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The World Economy’s Europe Problem

Thursday, May 7, 2009

As ‘green shoots’ of recovery sprout in the United States, potential crises in a number of European economies pose the main risk to any early global economic recovery.

As “green shoots” of economic recovery seem to be in evidence in the United States, potential crises in a number of East and West European economies seem to be the main risk to any early global economic recovery. Supporting this view is the sobering economic forecast put out earlier this week by the European Commission, which sees little prospect for a pickup in European growth before early 2010. Further bolstering this outlook is a recent International Monetary Fund report warning that the shortage of capital in European banks is larger than in American ones and that these banks could likely continue reducing their loan exposure to a troubled East European economy in the months ahead.

In contrast to the market expectation of a V-shaped economic recovery, the European Commission is predicting a long recession for Europe that will be followed by only a very gradual economic recovery expected to begin in early 2010. On this basis, the commission believes that the overall European economy will contract by as much as 4 percent in 2009 and will show virtually no growth in 2010. The commission is also anticipating that European inflation will slow to barely 1 percent in 2009 before picking up only modestly in 2010.

A great risk posed to the global economic recovery by a prolonged European recession is the precarious economic position of Ireland and a number of Mediterranean members of the euro zone.

The very weak European growth outlook poses a particular challenge to Europe’s beleaguered eastern periphery. Many of the countries in that region are highly dependent on a vibrant Germany as a market for their exports and they are also especially vulnerable to any further slowing in West European bank lending to the region. At the same time, the US$1.5 trillion in Western European bank loans outstanding to Eastern Europe underscores the importance for the West European banking system of an early resolution to the East European economic crisis.

An even greater risk posed to the global economic recovery by a prolonged European recession is the precarious economic position of Ireland and a number of Mediterranean members of the euro zone. Greece, Ireland, Portugal, and Spain are all neck deep in recessions of epic proportions that will soon raise unemployment to the highest levels in the past 70 years. In Ireland and Spain, the bubbles bursting in the housing market make the United States’ own predicament look benign. All four countries also must cope with a global collapse in trade and tourism, and with rapidly deteriorating public finances as a direct result of their deep recessions.

The German government now concedes that the German economy will contract a staggering 6 percent in 2009 before recovering only marginally in 2010.

Under usual circumstances, countries experiencing recessions of these proportions would sharply reduce interest rates and allow for a sharp depreciation of their currencies. However, stuck within the euro zone, Greece, Ireland, Portugal, and Spain have to live with interest rates set by an overly cautious European Central Bank (ECB) and with a euro whose relatively high price on world currency markets renders their economies grossly uncompetitive. Meanwhile, their deteriorating budgetary positions leave them with little room for fiscal stimulus.

The delicate position of many East European countries and of the weaker euro-zone members underscores the need for a more proactive fiscal policy posture in Germany, and a more aggressive ECB monetary policy. The German government now concedes that, with present policies, the German economy will contract a staggering 6 percent in 2009 before recovering only marginally in 2010. Absent more vigorous economic growth in Germany, it is difficult to see how Greece, Ireland, Portugal, and Spain can extricate themselves from deep recessions even if they ignore the European Union’s advice to tighten their budgets in the midst of deep recessions.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was managing director and chief emerging market economic strategist at Salomon Smith Barney and a deputy director in the International Monetary Fund’s policy and review department.

FURTHER READING: Lachman wrote “Can the IMF Really Save the World Economy?” and “Don’t Repeat Japan’s Mistakes,” which warns against the policies Japanese authorities followed during their financial crisis in the early 1990s.

Image by Darren Wamboldt/The Bergman Group.

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