The Road Ahead
The debate centers around the relationship between the strong and weak economies using the Euro. Because the Euro is made up of 17 different countries, there are inherent limitations in using monetary policy to control the supply of money – stronger countries helping out weaker countries – like we can do with our states here in America. One of the major questions being debated is should Germany assist the weaker countries (Portugal, Ireland, Greece and Spain) with fiscal payments. By looking at a graph of the balance of payments between Germany and the weaker countries, you can see when the imbalances began to widen. As you may imagine, this has not been a popular idea in Germany, and reports have surfaced that a new two-tier Europe could be one of the possible solutions.
Without expansionary monetary policies to match the austerity in the weaker countries, it’s likely that economic growth could be strangled by the paradox of thrift. This is when everyone tries to save simultaneously thus decreasing their consumption and in turn crippling aggregate demand. If these countries receive no help and cannot meet future targets, the outcome could result in the end of the euro and more economic pain. Perhaps creating a deflationary environment similar to what happened in Europe in the 1930’s. While possible, we do not see this as the most likely outcome. In fact, with the recent increase in the European aid package, it seems the European Central Bank is making an effort to prevent more trouble in the short-run. Finding a way to end the imbalances over the medium run is the next obstacle.
Bad Outcome = Positive Surprise?
Stock markets around the world will likely continue to see heavy volatility as the debate continues. However, with international markets bottoming near 35% from the most recent peak in April and the US market losing just under 20% during the same period, a very bad outcome may already be priced in to the markets. We’re still not sure how the European debt issues will be solved but if they can reach a solution, and that solution is better than expected, the markets could see a positive push going forward.