When I ask businessmen or investors about their biggest economic worry at present, they almost invariably put the housing-related slowdown in the American economy at the top of their lists. More recently, there has also been concern about the unexpected weakness of consumer demand in Japan. Much less widely noticed, but arguably more important, especially for British business, are newly published European statistics that show growth slowing sharply in Germany and coming to a standstill in France. The first official “guesstimate” for the whole eurozone for the third quarter, issued last Wednesday, showed a slowdown to 0.5 per cent from 0.9 per cent reported the quarter before. Forward-looking indicators of economic activity have been falling even faster. France has suffered a precipitous decline in consumption; in Italy consumer confidence is plunging and Germany has seen the steepest fall on record in the ZEW financial expectations index, now at its lowest level since 1993.

None of this seems to have made much impression on financial markets or politicians, who keep repeating the mantra that Europe can now feel confident about a healthy and robust economic expansion, which is more soundly based and sustainable than the debt-driven booms in America and Britain. By 2007, however, the business and financial world may be facing a very different reality. In January, the German Government will impose the country’s biggest-ever consumer tax increase, while Italy will implement an even bigger fiscal tightening, if the Prodi Government can push through its budget. The steady tightening of monetary policy since last December, operating with the usual one to two-year lag, should start to have a noticeable effect on the eurozone about the same time, as will the malignant hardness of the euro. Under these circumstances — and with the US, Asian and Middle Eastern economies also slowing — it is easy to understand why the expectations of European businessmen and financiers are in sharp decline.

Why, then, are financial markets, economic forecasters and policymakers unperturbed? The answer seems to be that financial traders believe that it is more important to anticipate and react to the actions or even words of central bankers than to make their own judgments about how the economy is performing. And the message from Europe’s policymakers has been loud and clear: the recent weak statistics are unimportant and should not discourage either tax increases or further monetary tightening.

The ECB has never cared much about stabilising short-term economic growth prospects, believing that its only duty is to maintain low inflation in the long term. Thus, Jean-Claude Trichet and his ECB colleagues simply ignore economic figures and repeat their mantra that interest rates are “low by historic standards”, that the rapid growth of Europe’s money supply points to serious inflation risks in the medium-term and that heightened monetary vigilance is still required. In taking this attitude, European policymakers are effectively following the deflationary model of the 1990s in Japan. Japan briefly pulled out of recession in the mid-1990s, recording the strongest growth among the G7 countries in 1996. But this was followed by a big increase in consumption taxes and a premature tightening of monetary policy by the Bank of Japan. So we should not be surprised by a Japanese-style deflation in much of Europe next year.

Deflation is now a serious prospect in Europe, with inflation already below 2 per cent in the eurozone and below 1 per cent in Germany. The German and Italian economies seem almost certain to be hit by recessions in real economic activity next year. On top of the tax hikes in both countries, Germany will probably see a fall in machinery exports as the Chinese, OPEC and eastern European investment booms all cool. Italy, meanwhile, will continue to suffer from a decline in export competitiveness and a further fall in investment and business confidence if the Prodi Government collapses, as it almost surely will. Just as the tax-induced Japanese recession of 1997 triggered financial crises in Thailand, Indonesia and South Korea, the German and Italian recessions may set off financial collapses in peripheral economies such as Hungary, Poland and Turkey.

There are, however, several crucial differences between Europe today and Japan ten years ago. The most important are the relative strength of the banking sector and the relatively low levels of household and businesses debt. Instead of repaying debt and building up their savings, as the Japanese did in response to deflation, European businesses and consumers have gone on a borrowing spree. This has sustained consumption and property investment, especially in France and Spain. Without this Mediterranean housing, mortgage and spending boom the European economy would have remained stuck in a Japanese-style depression and deflation throughout the past three years, regardless of the Chinese and Middle Eastern demand for German machinery, French champagne and Italian designer handbags.

Unfortunately, this boom in house prices and mortgage borrowing, which offers the only hope for economic growth next year in Europe, is exactly the process that the ECB is now trying to snuff out. The question raised by Europe’s weakening consumption figures is whether the Club Med’s borrowing and spending boom may be running out of steam, as consumers wonder whether huge gains in property prices will prove sustainable in a time of rising interest rates and weaker global growth.

If the ECB does manage to break the exuberance of mortgage borrowers, the next few years in Europe will be as miserable as Japan’s last decade.

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