Strong fundamentals should allow Europe’s economies to weather the current financial turmoil, sparked by subprime mortgage lending in the United States, relatively well.
In the advanced economies, the International Monetary Fund’s (IMF) latest Regional Economic Outlook (REO) for Europe says, average GDP growth is expected to slow to 2.2 percent in 2008, down from 2.7 percent in 2007, IMF.org reported.
In the emerging economies, growth should remain robust at 5.7 percent in 2008, down from 6.3 percent in 2007. But continued problems in the credit markets constitute a key downside risk to this outlook, the REO, published on November 12, cautioned.
Subprime Fallout
A still resilient global economy, combined with generally sound macroeconomic policies and increasing trade and financial integration in Europe, has yielded a vibrant regional economy.
After years of sluggish growth, the advanced economies in Europe are expected to outpace the United States this year and next, and the top-performing European emerging economies are posting growth rates second only to developing Asia.
But continued problems in the credit markets constitute a key downside risk to the outlook for Europe, especially for its advanced economies. While the broader financial system has continued to function well, money and credit markets remain tight. There is little doubt that protracted financial turbulence would have downsides for the real economy, especially as higher-than-expected oil prices increases and euro appreciation are providing some headwind.
Despite relatively high external vulnerabilities, the financial turbulence has so far had little effect on Europe’s emerging markets because of limited reliance on interbank markets and complex financial products. But risks have also risen for this part of the region, especially for those countries that have been funding large current account imbalances with foreign bank borrowing.
In this regard, the financial turbulence may herald a healthy correction to past exuberance, bringing risk spreads closer to fundamentals, improving credit discipline, and helping to reduce external imbalances.

Uncharted Waters
The problems in the credit markets have complicated policymakers’ task of maintaining growth without overheating, especially in advanced economies. While their response has been broadly effective so far, central banks will have to continue to stand ready to provide liquidity to deal with systemic risks.
In the euro area and several other advanced economies, monetary policy has been appropriately kept on hold in view of the downside risks associated with the financial turmoil. Looking further ahead, the baseline forecast assumes that these risks will gradually dissipate, in which case a further tightening may be required. Tighter interest rates would of course need to be reconsidered if the slowdown became protracted.
In the emerging economies, inflationary pressures and external vulnerabilities could warrant further interest rate increases. In countries where monetary policy tools are either ineffective or unavailable, the tightening will need to be achieved through fiscal restraint. Strong banking supervision will be critical throughout emerging Europe.

Supervisory Gaps
The subprime lending crisis has underscored the need for financial sector reform. The losses sustained by a number of European financial institutions revealed that private and public prudential frameworks have not kept up with developments in financial innovation.
Europe’s financial supervisors will need to do a better job going forward, not least in ensuring that new financial products do not exploit gaps in prudential frameworks.
That said, financial innovation is important to Europe’s overall competitiveness and needs to be encouraged. The challenge will thus be to make prudential arrangements, financial safety nets, and crisis resolution mechanisms more effective without stifling innovation.

Fiscal Policy
Looking beyond the current turmoil, Europe faces major challenges if it is to sustain reasonably robust growth. To deal with expenditure pressures from population aging, fiscal consolidation--based on expenditure reduction--needs to return to a more ambitious track.
For several advanced economies, an added reason for reducing expenditures is that deficits remain too high to deal comfortably with eventual downturns. In Europe’s emerging economies, more fiscal consolidation is desirable to mitigate convergence-related demand pressures and insure against risks posed by the rapidly rising indebtedness of the private sector.
Fiscal consolidation should be complemented by structural reforms that can help deliver on the promise of income convergence, including measures to advance economic and financial integration.

Serbia has finally initialed a long awaited deal that could lead eventually to full membership of the European Union (EU).
As reported by Ipsnews.net, the attention is now focused on the political conditions Serbia has met, or must, to sign the ’Stabilization and Association Agreement’ (SAA) that could set it formally on the path to EU.
These conditions include the arrest of Bosnian Serb general Ratko Mladic wanted for war crimes, and a more flexible approach to Kosovo, the disputed southern province of Serbia, where the ethnic Albanian population of two million is set to declare independence.
But little attention has been given to the economic difficulties Serbia must overcome to meet EU demands. That means all that goes with the painful transition to a market economy that still hurts most families.
Deputy Prime Minister Bozidar Djelic, who initialed the SAA with EU enlargement commissioner Olli Rehn, told Serbian media that the present agreement means that “until 2011 the country will see more than 650 million euros (910 million dollars) of pre-joining funds and an additional boost to our agriculture and economy in general.“
At the same time, absolute poverty seems to have fallen. Official figures say poverty now affects some 700,000 people, compared to 2.5 million in 2000, the last year of Milosevic’s rule.
Official statistics say also that production in the revived industry has risen sevenfold on average since 2000, with a stable gross domestic product growth of 6.5 percent annually.
But such numbers mean little to most people facing high unemployment and only a slow rise in living standards after a communist economy that collapsed in the 1990s switched to capitalism from 2000.
Many Serbs have simply come to believe over decades that the state will take care of them. “We have been relieved of the burden of individual responsibility, the state did everything for us,“ Prof. Mladen Lazic at Belgrade University told IPS. “We learned how to live in socialism, not in capitalism. We are yet to learn how to leave the state of acquired helplessness most people live in.“
Over the past seven years of transition, since the fall of former leader Slobodan Milosevic, the white elephants of the former communist state have been sold, and many public enterprises privatized. The privatization is due to be completed next year.
This process has led to unemployment of about 800,000 people in a nation of 7.5 million. Recent surveys show that only 10 to 15 percent of people are satisfied with their living standards, although the real income of those who are employed has risen tenfold since 2000.
“Macroeconomic indicators mean little to ordinary people,“ sociology researcher Zoran Stojiljkovic told IPS. “Most of them still dream about self- government (the system of former Yugoslavia), when you could hold a job for life, and the salary was not related to production.
“That is why our research shows that only 15 percent of people know what capitalism is about, and know how to deal with it. Most of the rest are lost in transition--people with poor education, low material status, the elders and farmers.“
“Serbs are people of many paradoxes,“ analyst Misa Brkic told IPS. “On the one hand, they want to live well, as in pre-war times. On the other, they wait for someone else to show them how. That can take a lifetime for many.“
Recent surveys show that two-thirds of Serbs are positive about joining the EU. But only a third are ready to learn or study further to meet job demands and to change their habits.
Svetlana Mirkovic, a training manager at a leading pharmaceutical company, says that “change of working habits, and attitude towards work“ are the biggest problems she faces.
“It’s a real challenge to train people who are not positive towards change -- they see it more as a potential threat than a good opportunity,“ she told IPS. “It’s best to work with the young; with others it can be a problem.“
Transition to the market economy is one of the favorite subjects for discussion among Serbs. Many Internet blogs and sites are dedicated to it.

Dollar denial--that state of willful blindness in which bankers and central bankers claim not to be worried about America’s falling currency--seems to be ending. Now even European Central Bank Governor Jean Claude Trichet has joined the chorus of concern.
According to Todayszaman.com, when the euro was launched, the US dollar-euro exchange rate stood at $1.16 per euro. At that price, the dollar was undervalued by roughly 10 percent relative to its purchasing power parity (PPP). Initially, the dollar’s price rose, but since 2002, it has, for the most part, fallen steadily. Every day seems to bring a new low against the euro.
In the face of the dollar’s ongoing fall, policymakers have seemed paralyzed. The reasons for inaction are many, but it is difficult to avoid the impression that they are related to the current state of academic theorizing about exchange rates.
Simply put, economists believe either that nothing should be done or that nothing can be done. Their so-called “rational expectations models“ predict that exchange rates should not deviate from parity in any lasting way. Believing that they have found a way to model how currency traders think, they see no need for intervention because, save for temporary deviations, markets always get currency values right.
“Behavioral economists,“ by contrast, acknowledge that currencies can depart from parity for a long period. But they attribute this to market psychology and irrational trading, not to the attempts of currency traders to interpret changing macroeconomic fundamentals. This implies that intervention is not only unnecessary; it is ineffective: Faced with wide swings and trading volumes of $2 trillion per day, central banks are helpless to counteract traders’ irrational zeal.
But both the “rational expectations“ and the “behavioral“ models are flawed, because they seek to generate exact predictions of human behavior. Both disregard the fact that rationality depends as much on individuals’ imperfect understandings of history and society as on their motivation.
If we place “imperfect knowledge“ at the heart of economic analysis, the implications of our limited ability to predict market outcomes becomes clear. When it comes to currency markets, parity levels based on international trade are merely one of many factors that traders consider. In attempting to cope with imperfect knowledge, they are not irrational when they pay attention to other macroeconomic fundamentals and thereby bid an exchange rate away from its parity level.
In the euro’s rise against the dollar, euro bulls supposedly have been reacting to America’s current account deficit, the strong euro-zone economy, and rising euro interest rates. What is irrational about factoring in such fundamentals when trading a currency?
Of course, persistent swings from parity do not last forever. While movements in macroeconomic fundamentals may lead bulls to bid the value of a currency further from parity, doing so simultaneously fuels concern about a counter-movement back to parity--and thus capital losses--which moderates the desire to increase long positions.
Relating the riskiness of holding an open position in a currency market to the exchange rate’s divergence from parity levels suggests a novel way to think about how central banks can influence the market to limit departures from parity.
Although the exchange rate ultimately reverts back to its PPP benchmark, in a world of imperfect knowledge market participants might ignore this possibility in the near term. But if central banks regularly announced their concern about significant departures from PPP, as they do now about inflation prospects, they would heighten traders’ concern that other traders will consider it increasingly risky to hold open positions that imply further movement away from parity levels. This should moderate bulls’ willingness to increase their long positions, thereby limiting the magnitude of the swing.