Global: Europe Is Giving Up on Itself

Morgan Stanley ^ | Sept 20, 2002 | Stephen Roach (New York)

[Gritty]

These past two weeks in Europe have been sort of an epiphany for me. The hopes and promises of the European Monetary Union (EMU) are now ringing hollow. Eleven cities later -- on the Continent and in the UK -- and there can be no mistaking the sense of despair that is gripping this region. Europe has lost its way. And with a deep sense of resignation, the Europeans know it.

The summer of 2002 unmasked the fault lines in the "new" Europe. Three critical flaws emerged -- the first being Euroland’s lack of autonomous support from domestic demand and a concomitant hypersensitivity to the ups and downs of external demand. The 2Q02 GDP report said it all: Domestic demand accounted for a mere 0.1 percentage point of pan-regional GDP growth (not annualized); believe it or not, that actually represents an improvement from the relatively stagnant conditions in the preceding three quarters. In the spring period, a modest rebound in private consumption was almost completely offset by yet another contraction in fixed investment.

Given this anemic growth in domestic demand, the Euroland growth story is now more dependent than ever on the US-led global trade cycle. While the external sector (net exports) also added 0.1 percentage point to Euroland GDP growth in the second period, there is good reason to believe that this contribution diminished over the course of the summer. That’s certainly the verdict from the sharp recent fall-off in business surveys across the region. And it also makes sense in the context of weakening demand in America, as underscored by July’s 1.0% drop in US imports -- the first such decline of the year. And the lagged effects of this year’s appreciation in the euro can only reinforce this trend. All it took was a double-dip scare in America for growth in the euro-zone to screech to a virtual standstill. Lacking in domestic demand, disturbances in the broader global economy have been magnified insofar as their impact on pan-European growth is concerned. Can you imagine what would have occurred had there actually been a full-blown US double dip? Or what might happen if there is one in the not-so-distant future?

Wrong-footed stabilization policies are a second fault line that is crimping Euroland growth. Given the covenants of the Stability Pact -- deficit constraints of 3% (as a share of GDP) -- the region is unable to jump-start its economy through fiscal stimulus. By our forecasts, Germany, France, and Italy could all violate this constraint during the next year. In large part, this outcome is a painful legacy of several years of fiscal lenience that preceded this year’s slowdown. But it also reflects a potentially fatal flaw in the Stability Pact itself: Rather than seek to achieve a target of budgetary balance at "full employment," fiscal targets are not adjusted for the ups and downs of the business cycle. By Eric Chaney’s reckoning, Euroland may well have to impose outright fiscal retrenchment in order to hit the 3% deficit target (see his 3 September dispatch, "The Arithmetic and Politics of Fiscal Policy"). In economists’ jargon, that’s tantamount to a "pro-cyclical" policy stance -- a policy thrust that, in this case, actually reinforces the downside of the euro-zone growth cycle.

A similar case can be made for the monetary policy stance of the European Central Bank. With backward-looking European inflation hitting 2.1% in August -- violating the upper limit of the ECB’s 0-2% definition of price stability -- Joachim Fels believes that any monetary easing is all but out of the question over the next several months. That leaves the central bank in a very tough place -- unwilling and/or unable to adapt a counter-cyclical policy stance in an increasingly shaky growth climate. In my view, the increasing threat of global deflation suggests that the ECB needs to be more forward-looking and anticipatory in setting its inflation target. If it were to do so and come to the conclusion that the balance of risks on the price front has shifted from inflation to deflation, then it would be better able to break the shackles of its pro-cyclical policy stance. The chances of that are slim, or next to none, in our view. Hence, with both levers of stabilization policies -- fiscal and monetary -- decidedly anti-growth as cyclical deterioration now intensifies in the real economy, the possibility of a euro-zone double dip is suddenly very real.

Euro-politics is the third flaw to get unmasked this summer. This is the least surprising of the three setbacks. Political risk has long been perceived as the Achilles' heel of EMU. Unfortunately, there have been numerous recent examples of politically inspired setbacks on the road to reform that threaten Euroland productivity and its long-term potential growth rate. The most recent, of course, was German Chancellor Gerhard Schroeder’s election-eve bailout of MobilCom -- a job-saving ploy that, in my opinion, can only perpetuate the capacity excesses that Germany and Europe need to rationalize. The same can be said with respect to state-sponsored support of France Telecom. Meanwhile, German labor unions have just warned of major work disruptions in the event of a victory by conservative Edmund Stoiber. At the same time, the electorates in Germany, France, and Italy have all cast their most recent votes in favor of large-scale tax cuts -- actions that would only deepen Europe’s fiscal conundrum. And, for the sake of the Stability Pact, Germany recently postponed tax cuts in order to fund its flood emergency program. Taken to its limit, the risk is that these political tensions could boil over into a more serious anti-Maastricht backlash that could shake the very foundations of EMU. I doubt if that’s the endgame, but the odds of such a tailspin are undoubtedly higher today than they were a year ago.

All this is a lethal combination for Europe. The lack of domestic demand leaves the region’s destiny in the hands of others -- in effect, a captive of a US-led global trade cycle. If I’m right and a post-bubble US economy remains dip-prone for some time to come, Europe’s externally led growth dynamic is a recipe for trouble. Nor can counter-cyclical stabilization policies be counted on to fill the void. Both monetary and fiscal policy settings are aimed in decidedly anti-growth directions. So, too, is the euro. Although currency appreciation has stalled recently, the euro has still appreciated about 10% versus the dollar over the course of this year. As if that’s not enough, anti-reform politics are in the ascendant in this election season -- hardly surprising in an economic climate of cyclical distress.

Suddenly, Europe looks like one of the weakest links in the global growth chain. In my view, that’s one of the biggest surprises to emerge in this summer’s global slowdown. For former Euro-skeptics like myself, this is a huge disappointment. Like many, I had become hopeful that EMU was the answer to Eurosclerosis. Those hopes may now be drawn into serious question. Over the past couple of weeks, Byron Wien and I met with about 1,500 European investors. They were as despondent a lot as I have ever seen. They’ve given up on the idea that Europe can shape its own destiny. Their only hope is that a US-led cyclical revival jump-starts an externally driven Euroland economy. Needless to say, I didn’t offer much encouragement on that count.

[The Vast Right Wing]

Don't forget the fact that they are COWARDS on the issue of Iraq, and in facing down tyrants in general. Perhaps if they took of their skirts it would help their economy too?

[Dark Wing]

ping

[gcruse]

With Euroland riding on American economic coat tails,
and Japan in danger of going nova, the tepid American
economy, rather than being bolstered by going to war,
will follow a plunging stock market and send the global
economy to the bottom. The next great depression may
be just over the horizon.