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Euroland: with your help, we can heal the world.

Last year was a significant one for the world economy. It was one of the few periods since the war when events in the US economy did not dominate developments elsewhere. Instead, the emerging market crisis was the dominant force, as it continued to spread, first from Asia, then to Russia, and finally on into Latin America. So far this year, some stability has returned to emerging markets. Problems in Brazil have not spread; instead they seem largely contained. Moreover, the relative stability of the dollar against the yen has created a positive background for Asian markets. In particular, there has been increased optimism about prospects in South Korea. Despite this, the emerging economies around the world are in difficulty. Although the picture varies from one country to another, a common theme in emerging economies is the continued weakness of domestic demand. This, added to sharp currency falls, has led to a shift towards exports, and many emerging economies are trying to export their way out of trouble. For this to be possible, growth elsewhere must be strong. One of the adjustment mechanisms for the world economy is strong growth in the major industrialised economies offsetting weakness in the emerging countries. So to ensure emerging economies do not pull the world economy down, it is necessary for the US, Japan and Europe to grow strongly. There is little doubt that the US is booming. But, by contrast, Japan and much of Europe are very weak. The US feels it is pulling its weight but thinks others are not. This has already fed protectionist sentiment in the US and has also led to pressure for Japan and Europe to boost their economies. One example of how the US is pulling its weight is the deterioration in the US trade deficit; as it booms it is sucking in record imports, particularly from the Asian economies. The US trade deficit is acting as an important safety valve. For the US, where demand is strong, the trade deficit is acting against inflationary pressures, helping to keep inflation down as cheap imports flood into America. And for the emerging countries, the deficit is enabling them to boost their exports. The trouble for the US is that this surge in trade deficit is not sustainable. It makes the US dependent on international capital flows, and there is no guarantee that international investors will continue to buy the dollar in the face of such a deficit. Lessons from the past show that countries that have large trade deficits either need to hike interest rates and curb imports to slow demand, or, at some stage, the currency will fall sharply. For the US, this latter case is more likely. In contrast with the US, where growth is strong and the trade picture is deteriorating, Euroland and Japan are weak and enjoy large current account surpluses. The question is, will they relax interest rate policy and share the US’s burden? There is little doubt that the Japanese authorities are taking aggressive measures to boost their economy. The route they are taking will work, but it will also take time to feed through. The government is spending to boost demand, but this has led to a large rise in the Japanese budget deficit. The corporate sector is adjusting, and although this is good for Japan’s economy, it is also creating rising unemployment, which is depressing consumer sentiment. Thus the full benefits of the Japanese measures may take some time to feed through, and there is external pressure on Japan to do more. This is understandable. In contrast, Euroland has largely avoided criticism. In recent years, policy there has been geared to the introduction of the euro. But now that the euro has arrived, monetary policy could be doing more to help both the European and the world economies. The euro has continued to weaken since its successful introduction in 11 countries. A weaker euro gives a competitive boost to European exporters but it does little to help the world economy. Europe and the world need a sustained rebound in domestic demand across Euroland, and a relaxation of policy would help. Interest rates in the 11 countries of Euroland are 3%. This may appear low, but not when measured against Euroland’s 0.8% rate of inflation. Of course, some countries, like Ireland, where inflation is at 2.2%, might prefer higher rates. But for the bulk of the major economies in the Euroland area, growth is weak and well below trend, unemployment is high, and inflation is not a problem. In Germany the inflation rate is only 0.4% and falling. In France, it is even lower, currently standing at a 44-year low of 0.3%. Although the small economies within Euroland are buoyant, it is the likes of Germany, France and Italy that matter for overall growth. If they remain weak, there will not only be pressure for lower interest rates, but also political pressure may mount for a relaxed fiscal stance. Yet the European Central Bank’s (ECB) president, Wim Duisenberg, believes that rates are already low enough. He shows no desire to ease further. Instead, the ECB appears to favour stability. But there is little doubt that interest rates will need to fall in response to the absence of inflationary pressures. By year-end, I expect the ECB to have cut its key interest rate from 3% to 1.5%. This contrasts with the market, which expects little change in rates. There is a danger that monetary policy in the new Euroland may become too insular. Things are different in the UK, where the deterioration in the world economy has been one of the factors cited by the Bank of England for its recent cut in interest rates. Since autumn, UK official interest rates have fallen from 7.5% to 5.5% and further easing is inevitable. But over all, the world economy is still vulnerable. This means that the industrialised economies need to pull their weight. In particular, there is a need for Europe to come to the rescue by relaxing monetary policy and boosting growth. Dr Gerard Lyons is chief economist at Dai-Ichi Kangyo Bank (DKB) International.

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