Thursday, April 29, 2010

The U.S Economy and the Eurozone Fiscal Crisis

Now, that the race to contain the fire set off by the implosion of the Greek economy has entered the home stretch, with an announcement of the specifics of an IMF-led bailout expected this weekend, here's a brief assessment on any likely impact of this episode on the U.S. economy.

The already unambitious forecast of about 1.5% GDP growth in the Eurozone bloc this year will need to be downgraded moderately, in the wake of the fiscal crisis that has engulfed a number of its member countries. The issue is no longer economic growth in Greece per se, where a contraction in output by as much as 7% is in the cards following the austerity measures that will be mandated jointly by the EU and IMF. The real issue is that the new dynamic that the Greece situation has unleashed, is likely to trigger enhanced fiscal austerity measures in the other vulnerable Eurozone countries (Spain, Portugal, Ireland, and Italy), as they struggle to fend off the specter of becoming the next Greece. In fact, their already sharply elevated borrowing costs in the last couple of months will inevitably necessitate offsetting domestic cuts, which will slow economic activity further in those countries, and, by extension, in the entire Eurozone.

U.S. exports to the Eurozone countries are running at over $15 billion a month and the demand for such exports is bound to be curtailed in the balance of the year and into 2011. This should have a non-negligible impact on the manufacturing sector in this country, given its export-oriented profile. However, the adverse impact of an export slowdown to the Euro countries on the overall U.S. economy is likely to be more mute, perhaps costing U.S. GDP growth 0.2 to 0.3% over the next four quarters. The export sector represents, after all, a relatively small part of U.S. GDP (12-13%).

On the other side of the ledger, there is an often unrecognized, inadvertent, benefit for the U.S. as a direct result of the fiscal upheaval in several Euro countries: the prospect that long-term yields will remain lower than otherwise, as the Treasury market continues to benefit from the lingering uneasiness about the creditworthiness of some Eurozone sovereign debt.

While the "natural" cyclical forces of an unfolding economic recovery might have exerted some moderate upward pressure on Treasury yields later in the year, that dynamic may countered by the global appeal of Treasuries as a relatively safer place to be for some time. Yes, it is true that the rumored 120-140 billion euro rescue package that Greece will be receiving is, by far, the most massive bailout operation even undertaken by the IMF and its partners (by comparison, the total IMF-led bailout of a number of countries during the Asian financial countries in 1997 was $120 billion, or roughly the equivalent of 90 billion euros). But this will not settle the background risk for a possible default of Greece down the road and the anxiety over how successful Portugal/Spain/Ireland/Italy will be in putting their own house in order.

In fact, the Asian financial crisis is a pertinent reference in attempting to evaluate the impact of the current Eurozone fiscal crisis on the U.S. economy. At the time, the immediate reaction to the crisis by most analysts was that the collapse of a bloc of countries representing nearly 1/3 of our exports market was bound to be highly detrimental to U.S. growth. However, funds fleeing the turmoil in Asia quickly found shelter in the U.S. Treasury market, driving long-term yields down by approximately one percentage point, producing a moderate stimulative effect on the U.S. economy in the first half of 1998.

On the assumption that the fiscal saga in the Eurozone does not lead to an outright blow-up of additional countries, the net effect of the Greek affair on the U.S. economy will likely be marginal. If, however, the instability emanating from this episode afflicts severely the macroeconomic picture of a longer list of countries and reignites fears about the fragility of European and global banks, then things can quickly take a more ominous turn.

Anthony Karydakis

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