Throughout the past three years, while most economists, politicians and business commentators have been wailing about the global recession, I have taken an unconventionally upbeat view. In the past few months, that has been favoured by the economic evidence. So it grieves me to report that while the world has become more bullish, my earlier confidence has been replaced with foreboding and gloom.
While Britain and Asia should prosper in the years ahead, as they did through the past three years of largely imaginary “recession”, the risks to the two main components of the world economy — America and continental Europe — are bigger than they have been at any time since the end of 1999.
Why should we worry? Just as the economic vulnerability in 1999 was symbolised by the ludicrously overvalued price of the Nasdaq index of US technology shares, the danger today can also be seen in a single number: the exchange rate between the dollar and the euro. In the past few days, the euro has shot up to $1.18, only a whisker below its all-time high, set in the aftermath of the Iraq war, and 31 per cent above the level at which it generally traded before spring 2002. This shift in global currencies, and in the flows of international capital, creates enormous risks for the world economy.
Many Europeans still see a “strong” currency as a symbol of economic strength. They think of a hard currency, such as the old German mark, as a sign of virility. But hardness can also be a precursor of disaster, as in a tumour. Which is why I believe that the euro today should not be described as “strong”, but as “malignantly hard”.
European politicians do not seem to understand this. Most are convinced that, after the Continent’s most painful recession since the 1974 oil crisis, the worst is now over. This was confirmed to me yesterday at a breakfast meeting with Giulio Tremonti, the Italian Finance Minister, who is also the chairman of the committee of EU finance ministers (the Orwellian-sounding Ecofin).
Signor Tremonti expressed deep concern about what he called the “asymmetry” between the depth of Europe’s economic problems and the shallowness of its institutions. He was also deeply worried about the overregulation of Europe’s domestic businesses, especially in contrast to what he considered the ultraliberal approach to trade in other countries, such as China, which do not burden their companies in the same way. The solution to all these problems, he insisted, would be found in the next phase of Europe’s development — which would focus on creating stronger political institutions, starting with the new constitution.
Meanwhile, the short-term economic outlook seems to be getting distinctly brighter. According to Signor Tremonti — and his view appears to be shared by all the other finance ministers — the continental economy will recover next year, thanks to a combination of accelerating growth in the US, the easing of interest rates by the European Central Bank and the various labour market and pension reforms announced by European governments.
He noted that an impressive cycle of structural reforms has been launched this year: “For example, we have seen pension reforms in the smaller countries from Finland to Austria, as well as in Italy, Germany and France.” EU finance ministers have also agreed on a modified version of Italy’s €90 billion government-backed investment programme, designed to renew Europe’s transport infrastructure and boost economic growth by as much as 0.5 of a percentage point.
The latest item of good news for Europe has been the compromise over the eurozone’s misbegotten Stability Pact, reached by the Ecofin meeting in Luxembourg on Tuesday. Ecofin decided not to impose sanctions on France, which has breached the pact for three years running, but Paris promised to try much harder to stay within its targets. So the pact can remain on the EU statute book — indeed, it will be engraved in the new European constitution if that is ever ratified — but eurozone governments can also feel freer to budget sensibly or ignore siren calls to take self-destructive actions such as raising taxes in a recession.
This is all very well. But for European leaders to congratulate themselves on the modest pension and labour market reforms — which will, at best, do no more than prevent the present oppressive business climate from getting even worse — is a classic case of rearranging deckchairs on the Titanic. While Europe’s policymakers argue about a meaningless Stability Pact or lay out blueprints for pension reform in 2010 and beyond, they seem to be deliberately ignoring an enormous iceberg that could sink all their efforts in a matter of months.
That iceberg is the rising euro. A stronger euro and weaker dollar would normally shift jobs and economic output across the Atlantic, creating more unemployment in Europe’s factories, while helping US manufacturers to create more jobs. But now, it would be endanger the entire global economy because Europe’s nascent economic recovery is still extremely weak, and a blow to employment prospects and profits could snuff it out.
In theory, the damage might be compensated by benefits across the Atlantic. But in practice it won’t, for three reasons that Europeans are wilfully ignoring.
First, the US economy is already growing strongly and will do so next year whether the dollar is high or low. There is a limit to how fast even America can grow without igniting inflation. The falling dollar will simply hasten the day when the US economy reaches this limit, either forcing the Federal Reserve Board to raise interest rates drastically, or causing panic in financial markets, when investors around the world conclude that the Fed has fallen behind the curve of rising inflation, as it often did in the 1960s and 1970s, with invariably disastrous results.
Secondly, Europe is uncompetitive with America, even at the present exchange rate. Largely because of the huge burden of social charges and other payroll taxes, an average factory worker costs 15 per cent more to employ in the eurozone than in the US and 50 per cent more in Germany. Despite these enormous handicaps, most European economies sell far more to America than they import. But this does not demonstrate a competitive advantage. Rather, it reflects the collapse of consumer spending in Europe and the willingness of European companies to accept lower profits than their US rivals.
Thirdly — and most importantly — the dollar is not just the currency of America, but also of Asia. China, for example, has pegged its renmimbi rigidly to the dollar since 1994 and is determined to stick with it for at least another year or two. So when the euro rises against the dollar, it does not transfer European jobs to the US, as it might in a world of freely floating currencies. Instead, it transfers jobs and output to China and Hong Kong, as well as to other Asian countries that informally link their currencies to the dollar and have therefore enjoyed a huge competitive advantage against Europe in the past 18 months. Japan, for example, has improved its competitiveness against the eurozone by 10 per cent since this time last year and by 30 per cent since early 2001.
Given that China, South Korea and Japan are already the world’s most competitive exporters, the weakness of the dollar exposes Europe to a devastating pincer movement. At the top end of the market — in technology, high-value services and luxury goods — Europe will lose ground to America, while at the bottom end, ever-cheaper Asian exports will decimate the labour-intensive low-cost industries that still provide millions of Europeans with jobs.
This pincer movement is by far the biggest economic peril facing Europe today. If the dollar goes on falling and the euro goes on rising, Europe’s tentative hopes of economic recovery will be shattered. At that point, the malignant hardening of the euro will become a political peril for every European leader — not just an economic headache for the finance ministers and central bankers. Then the governments of Europe may take notice. But by then, it will be too late. Another year of economic growth will have been wasted, thousands more businesses will have been ruined and the prospects of economic labour market and pension reform will have receded. In short, if the euro’s malignant hardening continues, Europe will soon be back in the cancer ward.
