Europe: From Bad to Worse

War fears are weakening the Continent's already fragile economy

Taillevent has consistently turned a profit since it was founded in Paris' fashionable 8th Arrondissement in 1946. But the elegant three-star restaurant frequented by Woody Allen, Catherine Deneuve, and Francis Ford Coppola barely broke even in January. This month, it likely will post its first loss. Owner Jean-Claude Vrinat says fear of war with Iraq is keeping tourists at home, while local businesspeople are eating out less. "Executives have lost their spirit," he gripes.

It's the same sad story across the euro zone. In every country, in just about every sector of the economy, managers complain that demand is falling, political uncertainty is rising, and profits are plunging. After a dismal 2001 and a sluggish 2002, the captains of Continental industry had hoped 2003 would be the year of recovery. Instead, things seem to be going from bad to worse. Oil prices are rising; the euro is soaring; government budget woes are mounting; and the dispute over how to disarm Iraq is bedeviling relations with the U.S. Rijkman W.J. Groenink, CEO of large Dutch bank ABN Amro (ABN ), says he doubts there is any chance of "a meaningful recovery" this year.

Such pessimism is prompting private-sector and government economists to slash their 2003 growth forecasts. The euro zone will be lucky to expand by 1%, they now predict. Only two months ago, they were estimating growth of 1.5% or more. Meanwhile, Germany will probably slip into its second recession in two years this quarter. When the Bank of England unexpectedly cut British interest rates to a 48-year low of 3.75% on Feb. 6, it cited the weakness of the Continental economy -- Britain's biggest trading partner -- as a key reason.

You don't need to go further than a neighborhood car dealership to see just how bad things are. New auto sales in Western Europe plunged by 7% last month compared with January of 2002, as customers cut back on big-ticket purchases in the face of soaring unemployment, rising income taxes and social security levies, and growing war fears. Germany's jobless rate topped 11% in January. Manufacturers now forecast that European car sales will fall 2% below last year's level. PSA Peugeot Citroen Chairman Jean-Martin Folz warns that "in an absolute nightmare scenario" -- a prolonged war in Iraq coupled with terrorist attacks -- the market could contract by up to 15%.

The outlook is just as gloomy on the travel and tourism front. By the end of 2002, European airlines were finally beginning to recover their equilibrium after the September 11 attack on the U.S. sent passenger numbers and earnings plummeting. Now, bookings are falling again. Germany's Lufthansa fears they could slump by 20% if hostilities break out. To make matters worse, oil prices -- already $7 a barrel more than the $25 most corporate planners assumed would be the average for 2003 -- keep going up. The U.S. Energy Dept. predicts they could rise 18% this year. Although the stronger euro partly protects the airlines, rising fuel costs will nevertheless translate into an average 5.2% increase in costs. "The situation is very fragile," says David Henderson, spokesman of the Brussels-based Association of European Airlines.

Industry's problems are hitting banks hard. On Feb. 13, ABN-Amro, one of Europe's strongest financial institutions, increased its loan-loss provisions by 17%. Corporate and personal insolvencies in Europe jumped 21%, to 240,000, in 2002, and a big increase is expected this year. Meanwhile, plunging equity markets are mauling insurers. Henri de Castries, CEO of AXA (AXA ), the large French underwriter, fears Europe could slip into Japan-style deflation. "The situation we have now of very depressed markets with very low interest rates is very, very unusual," he says.

European policymakers blame uncertainty over Iraq for the Continent's poor prospects. German Labor & Economics Minister Wolfgang Clement told Parliament on Feb. 14 that "the best economic program would be for this war not to happen." Says Belgian Prime Minister Guy Verhofstadt: "There is money. There are ideas. The only thing we need for recovery is stability in world affairs."

But even if there isn't a protracted war or stand-off -- a big "if" -- it is wishful thinking to imagine that the European economy would revive quickly. There are plenty of other brakes on economic growth besides fears of war.

Take the strong euro. After rising almost 18% in 2002, it's hovering around $1.08. Currency experts say that, whatever happens in the Gulf, the euro could reach $1.20 or more by the end of the year as investors continue to react to the $500 billion-a-year U.S. current-account deficit. That would cut the price of euro-zone imports. But it would make European goods less competitive abroad. Analysts calculate that a sustained 10% rise in the euro over today's level would knock almost a percentage point off growth over a year. The currency's rise has already wiped out the benefits of the 50-basis-point rate cut that the European Central Bank made on Dec. 5.

Some euro zone exporters are already feeling the pinch. Hannes Hesse, head of the German Engineering Federation, says Buderus, FAG Kugelfischer, and other engineering firms saw their foreign orders plunge by an average 19% in December. European carmakers are losing share to Japanese manufacturers whose competitiveness has increased in part because of the strong euro.

It all adds up to what one leading European financier calls "a toxic cocktail" that will keep euro zone growth well below the 2.8% forecast for the U.S. The U.S. economy has problems, but it is far more flexible. And it benefits from lower interest rates, a weakening dollar, and the prospect of big tax cuts. Even if the European Central Bank cuts rates to 2% this year, Europe won't be able to grow that fast.

Restaurateur Vrinat blames Europe's problems on inflexible labor laws, high taxes, and punitive social security charges. There's little chance that those problems will be tackled anytime soon, at least in the big countries. Maybe it's time for Taillevent to trot out the recession special.

By David Fairlamb in Frankfurt, with John Rossant and Christina Passariello in Paris, Kerry Capell in London, and Jack Ewing in Frankfurt

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