Saturday, March 29, 2008

Will Europe Decouple?

Now that it is increasingly indisputable that America has in fact slipped into a recession, the debate has shifted to whether or not the rest of the world will decouple from that downturn. In the case of Europe I have for a while argued that it will. I still stand by that view, but I should clarify it.

There is simply no rational reason for believing that an American downturn will cause a European downturn. Exports to the U.S. are in fact only about 2% of Euro area GDP. And even that overstates the dependence as it compares apples to pears. Exports are expressed in gross terms while GDP is expressed in value added terms. This is to say, some of the inputs used to produce that exports is imported. I don't have an exact number for how big distortion this creates, but it is nevertheless clear that an apples to apples comparison would show an even smaller dependence.

So, even a dramatic decline in exports to the U.S., say in the magnitude of 25-30% would only reduce Euro area GDP by a few tenths of a percentage point.

A somewhat stronger argument for believing in recoupling rather than comes from financial markets. As is obvious to anyone who follows the U.S. and European stock markets, there is a strong link between them. Whenever one falls, the other usually follows. This link is to a large extent based on the fallacy of a strong connection in the real economy based on trade that I refuted above, but it might to some extent be a self-fulfilling prophecy. But while it is a real factor, it is implausible to be significant enough that irrational stock market sell-offs is sufficient to push the European economy into a recession, especially as most continental European counties have much lower stock market capitalization to GDP ratios than for example the U.K. or the U.S.

However, while the U.S. downturn will not by itself cause a European downturn, that does not necessarily imply that a European downturn will not happen. It probably will not happen, but it might. If it does, however, it will be the result of home grown factors.

More specifically, some parts of Europe have experienced similar stories of excessive credit growth as the United States, and this will likely cause busts in these countries. We have already seen how Ireland has slipped into a recession, and the Baltic states are showing worrying signs of stagflation with double digit inflation and a sharp deceleration in growth. Both Ireland and the Baltic states are by themselves far too small to cause a European wide downturn. More worrisome is that Spain and Britain show signs of potentially slipping into a recession. Spain and Britain have both experienced similar kinds of housing bubbles as America and Ireland, and while there is no evidence yet that either country has slipped into a recession, there is a real possibility that it might happen. And if it did, it would be very serious for the overall European economy. While the German economy looks quite sound and strong as a result of years of free market reforms and austerity, it could have problems adjusting to a possible significant downturn in Spain and Britain.

At this point, there exists a great amount iof uncertainty over how the Spanish and British economies will develop, as well as how the overall European economy will develop. They may or may not slip into a recession. If they do, this will certainly hurt the German economy significantly. However, the point here is that while Europe may perhaps experience a downturn, this will not be a result of the American downturn. Instead it will if it happens be a result of the negative after effects of local bubbles.


Blogger Wille said...

There is no doubt that the UK has experienced a housing bubble, and some deflation of it will occur, however the UK differs from the US (and Ireland) in the respect that there is no great surplus of housing and that the housing deficit is growing year-by-year, especially in the overcrowded southeast of England.
This will probably support overall prices to some degree, although falls are inevitable - I don't believe there will a collapse of the proportions of the US (where land and housing is plentyful), although some grossly overpriced areas may see their prices collapse.
Knowing the southeast reasonably well, I think a 10-15% drop in nominal terms over a period of several years is likely in that area, considering inflation and income growth will pick up some of the slack in real terms. More scarcely populated areas, I wouldn't want to stick my neck out and make any predictions for.

Of course, anything I say at this time should be taken through a big filter of self interest and self delusion, considering I have just bought a property in London. :)

3:59 PM  
Blogger flute said...

wille - in my opinion the UK and Spanish housing bubbles will burst - and they will cause major troubles. The Swedish bubble will burst too, IMO. Housing has become too expensive by any measure, and will revert to and also go well below historical (inflation adjusted) averages. That's what an average means. If you go up above, you also have to expect the value to go down below. Many people believe that "housing deficits" (in Stockholm, southeast England, etc) will support prices, but a bubble is still a bubble, and in some way it will come down. Economic realities will force people to live in more crammed conditions.
As for decoupling, the original subject, my bet is that we will see the EU members slipping into recession one by one over the next couple of years. Ireland is just the first in a long row. As for Spain and the UK, isn't it pretty obvious that they're headed for bubble popping and recession soon? The credit and construction excesses there are simply too large to work out in any other way. And once these two go into recession, the ripple effects will take the other EU members down too.

9:59 PM  
Blogger Wille said...

A bubble is still a bubble, in the example of Sweden, things are more distorted because of the regulated rental market.
But in the case of the UK, the relationship between rental costs and ownership costs play a large role, and in the case of the UK, this relationship will support property values to a degree.

That doesn't mean that it won't be brutal in some places though: for a potential landlord, with a reasonable deposit (20% give or take), rental yields are still negative by up to 10-25%, and this is surely a ratio that is not sustainable, nor healthy, but ripe for "bubble popping".

I know for a fact that my current landlord is subsidizing me by around 30%, compared to what it would cost me to own the flat I am currently living in.

4:55 PM  

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