Hamish McRae: How long can the eurozone region continue to tolerate slow growth?

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The Independent Online

The eurozone slowdown has become quite alarming - and all the more so for being unexpected and coinciding with a parallel slowdown in Japan.

The eurozone slowdown has become quite alarming - and all the more so for being unexpected and coinciding with a parallel slowdown in Japan. During the final three months of last year Germany, Italy and the Netherlands all saw their economies shrink and eurozone growth as a whole was only 0.2 per cent - equivalent to an annual rate of only 0.8 per cent. That is only one quarter, sure, and there are some hopes that growth will resume this year. But it is troubling.

We don't yet have any details of the German picture, just the overall number, a contraction of 0.2 per cent in GDP. But it seems likely that falling domestic demand more than offset a reasonable export performance. In the case of Italy the contraction was slightly greater, 0.3 per cent, which seems largely to be the result of a fall in industrial production (see left-hand graph) And in the Netherlands, down 0.1 per cent, the problem was a fall in net exports and stocks, which more than offset a rebound in consumption.

Elsewhere in the eurozone there were some bright spots. The other two members of the eurozone's big five did well. France and Spain both had growth of 0.8 per cent, equivalent to an annual rate of more than 3 per cent. But the first three account for 63 per cent of the big five, the other two 37 per cent and this divergence creates an obvious problem for the European Central Bank. It has to set policies that are right for the region as a whole, which means that that will be wrong for some parts.

There is also evidence that the ECB has been wrong-footed by the poor performance. Goldman Sachs points out that as recently as 3 February it said it was expecting "ongoing moderate growth" in the final quarter and reckons that it had expected growth of about 0.5 per cent for the quarter. At any rate Goldman, which had also been modestly hopeful, has revised its forecast for eurozone GDP this year down to 1.4 per cent.

The performance of Italy and the Netherlands is worrying of course but the poor German growth somehow seems more embedded. By coincidence yesterday the Bank of England gave a two-page spread in its new inflation report to the problem of Germany's weak domestic demand. It argues that there are three main factors that contribute to low domestic demand relative to the rest of the euro area: low growth in the supply of labour, a fall in construction after the reunification building boom, and a fragile corporate sector.

The size of the German labour force is stable, whereas it is still growing, albeit slowly, in the eurozone as a whole. After reunification building shot up by 25 per cent, creating an overhang of empty property. That has dragged down new building and hence overall investment. And German companies have been under intense pressure to hold down their labour costs, both by shedding labour and by holding down wages. That, the Bank argues, has had a knock-on effect on consumption.

The right-hand graph shows the pressure on competitiveness. From 1991, immediately after unification, through to 1996 Germany became much less competitive. It has had a long haul back, gradually closing the gap in relative labour costs with other eurozone nations, and has closed the gap with the Netherlands, which is also performing badly by the way, but not yet with Italy, France and Spain.

This is sensible stuff. The conclusion of the monetary committee noted by the Bank that it is "cautious about prospects for German domestic demand and believes that growth there may remain lower than in the rest of the euro area" is pretty sensible too. But I wonder whether this is the complete answer.

Look at other countries where growth has been pretty stagnant: Italy and the Netherlands in Europe and Japan. Italy has become more competitive, as the graph shows, and has great capability to increase the size of its labour force because it has low participation in the job market. The Netherlands has low unemployment and a flexible labour market, so it ought not to be suffering too much. Indeed people used to argue that the Dutch were proof that a country could be economically successful and preserve the European welfare model. As for Japan, the problems of stagnant growth cannot really be attributed to a lack of competitiveness, though like Germany, it too had an excessive construction boom at the end of the 1980s and during the early 1990s.

No, I think there is something different happening. While I don't think we can fully understand it, there are some clues. The starting point is that countries where domestic demand is weak have managed somehow or other to create a culture where people don't want to spend more money - where people feel they are content with what they have. In the early post-war period after the catastrophe defeat of Germany and Japan (and arguably also Italy) there was a drive to do better, to prove something. That has evaporated. As anyone who has travelled in Germany (or at least the former West Germany) will testify, life is good. Hours are short, public services are competent, pay is OK. There is little prospect of making a fortune but most Germans don't see the point of that. That is why the average age that students leave university to enter the job market is 28. If you do want to make more money you come to London or emigrate to the States.

Similar attitudes colour life in the Netherlands. For many, maybe most people, life is comfortable. Why strive? In Italy, home of the "slow food" movement and with arguably the most-admired lifestyle in the world, there is a similar lack of desire to consume more. Sure, there are exceptions: Italy has long been one of the strongest markets for Porsches. But the general point is that people don't buy more because they don't want to push themselves too hard.

Japan is slightly different. People push themselves - or at least the men do - but in a structured way. Anyone who has walked round an office in Tokyo will note that people seem to be working furiously hard. But then you are walking round with the boss and a show has been put on for the two of you. The Japanese work long hours but if you measure by output rather than input it is evident that in offices (though not in factories) much of that time is wasted. There are other reasons for slow (or negative) growth of consumption in Japan: early retirement in particular, for this forces people to increase their savings. But there is a cultural pressure too against conspicuous consumption, a reaction perhaps to the excesses of the 1980s.

If this line of argument - that there are cultural pressures against excessive personal spending - has merit, then there are some quite alarming implications. One is that growth in Europe will continue to diverge. Another is that Germany and Italy will remain slow-growth zones. Still another is that when overall eurozone growth falls back, as it periodically will, several countries will dip into recession.

And that leads to a larger concern. How long can the eurozone continue to disappoint without there being a political discontinuity? Germany can cope with five million unemployed, well, actually six because one million jobs are artificial taxpayer-supported ones. But seven? Or eight?