Economic View: Europe wakes up to reality

The headlines last week about the eurozone economy were dreadful: "Recession spreads to three EU countries"; "Germany slips into recession as costly euro hits exports"; "Flat growth in eurozone casts doubt on recovery".

To any reader of this column, such headlines will come as little surprise. It has been clear to anyone with an intuitive feeling for the way economies behave that the eurozone would struggle to escape recession. European politicians and British cheer-leaders for the euro tried to pretend that things were all right when it was screamingly obvious that they weren't. The pro-eurozone camp has simply been in denial.

But now the complacency is starting to be knocked out of the European economic establishment. Even Chancellor Gerhard Schröder had to admit that Germany was stagnating - although "I would not", he told television viewers, "speak of recession at this stage". To say that when the German economy has shrunk for six of the last nine quarters (see left-hand graph) is pretty stupid, but at least to acknowledge stagnation is progress. Both Italy and the Netherlands, which have joined Germany in recession, do at least admit it.

Until you admit you have a problem, you can't fix it. But I do think we may be starting to see sufficient changes in economy policy, particularly in Germany and France, to create conditions that could sustain a real recovery. Governments cannot create economic growth; that has to come from the "animal spirits" (Keynes's phrase) of ordinary citizens. But they can remove barriers to growth and that is what, in a modest way, both Germany and France are doing.

Germany has gone further than France. Indeed, many Germans now feel they are in the early stages of a revolution that will reform the country's post-war social market economy. Just last week, the Chancellor won Cabinet approval to bring forward tax cuts for next year. That will help in the short term. He also got through a package of reforms in social security, cutting unemployment benefit and easing some of the restrictive labour laws that protect workers from being laid off.

In addition there are pension reforms, which include increasing the retirement age, freezing contributions and slowing the growth in pensions. There are also health reforms, which include greater competition in provision and higher patient contributions. Finally, there is further pri- vatisation, including the German post office and the rest of the telephone system.

You could say that Germany is now having its Thatcher revolution. And though this revolution is being carried out in a more measured and consensual way, some aspects of it - for example in health care - go further than anything yet tried in Britain. While the benefits of these reforms aren't likely to come through quickly, I am intrigued that UBS, which has studied reform both in Germany and France, has started to upgrade its growth forecasts for Germany as a result. It thinks the country's GDP could grow next year by 1 per cent rather than 0.5 per cent, and that growth could pick up further in 2005.

France is making slower progress than Germany, but since it has had a better performance, arguably it does not need to move so far. There are two main areas of reform: pensions and health care. Pensions contributions are being extended (rather than increased) and the qualifications under which people will receive a full pension are being tightened. France is also starting to encourage private sector funding along the lines of the pension systems in Britain and America.

In health, there will be reforms later in the year, the aim being to cut the costs of the system. France's health care is excellent but hugely expensive, with the result that there is a growing gap between outlays and the income available from social security contributions. The solution so far has been to try to trim costs and increase taxation. But the gap still widens. Ultimately there will probably be some form of partial privatisation, but that is perhaps another year away.

Germany and France together account for half the eurozone economy. It they make substantial reforms, they shift the whole ethos of continental Europe. If as a result they improve their economic performance, then they lift the whole of the eurozone with them.

But by how much? I don't think it is realistic to expect trend growth in the eurozone economy to be more than about 2 per cent a year. In other words, its trend growth rate is 0.25 to 0.5 per cent lower than that of the UK. But I do think it reasonable to expect eurozone growth to come back to its trend, even exceed it for a while.

In the right-hand graph are some long-term consensus forecasts for the eurozone through to 2007. As you can see, growth looks like remaining positive this year on an annual basis, with a better second half compensating for a bad first half. More importantly, the economists in the survey think there will be a recovery next year and that the run through to 2007 could be quite decent.

That general conclusion feels right. My guess is that the consensus is too optimistic for this year, because I think the rebound will take longer to come through. But next year could be a lot better. The long-term trend of growth does seem to be sinking slowly, but two or three years of above- trend growth are quite possible.

This may not be particularly exciting, but it is not nearly as dreadful as the recent headlines imply. The monetary and fiscal rules of the eurozone will continue to hobble its economy, but provided the reform process continues - and here Germany is the key - it could have a respectable few years of growth. People will date this recovery to the scare that the policy makers have received in the past 18 months.