As we entered the new year, the perceived global economic recovery continued to sputter along as it did in 2H09. Last year's recovery theme was centered on supporting the global banking system via the central banks' strategy of flooding the market with massive amounts of liquidity and support. With the banking system in much better shape by year-end, the G-10 economies were expected to slowly build on the positive momentum and show real, identifiable progress in 2010. In the U.S., job growth seems to be on the mend with retail sales and corresponding consumption estimates slowly improving. Asia continues to be supported by China's massive stimulus programs, with intra-Asia trading flows directly benefiting the region. Strong global commodity pricing has also benefited the commodity countries (Canada, Australia and New Zealand), with Australia's central bank (RBA) actually raising interest rates to stem a potentially overheating economy. The UK's situation indicates slow, but steady improvement as a result of a stabilized housing market and improving employment conditions. Euroland is another story and, unfortunately, a new and potentially larger problem has materialized this year: managing the sovereign risk of its weaker member countries led by Greece.
Euroland opened the year on very weak economic footing, as Q409 GDP was reported at an anemic 0.1 percent, with December industrial production dropping 1.7 percent. Beyond the region's economic numbers, the spotlight has been on the weaker member countries, specifically Greece and its inability to manage its sovereign debt obligations. The current Greek crisis is the first major test for the EU, testing the European Central Bank's (ECB) ability to address its internal imbalances without encouraging further bailouts in the future.
North vs. South
Underlying the crisis is the fundamental difference between the northern and southern Euroland countries, which appear to be diverging more than ever. The north, exemplified by Germany and France, relies on exports to power their growth, elevating savings and run trade surpluses. The southern economies, such as Portugal, Ireland, Greece, and Spain (known as the PIGS), have leaned too heavily on consumer spending, have relatively weak public finances and rely heavily on foreign capital to supplement their low savings. As finance ministers from the EU met earlier this month in Brussels for what was originally scheduled as a normal gathering, they, in fact, focused on one agenda topic: how best to help Greece avoid defaulting on its sovereign debts, while reassuring bond markets that the other euro-area counties with big budget deficits (PIGS) are still safe investments.
Road to Ruin
Greece's public finance problems were brewing long before the current financial crisis materialized. When it joined the euro in 2001, its public debt was already more than 100 percent of GDP and, despite a long economic boom spurned by low interest rates inside Euroland, Greece did very little to address its persistent deficits. Lower interest rates also spurred a spending spree, as the economy grew by an average of 4 percent per year until 2008. Once it was safely inside the euro, Greece relaxed its fiscal policies, ran up budget deficits and did little to cool its economy. Inflation rates rose well above the Euroland average, damaging its competitiveness and forcing the economy to rely on increased foreign borrowing. After its new government admitted last October that its budget shortfall would be 13 percent of GDP — more than twice the previous forecasts — Greece's cost of borrowing started to rise dramatically. Global investors were further unnerved by the revelation that Greece's public debt had been understated due to undisclosed obligations, which lowered its already weak credibility despite an attempt to rally confidence by announcing a tough austerity program in January.
As a rescue package is considered, the treaty governing the EU includes a "no bail-out" clause that was added in 1991 at the insistence of Germany during the EU summit in Maastrict, the Dutch town where many of the ground rules for the euro were set in place. Other treaty clauses, however, may allow for aid to an EU state in times of trouble. Another suggested remedy would be to arrange a bridge loan from another Euroland country in good credit standing, such as Germany. This arrangement may or may not be legal, but is perceived to make for terrible politics as voters in donor countries may be outraged that their hard work and savings are supporting a fiscally irresponsible neighbor. The crisis has uncovered the problem that the euro area has no clear mechanism to help a member country that cannot fund itself in the capital markets, making default plausible and forcing the ECB to come up with its own funding backstop for Greece — and quickly.
The bigger question remains: will the trouble in Greece threaten the break-up of the euro? European officials continue to compare their current situation to the large imbalances found in other large currency areas. They point to Spain's construction bust and rigid labor markets, which seem certain to condemn the country to years of economic struggle and elevated unemployment. This situation is similar to the troubles in Michigan, which is clouded by the long decline of the U.S. auto industry and its own elevated unemployment. Greece's struggle to raise funds in this hostile environment could also be compared to California and its troubled budget deficit struggles, although California accounts for a much bigger share of the U.S. GDP (1/8th) vs. Greece's portion of Euroland output (1/14th). The likelihood of Greece being forced out of the euro is perceived as far less than it choosing to leave, as any hint of that would cause a run on Euroland banks. A departing country would also be left with expensive euro debt to service, elevated borrowing costs and associated higher currency and inflation risk. A likely scenario continues to center around financial guarantees as proof of euro unity in times of crisis, but we shall see.
The upside of this sovereign debt crisis in Euroland has increased the pressure on other member countries to put their public finances in order, but probably at the price of curbing GDP in 2010. Another bright spot is that the trouble in Greece has driven the euro lower. For a region that relies so heavily on exporting its way out of trouble, the weaker currency is sorely needed.
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