Slow death spiral: Europe could be left behind as the US economy finds its feet

Risks of a double-dip recession in America are receding. Not even COVID-19 can repress the dynamism of US capitalism for long. The eurozone is another matter. The IHS Markit composite survey for September has fallen back to the boom-bust line at just 50.1. Services are in contraction again – even in Germany.

The equivalent US index is in rude good health, with business orders rising at the fastest pace in two years.

The coronavirus continues to batter already struggling European economies.
The coronavirus continues to batter already struggling European economies.Credit:AP

Europe’s recovery was already fading before the second wave of COVID-19 struck, a truncated V pregnant with economic, social, and political trauma to come.

It is why the EU cannot risk the unforced error of a no-deal Brexit, doubly so given that London is asking only for a bare-bones Canada tie-up. Brussels will have to dial down its extraterritorial demands to protect its £95 billion ($171 billion) trade surplus.


We are starting to discern a replay of the transatlantic decoupling seen after the global financial crisis. The US kept pumping in stimulus until the economy had reached escape velocity. The eurozone thought it had done enough – indeed, it tightened hard – committing a series of mistakes that ended in the Lost Decade. The contours are different this time. The divergence is not.

The US is still in trouble, but retail spending has held up better than feared since a divided Congress allowed the $US600 ($848) weekly aid package for 30 million people to expire (temporarily) in July. Households are still drawing down on $US1.6 trillion ($2.3 trillion) of excess savings accumulated over the lockdown. Homes sales hit a 14-year high in August.

For all the bluster on Capitol Hill, Congress is edging towards a bipartisan deal worth $US1.5 trillion, with $US500 billion for state and local governments, and a $US450 weekly check for those unable to work. Donald Trump says he can live with it. Whoever is elected, more is in the pipeline later.

“We’re unabashed optimists,” said Andrew Hollenhorst from Citigroup. The Federal Reserve has more or less pledged to avoid any repeat of past “taper tantrums”, keeping interest rates pinned to the floor and running the economy hot until 2023, even if inflation blows through 2 per cent.

It is impossible to be more dovish. The Fed is signalling that it will resort to the ultimate weapon of yield control if need be. It still has ammunition.

The eurozone is on another economic planet. The Bank of Spain has just downgraded its GDP forecast again, expecting a contraction of up to 12.6 per cent this year, with full recovery pushed out until 2023.

France has lifted its forecast slightly to minus 10 per cent this year (from minus 11 per cent) but may have jumped the gun. Emmanuel Macron is determined to avoid a second lockdown, but the 14-day toll of new cases has rocketed to 198 per 100,000 and is now worse than the first wave in March.

ECB President Christine Lagarde has begun talking up a further €500 billion of pandemic QE next year.
ECB President Christine Lagarde has begun talking up a further €500 billion of pandemic QE next year.Credit:Bloomberg

The French Conseil Scientifique has already laid out the criteria for extreme countermeasures. Should it declare that the pandemic has again reached a “critical state”, Mr Macron cannot ignore the advice except at great political risk.

EU leaders do not have any economic margin to play with. The Stoxx 600 index of European banks this week fell below levels seen during the panic sell-off in March, or even during the eurozone banking crisis.

It has been a slow death spiral, made worse by negative rates that erode their bread and butter lending models. Boston Consulting says the net interest margin of banks has been whittled down from 250 basis points to almost zero. Lenders will soon face the hammer blow of mass insolvencies from COVID-19 as government loan guarantees expire.

Consultants Oliver Wyman estimate that bank losses could reach €830 billion ($1.37 trillion) over three years, with half of the European lending system barely surviving, unable to generate enough from retained earnings to rebuild their defences. They are already acting pre-emptively to shore up their capital buffers, tightening credit lines to vulnerable firms.

European leaders hailed their €750 billion Recovery Fund as a Hamiltonian moment that finally endowed the EU with its own fiscal firepower. In reality the EU did just enough to muddle through the immediate crisis.

“Rather than a “game changer”, we see it as another example of the same “game” that has prevailed for the past decade. Whenever the cohesion of Europe faces clear and present danger, European governments agree to “the minimum demonstration of unity to keep the risk of break-up at bay,” said Arnaud Marès, Citigroup’s chief Europe economist.

What they created was a Brussels slush fund. The money does not kick in until mid-2021 and is then spread thinly across the EU over five years. The additive impact is trivial.

As always, the ECB is left to pick up the pieces. Christine Lagarde has begun talking up a further €500 billion of pandemic QE next year but such ritual incantations no longer have potency. The yield curve is already flat. Long bonds are on negative yields out to ten years’ maturity. The main policy rate is minus 0.5 per cent and at – or beyond – the “reversal rate” where cuts become counterproductive.

Japanification is setting in. Core inflation has dropped to an all-time low of 0.4 per cent. There is almost nothing that the ECB can do to combat this deflationary freeze or to revive economic growth, short of becoming a monetary-fiscal Reichsbank and financing deficits directly. Such action would court political fate when the German Constitutional Court is already on the warpath.

The messy Brexit negotiations continue cast an ominous shadow over the economy.
The messy Brexit negotiations continue cast an ominous shadow over the economy. Credit:Bloomberg

There is no immediate pressure on EU debt markets. ECB bond purchases hide all sins. Risk spreads are beautifully behaved. But this is not a stable equilibrium. Sovereign debt ratios will reach extreme levels across much of the Club Med bloc this year, hitting 160 per cent of GDP in Italy.

Whatever they claim, EU leaders never completed the eurozone banking union. The sovereign-bank “doom loop” of 2012 is still there. All that has changed is the scale.

It is said that British Brexiteers do not understand EU politics and are deluding themselves if they think that Angela Merkel and fellow leaders will compromise at the eleventh hour to avoid a trade shock. One might turn the accusation around.

The European Automobile Manufacturers Association last week issued a full-throated warning of a “€110 billion Brexit disaster” for the industry if there is no deal. It said auto trading on WTO terms would have a “catastrophic impact” coming on top of COVID’s wave one, let alone wave two.

The problem for Britain is no longer whether or not there will be a trade deal. Of course there will be a deal. The problem is that Europe’s economy is incapable of generating self-sustaining growth and is in fundamental crisis. And whether we like it or not, we are part of it.

Telegraph, London

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