Reflections on Europe's Recession

October 24, 2008

The PMI gauge of manufacturing activity in Euroland plumbed to a record low for this 11-year-old indicator of 41.3 in October, 3.7 points lower than in September, 7.9 points less than at mid-2008 and 15.5 points below the level in July 2007 just before the outbreak of the financial crisis. The new orders component has plunged to 36.2 from 55.3 in July 2007. The services PMI was at a five-year low of 46.1 compared to 48.4 in September, 52.1 in June, and 58.5 in July 2007. In the year to August, Euroland industrial orders declined 6.6%, including drops of 13.7% in transportation equipment and 19.5% in textiles.

Germany’s manufacturing and service PMI readings are now each below 50, signaling contracting activity. The business expectations index among service-producing industries was at 34.3, down from 40.1 in September, 49.4 at midyear and 54.0 in July 2007. The composite PMI score of 46.7 was the worst reading since mid-2003.

France posted an even lower composite PMI reading of 45.1, off two points from September and 13.8 points below the level in July 2007. Following yesterday’s news that French business sentiment fell 3 points in October to a 15-year low of 88, Italy today reported that business sentiment worsened for a fifth consecutive month to a record low of 77.7 versus 81.8 in September, 86.7 in June and 89.1 in March.

Dutch officials reported today that consumer spending posted a considerably smaller increase of 1.2% in the year to August than either the rise of 2.8% in the year to July or of 2.5% in the year to August 2007. Spanish officials released data showing another climb in unemployment to a 4-year high of 11.3%.

British real GDP fell 2.1% at a seasonally adjusted annual rate last quarter and posted on-year growth of just 0.3% down from 3.3% in 2Q07 before the banking crisis. Production industry GDP plunged 3.9% saar, while service-sector output fell by 1.7%, its steepest quarterly loss in 72 quarters.

European emerging economies like Belarus, the Ukraine, Russia and Hungary, as well as Iceland, are experiencing currency crises with very  ominous real-side implications.

The real economic impact of financial market strains began to be felt in Europe after the first quarter and escalated to recessionary force by the third quarter. Fourth quarter indicators reveal additional intensification of headwinds domestically, as well as in other regions.  Meanwhile, all kinds of asset wealth — stocks, real estate, bond funds, and commodities — are disappearing at a ferocious pace that will feed back negatively into consumer and business spending. From highs in 2007, the German Dax and British Ftse have lost roughly 49% and 44%, comparable to declines in North America. Japan’s Nikkei (-58%) and several Asian equity markets have sank even more steeply.

By orienting monetary policies toward containing inflation much longer than the Fed, Europe has insufficient credit policy relief in its pipeline. At the onset of the banking crisis in August 2007, the ECB repo rate was at 4.0%, just 25 basis points above the present level. The Bank of England repo rate was at 5.75% in August 2007, 125 basis points higher than now, but 4.5% is still inappropriately high in light of a warnings today from that bank’s chief economist that we could be facing the largest financial crisis of its kind ever and that the real-side damage is only beginning to be felt. Ironically, Europe’s best hope is coming from markets via lower energy costs and a much more competitive values for the region’s rapidly depreciating currencies.

Hindsight, as they say, is 20:20.  Considering that monetary officials had been warning for years that a big deleveraging move was probable and insofar as the crisis has festered for more than a year, the single-minded pursuit of price stability well past mid-2008 is looking nonetheless like a terribly flawed strategy. Commodity prices are not tumbling because of high European interest rates. They and overall inflation would be heading quickly south now even if the ECB, Bank of England, Swedish Riksbank, Norges Bank, and others had reoriented their policies sooner to the escalating downside risks to growth. Major policy errors are learning experiences. The experience of 2008 is likely to become hard-wired into future central bank thinking just as the misguided central bank accommodation of the first OPEC price shock in 1973-4 did for the past generation.



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