The bulls have fed…now the bears prowl

Date: 15/06/06

It is no wonder that businessmen, politicians and policymakers in Europe are watching the US and its economy nervously. They can see that we are approaching the end of an era.

Since the early 1990s the US has been on a consumer binge fuelled by low interest rates. This has helped its economy grow at more than 3% per year in real terms. Economic growth in the eurozone has been barely 2% over the same period and would have been even lower without the US sucking in Europe's exports.

But the days of the US being the world's consumer of last resort are coming to an end. That role has left the US nursing an $800 billion trade deficit which the International Monetary Fund has once again, in its latest World Economic Outlook, dubbed unsustainable. Reducing it will require, says the IMF, slower US growth and a fall in the dollar.

The US economic slowdown from the torrid 5.8% rate set in the first quarter of this year is already under way.

Given the close integration of the transatlantic economies (see box above) even a mild slowing will inevitably have a damaging impact on Europe. The OECD, for example, is expecting US growth to fall from around 3.6% in 2006 to 3.1% in 2007.

Private economists are not so sure the slow-down will be so gentle. Most are expecting a 17th increase in official short-term US interest rates in two years when the Federal Reserve meets later this month. This will take the Fed funds rate up to 5.25%, a move made necessary by a combination of excessive government and consumer spending, rising inflation and an erosion of confidence at the central bank since the arrival of its new chairman, Ben Bernanke.

Some private-sector economists believe that this increase will prove to be a step too far for a US economy that is already visibly weakening and that it will tip the US towards recession.

American investment bank Lehman Brothers for example, while projecting that 2007 will see US growth still chugging along at 2.9%, is warning that it could slump to 1%, the level at which a recession is likely.

Europe is watching all this with deepening anxiety. Hence the strangled cries of dissent from eurozone finance ministers last week when the European Central Bank (ECB) raised its main refinancing rate from 2.5% to 2.75%. Ministers fear that, with increasing evidence that the eurozone economy is expanding at close to, or even above, its long-term potential rate of growth this year (the OECD is predicting EU growth to hit 2.1% in 2006), the ECB may raise rates further. What, they wonder, will this do to the value of the single currency on the foreign exchange markets?

At EUR 1.28 it is already up by more than 7% this year against the dollar. With the IMF saying a further dollar depreciation is needed to reduce Washington's trade and current account deficit, eurozone politicians fear that if the single currency keeps on rising, too much of the burden of global adjustment will be heaped on the single currency region.

Vital EU exports to the US and other countries around the world will be hit by a combination of slower US growth and a stronger euro at a time when transatlantic ties will anyway be tending to erode the EU's rate of recovery.

Transatlantic distrust is also a problem. Much as American officials may want to present EU-US economic relations as running smoothly, Europeans are not so sure.

This year the US administration's economic policy team has been transformed. A new Fed chairman has replaced Alan Greenspan and, with the Doha trade round in trouble, a new Trade Representative, Susan Schwab, has replaced Rob Portman. This month Hank Paulson has arrived at the US Treasury, apparently confident that, unlike his predecessors, he will have a say in an economic policy that has hitherto been run from the White House.

The newcomers are not well-known on the international policymaking circuit. Their clout in Washington has yet to be demonstrated. And there is great uncertainty about how a famously unilateralist president will confront a global economic adjustment which requires multilateral co-operation to resolve it. So far, the signs are not good.

Washington is warning its partners that in order to accomplish a smooth and orderly adjustment of global imbalances they need to co-operate with the president. But Europe's policymakers see no signs of the president's willingness to co-operate with them by taking policy actions to make the US's contribution to the global economic rebalancing that is needed.

Where, they ask, is the evidence that Washington is prepared to cut a budget deficit which will start soaring again if the US economy stumbles, or rein in its gluttonous consumption of oil? Europe has reasons to be nervous.

Umbilically connected - the EU and US economies

The US and the EU together account for almost two-thirds of the world's output and two-fifths of world trade. Their economies are more deeply intertwined than ever before.

Trade flows across the Atlantic are running at EUR 1.7 billion per day. Transatlantic foreign direct investment in factories and services firms such as banks totals around EUR 1.5 trillion, split evenly between EU and US companies. Trillions of dollars and euros are also invested across the Atlantic in shares and bonds. EU-US financial markets are umbilically connected.

Author suggests that due to their deeply intertwined economies even a mild slowdown of the US economy would have a damaging impact in the European Union.
Article is part of a European Voice Special Report, 'EU-US Relations'.