Global: Europe's Wake-Up Call
Stephen Roach (from Venice)
Morgan Stanley
May 09, 2003
The European economy is an accident waiting to happen. Lacking in domestic demand, a sharply rising euro is crimping the continent’s main source of growth -- external demand. In my view, the combination of misguided policies, lagging structural reforms, and acute pressure on Germany leaves Europe both exposed and unprepared to cope with most shocks -- let alone the currency shock that is now unfolding. Europe needs to get its act together sooner rather than later. Steeped in denial, the risk is it won’t.
Euro-sclerosis has now become a reality. The region has not carried its weight in the global economy for a long time. Over the eight-year period, 1995 to 2002, Euroland real GDP growth has averaged just 2.2%. Such anemic growth accounted for only 9.6% of the average growth in world GDP over that interval, far short of the region’s 15.7% share of world output (as measured on a purchasing-power parity basis). Moreover, Europe’s now chronically weak contribution to world economic growth has gotten even worse in recent years. Over the 2001-02 period, Euroland GDP growth averaged a mere 1.1% -- accounting for only 6% of global GDP growth, or just 40% of the region’s share in the world economy. Our 2003 estimates point to more of the same -- a 0.8% increase in the Euroland economy that accounts for only about 4% of the growth we are estimating for the world at large.
Moreover, there has been an ominous tilt in the mix of European growth in recent years, shifting away from domestic demand and increasingly toward external demand. In six of the past eight years, swings in the foreign balance made disproportionately large contributions to overall Euroland GDP growth. The only exceptions were in 1998 and 1999, when European export performance lagged and domestic demand growth picked up the slack. Recent trends are even more disconcerting. The bulk of the Euroland growth slowdown reflects a sharp deceleration in domestic demand growth; over the 2001-03 period, our estimates suggest that Euroland domestic demand growth has been essentially on an anemic 1% trajectory, well less than half the 2.8% average pace recorded over the prior six years, 1995 to 2000. By default, an improved external balance -- adding an average of about 0.3 percentage point to Euroland GDP growth over the 2000-02 period -- has emerged as an important cushion in an otherwise weakening economy.
Therein lies the potential for a serious growth shock to Europe. Lacking in support from domestic demand, a sharply appreciating currency will likely deflate Euroland’s external growth cushion, unmasking the full extent of the weakness that has emerged on the domestic demand front. In that context, and with layoffs and unemployment back on the rise, it is all the more critical for policy makers to apply counter-cyclical stimulus in order to jump-start anemic growth in domestic demand. Unfortunately, those options have all but been closed off by the institutional constraints of the European Monetary Union -- the Growth and Stability Pact, which effectively rules out fiscal expansion, and the backward-looking inflation-targeting mandate of the ECB, which inhibits aggressive monetary ease. To borrow and slightly modify a line from Robert Kagan’s indictment of Europe (see his provocative book, Of Paradise and Power: America and Europe in the New World Order, Alfred A. Knopf, 2003), the region is so steeped in its rules-based approach to policy setting that it may simply be unable to adapt to rapidly changing conditions.
And dramatic change is exactly what’s now in the air. The Federal Reserve said it all with its extraordinary policy statement of May 6: After nearly 18 months of steadfast denial, America’s central bank has finally conceded that the risks are now skewed toward deflation. With most of Asia in deflation and US monetary authorities now sounding the alert, it’s hard to fathom the possibility that a structurally impaired Europe might be spared from this increasingly global phenomenon. If anything, the sharp appreciation of the euro makes the case for Euroland deflation all the more compelling. Yet the ECB’s stunning intransigence at its May 8 policy meeting takes the concept of denial to an entirely different level. I believe European policy makers are taking unnecessary risk when they can least afford to do so -- precisely the opposite of what is required to fight deflation. The strictures of EMU are being placed ahead of increasingly worrisome economic perils. Something has to give -- either the economy or an increasingly antiquated policy framework. I vote for the latter. Rules-based policy constraints don’t fly in an increasingly deflationary world -- especially if those rules are set with an eye toward fighting the old battle of inflation.
There’s an added twist to this unfortunate state of affairs -- the special problems of Germany. For years, the Europhiles have been telling us to ignore country-specific issues in the new “United States of Europe.” Just as Americans don’t worry about California, went the logic, Europeans shouldn’t worry about Germany. Never mind that Germany accounted for one-third of Euroland activity -- three times California’s share in the US economy. The model of EMU was built on the pan-regional policy design of “one size fits all.” The German experience draws that theoretical presumption into serious question. With Germany’s core inflation rate down to 0.8% in March 2003 -- essentially half the Euroland average -- deflationary perils in Europe’s largest economy are considerably greater than is the case elsewhere in the region.
Obviously, it wouldn’t take much to push Germany through the deflationary threshold. That push may now be at hand. With the German economy probably contracting in the current quarter and the unemployment rate extraordinarily high (10.7%) and rising, there is every reason to expect further disinflation in this extremely low-inflation economy in the months ahead. A whiff of German deflation could be complicated all the more by the nation’s increasingly fragile financial system -- banks and insurance companies, alike. The Japan comparison is no longer a stretch for Germany. And if that’s the case, you have to wonder if the rest of Euroland has the capacity to avoid a similar outcome. As I see it, the German experience has revealed a critical and potentially fatal flaw of EMU: Without true economic convergence, it may well be that the big economies in this heterogeneous union have to be treated as special risks. If and when they are judged to be in a state of acute distress, pan-regional policies may need to be tailor-made for the weak link in the chain. The mounting perils of Germany are now screaming out for just such a remedy. Euroland’s once proud growth engine has been transformed into the deadweight of an anchor.
A post-bubble world has come a long way since the Roaring Nineties. Japan was the first to go and now Washington recognizes the risks of a similar fate. Europe remains frozen at the switch -- unable or unwilling to stimulate its stagnant domestic economy and about to lose any support from external demand. And the special risks of Germany only compound the problem. Europe is in increasingly desperate need of bold policy actions. It is getting precisely the opposite.
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