12 Eurozone Downgrade Shock Waves Could Slam Into US Economy
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.
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).
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:
- Spend federal money like there is no tomorrow in an attempt to boost employment levels;
- Run federal deficit spending up to all new levels as the money is spent but taxes aren't increased;
- Massively bailout the US financial industry;
- Bailout other US major corporations as needed; and
- 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.
The second half of this article contains Shock Waves 8-12. Topics include: Federal Reserve bailouts, long term US dollar effects; state and local government insolvencies; the potential criminal prosecution of Standard & Poor's; and implications for long-term investors. There is a linked resource exploring the redistribution of wealth within Europe itself.
About Daniel Amerman CFA
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