Crunch time for Europe

The following is weekly market commentary provided by Raymond James & Associates.

The European debt crisis has been a long, slow motion catastrophe. The powers that be (the European Central Bank and European Union leaders) have lumbered from one critical juncture to another, doing just enough to prevent calamity, but not enough to solve the problems. For U.S. investors, the European crisis has repeatedly threatened to boil over, but then put at low heat on the back burner (never taken off the stove). The crisis in Greece is once again approaching another breaking point – but this time we are closer to a real change rather than another postponement of the seemingly inevitable.

Following the results of the May 6 election, Greece was unable to cobble together a coalition to run the government. Another election is set for June 17. Polls show that most Greeks prefer to stay in the monetary union. However, polls also show that most Greeks reject the severe austerity imposed upon the country. They can’t have it both ways – and the June elections are expected to result in a more significant push away from austerity. Hence, the odds of a Greek exit from the euro have risen appreciably. At the same time, it’s not exactly clear that Greece will leave the euro, or even how it would leave the euro. European leaders are still signaling a strong commitment to keep Greece in the monetary union, and there’s no exit plan.

The consequences of a Greek exit would be severe, but at this point, the country seems likely to be just as doomed if it decides to stay in. Going back to the drachma would give the country a way out. With its own currency, a devaluation would provide a necessary adjustment to relative wages. Staying in the euro would require a fiscal union and a further write-down of Greek debt, steps that the rest of Europe may not be willing to take.

Of course, a Greek exit would also raise the threat of contagion. Greece’s problems are a lot different than those of the other troubled countries of Europe. However, Spain and Italy are much bigger economies, with much bigger banking systems that are connected to the rest of Europe. Greece has experienced a slow-motion run on its banks, which may be accelerating. The European Central Bank would provide liquidity to counter a significant bank run in Greece, but the ECB will likely have some limits especially if it looks like the country will exit the euro. More significant runs on the banks of Italy and Spain would be a much bigger problem for the ECB.

If this all sounds scary, it is. Just a few months ago, there was a broad consensus that Europe would experience only a mild recession. The euro area’s real GDP fell 0.3% (q/q) in 4Q11, and was reported as flat in the flash estimate for 1Q12. Amusingly (it’s important to retain a sense of humor in a financial crisis), the financial press trumpeted that the euro area had “avoided a recession.” However, 1) flash estimates are clearly subject to revision, 2) “two consecutive quarterly declines in GDP” is only a rule of thumb, not a proper definition of “recession,” 3) there is clearly a potential for things to get much worse, and 4) the troubled economies are doing a lot worse than others.

A lot of Europe’s problems stem from a misdiagnosis. This is commonly called a “sovereign debt crisis,” but budget deficits weren’t the catalyst. Spain and Ireland had budget surpluses before the crisis and, while debt levels were high in Italy, the debt-to-GDP ratio was falling. The crisis was set up by capital flows. On entry into the euro, countries suddenly had lower borrowing costs and the rest of Europe was happy to supply capital. Now, those capital flows have reversed. Recession boosted budget deficits as tax receipts declined and social spending increased. Growth helps reduce budget deficits, but the pace of economic recovery was gradual. Austerity, imposed too soon, weakens growth, worsening the budget situation. The challenge should be to provide support to the economy first, then address budget situations later on. Granted, this raises a risk that growth won’t recover fast enough. Stimulus has to be temporary, of course, but if insufficient, the too-early fading of stimulus will limit the pace of recovery. One should plan on over-shooting fiscal stimulus. If too large, fiscal stimulus could be later scaled back or countered with monetary policy. However, if insufficient, it’s just about impossible to get more.

Some have suggested a more radical response – a temporary increase in inflation. Professor Bernanke had offered this as a solution for Japan’s woes in the 1990s. Real (that is, inflation-adjusted) interest rates are what matters for the economy. With low inflation, real interest rates will be higher than they would be otherwise. A temporary increase in inflation would lower real rates, supporting economic growth. However, the danger is that the increase in inflation wouldn’t be temporary. Inflation expectations could rise, providing momentum to higher inflation beyond the desired time frame. Moreover, the political resistance to such a strategy in Europe, especially in Germany, would be extreme. In the U.S., Fed Chairman Bernanke is not keen to follow his earlier advice (unlike Japan, according to Bernanke, the U.S. acted early and is not experiencing deflation).

What does the European crisis mean for U.S. investors? The U.S. economic outlook is not much different than a month ago. However, the downside risks from Europe have increased significantly. The higher level of uncertainty is a negative for the equity markets. While Europe could come to a decision on Greece soon, the process of exit from the euro is a complete unknown. How badly will fears spread to Italy and Spain? How will the ECB and European leaders respond if things spin further out of control? Moreover, this may take years to play out.

Scott J. Brown is the senior vice president, chief economist for Raymond James & Associates.

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