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Wednesday, November 16, 2011

The Financial Crisis in Europe and How it Affects the United States

Anymore seems like the world is questioning capitalism and even democracy.  Since 2008 we’ve had multiple bailouts in the US, a severe recession, and non existent job growth.  Many people thought that the problem was contained in the US, and the only loss of foreign capital was due to foreign funds actually invested in the US.  At this point though, we should all understand that we live in a global economy.  Just look at the trend of investments.  Foreign investors saw the US as a much safer investment than investing in their own countries.  Some sovereign debt overseas could be rated as junk bonds, so the safest bet is generally the US.  Add into the equation that mortgage backed securities (MBS) were rated AAA+ investments and offered a higher return than treasuries and we saw a huge wave of foreign capital enter the states.  Well we all know how that worked out.  The crash of the US housing market almost broke the back of the economy, and many foreign investors lost a significant amount of their investment.  Because of this, I think we were more inclined to bail out banks, GSE’s (Fannie Mae & Freddie Mac), insurance companies (AIG), and any other large corporation that held large amounts of these assets. 

This was the start of Europe’s financial problems though, you had foreign nations and foreign companies parking their cash in the US which led to them booking massive losses on these investments.  So a combination of 30% losses and a stagnant global economy led to many banks, companies, and countries being very strapped for cash.  Banks and corporations can figure out ways to find capital, but countries really don’t have many options.  That is what is happening in Europe right now, you have countries that have no way to service their debt unless some other country issues them a massive loan.  Even if they issue this loan, there is no way it can be paid back in a short time period.  Governments make their money from tax revenues.  Tax revenues increase for one of two reasons.  One is if taxes are raised.  Two is if the economy is growing and citizen’s taxable base increases.  So if a massive loan is issued it needs to stimulate the economy, so the country becomes wealthier which will increase the taxable base.  I mean think about it, lets say 10 countries pulled together to loan 1 trillion euro to the struggling countries in the EU.  The struggling countries will have to pay the interest on their sovereign debt, invest in the country, and facilitate growth.  Regardless of what they do we are looking at a 15+ year time frame for the loan to be repaid in full.  Sounds dismal, but this is the reality of the situation and this is why you haven’t seen any enthusiasm for bailouts of actual countries.  It’s because they know how difficult it will be to be repaid, and how long their money will be tied up with the loan.

So where do we fit in this equation?  I don’t remember France or Germany sending us a check to help us out w/ TARP.  So do we have an obligation to bail out some of the EU?  No, we don’t.  In fact, I think this is an opportune event that could possibly right the ship on some of the actions the fed has taken the past couple years.  First things first though:

-Let’s say Greece defaults on their debt.  You will see rating agencies questioning the standard AAA+ for sovereign debt.  You will see a severe decrease in the euro, and you will see a severe decline in the US stock market.  I don’t think any of this is bad though.  We can’t allow short term trends in the markets effect our long term vision of the economy.  The market is going to react differently all the time, we can’t take it to literal though.  Short term losses are always made up in time, we can’t let it dictate any form of domestic or foreign policy.  So the market reaction to the default will not be favorable, but in time the market will correct itself and continue trending upward.

-The Past four years people have not been impressed w/ the US stock market for their 401k’s, IRA’s, and other retirement funds.  They have not enjoyed the lack of consistency, and uncertainty due to the MBS situation.  Because of this a lot of people have been advised to invest overseas in the categorical equivalents of their respective US fund (meaning a blue chip US fund is equivalent to a blue chip foreign fund).  The issue is of course presenting itself now.  Equities are always risky, so no need to discuss this too much.  The scary part of this foreign investment is in fixed income funds.  People close to retirement will weight their portfolios more towards fixed income to protect themselves against massive fluctuations in the market.  And if they’re very close to retirement they’ll weight the fixed income part of the portfolio to sovereign debt.  US Treasuries weren’t paying out anything at the time, so investors were looking for safe bonds from EU nations.  The loss of principal already has been huge because of the sudden increase in rates (although increase in interest rates for fixed income doesn’t affect a bond if you hold it to maturity, but in a bond fund they’re traded daily so if you hold a bond with a YTM of 5% and they raise rates to 8% then the value of your bond has decreased dramatically).  Which brings me to my point.  The only valid reason for a US funded bailout is to limit the losses for US investors.

As you can see, the negative consequences of the EU financial crisis are mostly tied to US markets and investors.  I don’t think this is enough to actually dedicate funds to relieve these countries.  We can’t allow short term market reactions influence our policy decisions.  Plus I think there are a lot of positive aspects to an EU financial crisis:

-It’s no surprise to anyone that the US is facing some serious threats of inflation right now.  Two rounds of quantitative easing (which is the fed printing money to buy US treasuries to put more money in the economy) and a continuation of historically low interest rates will do the trick every time.  Even if the US experiences 20 years of 10% annual growth we will still have the issue of inflation because of these two things.  So what do we do?  We don’t do anything, but we can let the EU devalue the euro.  Eventually Europe will have to bail out probably 60% of the region and probably a lot of banks as well.  You will see a freeze in credit in Europe just like what happened in the US in 2009.  So what will the EU and IMF decide to do?  They know that they’ll have to influence the banks to lend by two ways.  One they’ll have to lower rates and secondly they’ll have to add money to the system.  They’ll lower rates through the central bank and I’m sure they’ll implement some form of quantitative easing as well.  Doing this will jump start the economy but in turn will devalue the Euro.  Hopefully when it’s all said and done we will have a dollar to Euro conversion at one.  This will positively affect commodity prices in our favor, it will encourage foreign trade, and will give us a fresh start to manage our currency.  Bottom line, actions by the central bank of the EU will counteract the actions of our Federal Reserve adding value to the US dollar and hopefully limiting the downside of domestic inflation.

-The second positive reason for EU turmoil is to instill more confidence in the US economy.  The US is still the most developed and diversified economy in the world.  We have so many different economic sectors that add to the countries growth.  Diversification is beneficial in your 401k and in a nation’s economy.  Most EU countries are moderately diversified, but if any national financial issue occurs it crumbles the system.  The world will notice that because of the diversification of the US economy, it’s once again the best place to invest.  This will add more foreign capital to our system.  It will provide growth in US corporations which will in turn increase GDP growth.  An influx of capital would give us the jumpstart we need to get the economy back on track.  Foreign capital coming back to the US will create value for the nation which will give us the GDP growth we need to get the economy back on track and also reduce the deficit.

-Lastly, allowing the default of EU countries will give our policy makers a wake up call on the role of government in the private sector.  EU nations struggle because of the large amount of entitlement programs, high taxes, and their anti-entrepreneurial business environment.  Countries flourish because of the growth and competency of the private sector.  Governments that try to do too much, spend to much, care to much end up failing because the numbers don’t make sense.  One plus one never equals three.  We need to have the government implement policy that rewards success and promotes private sector growth.  Once the country is in a better fiscal situation, then we can tackle issues like healthcare and social security reform.  Conservatives aren’t heartless to the struggles of the public, we just want to wait until we can do it right.  The fiscal disaster in Europe should act as a wake up call to all governments that big government and anti business policy isn’t beneficial or sustainable.

In conclusion, we have options when it comes to the EU situation.  I think the lack of commitment by the EU to help their brethren is completely contradictory to the way their currency is set up.  As a group they were more then happy to accept the benefits of the strength of the Euro, but then once some of the countries fall on tough times they want to abandon them?  It doesn’t work like that.  If you’re not committed to the Euro then abolish it and go back to individual currencies again.  But don’t be afraid to accept the consequences of a negative turn to the EU economy because your country isn’t as negatively affected as the others. 

Our central bank needs to take leadership and instruct congress and the white house on what to do with Europe.  The republican candidates can shun the establishment of the Federal Reserve but it is absolutely necessary for the stability of the economy.  Do we really want congress making decisions on monetary policy?  Back to the point though, the Fed knows the benefit of the EU engaging in quantitative easing.  It’s like a free pass for all of the cheap money we’ve had out there for the past three years.  The benefits of an EU default far outweigh the downside.  We need to look at all the facts and make our decision based on data, and not by watching the news and seeing the protests going on in Greece, Spain, France and other nations.  Data needs to drive the decision, not the media and not emotions.

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