European Affairs

Many people have doubted that Europe, on the other hand, will ever be able to follow suit. Europeans have been in the traditional position of countries with poorly performing economies. They have walked less tall, and spoken shorter - if sometimes better.

Even if fears for Europe's future may have been exaggerated, there is no denying that the U.S. economic performance has been impressive. It is neither surprising nor inappropriate that the dollar should be strong, while the euro - at the other end of the seesaw - should be weak.

But as the Federal Reserve brings the growth of private expenditure down into line with that of productive potential, as it has indicated clearly that it intends to do, it is appropriate, and to be expected, that the dollar will weaken, and the euro strengthen.

This need not be dramatic, and indeed is unlikely to be so. Throughout this latest spell of economic growth, the longest in U.S. history, the current account deficit has been willingly financed by inflows of capital from abroad. Some of these inflows were for the purchase of U.S. stocks, although most recently these have eased off in line with the fall in the NASDAQ.

Much of the remainder of the financing has taken the form of foreign direct investment. Foreigners - including importantly Europeans - have bought into U.S. corporations, in many cases to learn from, and participate in, the processes whereby U.S. companies implement new technologies.

As the European economy recovers, however, and margins of spare capacity diminish, European companies will need to start adding to capacity at home. Not in the auto industry, to be sure, but in telecoms, pharmaceuticals, some basic industries, and the services sector generally.

To the extent that this happens, foreign direct investment flows to the United States are likely to diminish, but they are unlikely to cease. Many European companies will continue to wish to buy into the U.S. high-tech experience. So, while the dollar will probably weaken, it is unlikely to collapse.

All of this presupposes, of course, that the European economy will indeed continue to expand as the U.S. economy slows down. Many commentators still judge Europe to be incapable of exhibiting anything like the same degree of corporate investment exuberance, and managerial and workforce flexibility, that has characterized this latest period of strong U.S. growth.

The view is widespread that structurally rigid Europe will run into inflation bottlenecks long before serious inroads have been made into high unemployment, still currently running at nearly 10 percent. Some investors have thought that Europe's structural policy problems are so severe that they will prevent even a cyclical upturn. These views seem to us to be too pessimistic.

Admittedly, European eco-nomies face considerably more structural policy problems than the United States. Empirical work by the OECD and by my company to quantify the extent of these problems shows, unequivocally in our judgement, that the extent of these structural policy problems is indeed markedly greater in Europe. But that same empirical work also shows that, over the last five years or so, these problems have been significantly reduced.

This suggests that, as the U.S. economy slows, the European recovery, now well under way, stands to continue for some years yet without running into serious inflation problems. In that environment, the euro will inevitably rise as the dollar comes down.

Furthermore, there is mounting evidence that investors are beginning to see matters in somewhat the same way. For questions are now starting to be asked about the macroeconomic sustainability of the present U.S. situation. There seems to be an increased risk that the United States will experience something of a hard landing.

Investors are becoming increasingly risk-averse, getting out of riskier, relatively illiquid, high-yielding assets. All the usual suspects are being affected. Thus, for example, the Canadian, Australian, and New Zealand dollars have all fallen sharply this year, even though their underlying economies are basically sound.

In Europe, the Czech crown and the Polish zloty have both fallen several percentage points. And in Hungary, and particularly in Poland, bond markets have sold off - both movements being in excess of anything warranted by the fundamentals.

This risk averseness on the part of international investors reached considerable heights in early summer. Indeed by our calculations, it has been as high as at any time in the past decade, other than over the period of the Russian default.

The paradox is that, as investors have fled these risky, illiquid assets in favor of less risky, more liquid, monetary investments, it is to dollar assets that they have tended to turn. Were they to have more faith in Europe, the euro would probably have strengthened significantly vis-ˆ-vis the dollar.

Our judgement is that the decline in the dollar, albeit modest, and the corresponding rise in the euro, will not happen to any significant extent until sentiment changes fundamentally. And there is probably little, near term, that European policy-makers can do to bring this about.

All that they can and should do is to continue to state, in a unified voice, that Europe's economy is in good shape, and that they judge that its recovery can continue for a good while yet without becoming seriously inflationary.

They should point out, for example, that Europe's growth in gross domestic product is both steady and widespread; and that employment is growing briskly (in France, for example, it is growing faster than in the United States). They should add that inflation is and will be firmly contained at or around its 2 percent target ceiling; that public sector deficits are coming down, from already acceptable levels; that the current account stands to remain broadly in balance; and that Europe has no foreign debt.

Beyond that, they will have to await the first visible signs that the U.S. economy is indeed starting to slow down. Some, at least, of the preconditions are increasingly evident, particularly on the corporate side.

For while American consumers still appear to have the bit between their teeth, corporate bond yields and spreads have risen considerably. Highly leveraged corporations, in particular, are starting to feel real pain. Perhaps the first signs of slowing will be in business fixed investment, and in early layoffs to maintain profits. But at this stage that can only be conjecture.

Longer-term, European countries need to continue with their processes of structural reform. In Lisbon recently, EU leaders committed themselves to this in an agreement which, though its implementation still has to be seen, in our view represents a more significant undertaking than has yet been generally realized.

At this stage, we can only guess whether events will work out in precisely this way. But we would be most surprised if the future were to reveal that the high-tech revolution has permanently and fundamentally changed not only the supply side of the U.S. economy, but also its basic macroeconomic relationships.

Periods of exceptionally good economic performance almost invariably turn out to have a significant cyclical element to them. This episode would seem unlikely to prove different. Given time, it will be the Europeans' turn to walk taller.


This article was published in European Affairs: Volume number I, Issue number III in the Summer of 2000.