Volume 60 | Number 11
We were in Stockholm this week to get an up close and personal look at the European crisis. We regret the delay in delivering this newsletter, but our luggage spent an extra day on vacation in Paris. As on two earlier trips this year, to Rome and Helsinki, we were struck by the division in expectations about the Euro. For most analysts who operate outside the Eurozone – especially in the US and UK – the unraveling of the Euro, starting with the imminent default and departure of Greece, is a near certainty. For those who live within the Eurozone, it is almost unthinkable that the Euro experiment would fail. For the English speakers (who suffer from potentially crippling political and economic problems in their own countries) every hurdle is insurmountable and any successes only a delay of the inevitable. For those inside, the messy progress is simply part of the Eurozone’s unwieldy system of government. It was a tough week for Euro skeptics as Greece passed it controversial property tax; the Finns handily voted for expansion of the European Financial Stability Fund; and the Germany overwhelmingly approved the EFSF, with Merkel’s coalition providing a majority without outside help. Still, on arriving in the US after a long flight, the news was about new hurdles from Greek public employee layoffs and the viability of Merkel’s coalition. It is surprisingly overlooked in the US that Merkel’s coalition contains the most conservative views on a Greek bailout. The opposing Green-Red coalition is even more pro-Euro, accounting for the whopping 523-85 vote in favor of expanding the EFSF in Germany.
The bottom line is that though the wealthy nations in Europe don’t want to pay for the Greek bailout, they are more worried about a meltdown in the European banking system. The game of brinksmanship is to extract the lowest cost, by shifting the burden to the periphery through austerity and to the rest of the world through international organizations like the IMF and World Bank. The latest expectation is for a 50% reduction in Greek debt, which would cut the load from a crushing 150% of GDP to a manageable 75%. Austerity will still be needed, but recovery is possible from these debt levels as Sweden’s experience has shown. Meanwhile, the finger pointing is now primarily at Italy, as Spain has taken measures to shore up its banks and finances. At roughly 120% Italy’s debt to GDP is almost double Spain’s 65%. Italy’s recent downgrade and growing political pressure (Prime Minister Berlusconi is facing three different trials) are forcing them to address long ignored imbalances. One can only wonder what took them so long.
Finally, it is critical to note that the Euro is far more than a simple monetary union. We heard from the Finns that their entry was in large part to escape the purview of the Russians. A Spaniard explained that his countries participation was in part to throw of the last vestiges of Franco’s isolationist policies. A German explained that Greece would never voluntarily leave the Euro, as it would be left friendless in a world surrounded by its traditional enemy Turkey and far cheaper labor in Albania, the former Yugoslavia and Bulgaria. Many analysts noted the profound increase in cross border trade when country tariffs and regulatory exclusions expired at the start of the Euro. Milton Friedman is famous for opining that the Euro would not survive its first crisis – but that is precisely the issue. The US would not exist if it did not survive the War of 1812, and many believed it would not – especially after its capitol was burnt to the ground. After each visit to Europe, we have come back more confident that the Euro can survive, though at what level to the dollar is still uncertain. In part, it is a realization that in Europe as here, no one has any confidence in the politicians – but they all like the ones they elected. The system is messy everywhere, but we still believe a muddle through is more likely in the global economy that a double dip – especially if the threat of a double dip sustains the pressure on financial markets and the politicians.
The US economy looks marginally healthier this week after the Chicago Purchasing Manager’s report and durable goods orders surprised to the upside. It is critical that these two reports reinforced each other, for both are notoriously volatile. Still, at a reading of over 65, the Chicago PMI’s new order index has moved back into the range that historically has suggested an expansion.
Note that the Chicago PMI tends to overstate economic expansion very early in the cycle – as in 1994, 2004 and early this year. Once it settles down, it has a strong correlation with durable goods orders due to the heavy concentration of capital goods producers in the Chicago area. The strength in nondefense capital goods orders excluding aircraft this month may be a late response to the combination of extraordinarily low interest rates for business borrowers and 100% expensing offered through the end of 2011.
Though the positive momentum in these manufacturing oriented indicators may only be temporary, any positive movement is welcome as it moves the US economy however slightly away from the risk of a double dip. We note that the second quarter real GDP was raised a modest 0.3% to a 1.3% annualized growth rate (after a miserable 0.4% rate in the first quarter.) The strength in capital goods shipments has also lifted the consensus opinion for the third quarter over 2%. Thus, the level of real GDP is now expected to be roughly 0.25% higher at the end of the third quarter (which is right now) than earlier expected. A simple rule of thumb translates 1% of GDP into one million jobs, or 250,000 more than expected earlier. Add in the modest 192,000 increase from the annual revisions reported this week and the level of employment looks modestly better.
Still, the direction and level of personal income are disturbing. Personal income fell -0.1% in August, as compensation continued to slow – but transfer income from Medicaid payments and unemployment insurance plunged. These hits to low income households translate directly into weaker spending. The drop in claims to less than 400,000 may have been due to volatile seasonal factors, but the 417,000 average over the past three weeks is almost exactly the 416,000 four week average three weeks ago. Moreover, continuing claims remain very stable though flat, suggesting weak – buy positive – employment growth in September. It is not much good news, but it reinforces our view of a muddle through rather than a double dip – assuming the politicians don’t screw it up again.