Wednesday, November 16, 2011

Why you should care about Europe

If you're like me you have a hard time understanding what's happening in Europe. We we all need to. It's going to bite us sooner or later. This is a long post, but read it anyway and amaze your friends at the next backyard barbeque.

Niall Ferguson, a professor of history at Harvard University and a professor of business administration at Harvard Business School, notes that for most Americans "places like Greece and Italy are primarily tourist destinations they’ll visit at most once. The finer points of Mediterranean politics leave them cold."

So why, he asks, should Americans care about any of this?
The first reason is that, with American consumers still in the doldrums of deleveraging, the United States badly needs buoyant exports if its economy is to grow at anything other than a miserably low rate. And despite all the hype about trade with the Chinese, U.S. exports to the European Union are nearly three times larger than to China.
According to the new president of the European Central Bank, Mario Draghi, a “double dip” recession in Europe is now all but inevitable. And that’s lousy news for U.S. exporters targeting the EU market.
But there’s more. 
Europe’s problem is not just that governments are overborrowed. There are an unknown number of European banks that are effectively insolvent if their holdings of government bonds are “marked to market”—in other words, valued at their current rock-bottom market prices. In our interconnected financial world, it would be very odd indeed if no U.S. institutions were affected by this. 
Just as European institutions once loaded up on assets backed with subprime U.S. mortgages, so most big U.S. banks have at least some exposure to eurozone bonds or banks. One institution—MF Global, run by former Goldman Sachs CEO Jon Corzine—just blew up because of its highly levered euro bets. Others are biting their fingernails because it is suddenly far from clear that the credit default swaps they have bought as insurance against, say, a Greek default are worth the paper they are written on.
But here's the biggie:
The third reason Americans should care about Europe is more important even than the risk of a renewed financial crisis. It is the danger that what is happening in Europe today could ultimately happen here. Just a few months ago, almost nobody was worried about Italy’s vast debt, which amounts to 121 percent of GDP. Then suddenly panic set in, and Italy’s borrowing costs exploded from 3.5 percent to 7.5 percent. 
Today the U.S. gross federal debt stands at around 100 percent of GDP. Four years ago it was 62 percent. By 2016 the International Monetary Fund forecasts it will be 115 percent. Economists who should know better insist that this is not a problem because, unlike Italy, the United States can print its own money at will. All that means is that the U.S. reserves the right to inflate or depreciate away its debt. If I were a foreign investor—and half the debt in public hands is held by foreigners—I would not find that terribly reassuring. At some point I might demand some compensation for that risk in the form of ... higher rates.

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