Contrary to the pessimists' view, Europe will show economic recovery this year and next. And that will ensure monetary union stays on track for 1999. In core Europe, super-cheap money has been complemented by weak exchange rates. And those easy monetary conditions are likely to win out over Europe's Maastricht fiscal masochism to produce economic recovery.
Final sales (domestic demand less inventory build-up) are already rising in Germany and France. Export orders are recovering everywhere too. Capacity utilization is rising and capital expenditure is on the mend. All that is needed is for household consumption to take off.
Europe is an economic soufflé with a collapsed core. The periphery (except for Italy) is growing fine. Once Germany and France start growing by 3% (my forecast for next year), the growth pop-up in the middle will change perceptions of Europe, Emu and interest rates, radically.
The recovery is driven from the supply-side by industry (exports and investment) and service-sector growth. Now footsteps echo in almost empty shops and auto dealers in Europe. But soon this will change and growth will spill over into the consumer sector. In some laggard countries, the consumer will stay worried by corporate rationalization. So the recovery will be less dramatic than in previous cycles. In core Europe, that means short-term interest rates will rise by 250 basis points instead of a typical 600bp to 800bp for this stage of the economic cycle. But growth does mean Emu will happen on time and will probably include 10 countries in the first wave. Bond yield convergence will continue, but around a rising interest rate trend in Germany.
Italy will be excluded from the first wave of Emu because much of its fiscal rectitude is unsustainable. Look at Italy's unfunded pension liabilities and public debt/GDP ratio beside the UK's. That should lead to a great difference in pricing. But until recently, both country's bonds had virtually the same yield spread to Bunds. Yet the UK is the much sounder economy. The economic cycle and overvalued sterling have been against gilts now. But I think the Prodi government will fall before winter, leaving a gaping policy hole behind it.
Monetary union, the single market and the fiscal straitjacket of the Emu stability and growth pact leave the European corporate sector exposed to the rude winds of global competition. The corporate shake-out in Europe will be vicious. Ultimately, that's good for growth, profit and shareholders. Good corporations get stronger and the weak disappear. But getting there means pain beyond our politicians' wildest nightmares.
The first impact of European integration will be falling prices for most goods and services in Europe. Massive lay-offs in manufacturing will be next. Behind this, the flipside of Schumpeter's "creative destruction" will be waiting - new jobs in services. But they will be there only if European politicians free up entrepreneurs to create those jobs at prices that allow new companies to thrive and to employ the unemployed at profitable rates. That means even freer labour markets than in the US to compensate for Europe's uneven infrastructure (which acts as a magnet, attracting investment into the overdeveloped core), and for Europe's more immobile labour forces.
However, in the meantime, Europe's financial markets are overly optimistic about two things. They ignore the extent to which profit-deflation is the first, but not the ultimate, result of deregulation. They underestimate the degree to which poor-sighted politicians will act like King Canute to prevent what must happen in labour markets. And they underestimate rising European interest rates. These negatives must still be priced into European equities, particularly French banks, which are the worst-run and least profitable in the developed world outside Japan.
This year will be the great turning point for the Deutschmark. Germany's economic cycle will force the Bundesbank to tighten policy. Stronger economic growth will mean the Bundesbank runs out of excuses why money supply is always outside its target range. In reality, lending to the private sector in Germany is what is driving credit growth. This is more symptomatic of economic recovery than the financing of excess inventories, which have fallen back to normal levels. I expect short-term German rates to rise by 140bp over the next 12 months and by 250bp over the next two years.
This will also be the year when the consensus view - that the euro will be a weak currency - changes. There are three reasons for this. First, the euro will be governed by the world's most conservative group of central bankers, operating a central bank dominated by Germany and its satellites, and with a constitution guaranteeing a degree of autonomy from political interference that would turn the Bundesbank green with envy.
These people will be hellbent on proving their monetary virility. They know the secret of a successful Emu is fast economic growth. But that can only happen if the euro is strong and domestic interest rates are low. Ultimately, the success of the euro depends on fast growth and deregulated labour markets combined.
Second, the euro area will be operating under a virtual balanced budget amendment, with markets empowered to police it and punish the fiscally prudent Germans for the sins of the errant high-deficit, high-debt countries, through the mechanism of unified interest rates in a single currency area.
Third, the euro will be one of the most over-reserved currencies in the world. The result is that the share of the euro in international reserves could rise from 18% (for candidate member currencies) to 25%-30%. The euro could account for about the same share of international trade invoicing, up from 17% today. That's why I'm telling clients to go long on the Deutschmark now, as the best way to invest in a future strong euro.
David Roche is president of Independent Strategy, a London-based research firm.