Wednesday, April 13, 2011

American investments and European problems

It's possible that America is headed for a patch of economic trouble. If that happens and further American investments are liquidated in Europe to shore up the books on the left side of the Atlantic, that will spell further trouble for the entire EU, not just the euro zone.

The IMF yesterday warned that public finances in the United States are spinning out of control--specifically, that the deficit is growing whilst the economy is not declining. Financial papers and pundits are all over it, from the mildly crazy to the staid and respected. There is therefore a convergence of attention and assessment. Public debt levels are at 100% of GDP. It is not too late to recover. Belgium and Italy both came back from debt levels exceeding 130% of GDP, but that road was hard.

The problem for Europe is this. Once the US government starts reducing borrowing and spending, the economy will shrink, and with it, corporate profits and investment positions. The likely impact will be large enough to incite companies and other investors to sell off some of what they have abroad to make up at least some of the difference. This means redemptions (investors cashing in their positions and repatriating the funds) from investment houses in Europe, reflected in reduced volumes of cash in European financial markets.

We saw what happened last time this occurred in 2008/2009. The dollar started out low in 2008 and then rose in value in 2009 as American redemptions meant selling euros and converting them into dollars. This means that they value of the euro will be pulled in two ways that may cancel each other out initially, but drag Europe down in the medium term. There will be a push upward on the euro for a short time, but those redemptions will lead to stock market declines that may very well spill into the real economy.

Ultimately, Europe will have to start thinking about how it will deal with American decline. When a key global institution joins the chorus of critics who demand you live more modestly, change will eventually happen. What we don't know is what exactly the timing will be or what event will start the rush toward the fire exits. There are no elections this year which serve as a defining moment of political clarity. But the current American showdown between Republicans and Democrats over the national budget will probably play the biggest role of all. 

1 comment:

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