Triple threat to eurozone recovery

FEW would have predicted the euro area would grow faster than the US and newly re-energised Japan at some point this year, yet that’s what happened.

High taxes and stifling regulations notwithstanding, the 12 nations sharing the euro have shown signs of economic life.

In the second quarter the economy expanded at its fastest pace in six years — 0.9% compared with the first three months. It was the first time since late 2001 that Europe’s economy had outpaced the US, which grew 0.6%.

Europe also outperformed Japan’s 0.7%.

The recovery was broadly based. Germany grew a faster than expected 0.9% in the second quarter, helped by spending on the soccer World Cup. In France, the economy expanded at a healthy 1.2% rate, its fastest in five years, although the permanently disappointing Italian economy only expanded 0.5% in the second quarter, down from the first.

The International Monetary Fund predicts the euro area will grow 2.1% this year, compared with 1.3% in 2005. The real issue is how durable this recovery is.

The global economy has been strong, exports have surged and low interest rates have fuelled booms in consumption and house prices. It isn’t hard for economies to expand in such benign conditions.

The big test comes in 2007 and there are three threats.

“A stronger euro, higher interest rates and a significant fiscal tightening will inflict a triple whammy on the euro area recovery next year,” Morgan Stanley economist Eric Chaney said in a note to investors last month.

The euro has been stable against the dollar for the last few months, yet we shouldn’t expect that to continue. Growth is set to slow sharply in the US and the Federal Reserve may have stopped raising interest rates.

The European Central Bank appears intent on further raising its main lending rate, now at 3% after four increases in eight months.

All the main euro area governments are embarking on a fresh round of fiscal tightening.

Germany, Italy and France are determined to reduce their budget deficits, either through higher taxes, lower public spending or a combination.

Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.