Can Europe take over?

Can Europe take over, if the US economy falters? Morgan Stanley's Eric Chaney certainly thinks so:

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. 

Chaney says that with Germany and Italy due to cut their budget deficits next year, we should not count on Euroland’s contribution in 2007.

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. ....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.

I think Chaney is being overly optimistic both about the prospects for global rebalancing, and the likely contribution Europe could make. We have been disappointed so many times about the Eurozone's growth prospects, its hard for me to muster too much enthusiasm for the Chaney scenario. I am also more sceptical than he is about the prospects for reform. Still, it makes a change for a market economist to be so upbeat about Europe's prospects. Food for thought.

Comments

[A. PERLA]

Chaney: "consistent investment in information technology by European companies is the fundamental reason for the productivity revival in Europe, beyond cyclical developments."

I doubt this. I don't think that European companies are investing in all that much IT any longer. European IT companies would be doing a LOT better than they are.

First of all, productivity enhancement of this kind needs to be justified by (1) a response to competitive pricing, (2) a response to heavily increased demand or (3) greenfield site installations of production means.

None of this has been happening. I suspect that productivity is being enhanced because companies are getting more out of their staff, but maintaining headcount as is. This is particularly true in France and Germany where unions have understood that the choice is either to work longer hours at the same pay or the job goes abroad.

Chaney: "Since unemployment is falling without generating inflation, the speed limit of the economy is likely to be higher than previously thought."

I suggest that this is due to unused capacity in existing production facilities that are gradually being reabsorbed (brought back on line). In some instances, this has reduced unemployment. But, for us to believe reduced unemployment is a long-term phenomenon will require another three or four months of convincing.

Frankly, the sooner it does happen, the better. But, neither Germany nor Europe seem to want more unraveling of their intricate labor-protection laws. Which is protecting what? The jobs simply shift eastwards.

Chaney: "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."

I wouldn't be so upbeat. For instance, Sarkozy for all his dynamism reminds us of a young French politician who was called the "bulldozer" (in 1987) for his way of getting his way (and things done). He became PM and is now President, being blamed for France's "immobilisme".

Politicians rarely change politics as much as politics changes politicians. Methinks.