Will Europe drag us all down?

While markets remain focused on the debt travails and bailouts of Europe, the underlying economy is in deep trouble. In fact, the Eurozone is plunging into recession – fast. Last night’s PMI was another shocker:

Conditions in the Eurozone manufacturing sector continued to weaken in October. At 47.1, down from 48.5 in September, the final Markit Eurozone Manufacturing PMI fell to its lowest level since July 2009 and below the flash estimate of 47.3. The PMI has remained below the neutral mark of 50.0 for three months. Signs of weakness are becoming increasingly apparent in the core nations, while the periphery remains mired in recession.

German manufacturing, one of the main drivers of the earlier Eurozone recovery, saw its PMI indicate contraction for the first time since September 2009. Rates of decline were the fastest for 27 months in both Austria and the Netherlands, while France signalled deterioration for the third month in a row. Rates of contraction accelerated sharply in Greece and Italy, with the performance of Italy deteriorating.

The drop is so fast that the final result undershot the flash PMI of a little over a week ago. The weakness is in both periphery and core countries:

New orders are also accelerating to the downside: Eurozone manufacturing output, new orders and new export orders all contracted at the fastest rates in almost two-and-a-half years during October…Ireland was the only nation to report expansions in output and new orders in October. Rates of contraction in production accelerated sharply in Greece and Italy, with the Italian output index suffering its sharpest month-on-month decline in the series history. France and Austria reported modest reductions in production, and slower rates of decline than in September. Marginal contractions were signalled in Germany (for the first time since June 2009) and the Netherlands.

We won’t know precisely how services are faring for two days but it’s certain to be much the same. Here’s how the services PMI looked last month:

So, the Eurozone is headed swiftly into recession. This is regardless of any further financial shock. To make matters worse, counter-cyclical policy is severely constrained. The debt wrangles of the European sovereigns means fiscal stimulus is dead (except perhaps for Germany?). Interest rates are already at 1.5% so cuts there offer limited scope as well.

Therefore, any rescue for the Eurozone is largely going to have to come from outside, that is external demand will need to offset internal weakness. Is that possible?

The EU27 constitute the largest economy in the world at over $16 trillion, roughly one quarter of global GDP (the Eurozone is roughly three quarters of this).  The US, China and Japan are the three economies of sufficient scale to deliver a boost to Europe. The US’s slow recovery continues. But the Fed last night cut its growth forecasts for next year from 3.3% to 2.5%. There is no chance of fiscal stimulus there (with a growing chance of a repeat of August’s debt-ceiling debacle as the fiscal cuts Supercommittee is gridlocked). Inflation is slowly falling so the Fed could opt for QE3, which would reflate markets at least but not unless things get worse first.

As Michael Pettis explains today, Chinese credit appears suddenly very tight and he is looking for authorities to begin to ease in the near future. The ore market seems to have a sniff of that as well as it stabilises. There is some hope for a kick along for growth there. However, as I’ve said before, the Chinese authorities look determined to cap realty prices so easing will be paced with declines in that sector. Unless of course they get spooked.

That is quite possible. The two channels of transmission for European weakness are, as we know, a financial or trade shock. Let’s assume there is no further financial shock coming. But the trade shock remains very real. The typical business cycle ends when some kind of shock (usually monetary but this time fiscal) delivers a blow to demand. The result is that producers find themselves suddenly overstocked with inventory and they cancel orders. Businesses along the supply chain start to furlough or fire workers to maintain margins. This, in turn, delivers a further blow to demand and a negative feedback loop forms that leads to recession. This is called the inventory cycle.

The good news is that the EU has a less pronounced cycle than the US. Owing to its stronger trade union base and more collaborative relations between capital and labour (like Germany’s kurtzabeit system), the EU inventory cycle is less severe. Thus downturns tend to be less precipitous and upturns less spectacular.

But the cycle still exists and the EU economy imported $282 billion worth of stuff from China in 2010. It also had $170 billion in imports from the US and $65 billion from Japan (and remember Japan’s latest good trade data was largely driven by an unexpectedly high EU result). These are wide channels for economic contagion to spread into already weak or weakening other large economies. I expect all three to show negative impacts in their export sectors for the next few months at least. The danger is, if these trade drops are severe enough, that the US and China also start losing jobs, threatening their own inventory cycles.

So, even without a renewed financial shock, the world is facing a very nasty period ahead in which external demand is subdued at best and probably falling. That is already apparent in the global PMI for October:

Conditions in the global manufacturing sector remained broadly stagnant in October. Levels of production and new orders fell slightly over the month, while new export orders declined at the quickest pace for almost two-and-a-half years.

At 50.0 in October, little-changed from 49.8 in September, the JPMorgan Global Manufacturing PMI™ remained within 0.2 points of the no-change mark for the third month running.

So will Europe drag the world down further? At this stage I’d say there is hope that the little cycle of growth that’s underway between China and US can hold things up for a little while, but the exports of both are going to remain under sustained pressure, especially China. And with European activity likely to keep plunging (rescue or not) I’d say that unless there is some major new source of stimulus in the near term, the answer is yes.

Euro Zone



Houses and Holes
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  1. Surely, Ireland shows us the way? It appears to have ‘got on with thing’; slashed public sector wages and held taxation low, seen it’s property market adjust and warehoused the national debts. Europe could ‘compete’ its way out of some of its problems if there was a co-ordinated cut in public sector wages – that would flow through to the private sector, and restrict any potential household debt increases. Compensate the household sector for its loses with lower interest rates, and stablise the system at a lower base.

    • Ronin8317MEMBER

      The Irish national debt is mostly a result of their bank bailout. While they’re not as far along the ‘bankruptcy’ path as Greece, however it’s heading there. The Irish deficit for next year is projected to be 11.6% of GDP!!!

      • Well the proposal is to slash another 4 billion Euro from the budget to get the deficit back to 8.6% of GDP next year. A slowdown in Europe will put a spanner in the works.

        Irelands “success” all sounds good on paper, but the effects on the ground there are terrible. People are really struggling and there is some austerity fatigue creeping in. Defaults are not just about an inability to pay, but also an unwillingness.

        However I don’t suspect Ireland will be the source of any serious trouble for the EU, they never want to be the bad boys of the class. They are more likely to put their hand up and ask “Why not me too?” once Greece or Spain or Portugal or Italy get the ball rolling.

  2. It might, but maybe Italy will be the next trigger if you look at the debt refinancing from 2012 on?


    Also the ongoing debt accumulation and lower growth don’t make this a rosy outlook for Italy.

    I don’t know, but the whole of the EU could drag us down if you start looking at the debt and the revised growth estimates.

    The G20 are talking about re-financing the IMF which Julia has agreed to, but where does that money come from when we’re running a CAD, increasing our foreign aid etc. If that IMF money is to go to bail out Greece then it might be well spent for a few months, but Greece, in it’s current form, is not viable so all we’ll do is throw more money away while the Greeks buy more German cars.

    As we’re seeing mixed messages… “it’s all fixed”, oh “it’s not fixed” and the markets are not really operating from the real data and are exhausted by all this IMO. Citi today say the bear market is behind us, but I’ve not see any evidence of that.

    As your post shows the trend is down. Thanks for the post H&H.

    • +1 a63 Good point re because we run a CAD every dollar we fund every international organisation we have to borrow!

      • So future Australian taxpayers will pay for this, so that Julia gets the chance to tell Euro leaders to get on with it at G20. Damned expensive lecture, stating the obvious. Hope Rudd nails her.

        • The unfortunate thing is Australia is calling for more of the same in Europe. We should be calling for reform, but of course this will not happen. People will stick with the status quo as long as possible, even though the case for reform becomes stronger every week.

          On the other hand, Australia should be calling for a much greater role for the IMF and should be demanding its capital be very greatly expanded. This is essential. We face the financial equivalent of a record bushfire season and have just a few old appliances on hand. We need to equip ourselves properly while we can.

  3. There is a plus side to a European recession but I guess it is outweighed by the international situation. Anyway my puls side is this. Inflation is headed our way out of China. Recession in Europe may well slow down, but not stop, the increasing wages cost and margin expansion in Chinese factories. So European recession may help to rreduce the rate of increase in inflation here. Thus, if the RBA is taking any notice of inflation at all (which i doubt:) ) then we may have lower interest rates here.

    OTH I don’t quite understand how we are going to continue to operate at RAT negative rates with a large foreign debt and the world scrambling for money over the next few years. We’ll keep ‘selling off the farm’ and that will certainly help.

    Then again hiho! hiho! a printing they will go! Europe heads for the presses as recession takes hold, QE3, we sell the farm, business as usual…sort of!

    Sorry for all the confusion and lack of clarity. It’s all a bit hard to hold in one’s head!

  4. It will be interesting if Julia funds the IMF bailout via AOFM and its used to purchase bonds, bit like European RMBS

  5. I really don’t know what your problem is. Over at Planet Carr he says:

    In Germany, the unemployment rate was up to 7 per cent from 6.9 per cent in October and the final estimate of the October PMI (for Europe) was little changed at 47.3. This series suggests activity is contracting but note that it is the only data print to do so and isn’t robust enough as an indicator to base a recession call on. In the UK, the construction PMI rose to 53.9 from 50.1 in October. That’s pretty much it.

    As usual, all good. Perhaps you should pop a Zoloft and stop bringing us all down with your doom and gloom.

  6. So the Greek money goes to French banks, the Euro taxpayer money goes to French banks, the EFSF money goes to French banks, the IMF money we cough up will go to French banks. Am I missing something here?

  7. Of course we get dragged down. First it was the USA, now Europe, next China.

    Remember this was all to avoid a recession in 2007/8 which would have been over by now. Blame politicians and bankers and next chance you get, vote out a sitting member.

  8. How brave of Greece and G Pap to swim against the tide of Euro domination and hang on to their sovereignty. I don’t think they have enough independence left to achieve what Iceland managed.

    • The package agreed to by the EU and Greece, if implemented and if it works, will consign the Greek people to many years, possibly decades, of hardship. The Greek PM is basically asking his people to submit to this. At least they are to be given some say in their destiny. If they reject the plan, they will be voting for bankruptcy and reconstruction outside the Euro zone and, most likely, outside the EU as well. There is no clear legal route to that destination. So the Greeks face a terrible choice – deflation or chaos.

      From my point of view, they have no choice: they have to vote for bankruptcy and reconstruction. These are inevitable in any case, as far as I can see, so they might as well get on with this and deal with the consequences now. Conditions for this are difficult at the moment, but they are not likely to be any better in the coming period. The Euro system clearly does not work, and the sooner they escape from it, the better.

    • Sometimes it’s better to ask for forgivenss than permission. Now which way will they vote? And what happens if they vote ‘No’?

      One intriguing thing about this for me anyway is that old saying – “If I owe the bank $5,000 I have the problem, if I owe them $5 billion, they have the problem”. Greece can call the shots here because it’s the French and German banks that have the problem.

  9. Diogenes the CynicMEMBER

    So real business conditions are heading south…that spells trouble for Europe and thereby China and thereby Australia.

    Lower interest rates won’t really help, but sure we will see a 2 handle on the official rate in the next 18 months.

    Can we withdraw from the IMF? Their solutions to date have only made things worse…

    • We can withdraw from anything we don’t like as we still have our sovereignty, even though our pollies would love to give it away.
      We could withdraw from to UN convention on refugees if we wanted to.
      We could sell or give Christmas Island to the Indonesians and solve the boat refugee disgrace if we wanted to. It’s 360 km from Jakarta, 2600kms from Perth.

    • Australia is a trading nation, a prosperous and economically strong nation. We have one of the world’s highest per capita incomes. And yet we should withdraw from the IMF? This is an absurd proposition.

      The global economic system faces very difficult challenges that will take many years to overcome. Multilateral institutions, such as the IMF, imperfect though it may be, are one of the very few instruments available to us to maintain funding for economies that face collapse.

      To pull out of the IMF is really saying to our trading partners, our investment partners, and our friends in other countries, “Up yours! We are ok and we could not care less about global financial and economic stability.” In some circles, this is otherwise known as the North Korean option – it would be insane.

      The IMF in fact needs to be radically strengthened – possible by a ten- or twenty-fold increase in its assets. The global financial order is in really serious danger and we should take what time is available to strengthen global institutions.

      This cannot happen quickly enough from my point of view.

      • I hope you are kidding. What makes you think that “maintaining funding” for a collapsing economy will do any good?

        Surely everyone should have learned that lesson by now; a collapsing economy will collapse, the only question is do you let it go now or do you kick the can and let it go later (but in a bigger way)?

        I’d love to hear of any IMF success stories though. I am not aware of any but i could be wrong.

      • OK by me if you pay for it, not me. Another couple of thousand in your taxes to be given to some poorly managed country sounds fair.

  10. That goes to show how good my geography is…I had no idea. It’s a wonder the Indos haven’t invaded the place to get it back long ago. No oil around it?

    • Yeah straight up. It has been a joke around these campfires for years.
      Xmas Is. an Aust. territory???
      Pull the other one.
      PS it has run out of Phosphate so Jakarta prolly dont want it.

    • It’s our Malvinas. Sits just off someone else’s border a damn long way from here. Nothing there worth having but the ranga would probably defend it to someone else’s death. We claim a couple of hundred kms of seas around it, which is why we have to bring the boat people here. The leaky boats obviously can’t make it to here but can usually manage a short trip from Indo to Christmas Islane as their last voyage.

    • I always wonder about the Coco’s & keeling Islands that are just off Sumatra as well, its a wonder that the asylum seekers dont head there.

  11. The wording is going to be critical. Agree
    it’s a choice of do want to be flogged hard or do you want a hard flogging!

  12. The EU have decided to cut off the money for Greece. I can see why they might want to do this. But what they have done is place their destiny in the hands of an irate Greek electorate.

    Really, anything can happen now.