U.S. Still Struggling, Paulson Warns EU; European Economy Looks To Be Headed For Similar Slump

Stephen Castle contributed reporting in Paris.

*As Treasury Secretary Henry Paulson Jr. travels through Europe this week, he wants to reassure jittery audiences that the United States will right its economy and its financial markets.

But with both sides of the Atlantic now suffering from a similar combination of sagging growth, rising inflation and shaky banks, Paulson's visit is turning into a case of misery loves company.

''There's no doubt that the second quarter will be a tough quarter,'' Paulson said during an interview after meeting with the president of the European Central Bank, Jean-Claude Trichet. ''There's no doubt in any of our minds that the high oil prices are going to have an impact.''

The meeting in Frankfurt came on a day when the European economy, which had recently been more resilient than that of the United States, began showing signs of an American-style slump.

Manufacturing activity in the 15 countries that use the euro shrank in June for the first time in three years, according to an influential survey of purchasing managers released Tuesday.

''I've never been one to accept the decoupling theory,'' Paulson said, referring to the idea Europe was immune to a malaise in the United States. ''In a global world, we're all interrelated.''

A weaker Europe has implications for the United States, Paulson said, because the United States has benefited from buoyant economic conditions overseas, in particular through exports.

Now, he said, emerging countries would provide the biggest lift to the global economy. Citing Russia, which he visited Monday, Paulson said that it and other nations with similar economic prospects were still growing robustly, though they, too, are grappling with rising fuel and food prices.

Fears of an inflationary spiral have prompted the European Central Bank to signal that it will raise interest rates this week. Trichet, has come under intense pressure from European leaders not to tighten credit at a time of weakening economic growth. But that is not expected to deter the bank.

Higher rates are likely to drive the euro up against the dollar because, with the Federal Reserve so far resisting a rate increase, it would widen the disparity in borrowing costs between Europe, where the ECB now has a benchmark rate at 4 percent, and the United States, where the Fed's base rate is 2 percent.

Paulson reaffirmed the importance of a strong dollar on his trip, which is scheduled to end Thursday in London.

But he declined to comment on the divergence between the Fed and the European Central Bank, saying he liked independent central banks. ''Whether it is Ben Bernanke or Jean-Claude Trichet, I relish that,'' he said.

European leaders have not been so shy.

President Nicolas Sarkozy used France's new status as the rotating president of the European Union to deliver a fresh warning to the bank not to imperil European growth with a rate increase.

''The ECB must ask itself about economic growth in Europe and not just about inflation,'' Sarkozy said on the France 3 television network Monday evening. ''You can double, triple interest rates and that will not bring a decrease in the price of a barrel of Brent.''

Even more significantly, the German finance minister, Peer Steinbrück, reiterated concerns he raised earlier about a rate increase. Unlike Sarkozy, who is a regular critic of the central bank, German officials are normally scrupulous about not meddling in monetary policy.

''The ECB should consider which effects an interest rate rise would have on economic growth,'' Steinbrück said Tuesday at the stock exchange in Frankfurt, according to Reuters.

The European Central Bank has proven resolute in the face of such pressure, and economists expect it to lift rates to 4.25 percent on Thursday, when its governing board is scheduled to meet. The question, given the record-setting pace of inflation, is whether it will stop there, or embark on a series of increases.

Inflation is already at 4 percent, double the 2 percent threshold set by the bank. With oil prices continuing to rise, some economists expect it to peak at 4.2 percent in August.

''If corporations are squeezed between rising oil prices and higher borrowing costs, that would be devastating,'' said Holger Schmieding, an economist at Bank of America in London. ''This horror scenario, which I wouldn't have believed a month ago, now seems more likely.''

The latest economic data paint a picture of gloom across much of the Continent, with manufacturing activity contracting in France, Italy, and Austria. The contraction is particularly dramatic in Spain and Ireland, where a collapse in the housing markets has aggravated the general malaise.

But Germany, the largest economy in Europe, reported a modest activity expansion, as well as a rebound in retail sales and a further drop in unemployment. At 7.8 percent, the jobless rate is the lowest since August 1992.

Paulson singled out these divergences as an issue for Europe's politicians and central bankers.

''The challenge they have is that Europe is not a homogeneous group of places,'' he said. ''In Germany, although the mood has turned down a bit, you've got a much stronger situation than in Spain or Ireland.''

German banks, Paulson noted, were facing some of the same fallout from the credit crisis as those in the United States. He said he had discussed financial market regulation with Trichet as well as Angela Merkel, the German chancellor, whom he met earlier Tuesday in Berlin.

Paulson is expected to elaborate on his proposals for stabilizing the financial system in a speech Wednesday in London.

Copyright 2008 International Herald Tribune