"Pessimism about the eurozone is misplaced"

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.

Print Friendly, PDF & Email


  1. François - Paris

    No time to read the whole thing in detail. But my information is that Munchau is right.

    The US/UK is significantly worse than continental Europe.

    Of course the “Club Med” will not perform nicely. But, my information is that France – where I live – is doing acceptably well. People are getting nervous but we see no sign of the current US credit crunch.

    The North of Europe is strong enough. Overall the South of Europe picture should allow the system to stay clear. I expect equity market to nosedive. But they have limited short-term impact on business and consumers here.

    Reading anglo-saxon press delivers quite a different picture. This is short-term decoupling.

    Should Asia start to cough, however, I have little doubt that Eurozone would stall. Not the case for the moment.

  2. Richard Kline

    If the EU’s banks are as badly hit as some sources, including yours Yves, imply, they cannot escape a bit hit. And I think the US will be more in a black hole than out of one, so that dark force sucks for the EUers knock-on also. OTOH, the saving grace for Europe may well be that capital fleeing a asset deflation in the US and a plunging $ shores up the banks and the currency in Europe and otherwise keeps them hale and limber: projections made on the fulcrum of _past currency and trade flows_ will be wrong, that’s the rub. It’s a New Day.

    The whole decoupling concept is wrong and is right. It’s wrong on time-frame but right on trajectory. Trade and finance are so interlinked that Europe (or E Asia) cannot but take their lumps and catch shapnel if the US endures a high-speed accident, yes; in that respect, decoupling won’t happen because it _can’t_ happen—near-term. Over the mid-term, though, demand growth in China (and perhaps India) and capital inflows in Europe have a very good chance of rebalancing the international weighting system, leading to advantages and growth outside the US neither dependent on or of the same directionality as that in the US.

    In my view, it would take a nuclear war for ‘reweighting’ _not_ to happen. . . . Let’s not root for that outcome, shall we? I think we’re stupid, but not crazy. Other countries _have_ gotten fascism in the kinds of fixes we may find ourself in to be sure; I really don’t see that as our ‘most probable’ outcome by any historical precedent, though. The Canadian border’s only two hours away, though, and I loooovvve the Sunshine Coast. (Gotta have a Plan B, is all I’m saying.)

  3. Anonymous

    This entire financial story last year, this year and the next (few) will be about universal depressed growth and thus fewer opportunities to increase cash flow. An atmosphere of obvious hype, cheerleading and denial will not materialize into economies with measurable gains.

    The banking environment linked to speculation and synthetic risk vehicles will continue to look more and more like a giant parking lot — versus a hyper-speed autobahn!

  4. Bob_in_MA

    There is a post today in the NYT about the fact that housing prices are now falling in many places in addition to the U.S., particularly Ireland, the UK and Spain.

    Granted, Ireland isn’t so large as to matter much, but as I point out in my (new) blog, the U.S., UK, Spain and Italy (not a bubble, but in a slowdown) account for 27% of Germany’s exports, which is 12% of GDP.

    So now the Eurozone will need to be not just decoupling from the U.S., but from the rest of Europe, and even itself.

  5. François - Paris

    Bob you said “Ireland, the UK and Spain.”

    You should mention the new eastern EC members that are quite imbalanced. But the macro-economic volume can be tackled.

    As I said above I remain relatively positive on the Eurozone since it is nearly financially balanced overall, a VERY important strength in current times.

    Richards you wrote If the EU’s banks are as badly hit as some sources, including yours Yves, imply, they cannot escape a bit hit.

    I’d like that you, Yves and others with insidish information on Eurozone banks to comment on the subject.

    My sources state that local practices (excluding Spain) still are relatively prudent. And you can feel it when trying to negociate a loan in a Eurozone bank… It never was easy even at the peak of the bubble. No e-mail mortgage…

    Should we understand that top executives of the Eurozone banks made massive risky investment bets in dangerous area and/or practices? Chilly.

    My understanding is that the scope of CDO exposure by Eurozone bankers is assessed if not published.

    Tough as it may be, I do not feel that it is a challenge that can not be met by the Eurozone.

    On tot this have information on:
    – highly radioactive CDS exposure,
    – liquidity support to the “shadow banking system” (as defined by the PIMCO folks)
    – other exotic stuff !

    You possibly have more information on the subject than ourselves:)

  6. vlade


    I believe that the various European banks have much much more of the toxic exposure than they let know, but most of them not being under such scrutiny are just quiet and hope it will blow itself out.

    The reason why I believe this is talking to some (now ex, but ex for some length of time, not recently) salespeople from GS, Merrill etc., who were happily selling credit products left right and centre on the continent – and they commented that hardly any of their EU customers admitted any writeoffs.

    I suspect there’s a bunch of toxic waste sitting in some of the German/Austrian/French/Italian banks. Spanish banks probably helped to originate them rather than holding it.

  7. Yves Smith

    vlade, François,

    My sources with the regulatory connections haven’t been terribly specific. They’ve simply muttered darkly that European banks are in no better shape than US banks and therefore Trichet will have to cut rates at some point.

    Per vlade, the FT and others reported that the later, junkier vintage CDOs (2006) were sold heavily into Europe, particularly to smaller banks. Because it’s all OTC, no one but the banks and perhaps their regulators would have a handle on how significant their exposures are.

  8. foesskewered

    Francois, vlade and Yves

    Not too sure how relevant this is but the FT did mention, in a very offhand way, that Deutsche (like Citi) has been trying to sell off LBO related issues since August, in other words, they’ve been having problems quietly, and that’s quite apart from the subprime exposure.How successful they are will indicate how much cash they are putting aside for the occasion where more than silent winces will be needed.

    Guess is, they are desperately trying to avoid the dividend cut route, which would be perceived as red flags

  9. Anders

    Well, the argument from Munchau seems to be that either a) the US won’t get as bad hit as you expect, b) if the assumptions of IMF is correct, then the eurozone should do better than they have forecast or c) pixies will grab big sacks of European money and fly to the US with them.

    Now, the last alternative is my own personal invention, and all Munchau is saying seems to be “look, either the US is going to drop further than what the IMF says and if it is, then eurozone will be hit hard, but if the IMF is right about the US, then eurozone ought to do better” – essentially, something fishy is going on with the IMF predictions since they seem to be internally inconsistent.

Comments are closed.