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The euro debt crisis isn't something happening over there--it will have profound effects--negative effects--on the future of the U.S. economy
12/06/2011 8:30 am EST
Putting together a list of the damage from the euro debt crisis in the United States is harder—the list is just about as long but the effects are often hidden and delayed. For example, the immediate effect of the crisis has been a rally in U.S. Treasuries that has driven U.S. interest rates down to historical lows. A good thing right? In the near term, yes, but not if it delays the day that the U.S. starts to deal with its own debt problems and leads to a build up of debt on the balance sheet of the Federal Reserve.
So, yes, putting together a list of the effects of the euro debt crisis on the United States is difficult. But it’s important because looking at the crisis from a U.S. perspective is an important indicator of what we can expect from the U.S. and global markets and economies over the next five to ten years.
I’d divide the U.S. effects of the euro debt crisis into three categories: inside-baseball effects, clearly visible systemic effects, and long-term psychological effects.
Inside-baseball effects on the financial markets will make money more expensive—and economic growth slower.
I don’t expect that most of us will notice this type of damage—it’s inside baseball, right, so the damage is apparent only to those who play deeply inside the game. But it might be the most significant in the middle term since it is this kind of change that constitutes the most likely mechanism for translating the euro debt crisis to the U.S. financial system.
Remember how during the Lehman bankruptcy and the 2008 global financial crisis the big worry was if contracts in the derivatives market might take down a big financial institution such as JP Morgan Chase (JPM) or American International Group (AIG)? That fear, indeed, was the key reason for the taxpayer bailout of American International. Nobody knew exactly how much “insurance” the company had extended to other financial institutions and no one knew what the effect of the failure of American International might be on those other institutions. Banks and other financial companies thousands of miles away from the New York epicenter of the crisis might fail if they were counting on derivatives contracts with American International on the other end to insure them against loss.
The inability of financial regulators and financial markets to figure out who might be holding the bag was the reason that post-Lehman financial reforms invested so much rhetoric into trying to move at least part of the derivatives market from private institution to institution agreements to derivative contracts traded on at least somewhat transparent public markets.
Now the euro debt crisis has brought the workings of the derivative markets back onto center stage by calling into question the viability of derivatives to act as insurance against default. At issue is a derivative known as a credit default swap. As the possibility of default on their debt by the governments of Greece, Portugal, Ireland, Spain, and Italy climbed, investors in the sovereign debt of those countries used credit default swaps as a way to lay off part of that risk. These derivatives acted as insurance.
But you’d have to question the value of any insurance that didn’t pay off in crisis, wouldn’t you? And that’s exactly what’s happening right now in the Greek debt crisis. Although banks and other holders of Greek bonds are being “asked” to take a 50% haircut on the value of their bonds, the International Swaps and Derivatives Association, the group that makes the call on when credit default swaps are triggered, has so far decided that the 50% loss on Greek government bonds doesn’t allow the buyers of this insurance to collect since the loss is voluntary.
Voluntary? Well, I guess breathing is voluntary since I could decide to stop. I’m sure that this ruling is producing a massive rethinking of the value of derivatives in laying off bond-market risk.
And the upshot of that is likely to lead to bond buyers demanding higher yields to compensate for the risk that they now don’t think they can lay off quite so easily or certainly. In other words, more expensive money—and that’s not good for economic growth in any part of the world.
The effects of this rethinking of the value of derivatives as insurance wouldn’t be nearly as important if it weren’t for second inside baseball effect of the euro debt crisis. In the 2008 global financial crisis the collapse in the price of mortgage-backed securities rated AAA by the credit rating companies had raised huge questions about the value of those ratings and the quality of the rating companies’ work. The collapse in price of sovereign debt carrying ratings that implied this debt was risk free has now further eroded the trust placed in the bond rating companies.
And you can see why that might be critical at this juncture—if credit default swaps don’t really provide insurance protection and if the ratings issued by the credit rating companies don’t accurately capture risk, then bond buyers, now on their own, would ask for even higher yields to compensate for that uncertainty. And it’s not as if the cost of money wasn't going up for other reasons.
The clearest systemic effects are an increase in the cost of money and a decrease in the availability of money.
In a stunning example of closing the barn door after the horse has run away, bank regulators around the world—and that includes in the United States—are asking banks to raise more capital and to keep more of it in reserve. The easiest way to do that in a financial market that’s not exactly begging to lend money to banks is for banks to sell assets—loans—and to make fewer of them. Having fewer assets on the books raises the capital ratio of a bank even if the bank doesn’t raise more capital.
So we’re got more expensive money—from the inside baseball effects—and less money too. Not good for growth. (And if bank lending follows form, especially not good for small and mid-sized companies. When money gets tight, the big guys can still borrow. It’s the economy’s smaller companies, the source of the bulk of the economy’s jobs, that have trouble borrowing.)
And we’ve also stored up problems in the U.S. economy for the day when we finally do get some growth.
First, the U.S. budget deficit needs to be reduced—and while Congress and President Barack Obama may be hesitant to cut too deeply into spending while the economy could slip back into recession, as soon as growth picks up (or the 2012 election is over), those restraints will vanish and the cuts will appear. Think of this as a brake on growth that will lower the economy’s top speed. (And the economy is already looking at another brake in the form of slow economic growth from Europe.)
Second, because the U.S. recovery has been so anemic—in part thanks to the uncertainty generated by the euro debt crisis and slowing growth from Europe—the U.S. Federal Reserve has continued to expand its balance sheet in order to prevent the U.S. economy from stalling. At some point, the Fed will need to start reducing the size of its portfolio of U.S. Treasuries and mortgage-backed securities. And just as buying those debt instruments put cash into the economy, selling them will take money out.
The recovery of the U.S. economy from the global financial crisis would have been long and difficult anyway—recessions set off by financial crises last longer than “normal” recessions—but the euro debt crisis has turned a long and slow recovery into a really delayed, really long, and really slow recovery.
It certainly doesn’t help either that the U.S. is an aging country in a more quickly aging world. Demographics aren’t destiny but history says that all else being equal older countries grow more slowly.
The psychological effects of the euro debt crisis make doing something, anything, to stave off a growth slowdown more difficult.
Even without the euro debt crisis it wouldn’t have been easy to break through the political gridlock that grips the United States. The psychological effects here in the United States of the euro debt crisis make that even less likely.
Think about your own first reactions to the euro debt crisis. Politicians don’t do anything. Governments are powerless to act. The most pressing problem is paying down debt. I would argue with all of those conclusions. (Politicians frequently act to make things worse, for example but occasionally do work toward useful solutions. Social Security, for example, has significantly reduced poverty among the old in the United States.)
But I think those are the popular reactions to the crisis. And they are profoundly self-defeating. If we can’t do anything for ourselves, then I think we are fated for a very low growth decade in the United States. If we compound that “fated” low growth with the politics of austerity, then “low” won’t begin to describe the growth in the decade.
That all sounds very depressing, I grant you. And it could get worse. The euro debt crisis isn’t over. It’s quite possible that the “solution” that EuroZone leaders come up with this week will simply kick the crisis down the road for a year or so, allowing it to smolder and then burst back into flame in 2103 when the world may be even less able to cope. Think about a re-emergence of the euro crisis in 2013 after U.S. domestic politics have locked the country into a round of budget cuts—and before the Federal Reserve has rebuilt its monetary powers. Then the United States would truly have even less room for maneuver.
The only good news I can offer is that projections of the future that rely on straight-line extensions of the present, as this one does, are almost always wrong. Maybe Angela Merkel and Nicolas Sarkozy will pull tighter EuroZone integration out of their chapeau and hutte and we’ll see a new assertive euro economy emerge in five years. Maybe rising labor costs in China will lead to a meaningful shift in jobs back to the United States. Maybe current trends in U.S. oil production will turn the United States into an oil-exporting nation. Maybe something that I can’t think about now will change the low-growth scenario that projections based on the euro crisis now make seem so inevitable.
But I think it’s important to realize that the profound pessimism that now colors how we see the future here in the United States because of the euro debt crisis is a powerful force in and of itself. That doesn’t make this pessimism correct. But we should recognize that it will be hard to reverse.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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