WITH hindsight, the European Central Bank’s decision to raise interest rates in July looks unfortunate. On Friday November 14th the European economy officially fell into its first recession in the ten years since the euro was introduced. Economic output among the 15 countries that share the euro fell by 0.2% in the third quarter from the previous one, marking a second consecutive quarter of falling output, the usually accepted definition of a recession.
The turn in Europe’s fortunes is sharp: in July economists only saw a roughly one-in-three chance of a recession, according to a poll by Bloomberg. It is also worryingly broad-based: a lack of credit is cramping consumer spending, business investment and exports in economies all across the region. One of the worst affected is Germany, the world’s biggest exporter and Europe’s biggest economy, where gross domestic product slumped by 0.5% in the quarter, after falling 0.4% in the previous quarter.
Germany’s woes owe much to cooling demand for the machine-tools, heavy equipment and other capital goods it churns out. Demand for these had been strong in recent years as emerging markets soared and high commodity prices spurred investment in mines, railways and ships. But with emerging economies slowing and commodity prices falling, new infrastructure projects are being shelved and ship orders cancelled. With orders and industrial output falling fast economists now expect a prolonged slowdown in Germany. Those at Commerzbank, a German bank, now expect output to contract by about 0.8% in the fourth quarter and perhaps by another 1% next year.
The ferocity of the downturn in Germany should cause it to consider using fiscal policy more aggressively to boost domestic demand in an economy that, until recently, has been powered largely by exports. It is well placed to do so. Its government bonds are prized by investors fleeing risky assets and it is entering the recession with a small budget surplus. A modest package unveiled on November 5th seems too small to provide much of a lift. “While we are sceptical that simply spending more money would help very much, the case for tax cuts, notably for aggressive cuts in the job-destroying payroll taxes, has never been stronger,” says Holger Schmieding, an economist at Bank of America.
Across most of the rest of Europe, the outlook is also grim. Output of all of Europe’s 27 economies, not just those sharing the euro, also slid by 0.2% in the quarter. The economies of Spain, Italy and Britain all shrank in the third quarter. Britain and Spain are likely to be hurt particularly by downturns in household spending as consumers worry about collapsing house prices and high levels of debt. In Britain and Italy there is little room for fiscal easing.
One country that has so far dodged recession is France. Its economy unexpectedly grew by 0.1% in the third quarter, buoyed by consumer spending and corporate investment. Most economists had expected it to shrink by 0.1%. Yet France may have merely postponed the inevitable, with many expecting its economy to shrink in the fourth quarter. Some signs of this are already emerging in the car industry where Renault and PSA Peugeot Citroën have both suffered falls in car sales and will cut production.
Amid the gloom there are however some grounds for hope. One is that the euro has plunged by over a quarter against the dollar in the past four months. The long preceding period of euro strength may have left European firms stronger, by forcing them to be more efficient. Its fall should now give exporters a better shot against American rivals in emerging economies (although exports to Britain, where the pound is weak, may be harder to achieve). European firms have also been quicker to gain a foothold in these markets. The euro area’s exports to oil-producing countries, for instance, are more than three times bigger than America’s, according to the European Central Bank.
Another is that inflation is now falling sharply. Consumer-price inflation slipped to 3.2% in October from 3.6% a month earlier. Some economists now expect it to fall below the ECB’s target of 2% next year, allowing the bank to cut rates forcefully. That earlier caution may now be thrown to the wind.
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