Just as the American economy appears to be improving, with higher sales and production, it risks being dragged under by Europe. On Wednesday Moodys announced that it might downgrade Spains credit rating. Riots have reached Britain from Greece and France in a reaction to austerity measures taken to cut budgets and services and to whittle down mountains of debt.
American Enterprise Institute resident fellow Desmond Lachman asks “Can the Euro Survive?” in a paper published by Britains Legatum Institute, a free-market think tank. He argues that Europes problems far exceed ours and are worsened by the common currency, the Euro, which will eventually have to unravel.
Should America be fortunate enough to achieve faster economic growth next year, our economy nevertheless may be dragged into Europes approaching cataclysm. Not only will America be called on to bail out Europes debts, but Europeans will have to cut back purchases of American exports.
Ireland and Greece have already been bailed out by International Monetary Fund (partly funded by the United States) and European Central Bank rescue packages, and Spain, teetering on the brink, will need its own rescue. With Portugal projected to follow Spain, this group of countries has earned the regrettable name of PIGS.
Unfortunately, as Lachman shows, the IMF/ECB rescue packages dont mean that Ireland and Greece are safely on their way to recovery. Au contraire, as they say in France. The conditions imposed on these countries as a price for the bailouts will increase unemployment and cause more political disturbances, destabilizing the governments and increasing the possibility of more defaults on loans.
The IMF and the European Union are lending Greece $140 billion on condition that Greece cuts its budget by at least 11% of GDP over the next three years, half of that in the first year. So Greece is required to implement significant tax increases and spending cuts this year. That means lower public sector wages and fewer public sector jobs in a country where the public sector is the major employer.
Spain will be next. Its massive housing boom, powered by low interest rates, dwarfed Americas, and before that bubble burst 18% of the Spanish economy was attributable to construction. Its public debt level of 65% of GDP is expected to increase as more banks require bailouts due to future defaults.
Spains unemployment rate is now about 20% and its deficit measures 12% of GDP. Construction loans account for 45% of GDP. The ECB has discounted $166 billion of bank loans.
The simplest solution would be for the PIGS to drop out of the Euro, or set up a second-tier Euro, so as to let their currencies depreciate. That would allow wages some flexibility to decline, and exports to rise, as Argentina did in the early part of this decade.
But as Ambassador Pierre Vimont of France told me earlier this year, this is absolutely impossible. The unity of the Euro is sacred.
Similarly in Berlin, it is to preserve the Euro, and the European Union itself, that Chancellor Angela Merkel has bucked public opinion in having Germany support bailouts for Ireland and Greece.
So the Euro is making it harder for Greece, Ireland and Spain to recover. They must cut their budgets even as unemployment is high and while the value of housing is still falling.
The bailout funds from the IMF and ECB are just a downpayment on the problem, because the stronger European countries have substantial exposure to the debt of the weaker.
French banks and financial institutions, with over $100 billion in loans to the PIGS, according to the Bank for International Settlements, are the worst affected. Then come German banks, with over $60 billion. America holds about $15 billion in debt to the PIGS, a relatively small amount.
Although Lachman is deeply worried, European investors appear to be less so, to judge from the levels of Euro stocks. A European banker, who spoke to me on condition of anonymity, said, “Im amazed that the European equity market is so strong at a time when the banking system is so close to collapse.” He told me that many banks have cut all their lines of credit to their Irish, Spanish, and Greek counterparts because of the risk of default.
Leaders of the 27 European member countries meet in Brussels Thursday to create a permanent European Stability Mechanism, a fund that would take effect in 2013 in order to provide funding for E.U. countries in financial difficulties.
To resolve constitutional doubts that nag in Berlin and elsewhere, EU leaders want to add two sentences to the Lisbon Treaty, which governs the workings of the EU. They would say that “The Member States whose currency is the Euro may establish a stability mechanism to safeguard the stability of the Euro area as a whole. The granting of financial assistance under the mechanism will be made subject to strict conditionality.”
Lachman told me this week, “I do not think that the stability mechanism will make much difference. The Euro zone is having a crisis right now and they are considering the introduction of something in 2013. While the kitchen is burning, they are discussing what new architecture the house might need.”
Its not clear that Germany will go along with the proposed mechanism. The Germans are giving every indication that they are opposed to a big increase in bailout resources and they would want tough conditions imposed. Mrs. Merkel is constrained by the German taxpayers, who are opposed to bailouts which they help to pay for, and she also has to contend with the German constitutional court that is against anything that weakens the Euro.
A large European collapse appears to be in store for 2011. And when it does occur, with the interweaving of global financial markets, America will not escape unscathed.
Original Source: http://www.realclearmarkets.com/articles/2010/12/16/will_europe_bring_the_us_down_98797.html