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 United States, 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. A “super-committee” of 12 members of Congress is at loggerheads, with only weeks to find ways to slash U.S. budget deficits before Draconian cuts kick in automatically. And in Europe, governments are wrestling over how to deal with the debt crisis in Greece and other countries.
Are things as bad as they seem?
Unfortunately, they are, say three Wharton faculty members who study economics and financial markets. At a recent presentation before Wharton board members, Franklin Allen, Richard Marston and Kent Smetters warned that a true recovery could be some time off, and that conditions could get worse before they get better. (For more about the challenges facing the eurozone, check out this video interview with Allen and Wharton management professor Mauro Guillen.)
But is the U.S. already in a recession? “Technically, no,” said Smetters, a professor of business and public policy, citing 4% annualized growth in gross domestic product in the second quarter, and signs from the futures market indicating investors think there is a 75% chance that growth will continue.
That doesn’t mean conditions are good, however. Much of the growth is being devoured by rising inflation, with “real,” after-inflation growth at only 1.3%, Smetters noted. GDP remains far below where it 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 turned jittery, as investors worry about what will come next. The financial-market turbulence is likely to continue worldwide, Smetters predicted. Costs of options contracts, which are used to insure against investment losses, have soared, indicating many investors agree. “The price has more than doubled in the past year and half, two years,” Smetters said. “The market itself is basically saying, ‘Yes, there [will be] a lot of volatility.’”
While the U.S. is technically in recovery, this one has some unusual features, added Marston, a finance professor. “Basically, we’re in a classic recovery in terms of the [financial] markets and in terms of consumption.” 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 is actually higher than it was before the recession, Marston said.
What, then, is the problem? Normally, consumption skyrockets after a recession ends; this time it has recovered 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% less than before the recession, and about a quarter of homeowners with mortgages owe more than their homes are worth. Millions of Americans face foreclosure.
In addition, “labor demand remains far below normal,” Marston noted. High unemployment, which remains stalled around 9.1%, means millions of people are not spending as they normally would, and many of those who are working have tightened spending because they feel insecure. Unemployment is lasting longer than usual, causing workers’ skills to erode and thus hurting the chances for earning as much in new positions as they did in their old jobs. The employment prospects are particularly bleak for 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 their investments by about 20% from the beginning of 2005 through the end of 2007. But the figure has since dropped, and is currently only about 5% above the 2005 level. Some large corporations are sitting on enormous reserves that could fund hiring or other expansion, but they do not spend because, with demand low, they don’t 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 don’t have enough cash on hand to pay for those projects, 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, Marston noted. Commercial and industrial loans remain far below their peak levels at the start of 2009, though cash 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 settlements in lawsuits brought by many states over the the banks’ role in selling mortgage securities that collapsed in value.
Fearing a Domino Effect
The debt crisis in Europe causes further difficulties for the U.S. According to Marston, the U.S. banks are interconnected with Europe. The problems in Europe are the key cause of increased talk about the possibility of another recession here, he added, noting that before the European debt crisis flared up this summer, stock markets were on a roll. Now they are stalled. “If Europe blows up, we will all go into a deep recession,” he warned.
Today, many U.S. corporations are heavily dependent on markets in Europe and other regions, Smetters said. In 2008, for example, nearly 48% of revenue for companies in the Standard & Poor’s 500 came from foreign 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 in the behavior of stock markets in the United States and Europe, which now usually march in lockstep. The ups and downs of the two markets correlate, or move in tandem, nearly 85% of the time, compared to less than 50% in the 1990s, Smetters stated.
The debt crisis in Greece poses the most serious immediate problem for Europe, and the collapse in prices on 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 about those countries as well.
Although leaders in France, Germany and other European countries are working to address the Greek problem, they cannot bring themselves to back a rescue similar to the Troubled Asset Relief Program used in the United States. “Northern Europeans don’t believe fiscal transfers [between countries] are fair,” Marston said, noting that German leaders have long argued that such transfers should not be a feature of the unified European economy. Northern European leaders also worry that Greece will follow a bailout by getting into trouble again.
At the same time, Northern Europeans are fearful of simply cutting Greece loose and allowing it to default, citing worries of a “domino effect” in Portugal, Ireland and perhaps Italy and Spain. French and German 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, forcing the country to deal with the problem quickly rather than dragging it out. But a European sense of solidarity makes leaders reluctant to do that, said Allen, a finance professor. Many believe the punitive Treaty of Versailles destroyed the German middle class after World War I, making it easier for the Nazis to gain power. Problems also ensued when France was forced to pay crushing reparations after the Franco-Prussian War.
“When people use this word ‘solidarity,’ that’s what they are talking about: ‘We don’t want to go back to what happened in the late 19th century and early 20th century,’” Allen noted. In contrast, Germany and Japan 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 would somehow 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 low interest rates, Allen said.
A third possibility would involve much bigger losses on debts, while a fourth would have Greece leave the euro zone and return to using the drachma as its currency. The fifth scenario: something completely unforeseen, which is always possible with multiple governments involved. “It’s a very complicated problem,” 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 impossible situation.” 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 gross domestic product have remained relatively steady, at 19% in 1970 and 18.5% in 2007, with the level expected to rise slightly to 20.8% in 2021. But government outlays are expected to soar, from 19.3% of GDP 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 health programs as the baby boomers age, people live longer and medical costs keep rising. Spending on these programs equaled 3.8% of GDP in 1970 and 8.2% in 2007, and is expected to reach 12% in 2021. Even if other spending falls as a portion of GDP, heaver entitlement spending will cause the annual budget deficit to 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 members of Congress, equally divided between the Senate and House, Democrats and Republicans. The group is to come up with $1.5 trillion in deficit cuts over 10 years. If the committee fails to agree on a package, or Congress 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 tax increases and Democrats resisting large cuts in entitlements like Social Security and Medicare. But even if the committee does hammer out a proposal that is approved by Congress, the U.S. will still face tough problems. “Even ... if they can come up with a couple of trillion dollars in deficit cuts," says Smetters, "it’s puny compared to what’s needed.”