Despite all the lurid headlines about the trade war causing a recession in the United States or some kind of collapse in China and its Asian neighbors, recent economic data reveal a very different picture: the US and Chinese economies have performed quite decently and in line with trends that were already well established before the escalation of the trade war. The main victim has been an innocent bystander: Europe.
The unexpected distribution of damage can be clearly seen in the International Monetary Fund’s quarterly revisions of its economic projections. The latest revisions, published in late July, forecast 3.2% global growth in 2019, down from 3.7% in the IMF’s October 2018 projection. But this downward revision was attributable to neither the US nor China. The Chinese economy is expected to grow by 6.2%, exactly the rate predicted a year ago. The forecast for US growth is 2.6%, up 0.1 percentage points from a year ago. The projections for Japan and other Asian economies are also essentially unchanged. This leaves Europe responsible for almost the entire global slowdown.
The IMF now expects eurozone growth to reach 1.3% this year, down 0.6 percentage points from its forecast a year ago, and German growth is expected to amount to just 0.7%, compared to the 1.9% rate predicted a year ago. Thus, if any region will soon pull the world into recession, it is Europe, and specifically Germany, not the US, China, or Asia.
There are three reasons why the European economy has suffered far more this year than either of the belligerents in the US-China conflict. For starters, Europe is extremely vulnerable to collateral damage from a trade war, because it is more dependent on trade. Exports account for 28% of the eurozone’s GDP, compared to only 12% for the US and 19% for China.
Moreover, Europe’s policy response to economic shocks is almost always wrong. When the US or China experience a shock that threatens to reduce economic growth, they generally respond with a pre-emptive and counter-cyclical demand stimulus. In response to the trade war, the US Federal Reserve Board almost immediately reversed its monetary-policy course and began cutting interest rates. China has expanded monetary, fiscal, and credit policies to ensure that consumption, housing construction, and infrastructure spending compensate for lost exports and private investment. In Europe, by contrast, the policy response to weak demand tends to be pro-cyclical: When growth falters, instead of expanding fiscal policy, European governments raise taxes and cut public spending to “control” budget deficits. And financial regulators tighten credit conditions by forcing banks to build up their capital and increase their provisions for risky loans.
Third, Europe has been hit by two internal political shocks that were even more damaging than the US-China trade war. Last summer’s budget clash between the European Commission and Italy’s new populist government revived fears of a currency and banking collapse even worse than the euro crisis that erupted a decade ago. And in March, just as the Italian risk subsided, a no-deal Brexit suddenly emerged as a serious threat. Because the EU exports almost twice as much to the United Kingdom as it does to China, a sudden stop in commercial relations with the UK could be as damaging as the sudden stop in finance that occurred in 2008.
Now for the good news. Two of the three reasons for Europe’s poor performance – misguided macroeconomic policies and conflict with Italy or Britain – are moving toward resolution. And although excessive exposure to global trade – especially in Germany – continues, at least Europe’s overdependence on exports is starting to be recognized as a structural vulnerability, not a sign of “competitiveness” or fundamental economic health.
Starting with macroeconomics, an easing of fiscal policy is now being seriously debated in almost every European country, within the incoming European Commission, and at the European Central Bank. While opposition to any significant fiscal expansion remains strong in Germany, the largest eurozone economy, resistance there is likely to crumble under the combined pressure of weak economic growth, fears of populist parties, demands for green investment, and increasingly pointed criticism from the European Commission and the ECB. And even if Germany sticks to fiscal retrenchment for another year or two, the rest of Europe will move toward lower taxes and higher public spending for a reason that is not widely recognized: the interaction between monetary and fiscal policy.
The ECB’s recent decision to resume quantitative easing and maintain negative interest rates without any time limit guarantees that debt-service costs will fall drastically for highly indebted governments such as those in Italy, Spain, Belgium, and France. Lower interest payments will give these governments more budgetary space to cut taxes or increase public spending. This is especially true for Italy, whose interest costs currently exceed 3.5% of GDP.
This easier fiscal environment has ended Italy’s conflicts with the EU over budget rules, which seemed to threaten a euro breakup a few months ago. At the same time, the UK Supreme Court’s decision striking down Prime Minister Boris Johnson’s suspension of Parliament has virtually eliminated the risk of a no-deal Brexit.
With the political and macroeconomic climate improving, Europe should be able to overcome the structural handicap of excessive exports and avoid recession. Germany may be less fortunate, because it cannot be cured of its export addiction until it abandons its misguided budget consolidation. Until then, Germany will be stuck in its unfamiliar new role as the laggard of Europe.
For the rest of the world, however, this may not matter. What matters for the global economy is whether Europe as a whole enjoys a strong recovery. The chances of that are considerably better now than they were a few months ago.