WHAT was the message of this year’s World Economic Forum in Davos? I don’t know what Bono or Angelina Jolie or the Metropolitan Patriarch of Antioch may have been saying at their sessions, but from the economic policy discussions that used to be the main point of Davos before they were demoted to an unglamorous wonkish sideline, the main message was clear enough: Europe is back.
Now that the annus horribilis of 2005 is over, European politicians seem to have recovered their self-confidence, businessmen boast that their profits have never been better, financiers are floating their way to riches on a tide of easy money, academics are dusting off their predictions of an ever stronger euro, central bankers are smiling condescendingly at their erstwhile critics (myself included) and even trade unionists are broadly satisfied, convinced that Europe’s “social-market model” has survived the neoliberal Anglo-Saxon threat.
The improving condition of Europe was not, of course, the main topic, since even the most fanatical integrationists now recognise that events in Asia and the Middle East are more important to the future of the world than anything that may or may not happen in Brussels or Frankfurt. Indeed, the fact that China has overtaken Britain and France to become the world’s fourth-largest economy was announced with great pomp by the Chinese Deputy Prime Minister in Davos. But everybody has known for years about the inexorable rise of China.
On the other hand, the sudden revival of economic and political self-confidence in Europe, which seemed to be in an almost existential crisis as recently as last autumn, was a genuine surprise. And since the unexpected events are the ones that are most important, especially for business and financial planning, it seems appropriate to focus on this issue as the main message from Davos.
There is also, I must confess, a personal reason for me to dwell on Europe in this report. If Europe does remotely as well this year as almost everyone is now expecting, I will have to eat a lot of humble pie.
Last January I started my work for 2005 with a very bearish column about the euro and the European economy, and I then got even more pessimistic as the year progressed. For most of 2005 this view, which contrasted sharply with the perennial optimism of politicians and central bankers, turned out to be right.
So why have Europe’s prospects suddenly brightened? There are three possible answers. One was discussed at length at Davos; the other two, which I find more plausible, were hardly mentioned. The widely recognised answer is that while politicians were on their wild-goose chase for a new constitution and a social model, European companies woke up to challenges of globalisation and have been aggressively restructuring their businesses, making them more innovative and efficient. The evidence can be seen in rising profitability, soaring stock markets, a frenzy of mergers and buyouts and a jump in business confidence to its highest levels since 1999.
Whether one talked to businessmen or central bankers, trade unionists or financiers, the triumph of private enterprise over European public bureaucracy was the strongest consensus that I could identify in Davos this year. But as the alpine train descends into the real world from the magic mountain of Davos, the question that has to be asked after identifying such unanimity is whether 2,000 top businessmen and politicians could turn out to be wrong.
The previous record of such consensus, whether on technology, terrorism, currencies, recession or the Iraq war, certainly suggests the possibility that “the view from Davos” should be treated as a contrary indicator rather than a guide to what will actually happen. So why could the confidence in Europe prove misplaced? This brings me to the other, less bullish, explanations of recent mild improvements in Europe’s economic performance.
The first is the lagged effect of the American and Chinese booms. The high level of business confidence, especially in Germany, can largely be explained by surprisingly strong exports. This strength is due not only to industrial restructuring but also more directly to an upsurge of demand from outside Europe for German consumer and investment goods. That upsurge in demand has less to do with the quality of German goods or the efficiency of German companies than with soaring house prices in America, and crazy levels of over- investment in China. With the lagged effects of monetary tightening and high oil prices likely to hit both American consumption and Chinese investment this year, anyone who expects Germany to enjoy export-led growth this year is likely to be disappointed. The slight weakening of the euro in the first half of 2005 also helped, but the single currency has now perversely bounced back to an almost unprecedented level of overvaluation, especially against the Japanese yen.
Meanwhile, Europe outside Germany faces totally different but complementary pressures this year. The modest improvements in the French, Spanish and Italian economies that surprised many commentators (myself included) last summer had nothing to do with industrial restructuring, exports or labour reforms. They were caused mainly by an AngloSaxon-style house-price and mortgage boom. In France, Italy and Spain, exports have been a consistently negative influence on economic growth and employment for almost five years. Almost all of the growth these countries have enjoyed this decade has come from consumer spending (plus a few government make-work programmes). This consumer spending has, in turn, been fuelled by house-price inflation on a grand scale. For the past three years, house prices and mortgage borrowing have risen much faster in Spain, France and Italy than in Britain or the United States. As a result, Spain has a current account deficit equal to 8 per cent of national income, one third bigger than the supposedly unsustainable and dangerous US trade imbalance and more than twice as big as the deficit in Britain.
This points to a very different analysis of Europe’s economic prospects from the one unanimously accepted at Davos. As long as house prices and mortgage lending in Southern Europe keep growing at rates of 10 per cent plus, growth and employment will probably continue to improve, despite a weakening export performance. But if the property boom in Italy, France and Spain comes to an end, Europe will soon sink back into recession.
The most important question for Europe in the year ahead, therefore, is whether house prices and mortgage borrowing will slow down. In principle there is no reason why they should, because property in many parts of Europe remains reasonably valued and homeowners have plenty of housing equity that they could gradually convert into debt. But will European policymakers be prepared to encourage, or even tolerate, this leveraging process? And will European homeowners have the courage to increase their borrowings, after a period in which prices have already doubled and at a time when central bankers are turning increasingly hawkish? Strangely enough, the connection between the European economy and the housing market seemed not to have been even mentioned or recognised in Davos. My view, for what it is worth, is that European property markets will take a breather for a year or two after their climb. As a result, mortgage borrowing and consumption will both prove weaker than expected, while exports are hit by a slowdown in the US and China. If so, the “view from Davos” will once again prove wrong. If not, I must prepare for a meal which has never figured on the menu at Davos: a slice of humble strudel.
