Stephen King: Germany is the West Ham of the world's economic league

The ECB's hair-shirt approach has forced firms to sell assets. It's like Joe Cole being sold to Chelsea

Remember the days when West Ham United were a footballing force to be reckoned with? Not too long ago, they were up there with the best: eighth in the Premiership at the end of the 1997-98 season, fifth in the following season and a creditable ninth in 1999-2000. Then it all went wrong. Down, up a bit, then rock bottom: relegated to the Nationwide First Division.

Are parts of the eurozone heading the same way? For Glen Roeder, should we read Gerhard Schröder? The latest data certainly reveal a worryingly sickly performance. Growth may have started to pick up a bit in some parts of the world - both the US and Japan surprised on the upside in the second quarter - but, sadly, the same does not apply to the eurozone. Germany has just announced its third consecutive quarter of contraction. Italy has contracted for two consecutive quarters. And, the way things are going, France is in danger of heading in the same direction.

Most economists tend to define a recession as two consecutive quarters of declining GDP so, on that basis, both Germany and Italy are now "officially" in recession. France is not far behind. They may not be the deepest recessions ever seen - the contractions have been very modest compared with earlier declines - but, nevertheless, they demonstrate that all is not well at the heart of the European economy. Like West Ham, high hopes have been followed by a rather depressing reality: the eurozone has found itself firmly at the bottom of the major economies' growth league (see table).

The weaker Europe gets, the more difficult it becomes to find a way out. Like the Hammers, there was a brief flirtation with success in the late 1990s when European companies began to believe in a bright new future. Like the Hammers, though, when the future finally arrived, Europe found itself with insufficient profits, plenty of debt and a singular reluctance to carry on spending.

Arguably, the mistakes made at West Ham were mirrored by mistakes across the eurozone. In response to a rapidly deteriorating global economic environment, the US cut interest rates and, through increased government borrowing, spent money. There may be no guarantee of success but at least there was an attempt at resuscitation. The European Central Bank only reluctantly cut interest rates and, through the Stability Pact, opted for fiscal restraint. This hair-shirt approach has forced companies to sell off assets to enable them to deal with their excessive debts. It's the equivalent of Joe Cole being sold to Chelsea. But then it becomes a lot more difficult to attract a bunch of international investors - or, for that matter, a cheering crowd - if you simply can't deliver the right results.

There, however, the similarities end. The eurozone has also suffered from external problems that have left it in an unusually vulnerable position. Specifically, this is a story about currencies - not something that is likely to be a big problem for West Ham, particularly while they remain outside the European Champions' League. The US would like a weaker dollar. A few months ago, the ECB was happy to accept a stronger euro. But, in the midst of all this bilateral excitement, someone forgot to look at what was happening elsewhere in the world.

Since the beginning of last year, the dollar's decline against its major trading partners at one point reached almost 20 per cent. Other than the Plaza Accord-inspired collapse of 40 per cent in the mid-1980s, this marks the biggest single dollar decline in the past 30 years.

Based on past experience, this really shouldn't have been a worry for Europe. Typically, the currency that took the heat when the dollar was coming down was the yen - if the dollar fell against a basket of major currencies by about 12 per cent, the decline against the yen alone could be expected to be 24 per cent. By the same token, a dollar decline of 12 per cent would be matched by a euro rally (or, in the old days, a synthetic euro rally) of less than 10 per cent.

Not this time, though. The dollar's decline has been associated with only a modest rise in the yen, up by about 14 per cent since the dollar first started to drop to its new level. The euro, though, has gone up dramatically; at one point, it was almost 40 per cent higher against the dollar. In other words, the eurozone has been cruelly exposed to a loss of competitiveness unprecedented in modern times.

This has happened, in part, because Japan chose to respond to the risk of dollar weakness whereas Europe didn't - Japan's foreign exchange reserves have risen dramatically over the past couple of years, a sure sign of heavy foreign exchange intervention, whereas the ECB chose to turn a blind eye.

There is one redeeming feature - in the past, when the Deutschemark went up, other members of the ERM struggled to keep up. Recognising this risk, markets would demand higher interest rates in France, Italy and other "untrustworthy" European countries. Nowadays, with no exchange rate risk within the eurozone, the interest rate risk is equally non-existent.

But there are other problems; in the past, when the mark was strong, other European currencies typically devalued against Germany. This option is no longer available. So, whichever way you look at it, the euro has risen by an extraordinary amount, a product of American desires for a weaker dollar, Asian desires for currency stability against the dollar and an increased European reluctance to invest abroad, reducing capital outflows and, thus, strengthening the euro. Put another way, the upside growth surprises in both the US and Japan may have come at Europe's expense.

Is this, though, a sustainable story? The obvious problem is debt, more specifically US debt. America's out-performance on growth vis-à-vis Europe is all very well but it implies a further widening of the US current account deficit - perhaps beyond 6 per cent of GDP during 2004. That, in turn, will require increasingly heavy funding from the rest of the world.

This is a bit like Chelsea's predicament last season. Desperate to keep up with the big boys, Chelsea found itself with heaps of debt. The attempted expansion was in danger of crumbling as creditors circled Chelsea Village like so many hungry wolves. So far, the US economy has managed to keep the wolves at bay - the dollar has come down but the authorities have still been able to raise the funds for expansion.

To my mind, though, it is difficult to believe that the world can continue to fund an ever-increasing US current account deficit, a clear implication of the ongoing outperformance of US domestic demand. Like West Ham, Europe may be taking the pain now but I wonder whether the US has simply deferred, rather than dealt with, its underlying economic problems. After all, even Roman Abramovich doesn't have deep enough pockets to save both Chelsea and the US economy over the next few years.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com