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U.S. needs economic allies

Marie-Josée Kravis

President George W. Bush may have unnerved his European allies with his views on the Kyoto accord, missile defense and the death penalty, but he could, in turn, complain that Europe has not been particularly helpful in sustaining world economic growth during this latest U.S. slowdown. The annual report from the Bank of International Settlements (BIS), released this week, comments that without stronger growth in Europe and Japan the world economy faces the likelihood of protracted weakness and instability. The huge U.S. current account deficit, high levels of personal debt and sluggish capital investment led the bank to conclude that the United States alone could not pull the world economy out of the current downturn.

The same day, Japanese authorities confirmed that their country’s gross domestic product (GDP) had dropped 0.2% in the first quarter, and warned that Japan was probably headed toward recession. Failure to tackle industrial and financial reform, combined with antiquated agricultural and distribution policies, have stopped Japan from sharing responsibility for global economic growth and development. The new Japanese administration appears to espouse the idea of reform and structural adjustment, but its political strength and ability to effect change have yet to be tested. Japan will be of little help in the immediate future.

What about Europe? For the first few months of the U.S. slowdown, Europeans were delighted to claim that they would escape such misfortune. They had not experienced the boom of the ’90s and they would therefore miss the correction. European exports would not suffer because intra-EU trade accounted for such a large share of orders, and a vibrant Europe would compensate for the gap left by a slowing United States. The move to a common currency would impose fiscal discipline, rein in inflation and force structural adjustment. Much to the surprise of European business people and political leaders, this optimism has been punctuated by the reality of rising oil prices, food safety crises, tight monetary policy, a weak currency, resistance to deregulation and slow transformation of industry.

As orders decline and inventories rise, Europe is begrudgingly acknowledging that a U.S. slowdown does matter. Preliminary data from the European Commission suggest that GDP growth in the last five months has declined to roughly 2.2% from a peak of 3.7% last August. Investment is dropping and consumer confidence is waning, especially in France and Germany, as unemployment begins to rise.

Despite the sluggishness, the European Central Bank (ECB) has ignored calls for monetary easing, and money supply in the euro zone has begun to falter in recent months. The ECB is now confronted by rising inflationary pressures in France, Germany and the U.K., as well as in Spain and Italy. While the ECB’s inflation target is 2%, German inflation hovers around 3.6%, France is registering a 2.5% hike and U.K. inflation rose to 2.4% in May. Granted, rising energy and food prices are the main culprits of higher European inflation, but external conditions have been exacerbated by the weakness of the euro. The prospect that the ECB might choose to raise interest rates to support the euro portends even more sluggishness in investment and growth. There was a time when a drop in European interest rates and an expression of support from the ECB to encourage continued economic growth might have fueled confidence in the euro. The bank has probably lost this opportunity as inflation concerns multiply and appear to preclude monetary stimulation. Meanwhile, markets have become increasingly skeptical of the bank’s commitment to sustained economic growth and stability, and weary of apparent contradictions among ECB policy makers. Again this week, Ernst Weltke, president of the Bundesbank, and Jean-Claude Trichet, governor of the Banque de France, expressed concern about the effects of a weak currency on inflation, while ECB president Wim Duisenberg said that the exchange rate ‘only becomes important if it no longer supports our inflation target in a serious way — and that is not the case.’ Contrary to U.S. Federal Reserve chairman Alan Greenspan’s actions in the United States, ECB’s Mr. Duisenberg has not shown concern with ensuring confidence in growth prospects in the euro zone.

Meanwhile, reports on European labour productivity suggest that EU labour market reforms have not been as effective and thorough as earlier believed. A study released by the Centre for European Policy Studies concludes that, in Europe’s seven largest countries, key structural reform — notably labour-market liberalization — has barely begun. Restrictions on hiring and firing, overly rigid work rules, high social security and other taxes, and excessively generous unemployment schemes remain an impediment to improved economic management. Despite the rhetoric, Europe has made little progress in addressing these issues, with the net result that European productivity has fallen 1.5% on average during the past five years. In Spain and Italy the deterioration has been even greater, with annual declines of 3.1% and 2.6% respectively. A slowing European economy decreases the likelihood that governments will envisage reform in the near term. On the contrary, slow growth will erode the resolve to modernize and will fuel measures such as those put forth in France to extend the application of rules limiting the work week to 35 hours. Such trends mean that the gap in economic performance between the United States and Europe will probably widen in coming years, sparking renewed complaints of U.S. domination and arrogance.

The problem is that the more the United States’ allies shy away from responsibility to defend not only political and military stability, but also economic progress, the more likely it is that the United States will ignore their sensitivities, and the more differences among them will intensify. The more they shun international responsibilities, the more ammunition they provide to isolationist forces in the United States. Economic policy coordination is an issue for discussion at the G7 summit this week, but broad agreement on fiscal and monetary stability will not suffice. Europe especially, and Japan, must behave as equal partners and commit more actively to reform. As the BIS reminded us, the ball is largely in their court.

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