From the August 2010 issue of Research Magazine • Subscribe!

How the Euro-Zone Affects U.S. Markets

The stage is set for a double-dip recession.

The government debt crisis involving Greece, Spain, Portugal and other European countries has been pretty good for the United States. It provided a moral satisfaction, of course, after the world ganged up on Washington in 2008, blaming American overconsumption, excessive borrowing and financial speculation for dragging the rest of the world into the most severe recession since World War II. Now, it has been pay-back time for U.S. economists and government officials, because while the U.S. economy has seen some economic recovery, excessive public sector debt accumulated by fringe euro-zone countries is creating problems for the rest of the world.

There have been substantial tangible benefits as well. The yield on the benchmark Treasury bond, which stood at 4 percent in early April for the first time since September 2008, declined sharply as investors sought protection from financial turmoil in Europe. By mid-June, the 10-year U.S. government bond yielded just 3.25 percent. Lower long-bond yields, and correspondingly lower mortgage rates, have been a blessing for the still-sluggish U.S. real estate market.

A Fly in the Ointment

The only problem has been in the stock market. On Wall Street, there has been little rejoicing over European debt problems. The Dow Jones Industrial Average surrendered the 10,000 level yet again in early June, and in fact gave back all of the gains accumulated since a robust 10 percent rally began in November 2009. Volatility returned with a vengeance, further scaring already scared stock investors.

Over the years, Wall Street has been a far better predictor of future economic trends than any economist. Based on the movements of the Dow in the second quarter, a double-dip global recession looks like a distinct possibility. Moreover, despite recent sharp declines in Treasury yields, there is reason to fear that government debt problems now plaguing weaker euro-zone countries will cross the Atlantic.

Euro-zone debt problems were set into motion by the global economic downturn, but they are inherent in the way the European currency union was set up. The euro-zone has one monetary policy set by the European Central Bank and a variety of fiscal policies set by individual governments. Each government has the sovereign right to run its own budget deficit and finance it with sovereign bonds.

When the euro came into existence in the 1990s, many economists were concerned about this flaw. The currency union united some of the world's leading industrial economies, such as Germany, Holland and France, with some that should be classified as emerging, such as Greece, Portugal, Ireland and even Spain.

In the past, weaker economies responded to economic pressures by devaluing their currencies. A devaluation curbed consumption of imports and made domestic products more competitive both at home and abroad. The advent of the single currency changed all that. But it opened an opportunity to borrow in euros cheaply and plentifully. For 10 years, investors were willing to lend to Greece on almost the same terms as to Germany. The current crisis broke out when investors suddenly began to differentiate among different European sovereign borrowers. They sold off Greek debt and bought German bonds. As a result, German long bonds yielded 2.7 percent in mid-June, while Greece had to pay over 9 percent on its 10-year bond. The crisis quickly deepened as investors realized that such interest rates will push Greece deeper down the debt hole. Greek government debt, which stood at an already onerous 117 percent of GDP last year, will reach an unsustainable 150 percent in 2011.

No More Deficits

In the United States, the level of economic development also varies greatly from state to state. States along the Eastern and Western seaboard are global leaders in the post-industrial economy, while the formerly industrial Rust Belt and the agricultural Deep South are much poorer. However, states are prohibited from running their own budget deficits, so that the U.S. dollar is backed by a single fiscal policy, matched by a single monetary policy set by the Federal Reserve. Eventually, the euro-zone may also have to impose a requirement on its constituent governments to balance their budgets.

However, this will not happen soon and will require a fundamental reform of the European Union. In the medium term, European governments will try something else: They will slash their budget deficits. Greece and Spain have already adopted major austerity measures, but even stronger economies in the euro-zone, including most importantly Germany and France, have committed themselves to spending cuts.

Credit Consolidation

Ironically, if European governments slash their borrowing, it will mean that the already massive U.S. budget deficit will balloon to eye-popping levels.

In the 2003-2008 global economic recovery, worldwide growth was fed largely by debt creation. Massive leveraging spurred the world economy, and rapid growth in turn stoked more lending. By 2007, pretty much any asset could be leveraged not only up to its full present value but also up to its putative future appreciation.

When the pyramid began to crumble, its weaker links were naturally affected first. The subprime mortgage segment in the United States was the weakest of them all, since homeowners in this segment could avoid default only if their homes kept rising in price rapidly. Once the subprime crisis hit, we saw first gradual -- and then abrupt -- withdrawal of consumer and business credit. This set into motion a potentially devastating chain reaction, leading to falling asset prices, defaults and, ultimately, a very likely worldwide depression.

Faced with such catastrophic prospects, governments of major industrial countries boosted their spending. Since they lacked accumulated resources or savings of any kind, they too had to borrow in order to spend, but the difference was that while businesses and consumers couldn't get credit, governments not only were still able to borrow, but could do so extremely cheaply. Central banks inundated the financial system with liquidity and, with stock, commodities and other assets depreciating rapidly, government bonds were snapped up by investors as the ultimate safe haven, driving down bond yields.

In the United States, for instance, federal government expenditure went from 19.6 percent of GDP in 2007 to 24.7 percent last year. In the euro-zone, government deficits rocketed from 1.9 percent of GDP in 2008 to over 7 percent this year, based on Economist Intelligence Unit forecasts.

In Greece, the budget deficit rocketed from around 5 percent of GDP in 2007 to 13.6 percent last year. Spain, which is the largest European economy in trouble, saw an even worse turnaround, with its budget going from a surplus measuring 1.9 percent of GDP to a 11.2 percent deficit over the same time period. But, even with such an across-the-board increase in public spending and government consumption, most industrial economies suffered a drop in GDP.

Now, however, European governments' ability to borrow has been tapped out. They will curb their spending at a time when the global economic recovery has not become fully established. This will mean a decline in economic growth in the euro-zone and, potentially, the second dip of a double-dip recession.

At the same time, China's ability to borrow is also declining. The Chinese government encouraged bank lending in 2009, when credit creation doubled last year. However, fearful that this will lead to a domestic debt crisis, the Chinese central bank has already increased its reserve requirements three times this year and is working to slow the pace of loan growth in other ways as well.

Ballooning U.S. Debt

This leaves the U.S. Treasury as the only entity in the world that is still able to borrow massively -- and cheaply. In fact, as investors flee to the safety of U.S. Treasuries, bond yields may continue to drop over the near term.

Even without forecasting a double-dip recession, the Economist Intelligence Unit estimates that Washington will see its debt rise to 95 percent of GDP two years from now. With a double recession, the deficit may balloon to $2 trillion or more next year.

Alexei Bayer is an economist and author based in New York City.

Reprints Discuss this story
This is where the comments go.