Germany's fiscal tightness threatens eurozone revival

It is really striking that the eurozone’s two largest trading partners, namely the UK and the US, are growing fast. In the first quarter of this year, the US economy contracted. Some people thought this heralded the beginning of a major US, and perhaps world, slowdown. I was always pretty sure that the softness was due to the appalling weather in North America in the first few months of the year. So it has proved. The US bounced back strongly in the second quarter. And the signs are that it has grown strongly in Q3 as well.

In the UK the recovery has, if anything, been more remarkable. The economy will grow by more than 3pc this year, and will probably grow by 3pc next. And outside the core eurozone, other European countries have been doing pretty well. In Q2, Sweden, Norway and Ireland all expanded.

So why the weakness in the eurozone? One explanation is that the Ukrainian crisis has depressed activity in Europe’s core, especially in Germany. There is something in this. The weakness of German business confidence is partly caused by this, as Germany is a substantial exporter to Russia. But this explanation alone does not bear much weight.

It is striking that some of the peripheral countries, especially Spain, have cut back their imports and increased their exports. This may have made things more difficult for the two big surplus countries, Germany and the Netherlands. To the extent that this has happened it is deeply ironic. For the German mantra has long been that the rest of the eurozone has been insufficiently Germanic. If the peripheral countries battened down the hatches and behaved as though they were, if not Prussian, then at least Bavarian, all would be well. In fact, I always suspected that Germany was able to be so Germanic precisely because the other members of the eurozone were not – that is to say, they spent freely and ran substantial current account deficits.

Meanwhile, two of the zone’s largest economies, France and Italy, are mired in a slump that is of domestic origin. Uncompetitive and anti-business, badly governed and failing to reform, short of a miraculous transformation or a strong pick-up in demand elsewhere, these countries will struggle to deliver reasonable growth.

In the face of all this, the German government is planning to run a balanced budget over the next several years even though the Maastricht Treaty would allow it to run a deficit of 3pc of GDP. German fiscal plans envisage its debt to GDP ratio falling sharply. So the German public finances will be in much better shape than just about anywhere else in the advanced world – including the UK. Bully for them. But this fiscal tightness will only worsen the economic crisis caused by a lack of domestic demand.

It is unusual for the UK and the eurozone countries to diverge this much. Not only is the eurozone the UK’s largest single market but we are also the largest market for the eurozone. I am tempted to feel that the UK’s expansion will founder unless the eurozone picks up. After all, we are running a huge current account deficit of some 4.5pc of GDP. As the UK economy continues to grow, if there is no recovery in the eurozone, this gap will only widen.

You could readily imagine this causing a sharp drop in sterling, leading to a spike in inflation that prompts a surprise rise in interest rates. This would clobber the housing market and the economy more generally. That would bring the UK’s growth rate crashing towards the eurozone’s paltry level – or even worse. Remember, this sort of thing has happened several times before.

Actually, if it were up to me, in these circumstances I would welcome the lower pound, put up with the spike in inflation, and forgo the rise in interest rates. But, as you will have guessed, it is unlikely to be up to me. Nevertheless, I suppose this is exactly what could happen, allowing the UK to continue to outperform the eurozone. However, given the inflation fetishism in the Bank of England and elsewhere in the British establishment, this cannot be taken for granted.

Alternatively, perhaps the eurozone will pick up, boosting British exports, narrowing our current account deficit and allowing the economic recovery to continue. That would require one of two things – either a major relaxation of fiscal and monetary policy, led by Germany, or a fracturing of the euro, led by someone else. Let’s face it, the eurozone is not exactly short of candidates.

The beauty of the Bavarian countryside may foster the idea that all is well, even in the world beyond the Alps. It isn’t – and the major causes lie close at hand.

Roger Bootle is managing director of Capital Economics.

roger.bootle@capitaleconomics.com

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