markets crisis euro us will the u.s. and europe rise again -- or sink together_ wharton oct 2011...

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Will the U.S. and Europe Rise Again -- or Sink Together?Published : October 31, 2011 in Knowledge@Wharton

These days, virtually everyone agrees that economies are a mess in the UnitedStates, Europe and much of the rest of the world.

On October 25, the Conference Board reported that sentiment among U.S.consumers had sunk to lows not seen since the height of the recession. Asuper-committee of 12 members of Congress is at loggerheads, with only weeksto find ways to slash U.S. budget deficits before Draconian cuts kick inautomatically. And in Europe, governments are wrestling over how to deal with thedebt crisis in Greece and other countries.

Are things as bad as they seem?

Unfortunately, they are, say three Wharton faculty members who study economicsand financial markets. At a recent presentation before Wharton board members,Franklin Allen, Richard Marston and Kent Smetters warned that a true recoverycould be some time off, and that conditions could get worse before they get better.

But is the U.S. already in a recession? Technically, no, said Smetters, a professor of business and publicpolicy, citing 4% annualized growth in gross domestic product in the second quarter, and signs from thefutures market indicating investors think there is a 75% chance that growth will continue.

That doesnt mean conditions are good, however. Much of the growth is being devoured by risinginflation, with real, after-inflation growth at only 1.3%, Smetters noted. GDP remains far below whereit would have been had it stayed on its pre-recession trajectory, he added.

Although some U.S. corporations are reporting handsome profits, others are not, including the major

banks. After rebounding from the spring of 2009 through the spring of 2011, the stock market has turnedjittery, as investors worry about what will come next. The financial-market turbulence is likely tocontinue worldwide, Smetters predicted. Costs of options contracts, which are used to insure againstinvestment losses, have soared, indicating many investors agree. The price has more than doubled in thepast year and half, two years, Smetters said. The market itself is basically saying, Yes, there [will be] alot of volatility.

While the U.S. is technically in recovery, this one has some unusual features, added Marston, a financeprofessor. Basically, were in a classic recovery in terms of the [financial] markets and in terms ofconsumption. In addition, exports are 10% higher than they were before the start of the recession.GDP, while below its long-term trend, is as high as it was before the recession, while consumption isactually higher than it was before the recession, Marston said.

What, then, is the problem? Normally, consumption skyrockets after a recession ends; this time it hasrecovered but not accelerated, Marston noted. Household balance sheets remain severely impaired,largely because of losses from the collapse in home prices. The typical home is worth 20% to 30% lessthan before the recession, and about a quarter of homeowners with mortgages owe more than their homesare worth. Millions of Americans face foreclosure.

In addition, labor demand remains far below normal, Marston noted. High unemployment, whichremains stalled around 9.1%, means millions of people are not spending as they normally would, andmany of those who are working have tightened spending because they feel insecure. Unemployment islasting longer than usual, causing workers skills to erode and thus hurting the chances for earning asmuch in new positions as they did in their old jobs. The employment prospects are particularly bleak for

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people without college degrees; unemployment for those with college degrees is only about 4.2%.

Most importantly, business investment remains depressed, Marston stated. Firms increased theirinvestments by about 20% from the beginning of 2005 through the end of 2007. But the figure has sincedropped, and is currently only about 5% above the 2005 level. Some large corporations are sitting onenormous reserves that could fund hiring or other expansion, but they do not spend because, with demandlow, they dont need to expand. In a normal recovery, companies spend money on office buildings,factories and other facilities, boosting the economy. This time, we have a legacy of a real estate boom,with little need for more space, Marston pointed out.

In addition, companies that do want to expand, but dont have enough cash on hand to pay for thoseprojects, are having trouble obtaining loans. Although many lenders have the money to offer financing,they are nervous about whether they will be paid back if economic conditions do not improve, Marstonnoted. Commercial and industrial loans remain far below their peak levels at the start of 2009, thoughcash assets at commercial banks are approaching $2 trillion, double the early 2009 level.

Banks are conserving money to meet new regulatory requirements, many of which are still taking shape,Marston said. Financial institutions also need reserves on hand in case they have to pay large settlementsin lawsuits brought by many states over the the banks role in selling mortgage securities that collapsed invalue.

Fearing a Domino Effect

The debt crisis in Europe causes further difficulties for the U.S. According to Marston, the U.S. banks areinterconnected with Europe. The problems in Europe are the key cause of increased talk about thepossibility of another recession here, he added, noting that before the European debt crisis flared up thissummer, stock markets were on a roll. Now they are stalled. If Europe blows up, we will all go into adeep recession, he warned.

Today, many U.S. corporations are heavily dependent on markets in Europe and other regions, Smetterssaid. In 2008, for example, nearly 48% of revenue for companies in the Standard & Poors 500 came fromforeign operations, up from less than 42% in 2003. Twenty-five years ago, that number was in the teens.Business interconnection means trouble in one region is more likely to affect another. That can be seen inthe behavior of stock markets in the United States and Europe, which now usually march in lockstep. Theups and downs of the two markets correlate, or move in tandem, nearly 85% of the time, compared to lessthan 50% in the 1990s, Smetters stated.

The debt crisis in Greece poses the most serious immediate problem for Europe, and the collapse in priceson Greek bonds have driven their yields through the roof, from less than 6% a year ago to more than 18%today. Such high yields indicate that the bond market expects Greece to default on its government bonds,according to Marston. Soaring yields on Irish and Portuguese bonds show investors are worried aboutthose countries as well.

Although leaders in France, Germany and other European countries are working to address the Greekproblem, they cannot bring themselves to back a rescue similar to the Troubled Asset Relief Program usedin the United States. Northern Europeans dont believe fiscal transfers [between countries] are fair,Marston said, noting that German leaders have long argued that such transfers should not be a feature ofthe unified European economy. Northern European leaders also worry that Greece will follow a bailout bygetting into trouble again.

At the same time, Northern Europeans are fearful of simply cutting Greece loose and allowing it todefault, citing worries of a domino effect in Portugal, Ireland and perhaps Italy and Spain. French andGerman banks hold large amounts of debt from those countries and would be badly damaged by defaults,Marston pointed out.

Some experts argue that it would be best to let Greece default and suffer economic catastrophe, forcingthe country to deal with the problem quickly rather than dragging it out. But a European sense ofsolidarity makes leaders reluctant to do that, said Allen, a finance professor. Many believe the punitiveTreaty of Versailles destroyed the German middle class after World War I, making it easier for the Nazisto gain power. Problems also ensued when France was forced to pay crushing reparations after the


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Franco-Prussian War.

When people use this word solidarity, thats what they are talking about: We dont want to go back towhat happened in the late 19 th century and early 20th century, Allen noted. In contrast, Germany andJapan flourished under the comparatively magnanimous treaties ending World War II.

An Almost Impossible Situation

According to Allen, there are five possible outcomes for the current debt crisis, all with relatively equal

probabilities.In one, investors would take partial losses on Greek bonds, and the other troubled governments wouldsomehow avoid default or the need for bailouts. A second scenario involves some kind of fudge,perhaps allowing more money to be printed and rolling debts over for 20 or 30 years with very lowinterest rates, Allen said.

A third possibility would involve much bigger losses on debts, while a fourth would have Greece leavethe euro zone and return to using the drachma as its currency. The fifth scenario: something completelyunforeseen, which is always possible with multiple governments involved. Its a very complicatedproblem, Allen noted. There are some benign outcomes, but there are some very scary ones as well.

Have a little patience with these politicians, Marston added. They are facing an almost impossiblesituation. This is also the case in the United States, where government debt threatens to soak up a

growing portion of economic output, Smetters stated.

According to figures from the Congressional Budget Office, federal tax revenues as a percentage of grossdomestic product have remained relatively steady, at 19% in 1970 and 18.5% in 2007, with the levelexpected to rise slightly to 20.8% in 2021. But government outlays are expected to soar, from 19.3% ofGDP in 1970 and 19.6% in 2007 to a projected 24% in 2021.

The main culprit is the growth of spending for Social Security, Medicare, Medicaid and other healthprograms as the baby boomers age, people live longer and medical costs keep rising. Spending on theseprograms equaled 3.8% of GDP in 1970 and 8.2% in 2007, and is expected to reach 12% in 2021. Even ifother spending falls as a portion of GDP, heaver entitlement spending will cause the annual budget deficitto rise to 3.2% of GDP in 2021, from 1.2% in 2007 and 0.3% in 1970.

In August, Congress created the Joint Select Committee on Deficit Reduction, composed of 12 membersof Congress, equally divided between the Senate and House, Democrats and Republicans. The group is tocome up with $1.5 trillion in deficit cuts over 10 years. If the committee fails to agree on a package, orCongress fails to approve one by December 23, cuts totaling $1.2 trillion will automatically be triggered,including severe cuts in defense.

As of late October, it is unclear whether the committee will succeed, with Republicans opposing taxincreases and Democrats resisting large cuts in entitlements like Social Security and Medicare. But even ifthe committee does hammer out a proposal that is approved by Congress, the U.S. will still face toughproblems. Even ... if they can come up with a couple of trillion dollars in deficit cuts," says Smetters,"its puny compared to whats needed.

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