Credit crunch Contagion could fracture eurozone

Larry Elliott

Somehow you always sensed that it was tempting fate when the German finance minister, Peer Steinbruck, said last month that the credit crunch was an American matter. How long would it be before

the contagion that knocked the stuffing out of Wall Street and the City of London would claim a eurozone bank or two? Well, the hubristic words were barely out of Steinbruck’s mouth before we had our answer. The Belgians and the Dutch bailed out Fortis bank; the Irish made a blanket guarantee on deposits amid fears that at least one, and probably two, of their big banks were about to go belly up.

Steinbruck’s musings on whether the US was losing its status as the world’s economic hegemon were interrupted by the need to seek approval from Brussels for the ill-fated EUR35bn rescue of Germany’s Hypo Real Estate banking group. And by the weekend the leaders of Europe’s big four — Germany, France, Italy and Britain — were calling for an emergency global summit next month. A lesson for finance ministers: try not to anger the gods.

The week’s events have challenged the smug notion that the credit crunch is a purely Anglo-Saxon affair. A glance around Europe shows this is far from the truth: from Iceland to Greece, there are signs of acute stress accentuated by the same marked slowdown as

in the UK.

France’s quarterly growth rate slowed from 0.7% in the third quarter of last year to 0.4% in each of the next two quarters, then went negative by 0.3% in quarter two of this year. Christine Lagarde, finance minister, expects GDP to contract again in the third quarter. Staring through this statistical fog is not easy, but a few conclusions can be drawn. The first is that no part of the developed world will be immune. The second is that the “real economy” effects took time to have an impact but are now intensifying.

In this respect, the actions — or rather inactions — of the European Central Bank are curious. Unlike the Federal Reserve or the Bank of England, the ECB decided that the rise in inflation caused by higher oil and food prices merited raising interest rates.

Inflation is now falling and, judging by the comments of Jean-Claude Trichet, its president, the ECB is moving towards easing policy by early 2009. By which time there will be abundant evidence that Europe, Japan and the US are in recession, and this will have a marked impact on Britain, where 50% of exports go to the rest of Europe. Trichet is doing a fair impression of the emperor Nero; perhaps Mervyn King would run him closest among central bank governors. A third conclusion is that the slow-burn effect on the European banking system probably has more to do with differences in accounting procedures than the way they were run. As Steinbruck well knows, German banks joined their British and American counterparts in the sub-prime casino and made the same dumb bets on risky derivatives. It has simply taken longer for the losses to surface.

A fourth observation — again fairly obvious — is that the eurozone remains a hybrid. It is a monetary union but not a political union, and so countries such as Ireland have had to go it alone in bailing out struggling banks. There is a clear distinction between the US, where the government has financial clout across all 50 states, and the EU. Calling a global summit is not the same as actually doing something, and Angela Merkel has made clear that Germany will not bail out dodgy banks in other EU countries. The European Investment Bank is releasing GBP12bn of emergency aid to small businesses, but given the EU’s size and the scale of the crisis, that is chicken-feed.

In the long term, monetary unions do not survive without political union, and so the fifth conclusion is that there are pressures both for closer integration and for disintegration. The crisis could strengthen those who argue that the halfway house is inherently unstable and will remain so until there is fiscal as well as monetary union. On the other hand, the growing threat of recession may make some countries question the value of remaining in a monetary union.

The London School of Economics’ Charles Goodhart noted last week that the past few years have seen extreme movements in competitiveness, unit labour costs and trade balances across the eurozone. Given the ECB’s concerns about inflation, these can only be rectified by the countries running large current account deficits, such as Spain, or suffering from an acute lack of competitiveness, such as Italy, growing more slowly and squeezing living standards. Clearly, this will not be wildly popular: Goodhart concludes that some members of the monetary union would vote against entry if deciding now.

Deciding not to join is different from deciding to leave, and there would be considerable repercussions for a country that reinstated its currency in place of the euro. Goodhart puts the risk that monetary union will break up at 10-20%, which is small but certainly not insignificant.