Last updated: September 06. 2013 9:56PM - 78 Views

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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.

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