The Economy’s Perilous Waters

What a difference a week makes. With their coordinated response to the international banking crisis, European governments — followed by the U.S. — appear to have calmed a worldwide market panic and eased fears of a devastating series of bank collapses. Investors from Tokyo to Tunis immediately sent stock prices shooting up again after a week of historic losses. But it’s still far too early to celebrate. The measures need to prove their effectiveness by unfreezing lending. And there’s still the huge challenge — no less urgent than fixing the banking system — of preventing an economic slump.

The credit crisis has had a chilling effect on economies around the world, and the International Monetary Fund (IMF) expects global growth to drop off sharply for the rest of this year and next as a result. The situation is particularly critical in Europe, where national economies were slowing markedly even before the financial crisis exploded. Most economic statistics in the U.K. and around the Continent already look awful, but the turmoil of the last few weeks will likely make the downturn longer and more painful. “You name it, it’s falling,” says George Buckley, a London-based economist for Deutsche Bank.

The result: economists across Europe are writing off 2009 as a year to forget, and some expect the weakness will continue into 2010 and beyond. Consumption will likely be sluggish and business investment soft. In European countries where the real estate market had overheated, including the U.K., Ireland and Spain, house prices are expected to continue tumbling. As the rest of the world also slows, exports will be hit — particularly bad news for Germany, which as recently as the first quarter of this year had served as the motor of Europe, thanks to its surging sales of machinery and other capital goods to places like China, Russia and the Middle East. In the last few days, companies ranging from motor manufacturer Deutz to Koenig & Bauer, which makes printing machines, have cut sales projections and warned about weak orders. “It’s a double whammy,” says Dino Sola, a finance professor at the University of Monaco. “First the credit crunch gets out of control and then, when we get our act together, we realize that we are in the midst of a recession that is potentially deep and long-lasting.”

A struggling Europe is bad news for the rest of the world, since more than one-third of all foreign direct investment into countries such as China and Brazil comes from the 27-nation European Union. The E.U. with its 490 million population has also been an ever larger consumer of goods and services from Asia; last year it imported about $1 trillion worth from emerging markets alone, and China is its biggest supplier. With the U.S. economy also expected to drop off, it’ll be up to Asia to generate its own growth for a while.

At home, a significant impact of the European slowdown is likely to be a rise in unemployment. The number of jobless in the E.U. dropped sharply between 2005 and 2007 and then flattened out at 25-year lows. But the latest statistics from France, Ireland, the U.K. and some other countries show that the unemployment rate is starting to pick up again. The IMF, which has slashed its growth forecast for the euro-zone countries for 2009 to a negligible 0.2%, predicts that the percentage of jobless in those 15 countries will jump above 8%. Worst hit will be Spain, where it predicts unemployment will be close to 15% next year, up from 8.3% in 2007.

This grim outlook presents some particularly tricky challenges to those in charge. In previous downturns, such as the early 1990s slump, governments typically ramped up state spending in order to offset the drop in business activity. But this time, the gigantic cost of bank bailouts will leave national treasuries with little room for maneuver. Indeed, the bailout plans — under which stricken banks will receive direct injections of taxpayer money to strengthen their capital base, while governments provide guarantees aimed at getting banks to lend to one another again — may well throw government finances seriously out of kilter.

Still, the picture isn’t one of unrelenting gloom. Interest rates are low, unlike in the early 1990s, and the price of oil has dropped from its peak earlier this summer as demand slows from the cooling global economy. That’s good news for consumers everywhere. But the signs of economic woe still add up to a minefield that European governments, central banks and other policymakers will have to navigate carefully. Here are some of the mines that lie in wait for them:

Vanishing Credit
One of the main consequences of the financial crisis is that credit will be a lot harder to obtain. That’s already happening in the U.K., for example, where the volume of home mortgages approved by lenders fell dramatically in August. Including other forms of consumer credit, total net lending plunged by 86% from its level a year ago, according to Bank of England statistics. Just as Europe’s banks were overextended, so consumers in many countries ramped up their household borrowing in the past few years — usually because rising house prices made them feel richer. For policymakers, the critical issue is the speed with which the inevitable weaning off of credit now takes place. If the “deleveraging” is quick, it will mean the European economy will be much better placed to rebound on a healthier footing. But curtailing credit would hurt consumers who are deep in debt, and would have serious consequences for retailers and others dependent on household spending for their livelihoods. If the deleveraging is slow, the economy could remain sluggish for several years, weighed down by debt levels. “It was transfusions of credit that made the economy buoyant, but if there’s no growth from credit now, what will support the economy in the longer term?” worries Véronique Riches-Flores, chief European economist at Société Générale in Paris.

In throwing a lifeline to their banks, European governments are insisting these institutions resume their stalled lending to businesses and individuals. But it’s clear that even if all goes according to plan, the sort of carefree dishing out of credit that marked the financial sector — and which both underlay the banking crisis and helped to propel Europe’s economies — is history. “There won’t be a return,” says Jean-Marc Franceschi, a banking specialist at law firm Hogan & Hartson in Paris. “It will never be like it was before.”

Inflation or Deflation
The amount of money that European governments and the U.S. are promising to put into the financial system is so vast — close to $2 trillion, if the cash injections and state guarantees are added up — that it could end up stoking inflation. Consumer prices have anyway been climbing for much of this year, as the cost of everything from oil to milk and cereal has risen. That trend is now changing as the global economy falters. Inflation leaped to a 16-year high in the U.K. in September, but elsewhere in Europe it has slowed, and economists say it should also drop back in Britain. Still, by borrowing huge amounts of cash to inject into the financial system, governments could create a medium-term inflation problem of their own. What’s tricky is that the alternative is also a serious possibility: if household spending and business investment drop sharply and exports don’t take up the slack, Europe could be confronted with deflation of the sort that took hold in Japan in the 1990s. “We’re somewhere between the two,” says Riches-Flores of Société Générale.

Figuring out exactly what’s happening and then reacting accordingly falls to the European Central Bank and its president, Jean-Claude Trichet. The bank has been nervous about inflation all year, but earlier this month it slashed its lending rates by 0.5% to 3.75% as part of a coordinated rate cut by the world’s biggest central banks. Riches-Flores expects the bank to cut rates further in the near future as the economy slows. At the weekend, the E.U.’s Commissioner for Economic and Monetary Affairs, Joaquín Almunia, even called for monetary easing “in the near term.” But Trichet is famously stubborn and independent, and the bank’s entire culture is built on a near obsession with inflation.

Fiscal Creep
Around Europe, that ripping noise you hear is the sound made by Treasury officials tearing up their 2009 budgets. With the economy slowing, tax receipts are lower than expected, and in Britain, France and elsewhere government spending is higher than forecast. Now comes the bank bailout, and with it, a huge increase in government borrowing. British Prime Minister Gordon Brown has been the first to detail his national package, and it’s making fiscal hawks shudder. It involves injecting up to $65 billion into three British banks — Royal Bank of Scotland, HBOS and Lloyds TSB — in exchange for equity stakes.

Under international accounting rules, the government should rightfully add the liabilities of those banks to its national debt. RBS’s liabilities alone exceed the total national income of the U.K. Even excluding them, Brown is almost certain to break one of his own cardinal rules by failing to keep the total debt level below 40% of national income. Carl Emmerson, deputy director of the Institute for Fiscal Studies in London, estimates that Britain’s budget deficit for the current fiscal year will likely grow from the government’s planned 2.8% of GDP to about 4.4%.

The problem of ballooning debt and deficits is the same elsewhere in Europe, especially in France, where the budget deficit was already perilously high before the financial meltdown. The consequences are that the E.U.’s rules stipulating that budget deficits shouldn’t exceed 3% of GDP and that debt shouldn’t go over 60% are about to be consigned to the trash heap — at least temporarily. “Fiscal rules are going to have to be abandoned,” says Buckley of Deutsche Bank. The E.U. commission, which is the keeper of those rules, has already given its green light. “The existence of exceptional circumstances allows a deficit temporarily above but close to 3% of GDP not to be considered as excessive,” it said after the announcement of the coordinated bank bailout. The crucial word there is “temporarily.” Much of Europe’s economic growth over the past few years came about because of a self-imposed fiscal discipline. But, as Patrice Poncet, a finance professor at ESSEC Business School in France, points out: “It’s the tendency of politicians to turn temporary measures into permanent ones.” Extraordinary times demand extraordinary measures. But for Europe’s leaders, deciding to bail out the banks may turn out to have been the easy part.