Europe’s economic woes may wash up on America’s shores

Europe is eco­nom­i­cally big — very big. The 17 nation euro-zone is approx­i­mately equal to the size of the U.S. econ­omy (depend­ing upon how val­u­a­tions are cal­cu­lated in terms of cur­rency con­ver­sions), and the more com­pre­hen­sive 27 nation Euro­pean Union (EU) is even big­ger still. Given the tremen­dous eco­nomic inter­de­pen­den­cies among coun­tries of the world, when an econ­omy as large as either of the above enti­ties begins to expe­ri­ence sig­nif­i­cant eco­nomic prob­lems, it is just a mat­ter of time until those dif­fi­cul­ties will be trans­mit­ted to the rest of the world.

And with­out a doubt, the euro-zone (or to a lesser degree the EU) is expe­ri­enc­ing a sig­nif­i­cant eco­nomic down­turn. While the euro-zone has not yet offi­cially been declared in reces­sion (some­times defined as two con­sec­u­tive quar­ters of GDP decline), the final quar­ter of 2011 saw the GDP fall, and few ana­lysts doubt the first quar­ter of 2012 — and per­haps much of the year — will exhibit con­tin­u­ing retrenchment.

While the prob­lems began about three years ago in Greece, the finan­cial mar­ket and real-economy crises have spread to other EU nations, par­tic­u­larly those in the south. After many years of high tax rates and high lev­els of gov­ern­ment spend­ing, deficit/debt prob­lems have become nearly impos­si­ble to accom­mo­date with their very mod­est growth rates (not to men­tion the cur­rent reces­sion­ary envi­ron­ment). As a result, both mon­e­tary and fis­cal author­i­ties in var­i­ous coun­tries have been forced into exe­cut­ing unwanted actions.

One increas­ingly sig­nif­i­cant — and very hes­i­tant — source of stim­u­lus is the Euro­pean Cen­tral Bank (ECB), the euro-zone’s equiv­a­lent of our Fed­eral Reserve Sys­tem. Over the past sev­eral months, the ECB has pumped nearly one tril­lion euros into Euro­pean finan­cial mar­kets via three-year loans to Euro­pean banks at extremely low inter­est rates. And what have the banks done with the funds? In many instances they have pur­chased the sov­er­eign debt instru­ments sold by trou­bled nations to finance their debt obligations.

So, why doesn’t the ECB just buy debt instru­ments directly from the nations involved? Because, given the ECB’s char­ter, the cur­rent ECB pres­i­dent believes they are for­bid­den from pro­vid­ing these kinds of direct loans to mem­ber nations, and so they have cho­sen this back­door method of lend­ing to trou­bled coun­tries with­out vio­lat­ing their char­ter. Sadly, the end-run is not work­ing, with finan­cial mar­kets sig­nal­ing that a one tril­lion euro injec­tion is not enough.

In recent weeks, both Spain and Italy (par­tic­u­larly the for­mer) have had trou­ble attract­ing finan­cial cap­i­tal at “rea­son­able” inter­est rates so as to pay off past investors and con­tinue attract­ing net new funds. Gen­er­ally, both coun­tries can pull off this trick so long as inter­est rates on 10-year notes remain below 6 per­cent. At times they have crossed over this line, though an auc­tion last week came in a bit below this crit­i­cal level.

Adding to the dif­fi­cul­ties of the region is the con­tin­u­ing reces­sion, since an eco­nomic down­turn tends to increase unem­ploy­ment, drive up gov­ern­ment spend­ing via auto­matic sta­bi­liz­ers, reduce gov­ern­ment rev­enues, and thereby widen the deficit. But with a wider deficit, bor­row­ing needs increase, mak­ing the coun­try less able to meet its finan­cial oblig­a­tions, and thus dri­ving up bor­row­ing costs to crip­pling levels.

So last week the Inter­na­tional Mon­e­tary Fund (IMF) said that Euro­pean nations needed to be more vig­i­lant in fight­ing deficit prob­lems while also con­tin­u­ing to fos­ter eco­nomic growth. A great sug­ges­tion if you can fig­ure out how to accom­plish these seem­ingly con­tra­dic­tory goals. The only real aid offered by the IMF was to go to its mem­ber nations and ask for more funds to be com­mit­ted to a bailout pack­age. Some nations did respond, though not the U.S., and the IMF’s lend­ing capac­ity for Euro­pean lend­ing needs rose to bet­ter than 700 bil­lion euros. Cer­tainly, a sig­nif­i­cant amount, but with the ECB hav­ing already loaned out one tril­lion euros to banks (to buy trou­bled Euro­pean sov­er­eign debt instru­ments), one has to won­der what these funds can do that ECB funds were not able to accomplish.

And how does all of this impact the U.S.? With con­tin­u­ing eco­nomic and finan­cial mar­ket tur­moil, the EU will be able to pur­chase fewer U.S. goods and ser­vices. As well, com­pa­nies heav­ily invested in the EU may place their great­est efforts there and EU direct invest­ments in the U.S. (and other coun­tries) will recede. Over time, the EU will trans­mit its eco­nomic dif­fi­cul­ties to other areas around the globe, much as the U.S. did back in the 2007–2009 time frame.

Dr. James New­ton serves as chief eco­nomic advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on Apr 24 2012. You can follow any responses to this entry through the RSS Feed. Comments can be made below.