Eurozone Economy: When Paradigms Collide

When scientific paradigms collide everyone should duck, at least that is the best advice I can offer at the present moment. The provisional German retail sales for January are now in, and they don’t make especially pleasant reading:

European retail sales dropped for the first time in 10 months in January as spending in Germany slumped, adding to signs economic growth is slowing, the Bloomberg purchasing managers index showed…..German retail sales had the biggest drop in two-and-a-half years, with its index declining to 43.9 from 55.2 in December

Now for those who have been following the German economy in recent months none of this should be particularly surprising, since as is reasonably well known Angela Merkel’s government has just upped VAT from 16% to 19% in an attempt to address the ongoing federal deficit problems. And of course, one months data never offer a complete picture. But this decline in retail consumption in Germany forms part of a much longer ongoing weakness in domestic consumption (and here), one which many were arguing had finally come to an end in 2006. Some of us, however, seriously doubted that this was the case, and hence the initial significance of today’s reading. In particular what we may be faced with are changing structural characteristics of economies as median population ages rise. In particular – and following the well-known life cycle pattern of saving and consumption – more elderly economies may have a higher rate of saving and a lower rate of consumption increase than their younger counterparts.

Some more evidence to back this point of view comes from Japan, where today we learn that household spending in December declined for a 12th straight month, dropping 1.9 percent from a year ago. Yet the Japanese economy is not in recession, and output is actually rising. As Bloomberg say:

Japan’s factory production rose to a record and household spending fell, underscoring the central bank’s concern that growth has bypassed consumers and left the economy dependent on exports.

So please note: growth appears to have by-passed consumers, and the economy is ever more dependent on exports. The same goes for Germany, and this is why I talk about paradigm collision, since the neo-classical theory of economic growth – with its core conception of ‘steady state’ growth – was never built to handle median age related changes in economic performance and structural characteristics. Something new is clearly needed.

Over the coming weeks I will undoubtedly have more to say about all this, as we get to see more of the 2007 Eurozone data, but for now let me point you in the direction of Claus Vistesen, who has been patiently toiling away trying to work through a hypothesis which, in terms of the data we are now seeing, certainly seems more in keeping with current economic realities than the view we currently see emanating from the ECB. His arguments on Japan can be found in depth here, and his latest piece on the eurozone is reproduced below the fold.
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Have Global Interest Rates Peaked?

With the ECB adamant that it will continue to raise rates this would seem to be the most untimely of questions, but there are now signs that this may well be the case.

Firstly this in Bloomberg today:

Federal Reserve to Cut Rates in 2007, Corporate Bond Sales Show

Thinking about refinancing your mortgage in the U.S.? Wait a year. Considering a certificate of deposit? Sign up now. While economists debate whether the Federal Reserve will cut its target interest rate for overnight loans between banks from 5.25 percent, investors have already decided the central bank will reduce borrowing costs next year. Nowhere is that clearer than in the market for floating-rate notes, whose interest payments rise and fall with central bank policy. Sales of so-called floaters are slowing for the first time since the Fed started raising interest rates in June 2004. They’ve fallen to $21.5 billion in September from a monthly average of $35 billion this year through August, according to data compiled by JPMorgan Chase & Co.

Now one swallow doesn’t make a summer, and it is early days yet, but take a look at ten year US Treasury Bonds:

U.S. 10-year Treasuries fell, halting a five-day rally, before a report today forecast to show consumer confidence gained this month.The gains ended on speculation yields at their lowest since March will deter some investors. The yield on the benchmark 10-year note rose 2 basis points, or 0.02 percentage point, to 4.56 percent as of 6:37 a.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 4 7/8 security due August 2016 fell 5/32, or $1.56 per $1,000 face amount, to 102 15/32. Bond yields move inversely to prices.

So today we have nudged the yield back up a little, but the rate has been dropping steadily since March. And yesterday Bloomberg were being even more explicit:
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Is Trichet’s Optimism Justified?

Our next anniversary guest post is from the estimable Mark Thoma.

The Fed and the ECB have different economic outlooks for the U.S. and European economies. For instance, the Financial Times reports:

Fed and ECB diverge on economic outlook, by Chris Giles and Ralph Atkins, Financial Times: The Federal Reserve and the European Central Bank painted contrasting pictures of the US and European economies… Together, the statement by Jean-Claude Trichet, ECB president, and the speech by Mr Bernanke indicated that European interest rates were likely to rise while there was no urgency for further US rate rises.
Mr Bernanke gave an optimistic assessment of the US economy’s ability to continue rapid economic growth without triggering further inflationary pressures. … Across the Atlantic, Mr Trichet announced big upward revisions to the ECB’s inflation forecasts … and called for “strong vigilance” to defend price stability – code words used to signal an interest rate increase in early October. … Mr Trichet’s comments followed the unexpected strength of the eurozone recovery in the second quarter, and ECB fears about the impact on inflation
in 2007… Eurozone consumers’ fears about inflation increased in August to the highest level since the introduction of euro notes and coins in 2002…

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Steinmeier on Belarus

Well, following up the last post on Belarus, it seems that German foreign minister Frank-Walter Steinmeier has mirrored what went on in that Patterson School command post exercise to an eerie degree. In the simulation, apparently, Gerhard Schröder made a fool of himself by lining up with the Russians…and, strange to tell, Steinmeier has done so too, at least in the eyes of Transitions Online’s Belarusoblogger.

Seems he’s arguing for a “measured” approach and more “dialogue” with the Belarus government – or to put it another way, doing nothing. Is it “the natural gas, stupid”? Perhaps. One of the delivery pipelines from Russia to Germany (the Yuma pipeline) passes through Belarus, but German policy seems to be more about bypassing the Central Europeans, and surely (as I blogged regarding the Ukrainian gas crisis) it would be in the EU’s interest to limit the degree to which Russia can disaggregate the customer states.

Deeper than that, I think it’s fair to say that Germany – or to be more accurate, the German foreign policy establishment – has an enduring preference for Moscow. As far back as Willy Brandt, in fact. The Treaty of Moscow in 1970 preceded the Treaty of Warsaw and the Grundlagenvertrag with East Germany, and extensive partnership agreements were signed with Gorbachev as a preliminary (indeed a quid pro quo) to the reunification. Timothy Garton Ash, I think, remarked that “this Germany and all previous Germanies have a special interest in good relations with Moscow”.

This was obviously true regarding Deutschlandpolitik and reunification–the Ostpolitik was a prerequisite of the Deutschlandpolitik. But is it still true now? Clearly the degree of hostility between Germany and Russia is much less, which is all good, but the degree of interdependence is much greater. And the conflicts of interest are hardly less.

One thing the German policy establishment did well in the 1970s, 1980s and 1990s was to synchronise their own policy with that of the EU. It would seem that a tension is emerging.

The Perrenial Euro Story (or lack of it)

Brad Setser has a post, the perrenial dollar story, which IMHO, has one large and significant ommission: it doesn’t really mention the euro. Personally I don’t really see how you can consider the future evolution of the dollar without taking the euro into account. This realisation provoked a rather long comment from me on Brad’s blog, and it is this comment, in a slightly modifed form, that I am now posting here. (Update: incidentally, I notice that Claus Vistessen has two highly relevant summaries of the great greenback debate (here, and here) which. among other things, serve as an excellent introdiction to the issues involved).
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More Pressure on the Yield Curve

One of the things about targeting expectations, and factoring-in changes, is that the world moves on at a very rapid clip these days. So the ECB rate rise in now, really, yesterday’s news. The big issue today is the fact that the easing cycle in the eurozone may already be over (we need to see the data going forward before we can be sure about anything here). Anyway, one thing the markets are sure about is that eurozone interest rates aren’t going anywhere very significant in the near future, and one of the consequences of this is the fact that 10 year German bund yields are on their way down again, as is the euro. (On this I continue to maintain my long held view that the situation is asymmetric: good news from the US, and bad news from the eurozone will send the dollar up, while the opposite will simply see exchange rates marking time. All of this has a floor, of course, somewhere, but I think we are still some distance from touching it). Of course all of this implies that the dangers of yield curve inversion in the US are now real and ever-present.

European bonds may gain for a second week, their first back-to-back set of increases in more than three months, on speculation any interest-rate increases from the European Central Bank will be limited.

The ECB raised its benchmark rate to 2.25 percent yesterday, the first time it has lifted borrowing costs in five years. ECB President Jean-Claude Trichet said the increase left rates in line with the bank’s goal of containing inflation, sending bond yields to a one-month low.

“There will be no additional rate hike immediately after this one, and the cycle will end at a relatively low level,” said Kornelius Purps, a fixed-income strategist at HVB Group in Munich. “That should be supportive for the bond market.” Economists at HVB forecast one more rate increase of a quarter percentage point next year.

The dollar rose for a second day against the euro on speculation a government report will show the U.S. economy added the most jobs in four months in November.

The U.S. currency also headed for a third week of gains versus the yen on speculation faster growth in the world’s largest economy will prompt the Federal Reserve to raise interest rates faster central banks than in Japan and Europe.

“There are no signs that the economy is slowing down,” said Niels Christensen, a currency strategist at Societe Generale SA in Paris. “Rate expectations in Europe and Japan are no match for the Fed, and so the dollar will keep rising.”

The Most Bizarre Monetary Policy DecisionOf Recent Times?

This was Wolfgang Munchau writing in the Financial Times a week ago:

The pre-announced interest rate rise that the European Central Bank is due to agree this Thursday must rank as one of the most bizarre monetary policy decisions of recent times. The economic recovery in the eurozone remains fragile, as last week’s German confidence indicators have shown. Even the ECB’s own forecast for headline inflation is relatively optimistic, while core inflation remained unchanged at 1.5 per cent in October.”

and he issued a warning:

“It is still not too late to propose ECB reform as part of the next treaty revision. For as long as EU leaders maintain the status quo, they have the central bank they deserve.

Central bank independence seems to be once more ‘a l’ordre du jour’, and the ECB may well live to find to its cost that there is one thing worse than actually playing the game, it’s playing the game and losing. Now why?
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The End of the Dolce Vita?

Are the good times and the good life still going to continue to roll in the Italy of the twenty first century? This is the core question the Economist’s Europe editor John Peet asks in the latest Economist Survey: Italy, Addio, Dolce Vita. As Peet says:

Italy is approaching a crunch. Rather like Venice in the 18th century, it has coasted for too long on the back of its past success. Again like Venice, it has lost many of the economic advantages which underpinned that success. For Venice, it was a near-monopoly on trade with the East that paid for the creation of its beautiful palaces and churches; today’s Italy has benefited hugely from a combination of low-cost labour and a switch of workers away from low-productivity farming (and the south) into manufacturing (mostly in the north). But such good things invariably come to an end.

Italy badly needed a dose of pro-market reforms, liberalisation, privatisation, deregulation and a shake-up of the public administration, all of which Mr Berlusconi had promised. He even pledged to cut taxes. A majority of Italian voters, backed by much of Italian business, were willing to overlook both his legal entanglements and his conflicts of interest and give him a chance to reform the country. But as the next election approaches, very little of what he promised has been delivered, so many of his erstwhile supporters are feeling disillusioned.
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Rational Markets?

The general impact of the French riots is, I feel, being ably covered by others here, what I am curious about is how financial markets reach their opinions. According to headlines in many newspapers, the euro is falling aginst the dollar as a result of what is happening in France (or see here). This may or may not be a good reading of why the euro is dropping, but if it was the explanation, I would say it was a far from rational response.
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More On Exchange Rates and Policy Rate Differentials

Morgan Stanley’s Stephen Len is obviously on the same page as I am about how the rising interest rate differential between Europe and the US is likely to drive short term currency movements:

Policy rate differentials are especially important now for the currency markets, and it pays to focus on central banks these days.

Reason 1. Global monetary paths are diverging, not converging. Among the major economies, only the US has an output gap small enough to support tightening. I doubt either the ECB or BOE will be in a position to tighten rates this year. Many now understand quantitative easing must be terminated by early next year, but no one has proposed actually raising interest rates from zero. Therefore, monetary paths are diverging, with the rest of the world having trouble keeping up with the Fed. This makes the Fed much more important for the USD than in ‘normal’ times.

Reason 2. Global equity portfolios are likely to be out of balance. Since 2003, there have been massive equity flows into Euroland and Japan. Since much of these flows occurred when the USD was still in structural decline, and some of the outflows reflected fears of a USD crash, it makes sense to suspect hedge ratios are quite low on these equity outflows. With the rise in the FFR and resilient dollar, the cost of running these currency exposures is increasingly unjustifiable. The equity market cap-weighted short-term interest rate differential between the US and the major markets is now around 180 bp, and still rising. If the Fed takes the FFR to 5.0% by end-2006, the differential will reach levels last seen in 2000.