Decoupling, can Europe avoid a recession?

A recession in the US appears imminent by now. Will Europe follow or can it ‘decouple’?  So far the ‘sub prime’ crises has affected European financial markets at least as much as those of the US although there is general agreement that in Europe there has been very little sub prime lending.  It might thus be useful to take a look at how the euro zone business cycle has been related to that of the US over the last ten years.

The academic community seems to think that the euro zone does not necessarily follow the US.  Following the example of the US, The leading Business Cycle Dating Committee was established some time ago for the Euro zone by the Centre for Economic Policy Research (CEPR). (Following the example of the US where the NBER dates officially the business cycle.) Its central finding (published in September 2003) was that “there is no clear pattern of lead-lag relation between the US and the Euro-area”.

There are two reasons behind this finding:

1) The US experienced (a short lived) recession in 2001, but not the Euro area.  In the US GDP declined for three consecutive quarters after the peak of 2000q4, with a cumulative decline in that period of -0.62%, the cumulative change of Euro area GDP from 2001q1 through 2001q4 was still positive, even if marginally so (+0.1%).  However, this does not imply that the euro zone fared better than the US in terms of growth since the US rebounded quickly after the recession whereas growth continued to remain sluggish in the euro area for much longer.  The US slowdown was thus short and sharp (conforming to the technical definition of a recession) whereas in Europe the slowdown was shallow and longer.  Figure 1 shows also that in terms of GDP growth the euro followed the US rather closely from a common peak in 2000 to a trough in 2001 (the annual growth rate never became negative for the US because of the quick rebound following the technical recession of 2001).

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2) A more important reason why at least formally one cannot establish a close correlation of business cycles concerns the evolution of employment. In 2001 in the euro area employment continued to grow (up about 1 %), whereas it fell sharply (by about 2.5 %) in the US.  This pattern seems to continue in the most recent data (see figure 2) with employment growth holding up in the euro area, but falling sharply in the US.  This relative strong performance of employment in the euro area might be the main reason why there have so far been few calls for fiscal boosts in Europe (see also comment by S. Dullien).

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What does this brief examination of the past suggest for the current situation?  The goods news is that the euro zone should be able to avoid a technical recession and that employment growth is likely to remain relatively robust.  Having a more sluggish economy has its advantages during bad times.  The bad news is that any recovery might also be much slower in starting in Europe.

One important aspect of how business cycles are experienced in real time (as opposed to how they look in retrospect) is that the data that are available in real time consist typically of first estimates which tend to exaggerate the size of the downturn.  This is illustrated in Figures 3 and 4, which show that for both employment and GDP growth the first estimates suggested that the euro area was in, or very close to, a recession in 2001, but subsequent data revisions, mostly upwards, did not support this view.  This pattern makes a timely policy response even more difficult to calibrate.  At the very least one should take these important data revisions as a warning against policy activism.

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5 Responses to "Decoupling, can Europe avoid a recession?"

  1. Geoff   January 23, 2008 at 12:11 am

    Looks pretty clear that GDP operates with a small lag, and that employment has a slightly longer one. So, given the US trend, I see no reason for a decoupling, just a “it’s not here yet.” And while Europe may again see a relatively less severe employment drop this time again, it is by no mean certain. Labor laws make their employment market relatively sticky, but changes since 2000 may make things a little less so.

  2. Ulrich Fritsche   January 25, 2008 at 3:57 am

    @ decouplingThe lead-lag structures are never stable. This is like the in famous quote by Milton Friedman on the “long and varying lags” of monetary policy. Historical analysis using cross-correlations is always difficult due to one-time events and different policy reactions in the past (this holds for the recession in the early 1990s where Europe and especially Germany was still booming due to re-unification and the fall of the iron wall but also to some extent for 2001). From an economic point of view there is no reason to believe why there might be a “complete” decoupling even if the transmission channels changed in strength and importance (financial market integration, market deepening, hegde funds….).Interesting question: What can stabilisation policy do at the moment? The “wait-and-see” position of the ECB will surely drive the Euro up in external value (interest rate differential and exchange rate show a stable relation)? This in turn drives Europe’s still healthy looking economy into the slowdown, isn’t it? Fiscal packages like in the US are seen very sceptical all over Europe. So, de-coupling depends mostly on the economic policy reaction. Since the ECB is a very careful central bank, the ECB hesitates to de-couple the European wagons from the train. Am I completely missing something?

  3. eparisi   January 25, 2008 at 1:34 pm

    Deutsche Bank has a nice chart showing a close correlation between total German exports and the US ISM Manufacturing Index. Since only 7.6% of German exports go directly to the US this means that Germany and Europe are indeed being influenced very strongly by the US business cycle, independently of any policy response.http://www.dbresearch.com/servlet/reweb2.ReWEB;jsessionid=e795%3A47544f7d%3Abdc433186d5dce2?rwkey=u40652080This does not mean that policy could not contribute its share but as long as we have missing structural reforms to blame…

  4. Satish   January 26, 2008 at 3:03 pm

    Decoupling is not going to happen. Europe is likey to have big recession on par with US and should pull the euro down. So the whole reserves of developing world is worthless.