Can Europe Take Over?
Sept 20, 2006
Eric Chaney (London)
Who could possibly replace American consumers as the engine of global growth, in case of a pronounced slowdown of the US economy? The short answer, in my view, is that a small decline of the glut of savings in the rest of the world would be more than sufficient to keep the global economy rolling. There is a caveat, however: rebalancing growth cannot work without the euro area. As for the latter, I find it hard to be optimistic for next year, but see some really encouraging signs that old Europe should be able to take the baton later on.
The euro area generates 20% of global savings
Global savings amount to roughly 10.5 trillion dollars, or 22.5% of global GDP, according to IMF estimates for this year. This includes savings by households and companies and is net of government shortfalls. The two main Anglo-Saxon economies, the US and the UK, where consumers are the most likely to become more thrifty in the coming years, are holding 21% of global savings versus 20% for the euro area, 17% for developing Asia and 11% for Japan. These numbers tell us two things. First, a large rise in the savings rate in slowing Anglo-Saxon economies could easily be offset by a small decline in the rest of the world: Four out of five dollars of global savings are generated outside of the US and UK. Second, euro area savings account for 25% of the rest of the world’s piggy bank, roughly as much as the savings held by China and Japan together and significantly more than developing Asia. If the US is out of the picture, the engine of the global economy will not have enough cylinders firing if ‘old Europe’ does not do its bit, in my view.
A growth-neutral rebalancing simulation
To illustrate my first point, let’s assume that in the US and the UK, the national savings rate (currently 14.1% in both countries) rose by three points (i.e., by 3% of their GDP) over the next three years, as a consequence of higher interest rates, to pick just one among many factors that should favour savings over consumption. Other things being equal, this would cut global demand and thus global GDP by 1%. Given the relative size of savings and of GDP, a 1.5 point decline in the savings rate of the rest of the world would leave aggregate savings unchanged and, consequently, would neutralise the dampening effect of rising savings in the US and UK. Which regions could take on their savings? The most promising candidates, in my view, are developing Asia (national savings rate: 39.2% of GDP), Japan (26.9%) and the euro area (21.1%). The very high savings rate of developing Asia is primarily explained by the rapid pace of capital accumulation this region needs to sustain, in order to fight poverty successfully, and secondly by the lack of social protection that leads wage earners to save excessively. In mature economies such as Japan and the euro area, national savings rates are probably supra-optimal for different reasons, such as unsustainable pension systems or excessive regulation bridling inland corporate investment. For these reasons, our scenario assumes that, as savings decline by 3% of GDP in the US and the UK, the euro area’s and Japan’s savings rates drop by 2.0% of GDP, versus only 1.3% in developing Asia and 1.0% in the rest of world (including oil exporters). Don’t get me wrong: this scenario does not seek to be a fully fledged realistic macro simulation. In particular, it voluntarily ignores second round and financial effects. However, it conveys a simple message: offsetting a 3% of GDP rise in the US and UK savings — taken alone, this would be a major blow for the global economy — would just require a relatively small decline in the rest of the world’s savings.
Don’t count on Euroland’s contribution in 2007
So will the euro area contribution to global rebalancing be commensurate with its abundant savings? Judging by its recent GDP performance, 2.6% annualised growth on average over the last four quarters, one is tempted to answer positively, all the more so given that growth was almost exclusively fuelled by final domestic demand (2.5% over the last four quarters). Unfortunately, the outlook is not as rosy as in the recent past. For starters, Germany and Italy, two of the largest euro area economies, have decided to cut their budget deficits next year, whatever happens. Even if Italy implemented only half of the announced spending cuts, a synchronised fiscal tightening in these two countries would cost close to half a point of growth next year. Adding up the effects of a stronger euro and rising interest rates, I am afraid that one full point of domestic demand will be missing next year in the euro area.
I hope my short-term pessimism proves to be wrong
Maybe European consumers will take more credit; maybe companies will squeeze profit margins instead of raising prices (not good news for shareholders in that case); maybe the official optimism shown by policymakers will prove justified. Maybe. But this could just be wishful thinking, as has often been the case. Even so, I think it would be a mistake to stop here and conclude that the euro area is condemned to stagnation after a short-lived recovery. I see three reasons for being optimistic about the medium term:
Medium-term positive factor #1: Faster productivity
First, productivity is recovering. According to our tentative calculations (official data are scarce and fragile), hourly productivity accelerated from 1.3% on average in the first six years of EMU to 2.4% in the last six months. Although the jury is still out, I firmly believe that a combination of accelerating corporate restructuring due to globalisation and consistent investment in information technology by European companies is the fundamental reason for the productivity revival in Europe, beyond cyclical developments.
Medium-term positive factor #2: Declining NAIRU
Second, labour market flexibility is improving. The year before EMU started, the unemployment rate was 10%. Last July, it had dropped to 7.8%. A few years ago, most academic studies concluded that, if unemployment dropped below 9%, wage inflation would surge, forcing the central bank to react swiftly in order to nip inflation in the bud. Guess what: wage growth is hardly catching up with energy-fuelled inflation: In June, the hourly labour cost index was up 2.4% from one year ago, while inflation was 2.5%. Since unemployment is falling without generating inflation, the speed limit of the economy is likely to be higher than previously thought.
Medium-term positive factor #3: Reforms
Third, reformers are scoring unexpected successes. Ironically, the most reformist government is the left-wing coalition led by Mr. Prodi in Italy: deregulation of services, large reduction in social security taxes and privatisation of industrial and real estate assets. In France, the two forerunners for next year’s presidential election, Mrs. Royal and Mr. Sarkozy, are more reformist than any of the candidates I have seen since 1986. Those trying to destabilise Mrs. Royal call her Blairite and those trying to derail Mr. Sarkozy call him pro-business. Both may well be right. Once Germany has digested next year’s bitter fiscal pill, I suspect that the largest euro area economy will re-accelerate and, boosted by stronger growth, have a greater appetite for reforms.
In the end, the world economy does not need a permanent US consumer boom to grow. I would go as far as saying that balanced and sustainable growth for the global economy is not compatible with an extravagant US consumer. Provided that the expected rise of national savings in the US and the UK is not excessively rapid, the rest of the world should be able to take over. Because of its weight, 21% of world GDP, the success of global rebalancing will be in the hands of the euro area. While I am confident that Europe will indeed take over in the medium term, I believe that there are some choppy waters to cross next year before we get there.
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Would the Real Business Sentiment Please Stand Up?
Sept 20, 2006
Elga Bartsch (London)
This week’s marked drop in the ZEW business expectations not only moved financial markets, it also caused business cycle watchers to re-examine their hypothesis about the relevance of the indicator and its potential implications for the near-term growth prospects in Germany. This is because the two most widely watched business cycle surveys, the ZEW and the Ifo, continue to diverge. This raises the question of which of the two is likely to send the more reliable signal on future GDP growth. The nature of the surveys — the collective ‘guesstimates’ of some 300 analysts and investors polled by the ZEW versus the assessment of 7,000 companies sampled by the Ifo Institute on how their business is going — makes most economists opt for the latter. Thus far, the main reason to look at the ZEW canvass has been that it comes out earlier than the Ifo business climate and, at least up until now, was closely correlated with the Ifo business climate. However, over the last year, the level of optimism conveyed by ZEW survey has consistently fallen short of the corporate buoyancy witnessed in the Ifo business climate.
Let’s recap how the indices are constructed. Like most sentiment surveys, both polls are based on qualitative information coming from answers to questions as to whether things are improving, staying the same, or deteriorating. The net balance of the share of respondents typically forms the basis of any sentiment survey. This series can then — like the Ifo business climate — be seasonally adjusted and transformed into an index choosing a certain time period as a baseline. Despite the information contained in sentiment surveys being of a qualitative nature, historically the extent to which there is a rise or a decline is seen by a large number of those polled as a good quantitative indicator of GDP growth. An important difference between the two surveys is how their respective headline indices are defined. The headline ZEW number refers to investors’ business expectations for the coming six months. The headline Ifo series, by contrast, is the average of companies’ business expectations and the assessment of current business conditions. In order to compare the two surveys on a like-for-like basis, we have created a ZEW composite index, which aggregates the headline business expectations and the separately reported current conditions into a single number. As for the Ifo sample, this composite ZEW index has a closer relationship to GDP growth than the business expectations component. The forward-looking business expectations sometimes give misleading signals about the business cycle, most recently in 2002 when business expectations initially surged, but when current conditions failed to improve, it corrected sharply.
Here is the catch: Despite a very close relationship with GDP growth historically, the Ifo business climate seems to have decoupled from GDP growth recently for reasons that are still not fully understood. Our conjecture remains that the German corporate sector is in much better shape than the overall economy because it is embracing the opportunities of globalisation more proactively and, thanks to offshoring and outsourcing to Central and Eastern Europe is in a very competitive position. Other potential explanations include that, after an extended period of a very depressed mood, the improvements are perceived to be much larger than they actually are. If this was the case, however, this bias only seems to have befallen the company captains canvassed by the Ifo Institute. Our ZEW composite index does not seem to wildly overestimate current GDP growth. In our mind, the discrepancy likely stems from the fact the companies primarily have their profits in mind when filling in the Ifo questionnaires, while analysts probably take a more macroeconomic perspective. However, analysts are still second-guessing what is going on in the economy.
The sharp drop in ZEW business expectations from -5.6 August to -22.2 in September, its lowest level in almost eight years, remains puzzling. Across the different countries for which the ZEW polls investor expectations, Germany saw the biggest downgrade by far over the last month. While the ZEW Institute stated that the plunge in German business expectations was driven — among other things — by rising concerns about the US economy, US business expectations hardly changed compared to the previous month. As before, a nearly 60% majority of respondents expect the US economy to deteriorate in the coming six months. The other factor cited by the ZEW — the three-point VAT hike — isn’t new news either. And even a VAT hike of this size should only cause a short-lived, albeit sharp slowdown — provided that no other adverse events occur (see The Anatomy of a VAT Hike, September 18, 2006). Historically, VAT hikes haven’t made much of a lasting impression on business sentiment in the run-up to tax rate change. In fact, business expectations start to bounce back several months ahead of the introduction of higher taxes.
Eventually, something has to give. Either we will see the Ifo business climate nose-diving towards the ZEW composite index or the ZEW index rebounding towards the Ifo business climate. Consensus and our own estimate for the upcoming Ifo business climate put the key indicator easing gradually to a reading of 104.2 from 105.0 before, thus remaining well above its long-term average of 95.5. This would be significantly above an estimate based on the ZEW survey, which would hint at a reading as low as 103.3. The last time such as marked discrepancy between the two surveys was observed was during the 1992/93 recession. Back then, the ZEW business expectations, which were all doom and gloom, initially rebounded towards a more robust Ifo business expectations, only for the two series to sink to new lows later on.
[i]Regular readers of our research will know that Will the Real …. Please Stand Up? is a title regularly used by my colleague Richard Berner, Morgan Stanley’s US Chief Economist, to discuss issues regarding various US indicators and the conflicting messages they send. While we are trying to get this series patented — wait for the little TM to pop up anytime soon — I am happily borrowing it.
P.S. I was of course just kidding about the TM.
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