Europe Economy May Stay Sick After Catching U.S. Cold (Update2)

Feb. 11 (Bloomberg) -- Europe's economy has caught the U.S.'s cold, and may be sick longer.

Persistent inflation and budget deficits may prevent policy makers in the 15 nations that share the euro from moving as aggressively as their U.S. counterparts to cut interest rates and taxes. Meanwhile, Europe's labor laws will make it harder for companies to speed a recovery in profits by reducing payrolls.

``A European downturn will take noticeably longer to run its course than the U.S. one,'' Nobel laureate Edmund Phelps, an economics professor at Columbia University in New York, said in an interview.

Next year ``might be a period of `reverse decoupling,' with the U.S. economy enjoying a sharp recovery and the euro-area economy stagnating,'' says Dario Perkins, senior European economist for ABN Amro Holding NV in London. ``A relatively inflexible economy and `sticky' inflation'' will hold Europe back, he says.

European Central Bank President Jean-Claude Trichet said twice last week that there is ``unusually high uncertainty'' about growth amid signs that Europe's resistance to the U.S. slowdown is finally wearing off.

``Risks are on the downside,'' he told reporters in Tokyo on Feb. 9 after a meeting of central bankers and finance ministers from the Group of Seven industrialized nations. The G- 7 officials said the U.S. economy may slow further, eroding global growth, and forecast no end to financial-market turmoil.

``Europe cannot go unscathed from the U.S.'s credit crisis,'' says Phelps.

Slower Growth

December retail sales in the euro region fell the most since 1995 and service industries grew in January at the slowest pace in more than four years. The European Union's statistics office will report Feb. 14 that the economy expanded 0.3 percent in the fourth quarter, less than half the pace of the previous three months, according to the median forecast of economists surveyed by Bloomberg News.

``Euro-zone growth is in trouble, and the risk of recession at some stage should not be underplayed,'' says David Brown, chief European economist at Bear Stearns International in London. He says the region will be ``very lucky'' to expand 1.5 percent this year, which would be the weakest since 2003.

Much of what ails Europe has its origins across the Atlantic. Borrowing costs for consumers and companies jumped as BNP Paribas SA and other European banks ran up losses on investments tied to U.S. mortgages. Exporters such as Heidelberg, Germany-based Heidelberger Druckmaschinen AG, the world's largest maker of printing machines, blame declines in the dollar and U.S. demand for hurting profits.

Short, Shallow Recession

Economists Jan Hatzius at Goldman Sachs Group Inc. and Richard Berner of Morgan Stanley say the U.S. economy is already in a recession, and they predict that action by policy makers will ensure it is short and shallow.

Federal Reserve Chairman Ben S. Bernanke and his colleagues have cut interest rates five times in less than five months by a total of 2.25 percentage points. Congress last week passed an economic-stimulus package worth about $168 billion.

European policy makers have been slower to administer medicine. The ECB has left its benchmark unchanged at 4 percent for eight months as inflation accelerated to the highest level in 14 years and workers sought more pay in response.

While Trichet last week signaled that he's open to cutting interest rates for the first time in almost five years, he also said he doesn't anticipate inflation will moderate until the second half of the year. Consequently, while investors increased bets on rate cuts last week, they don't expect the ECB to start easing credit before the second quarter.

Delayed Response

Trichet's ``somewhat delayed and gradual policy response'' means the euro-area economy will lag behind the U.S., growing just 1.4 percent this year and 1.6 percent in 2009, compared with 1.9 percent and 3 percent for the U.S., says Janet Henry, chief European economist at HSBC Holdings Plc in London.

Few economists yet anticipate a recession in Europe. Potential housing busts are limited to a few countries, unemployment is at a record low and demand from emerging markets offsets a decline in trade with the U.S.

Not Bad

``We are not in bad times,'' Luxembourg Finance Minister Jean-Claude Juncker said in Brussels today as he chaired a meeting of counterparts from the single currency bloc. European Commission President Jose Barroso said there is ``no rationale reason to fear recession'' in Europe.

Inflation still may not retreat fast enough for the ECB to cut rates as much as the Fed has. Price pressures persist longer in Europe than in the U.S. for several reasons. Competition among businesses is weaker, and employers have less flexibility on wages because of regulations that set minimum levels or tie worker pay to past inflation rates. German unions are still seeking above-inflation pay agreements.

The Paris-based Organization for Economic Cooperation and Development calculates that the U.S. gets three times the decline in inflation that Europe does from the same slowdown in growth below the long-term trend.

``Amid elevated risks to price stability, the ECB will likely drag its feet and not follow the Fed into rapid and decisive action,'' says Holger Schmieding, chief European economist at Bank of America Corp. in London.

Trichet is also opposed to the kind of fiscal-stimulus programs Bernanke has backed, and euro-area governments are less able to provide such a boost.

Budget Deficits

Italy and France are already running budget deficits close to the European Union's limit of 3 percent of gross domestic product. That's one of the difficulties of coming up with a coordinated fiscal response among 15 different governments.

While Spain's main parties pledge to use its budget surplus to enact tax cuts after March elections, officials in Germany express reluctance to reduce taxes after they returned their budget to balance last year.

``Budgetary positions do not look healthy enough to be of much help in many countries,'' says Michael Hume, chief European economist at Lehman Brothers Holdings Inc. in London. ``Only in Germany is there scope for major fiscal easing, but it does not have a tradition of pump-priming growth.''

European labor markets also aren't as quick to adjust as are those in the U.S. Stronger trade unions and employment- protection laws mean European companies retain more workers than they need during slowdowns. Thus they're more sluggish in rebuilding profits and hiring again after growth picks up, says Perkins at ABN Amro.

No Downsizing

``In Europe there's no downsizing, and it takes a longer time to reallocate the labor,'' Phelps says.

Perkins and Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Plc in London, look to the last slowdown for lessons about what may happen this time.

In 2001, an eight-month recession caused the U.S. economy to grow just 0.8 percent for the year. That was followed by a rebound to a 1.6 percent rate in 2002 and 2.5 percent in 2003. The euro area, by contrast, grew 1.9 percent in 2001 and then slowed below 1 percent in the next two years. The German, French and Italian economies all shrank.

``Europe may again end up losing more output than the U.S. even after the U.S. outlook looked more dire at the start,'' Cailloux says.

To contact the reporters on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net; Rich Miller in Washington at rmiller28@bloomberg.net.

To contact the editors responsible for this story: Riad Hamade at rhamade@bloomberg.net; Chris Anstey at canstey@bloomberg.net.