Hamish McRae: Is Europe's recovery just another false dawn?

Can the eurozone economy stand higher interest rates or will its incipient recovery be snuffed out when the European Central Bank increases rates, as it is widely expected to do next month? Or to put the question more broadly, has the eurozone learnt to live with the euro?

Yesterday there were three bits of somewhat encouraging information from three of the eurozone's four largest economies: Spain, Italy and France. Spain confirmed strong overall economic growth for the third quarter, Italy said household morale picked up in November and France released healthy consumer spending figures for October, which is helpful following a surprise slump in September.

One of the really encouraging features of the continental economy is that this year, for the first time for six years on my quick tally, it will end the year with a growth rate that is higher than the consensus forecasts at the beginning of the year. For a moment earlier this year it even looked possible that this would be the first time since its creation that the eurozone would grow faster than the UK. Now it is clear that it won't but that is because of faster-than-expected growth here rather than slower-than-expected growth on the Continent.

There are shadows of course. Just this week it was revealed that the French economy, generally the strongest of the eurozone big three, had failed to grow at all during the third quarter. Germany, where consumers have increased their spending in recent months in advance of a rise in VAT in January, will lose the boost that advance purchases have given once the rise comes through. Italian production remains depressed, following a progressive loss of competitiveness since it switched from the lira to the euro. And Spain, the fourth largest economy in the eurozone, is supported by a property and building boom that will at some stage inevitably peter out. At the moment Spain, with a population of 40 million, is building as many homes as the rest of the eurozone (population 265 million) put together. That cannot continue.

Still, the eurozone is growing steadily. Yesterday the London-based Centre for Economic Policy Research published its monthly assessment of growth performance, which confirmed that the economy was continuing its growth of around 0.6 per cent a quarter, or 2.4 per cent a year. The rate may have slowed a little, but not much.

On a longer perspective, the eurozone has been recovering slowly since the stagnation of 2002-03, as the first graph shows, but as you can see it is a long way from the performance of the late 1990s. Whatever view you take about the political decision to introduce the euro it is impossible not to notice that growth has been much lower since the introduction of the single currency.

Looking ahead, the issue is whether this quite modest recovery will be sustained. On the one hand, the financial markets are very positive, with lots of merger and acquisition activity and with shares yesterday at a six-year "high".

On the other hand, there are the headwinds. The economics team at UBS notes there are both external headwinds and internal ones. The former include slowing growth in the US, which has been widely noted, and, much less noted, signs of rising inventories outside the eurozone, which will eventually be corrected. The latter include rising interest rates and tightening fiscal policy in both Italy and Germany (including that VAT increase). On balance, UBS thinks concern about the VAT increase has been overdone: it is bringing forward some spending but may not affect overall growth to any significant extent. If that proves right, prospects for German growth next year would really turn on world market conditions, rather than specifically German ones.

Because growth in Germany has been so depressed we tend to forget how successful the country has been as an exporter. German exports, particularly of cars and other vehicles, have been brilliant, driving the country to being the world's largest exporter of manufactured goods.

Indeed, my main concern about the prospects for the eurozone next year would be the increasingly unbalanced nature of the continental economy. German industrial production has been remarkable, as the second graph shows. It has completely outpaced that of Spain and France, even though the Spanish and French economies have grown faster. And as you can also see, the real laggard has been Italy, where industrial production now is lower than it was in 1999.

This leads to what seems to me to be the biggest question of all. Will this lack of convergence prove the Continent's Achilles' heel?

Yesterday the European Commission acknowledged that there was a problem. In its review of the EU economy for 2006, the commission said many states have not adapted to the single monetary policy and currency. "More therefore needs to be done to improve growth performance and cement cohesion within the euro area in order to make the benefits of a single currency clearer to its citizens," it said. "Structural reforms must be accelerated and public finances more firmly consolidated to create the necessary margin for manoeuvre to weather the next economic downturn."

It was not, it argued, the fault of the euro, which had established itself as a strong, stable currency. In addition, it argued that euro- zone economies have responded well to soaring oil prices and financial market volatility, while inflation has been remarkably low and stable. "However," it went on, and here was the sting in its report, "a continued subdued growth performance and persistent divergences in growth and inflation show that internal adjustment in the euro area is sub-optimal and that some countries have not fully internalised the implications of living in a monetary union."

Strip out the jargon and it is saying that being a member of the eurozone imposes a discipline on how countries manage their financial affairs. It cannot say so explicitly, of course, but it would follow that one country - Germany of course - has buckled down to those disciplines but others - Italy, Greece, maybe Spain - have not.

My own view, for what it is worth, is that the present eurozone recovery will continue through next year and maybe 2008, with reasonable growth even in the laggards. But the economy remains very vulnerable to the next global downturn, as and when it comes. And that, reading between the lines, seems to be what the European Commission thinks too.