Hamish McRae: Cheer up, Germany and Italy: rising rates might hurt you but Europe's doing well

We will see more of the strains that are likely to test the eurozone
Click to follow
The Independent Online

Things are looking up at bit for Europe's economy. The vote for higher interest rates from the European Central Bank last week was a vote of confidence, and most of the latest data has supported this. But the prospect of higher rates will dismay the parts of the eurozone that are growing more slowly, most notably Italy, which did not grow at all last year.

The good news first. Probably the best forward-looking indicator, among the vast wodge of data, is the purchasing managers' index - in essence, what companies expect to be buying in the months ahead. Over the years, this has given a pretty good feel for the likely direction of the economy as a whole.

Capital Economics has plotted the two together in the left-hand chart. Assuming the relationship holds, there should be a marked speeding-up of the economy through the spring. There needs to be, for the last three months of 2005 were especially disappointing: growth down to 0.3 per cent - an annual rate of just 1.2 per cent - and household spending actually falling.

Other data confirms the increase in activity, with factors as diverse as the European takeover boom and a sharp rise in borrowing painting a positive picture. The main thing that has not improved much is unemployment, but that is a lagging indicator and will reflect the poor performance in the past rather than the pick-up now.

It was this better picture that gave Jean-Claude Trichet, the president of the ECB, the confidence not just to push up rates by 0.25 per cent but also to signal that further rises should be expected. The Bank of America's forecasts are shown in the right-hand graph: two more rises this year, bringing rates to 3 per cent, and then two further increases to 3.5 per cent during the course of 2007.

From a British perspective, even that would seem very low, and, indeed, in real terms it would be. Core inflation in the eurozone is around 1.7 per cent, but when you add in fuel and seasonal food, it is nearer 2.5 per cent. So on a crude calculation, the present 2.5 per cent interest rate is actually a zero rate in real terms, while even 3.5 per cent would be equivalent to 1 per cent real. Makes you wonder why on Earth eurozone citizens are not borrowing more and buying houses with the cash.

The answer is that some of them are. Loans for home purchases are running up more than 10 per cent year-on-year overall, but the patterns are uneven. In Germany, house prices have been stable or falling for a decade, while in Spain and Ireland they have risen sharply and are still climbing. So "free" money provoked a housing boom in some parts of the eurozone but not in others. Question: what will slightly more expensive money do?

A general point first. In all probability, Europe will still be moving to higher rates just at the time when the US Federal Reserve starts to reduce them. It is pure guesswork but there are enough signs of a slowdown in the US housing market to suggest that, by the autumn, the Fed will be cutting rates. The trend in house prices is not the only determinant of US monetary policy, of course, but it does matter. That relative shift should strengthen the euro vis-à-vis the dollar: good for inflation in Europe but bad for exports.

Thus Germany, which is very dependent on exports, will suffer more than, say, Spain, which is less dependent. Spain has a current account deficit of more than 7 per cent of GDP, the largest in the developed world. So the rise in rates will be a double burden on Germany but may not be sufficient to curb inflationary pressures in Spain.

The truth is that we just don't know how the different parts of the eurozone will react to somewhat tighter money. To outsiders, it may seem rather arcane to be fretting about half a percentage point either way. The experience of both the UK and now the US has been that you have to put rates up quite a lot to check a housing boom. But the central point is that this will only be the second cycle of rising interest rates in the ECB's existence, so it has little experience of how the economies will react to its policy.

So what do we look for? First, there will be the strength or otherwise of this coming growth phase. Will Europe start the sustained expansion that has eluded it for the past five years? The key will be employment. If it starts generating real jobs on a significant scale then consumption will rise and sustained growth should be in sight. If not, the next couple of years could continue to disappoint.

The next question is whether the countries that consider themselves disadvantaged by euro membership will continue to feel that way - indeed, feel more miserable as rates rise. Italy has been the most vocal critic of the euro, though in the Netherlands the currency is also unpopular. Italy does appear to be in a jam, for apart from the figures showing nil growth, it is suffering from a serious loss of competitiveness compared with Germany. I don't think the idea of Italy leaving the eurozone is a serious one in the coming economic cycle, but we could catch a glimpse of how the eurozone might break up at some stage in the future. At the very least, we will see more of the strains that are likely to test the eurozone.

A third question is whether rising rates will affect the pace of structural reform. Is it easier to push through, say, German labour reforms when money is cheap or when it is dear?

On paper, it should be easier to sustain reform when things are running in your favour. With growth, you can ease the pain: people who lose their jobs might be able to get new ones. But in practice, I'm not so sure. Germany has made much more progress in cutting costs than is generally appreciated, and that has happened during a period of slow growth. There was more German criticism of the ECB two years ago when rates were at 2 per cent, but the fact remains that companies pressed on with restructuring.

Indeed, the gradual rise in rates could be a useful discipline on European business generally, forcing it to keep squeezing costs.

That leads to the biggest issue of all: how Western Europe can adapt to the wall of competition from both the new EU states to the east and from China and India. The relevance of monetary policy to this will be mostly through the exchange rate. If the euro strengthens in response to higher interest then European business will be forced further upmarket. The higher the exchange rate, the more value-added goods and services you have to produce. So a stronger euro is good in the long term but tough in the short.

But back to the encouraging news: higher rates are a signal of better economic health. The eurozone will probably put in another year of slower growth than the UK, but it is a relief to see some uplift and we should welcome that.

Tessa, we don't talk about money either

Whatever the ultimate outcome of the travails of Tessa Jowell and her man, she should draw comfort from an improbable source: the Financial Services Authority.

Prescient, the financial advisers, have sent me a brief on the new FSA consumer website, which is designed to help people manage all aspects of their finances. It celebrated its launch with a look at how men and women fail to discuss their finances with each other.

"Men are prepared to do anything to avoid talking about finances, with almost a third (29 per cent) preferring to answer questions about their partner's personal appearance."

Further Jowell-friendly results from the FSA included: 27 per cent of couples regularly argue when discussing their finances; 32 per cent lie to their partners about credit card spending; 35 per cent lie awake worrying about money; and 43 per cent lie to each other about luxury spending.

So the apparent non-communication over mortgages in the Jowell household is completely normal. Were they to lie to each other about finance (obviously not suggested in this case), that too would be normal. Indeed, they are probably wise not to talk about money at all, given that it might well lead to an argument. If the FSA says so, it must be right.

Interested to know more? Visit "The world of money laid bare" on the FSA site. The bigger point here is that there are huge gaps in financial understanding, not just among Cabinet ministers but the populace at large. The site has two interactive tests: the debt test and the financial health-check. The FSA deserves a warm welcome for this initiative to help people's money management.

Of course, it cannot cover every eventuality: I could not find any reference to the best way to deal with gifts from Italy of a few hundred thousand. But I suppose that is just a touch unusual.

Comments