Friday, May 18, 2012

The Deadly 3-Ds Facing Europe and the U.S. ... Demographics, Debt and Deficits

Europe and the U.S. both face severe structural problems with the 3-Ds--- demographics, debt and deficits.

(1) We've getting older as a world, (2) are deeply in debt and (3) continue to pile more debt on debt with ongoing and unsustainable annual deficits.

Yet we hear complaints all the time about mean spirited "austerity" measures as we continue to  spend money that we don't have. That's called borrowing and it's sure not austerity.

So where are the 3-Ds leading Europe and the U.S., and will the path chosen by each lead to the same or different places?

Here's my bet. The U.S. will choose to go its own way and not follow Europe off the fiscal cliff ahead.  But my bet ain't no sure thing, of course. The outcome will depend in large part on how much we're "path dependent."

Path dependence is a term which in essence means that future economic outcomes are dependent on the path of previous outcomes, rather than simply on current conditions. In a path dependent process, history matters--a lot.  We have a tendency to keep doing the same basic things even after they've led us to the current crisis. I agree that it doesn't make much sense, but that's the way it all too often works.

If you don't like the term path dependent, how about calling it Can Kicking 101?

Accordingly, path dependence, aka can kicking, projects that many European countries will suffer serious train wrecks, and that they won't be able to stop the train before financial disaster hits.

Thus, most European sovereigns won't do the right things to address, let alone fix, their 3-D entitlement welfare state affordability issues, even though the path they're on is the road to catastrophe (sound familiar?).

There's simply too much European history of collectivism over individualism, especially in southern Europe.  As such, embedded socialism will prevent them from taking the painful but necessary actions to put their economies on a private sector led road to recovery. Thus, much of Europe is headed down the 3-D road to financial ruin. While I very much hope I'm wrong, that's my view.

So what about us?

Europe's New Woes Raise U.S. Threat deals with the potential harm that could befall the U.S. economy as a result of Europe's unwillingness to face the facts about 3-D.

Let's quote excerpts from the article:

"During bouts of European turmoil in the past two years, U.S. financial markets regularly stumbled and growth ebbed due to fears of a euro-zone meltdown. But Europe muddled through and avoided calamity, and the effects on the U.S. economy weren't all bad. U.S. exports to Europe rose, and many U.S. banks benefited as overseas competition fell away.

Now, the troubles in the currency union—the threat of a Greek exit from the euro zone, rising borrowing costs in Spain and Italy, recessions in several European countries—are renewing fears of an escalating crisis that could deliver a more serious blow to the fragile U.S. recovery. . . .OUTLOOKFederal Reserve Chairman Ben Bernanke recently noted that some of the improvement in financial markets late last year and early this year has been reversed by "what remain significant problems and concerns in Europe."

Despite Europe's debt woes, U.S. exports to the continent have been recovering since the 2008 financial crisis. By the first quarter of this year, U.S. exports of goods to Europe had returned to around their pre-crisis peak. Overall exports have been a critical driver of the U.S. recovery, far outpacing their growth in most recoveries since World War II.

One key reason: the U.S. dollar has remained relatively weak against the euro, at or above $1.30 for most of the past three years.

That could change quickly if a wave of deeper troubles in the euro zone, or interest-rate cuts by the European Central Bank, spur a flight from the euro. A sustained drop in the euro—even to just $1.20—could help European economies recover by boosting their exports.

While a cheaper euro would dent U.S. exports slightly, it could alleviate fears of a more disastrous scenario for Europe. That outcome "would be a reasonable trade-off for the United States," said Citigroup economist Nathan Sheets, who until last year led the Fed's international-finance division. "That might very well be a channel that helps Europe in solving this financial crisis."

Europe's weakening economy has already hit Asia harder than the U.S., slowing growth for major exporters such as China and India. That could also cool global growth, hurting U.S. export prospects.

But exports still account for a relatively small share of the U.S. economy—less than 15%. They're about 40% of Germany's output and about 30% of China's.

The bigger risk for the U.S. all along has been financial contagion, a spreading of the euro-zone turmoil to other markets. Weakening euro-zone economies could exacerbate their governments' debt burdens, driving up their borrowing costs and hurting European banks. More trouble in the European banking system could ricochet across the Atlantic and trigger problems for American banks or big losses for U.S. investors. . . .

The most positive scenario for Europe would be years of muddling through a difficult situation, hoping that painful economic overhauls will yield results in the long run. As Europe's economies weaken, even that scenario looks increasingly rosy."

U.S. Dollar Strength and its Impact on Exports and Import Costs

The U.S. dollar will continue to strengthen relative to the Euro. That means U.S. exports will be weak, but the cost of our imported goods will soften as well.

Since U.S. economic growth is not heavily dependent on exports, a stronger dollar is on balance a good thing--for both the U.S. and Europe. Crude oil is priced in U.S. dollars so our energy costs will be lower. In fact, we've likely seen the high for gasoline prices for both this year and next year.

To repeat, the cost of our imports will decline as well, as consumers get more bang for their bucks. These lower costs will apply to both finished goods and raw commodities, imported and domestic.  All of this represents good news for struggling U.S. consumers and domestic companies as well.

Deflation or Inflation

Most of Europe is a train wreck. It's happening in real time and right before our eyes.

Accordingly, as the world's economies continue to slow, including China and India, the prospects for inflation in the U.S. will become more remote. Commodities, including such things as crude oil, cotton, gold, silver and copper, will become less costly to U.S. buyers, both consumers and companies. See A Rare Speed Bump in Commodities' Long Run.

My view is that our real U.S. concern going forward will be related to deflation and not inflation. And if I'm right about that, the fight to fend off deflation will enable the Federal Reserve to keep U.S. interest rates low for several more years, thereby giving us time to get our fiscal house in order as our economy escapes stall speed and resumes solid economic growth.

Summing Up ... Biggest Threat To U.S. Is That We Follow Europe Down The Wrong Path

The biggest U.S. down-the-road-but-not-too-far threat is the same one Europe now faces--path dependency.

As We the People reject the path dependence road to ruin--unlike many European nations--and especially those in southern Europe--we will steer ourselves away from the spendthrift ways of a welfare entitlement state.

Then economic conditions in the U.S. will begin to improve on a solid but gradual basis. This projected improvement will be gradual and insufficient to bring unemployment rates down to the 6% level for several more years. Too much 3-D in our sights for anything speedy.

So while we still have time on our side, let's not waste this opportunity to observe and learn from the path dependent 3-D behavior of our European friends.

Finally, What About Europe?

For Europe, we'll continue to hope for the best while expecting the worst.

If European nations surprise us the next few years and decide to live within their means while pursuing private sector economic growth initiatives, that would make this a much better world for everyone. Let's hope that's exactly what they decide to do.

But even if the Europeans head off the cliff, We the People must insist that our U.S. politicians do the opposite and change course before we fall off, too.

Future generations of Americans deserve no less.

Thanks. Bob.