Hamish Mcrae: If the eurozone grows more quickly than the UK, it is good news for all

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The Independent Online

Things are looking up in Europe - sort of. After a sustained period of underperformance, there are signs that the core continental economy is performing a bit better. Indeed, it is just possible this will be the first year since the euro was launched that the eurozone grows more swiftly than the UK.

This really is welcome news, for the eurozone remains the most important market for UK companies, though its relative importance as an importer of our goods has been shrinking for more than 20 years as other parts of the world grow faster.

Nevertheless, what has been happening in recent weeks is a fascinating tale, in miniature, of the great big story of both the strengths and weaknesses of the core European economy.

A good starting place is the tantalising news this week from German consumers. On the one hand, their reported optimism has risen sharply in the past few weeks - people say they are the most optimistic they have been since early 2001. Retail sales had been running modestly up through the summer. But then, bang, came the December figures, which were down sharply. This followed another couple of bad months, leaving fourth-quarter sales 1.4 per cent down on the third quarter. For 2005 as a whole, sales were up just 0.7 per cent on 2004. We don't yet have figures for total consumption, which includes things such as holidays and rent and is obviously a much broader measure than retail sales. But it would be surprising were it up more than 0.5 per cent, which is not much fun.

You can see in the top graph the extent to which since 2001 German consumption has been depressed on both the retail sales and the wider consumption measure. But, but, but - the fact remains this is the most successful goods exporter in the world. It seems to be much less seriously challenged than some expected by the onslaught of lower-cost goods from Asia and eastern Europe, the former largely because it still has a quality edge and the latter because its own companies have been swift to establish factories there.

As a result of its exporters' success, German growth is running at about 1.5 per cent a year, which by recent standards is encouraging. French growth, too, is up a little from last summer, leaving only Italy languishing. You can see the albeit modest recovery in the bottom left graph. If only German consumers were to loosen up a bit, Germany could join France and achieve enough growth to make more of a dent in its unemployment total. Germany and France have made modest cuts in unemployment in recent months but employment, arguably a more significant measure, has barely risen.

The thing that Germany and France have succeeded in doing is to contain labour costs, in contrast to Italy (next graph). There has been a marked change in the mood of both labour forces. The German Chancellor Angela Merkel regrets so little progress has been made in reforming German labour laws but pressure from the east has had the practical effect of containing pay settlements. It looks too as though Germany will succeed in pushing up the retirement age for all workers, including public sector ones, to 67. Yesterday the ruling coalition brought forward its plans to so do - something we have so evidently failed to achieve in our public-sector labour negotiations.

In France, the change of mood in the labour market is mostly still to show through. Still, it is fascinating to see the people most opposed to the 35-hour working week are the very young, which suggests a generation from now, French working hours will rise to international levels.

Italy? Well, there is no problem of consumer inflation. As the third graph shows, membership of the eurozone has done its stuff, compressing inflation in the big three economies into a narrow band. I don't fully understand why Italian companies have been so unsuccessful at containing unit labour costs, given that while inflation has been towards the top end of the European range, it has not been at all dreadful. Mathematically it is much harder to contain unit labour costs if you are not increasing the number of units you are producing. So part of Italy's cost problem is that it is not growing fast enough. But this is a chicken-and-egg state of affairs: low growth means high unit costs, which means you are priced out of markets, which means you have low growth.

I suppose the simple explanation is different historical experience. German companies have had a long folk-memory of dealing with an overvalued mark during the 1960s, 1970s and 1980s and have pulled the same trick they managed time and time again: to drive up quality sufficiently to justify the prices they charge. Italian companies, for all their brilliance, have had the experience of successive lira devaluations and maintained their competitiveness that way. Except they can no longer devalue, at least not as long as Italy remains in the eurozone.

The tantalising thing is that Italy would seem to have a considerable competitive advantage at the high end of manufacturing - craft manufacturing - that is in great global demand. But somehow this does not appear to have translated itself into wider economic success.

That leads to what seems to be the greatest lesson of the past few weeks. There is no doubt growth is picking up a bit. There is no doubt consumption, particularly in Germany, remains a problem. There is no doubt export competitiveness of the rest of Europe is excellent. And there is no doubt that were core Europe to begin to achieve faster growth, it could tap its vast army of unemployed to sustain that growth.

But Europe is so uneven. You can see this uneven nature of the beast in the past few weeks. You can see twitches of reform, most particularly in Germany. What is happening in Germany under Ms Merkel is fascinating in that she is biting off little bits of reform that can be done with consent and achieving considerable popularity for so doing. The idea that the coalition would be toothless because the election was on such a knife-edge was wrong.

On the other hand, until European consumers are prepared to increase spending, overall growth will languish. It is simply not safe to rely on exports, as Germany has done, to maintain demand. Were the dollar to fall sharply, and the potential for that remains as strong as ever, the euro would inevitably find its overall value pushed up. It would be the main alternative for funk money - international funds trying to get out of the dollar in a hurry. That possibility will continue to hang over Europe through this year.

The best hope in the next few months will be for a solid consumer revival. Enjoy yourselves - go on a splurge! Don't mind the modest increase in interest rates from the European Central Bank - borrow a bit more! And if, viewed through the narrow prism of UK politics, it would be embarrassing for the eurozone to grow more swiftly than the UK, so be it. It would be much better for everyone were core Europe to have a little economic success.

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