BY LISA EMSBO-MATTINGLY, DIRECTOR OF ECONOMIC ANALYSIS, FIDELITY VIEWPOINTS — 05/14/10
Editors’ note: The editors of Fidelity Interactive Content Services (FICS) chose this story because it looks beyond the market’s recent volatility to address the fundamentals of the European debt crisis and its potential impact around the world.
With a robust rescue package, European policymakers appear to have stemmed a financial crisis that threatened global markets and the economic recovery. But that doesn’t mean Europe is out of the woods yet, says Lisa Emsbo-Mattingly, Fidelity’s director of economic analysis.
Just back from a whirlwind tour of Europe where she spoke with key policymakers and investors, Emsbo-Mattingly said she was encouraged by the Europeans’ decisive action. Still, she expects a combination of fiscal austerity and relatively tight monetary policy to keep European growth slow, which could alter the shape of the global recovery. Among the possible losers: commodity producers and U.S. exporters. Among the possible winners: global consumers outside of the Eurozone.
Q: How did Greece and Europe get into this financial crisis?
Emsbo-Mattingly: The crisis gained steam because sovereign debt holders began to worry about whether they would get repaid. Fear started to cascade, starting with Greece. Then Portugal started selling off, then Spain, then Italy. Many analysts thought, for example, that Spain had a credible fiscal package, but Spanish bonds were selling off dramatically as zero-risk-tolerant investors exited. Meanwhile, banks which hold a large amount of Eurozone sovereign debt began to run into trouble getting short-term money, and so the bank system started to freeze up. There were echoes of what happened after Lehman Brothers collapsed.
Q: So the policymakers had to act to prevent a panic?
Emsbo-Mattingly: This 870 billion-plus Euro package, produced jointly by the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF), sent a strong signal, diminishing sovereign debt concerns. Now it seems that those risk-averse investors and the banks that held large positions in Eurozone sovereign debt have regained some level of comfort. The worst case scenario of Greece’s sovereign difficulties cascading out of control seems to have been put into a very low probability corner. This rescue package was big, and while it lacked some clarity, big is better than too small or too late.
Q: Some are concerned that this is simply the ECB printing money, is this what we’re seeing?
Emsbo-Mattingly: The Eurozone is in a tricky situation because the ECB has only a price stability mandate, but not an economic expansion mandate like the Federal Reserve. The ECB couched its agreement to intervene in the markets in terms of reinstating financial stability, but still within the context of price stability.
One key tenet of the ECB, written in its charter, is that it is not allowed to buy sovereign debt directly. This tenet reflects the ghost of 1930s German hyperinflation. Although the ECB did agree to intervene in the secondary market – and this intervention was critical to the stability we’ve seen since the weekend – the decision was a very bitter pill to swallow.
Going forward, I think that the central bank is likely to be much more reticent and perhaps tighter than what we saw out of the Federal Reserve and the Bank of England following the crisis of ’08. If that’s the case, the downward pressure on Eurozone economies from relatively tight monetary policy while fiscal tightening is beginning is going to raise the risk of deflation there.
Q: So is Europe likely to face slower growth?
Emsbo-Mattingly: I think it’s going to be very hard to get robust growth with the fiscal packages that some of these economies are adopting. It’s what economists call procyclical—you’re tightening into a weak economy, rather than stimulating growth. While the current deficits are certainly unsustainable, the reality is that the proactive tightening that this crisis has forced on economies such as Spain and Portugal will slow the pace of the Eurozone recovery.
Q: Is Greece just the first domino to fall?
Emsbo-Mattingly: I’ve heard many people say that Greece is just a precursor to what will happen in the periphery countries in Europe, and it will then spread to the U.K. and the U.S. I would argue we face a very different situation.
Greece was an extremely profligate economy before this crisis and its problems weren’t accurately reflected in official data. Its civil service labor force is huge. Its pension liabilities are massive. Unit labor costs have been skyrocketing, while productivity has been plummeting, and the competitiveness of the Greek economy is very poor.
In contrast, the U.S. has an extremely flexible labor market, very high productivity, and unit labor costs are falling at the fastest rate in recorded history. While the size of government is growing, it is nothing on the order of the magnitude of Greece. Finally, U.S. industry is very competitive globally. So our economies look very different.
If there is a similarity, it is that much of Europe and the U.S. is running very large fiscal deficits. The big question going forward is how U.S. policymakers address the structural side of the U.S. deficit. If they are not proactive, then Greece does provide a warning: government spending does not translate into a robust and dynamic economy.
Q: Will the positive economic attributes you see in the U.S.—the flexible labor market, high productivity, etc.—give America the ability to grow out of the recession faster than Europe?
Emsbo-Mattingly: I believe so. In the short-term, I don’t see any strong indication that the Euro crisis will stop the cyclical rebound in the U.S. Of course, policy over the coming months and years will determine whether the flexibility and dynamism of the U.S. economy is maintained.
Q: What does the European slowdown mean to the U.S. and to investors?
Emsbo-Mattingly: It clearly impacts our export profile. So for example, pharmaceuticals took a hit in the market last week, and why was that? Because if you have fiscal tightening in the Eurozone, that impacts healthcare spending. It could also affect personal care and consumer staple companies that have large footprints in the Eurozone. The weak Euro also hurts companies with significant markets in Europe.
Overall, however, what this crisis may signal is that the engine of global growth continues to move away from the developed world and toward developing markets. Pharmaceuticals, personal care, and staples all have and will seek out vibrant markets elsewhere.
I had thought the growth profile in the U.S. would be very different from the last twenty years, with capital expenditures, exports, and investment spending driving growth ahead. But a weaker Eurozone—and a relatively stronger dollar—may tilt the balance towards imports and personal consumption. So U.S. retailers might get some help.
We also saw a negative reaction in the oil market, and that might be a sign that the big bull market we’ve seen in commodities is winding down. If growth in Europe is really going to be flat, that’s not a good sign for commodities.
Q: Within emerging markets, which countries are most likely to prosper?
Emsbo-Mattingly: I believe there are some parallels to how emerging market commodity exporters fared during the Southeast Asia crisis of the late 1990s. If a nation is significantly dependent on commodities that may be bad news. But, if you’re one of those big diversified economies like Brazil or Turkey, you are likely going to be able to weather this very well. The U.S. certainly is the consumer of last resort, but the Asian consumer, the Middle Eastern consumer, and some Latin American consumers are well positioned to become really important new sources of demand in the global economy.
Q: What are the key determinants of growth in the next five to ten years?
Emsbo-Mattingly: Of course, demographics and productivity are the key determinants of long-term economic growth in any economy. But the big question for the U.S., the U.K., the Eurozone, and the Japanese economy is what portions of their deficits are structural and what portions are cyclical. So far, I believe much of the U.S. deficit is cyclical and a result of the deepest recession since the Great Depression. However, the risk is that we could increasingly turn cyclical deficits into structural ones through policy decisions.
The size of the promises the U.S. government makes on Social Security, Medicare, Medicaid, and other entitlements will determine if the U.S. federal debt gets back under control. If government debt does not stop climbing, as we saw in Japan over the past 20 years, the private sector can become more and more enfeebled, as the financial system simply cycles savings into government spending. This is not a recipe for strong productivity and, therefore, not a recipe for strong growth.
In my opinion, the decisions policymakers make over the next five to ten years are going to be huge in determining which countries end up winners and losers. In the end, deficits are a function of receipts and expenditures; let’s hope we learn the lessons of Greece.