July 1, 2008 | posted by Michael Baxter in Eurozone | comments (0) |

Well, we won’t know for sure for several months.  But, according to the latest official data, the Irish economy contracted by 0.2 per cent in the first quarter of this year, and annual rate of growth fell from plus 5.5 per cent to minus 1.5 per cent.

With the Irish housing market collapsing faster than in the UK, construction output fell by almost 9 per cent.

According to Capital Economics: “There are very good reasons to believe that the worst is far from over. After all, the property downturn is still in full swing, with house prices now having fallen in each of the last 15 months. Prices are down by around 12 per cent from their peak and look set to drop considerably further. We have previously estimated that they will fall by 20%, but this is starting to look like a conservative estimate. Needless to say, this points to further sharp falls in construction output and investment.”

Jonathan Loynes, Chief European Economist, said: “All-in-all then, it seems clear that the Irish party is well and truly over and that the hangover is finally kicking in. It now looks like the economy will barely grow at all on average in 2008 and there is a very strong chance of an outright recession.”

June 6, 2008 | posted by Michael Baxter in Eurozone | comments (1) |

Time was when central bankers used to talk in code.  Alan Greenspan once famously said when giving a talk, “If I have made myself clear, you must have misunderstood me.”  On another occasion he said, “I worry incessantly that I might be too clear.”

It is not like that now.  There’s plain speaking Ben at the Fed, but at the European Central Bank, it appears the president should be named “heart on his sleeve Jean”.

This is what Jean-Claude Trichet said yesterday.  “We considered – it is not excluded – that after having carefully examined the situation, we could decide to move our rates [by] a small amount in our next meeting in order to secure the solid anchoring of inflation expectations, taking into account the situation.”

His heart rendering call for help continued;  “I don’t say it’s certain. I say it’s possible,” he said, all wide eyed, and puzzled.

He went on to talk about a “state of heightened alertness.”

So it seems the euro rate will be going up soon.    Capital Economics said, “But the Bank’s inflation phobia clearly increases the risks of a sharp slowdown in the eurozone economy next year, implying that interest rates may eventually have to fall sharply.”

It does mean that at some point during the next 12 months, eurozone and UK interest rates might converge.   At that point, expect the discussion to begin again about whether Britain should join the euro.

We tackled this controversial topic a few days ago, and one of our readers, Mr Morgan, said, “I’m a little baffled when I see commentators (including yourselves) agonising one day about whether the Bank of England should move our rate by 0.25 per cent, and the next recommending that we have a new currency and move rates by 1 per cent (or more). Some consistency would be nice!”

There are many argument against the euro, but the arguments for are as follows:

For the first time in a quite a while the UK and eurozone economies seem to be converging.

Secondly, the pound has fallen sharply.   The high value of the pound has made it difficult for UK manufacturing to stay competitive.    When financial markets finally restore, London will boom again, and the pound may well go back up.   Sometimes, when one sector is much more successful than others, sector problems can occur.  Economists refer to this as the Dutch problem, when oil exports from Holland pushed the guilder so high, Dutch business lost competitiveness.

By joining the euro when the pound is low, we can effectively lock in the benefit of this, and then, moving forward, expand through exporting, rather than through borrowing.
 

June 4, 2008 | posted by Michael Baxter in Eurozone | comments (1) |

The debate over whether Britain should enter the euro has hit the press again.

The FT seems to be at war with itself over the issue. Lex says maybe we should join; Willem Buiter, Professor of Economics, University of Amsterdam and former Professor at Cambridge, argued in the pink’n that, “The case for the UK shedding sterling and adopting the euro has never been clearer.” But Martin Wolf disagreed with his colleagues, saying, “Silliness is abroad in the UK … Lex is wrong. Whether the UK meets arbitrary tests at a particular moment is irrelevant. What is right today may be wrong tomorrow. If a country is to join the eurozone, its people must be willing to cope with the consequences for ever, however unpleasant they may sometimes be.”

Yesterday, Money Week jumped on the bandwagon and rattled off a list of reasons why we shouldn’t join. The main arguments on either side of the debate go like this.

The argument for is straightforward. Tony Blair used to talk about the five tests – about how the UK and eurozone must be in convergence – well, or so goes the argument, that time is now.

The anti argument is straightforward too. If we had joined the euro, the UK economy would be in an awful state right now, therefore we should never join.

Well, whatever your thoughts about the matter, the key arguments expressed against, and explained by Money Week yesterday, are wrong.

Yes, it is true that if the UK had joined the euro a few years ago, the property bubble would have been even more extreme, we would have had an even more unsustainable consumer boom, and inflation would be rocketing. But that isn’t the point.

The reason we didn’t join was that the economies weren’t in alignment. It would have been ridiculous for the UK to have joined any time over the last few years. But that is why we had the tests. The experience of the last few years merely shows the policy of the five tests was right.

But the arguments for joining now are different. The pound is now at its weakest ever point against the euro. Right now, Britain is more competitive relative to other euro economies, and the potential for exporting is greater.

Traditionally, the eurozone interest rate has been a lot lower than in the UK – so if interest rates imposed by the ECB determined rates in the UK, we would suffer from the fatal cocktail of a cheap currency and interest rates that are too low – inflation would be inevitable, cancelling out the benefits of a low conversion rate.

But right now, the euro rate of interest is just 1 percentage point lower than in the UK, and most expect the gap to get even smaller. The UK is a big economy; should we join the euro, the ECB would take into account UK inflation when setting rates, so it is quite possible that next year a eurozone with the UK would have exactly the same interest rate as a UK outside of the eurozone.

If we were to join when the pound is cheap, then the trade benefits of this would be locked in.

Of course, things change. Witness the problems of Italy and Spain to see an example of how the eurozone is flawed in many respects. The euro is also taking over from the dollar in some quarters as a kind of global currency – this means the currency may become far too expensive – just as the dollar was for decades. This won’t help exports.

Economies change; just because the UK and eurozone may be in alignment next year, does not mean they always will be in the future.

But if the UK is to ever join the euro, the right time would be 2009.

Mind you, any government that says that will lose the election. So whatever the economic case, it will never happen.

May 15, 2008 | posted by Michael Baxter in Eurozone | comments (0) |

The brakes are coming on so hard that you can virtually hear the screeching all the way from the South Coast.  The Spanish economy, for so long a superstar of the EU, is skidding to a near halt.

In the second quarter of last year, the economy expanded by a full percentage point. It has grown by more than three percentage points ever year for five years, but now it is ending.

Initial estimates suggest Spain expanded by 0.3 per cent in the first quarter of 2008.   

The Spanish housing market, after thwarting predictions of gloom for so long, is in trouble.    This is especially worrying as Spain’s economic boom has partially been propelled by construction.

Spain is also suffering from the strong euro.     Its current account deficit is massive – around 8 per cent of GDP last year.

But will Spain slow all the way to zero, like Italy appears to be doing, or merely stare recession in the eye, but avoid it?

Capital Economics had this to say: “We expect GDP growth to slow from 3.8 per cent to around 1.7 per cent this year and for activity to weaken further in 2009. What’s more, there is a growing chance that Spain could slip into a recession.”

Mind you, the Baltic states seem to be even worse off.  This is what Capital Economics says about them: “Events of the past week have blown any hopes for a soft landing in the Baltics to pieces. Data released this morning showed that the Estonian economy contracted by a massive 1.9 per cent in the first quarter of this year. Meanwhile, the Latvian economy appears to be shrinking at a similar pace. With inflation set to rise further over the coming months, the region will remain in a tail spin for some time to come.”

Thank goodness for the Germans.

April 4, 2008 | posted by Michael Baxter in Eurozone | comments (0) |

Spain and Ireland are in trouble.        Both have bloated housing markets, they have enjoyed years of rapid growth in GDP, leaving the two economies looking overheated, and they have both been over-reliant on a booming construction sector.    But both countries could be saved from disaster, thanks to one piece of perverse luck.

Neither Spain nor Ireland have especially sophisticated personal finance markets.    According to the IMF, both countries enjoy only limited equity withdrawals.

Take Ireland.  House prices have already fallen by 10 per cent, while Capital Economics has predicted an additional 10 per cent fall this year, but throughout the country’s boom it managed to retain a high savings ratio – around 10 per cent.   This means that the knock on consumer spending may not be as bad as you would have initially thought.

Mind you, despite the low equity withdrawal rates, both countries have high mortgage debt to income ratios.    Ireland is in fifth place and Spain in sixth place in the IMF list of 17 countries.  (Denmark, Netherlands, the UK, Australia and the US have higher debt ratios.)

But the two economies have this Achilles heel: construction.

Until recently, construction accounted for no less than 25 per cent of gains in employment in Ireland over the last decade.  But now there are signs it is going into reverse.    Capital Economics reckons Irish unemployment could rise by 100,000 or so over the next year or two as a result.

Actually, although the Spanish construction industry was vital to its economic growth, the sector is smaller as a percentage of GDP than in Ireland.

Even so, of the 17 major economies the IMF reported on, Spain has the second-most-active construction sector, as a proportion of GDP.

More worrying, the latest composite Purchasing Mangers index for Spain fell to a record low in March.     Even more worrying, it was the services sector that performed particular badly, so that means services are falling just at a time when economists expect the country’s recently buoyant construction sector to skid to a halt.

Mind you, although it expects growth to slow sharply, Capital Economics still reckons Spain will grow by 1.8 per cent this year, and Ireland by 1.5 per cent this year and 2 per cent next.

It does, however, say the risks to its forecasts are on the down side.

March 31, 2008 | posted by Michael Baxter in Eurozone | comments (0) |

What a dilemma.    It seems the Fed made two mistakes.     First, it let the rate of interest fall far too low earlier this decade – fuelling a consumer borrowing boom and a bubble in asset prices.  But, maybe more recently it was too slow to lower interest; as a result, the most recent cuts in rates seem to be having limited effect.  A stitch in time saves nine,  and it appears by lagging behind the curve, the Fed has left itself with lots of rapid stitching, in an apparently vain attempt to fix the threadbare fabric of the US economy.

But now, all eyes turn to the UK and Europe.     Many argue that the Bank of England and European Central Bank need to embark both on rate cuts, and on pumping money into the economy now, and in the process avoid the apparent panic that has become endemic at the Fed.

But inflation in Europe is on the up.

Many think the rate of inflation in the UK could once again move by more than a full percentage point above its inflation target within the next few months, thus promoting another of those embarrassing letters from the Bank’s governor to the chancellor.   In such an environment, how can the Bank of England start lowering rates?

Then this morning, news came in telling us that the CPI rate of inflation in the Eurozone is now 3.5 per cent, up from 3.3 per cent in February.

It now stands at the highest level since March 1992.

It’s a tough one.

If the global economy is set to slow dramatically, then that will presumably mean lower demand, and prices will then fall.  Think ahead, say those itching for rate cuts,  inflation is up simply because of one-off effects.  When they ease out of the system, inflation will fall rapidly – now is the time to allow for this.

But it appears a new school of thought is growing.  This school says first of all that in future, central banks must take into account inflation of asset prices when setting rates.   

Furthermore, goes the argument, the period of low inflation was not caused so much by low demand – which usually requires cuts in interest rates, but was simply down to external factors - one-offs, for example, advances in productivity and cheap imports.   It may be be a mistake to keep rates high now, because inflationary pressures are down to one-offs, but equally it was a mistake to let rates fall so low earlier this decade because low inflation was down to one-offs.

Maybe, then, monetary policy has got it completely wrong.  Rates were cut when demand was already too high.  Now rates are too high, when demand is falling off the edge of a cliff.

It’s all very well of course, but we are being wise after the event.

The conclusion: we now need to stitch this idea into economic thinking going forward, but it may not be that relevant to solving the crisis we are in right now.