Europe's Economy: Falling Down

Over the past year, at a time when the world economy has been buffeted by the U.S. housing and financial crisis, slowing growth in most developed nations and soaring inflation everywhere, one of the big surprises has been Europe's relatively strong performance. The picture has been uneven, with countries such as Spain and Italy — and increasingly the U.K. — running into problems. But overall growth, especially in the 15 nations that use the rapidly appreciating euro, has confounded the skeptics. In early June, the International Monetary Fund actually revised its 2008 growth forecast for the euro area sharply upwards, declaring that it had become "a zone of stability in the international economy." Likewise, in late May, the Organization for Economic Cooperation and Development praised the European economy for its "resilience."

That was then. Over the past couple of weeks, much of the economic news out of Europe has been weak, gloomy or downright terrible. Denmark has officially slipped into recession. Ireland, the star performer of the past decade, has slashed its growth expectations for this year close to zero. Spain has stopped growing. The U.K. is teetering on the edge of recession. And Germany, Europe's biggest economy, is finally showing signs of a marked deterioration. "It's hard to find a country that's keeping its head above water," says Véronique Riches-Flores, chief European economist at French bank Société Générale. Business leaders ranging from Sir Stuart Rose at British retailer Marks & Spencer to Renault's CEO Carlos Ghosn are sounding the alarm. At Burberry, the luxury-goods firm, CEO Angela Ahrendts frets about a combination of rising costs, falling demand and a strong euro that cuts into competitiveness. "There's a perfect storm out there," she says. Many investors would agree: this year, stocks across Europe are down 20% or more, the standard measure of a bear market.

So how bad will it get? Will Europe work through these difficult challenges and continue growing? Or is it headed for another of its periodic downturns, accompanied by job losses and protracted economic pain for corporations and citizens alike? Here are five key issues to watch:

The German Machine
After a decade in the doldrums, germany returned in 2003 to its traditional role as the motor of European growth, and has been powering forward ever since, dragging many of its neighbors with it. The German economy grew by 2.6% in the first three months of 2008, its best performance this decade, encouraging more optimistic assessments of Europe's underlying strength. Behind that showing is an export boom, as Germany's traditional industries such as machinery and machine tools benefit from a flood of orders from China, Russia, India and the Middle East. That in turn is driving investment at home, and has created tens of thousands of jobs. But the latest figures suggest the manufacturing boom has peaked — and the big question is, How pronounced will the slowdown be? On July 4, the government announced that orders to manufacturers dropped by 0.9% in May. Most economists had expected a modest rise, and the unexpectedly poor performance — combined with other data suggesting that business confidence is on the wane — caused much hand-wringing. "The outlook for German industry is worsening extremely rapidly," says Riches-Flores.

In Germany itself, some strongly disagree. At the German Engineering Federation, an association of about 3,000 German machinery firms, economist Olaf Wortmann acknowledges that there has been "a change of tempo," but he insists that the upward trend is continuing. The Federation tracks the order inflow of its members, and while that number fell 12% in May, it jumped a spectacular 35% in April. "There are always monthly fluctuations," says Wortmann. For the first six months of 2008, the industry is still expecting growth of at least 5%. One heartening factor: the engineering firms' factories continue to hum at an impressive pace — capacity use is at a near-record 91%, and there has been a big increase in investment to add new capacity, even this year. If he's right and the outlook for German exports and investment remains robust, it will do a lot to keep the rest of Europe afloat.

The War on Inflation
When Jean-Claude Trichet, the president of the European Central Bank (ECB), announced a 0.25 percentage point increase in Europe's key lending rate on July 3, he contended that it was critical to stave off the so-called secondary effects of inflation and "to neutralize the growing risks to price stability." In plain English, that means he's worried about an inflationary spiral in which manufacturers of industrial and consumer goods raise prices to compensate for higher costs — and workers demand hefty pay increases so they can afford the rising cost of their household purchases. The risk is very real. Soaring prices for oil, raw materials and food have taken a heavy toll on Europe's inflation rate, which hit 4% in June — more than double what it was a year ago.