When Wim Duisenberg bravely announced that interest rates would fall no further after he shaved 0.5 per cent off rates in early April, one couldn't help but reflect on George Bush's infamous "read my lips" comment on taxes earlier in the decade. The reality facing Duisenberg at that stage in April was that the euro-zone economy was displaying strong signs of still being in the doldrums and a meaningful recovery still looked rather elusive. The big question was how long it would take for growth to stabilise. Regardless of Duisenberg's public utterances, everybody recognised that if the euro-zone economy continued to head in a southward direction, the ECB president would have to sanction further rate cuts and he would be made look as silly as Bush was after he hiked taxes. In the event, Duisenberg has probably been saved the blushes as we are now at last starting to see some signs of economic stabilisation in the economy over which he holds sway and some brave souls are even beginning to contemplate recovery.
The performance of the euro-zone economy over the past year has been a mixed one. States such as the Republic, Spain, Portugal and Finland have enjoyed pretty robust growth. Others such as Belgium, the Netherlands, Austria and France have been growing close to or slightly below their long-term trend, but the two economies that account for nearly half of the eurozone economy, Germany and Italy, have been going through a pretty torrid time. Consequently, most attention has been focused on the two latter countries and interest rate expectations in the markets have hinged on economic data releases from these two. These data releases have in recent weeks started to paint a slightly brighter picture, but one should not in any sense get carried away. The change in sentiment towards the euro-zone economy commenced after the release of first-quarter growth figures in Germany which came in much stronger than expected. While it is possible to put some of the quarterly growth of 0.4 per cent down to statistical aberration, the simple fact is that Germany was spared the embarrassment of two successive quarters of negative growth, which would have counted as a technical recession.
Subsequent data releases for the second quarter have painted a somewhat mixed and confused picture, but overall there is clear evidence that the consumer side of the economy is doing pretty well, while the industrial sector is starting to trend upwards, albeit in a very mild manner. The key indicator to watch in Germany going forward is the influential Ifo survey of business confidence. This survey was pushed on a firm downward trajectory last year due to a combination of Asian and Russian worries, and the arrival of Lafontaine on the scene. With Oskar now gone, and with the global trouble spots starting to look considerably brighter, we have started to see some mild improvement in confidence.
It remains to be seen what impact the Government's recent fiscal plans will have on business sentiment, but the fear is that it will be limited as the corporation tax cuts will not be implemented until 2001, and will be at least partially funded by closing various loopholes and higher energy taxes.
However, it is probably safe to assume that Germany has left the worst of its problems behind and economic growth of at least 1.8 per cent now seems realistic. Italy is a more serious concern, particularly in light of the recent controversy in relation to the Stability and Growth Pact. It is by far the weakest economy in the euro zone, and there are some domestic concerns that it may have locked into the euro at too high an exchange rate. However, historically low long-term interest rates and the depreciation of the euro should enable the economy record growth of 1.5 per cent this year. Difficult times, but not quite recessionary. All in all, the emerging picture in Germany and Italy is looking somewhat brighter and suggests that the relatively upbeat comments from the ECB earlier this week are not off the wall. The recovery signs should be sufficient to convince Duisenberg that he has done enough on the rate front, but any upturn in rates is a long way off. The ECB's July report did point to double-digit growth in private sector credit as something that could warrant a change in its interest rate stance once economic growth starts to accelerate. This looks like typical central bank spoil-the-party-speak, and against a background of virtual price stability and double-digit unemployment the ECB would be ill-advised to contemplate any tightening of interest rate policy for at least the next year. In its May World Economic Outlook the IMF stated that the vast bulk of the euro zone's unemployment is of the structural variety and would be relatively unresponsive to a cyclical economic recovery. Similar comments were made about the Republic a decade ago, but as we now know economic growth has cut the rate by almost two-thirds. Nobody can argue that structural changes in the operation of the Republic's economy and the labour market have contributed in any meaningful way to the fall in unemployment. It has simply been driven down by economic growth.
Concepts such as NAIRU (non-accelerating inflationary rate of unemployment i.e. the rate of unemployment consistent with stable inflation) have been proved quite meaningless over the past decade and the ECB council members should take note. Stronger economic growth might just have a bigger impact on unemployment than current theory suggests it might.
Consequently, European policy makers should encourage the first stirrings of recovery in the euro zone and any mention of tighter monetary policy should be met with the derision it deserves, while the euro should be allowed down through parity against the dollar.
Jim Power is chief economist at Bank of Ireland Treasury
