Thu, Nov 22, 2007 page9

• The myth of Europe's successful decoupling

  • By Melvyn Krauss
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  The fact that the US economy is slowing is bad news for Europeans, regardless of claims that Europe's economy has successfully decoupled itself from the US. Decoupling is an idea that is based on bad economics -- and on some Europeans' reluctance to accept the fact that Europe's short but sweet economic expansion is also coming to an end.

  True, the US market has become less important for European exports, while Asia's trade significance for Europe has grown. So what? Trade is just one among the many linkages between the US and European economies that matter. In today's interconnected global economy, uncertainty about the US economic outlook increases one day, and Dutch consumer confidence, for example, takes a tumble the next.

  The links between Europe and the US are, frankly, much more complex than the advocates of decoupling appreciate. The US Federal Reserve, for example, is aggressively cutting interest rates to forestall a possible recession. As a consequence, the euro is rising not only against the US dollar, but also against Asian currencies, whose central banks intervene in foreign exchange markets to fix their currencies' value against the dollar.

  This damages European exports to both the US and Asia. Reduced European dependence on the US export market can hardly protect Europe from the effects of the US economic slowdown if the euro appreciates as much against the key Asian currencies as it has against the dollar.

  The decoupling argument also assumes that a US recession has no effect on Asia. This is nonsense. Asian income certainly will decline if Asians export less to the US, and this, in turn, will reduce Asian imports from Europe.

  Thus, the US slowdown affects European exports in two ways. It has an indirect effect on European exports to Asia, which can be sizeable because the US market is vital to Asian exports. And it has a direct impact on European exports to the US.

  Even in the case where the direct effect is small, the US slowdown still can have a substantial net impact on European exports because of its indirect effect on Asian imports from Europe.

  So Europeans should not be tempted to think that they are somehow "decoupled" from the US' foibles and woes. Until recently, many Europeans thought they were insulated from the current US housing and mortgage crisis. But in what has been a truly malignant "export" from the US to Europe, the US created "garbage debt" in the form of subprime mortgages, and Europeans -- hungry for extra yield, and as reckless as Americans -- bought it. Many European banks' balance sheets are now as contaminated as those of US banks, and no one is sure who is holding -- or hiding -- the junk, and how to value it.

  This is why European banks are now reluctant to lend to each other. They could be lending to an institution that is in serious financial trouble.

  It is hard to imagine that higher interest rates and reduced credit availability will not lead to distress for Europe's overall economy. Yet this is exactly the stance of the European Central Bank (ECB), which is treating the euro zone as if its financial sector were somehow decoupled from the rest of the economy -- and running a different monetary policy for each sector at the same time.

  By pumping in whatever liquidity the financial sector needs to alleviate the credit crunch, the ECB is effectively maintaining a deflationary bias for the financial sector, whereas it has announced an inflationary bias for the rest of the economy.

  A monetary policy at war with itself cannot long endure. The ECB's inflationary bias will most likely be dropped as the effect of the financial crisis and the US slowdown sends Europe's economy into a spin that even the ever-optimistic ECB will be unable to deny. That outcome should moderate Europe's inflation concerns.

  Until then, decoupling arguments, whether applied to relations between Europe and the US or Europe's financial sector and the rest of the economy, should be seen as having a single purpose -- to deny the very real threats to the continued expansion of the European economy. Some of this, no doubt, is wishful thinking on the part of economically unsophisticated people. Others have a special interest.

  After all, a strong economy makes it easier for the ECB hawks to sell rate hikes. It makes it easier to sell stocks and other investment vehicles. It makes it easier for politicians to sell their policies, themselves and their parties.

  But ordinary Europeans should not be fooled. The very existence of decoupling arguments is a warning that they should be concerned about the continuing robustness of Europe's economy. Special interests would not be peddling such dubious pabulum if they felt confident about the economy's future.

  Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University. Copyright: Project Syndicate
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