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OPINION

A euro surprise?

A euro surprise?
February 17, 2015
A euro surprise?

Despite last week's better than expected GDP figures, which showed the region's economy growing by 0.3 per cent in the final quarter of 2014, most economists are still quite downbeat. They expect real GDP this year to grow by only around 1.5 per cent - significantly less than the UK or the US.

And yet there are reasons for optimism. The weak euro should boost demand for exports. Insofar as quantitative easing does anything at all it should reduce companies' borrowing costs and so encourage investment. The lower oil price will raise companies' and households' real incomes; each $10 per barrel lower price, if sustained for a year, should add around 0.2 per cent to them. And there are even signs that bank lending has begun to reverse its long decline; loans to the private sector have risen in the last two months.

All of these factors, however, should be already embedded into economists' forecasts. Where, then, might the pleasant surprise come from? Aside from random noise - forecasts are usually wrong - there are two candidates.

One would be a reduction in uncertainty. Uncertainty tends to depress capital spending, simply by causing companies to postpone projects until better times. It's possible, though, that uncertainty will lift this year if the ceasefire in Ukraine holds and leads to less bad relations between Europe and Russia and if negotiations between the troika and Greece end satisfactorily.

One big reason to think this might unleash increased spending is simply that there is pent-up demand. The sheer length of the recession means that there is potential replacement demand for goods that have become out-moded or worn out. This is true both for companies - the volume of business investment is some 15 per cent below its 2007 level - and for households; even after their recent recovery, retail sales are still 2 per cent below their 2007 peak.

If spending should rise on this account, a second factor could then boost it further - multiplier effects.

We've heard a lot in recent years about fiscal multipliers. But there are also private sector multipliers, in three different senses. One is simply a knock-on effect; if one company steps up production, so too will its suppliers. Another is a sentiment multiplier. Christopher Carroll at John Hopkins University has shown that confidence spreads much like a disease; if others are more confident about the future, it increases the chances of their neighbours and friends becoming so. And then there is a social multiplier; our desire to keep up with the Joneses means that if our neighbours buy a new car, so too might we.

Through these multiplier effects, a small positive surprise can turn into a bigger one.

You might object here that stock markets are ahead of me. So far this year, euro area shares have risen 10.5 per cent in local currency terms - seven percentage points more than the MSCI's world index. Doesn't this show that markets are already anticipating good growth?

I doubt it. If they were, five-year nominal bond yields would not be negative in Germany. I suspect instead that what markets are anticipating is not so much good real growth as the likelihood that some of the money printed by the ECB will leach into share prices; this possibility, unlike the prospect of real growth, is consistent with negative bond yields. If so, then surprisingly good GDP growth might give a further boost to equities.

There is, however, a danger here. What if QE, cheap oil, a healthier banking system and reduced uncertainty don't raise growth? Fears would then intensify that the region is doomed to stagnate. And this could hurt equities not just by depressing dividend expectations, but also by increasing the fear of a political backlash against Europe's elites.