Can Europe ignore the credit crunch?
They’re less indebted than their Anglo-Saxon cousins, so it’s been assumed that Europe’s economies can stave off the worst effects of the US subprime crisis.
But that view is coming under increasingly harsh scrutiny. European banks were just as prone to buying dodgy subprime debt as their UK and US counterparts, so no one is sure who owns what on their balance sheets.
In the past three weeks alone, $50bn in mortgage-backed securities has been wiped off banks’ balance sheets, making them more reluctant to lend to one another, hence cutting the credit available to consumers or businesses. This week, three- month borrowing costs in euros rose to 4.85% – the highest in more than six years.
Is that the only problem?
No. The biggest worry for the eurozone right now is the weak dollar (also a result of the subprime crisis). The strong euro is making exports less competitive, and European industry is already feeling the strain. Industrial production has slowed 0.7% in the past three months, while the International Monetary Fund lowered growth forecasts for next year from 2.2% in November to below 2%.
Rumours abound that Airbus may move production of its A330 military tankers to Mobile, Alabama in the USA after Airbus CEO Tom Enders said last month that the dollar’s weakness was “life-threatening” for the plane maker. Aircraft are bought in dollars, and Airbus is losing $1.45bn for every ten-cent fall in the greenback, which is already down 16 cents against the euro this year.
And it’s not an isolated incident. French plane maker Dassault says it will also shift production overseas. Meanwhile, retail sales in the region fell by 0.7% month-on-month in October, giving an annual rise of just 0.2%.
So why not just slash interest rates?
It’s not that simple. Even as the eurozone economy is slowing, inflation is rising. Across the 13-member zone inflation hit a six-and-a-half year high of 3% in November, well ahead of the European Central Bank’s 2% target. The problem is particularly bad in Germany, where inflation grew to 3.3% in November, the highest rate since 1996.
Given their experience of hyperinflation in the 1920s, Germans are particularly sensitive to rising prices. “Today’s inflation figures are catastrophic,” Karsten Junius, an economist at DekaBank in Frankfurt told Bloomberg when the figures came out. “Nobody expected them to be like this.” Because it accounts for one third of the eurozone economy, what’s happening in Germany matters to the ECB more than anywhere else, which may be bad news for the other 12 members.
Why’s that?
Because while Germany’s concerns are more weighted toward inflation, many of the smaller countries are far more worried about the slowdown. Banking group ING reckons that the euro/dollar ‘pain theshold’ for firms operating in France is $1.20, and around $1.30 for Italy and Spain. But for Germany, where labour costs are far more competitive, it rises to $1.50.
Meanwhile, eurozone economies such as Ireland and Spain, which have seen massive house-price bubbles in recent years, are starting to suffer as those bubbles burst, something which simply isn’t an issue in Germany, where house prices have been moribund or falling for years. In other words, Europe’s economies seem to be diverging.
What could that mean for the euro?
“President Nicolas Sarkozy will not let Airbus go bankrupt, nor see decimation of the French industrial core, without an almighty fight,” says Ambrose Evans-Pritchard in The Daily Telegraph. And the European Commission rules allow for exchange-rate controls to be brought in, should enough EU finance ministers back it.
Interest rates spreads between German government bonds and those issued by other, less economically healthy countries in the union – such as Spain, Italy and Belgium – are rising, “a clear sign that markets are starting to price in a break-up risk”. “Sceptics like me have always said the operational viability of the single currency won’t be known until the system is tested by a serious downturn,” says Liam Halligan in the same paper. “That moment may now come soon.”
Currency unions: a brief history
Currency unions have traditionally smoothed the path of political union, as in Germany in the 1800s. The north German Zollverein, started in 1818, made Bismarck’s job of unifying German states a lot easier when they joined it. In 1876, the Prussian bank became the Reichsbank with control over all paper currency and coinage, which became Reichsmarks.
But where there isn’t political union and harmonised taxes, currency unions tend to fail, as in Scandinavia in the 1870s. Sweden, Denmark and Norway all recognised each other’s gold coinage as legal tender and later their banknotes. But when Norway declared independence in 1905, the Swedes dismantled the union.