Over the past few days, the U.S. has been in the world’s crosshairs. Political bickering in Washington produced a debt agreement widely criticized as insufficient and incomplete. Standard & Poor’s downgraded America’s credit rating, raising concerns about the health of the world’s most important economy. Slow growth in the U.S. is threatening the entire global recovery. Stock-market turmoil on Wall Street has turned markets from London to Seoul into volatile roller coasters. It is easy to be angry at the U.S. for the world’s economic ills right now. Perhaps the sentiment was summed up best by a recent headline in Chinese newspaper the Global Times: “The World Should Kick America’s Butt.”
Yes, the U.S. has been a source of much uncertainty in recent days. But in my opinion, the real danger for the global economy lies elsewhere: in Europe. If we’re going to have another financial crisis, chances are it will start in the euro zone, not Washington. Here’s why:
On a macro level, you could say the U.S. is worse off economically than Europe right now. Economists were frantically reducing their 2011 growth forecasts for the U.S. as its GDP limped along in the first half of the year. In Europe, growth is holding up. The IMF raised its growth projection for the euro zone in late June to 2%. And as a recent HSBC report noted, the state of American national finances is actually more feeble than the euro zone’s (taken as a whole):
Even before the financial crisis, the (U.S.) fiscal path was unsustainable: an ageing population combined with extravagant social security commitments suggested either the need for massive tax increases or draconian spending cuts. The crisis, however, made matters a lot worse. According to the OECD, the US federal, state and local government deficit (NOT the federal deficit alone) jumped from 2.9% of GDP in 2007 to 10.6% in 2010. Excluding debt interest payments and adjusting for the economic cycle, the so-called primary deficit rose from 1.5% to 7.0% of GDP, the biggest in the world. And the ratio of debt to GDP jumped from 62.0% to 93.6%. The eurozone is nothing like as bad: an average deficit of 6.0% of GDP, a primary deficit of 1.1% of GDP and a debt/GDP ratio about the same as America’s but rising nowhere near as quickly.
Though that may be true, the U.S. has one huge advantage over Europe at this moment: the luxury of time. Ironically, the reaction of the world’s investor community to the recent financial turmoil has been to rush into U.S. debt — yes, the very bonds downgraded by S&P. What that means is U.S. borrowing costs will continue to decline, and that buys Washington time to get its act together and put in place a real plan to fill the deficit and restore American growth. The euro zone, on the other hand, has no such luck. Borrowing costs for the zone’s weakest economies — the PIIGS, including Greece, Ireland, Portugal, Spain and Italy — remain highly elevated. That puts pressure on those governments to implement reform programs with great haste as well as pressure on the rest of the euro zone to take more and more dramatic action to stem the contagion.
We saw just that happen this week. The European Central Bank swooped in to buy billions of dollars of Italian and Spanish debt, pushing down the yields on their bonds and easing the debt crisis. This is a major deviation from the ECB’s usual policy. But we have to question how sustainable the ECB’s effort is. It is uncertain how much the ECB is willing to spend to strengthen the bond market. And past bond buying by the ECB had little lasting effect. So it is unlikely that the ECB can handle the crisis on its own over an extended period of time.
And the ECB may not be seeing much help anytime soon. The euro zone simply does not have enough cash allocated to fighting the debt crisis, and that is unlikely to change in the near term. Blame the self-centered nature of European politics. If you think Washington is screwed up, take a look at what goes on in the euro zone. With major decisions requiring the agreement of the zone’s entire leadership, getting anything done is a nightmare, especially since every member has to worry about how euro-zone policies play with voters back home. That’s why the dominant member of the zone, Germany, has to be dragged kicking and screaming into any effort to resolve the euro crisis. Chancellor Angela Merkel is facing a near revolt from her own supporters over her agreement to new rescue efforts. So she is adamantly rejecting calls for the zone to put even more money into its $1 trillion bailout fund. And without German support, nothing will happen.
Therein lies yet another reason why Europe is a bigger danger than America: its members are simply not willing to make the sacrifices necessary to resolve the debt crisis. Yes, the U.S. has serious political divisions, but at least everyone believes they are acting in the interests of one country, and necessary reforms, though painful, are primarily economic. Europe, on the other hand, faces fundamental political and economic change if its debt crisis is to be truly resolved. It will take a level of political and economic integration the individual members of the euro zone have been unwilling so far to consider. That may mean adopting dramatic reforms that directly impact national sovereignty, like the merging of national budgetary policies — a fiscal union to match the monetary union. Here’s HSBC chief economist Stephen King on the matter, from a recent study:
Ultimately, the survival of the euro depends on the creation of some kind of fiscal union … Creating a fiscal union cannot take place overnight but a useful first step might be to agree on a timetable for the creation of such a union. At the moment, the political will is lacking but, as the crisis develops, the choice will become increasingly stark.
At least the U.S. already has the tools in place to combat its economic woes. Europe does not.
So here’s my bottom line: The U.S. is a mess, and the recovery will remain feeble for some time. But America is far from a sovereign debt crisis, and a mere slowdown in the U.S. can’t spark a new global meltdown. However, we can more easily foresee a scenario in which the debt crisis of an individual euro-zone member — a large one, like Spain or Italy — spirals out of control, and the zone’s leaders are unwilling or unable to stop it. That would turn European sovereign debt into something toxic like the subprime mortgage securities of the 2008 crash, eating away at the European banking system and sending out shock waves around the globe. Then we could experience another ugly financial crisis. I’m not saying such a scenario will happen, just that Europe poses a bigger danger to the global economy at this moment than the U.S.
So maybe the world should kick Europe’s butt, not America’s.