Monday, February 8, 2010

A Matter of Degree

The acute trouble Greece's economy is in and its implications for the Eurozone have already received extensive coverage in the last few weeks- some of which in reasonably articulate and comprehensive articles (like the ones below).

The current predicament that the entire Eurozone entity and the euro as a currency are facing extends beyond Greece, as Portugal, Ireland and Spain are also confronting severe budgetary shortfalls and have shown widely varying degrees of willingness to tackle them effectively.

All in all, Ireland's measures announced late last year have received some cautious praise by the EU but, others, like Spain, are showing overt resistance to the idea of improsing draconian measures to bring their fiscal mess under control. Greece has now been cast in the spotlight due not only to the magnitude of the surprise that the country sprang on the EU last November by announcing "revised" data showing a deficit nearly triple of the previous "estimate" but also due to the country's sad history of avoiding to tackle some of the endemic problems that plague its economy.

How the whole crisis plays out in the next couple of months may have some implications for the dynamic of the U.S. economic recovery as well.

While the most likely outcome remains that, Greece (and, if need be, Portugal as well) will ultimately be rescued in some fashion, either by the EU or the IMF, a prolonged anxiety over the outcome and brinkmanship involved in the process can have wider repercussions for financial markets and the U.S. economy.

If the uncertainty over the fiscal crisis in those four Eurozone countries, which account for approximately 1/5 of the Eurozone GDP, is not convincingly contained soon, a further weakening of the euro can become an additional moderate headwind for the U.S. recovery, as the implied strengthening of the dollar will adversely impact the export-oriented manufacturing sector. This is a sector that has made a surprising comeback in recent months, with the ISM (the most comprehensive barometer of activity in that sector) currently standing at its highest level since 2004. But with more than 20% of U.S. exports going to EU countries, a further drop of the euro (used by only 16 of the 27 EU countries, but also tracked by a number of other currencies that aspire to join it) is bound to have more than just a negligible negative effect on the sector.

The other channel via which an extended period of doubts over the ability of any of the four Eurozone countries currently in the headlines to service their external debt without interruption is the equity markets. Equities have already suffered a setback in most European countries since the beginning of the year, in response to the dismal fiscal situation of some member countries, which has re-introduced a distinct element of risk aversion into the picture. The U.S. equity market has suffered in sympathy, as, one thing that has been learned all too well in the midst of the financial crisis in the last 18 months, is that markets are indeed global. As a result, any additional erosion in U.S. and global equities can impair the ability of households in this country to step up their spending in an environment of high unemployment and a recently elevated savings rate.

Greece is a small country with a pretty inconsequential GDP size within the Eurozone and, in different times, the gross mismanagement of its economy would not have attracted much attention outside its borders. But these are not exactly normal times, as such ripples come at a time when the global financial system is in its early phase of healing from a deeply traumatic experience and nerves can become frail more easily than in the past. Still, as the Dubai episode late last year demonstrated, financial markets have recovered enough to handle isolated glitches, but their ability to do so has its limits. Everything is a matter of degree and that is why the risk of possible contagion across other Eurozone countries bears close monitoring in the coming weeks.

Anthony Karydakis

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