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Europe’s misguided ‘growth pessimists’

by Melvyn Krauss

PALO ALTO, Calif. — So deep is the pessimism in Europe about the economy that the better the economy does today, the worse people think it will do tomorrow.

This year has been an excellent one for Europe’s economic growth, yet instead of thinking that the momentum building in 2006 will carry forward and make 2007 an even better year, Europe’s gloomy experts are predicting a significant slowdown. For them, it seems out of the question that Europe can have two good years in a row.

Of course, every year has its growth challenges, and 2007 will be no exception. What motivates — or frightens — the growth pessimists, in particular, are (1) higher European interest rates, (2) the slowing U.S. economy and (3) the increase in the German value-added tax (VAT) from 16 percent to 19 percent set for the beginning of the year.

But they are wrong to be frightened by these factors.

Fear over the growth effects of the European Central Bank’s 2006 rate increases is based on confusion between real and nominal interest rates. By the end of the year, European interest rates will have been raised 150 basis points (to 3.5 percent from 2 percent in January). But European inflation is growing at approximately the same rate.

This means that real interest rates — interest rates measured in terms of goods and services — have stayed the same. And it is the real interest rate — not the money rate — that counts for economic growth.

Europe must ask itself: How can interest rates induce a slowdown in 2007 when real interest rates have hardly budged despite an economically healthy 2006? Moreover, because profits are high in Europe, likely future increases in real interest rates needed to ensure price stability easily can be financed out of profits without economic disruption. The truth of the matter is that interest rates — both nominal and real — are too low in Europe, not too high.

As for the United States, plummeting gas prices — an extraordinary 25 percent decline in roughly one month — have increased consumer confidence and spending at a time when consumers were supposed to be in full retreat because of the housing market decline. Moreover, former Federal Reserve Chairman Alan Greenspan says the housing market correction is already almost over.

Pessimistic Europeans are behind the curve. They are bracing for a 2007 U.S. growth slowdown that already has taken place with little consequence for both the U.S. and European economies.

Of course, falling gas prices are occurring in Europe as well, and this will help take the sting out of the controversial VAT increase engineered by German Chancellor Angela Merkel. The German chancellor has been lucky. The falling gas price and Germany’s high profits will “finance” the tax increase, which should prove little more than a speed bump for the German economy, at least if lower gas prices hold into the coming year.

Indeed, the German government is slowly coming to realize that its pessimism about the economy has been misplaced, which is reflected in continuous “upward revisions” of growth forecasts throughout 2006.

Recently, the government raised its growth forecasts for this year and next from 1.6 percent to 2.3 percent for 2006, and from 1 percent to 1.4 percent for 2007. Expect further upward revisions as the government continues to be surprised by the economy’s ongoing strength.

An important byproduct of Europe’s good growth is that it is making the need for structural reform an urgent matter. The lack of structural reform of Europe’s labor markets, competitive practices and so on has meant that European potential economic growth — its growth ceiling — is lower than it should be. With a low growth ceiling, strong economic performance generates inflationary pressures at a relatively early stage in the growth process. This makes it hard for Europe to enjoy an extended period of high growth without inflation.

Premature inflationary pressures are a prime reason that both European Central Bank presidents, the late Wim Duisenberg and now Jean-Claude Trichet, have consistently pressed for structural reform in their press conferences and speeches. It is the ECB, after all, that must fight the inflation caused by Europe’s lack of structural reform.

Growth pessimists have a point if they are wary about Europe’s prospects in achieving structural reform to raise the growth ceiling. Europe’s politicians simply refuse to take the lead on this all-important issue.

They are wrong, however, about Europe’s prospects for achieving its restricted growth potential. Europe’s actual economic growth has been quite good and — thanks to low gas prices, low real interest rates, solid profits, and strong growth momentum — promises to get better before the ceiling is hit and inflationary pressures set in.

Call me a “growth optimist,” but Europe looks poised for another good growth year in 2007.