It’s nearly crunch-time

Co-ordinated policy action could be the only way to avoid an economic meltdown, writes Stewart Fleming.

It was left to Joaquín Almunia, the European commissioner for economic and monetary affairs, to lift the veil last week (9 November) on just how worried policymakers around the world, including bank regulators, really are about the febrile state of the world economy.

Presenting what is, in the circumstances, quite an upbeat assessment of the EU economic outlook, Almunia nevertheless remarked: "There is a clear risk of a disorderly unwinding of global economic imbalances, which is extremely worrying." This formulation is opaque. But if these fears were to be realised then we would soon be plunging into a serious global recession.

Almunia’s comments help to put into context some recent statements from other top public officials. On 7 November French President Nicolas Sarkozy warned the US Congress that the plunging dollar could trigger "economic war". The next day, Jean-Claude Trichet, the president of the European Central Bank (ECB), a man who errs on the side of caution in his public utterances, described the recent swings in exchange rates which have taken the US currency to a record high of $1.47 against the euro, as "brutal". It is a phrase which hints at a need for official intervention, something Japan also seems to have in mind.

The next day in Brussels, Ernest-Antoine Seillière, the president of BusinessEurope, an employers’ association, did not disguise his concerns when also calling for a co-ordinated international response to the blackening economic outlook. The time has come, Seillière said, for Europe’s economic policymakers to end their "passivity" vis-à-vis the US dollar, whose decline has driven the single currency to levels well beyond European exporters’ "pain threshold". Yes, he said, next week’s (28 November) top-level visit to Beijing by Almunia, Eurogroup President Jean-Claude Juncker and Trichet, is welcome. It is a sign that the EU is at last sending a strong political message to China about a currency policy which is keeping the yuan too low against the euro and giving China an unfair competitive advantage.

But Seillière clearly has his doubts about whether the EU’s single-handed diplomatic demarche will be any more effective than US Treasury Secretary Henry Paulson’s a year ago. It is time, he said, "for a global negotiation" aimed at rebalancing the world economy. "If we have some reason to act towards China for trade or currency reasons," he said, then the most effective way is for the EU and the US to work together, not independently. Juncker, after the Eurogroup meeting on Monday (12 November) was more discreet, but his message to China was pointed, too. "We will try to make clear to our Chinese friends that China has a growing responsibility as far as international monetary policy is concerned," he said.

What explains the gap between the quite optimistic economic forecasts and this anxious commentary? The Commission’s economic and monetary affairs department, DG Ecfin, has slightly cut its growth prediction for 2008 by 0.3% since the spring. But, like BusinessEurope, DG Ecfin is expecting real growth this year for the EU27 to be around 2.9%, then to drop slightly to 2.4% in 2008 and remain at this, by EU standards, healthy level, through 2009. The problem is, as Almunia pointed out, that some of the assumptions under-pinning these forecasts are already out of date and the risks are decisively on the downside.

If oil and commodity prices fall back significantly, the banking crisis eases swiftly and the dollar stabilises, these predictions, based in part on such eventualities, could well turn out to be right, especially since global economic growth, propelled inter alia by China and India, is still surging. DG Ecfin is predicting that global growth (excluding the EU) will continue at an unprecedented 5% plus for a fifth consecutive year in 2008.

But the sub-prime crisis in America, targeted like a cruise missile on the banking and housing sectors, has hit the US economy in its most vulnerable quarters. The view that the US is heading for recession is now conventional wisdom, even if it has yet to show up in official economic forecasts.

There is, critically, another element in the equation: inflation. Investment bankers at Morgan Stanley are warning that eurozone inflation could hit 3% in December, well above the ECB’s 2% target. No wonder Trichet was saying, in his press conference last week (8 November), that "inflation is the only needle on the ECB’s compass".

In the US too, inflation is rising - surprisingly so far, but not for long in view of the weakness of the dollar - rather less sharply than in the EU.

Professor Avinash Persaud, chairman of Intelligence Capital, a financial advisory firm in London, sees the dollar plunging vertically towards $1.70 to the euro. With inflation on the march, the Federal Reserve is not going to be able to slash interest rates as it did in 2001 to try to bail out the economy. In Europe, the International Monetary Fund even warns, in its new analysis of the eurozone, that inflationary pressures could require the ECB to raise interest rates if Almunia’s forecasts look like being realised. Even as things stand, most private economists are expecting the ECB to hold rates until well into next year even though, because of the banking crisis, financial market and credit conditions are tighter than they appear on the surface.

Almunia, in his press conference last week, did not actually use the word "stagflation", ie, sluggish growth and stubbornly high inflation. But that was clearly in his mind as he described the outlook. So there is a chance Europe will avoid recession, unless there is a truly gruesome global slump - but only just. Avoiding that woeful outcome will, as BusinessEurope’s Seillière says, require international co-operation.

An open question is whether China and the US in 2008, an election year, will be willing to act co-operatively with the EU to try to stabilise the world economy and avoid the global crisis that Almunia is worrying about.

• Stewart Fleming is a freelance journalist based in Brussels.

Co-ordinated policy action could be the only way to avoid an economic meltdown, writes Stewart Fleming.

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