Eurozone economic policy is stymied, despite the cut in interest rates that the European Central Bank is about to make.
That the ECB will now press on with rate cuts is hardly in dispute. Goodish inflation numbers this week from Germany and Italy give it the excuse to shave rates further, while the pretty dreadful Ifo survey of business opinion in Germany last week underlined the need to do so.
Expect therefore the ECB to start driving down eurozone rates in the coming months, though perhaps not quite as aggressively as the US Federal Reserve Board has driven down US ones. But it would be naive to expect that declining interest rates in Europe will have any more impact than declining rates in the US. In fact they will probably have less, for European consumers and businesses are less highly geared than their US counterparts. Given the lags in the system and the scale of the blow to confidence from the events of 11 September, falling interest rates will be unable to prevent a recession in Germany (and Italy too), just as they are unable to prevent one in the US.
Over the past 20 years that Ifo survey has been a good indicator of GDP movements in the eurozone as a whole (left hand graph) and the latest survey was the largest monthly decline since 1973. That does not show that a eurozone recession is inevitable (as opposed to a German one, which is) but it makes it an odds-on probability.
Looking beyond recession, low interest rates are a necessary but insufficient condition for recovery. They are necessary because without low rates, neither consumers nor businesses will feel confident enough to sustain recovery (witness their behaviour in Japan). But they are insufficient because if people are determined not to borrow, even zero interest rates will not persuade them to do so.
If monetary policy is unlikely to be much help, at least in the short term, what about fiscal policy? Here the guns are not just silent; they are pointing in the wrong direction. I was aware that eurozone countries were inhibited in their ability to relax fiscal policy by the stability pact but I had not appreciated that eurozone fiscal policy was being tightened further next year, in sharp contrast to the position in the US, Japan and the UK. The graph on the right, from Goldman Sachs shows changes in the structural budget position – i.e. what would happen at a constant level of demand. So as demand slows, expect the euroland deficits to rise rather than narrow. But the pressure remains to lean against growth rather than support it.
This may change a bit. France has just brought in a tiny package, equivalent to 0.1-02 per cent of GDP. Germany has said it won't, but may panic – sorry, relax its present line – next year.
If it does it will be because, as the single currency actually hits people's pockets and purses, there will be growing pressure for price harmonisation within Europe. The financial markets are starting to focus on the fact that there are large differences in the domestic price levels among the various the eurozone countries. Thus prices in Germany are nearly 25 per cent higher than in Spain and Italy. One effect of the single currency is for those prices to move towards each other. Of course differences will remain and assets like property will always have very different prices.
But assume that gaps in the price of the general basket of goods that people consume halves – that a 10 per cent gap, maybe a bit more, might remain. Assume too that the adjustment will be slow, taking a decade even to halve. That still means that prices will have to rise by one percentage point a year more in Spain and Italy than they do in Germany.
In a world of low inflation that might be acceptable: prices rising at, say, 0.5 per cent a year in Germany and 1.5 per cent in Spain. But in a world of zero inflation that would be more difficult: prices rising by 0.5 per cent a year in Spain but having to fall by 0.5 per cent in Germany. At the moment inflation is still around 2 per cent in Europe, so this is not an immediate issue. But project forward for what might happen, and suddenly you could see Germany in a similar position to Japan, where prices have fallen relentlessly through much of the past decade.
If such a narrowing of prices is indeed inevitable, and the price transparency that a single currency brings makes it very likely, some parts of the eurozone seem condemned to a decade of sluggish growth ... or worse.
The nearest historical parallel is sterling's return to the gold standard in 1925 at its pre-1914 parity. It led to the General Strike and six years of sub-trend growth. The spell was broken only when Britain came off the gold standard in 1931 – and then was able to stage a recovery.
There is a quiet debate going on in Germany now as to whether it has allowed political considerations to push it into two great currency mistakes in the space of 10 years. The first was the one-for-one conversion of the East and West German marks, overvaluing the East German one and thereby condemning it to 10, maybe 20, years of double-digit unemployment. The second was going into the euro at the wrong rate, with similarly serious consequences.
In the case of the two marks, most people at the time thought that West Germany would be strong enough to pull the East German one up. In some respects it has, but at the cost of enormous subsidies, the unemployment and a reduction of living standards in the West.
In the case of the euro, most people thought that the German economy would be strong enough to offset any adverse effects of too high an exchange rate. Again, in some respects it is succeeding, for West German industry has cut its costs and lifted its service enough to retain German export competitiveness. But the price, in four million unemployed, is very high. Given a good run in the world economy all might have eventually come right. But there is not going to be a good run; indeed it will be the worst run for a generation. And there is nothing, at a macroeconomic level, that Germany – or the other slower-growing European economies – can do about it.Reuse content