Brexit, Italy, trade: Risks piling up for Europe's economy

AP

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An aircraft flies over the bank buildings and the television tower before sunrise in Frankfurt, Germany, Monday, Nov. 12, 2018. (AP Photo/Michael Probst)

FRANKFURT, Germany (AP) Europe's five-year economic expansion is facing a mid-life crisis as it copes with potential debt troubles in Italy, a U.S.-China trade war and the risk of a disorderly British exit from the European Union.

How those risks play out will decide whether the economic upswing that began in early 2013 and has created 9.5 million more jobs ages gracefully for several more years or meets an early demise.

The economy of the 19 countries that use the euro stumbled in July-September, when quarterly growth halved to 0.2 percent. Some see that as a natural slowdown after much stronger, trade-fueled expansion of 0.7 percent at the end of last year.

But worries rose this week after new data showed Germany's economy, the currency union's largest, shrank 0.2 percent in the third quarter. Much of the fall can be attributed to delays faced by major automakers like Daimler and Volkswagen in getting cars certified under new emissions rules. However, a slowdown in exports also played a role, raising questions of how much more pain the U.S. trade war and uncertainties like Brexit could create for Europe's many exporters.

Holger Schmieding, chief economist at Berenberg Bank in London, says that surveys of business activity "point to a further loss of momentum in late 2018."

A key risk is the conflict between Italy's populist government, which wants to spend more on social welfare, and the European Union's executive Commission, which is demanding Italy lower its budget deficit under the rules that go with belonging to the euro. The danger is that if the Italian government persists in running larger deficits, its borrowing costs rise to unsustainable levels and the country is unable to roll over its debt at an affordable interest rate. Debt costs spiked in 2011 but fell after a reform-minded government took office and the European Central Bank promised to backstop the debt of countries that are facing high debt costs but show a willingness to correct their finances.

Italy is "the most serious risk facing the eurozone," Schmieding says.

He says an Italian financial crisis could erupt next year, but that it is more likely that the country would muddle through until a new recession perhaps in 2021 exposes the weaknesses in the economy.

Then there's Brexit. European officials are waiting to see if Prime Minister Theresa May can push through a deal on an orderly exit from the European Union. If the deal is rejected in parliament, in a vote that could be held in December, Britain could wind up leaving in March 2019 without a settled trade relationship with its biggest trading partner, the EU. That could reinstate tariffs and border checks on trade worth hundreds of billions of dollars.

Add to that the trade conflict between the U.S. and China. President Donald Trump has imposed new import taxes on Chinese goods, and the Chinese have responded with tariffs of their own. Europe is getting sideswiped by the U.S.-China collision as global trade slows.

"It is not our base-case scenario, but a fully-fledged trade war could obviously and easily push the eurozone economy toward the brink of recession," said economist Carsten Brzeski at ING Germany.

It's not as if things are falling apart. Unemployment, now at 8.1 percent, continues to fall from its 2013 peak above 12 percent as the eurozone slowly heals from a debt crisis that threatened to break it up in 2011-2012. Despite its woes, the auto industry remains solidly profitable, with major employers like Volkswagen, Daimler, BMW, PSA Group, and Fiat Chrysler enjoying steady profits in an auto market that grew 2.9 percent in the first half of the year ahead of the certification bottlenecks as consumers shelled out for new SUVs.

But none of that has stopped speculation about the future path of the European economy, especially with global trade slowing.

European Central Bank President Draghi said the bank was sticking with its plan to phase out its bond purchase stimulus program at year-end. The purchases are a way of pushing newly created money into the banking system, and, it is hoped, the wider economy. But he indicated that the bank could postpone a first interest rate increase, currently expected no earlier than September 2019, if things take a turn for the worse.

"There is certainly no reason why the expansion in the euro area should abruptly come to an end," Draghi said Friday in a speech in Frankfurt. He noted that the eurozone expansion is still "relatively short in length" at 22 quarters, compared to the average of 31 quarters for the five periods of growth since 1975.

Brzeski, the economist, said a downturn could find the ECB with few tools left to stimulate the economy. Interest rates are already at record lows, and the bank is phasing out its bond purchase stimulus in part because it is running out of eligible assets to buy.

History suggests that upswings keep going until they hit an unexpected obstacle, he said. Examples range from the 1974 crisis over the Arab oil embargo and the high inflation period of the late 1970s and early 1980s to the financial crisis of 2008 and the eurozone debt crisis that erupted in Greece in 2009.

It all proves, he said, that "eurozone recoveries don't die of old age they always need a special trigger."

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