Behind the Sell-off: Why Europe Matters Most
Here we go again. The markets today have been hit by a trifecta of worries.
First, data on unemployment claims, manufacturing and existing home sales lent weight to the case that the U.S. economy is slowing. (Of course, other data released this week, such as the leading economic index and retail sales suggests the U.S. economy continues to plow along at a positive, but not satisfactory, rate.)
Second, Morgan Stanley and Goldman Sachs downgraded their forecasts for global growth in 2011 and 2012. Stocks are leveraged bets on growth. The big firms that populate the Dow Jones Industrial Average and the S&P 500 now get a very large chunk of their revenues, and much of their growth, from overseas. The prospect of a growth slowdown in China and India is far more daunting to investors than the possibility that U.S. and European growth could fall.
Third, there are continuing problems emanating from the euro zone. Growth seems to have stalled in both France and Germany, the engines of the continent's economy. The big fear this week is that French and German banks might suffer a two-fold blow. They're heavily exposed to government and private-sector debt in Greece, Spain and Italy — countries whose ability to repay debts is being questioned. And they're also heavily exposed to consumers and businesses in their suddenly flat home markets.
Of the three problems listed above, it's the last that I find most troubling.
(In the accompanying video my Daily Ticker colleagues Aaron Task and Henry Blodget also express concern and discuss why the sharp selloff suggests the rally late last week and Monday was a reprieve rather than the end of the decline.)
Investors are now in a situation in which stability — and perhaps their ability to sleep — rests on effective European collective action.
Read the Financial Times, or read some histories of 20th century Europe, or spend some time in Budapest and Prague (as I did last month), and a theme emerges: European governments and institutions have been very poor at crisis management. Time and again through history, minor disputes over religion, borders or royal succession turned into wars that persisted for decades. The 1914 assassination of Archduke Franz Ferdinand by a Serbian separatist led to a devastating, continent-wide war that ultimately drew in the U.S. The 1920s and 1930s brought hyperinflation, banking system meltdowns, and the rise of Hitler. You can't spend 15 minutes in Prague without learning how Europe collectively sold out independent Czechoslovakia to Nazi Germany in 1938.
In the post-war era, Europe finally seemed to get its hands around the problem of collective action. The creation of NATO bound Western Europe together in a security alliance. The creation of a (very weak) common government, a (stronger) common market, and a single European currency under a single monetary policy lead many to believe that the United States of Europe had finally arrived. (See, for example, T.R. Reid's 2004 book: The United States of Europe: The Rise of a Superpower and the End of American Supremacy)
The collective arrangements worked well in the era of long expansions, from 1990 through 2008. But the European response to the rolling problems of sovereign credit debacles, banking system failures, sluggish economies and the need for reform, has been plagued by timidity, poor coordination and design flaws.
The difference between the United States of America and the (putatively) United States of Europe is instructive. In the fall of 2008 and winter of 2009, the U.S. central bank came in heavy, placing near-blanket guarantees on the nation's financial markets, and bailing out banks and investors from all over the world. The political system followed with a decent-sized stimulus — spending increases and repeated rounds of tax cuts. Meanwhile, while plenty of pain was delayed, the private sector was encouraged to get its house in order.
Europe has followed almost the opposite approach to its crises. Since problems cropped up in Greece, Ireland, Portugal and Spain, the European response has been a piecemeal one: tentative guarantees, hemming and hawing over bailouts, and half-measures. The collective action broke down over national differences. Many European leaders regard the activities as button-down northern Europe bailing out free-spending Southern Europe. (There's an element of truth to that. But by bailing out the countries of Ireland, Greece and Spain, the Europeans are really bailing out the banking systems of Germany and France.)
Rather than respond with collective fiscal stimulus, Europe has responded with collective fiscal contraction. In every instance, the price of the bailouts has been huge budget cuts and tax increases. The U.K. austeritized itself in the absence of any severe market or institutional pressure. The European policy-making elite believes that raising taxes and cutting budgets sharply in a time of slack demand would somehow lead to lower interest rates, greater confidence, and greater demand. That hasn't worked.
Meanwhile, the crisis has laid bare the conflict that lies at the center of Europe. European institutions, and especially the European Central Bank, are dominated by France and Germany. While the ECB is tasked with making monetary policy for countries from Greece to Belgium, it really makes it for Germany, which remains the world's most skittish inflation-phobe. Which helps explain why the ECB in April raised interest rates.
And if you think the U.S. left the banks off easy, consider what has happened in Europe. The stress tents European banks have endured were more like massages. Collective action has dictated that bondholders of failed private banks in Ireland, and of functionally insolvent governments like Greece not face significant losses on their holdings. (In the U.S., by contrast, the creditors of Lehman Brothers and plenty of other banks and bailed-out companies, took collective buzz cuts. )
Add it all up, and Europe is dishing up a toxic brew: a rigid currency, fiscal contraction, begrudging aid from the central bank, and a long history of enmity between its constituents. That's a recipe for collective paralysis, not for the sort of bold collective action that is required to halt banking crises. Pundits have floated the idea that Europe could solve its problems by issuing eurobonds. And it's true that selling bonds that are guaranteed collectively by European countries would allow countries to escape the tender mercies of the bond markets. But that plan, which would require true collective action, has been rejected.
The reality is that Europe today resembles the U.S. states during the Article of Confederation period — an agglomeration of allies and frenemies, unwilling fully to cast their lot with one another. European policymakers aren't inclined to take advice from American political thinkers. But they'd be well-advised to heed the warning Benjamin Franklin issued at a time when collective action was being considered: "We must all hang together, or assuredly we shall all hang separately."
Daniel Gross is economics editor at Yahoo! Finance.
Email him at grossdaniel11@yahoo.com; follow him on Twitter @grossdm.
