naked capitalism

Before we get to the meat of this post, I hope readers will bear with me for another day or two. I’m regrouping after being out of town, and have a busy next couple of days. On top of that, my subscription to the WSJ online expired over the weekend, and I can’t renew on its site. The postal service changed my zip code last July, but the Journal in its infinite wisdom refuses to believe it exists. Mayor Bloomberg is also in this zip code, so the demographics should be acceptable, but the Journal can’t be bothered to keep its system current. Even Verizon does better on this score. Calling the WSJ goes on the list with a half-dozen other nuisance items.

That’s a long-winded way of saying you may not get as much commentary as usual from me until I’ve cleared the underbrush.

Now to Wolfgang Munchau’s Financial Times piece, which argues that the IMF forecast for Europe (1.4% for 2008) is too low. Munchau, who is anything but a constitutional bull, gives a list of reasons why the EU may not do too badly.

I am nevertheless not too optimistic, even though Munchau is far better equipped to opine on this topic than I am. My reasons are simple. I think the deterioration in the US will be sufficiently severe that the effects on Europe will be significant. I expect we will have a deep recession in the US, and may get the worst of all possible worlds, a dollar crisis too. And I am told that their banks are in as bad shape as ours, but it hasn’t come to light yet. Continued stress in the financial system will depress growth.

However, the IMF forecast at issue is for 2008. The powers that be are doing everything they can to staunch this crisis. I doubt they will succeed, since their measures are almost entirely palliative and for the most part do not remedy the root causes. But they may succeed in keeping the crisis from worsening for a time, which could push back the slowdown in EU growth to 2009.

From the Financial Times:

I am puzzled by the International Monetary Fund’s latest growth projections for the eurozone. The forecasts in the World Economic Outlook show a mild recession for the US, with a positive annual growth rate of 0.5 per cent this year and a huge contraction in growth for the eurozone from 2.6 per cent in 2007 to 1.4 per cent.

This is puzzling to me for two reasons. First, what drives the US downturn is an immense property recession in combination with a credit crunch. That is, by and large, not the case in the eurozone despite a number of regional downturns, for example in Spain. Second, the economic news from the eurozone has been persistently better than expected so far and there may be a dynamism at work that is not yet fully understood.

One possibility is that some of the economic shock transmitters, especially the exchange rate, may work a little slower than they used to. Companies can hedge against short-term exchange rate fluctuation. The euro has also improved its status as an invoicing currency, which may offer eurozone companies some protection. Eventually, of course, the eurozone may run of luck, but it would have to run out of luck fairly soon for the IMF’s forecast of a sharp growth slowdown to prove correct for this year. Now that might still happen, especially if the US were to fall into a black hole. But I just cannot see how the IMF’s pessimism on the eurozone can be consistent with its relative optimism about the US.

Another possibility is that the eurozone economy may have become a touch more resilient. To be clear: I am no advocate of “decoupling”. It is a meaningless metaphor since no region in a globalised economy can be truly decoupled. But even if there can be no decoupling, there remains the perfectly legitimate question whether the relationship between the US economy and the rest of the world in general, and the eurozone in particular, may have changed over the years.

I suspect it has. One of the main economic arguments in favour of the euro was a lower cyclical dependence on the US. While that goal has clearly not been reached in full, it may have been reached in part. For example, Germany, which accounts for more than a quarter of the eurozone’s economic output, has coped better with a rising currency than it did in similar episodes of the past. And in one limited respect, we can even talk about “decoupling”: European monetary policy is far more independent of the US today than it used to be. The European Central Bank’s dogged pursuit of price stability continues to surprise even seasoned central bank watchers, who could not have imagined that the ECB would be able to leave interest rates unchanged during a period in which the Federal Reserve has cut by 300 basis points.

To see how much has changed over the past 10 years, just imagine what would have happened if there had been no euro. The European financial markets would have remained fragmented. Italy would have devalued its lira a long time ago. Spain would probably have announced a devaluation of the peseta right after the recent elections as the depth of its housing crisis became more and more apparent. Portugal and Greece would have devalued three or four times by now. President Nicholas Sarkozy of France might have been tempted to devalue the franc against the D-Mark shortly after his election. Today, the German, Benelux and Austrian economies would have been crippled by a super-hard D-Mark, guilder and shilling, which would have risen not only against the dollar, but also against the franc, the peseta and the lira. The US downturn would have brought havoc to the European economy – as it used to in the past. You remember that other tired old metaphor about the US sneezing and the Europeans catching a cold. Maybe we are now living in a world where the US is catching a cold and the Europeans are sneezing.

This does not mean that all is well with the eurozone. On the contrary, regular readers of this column will probably recall my almost obsessive pessimism about Germany’s economy and the country’s inability to create a dynamic services and financial sector. But there can be no doubt that Germany is more robust relative to past performance. This is in my view not an economic reform story, but the result of macroeconomic regime change. The euro created a large and stabilising internal market, almost as large as the US itself. Of course, the eurozone remains relatively more open than the US. It continues to depend on outside influences more than the US. But my point is that the eurozone is much less sensitive today than its constituent economies were 10 or 15 years ago. Economic forecasters should beware that not all past relationships can be safely extrapolated into the future.

Obviously, there may come a point when a US recession and a persistently weak dollar will affect the eurozone as well. There are several channels through which US economic weakness is transmitted to the rest of the world – bank profits, the stock market, falling exports among others. But these channels take time to work through the system. I would broadly concur with the IMF’s 2009 forecast for the eurozone – a growth rate of 1.2 per cent. But for growth to slow down to 1.4 per cent already this year, something dramatic would have to happen that I am not seeing elsewhere in the IMF’s forecasts.