Stephen King: Rudderless eurozone drifts towards weak recovery despite itself

It still has a sail, but really has no ability to head in one particular direction or another
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So, even the eurozone has entered a renewed economic expansion. This, at least, is the message coming from the latest numbers for economic growth. Last week, we found out that the eurozone as a whole expanded by 0.4 per cent in the third quarter of 2003 after a decline of 0.1 per cent in the second quarter. Hallelujah! Some people have got really rather excited about this piece of news, arguing that the eurozone has finally embarked on a "strong" recovery.

The left-hand chart puts this claim of strength into some sort of context: yes, the numbers for Germany and France look better than before but they still look woeful compared with the exhilarating performance of the US economy over the last year or so. Strong? Hardly: a better description would simply be to say that the eurozone has just about dragged its head above water.

The best way to think about the eurozone - a view that I think is abundantly clear from the economic data - is in terms of a rudderless boat. It still has a sail, but really has no ability to head in one particular direction or another and is permanently at the mercy of the economic winds and waves thrust upon it from other continents.

Why do I think this? For the simple reason that, in the third quarter, there is little evidence to suggest that the eurozone itself is responsible for any of the recovering. Rather, because the rest of the world has improved, some of this is beginning to rub off on to the economies within the eurozone. Take a look at the right-hand chart, for example. Here, I've tracked German export growth against German retail sales growth. Export growth surged ahead in the third quarter - despite the persistent strength of the euro - but retail sales actually fell. It's increasingly looking as though the recovery in eurozone growth is coming about only because of events taking place elsewhere in the world, not because of developments within the eurozone itself.

Had the recovery in exports occurred as a result of a weak euro, it might have been reasonable to argue that changes in economic policy within the eurozone - interest rate cuts designed to drive down the value of the currency, for example - might have made a contribution to this renewed period of economic growth.

But the truth is that the euro has been unusually strong over the last two years, not just against the dollar but also against all the currencies in Asia. The euro's strength is not all the eurozone's doing: the US has clearly been happy to talk down the dollar and Asian currencies have fallen with it. Euro strength, though, will have impeded rather than helped the export recovery. In other words, the eurozone has done better despite its own worst intentions.

Last week, Otmar Issing, the European Central Bank's chief economist, said the ECB could do nothing more to stimulate economic recovery. Interest rates had already fallen far enough and now it was up to the other participants in the eurozone economy - companies, labour, governments - to respond to the supportive framework already established by the ECB. All very well, but this looks like a complete misdiagnosis of the underlying issues.

The eurozone is increasingly looking like a failed business, one in which a blame culture is a dominant feature. Every actor in this story seeks to blame the other actors for underlying economic problems: no actor is prepared to accept either individual or collective responsibility for the ultimately disappointing results of this blame culture. The German and French governments blame the European Commission for a lack of flexibility in the Stability Pact. The Commission blames the Germans and French for not taking the fiscal rules seriously enough. The European Central Bank blames governments for a lack of fiscal reform. The governments blame the European Central Bank for a lack of aggressive monetary stimulus. And, internationally, the European Central Bank thinks that the US has got a screw loose, stimulating domestic demand at a time when the US current account deficit is heading through 5 per cent of its own GDP.

This is all very well, but the odd thing about these conclusions is that, deep down, eurozone policymakers are probably rather grateful for American "screwiness". If it weren't for the rapid growth of US domestic demand, it's rather doubtful that there would be any eurozone recovery at all.

Let me put it another way. Eurozone interest rates have fallen only very slowly. Eurozone fiscal policy has been loosened only begrudgingly. The exchange rate has risen, not fallen. Given all these things, European policymakers simply cannot justify slapping one another on the back, taking the credit for a recovery that ultimately was "Born in the USA".

If I'm right, the eurozone is still facing a rather difficult time. Global growth may have picked up and eurozone GDP may have stopped contracting, but it is difficult to see why, under current policies, the eurozone should enjoy anything other than a weak and disappointing economic recovery. Europe is perhaps being dragged along on the coat tails of success elsewhere in the world but it must be remembered that this is a relative game. If part of the US recovery is dependent on a weak dollar, that recovery must be coming at the expense of the eurozone, not in support of the eurozone.

Another way of putting this is that the eurozone is vulnerable to a continuous decline in its share of global trade and economic activity. If the policies pursued by the US and Asia imply continued euro strength - as they have done so far - eurozone growth inevitably will be constrained. There is a way around this, namely for the eurozone to loosen domestic monetary and fiscal policy enough to ensure a switch away from export-led growth towards domestic demand-led growth. So far, though, the appetite to go down this road seems hardly to be there.

I suspect, then, that the debate is not yet over for the eurozone. The shift from contraction to expansion is welcome news but the reasons behind this shift are less than convincing. Otmar Issing may be confident in his belief that there is no need to cut interest rates any further but should the dollar and Asian currencies continue to fall against the euro, the European Central Bank may have to think again about cutting interest rates.

The story, then, has not reached a conclusion. The eurozone is recovering in spite of itself. The foundations for recovery are crucially dependent on policies pursued elsewhere in the world but those policies, in turn, will heavily constrain the pace of European economic growth given their implications for exchange rate movements over the next couple of years.

Then again, when you see Paris bathed in sunlight - as I did last week - you begin to think that maybe the "go for growth" mentality seen in many other parts of the world is just not so relevant for the eurozone: why bother to grow when there are so many good things there already? That, perhaps, is the ultimate American frustration with the eurozone: economically, Europe may not be the powerhouse that it once was but its cultural legacy, its rich inheritance, makes its citizens draw on its extraordinary past, providing a very different set of values to those that have driven America's economic success in recent decades.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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