EVEN EUROZONE OPTIMISTS ARE NOT OPTIMISTIC / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Even eurozone optimists are not optimistic

By Wolfgang Münchau

Published: July 11 2010 19:34

Is pessimism about the eurozone overdone, as Jean-Claude Trichet, president of the European Central Bank, argued last week?

When trying to answer that question, one should distinguish between the short-to-medium-term economic outlook and the long-term sustainability of monetary union. So let us disentangle, and focus on, the first of these only. What kind of recovery, if any, are we going to get?

During the first half of 2010, the eurozone enjoyed nominal short-term interest rates of near zero, a big fall in the euro-dollar exchange rate and an expansive fiscal policy. Those three factors contributed to a recent increase in industrial orders in Germany, and resurgent optimism in that country’s business community.

As we enter the second half of the year, two of the three factors are changing. First, we are now seeing a policy-driven tightening in monetary policy. Mr Trichet is quite wrong to claim that the rise in interest rates has nothing to do with the ECB’s monetary stance. He cannot have it both ways.

When criticised last year for not pushing the official policy rate down to zero, the ECB correctly pointed out that what matters is the Euro Overnight Index Average (Eonia) money market rate, which until recently had been trading at 0.3 per cent. As a result of a recent shift in liquidity policy, the Eonia rate spiked to 0.5 per cent last month, and has since fallen to 0.4 per cent.

Some economists, who have done the maths on this, have calculated that the tighter liquidity conditions will gradually push the Eonia close to the repo rate, the ECB’s official policy rate – which is currently 1 per cent. In other words, by doing nothing, the ECB will effectively raise interest rates by almost three notches of a quarter point each.

To keep the Eonia at close to zero will require either a big cut in the main refinancing rate, a significant increase in the purchase of government bonds, or a return to more expansive liquidity support for the banks.

I would rule out the first two, and there is, at present, no consensus for the third.

Second, the recent increase in the euro-dollar exchange rate means that the euro is no longer heading in a direction that would generate a positive demand shock for products manufactured in the eurozone. The eurozone’s economic recovery strategy, which depends on an increase in competitiveness against the rest of the world, could be critically undermined by a rising exchange rate.

Third, the only good news, for now, is that fiscal policy is still loose – contrary to austerity rumours. The ratio of government deficit to gross domestic product will contract moderately in 2011 – by 0.5 per cent in Germany, Italy and Spain, and probably less for France. This will be followed by a further modest fiscal contraction in the years ahead.

If we were at the beginning of an ordinary cyclical recovery, the combined fiscal and monetary policy response would be reasonable. But considering the depth of the recent economic downturn and the continued presence of a financial crisis, I think it would have been wiser to postpone the combined monetary and fiscal exit until the recovery is firmly entrenched.

But even I do not expect that the fiscal consolidation will produce a double-dip recession. Alan Blinder, a former vice-chairman of the US Federal Reserve, pointed out last week that if you grow at only 1 per cent, then a half percentage point consolidation would get you uncomfortably close to a recession. My fear is that the eurozone may end up in a low-growth equilibrium for quite a long time, similar to Japan in the 1990s.

So what is the material difference between the optimists and the pessimists? The pessimists believe that a strong global recovery is unlikely given the persistence of financial stress, and the deleveraging of the private and public sectors across the industrialised world.

The optimists divide into two groups. There are those who have difficulties counting to zero, who cannot add up the global private, public, and foreign balances, which must equal zero by definition.

And then there are the rational optimists, whose expectations of resurgence in private sector demand must surely rest on the assumption of a return to even greater global imbalances than before the crisis, to which the eurozone will this time contribute actively. But this is surely not a sustainable position.

The pessimists would argue that global demand growth will not be sufficiently strong to support a self-sustained recovery in the eurozone. Even the rational optimists, who believe that this is possible, would probably conclude that these imbalances are not sustainable, and may trigger another financial crisis down the road. And if that is what you expect, you are not really an optimist.

If that analysis is correct, this is a debate between pessimists who worry about the long term, optimists, who are not really optimists, and optimists who can only say: hey, our sentiment indicators look good. In other words: an optimistic case that adds up beyond the very short term has yet to be made.

Copyright The Financial Times Limited 2010