If There Is a Serious Crisis In Europe, Bad News for America – Economic Ties With Europe Are Huge – Problem Is That Washington Has No Tools To Protect US

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By Paolo von Schirach

September 25, 2011

WASHINGTON – Washington is hopelessly divided, while America is economically very weak. Yesterday I expressed my hope that nothing bad would happen on the domestic or international economic front between now and the November 2012 elections. Indeed, if something major did happen, the US government has no wiggle room, no tools, no money and no united policy on just about anything.

Something bad happening in Europe

Well, I am afraid that something bad is really happening in Europe. If so, this new turmoil will hit America, turning a bad predicament into a real mess. Europe is in the middle of a confidence crisis on the reliability of sovereign debt, while the economies of many EU countries are sputtering, adding another layer of pessimism. If investors start running away from EU countries sovereign debt there is no way to predict what will happen next.

Europe is divided

On top of that, if Washington is divided, the 27 countries that make up the European Union, of which a critical subset are the 17 that belong to the Eurozone, are divided, confused, unrealistic, superficial, many of them led by uninspiring governments. If all this does not change, a weak, fractured and leaderless EU may very well wander into the abyss without even realizing it.

Inability to contain the greek crisis

But why all the pessimism? Well, the pessimism comes from observing the EU inability to isolate the Greek problem. As bad as Greece was two years ago, the EU could have built a fire wall around it. But it did not. Greece is bankrupt. But the other EU countries treated an insolvency problem as if it were a liquidity problem. So they provided more liquidity in exchange for promises of reform, privatizations and serious effort to improve tax collection, among other things.

Greeks broke and unserious

But the Greeks are both broke and unserious. They do not realise that it is their responsibility to spend less, work more, pay taxes and be frugal for many, many years. The Greeks dream. While the country is collapsing, the Greeks protest. They riot, they stage strikes in critical sectors demanding no cuts in salaries. Thy want to keep their benefits, pensions and what not. The point is, they never got the message. And the EU institutions, beyond the Papandreu government in Athens, are to blame for this disconnect and for failing to isolate the problem.

Confidence crisis spreading across Europe

But this is not even the half of it. EU policies failed to contain the damage beyond Greece. It is clear that Greek debt is held all over across Europe. Knowing this, investors, fearing an eventual Greek collapse, now are looking at German and French banks that hold a lot of Greek debt with increasing suspicion. And their doubts have just been confirmed by recent downgrades of major French banks by the rating agencies. And the downgraded banks have seen their stock sink, thus adding another layer of gloom.

Italy in the spotlight

As they are at it, investors begin to wonder how other highly indebted countries, such as Italy, will be able to meet their obligations. This new wave of skepticism regarding the quality of sovereign debt has already caused huge financial pain for Italy, Spain and even France. Investors are now afraid that all this debt may not be paid after all. So they demand higher interest rates to buy it. And this complicates debt financing for countries like Italy whose total debt now exceeds 120% of GDP.

If debt service becomes more and more expensive for the Berlusconi government in Rome, then the entire budget needs to be redone. And this turns an alreday precarious Italian debt management policy into a potential nightmare. Italy depended on low interest rates to keep financing its astronomic debt. If the cost of borrowing increases, then drastic spending cuts become the only alternative.

Banks holding government bonds are shunned

The trouble is that in weak economies drastic spending cuts have a recessionary impact. If you cut public spending to make debt service possible, you simply take some more oxygen out of the room, paradoxically making the debt problem even more severe. Meanwhile, the “Greek disease” has spread to other banks holding Italian debt. So, lack of confidence in sovereign debt issued by some EU countries is having a cascading effect. At some point, as financial institutions across Europe are all intertwined, there is a serious risk that nobody would trust anybody anymore, not knowing exactly who is healthy and who is affected by bad debt.

America should worry

But why should all this matter for America? Very simple. It does matter because the EU countries, in the aggregate, form the largest world economic block. If some European countries are in a serious crisis, while the damage cannot be credibly contained, we should expect a recession, or worse, in Europe. As Europe is a major trading partner for America, a collapse of economic activities and contraction of demand there would have very negative repercussions for US exporters already plagued by weak demand at home. If Europe contracts and stops buying, expect major US producers to cut production and, yes, employment here at home, making a tenous situation really bad.

Washington has no tools

Can America help in any of this? Not really. The problems are too big and the US has no tools left. Treasury Secretary Tim Geithner has said publicly that the Europeans should devise new policy mechanisms to harmonize fiscal policies and otherwise create ways to stop the impact of the Greek bleeding. But he also said that he is confident that the Europeans will do the right thing, as this is absolutely necessary. Geithner believes that the Europeans know exactly what needs to be done and now are just devising the appropriate political process to get it done.

Pray that the Europeans will do the right thing

Well, Geithner is correct. But he also really disingenuous in predicting that eventually the right thing will be done. This is just about the same as saying that both president Barack Obama and House Speaker Boehner know what needs to be done to fix US public spending and now are just figuring out how to get to a political agreement. Yes, the problem is finding a political formula. But, guess what, just as their ineffective Washington counterparts, the hapless Europeans are utterly incapable of agreeing on anything fast. And this is precisely the issue. Something needs to be done and it is not done.

No consensus, conflicting ideas

And so, German Chancellor Angela Merkel, French President Nicolas Sarkozy and all the others are circling around the problem with no new policy consensus in sight. In the meantime, in this policy vacuum, all sorts of conflicting ideas are floating. And this is damaging, as confusion reinforces the perception of disarray. Here are some samples:

Greece should stay within the Euro.

No Greece should get out.

There should be no Greek default.

No, we have to think of an “orderly restructuring” for Athens, (a polite way to say bankruptcy).

The Eurozone has too many undeserving members.

No, the Eurozone cannot be touched, as tinkering with it might cause the unraveling of the entire EU.

The European banks are in good shape, as they passed a “stress test” only a few months ago.

No, the “stress test” did not test much of anything, and thus it is inconsequential.

We trust the Italians to launch credible spending reforms that will stabilise their debt situation.

No, we do not trust them, as their government is led by Silvio Berlusconi, a perennially indicted Prime Minister surviving who knows how and happy to close each day while still in office. Besides, the Italian economy is not competitive and does not grow at all, not creating the surplus required to start paying back all that debt.

America bracing for the worst, with no protection

Given all the nasty stuff brewing in Europe, America should be prudent and prepare for the worst. The problem is, and Geithner knows it, that America is bracing for a possible hurricane with the protection of a few mended tents and not much else. The US shelters are under repair and we do not even have emergency rations, while the people in charge of operations are fighting one another.

US Business Does Not Invest – Tax Reform, Less Regulation, Entitlement Programs Overhaul Would Help – But Expect No Action: Obama and Republicans Will Not Compromise – New Direction Only After 2012 Vote

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By Paolo von Schirach

September 24, 2011

WASHINGTON– Healthy US companies, with positive balance sheets and lots of cash in hand do not invest. And why not? In Washington you get two kinds of pre-cooked replies, depending whom you are asking. Democrats would say that companies do not invest because there is not enough demand. In order to boost demand, America would need more public spending that would create more jobs and thus more people with more spending money. Previously unemployed workers would have disposable income with which they could buy things; this way stimulating demand for more goods and services. And increased demand would be the signal that companies need to jack up their own investments and hiring, thus mopping up more idle workers who will add to aggregate demand because they will have money to spend.

Republicans: lower taxes and deregulations will do it

The Republicans would say instead that companies do not invest because they have no confidence in the broader economic and policy fundamentals. They would argue that companies look around and see too many uncertainties. They do not know about their future tax burden. They have no idea as to how the new health care law will affect their costs. They are not sure as to how the regulatory burden, in particular environmental regulations, will increase their cost of doing business. Finally, they are intimidated by out of control federal spending, year after year. They believe that large deficits with no end in sight most likely will mean higher taxes down the line. And corporations are afraid that they will be called upon to foot the bill. So, the Republican recipe for new investments and consequently more employment is federal spending cuts, lower taxes and deregulation.

No compromise

There does not seem to be much room for reconciling these set views. And this causes policy impasse in Washington. The Obama administration would like to have more stimulus, (infrastructure projects, hiring more teachers), paid for through higher taxes for the wealthy. The Republicans say no to higher taxes, while they lampoon any stimulus as more of the same stupid ideas on how to throw money away. For its part, the Obama administration would never agree on spending cuts without tax increases for the better off.

With these entrenched positions, expect zero action between now and the November 2012 elections. In an ever more polarised climate, compromise would be interpreted by the rank and file on both sides as a political surrender. The belief shared by both sides is that there is more to be gained by keeping an intransigent, “pure” position.

In the meantime, with no light on what the future policy environment is going to look like, expect no new investments. Who knows really what the magic formula for business optimism should be; but this mess can hardly inspire confidence.

Huge debt load carried by the average American dampens consumption

Of course the Washington impasse is not the only issue affecting the business climate. Quite clearly, we cannot ignore that the 2008 financial crisis left millions of potential consumers not only worse off but also carrying a huge debt load. So, there is the double whammy of having lost the home or most of the home value due to market collapse (and previous equity extraction) and new debt incurred just to get by.

Even for a country that historically has had a fairly low savings rate, this high personal debt situation is highly unusual. And, as US GDP is 3/4 driven by consumer spending, when consumers cannot spend anymore because they are trying to get out of debt, there is not much that can be done to make them go to the mall. They simply do not have the cash.

This debt repayment process will take a while. Hard to say how long. Quite clearly, if the overall picture gets a little better, if people get higher salaries, then they can get back on their feet a bit faster. But if there is further decline, then expect a slower healing process.

So, corporations know that the customer is just not there. And this is hardly an inducement to invest. Simply stated: the market vanished.

Broad based tax reform, lighter regulation, spending reform would help

That said, the creation of a clearer, more business friendly environment should help. If corporate America could see tax simplification enacted, including permanent tax credit for R&D expenditures, in the context of a broad tax reform, (as opposed to short term tax fixes), more rational regulation and, say, a good long term energy policy that would give a sense of where to place strategic long term energy related investments, this would be extremely good.

And it would also help if Washington would agree on a long term, credible public spending reform plan that overtime would sensibly reduce spending and thus the national debt. This reform would have to include entitlement overhaul so that we can redesign the welfare state in a manner that will make it viable and fiscally sustainable.

A more business friendly environment may not be all, but it would help

Now, I am not sure that these structural reforms and significant changes would all of sudden re-energize business confidence. But I am sure that the creation of a policy and fiscal environment that tells business that America is business friendly and that the waters are calm would have a profoundly positive effect, not just on business, mind you, but on the entire nation. Right now Americans fear decline, while they see Washington entangled in fierce partisan fights. In other words, business is bad and no one is minding the store. New, sensible policies would change the national mood.

No chance of any action before the 2012 elections

The problem is that you can expect that none of this will be done between now and the November 2012 elections. America’s political leadership is hopelessly fractured and divided. President Obama has given up on governing and is now putting forward plans that have no chance of being passed by the Republican controlled House but that will make –he hopes– a good re-election platform. The Republicans have no interest in meeting this president half way, as they believe that their intransigence will pay off next year.

Let’s hope that nothing really bad happens between now and the elections. I doubt that this divided political leadership with no money, zero spare capacity and lots of debt would be able to do much of anything, should a real crisis come about. And it may come about, if not originated from within, probably coming from an equally challenged Europe that has even fewer chances of getting its act together on Greece, large debts and the inability to harmonize fiscal policies.

The Greek Debt Problem Will Not Go Away – Europe Is In A Dilemma, As The Bail Out Cost Is Causing Political Resentment – But No Way To Let Greece Drown

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By Paolo von Schirach

September 8, 2011

WASHINGTON – Greece for Europe is the mid sized problem that will not go away. But this is more than just an annoyingly chronic tooth ache. Greece is now an essentially incurable bleeding ulcer, requiring constant care and at the same time exposing deeps fissures within a European Union and a Eurozone not designed to endure deep, sustained stress. Simply put, both the EU and the Eurozone are predicated on the benign assumption that all members are capable and always willing to meet certain minimum performance standards.

Standards not met

But when they do not –and Greece is the glaring example– there was and still is no proven and legitimate mechanism to force compliance. And it is obvious that compliance is a lot easier when the standards are established among partners who have more or less have similar strengths. The systemic problem plaguing the EU and the Eurozone, as a subgroup of EU members that adopted a common currency, is discrepancies among them that are just too wide.

Greece cannot be fixed

Case in point, fixing troubled Greece in 2010 seemed painful but doable. After all, Greece is a relatively small country with less than 11 million people, home of a middling economy that ranks 39th place in the world, (when GDP is adjusted for purchasing power parity). It was assumed that a few cash transfusions coupled with some reforms and spending cuts would do the job, allowing Greece to catch its breath and get back in the race. But no, this medicine did not work, for Greece was not just in trouble: it was totally broke, corrupt and non competitive an any scale. So the Europeans (with the IMF) went back at it this year, with a bigger plan. And even this one may not work, for Greece is still broke –and now also comatose.

Political fissures

And so now you start seeing the political fissures. On the one hand, many Greeks essentially have not embraced the medicine. They protest and they riot against austerity measures, while they foolishly blame the EU partners for imposing them. Not a good start, and not the best way to show gratitude. On the other hand, some political forces within EU countries are protesting against an open ended bail out not matched by sufficient reassurances on the part of the beneficiaries –the Greeks– that they really intend to use this money as an opportunity to re-do their economy and start over on fresh basis.

The bail out political cost

And so, some Dutch, German and Finn politicians are increasingly vocal against the idea of doling out more money. The German Finance Minister, Wolfgang Schauble, warned the Greeks that they better behave if they want to see the rest of the aid come to them. So a financial rescue deal has morphed into a political problem. Greece is a bankrupt country that essentially lost its sovereignty. But there is no recognized mechanism to deal with this loss of sovereignty. So, the Greek feel outraged, while the Europeans watch with increasing anger.

No way out

Is there a way out of this? Apparently not. Many experts warn that throwing Greece over board is not possible. The economic and financial dynamics within the Eurozone are such that everything is tied to everything else. According to them, you simply cannot evict Greece without causing a financial earthquake whose effects would be felt throughout Europe, possibly bringing down many commercial banks in France, Germany and elsewhere now exposed to Greek debt.

So, here you have a bad dilemma that is becoming political poison. If you keep bailing out a country that is both very weak and recalcitrant, this may go on forever. If you do not, Greece’s downfall is likely to bring down half of Europe.

Of course, all this would go away if the Greeks could see the light and really start working to rebuild their country. But, given their psychological and cultural make up, this may not be possible, at least not within an acceptable time frame.

The rest of Europe does not shine

And so expect Greece to continue being a chronic illness affecting Europe. In the meantime, other pieces of Europe, (Italy, Spain), while not in free fall, are under severe stress because of weak growth, high cost of entitlement programs and unfavorable demographics indicating increased cost to pay for retirement and medical programs in the years ahead. Which is to say that, unless something major will change, a Greece-like future looks the likely end game for many countries that at the moment, while struggling, are still afloat.

As I said, Europe was supposed to be the home of relatively rich countries with relatively solid economies and public finances. Now it is a mixed bag. Germany, the Netherlands, Finland and Austria are doing fine; but they are many measures ahead of Portugal, Italy or Spain. Not to mention Romania or Bulgaria.

Deeper union is not possible

And for those who suggest a cure centered on deeper union among the members, including co-ordinated fiscal policies and the issuing of Eurobonds available to all but essentially guaranteed by the strongest members (read Germany) , I suggest they stop dreaming. A deeper European Union would be predicated by a shared sense of European identity. On a good day the Europeans are willing to share the advantages of borderless commerce and finance. But that is about as far as their sense of belonging goes.

At the moment, there is not even one single major national political leader within any EU member state strongly embracing a a political unification project. If anything, fringe and not so fringe political forces are protesting against the costs of the association as it currently is.

Europe will move on slowly and with increasing difficulty

Europe will continue to be mostly “a super charged chamber of commerce” without a political soul. And the EU is likely to become progressively weaker in the years ahead. Current trends indicate more fiscal pressure on already strapped governments to pay for welfare programs likely to become more and more expensive, (too many old people, not enough young workers to support them). And Europe, with exceptions, is not a hub of innovation and growth of dynamic new sectors. Even if at some point the Greek crisis disappears, increased entitlement costs, a shrinking revenue base and mediocre growth sadly indicate decline.

Policy Changes That Would Spur Small Business Creation

WASHINGTON – Not every economic policy change has got to cost money. Entrepreneur Henry Nothhaft in an op-ed piece in The Wall Street Journal, (A Labor Day Message for President Obama, September 3-4, 20110), provided a short but compelling agenda that President Obama could focus on. Acting upon it would have beneficial impact on start-ups, and business in general.

No money 

And this would cost any money. Nothhaft premise is that the real lever to get growth and employment creation moving again in America is to favor start-ups. This is where the real action is, in the US as in most of the world. Dynamic entrepreneurs and risk takers are also job creators. They give life to new businesses that require people in order to grow.

Reduce Sarbanes-Oxley burdens for small business

Well, for starters Sarbanes-Oxley legislation makes it far too onerous and expensive for small businesses to comply with all that is needed in order to keep their books in accordance to the law and particularly expensive to go public. And yet it is proven that start-ups get going and become truly profitable only after a successful IPO. It would be enough –Nothhaft suggests– to exempt firms that have less than $ 500 million in revenue from Sarbanes-Oxley mandates. This would allow many more small firms to go public, thus creating the preconditions for more rapid growth that would bring along more jobs.

Eliminate US patent office backlog

Furthermore, the US needs to overhaul its patent system. Right now America, supposedly the land of that encourages innovators more than any other, has an under resourced US patent office. Amazingly, currently there is a backlog of 1.2 million patent applications. It is obvious that patent protection in many instances is a critical precondition for launching a business based on one or more patents.

Allowing speedy processing and granting of patents would expedite the launching of hundreds, possibly thousands new businesses capable of creating, according to patent office estimates, ”millions of jobs”. Well, may be this an inflated estimate. But it looks intuitive that patent protection may be absolutely crucial to start a variety of new companies. Giving more resources to the US patent office cannot be that complicated. So, why not do it now?

Tax incentives for foreign manufacturers

The final recommendation is about offering tax and other incentives to manufactures willing to establish themselves in the USA. All countries offer incentives to lure new industries. And manufacturing is a force multiplier. For every new job in industry about 15 additional jobs are created up and down the supply chain and with other businesses that benefit from the creation of industrial activities.

Not a Grand Plan, just sound policy

This does not sound like a “Grand Plan”, a silver bullet for Obama bound to create millions of jobs between now and November 2012. So, politically these ideas may not be that hot. But these are sensible policy changes that would simplify and expedite the trajectory to success for enterprises, while encouraging many more would be entrepreneurs to start a new business.

Just think of it: Fast patent processing, diminished administrative burdens for small companies, easier transition to public company at a lower cost, incentives if you come from abroad. All this makes good sense. It would not cost anything and it would improve an investment climate no longer perceived by investors as truly favorable to business.