Stocks rallied powerfully late last week after European Central Bank President Mario Draghi declared that the ECB stands ready to do whatever it takes to preserve the euro. That was mighty tough talk, but analysts remain skeptical about the outlook for the common European currency. No one doubts that the ECB can provide short-term support for euro-zone economies. But even so, most forecasters believe that the euro zone is heading for a crisis. And whatever form that crisis takes, the impact on the U.S. would be negative.
So why did the Dow gain more than 400 points in two days, rocketing through the 13,000 mark to a three-month high, after Draghi’s speech on Thursday? The answer is that the euro’s eventual failure has been predicted for so long that it has become conventional wisdom. Each postponement creates a burst of optimism — not that the crisis has been solved but simply that it has been delayed.
But each respite is likely to last for a shorter period of time. And what has finally happened, in my view, is that the euro has passed the tipping point. From where things stand now, it seems as though the situation will only get worse — and the deterioration will probably accelerate.
There are three seemingly unavoidable problems:
The next round of losses in Greece cannot be charged mostly to private-sector lenders. When Greece was bailed out in March, banks and other private investors took most of the losses, which they were willing to do because they also stood to lose a lot if Greece defaulted. But now that the share of Greek sovereign debt held by commercial banks, insurance companies and investment funds has been greatly reduced, future bailouts will necessarily diminish the value of debt owned by government banks and international financial institutions. In some cases, those lenders may be restrained by law from cooperating with any such devaluation, and at the very least the costs that result will ultimately fall on taxpayers.
Austerity and ECB lending have not been able to hold down interest rates. Bailouts and budget cuts have been enough to persuade investors to keep lending to overindebted countries. As a result, bond yields were reduced for a time in key countries, such as Spain and Italy. Within the past month, however, yields on 10-year Spanish bonds climbed back up to 7.6%, well above the 7% that is generally considered to be the danger mark. Yields on Italian bonds also rose, reaching 6.6%. Since Draghi’s speech, yields in both countries have come down a bit. But it is notable that recent euro-zone rescue policies have been unable to hold Spanish and Italian bond yields anywhere close to a safe 5% level, where they were in March.
The growing magnitude of the problem will run up against political constraints. There is a limit to the amount of money the ECB, the International Monetary Fund and other such lenders have available for bailouts. As those institutions use up their reserves, they will need large amounts of new money if they hope to keep postponing a euro crisis. But where will that money come from? The number of countries in trouble keeps growing. Both France and the Netherlands, which supported and helped pay for previous bailouts, now have financial problems of their own. And resistance is growing in Germany against taking on further liabilities (not to mention the fact that contributing to larger bailouts may raise constitutional problems).
Of course, there is no way to know precisely when the scale of euro-zone financial problems will exceed the resources available to keep postponing them. But it is clear where the process is heading. And as soon as investors begin to think that endgame has started, interest rates will probably shoot up in Spain and Italy and accelerate the process.
Moreover, in any likely scenario, troubles in the euro zone could have a substantial negative impact on the U.S. before the November elections. Economies have been slowing in much of the euro zone — indeed, the private sector has actually been shrinking for six months. Outside the euro zone itself, the U.K. economy has been in recession for three quarters. In addition, China’s growth has dropped from double digits to 7.6%, the lowest level in three years.
Exports account for less than 14% of the U.S. economy, compared with more than 30% for the U.K. and almost 50% for Germany. Nonetheless, foreign business is extremely important for many of America’s largest multinationals and technology companies. Apple, Coca-Cola, Intel and McDonalds all get more than 60% of their sales overseas. As a result, any slowdown in foreign economies is a major drag on important parts of the U.S. economy. That’s one of the reasons that tech stocks have underperformed the broad market since April. And further weakness overseas would likely affect even more of the U.S. economy.
None of the possible outcomes for the euro zone augur particularly well. If some of the financially weak countries are forced to abandon the euro or the euro zone breaks apart, there will be shocks to the international banking system that would slow most major economies. And if international bureaucrats are able to sustain the euro for more than a few months through brilliant management, the austerity policies needed to do so would only push economies closer to a global recession. Either way, it’s hard to see how the U.S. can escape the fallout from a European financial crisis for very much longer.