The Economy's Perilous Waters

What a difference a week makes. With their coordinated response to the international banking crisis, European governments — followed by the U.S. — appear to have calmed a worldwide market panic and eased fears of a devastating series of bank collapses. Investors from Tokyo to Tunis immediately sent stock prices shooting up again after a week of historic losses. But it's still far too early to celebrate. The measures need to prove their effectiveness by unfreezing lending. And there's still the huge challenge — no less urgent than fixing the banking system — of preventing an economic slump.

The credit crisis has had a chilling effect on economies around the world, and the International Monetary Fund (IMF) expects global growth to drop off sharply for the rest of this year and next as a result. The situation is particularly critical in Europe, where national economies were slowing markedly even before the financial crisis exploded. Most economic statistics in the U.K. and around the Continent already look awful, but the turmoil of the last few weeks will likely make the downturn longer and more painful. "You name it, it's falling," says George Buckley, a London-based economist for Deutsche Bank.

The result: economists across Europe are writing off 2009 as a year to forget, and some expect the weakness will continue into 2010 and beyond. Consumption will likely be sluggish and business investment soft. In European countries where the real estate market had overheated, including the U.K., Ireland and Spain, house prices are expected to continue tumbling. As the rest of the world also slows, exports will be hit — particularly bad news for Germany, which as recently as the first quarter of this year had served as the motor of Europe, thanks to its surging sales of machinery and other capital goods to places like China, Russia and the Middle East. In the last few days, companies ranging from motor manufacturer Deutz to Koenig & Bauer, which makes printing machines, have cut sales projections and warned about weak orders. "It's a double whammy," says Dino Sola, a finance professor at the University of Monaco. "First the credit crunch gets out of control and then, when we get our act together, we realize that we are in the midst of a recession that is potentially deep and long-lasting."

A struggling Europe is bad news for the rest of the world, since more than one-third of all foreign direct investment into countries such as China and Brazil comes from the 27-nation European Union. The E.U. with its 490 million population has also been an ever larger consumer of goods and services from Asia; last year it imported about $1 trillion worth from emerging markets alone, and China is its biggest supplier. With the U.S. economy also expected to drop off, it'll be up to Asia to generate its own growth for a while.

At home, a significant impact of the European slowdown is likely to be a rise in unemployment. The number of jobless in the E.U. dropped sharply between 2005 and 2007 and then flattened out at 25-year lows. But the latest statistics from France, Ireland, the U.K. and some other countries show that the unemployment rate is starting to pick up again. The IMF, which has slashed its growth forecast for the euro-zone countries for 2009 to a negligible 0.2%, predicts that the percentage of jobless in those 15 countries will jump above 8%. Worst hit will be Spain, where it predicts unemployment will be close to 15% next year, up from 8.3% in 2007.

This grim outlook presents some particularly tricky challenges to those in charge. In previous downturns, such as the early 1990s slump, governments typically ramped up state spending in order to offset the drop in business activity. But this time, the gigantic cost of bank bailouts will leave national treasuries with little room for maneuver. Indeed, the bailout plans — under which stricken banks will receive direct injections of taxpayer money to strengthen their capital base, while governments provide guarantees aimed at getting banks to lend to one another again — may well throw government finances seriously out of kilter.

Still, the picture isn't one of unrelenting gloom. Interest rates are low, unlike in the early 1990s, and the price of oil has dropped from its peak earlier this summer as demand slows from the cooling global economy. That's good news for consumers everywhere. But the signs of economic woe still add up to a minefield that European governments, central banks and other policymakers will have to navigate carefully. Here are some of the mines that lie in wait for them:

Vanishing Credit
One of the main consequences of the financial crisis is that credit will be a lot harder to obtain. That's already happening in the U.K., for example, where the volume of home mortgages approved by lenders fell dramatically in August. Including other forms of consumer credit, total net lending plunged by 86% from its level a year ago, according to Bank of England statistics. Just as Europe's banks were overextended, so consumers in many countries ramped up their household borrowing in the past few years — usually because rising house prices made them feel richer. For policymakers, the critical issue is the speed with which the inevitable weaning off of credit now takes place. If the "deleveraging" is quick, it will mean the European economy will be much better placed to rebound on a healthier footing. But curtailing credit would hurt consumers who are deep in debt, and would have serious consequences for retailers and others dependent on household spending for their livelihoods. If the deleveraging is slow, the economy could remain sluggish for several years, weighed down by debt levels. "It was transfusions of credit that made the economy buoyant, but if there's no growth from credit now, what will support the economy in the longer term?" worries Véronique Riches-Flores, chief European economist at Société Générale in Paris.