The Euro Zone: Sunshine or Twilight?

Growth is threatened by rising interest rates, the currency's strength, and slowdowns elsewhere

After years of lackluster performance, Europe's economy is now growing at its fastest clip since 2000. The 12 nations that have the euro as their currency grew at an annualized 3.6%, faster than the U.S.—in the second quarter this year, according to flash numbers from Eurostat, the European Union's statistics agency.

Leading politicians around the Continent were quick to give themselves and their policies a pat on the back. Finance Minister Thierry Breton boasted France's growth strategy "is bearing fruit." In Germany, Economics Minister Michael Glos argued that the 3.6% annualized growth there showed that the country's economic prospects were "exceptionally positive."

Economists, however, remain decidedly skeptical. "The big question now," says Jonathan Loynes, chief European economist at London's Capital Economics, "is how long can the euro zone recovery continue?" The European Central Bank has been raising key interest rates, which most ECB watchers now expect to reach 3.5% by year-end, from 3% now.


  Already, there are signs the cumulative one- percentage point increase since the end of last year is starting to slow the surge in home loans that has fueled a housing construction boom in countries such as Spain and France. Also, the strong euro and slowing global growth could both hit Europe's still heavily export-oriented economies by making its goods and services more expensive in the rest of the world.

The biggest wild card is the German government's plan to hike value added taxes by three percentage points, to 19%, next January. The measure is intended to take a bite out of the federal government's budget deficit that has been running at more than 3% of gross domestic product. It could boost consumer spending at the end of this year as people rush to buy at the old rate.

But it could also knock the stuffing out of Europe's biggest economy in 2007, by snatching an estimated $25 billion from its consumers' pockets, or about 1.5% of household income, just as real wages turn negative.


  Too bad, because consumers in Germany seem to be hitting their stride. This year, there have been signs that consumer spending, rather than exports, is starting to stoke up the German economy (see, 6/15/06, "Germany Takes Out Its Wallet").

The country's Federal Statistics Office says construction and investment in equipment contributed to the second quarter's growth surge, adding it was too early to judge how much consumer spending during the soccer World Cup added to growth (see, 3/22/06, "For Germany, a Cup of Plenty?").

Paradoxically, the economic uptick in the first half of this year has led to a surprisingly big boost in tax revenues. The Handelsblatt financial newspaper reported last week that the combined tax take of federal and local governments through July was running some $25 billion ahead of official forecasts. The Finance Ministry said that tax collection is indeed better than expected, but wouldn't confirm the number.


  Still, the trend is prompting business leaders and other critics of the policy to demand the postponement or a reduction of the VAT hike. Others would like to see business taxes reduced more aggressively than planned. But there is little sign that Chancellor Angela Merkel's coalition is in any mood to change its mind.

France, the Continent's second-biggest economy, grew even faster than Germany, reaching an annualized rate of between 4.4% and 4.8% in the second quarter, according to Insee, the national statistics institute. That was only the third quarter in the past two decades to reach such high numbers. The institute said the acceleration from annualized 2% growth in the first quarter was due to stronger consumer spending and industrial activity. Though foreign trade was in deficit because of high energy imports, there were signs that exports to Asia were picking up.


  Several other countries, from the Netherlands to Italy, Spain, and Sweden, also delivered better-than-expected growth in the second quarter. That raised a glimmer of hope that the European recovery might become self-sustaining as well as Continent-wide. Most economists are tweaking their forecasts for Europe's growth in 2006 by adding a couple of tenths of a percentage point to their earlier estimates.

What everyone is wondering now is how long is Europe's nascent growth spurt—and how strong. The answer won't come into focus until detailed data are released in late August on how much consumption, exports, investment, and government spending contributed to the recent quickening of growth. Until those numbers are available, optimists can argue loudly that Europe might at long last be sloughing off the low-growth curse that has bedeviled it for so long.

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