Europe might be in serious trouble

The world has drastically changed during the last couple of years, mainly driven by technology. Every year, we see how companies try to pivot to the technological sector in the light of a brighter future, as these are the ones that seem to be performing better. 

In particular, in the last two years, we have seen how this phenomenon has intensified due to artificial intelligence. Because of AI tools, companies can produce more quickly, cheaply and better.

However, not everything has been positive in recent years. Since 2020, we have experienced several global catastrophes, namely the Covid-19 pandemic in 2020, the Russian invasion of Ukraine in 2022 and the Palestine-Israel conflict in 2023. 

On top of that, nations have been struggling to recover from the consequences of these catastrophes, especially those triggered by the pandemic and the Ukraine war. In particular, there is a macroeconomic phenomenon that most of the world has experienced – inflation.

According to the US Bureau of Labor Statistics, in the United States, people need $120 in October 2019 to afford what they could get for $100.37 in October 2023. In other words, the overall inflation rate in this particular country over those four years has been almost 20%. As a consequence of that, the governments and the central bank of most countries have taken action to bring inflation down, although not all economies have reacted the same way.

In the case of the eurozone, however, consumer prices slowed more than anticipated in October 2023. The main reason is that energy prices have decreased, resulting in lower inflation in food and services. 

Additionally, the Consumer Price Index (CPI) for the 20-member euro area dropped to 2.9%, compared to economists' expectations of 3.3%, significantly lower than September's value of 4.3%. Core inflation, which excludes food and energy prices, also decreased from 4.5% to 4.25%.

Despite the positive news about the eurozone's inflation numbers, there are concerns about a potential increase in energy prices, which could cause inflation to rebound. To control this, the European Central Bank is tightening its monetary policy, dampening demand for the European currency, the Euro. 

This situation led to a contraction in Europe in the third quarter of 2023, prompting European Central Bank President Christine Lagarde to observe a weakening activity across several sectors. This is an unintended consequence of tightening the economy to reduce inflation.

The divergence between the US and European economies appears evident. In the third quarter of 2023, the combined GDP of the European Union countries dropped by an annualised 0.4%. On the other hand, the US economy shows signs of strength, with a 4.9% annualised growth during the same period. Additionally, as mentioned before, European inflation is dropping faster than the US one.

But the gap between the two Western powers is not a new fact. Since the 2008 financial crisis, the economic growth of both groups has been taking different paths, with the Covid-19 lockdowns making the gap even more expansive. 

Additionally, conflicts in European territories have also caused an increase in energy and food prices, ultimately affecting household consumption. It is important to mention that since Europe is a net energy importer, it has suffered more from rising gas and electricity prices than countries like the US, which benefits as an energy exporter.

Another factor contributing to this divergence is that eurozone governments have been less liberal in spending to support demand than their US counterparts. It also seems like the world is experiencing a shift in consumption from goods to services, and geopolitical tensions are responsible for declining international trade. 

All this together has caused large manufacturers and exporters to be worse off. The case of Germany, a key player in Europe, is remarkable, which is stagnating due to the high-interest rates, the energy prices and weak foreign demand. By August, eurozone retail sales were 7.5% lower than in January 2022, compared to a 1.8% drop in the US. Germany experienced a 0.5% decrease in consumer spending over three months through June, while the US saw a 1.8% increase. 

The economic weakness experienced by Europe is also affecting its imports from China and the United Kingdom, which have significantly decreased due to a diminution in European household spending.

The widening growth gap between the European Union and the US shows that the European Central Bank's rate increases impact an economy already facing strong headwinds. Christine Lagarde explained that past interest rate hikes affect financing conditions and slow demand. 

On the other hand, some critics believe that if Europe follows the steps of the US Federal Reserve in increasing interest rates, eurozone policymakers risk widening the growth gap further, causing concern about a prolonged difference in income per capita.

If there's something the eurozone is doing well, it is controlling its debt. During the Covid-19 pandemic and the Ukraine War, Europe and the US had to borrow heavily to overcome multiple difficulties. However, once those events seemed to have lost economic relevance, the US continued to increase its deficit. In contrast, Europe appears to have learned the lesson from 2008 when some members of the European area defaulted.

Despite Europe's disciplined approach, it is not widely recognised globally. US government bond yields have risen, influenced partly by the US deficit, which reached $1.7 trillion or 6.3% of GDP in the past fiscal year. Without an accounting change related to a student loan cancellation program, the US deficit would have approached $2 trillion, doubling from the previous year. The anticipated projections are not optimistic, as the International Monetary Fund (IMF) projects US deficits for all governments to reach 7.4% of GDP in 2024 and 2025.  

Europe tells a different story, as the IMF believes that the combined deficits of eurozone governments will decrease to 3.4% of GDP this year from 3.6% in 2022 and further to 2.7% in 2024. Particularly noteworthy are the cases of Greece, Portugal and Ireland, which faced a deep crisis after 2008 and are now effectively controlling their debt levels. 

With that being said, and if those estimations are correct, European governments will no longer be a leading driver of the increase in the world's debts. It appears to be the turn of the US and China. Without them, the debt load would be decreasing.

There is no doubt that the economic situation in Europe is not very optimistic. Although lower debt levels are always positive, the European area is slowing down. Its households are reducing consumption, and its overall GDP is decreasing. 

In addition to that, international trade is also declining due to global conflicts. Inflation levels, though falling, are still far from what people would prefer. Future increases in interest rates could further decrease consumption and, with it, the European GDP. Christine Lagarde has to be very careful on that subject since increasing the interest rates too much may push Europe into a severe recession. On top of that, the threat of stagflation is just around the corner. 

In contrast, the US appears to have finished increasing its interest rates. It is a matter of time before we see what Europe will do. If the choices are not appropriate, Europe might be in serious trouble.

M. Kabir Hassan is a Professor of Finance at the University of New Orleans, USA.

José Antonio Pérez Amuedo is a Doctoral Student at the University of New Orleans, USA.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.