Europe No Longer Looks like a Safe Haven from the American Economic Tempest ; the European Central Bank Needs to Be Prepared to Make Itself Unpopular

Article excerpt

AN EARLY warning of trouble in the European economy is just starting to appear on radar. If it proves justified, there could be profound consequences, not just for financial markets but for the UK launch of the euro at the beginning of next year.

The story runs like this. A couple of months ago, the widely accepted view was that this year Europe would grow faster than America. There were a range of reasons for this view. For a start, the US cycle seemed to be running a couple of years ahead of Europe's. More specifically: the US was more vulnerable to a fall in share prices; it had a larger hi-tech sector; and the macro- economic fundamentals - in particular the negative household savings rate, the drum-tight labour market and the current-account deficit - were less favourable.

Europe, by contrast, had adequate spare capacity, particularly in the labour market, and home consumption looked able to replace exports to the US as a source of demand. True, falling share prices would worry companies, but European consumers had high savings and would not be much affected by global market weakness. So Europe would take over from America as the locomotive economy, pulling the rest of the world along behind.

That theory seemed plausible and could still be proved correct. But in the past two or three weeks nagging doubts have arisen that Europe might not have such a good year and that its growth might fall below even that of the US.

This is not yet a mainstream view. Even advocates of the "Europe slows" line, such as Merrill Lynch, reckon that the US will end the year with a lower overall growth figure. The company's new growth forecasts were for 2.2 per cent in the eurozone and 2.1 per cent in the US. (The EU as a whole was seen growing a little faster, at 2.5 per cent, pulled up by the UK, Sweden and Denmark.)

The problem for the eurozone is slowish growth forecast in Germany (2.0 per cent) and Italy (1.9 per cent). The Merrill Lynch view was that domestic demand would revive, but net exports were set to plunge. One result might be that industrial production in the eurozone would go negative. The car home market in continental Europe seems set to fall by 10 per cent this year (the UK is the only big market expected to increase, and German demand is running 12 per cent down), so this seems all too likely.

Will the European Central Bank cut rates fast enough to head this off? None of the bank economists surveyed yesterday by Bloomberg expected a cut at the ECB's forthcoming meeting, though all but four did expect a cut by the end of June.

The headline problem is European inflation, which at 2.4 per cent is above the top end of the ECB's target of 2 per cent. But the underlying problem is that the one-size-fits-all interest rates does not fit all. …