In a world where US growth is expected to decline, Europe holds out the most potential to support global growth going forward.
The EU-25 as a whole is a region of slightly larger GDP than the US and so has the potential to relieve it as a key engine of global growth. Unfortunately, while European growth is expected to look healthier than last year, it is likely to fall short of its potential both this year and next.
Like a troubled student, Europe has much potential but appears sometimes to lack application. Household saving rates in Europe are relatively high, suggesting plenty of scope to boost consumption. Many of the Anglo-Saxon economies, such as the US, Canada, Britain, Australia and New Zealand, have very low rates of household saving. Americans on average tend to save less than 1% of their after-tax income, compared with 7% at the beginning of the 1990s.
In Australia and New Zealand, conventionally measured saving rates are negative. Even Japan’s saving ratio has fallen from 15% in the early 1990s to 5% currently. By comparison, the saving rates in France, Italy and Germany are all around 10%.
Moreover, productivity growth is still tracking at a reasonably high level in Europe. The International Labor Organisation estimates productivity growth in Western Germany has risen by almost 2% per year on average since 1973. That is even faster than the impressive US result. Productivity growth is slightly slower in France, but still betters the US.
So if the potential is in Europe, why isn’t the promise?
The biggest challenge facing the European economy is that it is highly regulated. Ironically, it is the highly regulated labour market that explains why productivity in Europe is so high. In Germany it costs 21.3% of one year’s salary to hire a person. In France it is 47.4%. This compares with 8.5% in the US1.
The expense and inflexibility of hiring and firing labour in Europe has left businesses with no choice but to find substitutes for labour. This has helped to boost business investment, which has grown almost twice as fast as the overall economy in the past year. It has also encouraged merger and acquisition activity. In 2005, European M&A activity was worth $1 trillion, 49% higher than in 2004. This compares with $1.18 trillion in activity in the US, 32% higher than in 2004.
The less favourable consequence of such a highly regulated labour market is high unemployment. The situation is particularly bad for Europe’s young and low-skilled workers, where the unemployment rate is more than double the overall rate, at around 22% in France. In Germany the rate is lower, at 15%.
So Europe faces a challenge in unleashing its consumers, despite the potential. Adding to the headwinds are higher interest rates from the ECB and an increase in the value added tax in Germany early next year. Rates have been raised three times already and the expectation is that more hikes will follow as inflation pressures creep higher.
The situation is not all bad, however. The labour market has improved leaving private consumption spending slightly stronger. Pressure is also mounting to implement some much needed reform. Tax reform is already underway in Germany, with further measures slated to reduce the tax burden on corporates. In terms of labour-market reform, the German Government has approved an increase in the retirement age, a reduction in unemployment insurance contributions and financial incentives for working mothers. Reform appears off the cards for now in France, however, following the youth backlash to attempts earlier this year and with the Presidential elections slated for next year.
Overall, the tepid economic recovery currently underway in Europe is expected to continue at around a 2% pace. With business confidence at a 15-year high in Germany, and corporate balance sheets healthy, much of the strength will continue to come from the corporate sector.
The risk to the growth outlook for Europe is a downturn in exports and a renewed spike in oil prices. Germany, the world’s largest exporting nation, is most at risk in this regard. Growth in Germany is expected to remain a muted 1%. Some of the smaller European economies will sport faster growth rates next year, but rely heavily on trade with Germany. France is more dependent on its domestic sector, and is likely to put in slightly faster growth of around 2% next year.
The UK economy is expected to growth at a slightly faster pace than continental Europe; around 2.5% next year led largely by domestic demand. This is a big improvement on the sub-2% print last year. Labour-market conditions remain sound from a historical perspective and the housing market appears to be in recovery mode after last years decline. The risk for the UK is a sharp slowdown in the US as 15% of British exports head that way every year (compared to only 8.7% of German exports).
While technically in recovery mode, Europe is still a second-string substitute to a sharply slower outcome in the US. Next week we will review the outlook for the US economy and weigh in on the probability of a sharply slower growth scenario.
By Tracey McNaughton, senior economistwith BT Financial Group.*
1 Doing Business Database http://www.doingbusiness.org/
