Volume 61, Number 6
The change of governments in both Greece and Italy is setting the stage for fresh commitments to needed austerity. Now, the question is whether France and Germany can survive the cure. The heavy exposure of French banks to Italian debt has already blown out French yields relative to the Germans. However, it is the Germans who have been running a large trade surplus with Italy and the rest of Europe based on profligate lending by the French (plus the Germans and other savers) to the over indebted spenders in Europe. While French banks are clearly under pressure, the bigger question is how will Germans keep saving when they have no one to buy their exports? Austerity in the periphery has already brought Europe to the edge of recession. Italian austerity will be a double dose compared to the past year. With no monetary stimulus to offset the fiscal restraint in so large a part of the Euro zone, recession seems likely, and is rapidly becoming the consensus – a process which reinforces the march to economic correction. German production headed for Italy will have to be reduced, and it is unlikely domestic demand will fill the gap. There is no one else in Europe to take up German excess production, even at lower prices, without crowding out their own already softening output. Nor is it likely that the stronger Asian economies will absorb the kind of goods Germany exports to Italy as income levels are significantly different. Financial markets may be focused on French banks, but we are more worried about how Germany rebalances its economy.
For twelve years from 1777 to 1789, the United States operated as a confederation – and remained a second rate country in Europe’s eyes even after having defeated the most powerful army on earth. As America tried to negotiate trade agreements with Europe, the fact that every state had to approve them separately became a major stumbling block. Meanwhile, state governments refused to fund the central government’s expenditures on defense, in part because they were already running deficits at the state level. When the new Constitutional Congress was convened one of the thorniest points in the negotiation was the assumption of some states’ unpaid war debts by the central government. Sounds a lot like Europe these days.
Europe had tried to square the circle by requiring states to limit their national deficits to 3% of GDP under the Maastrict Agreement. In exercising sovereign power, most found their way around this limitation. Now, the over-spenders are being forced to adopt balanced budgets – yet they will still have to contribute to the EFSF bailout fund even if they are also drawing from that fund. This seems strange on the surface, but it is precisely how we conduct business in the US — where states operate under balanced budget amendments (which still allow borrowing), while the federal government collects a second round of taxes and runs deficits to smooth out the economic cycle (well, that was the theory). Now that the market has learned that not all European governments deserve German borrowing costs, it will inflict better market discipline on national expenditures. Bottom line, if Europe survives this episode it will make it stronger. The question is whether it will survive as we hear calls for a two tier Euro (North and South), which would only bring a second round of woe with two uncoordinated confederations. It is an all or nothing moment for Europe.
Turning the Corner?
US policy makers are facing their own defining moment in the next two weeks as the Super Committee is supposed to report out on Wednesday before Thanksgiving (then bolt for home and the Holidays). We do not hear anything good and Washington is not the kind of a place that keeps a good secret. The experience of the past year has shown that politicians simply will not make bold moves unless they are threatened with extinction. Unfortunately, the market pressure that existed during the debt ceiling debate is not present now. We expect the minimum, as politicians seem fine with letting the sequester take place – in January 2013. Politicians will always wait for one more election (or poll) before acting unless the markets create enough uproar to focus their attention on one dollar-one vote as opposed to one man-one vote. Ask ex-Prime Minister Papandreou. Now the question becomes, how will the markets react to the minimum, and it seems ready to accept it. While we do not think another year of interminable debate leading up to the election will cause a double dip, we do not see businesses expanding aggressively either. Just more muddle through.
There are nascent signs that some businesses are beginning to loosen their purse strings to spend on plant & equipment and even some hiring. Initial claims for unemployment fell to 390,000 this week, breaking out to the downside after a long sideways move in the aftermath of the Japanese earthquake. Some have speculated that the early snowstorms may have influenced the numbers, but the same trend is seen in the state level data which lags by a week (so before the storms hit). Moreover, there was a sharp decline in the number of benefit receivers in the first 27 weeks of unemployment – again a statistic which pre-dates the storms by a week. It would appear that the better economic data recently – and, in particular, the demise of the threat of a double dip – has sparked a modest improvement in hiring. Now, we have to wait and see if it can survive the Super-Committee – and then the expiration of the 2% FICA tax break on January 1st. There is still a very steep wall of worry to be climbed in the next several weeks – but the light at the end of the tunnel may not be a new freight train coming this time.
Closing the US trade balance is essential to narrowing the US budget deficit, since otherwise the burden of higher taxes or lower spending would fall directly on either the domestic household or business sectors. Policy makers have long known that to maximize the political acceptance of narrower budget deficits one should also try and shift the burden beyond your political borders. Tariffs, taxes on tourists, taxes on production from outside your state (like energy or automobiles), and reduced foreign aid are all tried and true. Competitive devaluation has also been a mainstay of policy makers, but it can take surprisingly large devaluation in ones currency to generate a significant impact on trade. Since 2001, the dollar has fallen by more than a third against the Euro, Yen and Canadian dollar only starting to reverse the trend in the trade gap with developed nations. It has fallen 30% against the yuan since 2005 and by more against other emerging market currencies, yet only slowed the decline in their trade gap with the US.
As disagreeable as it may be, the US trade gap with the emerging markets makes sense based on comparative labor costs. The trade gap with oil producers is a policy decision to use theirs while savings ours – a concept which provided the US a significant advantage from 1984 through 2006. It is the US trade gap with other developed nations which makes the least sense. These nations are all comparable in labor cost, capital stock, democratic status, educational attainment, etc. with the US, yet we buy more goods from most than they buy from the US – despite a wide range of currency values. Now, Europe will embark on a process of reform designed to spark competition within and between its own members. Given policymakers desire to shift the burden offshore (like to the IMF,) it seems likely European reforms will provide even less access for US firms. Many analysts, including ourselves, expect a decline in the Euro as Europe rights its ship. History shows a 25% move is just an opening bid if you want to affect trade.
Unfortunately, that will shift the burden back to the US just as it is seeing its first improvement in trade with developed nations. Risks of protectionism will run high as long as the unemployment rate remains so steep. More competitive devaluation from the US may be called for if Europe, as is widely expected, resorts to quantitative easing. The UK is already in its second round. Stimulus from the rest of the world may help, but China, Brazil and India are still fighting high inflation. All eyes now turn to the Super Committee and a signal as to whether the US will simply tread water for a year, or actively engage in enhancing its competitive position in a rapidly changing world.