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Since last summer, the economic slowdown in the US has accelerated and many indicators suggest that the American economy might already have entered a recession. The recent discontinuity in the economic series, with brutal surprises on the downside (e.g. Philadelphia Fed index, employment reports, ISM non-manufacturing index), is indeed typical for the early phase of a recession. Economies don’t slowly slide into recession, they tend to suddenly drop into it.

A Euro Zone Slowdown in the Making
Media and economists have spent a lot of time commenting on and analyzing the subprime debacle, the liquidity crisis and the downside risks to the US economy. However, relatively little has been said about the risks to the Euroland economy. One reason might be the theory of the decoupling between the US and the European economies – quite popular just six months ago. Yet decoupling seems to be less en vogue today. Some questions have been asked about the transmission mechanism of the US economic slowdown to Euroland. So far, though, few have considered whether Euroland itself has in the last years created the conditions for an internally driven slowdown. The aim of this edition of European Perspectives is therefore to analyst the factors, internal and external, that could cause an economic slowdown in Euroland and ultimately lead the European Central Bank (ECB), which has a track record of being proactive, to cut maybe sooner than expected.

The economic slowdown, which started in the US in 2006 with a recession in the construction sector, is spreading across the globe. Already we are seeing signs of contagion in major economies like Japan, the UK and Euroland. Emerging market economies and those benefitting most from them, like Australia, are still showing strong economic prints, but worrying signs are accumulating there too. In Euroland, the slowdown is now about one year old and probably traces its origins back to the construction sector in some countries as well. This seems to be the case particularly in Spain and France where it is spreading to other parts of the economy as the example of France shows (Figure 1). Leading indicators suggest there is more to come, and at PIMCO we believe Euroland would print economic growth in 2008 below the 2.25% often considered the potential growth rate. Some drivers of the Euroland economic slowdown are external and some are internal.

External Factors of the Cycle
There are several transmission mechanisms for a US slowdown to affect Euroland, which I have described in more detail in the European Perspectives of February 2007. Currency is the most obvious channel as the stronger euro is impacting exporting countries like Germany negatively. In addition, business confidence and risk appetite are highly correlated at the global level as are financial markets and credit risk premia (Figure 2). What my piece from February 2007 failed to identify at the time was the exposure of the European banking system to the US real estate market, via investments in structured products, mortgage-backed securities (MBS) and asset-backed securities (ABS), as well as the liquidity crisis of the last months, the magnitude of which resulted in a sharp widening of spreads even for the highest quality ABS (Figure 3). All these factors are now adding to the external headwinds the Euroland economy is facing. Can domestic strength help counteract these forces?

The State of the Four Big Euro Zone Economies
The contribution from the external sector on the one hand and the booming real estate markets in some euro zone countries on the other hand were the key for the economic recovery in Euroland from 2004 to 2007. They explain not only the stronger economic growth but also a big share of the acceleration in private credit growth, for example, the mortgage growth in Spain alone contributed more than a quarter of the Euroland private credit growth. Get these two engines of growth into trouble and you should worry about Euroland economic growth in general rather than the strength of the monetary aggregate. Let’s focus on the four biggest countries of the euro area: Germany, France, Italy and Spain.

During the economic recovery cycle of the last years, Euroland was very much divided in three categories of countries: those countries which enjoyed strong exports but sluggish domestic demand (Germany), those with strong domestic demand supported by the real estate market boom (France, Spain) and those in between, not really strong in exports nor in domestic demand (Italy). The four biggest Euroland economies have been slowing down since last summer.

Germany is now suffering from a deterioration of the international environment and from sluggish internal demand. Its fiscal situation is much healthier than France’s, though.

In France, the economy was basically driven by consumption in the last year, which was supported by the booming real estate market with rising prices and a high number of transactions. Now that the housing market is continuing its slowdown, it is no surprise to see consumer confidence at its lowest level since 1987 as shown in Figure 1. The French political disillusion might also contribute to the lack of confidence in the future of the French consumer.

The result? The French economy is weakening and most economists have recently revised their forecasts for 2008 GDP growth down to less than 2% year on year. One reason for the weakness is that France shied away from reforms in the past, unlike Germany under the former Chancellor Gerhard Schroeder. As a result France currently exhibits a relatively high budget deficit (estimated to be around 2.4% in 2007 as opposed to a small surplus in Germany) and a deteriorating trade balance. So, France’s problem has not been a shortage of purchasing power but a shortage of reforms. Now has come the time to carry out the necessary reform, but this means that we can’t count on France to support Euroland economic growth in the short run.

Italy is probably already in a recession. Look at the industrial production (Figure 4). For the fourth month in a row Italian industrial production declined in December, suggesting that the GDP growth in the fourth quarter 2007 was probably negative.

If we stressed the lack of potential fiscal stimulus in France, given the already high deficit and the need for structural reforms, then Italy is even worse. With a debt to GDP ratio north of 100% and a deficit close to 3%, Italy has no room whatsoever for fiscal stimulus. In the old days of the lira, Italy would probably have bet on the benefits of a devaluation of its currency to cope with its lack of competitiveness, but what could Italy call on now? Italy will have to go through a long period of painful structural reforms (with low real wage growth and sluggish internal demand, like Germany had to experience). Euroland can’t therefore count on Italy to support its economic growth either.

This leaves Spain. If a country is vulnerable to the real estate slowdown, then it is this one. The real estate boom has been so strong that the share of the residential construction sector in GDP is north of 9%, more than at the peak in the US or in Germany after the reunification. The real estate boom, with rising prices and a large number of transactions which typically generate new purchases of goods like refrigerators, TVs, and furniture resulted in strong consumption and a deteriorating trade deficit. Unlike in France or Italy, though, Spain’s government has – like the one in Germany – the potential to spend money, given the healthy state of public finances. Spain has a 2% budget surplus.

Money Is Getting Scarce
Financial conditions are an important factor to forecast economic growth. Financial conditions have worsened significantly in Euroland since last summer, even though the ECB has stopped hiking its refinancing rate. Credit spreads have widened dramatically, parts of the credit market like ABS are not functioning and the availability of credit has dropped sharply. This will likely reduce consumption and business investments.

In addition, Euroland banks have to show on their balance sheets loans and credits that they used to externalize or sell. This process of re-intermediation results in tighter credit conditions for consumers and businesses. The losses that these banks are writing down and their need to recapitalize in some instances have led the management of these financial institutions to switch from a shareholder-friendly attitude (optimization of the balance sheet towards more profits) to a bondholder- friendly stance (consolidation of the balance sheet to protect the credit worthiness of the institution). This trend is positive for bondholders as it reduces the risk of default, everything else being equal. However, in the bigger economic picture it is another blow to the Euroland growth.

Conclusion: Below Par Growth
The combination of external headwinds (global slowdown, global increase in risk premia and decrease in risk appetite) and internal sources of concern (real estate markets, Euroland banking sector crisis, need for reforms) lead us to conclude that the Euroland economy will probably grow below par this year; downside risks are abundant. A recession, however, is not the base case scenario as Euroland is entering this economic slowdown with a positive savings ratio in the private sector unlike the US. Nevertheless, we can’t ignore recession as a possibility. The economic reports of the next months will be key. In the meantime, a proactive central bank has enough reasons to act now. Euroland inflation will fall this year to the extent that base effects and stabilizing energy prices permit. The ECB started its last cutting cycle in May 2001 by cutting its base rate by 25 basis points to 4.50%. Remember what the headline inflation rate was in April 2001 in Euroland? 3.1%, the same rate we have now…