Are you sure?

Europe bets on weathering a US downturn

Currency traders have become convinced over the past two weeks that something big is afoot in the global economy.

They are not convinced by the sanguine noises coming from the Federal Reserve and think the risks of a “hard landing” in the US economy have risen. But, in a departure from the old wisdom, they do not seem worried about the effects of a US downturn on European economies – rejecting the old adage that “when the US sneezes the rest of the world catches a cold”. They appear to be trading on the belief that, while US interest rates will fall in an effort to counter a slowdown, European rates will continue to rise – and, by implication, that Europe’s economic upswing has some way to go. This has led to steep declines in the dollar, which tumbled to a 20-month low against the euro and to a 14-year trough against sterling. Asraf Laidi, chief foreign exchange analyst at US-based CMC Markets, reflected the optimism in Europe last week as the dollar continued to plunge: a five-year high in Germany’s consumer confidence, combined with renewed readiness at the European Central Bank to raise interest rates, “further cements the fundamental backdrop of the euro rally”, he said. But can that tale of two diverging economies be true? Most economists had the same thoughts back in 2001 when, in the midst of a US recession, the chancelleries and ministries of Europe were confident that the old continent could go it alone. An ambitious “Lisbon agenda” had been launched to propel Europe to the top of the competitiveness league. But within a few years, such hopes had evaporated.

Europe’s main economies had slowed to a crawl as the collapse of the dotcom boom and terrorism hit the global economy. Will it be different this time? Is Europe’s economy really “decoupling” from that of the US? There are few better places to observe the extent of economic ties between North America and Europe than the top of a grain silo 12 storeys above Liverpool’s docks. Below, on the quayside, a ship unloads wheat from Canada, while another brings US soya-beans. In a nearby terminal that handles some 30 per cent of the UK’s containers on the North Atlantic route, cargo speeds on and off vessels waiting for the next high tide. In 2001, the US recession led to falling trade volumes between Britain and the US, says Frank Robotham, group marketing director of Peel ports group, the owners of Liverpool’s docks. Yet he is not worried about the effect of a slowdown. “We’re not pulling our hair out,” he adds. Europe’s policymakers are similarly relaxed. Joaquin Almunia, the European Union’s monetary affairs commissioner, said last month: “So far our estimate for the net impact of the US slowdown on the European economy is not very important because our growth is mainly based on internal demand.” Look to the other side of Liverpool’s Mersey River and you can understand Robotham’s confidence. There, in Birkenhead, is a giant pontoon handling traffic from Ireland, which today represents a bigger slice of business for the port than its North Atlantic trade. While container volumes on North Atlantic routes have doubled over the past 20 years, traffic to Ireland has risen sixfold. Similar stories of diversification from US business are increasingly told in continental Europe. At weekends the narrow streets of baroque Heidelberg, on the Neckar River in southern Germany, bustle with tourists. Its castle on the hill and university buildings below are particular attractions. US citizens comprise the largest share of foreigners. But what would happen if a US economic slowdown meant that suddenly fewer came? It is the sort of scenario for which Nils Kroesen, for 37 years managing director of the city’s convention and visitors centre, has prepared. After the first world oil shock in the early 1970s, he led an initiative to encourage Japanese visitors. “At that time we decided that we wanted to create additional markets alongside the US,” he says. Now Heidelberg is seeing 40,000 overnight stays by Japanese visitors a year, with many taking advantage of wedding packages. Japanese signs are obvious in tourist shops, but recent years have also seen significant growth in visitors from the Gulf States, China and India. Clubs to promote the city have been established recently in Delhi and Beijing. “The mix of nationalities on the demand side means we have few worries about visitor numbers,” says Kroesen.

For Heidelberg, a US economic slowdown “is not a big risk”. Economists and European policymakers regard Liverpool’s docks or Heidelberg’s tourism as good examples of the new European economy: robust, diversified and able to sustain growth without a US motor. But anecdotes cannot supply conclusive proof of Europe’s new resilience. Sceptics, who have heard talk of recovery and strength in Europe’s economies many times before only for it to have been exposed as an illusion, want to know what is different this time. In recent months, the debate has been fierce, with opinion among economists split roughly equally between optimism and pessimism. The first point made by optimists such as Dirk Schumacher, economist at Goldman Sachs, is that economic cycles in the US and Europe are linked less than we might think. The 2001 downturn was rare in being synchronized globally: in the early 1990s, 1980s and mid-1970s, US recessions were not strongly correlated with Europe. Schumacher argues that the correlation between US and eurozone growth can vary, and that when there has been a strong correlation, it might have been because both regions were hit by a common shock, rather than any intrinsic link. That was true in 2001, he argues, when both Europe and the US were hit by an equity market collapse and the effects of September 11 2001. “What we have now is a US domestic-specific reason,” he says. Mervyn King, governor of the Bank of England, made a similar point at a recent press conference. “I know there’s this phrase ‘when the US sneezes the rest of us catch a cold’, but I think we need something a bit more sophisticated to make that analysis now and it’s got to take on board why the shocks occur,” he said. “In 2000, when we also had this debate, the original shock was a worldwide slowdown in the IT sector. What we’re seeing now in the US is not a consequence of a worldwide slowdown – world growth has been and continues to be pretty strong – rather we’re seeing a slowdown in the US housing market.” The second reason for optimism is reduced dependence on trade with the US, cited last month by the European Commission. Over the past five years the relative importance of the US as a destination for EU exports has declined and EU25 countries, on average, are dependent on the US for only 8 per cent of their exports of goods. Third, the Commission points to the revival of domestic demand in Europe, and especially the revival of the German construction industry, which had acted as a drag on growth over much of the past decade. Corporate balance sheets were also in better shape compared with 2000-2001. The Commission’s figures bear out its argument. While many commentators focus on the exporting power of Germany, the importance of net exports for Europe’s growth is minimal. Consumption accounted for three-quarters of Europe’s relatively weak growth in the five years between 2001 and 2006, with investment accounting for the other quarter. Net trade detracted only marginally from growth in the same period, according to the Commission’s autumn forecast. Fourth, the European Central Bank thinks the pattern of internal demand can continue with strong investment from European companies, which have undertaken extensive restructuring in recent years and show strong profitability, alongside private consumption growth in line with rising incomes. Further grounds for optimism come from the health and potential strength of European labour markets.

The positive surprises to growth this year across continental Europe have come from higher-than-expected consumption, linked to strong employment growth. Given low levels of labour market participation in many parts of Europe, the scope for further employment and consumption gains are considerable, optimists say. But these arguments are not enough to convince sceptics, who believe Europe remains in thrall to the US economic cycle. Jacques Cailloux, an economist at the Royal Bank of Scotland, is one who believes trade figures understate these tight linkages: “Looking at the size of the trade share is unlikely to be a good guide to how exposed we are.” Increasingly, for example, direct investment has taken the place of trade: a European company that wants to sell goods in the US is nowadays more likely to build a factory there than produce the goods in Europe and export them. For this reason, sales by US subsidiaries of European companies are five times higher than European exports to the US. Moreover, if a US subsidiary of a European company is hit by lower sales, that does not show up in European export or gross domestic product figures. But it would hit company profits, creating “a direct link between sales abroad and decisions by the managers of firms based in Europe”, according to Cailloux. Others, such as Michael Dicks of Lehman Brothers, also believe the links are closer since the forces of globalization and modern information flows affect confidence in similar ways on both sides of the Atlantic. He argues that in the years since 2000 the eurozone has underperformed when the US has done badly, and vice-versa. And Stephen Roach, chief economist of Morgan Stanley and a longstanding pessimist about the ability of other economies to withstand a US downturn, says that for Europe to decouple it needs self-sustaining private consumption, a diversified export mix and policy autonomy. He argues that Europe fails on two counts, since its consumption has been sluggish for the past five years and both monetary and fiscal policy have little scope to respond to boost demand. The arguments cannot be resolved in advance, nor is it clear how deep or long any US slowdown will be. But it is clear that something different to 2001 would have to happen this time if Europe were again to suffer the effects of a US slowdown. If Europe cannot show resilience this time it would prove that, while the old continent no longer benefits much from a long US upswing, it automatically shares in the hard times. (FT.com)