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Europe Fires the Bazooka
By: Dr. Charles Lieberman
Date: 5/10/2010
Greeces risk of default has the potential to disrupt markets globally, depressing stock and most commodity markets, while pushing the safest bonds, Treasuries, to artificially high values. Economic recovery in the U.S. would move markets in almost exactly the opposite direction, providing a sound basis for stocks to rally and bond prices to decline. With both events happening simultaneously, the outcome is indeterminate and investors are appropriately very uncertain. It is unclear which behavior will dominate. Hopefully, European governments have gotten the message that they must move aggressively to prevent the Greek problems from undermining confidence across Europe. The announced support deal, more than $900 billion including IMF money, is large enough to buy time for these governments to reduce their budget deficits. (Hopefully, the details and implementation of the package are as promising as its announced size.)
It is not yet clear whether the Greeks or the Europeans have recognized what they must do, although the announced package is clearly a major step in the right direction. Greece can no longer borrow at a reasonable cost from the market to pay the difference between its very generous government programs, pay scales, benefits and programs compared to that nations meager tax collections. If they want a large government sector, with very generous benefits for the public at large, they must raise the tax revenues to pay for it all. Will the government actually implement the budget restraint that is required? The riots and strikes make no sense and the sooner the government helps explain this to the public, the better. (In fact, some members of the public understand this, but riot anyway in the hope of forcing others to pay. The anarchists seek anarchy, which is no solution at all. Does the rest of the public understand?)
The rest of Europe must lend Greece enough money to finance the country while it gets its fiscal house in order, or risk contagion spreading to the rest of Europe and undermining Spain, Portugal and Italy. German and French banks made those loans by buying Greek bonds. A Greek default would be very costly to these banks and would undermine other borrowers, causing even larger losses and bank failures across Europe. Containing the problem to Greece and limiting its spread to the rest of Europe is of the greatest urgency. Since the debt problem is large, the support package must be equal to the task in both size and its level of support and it appears to be so. Now, they must follow up with appropriate deficit reductions efforts across Europe.
In the U.S., we are mesmerized by the developments in Europe, partly because we have recently experienced how the failure of a single notable player, Lehman in our case, spread through our capital markets, which ceased functioning. So we and the Europeans have seen this movie before, which makes it all the more frustrating and disturbing that the Europeans moved so slowly before finally becoming aggressive to contain the problems to Greece.
Domestically, the economy continues to improve. Doubts have been expressed about the sustainability of our economic recovery. The latest employment figures should go far to laying those concerns to rest. Every aspect of the jobs report was strong, including the rise in the unemployment rate. When an economy lapses into recession, unemployed people stop looking for jobs, since they know jobs are extremely difficult to find and this artificially depresses the measured unemployment rate. As job growth resumes, those people resume seeking employment, which increases the pool of unemployed, at least until enough hiring has occurred to overcome this surge in the labor force. In fact, hiring rose sharply, but the length of the workweek also rose, which indicates a significant need by business to increase its work force. This is extremely promising for future hiring. Most importantly, the sizable rise in hiring also boosts household income, which gives people the financing to pay for increased spending and requires yet more firms to hire more workers. So, it now appears that the expansion is becoming self-reinforcing and self sustaining and the risk of a double-dip recession is disappearing rapidly.
Without Greece to worry about, the Fed would be thinking about raising interest rates sooner rather than later. The need for an exceptionally stimulative monetary policy is already past. Based solely on domestic considerations, we would be extremely bullish on stocks and bearish on bonds, especially government bonds. With Greece as a possible disruptive force to global capital markets, the Fed will be hesitant to raise rates. Moreover, European economic growth will be undermined by the more restrictive fiscal policies that will be required in Greece, Spain, Portugal, Italy and the U.K. So, U.S. exports to Europe will also weaken. While a less expansion oriented monetary policy will still be needed in the U.S., it will come later given the disruptive forces from Europe that will restrain global growth. Similarly, we would want to see that Europe is addressing its credit problems before we commit all our cash resources towards equities. We will become more aggressive in our positioning once we think the situation is Europe is stabilizing. If the announced package is supportive in its details, which are still not public, we will be far more comfortable with our bullish stance on equities.
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