After a flying start into 2008, European economic growth ground to a halt over the spring and summer. Six months ago many observers had hoped that at least the 15 eurozone countries could weather the global storm unleashed by the U.S. mortgage crisis with limited damage. These hopes have now been dashed for good. The eurozone is mired in stagnation. We cannot even rule out a genuine recession. But the U.S. credit crisis is not the major culprit. The oft-touted scare scenario, namely that European banks burned on the U.S. market would deny credit to worthy borrowers at home, has not come true.
Instead, the eurozone has been hit by two other shocks. The surge in oil prices from $73 per barrel in 2007 to a peak of $146 in July 2008 has forced consumers to spend almost the entire gain in their incomes so far this year on higher energy and food bills, leaving them little extra money for other goods and services. In addition, the rise in the exchange rate of the euro from an average of $1.37 last year to a peak of $1.60 this July went beyond what even the eurozone could bear, despite its reform-enhanced resilience.
The eurozone is now faring worse than the United States. Helped by an undervalued exchange rate, the United States enjoys a boom in exports, with annual growth rates of close to 20 percent, whereas the eurozone is now struggling to raise its exports at all. In addition, while oil prices soared to their peak, the U.S. government sent its consumers tax-rebate checks that, by chance rather than design, offset much of the increase in the average energy bill. In the eurozone, higher levels of government debt make such largesse impossible.
Fortunately, the current European malaise need not last beyond the coming winter. The fact that it took two giant external shocks—spiking oil prices and the rising euro—to derail the upswing offers hope for the future. The shocks are unlikely to be repeated. Oil prices are now more likely to settle down than to rise further, barring any catastrophic geopolitical accident. Demand for oil is already declining in many countries (though not in China). Consumer spending in the eurozone usually starts to recover six to nine months after a peak in oil prices. Oil prices have already dropped by about $25 per barrel since mid-July. If they stay below the peak, consumer spending could start to firm again next spring. If oil prices decline further, as they may, the rebound could be pronounced.
The long rise of the euro, which had started at a trough of $.82 in October 2000, seems to be over, thanks partly to a shift at the European Central Bank. Initially, the bank had seen the surge in oil prices mostly as a threat to price stability. It took a tough anti-inflation stand that culminated in a July rate hike, which helped drive the euro up until mid-July. Since then the appeal of the euro has waned. Chastened by the unexpected economic downturn, the ECB started to sing a softer tune in August. As a result, the euro has fallen by almost eight percent to $1.47 over the last six weeks.
More important, the tide of global fundamentals is gradually shifting in favor of the greenback. Due to its surging exports, America's external deficit is declining. Although the Fed is certainly not in a hurry, chances are that it will start to gradually increase interest rates at the end of 2008 or in early 2009 if the U.S. economy stays sufficiently resilient. At 2 percent, Fed rates are less than half the ECB's 4.25 percent. This has made the dollar unattractive for investors. However, the United States has higher inflation and more economic growth than the eurozone. Over time, it will make sense to narrow the interest-rate gap between the two sides of the Atlantic. As the market looks forward to this, the U.S. dollar could well strengthen significantly. Our foreign exchange strategists expect a euro exchange rate below $1.40 within one year, with a good chance that the euro could fall even closer to its long-term fundamental value of $1.15–to-1.20 in due course.
Lower oil prices and a less overvalued euro could make life more pleasant for consumers and producers in the eurozone. While exports could regain momentum, consumer spending could gradually recover once households no longer have to hand the increase in their incomes over to the oil producers. Lessening inflation pressures in the absence of any new oil shock could enable the ECB to stay on hold until late 2009 even if growth gets going again next spring.
Most fundamentally, the eurozone has not yet reaped the full benefits of the labor market reforms Germany instituted from 2003 to 2007, and that France is pushing through now. In the next few years, the employment and income prospects in Europe's two largest economies should improve. There are downside risks. The U.S. economy could lurch into a severe recession. The global financial crisis could get much worse, bringing the credit crunch to the eurozone. But these risks can be avoided. It will probably take until mid-2009 for the upswing to regain some of the vigor it had before the oil and euro shocks blew it off-course.
Schmieding is chief economist for Europe at Bank of America in London
6 months ago