Eurozone could face stagflation

Author: Countries and Consumers

Date published: 1 Feb 2008

The global credit crunch, brought on by the subprime mortgage woes in the USA, could have consequences beyond American borders. The eurozone is in danger of experiencing stagflation – a combination of slower economic growth and high inflation. A strong euro has been impacting exporters and, consequently, consumers negatively by putting jobs at risk. However, lowering interest rates to promote economic growth could push inflation even higher.

Issue

Although the credit crunch of 2007, defined as the reduction in liquidity and money-lending capabilities of the financial institutions and markets, has had a more marked effect on the US economy, its reverberations are also being felt throughout the rest of the world, including the eurozone:

Within the eurozone, growth in its more prominent economies, such as Germany, vary considerably compared with lower profile countries, such as Finland and Luxembourg. Commentators are predicting lower growth going forward;

eurozone growth for selected countries: 2006-2008

Source: Euromonitor International from national statistics

The eurozone is also facing the additional spectre of inflation, with rising fuel and food costs putting pressure on consumer prices. Inflation in the eurozone registered at 3.1% in November 2007, compared with 1.9% a year earlier.

Economic conditions could be more difficult for eurozone consumers and businesses going forward.

Importance

The effects of the credit crunch are of material importance to the various economies of the eurozone:

The tightening liquidity conditions has translated into more constrained credit lending terms, which could put a dampener on prospects for house price growth, which have boosted economic growth in countries such as Ireland and Spain;

The rapid appreciation of the euro in reaction to the slump in the US dollar could have considerable consequences for eurozone countries, making their goods and services more difficult to export. The euro has appreciated by nearly 25% versus the US dollar between 6th June 2003 and 14th January 2008;

A higher rate of inflation points to potentially higher interest rates going forward. Although the eurozone interest rate remained at 4.0% in January 2008 for the seventh consecutive month, the tone of the ECB (European Central Bank) has been signalling rate hikes.

eurozone interest rate progression: June 2003 – January 2008

Source: ECB

Implications

The pressure that the credit crunch has placed on the eurozone economies, owing to tightening credit conditions, has far reaching consequences for consumers and businesses:

A reduction in the availability of credit could hamper housing markets in the short term. Furthermore, in the more mature property markets of Spain and Ireland, which have been characterised by steep house price rises, the credit crunch could precipitate a material correction. Consequently, the wealth effect created by the increases in property equity would fade and affect consumer spending patterns adversely;

A more expensive euro will have considerable impact on the eurozone's exporters, making their task more arduous, particularly in the face of competition from the lower cost regions of the world, such as China and India. Importers would benefit from the trend of a higher euro, which will benefit consumers if the lower cost of goods is passed on;

The pressure on exporters could ultimately lead to job losses at the very time that the eurozone has been lowering its unemployment rate from 7.8% in December 2006 to 7.2% in November 2007;

Higher inflation could lead to higher interest rates, which would affect eurozone economic growth negatively, given that businesses will be less able to borrow funds to invest, particularly after the credit crunch has made such borrowing more onerous;

Consumers are also likely to be negatively impacted by higher interest rates as their disposable incomes are eroded through the increased servicing of debt, particularly mortgage debt. GDP per capita for the eurozone was US$34,587 in 2007;

Consumer confidence in the eurozone has decelerated since news of the credit crunch broke in summer 2007. In May 2007 the indicator registered a figure of -1.3% and finished the year with a reading of -8.6%.

Future scenarios

The consequences of the credit crunch mean that the euro area could be facing stagflation in the short term, which is lower GDP growth combined with higher inflation. This would be detrimental for consumers and businesses alike.

The hawkish tone of the ECB, pointing to higher interest rates, will also continue to push the euro higher versus the US dollar and sterling. This is likely to place European exporters under even more pressure.

A continuation of tight credit conditions could also see further interventions by the world's central banks, as was seen shortly after the extent of the credit crunch became known in summer 2007. This could result in future injections of cash into the European financial system to oil the wheels of business and encourage borrowing by companies and individuals.

The prospect of stagflation makes the ECB's job extremely difficult: higher interest rates would curb inflation but would also have a negative impact on growth. Lowering interest rates would encourage consumer spending and business investment as well as helping exporters but would have an inflationary effect.