The American economy seems to be improving, albeit slowly. The labor market has had four straight quarters of positive data. Holiday sales were strong. The S&P 500 might have registered a positive return for the year had it not been for the debt ceiling debacle and subsequent downgrade of U.S. Treasury securities and, of course, the debt crisis in Europe. So far in 2012, it seems that not much has changed. The darkest cloud hanging over the American economy is still what is happening in Europe.
As we move into 2012, it is likely that the European debt crisis will continue to dominate the market headlines. The Europeans are in the process of approving plans to tie themselves more closely together fiscally. This is a positive development but it is too late. Had rules been created to limit budget deficits when the currency union first came into existence, today’s crisis may have been avoided. Now these rules will more likely exacerbate the crisis rather than mitigate it.
Europe’s economy needs to grow to create more tax revenue for its governments’ coffers. Raising taxes and cutting government spending does not create economic growth during times of economic weakness. Chances are that the fiscal steps the Europeans are taking to try to dig themselves out of the crisis will send the Euro Zone into recession and have the opposite effect of their intended purpose.
As we move into 2012, it is likely that the European debt crisis will continue to dominate the market headlines. The Europeans are in the process of approving plans to tie themselves more closely together fiscally. This is a positive development but it is too late. Had rules been created to limit budget deficits when the currency union first came into existence, today’s crisis may have been avoided. Now these rules will more likely exacerbate the crisis rather than mitigate it.
Europe’s economy needs to grow to create more tax revenue for its governments’ coffers. Raising taxes and cutting government spending does not create economic growth during times of economic weakness. Chances are that the fiscal steps the Europeans are taking to try to dig themselves out of the crisis will send the Euro Zone into recession and have the opposite effect of their intended purpose.
A European recession certainly doesn’t help the American economy but its effects probably won’t be enough to cause a recession on this side of the Atlantic. The problem responsible for the market volatility we experienced in 2011 has a lot to do with the European banking system. Modern economies need a well functioning banking system to prosper. When banking systems do not function, the credit that businesses and households need dries up, slowing economic growth. We saw this with the failure of Lehman Brothers in 2008 and subsequent global recession. We are already seeing the types of strains in the European banking system that we saw in September of 2008. European banks are borrowing from and parking funds at the European Central Bank (ECB) instead of with each other, and at levels that signify significant stress in the banking system.
Banks are borrowing from the ECB because they don’t trust each others’ stability. They are worried about each other’s exposure to the sovereign debt of the countries that may not be able to pay their obligations. Banks are required by rules and their creditors to maintain certain capital ratios. This means that they must have certain levels of assets to back up their liabilities. Now assets that used to be safe – European sovereign bonds – are no longer and may not qualify as the right kind of capital to keep the banks’ capital ratios where they need to be.
This exposure goes far beyond simply holding bonds that may not be repaid. This size of each of the sovereign debt markets is known; however what is not known is the exposure in the form of credit derivatives known as “credit default swaps.”
Credit default swaps are a form of insurance against a loss on an investment or groups of investments, in this case, the investments we are worried about are the bonds issued by countries like Greece, Ireland, Portugal, Spain, Italy as well as banks holding their debt. If there is a default, the sellers of this type of insurance are on the hook for the loses.
The problem is that this market is opaque; no one really knows who will be on the hook for how much. There is no way for banks to know if their lending partners will be decimated by a credit event or not. This is one of the major reasons confidence among banks is waning.There are a few solutions that economists believe may solve the European debt crisis. It is believed that the most effective solution would be for the ECB to purchase the debt of the distressed countries. This would create demand for their bonds, increasing the price and lowering the interest costs. However, there are several problems with this solution. Unlike the Federal Reserve (Fed) in United States, the ECB has no mandate to promote full employment.
The ECB is only charged with maintaining price stability. The ECB is not a lender of last resort and is not charged with spurring economic growth like the Fed is. For the ECB to buy bonds, it must issue bonds backed by the European Union itself. The Europeans have created a mechanism to buy distressed sovereign debt called the European Financial Stability Facility. It is doing this on a very limited scale but a few billion in bond sales at a time is not going to do much to solve the crisis.
This exposure goes far beyond simply holding bonds that may not be repaid. This size of each of the sovereign debt markets is known; however what is not known is the exposure in the form of credit derivatives known as “credit default swaps.”
Credit default swaps are a form of insurance against a loss on an investment or groups of investments, in this case, the investments we are worried about are the bonds issued by countries like Greece, Ireland, Portugal, Spain, Italy as well as banks holding their debt. If there is a default, the sellers of this type of insurance are on the hook for the loses.
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The ECB is only charged with maintaining price stability. The ECB is not a lender of last resort and is not charged with spurring economic growth like the Fed is. For the ECB to buy bonds, it must issue bonds backed by the European Union itself. The Europeans have created a mechanism to buy distressed sovereign debt called the European Financial Stability Facility. It is doing this on a very limited scale but a few billion in bond sales at a time is not going to do much to solve the crisis.
Right now, the ECB is buying limited quantities of the distressed nations’ debt; it is providing low interest loans to European banks; and allowing the banks to park the borrowed cash at low overnight rates. The ECB’s 3-year loan program resulted in over half a trillion dollars of low cost loans to banks. It is encouraging that the ECB is taking these steps but the extent to which European banks are using these programs is very concerning. Banks that use low interest loans from the ECB, then turn around and park the funds overnight at the ECB are not necessarily using the funds for all of their intended purposes. Funds parked at the ECB are not being used to lend to businesses and households to foster economic growth. On the bright side, some of the funds borrowed from the ECB have been used to buy European sovereign debt, another purpose of the loans.
The idea of expanding this plan to allow for the unlimited sovereign debt buying necessary puts Europe’s two largest economies on the spot, France and Germany. France would probably back a bond buying spree by the ECB but knows it will do no good to support that action if Germany is not on board. Germany does not want the ECB to buy more bonds and it is questionable whether they will change this stance if the fate of the currency union hangs in the balance.
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The idea of expanding this plan to allow for the unlimited sovereign debt buying necessary puts Europe’s two largest economies on the spot, France and Germany. France would probably back a bond buying spree by the ECB but knows it will do no good to support that action if Germany is not on board. Germany does not want the ECB to buy more bonds and it is questionable whether they will change this stance if the fate of the currency union hangs in the balance.
We can also question whether France and Germany can regain their AAA bond ratings if the ECB began issuing European Union Bonds. If they are put on the hook for Euro area bonds they may not look as creditworthy as before. If Germany and France were downgraded, the problems described earlier about maintaining certain capital ratios would be magnified. French and German bonds would not be considered as the gold standard in capital any longer. Luckily, when this happened in the United States, there were not the calamitous credit market reactions that some foretold. In essence, if things don’t improve in Europe, it will be up to Germany and Angela Merkel’s willingness to save the Euro in its current form.
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