by Simon Tilford

A year ago the prospect of the dollar falling to 1.60 against the euro would have brought on cold sweats across Europe. Yet, here we are and there is no sense of crisis. Indeed, business confidence remains strong across much of the eurozone, credit is expanding rapidly, and exports are holding up well. On the face of it, the eurozone really does seem to be shaking off the recession in the US and the steep rise in the value of the euro. A closer look, however, reveals a less rosy picture.

It is true that credit growth remains robust, but this is a backward looking indicator. A lot of these loans will already have been in the pipeline. Higher money market rates and the delayed impact of last year’s interest rate increases by the European Central Bank (ECB) will slow credit growth over the coming months. Moreover, domestic consumption is weakening across the eurozone. Crucially, German consumers remain as cautious as ever, despite employment having boomed in the country over the last two years. German retail sales were lower in February than a year earlier, with people particularly keen to avoid large purchases. The German car industry may be flourishing, but this is despite, rather than because of, what is happening in Germany: car sales were down 14 per cent year on year in March. This was an even bigger decline than in the US.

The ECB will not ride to the rescue. Despite the strength of the euro (which lowers the price of imported goods), eurozone inflation hit a record 3.5 per cent in March, over one and a half percentage points above the ECB’s inflation target of “close to but less than” 2 per cent. The strength of inflation is largely down to rising energy and food prices, but it also reflects a pick-up in “core” inflation pressures. With the ECB worried about rising wage settlements in Germany and elsewhere in the eurozone, it is very likely that there will no easing of monetary policy in the eurozone this year.

Nor can eurozone firms look to exports for support, especially if, as appears likely, the euro is set for a period of prolonged strength. The high-flying currency is already hitting exports from the Mediterranean countries hard, and will soon have a similar impact further north. There is little empirical basis for the widespread belief in Germany that demand for that country’s exports is largely unrelated to price. The strength of the global economy is important of course, but there is a close correlation between demand for German exports and the exchange rate.

Of course, there are some exporters for whom the strength of the euro is not a pressing issue. Demand for certain very specialised equipment, such as printing presses or mining machinery, probably varies little by price, because there are few makers of such equipment. Buyers expect the machine to last a long time and are hence more concerned about servicing and reliability than price. But the majority of exporters do not operate in such markets. For example, makers of white goods such as dishwashers and washing machines as well as office equipment and cars – all big German exports – operate in very price-sensitive markets.

The eurozone as a whole is certainly better placed than the US, but Europeans are too complacent about the ability of their economies to ride out the current storm. First, the sensitivity of exporters to the strength of the euro is greater than many believe. Even the eurozone economies most confident about their export prospects – Germany, the Netherlands and Finland – will experience a sharp slowdown in external demand. Second, rising inflation all but rules out cuts in eurozone interest rates in 2008.

Simon Tilford is chief economist at the Centre for European Reform.