The U.S. economy has so far shown remarkable resilience in the
face of several roadblocks year. It has
shrugged off the threat of wars in Ukraine and the Middle East, has ignored the
tapering of QE, and has been generally unfazed by every other obstacle in its
path, whether real or imagined. Now,
however, another threat looms in the horizon and poses a much bigger threat
than previous challenges.
Europe’s economic slowdown has weighed on the global economic
outlook all year. More recently it looks
like several countries in the euro zone may even be headed into deflation. Investors worry that deflation in Europe could
spill over onto U.S. shores and ruin what has been an impressive recovery up
until now.
One reason for Europe’s lagging performance is
the size and scope of its welfare state.
Economist Ed Yardeni observes that in Europe, “There are too many government regulations and regulators, and not enough
startups and entrepreneurs. Labor
markets remain too rigid.” He also
points out that Europe’s bankers aren’t lending, while capital markets remain
“relatively limited” sources of capital.
The region is also highly dependent on Russian gas, and, unlike the U.S.
has made no effort at developing domestic sources of energy.
While credit is plentiful in the U.S., it
remains much tighter in the euro zone.
According to Yardeni, over the past 12
months through May, short-term business credit rose to a record-high $2.0
trillion in mid-August in the U.S. In
the euro zone by contrast, bank credit is down 2.2% over the past 12 months
through June.
It seems counterintuitive that there could be so much economic
weakness in the euro zone even as the U.S. experiences a strengthening
economy. France is experiencing economic
stagnation while Italy is back in recession.
Even Germany’s mighty economy shrank in the second quarter, according to
a Businessweek report. Why?
The primary culprit is the fiscal austerity measures enacted by several
European governments in the wake of the financial crisis a few years ago. While the U.S. evaded a major deflationary
scenario through the Federal Reserve’s ultra-easy monetary strategy, policy
makers in Europe took the hard road of fiscal belt tightening. Those chickens are now coming home to roost, as
several European countries have discovered to their chagrin.
Many economists now recognize the need for Europe to reject the
failed austerity policies of recent years and replace them with an aggressive
monetary policy. European Central Bank
president Mario Draghi has gone on record stating that the ECB stands ready to
do “whatever it takes” to buoy the euro zone economy. Some observers have urged the ECB to take an
even more aggressive stance in combating the lingering effects of the deflationary
crisis years.
Until Europe’s structural problems are addressed, what could lift the
region from its current quagmire?
Margaret Carlson writing in Businessweek
provides the answer: “Europe needs quantitative easing of the kind the U.S.
Federal Reserve has used to good effect – that is, bond purchases financed with
newly created money. Forthright action
can’t wait any longer.” Many analysts
would disagree with this assessment on a visceral level, but there can be no
denying the need for serious monetary policy action in Europe. If the euro zone is to escape the negative effects
of misguided austerity, central bank intervention may be its best, and
certainly swiftest, bet for dodging deflation.
In the meantime, foreign investors are moving to the dollar as the
U.S. has emerged as the world’s premier safe-haven economy. Below is a chart of the PowerShares U.S.
Dollar Bullish Fund (UUP), a proxy for the dollar index. UUP has had an explosive last two weeks and
stands at a new new 52-week high – the first one in a long while.
The strength in the dollar index this summer has been mainly a
function of the bottoming deflationary long-term cycle. In other words, investors are increasing
their cash holdings as a cushion against potential volatility in equities, as well
as geopolitical and global economic uncertainty, especially in Europe. Initially, this fear of the unknown worked in
favor of the gold price but at this point it appears that the dollar trade is
simply a hedge against the unknown rather than a major bet against the
financial market. This incidentally
explains why gold hasn’t benefited from investor psychology in recent weeks.
Returning to the question posed in our headline, will Europe’s
woes hurt the U.S. economy? Not
likely. With a new long-term
inflationary cycle kicking off by October, the U.S. should see the deflationary
undercurrents of the last decade steadily shrink. Europe will have a chance at emerging from
its deflation conundrum, but only if its leaders can agree to abandon the
disastrous austerity policies of recent years and loosen bank lending. The U.S. has proven to be relatively immune
from overseas turmoil this year, a sign of a strengthening economy and
financial market outlook. This growing
strength should serve us well in the coming year regardless of what happens in
Europe.
