Some thoughts on decoupling from a European perspective

By: Eurointelligence ECB Watch

 

 

 

In its latest World Economic Outlook, the IMF has had an interesting article on whether the world can decouple from the US. The short answer is no: the world has become increasingly integrated, which means that shocks are no longer confined to a single economy. There is a long answer, which says that it depends on the kind of shock, and the extent of the shock. Obviously, Nafta countries would be most clearly affected by a sharp US downturn, due to the strong trade links, as would be parts of Asia, especially China.

 

What about the euro area? The IMF’s report does not focus much on Europe itself, but some of its conclusions can be applied to the euro area specifically. Direct trade links are not a major channel, as the euro area trades less with the US than even with the UK, both in terms of imports and in terms of exports. The channel that matters most for the euro area is the financial channel – given the extensive interlinkage of the American and European financial sectors. This would suggests that a simple economic downturn – or even a sharp economic downturn in the US – without any financial distress would probably not be such a big deal for the euro area as such. This is particular true, given that the euro area currently enjoys a strong domestic recovery, with a good internal dynamic. It will take more than a mere economic downturn in the US to derail the euro area economy at present. But if and when the US downturn hits the US financial sector, we will be entering a different world. Unfortunately, this is a fairly likely scenario.

 

But there is good news and bad news. The good news is that the euro area has become a lot more resistant against shocks for three reasons.

 

1. A size effect. The euro area is a large and increasingly integrated economic union that is less prone to external shocks simply because it is larger. In other words: if the euro area is more than the sum of its parts, it dependency on the rest of the world would be less than the sum of the dependencies of its parts.
2. Improved monetary policy. The inflation targeting framework of the European Central Bank assures an anti-cyclical policy response if the euro area was hit by a symmetric shock, for example an exchange-rate shock. An appreciation of the euro could easily be compensated by lower interest rates. In the pre-EMU period, most EU currencies were tied to the D-Mark, with German policy often not optimal for the other countries.
3. Improved fiscal policy. Despite the many criticisms, especially by academic economists, the stability and growth has introduced a counter-cyclical fiscal policy in many countries for the first time. If the euro area was hit by a big external shocks, the automatic stabilisers have the effect to soften the blow.

 

At this stage, the euro area is not a fully integrated economy, in the way the  the US is integrated. It also has a larger external sector. Over time, one should expect the euro area to display similar characteristic than the US in terms of the real economy – minus the financial markets.

 

And this is where the bad news comes in. The US is still such a dominant player in the global financial markets – and the euro area relatively underdeveloped – that any financial distress would immediate spill over into the euro area, with effects that might be much worse than in the US itself. The IMF report includes an interesting box on the financial sector (Box 4.1: “Financial Linkages and Spillovers”, page 130-132). The US accounts for about 40% of global stock market capitalisation. It quotes an interesting study by Ehrmann, Fratzscher and Rigobon according to which 26% of the variation in European asset prices is due to developments in the US, against only 8% the other way round. The spillover is particular strong in equity markets, where it accounts for more than 50%. That means European assets are driven more by events in the US than in Europe itself.

 

We saw these interlinkages again during the most recent period of market turmoil, when European markets fell in line with US markets. We saw similar co-movements in credit spreads, and premia in the markets for credit default swaps. As the US suffers from a problem in its subprime mortgage sector (one would have thought this is to be local problem), the European iTraxx indices shot up in line with comparable indeces in the US. One of the transmission vehicles are Collateralized Default Obligations (CDO), special vehicles that buy in, for example, mortgage debt, and which issue different layers of their own, normally much higher rated debt securities. CDOs are bought by hedge funds worldwide, and are one of the transmission vehicles for local credit crises to the rest of the world. Furthermore, since banking practices, such as those that led to the mortgage disaster in the US, are rarely confined to a local market, similar problems pop up elsewhere. There is an equivalent of a subprime industry in the UK, in Spain, and in Ireland, and in large parts of East Europe. The credit crunch that the subprime meltdown has caused in the US will equally be transmitted to Europe.

 
When it comes to global linkages, from a European perspective at least, don’t follow the goods, follow the money. The financial markets, not trade, is the reason why Europe is not decoupling.  

 

 

 

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