The Euro and You

If you've read, watched, or clicked on any news media recently, it's probably safe to say that you've heard about the Euro crisis.

It has dominated the headlines of the world's news outlets, from the Washington Post, to the Wall Street Journal, and everywhere in between. There's a lot of information out there about this incredibly important development, but I've found that few people I know have a good idea of what's really going on. What's more, it can be hard to understand how and why fiscal and monetary policy half a world away can affect our lives in the U.S. and other countries, in major ways. Furthermore, the discourse around the Euro crisis, and economics in general, is studded with jargon and technical terminology. The net effect is that many people simply choose to tune it out. It's too hard to understand, and anyway, how could it possibly affect me? But this would be a massive miscalculation. And I'll tell you why:

For one, the Euro crisis has, and will continue to have, seismic effects on the world, and the U.S. economy in particular. However the crisis plays out, we'll feel it. Everyone will. This primarily stems from the enormous size of the EU economy. With a nominal GDP of roughly $17.5 trillion, the EU outweighs the U.S. economy by  about $2 trillion, and absolutely dwarfs China's comparatively paltry $7.3 trillion. Admittedly, the EU contains several large economies not on the Euro, most notably Poland and the U.K., but these countries are extremely closely linked with the Euro zone economically, and will feel the effects of the Euro crisis more than most. As can be seen, taken together, the EU comprises the world's largest economy. The sheer size of it guarantees that shockwaves from the Euro crisis will ripple across the globe.

The Eurozone is particularly important to the U.S. economy, because they buy our stuff. A lot of it. According to the U.S. Census Bureau, as of 2011, the EU bought $268.6 billion worth of U.S. goods. Meanwhile, we imported  $367.8 worth of stuff from Europe, which comes out to a whopping $636.4 billion in total trade. This makes the EU our largest trading partner, in terms of total trade. So a crash in the European economy would have massive detrimental effects on the U.S. economy.

Should the Euro devalue significantly, or breakup all together, Europe would be plunged into a massive recession/ depression. With such an economic downturn, Europeans would be less able to pay for expensive U.S. imports. What's more, as investors flock to U.S. Treasuries as a safe haven, the dollar appreciates. We always hear about how a strong dollar is a good thing, but this is not always the case. As the dollar becomes more valuable, U.S. imports become more expensive for Europeans, and consequently, they buy less of them. Other traditionally "solid" currencies will face the same fate. Indeed, the Swiss have already anticipated this, and have taken measures to hold down the value of the Swiss Franc. They'd face the same problem we would, in that their exports would become prohibitively expensive in their largest market. That's bad news. In times of trouble, even a strong currency can be a liability.

We'll also feel economic shocks by way of China, should the Euro descend further into crisis. The EU is also China's largest trading partner. And although the Chinese have artificially held down the value of the Yuan in order to ensure that their exports stay cheap, a massive decrease in demand in Europe for Chinese products will spell disaster for economies of scale. Factories designed to produce 10,000 shirts per day will only have the market to produce 7,000. When that happens, prices go up. For everyone, including the U.S. Indeed, so much of the American lifestyle is predicated on cheap consumer goods from China, it's almost unthinkable to imagine what a spike in Chinese prices might spell for your average American. Suffice it to say, it would be bad. Very, very bad.

Aside from the the fact that the Euro crisis will have untold effects on the U.S. economy, it's also important that we understand it because of the lessons we can draw from the Euro-zone's trials and travails. It's pretty much become common knowledge that Greece was ground zero for the meltdown now facing Europe. Indeed, just a few days ago, Greece elected a new government, in an election that will do a lot to determine how the crisis is resolved. Greece's conservative New Democracy won, which is good for Greece, and Europe as a whole. While ND's leader, Antonis Samaras intends to negotiate less austere terms for Greece's bailout, his plans pale in comparison to the Socialists' plans to do away with all austerity measures for Greece. This would put them right back where they started, with an unmanageable sovereign debt.

Creditor nations like Germany are caught in the proverbial Catch-22. Conventional fiscal conservatism might say to let the Greeks implode and reap what they've sown. Indeed, many German taxpayers have started to give voice to this position. Unfortunately, reality dictates a much more nuanced, and painful, approach. It's like this; Greece's house is going up in flames, and even though their neighbors, the Germans, told them repeatedly to fix their faulty wiring, the house still went up. Now, the Germans could let them deal with it on their own, but the fire will spread to Germany. If Greece should implode, Europe could see a chain reaction that includes Spain, Italy, Portugal, and Ireland. Even Belgium and France have serious borrowing problems, that might become acute if such an implosion should occur. So now Germany's house is in danger of catching fire. Even if they took extreme measures to cordon themselves off, like re-introducing the mark, they'd still feel the crushing effects of a stalled European economy.

Even so Germany may be willing to help, but at a price. Chancellor Angela Merkel is demanding extremely strict austerity measures from the Greeks in return for bailout funds. Unfortunately, such measures have proved extremely unpopular with the Greek people, as they've taken to the streets to voice their protest. Perhaps Ms. Merkel's memory is short, but she'd do well to remember that her predecessor Gerhard Schröeder's own fiscal reforms in Germany in the early 2000s brought him the ire of the German public, as they perceived him dismantling the German welfare state. However, the pain then seems to have undergirded Germany's current economic performance. Merkel wants too much, too fast. While Greece needs to implement austerity measures, she ought to remember that financial reform is always a slow and painful process. People don't like when you take things from them that they've come to consider theirs by right. By demanding too much, too quickly from Greece, she risks accomplishing nothing, and in the process, plunging Greece into a deeper depression.

But what went so colossally wrong? Wasn't it only a few years ago that American rappers featured Euros in their videos and Giselle Bündchen famously demanded to be paid exclusively in the currency? Greece provides us a tragic warning about how an economy can sink to unimaginable lows. Greece should have been a success story. When the single currency came into effect in 2001, money poured into Greece from foreign and European investors. But that money was poorly invested. Greece spent way too much on the Olympics in Athens, and wound up with nothing to show for it.

Instead of investing in human capital by putting money into education and professional development, government payrolls ballooned. Political corruption abounded and favors replaced selection based on merit. To compound things, tax evasion ran, and still runs, rampant in Greece, so they were without the tax receipts to offset the mushrooming cost of the government. The bloated government was inefficient and overpaid. Worse, Greece rolled out the red-carpet for social welfare. Pensions exploded to unsustainable proportions. Wages rose artificially without a corresponding increase in productivity.

This all combined in 2009 when investors finally took a close look at Greece's books, and found that the country had been doctoring many of its financial statements in order to appear like it was operating within the bounds prescribed by the European Commission. But by then, the damage was already done. Greece's borrowing was unsustainable. Worse, they wouldn't be able to borrow their way out of the financial mess. Investors had lost confidence. As such, Greece's borrowing rates soared, and only a bailout with artificially low repayment rates could possibly save the economy. And because they were tied to the Euro, the Greeks could not de-value their currency in order to make exports cheaper to make up for their lower productivity. Because of this, the Greek economy has become structurally uncompetitive. And in a global economy, that spells death. There are infinite other countries to buy things from, and Greece produces nothing unique. To throw salt on the wound, the civil unrest has decimated the tourist industry.

What's disturbing, is that many of the elements that sank Greece, and raise questions about other Euro economies, are present in the U.S. economy. Spain for example, has a generally competitive economy, but they are still dealing with the fallout from their property bubble, much like the U.S. Even after significant austerity measures reduced the deficit, and even a constitutional amendment mandating a balanced budget was passed, Spain has faced increasing borrowing costs, (up near, 7%) as a consequence of its credit downgrade to Baa3, one grade above junk. This came on the heels of Spain accepting a bailout package worth 100 billion euros in order to recapitalize their struggling banks. Beyond similarities due to the property bubble, the U.S. also faces many of Spain's banking problems. Like the U.S., Spain's banking system received bailouts before, and weak banks were restructured and subsumed into larger ones.

The problem, is that these new, larger banks still have many of the old bad investments on their balance sheets. The same is disturbingly true in the U.S. Indeed, JPMorgan boss, Jamie Dimon testified to Congress just last week about his otherwise profitable firms recent $2 billion loss. Bad investments don't go away magically with a bailout. They stick around to haunt firms, and the taxpayers who bail them out, until they're written off.

The comparisons don't end there. The U.S. famously faced its own credit downgrade last summer, and while its effects have not been as acute as Spain's, the fact remains that investor confidence is not what it once was in the "full faith and credit of the U.S. government." Further, while unemployment is down from its highs of 11 and even 12% in the past few years, much of that hiring has occurred within the public sector. If Greece teaches us anything, a large government payroll, combined with low tax receipts, spells certain economic disaster. Finally, education and infrastructure spending in the U.S. lags behind such sacred cows as defense. Again, bad investments will come back to bite us.

The Euro crisis is vitally important to us across the pond. It will reach into your life and affect you in ways you might not even imagine. But the silver lining in all this, is that we can learn from the failures in Europe, even as we look inward to exorcise our own economic demons.