So far, economists are more optimistic than investors about the potential impact of the European debt crisis on the nascent U.S. recovery. They are making only minor tweaks to their forecasts, predicting the crisis will be contained and any headwinds will be manageable. Investors aren’t buying it. Amid growing fears of contagion, U.S. stocks fell more than 4 percent last week and despite a bounce on Friday are off about 10 percent since their late April highs. The question is who’s right?
Many economists believe the trouble will be largely limited to European banks, Europe’s credit conditions, and its growth prospects. An advantage for the U.S. is that its recovery is increasingly driven by home-grown demand from consumers and businesses, amid low inflation and interest rates. Although stock market gains from 2009 lows helped drive the improvement in confidence and spending, and recent losses could be a drag on growth, economists at Barclays Capital note that there’s often a long lag between changes in household wealth and spending habits. Any drop in stock prices would have to be both significant and persistent to have any real impact.
The market drop even created some offsetting benefits for U.S. growth. The 18 percent decline in the price of oil since late April to around $70 per barrel is a plus for the purchasing power of both households and businesses, and lower yields on long-term Treasury securities as their prices rose in a flight to safety, will help keep mortgage rates down.
There are other reasons to be hopeful. The European crisis can hurt foreign trade, but U.S. shipments to the euro zone are only 15 percent of the U.S. total, and U.S. exports are only 11 percent of gross domestic product. That means the euro’s 8 percent decline against the dollar since mid-April, which lifts the euro zone’s competitiveness in the U.S., is small potatoes for the broad trade-weighted dollar value, which is the key to trends in U.S. exports.
Europe is already the laggard in the global recovery, and no one expected much of a contribution from the region in the first place. The U.S. export boom is powered by Asia, Latin America, and Canada, not Europe. Economists say that each percentage point reduction in Europe’s growth is worth only a couple tenths of a point on U.S. growth.
At UBS, economists say they are maintaining their forecasts for U.S. growth in real gross domestic product of 3.2 percent in 2010 and 3 percent in 2011, believing that continued recovery, especially in the job market, will offset any reduction in trade with Europe. Analysts at JPMorgan Chase say they’ll be monitoring economic data but it’s too early to shift their growth projections of 3.5 percent economic growth this year and 3.1 percent next year. They say the recent turmoil only reinforces their belief that inflation will stay low and the Fed will not lift interest rates until 2011.
Reasons to Worry
Still, economists see several ways the U.S. could be hurt, including reduced foreign trade, direct U.S. bank exposure to European debt, and heightened attention to the U.S. fiscal situation. Analysts say the biggest immediate threat is increased aversion to risk in global financial markets that could reverse the improvement in financial conditions over the past year. That progress has been crucial in rekindling U.S. growth.
The crisis is shifting from worries about the solvency of Greece and Europe’s fringe nations to concerns about liquidity in Europe’s credit markets. A recent rise in the London interbank offered rate (Libor), a benchmark interest rate, suggests banks are starting to question the quality of their counterparties’ collateral. Interbank borrowing costs are rising despite nearly $1 trillion in backup credit facilities, bond purchases, and liquidity injections from the European Union and the European Central Bank, along with the reopening of the Federal Reserve’s currency swap program, aimed at pumping dollars into Europe’s banks to meet short-term credit needs.
Those efforts will limit liquidity problems and help prevent markets from freezing completely as they did in 2008. Analysts at Morgan Stanley calculate that the direct exposure of U.S. banks to European debt is low, only about 4.1 percent of total U.S. bank assets. The majority of those claims are in the U.K., while exposure to other European countries is only 1.1 percent of U.S. bank assets. But while that’s hardly worrisome in direct terms, the financial meltdown in 2008 shows that even small exposures can become systemic problems if there is a loss of trust.
Although chances seem good that the U.S. recovery will survive the distress, one ominous factor lurks: Like several European nations, the U.S. must eventually come to grips with its own unsustainable fiscal policy. For now, global investors are snapping up U.S. Treasuries seeking what they perceive as quality investments. However, economists at Morgan Stanley offer a warning,”We believe that the current turmoil in markets is masking the risk that U.S. rates will go significantly higher once the intractable nature of our longer-term fiscal problems resurfaces.” Put another way, the U.S. could end up crawling out of the frying pan and into the fire. Maybe the investors are onto something.
