Like a manic depressive, the eurozone economy is either up or down, exuberant or glum, rarely in a state of normality. If you look back at the annual growth rates over the past 10 years of the 12 countries currently constituting the eurozone, you see an extraordinary degree of volatility. The eurozone economy managed to come close to its estimated cyclically adjusted annual growth rate of about 2 per cent in only two years out of 10. In most years growth was either above 2.5 per cent or below 1.5 per cent, and often quite a bit higher or lower.

Is there an end to the boom-bust ride in sight? Probably not. What is far more difficult to discern, however, is whether we are heading up or down, or both.

Readers of this column will know I have expressed scepticism about the eurozone’s long-term growth prospects in the past. But let me try to make the optimistic case for once. The optimists, most of the investment banks among them, assume a relatively stable global environment – a “soft landing” for the US economy and no further devaluation in the dollar’s exchange rate against the euro. They also assume, correctly in my view, that the 3 percentage point increase in value-added tax in Germany will be less of a big deal than feared. There is a fair degree of self-sustaining positive dynamics at work.

The optimists argue further that Germany, in particular, managed to improve its competitiveness through wage moderation. The country is now benefiting from an export-driven boom. That is true as well, though this can hardly count as a viable strategy for the long run. I am even less persuaded by the argument that the few structural reforms have already raised the structural growth rate. Even the best reforms take time to work through the system. And the eurozone did not have the best.

As far as the global environment is concerned, the optimists may turn out to be right once again – they have been right for some time now. What we do know is that global imbalances will adjust one day and that such an adjustment would almost certainly be accompanied by a devaluation of the dollar. If that adjustment came about quickly, for example through an economic downturn in the US, it would undoubtedly reduce world economic growth. Of course, we have no idea when or how it will occur. In other words, the optimists will be right until they are wrong.

The case of the pessimists is intellectually more persuasive. While the timing of the adjustment is impossible to predict, it is certain it will eventually happen. Once it happens, the eurozone will take the full brunt of this adjustment. While the eurozone trades less with the US even than with the UK, a significant devaluation of the dollar would normally leave the euro also strengthened against third currencies, especially from Asia. With its reliance on exports of manufactured goods and an underdeveloped services sector, the eurozone is not in a strong position to switch from the production of tradeable to non-tradeable goods. Like a supertanker, the eurozone can pick up and maintain speed, but it is not built for sudden changes of direction.

The eurozone faces three specific, and to some extent related, risks next year: a US recession, a collapse in the dollar and further rise in eurozone interest rates. Over the past month, we have had a taste of each. There have been signs of a slowdown in US growth, especially in the housing market. There is great uncertainty about the near-term outlook, with the bond market taking a much more glum view than the Federal Reserve. The euro appreciated against the dollar by about 5.5 per cent during that period and eurozone short-term interest rates have been rising and will probably continue to rise next year. The European Central Bank remains concerned about the impact of next year’s German wage round and strong growth in money supply and private credit. As long as these uncertainties persist, the ECB can be counted on to tighten policy further.

Of course, the best outcome would be a couple of years of strong growth with low inflation, while global imbalances gradually adjust. But it is also possible that boom and bust could follow in quick succession. The eurozone may boom until hit by the combined force of higher interest rates, a higher exchange rate and possibly lower global equity prices.

This is the granddaddy of all boom-bust scenarios. I am not predicting it. But then I am not sure this scenario is any less likely than the optimists’ case, according to which global imbalances either never adjust or adjust in a benign way. We have no way of assigning probabilities to any of these scenarios. The best policy advice to the eurozone is to be prepared for a disorderly adjustment. It is advice the eurozone’s policymakers have yet to take on board.

munchau@eurointelligence.com

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