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The German euro is undervalued

I keep telling people that the German euro is undervalued, but some folks seem not to believe me. (See the comments section from this post last year for an example.) But this is a really big deal. The dominant narrative about the eurozone crisis is that fiscally irresponsible countries like Greece were bringing the once-proud currency to its knees, and weakening the European project to boot. Meanwhile, the virtuous Germans keep on cranking out trade surpluses and have to bail out Greece, Ireland, Portugal, and Spain. And it’s pretty clear that the Germans believe this version of events.

Never mind that Spain and Ireland, for two, had budget surpluses prior to the crisis, or that Spain’s economy is five times as large as Greece’s. What’s going on in Greece is supposedly the true explanation for the eurozone’s problems.

Let me challenge that narrative that with a simple thought experiment. Instead of one euro, let us reason as if each of the 18 eurozone members had its “own” “euro.” Let’s begin by thinking about what creates the value of the current 18-country euro. We might include interest rates, inflation rates, growth rates, and trade balance, among other things, and of course expectations for all these variables. What we need to remember is that the value of today’s euro represents the averaged effect of all these variables in all 18 countries, rather than reflecting the economic conditions of any one of them.

So the euro is currently worth about $1.25. It used to be higher; what is dragging it down? The simple answer is that conditions in Greece, Spain, Ireland, Portugal, and at time Italy have pulled its value down. As has often been noted, if Greece pulled out of the euro it would then devalue the drachma, becoming internationally competitive again without the need for the brutal austerity that has pushed its unemployment rate over 25%. The same is true for the other peripheral countries. By looking at what would happen to the drachma/punt/peseta/escudo, we can see that, for these countries, the euro is overvalued. Another way to say it is that the “Greek euro,” for example is overvalued.

So why isn’t the value of the euro lower than $1.25? The answer, of course, is that Germany, the Netherlands, Austria, Luxembourg, and so forth, are performing well and pushing the value of the euro upwards. These countries, by contrast, would see their currency values rise if the euro were suddenly abolished. For Germany, for instance, the euro is undervalued; an equivalent DM would rise in value.

U.S. officials constantly rail about the undervalued Chinese yuan and the huge bilateral trade deficit it creates for this country. But officials could (and to some extent do) say the same thing about Germany, which now has a larger trade surplus than the vastly larger Chinese economy. In fact, last year Morgan Stanley estimated that a stand-alone German euro would be worth $1.53, compared to the actual euro exchange rate then of $1.33.

With an undervalued currency, Germany gets a much larger trade surplus than it would have had otherwise, magnifying trade deficits in the United States and elsewhere. At the same time, it gets to pretend that this surplus is simply due to German thrift and virtue, rather than currency misalignment. It then points to its virtue as justification for doing nothing to increase domestic consumption, wages, or inflation, and for demanding austerity from the countries to which Paul Krugman rightly says Germany is exporting deflation.

Let me leave you with Krugman’s chart. You can see at a glance that Germany has throttled nominal wage growth and has inflation far below the European Central Bank’s announced target of just under 2%. When you combine its low inflation with an undervalued exchange rate (remember, low inflation should tend to raise the currency’s value), you come to realize that Germany is a huge part of the world economy’s problems today.

 

Credit OECD and IMF

Source: Paul Krugman

Cross-posted from Middle Class Political Economist.

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1/24/12 Links worth noting: Germany rejects Swiss banking secrecy deal; Labor Devaluation

1/24/12  Links worth noting by Linda Beale:

Germany rejects Swiss banking secrecy deal;   Labor Devaluation 

David Jolly, German Lawmakers Reject Swiss Tax Deal, New York Times (Nov. 23, 2012).
The US and other countries like Germany have been pressing the Swiss on their bank secrecy, which allows U.S. and other foreign citizens to establish bank accounts without the knowledge of the home country and thus hide assets and income from home-country taxation.  The US passed laws (called by the acronym “FATCA”) that require foreign banks to actively report information on US accountholders.   The hope is that every country will recognize the harm done to tax systems by banking secrecy and join in imposing similar information-reporting requirements.

The Swiss, meanwhile, have been trying to circumvent universal adoption of such laws.  See, e.g., Nicholas Shaxson, A scheme designed to net trillions from tax haves is being scuppered, Guardian.com (Nov. 22, 2012).   Britain, Luxemburg and Austria are cited as being in the forefront of the scuttling movement:  Britain, for example, has entered into a “Rubrik Agreement” with the Swiss.

The Swiss thought they had a deal with Germany.  This would be a bilateral deal in which the Swiss agree to an upfront payment in lieu of any back taxes on the accounts and then agree to act as tax collector for the foreign government on the accounts, thus maintaining secret the identity of the foreign taxpayers.
Such an agreement is problematic for two reasons:  (i) it requires the foreign government to trust the Swiss banks to pay the right amount over in taxes and (ii) it undermines the drive to eliminate offshore banking secrecy as a cover for tax evasion.

Transparency in international banking and taxation matters would require that banks provide information on accounts held by foreigners to the foreigners’ home jurisdictions, without any account-specific or accountholder-specific request required.  The reason for a more transparent rule is that otherwise the home jurisdiction has to have information it does not have (who has an account at a Swiss bank) before it can ask for the information it needs to ferret out who has such an account and may be engaging in tax evasion.  The biggest cracks in banking secrecy have thus come from  whistleblowers and opportunists who sell account-holder information to purchasing jurisdictions.

Friday, the Germans rejected–for now at least–a German-Swiss deal supported by Chancellor Merkel that had been two years in the making.  France is apparently also considering rethinking a similar deal.
The Swiss leverage was clearly stated by Swiss banking official Mario Tuor, who “noted that without a deal, the status quo would remain: German officials can seek specific information from the Swiss government on people suspected of tax evasion, or go back to buying data stolen from Swiss banks. ‘With an agreement, every German taxpayer in Switzerland would be taxed,’ Mr. Tuor said.” German Lawmakers Reject Swiss Tax Deal

The Steady Devaluation of Labor, Two Half Hitches (Feb. 2012).

This is an oldie but goodie, one worth reminding you of (or calling to your attention for the first time).
[The] minimum wage, in constant dollars, has had its ups and downs since 1970 but the overall trend indicated by the straight black line is down. The numbers show that the American economy puts less value on the entry level worker than it did in 1970. Why is that? Are minimum wage workers less intelligent now than they were forty years ago? Are they lazier?

The reason probably has a lot to do with the rise of the global economy and cheaper Chinese labor. It may also have to do with basic attitudes toward labor. Some see labor as a commodity, while others believe it is not. 

***
Representative Steve King (R-IA) on the floor of the House of Representatives last year:

“Labor is a commodity just like corn or beans or oil or gold, and the value of it needs to be determined by the competition, supply and demand in the workplace.”

***
Samuel Gompers, cigar maker-turned-labor organizer and founder of the American Federation of Labor in the early 20th Century, had a different business ethic related to labor and said this:

“You cannot weigh the human soul in the same scales with a piece of pork.”

Labor advocates actually managed to insert a statement affirming the status of human labor in the 1914 Clayton Antitrust Act“The labor of a human being is not a commodity or article of commerce.”

cross posted with ataxingmatter

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Germany the Euro winner?

Update: This post from 6/28 has been re-posted today 7/04 as I believe it was lost in last Thursday’s reaction to the Supreme Court’s ruling on the health care ACA. Robert Waldmann has also subsequently expressed an opinion on how Germany should proceed.

Re-posted:
The NYT carries a data filled op-ed by Gunnar Beck, and takes a stance not widely discussed in media (at least from a quick survey). Assuming the figures are reasonably accurate,   and knowing there are ins and outs to the idea not in the article,  what about it?

…Those who think that Germany has been a winner with the euro almost always rest their case on Germany’s export surpluses. The euro created stability; it eliminated exchange rate risks; appreciated less than the Deutsch mark would have, and thus aided German exports.

But has the euro benefited Germany more than other countries?

According to my calculations, based upon the federal statistics, German exports rose most — by 154 percent — to the rest of the world; by 116 percent to non-euro E.U. members; and least of all, 89 percent, to other euro zone members. In 1998 the euro zone still accounted for 45 percent of all German exports; in 2011 that share had declined to 39 percent.

Between 1995 and 2008, Germany saved more than most, yet it exhibited the lowest net investment rate of all O.E.C.D. countries. On average, from 1995 to 2008, 76 percent of aggregate German savings (private, governmental and corporate) were invested abroad.

There is more of course, so it is worth a visit to see his complete reasoning.

Certainly worth a discussion, and has implications for domestic economic reform in Germany.  Does it have implications for Germany’s needs in the Eurozone?

Update 2: Also see The euro without Germany by Anatole Kaletsky (Inside the Markets, Business section, June 29.

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German Construction Is Looking a Bit ‘Bubbly’

by Rebecca Wilder

German Construction Is Looking a Bit ‘Bubbly’

Eurostat released its volume-adjusted estimate of construction for April (release here, .pdf). Over the month, Euro area construction declined 2.75% following a large 11.41% monthly increase in March. Across the countries that make monthly data available (8 countries total), Slovenia and Portugal saw the largest decline in April construction activity, -9.3% and -6.7%, respectively, while France was the only country to see an increase in construction, +2.3%. The trend is clearly down, as 3-month over 3-month Euro area construction declined 4.8% through April.

Germany is getting a bit bubbly as regards domestic construction. This shouldn’t be surprising, given that longer dated bunds (even the 10yr) are negative on a real ex-post basis, i.e., using historical measures of inflation.

Note: I re-scaled the volume-adjusted indices to 2001=100 to fully capture the bubble in countries like Spain – the bubble illustration wouldn’t be quite as obvious with Eurostat’s index to 2005. Furthermore, the chart illustrates the monthly construction, while some countries, like Greece or Ireland, for example, list construction solely on a quarterly basis. Eurostat simply estimates construction in these countries to produce the Euro area aggregate on a monthly basis.

Going forward, this construction data does give real-time evidence that the German economy is moving marginally toward domestic-led growth….or we’re seeing the outset of a bubble in German construction

crossposted with The Wilder View…Economonitors

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European Policy Makers Don’t Understand But Markets Do

By Rebecca Wilder

European Policy Makers Don’t Understand But Markets Do

So here we are: the Italian yield curve is flat at above 7%; the government institution is in question; and the ECB is using its SMP purchase program as a carrot to drive austerity implementation in and Berlusconi out. Some would argue that the ‘market is irrational’ – Italy faces a liquidity not solvency crisis. That’s the IMF’s line, and I don’t buy it.

See Italy’s situation is simple: given the Italian debt profile and initial conditions, the Italian sovereign should be able to stabilize its debt levels – even at 8% interest rate (borrowing costs) – PROVIDED (1) it grows, and (2) the sovereign increases its primary surplus (Italy is 1 of just 2 G7 countries expected to run a primary surplus in 2011, according to the IMF). The problem is, that (1) Italy’s contracting, and (2) a higher primary surplus is more likely than not going to aggravate the recession. Something has to change to break the link – this is where I encourage you to read Nouriel Roubini’s latest.

In my view, the market is behaving very rationally. The Troika (ECB+EU+IMF) adapted the standard IMF model to the European sovereign debt crisis as a means to regain market confidence amid a sovereign liquidity crisis. The plan is to enhance fiscal discipline and become more ‘competitive’ (usually that means coincident with currency devaluation).

So fiscal discipline + new competitiveness = market confidence. Right? Wrong.

Italy’s solvency is now under question amid current IMF-style bureaucratic policy in Europe. Why they haven’t figured out the following is beyond me: austerity and competitiveness gains only works if monetary policy is easy and/or the global economy is expanding, and that’s with nominal devaluation.

Either the IMF model will fail or the Euro area will

Here’s the problem with the IMF model:

1. None of the program countries are unequivocally more competitive. Devaluation would help here, but no Euro area (EA) economy can devalue unless they exit the EA.

The table below illustrates the gains in competitiveness by key EA markets since the beginning of the peak of the last cycle, Q1 2008. Competitiveness here is broadly measured by shifts in the real exchange rate, as calculated by relative prices, relative unit labor costs, and relative GDP deflators. The red cells highlight country real exchange rate gains/losses that undercut Germany.

Broadly speaking, no country except Ireland trumps Germany in two out of three measures of real depreciation. At best, the results on which country has indeed gained competitiveness against the 6th most competitive country in the world, Germany, is mixed. Furthermore, Europe as a whole is cutting labor costs, not just the program countries, and dragging domestic demand of the EA as a whole.

Ireland is the only country to have experienced broad depreciation across all three measures and against Germany. But I would argue this: they had further to go. The chart below illustrates the CPI-based real effective exchange rate. Spanning the period January 2007 to April 2008 (the peak), the Irish real exchange rate appreciated 10% against its major trading partners. As such, the 13.6% real depreciation since April 2008 is more reflective of mean reversion rather than competitiveness gains.

2. The second part of any IMF program (first, really) is controlling fiscal balances through ‘austerity’; but this is not possible if the private sector is simultaneously deleveraging and external demand is not sufficient. Spain and Ireland seem to be on track at this point – but they won’t be for long. The inevitable EA recession will increase the required ‘cuts’ to facilitate the reduced revenues; this is both logistically and nationalistically difficult. Global monetary easing is likely to help, but it’s too late for Europe.

Eventually the population will appeal to the economic malaise that is the disintegrating labor markets in program countries and fight against reform.

The divergence in economic performance is quickly turning into convergence, as the sovereign debt crisis inflicts the core economic performance. Shoot, even the ECB has acquiesced and is now calling for a ‘mild recession’.

Markets understand what policy makers in Europe do not: the European IMF-style model is not and cannot work under these conditions. Monetary policy is too tight, the global rebound has dissipated, and fiscal austerity is killing aggregate demand.

And here I get to my favorite quote of the day. From Bank of America’s Athanasios Vamvakidis (no link), a former IMF economist:

“In our view, there are two ways for a country to bolster market confidence in its economic policy: either through the intervention and support of an international institution, or through effective commitment to reform.”

Italy doesn’t need foreign capital, nor does it need effective commitment to reform. It needs a credible path of adjustment. And this involves all EA members, not just Italy. See Martin Wolf’s FT article from October 5, and Nouriel Roubini’s article today on EconoMonitor.

originally published at The Wilder View…Economonitors

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Don’t Hold Out for a Lasting German Economic Rebound

by Rebecca Wilder

German industry is plugging away. Ending in August, the 3-month average of the seasonally- and calendar-day adjusted volume of industrial production (excluding construction) maintained a quick 8.3% annualized pace. Even if this core measure of industrial activity falls another 1% in September, the Q3 quarterly annualized pace would be 10.5% – a robust acceleration from Q2 (6.3%). This suggests that the German economy quickened in Q3 – does that mean it’s all clear for the Euro area?

I think not.

According to The Wilder View Leading Economic Indicator (TWV-LEI), the annual pace of German manufacturing is set to slow quickly, if not contract, by the end of this year. (I constructed my own indicator since the OECD indicators are generally lagged by two months.) In September, five of the seven components that drive the index confirm a sharp deterioration in economic activity (the final two indicators have not been released yet). This downward trend in TWV-LEI for Germany has been in play since August 2010 and is yet to be fully reflected in industrial production (IP); that will change.

The chart above illustrates The Wilder View’s leading indicator for Germany (TWV-LEI, Germany). TWV-LEI is a composite of the following variables: PMI manufacturing, Ifo business climate index, manufacturing orders, employment opportunities index, inflation expectations, consumer confidence, and the terms of trade. I’ve found that these indices have the highest correlation with current economic activity, which is measured by industrial production. The r^2 of a simple univariate regression of annual industrial production growth on the 5-month ahead leading indicator (annual growth) reveals an 81% correlation – Implied IP is the fitted dynamics of this univariate regression. Unless leading surveys improve dramatically, I expect the German economy to soften much further in coming months.

Using the 1993-2011 time series, the precipitous drop in the TWV-LEI portends a sharp slowdown in German industrial activity, even contraction by December 2011. The implication is that German economic activity, while accelerating in Q3, is likely to contract in Q4.

The policy ramification is clear: It’s going to get a lot more difficult to sell a‘comprehensive solution’ if the leading Euro area economy is in recession.

originally published at The Wilder View …Economonitors

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Wilder on ‘Real retail sales in Europe: will German consumers save the day? Maybe, perhaps’

After the US report on Q2… Angry Bear and credit market weakness in the eurozone, Rebecca takes a look at the retail side of the economy:

Retail sales in Germany and Spain were reported last week for the month of June. On a working-day and not-seasonally adjusted basis, real retail sales fell 7.0% on the year in Spain. In contrast, working-day and seasonally adjusted real retail sales surged over the month in Germany, 6.3%, and posted a 2.6% annual gain.
But the Spanish data is better than the non-seasonal numbers would suggest. In fact, accounting for seasonal factors as in the manner done by the Federal Statistical Office of Germany, Spanish real retail sales posted a monthly gain, 1.2% in June. Don’t get too giddy on me – the Spanish data looks awful in a small panel (time series and cross section).

The rest of the post is here: Real retail sales in Europe: will German consumers save the day? Maybe, perhaps

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"Survey says"…. German growth has probably peaked

This week further evidence has emerged of Germany’s slowing growth trajectory. At 4.9% annual growth (calendar-adjusted) and a tightening bias from the ECB, this was, of course, to be expected.

READ MORE AFTER THE JUMP!
Yesterday the Manufacturing May ‘Flash’ PMI by Markit Research highlighted, in my view, that sentiment is unlikely to remain at these absurdly elevated levels indefinitely, as the index dropped to 58.2 from 62 in April. Notably, the index remained above 60 for five consecutive months.

Today the Ifo Institute released its business survey for May, revealing that industry and trade remained stable in May. This index hovers at record highs compared to a post-unification time series.

Overall, while the two sentiment indicators diverged this month (the PMI waning, while the Ifo holding firm), the story remains that Germany is slowing down. Furthermore, the Ifo survey portends a deceleration in industrial production growth (IP), perhaps over the next quarter.

Exhibit 1 The ratio of the components of Ifo – expectations and current conditions – suggest a sharp reversal in the industrial production growth trend.

The chart correlates annual industrial production growth with the % differential between the expectations and current conditions components of the Ifo index at a 6-month lead. I don’t expect IP growth to turn negative, but a slowdown is certainly due.

Exhibit 2 Take the Ifo sentiment with a grain of salt!

Ifo really is more of a coincident indicator of economic growth than anything else. For example, the Ifo composite has a 77% correlation coefficient with annual real GDP growth. Previous to the current recovery/expansion, the Ifo index hit a peak of 108.7 in March 2008 only to see growth decelerate sharply the next quarter, 2.7% Y/Y to 1.6% Y/Y. My point is, while it’s a decent indicator of economic strength during expansions, it’s a terrible predictor of turning points.

We’re not at a turning point now – Ifo plus PMI demonstrate that the German economy continues to expand, albeit at a slower pace.

The real question is, what does this mean for the rest of Europe, specifically the Periphery? It’s not totally clear, but certainly with Germany contributing more than 50% to the quarterly growth rate in Q1, downside risks are emerging. Prieur du Plessis argues that this is related to the global slowdown in manufacturing.

Rebecca Wilder

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Euro area GDP report: unbalanced

Today Eurostat released their estimate of Euro area growth for the first quarter of 2011. The economy grew smartly, or 0.8% on the quarter on a seasonally- and working day- adjusted basis. On the face of it, Euro area growth, which is 3.3% on an annualized basis, dwarfs the 1.8% seen in the US economy. Really, though, it’s joint German and French growth that tower US Q1 GDP growth.

Eurostat doesn’t explicitly highlight how inordinately unbalanced is growth across the region in their report . Germany and France alone accounted for roughly 72% 78% of the quarterly growth of Euro area GDP.

(As I highlight below, the Euro area quarterly growth rate in the chart is slightly different to that in the Eurostat report since some euro area members are missing. The cross-sectional contribution should be roughly unchanged during the revisions, though.)

Update: This chart has been re-posted with only slight modifications from the original. It does not change the article’s premise in any way. H/T to Philippe Waechter in comments below.


READ MORE AFTER THE JUMP!

If final demand was growing so quickly in Germany, I would say that the Euro area is adjusting more healthily than I had expected. Spenders become savers and vice versa, and capital flows adjust current account balances (and trade) accordingly. Germany spends more at home and abroad, while the Periphery less so. This does seem to be occurring according to the Federal Statistical Agency:

In a quarter-on-quarter comparison (adjusted for price, seasonal and calendar variations), a positive contribution was made mainly by the domestic economy. Both capital formation in machinery and equipment and in construction and final consumption expenditure increased in part markedly. The growth of exports and imports continued, too. However, the balance of exports and imports had a smaller share in the strong GDP growth than domestic uses.

Euro area average growth is likely slow down a bit, as the global economy moves toward a tightening bias and fiscal austerity clenches demand further. However, the outlook for the Euro area as a whole does look increasingly reliant on the trajectory of German and French economic conditions. This is a risk, especially since Germany is an export-driven economy.

As a comparison, 2005 saw growth as broadly more balanced, where Germany and France contributed a smaller 50% to total Euro area growth.


The Q1 2011 growth trajectory (top chart) is entirely consistent with ECB targeted at the core countries.

Rebecca Wilder

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Europe’s industrial new orders: 3 very different stories

Spain vs. Germany vs. UK: production trends showing holes in some growth stories

Eurostat reports new orders for January:

In January 2011 compared with December 2010, the euro area1 (EA17) industrial new orders index2 rose by 0.1%. In December 20103 the index grew by 2.7%. In the EU271, new orders increased by 0.2% in January 2011, after a rise of 2.9% in December 20103. Excluding ships, railway & aerospace equipment4, for which changes tend to be more volatile, industrial new orders increased by 1.6% in the euro area and by 1.9% in the EU27.


This was a disappointing report, as Bloomberg consensus was expecting a 1% monthly gain. The Eurostat press release reports new orders by country and production type only(capital, consumer, intermediate, durable, and nondurable). However, I look at the origination of orders by region: domestic, non-domestic extra-euro (which is the same as non-domestic for the Euro area as a whole), and non-domestic intra-euro.

The idea is, that with ubiquitous fiscal austerity, Euro area countries rely on external demand for growth. So here’s my question: how’s Spain to survive? (more after the jump)

Exhibit 1: Spain’s industrial sector is barely growing amid fiscal austerity

No industrial production growth = a big problem. It’s not just fiscal austerity, per se, it’s that the economy needs plenty of nominal income gains to improve the cyclical budget deficit in order to even see the benefits of structural adjustment. The structural balance cyclically adjusts the government deficit (or surplus) for non-structural items to leave just the structural deficit (net spending on pension payments, unemployment insurance, normal capital expenditures, etc.).

Without growth to increase nominal revenues, the negative cyclical balance will keep the overall balance very much in the red. Spain needs growth! Apparently, it’s not coming from the industrial sector.


Spain was deriving quite a bit of industrial demand from within the Eurozone (the red line in the chart above) through the end of September 2010; however, that source of order growth is tapering off. Now, it seems that extra-euro industrial orders growth (the green line) may start a sideways trend, too. Normally I wouldn’t put too much stock in one data point – but with tightening across Asia and possibly the UK (not the US for a bit), slower orders growth is inevitable.

Exhibit 2: The German industrial machine

The German machine is also deriving industrial production growth from extra-euro orders. Notably, too, domestic orders have been strong. But for all of the talk about Germany’s overheating export sector, industrial production is still near 6% below its Q1 2008 level.

And finally,

Exhibit 3: The poster child for fiscal austerity, the UK.

Why? Because they’re nominal exchange rate depreciated quite markedly, allowing the trade-sensitive industrial base to find a very shallow bottom. On a trade-weighted basis, the British pound is 24% lower than in mid-2007, according to the JP Morgan nominal effective exchange rate index.

I’d like to hear how you all think that Spain’s going to get through this as the ECB raises short-term rates (for those of you who do not know my Euro-centric commentary, you can see a list of my recent commentary on the Eurozone, which includes articles on the ECB by my name on the AB sidebar), Germany slows, the US struggles to keep the consumer alive, and emerging Asia tightens its belt.

Spain’s a trillion dollar economy, and the fourth in terms of GDP in the Eurozone…

Rebecca Wilder

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