17.04.2007

Why Europe will not decouple from the US

By: Alan Ahearne, Bruegel and NUI Galway

The global economy has relied for too long on the United States as a locomotive for growth. Partly as a result, the U.S. current account deficit has swelled to unprecedented and perhaps dangerous levels as U.S. imports outpaced exports. To reduce the risks of a disorderly and costly unwinding of the U.S. external deficit, it is important that other economies now step up to the plate. What is needed, along with movement in exchange rates, is a sustained period of strong domestic-demand-led growth in China, Japan, and the euro area. The precarious state of the U.S. economy, which some commentators are forecasting may fall into recession by the end of the year, makes it all the more urgent that the baton of global growth be passed to these countries.

Recent economic data from the euro area, and arguably to a lesser extent from Japan, appear fairly encouraging in this regard. Fixed investment in the euro area jumped 5.3 percent in 2006 (on a Q4/Q4 basis) compared with 2.5 percent in 2005 and 1.9 percent in 2004. In addition, personal consumption expanded at a reasonably respectable pace of 2 percent rate last year, up from 1.2 percent in 2005. But questions remain about the robustness of the recovery in the euro area, and in particular about the extent to which growth in the single currency area is self-sustaining. We have, after all, seen false dawns in the euro area before.

Notwithstanding the pick-up in domestic demand, net exports remain an important source of growth for the euro area. Of the 3.3 percent growth in euro-area GDP last year, net exports contributed as much as 1 percentage point, almost as large a contribution as from consumption and investment. Importantly, a U.S. recession would not only depress euro area exports, but would also hurt business investment in export sectors as well consumer spending by workers in those industries. As Wolfgang Munchau pointed out this week, the critical question then is whether the euro-area economy can withstand a recession in the United States. In the words of the latest IMF report on prospects for the global economy*, can the euro area “decouple” from the U.S. train?

Any analysis of the effect of a U.S. recession on growth in Europe must begin, I would argue, by identifying the shocks that cause the U.S. downturn. The most likely candidate I see at the moment is a further deterioration in conditions in the U.S. housing market, involving substantial declines in house prices and residential investment. Personal consumption would also likely take a substantial hit, given the importance until late of increases in housing wealth in supporting U.S. consumer spending.

Worryingly, evidence presented in a cross-country study of house price booms and busts** that I wrote with some of my former colleagues at the Federal Reserve Board suggests that changes in house prices seem to be positively correlated across countries. The chart below (which is taken from that study) shows the number of countries experiencing rapid declines in real house prices and the number of countries experiencing rapid increases of real house prices over the past 35 years. Each of the past episodes of rapid price increases was followed by a period in which a large number of countries experienced real house price declines.

The implication is that if U.S. house prices do crash, and if house prices follow the same patterns as before, other countries will also experience crashes. The euro-area housing boom is unlikely to escape. Residential investment and personal consumption in the euro area will be depressed as a result. Of course, this would be not so much a contagion effect from the United States, as a common shock. It would simply be the case that the U.S. housing bubble busted before Europe’s because interest rates began to rise earlier in the United States.

Aside from the common shock to housing markets, the main reason I see why Europe will not decouple from the United States is old-fashioned animal spirits. If the U.S. economy goes belly up, European business sentiment will tank and capital spending in Europe will drop. Rightly or wrongly, business leaders in Europe (and elsewhere in the world) still view the United States as the locomotive for global growth. Until we see more convincing evidence of internal dynamism in the euro area, those perceptions are unlikely to change.