Hamish McRae: Welcome a cut in eurozone interest rates today - but beware deflation in Germany

Europe will get its interest rate cut today and that is fine. For months now the European Central Bank has been attacked for having its guns aiming in the wrong direction: aiming out to sea at the old enemy of inflation instead of inland at the greater peril from deflation. Of course we don't yet know whether the cut will be the minimum of a quarter-percentage point or the more probable half-percentage point but at least there is movement. And it can always move again – at least the eurozone is not in the position of Japan and maybe the US, where short-term rates are so low that further cuts are ineffective.

Now the concerns will change. Instead of worrying about the failure of the ECB to cut rates, people will start to worry about the slow response of the core European economy to cheaper money. One problem that has rightly attracted huge attention is the contrast between the core and the fringe. The core – Germany in particular but also Italy and to a lesser extent France – has been stagnant while the fringe has kept growing. But partly because of the weight of the core there is also a general sluggishness throughout the region. Real gross domestic product in the eurozone grew by about 1.6 per cent in the first half of this year, which is OK, but seems to have fallen back to little more than 1 per cent in the second half.

The key is domestic consumption. Europeans have gone on something akin to a spending strike and it is not quite clear why. You can see this in the top graph: consumption growth is only just positive and attitudes to major purchases are really very negative indeed. You can just detect a tiny kick up in the confidence in the retail trade figures (middle graph) but it is really very tiny. European retailers are still profoundly gloomy; merely a little less gloomy than they were a month or two ago. At any rate, in the year to end-June 2002, consumption in the eurozone rose by only 0.7 per cent. This compares with a rise of 4 per cent in the UK and 3.1 per cent in the US. It was even lower than Japan, where consumption rose by 0.8 per cent.

But why? There is an obvious general explanation in the global downturn and the rise in unemployment that has happened in core Europe. But the US has seen a sharper rise in unemployment, albeit from a lower level, and has in any case a much weaker social security safety net. Yet consumption there has gone on rising. (In Britain consumption has also continued to rise, though intuitively I suspect that it may come off surprisingly sharply next year.)

Part of the explanation lies in the inflationary impact of the introduction of the euro. The official figures suggest that it has not led to any particular rise in inflation, but hardly anyone believes them. This distrust is measured in the bottom graph, in which the economists at JP Morgan have plotted perceived inflation against consumption. As people have thought inflation has risen so they have cut their spending.

There are several reasons the official figures should not reflect what people are feeling. One is that in some instances the index seems to have been massaged, by changing the items in the sample, to show lower inflation than is the case. Another is that some of the prices people notice – personal services such as a cup of coffee or a haircut – have indeed risen sharply, but they account for only a small proportion of total spending. Another is the way that for technical reasons the European measure does produce a lower number than, for example, the UK retail price index. Still another is that people notice price rises more than falls, particularly when they are confused by a change in the currency.

But I cannot believe the lack of consumption in Europe is just an adverse reaction to the euro. It must surely reflect wider concerns. It is very hard to catch a grip on these in any scientific way. But I suspect that they include worries about how an ageing population will care for its elderly, rising taxation, the indebtedness of the state, and the ineffective response of many Continental European politicians to these concerns.

This is a quite disturbing combination. You might expect some spontaneous recovery in consumption as memories of the introduction of the euro fade – economies are to some extent self-adjusting – but the longer-term concerns will not go away. Indeed insofar as they are the result of demography, they will get worse. In this context, can an interest rate cut help?

Well, it must help a bit. It will help business confidence, which it also pretty shot. (You think British business executives are gloomy? You should talk to their German counterparts.) But unfortunately the eurozone economies are not so sensitive to interest rates as are the US and UK. Housing debt is mostly fixed rate and therefore a cut in rates does not have an immediate impact on monthly budgets through a cut in mortgage payments. In most countries the extent of home ownership is smaller. And consumer debt is smaller too. On a long view that may be no bad thing, for there are legitimate concerns about the scale of UK and US household debt. But if you want to pump up consumption in the eurozone, do not expect a cut in rates to be a particularly effective way of so doing.

So what will happen? In the short term expect some modest recovery in consumption in Europe. But expect also the economic divergence between the core and the fringe to widen still further.

However big the cut in rates by the ECB today, rates will still be too high for Germany. This is partly because it entered the euro at too high a rate: according to the International Labour Organisation German manufacturing labour costs are 45 per cent higher than in France and 66 per cent higher than Italy. Gulp. But it is also because Germany, which is growing very slowly if at all, has real interest rates that are much higher than, say, Spain, which is growing strongly. With differential inflation rates across the eurozone, a single nominal interest rate means very different real interest rates. Spain needs higher real interest rates than Germany but actually has lower.

The main worry in the next two to three years is that Germany follows Japan into deflation. The way to stop that will be for the ECB to cut rates even more aggressively in the months ahead. There is an interesting prediction by the independent consultants, GFC Economics, that European rates will have to fall much further in the next year. We will see. But if deflation does take hold in Germany, not only will that be very hard to shake off; it will destabilise the whole eurozone. So do welcome the cut in European interest rates. But don't expect it to be particularly effective in boosting demand in the short-run. And be aware that it solves none of the longer-run problems of a one-size-fits-all interest rate that manifestly does not fit the eurozone's biggest member.