1 in September from 49.7 in August - this is the weakest showing from German manufacturing since July 2003. Even more preoccupying was the fact that the reading for the volume of new export orders was particularly weak, with the sub component showing the lowest level for eight years. This seems to indicate that we can expect the sector to weaken further in the months to come, and really the explanation for this sudden deterioration in German exports is not that hard to find, it lies in the financial aftermath to all those Russian tanks rushing through the Roki tunnel into South Ossetia recently, as I explain briefly in this post here (more on this below).

The only bright spot was that French services did expand slightly in September it seems, rising to 50.4 from 48.0 in August.

As I say, we don't have detailed data for Spain and Italy, at this point, but if you are feeling in a masochistic mood, then you could try glancing at Italy's August manufacturing PMI chart (see below), where you will be able to see that Italian industry hasn't been in growth territory since last February (and it is hard to see any kind of expansion "break out" in September, especially if you look at the business confidence reading, the best that could realistically be hoped for is a reduction in the rate of contraction):

Or if your stomach hasn't been turned to much by Italy, then you could move on to the Spanish one, where the really notable thing you will find is the "vigour" of the contraction, this is an economic decline with "gusto":

Consumer and Business Confidence

One interesting detail about the data we have been seeing this September is the strange mismatch we are getting between the consumer and business confidence readings. The most recent surveys of consumer confidence in all the eurozone big four countries have been up, albeit from very low levels, seeming to suggest that consumer sentiment is very inflation-perceptions driven, and that the fall back in oil prices has brought almost instantaneous relief across the hearts and minds of eurozone consumers (although not perhaps their wallets, so don't be in too great a hurry to extrapolate this slight uptick in sentiment through to increased end consumption just yet, since there is still the availability of credit to think about):

On the other hand, business confidence continues to decline right across the big four, which simply reinforces my point about not being too eager to translate rising consumer confidence (however long it may last or not last) through to end sales for companies. In fact German business confidence declined to its lowest level since May 2005 in September according to the Munich-based Ifo institute's business climate index, which fell to 92.9 from 94.8 in August. As can be seen in the chart, it isn't exactly falling off a cliff, but it ain't far off.

So Where Do We Go From Here?

Well, as Frank Atkins suggests, a technical recession across the eurozone in quarters 2 and 3 would seem now to be more or less a done deal (that is, we could say that the eurozone recession technically started on 1 April 2008), and the real front-end-of-the-curve argument is, how long will it last? Now according to received wisdom (you know, the Bible as written on Kaiserstrasse and handed down - or perhaps read out at post rate-setting press conferences - to us mere mortals), growth should start to bounce back in the last quarter, and then a full recovery should begin in early 2009. But remember, this argument was brought to you by those who a mere three months ago were busy saying that the German economy was looking as safe as houses (although not, I should hasten to add, US houses, or Spanish ones for that matter) and looking at what has been happening in global financial markets over the last two or three weeks, I have to ask myself whether there is anyone left who can still recite this version of the authorsied psalter and manage to keep a straight face?

It could be that the zone as a collective entity will expand slightly quarter on quarter in the last three months of the year, I think it is far to early to start speculating on this, but what I do think we can say with almost categorical firmness is that growth in all of the big four eurozone economies is likely to remain weak throughout 2009 (and by weak I mean moving up and down around the zero percent mark, although in the Spanish case I think I would go so far as to say that it is quite unlikely that the economy will break zero in any of the four quarters), and that is really as far ahead as I am willing to speculate at this point. That is we may well see a pattern where one quarter of weak expansion is followed by another of weak contraction, as we have been growing accustomed to seeing in the Italian case since mid 2007. In a sense this is what a credit crunch plus excessive inflation means, and the only question is at what level the "barème" should be set. What I really do seem to be unable to find at this stage are any compelling reasons for thinking that we should anticipate any kind of rapid rebound, indeed it is far easier to think of reasons why we shouldn't.

Three key factors come immediately to mind in this context: the price of oil, the relative value of euro-dollar, and the availability of credit. The first of these three hits consumers directly (and producers indirectly since it becomes that much more difficult to sell), the second (a high euro, which we should expect to some extent to be the by-product of the continuing weakness in the US economy, although exactly where euro-USD will settle is one of the greatest incognitas of the current conjuncture ) hits export-dependent economies hardest (Italy and Germany come immediately to mind, but now arguably Spain has now become an export dependent economy, at least for the duration of its structural move away from construction dependence), while the third (credit availability) will affect the real economy as a whole, by restricting the ability of consumers and corporates alike to borrow, and thus finance acquisitions of one kind or another. Really each of these three merit an article in their own right. In comparison the fourth wild card - interest rate policy at the ECB - seems like rather small beer at the end of the day, and indeed the ability of the ECB to sustain (say) Spain's troubled banking system may constitute a far more important contribution from the bank at this point than a few quarter point reductions in the repo rate, at least in the short term. Of course, it is just this ability to continue to keep the Spanish banks afloat in the mid-term which constitutes another of the big eurozone forward-looking enigmas.

Taking The Eurozone Piece By Piece

One of the biggest obstacles to getting to grips with the economic issues facing the individual member economies of the eurozone is quite simply the inherent tendency to lump what are effectively apples and pears all together in one and the same basket. As as result we tend to hear very little (for example) about specific policy measures designed to handle the almost unique problems now facing the Spanish economy. Hence it is difficult for journalistic observers to understand just why it is that the Spanish banks most definitely do need some kind of special treatment (and indeed far more than they have been getting) from the ECB, or - to take another tack - why the terms of the Stability and Growth Pact Mark II (3% annual deficit limit, 60% debt to GDP maximum), should not be simply applied in blanket fashion, and why France may with some legitimacy say that the 2011 balanced budget target is not as urgent and pressing a matter for them as it is, say, for Italy, and indeed why it may be in the collective interest of the entire zone to go easy on France (and indeed Spain) in this context (more below).

But as I say, what we have here are apples and pears, and what we badly need is some sort of consensus typology of the individual national economies, on the basis of which effective policy could be developed. In each of the big four cases the problem is different, and the sooner we wake up to this the better.


The Italian situation is really most preoccupying, since output seems to have hit some sort of ceiling or other. As I suggest in this post, retail sales may well now have passed their historic peak as the problem of population ageing starts to get a hold, while, as Ugo Bardi points out in this post here, if oil stays over $100 in the longer run, then expansion may well become a thing of the past for Italian industry. Given that - with a debt to GDP level of around 105% - the Italian government now has to systematically reduce spending or risk credit downgrades with all that that would entail in the present climate, then quite simply it is hard to see where any growth at all is going to come from for the Italian economy in the years ahead. As we can see in the chart below, Italian GDP growth has been in trend decline for some time now, and certainly at this point trend growth cannot be much outside the 0% to 0.5% range (and it may even have turned negative in the eventually that oil stay high).

As can be seen in the chart, growth in the Italian economy has now lagged well below the eurozone average for more than a decade and growth is surely set to be the slowest in the euro region this year, even according to the latest European Commission forecast of a positive 0.1% issued on Sept. 10. The Italian employers group Confindustria - whose forecasts have been far and away the most realistic all this year - last week suggested the Italian economy would actually have a whole year contraction of 0.1 percent in 2008. If the prognosis is realised this will be the first annual contraction in the Italian economy in 15 years, and only the third annual recession since WWII (the others were in 1975 and 1993). In fact this is even worse than I was (I thought) pessimistically predicting at the start of this year (see my posts on my Italy blog), and in fact the outlook for next year would seem to be worse not better.

The Italian government has also cut its 2008 economic-growth forecast this week, but they continue to cling on to the hope that the economy may expand, however slightly, revising their outlook to a 0.1 percent increase this year, down from the 0.5 percent predicted on June 24.

The latest forecast was made public in just the same moment as Finance Minister Giulio Tremonti prepared to announce government spending for the proposed 2009 budget (which was submitted this week to the Italian Parliament for approval). Tremonti's three-year spending proposal, which represents an attempt to maintain the objective of balancing the budget by 2011, incorporates 10.4 billion euros ($15.3 billion) in cost cuts and savings for 2009. These saving rise to 17.2 billion euros in 2010 and 31.2 billion euros in 2011 in the hope that Italy will be able to balance the budget by that year. Tremonti has indicated that Italy's fiscal deficit will deteriorate slightly to 2.5 percent of GDP this year from 1.9 percent last year, but has asserted that in 2009, the budget shortfall will drop to 2.1 percent (although this is based on a government forecast of 0.5% GDP growth in 2009 which may well not be achieved).

Clearly this attempt to stay on course for a reduction in the level of Italian government debt is a laudable objective given the risk that any slippage will result in downgrading of Italian sovereign debt by the rating agencies, but it will be a very hard medicine for Italian citizens to swallow, since it will mean that the fiscal stance will be biased towards contraction at just the time when global credit conditions may remain tight and oil may stay over $100 in the mid term, in which case it is hard to see how negative growth in 2008 will not be followed by more of the same in 2009, and ditto in 2010. This at least is the big risk as I see it.


The German economy also suffers from congenitally weak internal demand (as I explain in some considerable detail here) and has thus become entirely dependent on exports, a characteristic which is doubly the case when you take into account that the 2011 balanced budget also means that there is very little in the way of expansionary fiscal support available to the German economy either. Like the Italian economy, the German economy contracted in the second quarter of 2008, but in the German case the q-o-q decline was especially dramatic, as can be seen in the chart below:

This is what it means to be totally export dependent, your headline GDP growth simply is very sensitive to any sudden sharp move in the rate of export growth. This is why most observers have been surprised by the severity of the German downswing, since they have simply not factored-in congenital export dependence (which is related to the age structure of the German population as far as I am concerned). For similar high median-age-related reasons German retail sales also seem to have peaked, in the German case in 2006 (see chart below) while the representatives of the construction industry have looked more like a set of dead men walking (or should I say following Eugen Leviné, dead men on leave) since the bursting of the last construction boom in 1995 . (I think a nice exam question for a 101 course in neo classical economics might be: the German and Spanish economies have had the same monetary policy applied since 2000, with differing outcomes for the respective housing sectors, explain).

As I said above, the final nail in the coffin for the most recent German expansion seems to have been hammered home by those Russian tanks going full throttle though the Roki tunnel, since Russia was really one of the last remaining areas of export expansion for German industry after all the others had steadily fallen down one by one (parodying Oscar Wilde, losing one of your customers might be thought to have been an accident, but losing all of them, one after another....). The big risk, as far as I can see is not simply that Russia ceases to be such an important source of German export demand, but that the slowdown in Russia also impacts on other countries who are close trading partners with Russia, such as the other economies in central and eastern Europe. Should this happen, and there are already signs that it is, then the impact will basically be a second shoe to drop for Germany, via the indirect route, since these countries are also important customers for German exports in their own right (especially the Czech Republic, Poland and Hungary).

German exports to Russia were up by 23 per cent in the first half of 2008 to €15.8bn ($22.5bn), according to the latest data from the German Federal Statistics Office. To put this in perspective, this is roughly 45% of the €36.8 billion euros worth of goods sent to the USA over the same period. It is not so much the volume as the rate of increase or decrease that matters, so while exports to the UK dropped 1.5% in H1 2008, while to the eurozone they were only up 3.9%, these Russian purchases were giving the much needed life blood to German industry.

Spain is Different

As always Spain's case differs from the other members of the "big four". Long the star pupil of the monetary policy classes being offered over in Frankfurt, Spain's stellar growth has now all of a sudden been transformed into its opposite. I have already gone into the background to all of this in two extensive posts on this site (here and here), so I will not burden you, dear reader, with more paraphenalia, beyond saying that Spain appears to be suffering from a systemic banking and financial structure crisis, and that the slowdown in the construction sector and the increase in unemployment is simply a surface reflection of this. This problem needs urgent attention (indeed it is possibly the most urgent item in the ECB in tray at the present time), but for our present purposes what matters is that the eurozone can in no way count on a growth contribution from Spain in 2009, in fact quite the contrary, we are more than likely going to see a Spanish GDP annual contraction, and possibly a quite substantial one.

France: Monsieur Average

Well, while the Spanish economy has long been the ECBs leading pupil, and the Italian one has been more like "l'enfant terrible", France has distinguished itself over the years by being, quite simply, extraordinarily ordinary. French GDP growth has excelled neither on the upside, nor on the downside in recent years, and in that sense France may be thought of as constituting something of a pole of potential stability during the current downturn (if Sarkozy and Trichet can put the knives away that is, and settle their differences in traditional gentlemanly fashion).

To be sure, the French economy needs structural reform, and the French system of public finances does need a huge overhaul, but, if we are more pragmatic than ideological, the fact that France is not under the same structural and demographic pressures to balance its budget by 2011, and the fact that France is running something of a trade deficit at a time when the other three big four economies badly need to export cannot be such a bad thing.

Indeed French President Nicolas Sarkozy's announcement today that he intends to shelve for the time being the deficit-reduction objective in the 2009 budget can be read as a move in that direction. The French budget is based on an economic growth forecast for this year and next of 1 percent, less than half the 2007 pace, and this seems fairly realistic, but it will leave France with less revenue and higher welfare costs than previously anticipated. Sarkozy intends to keep the budget shortfall at 2.7 percent of gross domestic product this year and next, which means that the French government won't be able to balance the budget in 2012, as previously pledged (France had already indicated a delay of one year over the norm). And all I can say is, more power to his elbow, since as I indicated above, I don't see this kind of decision as especially problematic, as long that is as the structural changes which are so necessary to guarantee sustainability in the longer term are implemented at the same time.

More Pragmatics Less Dogma

Well in this post I have attempted to argue a number of things. Firstly, the eurozone is now, in all likelihood, in its first recession. The bride can no longer wear white. But this had to happen one day or another, so it isn't exactly the end of the world. What we do now need to do though is face up to the reality of what is happening, and work to devise the policies which will help move our economies forward.

I am also arguing that this goal requires a recognition of that other reality, the de facto one of the existence of varying typologies across each of the individual big four eurozone economies, together with an acceptance of the inherent strength and weaknesses of each and every one of them, and the abandonment of the idea that they are all converging towards one common "ideal type", which they clearly aren't, except perhaps in that famous longer of longest terms mentioned by Keynes.

This recognition should open the door to the possibility of a rather more flexible policy, giving support where support is needed and not demanding uniformity simply for the sake of uniformity. Of course, I have long found myself being accused of being an idealist, and perhaps the vain hope that we could react flexibly and pragmatically to our common problems is just one more example of my "rotten to the core" idealism. Maybe it is, but I certainly hope not.

Tuesday, September 23, 2008

Happy Families Russian Style

"Happy families are all alike; every unhappy family is unhappy in its own way"

President Dmitry Medvedev’s recent decision to inject $20 billion into Russia’s flagging stock markets – which were down nearly 50% from last May at the time - together with the $60 billion odd dollars of support injected into its groggy banking system served to draw attention to the fact that it wasn't only “over there” on the other side of the Atlantic that the financial turmoil was busy raging. This simple point was further emphasised, if need there was for it, by the fact that both the Russian bourses – the MICEX and the ruble denominated RTS - were only working on a “now you see me now you don't basis” for the best part of a week in mid September. Stealing an idea from Tolstoy’s Anna Karenina, every financial boom is (boringly) the same, but every financial crisis is different in its own special (and intriguing) way. What just happened in Russia merely serves to prove Tolstoy’s point.