The global financial crisis: recession bites into Western Europe

Western Europe is among the regions worst hit by the 2008 global financial crisis, with almost all major economies facing recession in 2008-2009. Unemployment, consumption and exports are set to deteriorate. Inflation is easing to the benefit of consumers as the world economy slows, yet the risk of deflation (a decrease in price levels) is a growing concern.

A positive sign has been governments’ ability to coordinate monetary and fiscal policies in response to the crisis, despite the region’s political and economic diversity. Western Europe is expected to return to growth in 2010.

Key points

  • The global financial crisis, which started in 2007 with the collapse of the US sub-prime mortgage sector, affected Western Europe’s financial systems through its exposure to foreign financial assets with high levels of risk. As conditions deteriorated rapidly in September-October 2008, bank failures became a dangerous possibility, requiring government intervention and bail-outs;
  • Troubles in the financial sector spread quickly to other parts of the economy. Countries with falling housing markets, notably the UK, Ireland and Spain, are expected to suffer more than others;
  • Faced with recession, rising unemployment, falling housing markets and difficulty in obtaining credit, consumers are cutting spending. This will have a dampening effect on domestic output and exports as most Western European trade is conducted within the region;
  • A positive effect of the slowdown has been the easing of inflation falling in the eurozone from a record high of 4.0% in July 2008 to 2.1% in November 2008. Yet some analysts fear that in 2009 inflation could reverse into deflation i.e. a persistent decrease in price levels, which could aggravate the recession;
  • In response to the crisis, European governments have demonstrated an ability to coordinate monetary and fiscal policies, despite considerable differences. Coordination could prove vital to return Western Europe to economic recovery in 2010.

Background

Western Europe proved especially vulnerable to the 2008 global financial crisis:

  • Finance and real estate typically make up between a fifth and a third of GDP of Western European economies. The sector employed an average 12.8% of the employed population in Western Europe in 2007. Thus, financial losses and layoffs had a considerable impact on the region’s economy;
  • Due to the crisis in the financial sector, consumers and businesses are having difficulties obtaining credit and so demand and investments are softening. In countries with falling housing markets, such as the UK, Spain and Ireland, difficulties in obtaining credit reinforce the downward trend of housing prices;
  • The damage to the real economy was almost immediate. The region’s major economies, Germany, UK, Italy, and Spain contracted in Q3 2008, with France growing by a mere quarterly 0.1%. Most major economies in the region are expected to enter recession in 2008-2009.
Finance, insurance, real estate and business services as share of GDP and employment: 2007

Source: Euromonitor International from International Labour Organisation/national statistics.

European response to the crisis

Western European governments’ ability to coordinate their responses to the crisis is a positive sign:

  • After initial confusion in October 2008, governments in Spain, Germany, Switzerland and other countries followed the UK’s lead to recapitalise banks in order to prevent a financial meltdown;
  • Interest rates have been slashed across the continent with the Bank of England lowering its rate from 5.0% in September 2008 to 2.0% in November 2008. Similar cuts were made by the European Central Bank and Sweden’s central bank;
  • A coordinated fiscal stimulus was proposed by the European Commission in December 2008 amounting to €200 billion, mostly to be implemented through national budgets. Stimulus measures vary between member states. Whereas the UK chose to cut taxes to encourage consumption, Germany indicated that it will focus on investments in industry and infrastructure;
  • However, the proposed EU stimulus is much smaller than in the USA, where the stimulus package is expected to exceed US$500 billion or China’s stimulus package of US$586 billion. Coordinated EU action and intervention may prove necessary to prevent further deterioration.

Consumer confidence plummets

Consumption is falling as consumers tighten their belts:

  • Unemployment in the eurozone rose to 7.7% in October 2008, compared with 7.3% a year earlier. Spain was worst hit with 12.5% unemployment. The UK had in November 2008 the sharpest rise in unemployment in 16 years to 5.8%;
  • As consumers fear job losses, they reign in spending, especially on discretionary purchases. In the UK consumer expenditure fell by 0.2% in the third quarter 2008 and in France consumer expenditure fell by a monthly 0.4% in October 2008;
  • Consumers with high levels of household debt are more exposed to the recession, as job losses could result in defaulting on mortgages or other loans. Countries which went through housing bubbles typically have high levels of consumer indebtedness;
  • Consumer confidence has fallen sharply as Western European consumers brace themselves for a recession which could be the worst in decades. Between December 2007 and November 2008, the consumer confidence indicator fell in the UK from -5.0 in to -26.8 in; in France from -9.8 to -29.3, and in Germany from 2.1 to -14.7. Similar worsening in consumer confidence was recorded throughout the continent;
Monthly consumer confidence in the UK, Italy, France and Germany: 2007-2008

Source: EurostatNote: The consumer confidence indicator refers to the Financial situation over the next 12 months, General economic situation over the next 12 months, Unemployment expectations over the next 12 months and Savings over the next 12 months. The figures are the arithmetic average of these balances.

Exports weaken

Softening consumer demand will affect exports as most Western European trade is conducted within the region:

  • Western European trade is mostly conducted within the region with 80.0% of exports destined to European countries in 2007. 7.6% of exports were destined to North America and Australasia, which are also facing downturns;
  • Some economies are highly dependant on exports. In 2007, exports as a share of GDP amounted to 61.3% in the Netherlands, 40.0% in Germany, and 37.2% in Sweden. France, Italy, Spain and the UK were far less dependant on exports, which contributed less than a quarter of their GDP.

Inflation or deflation?

As a result of the downturn, inflation is easing across Western Europe. This is a welcome development but some fear that falling inflation could become deflation, i.e. a persistent decrease in price levels. Deflation could have dire consequences:

  • Inflation in the eurozone eased from 4.0% in July 2008 to 2.1% in November 2008, as a result of falling global commodity prices and softening consumer demand. The receding threat of inflation enables central banks to lower interest rates to stimulate the economy. Consumers benefit directly from the slowdown of inflation as their purchasing power is sustained;
  • Yet some analysts fear that falling inflation could become deflation, that is, a sustained fall in the price of goods and services. Deflation could have a negative impact on the economy. When prices fall, consumers defer purchases in the hope for cheaper prices; similarly, businesses and investors hoard money rather than spend or invest it. This in turn reduces demand, causing prices to fall further and aggravating recession. While the chances for deflation in 2009 remain low, this potential is a major concern.

Recession will be harder for some countries

While virtually the entire region is facing recession, some countries are expected to fare worse:

  • The eurozone officially sunk into technical recession in Q2 and Q3 2008, as two of its biggest economies, Germany and Italy, shrank for two consecutive quarters. Sweden and Ireland have also slipped into ‘technical recession’ in 2008 and Spain and the UK are expected to enter technical recession in the last quarter of 2008;
  • The UK is expected to be among the worst hit by the crisis, mainly due to its bursting housing bubble, high household debt, a large government budget deficit and overdependence on the troubled financial sector. The UK’s problems have been exacerbated in Q4 2008 by the depreciation of the Sterling. The currency depreciation increases the price of imports, thus burdening consumers and businesses who are already suffering because of the recession. The UK economy is expected to shrink by -1.3% in 2009;
  • Germany’s economy, while in ‘technical recession’ after shrinking -0.4% in Q2 2008 and -0.5% in Q3 2008, remained less troubled by the mortgage crisis and consumer confidence is higher than in other economies. Yet Germany’s dependence on exports puts it in a weak position and its economy is expected to contract by -0.8% in 2009;
  • France has managed to escape a technical recession so far, as consumer expenditure and business investments remained strong in Q3 2008 and propelled the economy to growth of 0.1%. However, the French economy is slowing and expected to contract by -0.5% in 2009;
  • Turkey is perhaps in the best position to escape recession in 2009. Turkey is an emerging economy so its less developed financial system and reforms since its 2001 crisis have prevented it feeling the impact as severely as other Western European countries. Turkey’s demographic profile is considerably younger than other countries in the region and this supports consumption. Turkey is expected to grow by 3.0-3.5% in real terms in 2009.
  • In November 2008, the IMF slashed growth predictions for all developed economies. All major economies in Western Europe are facing a recession, while the UK is expected to fare worst by shrinking -1.3% in 2009. France is expected to contract by -0.5%, Germany by -0.8%, Italy by -0.6% and Spain by -0.7%;
  • Job losses are expected to be severe. In the UK it is estimated that unemployment could rise to 9.0% by 2010 from 5.8% in 2008;
  • A coordinated Western European fiscal stimulus could prove vital for economic recovery. In November 2008 the UK put forward a stimulus package of £20 billion and Germany, the region’s biggest economy, announced a €23 billion package. Many, however, see the German stimulus as insufficient and Germany indicated more steps could be announced in January 2009;
  • Western Europe is expected to emerge from the crisis and return to growth in 2010. The bursting of the housing market is expected to recover slowly and more painfully in the UK, Spain and Ireland.