Europe's Hangover

By Thomas Mayer
Thursday, August 21 2008

The 0.2% drop in the euro zone's second-quarter GDP was not according to script. Only two months ago, European Central Bank President Jean-Claude Trichet had expected the economy to continue to grow "at a moderate rate." Now, with the latest business and consumer confidence indicators suggesting also a weak third quarter, the signs point to a recession.

Many Europeans are exasperated. How is it possible that the euro-area economy is feeling the pinch while the U.S. economy, where the financial crisis originated, seems to be getting away relatively lightly?

Well, the euro-area economy has been anything but an innocent bystander to the merry party going on across the Atlantic during recent years. Rather, it has actively joined in and is now suffering from a major hangover. But unlike the U.S. Federal Reserve, the ECB has been withholding the aspirin.

It all started with the heavyweights of the emerging markets, notably China, India and Brazil, opening up to international trade. Combined with their pursuit of competitive exchange rates and their emphasis on sound government finances, this liberalization paved the way for rapid export growth.

The economic dividends of this development strategy quickly piled up: Previously unproductive Chinese peasants became efficient assembly-line workers; a new class of Indian "knowledge workers" was created; and Brazil used its vast natural resources more productively.

The emerging heavyweights' growth strategies, though, caused some headaches in the industrialized world. Here, cheap imported products and services were crowding out more costly domestic substitutes, depressing prices and wages, and causing job losses. Policy makers, with the Fed in the vanguard, fought back by stimulating demand through lower interest rates.

Easy money seemed a low-risk strategy in a world threatened by deflation. However, cutting the risk-free rate to record low levels had its side effects. Asset prices surged and, more importantly, speculation was encouraged. As predicted by post-Keynesian theories of financial instability, financial markets and business cycles fluctuated between expansion and contraction.

The first big cycle affected the equity markets, culminating in the dot-com bubble of 1999-2000 that was followed by a rerating of equities and deleveraging of the corporate sector. The second big cycle is now running its course in the housing markets and, thanks to the especially high degree of leverage associated with this asset class, in the credit markets. Moreover, a third, smaller cycle is playing itself out in the commodities markets.

The industrialized world's economic growth -- largely driven by monetary policy -- had its counterpart in explosive export-led growth in the emerging market economies. Despite huge swings in a few equity markets, the global financial instability didn't affect emerging market economies as much as industrialized countries, where the financial sector plays a bigger role in the economy

Rather, the expansion has run into supply bottlenecks -- created mainly by the low supply elasticity of primary commodities, where rising prices don't lead to more production -- and rising consumer goods inflation. Instead of exporting deflation, emerging-market economies have now become a source of inflation (mainly by boosting commodity prices), which is hitting industrial countries like a boomerang.

With the turn of the U.S. housing market, the associated subprime crisis, the full-blown global financial crisis, and the break-out of previously suppressed inflation, the credit-driven expansion has come to an end. Like a wave crashing ashore, it is creating significant economic turbulences.

The credit-driven expansion at the global level has had its mirror images within the euro area. Some countries, such as Spain, France and Ireland, also grew on the back of a credit-financed and housing market-driven consumption expansion, following the U.S. example. Others, most importantly Germany, supplied the goods demanded by consumers and investors in other euro-area countries and the rest of the world, playing a role akin to that of the emerging-market countries with large current-account surpluses. When the credit cycle turned down, the music also stopped for the euro area economy. But the reaction of policy makers was significantly different.

The Federal Reserve, under the leadership of Chairman Ben Bernanke, tolerated a rise of inflation on the back of higher commodity prices -- which it expected to be reversed once the commodity cycle turns down -- and focused on the eventually deflationary effects of the housing slump and credit market downturn. Aggressive interest-rate cuts and the government's fiscal-stimulus program seem to have helped the U.S. economy avoid an outright recession. These policy measures may not, however, spare the economy a longer period of protracted weakness.

Against this, the European Central Bank, probably underestimating the severity of the global economic downturn and relying on the euro area's seemingly robust economic fundamentals, stepped on the brakes in response to the rise in headline inflation and inflation expectations. According to Deutsche Bank estimates, monetary conditions tightened by an amount equivalent to an interest rate increase of 1.5 percentage points between mid-2007 and mid-2008. About half of that tightening came from the trade-weighted appreciation of the euro, while the other half came from the increase of the ECB's policy rates and the widening of the money-market spreads over the latter.

Weighed down by the global housing-market downturn, the financial crisis, the commodity price shock and the tightening of monetary policy, the euro-area economy appears now to be succumbing to recession.

Assuming a timely correction of monetary policy and some help from fiscal policy in the countries suffering most from the housing slump, the recession may not be very deep. But past experience with housing-market downturns and financial crises suggests that the period of economic weakness could be rather protracted, and the eventual economic recovery fairly sluggish. As these events unfold, fears of inflation will be waning.

Down the road, the inhabitants of the euro zone may be wondering why their hangover after a party always seems so much greater than across the Atlantic even though the U.S. has had more from the punch. The secret of the U.S. resilience may well be its greater economic flexibility and more proactive use of macroeconomic policy.