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Is Europe Headed for a Recession?

Wednesday, September 17, 2008

Recent economic data paint a gloomy picture.

At the beginning of the year, many observers believed that this time around the global economic cycle would be different. As evidence mounted that the U.S. economy was experiencing its worst housing-market and credit-market busts since World War II, many cherished hope that the fundamental strength of the European and Asian economies would prevent them from catching the proverbial cold when America sneezed. 

Recent economic data suggest that such “decoupling” was never more than a pipe dream. It now appears that the French, German, Italian, UK, and Japanese economies all contracted in the second quarter of 2008. Meanwhile, the massive housing-market bubbles in Ireland, Spain, and the United Kingdom have all collapsed. These housing busts have taken a harsh toll on economic growth; so have high oil prices and the global credit crunch. Europe is also suffering from the combined effects of a relatively strong euro and the European Central Bank’s tight monetary policy. 

Since August 2007, European banks have recognized $230 billion in loan losses—nearly as much as the $250 billion in loan losses that U.S. banks have recognized over the same period. In recent months, European credit creation has ground to a halt. More troubling is the likelihood that the losses suffered by European banks will be exacerbated by an economic slowdown and by the ongoing housing busts in Ireland, Spain, and the United Kingdom. 

Given the slowdown in Europe, U.S. policymakers should not count on export growth to continue bolstering the American economy as it did in the first half of 2008.

American banks have not responded to their loan losses by raising an equivalent amount of new capital, and neither have their counterparts in Europe. This suggests that European banks, like those in the United States, can be expected to tighten credit conditions further as they try to repair their damaged balance sheets. 

While the impact of high commodity prices on the European economy has been softened by the relative strengthening of the euro, one should not minimize the severity of the oil and food shock, which has contributed to a much tighter monetary policy stance in Europe than in the United States. The European Central Bank, remember, has a single mandate: securing low domestic price inflation. 

The most notable development in global currency markets since 2002 has been the depreciation of the U.S. dollar under the weight of a large external current account deficit. The brunt of dollar depreciation has been borne by the euro, as most Asian countries intervened to prevent any undue strengthening of their own currencies. The combination of a strong euro and a U.S. downturn has weakened export growth in the major European economies (particularly Germany).

European policymakers must be sensitive to the downside risks facing their economies. Indeed, considering not only the specter of recession but also the recent drop in oil and food prices, perhaps the European Central Bank should loosen its monetary policy. 

Meanwhile, given the slowdown in Europe, U.S. policymakers should not count on export growth to continue bolstering the American economy as it did in the first half of 2008. Additional action is needed to arrest the downward spiral of U.S. home prices, which threatens to intensify the ongoing global credit crisis. 

Finally, policymakers in Europe and America must combat a rising tide of protectionist sentiment. Anti-trade measures would only exacerbate our present economic difficulties and make a global recession more likely. 

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Image by The Bergman Group/Darren Wamboldt.

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