All of the events in the Eurozone seem so distant and inconsequential to those of us living on the west side of the Atlantic Ocean but, as we found out in 2008, the world's economy is very strongly integrated; when one major trading nation or block fails, it is felt throughout the world. Right now, those of us in North America seem to have developed an immunity to the Euro Influenza, but is that really the case?
Desmond Lachman, a Resident Fellow at the American Enterprise Institute recently published a brief study entitled "Europe as a major risk to the US economic outlook". In this study, he notes several reasons why the troubles plaguing the Eurozone will eventually wash ashore in North America. With Europe's economy comprising roughly one-third of the world's total, a slowdown there will impact the volume of imports from North America. Not only that, the North American banking system is tightly interlinked with its counterpart in Europe and, just as we saw in 2008, when one part of the banking family struggles, the rest of the family eventually faces difficulties.
Here are several issues that are now defining the deteriorating economic situation in Europe:
1.) Greek Economy: The economy of Greece is showing a decline of 14 percent since 2008 and a Q4 2011 drop of 7 percent, an all-time negative record in the EU. Here is a graph showing the real GDP growth rates for all EU-27 countries, noting how Greece’s situation is dire:
Greece's unemployment is among the highest in the Eurozone at 18.5 percent and its youth suffer from nearly 50 percent unemployment, the second highest in the EU-27 as shown here:
Greece is seeking an orderly de facto default on its debt which could end up with bond investors taking a rather severe haircut and Greece losing credibility as a borrower. Unfortunately, the potential of a rather uncomfortable haircut is only a short-term solution; this will result in Greece paying back only €103 billion of its €206 billion debt, cutting annual interest expense from €10 billion to €4 billion. My concern is that Greece will not be able to cut its deficit, its economy will continue to shrink and it will be like getting blood from a stone when investors come knocking for their principle and interest as has been the case with some of Argentina's bondholders.
2.) Italy's Situation: The Eurozone Influenza has spread past the original debt transgressors of Greece, Ireland and Portugal to two of Europe's core nations; Italy and Spain which are Europe's third and fourth largest economies. While the situation in Italy seems to have stabilized, at least for the short-term since Mr. Berlusconi's departure, a messy debt negotiation in Greece (and now likely Portugal) could cause the world's bond markets to lose faith in Italy, holder of the world's third largest nominal debt. If interest rates for Italy's debt were to rise much above their current level, the situation could rapidly deteriorate and no amount of intervention from the ECB, EU, IMF or EFSF will be able to bail out those investors. Here is a graphic showing just how extreme Italy's debt situation is compared to its neighbours:
Here's a graph showing how interest rates among the debt transgressors has risen and how vast the spread is between Germany's debt and that of Greece, Portugal, Ireland, Italy and Spain:
While the spread has fallen somewhat in recent weeks, the basics of the debt situation have not really changed.
3.) Credit in Europe: Europe's banking credit situation is frozen. To meet the new requirement of Tier 1 capital asset ratio of 9 percent, Europe's banks are having to clean up their balance sheets as loan losses mount. This means that the banks are much less interested in loaning to consumers and businesses, let alone depositing funds with each other and analysts project that Europe's banks may cut lending by as much as €2.25 trillion in the next year and a half. Debt defaults will put increasing stress on bank balance sheets with the combined debts of Greece, Portugal and Ireland reaching €800 billion. Estimates suggest that Europe's banks are undercapitalized by between €225 and €300 billion
4.) Recession in Europe: By all appearances, Europe is headed toward a recession with Q4 2011 already showing a mild 0.3 percent contraction. Even Germany, the strongest economy of the 27 nations, saw a minor contraction in economic growth in the last quarter of 2011. A contraction will make it increasingly difficult for nations like Ireland that are counting on growing their way out of debt. With the centre of Europe's economy expecting mild economic contraction, nations on the periphery (particularly the south) of the Union will suffer even more with Italy's economy expected to contract by 2.2 percent, Spain's by 1.7 percent and Portugal's by 3 percent. My suspicion is that when we look back in one year, those numbers will look highly optimistic.
5.) Budget Adjustments: As the European economy shrinks, so does national tax revenue as tax bases erode. This makes proposed reductions in deficit-to-GDP less likely to meet targets, particularly in Ireland, Italy, Portugal and Spain. The debt masters (i.e. ECB, IMF et al) are forcing austerity measures including tax increases on the debtor nations as part of the condition for receiving assistance; if the Eurozone economy continues to contract, the more onerous tax regimes may push these nations further into recession and lead to greater public resistance.
One of the biggest problems facing the Eurozone debt transgressors is the single currency. This prevents countries like Greece from devaluing their currency to make their exports more attractive to outside countries. This also prevents less efficient economies within the EU from competing with their more efficient neighbours, particularly Germany.
To summarize, all of these issues could well have a marked impact on the United States (and Canadian) economies. Together, the EU and the United States account for about half of the world's GDP and about 31 percent of world trade flows. The EU imported €169.5 billion worth of goods from the United States in 2010 and €131 billion worth of services as shown here:
The two economies have the world's largest bilateral trade relationship with Europe accounting for 19.2 percent of all United States exports as shown here:
Here is a chart from the United States Census Bureau showing how important exports to Europe are to the United States economy, accounting for about 2.2 percent of GDP in 2011:
The European Commission estimates that 15 million jobs in both countries are linked directly to the transatlantic economy. All that America's marginally employed need is to have additional stresses from Europe's crisis placed on their already fragile employment situations.
From this data alone, we can see that if Europe's sneezes, the American economy is most likely going to catch a cold at some point in time and from the first part of this posting, we can see that there is plenty of opportunity for the crisis to spread. While we keep hearing that the American economy has experienced a recent "surge" in growth, the "surge" could be very short-lived if the European influenza spreads across the Atlantic Ocean.