Economic Commentary -- June 2011

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

The Eurozone Debt Crisis, Redux
The seeds of the Euro, and the current eurozone crisis, were sown in the late 1980s and early 1990s when European leaders first began to contemplate the idea of a single currency to unify the continent. In 1991, the then-15 members of the European Union (EU) met in Maastricht, Netherlands and agreed to a path toward a common currency as part of an overall plan for an economic and monetary union.As part of those plans, the European Central Bank (ECB) was created. Unwilling to surrender their sovereign power over their currencies, the United Kingdom, Sweden and Denmark opted out of the currency plans but stayed in the EU. Greece was initially excluded from the adoption of the Euro due to its weak economy but was added in 2001.

Although the idea behind the Euro was to create a fiscal and monetary union, the countries involved weren’t willing to give up much control, so while debt targets were agreed upon, there were no penalties for non-compliance.

The Euro was officially launched at the beginning of 1999 as an electronic-only currency with overall zone interest rates set by the ECB. Three years later, the paper currency launched for the 300 million residents of the 12 initial eurozone countries. Since then, the Euro has added five members: Slovenia, Malta, Cyprus, Slovakia and Estonia. Original members are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal and Spain (Fig. 1).

Although the Euro had its ups and downs, it wasn’t really threatened until the global financial crisis hit, and even that was delayed, as it took problems several years to reach crisis proportions, amid squabbling between EU and eurozone finance ministers. While Greece suffered and bond markets raised rates, EU ministers were either unwilling or unable to comprehend the danger posed to the eurozone.

In the end, they created a gigantic bailout package of nearly $1 billion to soothe restless markets about the ability of the Euro to ride out this crisis, which by then included Ireland and later spread to Portugal. Ultimately, the International Monetary Fund (IMF) was brought in to assist with the bailout funding and lend its expertise in handling financially troubled sovereign economies. This brought the entire membership of the IMF – including the U.S., China and many others – into bailing out Greece, Ireland and now Portugal.

A year later, the crisis is intensifying again, although it has not reached the headline attention it attracted in the first round. Greece needs a further rescue package, eurozone leaders can’t agree on the terms, and, to top it off, the IMF managing director who drove much of the consensus in the past year, Dominique Strauss-Kahn, was arrested in New York City and charged with sexual assault. Although he resigned shortly after his arrest, Strauss-Kahn’s absence at talks aimed at figuring out an answer to the latest Greek crisis and the vacuum in IMF leadership didn’t help.

In this month’s commentary, we’ll examine where the eurozone crisis stands, the background leading up to the crisis, some possible implications for the U.S. and global economies and where we’re headed as a result.

Current Events Overview
While the $1 billion bailout package quieted the markets just as it was designed to do, there have been rumblings over the past six months that all wasn’t going quite as well as expected below the surface. Greece and Ireland received bailout funds as promised as part of a joint IMF-ECB bailout, but at the price of severe budget cuts that drove both economies further into a recession. Ireland actually descended into an economic depression, defined as 10 straight quarters of GDP contraction, in May 2009 (Fig. 2). However, Ireland, which received more funding from the ECB and IMF in May, is in better financial shape than Greece and isn’t believed to be at risk of default – at least not at this time.

In April, yields on Greek debt jumped by more than 10 percentage points as markets began to factor in the instability of Greece into their calculations (Fig. 3). Increases in rates make it even harder for Greece to attempt to raise funds in the markets because the interest rates attached to such a bond issuance would be prohibitively high. EU ministers, especially in Germany, found fault with Greece for not implementing austerity measures or privatizations quickly enough, especially in light of the realization that Greece would likely run out of money by the second half of 2012, which would necessitate a further round of bailout funding.

Just like last year, with the twist of the leadership vacuum at the IMF, EU ministers are quarreling over exactly what needs to be done to rescue Greece. Germany is adamantly opposed to a restructuring – essentially a default – on the part of Greece that would allow it to write off some of its debt to ease the overall debt load. However, markets are pricing some kind of restructuring into the picture, and most experts believe that despite the objections of Germany and other EU members, it’s inevitable. Most believe it’s a matter of when a restructuring will take place and how it will happen, rather than if.

When times were good, members of the Euro, especially those on the periphery like Greece, benefitted from the low interest rates available via membership in the eurozone. Like the others, its economy grew briskly (Fig. 4). Too briskly, in fact, as the same real estate bubbles that infected the United States existed in Europe, especially in Ireland and Spain, and to a lesser extent in Greece.

Now, the weakest members of the eurozone are paying the price for the good times. Because they are tied to the monetary and interest rate policies set by the ECB, they can’t print money to spark economic growth like the U.S. Federal Reserve has in its two rounds of quantitative easing. That means years of a painful economic restructuring for these countries as government spending aligns with new economic realities, with economic contraction at worst and no or low growth at best.

In fact, the stage was set for future problems when the Euro was created because member countries weren’t willing to compromise their economic sovereignty by adopting the strict rules necessary for the further economic union that would support the monetary union. Without economic and even political union, the eurozone was bound to run into trouble sooner or later. Member nations were fortunate that the launching of the Euro coincided with a general period of economic growth; unfortunately, that lead to the illusion that the eurozone’s structure was more stable than it has proven to be during the past several years.

Greece wasn’t the only country violating the zone’s debt guidelines; most other countries were in violation at one point or another during the Euro’s first decade. However, such violations were ignored because they didn’t create problems. But once the party was over, it rapidly became apparent that the lack of compliance and enforcement to zone guidelines and a lack of rules was a problem.

Impact of Austerity
Austerity is a by-word in government budget discussions around the developing world. Deficits pose multiple long and short-term dangers to the fiscal health of economies. However, when an economy is struggling to emerge from a recession, budget cutbacks can kill a nascent recovery and send that economy right back into a recession.

There’s a special danger in imposing austerity on a country that is already struggling economically, such as the weakest members of the eurozone, including Ireland, Greece, Portugal and potentially Spain and Italy. Those economies, already reeling from the implosion of housing bubbles with demand falling through the floor, are extremely vulnerable to years of economic misery as their economies and citizens adjust to the new economic reality.

Without the option of printing money to inflate their way out of a recession – as the U.S. Federal Reserve has been doing – Ireland and Greece will likely be stuck in a no-growth mode, at best, or a negative growth mode, at worst. In fact, Ireland’s economy shrank by 12 percent during the past three years, according to TK. And the IMF and ECB bailout mandated massive government spending cuts and tax increases that amounted to 18 percent of GDP.

Translated into the U.S. budget for comparison purposes, that would amount to a package of $2.7 trillion in budget cuts and tax increases, according to the Economic Policy Institute. That’s far beyond what any member of Congress, no matter how much of a deficit hawk, would propose. In addition, Irish national income has fallen by 17 percent, the largest plunge of any western country since the Great Depression.

The situation in Greece isn’t much better: GDP contracted 6.6 percent in the fourth quarter of 2010, following a 5.1 percent contraction in the third quarter. In fact, GDP has fallen in every quarter since the last quarter of 2008, according to the Hellenic Statistical Authority. On an annual basis, the IMF projects that the Greek economy will contract by three percent in 2011 and will gradually begin to grow in 2012.

As government elections loomed in Spain in mid-May, riots erupted in cities across the country, despite the government’s attempts to outlaw them. Protesters were up in arms over proposed austerity measures that the major parties contending in the election were promising to adopt. While Spain hasn’t yet asked for or been in urgent need of a bailout, the persistent weakness of its economy in the wake of a crushing collapse of its housing market has left it in a perilous position. Many experts believe it’s only a matter of time until Spain, and perhaps Italy, requires assistance from the bailout fund the EU established last year.

Portugal, which received approval for a 78 billion Euro bailout package in mid-May, cut spending to meet the terms of the aid package. This requires Portugal to trim its large budget deficit to 5.9 percent of GDP this year, to 4.5 percent of GDP in 2012 and to three percent of GDP in 2013. The Bank of Portugal issued warnings of a prolonged recession, contractions in personal income and high unemployment – consequences of the required austerity.

The Statistical Office of the European Communities (EUROSTAT) reported that official seasonally adjusted unemployment rates for Europe are as follows:

Unemployment rates for Spain are off the charts and are much higher than the rates for the U.S., Greece and Portugal. Rates for the EU and eurozone are a bit higher than the U.S., but not much. As U.S. policymakers have found, without economic growth it’s very difficult to increase employment. And with economic contraction, higher unemployment is near certain. Housing prices are also falling in these countries, making it even more difficult for them and their consumers to climb out of the debt they’re trapped in.

As a country’s economy contracts, its share of debt becomes larger, making it even harder to pay off. This creates a vicious cycle because austerity produces further contraction, rating agencies downgrade credit ratings, interest rates on debt skyrocket, and countries such as Greece and Ireland are stuck waiting it out since they can’t print money to get themselves back on a growth track.

Future of the Euro
In the immediate future, EU ministers, IMF representatives and Greek politicians will continue to negotiate over the terms of further funding for Greece. Germany, especially, favors a course of action that involves holding Greece to its promise to follow the EU/IMF austerity plan and providing Greece with more funding to tide it over for a few more years. Politically, such austerity is very difficult for Greek leaders to sell to the populace, who face years of high unemployment, a diminished social safety net and declining real estate values.

Other options include a “hard” restructuring versus a “soft” restructuring. Under a soft restructuring, also known as re-profiling, bondholders would agree, perhaps with some arm-twisting, to exchange current Greek debt for debt with a later maturity. However, several rating agencies have stated that they would consider a soft restructuring as default, which would trigger a default credit rating and make it impossible for Greece and other weak eurozone members to borrow in the bond markets. Under a hard restructuring, bondholders would be required to receive less than the full value of their bond holdings.

Longer term, while everyone involved insists that the Euro is solid and that every single one of the 27 countries in the eurozone will continue to be a member, that’s hardly certain. Breaking up the Euro would be a shock to the European and global financial system, much greater than the previous financial crisis, so political and economic leaders are going to do everything they can to avoid it. But as the markets squeeze the weakest members with ever-increasing interest rates on debt, credit ratings get cut to near junk status and eurozone ministers argue about the details of future bailouts, the future gets murkier.

It wouldn’t be easy by any means for Greece – or any other of the weaker members of the Euro – to leave the eurozone and go back to their former currencies. Should Athens take such a step, analysts predict that the new Greek currency could lose 50 percent of its value, plunging Greek banks into crisis and propelling national debt to new heights. European and U.S. banks, holders of many eurozone and Greek bonds, would be rocked as well, and the entire global financial system could find itself in a liquidity crisis worse than the one that followed the Lehman Brothers collapse in the fall of 2008.

Implications for the U.S. and Global Markets
There are several potential implications for the U.S. economy and global markets in the eurozone’s struggle. U.S.-based banks, for one, have a lot of skin in this game in the form of $1.4 trillion of European debt on their books. In fact, Europe is our largest trading partner, purchasing 21.4 percent of American exports. U.S. corporations have far more invested in Europe than Asia.

The U.S. has a major stake in the economic stability and prosperity of Europe. Not only banks, but also manufacturing firms, would be affected if the eurozone experiences more economic turmoil. A default, let alone the failure of the eurozone, could precipitate a financial crisis that would extend beyond Europe. Even continuing economic uncertainty in Europe won’t help banks in the U.S. and around the world and the global economy. It could undermine the already fragile U.S. economic recovery, which needs healthy banks and every export market possible.

What to Watch For
If EU/IMF officials and Greece come to a quick agreement for additional funding that wouldn’t involve either a hard or soft restructuring, economic stability in Europe would likely be preserved – at least in the short term. If those talks drag on or become contentious, markets would likely react unfavorably, increasing yields and decreasing the value of existing Greek debt. Greece might also face additional credit rating downgrades, this time to non-investment grade or junk status.

Portugal just received funds, and Ireland is on track to get another infusion. Those situations seem relatively stable, at least for now. Keep an eye on Spain, where the collapse of the housing bubble has wreaked havoc on the entire economy. Official unemployment is running near 20 percent, while unemployment among the young is more than 40 percent. Spain’s economy is much bigger than that that of Greece, Ireland and Portugal; it’s the 12th largest economy in the world and the fourth largest in the eurozone. If Spain needs help, the size of the package will strain resources not only of the EU but in the U.S. as well. It might strain the resources of the EU to the breaking point.

Monitoring a country’s government bond yields may be the best way to assess the magnitude of the crisis. This map illustrates the EU “periphery” countries by highlighting those with the highest government bond yields (Fig. 5).

Where We Are Headed
As we go to print, Greece faces pressure to sell state assets while the Greece 10-year bond rises to an all time Euro high. The IMF has just approved a loan package for Portugal. European headline news is driving credit markets day to day. Investors should view crises dominated by non-related scandal (the arrest of the IMF head) at arm’s length. We see little to no value in trying to adjust portfolios for the purpose of guessing resolution or outcomes.

The S&P 500 is higher by more than 15 percent since we last wrote about the European debt crisis in March 2010. Are the markets likely to match that return going forward in the late stages of an economic recovery? Unlikely. But given low interest rates and low, albeit rising, levels of inflation, a balanced investment policy with a mix of fixed income and equity exposure makes sense for long-term investors. We advise sticking with your plan.

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

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