The Best Is Yet to Come

Be careful what you wish for. since 1999, central bankers in Continental Europe had pushed for a strong euro. In the past few years, they also urged more attention to market risks. Both wishes have now been granted. The euro is trading at a record high to the U.S. dollar. And markets are now so fixated on risks that banks are becoming more reluctant to lend. Add exploding oil prices to the mix and it is easy to see doom and gloom ahead for the European economy. But that would be premature. Financial turbulence could be a prelude to a European recession if policymakers mishandle the situation badly or if the turmoil reveals a major underlying problem. This was the case in 2001, when we learned that much of the dotcom boom was based on dreams rather than realistic revenue projections. Other periods of turbulence, such as the mini-crash of 1987 triggered by U.S. and German interest rate hikes and the gyrations of 1998 after the collapse of a major U.S. hedge fund, caused no more than a temporary dip in European growth.

So far, euro policymakers have reacted well to the recent upheaval. The European Central Bank has postponed a rate hike and injected generous amounts of liquidity into the markets instead. More important, Europe does not have a major underlying problem. The risk that the eurozone could be heading for a U.S.-style housing crisis looks remote.

Also, eurozone consumers did not go on a U.S.- or U.K.-style borrowing binge. Debt levels have risen, in some countries substantially. But unlike Britons and Americans, Continental Europeans stuck more to the traditional sort of debt. The Anglo-Saxon habit of making mortgage-equity withdrawals—taking out a second or third extra mortgage on the rising value of a house to buy a second car and another fancy dress—is virtually unknown in much of Continental Europe.

This is not to say that the next year will be smooth sailing. The money-market disruptions could still force European banks to tighten their lending standards significantly until mid-2008. After years of sluggish growth in domestic demand in their European home base, some banks may have comparatively vulnerable balance sheets. The European Central Bank's latest survey of bank lending foretells tighter credit conditions to come. In July, only 7 percent of eurozone banks wanted to impose tougher conditions on credits to corporates in the next three months. According to the European Central Bank's October survey, 30 percent now intend to do so, with merely 2 percent planning to ease their standards.

To make matters worse, the falling dollar projects America's current economic weakness into Europe. Eurozone corporations are finding it harder to compete against producers from the United States who pay their workers in cheap dollars. Eurozone export growth has come down from 8 percent in 2006 to an average of 7 percent so far this year, which is, of course, still quite strong. But a further loss looks inevitable. In addition, companies may shelve some of their investment and hiring plans for a while amid demand uncertainty.

Consumers, meanwhile, are facing the spike in oil and food prices. If they have to pay more for their basic necessities, they have less money left to spend on other goods and services. Taken together, tighter credit conditions, the surge in the euro and the spike in oil and food prices matter. Eurozone economic growth could dip to 1.6 percent early next year, far below the 3.3 percent recorded in late 2006.

Fortunately, such shocks do not last forever. The Continent continues to reap the benefits of corporate restructuring and recent economic reforms. The results show up in buoyant business profits, a decline in unemployment to a 16-year low and firmer consumer incomes, which are now rising at almost 4 percent before inflation.

Even a strong exchange rate can be a blessing in disguise. The more European companies shape up to cope with the super-euro now, the better placed they will be once the euro succumbs to gravity and returns to more normal levels in the future. In the past few years, European firms have made relentless efforts to globalize production, partly in response to earlier bouts of euro appreciation. With diversified sourcing, European companies can better deal with exchange-rate gyrations. Also, Eastern Europe and East Asia are no longer places to which Europe is exporting mainly jobs. These regions are becoming attractive consumer markets. As their populations move up the income ladder, they are developing a taste for French wine and Italian handbags. Some Chinese are even spending their holidays driving fast cars on the German autobahn.

All this will help the eurozone to overcome the shocks. After a rough winter, the sun could well be shining again next spring, with growth rebounding to a pace well above 2 percent. Despite a likely setback near-term, the best times for Continental Europe are yet to come.