May 2010invisible

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D.

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Executive summary

  • The U.S. economy averaged an annualized growth rate of 3.8 percent over the three quarters ending in the first quarter of 2010. I expect that the economy will continue to grow at least this fast over the remaining three quarters of 2010. Real growth may slow a tad in 2011 but it still is expected to be above trend.
  • According to the Bureau of Economic Analysis, real gross domestic product (GDP) grew at a 3.2 percent annual rate in the first quarter. This was not as solid as my estimate or the consensus estimate at the time the number was reported. The shortfall was due in large part to more weakness in state and local government spending than expected and a larger weather-induced setback in residential investment than expected.
  • Nothing in the advance estimate of real GDP has altered the outlook. I continue to expect the economy to grow at or very near 4.0 percent this year and 3.5 percent next year. Inflation is expected to remain very benign at least through the end of 2011, which means that the Federal Reserve will not be rushed to remove aggressively its very accommodative monetary policy stance. However, a very gradual shift to a somewhat less accommodative policy stance before the end of this year still seems likely, with a more deliberate move in that direction in 2011.
  • For the second quarter of 2010, the consensus forecast for real growth has been revised upward, such that it is now more in line with the Laufenberg Economic Quarterly forecast. However, the consensus outlook for real growth in the second half is still too low. I remain convinced that the source of real growth will shift from the change in business inventories to real final sales.
  • The April employment report finally brought some encouraging news on the jobs front, despite the uptick in the civilian unemployment rate. Not only did payroll employment increase a larger than expected 290 thousand in April, but employment was revised higher for each of the preceding two months. Moreover, the bulk of the gains were in the private sector and not temporary government jobs to administer the census. Also, the unemployment rate edged up because more people went looking for jobs in April than found jobs. The fact that people are looking again was encouraging but that many of them found jobs was even more encouraging.
  • Prior to the release of the April data, most economists were convinced that the lack of job growth was a threat to the recovery. Now it appears that the U.S. is on track to create nearly two million new jobs this year. Although it is not enough to recover all the jobs lost in the last recession, it may be enough to induce the Federal Reserve to be less accommodative.
  • Fear has gripped global financial markets once again, reflecting concerns that the debt problem in Greece was just the tip of the iceberg. Some major political maneuvering by the European Union to trade "good" debt for "bad" debt most likely will avoid disaster for now.

Forecast details

Forecast Chart

Economic Growth: Rotating from Inventory to Sales

According to the Bureau of Economic Analysis (BEA), real gross domestic product (GDP) grew at a 3.2 percent annual rate in the first quarter, which was a tad light of both my estimate of 3.5 percent and the consensus estimate—just prior to the time the number was reported—of 3.4 percent. The consensus was not always so optimistic about the first quarter. As recently as a month ago, the consensus for real GDP growth in the first quarter was still at 2.5 percent. Since then, many of the economic data releases have surprised on the upside. In the February 2010 issue of the Laufenberg Economic Quarterly (LEQ), I noted that there would be “more upside surprises ahead” and that real GDP was on track to grow at a 3.5 percent pace in the first quarter.

Although my February estimate of first-quarter real GDP growth was high, I missed by only $10 billion in a $14,601.4 billion economy. This is a mere 0.07 percent, or a miss of roughly 0.3 percent annualized. Also, this was the “advance” estimate, which will be followed by two revisions over the next two months—the “preliminary” estimate will be released later this month and the so-called “final” estimate in late June. Of course, even the final estimate will be subject to benchmark revisions in each of the next three years. In other words, I still have several opportunities to be proven correct. The problem is that if I am proven correct in the revised data, few will notice and even fewer will care.

More importantly, despite the growth rate of first-quarter real GDP coming in a tad short of expectations, it does nothing to change my outlook for 2010 or 2011. I continue to expect real GDP growth of roughly 4.0 percent this year and 3.5 percent next year. In both cases, the LEQ forecast remains above the consensus forecast of roughly 3.0 percent growth each year. For this reason, I continue to expect upside surprises in the economic data in the months ahead.

In addition, inflation most likely will remain benign this year and next. This does not preclude higher commodity prices. However, it is unlikely that these higher costs to producers will be passed through completely to consumers. Much of the higher costs will be offset by improved productivity and mildly narrower profit margins. For this reason, the Federal Reserve is expected to be very slow to tighten its policy stance and very gradual when it does.

The U.S. economy: A good start and expected to get better

At first blush, the BEA’s advance estimate of first-quarter real GDP growth was mildly disappointing relative to the February forecast. In particular, real final sales (which are defined as real GDP less the change in business inventories) increased only 1.6 percent at an annual rate, which was slower than the 2.5 percent gain shown in the LEQ forecast in February, while the change in business inventories added considerably more to growth than expected (1.6 percentage points versus 0.9 percentage point). The first-quarter shortfall in final sales caused some economists to take a more cautious view on the outlook. I was not one of them. I remain convinced that final sales growth will accelerate over the remainder of this year and remain solid throughout 2011.

As shown in Chart 1, real final sales growth has lagged real GDP growth in each of the last three quarters, causing some to question the sustainability of the recovery. However, in each of the seven quarters prior to the third quarter of 2009, the change in business inventories was a drag on overall GDP growth; that is, either real final sales growth was weaker than real GDP growth or the rate of decline in final sales exceeded the rate of decline in GDP. The U.S. economy now seems to be experiencing the reversal of the steep and prolonged inventory correction of 2008 and early 2009. As I have argued on numerous occasions in the past, neither economic expansions nor economic contractions can be sustained by changes in inventories. Eventually, final sales need to account for a larger share of overall GDP growth. Although it may not be obvious in the first quarter data, it looks like this rotation to final sales from the change in inventories is just ahead.

chart 1

First, the shortfall in final sales growth in the first quarter certainly was not due to a slumping consumer sector. Indeed, real spending by consumers increased at a very solid 3.6 percent (annualized) pace in the first quarter, which was even stronger than my above-consensus estimate of 3.0 percent. This increase followed gains of 1.6 percent and 2.8 percent in the third and fourth quarters of 2009, respectively. In addition, the increase in consumer spending in the first quarter was widespread, led by an 11.3 percent jump in durable goods spending. I doubt that durable goods spending will increase at this same torrid pace over the remainder of the year, but solid gains in nondurable goods spending and more importantly spending on services likely will more than make up the difference.

Second, real nonresidential fixed investment increased at a 4.1 percent annual rate in the first quarter, roughly in line with my expectation of 4.3 percent. All of the gain came from the 13.4 percent surge in spending on equipment and software. Businesses reduced their real spending on structures by 14.0 percent last quarter. Going forward, business spending on equipment and software should remain robust. However, one of the keys to better final sales growth over the remainder of 2010 will be that business spending on structures stops falling in the second half of the year.

Third, real residential investment (i.e., housing), which declined 10.9 percent at an annual rate in the first quarter, will be another key to better final sales growth over the remainder of 2010 and into 2011. Unusually bad weather from December through February in many areas of the country most likely was the primary factor behind residential investment’s disappointing performance in the first quarter. Now that the weather is back to normal and housing starts are showing some signs of improvement, residential investment should improve as well. I am not forecasting a return to the housing boom of old. Starts are still at very depressed levels and are likely to remain below trend for quite some time. However, since starts are at such depressed levels, it will not take much improvement to register very sizable percent gains in residential investment.

Fourth, real government spending also was a bit of a disappointment. I knew that large budget deficits at state and local governments would restrain spending in the near term, but I did not expect state and local government spending to fall as much as it did in the first quarter. Indeed, it looks like a large part of the spending cuts that I expected from this sector for all of 2010 occurred in the first quarter. I doubt that state and local government will register declines as large over the remainder of the year. As such, the anticipated gains in spending expected at the federal level should more than offset the weakness in spending by state and local governments. For this reason, I expect total government spending on goods and services to increase marginally in each of the next three quarters, which in turn will be another key to stronger growth ahead.

Finally, international trade should be a mild drag on growth over the remainder of the year, but maybe not quite as much of a drag as it was in the first quarter. According to the BEA’s advance estimate, real net exports (which are defined as real exports less real imports) were a negative $367 billion in the first quarter. This was about $19 billion wider than the trade gap in the previous quarter and detracted about 0.6 percentage point from first-quarter real GDP growth. I expect that the international trade sector will be a net drag on growth for all of 2010 but it will detract only about half as much for the year as it did in the first quarter.

The bottom line is that real final sales, which grew at an anemic 1.6 percent pace in the first quarter, still are expected to increase about 3.5 percent for all of 2010. However, this outcome requires further upside surprises in the months ahead. I believe it can happen and will. After all, consumer spending and business spending on equipment and software, which together represent 78 percent of GDP, are off to very good starts so far this year. In other words, 78 percent of the economy is on track to deliver the growth in real final sales that I expect for all of 2010. And I believe that it will be only a matter of time before nonresidential structures, residential investment, and government spending get on track as well.

The only major component of GDP not discussed so far is the change in business inventories. Although the change in business inventories contributed more to growth in the first quarter than I expected, it still fits my inventory story for the year. That is, I remain convinced that the change in inventories will add about 0.5 percentage point to real GDP growth over the four quarters of 2010. This seems like a lot to expect from the change in inventories after the huge contribution it made to growth in recent quarters, but it still would not offset the total drag from the change in inventories over the prior three years. And the only difference in the forecast now versus the forecast in the February issue of the Quarterly is that the expected contribution from inventory accumulation apparently will occur earlier in 2010 than initially anticipated.

Finally some jobs

Clearly my more optimistic forecast for real growth over the next couple of years relies heavily on consumers continuing to register solid gains in spending. For consumers to spend, they need income, and to acquire income, they need jobs. In this regard, the April employment report was very encouraging, despite an uptick in the civilian unemployment rate.

Recall that the results of two surveys (the household survey and the establishment survey) are included in the monthly employment report from the Bureau of Labor Statistics (BLS). The BLS uses the household survey data to calculate the unemployment rate and the establishment survey data to measure the change in nonfarm payroll jobs. The most striking feature of the April employment report was that the number of employed/jobs increased markedly in both surveys. The reason the unemployment rate moved higher was because the gain in employment was more than offset by a surge in the labor force, which is not unusual at this stage of an economic recovery.

In the establishment survey, payroll jobs jumped 290 thousand in April, following sizable upward revisions to jobs in each of the prior two months. The data now show that payroll jobs increased 283 thousand over the first three months of the year rather than the 162 thousand reported a month ago. As a result, the U.S. economy has generated 573 thousand new jobs since the end of 2009. Moreover, the total hours worked index for April, reflecting both more jobs and a longer workweek, was at a level that was already well above its first-quarter average, suggesting very robust real output growth in the second quarter.

Jobs are being created, but are they enough to sustain the recovery? Will the new jobs be good jobs? Where are the jobs likely to come from? Are the jobs that were lost during the last recession lost forever? Will the unemployment rate remain high? These are just some of the questions that people are asking about the labor market. Interestingly, these same questions have been asked before, typically in the early stage of an economic recovery. For example, Andrew Cassel wrote in the Philadelphia Inquirer that the “jobless recovery was the label used in 1992 and 1993 to describe what some feared was just the beginning of a long, slow period of economic decline. That's not how it turned out, of course. By 1995, the economy had found a new set of growth engines, and jobs were being generated in numbers large enough to drive unemployment lower than even optimists had dared hope. The latter 1990s brought a boom that made the '80s look lame, and carried the United States to its longest period of uninterrupted growth on record: 10 years in all. It's worth keeping this in mind these days, because the pessimists are back.” Although this reads like something that might appear in the newspaper today, it was written on November 4, 2002.

Payroll employment for all of 2010 should total nearly two million, compared to a decline of about five million in 2009. But there is more. Payroll jobs are expected to continue to climb in 2011, and probably at an even faster pace than expected this year. After all, it will take a few quarters of solid final sales growth to convince business managers that the economic expansion will be sustained and that adding to payrolls will be necessary to keep pace. I contend that the economy is already on that path, but managers still seem to be uncertain about the economy’s performance in the second half of this year. Once managers become more confident that the expansion will be sustained, they will be more aggressive about hiring new workers. Indeed, the pace of hiring in the U.S. is expected to be stronger than the consensus now expects, which most likely reflects my above-consensus estimate of real GDP growth in 2010.

Despite relatively robust job growth this year and next, it still will not be enough to recover all of the roughly eight million jobs lost during the last recession. It will take several years of strong job growth to do so. My best guess is that it will be late 2012 or early 2013 before total nonfarm payroll jobs exceed their peak of December 2001. By the way, it is not unusual for jobs to take years to recover, while recovery in real output only takes a few quarters. In this regard, real GDP is expected to recover everything that it lost during the last recession by the end of the current quarter.

Most new jobs will be good jobs. Although information about the quality of jobs is scarce, if we compare the average hourly wages for the industries creating jobs, about two-thirds of the new jobs are in industries that pay an average hourly wage equal to or higher than the average wage in manufacturing. And the jobs created are jobs that the U.S. economy can support—high-wage, high-skilled jobs and low-wage, low-skilled jobs. What the U.S. economy cannot sustain are high-wage, low-skilled jobs. Those jobs will move elsewhere or be replaced with improved robotics/technology. How many times do you talk live to a person when you phone a company with a service request or a question? Typically, you will get an automated menu instead. For example, I can activate a credit card, order new checks, renew my drug prescriptions, or schedule an appointment over the phone but without talking live to anyone.

As such, some jobs are lost forever—some are lost to other countries because they can do the job cheaper but others are lost because they simply are no longer needed. I like to remind people that in the mid-1800s, nearly half of all jobs in the U.S. were in agriculture. Now about one percent of all U.S. jobs are in agriculture, yet we produce substantially more food today than we did in the mid-1800s. In other words, the industries that are more likely to create new jobs still may be in the incubator stage. Mature industries account for the bulk of jobs but new and growing companies tend to account for the bulk of new jobs.

Finally, the unemployment edged up 0.2 percentage point to 9.9 percent in April, but was still below its recent high of 10.1 percent registered in October 2009. Interestingly, the unemployment rate increased in April for the right reasons—according to the household survey data, total employment increased a solid 550 thousand, but the labor force surged 805 thousand. In other words, more people had jobs in April than a month earlier, even though more workers were considered unemployed. Indeed, I expect the unemployment rate to trend downward over the next several years, but not necessarily every month. Labor force growth will fluctuate more than employment growth, reflecting an uneven pace of reentrants into the labor force in the hope that an improving economy will generate more job opportunities. In contrast, the aging boomer population means that an increasing share of the population will be retiring and leaving the labor force. The net effect of all this may be small but it seems that the unemployment rate actually may be mildly lower than it would be otherwise over the next decade or so. Unfortunately, the unskilled, unemployed will have a more difficult time finding jobs over this period as an increasing number of new jobs will be in industries requiring more skilled workers.

Budget deficits matter

It was only a decade ago that the prospect of perpetual budget surpluses had people predicting that the entire U.S. Treasury debt outstanding would be repaid; that eventually U.S. Treasury obligations would disappear. In fact, the concern among investors then was what debt obligations would be considered alternatives to U.S. Treasury debt as a safe haven. The obvious choice at the time was U.S. agency debt, including debt issued by the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Corporation (Fanny Mae). Indeed, debt issuance by these agencies was encouraged by politicians and investors for several reasons, including that they made housing more affordable through lower mortgage rates and they offered investors what was perceived to be a relatively low-risk, higher-yielding alternative to U.S. Treasury debt. Indeed, it was investors stretching for higher yields on their bond portfolios without fully understanding the risk they were assuming that made it possible for investment banks to offer the highly leveraged and very complicated structured debt obligations that followed. It is amazing how quickly times change.

Recall that the federal budget surpluses arose following a period where federal budget deficits were considered to be on a trajectory that would have proved ruinous for the U.S. economy. Budget deficits became a hot political issue, forcing Congress to act. They did, but it took a long time for the benefits of their action to materialize. It seems that we have returned to a budget deficit trajectory that could be problematic once again if Congress does not act. According to the Congressional Budget Office (CBO), the federal budget deficit in the current fiscal year will be close to $1.5 trillion, following a deficit of $1.4 trillion in fiscal year 2009. Indeed, according to the CBO, the deficit this fiscal year will be a whopping 10.3 percent of GDP and the deficit in fiscal 2011 is expected to still be nearly 9.0 percent of GDP.

In fact, a series of large budget deficits over the next several years is expected to add markedly to the level of government debt outstanding. By the end of fiscal 2015 federal government debt held by the public is estimated to represent nearly 73 percent of GDP, up sharply from 53 percent in fiscal 2009. Gross government debt as a percent of GDP, which is the number that is more often referenced by the media, is expected to reach nearly 103 percent by the end of fiscal 2015 from about 84 percent in fiscal 2009. Moreover, with the flurry of new and expanded entitlement programs enacted, it is very likely that in the absence of any deficit reduction measures, the situation will deteriorate much faster than the CBO projections suggest.

Historically, gross government debt as a percent of GDP is already high. The last time gross debt represented more than 100 percent of GDP was during World War II; this statistic peaked at 121.7 percent in 1946. It may be of some interest to know that the low for this statistic was 32.5 percent in 1981. The same was true of government debt held by the public as a percent of GDP—this statistic peaked at 108.7 percent in 1946 and bottomed at 25.8 percent in 1981.

Indeed, it appears that debt as a percent of GDP was at its best when inflation was at its worst. As a result, some analysts suggest that the federal government will rely on inflation once again to get its fiscal house in order. Two things to remember in this regard, even though deficits were small relative to GDP in the early 1980s, it did not prevent the economy from experiencing what was at that time its worst recession since the Great Depression. Also, income tax brackets have been indexed to inflation since early 1980s, making it far more difficult for the government to rely on inflation to boost income tax receipts.

So what are the policy prescriptions that are likely to be followed to avoid a debt crisis in the U.S.? The obvious answer is either to cut spending or raise taxes. Efforts to cut spending most likely will lead to a repeat of spending limits similar to the old Gramm-Rudman pay-as-you-go rule. In other words, you cannot add a new spending program without an equal cut in spending somewhere else, and the spending cuts need to be actual cuts rather than cost savings assumed through increased efforts to reduce inefficiencies, fraud and abuse. Another aspect of the federal budget is that discretionary spending represents a much smaller share of government outlays than they did in the 1980s. In other words, the ongoing expansion of entitlement programs makes it increasingly difficult to manage spending cuts. This is likely to get even more difficult as an increasing number of boomers become eligible for Social Security and Medicare.

Raising taxes is an even more difficult proposition. I am certain that tax rates will rise, it is just a question of how and who will pay. Many of the tax cuts that were put in place during the Bush administration are scheduled to expire at the end of this year. In the absence of legislation extending these cuts, taxes will be higher in 2011. And the health care legislation passed recently will lead to higher taxes for upper income households in 2013. In other words, higher tax rates and not just higher taxes are already in the cards.

Another option that has received considerable attention recently is a value added tax (VAT). Former President Bill Clinton was promoting such a tax in an interview on CNBC recently. He argued that it would put the U.S. on a more level playing field with other countries, since most of our trading partners have a value added tax system. I found this to be a more compelling argument for a VAT than anything else I have heard or read, but there may be some unintended consequences of a VAT.

Mr. Clinton did not suggest that the VAT would replace the income tax. Instead, he suggested that the income tax could be reduced with the introduction of a VAT. As he mentioned, a VAT essentially puts a tax collector at every stage of production, collecting a tax based on the value added to the product at that stage (revenues less costs). I have argued in the past that a VAT essentially taxes the same base as the income tax, since GDP, and in turn Gross Domestic Income (GDI), is nothing more than the sum of all value added in the U.S. economy. One difference is that capital gains on assets other than residential real estate are taxed under the existing income tax code, but there are no capital gains or losses in GDI or value added. A VAT in my opinion would simply increase the taxes on roughly the same tax base but not equally across taxpayers. In fact, it would be a regressive tax, since it essentially would be a federal sales tax on all goods and services. The government could generate added revenues in a more equitable way by raising income taxes proportionately. But what the Clinton interview did for me is question whether the VAT could be a way for the federal government to reintroduce inflation as a means to boost tax receipts. After all, if costs increase 10 percent and revenues increase 10 percent, then value added, and in turn the tax base, increases 10 percent.

At the moment, significant spending cuts or tax increases seem unlikely. The concern is that perpetual budget deficits will be so large that they could push the U.S. government into a debt crisis of its own. In other words, into a situation where investors would be increasingly reluctant to own federal debt of any kind, but especially federal debt denominated in U.S. dollars. Although I doubt that we will ever let it get to that point, it will take some serious political will to prevent it from happening, given the penchant of government to expand spending on entitlement programs without seriously addressing the revenue needed to avoid the use of debt financing.

However, just because I believe we will avoid a debt crisis does not mean that budget deficits do not matter. They do! For the most part, large federal budget deficits over an extended period of time reduce the secular performance of the economy. In particular, business cycles become shorter, resulting in more frequent recessions. Such recessions deny the economy from performing as well over the long run as it could. A weaker economy means lost potential, which in turn means lower living standards for my grandchildren. This is not because they are expected to repay the debt with higher taxes, but rather because it will raise the cost of building the capacity needed to increase the supply of goods and services, and in turn real income, available to future generations.

Investment implications

After what appeared to be a reprieve from the intense risk aversion in the midst of the mortgage crisis, market participants in the last month or so have become very fearful once again. However, this time the fundamentals do not justify the fear. Indeed, investors were already very bearish on the near-term outlook for the economy, which is why the economic releases continue to surprise on the upside.

The Fed has started to prepare us for the inevitable. Chairman Bernanke has told us that the Fed plans to exit from the very accommodative policy stance currently in place, but not when. I remain convinced that the Fed will start to exit sometime this year, probably late in the second quarter. However, the Fed will be extremely gradual in its approach because benign inflation will make it difficult for the Fed to be anything else in an election year. That being said, politics will not prevent the Fed from raising its target for the federal funds rate, but it could influence the extent of the Fed’s actions and the timing. For example, the Fed will not only have to convince investors that the economic recovery can withstand a less accommodative monetary policy before they make the move, but that such a policy move is a necessary step in its plan to avoid inflation down the road. At best, I think the Fed could get away with raising its federal funds rate target by a quarter to a half of a percentage point by the end of this year. Since the Fed historically is reluctant to make any policy moves immediately ahead of the mid-term elections in November, they may feel the need to do something sooner rather than later. Another strong monthly employment report in early June, which I expect, would go a long way toward that end.

The Treasury yield curve has shifted downward across the board over the last month, reflecting the flight to quality in response to the European debt concern. I doubt that this downshift will persist for very long. At some point very soon, longer-term interest rates will rise again in anticipation of the Fed raising short-term interest rates, most likely causing an already steep yield curve to become even steeper. If this is the case, then longer-term rates, which most likely will be at already higher levels, will edge up once the Fed starts to hike short-term rates but will not keep pace. As a result, the yield curve experiences a bear-market flattening. Exactly how bearish the market is likely to be over the remainder of 2010 will depend on investors’ perceptions of how successful the Fed’s exit strategy will be. If investors become convinced that the Fed has engineered a perfect landing for the U.S. economy—the combination of solid growth and low inflation, then longer-term interest rates could actually retreat a bit once again in late 2010. But this too will not persist much beyond 2011.

Once again, the bottom line has not changed from three months ago. “Equities, non-government taxable bonds and tax-exempt bonds still look attractive, but asset selection can make a difference. In a broader sense, asset allocation standards should be followed carefully over the next several years in the wake of what is likely to be very volatile markets. This includes frequent rebalancing of investment portfolios to keep risk within investors’ tolerance levels.” 1 Never forget that business cycles have not been repealed.


1 See “More upside surprises ahead,” Laufenberg Economic Quarterly, February 2010, pp 4-12.

Greece: A test of Europe's resolve to remain united

Debt burdens are haunting global financial markets once again, but this time the concern has shifted from private debt to sovereign debt. Greece is the latest example of what happens when investors question the ability of a borrower to service its debt. Bond prices fall and yields climb, making it more costly for the borrower—in this case Greece—to roll-over its outstanding debt, let alone issue more debt. The overriding issue is whether Greece is just the tip of the iceberg, since so many other countries, not only in Europe but elsewhere in the world, are facing very large debt burdens of their own. On the short list of candidates at the moment are a few other member countries of the European Union, including Spain and Portugal. However, some analysts have suggested that the U.S. government should be added to the list as well. I contend that the U.S. government is far from defaulting on its debt, although we are certainly heading in a very costly direction in that regard.

When the European Union (EU) was established eleven years ago, many expressed concern that without a greater institutional and political union, a common currency would be tested from time to time. I contend that Greece is a test of Europe’s resolve to remain united. Recall that as recently as 2004, Europe tried to pass a constitution but failed to do so. That was the first hint of a crack in their resolve to be truly united.

I remember being asked in an interview I had with an Austrian newspaper during a business trip in 2004 about the sustainability of the European Union. My response was that if Europe wanted to be a union, then they should be a union in more than currency. Unfortunately, nothing has changed since then. Moreover, the more defined political union that I had in mind may not have averted a debt problem in Greece, but the problem may not have been allowed to get to this point or the rescue may have come sooner than it did to ease market jitters.

Lessons from the past

There may be some lessons learned from past sovereign debt crises that we could apply to European situation. After all, there have been plenty to consider. First lesson—any rescue plan should be substantially larger than anyone would reasonably expect. This was certainly the case with regard to the EU plan. The nearly $1 trillion rescue plan for Greece seems to be far more than is likely to be needed. This approach has been used before in an effort to restore confidence to bondholders quickly. Second lesson—a rescue does not preclude an economic slump. Government austerity programs need to be put in place in terms of fiscal policy, but other policies need to be synchronized to promote growth. The desired outcome for Greece, as well as Spain and Portugal, may be something similar to the outcome for Mexico following its crisis in 1994. Unfortunately, Mexico experienced a rather-severe recession as a result of the crisis, and the so-called tequila effect did spread to Argentina. But for Mexico, the economy recovered relatively quickly and it was able to sustain the recovery longer than Argentina. The key in my view was that Mexico allowed its currency to float, whereas Argentina decided to avoid currency depreciation. As a result, Mexico devalued its currency rather than its economy, while Argentina devalued its economy rather than its currency.

Here is the rub about the current situation in Europe. The countries facing a debt problem share the same currency with a host of other countries. For this reason, the situation is similar to one in the U.S. where a state government faces concern that it cannot honor its debt outstanding, let alone issue more. In these instances, painful austerity programs are implemented. It is unclear that the states or cities in the U.S. that have been rescued from debt crises make permanent changes to their behavior but they do change at least temporarily. But the European Union differs from the United States. The states in the U.S. are united in more than just currency. In particular, the states share common institutional, legal, economic, and political features that the European Union does not.

Another point to consider is whether the crisis arose because the country is unable to service its debt or if it is simply reluctant to pay higher interest rates on any new debt or outstanding debt that needs to be rolled over. For example, Greece seems to think that it should not be required to pay a higher interest rate on its debt than other EU member countries pay. However, the union does not guarantee that all countries in the union pay the same rate of interest—credit quality differences still persist. That is true of all borrowers, including the various government entities around the world.

Indeed, at the end of 2009, the levels of government debt outstanding as a percent of the levels of gross domestic product (GDP) for several European countries were high. For example, debt as a percent of income for Italy at 115.2 percent was above the 113.5 percent for Greece. Moreover, government debt for France and Germany represented 79.7 percent and 77.2 percent of GDP, respectively at the end of last year, whereas debt as a percent of GDP for Portugal and Spain were 75.2 percent and 50.0 percent, respectively. For the entire EU, government debt was equal to over 60 percent of GDP last year, but is expected to reach nearly 80 percent by the end of this year. Hence, the level of debt outstanding of a particular country alone does not cause a debt crisis, but it matters when bondholders’ question the country’s ability to service its debt. The key to easing this concern is to regain investor confidence. The best way to do that is increase the borrower’s ability to service its debt, either by reducing the level of debt or increasing revenues by growing the tax base. The second option is preferred but more difficult to execute effectively. It will take time to turn things around in Europe, especially Greece. But a complete turnaround in Europe is not needed to get the rest of the world to relax. What the world needs is something to suggest that the turnaround is underway. That can happen surprisingly quickly.

A union still trying to be united

Recall that in 2004 and 2005, the European Union tried to ratify a constitution establishing a united Europe. The Treaty establishing a Constitution for Europe (TCE), (commonly referred to as the European Constitution or as the Constitutional Treaty), was an unratified international treaty intended to create a consolidated constitution for the European Union (EU). It would have replaced the existing European Union treaties with a single text, given legal force to the Charter of Fundamental Rights, and expanded Qualified Majority Voting into policy areas which had previously been decided by unanimity among member states. It failed in referendums in France and then in Denmark. Since then, Europe has approved the Treaty of Lisbon, which incorporated many of the provisions of the TCE but without the legal force of a constitution.

On balance, I consider the debt problem in Greece to be a European problem much like the debt problem in California would be considered a U.S. problem. If California becomes a serious default candidate, the dollar most certainly would suffer. Hence, it is no wonder that the euro is being punished for debt concerns in Greece. The one aspect of a weaker euro that is not discussed is that it could have a net positive impact on European net exports, which actually may benefit the economies being asked to finance the rescue plan.

In terms of the European debt problem’s impact on the U.S., I doubt that it will be as troubling as many now seem to suggest. The weaker euro certainly makes it more difficult for U.S. exporters to compete in global markets, but at the same time it makes imported goods and services less expensive to U.S. consumers and manufacturers. However, I doubt that the euro will remain weak very long. Once it becomes clear to investors that the EU is resolved to remain united, and indeed may use this opportunity to strengthen the union, any adverse effects on the U.S. economy will be short-lived. In fact, a reversal in the foreign exchange value of the dollar could be another contributing factor to solid U.S. economic growth in the second half of this year.

Obviously, I could be wrong. If it turns out that the European debt problem is not resolved quickly, it could be a mild drag on the U.S. economy in the second half of 2010 and into 2011—fewer exports and more imports. In particular, a stronger dollar eventually leads to lower inflation, which in turn can be translated into lower interest rates. The combination of lower interest rates and lower import prices generally would provide consumers with the wherewithal to increase spending. The problem is that interest rates are already very low, real estate is not as acceptable as loan collateral as it was a few years ago, and lending institutions are a bit stingy about underwriting unsecured consumer loans. The implication for the U.S. economy would be a less robust consumer sector and a more sluggish manufacturing sector in 2010. In addition, such a development could mean that the Federal Reserve does not raise its federal funds rate target until the sovereign debt problem eases.

But this is the scenario if I am wrong. Since I expect to be right and for the European debt issue to be resolved soon, I remain more optimistic about the outlook than the consensus. Nevertheless, in a concession to the pessimists, I now would give this alternative scenario a slightly higher probability than I did a month ago. This is just another way of saying that I still expect the U.S. economy to do very well in 2010 (grow above trend and create about 2 million jobs without inflation being an issue) but I am not quite as confident about this as I was. Stay tuned.


The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


November 2009 - LEQ (PDF)
February 2010 - LEQ


Executive Summary

Forecast Details

Economic Growth: Rotating from Inventory to Sales

Greece: A test of Europe's resolve to remain united

~ ~ ~ ~


Executive Summary

Forecast Details

Economic Growth: Rotating from Inventory to Sales

Greece: A test of Europe's resolve to remain united

~ ~ ~ ~




Executive Summary

Forecast Details

Economic Growth: Rotating from Inventory to Sales

Greece: A test of Europe's resolve to remain united

~ ~ ~ ~