Litmus test for European economic unity

When the European Central Bank decided to host a conference on Friday on the “lessons and challenges” of 10 years of the euro, it could hardly imagine the scale of the current challenge facing the 15-country eurozone.

As economists and academics gathered at Frankfurt’s InterContinental hotel, official data confirmed that the region had fallen into its first recession. The global slowdown and changing financial landscape, “may well turn out to be a litmus test for the functioning of the economic and monetary union, both in economic and institutional terms,” admitted Jürgen Stark, an ECB executive board member.

The data for the three months to September, showing a second consecutive quarterly fall in gross domestic product, were alarming on their own: the slowdown has been faster than in the US. But economic news in the coming weeks and months will be even bleaker.

The impact of the intensified financial market turmoil that followed the collapse of Lehman Brothers in mid-September has yet to feed through into official data. Anecdotal evidence and survey data, however, point to a huge fall in business confidence, with companies finding it ever harder to obtain credit, even if the demand is there.

The ECB has cut its main policy interest rate half a percentage point twice within a month in response to what Jean-Claude Trichet, its president, described at Friday’s conference as “a shock that was being transmitted around the globe with lags measurable in hours”.

Gilles Moec, a Europe economist at Bank of America, predicted “a significant slump in capital expenditure in coming quarters”.

As Mr Trichet’s comments suggested, the eurozone slowdown reflects the rapidly deteriorating global economic outlook as well as the psychological blow dealt by Lehman’s collapse. Germany, Europe’s largest economy, has appeared particularly prone, hit by weakening demand for its exports from previously fast-growing emerging market economies.

German GDP fell 0.5 per cent in the third quarter, compared with a 0.2 per cent fall for the eurozone as a whole. By comparison, the US economy contracted 0.1 per cent, after 0.7 per cent growth in the second quarter. An early eurozone rebound could therefore depend on internal factors. With Berlin politicians bickering, economists see little chance of a meaningful fiscal stimulus in Germany: other countries’ budget situation leave them less room for manoeuvre.

But the prospects for domestic demand are not all gloomy. A bright spot on Friday was a pick-up in French consumer spending, which helped the eurozone’s second largest economy avoid a recession. German unemployment has continued to fall this year, and pay increases could persuade the country’s notoriously cautious shoppers to open their purses. Overall, eurozone households are not as indebted as counterparts in the US. With the exception of Spain and Ireland, the region has largely avoided the damaging effects of collapsing house prices.

In the course of next year, the eurozone should start to see the beneficial effects of the substantial cuts in official interest rates, lower energy prices, and a softer euro. A sustainable recovery could have started by mid-2009.

Mr Stark argued that the euro itself was also providing protection: without it, currency crises would have gone “hand in hand with banking crisis and real economic disruptions at the country level”, he said. Still, considerable economic damage is likely to be inflicted. The Paris-based Organisation for Economic Co-operation and Development this week predicted that the eurozone would contract 0.5 per cent next year, before growing 1.2 per cent in 2010.