Beware the decoupling complacency

Current debate about the business cycle in Europe is exhibiting a relative complacency about the potential fallout from America’s current economic woes. The latest piece of evidence comes from Daniel Gros who has advocated that while the European economy might slow down as a result of a US recession but might actually escape negative sequential growth rates.

Since summer 2007 I myself have been in the staunchly optimistic camp regarding the US economy. For the most part because a) the US housing market bubble was characterised by excessive construction which was going to be corrected over time by the following construction slump and b) restrictive lending practises could be found in the Fed’s Senior Loan Officers’ Survey but not really in the weekly lending data of commercial banks. What has changed my mind, however, quite profoundly in recent weeks about the chances of a US recession in 2008 was the run-up of oil prices in the last quarter in 2007. While real labour income was still rising by 2.9% y-o-y in September 07 it’s been reduced to just 0.3% by December. Moreover, purchasing manager surveys – especially the latest Philly Fed index – indicate that US businesses are currently aiming for a major correction of their inventories. It seems fairly implausible that – given the income situation of households – this can be achieved without a massive reduction in industrial output. So by summer we might well see the normal recessionary spiral from inventories to equipment and software spending on the one hand and employment on the other.

One of the most common arguments in favour of decoupling is that the US housing woes are domestic – no matter that e.g. US mortgage backed securities or CDOs are clearly not – and thus spillovers should be more muted than in the global IT-related meltdown of 2001. Derived from this is the argument that a) the direct trade channel is limited and b) third country effects, e.g. from Asia, would not matter much.

Well, first of all, I do not think that the same kind of argument should be holding with regard to oil prices. One of the main features of optimistic growth forecasts for Europe is based on a consumption revival – especially in Germany. While some of the secular features for such a revival are certainly in place, e.g. a turnaround in wages and strong employment growth, recent evidence from consumer surveys is definitely not encouraging. In lieu with the run-up in oil prices both income expectations and purchasing intentions have declined rather steeply even below levels seen right before the German VAT hike at the start of 2007.

In addition to this, we should bear in mind that a sizeable chunk of the rise in European employment has been in the "second-tier" labour market, i.e. temp-workers or fixed-term contracts. While I personally would not agree with the often-voiced criticism that these are generally inferior to other forms of employment, Daniel Gros’ position that employment is (still) slower to react in Europe to a downturn might be severely tested over the next two years.

Moreover, one of the underlying assumptions in the case for European decoupling from a US downturn is that EMU economies are in a (far) earlier stage of the business cycle than the US. But is that really true? Sure if we go by the aggregate EMU sector accounts the nonfinancial corporate sector is not exhibiting a significant financing gap but a rather meagre 2.8% of GDP. Usually, this is a good proxy for how close an economy is to a recessive retrenchment. But look a bit closer below the headline figure and you find that, e.g. in Spain this figure currently stands at 14% of GDP (something unprecedented in any industrial economy) and running at almost 6% in France. What is keeping the aggregate EMU number up is Germany alone. In this latter case, the corporate sector is close to balance due to a massive trade surplus. So all that can be potentially be made from that number is the case for a rebalancing within EMU member countries but not really that Europe in general can be seen as early cycle vis-à-vis the US.

As so often, professional forecasters are currently coming up with lots of reasons for a potential decoupling of the European economy only to be disappointed by the fact that all the data tend to show is a secular tendency for a time lag of six to twelve months between the US and the European business cycle.