Don’t forget Europe

The strong decline of the US dollar against the euro – it has fallen to a 20 month low – has put renewed focus on problems facing the US economy.

The unsustainability of US consumptions funded by enormous current account deficits, the slowing of housing demands, continued low savings and hence the likelihood of future US interest rate cuts in 2007 are among the factors widely – and correctly – cited as explanations of the weakness of the US dollar. A plausible story is that emerging economies are becoming reluctant to fund high levels of US consumption by purchasing US debt. The implication is that the US economy will have to go through a sustained period of lower growth – a non-catastrophic event provided the dollar does not undergo a sharp plunge.

But there is a second side to any exchange rate story since an exchange rate says something about the relative performance of economies. A widespread perception is that the US economy has outperformed the world’s other rich economies – notably Europe - in recent years because of much higher productivity growth. But as The Economist December 2-8 (subscription required) has pointed out recently, once real GDP growth rates are computed in real per capita terms, productivity growth in the euro area is about the same as in the US over the past decade.
Moreover Europe has not been forced to rely on huge public sector deficits to ‘steroid pump’ its economies – nor have its domestic savings rates collapsed. Europe is hobbled with inflexible product and labour markets but that, if anything, indicates potential for future one-off gains from liberalization. Some European economies are beginning to contemplate reform and investors spotting this are likely to assume the euro is a better long-term bet. Strengthening this view, while the US Federal Reserve has not raised interest rates for 5 months, strong recent growth in the European economies suggests more interest rate hikes. Europe’s biggest economic force – the German economy – for many years a poor performer – is starting to look stronger.

Australians when looking at their global economic environment tend to look at Asia and at the direct implications of US economic problems and their indirect implications via effects on Asian economies. It is important not to ignore developments in Europe and not to take a stereotyped view of the failures of Europe as an overregulated set of economies which have ceased to be significant drivers of global demand.