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Europe is facing the twin factors of a stalling continental economy and rising inflation.
This “stagflation,” combined with the European Union’s disjointed fiscal and monetary policy regimes, threatens to foment a protracted recession in Europe that will quickly spread eastward to Central Europe and the Commonwealth of Independent States.
Europe’s brewing economic crisis has two causes. Internally, inflation creeps steadily upward. Externally, the low demand for European goods drains vitality from the continent’s heart. This combination of events fosters stagflation — the rueful marriage of stagnation and inflation. Europe’s own disjointed policies are only intensifying the downturn, ensuring it becomes a true recession — and a persistent one at that.
Stagflation is difficult to combat, especially when accompanied by external forces or rigid domestic policies. Efforts to spur growth generally spike inflation, and efforts to tame inflation generally gut growth.
The euro zone’s inflation rate topped 2.9 percent in April, the 11th consecutive month it exceeded the European Central Bank’s 2 percent target.
The causes of this inflation are deep and chronic. First, higher oil prices have taken their toll on Europe. Second, the Union has suffered two major health scares in its beef industry. As consumers flock to goods perceived safer, and as the Union attempts to bailout the beef industry, food prices will fly ever higher.
Europe’s inflation is not limited to energy and beef. Pricey energy translates into higher manufacturing and transportation costs. The quarantines to contain foot-and-mouth disease complicate economic activity over wide swathes of territory. And falling investment — both local and international — raises the cost of doing business.
The weak euro further complicates matters, concludes STRATFOR, the global intelligence company. The sagging common currency increases import costs — particularly of oil and natural gas — both priced in dollars.
Inflation impacts Europe across the board. Every state in the euro zone has broken the 2 percent barrier. Germany expects its May rate to top 3.5 percent; its current 2.9 rate is already a seven-year high.
So long as inflation remains high, the ECB will find it difficult to pare interest rates and jolt the economy forward. Interest rate cuts tend to bolster inflation.
European leaders have long claimed — wrongly — that Europe is immune to the global doldrums. But while Europe does manage to keep itself somewhat isolated, it is much more exposed to the global economy than the United States. Less than 15 percent of America’s GDP depends on foreign trade. For Germany, the exposure is about one-third of GDP.
It shouldn’t be a surprise then that the most globalized of the European economies, Germany, is reacting the most to the global slowdown. Germany’s $2.1 trillion economy is also Europe’s largest, comprising 31 percent of the euro zone’s economy; its slowing heft acts as a brake on the rest of Europe. The European Commission estimates Germany will grow the least of any European state in 2001. This has harrowing implications for the rest of Europe; Germany absorbs one-fifth of all EU exports.
The most visible — and loudest — effects will be in France, Germany’s largest trading partner. French first-quarter 2001 GDP figures struck a two-year low, while industrial production dropped for the first time in six months in April; Germany’s most recent numbers were equally disappointing.
Some Europeans are finally realizing the future isn’t as bright as they have steadfastly maintained. Germany has cut its growth target to around 2 percent. Since that assumes the slowdown doesn’t intensify — and consumer spending, export growth, industrial production, rates of growth and business confidence are all pointing in the wrong direction — the actual rate is bound to be much lower. Paris even trimmed a few points off its fourth-quarter 2000 figures. Between them, France and Germany constitute more than half the euro zone economy.
The international exposure does not end with Germany. Only about 3 percent of Europe’s GDP directly depends on trade with the United States. With the U.S. economy beginning to perk up, one may think Europe will soon follow. But the rest of the world is slowing too; Europe is getting hit from multiple directions — hits from Asia will be particularly hard.
The net result is stagflation. The Netherlands is a case in point. Its inflation rate — at 5.3 percent — is at its highest in 20 years, while its growth rate is at an eight year low. As the European core slows, and inflation rises, the Dutch will have plenty of miserable company.
Even an experienced central banker backed by a skilled executive
with an array of policy tools would have a problem averting a
slowdown with such varied and reinforcing causes.
Europe, however, lacks all of that.
Despite a six-month track record of championing inflation control over growth, the ECB shocked markets by cutting rates 0.25 percent on May 10, a move that typically spurs inflation. In rationalizing its move, the Bank claimed inflation would be high anyway, and it had discovered an ideal rate to promote growth. Aside from sparking pundits to resurrect the term “voodoo economics,” the move badly battered the Bank’s credibility, which after previous snafus was already wobbling. The markets duly punished the bank, sending the euro to fresh lows.
Europe’s next policy weakness is it overall structure. Unlike the United States, it lacks a single fiscal authority. Unlike Asia, its states lack true fiscal independence. So, instead of each state being able to freely choose a policy — or having a central authority foist one on them — there are seemingly endless policy comparisons, coordinations and compilations among the Union’s members: the European Parliament, the European Commission and the ECB. This policy-by-committee mentality retards governments’ reactions. It is telling that the United States has cut interest rates sharply five times and has a massive tax cut on the verge of adoption, while Europe has largely busied itself with noting each negative statistic in excruciating detail.
Finally, Europe’s social-welfare model has fostered a rigid labor market that makes Europe uniquely unable to react quickly to changing economic conditions. In the United States letting workers go, as employees of Dell Computer Corporation — a major American firm headquartered near our offices in Austin, Texas — discovered this past month, takes mere hours. In Europe, however, staff reductions by British retailer Marks and Spencer in France take months and have already triggered lawsuits — the first of which M&S actually lost April 10.
Making matters worse, the Commission is flirting with strengthening these labor protections. Such blatant anti-business policies will only encourage capital flight, weakening the euro and prolonging Europe’s downturn.
What will make Europe’s coming recession particularly robust and resilient are the overlapping natures of events and European policies. Poor policies drive away investment, which weakens the euro. A weakened euro raises the cost of imports, strengthening inflation. Higher inflation limits new investment, leading to layoffs. In social-democratic Europe, that triggers support for policies supporting workers rights, which starts the cycle again. It is a cycle Europe will find difficult to escape; on May 24 all of these factors conspired to almost push the euro down through the 85-cent barrier, less than 4 percent from the euro’s all time low.
It would be bad enough if a European slowdown happened in isolation. But an $8 trillion economy cannot stumble without serious external repercussions. The first casualties will be the states to the Union’s east that are busy lashing their economic, political and legal systems to the Union’s framework.
These states will soon discover that while membership has its privileges, it is not risk free. Like the rest of Europe, most of these states count Germany as their largest trading partner, and — like the rest of the EU — all trade more with the European Union than any other entity. But unlike the Union, they lack the well-funded social support systems that keep Western Europe politically quiescent. Central European states, already struggling to meet rigorous EU accession requirements, will suffer doubly from their prime market’s faltering.
Further east, the results will be even more ugly. Russia’s trade may be diversified away from Europe more than Poland’s, but the nature of that trade is far more concentrated. Energy and raw materials comprised two-thirds of Russia’s 2000 exports. The European slowdown — and Asian and Latin American slowdowns — will send prices plummeting for these exports, the backbone of the Russian economy and federal budget. Combine the lack of income with a weak political system, an economy bereft of foreign investment, and an increasingly towering debt repayment schedule and the rest of 2001 and 2002 shape up very dark indeed for Russia.
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