If it’s crunchtime in the US, what time is it in Europe?

Rumours strongly suggest that the US economy is stalling. Adherents to the mimetism school are already predicting a recession in Europe while others argue that there will be a “decoupling”. Who is right?

The first honest answer is that we do not know. For about ten years now, the European economy has followed the US economy, but with a lag of two to three years. This was the case even after the 2000 bursting of the tech bubble, followed by 9/11 a year later.

But the situation was different then. All European countries were directly involved in the ‘Information Technology revolution’. This time around, the housing market contraction is largely a US phenomenon, which affects non-traded goods; the UK and, maybe, Spain are the only other large countries where housing prices rose too far and are adjusting downward.

A second answer concerns the interbank market crisis. Here we have direct contagion because, one way or another, the infamous subprimes have been absorbed by many banks and international institutions around the globe.

Indeed, the interbank markets dried up on both sides of the Atlantic at the same time. Four months later, they are still not functioning normally. The question is whether this will contribute to a recession.

The interbank market is the ‘mother’ of all credit markets, including bond and stock markets. Its malfunctioning, therefore, is a direct threat to the most fundamental underpinnings of our economies. It does not follow, however, that a serious slowdown is all but guaranteed.

To start with, the crisis hit when the European economies were in strong cyclical positions. The avalanche of bad news, including the interbank market crisis and sharply rising oil prices, is bound to sap consumer confidence.

This undoubtedly means a less satisfactory performance, already visible, but not a fully fledged recession, at least not yet. Indeed, the impact on consumer and corporate credit remains to be seen.

Because of massive central bank interventions, banks are generally highly liquid. What else can they do with their liquidities than to lend? Of course, the deterioration of their balance sheets pushes them to be highly selective in their lending practices, so risky borrowers – some of whom are highly promising but yet untested upstarts – will be turned down, but most well established borrowers should not find it particularly harder to borrow.

In addition, the interbank market crisis does not have to go on indefinitely. In fact, it is quite surprising how long it has already lasted. After all, the crisis is the result of extraordinary caution on the part of large banks and financial institutions – which displayed an amazing willingness to absorb the highly risky subprimes – when they lend to each other.

This caution comes down to the belief that other banks are concealing large losses, surely reflecting what each one actually does. The game, it seems, is to hope for some miracle to happen and boost profits, which would avoid presenting bad news to angry shareholders. Needless to say, keeping the interbank market illiquid is the best way to make things worse for everyone.

Soon either banks will realise that the game they are playing is a losing one, or the authorities will have to step in and impose the truthful revelation of what is in the books. We seem to be nearing the time when this will happen. Indeed, already four major banks have taken their losses and recapitalised. A rapid resolution of this crisis would lift a major cloud.

There remain the more usual concerns of high oil prices and a US slowdown. These are bad news and, even though Europe is a relatively closed economy, they will exact a toll. There is better news coming from south-east Asia, which appears so far to be sailing through the raindrops. As is so often the case, the answer is not black or white. It is greyish and, so far, of a rather light tone.

  • Charles Wyplosz is professor of international economics at the Graduate Institute of International Studies, Geneva.