Europe’s Debt Crisis May Help U.S. Economy

Europe’s Debt Crisis May Help U.S. Economy

Iva Hruzikova/The Fiscal Times
Investors fear Europe’s debt crisis will turn into 2008-09 all over again -- with a global economic meltdown and huge stock market declines. A better analogy might be the 1997-98 Asian financial crisis, which also involved heavy debt, currency pressure and the threat of contagion.

In the end, the Asian crisis was regionally contained and the turmoil ended up boosting U.S. growth by keeping inflation and interest rates low. As Asia worked through its problems, commodity prices fell and overseas money sought the relative safety of U.S. investments. The U.S. stock market recovered from its initial recoil, and the U.S. economy grew nearly 5 percent in both 1998 and 1999.

Certainly, for the next couple of years, low inflation and interest rates would be just what the doctor ordered for the continued healing of this country’s housing, banking and consumer sectors. "The U.S. may actually be an unwitting beneficiary of the crisis in Europe, much as it was during the Asian currency crisis," St. Louis Federal Reserve Bank President James Bullard told an audience in London on May 25.

Already, prices for the benchmark 10-year Treasury note have surged as investors piled in, pushing the yield down to about 3.3 percent at the end of May, from 4 percent in early April. (Bond yields move inversely to prices.) As a result, 30-year fixed mortgage rates, which track Treasury yields, are once again near historic lows. They fell to an average 4.78 percent  on May 27, the lowest since December, according to Freddie Mac’s weekly survey. Refinancing activity is surging, according to the Mortgage Bankers Association’s tally, putting extra cash in people’s pockets. Plus, oil prices have fallen by about $10 per barrel, driving down gasoline prices, which will help consumers stretch their paychecks during the summer driving season and may encourage spending.

Europe’s woes also may make the Federal Reserve less eager to raise its target interest rate any time soon, amid new market worries and more downward pressure on inflation. Even some who had consistently expected the Fed to begin raising rates this year are thinking differently. “We are changing our longstanding call for U.S. interest rates,” Morgan Stanley economists Richard Berner and David Greenlaw said in a recent research note. They now expect the Fed to maintain its current low interest rate policy on hold until early 2011. This not only keeps borrowing costs low in general, since many rates are tied to the Fed’s target, it also boosts banks’ profitability and balance sheets by keeping their cost of funds exceptionally low relative to rates they can charge on loans.

For now, at least, fears that a sudden spike in risk aversion could freeze credit markets and kill global growth, as happened three years ago, may be easing. The U.S. stock market has fallen from its 2010 highs, but major indexes ended May slightly higher than they were on May 20, and the rates banks charge each other for loans (a measure of  concerns about credit quality) while still elevated, fell on May 28 for the first time in two weeks, as tensions eased.

The mood in the financial markets has been a lot gloomier than the economic data, which show U.S.  employment income picking up and corporate profits soaring.

The near-term outlook for U.S. and global economies continues to improve, according to the Organization for Economic Cooperation and Development. The OECD on May 26 raised its growth forecasts for its 30 member nations to 2.7 percent in 2010, from November’s 1.9 percent projection. The OECD now sees the U.S. growing 3.2 percent this year, up from 2.5 percent.

The risk that Europe’s troubles could spread hasn’t gone away, but unlike Asia in 1997, Europe has much more time to deal with its problems. Much of the debts that Thailand, Indonesia and South Korea had piled up were short-term bank loans, making that crisis more incendiary. Europe’s problem is concentrated in longer maturities, which lessens the immediate pressure on banking-sector liquidity and the chances of contagion.

Also unlike the Asian turmoil, Europe’s problem is sovereign debt. Overleveraged private-sector companies can more easily walk away. “Countries do default or restructure their debt from time to time, and the world goes on,” the Fed’s Bullard said in London. He believes there is no compelling reason a sovereign debt crisis has to become an important shock to the global economy.

The European Union and the European Central Bank already have essentially guaranteed the soundness of Europe’s banks with nearly $1 trillion in promised emergency funding. That’s enough to cover the debt-servicing obligations of Greece and the eurozone’s other fiscally challenged nations for the next couple of years. During that time, the financial markets will want to see these economies making progress toward fiscal consolidation.

As long as the sovereign debt problems in Greece and elsewhere in the eurozone remain Europe’s problems, the U.S. recovery will benefit and stay on track. So far, U.S. growth has been driven by a combination of homegrown demand by consumers and businesses and strong exports fueled by booming growth in Asia. For now, American credibility in global financial markets is a major plus for its outlook, but as Europe’s situation shows, keeping that edge will require hard policy choices down the road. In order to assure a lasting upturn, the U.S. will have to tackle its own fiscal problems.