Europe's Slump Settles In

From his effice 32 stories above Frankfurt, Hilmar Kopper's view of Germany's physical and economic landscape is unequaled. But Deutsche Bank's affable chief executive has a hard time glimpsing the sustained German economic upturn that Europe and the global economy are desperate to find. "The good news," he says of Germany's worst recession in 45 years, "is we've hit bottom. The bad news is we're going to stay there for some time."

That's exactly the kind of stalemate Europe's policymakers tried all summer to prevent. Six weeks ago, it seemed the European community had hammered out a solution to its recessionary woes. An agreement to allow wider currency swings inside the European Monetary System would let France and other countries lower interest rates without waiting for the go-ahead from Germany's inflation-obsessed Bundesbank. Policy- makers figured the German central bank, freed from its obligation to prop up the franc and other currencies, would get its monetary house in order and push through deep rate cuts, too.

But as autumn begins, the Continent still faces the threat of more currency turmoil and an economic stalemate. True, the Bundesbank surprised markets by cutting its key discount rate by half a percent on Sept. 9, to 6.25%. But around Europe, governments are refusing to move any faster than the German central bank to restore growth--even though they have every reason to cut interest rates fast and boost business activity. Earnings at such corporate giants as Renault have plunged. Unemployment has reached 11.7% in France, 7.5% in Germany, and 10.5% in Italy.

HOW BAD? But this recession is unlike anything postwar Europe has seen. Forced to counter the hugely underestimated costs of unification, the Bundesbank is stubbornly trying to slash Germany's 4% inflation in half. After its latest rate cut, many analysts believe it will be some time before the Bundesbank takes out the hatchet again. For one thing, says one central banker, the Bundesbank is still struggling "with a seeming inability to control their money supply," a key determinant of further interest rate cuts. And the upcoming change of presidency at the Bundesbank on Oct. 1, when hard-line outgoing President Helmut Schlesinger retires, may lead the Bundesbank to tread cautiously on rate-cutting for fear of leading markets to believe it has gone soft on inflation.

This monetary quandary effectively deprives Europe of the leadership that Germany traditionally assumed in recoveries. Abandoning the straitjacket of fixed exchange rates was supposed to give other countries the chance to slash rates and turn things around themselves. But from Paris to Brussels to Madrid, there's scant evidence that the former prisoners of German monetary policy are using their freedom to cut rates, devalue currencies, and spur growth. France didn't even match the Bundesbank's Sept. 9 cut with a reduction of its key intervention rate.

In Belgium, officials worry that further devaluation will bring inflation roaring back. In France, high-ranking functionaries want to avoid discrediting the franc fort policy. Finance ministers everywhere fear that a rate cut here and a rate cut there could rapidly spiral into a downward cycle of devaluations that would bury any hopes for stable exchange rates. In that scenario, only Germany would be left with high interest rates and a strong currency. That would continue to hurt German exports badly and threaten any European recovery.

What a mess. The most optimistic investors and executives think the central banks can slowly but steadily lower interest rates and nurture the rebound that some businesses started to feel in the first half. Interest-rate cuts earlier this year generally boosted financial-services companies across Europe and closed the chapter on Sweden's severe banking crisis. British retailer W.H. Smith Group logged a 5.3% hike in pretax profits that was higher than expected. Philips Electronics showed a 48% jump in second-quarter net earnings because of tighter financial management and stronger results in semiconductors and medical systems.

INTENSE PRESSURE. But the pressure of overvalued currencies on exporters remains intense. In Belgium, "There has been little impact so far" from the EC's latest currency solution, complains Erik DeJonghe, chief operating officer of custom-video-display maker Barco. Despite a 4% devaluation of the Belgian franc since the Aug. 2 currency-rescue plan, he says, "when you sell 90% of your products as export, we're still behind."

DeJonghe's voice is just one in a rising chorus of business leaders, currency traders, and economists pressing the Belgian government to drop its policy of shadowing the mark. In France, unions and growing numbers of businessmen figure the franc can spare some prestige if it means additional economic growth. "The consumer is not spending, but putting his money in a woolen sock," complains Peugeot Chairman Jacques Calvet, who wants a cut in interest rates to stimulate consumption.

Without some break in the tension, Europe could easily be heading for another round of currency turmoil as traders target governments that this time won't be able to call on other EC central banks to prop up currencies. With such uncertainty, no wonder that Frankfurt's recent bourse rally has shown signs of fizzling. Still, if a stock market correction is all the turmoil Europe endures in the coming season, EC leaders will breathe a sigh of relief.

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