On top of this recession there are now serious risks of a systemic financial crisis in the US as the financial losses are spreading from subprime to near prime and prime mortgages, consumer debt (credit cards, auto loans, student loans), commercial real estate loans, leveraged loans and postponed/restructured/cancelled LBO and, soon enough, sharply rising default rates on corporate bonds that will lead to a second round of large losses in credit default swaps. The total of all of these financial losses could be above $1 trillion thus triggering a massive credit crunch and a systemic financial sector crisis.
There is now some delusional hope in Europe and in the European Central Bank that this region can shelter itself – or decouple itself – from the effects of the US hard landing. But 2008 will be the year of re-coupling rather than decoupling for Europe.
Let us discuss next why, the detailed channels of transmission from the US to Europe and the other internal vulnerabilities of the European economies…
First, of all, the US still accounts for about 25% of global GDP. Thus, when the US sneezes the rest of the world gets the cold. But now the US will not just experience a case of common cold; rather it will be an ugly and painful case of pneumonia. Therefore the rest of the world – including Europe – cannot avoid the financial and real contagion of the US recession virus. The ECB instead – by looking at the back mirror – is ignoring the downside risks to European growth and obsessing excessively about inflationary pressures that will fade once the Eurozone growth slowdown gets into full swing.
Certainly the US sub-prime meltdown – that has now spread to the rest of the financial and credit markets – has already led to severe financial contagion in Europe where, since August, a serious liquidity and credit crunch has emerged. Since European firms depend on bank lending more than US ones the emerging credit crunch in Europe will hit the European corporate sector and its ability to produce, hire and invest. And losses in the banking and financial system and among investors will increase as the European economy slows down in 2008, some economies experience an outright recession and a growing number of firms in the corporate sector face financial distress and defaults.
And there are now many signs in Europe of a serious economic slowdown with some economies directly at risk of an outright recession. Housing booms and bubbles were not limited to the US; similar bubbles occurred in Spain, the UK, Ireland and, in part, also in France, Portugal, Italy and Greece. Now such housing bubbles are starting to deflate in many countries, leading to mortgage delinquencies and defaults, hurting households and adding to the downside growth risks.
The relentless rise of the Euro – now close to 1.50 relative to the US – is another threat to Eurozone growth. Many countries such as Italy, Spain, Portugal and Greece had already lost competitiveness over the last few years because their wage and labor costs increased more than productivity, thus increasing unit labor cost and leading to a real appreciation of their currency. The rise of China and Asian export competitiveness was a second and further blow to these countries’ competitiveness; and now the sharp increase in the value of the Euro is a further blow to European competitiveness, not just for the “Clud Med” members of the Eurozone but now even in previously competitive Germany and other Eurozone members such as France.
In the meanwhile high and rising oil and energy and commodity prices – including now food prices – are taking a toll on European households’ incomes and purchasing power. This negative shock is likely to reduce growth further in a region that is already buffeted by a number of other negative shocks.
Moreover, European economic sentiment has continued to deteriorate according to the European Commission Business and Consumer Survey and retail sales were very weak in December in the Eurozone. Investor confidence in Germany fell to the lowest in 15 years on concern that a U.S. recession will deepen the slowdown in Europe’s largest economy. In Spain the spectrum of housing recession and contracting private consumption are looming on the outlook and a recession looks likely. The U.K. economy appears to be following – with a few quarters lag – the path that led to a hard landing in the US: housing bubble busting and excessive leverage by the households creating financial distress and contraction in consumption. The Irish economy has similar problems and risks as the UK economy. Italian growth is also sharply slowing down due to high oil prices, a strong euro and the deflation of and housing boom; add to this falling retail sales, weak business and consumer confidence, and a manufacturing sector close to a recession.
In Central and South Europe credit and housing bubbles – as well as large current account deficits and other financial vulnerabilities – may lead to financial distress – if not outright economic and financial crises – in the Baltic countries, in Hungary, Romania, Bulgaria and even Turkey as the global credit crunch and a sudden stop of capital to this region may occur.
Thus, Eurozone GDP growth will be well below its potential rate in 2008. And some economies – UK, Spain, Italy and possibly a few others including some in recent EU members – may experience an outright recession.
Moreover, in spite of these serious downside risks to growth, the room for macro policy – monetary and fiscal – easing is limited. The room for fiscal stimulus is constrained by the large structural deficits in many of the Eurozone economies; the major economies in the Eurozone exceeded the 3% fiscal limits of the Growth and Stability pact during the economic slowdown of the last few year; thus, they are now constrained by the need for fiscal retrenchment and don’t have many fiscal bullets to use to ease the economic slowdown.
As for monetary policy, while the Fed has already started to aggressively cut interest rates by 100 basis point, the ECB is deluding itself that it could raise its policy rate further once the financial crunch – that the ECB believes will be temporary – is past. What the ECB should instead to is to start cutting its policy rate now. While the Eurozone inflation rate is above the comfort zone of the ECB the slowdown in growth, the ensuing slack in labor markets and the likely fall in world oil, energy and commodity prices following the US recession and a sharp global economic slowdown will reduce such inflationary pressures in Europe.
Thus, looking ahead in the Eurozone the risks are biased towards downside growth surprises rather than upward inflation surprise. Waiting, like the ECB did in the 2001-2002 episode, will ensure that the negative financial and growth contagion from the US to Europe will be more seve
re and protracted. The time to cut policy rates and reduce the risks of a serious economic slowdown is now; but the temporizing by the ECB will ensure an even larger economic slowdown than the one that is already underway given the variety of negative and economic shocks that are now buffeting the European economies.