The global effects of the European crisis

by John Rapley

However brief the pause turns out to be, last week offered a bit of a hiatus in the European crisis. That led everyone to think of what comes next.

Arguably, the global financial crisis that broke out in 2008, actually started a decade earlier. One could trace its origins to the United States market crash of 2000, or back further to the collapse of Long Term Capital Management, or even as far back as the Mexican peso crisis of 1994. But a case can be made that all these events represent the surfacing of deep currents of financial contagion, unleashed by global instabilities.

What also seems apparent is that each crisis is successfully worse. Political and monetary authorities use ever more of their resources to stick fingers in a dyke which is growing fuller by the day. It may not be unreasonable to predict that in the next year or so, we will reach a terminal phase to this process. Nonetheless, if there is light at the end of the tunnel, it doesn't mean the landscape we find on the other side will be all green.

Europe was bound to be the next domino. The result of the contagion, which spread from US property markets to European government bonds, are now starting to be felt. Recently, the European Commission sharply downgraded its outlook for the European economy. Last week, the Bank of England added the United Kingdom economy to the slowdown list. In Europe as a whole, if not outright recession, the coming year will witness economic stagnation.

A bad time for the US

This news comes at a bad time for the US. While its economy has been showing signs of renewed life, the Americans were hoping, at least in part, to export their way back out of recession. The European slowdown will weaken demand. It could also strengthen the US dollar vis-à-vis the euro, which would weaken the competitiveness of US exports.

All the while, American banks have some exposure to European sovereign debt, which they own. With Italian bond yields still hovering in a danger zone that financial analysts consider unsustainable, a renewed financial crisis in Europe would almost certainly have a negative impact on the American financial system.

To prepare for this eventuality, American banks may reduce their lending to conserve capital. This, in turn, would further inhibit growth. With mortgage lending and new investment down, home and share prices will continue stagnating. Eager to hold on to their nest eggs, Americans may tighten their belts, further limiting a rebound.

Should the American and European economies slow down, or worse, that would leave the Chinese economy as the major remaining pole of planetary demand. Lots of governments have been hoping they can export to China to get back on a growth path. The Americans, in particular, spend a lot of time pressing the Chinese to revalue their currency, so as to make US imports cheaper there.

China's problems

However, while it continues booming, China has some of its own problems. To begin with, it, too, has relied on exports to drive its economy. With demand weakening elsewhere, tensions at home will rise. With masses of Chinese moving from the countryside to find jobs in the coastal cities, the government has encouraged a construction boom.

Private banks have got in on the action. The result, as elsewhere, has been a bubble in property values. Rising rents have led to rising discontent, but so far, this has been offset by rising wages. However, if slowing exports hurt growth, social discontent may sharpen. Yet the Chinese authorities know that if they prick the property bubble to lower rents, they may have their own financial crisis on their hands.

Should that happen, it may be the final act in this long global crisis. But if the moral of the story then emerges, it won't be a particularly happy ending.

John Rapley is a research associate at the International Growth Centre, London School of Economics and Political Science. Email feedback to columns@gleanerjm.com and rapley.john@gmail.com.