Will Europe’s Woes Hurt The US Economy?

The U.S. economy has so far shown remarkable resilience in the face of several roadblocks year.   It has shrugged off the threat of wars in Ukraine and the Middle East, has ignored the tapering of QE, and has been generally unfazed by every other obstacle in its path, whether real or imagined.  Now, however, another threat looms in the horizon and poses a much bigger threat than previous challenges. 

Europe’s economic slowdown has weighed on the global economic outlook all year.  More recently it looks like several countries in the euro zone may even be headed into deflation.  Investors worry that deflation in Europe could spill over onto U.S. shores and ruin what has been an impressive recovery up until now.  

One reason for Europe’s lagging performance is the size and scope of its welfare state.   Economist Ed Yardeni observes that in Europe, “There are too many government regulations and regulators, and not enough startups and entrepreneurs.  Labor markets remain too rigid.”  He also points out that Europe’s bankers aren’t lending, while capital markets remain “relatively limited” sources of capital.  The region is also highly dependent on Russian gas, and, unlike the U.S. has made no effort at developing domestic sources of energy.  

While credit is plentiful in the U.S., it remains much tighter in the euro zone.  According to Yardeni, over the past 12 months through May, short-term business credit rose to a record-high $2.0 trillion in mid-August in the U.S.  In the euro zone by contrast, bank credit is down 2.2% over the past 12 months through June. 

It seems counterintuitive that there could be so much economic weakness in the euro zone even as the U.S. experiences a strengthening economy.  France is experiencing economic stagnation while Italy is back in recession.  Even Germany’s mighty economy shrank in the second quarter, according to a Businessweek report.  Why?  The primary culprit is the fiscal austerity measures enacted by several European governments in the wake of the financial crisis a few years ago.  While the U.S. evaded a major deflationary scenario through the Federal Reserve’s ultra-easy monetary strategy, policy makers in Europe took the hard road of fiscal belt tightening.  Those chickens are now coming home to roost, as several European countries have discovered to their chagrin. 

Many economists now recognize the need for Europe to reject the failed austerity policies of recent years and replace them with an aggressive monetary policy.  European Central Bank president Mario Draghi has gone on record stating that the ECB stands ready to do “whatever it takes” to buoy the euro zone economy.  Some observers have urged the ECB to take an even more aggressive stance in combating the lingering effects of the deflationary crisis years. 

Until Europe’s structural problems are addressed, what could lift the region from its current quagmire?  Margaret Carlson writing in Businessweek provides the answer: “Europe needs quantitative easing of the kind the U.S. Federal Reserve has used to good effect – that is, bond purchases financed with newly created money.  Forthright action can’t wait any longer.”  Many analysts would disagree with this assessment on a visceral level, but there can be no denying the need for serious monetary policy action in Europe.  If the euro zone is to escape the negative effects of misguided austerity, central bank intervention may be its best, and certainly swiftest, bet for dodging deflation.

In the meantime, foreign investors are moving to the dollar as the U.S. has emerged as the world’s premier safe-haven economy.  Below is a chart of the PowerShares U.S. Dollar Bullish Fund (UUP), a proxy for the dollar index.  UUP has had an explosive last two weeks and stands at a new new 52-week high – the first one in a long while. 

The strength in the dollar index this summer has been mainly a function of the bottoming deflationary long-term cycle.  In other words, investors are increasing their cash holdings as a cushion against potential volatility in equities, as well as geopolitical and global economic uncertainty, especially in Europe.  Initially, this fear of the unknown worked in favor of the gold price but at this point it appears that the dollar trade is simply a hedge against the unknown rather than a major bet against the financial market.  This incidentally explains why gold hasn’t benefited from investor psychology in recent weeks.

Returning to the question posed in our headline, will Europe’s woes hurt the U.S. economy?  Not likely.  With a new long-term inflationary cycle kicking off by October, the U.S. should see the deflationary undercurrents of the last decade steadily shrink.  Europe will have a chance at emerging from its deflation conundrum, but only if its leaders can agree to abandon the disastrous austerity policies of recent years and loosen bank lending.  The U.S. has proven to be relatively immune from overseas turmoil this year, a sign of a strengthening economy and financial market outlook.  This growing strength should serve us well in the coming year regardless of what happens in Europe.

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