Even though US economic imbalances were the main focus of interest at the start of the crisis in 2007, the state of the European economy was certainly not more favourable. Strangely enough, the countries that were held up as examples to follow proved to be the most fragile. Indeed, several of them had a macroeconomic framework similar to that of the US: robust economic growth sparked by a booming real estate sector, which triggered a large increase in household and corporate debt and a widening of the current account deficit. This was the case of Spain, Ireland and the UK, among Europe’s leading economies, and of the Baltic countries, an extreme case, whose economy has now been completely paralysed by the negative repercussions of a huge current account deficit and household debt in foreign currency (Latvia’s current account deficit peaked at 25% in Q3 2007).
It is not a surprise that Spain and Ireland are the countries that are suffering the most within the Eurozone. As an example, the Spanish unemployment rate has climbed to 18% and is highly likely to exceed 20% in coming months due to the sharp downturn in the housing sector. Therefore these countries need to correct the excesses of the past to return to grow. A positive signal came from Ireland, whose current account deficit/GDP ratio fell to 0.9% in Q4 2008 from 6% in the previous quarter, and even recorded a surplus in the first quarter of this year. The OECD’s estimate of a narrowing of the deficit during 2009 to 0.6% of GDP could be too pessimistic. By contrast, Spain’s chances of returning to more normal levels of current account deficit look slim, at least in the short term. The country’s current account deficit stood well above 7% until Q1 2009 even though the OECD’s projections are for it to weaken to 6% in 2009 and to 5.6% in 2010.
What is more, Spain and Ireland will not benefit from the currency depreciation, which would have undoubtedly occurred outside the Euro area, given that international investors have continued to reward the single currency against other major international currencies. A mild currency depreciation, as was the case with the United Kingdom, a country with similar problems to those experienced by Spain and Ireland in terms of debt rise and property market bubble, would allow both countries to gain competitiveness and profit by exports to improve economic conditions. On the contrary, not only will Spain and Ireland have to cope with a persistently strong Euro, which is 15% overvalued against the US dollar based upon the OECD’s PPPs calculation, but also with a real exchange rate calculated by Eurostat that is forecast to be 30% higher than in 1999 for Ireland and 16% for Spain. By contrast, the real exchange rate for Germany is seen decreasing by 8% in the same period. Accordingly, the OECD sounds more optimistic in its estimates than other international agencies and expects the Spanish and Irish economies to contract in 2010 as well (-0.9% and -1.5% respectively), contrary to the whole of other major European economies. The latest projections by the European Commission are even more negative, with the Irish and Spanish economies expected to shrink by 2.6% and 1% in 2010 respectively, with negative repercussions on public finances. The European Commission is looking for a double-digit deficit / GDP ratio in Ireland over the next two years (with a national debt expected to double at the end of the two years), while it should exceed 8% in 2009 and 9% in 2010 in Spain (the total debt should rise by 22%). Both countries are to meet with a total debt level that is higher than when the crisis broke out.
Nevertheless, other European countries are being hit by the global turmoil. The German growth model based on exports has turned out to be unsustainable following the steep decline in international trade. Exports, which accounted for 48% of German GDP in the first quarter of 2008, were no longer able to underpin the economy. Now that exports account for only 40% of GDP (but accounted for 32.5% of GDP in Q1 2000), the German government should implement new policies aimed at boosting private consumption, which has only edged up over the last few quarters. With a looming worsening of labour market conditions, an improvement in German consumer spending seems to be unrealistic.
Italy and France, while not presenting large macroeconomic imbalances on the private side, do not appear to be able to grow independently. The situation is slightly more negative in Italy due to the high level of public debt and the loss of competitiveness in recent years. Nevertheless, both countries should be able to weather the crisis with less accentuated imbalances.
All in all, only an international recovery may represent the real growth trigger for Europe. With US consumption likely to stay sluggish for some time, and Europe to be unable to bolster the international economy, emerging countries - China above all, will likely lead the world out of recession.