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France and Leading Indicators

May 30, 2005

This week is we look at two short articles on different topics from some of my favorite writers. The first is by Anatole Kaltsky of GaveKal Research and looks at some of the recent political and economic problems in Europe and what must be done to help turn the EU around. Germany recently had state elections (big upsets), the French vote on the EU constitution was this weekend (expected to be a rejection). These and other issues will have interesting long term implications for Europe and the European economy. (I am writing this week's OTB a little head of time to take a holiday on Monday, so I am not sure of the French vote.)

The second article is by Paul Kasriel of Northern Trust and discusses the leading economic indicators (LEI) and why economists seem to ignore what it is telling them. Paul finds a strong correlation between the LEI and recessions. Can you guess what it might be telling us now?

These two articles were both short, but had some interesting things to say so that is why they were both picked for this week's Outside the Box.

John Mauldin, Editor
Outside the Box

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The Death of the Federalist Project?

Why are the people of Europe so angry? The standard answer, as the Germans, French and Dutch all turn against their governments, is that the European project has gone too far and that political elites have over-reached, losing touch with the ordinary people. Their resentment about the loss of national political control to unaccountable Eurocrats of Brussels has finally boiled over. The French may be voting Non to defend their country against a European Union which they now see as a Trojan horse for ultra-liberal Anglo-Saxon values, while the Dutch (and the Danish and British) rejectionists may be driven by exactly the opposite motive, believing that the EU Constitution is trying to ensnare them in a centralised, over-regulated, Gallic state. But far from discrediting the anti-EU movement, this diversity of opposition actually accounts for the power of the revolt.

What people are voting against is not just one or other particular clause of the constitution, nor even its general tenor, whether this is too liberal or insufficiently so. The real bugbear is the idea of any unified Constitution which attempts to impose a single system of government on the whole of Europe and purports to harmonise away the political philosophies, economic preferences and social traditions developed in different nations over hundreds of years.

But before we assume that the federalists will simply give up in desperation, it is worth considering another possible explanation for the popular revolt against European elites. In Sunday's German election, which effectively destroyed Gerhardt Schroeder's government, his recent ratification of the EU constitution was not even an issue and Europe was far from the voters' minds. Two months earlier, the Berlusconi government suffered a similar fate in Italy, a country where Euro-enthusiasm remains undimmed. Why did this happen? In our view the answer is simple: It's the economy, stupid! As regular readers may be aware, we have always argued against economic determinism in British or US politics. But that is because the British and American economies have on the whole been performing well since 1992. Europe meanwhile has become an economic disaster.

The people of France, Germany, Italy and Holland may be angry about globalization or ultra-liberalism or immigration, but this anger reflects a deeper malaise. Their living standards are falling, their pensions are in danger; their children are jobless and their national pride is turning into embarrassment and even shame. In sum, they feel that their countries, which numbered among the richest and most powerful nations on earth as recently as the middle of the last decade, have gone to the dogs under the leadership of the present generation of politicians. And, at least in the economic sense, they are absolutely right.

The relative economic decline of "old" Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years.

This dreadful economic performance is more than enough to explain the political angst among Europeans. But what does it mean for the future of Europe? If Europe's economy remains paralysed, then the federalist project is clearly dead, as are all hopes of further significant EU enlargement. But if the economy recovered, the disillusionment with EU politics might quickly vanish.

What could bring about this miraculous transformation? The answer is surprisingly simple. European policymakers could kick-start growth and break the spiral of economic and political pessimism by doing exactly what America did in similar circumstances in 2001. They could drastically reduce interest rates and devalue their currency. As in Japan, interest rates could be reduced all the way to zero and the euro could be pushed down through intervention in currency markets. Such an aggressive policy of monetary stimulation could be guaranteed to revive economic growth, whether or not voters could be persuaded to endorse the labour market and pension reforms which Europe certainly needs in the long- run, but which can actually aggravate economic stagnation in the short term, as Chancellor Schroeder has learned to his cost.

There is only one obstacle to this monetary solution of Europe's problems. That is, of course, the European Central Bank. It is no coincidence that Europe's economic underperformance started with the centralisation of monetary policy under the German Bundesbank from 1991 onwards and deteriorated further with the formation of the ECB in 1999. In fact, the behaviour of the ECB has transformed the euro from a giant step towards European integration into the biggest single obstacle to the further development of the EU.

This is not the place to discuss in detail the ECB incompetence (Charles took a whole book, called Des Lions Menes Par Des Anes, to do that) which largely accounts for the economic and political malaise in Europe today. Suffice it to say that all of the major shocks to the world economy since the ECB was created have originated outside Europe - the internet boom and bust, the terrorist attacks of 9/11, the Iraq oil shock, the US corporate scandals, the rise of China... Yet in every case, the euro-zone has suffered more economic and social disruption than America, Britain or Japan.

If Europe's leaders want to revive any hope of EU integration - or even if they just want to save their own political skins - they have one obvious recourse. The first order of business in any revision of the European Constitution must be to change the objectives of the ECB and bring central bankers under the explicit political control which is taken for granted in Britain, America and Japan. Imposing some political discipline on the ECB would not guarantee popular support for EU integration, but it would at least acknowledge to voters that Europe has now suffered from a decade of economic incompetence bordering on sabotage.

Why Don't Economists Follow The Leaders?

The "leaders" to which I am referring are those in the Conference Board's index of leading economic indicators (LEI). The Conference Board on Thursday announced that the LEI fell 0.2% in April after having dropped a downwardly-revised 0.6% in March. On a year-over-year basis, the April LEI index is down 1.2% -- the largest year-over-year percent decline since the 2.0% drop in April 2001. I tuned in CNBC at 10:01 am EDT on Thursday morning, one minute after the release of the April LEI index report. Perhaps the CNBC commentators mentioned the report as it hit the wires, but there was no discussion of it in the minutes immediately after the release. In the Thursday edition of The Wall Street Journal, some economists were disparaging the LEI index as information that not only was "old," but also subject to revision. Moreover, the LEI index, in the opinion of these economists, is irrelevant in today's services-oriented U.S. economy. It is amusing to hear economists deride the LEI index for containing data subject to revision. Economists attach great importance to a report released the first Friday of the month, a report that is a coincident indicator of economic activity, which is subject to huge revisions. As for containing stale information, mainstream economists pay little attention to the two most highly-weighted components of the LEI index when they first become available, namely the yield spread between the Treasury 10-year bond and fed funds and the real M2 money supply. So, I suspect that it is not because the LEI index contains old news that most economists ignore it. Rather, it is because the LEI index contains some variables that most economists believe are uninformative. Why do they find these variables uninformative? Probably because they took the word of some "authority" figure rather than having the curiosity to find out for themselves what the relationships are.

I think I have figured out why economists downplay the significance of the LEI index. It is to preserve their jobs. After all, if the LEI index does a better job of forecasting the behavior of the economy than do economic forecasters, why do we need economic forecasters? A few months ago, we called the Blue Chip survey folks to find out if the consensus of the best and brightest had ever forecast a recession. Blue Chip's answer was "no." As Chart 1 shows, the LEI index has done an excellent job of forecasting recessions. The year-over-year percent change in the LEI monthly index has gone negative prior to the onset of every NBER-designated recession since 1960.

Chart 1

Now, it is true, that the LEI index has sent some false recession warnings. That is, there have been some occasions when the year-over-year percent change in the LEI index has gone negative and no officially-designated recession ensued. But that does not mean that the weakness in the LEI index was not signaling a developing weakness in the growth of economic activity. Chart 2 shows the relationship between growth in the LEI index and the Coincident Economic Indicators index. (The Coincident Economic Indicators index is made up of nonfarm payrolls, real personal income less transfer payments, real manufacturing and trade sales and the Fed's index of industrial production.) We can see in Chart 2 that although a contraction in the LEI index may not always signal an NBER-designated recession, it does signal weaker growth in the Coincident Economic Indicators index. By the way, the highest correlation, 0.77, between the growth in the Coincident index and the Leading index occurs when the Leading index is advanced by 7 months. A correlation coefficient of 0.77 is not perfect. Perfect would be 1.00. But folks, a correlation of 0.77 is fantastic for government work and its darned good for private sector work, too.

Chart 2

But how relevant is the Coincident index to real GDP in today's post-modern economy? Chart 3 shows the relationship between growth in the Coincident Economic Indicators index and growth in real GDP. The correlation between the two has diminished in recent years. Between 1960:Q1 and 1994:Q4 the correlation was 0.91. It has slipped to 0.79 in the period between 1995:Q1 and 2005:Q1. I don't know about you, I would say that a correlation of 0.79 still is relevant.

Chart 3

Lastly, another reason you should be paying attention to the behavior of the LEI index is that the Fed has been raising its policy rate. As Chart 4 shows, a rising fed funds rate goes hand-in-hand with a declining growth rate in the LEI index. Perhaps economists are surprised to learn that when the Fed starts to restrict the flow of the credit it creates out of thin air, the pace of economic activity slows down. But I bet you are not surprised by this.

Chart 4

Paul L. Kasriel, Director of Economic Research

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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I hope you enjoyed both articles this week. You can find the original and past commentaries by Paul Kasriel at http://www.ntrs.com/library/econ_research/outlook/index.html.

You can find out more about GaveKal and their research by going to www.GaveKal.com.

Your watching the leading economic indicators analyst,

John Mauldin

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