The U.S. economy appears to be on a sustainable growth path while the euro zone remains mired in debt emergencies, largely because of its much weaker policy response. Therefore, rate increases by the European Central Bank (ECB) at this stage would be a policy mistake, but that is not to say that they won’t raise them. In the lead-up to the Great Recession it was generally understood that the U.S. was in a worse position than the euro area to weather the crisis. After all, the U.S. had over-consumed for decades and its housing bubble was at the very heart of the meltdown. Yet fast-forward to the present and the U.S. economy appears to be on a sustainable growth path while the euro zone remains caught up in periodic crises. On the surface and when viewed in aggregate, the euro area appears fundamentally sounder:
- Its current account is roughly in balance, while the U.S. balance-of-payments deficit still exceeds the critical 3% level
- The U.S. housing bubble gave rise to far greater use of toxic paper which seems to be lingering
So why has U.S. growth fared so much better than the euro zone in the aftermath of the crisis? The major reason for the euro area’s woes is that the policy response has been far too timid. The differences between the European and American approaches may be divided into three related categories: Fiscal policy, monetary policy and banking sector health.
Monetary and fiscal policies, as well as the comparative health of the banking systems, largely explain why the euro area has lagged the recovery in the U.S. since the Great Recession. In contrast to the Fed, the ECB has already made several attempts to withdraw liquidity. Even now, with the sovereign crisis still smoldering, the ECB is once again publicly discussing policy normalization, including raising rates. Meanwhile, the banking system in the euro area has become more fragile than in the U.S. Going into the downturn, the potential for credit losses in the U.S. was far greater and U.S. consumers were much more leveraged than their European counterparts. But U.S. banks are healing, while European problems remain unresolved and have spread into several sovereign debt markets. Banking is a confidence game, so markets need to be assured that large, systemically important banks cannot fail. The U.S. achieved this by:
- Having its huge failures occur early in the crisis
- Providing credible stress tests to define losses
- Arranging for capital injections when banks came up short
In contrast, European stress tests lost credibility as a result of Irish bank defaults. Finally, despite lower deficit and net debt levels, the euro area is viewed as the sovereign debt trouble spot because of its uneven distribution of debt. None-the-less, Europe is withdrawing fiscal stimulus much more quickly than the U.S. The fiscal drag is crippling growth in some of the weaker peripheral countries and thereby further weakening the euro banks.
Our hearts and minds are with the people of Japan following the sad and tragic events that have happened and are still unfolding there. Although the Nikkei has plunged, natural disasters rarely change an economy’s growth trajectory and this earthquake, though massive, should be no exception. Of course, until the nuclear situation stabilizes, the total damage to Japan’s infrastructure and public confidence is unknown. Nonetheless, the steep drop in the Japanese equity market is no doubt at least partially caused by panic. Key global averages had begun correcting before the earthquake hit Japan given that many markets seemed technically overstretched. The Japanese disaster has clearly increased investor anxiety which guarantees a period of high price volatility. But so far, it seems unlikely that the global growth trajectory will be meaningfully altered. In other words, the cyclical backdrop for risk assets is still positive and is, as of yet, not significantly changed by events in Japan. A spike in oil prices continues to be the more pressing risk to global bullishness and needs to be monitored closely.
Michael Ashley Schulman, CFA
Hollencrest Capital Management