12 Eurozone Downgrade Shock Waves Could Slam Into US Economy
By Daniel R. Amerman, CFA
Standard & Poor's missed the point when they "only" put 15 Eurozone nations on credit watch for possible near term downgrades. In this highly interconnected world - most of Europe can't be put on credit watch without putting much of the world on credit watch, with the United States being particularly vulnerable to global "contagion" risks.
Twelve possible implications for the United States are concisely explored herein. These "shock waves" include everything from the value of the dollar, to unemployment, gas prices, stock prices, derivatives, US bank stability, inflation, retirement investing, Federal Reserve reactions, the US deficit and credit rating, the potential criminal prosecution of S&P, and more.
Each potential "shock wave" assumes: a) that Eurozone leaders fail to credibly reach consensus; b) that this political breakdown does lead to an actual credit downgrade; c) that several European nations default on their debts; d) that there is least a partial collapse in the value of the euro; and e) that this all leads to a major downturn which materially reduces the size of the European economy. Those assumed events will not necessarily happen - much is still in play - but if even a partial Eurozone collapse does occur, then the resulting "shock waves" could rapidly change lives, standards of living, and investment values in the US and around the world.
1. US Dollar, Short Term
The US dollar's value as the world's reserve currency is likely to be substantially strengthened in the short term, as a panic-stricken globe seeks refuge from the euro collapse. The buying power of the US dollar may surge in this global rush for safety.
2. Consumer Prices
The rapidly rising value of the US dollar would have the immediate effect of making almost all imports cheaper to buy, and so a trip down the aisles of Wal-mart may for a brief period become less expensive for the American consumer. The price decreases could be exacerbated by exporters from around the world engaging in vicious price competition within the US market, trying to keep their factories going and to offset the loss in consumption in Europe.
Expanded Analysis Of Shock Waves 1-4
3. Unemployment
Because of the combination of the surge in the value of the US dollar and the reduction in the size of the European economy, US workers may face devastating job losses in two major categories: exports to other nations, and goods consumed in America.
American workers in export-driven industries will lose jobs because dollar-priced US goods will be more expensive for the rest of the world to buy. This decreasing competitiveness will be compounded by a drop in consumption in the huge European markets, resulting in less US exports. There is also the third danger of a drop in overall global consumption, as the result of exporting nations losing employment on a global basis.
In a global scramble to maintain employment even as consumption falls, the last thing workers want is to be handcuffed by having their products priced in the world's "reserve currency" - and that is the exact situation that American workers will be in.
The second major category of job losses will be found among the producers of goods consumed in the US. Because the dollar is more expensive, American workers will be undercut by other workers around the world, as imports grow cheaper and more difficult to compete with. These lower-cost goods mean that there may be a brief "Indian Summer" of lower prices for American consumers.
However, this will sadly likely be accompanied by a fundamental weakening of the US economy as unemployment surges, and fewer people can afford to make the purchases at all. Which then further reduces overall global consumption, intensifying the competition among exporters.
There may also then be increased "outsourcing" as American corporations seek to lower production costs by moving employment out of the US.
4. Gasoline & Energy
As a result of a likely depressed global economy leading to reduced energy usage, most nations are likely to see a declining cost of energy imports (with the exception of Europe, depending on how devastating the currency damage turns out to be). Because the US will benefit in this regard from the 1-2 combination of a higher valued currency and decreased global demand, the decline in the cost of energy may be particularly sharp in the United States, and could even briefly bring the cost of gasoline back down to under $2 a gallon. This cheaper energy will be an offsetting factor when it comes to global competitiveness for US firms, but likely not nearly enough to overcome the dollar's strength.
5. US Financial Institutions
Up to this point, the markets have been focusing on the US financial institutions which have the greatest direct exposure to Europe and European banks. However, in the months following a potential Eurozone collapse, the secondary or ripple effects are likely to dwarf the first round of primary effects – and few major banks will be positioned to withstand it. After all, the US economy is still reeling from the last financial crisis, and there has been no real recovery to date.
A new second round of depression slamming into the global and US markets means a potentially massive increase in unemployment, with delinquencies soaring in all categories of consumer credit along with bankruptcies. There will also be dire financial implications for firms relying on exports or US consumer sales - and those two categories cover most of the private economy. This could all lead to a rapid increase in corporate loan losses. Most important of all could be the extraordinary effects upon the derivatives markets (see "Derivatives" below).
Over time, and as the interrelated negative effects compound upon each other, the direct and indirect effects of a Eurozone collapse are likely to be a "doomsday" event for the major US banks, absent another likely round of massive government interventions (see "US Deficit & Credit Rating" below).
6. Derivatives
A potential euro collapse threatens the possible near term annihilation of the financial system through both credit derivatives and interest rate derivatives losses. The near criminal insanity of investment bankers writing themselves massive bonus checks for effectively standing in a circle and making promises to each other that none of them have ever had the capital to back up (in the event of genuine systemic crisis), will be brought to the fore.
Absent massive government interventions, we may have a bankrupt financial system where none of the highly leveraged big players have any real capital remaining because their loan and investment portfolios went bad, but they still owe massive amounts of money to each other as counterparties on the hundreds of trillions of dollars in derivatives contracts.
The nominal sum of derivatives contracts outstanding is about $700 trillion, while the global GDP is estimated to be about $63 trillion. If the governments assume and honor the derivatives contracts, then they could be on the line for a cumulative bailout that exceeds the size of the global economy (though this would be reduced by the netting out of offsetting contracts). As a more likely alternative, there would be attempts at a legal "fix" of some sort, where governments use their lawmaking, regulatory and monetization powers to maintain a functional banking system, but would effectively set aside the rule of law (in one way or another) when it comes to derivatives contracts.
7. US Deficit & Credit Rating
If the Eurozone economy collapses, then coming into a presidential election year, the US government is likely to face a situation of soaring unemployment, a failing economy, and a bankrupt financial system. Given the political realities and the track record, the reaction of the US government is all too predictable:
1) Spend federal money like there is no tomorrow in an attempt to boost employment levels;
2) Run federal deficit spending up to all new levels as the money is spent but taxes aren't increased;
3) Massively bailout the US financial industry;
4) Bailout other US major corporations as needed; and
5) Create trillions more dollars out of thin air to finance the above (see "Federal Reserve & Monetization" implications below).
This radical increase in the federal deficit accompanied by "printing" ever more money should "downgrade" both the US dollar and the entire US financial system as well as the US government. Whether or not subsequent rating downgrades occur is ultimately a political decision, and may have more to do with the outcome of the US Justice Department's (effectively) punitive investigation of Standard & Poor's that began shortly after S&P's previous US downgrade, rather than the actual facts of the situation.
8. Federal Reserve & Monetization
Federal Reserve responses to the events of late 2008 and beyond may serve as a guide to some of the strategies that could be deployed in a new crisis. There are likely to be multiple key stages in a developing crisis, where the Federal Reserve will use its unique powers to create and give out trillions of dollars - with little public attention - either in asset purchases (at non-market prices), or in actual and contingent lines of credit, or in dollar swaps, or in hidden bailouts that are only limited by the imagination of the Federal Reserve.
The Fed will again want to move quickly and without Congressional approval, and will particularly seek to avoid openly including the bailouts in the federal budget. Beneficiaries are likely to include US banks, foreign banks, and major US and foreign corporations.
There may also be massive monetary-creation events for the dual purposes of funding radically increased US deficit borrowing, while still keeping borrowing rates below the rate of inflation.
Rather than another TARP-type program for troubled assets that have not actually defaulted, look for the Federal Reserve to take to all new levels its program of directly creating money and using that to purchase investments from banks at non-market prices. This is likely to contribute to the "hollowing out" of financial institutions on a global basis, as performing economic assets are increasingly replaced by central bank reserve balances which have no inherent economic value.
Primer On Monetary Creation & Hollowing Out Banks
9. US Dollar, Long Term
After the immediate crisis and panic-induced global dash for safety is over, then the United States will be in a highly unstable and precarious position, with an effectively artificial economy that is not putting out the goods needed to pay for what it consumes. There will be massive paper money creation as the US engages in currency warfare to bring down the value of the dollar, even as artificially-funded jobs are created all across the country. Something will have to give - as historically, it always eventually does.
From one source or another there will be a push. That push could have a domestic origin, or more likely an international origin. Either way, because the underlying fundamentals will have already collapsed, and all that will be holding up the value of the dollar is a collective belief system, then once the fall of the US dollar gets going and the rest of the globe heads for the exits, it could be very rapid and near impossible to stop.
We could see a whipsaw in import costs if this scenario occurs. There will be a soaring cost of energy and gasoline as the dollar implodes and oil-exporting countries no longer want US dollars that are plunging in value. We could see a sudden spike in the cost of virtually all the imports that are consumed by the US, with that external supply shock inflation rapidly becoming internalized, and domestically produced goods and services soaring in price as well.
This very high rate of inflation would be economically devastating, and ultimately the only way to stop the damage will be to stop the monetary creation and stop the stimulus spending. Which means that more millions of people would become unemployed as the economic damage that was done to the corporations, banks, and state and local governments must finally be recognized.
10. State & Local Governments
State and local governments are likely to face a deadly combination of soaring unemployment which increases expenditures, even while income and sales tax revenues are falling with employment and consumption. This may be compounded by highly adverse results in pension investment portfolios, thereby pushing highly stressed states and cities into insolvency across the nation. What is more likely than this scenario of nationwide state and local government bankruptcies, however, is a massive Federal government bailout, that would likely be financed through the Federal Reserve creating still more money out of thin air.
11. Standard & Poor's Business Model
In the process of hastening along a potential "extinction event" for the euro, Standard & Poor's Corporation may also be creating an "extinction event" for its own business model. The US federal government's response to S&P's August downgrade came in the form of a Justice Department investigation of S&P. This message is far from subtle, when it comes to the consequences of angering those in power.
The European governments were already quite unhappy about having only US-based rating agencies. They were displeased about the influence of these foreign corporations upon the European financial system, and there has already been discussion of a European credit rating agency.
The fact that New York-based Standard & Poor's used its power in the midst of crisis to increase the problems faced by Eurozone governments is likely to be viewed as unforgivable, and an acceleration of the process of creating a more compliant European credit rating agency should be anticipated, regardless of whether there is a near-term S&P credit downgrade or not.
If the European governments view Standard & Poor's Corporation as having helped to create a catastrophic financial crisis, then in the search for scapegoats, do not be surprised if there are not only civil but potentially criminal implications at some point for Standard & Poor's and its employees.
Ultimately, European law is what European governments say it is, they are likely to be mighty angry, and the payments received by rating agencies for their role in the sale of defaulted subprime mortgage-backed securities within Europe may yet constitute a rich hunting ground for highly motivated European prosecutors.
12. Long-Term Investment
Even a partial euro zone currency and economic collapse would have serious negative implications in multiple categories for US investments. Corporate earnings growth rates could turn negative on a global basis as a result of the new global depression, thereby slashing stock market values.
As discussed previously, the likely US response of trying to cover over negative short-term economic developments by simply creating more money, has highly negative implications for the long-term value of the US dollar. Quite simply, the more money that is created in the attempt to prop up an artificial economy, the greater the long-term damage to the US dollar, and the higher the likely future rate of inflation.
This would mean that both bonds and stocks - the two cornerstones of conventional long-term investment strategies - could face devastating and sustained losses, which might never be recovered.
As discussed in the article linked below, the eventual US response to a new unemployment crisis is likely to effectively be currency warfare, which may have particularly unfortunate consequences for retirees and retirement investors.
While these twelve "shock wave" explorations are "US-centric", the article link below explores the rapid redistribution of wealth that may occur within Europe itself.
European Redistribution Of Wealth
