Stephen King: Beware false dawns... Germany's renaissance has boosted Europe, but a US slowdown could hurt

The increases in labour costs in France and Italy threaten to leave them in the slow lane

One of the main economic surprises in 2006 has been a newly-invigorated European economy. Growth has come in well ahead of most forecasters' expectations. As we head towards 2007, many people are declaring the end to the eurozone's hitherto-intractable economic malaise.

Beware false dawns. Much the same was said in 2000 and the first half of 2001, when the US economy was slowing but the eurozone appeared to be doing rather well. The first chart shows economic growth for the eurozone "Big Three" since then. Growth was, admittedly, very good in 2000. Sadly, though, the good news didn't last. Growth slowed through 2001 and, over the following two years, most eurozone economies spent most of their time flirting with recession.

Up until now, strong growth in Europe has been a bit like good vintage champagne: it only crops up every so often, and one year's good performance says very little about outcomes in subsequent years. So why is it that commentators are, this time, so optimistic.

The answer, very simply, is Germany. Of the Big Three, Germany has suffered the most in recent times. After the reunification boom at the beginning of the 1990s, Germany endured a protracted hangover. Year in, year out, growth remained weak, unemployment remained high and German politicians wrung their hands in despair.

A lack of construction activity was the initial drag on demand. During the reunification boom, buildings went up with a potency that's more commonly associated with Viagra but, thereafter, German property investment stagnated and, with it, so did economic growth. Germany also suffered from "hollowing out". Faced with plentiful cheap labour in central and eastern Europe, German companies stopped investing in Germany itself and, instead, built their factories in Poland, the Czech Republic, Hungary and a host of other formerly Communist nations. Households, fearing the worst, became ever-more cautious in their spending.

For a while, it looked as though the German economy was destined to stagnate. Yet, over the last couple of years, its performance has brightened. As the chart shows, German growth has both accelerated and, perhaps more revealingly, started to outpace that in France and Italy. Germany, always the laggard, has now become the driving force in European economic expansion.

Because Germany is often seen as the bellwether for the eurozone as a whole, it's no great surprise that forecasters have become more optimistic about economic growth across the entire region. Having recently introduced some fairly significant labour market reforms which may be contributing to a structural reduction in unemployment (the so-called Hartz IV reforms), perhaps there's some substance to the view that where Germany leads, others follow.

I'd like to think this more optimistic view of the world is correct. After all, if the US economy is slowing down - and the evidence increasingly says it is - the world needs some other region to take up the slack, otherwise there's the danger of a major global economic downswing. Perhaps the eurozone is beginning to perform this role. If it is, there's also a good chance that external imbalances will be gently removed: if nothing else, stronger European growth will boost demand for US exports and, therefore, help to shrink the US current account deficit.

There's nothing wrong with dreams. Reality, though, is a little more complex. Germany's renewed economic strength is mostly an export and investment story. Households remain cautious, leaving consumer spending moribund. And exports and investment are doing well for one reason: German companies have been slashing labour costs. From a corporate perspective, the great thing about having millions of eastern European workers on your borders is the ability it gives you to drive down your domestic cost base.

The second chart shows unit labour costs for the Big Three. These costs capture changes in wages and other labour costs adjusted for changes in productivity. For Germany, labour costs have slowly declined. For France and Italy, labour costs have headed upwards.

German companies have done what they've always done. Faced with a more difficult global environment, they've worked hard to improve their competitiveness through aggressive cuts in employment costs. Not surprisingly, their exports have picked up and, as a consequence, capital spending has begun to recover. Consumer spending is weak in part because households have to deal with greater job insecurity than before.

For the eurozone as a whole, life is a little tougher. Germany's success reflects others' failures. Germany has gained competitiveness not so much at the expense of countries outside the eurozone but, rather, at the expense of countries within it. Increases in labour costs in France and Italy threaten to leave them in the slow lane of eurozone economic growth.

The Germans have learnt a lesson from the Dutch. Through the 1990s, the Dutch managed to pull off a string of wage deals that deliberately undercut wage levels in Germany and France. By doing so, Dutch exports remained competitive and the guilder was able to stick, limpet-like, to the all-powerful Deutsche-mark. The Germans and French were mildly irritated by this Dutch version of a relative incomes policy, but the Netherlands was too small to matter for the overall health of Europe.

Germany seems to be embracing the Dutch model. Maybe the declines in German labour costs are the natural response to the sudden availability of cheap labour on Germany's eastern border. Germany's response, though, has not been matched elsewhere. In the old days, other European countries had a not-so-secret weapon to unleash in the face of stiffer German competition; it was called devaluation. Countries that couldn't keep paceon the competitive front simply allowed their currencies to fall in value.

The euro has removed this option. The French and Italian labour markets are still behaving as though the option still exists. Not surprisingly, their economies have started to slow. Their leaders face awkward choices. Do they go down the Ger-man route, cutting labour costs left, right and centre? Globalisation probably demands this more draconian approach, but it requires a level of national abstinence that's never easy to pull off. Alternatively, do they try to protect their workers, not so much against a German onslaught but, rather, by persuading all eurozone countries to insulate themselves from the labour market threats from the East? That would mean less migration, less outsourcing and more protectionism.

However reluctantly, Germany may slowly be coming to terms with the new realities of globalisation. By doing so, it has thrown down the gauntlet to its European partners. German economic performance has certainly improved but it may no longer be the bellwether for the eurozone as a whole. Germany's gain amounts to French and Italian pain. With the US economy slowing and with the euro appreciating in response, life is getting tougher for many of Europe's exporters. As the eurozone as a whole reels from the pressures of global competition, we may eventually look back on 2006 as one of the few vintage years for European growth. Perhaps the champagne should be kept on ice.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com