A crisis for those whose first language is English

We have been saying for a long time that the credit crisis is extremely severe, that it will probably bounce the US into a recession, and that it will spill over to the rest of the world economy. However, it is important to assess the spillover mechanism in some detail.

 

There are many direct and indirect channels through which the combination of a global credit crunch and a US recession affect the euro area. The US-Euro exchange rate, of course, is one such mechanism, which will undoubted affect the relatively small trade flows between the euro area and the US, and the larger trade flows between the euro area and other dollar-linked economies. The financial markets are also an important channel. And so are the entrepreneurs' animal spirits. There is going to be less confidence in the global economy in the next few years than there was previously. So no doubt, this is a serious crisis, possibly even the worst financial crisis in history.

 

It certainly implies a fall from the dizzy heights of economic growth at close to 3%, which we have experienced during the recent upturn. But that does not necessary imply a recession for the euro area.

 

There are three important stabilisers at work in the euro area. The first is the European banking system. Of course, this is global credit crunch, but European banks are in relatively much healthier state than their US counterparts. Stories such as those of IKB Industriebank or SachsenLB may have hit the headlines, and there are many European banks with subprime investments. But this is nothing in comparison with what we have seen from Citigroup, Wachovia and Merrill Lynch. The fact of the matter is that this is a highly asymmetric crisis. It affects countries harder, whose first language is English, as opposed to countries, where the main languages are French, or German, or Italian, or even Spanish.

 

The second stabiliser is fiscal policy. The global economic downturn in conjunction with a credit crunch constitutes one of the few situations where the Maastricht Treaty's deficit rules - which impose a maximum deficit-to-GDP ratio of 3% - are likely to be suspended. Fiscal policy will not neutralise this economic impact completely, but it will constitute a much more powerful counter-cyclical policy instrument than during the previous downturn, when fiscal policy had a largely pro-cyclical effect.

 

The third stabiliser is the savings-rich European consumer in general, and the German consumer in particular. German consumers are not about to take over the binge-baton from their American counterparts, but they are one of the few groups in the global economy virtually immune to conditions on the credit markets. They have a huge arsenal of savings into which they can tap.

 

The only thing that could prevent that from happening would be a sudden and steep rise in euro area unemployment. It is possible that global downturn is so severe, and so symmetric, that the export industries are going to destroy all those jobs that were created since the end of the last downturn. We believe this is highly unlikely.

 

Of course, if the US economy were to enter into a 30s-style depression, if China's asset price bubble were to burst, if euro/dollar exchange goes up to $2, and if oil hits $150, all might be possible. But in the absence of such an uber-extreme scenario - merely a "normal" US recession, a "normal" spill-over to the rest of the world economy - we would expect the euro area to continue to register positive growth rates - in the range of 1-1.5%. Nothing spectacular certainly, but not a catastrophe either.

 

As long as the European policymakers keep their nerve - which is admittedly not guaranteed - the euro area will be ok.

Eurointelligence ECB Watch

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