Opening the EU trapdoor at the worst time…

The avoidance of an extreme election outcome in the Netherlands is reassuring markets. But, tensions with Turkey have thrown up a new risk – where one country’s referendum spills over into another’s election. As for the UK, we could be inflaming the situation by opening the EU ‘trapdoor’ at such a politically sensitive time.

Tackling the cause of the euro’s underlying problems without stoking further social tension needs more than monetary expansion. So, to test whether the macro strains in the periphery are still holding back the core members, we update our ‘Misery Indices’ (MIs).

Off-the-wall methods for proxying economic hardship include an index adding together a country’s unemployment and inflation rates. Though hardly scientific, they become especially flawed in a low inflation world when the components may move in opposite directions. We thus offer a more logical alternative to previous MIs, and to conventional GDP estimates, for example, which are produced with a lag and frequently revised. Our MIs are the sum of two parts:

  • the absolute divergence of a country’s CPI inflation from the 1.9%yoy synthetic average since convergence was kick-started by the Maastricht agreement, in February 1992; added to
  • the divergence between that country’s unemployment rate and, to gauge the economic cycle, its previous five-year rolling average.

Chart 1 shows our predictions for 2017 and 2018. Rising MIs predict greater expected economic hardship, relative to that country’s recent past.

Chart 1. The method & sample data behind our Misery Indices (MIs)

The higher the ‘Misery Index’, the greater the economic hardship

First, after a marked deterioration in euro-zone members’ MIs during the global crisis, improvement since 2014 looks like being sustained.  As a bloc, the euro-zone’s (weighted) MI, at -1, this year should be its lowest since 2007.

Second, it’s not surprising to see as the ‘most miserable’ some of those members running austerity to cut deficits and debt. In 2017 Italy will, for the eighth year running, lie in the above-average-misery zone in chart 1. However, even this is much improved on 2010-14, and further gains look likely across the periphery.

Chart 2. Meaning their divergence from the core is correcting

The higher the ‘Misery Index’, the greater the economic hardship

Unhelpful euro-zone divergence is correcting…

Third, most revealing is what our MIs say about convergence. Chart 2 shows the two stages of convergence: from Maastricht in 1992 to the euro’s birth; thereafter, with the euro, a steady re-widening as policy discipline waned.

Our MIs confirm that convergence after Maastricht was solid. They proxy convergence by tracking the highest and lowest MIs each year. In 2017, Spain looks the ‘happiest’ relative to its recent past (where GDP last year grew 3%yoy), with Finland/Italy the ‘most miserable’ (GDP +1%yoy). Greater convergence is shown by the narrowing gap between the two extremes. It suggests misery is back down to when the euro became the single currency, with the gains driven by the periphery.

This combination of reducing macro strains in the periphery with a relatively slower improvement in the core means the divergence since 2008 is correcting. This is encouraging, though not of course sufficient for returning to economic health. This still rests on the core members, which account for 80% of euro-zone GDP.

Yet, despite the relative improvement, it will take years before the converging countries can reclaim their GDP. The typical lags involved point to structural unemployment remaining high, while the reform needed for greater economic union unintentionally holds back growth.

But, while far from fixed, the worst of the euro-zone’s macro strains does at least look behind us. Which is just as well, given the years it’ll take to reach the “balanced growth” sought by G20 governments, and – critically in 2017 – Europe’s highly-charged political year.

Neil Williams is group chief economist at Hermes Investment Management

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