Eurozone Watch nominated for Satin Pajama Blog Award

For the third time in a row, the blog “A fistful of Euros” is conducting its poll on the “Annual Satin Pajama Blog Award”. For the first time, Eurozone Watch has been nominated in two categories: “Best Economics Weblog” and “Best New Weblog”.

So far, we are doing quite well in the “Best Economics Weblog” category (especially given that we are a little late actually alerting our readers about that competition – the polls opened on May 23 and this post dates from May 27), at the moment behind only a fraction of votes behind Nouriel Roubini’s blog.

So, if you wish us luck, go to the Afoe website and vote for us – its fun and free. Click on the banner below:

Eurozone enlargement: Evaluating Cyprus and Malta

Last week, the EU commission confirmed what seemed to be clear for quite a while now (see our predictions for 2007): Malta and Cyprus managed to fulfill all of the Maastricht convergence criteria and will thus join EMU on January 1, 2008, taking the number of club members to 15. In both countries, inflation and budget deficits seem to be under control (an excessive deficit procedure against Malta has been ended) and the long-term interest rate suggests that financial market participants believe that this will remain so in the foreseeable future. With regard to government debt, both countries have debt-to-GDP ratios of above 60 percent, but profited from the rule that this is acceptable as long as the ratio is approaching this mark at a “satisfactory pace” which the commission judged to be the case now.

While Eurozone Watch has argued before that the convergence criteria are not necessarily the best criteria to check whether a country is ready for EMU, in fact, there do not seem to be a lot of problems for Malta and Cyprus entering the currency union. We have argued that instead of only looking at inflation and budget deficits, one needs to look for signs of overvaluation prior to entering EMU as adjustment in the form of real depreciation within a currency union might be very painful and costly (see the argument here ).

On this regard, Malta and Cyprus seems reasonably well positioned compared to some of the other countries which are striving to join EMU over the coming years. While the current account deficits of both Malta and Cyprus are already significant (at about 5 percent of GDP) which might signal a slight overvaluation, this still compares favorable to the double digit figures of the Baltic countries (which want to join EMU in 2009 and 2010). In both countries, wage growth is rather limited at the moment (3.5 percent in Cyprus and 1.5 percent in Malta), meaning that the competitive position of the islands is not deteriorating anymore and giving reason for hope that their labour markets will work well in an EMU-environment. This conclusion looks even more solid as both countries record decent (even if not overly strong) productivity increases (in contrast to countries such as Spain or Italy which have comparable wage growth to Cyprus).

However, especially for Cyprus some risk remains: Should Cyprus be reunited with the North of the Island, the necessary investment in infrastructure update might cause a boom which in turn might lead to strong wage increases on the island, similar to what Germany has experienced after its reunification in 1990. Short of this development, however, the two new euro states look reasonable ready for the common currency.

EU-commission simulation shows an outperforming German economy until 2014

Air travel in Europe can be extremely exhausting. Delayed departures, hours of waiting in airport lounges, some more hours of waiting on the tarmac. However, I often manage to do a good deal of reading, taking all those papers with me that I wanted to read in the months before, but which I just had not managed to have a good look at.

So, an extremely interesting simulation study by two economists from the EU commission already published in March (European Economy Economic Paper No. 274) came across my way this week. Sven Langedijk and Werner Röger have built an economic model in which they try to replicate the divergent developments in growth, current account and inflation in some countries (Germany, Spain, Netherlands, Portugal, Italy and Ireland) of the euro area over the past years by introducing some external shocks.

For Germany, they explain the weak growth since 1999 with four factors: First, the German economy entered EMU at a slightly overvalued exchange rate. Second, Germany lost its interest rate advantage vis-à-vis the rest of the euro area with the start of EMU. Third, as Germany had seen overinvestment in construction in the reunification boom, there was less demand for housing afterwards. Forth, structural change in the German banking system increased lending rates which hindered fixed investment.

For Spain, they explain the strong growth with the fall in the country-specific risk premium and thus interest rates with the beginning of EMU. Housing investment has also benefited from financial market liberlisation. In addition, there has been a lot of immigration and some changes in the wage setting process as well as an increased degree of import penetration in the Spanish economy which has increased competitive pressure on Spanish companies. In addition, Spain has seen a rising demand for housing from abroad.

Building on this exercise, they use their model to simulate the developments in the years to come for Germany and Spain. They assume that the correction in the German housing market will soon be over (for which in fact there is good evidence), that the situation in the German banking sector has normalised and that there will no further shocks to German corporate investment. On the downside, they assume that productivity growth in the German non-tradable sector will even decline, towards levels of the rest of EMU. Under these assumption, the outlook for Germany is pretty bright: In the simulation, output growth in Germany (in per-capita-terms) will outperform that of the euro-area until the end of the simulation period in 2014. The same is true for employment, investment and housing.

For Spain, the scenario is much less benign: The authors assume that the housing boom will fade in late 2007 (a development we also have already seen some evidence for). On the positive side, they assume that productivity growth in Spain will pick up strongly and reach the level of the other euro area countries. However, even with this positive productivity shock, Spain will not be able to outperform the rest of the currency union anymore. Investment demand will slow sharply and will undershoot euro area investment growth until 2011. Growth in private consumption will also drop below the euro zone average and will remain subdued until 2015.

While especially the Spanish scenario carries a lot of downward risks (betting on a pick-up in productivity is always tricky as we do not know much about where productivity comes from; in addition, the authors believe in a rising employment ratio which seems questionable given the weak demand scenario of the model), the basic message is very similar to the analysis of Eurozone Watch: Chances are good that there will be a long period of over-performance in Germany and a long period of underperforming in Spain.

Analytically, we can say that we see a prolonged business cycle in the euro-zone: After Germany experienced a long period of adjustment since the beginning of EMU in 1999 with growth rates significantly below those of the rest of the Eurozone, it might now see a long upswing. The opposite is true for Spain. One of the reasons behind this is the common monetary policy in EMU with a fiscal system which could stabilize business cycle fluctuation. A boom fuels itself since higher inflation in one country leads to lower real interest rates and thus higher (housing) investment. Only after years, when the competitive position has deteriorated significantly enough and export demand is slowing, the boom will come to an end and a long period of adjustment follows.