1 January 1970

Eurozone instability: the domino effect

“A currency which keeps its value fully in line with its definition of price stability , with (an) annual inflation rate of less than two percent , close to two percent , over almost 12 years is a currency which inspires confidence .”

- Jean Claude Trichet , president, European Central Bank

The quote above was taken from a German newspaper days after governments of the eurozone pledged more than €500 billion to stave off crisis for its member states, including, of course, Greece. This pledge, in conjunction with another €200 million from the International Monetary Fund and a commitment to buy government debt from the European Central Bank (ECB), itself a massive about-face, was meant to stop the brewing crisis in its tracks. Under those circumstances, one certainly could argue that Trichet’s quote offered a painfully narrow view of the performance of national governments and multilateral agencies (including his own) in response to what many consider to be Europe’s own home-grown Lehman catastrophe.

Indeed, the disbelief and dithering in US political circles in the run-up to the Lehman default bears a striking resemblance to European attitudes towards the fiscal problems in the ‘peripheral’ (or Club Med) eurozone economies in the weeks preceding the support package. The very same day as Trichet’s interview, newspapers in several European countries reported that Nicolas Sarkozy, the French president, had threatened to reconsider the single currency should eurozone members not unanimously agree to the spectacular bailout package.

Three thousand miles away, another government official, US Treasury Secretary Tim Geithner, was busy over the same weekend convincing a different media outlet that Europe “has the capacity to manage through this” and that the US economy is on a strong growth path to recovery—strong enough to weather fallout from a European crisis.

Despite the prevailing sentiment that the problems in the eurozone are a ‘new’ crisis, or a phenomenon unrelated to recent history, we view the current difficulties as a continuum. For nearly two years, we have been living in a world where developed nations’ governments have seemingly been ‘all in’ and the government-fix-all philosophy, until recently, went virtually unchecked by market scepticism.

The pervasive Keynesian theory is that if interest rates are low enough, and government spending and subsidies are large enough to offset consumer and financial deleveraging, a multiplier effect will eventually take hold. Consumers and businesses will then spend/invest more, providing the foundations for a sustainable recovery. On the surface, it sounds plausible, but economic cycles marked by heavy doses of monetary and fiscal medicine are often associated with big swings in quarterly growth rates, and this is precisely what we may be experiencing now. Generating massive debt to finance debt rarely pays for itself, and eventually markets and economies, too dependent on government support, will have to learn to live without its crutches. The latest round of sovereign bailouts may have stemmed a rapid escalation of economic strife, but it has done little to put the nations involved on a solid growth footing for the future.

"Generating massive debt to finance debt rarely pays for itself, and eventually markets and economics, too dependent on government support, will have to learn to live without its crutches."

Most recently, after a period of relative calm (and strongly rebounding asset markets), there has been a large increase in volatility across markets, due primarily to events in Europe. There remains, however, the consensus theory that something of a self-sustaining economic recovery could be brewing in the US. Although we can certainly concede that there have been some areas that have shown significant recovery in the latter part of 2009 and into 2010, there are two areas, unemployment and the housing market, which keep us from joining the parade of forecasters who have raised growth estimates to figures in excess of ‘trend’ growth for 2010. Intuitively, the weakness in the housing market has everything to do with the rate of national unemployment and underemployment. Without a sustained upturn in housing, consumer expenditure will have little chance of approaching the pace at which it grew in the last expansion.

Industrial production

First the good news. Industrial production, by either purchasing manager survey measures or official estimates, improved markedly in the US in the first and second quarters of 2010. After the worst recession sinceWorld War II, culminating in a severe period of financial and inventory deleveraging in mid-2009, inventories actually rose in the first quarter of 2010. It looks as if roughly 80 to 90 percent of the inventory stabilisation recovery has run its course, but nonetheless, manufacturing has been the single best source of positive growth in 2010. Some of the strength can be attributed to fiscal stimulus, but there is a substantial contribution from a resumption of growth in the more dynamic economies of the world—the emerging markets, particularly Asia.


Unfortunately, two-thirds of the economy is consumer-related and, despite stabilisation in prices and some activity at the margin, primarily associated with the first-time buyer tax credit, the housing market has remained moribund. During both the refinancing boom prior to mid-2005 and the housing bubble from mid-2005 through 2007, massive amounts of Adjustable Rate Mortgages were issued. In total, more than $1 trillion worth of mortgage debt will be reset in 2010, 2011 and 2012. Of that total, $253 billion comprises ‘option arms’, the nuclear product that forced Wachovia into the arms (no pun intended) of Wells Fargo and that consistently defaults at a multiple to prime fixed-rate mortgages.

It goes without saying that the availability of mortgage credit has tightened significantly, and these resets present a tangible headwind to consumers. Additionally, prices seem to have begun to fall once again, inventory levels are still high and there is a large so-called ‘shadow inventory’ of homes. This shadow inventory consists of properties that banks should own, but either haven’t foreclosed on because the government is paying them to delay foreclosure through the Home Affordable Modification Programme or that are ‘real estate owned’ by banks, but not officially on the market. Most of these properties will eventually hit the supply chain in the market, weighing in on non-distressed owners’ chances of home price appreciation for many years to come. What you are left with is a picture of the housing market that does not look poised to spring back to life immediately.


As we are speaking about stabilisation, much has been made of the stabilisation and small growth rate in job numbers in the first half of 2010. From our vantage point, we can concede that the worst is over and outright job losses have abated, but what we are left with is a structural unemployment and underemployment problem that is going to take many years to remedy.

By mid-summer, 32 months into the so-called ‘Great Recession’, we will still see the overall narrow, or headline measure, of unemployment at higher than nine percent. As we write, unemployment has risen to 9.9 percent, and underemployment, defined as those who are unemployed, employed part-time for economic reasons but who would prefer to work full-time and discouraged workers, was at 17.1 percent. More than 6.7 million people (out of 13 million) have been out of work for six months or more, roughly 46 percent of the total pool of unemployed labour. The average (average!) duration of unemployment in the US is 33 weeks.

Lastly, hourly earnings are nominally positive, but are trending lower and have been for more than two years, with the nominal pace of gains being exceeded by the Consumer Price Index. Real wages in America are falling, and while the tentative signs of renewed growthin hiring is better news than broad-based firing, we are facing a longterm secular problem, rather than just a simple cyclical downturn. Coupled with the distress in housing, secular unemployment will continue to keep consumer spending subdued for some time.


Despite our admittedly downbeat view of near-term sustainable growth in the US, we are not doomsday prognosticators. We do not believe the US economy is destined to, or even likely to, ‘double dip’ back into severe recession. Also, despite our commentary above relating to the structural problems in Europe that were thrown into sharp relief recently, we do not believe in the demise of the eurozone, or the common currency. What we would warn against is complacency.

Prior to the eurozone rescue package, markets were pricing in an aggressive federal tightening cycle beginning at the tail end of 2009. Indeed, many of the US and international extraordinary liquidity support programmes designed to ease the banking crisis had almost (but not quite) disappeared entirely. In the space of three weeks, that has changed dramatically, and our view is that markets have consistently underestimated the lasting effect of the credit crisis and the recession that has followed. Headwinds to sustainable growth in the US remain, and the situation in Europe does not exist in isolation—it has simply created another impediment to rapid recovery.

Andrew Baron, CFA, is a senior portfolio manager at Butterfield Asset Management, part of the Bank of N.T. Butterfield & Son Limited. He can be contacted at: