[PEN-L:30459] Euroland Economy: one of the weakest links

[Sabri Oncu <soncu@xxxxxxxxxxx>]

Europe Is Giving Up on Itself

Stephen Roach (New York)

Global Economic Forum, Sept 20, 2002


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.

Article at:
http://www.morganstanley.com/GEFdata/digests/20020920-fri.html