Europe's Economy: Falling Down

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Trichet's critics, including French President Nicolas Sarkozy, say it makes no sense for the ECB to raise interest rates to fight frothy commodity-market prices, and Trichet himself signaled that the bank isn't planning any more rate hikes in the near future. But surging inflation poses a huge threat to Europe's chances of beating the downturn, especially when combined with weak growth. Inflation is perhaps the trickiest economic indicator to forecast: for example, over the past year, the ECB's staff has based each of its inflation projections on an assumption that oil prices will stabilize — and each time they have risen further, to a current level of around $140 per barrel, or double the price of a year ago. Western economies as a whole are far less dependent on oil than during the two big oil shocks of the 1970s, but with food prices also on the rise, the situation remains highly volatile. If inflation continues to soar, expect more central bank tightening and a growing risk of recession.

Consumers: The Party's Over
Oxford Street, London's busiest retail area, is still teeming with shoppers hunting for end-of-season sales bargains, but the store owners are anything but happy. Marks & Spencer's stock dropped 25% in a day on July 2 after the firm issued a profit warning. At privately owned rival John Lewis, sales in the summer-clearance week at the end of June fell more than 8% compared with the same week in 2007. Patrick Lewis, who heads the company's retail operations, said the market "has certainly got an edge tougher."

The slowdown in British consumer spending is echoed in Ireland and Spain, although consumers are holding up a bit better in France. In Germany, economists have been waiting for a decade for a consumer-led rebound — and they're still waiting, even though the economy had fared well until recently. Crucially, employment remains buoyant in most countries other than Spain, and so far, despite some job cuts — especially at banks — the overall jobless level remains stable. For example, a regular survey of job opportunities posted online throughout Europe showed no change overall in June; indeed, there was a sharp increase of postings for jobs in tourism, hospitality and health care, according to the online recruiter Monster, which compiles the survey. Still, fueled by negative headlines, fears abound about harder times ahead: in the U.K. consumer sentiment has sunk to its lowest level since 1990, according to a poll by market research firm GfK NOP; back then the country was heading into a deep recession. Riches-Flores of Société Générale reckons Europe may already be in the midst of a consumer spending recession.

Housing: End of the Boom, or Bust?
Consumption has been so strong in the U.K., Ireland and Spain for the past few years in part because house prices have been soaring, making consumers feel a lot richer and enabling them to borrow against the rising value of their property. But gravity has finally caught up with the housing market in much of Europe, especially in those three countries. It's anybody's guess how far prices will fall, but the signs aren't encouraging.

This month Taylor Wimpey, Britain's biggest housebuilder, failed to secure badly needed new funding from existing shareholders or new investors; its stock has dropped by 95% in the past year. Several Spanish homebuilders and construction firms are also struggling. Hetal Mehta, an economist at Ernst & Young in London, says U.K. house prices — which have dropped about 8% from their peak last year — could fall another 10%. Deutsche Bank figures the total drop could be closer to 25% by the end of 2010. Whatever the eventual decline, housing woes are already casting a chill on spending. For example, says Mehta, there has been "a dramatic fall" in sales of household goods such as dishwashers and refrigerators in the past six to eight months because people aren't moving as often. But real estate is an intensely local business, and in many markets it remains robust: for example, all of Germany, and the desirable parts of desirable cities like Paris and London. If enough places hold up and the declines elsewhere are short-lived, the damage could be limited.

Financial Risk
Across Europe, banks have put a brake on their lending, both to individuals and to companies. Indeed, credit conditions have so drastically tightened that Mehta of Ernst & Young jokes that, for a first-time home buyer in the U.K. these days, "getting a mortgage is like winning the lottery." That's an inevitable reaction to a slowing economy and the worldwide financial squeeze triggered by the U.S. subprime debacle. What nobody can predict with certainty is whether there are any huge financial risks still lurking undetected; in the aftermath of the subprime crisis it turns out that many banks underestimated the risks posed by the often-arcane financial instruments they were trading. European banks themselves say that most of the bad news is already out, and some — including Barclays, Crédit Agricole and the big Swiss banks — have raised billions of dollars in fresh capital to strengthen their balance sheets. That may not be enough: a recent report by Goldman Sachs estimated that European banks will have to raise a further $95-$140 billion in fresh capital. And in the event of another Northern Rock-style meltdown, all bets about the banks' stability — and Europe's economic resilience — will be off.