How Is Europe Doing Amidst All This Chaos?

If the structural threats to world trade are serious, but not to the point of jeopardizing growth in the European Union, what about domestic demand, which represents 83% of the final demand addressed to its producers? Although mixed, news on this side are not so bad.

In continental Europe, demand is supported by German wages…

As previously mentioned in this blog, the German economy is at full employment, if not beyond, and the impact on wages is clearly visible. In sectors where manpower shortage is most acute, such as that of construction, wage costs are rising by 4% per year. In services, the rate is around 3% and, even in the industry, wages are rising faster than in the rest of the eurozone. Despite what is often said on this side of the Rhine, the excellent health of the German labour market is a boon for its neighbours, because it benefits consumption, and reduces the competitiveness gap, provided, of course, that domestic wages remain under control. The Macron-Philippe team is well-aware of this, since it resisted the sirens’ call for an increase of the minimum wage.

... and the stimulating policies of the ECB, France and Italy

Second, economic policies are - generally - in favour of growth. Even if the European Central Bank has stopped adding, month after month, further stimulus in the form of purchases of government and corporate bonds, it continues to step on the gas by leaving its rates and balance sheet unchanged. The best evidence for this is that narrow money supply (M1), often considered to be a coincident cyclical indicator, grew at an annualized quarterly rate of 7.1% at the end of 2018. Also, its broadest version, M3, was at a rate of 5.1%, which is higher than current GDP growth, and is thus signalling an abundance of liquidity. Furthermore, since wages are rising faster in Germany than in other countries of the Eurozone, the common monetary policy is more stimulating there, because inflation-adjusted interest rates are what matters most to the economy.

Unless there is a major supply shock (competitiveness) or demand shock (confidence), the European economy should be - in theory at least - less sensitive to the global slowdown than China or the United States, thanks to the good performance of its domestic demand. The probability that the economic outlook will not follow this reasonable and rather optimistic scenario is unfortunately significant, due to two internal EU risks.

Two risk factors: Brexit and Italy

We have talked about the first risk so extensively that we might end up underestimating it. If, on 1 April, the United Kingdom left the EU without any further ado, the supply shock caused by the temporary fall in trade and the disruption of production chains could be considerable. Of course, it would be much more important for the United Kingdom than for the EU-27. Of course, continental economies are more deeply intertwined than with the UK, at least for the production of goods. Yet the fact remains that the shock would be negative, and that its magnitude cannot be quantified precisely in advance, because network effects are too difficult to assess, particularly in finance.
 
The second risk is the path of the Italian economy. Although it is known in Brussels that Italy poses a systemic risk, and in Rome that the Italian population values the economic stability provided by the Euro, the fact is that the economy has been stagnating over the past six months due to the tightening of monetary conditions, particularly in credit to SMEs. The tightening was caused by investors’ distrust (i.e. mainly Italian savers) towards the extravagance of the agenda of the Lega-Five Star coalition. Fiscal stimulus should revive the economy, but it will also rekindle the doubts that the markets and eurozone partners of Italy which guarantee its monetary credibility - Germany above all -, already have about the sustainability of Italy's public debt, and the soundness of its banking system. The latter’s balance sheets are far from being cleaned up from the bad loans accumulated over the last ten years. Yet, experience has shown that the Italian economy is resilient, that its public debt, while not sustainable in the long term, is well managed, and that companies, which are often operating via networks in Northern Italy, are innovative and highly adaptable. In the short term, the risk thus seems to be more political than financial or economic.

In France, manufacturers are rather optimistic

To conclude, a word on France. If 2018 was a disappointing year, ending with a stagnant domestic demand, prospects for 2019 could be more promising. Let us start with the bad news. In January, the National Institute of Statistics and Economic Studies’ (INSEE) monthly survey of real estate developers showed a further deterioration in the demand for new housing. Forecasters pay attention to this survey, because it has often warned of turning points in advance in the past. However, an exogenous factor, i.e. the replacement of a broad-based wealth tax (ISF) by a narrower one, focused on real estate (IFI)the ISF is likely responsible for this fall, illustrated by the sharp deterioration in upfront payments reported by developers.

Industrialists thus cite the creation of new capacities as their investments’ main target, with a confidence unseen since the boom of 1999-2001. As for the good performance of demand reported by companies, which is a good surprise, it illustrates the fact that, on the whole, the French industry is less sensitive to fluctuations in world trade than its German counterpart and, on the other hand, is sensitive to both domestic and German demand.
 
In 2019, the French economy could paradoxically do well in a general context of slowdown and political risks. An excellent reason to keep the reforms going!