- Two entities that were created to help preserve financial stability in Europe may not be able to achieve their mandate.
- Growth in the eurozone may be hamstrung by the fact that credit markets in the U.S. have been thawing, while those in Europe have been freezing.
- Slow growth in Europe is affecting global growth.
- Until the E.U. takes decisive action, financial markets are likely to continue their volatile ways.
Sovereign debt crises can spread like a virus, not only from country to country but also from the public sector to the private sector. In this way, Europe seems to be infecting the U.S. and the global economy through the financial system and through international trade. What's more, the inability of European policymakers to take decisive action has transformed what could have been a quarantined problem into a spreading and increasingly worrisome disease.
Two entities created to preserve financial stability in Europe may not be able to achieve their mandate
One of the more decisive steps taken by European leaders was on May 9, 2010. On that day, leaders from the euro area member states decided to create the European Financial Stability Facility (EFSF). The EFSF can issue 440 billion euros of bonds, guaranteed by the euro area member states; make loans to member states; and buy their bonds, if necessary. Since the EFSF is slated to close down after three years, or once its last legal obligation has been fully repaid, the plan is to have a permanent facility in place by June 2013. This permanent facility is called the European Stability Mechanism (ESM), and its mission is to provide funding to beleaguered eurozone governments.
There are two big problems with the EFSF and the ESM. First, it seems to me that the EFSF and ESM should be able to provide up to 1 trillion euros in funding instead of a mere 440 billion euros. The higher number would send a clear signal that the eurozone will not let the current problems spread further. Second, the terms of the loans and activities these entities can take on need to be unanimously agreed to by the euro area member states, effectively giving any one of the 17 eurozone countries veto power. As a result, when it comes time to tap the credit lines of the EFSF or ESM, it's possible that the tap will be closed. This problem could possibly be eased if the European Central Bank (ECB) played a bigger role, since the ECB only requires a majority to agree to any policy action. But the ECB has a mandate to pursue price stability, and getting involved in buying up the debt of member countries could undermine that goal.
Growth in the eurozone may be hamstrung by thawing U.S. credit and freezing European credit
Because French and German banks are such large holders of debt issued by euro area member states, investors seem concerned about the viability of these large banks. That concern makes it such that these banks are more reluctant to lend, since they are trying to conserve or raise capital. Growth in eurozone may be hamstrung by the fact that the credit markets in the U.S. have been thawing, while the European credit markets have been freezing. This trend is also having knock-on effects globally, as investors begin to question which banks have exposure to the eurozone sovereign debt and the European banks that may have issues.
Compounding this growth drag from a freezing banking system are the austerity measures euro area states are taking. Granted, these countries need to get their budget deficits under control, but there are smart ways and some not-so-smart ways to do it. Because the problems have been decades in the making, I don't think they can be fixed overnight. I would prefer to see a sequential approach taken to austerity, beginning with spending cuts and ending with tax increases. In the midst of what could be considered a recession in Europe, tax increases are a terrible tonic; yet that is what many of the eurozone countries are doing. This toxic combination of curtailed bank lending and unwise austerity is manifesting in very slow, if not negative, growth. Even Germany, the bastion of growth and frugality in Europe, had a mere 0.1% growth in gross domestic product (GDP) in the second quarter.
Slow growth in Europe is affecting global growth
The E.U.'s GDP for 2011 is estimated by the International Monetary Fund to be approximately 20% of global GDP, showing just how much slow growth in Europe can affect global growth. And according to 2011 estimates from the Census Bureau, $133.494 billion of U.S. exports go to the E.U. That's 18.4% of U.S. exports that a slowdown in Europe could certainly affect. There are also indirect links between a slowdown in Europe and U.S. trade activity, since a slowdown in Europe can affect other U.S. trading partners as well.
In these ways, what could have been a contained problem in Europe has spread like a virus to the rest of the world. Decisive policy action coming out of Europe could be the antidote. But until such action is taken, I expect financial markets to continue with their volatile ways.