Economic View: The higher they climb ...

The worse the economic performance of the eurozone, the less Britain will find the prospect of closer ties attractive
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The Independent Online

If you find the great euro debate a touch tedious, be glad you are not in the Cabinet: to have to read 2,000 pages on the Treasury's five tests is enough to muck up any weekend.

If you find the great euro debate a touch tedious, be glad you are not in the Cabinet: to have to read 2,000 pages on the Treasury's five tests is enough to muck up any weekend.

It cannot, however, be a great weekend for government ministers in the eurozone, either, for new figures show that these countries may be tumbling back into recession. Last Thursday, Germany, Italy and the Netherlands all reported that their economies had shrunk in the first three months of this year. In the case of Germany, this follows three previous months of contraction, so assuming the figures are not revised, the eurozone's largest economy is already technically in recession. France, meanwhile, has just downgraded its official forecast for growth this year, to only 1 per cent.

While this poor performance should come as little surprise to readers of this column, it does seem to have come as a shock to the European monetary and fiscal authorities. The European Central Bank, for example, will surely cut its intervention rate, currently 2.5 per cent, soon. But it has to wrestle with a region that needs very different interest rates, a fundamental design flaw.

As far as the UK is concerned, whatever the detail of the five tests, we know that the verdict will be that useful Scottish one of "not proven". Whether and when the Cabinet chooses to call the referendum may still be an open issue, but delay until after the next general election seems probable. In practical terms, therefore, much will depend on the performance of the eurozone in the next couple of years. This is why the sudden deterioration of the region's prospects matters so much. The worse the economic performance of Europe, the less attractive the prospect of closer ties, even if that poor performance should not wholly be attributed to the eurozone's monetary and fiscal rigidities.

How much is Europe's performance likely to deteriorate in the next couple of years?

The first imponderable is how much the euro will climb in the coming months. On a trade-weighted basis it is back to where it was when it was introduced (see first graph above) but much of that was simply a correction against an overly strong dollar. It may have a lot further to go. Already, however, the rise is doing serious damage to Europe's exports.

That damage is different in different markets. The euro has risen most against the dollar and least against the eastern European currencies, with the rise against the pound in between (next graph). Overall, there is a quite close relationship between euro strength and the region's exports (third graph) but exports to eastern Europe should be all right. Exports to the US will be very difficult. And even the more modest rise against sterling seems to be doing serious damage. ABN Amro, which produced these charts, points out that, already, euro-area firms are losing market share to UK ones.

So maintaining growth this year is going to turn on eurozone consumers. Unfortunately consumer confidence is at or close to historically low levels, and the links between interest rates and consumer demand are much less direct in the eurozone than in the UK. At the moment the median growth forecast for the eurozone, according to the Euro Zone Barometer, is 0.8 per cent, with the lowest from Société Générale at 0.5 per cent.

This is really rather alarming. It is very hard to see what can be done. Ease the stability and growth pact? Germany, the worst performer, looks like having a budget deficit of 4 per cent on these forecasts but it may well be higher still. Now I could envisage the pact being eased to allow a 4 per cent deficit instead of a 3 per cent one but it would be hard to see it being widened still further. In any case, if a deficit of 4 per cent of GDP does not boost the economy, why should anyone believe that a 5 per cent one will do the trick?

Cut rates? Suppose, just for the sake of argument, that the ECB cuts rates by 1 per cent to 1.5 per cent. This would give Spain, the fastest-growing large economy, a negative real interest rate of about 2 per cent and would be at the outer limits of the credible. That would offset less than half of the rise in the euro that has taken place in the past 12 months, for a rise of 4 per cent in the euro is roughly equivalent in its impact on demand to a 1 per cent cut in rates.

Structural reform? Well, yes, that is needed but the time lags before such reform has any impact on demand could be several years. Eventually the German economy will produce some growth, but underperformance for at least another five or 10 years seems certain.

Of course, some parts of the eurozone are sustaining reasonable growth. Spain, for example, is going great guns, partly thanks to going into the zone at an undervalued rate and partly because of the labour market and reforms carried out by the Aznar government. But the winners are not big enough to pull along the losers.

Surely all this should have been obvious? A new and thoughtful assessment of EMU by Christopher Allsopp and Michael Artis in the current Oxford Review of Economic Policy concludes that it has been a great political achievement. But monetary policy has been characterised by delay and conservatism in adjustment, and this has put pressure on the stability and growth pact. The problems show up the weakness of the "consensus view" of the interaction of policy.

Great politics, shame about the economics: at 29 pages (including footnotes) that paper might be a better weekend read for the Cabinet than the five tests marathon.