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Tuesday, December 12, 2006

The French Enigma

There's a lot of interest focusing on the future evolution of the Eurozone economies at the moment. Claus Vistesen has been following the debate closely on his blog (and in particular this post).

Many observers are at this point fairly optimistic about the future of the eurozone economies as a group, but, as I keep pointing out, domestic consumption in both Italy and Germany continues to remain weak, and there may be sound theoretical reasons for assuming that this situation isn't going to change, and at the same time these two countries also face fiscal tightening problems as we enter 2007, due to the costs imposed by their rapidly ageing populations.

As Claus says:

Many Eurozone countries indeed need structural reforms .....Yet the thing we must ask ourselves is whether this will be enough? And this dear readers is where demographics come in and more specifically why we need to look at the population structure of for example Germany and Italy in order to really understand what is going on before our eyes. Why for example is consumer spending persistently low in these two countries and why is Germany running a trade surplus of 6% of GDP.

Of course, the ageing population in Europe is not a topic which has just appeared on the center stage of economic discussion and neither is the need for structural reform in Europe. In fact, these two aspects are often tied together; in order to amend the effects of an ageing population we need structural reforms on the labour market (to free up ressources), pension systems (cost cutting), and health care systems (cost cutting). The last two cannot be accomodated by slashing benefits all together and as such fiscal tightening is an integral part of this; just look at Italy and Germany at the moment.

But will structual reforms really neutralize the effects of ageing population effects in Europe? The bets are still out but I would argue that this is highly unlikely.

Now there is a lot of talk about Germany and Italy here, and there are of course other countries in the 12 nation zone, in particular Spain and France.

In fact France is an interesting case here, since in theory France's ageing problem is a lot less severe in the short term than that of either Germany and or Italy, and indeed in recent years, and despite having carried out a lot less in the way of structural reforms than Germany, French GDP growth has consistently outperformed the other two.

Which is why it was really something of a shock when France turned in a zero % third quarter GDP growth reading. Not that it should have been a complete surprise, since the slowdown in the rate of increase in industrial production in France in June and July was already something of an early warning for those who were watching.

However growth across the zone generally has been so strong through 2007 that one would have expected France to pick up again, but apparently this was not to be:

French industrial production unexpectedly fell in October after economic growth stagnated in the third quarter. Production at factories, utilities and mines fell 0.1 percent from September, when it fell a revised 0.8 percent, Insee, the national statistics office, said today in Paris. Economists expected a gain of 0.5 percent, according to the median of 22 forecasts in a Bloomberg News survey. Manufacturing of machinery and equipment fell 0.2 percent.

As I suggest, personally I was surprised when France came in so weak in the third quarter:

France's economy failed to grow in the June-September period, resulting in the smallest job creation since the second quarter of 2005. The 8.8 percent jobless rate, though down from 10.1 percent in May 2001, remains the highest in the 12-country euro region, according to Eurostat.

Now domestic consumption as I have also suggested is endemically weak in Italy and Germany, but they have been able to leverage exports to some extent (Germany a lot more than Italy):

``Industrial production in France isn't taking off,'' said Sylvain Broyer, an economist at Natixis in Paris. ``Growth in Europe is being pushed by investment, and France isn't strong with investment goods like other countries, such as Germany and Italy, are.''

So we could draw the conclusion that the French economy could survive better if internal consumer demand in some other eurozone countries was stronger, but since this isn't the case the weakness in consumption in Italy and Germany then feeds back into France.

This is just a hypothesis at this stage, but it did receive a bit more support from today's trade data from France:

France's trade deficit widened in October for the first month in three as the rising euro undercut exports and boosted imports. The shortfall grew to 2.71 billion euros ($3.6 billion) from 1.51 billion euros a month earlier, the Trade Ministry in Paris said today.

and this whole evolution has now lead INSEE to substantially revise downwards its growth estimate for 2007:

French economic growth will slow in the first half of 2007 as foreign demand cools, the national statistics office forecast.

The world's economic expansion will fade in 2007 to its weakest in four years, dragged down by a U.S. slowdown, the Organization for Economic Cooperation and Development said last month. Insee sees exports of manufactured goods rising 1 percent in each of the first two quarters, down from 2 percent in the last three months of 2006. Import growth will also slow to 1.5 percent from 2.2 percent, it said.

So what we have at the moment is indeed a curious situation as the two weaker economies continue to outperform what has, until now, been thought to be the rather stronger one. My own view is that in the course of time things will return to their natural order and Italy and Germany will underperform France in 2007 (and possibly by a wide margin) but for the time being we remain with the enigma, which is undoubtedly in some way associated with continuing euro strength. So it will now be interesting to watch this situation moving forward, and particulary over at the ECB where we may reasonably expect enthusiasm for further rate rises to begin to cool notably.

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