Why has the European Union suffered so badly in a crisis that began in the US?
The answer is to be found in four weaknesses:
first, Germany, the EU’s biggest economy, is heavily dependent on foreign spending;
second, several western European economies are suffering from post-bubble collapses in demand; third, parts of central and eastern Europe are also being forced to cut spending; and, fourth, European banks proved vulnerable to both the US crisis and to difficulties nearer home.
Given these realities, recovery is likely to be slow and painful.
According to the latest consensus forecasts, the EU economy is expected to contract by 3.6 per cent this year and the eurozone’s by 3.7 per cent, while the US is forecast to shrink by only 2.9 per cent. Thus the crisis punishes the frugal more than the profligate. It seems so unfair. It is not: the frugal depend on the profligate.
A remark in the European Commission’s spring forecast gets to the nub of the problem: “As exports are usually the first component to recover in the eurozone business cycle,” it argues, “the export outlook is key.” The eurozone is the world’s second largest economy. Why should it depend for recovery on external demand? The answer lies with Germany. The Commission forecasts that the fall in net exports will account for three-fifths of its 5.4 per cent economic shrinkage this year.
One way of illustrating what is happening is in terms of sectoral balances – the difference between income and expenditure (or savings and investment) in the three principal sectors: government, private and foreign. By definition, these add to zero. Normally, changes in the private sector’s balance drive the economy. When the private sector cuts back on its spending, the current account deficit shrinks and the fiscal balance deteriorates. Which of the two predominates depends on how a particular economy works.
We can derive implicit private sector balances from the Commission’s forecasts. Within the eurozone, the Netherlands and Germany ran huge private surpluses in 2007, at 9.5 per cent and 7.8 per cent of gross domestic product, respectively. These were offset by current account surpluses, at 9.8 per cent and 7.6 per cent of GDP, respectively. Overall, however, the eurozone had almost no private sector and current account surpluses. Thus the German and Dutch surpluses were offset by deficits elsewhere. Spain’s were the most important: its bubble-fuelled private sector deficit was 12.3 per cent of GDP in 2007 and its current account deficit 10.1 per cent. But Greece, Ireland and Portugal also ran large private sector – and current account – deficits.
Between 2007 and 2009, private sector balances of bubble countries are forecast to swing dramatically towards surplus, by 15.8 per cent of GDP in Ireland and by 14 per cent in Spain. In both countries, the principal offset will be a huge deterioration in fiscal positions, but external balances are also expected to improve, by 3.6 per cent and 3.2 per cent of GDP, respectively. The UK’s private balance is also forecast to improve by 8.9 per cent of GDP, offset by the huge deterioration in the fiscal position. In the US, the private balance is forecast to shift from a deficit of 2.4 per cent of GDP to a surplus of 8.6 per cent over the two years, a swing of 11 per cent of GDP.
In essence, in post-bubble economies the private sector is expected to spend much less, relative to income, this year than two years ago. The impact on the surplus countries dependent on exports of manufactures has been devastating. In Germany, the private sector balance is barely expected to change but, as an export-dependent economy, it is badly affected by the declines in spending elsewhere.
The impact of the crisis on central and eastern Europe is also striking. According to the latest World Economic Outlook, capital flows to emerging Europe will fall from 9.5 per cent of GDP in 2007 to -0.7 per cent this year. This swing will force huge declines in external deficits and very big recessions. The figures for the tiny Baltic states are extraordinary: reductions in current account deficits forecast by the Commission of 21 per cent of GDP for Latvia, 17 per cent for Estonia and 13 per cent for Lithuania between 2007 and 2009. In Latvia, the private sector balance is expected to shift by 32 per cent of GDP in two years. No wonder the Commission forecasts that GDP may shrink by 13 per cent in Latvia, 11 per cent in Lithuania and 10 per cent in Estonia in 2009.
Europe’s banking sector is also badly damaged. According to the International Monetary Fund’s most recent Global Financial Stability Report, expected writedowns on bank assets in 2009 and 2010 are $750bn (€536bn, £471bn) in the eurozone and $200bn in the UK, against just $550bn in the US. Moreover, the equity needed to reduce leverage of eurozone banks to 25 to one would be $375bn and of UK banks $125bn, against $275bn for US banks. Western banks are also heavily exposed in central and eastern Europe: as the Commission remarks, “banks from the ‘old’ member states account for about €950bn foreign claims in the ‘new’ member states and the other European emerging markets, altogether around 82 per cent of total foreign claims. In absolute terms the largest exposure is by banks from Austria, Germany, Italy and France.”
The details may seem complex. But the fundamental point is not: the European economy gained an illusion of health from unsustainable spending in peripheral countries in its west, south and east. The asset price bubbles, credit growth and investment booms that characterised this spending have all collapsed, at the same time as an even more significant bubble burst in the US. This timing is not, of course, a coincidence. The collapse has devastated activity in the export-dependent countries, of which Germany is much the most important. Moreover, as a result of poor risk management, many European banks have also been badly damaged.
The question is whether the European economy can hope to return to health via a normal private-sector-led recovery. Unfortunately, in the post-bubble economies such a recovery is unlikely: one would have to hope for the piling of yet more debt on to the already highly indebted.
This leaves two European answers, one likely but undesirable, the second unlikely but desirable. The likely answer is that demand will be driven by unsustainable fiscal expansions in post-bubble economies. The unlikely answer is that private demand will pick up in creditworthy economies, particularly Germany. In the absence of either, Europe will wait for the US to spend itself back into (temporary) vigour. It is a sad picture, whatever the “green shoots” may seem to show.
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