The Eurozone Crisis: Lessons for America

The Eurozone is in crisis and it is no longer limited to the basket cases that we have frequently discussed.  In fact, several days ago Moody’s stripped France of its AAA credit rating citing deteriorating economic prospects, the long‑standing rigidities of its labor, goods and services market, and exposure to peripheral Europe.  And it could get worse.  The Wall Street Journal points out that Moody’s also issued a statement that it would downgrade the rating further in the event of an additional material deterioration in France’s economic prospects.

Of course the French claim that the downgrade does not call into question “the economic fundamentals of our country.”  We would disagree.  Let’s compare, as The Journal did, a previous socialist government.  France, while Mitterrand was in office, had a national debt amounting to 22% of GDP; it is now four times greater than that.  In the intervening years, France’s economy has grown, but President Francois Hollande is now ignoring the supposed growth killing effects of the spending cuts being demanded of him by the European Union.  Of course, if spending beyond one’s means could stimulate an economy, France would not be looking over the border with envy at Germany’s growth, debt and unemployment figures.

There is an additional problem.  Germany is drifting toward recession.  The slump that began in Greece and spread to other peripheral countries in the single currency bloc has spread to the core with the regions two largest economies, France and Germany, now heading for recession.  It is the worst reading since June 2009, and it indicates that the recession across the region is deepening.  The slump in Germany is extraordinarily worrying.  The Eurozone has slid further into decline for the start of the 4^th quarter, says Chris Williamson, chief economist at Markit.  “Even Germany is not immune and it is very disappointing; it is a depressing scenario, as things are getting worse.”  The rate of decline is even more brutal in France.  The economy is plunging deeper into the mire under socialist President Francois Hollande.

The European Central Bank, basically following the lead of its strongest economy, has financed Greece and is now about to give the country yet a further stay of execution on repayment of their debt.  The Organization for Economic Cooperation and Development warned just last week that gross domestic product will decline by 0.1% in the Eurozone, having previously expected GDP to grow by 0.9%.  A 0.1% decline is even worse than it seems because if Germany were factored out, you probably would have a 1% to 2% decline across the board.  Unemployment in the region is forecast to rise to 11.9%.

Then, as if to punctuate the seriousness of the Eurozone’s financial problems, Moody’s, this weekend, went a step further and downgraded, the European Stability Mechanism (ESM) itself, which is Europe’s primary bailout fund with a lending capacity of 500 billion Euros.  The European Financial Stability Facility, which backed the earlier bailouts of Greece, Portugal and Ireland and which was to be replaced by the ESM was simultaneously downgraded by the rating agency.  If this all sounds confusing, it really isn’t.  Next to Germany, France is the largest contributor to these bailout efforts, and Moody’s is simply recognizing the high correlation between the creditworthiness of the bailout funds and that of the largest contributors to them.  A worldwide (and unspoken) new definition of “safe harbor” seems to be evolving.  They are simply become least worst places for investors to channel resources for sovereign debt.

“The Euro area, which is witnessing significant fragmentation pressures, could be in danger,” wrote Pier Carlo Padoan, OECD’s chief economist.  The danger of a messy end to the region’s debt crisis is pushing up yields on sovereign debt, hurting Europe’s banks and driving fears that a country could be forced to leave the continent’s monetary union.  On top of all of this, Spain, which has become the latest basket case in the European Union, is now facing a political crisis.  The Catalan region is threatening to secede from Spain.  Catalonia is the largest economy inside Spain, the most profitable and has long dreamed of separation; and the Eurozone crisis has only pressed it along.

Spain may have gotten a break last week when the principal proponent of secession was forced into a coalition government and so he may not be strong enough to carry the referendum, which is scheduled for this weekend.  But if, in fact, a referendum, now or in the future, favors secession from Spain, those political pressures will cause even further disappointment and weakness across the entire Eurozone.  It is very difficult to be optimistic when many economists report that the Eurozone is already back in recession and would likely not recover until 2014 or 2015.  If the German economy slides back into recession in the final three months of 2012, then there will be no recovery for France, Italy or Spain until 2015 at the earliest.  The picture for the Eurozone economy remains extremely bleak.

To make matters worse, there is now significant disagreement between the German government and the IMF.  The issue is how to have Greek finances at least appear to be on a stable and sustainable path, which in this case is defined as achieving a sovereign debt level of 120% of GDP by 2020.  Delaying this fiscal objective by two years, as the Greek government has asked, simply effectively means putting off the day of reckoning that everyone knows is coming. The IMF is apparently digging in its heels.

Angela Merkel has elections looming in the autumn of 2013.  She can only go so far, so it is the overriding principle that needs to be established now.  The real details can wait until Greece fails another review, possibly as early as the end of next year.  As Deutsche Bank analyst, Mark Wall so tactfully put it in his latest report on the situation, “The objective of the current round of decisions will be to ‘kick the Greek can’ beyond the German elections in September 2013”.  By that point, unemployment may be over 25% and with people possibly being asked to grin and bear a seventh year of recession, we may well be rapidly closing in on a “just how much of this can you really stand”.  And, assuming we get up to the German elections without all hell breaking loose, what is going to happen once the German election has passed?  To the external observer, it does look like fund managers from across the planet are being told one thing (that Germany will then take the bold steps to shore up the common currency), while German voters will be voting to stop further German support of the Eurozone’s troubled states.  So somebody is going to be very disappointed.

We believe that what all this portends is that the Euro itself may finally be deemed unsustainable. In a worse case scenario, Greece could have to return to the drachma, Spain to the peseta, France to the franc, and Germany to the mark.  A common currency without common budgetary discipline as we have written before, is simply not a perpetual motion machine.

Now what does this mean for the United States?  Essentially the United States with its own single currency, and the ability to print money, is in relatively good shape, except that our level of total debt is now approaching some of the worst cases in the European Union.  We can inflate our way out of it, but the costs will be onerous.  If that is Barack Obama’s program, then in addition to all of his tax increases, we will pay a hefty price in U.S. inflation.  We are not immune from the laws of economics.  This act has been seen before, and it has never had a happy ending.  It is time to get our fiscal house in order.  President Obama is insisting upon raising tax rates, and since elections have consequences, he may well get his way, and not through the Republicans’ preferred method, of capping deductions, which would mostly affect the wealthy.  Rates will go up in addition to the rates that are already scheduled to increase, along with the additional taxes that are mandated by Obamacare.  We are hurtling headlong into our own financial crisis, and that’s without the so‑called fiscal cliff.  Sequestration alone is a disaster, and we are, of course, much closer to that than we were just two months ago. One politician after another tells us he prays it won’t happen. That’s a prayer that won’t be answered without leadership in Washington. And that’s something that is sorely lacking.