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October 11, 2002, 9:00 a.m. Eurozone Alert Second-recession signals abound.

he Eurozone economy is dangerously close to a second recession — and it needs multiple fixes in order to achieve normal growth. These include sweeping labor reform, lower tax rates, smaller government, lower interest rates, and a new monetary policy to replace the backward-looking inflation target and euro instability of recent years.

The only growth in the lackluster Eurozone economy in the first half of 2002 came from stronger exports — much of which was to the U.S. — and that export growth is fading now, with no offsetting increase from the domestic economy in sight.

Global recovery from the 2001 recession — due to weakness in productive investment in much of the world — will be very shallow. But the sluggish global rebound really translates into a sub-par Eurozone recovery. Eurozone growth will lag U.S. growth due to eurosclerosis, a combination of structural and macroeconomic impediments.

One factor holding back Eurozone growth is the overly tight monetary policy of the European Central Bank. The stickiness of inflation may keep the ECB from easing this year. If so, domestic demand (particularly, investment) will continue to languish.

More, the continued productivity-growth differential in favor of the U.S. should lead to a general appreciation of the dollar against the euro.

The Eurozone's slowdown has been most evident in the manufacturing sector. In September, the Eurozone purchasing managers' index (PMI) of manufacturing activity fell to 48.9 from 50.8 the previous month. This was the first retreat below 50 since February 2002, and signals contraction in the sector.

In particular, the German PMI index exhibited the biggest decline in September, falling below the critical 50 level in both August and September.

So, what can be done? Given the dormant state of domestic demand, it is clear that Eurozone monetary policy is too tight. The ECB's relatively modest response to last year's global recession has been insufficient to generate the domestic-demand growth required for a sustained Eurozone economic recovery.

Nonetheless, the ECB continues to be focused on fighting last year's inflation, since the rate remains at or above the top of the ECB's desired range (0% to 2%). Eurozone inflation measures have been elevated by the rise in oil prices in 2002, the prevalence of government-administered prices, and the introduction of the physical euro.

Recent readings on key economic indicators show that the Eurozone economy is currently softer than it was prior to previous ECB rate cuts — in April 1999 and May 2001. The current state of the economy calls for a rate cut, but current inflation is higher than at previous cuts, a condition that may make the ECB less willing to act now. And no action may translate to no turnaround.

— Mr. Malpass is the Chief International Economist for Bear Stearns.