[A-List] Germany to leave eurozone?

["Keaney Michael" <Michael.Keaney@xxxxxx>]

The eurosceptic McRae engages in a little thought experiment, or should
that be called wishful thinking? Far more likely to happen, and what
many would like to see happen, is the scrapping of the stability and
growth pact and the reining in of the ECB, along lines suggested by Mark
earlier.


Hamish McRae: Germany to abandon euroland? It may yet come down to that
The Independent, 12 September 2002

There is a problem with Europe. But we don't know how serious it is and
while we can see in general terms the causes of its difficulties it is
hard to see quite what should be done about them.

The problem is that the recovery in the eurozone has stalled. It is at
the moment still inching forward but there is a serious danger that it
will experience a second leg to the recession. There is a very serious
danger that some parts of the zone, Germany in particular, will slip
back into negative growth. Even if Germany does escape recession it is
unlikely that growth will be fast enough to make any inroads into its
army, 4 million strong, of unemployed. Worse, both France and Italy, the
other two big eurozone economies, show signs of suffering from the
German disease, albeit so far in milder form.

At the moment all the private sector forecasters are downgrading their
expectations for the eurozone this year. The Eurozone Barometer, which
tracks 22 forecasters now comes out with only 0.9 per cent growth this
year, which is pretty dire, though the figure for next year is a more
respectable 2.2 per cent. The problem is partly slow growth in export
demand, as you might expect, but more the lack of domestic demand.
Private consumption is forecast to be up only 0.7 per cent. Add in lower
company investment (which is down) and total domestic demand has gone
negative, as the left-hand graph shows.

It has gone most negative in the largest economy, Germany, the red line
on that graph, but as you can see it is also falling in France, the next
largest.

Why? Well for Germany there is a plausible explanation: interest rates
are too high. There is a rather technical way of calculating the "right"
interest rate developed by an economist called John Taylor. It takes
into account the equilibrium real interest rate, the current inflation
rate, the output gap and the gap between actual inflation and targeted
inflation. It is a useful guide. The economics team at ABN Amro has
calculated the Taylor rule for the eurozone as a whole and for Germany
and compared it with actual eurozone interest rates.

As you can see from the middle graph, actual interest rates (the yellow
line) were too high both for Germany (the red line) and for the eurozone
(the black line) through to 1999. But since then they have been about
right for the eurozone as a whole - but far too high for Germany.

This is a terrible bind because there is nothing the German authorities
can do about it. Worse, it now looks as though Germany has joined the
eurozone at the wrong rate, a rate that is too high for its
competitiveness. Again, short of exiting the eurozone and bringing back
the mark (of which more in a moment) there is nothing the German
authorities can do about it.

If Germany has the wrong monetary policy, it is also hemmed in on fiscal
policy. Tax receipts are plunging and the deficit this year is now
projected by several forecasters to rise above 3 per cent, the official
ceiling (or floor) under the Stability and Growth Pact. The pact ought
to be eased for France will probably breach it too, and Portugal is
already over the top. But Germany, the main architect of the pact, is
determined to stay below the 3 per cent - both parties in the
forthcoming election say so - even though overall borrowing is stable at
about 65 per cent of GDP. So Germany will have too tight a fiscal policy
too.

But the eurozone problem is not just a German one. There is the wider
issue of lack of consumption. Most Europeans, unlike Americans or Brits,
seem to be frightened of spending their money.

I don't think we know why this should be the case. It may have something
to do with the very high levels of unemployment in most of Europe. It
may have something to do with the high tax take on earned income. It may
be the result of the perceived rise in prices since the euro was
introduced. The figures suggest that the rise was actually quite modest
but that is not what people feel, or indeed what British tourists to the
eurozone report back. In Greece there has just been a 24-hour consumer
strike protesting at price increases. And if you are interested in
consumer confidence, what people feel matters more than what the
statisticians claim to be the case.

At any rate there is a factor x, an unexplained element in the mix, that
is actually very disturbing for the economic health of the eurozone.

So what will happen? Structural reforms in Germany, put in place by the
new government, whoever wins, will help a bit. But they will probably be
inadequate for it is difficult for Germany to move without a social
consensus and the electorate is not yet persuaded of the need for
radical reform of the two things that most need doing: labour laws and
pensions. There will be some general uplift in the eurozone next year,
but at the bottom end of the expected range. GFC Economics, a research
group, thinks there is a risk that growth will not accelerate and will
stagnate at about 1 per cent. If that proved the case, it would not be
enough to stop the present rise in unemployment carrying on skywards.

Rising unemployment is hugely expensive for those who remain in jobs:
Germany now spends nearly 2 per cent of GDP on unemployment relief.
Maybe 4 million unemployed is sustainable - though in human terms that
level is deeply disturbing - but suppose it rose to 5 million?

More generally, if the argument above is right, then Germany is going to
experience a decade or more of very slow growth. It may even slip into
deflation, like Japan. What then?

Well it means that the eurozone will in general have very slow growth
because it will be dragged down by its largest member. It is pretty
unhelpful to Britain, for Germany remains our second-largest market for
exports, after the US. We would have to redouble our efforts to
diversify away from the continental European market and try to improve
our trade relations with faster-growing markets elsewhere.

It may be that after five or 10 years of cold turkey, German costs come
down enough to make it more competitive. Couple that with structural
reforms and maybe Germany's technical excellence will enable it to
struggle through. It may be that for the sake of social cohesion, west
German workers will be prepared to see a continued squeeze on their
living standards, just as they have for the past decade to help rebuild
the infrastructure of the former East Germany.

Then there is the unthinkable. It may be that the mathematics will
become unsustainable and Germany will be forced to devalue, readopt the
mark and set interest rates appropriate to its needs.

Until a few weeks ago I had not heard anyone advance this even as a
possibility. Now I have heard it more than once. My instinct is that
this is all 10 years away, maybe longer. It would be very difficult for
there is no mechanism for leaving the eurozone. But the mayhem of past
few years have taught us that the unthinkable sometimes occurs.