Wed, Nov 08, 2006 - Page 9 News List

Europe's `growth pessimists' are making a good thing look bad

By Melvyn Krauss

Such is the deep 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 this year will carry forward and make next year an even better year, Europe's gloomy experts are predicting a significant slowdown. For them, it seems out of the question that Europe could have two good years in a row.

Of course, every year has its growth challenges, and next year will be no exception. What motivates -- or frightens -- the growth pessimists is higher European interest rates, a slowing US economy and the increase in the German value-added tax from 16 percent to 19 percent for the beginning of next year.

But they are wrong to be frightened by these factors.

Fear over the growth effects of this year's European Central Bank 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 interest rates can induce a slowdown next year when real interest rates have hardly budged despite this year being economically healthy.

Moreover, because profits are high in Europe, likely future increases in real interest rates needed to ensure price stability can easily 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 US, 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 US growth slowdown next year that has already taken place with little consequence for both the US 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 value-added tax increase engineered by German Chancellor Angela Merkel. She has been lucky, because the falling price of gas 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 this year. Recently, the government raised its growth forecasts for this year and next, from 1.6 percent to 2.3 percent for this year, and from 1 percent to 1.4 percent for next year. Expect further upward revisions as the government continues to be surprised by the economy's ongoing strength.

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