Europe’s troubling new normal

Still, Europe is by no means out of the running. It has been hard even for rootless cosmopolitans like me to focus on Europe’s woes while we have our own freak show happening here, but things are going amazingly wrong there. The refugee crisis tops the list, probably followed by the risk of Britain’s exit from the European Union. But the economic woes of the eurozone are still with us. There was a bit of a false dawn recently, as overall growth on the Continent finally returned in 2014-15 and the risk of deflation seemed to recede.

But the economics analysis site Eurointelligence recently pointed out that core inflation seems firmly stuck below 1%, and Gavyn Davies at The Financial Times reported in late February that “nowcasting” models show a sharp slowdown on the Continent.

What’s going on? Basically, “morning in euroland,” such as it was, reflected one-time developments that are now in the rearview mirror. First, there was the stabilization of financial markets after European Central Bank President Mario Draghi declared that the bank was ready to do “whatever it takes” to preserve the euro. Then there was the end of ever-intensifying austerity, which removed a big drag on growth. Finally, there was a boost from the weakening of the euro (which I would attribute to market perception that Europe will stay weak indefinitely).

All that is now past and Europe can return to its normal state - which sure looks like secular stagnation.

What Happened to the Great Divergence?

That’s the title of a very interesting speech delivered recently by Lael Brainard, a member of the Federal Reserve’s Board of Governors who has been warning for a while that international finance - the importation of overseas weaknesses via the strong dollar, in particular - made the case for interest rate hikes in the United States very dubious.

Now she has expanded on that theme in her speech: “Beginning in 2014, we saw confident predictions of a coming strong divergence in monetary policy among the major economies. To date, there has been less policy divergence in reality than had been predicted. This observation raises the question of whether there may be limits on policy divergence in current circumstances. Such limits might reflect common forces buffeting economies around the world or the powerful transmission of shocks across borders through exchange rate and other financial channels that may have the effect of front-running monetary policy adjustments in the vicinity of the zero lower bound. Put differently, predictions that U.S. monetary policy would chart a notably divergent path have been tempered by powerful crosscurrents from abroad.”

As I understand Ms. Brainard’s argument, it’s fairly close to what I was saying a year ago when I wrote: “The U.S. economy reaps the bulk of the gains from rising demand relative to other countries if and only if that relative rise is perceived by markets as temporary. If it’s seen as permanent - if, say, investors see strong U.S. demand, but Europe stuck in secular stagnation - we should expect a strong dollar to undo a lot of the gains.”

In a world still awash in desired savings with no place to go, it’s really hard for any one economy to boom while the rest remain in stagnation.