Europe’s Misguided “Growth Pessimists”

Such is the deep pessimism in Europe about the economy that the better the economy does today, the worse people think it will do tomorrow. This year has been an excellent one for Europe’s economic growth. Yet instead of thinking that the momentum building in 2006 will carry forward and make 2007 an even better year, Europe’s gloomy experts are predicting a significant slowdown. For them, it seems out of the question that Europe can have two good years in a row.

Of course, every year has its growth challenges, and 2007 will be no exception. What motivates – or frightens – the growth pessimists, in particular, are (1) higher European interest rates, (2) the slowing US economy, and (3) the increase in the German value-added tax (VAT) from 16% to 19% set for the beginning of the year.

But they are wrong to be frightened by these factors.

Fear over the growth effects of the European Central Bank’s 2006 rate increases is based on confusion between real and nominal interest rates. By the end of the year, European interest rates will have been raised 150 basis points (to 3.5%, from 2% in January). But European inflation is growing at approximately the same rate. This means that real interest rates – interest rates measured in terms of goods and services – have stayed the same. And it is the real interest rate – not the money rate – that counts for economic growth.